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Sunday, June 5, 2016

The Pointlessness Of Helicopter Drops

The great "Helicopter Money" debate has opened up again. Although the idea has been effectively skewered elsewhere, I just wanted to point out that this is an excellent example of why money needs to be abolished -- from economic theory, at least. Whether or not spending is "money financed" is a distinction that matters as much as whether the government prefers to issue 1-month Treasury bill instead of 3-month bills.

For further reading, the following recent articles explain the theoretical weaknesses of Helicopter Money. My discussions here overlap these arguments.

Money Just Another Financial Instrument


Money is just another financial instrument. However, for historical reasons, economic theory has been warped by the concept of money. As a result, any debate involving money usually takes place behind a cloak of unreality.

As I will discuss below, the use of "helicopter money" offers no new policy space. At best, there is a reshuffling of central government liabilities amongst holders.

If someone presented us with a theory that by issuing Floating Rate Notes instead of fixed coupon bonds, all our economic ills would suddenly disappear, people would not take the theory seriously. But by replacing "Floating Rate Notes" with "money," we end up with an interminable debate.

The rest of this article explains why Helicopter Money offers us no new policy options, instead it is akin to fooling around with the mix of types of Treasury bonds and bills issued.

What Is Helicopter Money?

"Helicopter money" consists of the central bank transferring money to lucky citizens (or all citizens). Although this is usually thought of to be the result of an interbank transfer, one particularly bad way to accomplish this would be to drop newly-printed money from helicopters. (I still think that the literal use of helicopters dropping currency to provoke riots for the amusement of autocratic technocratic overlords would be a good plot device for a dystopian action film.)

Since such an action is obviously outside the remit of central banks, one accepted variation is for the central bank to "finance" a handout of cash by the fiscal agency of the central government (the Treasury).

Yes, The Euro Area Is An Exception

To begin, I accept that a "helicopter drop" would be an improvement over the existing framework in the euro area. This partially reflects the utter failure of the design of the euro. It also reflects the fact the reality of ECB policy. This is a central bank that deliberately smashed the Greek economy for political reasons. Any policy framework is going to be more benign than that. However, this tells us nothing about policy in less dysfunctional regions.

No Operational Expertise

The central bank has no ability to make transfers to the population itself. It would be a massive waste of real resources to build an infrastructure to allow it, since it would be needed only extremely infrequently.

If all the central bank is doing is "financing" Treasury expenditure, we run into the obvious issue: developed Treasurys have been financing themselves for decades without incident.

Fiscal Policy Can Do The Job

Although many economists dismiss the idea of using fiscal policy in a counter-cyclical fashion, the experience around the Financial Crisis showed that an active fiscal response is probably just as effective as that of the central bank in practice (other than the lender-of-last-resort operations).

Fiscal policy did exactly what it was expected to do. During the crisis, almost all countries had well-timed discretionary fiscal responses that help reduce the impact of the freezing of the financial system. (Of course, there was a considerable automatic response as well.) After the crisis, fiscal policy was tightened fairly quickly, and growth slowed rapidly, as one would have expected.

Of course, the people implementing the fiscal tightening expected the economy to expand, based on the theory of "expansionary austerity." All that proves is that many people are clueless. (Since the ECB was a major backer of "expansionary austerity," we can see that central bankers have no particular claim to the possession of clues.)

Hawkish central bankers have been screeching for tighter policy almost as soon as the dust settled after the Financial Crisis, and some central banks even raised rates despite the obvious signs of weakness. Therefore, there is no reason to believe that giving the central bank fiscal powers will mean that it will be deployed any more effectively than by politicians.

Involuntary Default Risk Unchanged

  • Probability of a nation with currency sovereignty being forced into involuntary default without Helicopter Money: 0%.
  • Probability of a nation with currency sovereignty being forced into involuntary default with Helicopter Money: 0%.
(See Understanding Government Finance for a longer discussion of this assertion.)

Financing Costs -- Small Changes

The use of Helicopter Money would change the mix of liabilities issued by the consolidated central government. The new instruments may have a slightly lower interest cost. (Why this is just a mix change is detailed below.)

However, it is unclear whether this will reduce the aggregate interest costs. Since the purpose of interest payments by the central government is regulate economic growth (and inflation), if we lower the relative costs of some instruments, the  interest rate across other instruments might need to rise to compensate. The net effect on interest expense is unclear

We would need an accurate and detailed model of the effect of interest rates on the economy to judge the effect, and that is precisely what decades of mainstream monetary research has not produced.

Cannot Force An Increase In Currency Holdings

Mainstream economists have a strange tendency to lump currency holdings (notes and coins) with settlement balances at the central bank ("reserves"). These are very different economic animals.

In a positive interest rate environment, the level of currency holdings is largely voluntary. People only hold currency for small transactions, and for illicit activities. Unless the central bank decides to purchase a large amount of product from neighbourhood drug dealers, there is no way of forcing an increase in currency holdings. The central bank can only "control" the level of settlement balances, which I discuss next.

In a negative interest rate environment, the central bank could induce an increase in currency hoarding. But in a negative interest rate environment, zero interest money is the high cost source of government financing; "money financing" increases the interest burden.

Excess Settlement Balances -- Must Pay Same Interest Rate As T-Bills

If the central bank induces an excess of settlement balances at banks, those banks will wade into the Treasury bill market if the interest paid on those excess balances is less than the rate on Treasury bills.

In other words, the central bank has to keep the interest rate paid on excess settlement balances to be the same as the policy rate. There may be a gap of a dozen basis points, but that is not enough to have a visible effect on anything.

If the interest rate on excess balances is 0%, the Treasury will be able to issue Treasury bills near 0%, and there is essentially no reduction in the interest burden.

Who Pays The Interest Does Not Matter

Proponents of "helicopter money" often underline that the central bank will be paying the interest, not the Treasury. This does not matter (outside of the dysfunctional euro area). As long as rates are non-negative, the central bank will always have a positive net interest margin if there are no excess settlement balances (its liabilities pay 0% interest). All profits are paid to the Treasury at the end of the accounting period.

If the central bank pays interest on excess settlement balances, it will cut dollar-for-dollar into the dividends paid to the Treasury. Any competent credit analyst would therefore not distinguish between interest paid by the central and the interest paid by the Treasury when assessing interest cost trends (even if we do not consolidate the central bank).

Increasing The Reserve Ratio -- Can Always Be Done

The only way of reducing interest costs for the central government is to raise the required reserve ratio for banks. This turns "excess" settlement balances into "required" settlement balances, which pay 0% interest. Since the banks cannot reduce their settlement balance below the required level, they cannot use those balances to buy Treasury bills. This allows the policy rate to be held above 0% (which is how the pre-2008 system worked in the United States).

Although such a step would reduce interest costs, it is a policy option that is always available to the government.

However, it is bad policy. Required reserves are just a tax arbitrarily hitting one segment of the financial sector. Although not too many shed tears about the fate of bankers, "shadow bankers" are even less popular. Increasing required reserves makes banks less competitive versus other financial firms, which face much less regulation. One of the reasons why countries like Canada abolished reserve requirements on the basis that it made no sense to favour unregulated lenders over regulated entities.

Why Are We Debating This?

Even though "Helicopter Money" is a completely pointless exercise, do not expect the debate to go away any time soon. The only value of the discussion is that it provides a demonstration how economic theory cannot properly deal with money.

(c) Brian Romanchuk 2016

12 comments:

  1. “At best, there is a reshuffling of central government liabilities amongst holders.” Nope: QE is a “reshuffle”. Helicopter money (HM) is a chunk of ENTIRELY NEW paper assets for the private sector. It adds to what MMTers call “private sector net financial assets”.

    “..we run into the obvious issue: developed Treasurys have been financing themselves for decades without incident.” Yes, of course. But the whole need for HM arises where treauries / politicians / fiscal policy is not doing enough.

    “The new instruments may have a slightly lower interest cost.” Well that’s an advantage isn't it?

    And finally, there is a fundamental absurdity inherent to conventional fiscal stimulus, i.e. having the state borrow money and spend it: the absurdity is that BORROWING is deflationary. That is, what’s the point of doing something DEFLATIONARY when the object of the exercise is the opposite, namely STIMULUS? You might as well chuck dirt over your car before washing it.

    Put another way, a wholesale abandonment of conventional fiscal stimulus, and replacing it lock stock and barrel with HM would actually make a lot of sense, though that obviously involves a fundamental change in the responsibilities of central banks and treasuries.

    Such a system is actually at the heart of a work (link below) published by Positive Money, the New Economics Foundation and Prof Richard Werner. That work actually advocates full reserve banking as well, but full reserve is not an essential ingredient in the latter “fundamental change”.

    http://b.3cdn.net/nefoundation/3a4f0c195967cb202b_p2m6beqpy.pdf


    ReplyDelete
    Replies
    1. By issuing 1-month Treasury bills, Treasurys can issue instruments with lower expected returns (=lower interest cost). But as I noted, the net result is that the entire yield curve may need to shift higher to compensate. As a result, we cannot conclude that the aggregate interest cost is lower.

      Any consolidated government transfer of cash to the private sector will result in excess reserves/bond issuance. The bond issuance is not deflationary, since the money to pay for the bonds came from the issuance. The net effect on growth depends upon your belief about the fiscal multiplier.

      Outside the euro area, policy makers have been throttling back stimulus (as they see it). In other words, there is no need for HM. When there was a need, countries undertook fiscal expansion in a timely fashion. It may not have been enough, but the political consensus at the time was that it was enough. So the addition of HM adds no additional "policy space". (The euro area is an exception; but almost anything is better than the current policy stance there.)

      Delete
  2. "The only way of reducing interest costs for the central government is to raise the required reserve ratio for banks. This turns "excess" settlement balances into "required" settlement balances, which pay 0% interest."

    Just a pedantic note, interest on required reserves is an independent policy variable doesn't necessarily have to be 0%. The Fed for example pays the same 0.50% rate on IORR as IOER. https://www.federalreserve.gov/monetarypolicy/reqresbalances.htm

    I don't know why the Fed made this choice and haven't seen any analysis or really even any acknowledgement of it in the many discussions of IOR. I'd be very interested in your thoughts on the question.

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    Replies
    1. Good point. Even if I were aware of the Fed policy, I forgot about -- it was essentially near 0%, so it was not a big deal.

      If the policy rate is ever near 1%, the distinction starts to matter. However, working from memory, the excess reserves were larger than required reserves, and so it did not make much of a difference.

      If the Fed pays interest on required reserves, it eliminates much of the cost for banks. This eliminates the regulatory issues I discuss. However, it means that reserves are truly the same thing as overnight T-bills, and so it does not reduce the government's interest bill. (Technically, there is no reason to care about the interest bill, but politically, politicians would much rather spend money on new projects rather than hand cash over to bankers.) Furthermore, it raises the risk that the Fed will have negative equity, which may matter politically. (Economically, it does not matter, but Congress could make the Fed's life difficult if they are "losing money.)

      I guess I should try to look up the Fed's thinking on the matter.

      Delete
    2. "politicians would much rather spend money on new projects rather than hand cash over to bankers"- that's debatable :)

      Delete
  3. Agreed Brian, if we called Treasury bonds 'FRNs', or Fed bank 'CDs', or Fed 'Term Deposits', instead of 'debt', there would be no debate...IMO, all federal gov't deficit spending is a congressional-approved Fed helicopter drop ('money-financed') under the guise of being a Treasury helicopter drop ('bond-financed'). Instead of trying to do a helicopter drop without legislative approval (Bernanke's 4/15/16 blog idea he calls a "People's QE"), just level with the American people and stop using the outdated, gold-standard issue playing cards of a bygone era. That way Congress would not only approve productive, counter-cyclical fiscal measures, they would actually understand it.

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  4. Brian, I think you need to consider the TWO ways government can BORROW money: borrow from itself or borrow from the private sector. The effects on the economy (between the two methods) are very different.

    ReplyDelete
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    1. Government spending creates liabilities in the hands of the non-government sector. If the government wants to keep interest rates positive, it has to pay interest on those liabilities. Governments can borrow from themselves, but that does not effect the liabilities held by the private sector.

      Delete
    2. Another way of thinking: The recipients of government spending have gained the ability to buy anything-for-sale in the economy. These folks have received an ASSET.

      Couple that thought with TWO sources for government BORROWING.

      Delete
  5. Best piece I've seen on this. Thanks.

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  6. This short article is the best I've found on the original meaning(s) of "helicopter money."

    What is helicopter money?
    https://www.weforum.org/agenda/2015/08/what-is-helicopter-money/

    Friedman - drop cash from helicopters, or more specifically, print currency to give to each poor or working class household. The effect or outcome depends on whether households want to repay debt, otherwise "save", or decide to actually spend the "helicopter money."

    Bernanke (2002) - "A broad-based tax cut, for example, accommodated by a programme of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices. Even if households decided not to increase consumption but instead rebalanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman’s famous ‘helicopter drop’ of money.”

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