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Tuesday, August 9, 2016

No Free Lunches Courtesy Of Helicopter Money

Although economists love to tell themselves that economics is a highly quantitative, empirical discipline, the reality is that when it comes to money, clear thinking goes out the window. Forcing banks to hold reserves at a below market rate of interest is obviously an imposition -- a tax -- but it is somehow excused as being some form of a free lunch, because reserves are "money."

In "Why Helicopter Money Is A 'Free Lunch'", Biagio Bossone argues:
As such, the elimination of interest payment on excess reserves (or its offsetting through the levy of an explicit charge on commercial banks, as suggested by Bernanke) would only amount to eliminating (or compensating for) the policy-determined price distortion discussed above. Consistently with this, the imposition from the central bank of a non-interest bearing compulsory reserve requirement equivalent to the amount of the monetary expansion under HM (or the levy of a charge to offset the interest net payments to commercial banks) would not represent a form of tax financing.
This argument is at best misleading. If the argument is that a "levy" is not really a "tax," it is just a word game. Otherwise, if the central bank increases the amount of reserves that are required to be held by banks, it is an imposition on the profits of banks, and bank shareholders would correctly regard such "financial repression" as a form of tax. I explain this in further detail below.

The apparent "free lunch" Bossone identifies is what is normally called seigneurage "revenue" -- the amount of interest cost saved by replacing debt by non-interest bearing "money." The annual amount of seigneurage revenue is calculated by multiplying the monetary base by the short rate -- which is the interest savings created by replacing treasury bills/bonds by "money."

If the monetary instrument we are referring to is currency (notes and coins) that are voluntarily held by households, it might reasonably be viewed as a free lunch; the government gets a reduced interest cost as a result of the decision to hold a liquid instrument. However, if banks are forced to hold instruments with a below market rate of return, this will result in an involuntary reduction in bank profits, which is undoubtedly a form of a tax.

In any event, if forcing banks to hold reserves at a below market rate of interest is somehow cost-free, forcing all investors to hold special Treasury bills that pay a below market rate of interest would also be cost free. If the reader believes that this is the case, I would suggest pitching that idea to some institutional investors to see their reactions.

Required Reserves -- A Lunch Paid For By The Banks

 Let us assume that the prevailing short-term risk free rate is 2%, and the central bank forces an unlucky bank to hold $100 in non-interest bearing excess reserves.

The bank suffers an annual opportunity cost of $2, as it could have held $100 in Treasury bills that would have paid $2 in interest.

That $2 loss in profits by the bank is exactly equal to the seigneurage revenue that is generated by replacing $100 in Treasury bills by non-interest bearing reserves. That is, the bank is paying for what is allegedly a "free" lunch.

Meanwhile, forcing a bank to hold reserves cannot be construed as doing it a favour (as a result of improving its liquidity position). If a bank is forced to hold $100 million in reserves, that represents $100 million in assets that are utterly immobilised. If it has a liquidity drain, it cannot draw on those reserves, it needs to sell something else (or borrow against something else) in order to keep its reserve levels at $100 million.

The situation is not greatly helped even if the liquidity loss is the result of a reduction of deposits against which reserves are held. (Not all classes of deposits create a reserve requirement.) Reserve calculations are not done in real time, and so reserve requirements are fixed until the next accounting period. (The drop in deposits would apply some relief in the next accounting period; however, required reserves would only drop by the reserve ratio times the deposit loss. For example, if the reserve ratio is 10%, $1 in lost deposits would free up $0.10 in reserves; however, the remaining $0.90 would still have to be raised by selling liquid assets.)

(UPDATE: My arguments here are fairly standard MMT analysis, and not viewed as very original. The arguments are closer to the article "Helicopter money: The illusion of a free lunch" by Claudio Borio, Piti Disyatat, Anna Zabai than I remembered (I had read the article a few months ago and did not remember the details). The Bossone article was a response to the Borio et al., paper, and so one might ask why my response here was not covered by his discussion. The observation that increasing required reserves is not just a question of interest rates, but also creates immobilised assets which are effectively useless for liquidity management, was not not addressed in the Bossone article. I thank J.P. Koning for nudging me to look at the Borio article again.)

Background On Interest On Excess Reserves

One point which may not be clear to those who are new to this topic is the question of interest on reserves. Since they look like a form of "money," why should they pay any interest?

Since banks are not required to hold these excess reserves, they will attempt to trade them away. They would be extremely likely to buy Treasury bills, which are a liquid short-term instrument. The market rate on Treasury bills will inevitably converge towards the interest rate paid on excess reserves.

If the central bank does not pay interest on excess reserves (like other forms of "money"), the implication is that short rates would be stuck near 0%. There would be no way for the central bank to raise interest rates; that is, they will have lost control of interest rates. (The pre-2008 Federal Reserve was in this position as a result of the prevailing institutional structure, where all reserves did not pay interest. This was changed, bringing the Fed closer to the operational practices of other central banks.)

The Bossone article discusses this loss of control of interest rates, and it explains why he is suggesting to impose additional reserve requirements on banks (to compensate for "helicopter money"). The extra reserve requirements will wipe out the "excess reserves," and so market interest rates can once again be decoupled from the rate of interest paid on required reserves. (I found that parts of his discussion on this topic were somewhat unclear, so I wanted to add some explanatory comments. UPDATE: This topic is covered in more depth by the Borio et al. article linked above.)

Concluding Remarks

If money were not viewed as some magical substance within economic theory, we would not be having these discussions. It would be obvious that obligatory reserve holdings is a tax on the banking system (which of course is going to be passed on via lending spreads), and we would start asking ourselves whether such a tax makes sense in the first place. After all, economists howl about the "distortionary" effects of taxes; imposing a severe competitive disadvantage on the formal banking system versus the poorly regulated non-bank financial sector is an obvious distortion that one should be concerned about.

(c) Brian Romanchuk 2016


  1. The situation is more complicated because a central bank must provide liquidity in a financial crisis and government(s) must provide equity in a national bank solvency crisis or else there must be a write-down of bank equity against a large pool of bad assets. No private investor will put capital into a bank expecting a large write-down and depositors tend to withdraw uninsured investments from a bank that may be facing a large write-down on its asset position. If the legislature imposes a debt ceiling on the Treasury then the central bank and Treasury must provide risk-free assets both to banks and non-banks in a manner that respects the debt ceiling. The banks need regulatory forbearance to carry bad loans and write-off losses over a longer period of time meanwhile the central bank and Treasury provide more guarantees for savings and investments on the liability side of the aggregate bank balance sheet to avoid deflation and unemployment spiral in the economy. Banks are getting a bailout and are not being taxed by efforts to save a banking system that would spiral into reverse under market forces in the absence of liquidity and capital injections from central banks and governments. Bankers in particular are getting salary, bonus, and stock options that would be less valuable in the absence of central bank and government support so a "free lunch" of sorts is taken by the aggressive bank managers whose compensation would be harmed without a bailout and is not questioned or reduced when a bailout is performed (during the Great Depression strings were attached to govt support for the failing financial sector and large industries).

  2. I agree with your main point about required reserves acting as a tax on banks. And I can understand why short term rates on 100% safe loans would get stuck near zero in the absence of interest on reserves. But I am not sure why that would be a bad thing. Why is it in our interest to guarantee a risk free return on money? I always thought that the QEs were designed to lower that return in the first place so that people would be more inclined to make riskier, but more productive, investments to receive a return. Or at least thought that that was the justification given for them.

    1. It's not just money (reserves) that are stuck at 0%; it's Treasury bills as well (and hence Treasury bonds). That means that the entire yield curve is stuck at 0% (until the excess reserves are drained). This means that the central bank has lost control over interest rates, and it means that the policy could not be easily reversed when the economy gets better. The Fed got out of this problem by paying interest on reserves; this allowed them to raise rates. It also meant that there is no was no interest savings by creating reserves.

      These were the concerns that people had with helicopter money; Bossone wants to increase required reserves so that there was no need to pay the interest on reserves.

  3. I notice that a number of writers find a problem with central banks paying interest on borrowed money: The practice is a 'cost' for the central bank or the government.

    But why do they say that? When the either the central bank or government consistently borrow to pay part of their expenses, both are borrowing with no intent to repay. With no intent to repay, the money borrowed is free money including the borrowed portion that is used to pay 'interest'. There is no cost to government if the money spent is free at origination.

    The problem with this practice comes from how money is valued. The valuation of newly-formed-money-mixing-with-existing-money is another subject.

    1. Whether the government should care about paying interest is a good question, but it is well outside the scope of the article. I needed to accept the basic assumption - that interest payments are a cost - in order to intelligibly debate the original premise. If we do not view interest payments as a "cost," then all government liabilities are a "free lunch," and the entire argument disappears. However, that then just creates a brand new debate - how is it possible that interest payments are not a "cost"? At that point, the article woukd bear no resemblance to Bossone's original point.

  4. Economists define the federal surplus as "govt saving" and some folks think the government should save like everyone else instead of operating a balanced budget (deficits accumulate no faster than assets of government so net worth is zero) or allowing govt net worth to go negative while providing more net financial savings to other sectors. Also if interest rates rise the interest payment on the debt as a percentage of GDP becomes a larger proportion of the govt budget in that scenario. Finally there is a theory that taxes must rise in the future to keep the debt to GDP ratio from growing exponentially. This theory is called the inter-temporal budget constraint. The idea that the government should generate a long run net surplus for reasons of common sense or household prudence is the only clearly bad idea among these three. The others may have merit for political reasons and/or be an systemic feature of the financial system.

  5. Brian, you are exactly right on this issue.

    Advocates of H money (Turner, Bernanke and now you have found another) claim they can deal with the "calibration" problem by just increasing reserve requirements or -- in Bernanke's case -- extracting some other convoluted tribute from the banking system to make it seem like a fiscal expansion is "money" financed when in fact it is financed with hidden taxes later on. Bernanke is particularly egregious on this point, for being the most convoluted.

    We can argue about the value of taxing the banking system. To claim it is money finance is absurd, as you point out. You need to correct an earlier comment you made that you do not understand the simple case against H money. You have discovered it for yourself.

    Well done. This puts you in the 0.1%

    But this leaves an open question. Why do the great and the good feel such an need to be dishonest about this? And why are the hangers on so embarrassingly gullible?

    1. Thanks.

      Why H money? Seems to be two reasons.

      In the euro area, the attraction of H money is the fact that the system is broken, and the only way of doing anything is to get the ECB to do quasi-fiscal operations. I am tired of citing the euro area as an exception (e.g., developed countries being immune to involuntary default), but this is another area where it is an important exception. Particularly for Europeans, the situation in the euro area is important, and so anything that can help there is of interest.

      Outside the euro area, my feeling is that it is a continuation of the "fiscal policy bad, monetary policy good" Monetarist doctrine. I am filling out the text for "Abolish Money (From Economics)!", and the case is more and more convincing as I tie the concepts together...

    2. If you start out in a framework where money is debt and fiat money has value ultimately mostly because of government taxes, which is where I am, then helicopter money is hidden taxes whether as inflation or actual taxes later. But I could still support it when the political system is broken, like Brian says in Europe, or even when it was just heavily damaged by government debt phobia like the U.S. has had. If for political reasons the government would not deficit spend if it was necessary, then helicopter money might be a politically palatable alternative because it would not increase "government debt" as is commonly understood in news stories. Not sure how dishonest that would be, maybe it is. If it is gullible then of course that precludes me from knowing.

      But if you start out from a theory that says money is mainly an exchange unit and that its value is determined through convenience factors and through your beliefs that others will also value it similar to you, is there anything dishonest about advocating helicopter money when you think money is in too short supply (and therefore overvalued) for an economy to operate at its best? Helicopter money in this case does not necessarily imply higher taxes because the value of money is not dependent on taxes.

      In any event, I am looking forward to Brian's "Abolish Money (From Economics)!" because I don't see how that can be done.

    3. Are people free to advocate helicopter money - sure they can, it's a democracy. We allow people to advocate any number of nutty ideas.

      Is it a good idea politically? No, because you are handing fiscal policy to an unaccountable body. A good portion of the development of the English parliamentary system involved the Parliament fighting for the power of the purse. Although the euro area may have few other good choices, the complete breakdown of democratic governance on the continent is going to be costly in the long run. Moreover, it also is going to be largely ineffectual, because the potential size of the programme is too small. It distracts attention from what would work - fiscal policy.

      From an analytical standpoint, even if people think "money" is special, helicopter money does not do what many of them say it will. They need to analyse the mathematics of what is in their models, and not project what they wish the results were. In this case, the use of helicopter money is not "free" once we see what the effects on the economy are. This would be seen regardless of the base assumptions of the economist are (unless those assumptions result in predictions that are obviously incorrect, in which case we can reject them).

    4. I agree with everything you just said there Brian. If the economy is in a state where you think fiscal expansion is necessary, then it is more honest to advocate for that fiscal expansion than to advocate helicopter money from the central bank. Especially if you believe in democratic systems. Because it ends up with the same effects except that you cede the spending authority to an appointed rather than elected group. So I agree.

      But what I was saying is that in a situation where fiscal policy is constrained for political reasons only, that H money might be a next best solution or at least better than nothing in the short term. But I agree that in the long run it would be better politically to make the case to people and convince them to support representatives that do not have a debt phobia at all times. But I think you would agree that is a very long term project that might not occur in the time frame when H money might be better than nothing.

    5. If fiscal policy is constrained for political reasons, HM supporters should stop wasting their time pretending that it will help, and attack the troglodytes who are creating those political constraints. In fact, some of the HM proponents are busy propagating the myths that the troglodytes rely upon. In some cases, they are part of the problem, not part of the solution.

    6. I can't disagree with that either.

    7. Brian,

      Do you equate large scale asset purchases (LSAP) of the central bank, also known as quantitative easing (QE), with helicopter money?

      Do you think QE does or does not help prevent deflation in a financial system where many units would otherwise be forced to "sell position to make position" as phrased by Hyman Minsky?

    8. No, since QE is a purchase of an asset that generates no income (except potential capital gains), while "helicopter money" is an unconditional transfer that generates income.

      Some people want to call having a fiscal deficit plus QE as "helicopter money," in which case the term becomes essentially meaningless.

      QE accomplishes very little (not counting something like the lender-of-last-resort operations undertaken by the Fed after the crisis).

    9. If one consolidates the central bank with the federal Treasury as exist in US, Japan, UK, then on can write a symbolic balance sheet:

      Assets = K + F
      Liabilities = R + C + B
      Net worth = Assets - Liabilties = N

      The two kinds of assets that can be purchased and held by the combined government are non-financial assets K and financial assets F. The three kinds of liabilities that can be issued by the combined government to pay for assets are bank reserves R, currency C, and Treasury securities B.

      Helicopter money under your definition could have two meanings. Either the government prints and spends currency to cover a deficit, or the government credits banks with reserves and the banks credit nonbanks with checking deposits, meanwhile the government debits (reduces) its own net worth. A third type of helicopter money already exists in a country that sells Treasury securities to cover the deficit with debit (decrease) in its own net worth.

      The US now makes direct student loans which are not financed by a tax earmark so the Treasury sells bond (increases B) to hold more student loans in financial assets F. The default rate on student loans either requires a decrease in net worth N per the write-downs or taxes to reduce the debt or accumulation of debt with negative net worth (helicopter money). Quantitative Easing means the central bank purchases financial assets F and these would be financed by the increase of currency or reserves. If this keeps the price of nonfinancial and financial assets from plunging in markets then it prevents a balance sheet recession or depression in the market sector but the scenario is counter-factual so a guy like Bernanke who will not let deflation ruin the whole economy may be smarter than the armchair critics but no one has proof of the counter-factual if QE actually works to keep asset prices from falling in markets.

    10. If we consolidate, "helicopter money" loses its meaning. The point is that it is a gift of the central bank, and not from the Treasury.

      I am not saying that this makes sense, but that is how the term is typically understood. (Of course, people have been calling any number of policies "helicopter money", since it's popular.)

    11. I am not aware of any central bank that spends money without purchasing a nonfinancial asset, a financial asset, or holding a loan as a financial asset. When a central bank services the currency drain it purchases financial assets and issues bank reserves to keep the aggregate bank from being depleted of reserves via the currency drain. This means actual central banks do not spend helicopter money and if one combines the central bank and govt then helicopter money would only be spent via legislature authorizing a set of tax, spend, and credit programs that also tend to reduce the combined net worth. Trying to get rid of the term "money" is not going to give people insight into the debit and credit mechanics and balance sheet positions which is the means by which the consolidated govt effects monetary, fiscal, and credit policy.

    12. Yes, they currently only buy assets for money, and not just give it away. That is the distinction between helicopter money (were they would give it away), versus existing open market operations. It's effectively fiscal policy being done by the central bank (although that phrasing offends some helicopter money supporters).

    13. In my model and lexicon fiscal policy usually refers to the difference between federal government taxes and government spending programs. A third type of policy would be credit policy although perhaps others regard this as fiscal policy. A government usually extends credit by a Treasury or other agency guarantee of the liabilities of banks (deposit insurance) or the liabilities of other government sponsored enterprises which resemble private financial corporations. A government can also make direct loans under a variety of programs. The central bank usually uses credit policy and its balance sheet to conduct monetary policy, that is, to generate low and steady inflation, avoid rapid inflation, and avoid deflation. If the banking and financial sector is generating deflation then the central bank must "push on a string" to prevent deflation. So the question becomes which tools are the proper policy mix under different conditions in the economy and whether quantitative easing has some value to prevent deflation if the legislature does not authorized alternative tools in the fiscal/credit policy mix.

  6. Brian, is it fair to say that you are on board with the Borio et al critique of helicopter money as a free lunch?

    1. Yes. I thought their critique was different, but having read it again, it's pretty much what I wrote here. (I have seen similar discussions by post-Keynesians some time ago, so I am not sure who said what first.)

  7. "Forcing banks to hold reserves at a below market rate of interest is obviously an imposition -- a tax -- but it is somehow excused as being some form of a free lunch, because reserves are "money.""

    Why are (central bank reserves) "money"?

    1. They are part of the "monetary base," and so considered part of the "money supply" by most. Since I want to abolish "money" from economic theory, I am indifferent to whether it is part of the monetary base or not...

    2. "They are part of the "monetary base,""


      "so considered part of the "money supply" by most."

      I don't think central bank reserves are either medium of account (MOA) or medium of exchange (MOE).

      "Since I want to abolish "money" from economic theory"

      Unless entities barter only, I don't see how that can work.

    3. Since deposits at the central bank defines the national monetary unit, not sure how they cannot be a medium of account.

      As to how it would work, there are plenty of economic models where money does not effectively appear, only Treasury bills. There is a unit of account, but no need for an instrument that acts as that unit.

      I buy things with my credit card, and no "money" is involved (until I settle my account).

    4. "Since deposits at the central bank defines the national monetary unit, not sure how they cannot be a medium of account."

      Not sure I am reading that right, but I will try with currency and gold.

      MOA would be currency. $1 of currency is unit of account. It is similar to gold with a gold standard. MOA would be gold. 1oz of gold would be unit of account.

      "I buy things with my credit card, and no "money" is involved (until I settle my account)."

      Actually, using your credit card means you are borrowing demand deposits. I consider demand deposits to be "money", so "money" is involved.

      "As to how it would work, there are plenty of economic models where money does not effectively appear, only Treasury bills."

      Not sure about models, but in the real world t-bills (bonds) are not money. Their value changes. If someone offers me a t-bill, I will not accept it. I will say cash it in for currency and/or demand deposits.

    5. When I make a payment, it could involve a transfer from a securities account. A bank deposit is created/destroyed intraday, and would never show up in the monetary aggregates that are allegedly important. Changes to the "money supply" have no bearing on my ability to do that transaction.

      A model could never capture that level of detail involved in modelling the payment system. Since the monetary aggregates have absolutely no predictive value about anything, they are easily jettisoned without losing anything of importance.

    6. "When I make a payment, it could involve a transfer from a securities account."

      What do you mean by securities account here?

      "Since the monetary aggregates have absolutely no predictive value about anything, they are easily jettisoned without losing anything of importance."

      I agree they are not as predictive as economists think. I don't think they can jettisoned completely. For example, have the treasury print up some currency (with no bond "attached" as a backing asset) and give to poor people. They will spend it. Quantities will rise. Prices will probably rise too.

    7. Securities account -> brokerage account.

      In your example, prices would (eventually) arise, but that is always true about fiscal policy. Whether the private sector is holding something in the monetary aggregates, or Treasury bills/bonds, will not really affect the outcome.

    8. I checked my online brokerage account. The "account" is FDIC insured and administered by a commercial bank. If you pay from the brokerage account, I am pretty sure you are using demand deposits.

      "Whether the private sector is holding something in the monetary aggregates, or Treasury bills/bonds, will not really affect the outcome."

      If you are talking about spending, entities do not spend Treasury bonds/bills.

      "In your example, prices would (eventually) arise, but that is always true about fiscal policy."

      It depends on whether there is a bond involved and what the repayment terms of it are.

    9. In my case, there is a transfer *through* a chequing account. I could have had $1 in the chequing account, and transfer $1000 from my brokerage account - which is not an entity shows up in "money supply" numbers - to pay a $1000 credit card bill. That is, you coul not look at my end-of-day demand deposit account to conclude anything about my ability to consume.

      Repeat: I am not advocating abolishing "money" in the real world. I am just advocating it from abolishing it from economic theory, which cannot hope to handle the intracacies of the payments system. In most models, all transactions settle simultaneously at the end of the accounting period (often quarterly). In such a framework, the payments system is completely out of scope.

      If I were an American, I could write cheques (I guess checks, since I would be an American...) against my money market fund. The money market fund is not within narrow money aggregates, and the underlying instruments may be Treasury bills (which are distinguished from "money" in economic models). Furthermore, investors routinely borrow against Treasury/bonds to finance securities positions; no demand deposits needed.

    10. "In my case, there is a transfer *through* a chequing account. I could have had $1 in the chequing account, and transfer $1000 from my brokerage account - which is not an entity shows up in "money supply" numbers - to pay a $1000 credit card bill. That is, you coul not look at my end-of-day demand deposit account to conclude anything about my ability to consume."

      If brokerage balances are not included, they should be. That is why I put the part in about FDIC insurance and administered by a commercial bank.

      "If I were an American, I could write cheques (I guess checks, since I would be an American...) against my money market fund."

      I believe a check is not written against a money market fund. Writing a check means to get your demand deposits back plus interest. The money market fund either sells assets for demand deposits or has a bond come due so the fund receives its demand deposits back plus interest.

    11. I could use margin and sell something to close out the balance, so there would be no brokerage balance. In any event, I do not believe that brokerage balances are included in most "money" numbers, other than possibly the widest aggregates.

      I am pretty sure that one of the innovations in the 1970/80s in the US was the abiliy to write checks againat money market funds; this created a lot of competitive pressure on banks. (I never saw such a feature in Canada.) How the money market fund deals with check clearing does not affect my decision making.

      In any event, there is nothing that stops demand deposits are created/destroyed intraday, which means that they do not show up in the monetary aggregates.

  8. HM delivers increased demand assuming the very orthodox Riccardian Equivalence (RE) concept holds because the money-financed government spending never has to be paid back. But RE has always been dubious empirically even amongst orthodox economists - just look at how beneficial pension and housing policies have been for baby boomers but not for their kids.

    Why has this assumption been overlooked?

    1. "Money" is overlooked in the standard formulation of RE because it does not pay interest. The "seigneurage revenue cancels out the interest. But if "money" pays interest - such as excess reserves, it will appear in the formulation. (John Cochrane had an article about that a few years ago; I covered it in an article here.)

      The use of "required reserves" is a dodge that is somewhat unusual; I have not seen a treatment that covers incorporates it explicitly. But it would be another mechanism that creates seigneurage revenue that wipes out the interest cost. Since standard DSGE models do not have banks, there is no clean way to specify how "required reserves" work.


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