Helicopter drops would work, but “helicopter drops” might well fail

Steve Waldman has a post discussing the problems involved in making monetary stimulus effective.  He ends up by claiming that “helicopter drops” would certainly work, but the Fed isn’t authorized to do them:

To the degree that our problem is on the demand-side and stems from private-debt-overhang-induced risk aversion or a desire to hoard money, we know the solution. That problem, if it exists, will go away if we give everyone money. But giving everyone money is not conventional, authorized, monetary policy. It requires new law.

In macroeconomics the term “helicopter drop” refers to combined fiscal and monetary stimulus, essentially have the Fed print money to finance a budget deficit.  In recent years the phrase “print money” has become slightly misleading, as the Fed has turned bank reserves into interest-bearing debt.  But with or without interest on reserves, a “helicopter drop” is not a foolproof escape from a liquidity trap.  To see why, consider why conventional monetary policy is often ineffective.

In the early 2000s the BOJ printed lots of money, and the Japanese government issued lots of debt.  That should have been inflationary, if helicopter drops really worked.  But it wasn’t, because the BOJ also hinted that they’d eventually pull the money back out of circulation, to prevent prices from rising.  And in 2006 they did just that, and prices didn’t rise.

Many people assume this “expectations trap” (popularized by Krugman) applies only to conventional monetary stimulus.  Actually, it also applies to a combined fiscal and monetary stimulus, as we saw in Japan.  Temporary monetary stimulus won’t be effective.  It won’t work if rates are zero.  It won’t work if rates are positive.  It won’t work if combined with fiscal stimulus.  It simply won’t work, if temporary.

The Fed has also promised their monetary injections will be temporary, and hence they haven’t worked, just as in Japan.  You might argue “what else could they do, if they promised the tripling of the base was permanent, we could end up with hyperinflation.”  Yes, they can’t say it’s all permanent, but they could tell us how much.  But Steve Waldman says they won’t do that.  In that case there is no reason to expect any stimulus from more money, helicopter drop or not.

And yet, the market reaction to hints of QE2 suggests that open market purchases can be successful, even at the zero bound.  The most likely explanation is that the markets weren’t reacting so much to the action itself, but rather to the implied signal it sent about Fed determination to prevent deflation.  And the Fed action succeeded (so far) in preventing Japanese-style deflation.

And now for the perplexing title of this post.  When I put “helicopter drop” in quotation marks, I mean money financed deficits.  When I don’t use quotation marks, I mean real cash and real helicopters.  An elite macroeconomist would tell you it makes no difference, and in a purely technical sense that’s true.  But in terms of expectations it makes all the difference in the world.  An actual helicopter drop, Ben flying across America dumping hundred dollar bills out of a helicopter, would almost certainly raise inflation expectations sharply.  Especially if he dressed up like Peter Pan and kept announcing through a megaphone “if you believe you can inflate.”  The imagery would be powerful and evocative.  Indeed so much so that it would probably require only a tiny amount of actual $100 bills–just make sure the news cameras were there.  Better yet, do it over minority neighborhoods, to triggers subliminal concerns among Fox News viewers.

Of course all this would be crazy, and I am not advocating it.  But these thought experiments illustrate that we’d be much better off if the Fed simply told us where it wanted to go, and how it was going to get us there.  I get frustrated when Waldman says the only reasonable policy is a non-starter, because it’s not what the Fed wants to do:

The Fed is not going to target NGDP or a price level path over any relevant time frame without a change in governance structure or mandate. People on the left and right and especially the technocratic center who like to see the Fed as a loophole through a dysfunctional Congress are kidding themselves. The Fed is a political creature, not some haven for philosopher-economists in togas who will openly consider your ideas. Get over it and get your hands dirty.

Look, we’ve already established that what the Fed “wants to do” won’t work, it will fail.  It’s our job as pundits to suggest policies that actually will work.  If our society is suicidal then there’s nothing we pundits can do about it.  If we are told that every single suggestion that will work is politically unacceptable, there is nothing we can do about it.  Except keep trying to educate people.

Now I have to go iron my toga for a party tomorrow night.

Helicopter drops are a really, really, really, really bad idea

So I had the following dream last night:

Me:  Honey, I decided not to teach summer classes this year.

Honey:  Oh Scott, you’ll just spend the time out on the golf course

(I grab a shotgun and shoot off one of my feet)

Honey:  Why did you do that?

Me:  To convince you that I won’t go golfing this summer.

Honey:  Um, you could have just promised not to go golfing.

Me:  But I thought you won’t believe me.

Honey:  But you never even tried to convince me. I might have believed you.

Me:  Oh.

Honey:  I never realized how weird you are.

(Just then my friend Paul walks in to the room)

Paul:  You’re not going to believe him are you?  He could put on a peg-leg and hobble around the golf course.

Honey:  And your friends are even weirder than you are.

If your brain is as twisted as mine, you see the obvious connection to helicopter drops of cash.  To me, there is a sort of surreal quality to discussions of liquidity traps.  The discussion starts with the premise that it is hard to expand aggregate demand when nominal rates are close to zero.  (Which is false.)  Then there is a discussion of all sorts of crackpot schemes like negative interest rates on $20 bills.  Or dropping cash out of helicopters.  Then the liquidity trap proponents come up with ever more far-fetched reasons why this wouldn’t work.

In fact, these discussions are flawed from the very beginning, as they assume there is some sort of “trap” that prevents central banks from boosting AD.  Central banks operating under floating exchange rate fiat regimes can always increase AD if they want to; in all of recorded history there are no failures.  But people think otherwise because they see central banks do things that look expansionary when rates hit zero, and in many cases AD does not increase.

Krugman’s right that a helicopter drop is not necessarily inflationary.  Suppose the government dropped 50 $100 bills for every US citizen out of an airplane.  If the public expected the government to institute a $5,000 per capita tax in the very near future, and retire all that cash from circulation, it would have no effect.  But of course that would be a really, really stupid thing to do.  Taxes have deadweight losses, so the net effect of the money drop plus tax would be simply the destruction of wealth, that is all.  It would be like me shooting off my foot to convince my wife that I wouldn’t play golf, but then putting on a peg leg and going out golfing anyway.  Sure that’s theoretically possible, but why would I do it?  If the government behaves like a bunch of reckless lunatics hell-bent on hyperinflation, it is a good bet that they are a bunch of reckless lunatics hell-bent on hyperinflation.

[You might argue that fiscal authorities do nutty things like this.  Yes, but they don’t have the alternative of using the printing press.]

So I think a big helicopter cash drop would almost certainly boost AD.  But it would still be a terrible idea.  Here’s why.  If the Fed did this without an explicit inflation or NGDP target, then it would likely result in hyperinflation.  The public would be frightened, and I can’t say I’d blame them.  But if the Fed did accompany the drop with an explicit price level target, then the optimal helicopter drop would be less than zero.  Indeed if the Fed committed to say 4% inflation, the public would not want to hold even the current $2 trillion in base money (unless they were paid to do so with an interest on reserve program.)  So to summarize:

1.  Helicopter drops might not work, but almost certainly would.

2.  Helicopter drops are a really stupid idea, especially if the central bank did not first try to inflate using traditional tools.  There are numerous recent statements by Fed officials to the effect that they have the tools they need, it’s just that they don’t think the economy needs more AD.  Why pull the nuclear option without first doing something simple, LIKE SAYING YOU’D LIKE TO HAVE HIGHER INFLATION?

3.  The helicopter drop might result in hyperinflation, which would be worse than what we have now.

4.  Even if an explicit 4% inflation target prevented hyperinflation expectations, the Fed would probably have to reduce the base to hit the target.  I.e., no helicopter drop.

Just to be clear, it isn’t just a really silly idea for the real world because it might overshoot to hyperinflation.  It is really bad to even discuss it as a hypothetical, because it feeds into the view that the Fed, ECB, and BOJ want faster inflation, but just don’t know how to get it.  And that’s false.  They don’t want faster inflation, and they know perfectly well how to get it if they change their minds.

PS.  I agree with Tyler Cowen’s take on this issue.  My only problem with his analysis is that he shows too much respect to the idea itself, and the hypothesis that a helicopter drop might not boost inflation expectations.  Cowen’s right, but as soon as you start trying to defend these ideas in a serious way, you play right into the hands of sort of people who think it is sensible to consider a scenario where someone shoots off their foot with a shotgun, and then installs a peg-leg so they can play golf.

When the day arrives where the BOJ says they want 2% inflation but can’t achieve it, come back to me and we can start talking about shooting off feet with shotguns.  Until then I see no point in having this conversation.  It’s like arguing with 9/11 conspiracy nuts.

And I hate golf.

PPS.  After I wrote this it occurred to me that people might think I was talking about the “drop” of commercial bank deposits at the Fed.  It’s cash to the public I have in mind.  Reserves are too esoteric, and too much like T-bills these days—so they might not affect inflation expectations very much.  I am talking about actual helicopter drops, not tax cuts/open market purchases.