Understanding Helicopter Money

Should a recession ever occur, what tools do central banks have left in their policy repair kits? In the world of negative interest rates and other unconventional tactics, it may appear they are running out of options. Will Milton Friedman’s famous parable of the “helicopter drop of money” be the ultimate “unclear” solution for deflation, the liquidity trap, and prolonged stagnation? Friedman proposed this concept nearly 50 years ago in his now-famous paper, “The Optimum Quantity of Money,” to illustrate how price levels are affected by a sudden change in quantity of money. While Friedman used the hypothetical example to illustrate his point, today “helicopter money” is being discussed as a potential policy option.

Money and Demand

Many experts believe that helicopter money would be effective in fighting deflation and recession, but I think the answer is not so straightforward. In essence, the debate or skepticism is about whether or how a permanent increase in money stock can alter final demand, allowing an economy to achieve equilibrium.

Neoclassical economics believes that a change in the quantity of money can affect final demand only via interest rates. This concept can be understood in the context of aggregate demand, which consists of consumption, investment, net government spending, and net exports. Money does not directly make its way into the demand function. According to this school of thought, the only way that money affects the economy is via interest rates—rising rates encourage more saving and less consumption and investment, and vice versa.

Arthur Cecil Pigou (1877-1959), an English economist, argued that aggregate demand can be affected by a change in the real money balance. Nevertheless, he had a difficult time formalizing the idea, let alone proving it. Importantly, the so-called “Pigou effect” has lacked empirical evidence and thus is generally disregarded.

In today’s world of zero interest rates and outsized central bank balance sheets, what might the helicopter drop of money mean for an economy?

The Experiment

At the onset, we should take note that quantitative easing (QE) programs are already a form of helicopter money. The only difference of the modern version of helicopter money (i.e., quantitative easing programs) from Friedman’s is that a central bank is essentially swapping central bank liability—money—for government liabilities for financial institutions.

In other words, QE programs are equivalent to money being dropped into the banking system with the hope that central bank purchases of government bonds would compress interest rates for businesses and consumers, thus stimulating demand. In doing so, base money will be increased, which should lead to an expanding money stock via credit creation.

Whether or not QE has been successful is highly debatable. It is fair to say that QE has been at least partially effective because it appears that the G7 economies would have been worse without it. Nevertheless, it is also obvious that QE has been much less effective in boosting the propensity to spend and invest, and thus failing to quickly push economic growth to its potential rate.

Importantly, the QE programs implemented to date have been much less effective in halting the deflationary tendencies of the world economy than most people expected (see Chart 1). Now eight years into quantitative easing around the world, aggregate demand remains inadequate in the global economy, trade prices are falling, and money multipliers are still depressed. As a result, high-power money—bank reserves—has failed to create more credit and thus expand the money supply.

Targeting Demand Directly

Milton Friedman’s version of helicopter money targets consumers or businesses directly. No one knows exactly how to do it, but to illustrate the point, we can assume that each household is handed a check of $1000, which can be drawn on either the Federal Reserve (Fed) or U.S. Treasury.

If the check is drawn on the Fed, it means that each household is effectively given a $1000 dollar bill, issued by the Fed. In this case, each household ends up with $1000 more income for that year, and the Fed will carry a bigger balance sheet.

If, however, the check is drawn on the Treasury, the end result is the same for consumers. However, the government will have newly incurred debt that is fully funded by the Fed. Therefore, the government ends up with a larger debt load and the Fed carries a bigger balance sheet.

What consumers do with the newly gained money is not up to the central bank to decide. Whether or not they spend the money depends on how the monetary windfall is delivered to them.

If the windfall is transitory, the increased income will more likely be saved than spent, rendering virtually no impact on nominal gross domestic product (GDP). Even if some of the newly increased income is spent, the boost to spending is a one-off event, and the impact dies down the next year. Therefore, I believe it is almost certain that a one-time helicopter money distribution will not be effective in stimulating nominal demand.

The converse of this argument suggests that only when the helicopter money becomes a permanent, recurring shock can consumers be expected to spend their increased disposable income proportionately to their propensities to spend. In essence, if policymakers indeed make the helicopter money a permanent policy, it is actually no different than a permanent tax cut—both have the effect of increasing disposable income. Therefore, in this sense, the helicopter drop of money will be as effective as a tax cut in stimulating aggregate demand.

It is important to remember that although tax cuts are no doubt good for economic growth and consumption, their impact on aggregate demand is much less than that of fiscal spending because a part of the increased disposable income will always be saved. It is exactly for this reason why the impact of the tax multiplier is always smaller than the spending multiplier on GDP.

The bottom line is that “the helicopter drop of money,” if permanent, is equivalent to a tax cut, and its net impact on aggregate demand will be positive. Nevertheless, don’t overestimate the impact. Simply put, helicopter money has a more subtle effect rather than a nuclear impact, with a potential boost to GDP growth similar to that of the tax multiplier.

The Right Way

The natural conclusion from our analysis is that once interest rates have fallen to zero, monetary policy and fiscal policy will become entangled. They have already, but will become more so when another recession hits. The helicopter drop of money may sound very dramatic, but it turns out to be just a form of tax cut funded by the central bank’s balance sheet or money issuance.

If it essentially has the same impact as a tax cut, why not simply opt for fiscal spending to maximize policy impact on aggregate demand? In fact, fiscal spending may be the only effective way to augment aggregate demand, especially when the next recession arrives. With the private sector’s excessive saving surging, government sector dissaving becomes imperative to avoid sustained price deflation.

Finally, in a liquidity trap where the private sector always saves more than it invests, fiscal deficit will inevitably become a chronic phenomenon as the government tries to prevent nominal contraction. In this type of environment, the policy calculation is that for any given amount of budgetary deficit, public sector spending is more efficient than tax cuts when it comes to stimulating demand.

Nevertheless, monetary policy is ineffective in a traditional sense. Once an economy is caught in a liquidity trap, there is no “nuclear” option that can make a huge, immediate impact as far as monetary policy is concerned. At that point, the only marginal contribution a central bank can do and should do is to underwrite the fiscal deficit—be it caused by spending or tax cuts.