What to fear

The Federal Reserve was founded in 1913 in response to perennial liquidity crises — financial emergencies that caused cash to be suddenly unavailable. In addition to being the lender of last resort, its role evolved into managing inflation, and over the last 10 years the focus has been on staving off deflation.

Deflation is a situation whereby prices fall. It sounds like a shoppers dream, but remember that prices are only falling if demand is down, and demand usually falls in response to job losses or wage cuts. Deflation is caused by a shock to the economy such as a large percentage of homeowners defaulting on their mortgages.

Today, the Fed’s deflation toolbox has only one widget: Quantitative Easing (QE). QE is when the Fed prints money to buy treasury’s or other bonds. This floods our economy with cash and prevents systemic collapse. QE is alive in our banking system and has worked well — our economy has continued to grow. But at the same time, it has also exacerbated income inequality.

Contrary to initial worries that QE would cause hyperinflation, it led to only asset price inflation. Stocks and bond prices rose in a fashion not commensurate with economic growth. Over the last 10 years, the S&P 500 almost tripled and home prices almost doubled. Yet our economy slowed to 1 .7 percent growth per year, from 3 percent prior to QE.

Meanwhile, wages have increased by a quarter. Taking into account the fact prices are up 20 percent over this same period, wage earners are only 5 percent better off while the rich more than doubled their wealth.

Tomorrow’s Fed toolkit needs not only QE, but also “helicopter money.” Helicopter money is a term first coined by Milton Friedman and alludes to a scenario where the Fed would make payments directly to households during a deflationary emergency. It is a mechanism that has been supported by Ben Bernanke, former chairman of the Federal Reserve, as well as other academics. Providing liquidity directly to households is important because, while in theory, the liquidity injection from the Fed to the banks should get passed on to households who need it.

Some will argue that helicopter money would be highly inflationary and therefore something to be avoided. It is true that we could get some inflation, but would that be so terrible in a crisis that threatens to push the economy into deflation? Inflation (excluding food and energy) has been perpetually below the Fed’s mean target of 2 percent for at least the last 20 years here in the U.S. The same is true for Europe, and Japan has not had the luxury of inflation worries for at least three decades. If there is anything to fear, it is deflation.