Tag Archives: helicopter drop

The uselessness of helicopter drops

I’ve received some skeptical feedback on my last post about how money is just another form of debt, particularly its implications for the effectiveness of a “helicopter drop”. This topic deserves more attention: for reasons I don’t understand, some very smart observers regard the helicopter drop as one of monetary policy’s most potent tools.

What’s wrong with these claims? First, let’s be precise: there are two ways to do a helicopter drop.

Option one: the Treasury and Fed coordinate. The Treasury uses bonds to raise money for a tax rebate, while the Fed immediately buys those bonds. This is just a fiscal transfer plus an open-market operation. Is either component particularly effective? Certainly the open-market operation doesn’t do much: in the current environment, exchanging reserves for short-maturity T-bills is meaningless. Trading reserves for longer-maturity Treasury securities, as in QE2, probably has a minor effect, but the Treasury could achieve the same effect by issuing short-maturity debt itself. Adding the Fed to the picture accomplishes nothing.

The case for this type of helicopter drop, then, is really no different from the case for traditional fiscal transfers during a recession—the Fed’s participation is irrelevant and unnecessary.

To be fair, depending on the Fed’s long-term objectives, there may be a monetary side to the policy. As Gauti Eggertsson once argued, a large debt load can serve as a useful commitment device to generate expectations of future inflation. If the Fed cares about the government’s overall budget, it may be tempted to tolerate inflation to eat away at the real value of the debt—and if everyone expects more inflation, the liquidity trap becomes less severe.

But there are also plenty of caveats. First, since you need a fiscal transfer large enough to materially affect the government’s long-term budget, the scope of the transfer must be enormous. When the long-term budget picture is already so questionable, it’s far from clear that this is a wise choice. Second, there’s little evidence that the Fed sets policy with the Treasury’s debt problems in mind. In practice, the Fed seems dedicated to pursuing its interpretation of the statutory mandate for price stability and full employment. No one at an FOMC meeting has ever suggested inflating away the debt, or even anything close.

And regardless, the Fed’s direct participation still doesn’t matter: trading T-bills for reserves when the policy is enacted has nothing to do with the longer-term decision to tolerate a higher level of inflation.

In the alternative kind of helicopter drop, the Treasury doesn’t issue any new debt: instead, the Fed somehow directly distributes money to households without obtaining any assets in return. This creates a hole in the Fed’s balance sheet, which has traditionally held assets (Treasuries, MBS, etc.) to back its liabilities (money). What happens then? If the hole is small enough, very little: the Fed will simply recapitalize using the profits it otherwise remits to the Treasury. Over time, Treasury will need to issue slightly more debt (since it’s receiving less money from the Fed), and in effect the transfer will turn out to be debt-financed. This is really no different from the first scenario.

What if the hole is large enough that it’s not clear the Fed can patch it using profits—in other words, if there’s a risk that the Fed is actually insolvent? This is murkier territory. First, it’s not clear that the Fed can ever really go broke: as Tyler Cowen points out, it always has the option to print a bunch of money and buy something valuable. Printing a few trillion and stocking up on equities (or even high-yield debt) will probably do the trick. Alternatively, in a crisis it can run to Congress. Both these possibilities seem far more likely than the notion that an undercapitalized Fed will somehow be forced to allow higher inflation.

In any case, a direct helicopter drop by the Fed only affects the future path of monetary policy if it puts the Fed’s balance sheet in peril. Otherwise, there’s no reason to think that the FOMC will make decisions any differently. (If it’s not externally constrained, why stop targeting its mandate?) And this is a very dangerous game to play: if you deliberately sabotage the central bank, it’s hard to know what will happen.

Ultimately, I agree with Scott Sumner: it’s bizarre to use a helicopter drop to create inflation expectations when you haven’t tried the much easier route of saying you want inflation. This is doubly strange when you realize that a helicopter drop only “works” if it irresponsibly endangers the Fed’s balance sheet. If you want inflation, say it. If you want to write more checks to households, tell the Treasury to do it. The “helicopter drop” is just a strange mishmash of fiscal and monetary policy that adds nothing.

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Money is debt

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.

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