A Checklist for Wanna-be Helicopter Pilots

PERSPECTIVES JUNE 2016
This is for investment professionals only and should not be relied upon by private investors
A checklist for wanna-be helicopter pilots
Over the past several weeks, policy makers have taken an interest in
monetary financing, or ‘helicopter money’, seen as the next and possibly
inevitable step in monetary policy.
Originally defined by Milton Friedman, monetary financing can be a
tempting solution when traditional central bank tools fail to revive
inflation and growth. We believe that for equities and inflation-linked
investors, the higher volatility of nominal growth expectations that
monetary financing would bring may be a desirable outcome.
For fixed income investors, however, ‘helicopter money’ is neither
necessary nor warranted at this point, as it risks eroding market
confidence in central banks and calls their independence into question.
Proponents of the helicopter thesis suggest that the write down of government
bonds and the implied budget financing by the central bank is a free lunch. This,
however, is unlikely to be the case, as bond yields would quickly rise to reflect
the higher anticipated volatility of nominal growth, not to mention the political
and operational risks associated with such a strategy.
Of the G-4 countries, Japan appears closest to a scenario where monetary
financing may be necessary and is probably also best equipped to do so
without losing control over its currency.
For those ready to jump into the cockpit, here's a checklist before take-off.
Step 1: Read the manual
The starting point when we talk about ‘helicopter money’ is the monetarist
observation that inflation is always a monetary phenomenon. In other words, if
all other means fail to avoid deflation, one can consider a one-off increase in
the monetary base (the sum of all currency in circulation and of all deposits held
by banks with the central banks) to stimulate nominal GDP growth. The
emphasis is on “one-off” as any hint of ongoing monetary financing would
eventually lead to hyperinflation, because the central bank loses control over
the monetary base.
The key difference between monetary financing and quantitative easing (QE) is
that under monetary financing, the central bank credits money directly to either
governments’ or individuals’ accounts without any future liability against it.
Thus, in theory, money can be spent without remorse.
As an additional benefit, the direct distribution of money bypasses the banking
system and any credit constraints that may limit the traditional transmission
mechanism for monetary stimulus.

DIERK BRANDENBURG is a
Senior Sovereign Analyst at
Fidelity. Dierk joined Fidelity in
1996 as a senior credit analyst
and currently leads the
financial team in the fixed
income division.
Prior to joining Fidelity, he held
the role of Deputy Head of
Credit at the Bank of
International Settlements.
ANDREA IANNELLI is an
Investment Director at Fidelity.
Andrea joined Fidelity in 2015,
and represents the Fidelity fixed
income investment team to
institutional and wholesale
clients in Southern Europe and
Latin America.

PERSPECTIVES | A checklist for wanna-be helicopter pilots 2
Should helicopter money be implemented, it is most likely that the freshly-
printed cash would be given to the government, which can then invest it either
into a tax rebate or spend it on projects outright. Unlike standard, deficit-
financed public spending, there is no increase in debt issuance by the
government and no future burden on tax payers. A variation would be to credit
the money directly to individuals’ accounts in the form of a citizen dividend or
‘people’s QE’. Ultimately this is a political choice; the only thing that matters
from a monetary policy perspective is whether the money is indeed spent rather
than saved (as happened with the oil windfall to US consumers last year).
Step 2: What’s the weather like?
Proponents of helicopter drops reserve them for really bad flying conditions –
for deflationary spirals with falling prices, rising unemployment and weakening
demand. The latest data releases do not paint such a picture, although we
could, of course, get there in the next downturn, as policy makers would have
very little left in their armoury to stimulate the economy.
In the G-4, key variables such as wage growth and core consumer price
inflation are all in positive territory, and while some countries have high
unemployment rates by historical standards, employment is rising everywhere.
So there are no signs of a negative wage/price spiral. However, given the lower
levels of price and wage inflation in Japan and the Eurozone (which also
struggles with high unemployment) these two economies would appear closest
to take-off. However, , it would be a very difficult call for the European Central
Bank (ECB) to make – much harder than for the Bank of Japan (BoJ) - given its
narrowly defined licence.

Chart 1:
Core inflation rates are positive (annualised)
Chart 2:
Employment rates are recovering (yoy)
-2%
-1%
0%
1%
2%
3%
4%
5%
1990 1995 2000 2005 2010 2015
US (core PCE) EUR UK JP
-4%
-3%
-2%
-1%
0%
1%
2%
3%
4%
1990 1995 2000 2005 2010 2015
US EUR UK JP
Source: Fidelity International, Haver, 26 May 2016. Source: Fidelity International, Haver, 26 May 2016.
Recent experience has shown that even in countries where the economy is
holding up, central banks’ efforts to stimulate growth by increasing the monetary
base have had a limited impact on nominal GDP, as they were met by a
corresponding fall in the velocity of money. Money velocity is the ratio of
nominal GDP to money supply, and can be thought of as the number of times
that money is exchanged to purchase goods and services generating value-
added.

As a result, despite substantial QE, post-crisis nominal growth in developed
markets has been weak across the board. Furthermore, low nominal bond
yields imply that growth is expected to remain at subdued levels for a long time,
or could indeed go even lower. This situation has left central banks with the
temptation to apply monetary financing and shift expectations towards higher
nominal growth and inflation. The risk they face is that a change in the
monetary regime and concerns over central bank independence could lead to a
rise in velocity and higher inflation than what they currently target. In turn, this
could push bond yields up very quickly, thus eliminating a key benefit of the
policy – the free lunch. In other words, a move to monetary financing could spell
the end of the ‘great moderation’ that has so benefitted bond investors over the
last several years. They are unlikely to part with it quietly.

Chart 3:
Room for growth? Central bank assets, % of GDP
Chart 4:
Velocity of money has been declining (M2)
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
2006 2008 2010 2012 2014
BOJ Fed ECB BoE
0.5
1.0
2.0
4.0
1987 1992 1997 2002 2007 2012
US EUR UK JP
However, some observers will argue that velocity is already too low due to
credit constraints on the banking system. That is particularly visible in the
Eurozone and in Japan. Central banks may prefer to bypass the financial
system and advance cash directly to the economy to increase policy
effectiveness. Although the argument holds, the issue can also be addressed
by purchasing private sector assets such as equity ETFs (in the case of the
BoJ) or corporate bonds (in the case of the ECB). Unlike monetary financing,
these two solutions do not eliminate funding costs, but they do lower the cost of
capital. So the helicopter may be better off remaining in the hangar under these
conditions.
Step 3: Take a look at the control panel
The control panel is the balance sheet of the central bank, an area that
Keynesians don’t look at that often and usually do not consider to be a
constraint. However, for monetary financing to work properly, credibility (i.e. a
strong balance sheet) is key. Without it, there is a risk that either the added
stimulus is saved in anticipation of worse times ahead, or that a sharp selloff in
the currency increases money velocity, pushing inflation out of control.
The main operation in monetary financing is to fill the government’s account at
the central bank with cash that the government can then withdraw without
incurring a corresponding liability to the central bank. Without an offsetting
asset, there is no explicit backing for the monetary base, making it harder for
the central bank to control inflation.

Table 1:
Central bank balance sheet under QE
Table 2:
Central bank balance sheet post monetary financing
Assets Liabilities
Repos Repos
FX reserves
Currency in Circulation
Domestic Equities and
Bonds
Domestic
Government
Bonds and Bills
Bank Reserves
Government Deposits
Free Cash-Flow
Assets Liabilities
Repos Repos
FX reserves
Currency in Circulation
Domestic Equities and
Bonds
Negative Equity /
Cash-flow
Bank Reserves
Interest on Reserves
Step 4: Test the landing gear
Without assets, the central bank cannot easily drain liquidity from the banking
system should it consider it necessary to fight inflation. Absent open market
operations, the central bank would need to remunerate bank reserves to
manage interest rates, similarly to what the Fed is currently doing through the
Interest on Excess Reserves (IOER).
The need to pay interest to banks on what would be a much larger monetary
base neutralises the key benefit of monetary financing. This could possibly be
addressed by taxing banks’ income or imposing very high levels of
unremunerated minimum reserves.
When comparing their respective balance sheets, the starting positions of the
G-4 central banks are quite different. The BoJ owns by far the biggest share of
government bond stock, followed by the Bank of England (BoE) and the Fed,
leaving the ECB as a distant fourth, although it will catch up as its QE
programme continues. When measured against money stock, the Fed owns the
biggest share of government bonds, followed by the BoJ and the BoE. In all
cases, monetary financing would result in very substantial excess liquidity that
central banks will find hard to manage.

Chart 5:
ECB catch-up: Central bank government bond holdings
as a % of outstanding stock of government bonds
Chart 6:
Fed lead: Central bank government bond holdings as a
% of the money stock (M1)
0%
5%
10%
15%
20%
25%
30%
35%
40%
2009 2010 2011 2012 2013 2014 2015 2016
Fed BoE BoJ ECB
0%
20%
40%
60%
80%
100%
2009 2010 2011 2012 2013 2014 2015 2016
Fed ECB BoE BoJ

Step 5: Check the fuel lines
Another key element to consider are international constraints. G-4 countries all
have flexible exchange rates with no capital controls and, with the exception of
Japan, own very little foreign exchange reserves as their currencies are
considered reserves themselves. Presumably, they want to keep that financing
advantage in the tank.
Their respective international positions leave G-4 central banks at opposite
ends in terms of international confidence. Owners of JPY-denominated assets
would be least concerned about monetary financing as the value of the
currency is backed by plenty of international assets. USD-asset owners would
have little choice but to remain in USD, due to their sizeable holdings and the
status of US assets as a global reserve. The BoE and the ECB would need to
consider the external constraints as non-residents could lose confidence in the
central bank’s ability to control inflation with monetary financing and choose
instead to sell the currency. The fragile architecture of the Eurozone would
exacerbate the concerns for the ECB.
Step 6: Rehearse the crash landing
The most spectacular helicopter crash in recent memory is Argentina, where
pilots went far beyond the call of duty and sent inflation soaring all the way to
25%. That was with a monetary base of only 14% of GDP but with 8x money
velocity. Argentina shows that the main risk with monetary financing is that,
once it begins, it may be hard to stop. One could in theory give an independent
central bank control over the cash account of the government (as proposed by
former Fed Chairman Ben Bernanke), but history has shown that this can be
risky business. Economic historians, for example, will remember BoJ governor
Takashi, killed by the military in 1936 after he tried to end monetary financing of
military expenditure...
Under the seat pocket: Gresham's Law
Taking the long view suggests that monetary financing is the oldest trick in the
book for governments to achieve their political goals. It has often been used to
finance wars over the centuries. The resulting deficits in the national accounts
were usually not a problem for as long as the war was won and the tax base
could subsequently be expanded. However, it has long been known that
debased currencies can quickly become obsolete. As long ago as in early
Tudor times, when shillings were debased from silver to nickel, Thomas
Gresham warned that ‘bad money’ eventually drives out the ‘good money’.
Comparing the G-4’s fiat currencies to assess whether they are in any way
becoming debased requires a benchmark such as gold, or a CPI goods basket.
Running the numbers shows that, since the crisis, the debasement has been
strongest in GBP (an early adopter of QE and devaluation) and weakest in JPY,
where savings have been depressing domestic demand, regardless of policy,
with no end in sight. It is difficult to see whether monetary financing can make a
difference here.

Chart 7:
GBP most affected by QE debasement as measured
against gold: Krugerrand (2007=100)
Chart 8:
GBP most affected by QE debasement as measured
against consumer goods basket (2007=100)
0
50
100
150
200
250
300
350
400
1989 1994 1999 2004 2009 2014
USD EUR GBP JPY
60
70
80
90
100
110
120
130
1989 1994 1999 2004 2009 2014
US (PCE) EUR (HICP) UK JP
Source: Fidelity International, Haver, 26 May 2016. We refer to the Krugerrand, a
widely available 1-ounce gold coin, as it trades purely on the basis of its gold
value, it has legal tender and can be easily traded and converted into any fiat
currency.
Source: Fidelity International, Haver, 26 May 2016.
The low impact that central bank actions have had to date, on both growth and
inflation, make monetary financing an attractive proposition. However, we would
caution against considering ‘helicopter money’ as the panacea that many
believe it to be. While it would have a positive impact on inflation, therefore
benefitting real assets, equities and inflation-linked bonds, G-4 data releases
show that taking such a dramatic step is not warranted at this time. More
importantly, the risks that it brings to central bank credibility are too high to
consider it as a viable option. Adding more permanent monetary financing risks
fuelling a sharp rise in inflation expectations, which central banks will find very
hard to control, or will only manage to do so at a great cost to the real economy.


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