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Fifteen years after embarking on its largely ineffective quantitative easing program, Japan appears poised to try the form recommended by Ben Bernanke in his notorious "helicopter money" speech in 2002. The Japanese test case could finally resolve a longstanding dispute between monetarists and money reformers over the economic effects of government-issued money.

When then-Fed Governor Ben Bernanke gave his famous helicopter money speech to the Japanese in 2002, he was talking about something quite different from the quantitative easing they actually got and other central banks later mimicked. Quoting Milton Friedman, he said the government could reverse a deflation simply by printing money and dropping it from helicopters. A gift of free money with no strings attached, it would find its way into the real economy and trigger the demand needed to power productivity and employment.

What the world got instead was a form of QE in which new money is swapped for assets in the reserve accounts of banks, leaving liquidity trapped on bank balance sheets. Whether manipulating bank reserves can affect the circulating money supply at all is controversial. But if it can, it is only by triggering new borrowing. And today, according to Richard Koo, chief economist at the Nomura Research Institute, individuals and businesses are paying down debt rather than taking out new loans. They are doing this although credit is very "accommodative" (cheap), because they need to rectify their debt-ridden balance sheets in order to stay afloat. Koo calls it a "balance sheet recession."

As the Bank of England recently acknowledged, the vast majority of the money supply is now created by banks when they make loans. Money is created when loans are made, and it is extinguished when they are paid off. When loan repayment exceeds borrowing, the money supply "deflates" or shrinks. New money then needs to be injected to fill the breach. Currently, the only way to get new money into the economy is for someone to borrow it into existence; and since the private sector is not borrowing, the public sector must, just to replace what has been lost in debt repayment. But government borrowing from the private sector means running up interest charges and hitting deficit limits.

The alternative is to do what governments arguably should have been doing all along: issue the money directly to fund their budgets. Having exhausted other options, some central bankers are now calling for this form of "helicopter money," which may finally be raining on Japan if not the US.

The Japanese Trial Balloon

Following a sweeping election win announced on July 10th, Prime Minister Shinzo Abe said he may proceed with a JPY10 trillion ($100 billion) stimulus funded by Japan's first new major debt issuance in four years. The stimulus would include establishing 21st century infrastructure, faster construction of high-speed rail lines, and measures to support domestic demand.

According to Gavyn Davies in the July 17th Financial Times:

Whether or not they choose to admit it -- which they will probably resist very hard -- the Abe government is on the verge of becoming the first government of a major developed economy to monetise its government debt on a permanent basis since 1945. . . . The direct financing of a government deficit by the Bank of Japan is illegal, under Article 5 of the Public Finance Act. But it seems that the government may be considering manoeuvres to get round these roadblocks. Recently, the markets have become excited about the possible issuance of zero coupon perpetual bonds that would be directly purchased by the BoJ, a charade which basically involves the central bank printing money and giving it to the government to spend as it chooses. There would be no buyers of this debt in the open market, but it could presumably sit on the BoJ balance sheet forever at face value.

Bernanke's role in this maneuver was suggested in a July 14th Bloomberg article, which said:

Ben S. Bernanke, who met Japanese leaders in Tokyo this week, had floated the idea of perpetual bonds during earlier discussions in Washington with one of Prime Minister Shinzo Abe's key advisers. . . . He noted that helicopter money -- in which the government issues non-marketable perpetual bonds with no maturity date and the Bank of Japan directly buys them -- could work as the strongest tool to overcome deflation . . . .

Key is that the bonds can't be sold and never come due. In QE as done today, the central bank reserves the right to sell the bonds it purchases back into the market, in order to shrink the money supply in the event of a future runaway inflation. But that is not the only way to shrink the money supply. The government can just raise taxes and void out the additional money it collects. And neither tool should be necessary if inflation rates are properly monitored.

The Japanese stock market shot up in anticipation of new monetary stimulus, but it dropped again after the BBC aired an interview with Bank of Japan Governor Haruhiko Kuroda recorded in June. He ruled out the possibility of "helicopter money" -- defined on CNBC.com as "essentially printing money and distributing payouts" -- since it violated Japanese law. As the Wall Street Journal observed, however, Bernanke's non-marketable perpetual bonds could still be on the table, as a way to "tiptoe toward helicopter money, while creating a fig leaf of cover to say it isn't direct monetization."

Who Should Create the Money Supply, Banks or Governments?

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