Ben Bernanke has done a series of posts on what central banks can do at the zero bound. His first post looked at negative IOR, and the second examined targeting long-term interest rates. Of course Bernanke has also advocated the use of QE. Now he looks at the helicopter drop option. Bernanke agrees with my view that helicopter money should be used as a last resort. Where we may differ slightly is how many options need to be tried before reaching that point.
In my view, it’s too soon to jump to helicopter money, just because the techniques mentioned by Bernanke have been exhausted. I recall Bernanke once arguing that the inflation target might have to be raised if there was a danger of hitting the zero bound, but he doesn’t mention that here. In my view there are many alternatives that we’d need to run through before considering helicopter drops, such as a higher inflation target, or price level targeting, or better yet NGDPLT. I’d also want to go beyond T-bond purchases, to the purchase of other assets. Thus creation of a sovereign wealth fund would be far superior to helicopter drops.
For some reason Bernanke doesn’t consider those alternatives, perhaps because he doesn’t think they would be needed:
In this post, I consider the merits of helicopter money as a (presumably last-resort) strategy for policymakers. I make two points. First, in theory at least, helicopter money could prove a valuable tool. In particular, it has the attractive feature that it should work even when more conventional monetary policies are ineffective and the initial level of government debt is high. However, second, as a practical matter, the use of helicopter money would involve some difficult issues of implementation. These include (1) the need to integrate the approach with standard monetary policy frameworks and (2) the challenge of achieving the necessary coordination between fiscal and monetary policymakers, without compromising central bank independence or long-run fiscal discipline. I propose some tentative solutions for these problems.
To be clear, the probability of so-called helicopter money being used in the United States in the foreseeable future seems extremely low. (emphasis added)
Almost everyone agrees that the US is likely to hit the zero bound in the next recession. So obviously Bernanke doesn’t think being at the zero bound, in and of itself, calls for helicopter drops. But then what would be the trigger? On that issue he’s a bit vague.
Suppose we assume that “extremely low” means “1% chance”. My response would be that we could lower than number to something closer to one in a million by adopting a different policy target, and giving the Fed the responsibility to “buy whatever it takes” to keep as close to the target as possible. Then helicopter drops could be used as a fallback to make the “Chuck Norris effect” credible, without ever actually having to use the policy.
To his credit, Bernanke sees the problems with the helicopter drop theory—it doesn’t really solve any fundamental problem. Even a helicopter drop may not be effective if the money supply increase is not viewed as permanent. This causes Bernanke to suggest exotic extensions of the traditional helicopter drop:
As I’ve stressed, MFFPs [money financed fiscal policies] differ from ordinary fiscal programs by being money-financed rather than debt-financed. In my illustrative fiscal program, government spending and tax cuts are paid for by the creation of $100 billion in new money. To have its full effect, the increase in the money supply must be perceived as permanent by the public.
In practice, however, most central banks do not make monetary policy by choosing a fixed amount of money in circulation. Instead they set a target for a short-term interest rate (in the U.S., the federal funds rate) and allow the money supply to adjust as necessary to be consistent with that target. The rationale for this approach is that the relationship between interest rates and the economy appears more stable and predictable than that between the money supply and the economy. If central banks target interest rates rather than the money supply itself, than it’s not immediately obvious how the idea of a “permanent increase in the money supply” can be made operational.
One possible solution for that problem is that the central bank, rather than making an explicit promise about the money supply, could temporarily raise its target for inflation—equivalently, it could increase its target for the price level at each future date. Since the price level and the money supply tend to be proportional in the longer run, aiming for a higher price level could approximate the effects of committing to a higher money supply. A shortcoming of this approach is that it obscures the fact that the fiscal package is being financed by money creation rather than by new debt—a distinction that, again, the public must appreciate if the MFFP is to be fully effective.
This is not just a theoretical possibility. We know that helicopter drops failed in Japan, because the monetary injections were viewed as temporary. Bernanke correctly notes that shifting to a level target for prices can overcome this problem. But then level targeting also overcomes the main weakness of QE. Thus if we do what Bernanke suggests, we don’t even need the fiscal component.
The methods that central banks use to meet their interest-rate targets pose further complications. Before the financial crisis, the Fed continuously varied the amount of money in the system (more precisely, the quantity of bank reserves) to keep the funds rate near the desired level. In the years since the crisis, however, several rounds of quantitative easing have resulted in very high levels of bank reserves, to the extent that the traditional method of making marginal changes to the supply of reserves is no longer effective in controlling the federal funds rate. Instead, following practices similar to those of other major central banks, the Fed currently influences the funds rate by varying the interest rate it pays on bank reserves and on other short-term investments at the Fed. [8]
As my former Fed colleague Narayana Kocherlakota has pointed out, the fact that the Fed (and other central banks) routinely pay interest on reserves has implications for the implementation and potential effectiveness of helicopter money. A key presumption of MFFPs is that the financing of fiscal programs through money creation implies lower future tax burdens than financing through debt issuance. In the longer run and in more-normal circumstances, this is certainly true: The cost to the Treasury of spending increases or tax cuts – and thus the future tax burden – will be lower if the Fed provides the financing. In particular, when the Fed’s balance sheet has shrunk and reserves are scarce again, the Fed will be able to manage short-term rates without paying interest on reserves (as it did traditionally), or in any event by paying a lower rate on reserves than the Treasury must pay on government debt. In the near term, however, money creation would not reduce the government’s financing costs appreciably, since the interest rate the Fed pays on bank reserves is close to the rate on Treasury bills.
Both interest-rate targeting and the payment of interest on reserves make it more difficult to achieve and communicate the cost savings associated with money financing. Here is a possible solution. Suppose, continuing our example, that the Fed creates $100 billion in new money to finance the Congress’s fiscal programs. As the Treasury spends the money, it flows into the banking system, resulting in $100 billion in new bank reserves. On current arrangements, the Fed would have to pay interest on those new reserves; the increase in the Fed’s payments would be $100 billion times the interest rate on bank reserves paid by the Fed (IOR). As Kocherlakota pointed out, if IOR is close to the rate on Treasury bills, there would be little or no immediate cost saving associated with money creation, relative to debt issuance.
However, let’s imagine that, when the MFFP is announced, the Fed also levies a new, permanent charge on banks—not based on reserves held, but on something else, like total liabilities—sufficient to reclaim the extra interest payments associated with the extra $100 billion in reserves. In other words, the increase in interest paid by the Fed, $100 billion * IOR, is just offset by the new levy, leaving net payments to banks unchanged. (The aggregate levy would remain at $100 billion * IOR in subsequent periods, adjusting with changes in IOR.) Although the net income of banks would be unchanged, this device would make explicit and immediate the cheaper financing of the fiscal program associated with money creation.
Or we could just raise the inflation target to 3%.
Or even keep it at 2% and do level targeting. Or NGDPLT. All these epicycles to make helicopter drops work make me dizzy. The simple truth is that monetary policy is all we need if used intelligently, and if not used intelligently (as in Japan pre-2013), even helicopter drops won’t get the job done. So let’s K.I.S.S., and work out fallbacks that don’t require wildly unrealistic assumptions about cooperation between the Fed and GOP-controlled Congresses. Instead let’s simply shift the target slightly (4% NGDPLT anyone?), and perhaps add to the securities that the Fed is eligible to buy.
I am more sympathetic to Olivier Blanchard’s view of helicopter drops:
One thing he is not worried about is running out of monetary ammunition. “There is an argument that QE actually becomes more effective, the more you use it,” he said.
As a central bank buys more bonds, the more it has to pay to convince the last hold-outs to sell their holdings. “The effect on the price plausibly becomes stronger and stronger,” he said.
Prof Blanchard said the authorities should stick to plain vanilla QE rather than experimenting with “exotic stuff”.
He waved aside talk of ‘helicopter money’ with contempt, calling it nothing more than a fiscal expansion by other means. It makes little difference whether spending is paid for with money or bonds when interest rates are zero.
Blanchard favors a 4% inflation target, so that central banks would not hit the zero bound. Again, K.I.S.S.
HT: Benn Steil, James Alexander, et al.