Quantitative easing and ultra-cheap money have failed to live up to their promises. Negative interest rates have proved even more disappointing. Economic growth in the developed world remains lackluster. Central bankers fret about lingering deflation. The next product from the monetary laboratory may well be so-called helicopter money. Whether or not a deluge of cash from the skies will solve economic woes, one potential consequence is the massive destruction of financial wealth. It is surprising to find so many investors extolling such a policy.
The sight of central bankers – and the investors who obsessively follow their every move - failing to anticipate the outcome of their monetary experiments is by now commonplace. Among the many unforeseen consequences of monetary authorities buying up securities and charging no interest on capital since the great financial crisis have been rising wealth inequality, pension insolvencies, falling productivity and deflation. To cap it all, reports suggest that negative interest rates in Europe and Japan have promoted the hoarding of cash – the exact opposite of their intended effect - while simultaneously reducing appetite among banks to lend.
As all else appears not to be working, the idea of helicopter money – a notion coined by economist Milton Friedman in 1969 to denote the idea that central banks might boost inflation and economic production by effectively offering a one-time transfer of wealth directly to the pockets of the people – is gaining favor. Several investors have written in support of the idea. In his latest monthly letter, Bill Gross, the Janus money manager who earned the sobriquet “Bond King” in a previous guise, appears sanguine about its imminent appearance.
“There is a rude end to flying helicopters, but the alternative is an immediate visit to austerity rehab and an extended recession,” Gross, manager of the $1.3 billion Janus Global Unconstrained Bond Fund, wrote last month. “I suspect politicians and central bankers will choose to fly, instead of die.”
But he and other exponents of this last trick in the central bank experimental toolkit need to fully consider the potential adverse financial consequences of this radical policy.
Helicopter money enthusiasts are making certain assumptions. First, it’s assumed that the economies for which the trick is advocated have plenty of slack. Secondly, it is taken for granted that the inflation created by money from the skies won’t run out of control. Thirdly, it’s believed that conjuring money out of thin air will leave no one else worse off. In other words, helicopter money is supposed to be a free lunch - “Manna from Helicopters”, as Michael Biggs, a strategist at GAM in London, suggests in the title of a recent article advocating the policy.
These assumptions are dubious. For a start, it’s notoriously difficult to gauge accurately an economy’s spare capacity in real time. The lacklustre growth of developed economies in recent years may not indicate vast untapped resources. It could be a sign that capital has been misallocated during the easy-money era and that persistently low levels of investment in developed markets have reduced potential economic growth. If conventional wisdom is currently overestimating the degree of excess capacity in the American economy and elsewhere, then dropping bales of money won’t stimulate much growth in the near term.
Under such circumstances, helicopter money would result in greater price increases than expected. If and when inflation arrives, it’s not clear why it should hover around the central banks’ desired 2 percent target. In short, helicopter money could well result in a central banker’s worst nightmare: inflation expectations becoming “unanchored”.
Then there’s the question of the free luncheon voucher promised by the helicopter-money supporters. The capitalist system is made up of a vast and complex web of interconnected balance sheets. As their name suggests, they are supposed to balance out. Helicopter monetarists claim that the central bank is an exception to this rule. After all, only the Federal Reserve and its kind can print their own liabilities. It doesn’t matter, according to this way of thinking, whether a central bank is insolvent from an accounting perspective.
This sounds too good to be true because it is. If the central bank’s balance sheet doesn’t balance after its helicopter-money flight then the loss must fall somewhere. The only question is where? First in line for a haircut are the holders of money – or bank depositors. Helicopter money, as Tim Lee of Pi Economics writes, “represents pure inflation - it is the simple destruction of the value of money.” Banks are another potential victim since they would be obliged to hold cash reserves on which the central bank is committed to paying zero interest.
More worrying still is the potential impact that rising inflation expectations might have on the fixed-income markets. In recent years, investors have responded to negligible short-term rates by acquiring longer-dated bonds with higher yields. Their increased exposure to duration creates the potential for large portfolio losses from a relatively small rise in long-term rates. The popular “risk parity” strategy promoted by Bridgewater Associates and other hedge funds has also left many institutional investors holding leveraged positions in bonds. This further increases the prospect of investment losses if long-term rates rise unexpectedly.
The potential for a bond market rout is increased by the fact that investment banks have been withdrawing from their traditional role of making markets. As liquidity dries up, bond markets are becoming more volatile. If long-term rates were to climb sharply after a helicopter-money drop, then just about every asset which has seen its market price inflated in the era of low interest rates – including equities, real estate, and various “carry trade” plays, such as junk bonds and emerging-market debt – is potentially at risk.
A pickup of inflation and rising interest rates might well have certain long-term advantages for the sclerotic economies of the developed world. Higher inflation would clear away the overhang of excess debt that has accumulated over many years. A collapse in asset prices would abruptly reverse the trend to ever greater wealth inequality. House prices would become more affordable. Higher interest rates would improve the solvency of pension funds and alleviate the woes of insurers. Higher interest rates might even, over time, improve the allocation of capital and thus boost productivity and income growth.
Notwithstanding the theoretical economic merits of helicopter money, its implementation is likely to unleash great financial turbulence. Investors advocating this policy might consider themselves to be providing a public service. But their job is to deliver investment returns. As a squadron of central-bank choppers seems prepared for take-off, that task is set to become a lot more difficult.