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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15 Comments

Filed under fiscal, macro

15 responses to “The uselessness of helicopter drops

  1. K

    Matt,

    “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.”

    Everything the Fed’s been doing for the past 3 years is “a strange mishmash of fiscal and monetary policy.” For some reason lots of people are happy to call it monetary policy. Of course they should be trying to raise inflation expectations right now, but in general, with monetary policy alone (i.e. fully and publicly elaborating the dynamics of the short rate process) it’s not clear that they always have the ability to avoid or escape any liquidity trap in a timely manner. In particular, to the extent that the yield curve approaches zero, so does the implied probability of escape, and with it, the potency of inflation expectations *contingent* on escape. In which case, only the threat of actually mailing people checks or maybe buying high beta assets (whether ever realized or not) would have the power to raise expectations.

    So the question is, should the Fed possess tools to credibly threaten something effective in all circumstances (even something fiscal) or are we willing to leave it up to the fiscal authority to act quickly and correctly in dire circumstances? Personally, I think providing the Fed with a tool such as a helicopter drop, or maybe direct manipulation of an NGDP futures contract, would be an acceptable compromise, and certainly better than them abusing their lender of last resort powers to prop up insolvent institutions in the name of economic stabilization.

    “Both these possibilities seem far more likely than the notion that an undercapitalized Fed will somehow be forced to allow higher inflation.”

    Why can’t an insolvent Fed, faced with inflation, just offer to borrow at a high rate? Without collateral. Is it a problem that the interest paid will introduce more money into circulation? Or do we still believe that real effects will dominate? (I definitely don’t fully understand the dynamics.)

    • So the question is, should the Fed possess tools to credibly threaten something effective in all circumstances (even something fiscal) or are we willing to leave it up to the fiscal authority to act quickly and correctly in dire circumstances? Personally, I think providing the Fed with a tool such as a helicopter drop, or maybe direct manipulation of an NGDP futures contract, would be an acceptable compromise, and certainly better than them abusing their lender of last resort powers to prop up insolvent institutions in the name of economic stabilization.

      This is a fair argument—even if the Treasury *could* just as easily perform a certain operation, maybe Congress won’t get its act together in time, and we want to give the Fed some power so that markets can be assured of a timely, effective response. (This was, ironically, the logic behind a lot of the Fed’s forays into financial markets.)

      My skepticism on this point ultimately stems from my skepticism of the effectiveness of fiscal transfers in general, at least compared to the other tools at the Fed’s disposal. Perfect Ricardian equivalence surely doesn’t hold in practice, but there is also no reason to expect consumers to spend a substantial fraction of their transfers right away—even if they think that the transfers are net wealth (i.e. they don’t realize they or their descendants will need to pay more taxes as a result), they will spread out that net wealth over a number of periods, unless they are incredibly credit constrained or are “rule of thumb” consumers. Some countercyclical transfer policy is probably a decent idea to try (we don’t know the exact effects, and why not throw everything we have at the problem in case it works?), but I’m not convinced that the benefits of an aggressive operation outweigh the costs.

      The Fed’s ability to shape expectations about future interest rates seems like a much more effective tool to me. Theory tells us (and I think this holds in the real world too) that a credible commitment to 1% lower rates 3 years from now has just as much macroeconomic impact as 1% lower rates today. And I suspect that 1% lower rates today would be a pretty big deal—certainly as much as most transfer policy.

      Why can’t an insolvent Fed, faced with inflation, just offer to borrow at a high rate? Without collateral. Is it a problem that the interest paid will introduce more money into circulation? Or do we still believe that real effects will dominate? (I definitely don’t fully understand the dynamics.)

      The problem is that if an insolvent Fed pays an interest rate higher than than the rate of economic growth—and gets the funds by simply creating more money—over time its liabilities (money) will become arbitrarily large relative to the real economy, which is not a sustainable situation and would eventually cause hyperinflation. There are a few ways around this:

      (1) In normal times the Fed is able to earn a decent amount of seignorage income, and eventually this income might be enough to fill the gap.

      (2) Maybe on average, the Fed would be paying an interest rate below the rate of economic growth, so that its liabilities would ultimately shrink to zero relative to the economy (and thus the Fed’s revenue generating potential, making this a corollary of (1)). For me, the problem is that this is quite risky, and will definitely start to fail at sufficiently high levels of aggregate government debt. I addressed these issues in more detail in a response to comments on an earlier post.

      • K

        “Theory tells us (and I think this holds in the real world too) that a credible commitment to 1% lower rates 3 years from now has just as much macroeconomic impact as 1% lower rates today.”

        Agreed. But I think you missed my point about the implied probability measure of the yield curve. If the yield curve is at zero out to five years, then the market is pricing zero probability of a rate hike for five years. Assuming that the short rate would rise within 1 or 2 years following the beginning of rising inflation, this means the market is pricing zero probability of an upward cumulative natural rate for at least 3 years. In that case you can talk till you are blue in the face about what you are going to do contingent on an upward path of NGDP/inflation whatever. The market prices zero probability of that occurring so it doesn’t care what you might do in that circumstance. Once the yield curve falls to zero out to a distant horizon it becomes difficult to see how an expectation of inflation occurring beyond the end of that lifetime would transport a purchase into the present. At best it can be transported back to somewhere slightly before the forward curve rises above zero. Why would I buy it now if the market says I can safely wait five years before there is any probability of inflation kicking in?

        As far as borrowing by an insolvent Fed goes, it only seems risky to the extent that the expansion of outside money effect overrides the real (NK) rate effect. As you discussed in an earlier post, it seems that we are an extremely long way off from that being a problem (tens of trillions of dollars). And we always have taxes should we need them.

      • K

        Matt: “Theory tells us (and I think this holds in the real world too) that a credible commitment to 1% lower rates 3 years from now has just as much macroeconomic impact as 1% lower rates today.”

        K: “Agreed.”

        Actually, I don’t agree at all! What theory is this? Let me grant you rational, omniscient agents. But do all the people in your world also have access to unlimited credit? At the *same* rate? And do they have CARA utility functions or complete access to markets that span their entire future income stream? Or does it have a large fraction of agents who couldn’t advance consumption ahead of their next paycheck even if Bernanke told them prices were going to double next month?

        The problem with the current crisis is that it breaks the usual models on exactly the assumptions on which those models depend most critically. In *huge* ways. Equal and unlimited access to funds at the risk free rate may not be the most ludicrous of the common assumptions, but it certainly comes to mind in the current context.

      • K

        Matt: I reread your above comments and noticed that you did explicitly assume that agents aren’t “incredibly credit constrained.” Fair enough. But I think it’s fair to assume that many of them are quite, or very credit constrained. And what if we imagine that there’s a strong correlation between paying high rates to borrow and having a lower permanent income. I think that’s fair too. Lets imagine that the bottom quartile makes about $25K/year and the top quartile makes $150K. Of that, the “lucky duckies” at the bottom only pay $5K in various taxes, and the “rich” ones at the top pay $60K. So the top ones pay 12 times as much tax as the bottom ones.

        Now lets imagine that we send everyone a $10K check. We’ll assume full Ricardian equivalence and that the current ratio of relative tax liabilities is maintained, so that the top quartile expects to bear 12 times the future tax liability of the bottom quartile. So in present value the poor ones expect to pay back $20000/13=$1540 and the rich ones 12*$200000/13=18460. So what it does is to transfer $8460 from the rich to the poor.

        The rich ones will most likely respond to their loss of $8460K by deleveraging and selling some assets and slightly reducing their consumption by an amount equal to their loss of permanent income. The relevant rate of interest for the rich is the expected rate of return of their capital assets. Lets call it 3% (though really it’s the risk adjusted return which is zero). So the loss of permanent income is at most a few $100 per year. The relevant rate of interest for the bottom quartile is charge on department store credit cards, i.e. about 28% (or higher – many have access to payday lenders or no access to credit at all). So the effect of new wealth is to increase their permanent income by at least 28% on the amount of that wealth.

        So the effect on the economy is, to first order and without any multiplier and assuming we are far from supply constraints, to increase NGDP/capita by $8460*(28%-3%) = $2115/year ongoing. Put that in your pipe and PV it.

  2. JKH

    I agree entirely with the last two sentences of your post.

    There are multiple institutional constraints that obstruct the origination of helicopter drops at the Fed (your type II), although the wacky platinum coin idea may be the least constrained operational possibility so far. But given the intended nature of the institutional separation of the Fed and Treasury, it’s mostly a waste of time discussing this sort of idea in the form of proposed operational rearrangements.

    Better to focus on the higher question of institutional separation per se. The capital position of the Fed, which is a constraint at the institutional level, is no constraint for the counterfactual case of managing a fully integrated Treasury/Fed balance sheet. The capital position for the latter is monumentally negative, of course, considered at the same level of bookkeeping entries. Economics can be left to interpret this undoubted fact of consistent bookkeeping. Some may choose Ricardo. I prefer the idea that the power of the state to create low risk liquidity in size is what dominates the conventional balance sheet interpretation of insolvency – i.e. the government is a special case where the cash flow interpretation obviously overpowers the balance sheet interpretation.

    If after that one ends up back at the place where institutional separation remains desirable, then discussing helicopter operations becomes a total waste of time. If not, then taking more time to discuss formal institutional integration becomes desirable.

    (This is a general point, not at all directed at your post per se, which is very good.)

    • Better to focus on the higher question of institutional separation per se. The capital position of the Fed, which is a constraint at the institutional level, is no constraint for the counterfactual case of managing a fully integrated Treasury/Fed balance sheet. The capital position for the latter is monumentally negative, of course, considered at the same level of bookkeeping entries. Economics can be left to interpret this undoubted fact of consistent bookkeeping. Some may choose Ricardo. I prefer the idea that the power of the state to create low risk liquidity in size is what dominates the conventional balance sheet interpretation of insolvency – i.e. the government is a special case where the cash flow interpretation obviously overpowers the balance sheet interpretation.

      This is a tricky issue. No doubt there is some kind of liquidity premium on Treasury debt relative to most other securities, one that makes this debt relatively cheap to finance. But does the Treasury’s power to create liquidity arise from the liquidity premium itself? No one ever doubts the Treasury’s creditworthiness because financing its debt is so cheap that it’s always possible, which is in turn because there is such confidence in the Treasury that everyone is happy to treat its debt as liquid claims?

      That’s a little circular for me—I’m not saying that it’s wrong, but I’m certainly not positive that it’s right, and I feel that there is a substantial risk that this good equilibrium would break down if not backed up by the credible Ricardian promise to levy taxes (if necessary) to pay back the debt.

      If after that one ends up back at the place where institutional separation remains desirable, then discussing helicopter operations becomes a total waste of time. If not, then taking more time to discuss formal institutional integration becomes desirable.

      If you’ll forgive my ignorance, I don’t think I know what the benefits of formal integration are supposed to be. Is the idea that the Treasury’s liquidity-creation decisions play a large role in determining the liquidity premium, which has such substantial macroeconomic consequences that it should be a lever of Fed macroeconomic stabilization policy? I can see that, but in normal times I think the Fed’s power to adjust the federal funds rate is vastly more important to macroeconomic outcomes, and even at the zero lower bound there are more effective tools using this instrument (e.g. conditional interest rate commitments) if only the Fed would use them.

      • JKH

        My qualifier was low risk in “low risk liquidity”; yours was “if necessary” in “promise to levy taxes (if necessary)”. If you combine those two elements, it may not be quite so circular.

        The “low risk” element means the risk free rate is available for government finance, and has the best chance of producing sustainability in the long run. The liquidity characteristic is a function of both the low risk feature for the holder and the ease of production for the issuer.

        I’m no expert in Ricardian equivalence, but I recall a formula that is not so qualified. I can’t square the Ricardian ex ante logic at face value with ex post evidence that debt is not repaid in total. But I think the tax qualification makes intuitive sense, ex ante.

        Regarding formal integration of Treasury and the Fed, the idea was qualified as held by those who actually believe that it has value. I don’t know for sure about this, but there are those who probably should, in my view, based on what they believe otherwise.

        Some (not all) in the MMT group believe that the Treasury should just stop issuing bonds. That is possible, operationally. If that’s done, it suggests formal bookkeeping integration, and by default, management integration. In that environment, there’s no structural justification for a negative capital position on a stand-alone Fed balance sheet. The Treasury and Fed balance sheets should be combined. One can interpret the resulting net liability profile of the combined entity similar to the way one interprets the Treasury balance sheet now. The liability profile becomes a mix of mostly reserves and currency without bonds. One can interpret this alternatively as the Fed balance sheet absorbing the Treasury position. Or, as I tend to think of it, the Treasury function takes on the money issuing characteristics of a bank. From a management perspective, it is natural then to view the main Treasury function as overseeing deficit policy, and the banking function within in as overseeing the implementation of that policy, including accounting for reserves and managing currency flows, along with the pure central banking function of lender of last resort.

        QE and “helicopter drops” are in effect milder, limited versions of the same idea. Even the fact that the non-crisis Fed balance sheet mostly works off Treasury bonds as internal assets is a variation of it, since Treasury is using the Fed balance sheet to finance a chunk of the cumulative deficit. Now obviously none of these things require integration of Treasury and the Fed, but they open up that question, I think. So I’m not declaring an advantage so much as opening it up to inquiry.

        The current independence of monetary policy would be a concern, but also open to institutional reform. It’s probably not a good idea to have an institutional mechanism that seizes up every 60 or 80 years due to extraordinary financial conditions. The ongoing debate about the appropriate mix of fiscal and monetary policy at the zero bound is a indicator of such seizing up. It’s probably better to build the risk of these conceivable but infrequent scenarios into the design of the management process on a permanent basis.

        In a commercial bank, the people who set the interest rates aren’t the same people who manage the capital position. Those are analogous responsibilities to setting monetary policy and fiscal policy. In the case of a commercial bank, everything is done under the ultimate supervision of the Board of Directors. The analogous supervisory function is Congress for both monetary and fiscal policy. The people through Congress can always fire the CEO (the president) for poorly managed policy on the combined basis. None of that would necessarily undermine the operational independence of the monetary policy function. “You gotta’ serve somebody” in any case.

        BTW: I come from a background where the term “liquidity premium” is sometimes used to describe the interest rate (spread) cost of illiquidity. It’s an ascribed cost, alongside a pure credit risk premium, reverse engineered by comparing the interest rate cost of instruments with the same credit risk across differing liquidity attributes. (A simple example might be a comparison of costs between a fixed bank term deposit and a marketable instrument for the same term.) So I pause when trying to back out the usual economists’ meaning of “liquidity premium”.

  3. Dan Kervick

    The monetary authority of the United States belongs, under the Constitution, to the US Congress. It has been delegated to the Fed. But the manner of those delegations can be changed at any time by legislation. The existing laws can be superseded and replaced by new laws.

    Congress could at any time authorize, or even mandate, that the Fed credit the accounts of the Treasury Department by any number of dollars X. It could then authorize the spending of those dollars in the usual way. Done. End of story. No new taxes; no new borrowing.

    The idea that money represents some kind of liability by the Fed or the US government seems largely like an accounting fiction surviving from an earlier age. A liability for what? A liability for more money? Big deal. Someone wants to exchange their old money for new money? What does that matter when I can produce all the money in the world for free under the law?

    A liability in the sense that people can discharge their tax debts with it an any time? That does’t make much concrete sense either. If the whole world owes me, Dan Kervick, $1million, but if there are several “Get Out of Kervick Debt for Free” vouchers out there that I have issued amounting to $100 thousand, then that is a real liability for me, because their existence cuts into what I can acquire from the rest of the world. But the government can make up any money it needs out of a few electrons. It only collects taxes to regulate the amount of money and purchasing power in other people’s hands.

    • The idea that money represents some kind of liability by the Fed or the US government seems largely like an accounting fiction surviving from an earlier age. A liability for what? A liability for more money? Big deal. Someone wants to exchange their old money for new money? What does that matter when I can produce all the money in the world for free under the law?

      I have a much more comprehensive reply in response to your previous comment, which touches upon many of the same issues.

      Suffice to say this: to maintain the real value of money, the government needs to promise some combination of (1) implicit liquidity services from that money, (2) explicit interest payments on that money, and (3) a certain trajectory for the future real value of that money. Otherwise people won’t want to hold the money, and in their attempt to dispose of it in the aggregate we’ll see inflation. So if the Fed wants to avoid an inflationary explosion, it needs to promise some kind of “yield” on money that is acceptable to the market. This is similar to debt in general, and that’s why it is conceptually coherent to call money a “liability”.

      The reason people are confused on this issue is that the Fed has traditionally financed its money liabilities through implicit liquidity services, not explicit payments. (That’s why it’s needed to be so careful about the quantity of base money, passively adjusting it to maintain an interest rate target.) But when there is more base money, the marginal liquidity services that money provides go to zero, and the Fed has to find some other way to convince people to hold money. Otherwise, there will be severe inflation. Conditional on wanting to avoid destabilizing bouts of high inflation, the Fed needs to treat money like a liability.

      • Dan Kervick

        Thanks for your explanation Matt. My concern in all this is the bearing of the money-as-debt picture on the second form of helicopter drop.

        Based on your explanation of the steps a government needs to take to maintain the real value of money, it still seems to me that the money itself is not a debt or liability. Suppose I build a very useful tool shed in my back yard. I have a household policy goal of making sure the tool shed retains its value to our home over time, and does not fall apart, and in a sense then, given that policy goal, I have committed myself to future courses of expenditure designed to support the value of the tool shed over time – including buying on occasion more wood, nails, shingles, paint or a Shop-vac as conditions warrant. But the fact that my policy goals commit me to additional expenditures doesn’t mean that the tool shed itself is a liability, does it?

        So returning to the helicopter drop, I’m wondering what role the Fed’s balance sheet and asset-liability financial accounting really plays. The country’s monetary authority engages in the creation and destruction of money continuously. It has various policy goals in view as it does this. But I don’t see intuitively why those activities have to strike the particular sort of accounting balance over time that I think you are describing. The monetary authority can’t really be insolvent except in the most extreme of circumstances, so I don’t really understand the particular kind of balance sheet peril you say it has to avoid. That isn’t to say that there might not be very good policy reasons for avoiding a sustained excess of production over destruction, or vice versa, over time. Presumably we want some price stability and don’t want the growth in the supply of money to run far ahead of growth in the production of goods and services. And given the circumstances, heavy additional government purchases paid for with newly-produced money could distort and damage the private sector economy. And if we are determined that the purchases are only going to temporary, we have the policy problem of figuring out how to gradually transition the production it is temporarily employed by government back to the private sector.

        The economy of money production is hard to grasp, I think, because money is such an unusual product. It’s production is coordinated by a large monopolistic producer that is supposed to operate for public purpose without a profit, and the product itself can be produced on massive scales at minimal cost – very low overhead and nearly zero cost of raw materials. If you produce too much of it you damage the value of the rest of the product. And hardly any of it gets consumed, so if you want to get rid of some of it you need to destroy it.

  4. Scott Sumner

    Needless to say I agree with the post. I’d just add that I can’t recall another case where so much effort was expended by economists to solve a “problem” that as far as I can see has never existed; fiat money central banks that wanted to inflate, tried, and failed. Until that problem occurs, I think all attempts to solve the “problem” are a waste of time and effort by some very brilliant minds.

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  6. espinosa.dv@gmail.com

    Matt,
    “…exchanging reserves for short-maturity T-bills is meaningless… ” I think you may misunderstand the purpose of a helicopter drop. I agree that when the banking system does not demand reserves, OMO is essentially the same as fiscal policy — an asset swap with no monetary policy implications. However, the whole purpose of money-financed deficits is to create demand for bank reserves.

    Take the example of where private credit has been declining, pulling down total credit; as a result the banking system does not demand more reserves. Now, start increasing public credit demand by more than the private credit shrinkage, and promise to do this for years. As a result of total credit/deposit growth, the banking system will be short reserves, and the Fed’s OMO will, all else equal, create more money and raise the price level.

    Money financed deficits are a “foolproof” way of generating inflaiton. To work, they have to 1) be large enough to create total credit/deposit growth; 2) be sustained over time. Unfortunately, money financed deficits are also the source of high and variable inflation regimes.

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