Scott Sumner  

Open market operations vs. helicopter drops

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Patrick Sullivan directed me to Brad DeLong:

Bernanke (2000):
Contrary to the claims of at least some Japanese central bankers, monetary policy is far from impotent today in Japan...
Why is it not impotent? Because of:
what amounts to an arbitrage argument ---the most convincing type of argument in an economic context.... The monetary authorities can issue as much money as they like. Hence, if the price level were truly independent of money issuance, then the monetary authorities could use the money they create to acquire indefinite quantities of goods and assets. This is manifestly impossible in equilibrium. Therefore money issuance must ultimately raise the price level, even if nominal interest rates are bounded at zero. This is an elementary argument, but... quite corrosive of claims of monetary impotence...
In Bernanke's arbitrage thought experiment the central bank is not just swapping one zero yielding government asset for another. If it were, the argument would not go through: the government could issue an indefinite amount of cash and acquire an indefinite amount of zero-yielding assets as the mirror to a private-sector balance sheet that has an indefinite amount of cash balanced by being short an indefinite amount of government discount bonds value at par, and the price level would not change. What makes the arbitrage argument work is the word goods. The government prints money, and buys roads, bridges, the bearing of duration risk, biomedical research, human capital for twelve-year olds--whatever. This is helicopter money.

But the price level is independent of money issuance if one raise the money supply via open market operations and the marginal dollar of cash is held as a savings vehicle...


DeLong is confusing two unrelated issues. One question is whether the central bank ever runs out of ammunition. The answer is no. The second issue is whether the central bank might ever need assistance from fiscal authorities at the zero bound. Again, the answer is no.

Bernanke is saying that if the BOJ had been serious about monetary stimulus, they could have bought up all of the financial assets in the world. Japan would then essentially own the world, and the Japanese could all retire, living a lavish lifestyle off the sweat of labor in other countries. That's all from just open market purchases with no assistance from the fiscal authorities in Japan.

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For some odd reason, Keynesians have begun defining monetary policy in terms of the purchase of only a single type of asset---T-bills. (Nick Rowe also complains about this.) The purchase of any other asset; long term bonds, corporate bonds, municipal bonds, equities, etc., etc., is regarded as "fiscal policy". But it isn't, it's just another type of financial asset being purchased in open market operations. That's monetary policy.

This is not just a question of semantics. An actual helicopter drop worsens the fiscal authority's consolidated balance sheet. It is deficit spending. It leads to higher (distortionary) taxes in the future. An open market operation has no effect, on average, on the country's fiscal situation. Two assets (money and bonds) are swapped at equilibrium market prices. Yes, the central bank is exposed to a bit more risk, but that's a second order effect.

The inflationary effect of the BOJ buying up the entire world does not come from the BOJ absorbing risk (as Keynesians might tell you), but rather from the fact that the rest of the world does not feel too happy about selling off their entire stock of wealth for some dubious Japanese currency notes, denominated in yen. They would quite rightly smell inflation ahead, and thus the thought experiment would never actually be carried out. The mere intention to do monetary stimulus "à outrance", if necessary, would create any desired inflation rate. And that means that the policy even lacks its one supposed drawback---it does not in fact add risk to the central bank balance sheet. The balance sheet never gets very large (as a share of GDP), in a truly inflation policy regime.

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People seem to miss the entire point of Bernanke's thought experiment. The point is not that central banks must buy up massive quantities of assets at the zero bound. Rather that it is not necessary to buy up lots of assets, if the central bank is truly committed to inflation. If BOJ officials unanimously said, "we will do this if necessary", it would not be necessary.


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COMMENTS (13 to date)
TravisV writes:

Great stuff!

I like the thought experiment of committing to a 4% inflation target for TIP spreads, buying $40 billion of bonds the first week, then buying $80 billion of bonds the second week, then buying $160 billion bonds the third week.....

In that scenario, what would happen first: 4% TIPs spreads or the purchase of $160 billion? Almost certainly the former.

If only Bernanke had used that thought experiment instead! :)

Jose Romeu Robazzi writes:

Prof. Sumner,
From the point of view of investors, this phrase actually says the same thing in two different ways:
"The inflationary effect of the BOJ buying up the entire world does not come from the BOJ absorbing risk, but rather from the fact that the rest of the world does not feel too happy about selling off their entire stock of wealth for some dubious Japanese currency notes, denominated in yen."

While the currency is deemed riskless and demand for currency is up, market participantes may well sell some of their wealth to the monetary authority. At some point , after some QE, the risk of holding a certain basket of risky assets will equate that of holding a potentailly devaluing currency. Although a lot of what is going on depend on expectations on NGDP growth, if demand for riskless assets (currency) has gone up, at least som QE will have to happen before expectations on the nominal growth change again.

In other words, unloading risky assets to the CB is no different an action than unloading a devaluing currency back to the CB, repurchasing in this case a basket of not so risky assets...

Mike Sproul writes:

"The government prints money, and buys roads, bridges, the bearing of duration risk, biomedical research, human capital for twelve-year olds--whatever. This is helicopter money."

There's DeLong's mistake. True helicopter money is given away, not used to acquire new assets. If the Fed prints $100 and buys $100 worth of bonds or farmland, then the Fed's assets rise in step with its issue of money, and the Fed is fully capable of using its new assets to buy back the $100 it issued. But if the $100 is dropped out of a helicopter, the Fed gains no assets, its net worth drops $100, and the Fed no longer has enough assets to buy back the money it has issued (assuming it does not have a big cushions of other assets).

bill writes:

I guess that either (a) Bernanke chickened out once he was in charge or (b) he was not able to convince the other Fed members. I'm still very frustrated that they neutered the QE that they did do by paying IOR.

Market Fiscalist writes:

I'm not sure I agree with "An actual helicopter drop worsens the fiscal authority's consolidated balance sheet. It is deficit spending. It leads to higher (distortionary) taxes in the future. An open market operation has no effect, on average, on the country's fiscal situation.".

With govt-issued money all increases in the money supply must in the long term be funded by deficits. This is easy to see if the govt funds part of its deficit with newly printed money (or the CB buys bonds back after the govt has sold them). But its also true if the CB increases the money supply by buying private assets - in the long term these will bring in interest revenue that will be passed onto the govt and allow it to spend more or tax less than otherwise.

Therefor "It leads to higher (distortionary) taxes in the future" is not correct IMO. If the authorities wish to withdraw money that was introduced by helicopter drops it will have total control over if it increases taxes a lot in the short term, or it spreads the tax increases over a longer period by bond-policy.

Like wise "An open market operation has no effect, on average, on the country's fiscal situation." is incorrect IMO once the long term flows of interest payments from OMO are factored into future taxation requirements.

Scott Sumner writes:

Travis, I agree.

Jose, You said:

"Although a lot of what is going on depend on expectations on NGDP growth, if demand for riskless assets (currency) has gone up, at least some QE will have to happen before expectations on the nominal growth change again."

I don't agree, and would cite 1933 as a counterexample.

Mike, You said:

"There's DeLong's mistake."

Correction, that was his second mistake. The first one is discussed in this post. But yes, I agree. On the other hand lots of other people use the term 'helicopter drop' for combined fiscal monetary expansion, so he's following in that tradition.

Bill, I think the mistake people made was assuming the Fed wanted a faster recovery. That was true for a brief period, but overall it was not true. There's a reason for the three QEs. The first two were ended, because the Fed was satisfied with the recovery in the economy.

Market, I'm afraid I don't follow your argument.

Will writes:

It seems to me that helicopter money just bypasses the whole reserves/Fed balance sheet part. The Fed just opens an account for the Treasury and gives them "printed" X amount. The Fed can never get those dollars back unless it uses alternative means to shrink the money supply.

Market Fiscalist writes:

Attempt at clearer restatement:

The monetary authorities wish to generate more inflation.

Among the ways they could do this are:
1. Reduce taxation while holding govt spending steady and fund the gap by printing new money.

2. Buy up non-govt assets with new money. These assets pay interest which the CB will give to the govt and over time (holding govt spending steady) taxes will be lower than otherwise

In both 1 and 2 higher inflation is "funded" by lower taxation - option 2 just spreads out the tax cuts over time. You could equally hold taxation steady and adjust govt spending with the same conclusions.

If the monetary b authorities wish to back out of the extra inflation they have the opposite options to above. They can use increased taxation or increased bond sales totally independently of what method they used to increase inflation in the first place.

Monetary policy is just a (very useful) way of spreading out fiscal policy through time !


Sven writes:

Scott, you rightly distinguish monetary and fiscal policy by stating that the latter leads to more taxation in the future. But you wrongly conclude from this, that helicopter drops are fiscal spending, while in truth this is only the case if the government (treasury + central bank) does not want the additional money lead to more inflation!

In reality, the government can always decide if some action involving monetary spending (either from the central bank or from other parts of the government) should be paid for by inflation "tax" or by more "conventional" taxes in the future. A helicopter drop with the willingness to pay for it with an inflation "tax" is therefore not fiscal policy according to your own definition.

Does the above description make any sense?


Thinking further about this, even conventional monetary policy actions like buying very short term government bonds can be classified as fiscal policy instead of monetary policy if the FED is not willing to cause inflation with it. Instead, these purchases of bonds will then be paid for by conventional taxes (because the FED gives smaller seigniorage checks to the treasury).
Note how performing the bond purchases like this (i.e.: with fiscal policy) really leads to redistribution from tax payers to bond holders (i.e.: exactly what some critics wronlgy accuse "real" monetary policy to cause).

Scott Sumner writes:

Market, In option #1, taxes will be lower in the short run but higher in the long run.

Dr. Sumner,

Many writers on this subject conflat a Helicopter Drop with a conventional Keynesian or Fiscal Stimulus. The latter is an effort of extended length of increased spending by a central government to increase employment, capital expenditures, and to increase aggregate spending. Dr. Keynes argued that such a project should be funded by tax reductions and deficit spending. This is a task enacted by a legislature and carried out by an executive office. A central banks role is this at best minimal being to ensure that there is sufficient money to

A Helicopter Drop is not this at all. The concept of the Helicopter Drop was developed by Dr. Milton Friedman in 1969 in his paper "The Optimum Quantity of Money".

In this paper Dr. Friedman constructs and artificial community of whose numbers do not change as they are both immortal and sterile. Similarly capital is immortal is it never wears out and requires no maintenance. Neither physical nor financial capital can be bought or sold, lending and borrowing is prohibited. Further money is all paper and the volume of that money is fixed at 1,000 separate dollar bills. Only goods and services may be purchased with these 1,000 dollar bills.

Using the Fisher Equation; MV = Py where M is the money supply, V was the velocity at which money changes hands, P was the average price of goods and services, and y was the total quantity of goods and services, Dr. Friedman has set M and y as constant. While P and V are not legally fixed, given the theoretical constraints, neither would ever change.

Dr. Friedman then conducts a thought experiment, he writes:

"Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community. Let us suppose further that everyone is convinced that this is a unique event which will never be repeated.”

"Under those circumstances, it is clear that the price level is determined by how much money there is—how many pieces of paper of various denominations. If the quantity of money had settled at half the assumed level, every dollar price would be halved; at double the assumed level, every price would be doubled."

"Hence, the final equilibrium will be a nominal income [that has doubled] ... with precisely the same flow of real goods and services as before."

"The additional pieces of paper do not alter the basic conditions of the community. They make no additional productive capacity available. ..."

Expressed mathematically, in this world, if M doubles, P doubles but capital remains fixed. The point is that in Dr. Friedman's thought experiment, economic growth, capital formation, was impossible. His interest was on the impact of how changes in the quantity of money impact prices.

Dr. Ben Bernanke is commonly associated with the concept of Helicopter Drops since he famously quoted Dr. Friedman on the subject in 2002. He was speaking about how to combat deflation, i.e. how to stimulate inflation. He wrote:

"Each of the policy options I have discussed so far involves the Fed's acting on its own. In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program 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 re-balanced 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."[1]

Like Dr. Friedman, Dr. Bernanke was not focusing on actions which would stimulate economic growth per se but rather how to cause inflation.

When Japan first began to experience deflationary pressures, the Japanese government actually implemented an actual Helicopter Drop. In the spring of 1999 the Japanese government distributed shopping coupons worth 20,000 yen (about 200 dollars) to families with children under the age of 15 and to more than half of the elderly population. In total, 620 billion yen (about 6 billion dollars) worth of coupons were distributed to 31 million people. The coupons had to be spent in the recipient's local community and expired within six months[2]

Of particular note, the Bank of Japan played little or no role in this practical expertise in a Helicopter Drop. The point here is that central banks cannot execute a Helicopter Drop by arbitrarily transferring money into banking accounts of random consumers but must be achieved by governments in a way that will strongly encourage immediate spending. Central banks lack any actual mechanism to conduct a Helicopter Drop, it is, of necessity, a programme to be executed by a government. If you like, central banks do not own helicopters, only government do.

However, with that noted, nothing was built, no one was employed, it was simply a give away of gift cards for people to spend as they saw fit locally and within a short period of time, almost exactly as described by Dr. Friedman 30 years earlier. This programme did not aim at creating economic growth and none was achieved but inflationary pressures were generated.

Suffice it to say, a Helicopter Drop is not a Keynesian Fiscal Stimulus nor can it be Monetary Stimulus executed by a central bank. It is, in it original sense and in the only practical sense, a Helicopter Drop monetary policy conducted by governments instead of central banks.

[1] http://www.federalreserve.gov/boarddocs/Speeches/2002/20021121/default.htm

[2] http://faculty.chicagobooth.edu/chang-tai.hsieh/research/coupon.pdf

[Shortened URLs change to full URLs--Econlib Ed.]

James writes:

What do you mean a central bank can't run out of ammo? If a central bank devalues a currency so much that people resort to currency substitution, then the central bank is effectively out of ammunition. Of course by the time that happens, the central bank will have caused a great deal of misery to the people it is supposed to be helping. I suppose to some that may be acceptable collateral damage in the quest to hit a nominal target.

If the BOJ wanted to buy all the world's financial assets they would have to pay acquisition prices rather than the share price found in normal citcumstances, first converting Yen to the currency that those assets normally trade in. The acquisition premium and FX rates would prevent the ROI from being "lavish."

Market Fiscalist writes:

Scott,

Why would inflation brought about by a money-printing financed tax cut lead to taxes being higher in the long run ? They would only return to the levels before the tax-cuts as far as I can see unless the inflation had to be reversed out.

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