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Much-criticized modern monetary theory (MMT) and its next-of-kin, “helicopter money,” are the inevitable measures to resuscitate the economy in the crisis it faces.
The tools utilized by the Federal Reserve in responding to the global financial crisis (GFC) in 2007-2008 may well shape the response to the COVID-19 pandemic. In September 2008, the Federal Reserve Bank of New York “created” $85 billion to bail out AIG, an insurance company with exposure to credit default swaps (CDS). Had the FRBNY chosen not to supply these funds, AIG would have been forced to declare bankruptcy, defaulting on its CDS obligations to a number of firms including Goldman Sachs and JP Morgan Chase.
In an enlightening interview with Scott Pelley of 60 Minutes in 2010, Ben Bernanke was asked about how the U.S. government financed the payment of the $85 billion to AIG. He responded, “To lend to a bank we simply use the computer to mark-up the account they have with the Fed.” This comment raised an important question that will undoubtedly become relevant as the government confronts the economic and financial costs associated with the COVID0-19 pandemic.
If the Fed can create funds to support financial institutions, why can’t it provide support to businesses and individuals who are suffering due to losses associated with this pandemic?
If the Fed can create $85 billion “out of thin air” to support AIG, then it must be able to do the same today for individuals and businesses that suffer due to the pandemic.
The lessons we learned from Bernanke’s comment during the GFC underscores the analysis offered by proponents of MMT and helicopter money. Bernanke’s comment confirmed that money is not scarce.
So what is money? Commercial banks uniquely within the private sector are granted the privilege of creating money “out of thin air.” How does this happen? When a bank makes a loan, given double-entry bookkeeping, it also creates a deposit in an identical amount. The deposit that is created is money. In other words, banks create money when they make loans. It is just that simple. And the same holds true for a central bank. There is no need for physical (commodity or fiat) money to exist for a bank to be able to extend credit. It simply marks up the account, as referred to above by Bernanke.
This reality may take a while to digest, given that most of us tend to think that banks first collect deposits and then make loans, based on the finite supply of funds. This notion is just plain wrong! More than 95% of all money is created when banks make loans. The Bank of England (2014) wrote two seminal articles in support of the concept that loans create deposits “out of thin air” (see citations at end). A government with a sovereign currency can create its own money without limit. But countries with a common currency, e.g., the euro, do not have this luxury, so they tend to experience turbulence when problems emerge (as they did in Greece, Portugal and other countries earlier in this decade and arguably in Italy today).
Given the significant debt burden, the response by the government to the potentially devastating impact of COVID-19 on economic activity will require helicopter money. Quantitative easing (QE) will not help address this issue. The impact of QE policies engineered by major central banks over the past decade boosted the prices of stocks and other financial assets. However, the benefits of those policies in the U.S. accrued mostly to the top 10% of households, who own 90% of stocks. This policy did little to nothing to assist the bottom 90% of households, given that the reserves created by the central bank were walled off in the banking system.
Helicopter money is far more democratic than QE. Helicopter money (or MMT) can target households and/or businesses that have suffered economic and financial losses due to COVID-19. For example, the Treasury could instruct the Fed to deposit funds in the bank account of each affected adult. These households (businesses) can then spend those funds or use them to pay down debt. The Treasury and Fed could also create an infrastructure program, along lines similar to the Reconstruction Finance Corporation (RFC) that was created during the Great Depression. This program or facility can provide badly needed improvements to roads, ports, electrical grids, medical facilities, transportation system, etc. and will provide jobs for unemployed people. Most importantly, public investment can stimulate aggregate demand and economic growth and will be quite appealing relative to the waste generated by corporate stock buybacks in recent years. This process might actually help turn the U.S. toward a healthier source of economic growth that reduces, rather than increases inequality.
This approach has the potential to generate inflationary pressures, given that it targets the bottom 90% of the population and not the financial markets. The main risk with helicopter money is that it permits inflation to get out-of-hand. However, given the magnitude of private sector debt and the need to address the aftermath of the pandemic, inflation may be less of an issue than one might think, especially if the objectives of the approach are well-defined. And there are other measures that can be utilized to control inflation, should it become an issue.
The good news is that there is precedent for these actions. The Treasury and the Fed collaborated in financing World War II. In 1942, an exemption to the Banking Act of 1935 allowed the Fed to directly purchase Treasury debt, given the enormous and growing need to finance the war. And this exemption was renewed several times after the war ended and remained in effect until it expired in 1981. During World War II, the Treasury instructed the Fed to issue bonds at a fixed interest rate (0.375% for short-term and 2.50% for long-term) bonds. Any bonds that were not purchased by the private sector would then be held by the Federal Reserve. This approach bypassed the primary dealers, who from 1935-1942 and again since 1981, were required to act as intermediaries between the Treasury and the Fed.
Such an exemption to the Federal Reserve Act would need to be agreed to by Congress, by once again authorizing the Fed to directly purchase Treasury debt and then hold it on its balance sheet. This will require collaboration between the Fed and Treasury, which might undermine the case for the Fed’s independence. Since the Fed obtained its independence, it has become captive to the finance industry, so removing the independence might not be a bad thing, especially given the special circumstances.
This is precisely what the Bank of Japan and the government of Japan have been doing successfully over the past few years. If the Fed holds the debt, then the payment of interest from Treasury to the Fed is returned to the Treasury as part of the Fed’s surplus. Financing will be needed to address the economic recovery from the pervasive impact of COVID-19, perhaps paralleling the need to finance World War II. The legacy of the GFC remains with us; private sector debts remain elevated, especially for the bottom 90% of households, and this situation will further complicate what will need to be done, making helicopter money, perhaps, the “least-worst” option.
Higher inflation may become a challenge, but would it be bad? The Fed has been trying to raise the inflation rate for more than a decade since the GFC without much success, largely given the enormous private debt outstanding. The crisis was mainly caused by two policy decisions: the disastrous decision to deregulate finance (which resulted in the financialization of U.S. economic activity) and the effort to suppress wages. Both of those contributed to the crisis, the weak recovery thereafter and the rapid rise in income and wealth inequality.
If the liquidity the Fed creates does indeed cause inflation to rise, that might be a sign of the program’s success, not failure. And it is well past time for the economy to transition away from its financialized state toward more productive sources of economic growth, including improvements to infrastructure.
Had COVID-19 not become a pandemic, perhaps MMT would have been deployed to combat the sharp rise in household debt levels, inequality and the emergence of populism.
In any case, proponents of helicopter money and MMT correctly make several important points. Governments that borrow in their own currencies cannot go bankrupt. That is a statement of fact. For those governments, currency can be created by their central banks, as Bernanke put it, simply by marking up the accounts, especially the U.S., which has the world’s primary reserve currency. The only limitation to creating money is the risk of rising inflation. During the Second World War, the U.S. government put in place other policies to manage inflation that included price controls and higher marginal rates of taxation, etc. These policies were designed to mitigate inflationary pressures and worked quite effectively. Inflation averaged about 3% between 1942 and 1945, though it did spike briefly after the war ended, given pent-up demand.
Once we understand that loans create deposits and that there is no limit to the availability of funds, the solution to COVID-19 comes into focus. Unfortunately, making this approach fully operational will require a legislative fix. This approach is inevitable, given debt levels already outstanding and the massive impact the COVID-19 pandemic has already had across the globe. The issues it presents are solvable, but it will require that all of us work together in an out-of-the-box manner to resolve this situation.
We will need to shed our ideological priors as to the virtues of financial markets. The neoliberal-financialization experiment has failed to deliver the promised “marketplace magic,” an issue I will cover in a subsequent article. We can ill-afford for the solution to this problem to be held hostage by the financial markets.
John Balder’s experience combines more than 25 years of work building innovative investment strategies at firms that include GMO and SSgA. He previously worked with the US Treasury and Federal Reserve Bank of New York after beginning his career with the House Banking Committee on Capitol Hill. His research has focused on the topic of financial stability and the real world relationship between economics and finance.
Citations
Bank of England (2014). “Money in the Modern Economy: An Introduction,” Bank of England Quarterly Bulletin, Q1 2014.
Bank of England (2014). “Money Creation in the Modern Economy,” Bank of England Quarterly Bulletin, Q1 2014.
Brown, Ellen (2019). Banking on the People: Democratizing Money in the Digital Age, the Democracy Collaborative, 2019.
Garbade, Kenneth D. (2014) “Direct Purchases of U.S. Treasury Securities by Federal Reserve Banks,” Federal Reserve Bank of New York Staff Reports, August 2014.
Werner, Richard (2014). “Can Banks Individually Create Money Out of Nothing? Theories and Empirical Evidence,” International Review of Financial Analysis, 36:2014.
Read more articles by John M. Balder
