Heike Hoffman is a fruit seller in Germany. She is 54 years old.
Two years ago, the European Central Bank cut interest rates to below zero. It was intended to encourage businesspeople, like Heike, to spend and boost economic growth.
But when Heike heard that the ECB was cutting the interest rates to below zero she thought it was ‘madness’. She immediately cut her spending and bought gold.
‘I now need to save more than before to have enough to retire,’ she said
And she is not alone. It seems that this move by the ECB is having the opposite effect. Businesses are deciding to save more money instead of spending it.
Heike’s story, featured in the Wall Street Journal, is a clear example of how keeping interest rates low for a long time or bringing them into the negative to increase spending may actually backfire.
Low interest rates are becoming an endemic problem in our world. The Euro, the US, Japan and Australia keep on lowering interest rates to increase inflation. But inflation persists well under their desired 2–3%.
Yet central banks have a tool in their arsenal that can create inflation: they have helicopter money.
Imagine a helicopter flies over a community and drops a load of money. People scramble around to pick up as much of it as they can. They don’t know if this is a one off event, or if the helicopter will fly by again.
So what do they do with all that extra money? They spend it, boosting the economy. And increasing inflation in the process.
Now, many economists are defending the use of helicopter money — or government’s printing money — to artificially create inflation. They argue that lowering the interest rates is not doing enough. And are actually egging on central banks to directly hand money to consumers.
Yellen has already admitted that she wouldn’t rule it out as an option in an extreme circumstance.
So why aren’t the RBA, the Fed, the BCE and the Bank of Japan printing money to activate the economy?
Because it has been used before in places like Argentina, Zimbabwe, and in 1920s Germany. Each time with disastrous effects.
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Argentina’s Helicopter Money Problem
Take the case of Argentina. Argentina printed money for years.
In 2001, Argentina’s debt to GDP ratio had increased dramatically. You see, they had been trying to keep the value of the Argentinean peso in parity with the US dollar.
But in 2002, they admitted defeat and left the peso to fluctuate. They also announced a default on their debt and offered to restructure the payments.
Many bond holders rejected their proposal, and blocked Argentina out of the international capital markets. The Treasury had difficulties in the following years issuing new debt to finance the large public deficit.
Argentina should have reduced spending and increased taxes to decrease the deficit. After all, that is what you should do when you have spent beyond your means.
But they decided to do something else instead. They knocked on the Central Bank’s door and asked them to print some money.
And then went on a spending spree, to spur growth.
Financing their deficit by printing money increased inflation. And has kept it high for years.
Source: The World Bank
Inflation ate away Argentineans’ purchasing power. And even though spending grew, it was only because it was a better alternative than saving.
Helicopter money can spur economies and create inflation. But there is no control on how much inflation it creates.
And once this tool is used, who will stop central banks from continuously using it?
Lowering interest rates to generate inflation is becoming ineffective. The rates have been low for too long now. Countries have no growth. In fact, they are flirting with deflation.
So how long will it be until Central Banks are desperate enough to start betting on this risky tool?
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PS: Selva recently joined the Port Phillip Publishing team as our macroeconomic analyst. She works closely with The Daily Reckoning editor Vern Gowdie on his advisory service,The Gowdie Letter.