Thursday, February 25, 2016

Negative rates and FTPL

I've devoted most of my monetary economics research agenda to the Fiscal Theory of the Price Level in the last two decades (collection here). This theory says, fundamentally, that money has value because the government accepts it for taxes, and inflation is fundamentally a fiscal phenomenon over which central banks' conventional tools -- open market operations trading money for government bonds -- have limited power.

Since I grew up in the 1970s, I figured the FTPL would have its day when inflation unexpectedly broke out, again, and central banks were powerless to stop it. I figured that the spread of interest-paying electronic money would so clearly undermine the foundations of MV=PY that its pleasant stories would be quickly abandoned as no longer relevant.

I may have been  exactly wrong on both points: It seems that uncontrolled disinflation or deflation will be the spark for adoption of FTPL ideas; that the equivalence of money and bonds at zero interest rates,  and central banks powerless to create inflation will be the trigger.

These thoughts are prodded by two pieces in the Economist, "Out of Ammo:" and "Unfamiliar Ways Forward" (HT and interesting discussion by Miles Kimball)

If you want inflation (a big if -- I don't, but let's go with the if) how do you get it? Ultra-low rates, huge bond purchases, and lots of talk (forward guidance, higher inflation targets) seem to have no effect. What can governments actually do?

"Out of ammo" explains
... At least some of them [politicians] have failed to grasp the need to have fiscal and monetary policy operating in concert....
... One such option is to finance public spending (or tax cuts) directly by printing money—known as a “helicopter drop”. Unlike QE, a helicopter drop bypasses banks and financial markets, and puts freshly printed cash straight into people’s pockets. The sheer recklessness of this would, in theory, encourage people to spend the windfall, not save it. 
The "recklessness" part is crucial. "Unfamiliar ways" has a more intricate scheme to communicate that recklessness
..a central bank and its finance ministry ... collude in printing money to pay for public spending (or tax cuts). ...the government announces a tax rebate and issues bonds to finance it, but instead of selling them to private investors swaps them for a deposit with the central bank. The central bank proceeds to cancel the bonds, and the government withdraws the money it has on deposit and gives it to citizens. “Helicopter money” of this sort—named in honour of a parable told by Milton Friedman, a famous economist—is as close as you can get to raining cash from a clear blue sky like manna from heaven, untouched by banks and financial markets.
Such largesse is, in effect, fiscal policy financed by money instead of bonds... But the unaccustomed drama—indeed, the apparent recklessness—of helicopter money could increase the expected inflation rate, encouraging taxpayers to spend rather than save.
Simpler, in my mind, the Treasury borrows and sends checks to voters. The Fed buys the bonds and then cancels them.

In addition to rather convoluted scheme, the pieces are not quite clear why the fiscal counterpart is necessary -- or why money has to be involved with fiscal policy.  That was not a central part of Friedman's helicopters. Miles is clearer about this:
the government give[s] away so much money that people would be convinced there was no way the government could ever sell enough bonds to soak that money up. 
This is clear and good FTPL thinking. The value of money is set by how much there is vs how much people expect the government to soak up via taxes -- or bond sales, backed by credible promises of future taxes.

If the government drops $100 in every voter's pocket but simultaneously announces "austerity" that taxes are going up $100 tomorrow, even helicopter drops would have no effect.

Helicopter drops are a clever fiscal signaling device. Canceling the bonds in the Economists plan is the crucial signaling device. They say "we are really going to be reckless."  When governments sell a lot of bonds, people think  the government is sooner or later going to soak up these bonds with taxes, and do not spend. That's the whole point -- bond sales are set up to raise revenue, not to create inflation.  The whole canceling the bonds thing in the Economists's plan, or the helicopter drama in Friedman's, is a clever psychological device, to convince people that no, the government is not going to raise taxes to soak money or underlying bonds up, so you'd better spend it now before it loses value.

Well if (if) our central banks want inflation, why not get out the helicopters?
Such shenanigans are not possible in the euro zone, where the ECB is forbidden by treaty from buying government bonds directly. Elsewhere they might work as follows: 
monetary financing is prohibited by the treaties underpinning the euro, for example
The US Federal reserve is similarly constrained to always buy something in return for creating money -- it can't send checks to voters.

Why?  The people who set up our monetary systems understood all this very well. Their memories were full of disastrous inflations, and they understood that printing money without clear promises that taxes would eventually soak up that money would lead quickly to inflation. So, yes, central banks are prohibited from doing the one thing that would most quickly produce inflation! For about the same reason that wise parents don't keep the car keys in the liquor cabinet.  (There are also all sorts of good political economy reasons that an independent central bank should not lend to specific businesses or send checks to voters.)

The Economist articles are also quite good at the evidence that current monetary policy is essentially powerless.
If policymakers appear defenceless in the face of a fresh threat to the world economy, it is in part because they have so little to show for their past efforts. The balance-sheets of the rich world’s main central banks have been pumped up to between 20% and 25% of GDP by the successive bouts of QE with which they have injected money into their economies (see chart 1). The Bank of Japan’s assets are a whopping 77% of GDP. Yet inflation has been persistently below the 2% goal that central banks aim for.
The power of open market operations -- buying bonds in return for money - is just dramatically refuted, at least at zero interest rates, by recent experience.
One way to get them back up might be to set a higher inflation target. But when inflation sits so persistently below today’s targets, persuading people that higher targets would produce higher rates will require action, not just words.
Or as I call it, the speak loudly because you have no stick policy. If central banks announce a 5% inflation target, and inflation goes down anyway, now what? Announce a 10% target?

Miles goes on about the power of negative interest rates to stoke inflation, which will be a topic for another day. If negative 2% real rates (2% inflation, 0% interest) didn't stoke "demand" and revive the extinct Phillips curve,  I don't see how negative 3% (2% inflation  -1% interest rate) or negative 5% will finally do the trick. In the standard models I've been playing with,  raising nominal interest rates, and committing to keep them there, is the way for central banks to raise expected inflation. That action would, however, also cool the economy, producing stagflation, and thus be particularly pointless.

I also fully admit that I'm cherry-picking the things I like from the Economist article, and ignoring all sorts of things that seem pretty silly to me. The point: I'm glad to see fiscal-theory thinking making its way out of academic debate into real-world commentary, if only in the "radical ideas" section.  Now, on to the "conventional wisdom" section!


  1. I was disappointed not to see any quantitative arguments in your post. What quantum of helicopter drops would have caused inflation? I suggest that it would have required more than $3 trillion.

    I must show how I arrive at that figure. My argument will also show why central banks' actions have yielded such meagre results.

    It is not an accident that the Great Recession, like the Great Depression, followed a massive asset market crash. In the crash, a huge part of the population lost a substantial part of their net worth. The Survey of Consumer Finances 2010 showed that the median US household lost 18 years of net worth. To recoup that net worth the median household would have had to double its saving rate for 18 years.

    So any additional fiscal spending by the government would have been entirely saved; thus the Keynesian multiplier would have been negative during the course of the recession and not much higher than zero for a long time thereafter. An additional fiscal spending of $1 trillion would have contributed, at an enhanced saving rate of 7.5%, a mere $75 billion to restoring lost net worth. The absolute value of lost net worth must have been more than $3 trillion; this is taking 10 times the annual saving of $300 billion or so just before the crash (a very rough guess, and probably an underestimate).

    To restore the status quo before the crash and cause inflation only a direct helicopter drop of roughly the increase in the Fed's balance sheet would have made any difference.

    My book "Macroeconomics Redefined" has a detailed analysis. To make matters worse the Fed is squeezing at a time of monetary contraction, thus paving the way for the next crash which will likely happen before the end of this year.

    See the graph on

    1. Analysis along one dimension.

      Decreased asset prices are an issue for the owner/seller, but are a net gain for the buyer. If you don't include the wealth effect of those buying at the bottom you skew your results.

    2. What is it with this "great Recession" meme? Seems to me at least little more than an attempt at self importance by economists. We had a huge inventory shock as the US working capital system ground temporarily to a halt. This was fixed by QE1 and if you look at Consumers' expenditure over the period there was barely a blip. Sure unemployment rose to levels not seen since the 1980s (why wasn't that a Great Recession? Sure seemed worse back then) and the pool of available labour jumped sharply by about 8m in 18months, but within 2 years 60% of that had been worked off, and now it all has. More pertinent to your points though, it looks like the wealth effect has been wildly overdone for the average American - influenced perhaps by the fact that most policy makers and those lobbying them are the ones dis-proportionately exposed to asset markets. The Federal Reserve measure of Household net worth showed a sharp drop from $68trn in q3 2007 to $55trn in 2008, but by 2012 it was back above the 2007 level and is now 27% higher. But we know that hasn't reduced savings. Perhaps this is because on their numbers real estate, pension fund reserves and non listed equity add up to around 60% of total assets and are not really marked to market so do not really affect spending behavior. Given that this appears to be the key justification for ongoing QE, this is an important discussion point.

  2. John, helicopter drops are absolutely legal in Eurozone

    1. In the US too. CFR paragraph 91.15

    2. "helicopter drops are absolutely legal in Eurozone"

      A tax cut funded by borrowing is a "helicopter drop".

    3. Absalon
      No it's not. A tax cut funded by borrowing is a transfer.

    4. John,

      "No pilot in command of a civil aircraft may allow any object to be dropped from that aircraft in flight that creates a hazard to persons or property. However, this section does not prohibit the dropping of any object if reasonable precautions are taken to avoid injury or damage to persons or property."

      Too funny!!!

      Presumably this would not be a civilian air craft making the drops and as long as a couple hundred rolls of pennies are not dropped, all will be well.

  3. John, you don't consider the 'constant reserves multiplier' CB transfers cash to households and issues debt immediately to keep reserves constant. All empirical evidence says demand rises. Helicopter drops are not temporary tax cuts.

  4. "Simpler, in my mind, the Treasury borrows and sends checks to voters. The Fed buys the bonds and then cancels them."

    Why is this reckless? The Fed'll still be committing itself to soaking up excess money once inflation rises above 2%. If it doesn't have enough bonds for open market sales--it decided to burn them--than it can just reduce the profits it provides to the Treasury or ask for a capital boost. Reckless to me is the Treasury saying to the Fed: burn your bonds and by the way, we will never recapitalize you. That would leave the Fed unable to hit its inflation target.

    1. By the way, Nick Rowe had a great post on this topic.

      Wondering why you titled this blog post "Negative rates and FTPL." You don't really go into the former. Should've been "Helicopter money and FTPL," no? Looking forward reading more about why your are skeptical of the power of deeply negative rates to stoke inflation.

  5. An effective way to create inflation by being reckless might be to be late on some bond payments.

  6. "The US Federal reserve is similarly constrained to always buy something in return for creating money..."

    It's possible to have central banking and divorce it from the fiscal authority. Think ECB, roughly (though of course we know fiscal elements are intruding on what they do). Indeed, when the Fed was set up, no one envisioned open market operations - the people who framed the Federal Reserve Act had in mind a decentralized system of central bank lending funded by money creation. So, for example, we could imagine a Fed that holds only assets that are loans to financial institutions. If we want to leave the fiscal authority out of this altogether, the loans could be secured only by private assets (i.e. "real bills"). In that setup, the Fed can create as little, or as much, inflation as it wants. And if it lends against good collateral, it should never have to be bailed out by the fiscal authority. It has a monopoly on money issue, and turns over its seignorage to the fiscal authority (i.e. it's a divorce with some alimony payments). This arrangement is feasible - it's just a large TAF program.

    1. Quite right - and this is the direction the ECB has to travel because it is prohibited from funding the government directly. TLTROs are loans to banks. The ECB goes further at every stage - relaxing collateral, extending term and reducing rates. In extremis, they provide perpetual loans with no interest or collateral.

    2. I am not convinced. By buying private assets through money creation, the CB would still not affect net public debt because government assets (loans to the private sector) would go up by the same amount of governmn liabilities (money). So that would not affect net public debt and hence would not have any effect on inflation if the ftpl holds. This under the assumption that government debt and money are perfect substitutes, of course.

  7. John, The Fed raised rates in December to prevent inflation from overshooting their target. Thus it was bizarre for the Economist to claim central banks are out of ammo. If that were true then there would have been no rate increase in December. They are clearly not facing any sort of zero bound impotence.

    I happen to think that the Fed is wrong about inflation, but that doesn't matter. What matters is what the Fed thinks. They believe that the expected future inflation rate is precisely where they want it.

    1. Just because the Fed raised rates, and believed it to have an effect, does not imply that raising rates has that effect.

    2. The Fed's doubling of the interest rate it pays banks not to lend money (instead to hold it as excess reserves) sure seems to have had an effect. Like the Dow plunging a thousand points--it was about $17,500 when Yellen announced the policy.

      Btw, what would happen to the price level if the nation's counterfeiters made a technological breakthrough and could produce $100 bills of a quality the same as the ones the government produces? Would that raise prices, even though the government wasn't buying bonds?

    3. Here's another effect from the December 16th Fed announcement of 'higher interest rates': on that day the 10 year Treasury yield was 2.30%. By January 15th it had dropped to 1.77%, and got as low as 1.68% by February 2.

      It's recovered somewhat since then--with the Fed announcing it's holding off on further rate increases--but it is well below what it was back in December when Yellen made the announcement (1.96% today).

      So, the Fed said they wanted HIGHER rates, and got lower ones. Which I predicted at the time would be the result. Maybe the Fed should expansionary monetary policy, such as cutting the rate they pay on excess reserves to ZERO.

    4. If these $100 bills were accepted (because nobody knew) they would cause inflation if the economy were at full capacity (not the case today). However, when below capacity, an increase in money usually results in more real goods and services sold, not higher prices. That's an important feature of a modern competitive economy. In plain English, if business has been slow, you are happy to get more stuff out of the door. The last thing on your mind is raising prices.

    5. @Charles, and then the economy would get to full capacity as monetarists have said and then at some point prices would rise, no? If someone had that machine, couldn't they keep using it until we got some inflation?

    6. "Just because the Fed raised rates, and believed it to have an effect, does not imply that raising rates has that effect."

      Yep. Another tautology from the MM's: The Fed raised rates, ergo it has effect.

    7. Anon Yes, exactly. They could keep doing that until full employment and then rising inflation. Thanks.

  8. I do not believe in the magical powers of inflation to stimulate the economy. My observation is that expectation of future inflation stimulated the economy in the past by encouraging the middle class to over invest in housing. The long term effects were not positive.

    All of the proposals you refer to amount to the government borrowing money, by one means or another, to soak up global savings and using the money to increase demand in the United States. We have excess global savings and that excess is creating a huge drag on the global economy. Rather than worrying about how best to trick the American middle class into overspending, the Fed should be asking who exactly is piling up those excess savings and can we cut the total back?

    Capital flight from China, Russia, and Africa is a deflationary factor for the whole world. The artificial channeling of profits by multi-nationals (Google, Apple, Cisco etc.) and the wealthy to tax havens where the money then becomes stranded is a deflationary factor for the whole world.

    Economists argue over whether the solution is "monetary" or "fiscal" when the real solution might be legislative.

    1. Absalon,

      "Economists argue over whether the solution is monetary or fiscal when the real solution might be legislative."

      Assuming you can count on 435 House Representatives and 100 Senators to reach the right solution. We have a central bank precisely because Congress (the legislature) cannot be expected to manage monetary policy.

      Perhaps the solution should come from the Executive branch of government instead.

    2. "Congress (the legislature) cannot be expected to manage monetary policy."


      My point is that maybe monetary policy and fiscal policy are the wrong tools. I personally think that part of the solution for Japan, America and Europe is a co-ordinated LEGISLATIVE move against the use of tax havens.

    3. Absalon,

      As if getting the U. S. Congress and Senate to agree on something is bad enough, you think it will be easier getting the legislatures or America, Japan, and all of Europe on the same page with regard to tax policy? Good luck with that.

    4. Frank

      The beauty is that countries can move unilaterally and European countries already are. They are tired of Google claiming that all its profit is earned in Ireland.

      Donald Trump is likely to be the Republican candidate and he wants to move against off shore profits. I think that the tide in the developed world is very much against the current use of tax havens.

    5. Absalon,

      Let me say I am dubious. Yes countries can move independently of each other, but it only takes one country that refuses to move to make the effort a waste of time.

      As for Donald Trump, he has indicated his intent to build a wall across the Mexico / U. S. border. Whether that is just for effect, or whether he is truly serious - I can't take a lot of what he says seriously.

  9. John,

    "Miles goes on about the power of negative interest rates to stoke inflation, which will be a topic for another day."

    Actually, Miles describes negative interest rates on paper currency as a way to stoke credit creation.

    I disagree. The first order effect of negative interest rates on paper money / deposits is monetary contraction. More likely the second order effect will be credit contraction. Negative rates on currency / deposits create a wider spread between the interest on current debt obligations and money used to dispose of those obligations. And so if I am holding depreciating currency while I am also engaged in a fixed rate loan agreement, my inclination as a net debtor would be to increase the rate at which I am paying off my existing loan.

    The question becomes does new credit created at presumably lower long term rates offset credit contraction on existing debt arrangements? I don't think it does.

    The first reason is loan approval / repayment timing. Loan approval periods can take months. Decisions to accelerate loan repayment can be made over night.

    The second reason is the return of barter. At sufficiently negative rates on money, barter makes more sense as a means of exchanging goods.

  10. I think buying MBSs helped. Why not buy more private issued assets, as opposed to just buy treasuries? Private assets the monetary authority buys are final sales, they don't have to be "returned"...

  11. "The US Federal reserve is similarly constrained to always buy something in return for creating money..."

    Hasn't the Fed been creating money without buying something since it began paying interest on reserves? And didn't the Fed in December, by hiking the interest rate, decide to stuff a bit more money in its "helicopters"?

    1. Just the opposite, Torgeir. By increasing the incentive to hold money as excess reserves, rather than lend it out in the marketplace, the Fed contracted monetary policy.

      The LOWER interest rates you see (like the 10 year Treasury) since the Fed's December announcement, as well as the lower stock market, are evidence of that contractionary policy.

    2. Torgeir,

      No, the interest that it has been paying on reserves is simply the interest that it receives from the Federal Government on the bonds that it holds.

  12. On reflection, the Bank of Japan is already engaging in helicopter drops. By leaving the IOR on all existing reserves unchanged and simultaneously cutting interest rates on "new reserves" and engineering negative rates across the yield curve, the BoJ is simply making a transfer payment to banks to preserve their profitability. Why not raise the interest rate on existing reserves ...

  13. "Money has value because the government accepts it for taxes". Requiring the payment of taxes using the state's money helps establish a network. Once network externality established v hard to break. Fiscal theory of price level may be premised on denial of distinction between money and debt. Of course, everything is easier to model with no money!

  14. You mention one restriction is that the Fed and ECB couldn't buy bonds directly from Treasuries then cancel them. What is to stop the Fed and ECB buying bonds from the secondary market then cancelling them?

    1. Stewart,

      Treasuries are a liability of the federal government. Only the federal government can "cancel" them by returning payment in full.

  15. Absalon:

    "I do not believe in the magical powers of inflation to stimulate the economy."

    With helicopter drops you simply give new spending power for the government or the people to spend: you actually raise aggregate demand. Whether and when you get inflation depends on how much slack you have in the economy and on the economy's supply response. Eventually you get an increase in wages and prices, but in the meantime you reach the first priority objective, which is that of allowing people to spend, output to expand, and employment to rise. The newly created money can be used by the government in public spending programs or can be distributed to people (especially those with a higher propensity to consume) through tax cuts. Under the permanence assumption (by having the central bank canceling the bonds purchase from the government), you avoid possible Ricardian equivalence effects that might weaken the impact of helicopter drops on aggregate demand. Helicopter drops = monetary + fiscal policies = more demand = more output, higher prices and wages. In deeply stagnant and largely indebted economies, with no fiscal space (and I am not thinking of the US), that's the only sensible thing for the monetary and fiscal authorities to do.

  16. Wouldn't the rate rise increase inflation only if the government is not expected to increase taxes in response?

  17. This is the genius of a 15$ minimum wage, it commits the Fed to engineering an inflation.

    1. Hadn't thought of it that way. Very interesting. I guess it depends somewhat on how they view their dual mandate.

  18. If John Cochrane is correct, we should invite counterfeiters to the US, and even set-up training camps with great printing equipment.

    The other thing to do is liquidate the national debt. Indeed, this should make the public think the government and currency is stronger than ever as the tax burden will be reduced. No more $200 billion a year in interest.

    There would be no inflation, but more economic activity.

    Oddly enough, you have probably read when the Spanish conquistadors brought gold back to Spain, there was inflation. Economist Earl Hamilton argues that prices in Spain rose 300 percent between 1500 and 1600.

    Sound like a lot. It turns out to be about 1.4% annual inflation.

    Maybe Cochrane is right. No matter how much demand there is, there will not be inflation (or much) due to FTPL.

    Dudes, let it rip. We should print money until we are wiping our rear apertures with Benjamin Franklins (real or ersatz).

  19. "Or as I call it, the speak loudly because you have no stick policy. If central banks announce a 5% inflation target, and inflation goes down anyway, now what?"

    Week 1. Market forecasts predict inflation (or NGDP or whatever nominal variable you like) is under target. Buy $1 million in government bonds with printed dollars.

    Week 0. Expectations are still under target. Buy $2 million


    Week 33 Still under target, buy $ 8.5 trillion

    Week 34. There are no government bonds left to buy. Buy a $1 million dollar basket of european government bonds and stock market index.

    Week 35. $2 million of stocks and foreign bonds.

    How long do you really think this can keep going? One of two things will happen. Either at some point the dollar actually depreciates, or the entire world economy gets willingly sold to the Fed for little green pieces of paper.

  20. A bit late, but does FTPL imply that monetary policy should be pro-cyclical? A positive shock to growth rates increases primary surplus, which is deflationary. The gov't should expand the monetary base to avoid deflation. Is that the story? It seems counterintuitive.

  21. I would say that QE, negatives rates, forward guidance all work, just their effect is very small. Why is that? If you look at Japan you can easily spot part of the answer: Their government bond yields are mostly negative, yet people are willing to hold a huge amount of capital in government debt securities (230% of GDP). If you now give them money which is a better asset than the 10 year they will naturally be happy to hold on to that as well, if you don't buy more (or at least threaten to buy more) than the outstanding debt people are already willing to hold.
    Buying 80% just doesnt do enough to lift inflation expectations by a lot.
    Japan actually has lifted its inflation especially compared towards its peers in the last couple of years. Given the oil price slump they would be at least 1 percent lower otherwise.


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