October 16, 2019

In the next two or three years there’s a good chance that something big is going to happen to the economy. In fact, not just big, but also deeply weird.

No, I don’t mean Brexit — after all there’s nothing especially odd about a major economy having its own trade policy and controlling its own borders. What I’m talking about has no precedent: helicopter money.

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What used to be a wild ‘thought experiment’ among economists is now closer to actually happening than ever before. If it does, we, as citizens, need to be prepared — because there are profound implications for the conduct of economic policy and, I’d argue, our entire system of government.

So, here’s what you need to know now before it happens. Let’s start with the most basic question:

What the heck is helicopter money?

Helicopter money is money that a country’s central bank (which in Britain is the Bank of England) creates out of thin air and then gives to the government or directly to citizens in return for… nothing. Though the process of money creation (and distribution) would be done electronically, it’s basically the same thing as printing off bank notes and handing them out.

It’s called helicopter money because the economist Milton Friedman once compared the process to a helicopter dropping banknotes over a crowd of people waiting below. In practice, the distribution would be more orderly. For instance,  a sum of money could be transferred into the bank account of every qualifying recipient; or it could happen indirectly, the money going to the government to fund tax cuts or extra spending. Either way, the purpose is to increase the money supply and stimulate demand in a slowing economy.

Doesn’t this sort of thing cause inflation?

It could, and at various points in history it has — sometimes triggering hyperinflation.

However, central banks, especially in the Eurozone and Japan, are more worried about deflation — a sustained, growth-killing fall in prices. That’s why governments instruct central banks to do what’s necessary to maintain a low, but positive, inflation rate — typically 2%.

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To stop inflation from over-shooting the target, central banks put up interest rates to discourage borrowing and thereby shrink the money supply. This decreases demand for goods and services — and thus lowers prices. However, since the financial crash of the last decade, the big challenge has been to stop inflation from under-shooting the target. There’s been too little demand in the economy, which is why central banks have cut interest rates to encourage borrowing. More money floating around the economy ought to push up prices just enough to hit the inflation target.

But here’s the thing: despite cutting interest rates to record lows, the anticipated inflationary pressures have failed to materialise — in fact, central banks have struggled to produce even the small amount of inflation they need to hit their targets.

With interest rates on the floor, what else can central banks do?

Weirdly, zero isn’t as low as interest rates can go: some countries have experimented with negative interest rates — meaning that it is the lender not the borrower who pays interest on the loan.

You might ask why anyone would lend money on these terms. But for large organisations who manage massive piles of cash, it might be the least worst option if other stores of value are riskier. Think about it as paying someone to look after something valuable for you.

However, there are limits to how far interest rates can go into negative territory. Too far and the economy starts seizing up — as people do what’s necessary to protect their money from evaporating before their very eyes. For instance, they could send it abroad or convert it to illiquid assets like gold. This would defeat the main objective of reducing interest rates, i.e. to increase the money supply.

Therefore, when interest rates really can’t go any lower central banks need a completely different way of expanding the money supply. Which brings us to quantitative easing…

What is quantitative easing?

Quantitative easing, or QE, was first used in the wake of the 2008 financial crisis. Here’s how it works:

The central bank creates money out of nothing. It then uses it to buy up financial assets, mostly government bonds, from financial institutions like banks, pension funds and insurance companies.

This has several effects. Firstly, it provides a big injection of cash into the financial sector. Secondly, all that extra demand means that bond prices go up and the return they need to provide to keep investors interested goes down. Anyone looking for a higher rate of return therefore needs to move their money into other, somewhat riskier ventures. In theory, there ought to be a cascade of lending and investment throughout the economy, thereby stimulating consumption and enterprise.

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When central banks, at the direction of governments, started QE, there were warnings that this would unleash inflation. But, as was the case with slashing interest rates (see above), it didn’t. Even with close to full employment in America, Britain and the privileged parts of the Eurozone, there’s been little sign of the economy overheating — despite all those QE money injections.

In any case, QE can be reversed — or ‘unwound’, to use the jargon. A central bank can sell the assets that they’d previously purchased from the finance sector. The money generated by the asset sales would then be destroyed — remember it was created out of nothing in the first place and the central bank would return it to nothing. This would obviously shrink the money supply back down again and cool any overheating in the economy.

Indeed, this was always the plan: QE was never supposed to be permanent — just a temporary shot in the arm during the trauma of the Great Recession and its aftermath. Once things were back to normal, QE would be unwound and interest rates put back up again.

But there was no return to normal. Ten years after the end of the recession, QE has not been unwound. Interest rates remain on the floor — and deflation, not inflation, remains the main threat. Indeed, with worrying signs of a new economic downturn in Europe, the European Central Bank has recently restarted QE.

If QE doesn’t cause inflation, what’s wrong with doing more of it?

Well, the clue is in the question — QE was meant to cause enough inflation to end the danger of deflation and return the economy to ‘normal’, but in this respect it’s proved to be weak medicine. What’s more, QE has damaging side effects. By pushing up asset values, it widens wealth inequalities between people who own lots of assets (like bonds, shares and property) and those who don’t.

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Hence the argument that the central banks need an alternative to both interest rate cuts and QE, which is where helicopter money comes in.

How does helicopter money differ from QE?

With QE, the central bank creates money and transfers it (via asset purchases) to the financial sector. To have the desired impact, the institutions that make up the financial sector need to lend that money to the rest of the economy, i.e. to individuals, private companies and public sector bodies, who’d use the supply of credit to buy things and make investments.

There’s a number of reasons why this hasn’t worked. Firstly, rather than lend the money out, financial institutions have stockpiled cash and assets. Secondly, individuals, enterprises and governments have been reluctant to borrow and spend — especially those with too much debt already. Thirdly, a lot of the money that has been borrowed has been used to finance the wrong things — like property speculation and keeping failing ‘zombie companies’ alive (thus tying up capital and talent that might be more productively used elsewhere).

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Helicopter money, on the other hand, would by-pass the financial sector and go straight to the ‘real economy’. Furthermore, the recipients would get it without having to go deeper into debt, making it more likely that they’d spend it. Thus, in theory, it would not suffer from the impediments that stopped QE from working.

If it worked too well and sent inflation soaring above the target, central banks would have plenty of tools to calm things back down again. Stopping the helicopter money, unwinding QE and putting up interest rates would all be options.

OK, but nobody serious is serious about this, are they?

Adair Turner, former chief of the Financial Services Authority and the CBI, is an advocate of helicopter money. The economist Frances Coppola wrote a book this year making the case. There’s an argument for it in a recent report from Deutsche Bank. It’s now regularly discussed as a possibility by financial journalists and investors (if not always supportively).

So far, we haven’t had any senior politicians or serving central bankers stick their heads over the parapet, but if (or when) there’s another recession and nothing else is working, the pressure on the decision makers will become intense.

Remember that before QE happened it was seen as a purely theoretical idea — and far too unconventional for monetary policy in the real world. But with the financial crisis at the end of the last decade, the tried-and-tested options were exhausted one-by-one, leaving QE as the next untried option. 

Now, it’s helicopter money that is the next untried option.

What are we waiting for, then?

Helicopter money could be a powerful policy instrument, but it reeks of desperation. Unlike the obscure technicalities of QE, we’d all notice if the state started giving us cash-stuffed envelopes. Suspicions of this free lunch could shake rather than bolster consumer confidence — a counterproductive outcome.

Central banks could make their move less obvious to the public by giving the money to governments to spend on our behalf. Except that would be illegal under Article 123 of the Treaty of the Functioning of the European Union. Britain might be free of this restriction after it leaves the EU, but that probably wouldn’t be the best time to turn on the printing presses. Besides, it is the Eurozone that’s at the greatest risk of deflation, so it’s the European Central Bank that should take the initiative.

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If the ECB found a way around Article 123, helicopter money would still be a political minefield. For instance, if the cash went directly to individuals would all Eurozone citizens get the same amount per head or would it be pegged to average income in each member state?

Once a central bank starts handing out cash to citizens or to governments, the distinction between monetary policy (interest rates, QE, etc.) and fiscal policy (tax, benefits, etc.) becomes blurred. Indeed, the central bank starts to look like a government — which is awkward in a democracy because it isn’t elected. Within the context of the EU and the Eurozone it’s especially awkward, because monetary policy would be seen as a means of integrating fiscal policy by the monetary backdoor.

Any other problems?

According to a post on the Bank of England’s staff blog, issuing helicopter money would make the central bank technically insolvent. That’s because creating money means that those who get it have correspondingly bigger deposits with their banks and the banks, in turn, have correspondingly bigger deposits with the central bank. From the central bank’s point of view these are extra liabilities. In the case of QE, that’s doesn’t matter because in buying up bonds it acquires assets that balance the liabilities. But with helicopter money the central bank acquires new liabilities (an inevitable consequence of money creation) but no new assets — because it doesn’t get anything in return for the money it gives away.

That doesn’t matter if the general bank doesn’t have to pay interest on the deposits it holds. But that implies that interest rates would have to stay at zero forever — meaning the economy would never get back to normal.

Another hazard is that government gets a taste for helicopter money — after all, it’s free! It’s meant to be a one-off emergency measure, and no doubt that’s how it would be sold to a sceptical public. But that’s what they said about QE and yet, rather than being temporary, it’s become a fixture of economic policy. Helicopter money could prove to be equally addictive, if not more so — which would leave the solvency of the entire system dependent on permanently supine interest rates.

What’s wrong with zero interest rates forever?

Ultra-low interest rates are the result of a low growth economy; but, with vicious circularity, they’re also the cause of it. As I’ve argued before, cheap credit destroys enterprise by making banks risk averse and by increasing ‘market concentration’ (i.e. reducing competition) in the real economy.

Ultra-low interest rates are the economic equivalent of empty calories. They feed a bloated, sluggish form of capitalism — to the detriment of risk-taking, innovation, productivity and wage growth.

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Enterprising, inventive, fast-growing economies have no trouble avoiding deflation because with so many opportunities to invest in a brighter, more prosperous future, there’s a constant demand for money. A hunger to commit today’s resources to building tomorrow’s bigger, better economy is a good thing, but of course it pushes up interest rates.

Loaded up with debt, governments have a perverse incentive to suppress investment in genuinely productive economic activity. If, through the use of helicopter money, we load up the central banks with liabilities we’ll only make the problem worse.