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September 2016

Helicopter money: credible irresponsibility in Japan?

Has the Bank of Japan run out of options? We argue that it has yet to deploy its most powerful and perhaps controversial tool: helicopter money.

The Bank of Japan is at a crossroads. Its Quantitative and Qualitative Easing (QQE) programme, in operation since 2013, has failed to either push inflation towards its 2 per cent target or raise inflation expectations.

Its surprise shift to negative interest rates in January was equally unsuccessful, doing nothing to arrest a recent decline in consumer prices, which in May fell at their fastest pace in three years.

To make matters worse, Japan’s economy is facing a new foe in the shape of Brexit.

Following Britain’s vote to leave the European Union, the safe-haven yen appreciated past JPY100 against the US dollar, the highest since November 2013. The yen appreciation is further dampening inflationary pressures and making the country’s exports even less competitive.


Source: Pictet Asset Management / * Money-Financed Fiscal Programme / ** Money-Financed Debt Relief

Pressure is consequently rising on the BOJ to roll out yet more monetary stimulus. The problem is that doing more of the same will not work.

Attempts to push rates deeper into negative territory will further upset financial institutions, which are being hit by lower returns on their assets and by a squeeze on lending margins.

Printing more money in the form of buying additional government bonds (JGBs) solely from banks is equally unlikely to provide an economic boost.

This is because banks, facing sluggish demand for loans from businesses and households, simply take the proceeds from their JGB sales and park them right back with the central bank.

To illustrate this point, Japan’s broader money supply – which includes money held in the banking system – has barely expanded above 3 per cent a year. In contrast, monetary base – a narrower measure that looks at central bank money in circulation – grew by a whopping 35 per cent a year on average.

Powerful weapon – helicopter money

So has the BOJ run out of options? We don’t think so. The central bank has yet to deploy its most powerful and, perhaps most controversial, tool – helicopter money.

An idea originally popularised by American economist Milton Friedman, helicopter money is defined as funding of fiscal expenditures via the creation of new base money and a promise that any increase in the monetary base will not be reversed.

Essentially, it means monetary authorities give people extra money in the form of a tax cut, vouchers or an increase in public spending. At the same time, the authorities make a "credible promise to be irresponsible"1 - pledging that they will not raise taxes at a later date to recoup this extra money. Assured that the extra money they receive will not be taken away later, people should then start spending that cash, boosting economic activity and inflation.

Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community. Let us suppose further that everyone is convinced that this is a unique event which will never be repeated.

Milton Friedman

Helicopter money scenarios

How can the BOJ engage in a helicopter drop of money? Much of the discussion on helicopter money has centred on former US Federal Reserve Chairman Ben Bernanke’s idea for a money-financed fiscal programme (MFFP). This would involve either an increase in public spending or a tax cut that is financed with newly printed money by the central bank.

However, in the case of Japan, years of fiscal stimulus have failed to boost domestic demand and lift inflation as the public increased their savings in anticipation of higher tax rates to come.

What makes more sense, in our view, involves a sort of debt cancellation. Former Chairman of the UK Financial Services Authority Adair Turner has proposed that policy authorities convert some or all of the central bank’s JGB holdings into perpetual non-interest-bearing bonds, in what we call Money-Financed Debt Relief (MFDR).

We propose a more radical option of MFDR – an outright write-off (see chart above).

Essentially, the central bank prints money to buy a government bond. It then writes it off.

At first glance, that might seem radical. But that option looks far less extreme when set against where current policies are heading to.

We propose a more radical option of MFDR – an outright write-off .

Assuming the BOJ’s debt buying programme runs into 2020 at the current pace, the BOJ’s total assets will have swollen to a record 150 per cent of GDP by mid-2020 (see Fig. 2). By then, its share of the JGB market will rise to a massive 63 per cent from 37 per cent today. Carrying on its purchases of exchange-traded equity funds at the present pace would take its share of Japan’s stock market – as measured by its total market capitalisation – to 10 per cent.

Cancelling even a small part of the public debt – let's say JPY10 trillion2 - can send a powerful message to the financial market and the wider public. In this case, the BOJ has permanently replaced JGBs with fresh base money worth JPY10 trillion.

We think MFDR should work well in highly indebted Japan. Debt write-offs will reduce the government’s outstanding debt and improve its credit profile. It can also promote private investment and consumption by incentivising businesses and households to reduce excess savings, leading to higher inflation.

An insolvent central bank?

After writing off the government’s debt, the BOJ will face negative equity as it holds liabilities in excess of assets3. At this point, one can say the BOJ is technically insolvent.

However, central banks are not subject to the same solvency tests as private-sector banks. Nor are they required to have the same capital adequacy ratios.

Indeed, running negative accounting equity is nothing new in central banking. The Bank for International Settlements cites Chile, the Czech Republic and Israel as the examples of central banks that have for years operated successfully with negative capital.

Helicopter money is not without its risks. Negative equity and the possible loss of financial independence may hurt a central bank’s credibility and raise doubts about its ability to deliver on policy targets. However, we think that the BOJ’s failure to reach the inflation target has already damaged its reputation. Helicopter money is a way for it to repair that damage.

BOJ balance sheet.png

Source: Ministry of Finance, IMF, Bank of Japan, Pictet Asset Management

Regime change in monetary policy

In the near term, we expect the BOJ to widen the scope of its QQE, by buying more ETFs and J-REITs.

However, such a policy cannot continue indefinitely. By 2020 at the very latest, the BOJ’s quantitative easing will have reached a critical stage, threatening the smooth functioning of capital markets. At that point, the BOJ will have no choice but to resort to helicopter money. In our view, it is far better for the BOJ to act sooner rather than later.

A debt write-off is a way for a central bank to commit even more credibly to the promise of permanent money creation. Once the market starts to price in this probability, however small it is, inflation expectations should begin to move up, leading to higher asset prices.

By deploying helicopter money, the BOJ will demonstrate that it has a plenty of effective policy tools. In doing so, Japan will open the door to a new era of unorthodox monetary policy making.

  • The BOJ’s QQE policy has failed to boost growth and lift inflation
  • The BOJ still has a radical option of helicopter money
  • We think Money-Financed Debt Relief (MFDR) will make the most sense in highly indebted Japan