It’s just another type of debt.
Following Thomas Sargent’s recent Nobel Prize, I came across this excellent excerpt from a 1989 interview:
The essential job of the Fed from a macroeconomic point of view is to manage the government’s portfolio of debts. That’s all it does. It doesn’t have the power to tax. The Fed is like a portfolio manager who manages a portfolio made up wholly of debts—it determines how much of its portfolio is in the form of money, which doesn’t cost the government any interest, how much is in the form of T-bills and how much is in 30-year bonds. The Fed continually manages this portfolio. But it doesn’t determine the size.
Exactly. The Fed can trade money for bonds, but this doesn’t change the overall level of government debt—just its composition.
This is important to understand the fallacy in common arguments for “helicopter drops”. You often hear people saying roughly the following:
The Fed has the power to create money and hand it to consumers, stimulating the economy. Normally, the problem with this policy would be inflation, but clearly the dominant risk today is deflation, not inflation—so what’s the downside?
I agree that inflation is low on the list of important risks, but this is nevertheless a deeply flawed argument. Holding more debt in the form of money now is not an inflation risk, but the money doesn’t magically disappear after a few years. It’s still out there, and it’s still on the Fed’s balance sheet. It’s still debt.
Suppose that the Fed creates $1 trillion out of thin air and sends every American an equal share. For a while, this will be fine. Assuming that the intervention doesn’t drastically change the demand for currency, the new money will be held mainly in the form of reserves. The Fed will pay 0.25% on these reserves—not a big deal. So what’s the problem?
Again, the money doesn’t go away—the Fed still has an enormous liability on its books. With so much money in circulation, the marginal investor won’t be willing to pay a premium to hold money. The federal funds rate will therefore be roughly the same as the interest rate paid on reserves, which will also be roughly equal to the rate the Treasury pays on T-bills. In other words, holding debt as money won’t be any cheaper than simply holding it in the form of short-term bonds. The government can’t escape the cost of financing its liabilities. Giving money to households via a helicopter drop is fundamentally the same as giving them money via an act of Congress, with all the usual benefits (improved aggregate demand in the short term) and costs (burdensome future taxation to pay back the debt).
Admittedly, it’s possible that the increase in debt load will cajole the Fed into pursuing easier monetary policy in the future. The more nominal debt you’re trying to finance, the more tempting it is to push down interest rates and spur inflation. (In fact, Sargent and Wallace’s famous paper deals with an extreme case of this phenomenon, where the central bank is forced to make up for the fiscal authority’s inadequacies.) If you’re trying to create expectations of future inflation, this is arguably a good thing.
But it’s not clear why a helicopter drop should provoke such a change in incentives, unless it’s of truly overwhelming magnitude. Excluding intragovernmental holdings, the public debt is currently over $10 trillion. Even a $1 trillion helicopter drop would only add 10%. Is a 10% increase in debt enough to dramatically change the Fed’s incentives in the future? It’s possible, but I’m skeptical. Historically, we’ve seen much larger swings in the government’s balance sheet, and the Fed’s response has been minimal at best.
Bottom line? Money is a form of debt. Whether an operation’s short-term financing comes from “bonds” or “money” makes no difference; the cost is the same, and the usual tradeoffs of fiscal policy remain.