Saturday, February 9, 2013

Helicopter Drops

Carney apparently mentioned "helicopter drops," in his testimony before the British Parliament and Wren-Lewis commented.

Wren-Lewis argued that a "helicopter drop" of money combines fiscal policy--a tax cut funded by government borrowing--along with a conventional open market operation--a central bank purchasing government bonds with newly-created base money.     In this scenario, the net effect is that the given level of government spending is funded by money creation rather than taxes and the private sector pays lower taxes and ends up with more base money in its possession.

I find this a useful framing as well.   For economists like Wren-Lewis, generally focused on interest rate targeting, if the central bank holds its policy interest rate constant, then a debt-financed tax cut will have automatically have this effect.   The government funds its spending by selling additional debt, which puts downward pressure in bond prices and upward pressure on short and safe interest rates.  To prevent those interest rates from rising, the central bank's open market trading desk purchases government bonds, creating new money.    The net effect is that government as a whole, including the central bank, has funded more government spending with money creation and less with taxation.

Of course, with New Keynesian economics, the policy interest rate is adjusted according to deviations of inflation from target (usually two percent) and deviations of real output from capacity.   Starting from equilibrium, the money financed tax cut would require a higher interest rate to prevent output from rising above capacity or else inflation rising above target.   If the central bank increased interest rates by selling off bonds, then the tax cut would have been financed by bonds after all.  

It would be possible for the central bank to instead raise the interest rate paid on reserve balances to increase market interest rates.    Again, looking at the government as a whole, it is funding government spending by borrowing--by enticing someone to hold larger balances of interest bearing money.   It is only through the lens of central bank financial independence that it would be a central bank borrowing by enticing banks to hold larger reserve balances, in turn lending that money to the government, and then collecting interest payments from the Treasury and paying them out to the banks.   Consolidate it all, and the government is borrowing by enticing banks to lend to it.

If, however, the central bank needs to lower interest rates to keep output from falling below capacity or inflation falling below target, or if a shortfall of demand already exists and the central bank needs to reverse it, but for some reason, the central bank considers the current interest rate already too low, then the "helicopter drop" still suggests interest rates would end up higher than otherwise, but under that circumstance, it rather avoids the need for a further reduction.   

Sadly, it appears that central banks just don't like very low interest rates, perhaps because those earning interest income from short and safe assets have substantial political power.   Still, if interest rates were so low, probably slightly below zero, such that a currency drain would develop, the ability to increase demand by money financed tax cuts, and so without further decreases in short and safe interest rates, becomes important.

Wren-Lewis claims that perhaps from a political perspective, handing out free money to people to expand demand is more acceptable than increasing government debt.   I have my doubts about that.    In fact, with a strong commitment to a nominal anchor, it is really no different.

But Wren-Lewis also suggests that a helicopter drop is related to increasing the target for inflation.   He suggests that if the central bank were to take the bonds it purchased and destroy them, then this would be an increase in the inflation target.   The idea is that because the central bank has not government bonds to sell, it would not be able to reverse course and reduce the quantity of base money at some later time.   The increase in the quantity of money would be permanent, which would eventually result in a higher price level.   Getting to that higher price level would involve higher inflation.

The problem with this argument is that simply throwing out the added government bonds would do little good as long as the central bank continues to hold an ample portfolio of government bonds.   For example, a central bank that starts with base money at $1 trillion and an asset portfolio of $1 trillion worth of government bonds would need to increase base money by more than $1 trillion (along with throwing out the government bonds it purchased) to make any increase in base money permanent in the sense that the central bank would not have enough assets to retire the money.

Surely, a central bank that wanted to guarantee that it would never reduce the quantity of money would need to get rid of all of its assets.   (Oddly enough, Ron Paul proposed that the Fed do exactly that, forgiving the Treasury for all the government bonds it holds and so solving the debt limit for a time.)      Of course, there is still the possibility of paying interest on reserve balances.     Again, from the perspective of the government as a whole, including the central bank, the government would be borrowing money by encouraging people to hold more interest bearing money.

Wren-Lewis does say that he would prefer arguing that there is little need to worry about government debts when there is a recession and that the inflation target should be increased.   Hoping that handing out free money without there being any matching government bonds on the central banks balance should would have the same effect with a different political effect is not his first preference.

However, it seems to me that key problem is inflation targeting.    If the goal is to target a growth rate, then a temporary release from that rule, raising the target inflation rate for a time, looks to be irresponsible.   How can a credible central bank credibly promise to be "irresponsible?"    Money financed tax cuts and destroying the central bank's asset portfolio?

Surely the only responsible solution is to change the target.   However, it is not responsible to change the target to achieve today's discretionary goal.   What is needed is a new target that can be adopted permanently.     That is why a nominal GDP level target is so important.     And further, the commitment to the target should be so strong (in my view, constitutional.)   The notion that "money" should be issued in such a way that its quantity cannot be decreased with the demand to hold it falls, given the target level of nominal GDP (the nominal anchor,) is wrongheaded.

In my view, the political problem faced by new Keynesians like Wren-Lewis (or Paul Krugman) is that handing out money to people to cause higher inflation sounds bad.     Keeping spending on output growing with productive capacity sounds more responsible because it is more responsble.   Nominal GDP targeting is the more responsble alternative to inflation targeting.

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