Are Helicopter Drops A Fiscal Operation?

| About: ProShares Inflation (RINF)

This is meant to be a quick note on what I think is a common misconception about helicopter drops. I am not advocating that the Federal Reserve or any other central bank undertake the actions I am going to describe nor do I care about whether it is legal for the Federal Reserve or any other central bank. All I am concerned with is helicopter drops on a theoretical level. With that being said, let me get to what I believe is a misconception.

First, some context. Typically, when the Federal Reserve wants to increase the money supply, they buy assets on the open market in exchange for bank reserves. These are called open market operations. One potential problem is that the Federal Reserve is typically purchasing short-term government debt. When short term nominal interest rates are near the zero lower bound, many believe that open market operations are impotent since the central bank is exchanging one asset that does not bear interest for another asset that does not bear interest. Banks are indifferent between the two. The exchange has no meaningful effect on economic activity.

Given this problem, some have advocated a "helicopter drop" of money. Typically, they don't mean an actual helicopter flies overhead dropping currency from the sky. What they are referring to is something like the following. Suppose that the U.S. Treasury sends a check to everyone in the United States for $100 and issues bonds to pay for it. The Federal Reserve then buys all of these bonds and holds them to maturity. This is effectively a money-financed tax rebate. Thus, it resembles a helicopter drop because everyone gets $100, which was paid for by an expansion of the money supply. However, many people are quick to point out that this is actually a fiscal operation. The U.S. government is giving everyone a check and the Federal Reserve is simply monetizing the debt.

But are helicopter drops really a fiscal operation? Certainly if we think about helicopter drops as I have described them above, it is correct to note that such action requires monetary-fiscal cooperation. However, let's consider an alternative scenario.

The Federal Reserve has a balance sheet just like any other bank. The Fed classifies things on their balance sheet into 3 categories:

  1. Assets. Assets include loans to banks, securities held, foreign currency, gold certificates, SDRs, etc.
  2. Liabilities. Liabilities include currency in circulation, bank reserves, repurchase agreements, etc.
  3. Capital.

The balance sheet constraint is given as

Assets = Liabilities + Capital

Let's consider how things change on the balance sheet. Suppose that the Fed took large losses on the Maiden Lane securities purchased during the financial crisis. What would happen? Well, the value of the Fed's assets would decline. However, the liabilities owed by the Fed would not change. Thus, for the balance sheet to remain in balance, the value of the Fed's capital would have to decline.

So imagine the following scenario. We all wake up one morning to discover that actual helicopters are lifting off from the rooftops of regional Federal Reserve banks. The helicopters fly through each region dropping currency from the sky. People walk out of their homes and businesses and see money raining down upon them. They quickly scoop up the money and shovel it into their pockets. It is a literal helicopter drop of money!

But how can this be? How could the central bank do such a thing?

If the central bank were to do such a thing, think about what would happen to its balance sheet. Currency in circulation increases thereby increasing Fed liabilities. However, asset values are still the same. So capital declines. (The latest Fed balance sheet suggests that the Fed has $10 billion in surplus capital. This would decline dollar-for-dollar with the increase in the supply of currency.)

What this implies is that a central bank could (in theory) conduct a helicopter drop by effectively reducing its net worth. In the future, the Federal Reserve could restore its capital by reinvesting its earnings into new assets. Thus, the helicopter drop is a form of direct transfer to the public that is paid for by the Fed's future earnings.

[Now, some of you might be saying, "Ah ha! If the Fed is retaining earnings these are earnings that would have otherwise gone to the Treasury and so it is still a fiscal operation." I would argue that (a) this is semantics, and (b) there is no reason to believe this is true. The Fed, for example, could simply have used those earnings to furnish new offices at the Board and all of the regional banks - in that case it would be a transfer of wealth from the staff to the general public.]