Quantitative Easing and Helicopter Money

The US Federal Reserve Bank is to end its programme of quantitative easing (QE). QE was introduced by former chairman Bernanke as a response to the financial crash starting in 2008 (or 2007, or whenever). A colleague asked me a few years ago if I understood QE.

I didn’t. Now I (am under the illusion that I think I) do.

I am prompted to write about it because last week I came across a startlingly readable book by British-educated economist Roger E. A. Farmer, who is at UCLA and still advises the Bank of England as well as various branches of the U.S. Federal Reserve. He won the inaugural 2013 Allais prize, with coauthors Carine Nourry and Alain Venditti of the Université Aix-Marseilles for a paper on why financial markets don’t work well in the real world. Maurice Allais won the 1988 Nobel Memorial Prize, and is most well known for his paradox. He was at the Ecole des Mines in Paris, whence in an earlier era the great mathematician Henri Poincaré entered on his program to synchronise the world’s clocks (Peter Galison, Einstein’s Clocks, Poincaré’s Maps, W. W. Norton, 2003).

Where was I? Roger E. A. Farmer, How the Economy Works, Oxford University Press, 2014.

The point of QE is as follows. Central banks such as the Fed and BoE traditionally attempt to regulate the rate of inflation in the economy by buying three-month government bonds in the market. The price they are prepared to pay says what they intend overall prices to do in the next three months. But suppose the interest rate, as given by government bonds, is 0, or very close to 0 . Who’d care about selling bonds to the Fed or BoE? It takes somebody some work (keys have to be pushed on computer terminals and so on) for no gain at all.

So maybe there’s something else to be bought which could influence economic activity? Say, long-term government bonds, and commercial paper. The centrals buy it from banks which hold it. That’s QE. Commercial paper is short-term bonds issued by companies rather than government. Now, the central bank doesn’t actually have to cash in that paper, and neither did the banks which previously held it. But if your paper is held by the BoE rather than, say, Lehmann Brothers, you as a company have a little more security that no one is going to come after your money soon. In other words, your loan has become a retrospective government grant. And the banks which held all those long-term bonds get to cash them out right away – long-term has become short-term. (They could always do that on the markets, but on worse terms; the central bank is working by fiat.)

So, obviously, under QE more cash gets injected into the economy. It’s called “liquidity” (liquidity is stuff which can be moved around the economy quickly. Like cash. People judge the health of economies by the “velocity of money” and it’s publicly measured by, for example, the St. Louis Fed). There was a big discussion whether the 2008 crisis was caused by illiquidity or insolvency. Michael Lewis proposed a third possible factor: greed. This was so obviously right that nobody argued. (Greed, BTW, is not a concept that you find in most economics textbooks. Adam Smith is said to have shown that “greed is good” and it thereafter disappeared from the vocabulary of “serious” economics, or so Wall Street would have us believe. Not all of us agree with that, especially after 2008.) Anyway, this placates the illiquidity proponents, leaving the legal system and courts free to deal with the insolvency bit (um, did that happen? Oh, I forgot: “too big to fail”. That’s all right then).

The big idea is that “the people who know where the money should go”, namely the banks which sold their paper and long-term bonds to the central bank, are then giving it away to those who need it for good purpose. Say, British manufacturers. So British manufacturing should have been on the up and up. Well, it’s a bit up, I understand. So who did go on the up and up? The London housing market in particular and the British housing market in general. Well, duh, isn’t that where we came in?

There is a short article in The Guardian today by one of their economics commentators, Larry Elliot. Elliot compares QE with a mooted alternative, “helicopter money”. That’s Milton Friedman’s idea that you could fly helicopters over the country and drop money from them. Or, more soberly, as Farmer says (I think it’s somewhere in his book), the central bank writes a check for £2,700 to every man, woman, androgyne and child in the country. The idea is they go spend it where they want and thereby demonstrate true demand, which has been thwarted or at least distorted by the crisis. As we might guess, everyone will go out and buy undersea cables, high-performance aircraft engines, and the occasional bit of railway signalling and new track, won’t they? It would be just toooo Victorian to imagine it’ll go on drugs, sex and booze, but if it does, the British government might not be quite so furious at the consequences of sex and drugs now being included in the national accounts.

Actually, provided that Vodaphone can in the future find a way around charging people £15,000 for an evening’s phone “usage”, it might well be spent on telecommunications and digital entertainment, that is, demand-attentive networks and the iTunes store. Yes, those phones and tablets are made elsewhere, and (not-)taxed in Ireland, but they all use ARM chip designs from Cambridge. So the British public wins: sex, drugs AND rock n’ roll, all now in the national accounts!

You see, I do understand QE. Don’t I? I suppose you’re thinking “he’s being silly”. But go a little further. If you suppose “he’s being silly, but come to think of it nobody can really do much better”, I could imagine you have thereby deemed me An Economist!

One thought on “Quantitative Easing and Helicopter Money

  1. I’m not convinced you understand QE yet.

    The redemption yield on Government bonds is inversely correlated with their price, because they are redeemed at par. The running yield is also inversely correlated with the price you pay for the bond (because the income is fixed).

    There will always be a price at which banks will sell their holding of bonds. If you bid to buy at a price higher than the price they will have to pay to replace the bonds, they can just make a quick profit.

    In my opinion, that’s what QE was about. The banks needed recapitalisation. Increasing banks’ profits gave them capital. QE was a way of giving banks extra profit that was more politically acceptable than just printing money and giving it to the banks. (Unfortunately, bankers took credit for generating this profit and took increased bonuses).

    Of course, it also had the effect of reducing interest rates, because if you buy at higher than market prices your demand pulls up the prices and the yield falls. (See above). So anyone who needs yield has to buy assets other than Government bonds. This leads to rising demand for other asset classes such as property, and therefore to price increases. So the rich (who own more assets than the poor, by definition) see their assets increase in value, widening inequality. And the rich, though feeling even richer, don’t increase their spending by anything like the amount of new money created.

    If, alternatively, you give money to people who are poor, they buy food and clothes and take out fewer payday loans and pay the rent and pay off some debts and (over all) spend more of their extra income than the rich would. This stimulates the economy, leads to growth, feeds through to more employment, higher tax revenues, and a reduced fiscal deficit.

    That’s what I understand to be the reason why Keynes proposed dropping banknotes from helicopters. (Not really – it was his metaphor).

    I’m surprised if Milton Friedman also proposed this. As a monetarist he would expect it to create inflation. But maybe he did; if so, please post a primary source reference.

    Anyway. If you understand QE, tell me this: is there a reason why the BoE should not just destroy the gilts it has bought? It is already returning to the Treasury the interest that the Government pays on these bonds. If it continues to hold them, what will it do with them in the future? Sell them in the market to push up interest rates and to reduce the Government’s ability to borrow?

    This story is not over yet.

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