Although I try not to seem overly self-confident or self-satisfied, I do give myself a bit of credit for being willing to admit my mistakes, of which I’ve made my share. So I am going to come straight out and admit it up front: I have not been reading Nick Rowe’s blog lately. Realizing my mistake, I recently looked up his posts for the past few months. Reading one of Nick’s posts is always an educational experience, teaching us how to think about an economic problem in the way that a good – I mean a really good — economist ought to think about the problem. I don’t always agree with Nick, but in trying to figure out whether I agree — and if not, why not — I always find that I have gained some fresh understanding of, or a deeper insight into, the problem than I had before. So in this post, I want to discuss a post that Nick wrote for his blog a couple of months ago on “helicopter money” and the law of reflux. Nick and I have argued about the law of reflux several times (see, e.g., here, here and here, and for those who just can’t get enough here is J. P. Koning’s take on Rowe v. Glasner) and I suspect that we still don’t see eye to eye on whether or under what circumstances the law of reflux has any validity. The key point that I have emphasized is that there is a difference in the way that commercial banks create money and the way that a central bank or a monetary authority creates money. In other words, I think that I hold a position somewhere in between Nick’s skepticism about the law of reflux and Mike Sproul’s unqualified affirmation of the law of reflux. So the truth is that I don’t totally disagree with what Nick writes about helicopter money. But I think it will help me and possibly people who read this post if I can explain where and why I take issue with what Nick has to say on the subject of helicopter money.
Nick begins his discussion with an extreme example in which people have a fixed and unchanging demand for money – one always needs to bear in mind that when economists speak about a demand for money they mean a demand to hold money in their wallets or their bank accounts. People will accept money in excess of their demand to hold money, but if the amount of money that they have in their wallets or in their bank accounts is more than desired, they don’t necessarily take immediate steps to get rid of their excess cash, though they will be more tolerant of excess cash in their bank accounts than in their wallets. So if central bank helicopters start bombarding the population with piles of new cash, those targeted will pick up the cash and put the cash in their wallets or deposit it into their bank accounts, but they won’t just keep the new cash in their wallets or their banks accounts permanently, because they will generally have better options for the superfluous cash than just leaving it in their wallets or their bank accounts. But what else can they do with their excess cash?
Well the usual story is that they spend the cash. But what do they spend it on? And the usual answer is that they buy stuff with the excess cash, causing a little consumption boom that either drives up prices of goods and services, or possibly, if wages and prices are “sticky,” causes total output to increase (at least temporarily unless the story starts from an initial condition of unemployed resources). And that’s what Nick seems to be suggesting in this passage.
If the central bank prints more currency, and drops it out of a helicopter, will the people refuse to pick it up, and leave the newly-printed notes lying on the sidewalk?
No. That’s silly. They will pick it up, and spend it. Each individual knows he can get rid of any excess money, even though it is impossible for individuals in the aggregate to get rid of excess money. What is true for each individual is false for the whole. It’s a fallacy of composition to assume otherwise.
But this version of the story is problematic for the same reason that early estimates of the multiplier in Keynesian models were vastly overstated. A one-time helicopter drop of money will be treated by most people as a windfall, not as a permanent increase in their income, so that it will not cause people to increase their spending on stuff except insofar as they expect their permanent income to have increased. So the main response of most people to the helicopter drop will be to make some adjustments in the composition of their balance sheets. People may use the cash to buy other income generating assets (including consumer durables), but they will hardly change their direct expenditures on present consumption.
So what else could people do with excess cash besides buying consumer durables? Well, they could buy real or financial assets (e.g., houses and paintings or bonds) driving up the value of those assets, but it is not clear why the value of those assets, which fundamentally reflect the expected future flows of real services or cash associated with those assets and the rates at which people discount future consumption relative to present consumption, is should be affected by an increase in the amount of cash that people happen to be holding at any particular moment in time. People could also use their cash to pay off debts, but that would just mean that the cash held by debtors would be transferred into the hands of their creditors. So the question what happens to the excess cash, and, if nothing happens to it, how the excess cash comes to be willingly held is not an easy question to answer.
Being the smart economist that he is, Nick understands the problem and he addresses it a few paragraphs below in a broader context in which people can put cash into savings accounts as well as spend it on stuff.
Now let me assume that the central bank also offers savings accounts, as well as issuing currency. Savings accounts may pay interest (at a rate set by the central bank), but cannot be used as a medium of exchange.
Start in equilibrium where the stock of currency is exactly $100 per person. What happens if the central bank prints more currency and drops it out of a helicopter, holding constant the nominal rate of interest it pays on savings accounts?
I know what you are thinking. I know how most economists would be thinking. (At least, I think I do.) “Aha! This time it’s different! Because now people can get rid of the excess currency, by depositing it in their savings accounts at the central bank, so Helicopter Money won’t work.” You are implicitly invoking the Law of Reflux to say that an excess supply of money must return to the bank that issued that money.
And you are thinking wrong. You are making exactly the same fallacy of composition as you would have been making if you said that people would leave the excess currency lying on the sidewalk. “People in aggregate can only get rid of the excess currency by depositing it in their savings accounts (or throwing it away) therefore each individual will get rid of his excess currency by depositing it in his savings account (since it’s better than throwing it away).“
There are 1,001 different ways an individual can get rid of excess currency, and depositing it in his savings account is only one of those 1,001 ways. Why should an individual care if depositing it in his savings account is the only way that works for the aggregate? (If people always thought like that, littering would never be a problem.) And if individuals do spend any portion of their excess currency, so that NGDP rises, and is expected to keep in rising, then the (assumed fixed) nominal interest rate offered on savings accounts at the central bank will start to look less attractive, and people will actually withdraw money from their savings accounts. Not because they want to hold extra currency, but because they plan to spend it.
There are indeed 1,001 ways that people could dispose of their excess cash balances, but how many of those 1,001 ways would be optimal under the assumptions of Nick’s little thought experiment? Not that many, because optimal spending decisions would be dictated by preferences for consumption over time, and there is no reason to assume that optimal spending plans would be significantly changed by the apparent, and not terribly large, wealth windfall associated with the helicopter drops. There could be some increase in purchases of assets like consumer durables, but one would expect that most of the windfall would be used to retire debt or to acquire interest-earning assets like central-bank deposits or their equivalent.
So, to be clear, I am not saying that Nick has it all wrong; I don’t deny that there could be some increase in expenditures on stuff; all I am saying is that in the standard optimizing models that we use, the implied effect on spending from an increase in cash holding seems to be pretty small.
Nick then goes on to bring commercial banks into his story.
The central bank issues currency, and also offers accounts at which central banks can keep “reserves”. People use both central bank currency and commercial bank chequing accounts as their media of exchange; commercial banks use their reserve accounts at the central bank as the medium of exchange they use for transactions between themselves. And the central bank allows commercial banks to swap currency for reserves in either direction, and reserves pay a nominal rate of interest set by the central bank.
My story now (as best as I can tell) matches the (implicit) model in “Helicopter Money: the Illusion of a Free Lunch” by Claudio Borio, Piti Disyatat, and Anna Zabai. (HT Giles Wilkes.) They argue that Helicopter Money will be unwanted and must Reflux to the central bank to be held as central bank reserves, where those reserves pay interest and so are just like (very short-term) government bonds, or savings accounts at the central bank. Their argument rests on a fallacy of composition. Individuals in aggregate can only get rid of unwanted currency that way, but this does not mean that individuals will choose to get rid of unwanted currency that way.
It seems to me that the effect that Nick is relying on is rather weak. If non-interest-bearing helicopter money can be costlessly converted into interest-bearing reserves at the central bank, then commercial banks will compete with each other to induce people with unwanted helicopter money in their pockets to convert the cash into interest-bearing deposits, so that the banks can pocket the interest on reserves. Competition will force the banks to share their interest income with depositors. Again, there may be some increase in spending on stuff associated with the helicopter drops, but it seems unlikely that it would be very large relative to the size of the drop.
It seems to me that the only way to answer the question how an excess supply of cash following a helicopter drop gets eliminated is to use the idea proposed by Earl Thompson over 40 years ago in his seminal, but unpublished, paper “A Reformulation of Macroeconomic Theory” which I have discussed in five posts (here, here, here, here and here) over the past four years. Even as I write this sentence, I feel a certain thrill of discovery in understanding more clearly than I ever have before the profound significance of Earl’s insight. The idea is simply this: in any intertemporal macroeconomic model, the expected rate of inflation, or the expected future price level, has to function, not as a parameter, but as an equilibrating variable. In any intertemporal macromodel, there will be a unique expected rate of inflation, or expected future price level, that is consistent with equilibrium. If actual expected inflation equals the equilibrium expected rate the economy may achieve its equilibrium, if the actual expected rate does not equal the equilibrium expected rate, the economy cannot reach equilibrium.
So if the monetary authority bombards its population with helicopter money, the economy will not reach equilibrium unless the expected rate of inflation of the public equals the rate of inflation (or the future price level) that is consistent with the amount of helicopter money being dropped by the monetary authority. But the fact that the expected rate of inflation is an equilibrating variable tells us nothing – absolutely nothing – about whether there is any economic mechanism whereby the equilibrium expectation of inflation is actually realized. The reason that the equilibrium value of expected inflation tells us nothing about the mechanism by which the equilibrium expected rate of inflation is achieved is that the mechanism does not exist. If it pleases you to say that rational expectations is such a mechanism, you are free to do so, but it should be obvious that the assertion that rational expectations ensures that the the actual expected rate of inflation is the equilibrium expected rate of inflation is nothing more than an exercise in question begging.
And it seem to me that, in explaining why helicopter drops are not nullified by reflux, Nick is implicitly relying on a change in inflation expectations as a reason why putting money into savings accounts will not eliminate the excess supply of cash. But it also seems to me that Nick is just saying that for equilibrium to be restored after a helicopter drop, inflation expectations have to change. Nothing I have said above should be understood to deny the possibility that inflation expectations could change as a result of a helicopter drop. In fact I think there is a strong likelihood that helicopter drops change inflation expectations. The point I am making is that we should be clear about whether we are making a contingent – potentially false — assertion about a causal relationship or making a logically necessary inference from given premises.
Thus, moving away from strictly logical reasoning, Nick makes an appeal to experience to argue that helicopter drops are effective.
We know, empirically, that helicopter money (in moderation of course) does not lead to bizarre consequences. Helicopter money is perfectly normal; central banks do it (almost) all the time. They print currency, the stock of currency grows over time, and since that currency pays no interest this is a profitable business for central banks and the governments that own them.
Ah yes, in the good old days before central banks started paying interest on reserves. After it became costless to hold money, helicopter drops aren’t what they used to be.
The demand for central bank currency seems to rise roughly in proportion to NGDP (the US is maybe an exception, since much is held abroad), so countries with rising NGDP are normally doing helicopter money. And doing helicopter money, just once, does not empirically lead to central banks being forced to set nominal interest rates at zero forever. And it would be utterly bizarre if it did; what else are governments supposed to do with the profits central banks earn from printing paper currency?
Why, of course! Give them to the banks by paying interest on reserves. Nick concludes with this thought.
The lesson we learn from all this is that the Law of Reflux will prevent Helicopter Money from working only if the central bank refuses to let NGDP rise at the same time. Which is like saying that pressing down on the gas pedal won’t work if you press the brake pedal down hard enough so the car can’t accelerate.
I would put it slightly differently. If the central bank engages in helicopter drops while simultaneously proclaiming that its inflation target is below the rate of inflation consistent with its helicopter drops, reflux may prevent helicopter drops from having any effect.