During the Covid-19 pandemic, central banks have pushed to the extreme the tools they had created after the Global Crisis: targeted lending, large asset purchases, and negative interest rates (Hartmann and Schepens 2021). This is especially true in the euro area. The balance sheet of the ECB amounts to 60% of GDP, it holds around 25% of public debt of the euro area, and the deposit facility rate is at -0.5% (-1% for targeted long-term refinancing operations, or TLTRO). These measures were useful and necessary to avert deflation both during the 2010s and in the Covid-19 crisis. However, since 2015 the annual inflation rate has been around target only 10% of the time (see Figure 1). Based on its June 2021 forecast, the ECB itself anticipates (after a temporary increase in 2021) an average inflation rate below its 2% target at 1.5% in 2022 and 1.4% in 2023.
Figure 1 Distribution of monthly inflation in the euro area, 2015-2021
What else can the ECB do to get to its inflation target? Can and should it expand existing tools further if another crisis hits? Can other instruments do better especially in the context of the euro area? We attempt to answer these questions in two joint reports (Martin et al. 2021, Renault and Savatier 2021).
More of the same will have to pass the credibility test given the difficulty to attain the target and will not be without problems. One potential problem is that the purchase of public debt increases the risk, in the long run, of fiscal dominance. The ECB insists that it is not in this situation, because monetary policy remains guided by the objective of price stability and not by an objective of reducing the public debt burden (Schnabel 2020). This may be the case today, but there is a risk if persistently low inflation generates an anticipation of persistently higher public debt purchases (Garicano et al. 2020). In addition, these instruments also have consequences (like all monetary actions), in terms of inequalities (Amberg et al. 2021, Andersen et al. 2021). Although asset purchases by central banks have contributed to lower income inequality through their impact on economic activity and employment, they contributed to increasing asset prices by decreasing and flattening the yield curve. In addition, keeping interest rates in low and negative regions for a long period of time may have some unintended effect on financial stability.
Economists have anticipated these limits and considered alternative powerful instruments to strengthen economic activity and inflation. A widely discussed option in the profession is ‘helicopter money’ (Ball et al. 2016, Mullbauer 2014, Mullbauer 2016, Barstch et al. 2019, Gali 2020, Yashiv 2020, Bilbiie and Ragot 2020). The principle here is to create money through a direct transfer to individuals1 instead of through lending to banks. The transmission mechanism would be more direct and, according to economic theory, more effective. Following several authors (Cohen-Setton et al. 2019), we explain why – contrary to the Federal Reserve – the ECB can implement a direct transfer to individuals without major legal barriers. We view the use of helicopter money as a contingent strategy in the case where inflation falls persistently and dangerously below target, activity stalls, and no coordinated fiscal response (either at the European or national level) is put into place.
How large should this new instrument be to attain the inflation ECB target? Despite numerous theoretical discussions, few contributions have provided quantitative estimations of the impact of such transfers. Renault and Savatier (2021) attempt to answer the question.
Quantifying the effect of monetary transfer on inflation
Two different estimation methods are used to assess the potential impact on inflation of a monetary transfer to households. First, the joint impact of a standard exogenous monetary policy shock (i.e. on the interest rate) on inflation and consumption is assessed. Under the assumption that inflation responds to monetary policy through its effect on aggregate demand (consumption), we can infer the impact of an exogenous consumption shock on inflation. By taking into account the effect on consumption of a transfer to households (social benefits, etc.) as estimated in various academic works (i.e. the marginal propensity to consume), we can evaluate how much a monetary transfer would affect consumption and then inflation. From these different estimates, we estimate that a monetary transfer of 1% of GDP would generate an increase of 0.5% in consumption and 0.5 percentage point in inflation (Renault and Savatier 2021).
Second, a monetary transfer to households can be considered equivalent to a tax cut in an environment of accommodating monetary policy. The impact of fiscal policy on inflation is still much debated in the academic literature. However, econometric work that has causally identified tax shocks finds a significant effect on inflation. Using (confidential) euro area data, van der Wielen (2020) estimates that a fiscal expansion of one percentage point increases inflation by 0.43% over a one-year horizon. Using UK data, Cloyne (2013) finds an effect of around 0.6% in the fifth quarter after the shock. Renault and Savatier (2021) estimate the impact of German tax shocks on inflation using data from Hayo and Uhl (2014). In the case where economic activity is below its potential level (which would be the likely situation where helicopter money is considered), the estimates also show that a tax cut of 1% of GDP increases inflation by 0.3 percentage points after six quarters, and 0.5 percentage points after eight quarters.
Figure 2 Effect of an exogenous tax cut on inflation in Germany, depending on the state of the economy, 12 quarters ahead
Source: Authors based on data from Hayo and Uhl (2014).
These macroeconomic estimates should be treated with caution, yet it is interesting that different methods lead to similar orders of magnitude: a monetary transfer of 1% of GDP would increase the inflation rate by 0.5 percentage points over a one-year horizon. Table 1 lays out the transfers required to eliminate the inflation deficit relative to the target. It shows that only a large inflation deficit of 1.5 percentage points would require a transfer to households quantitatively close to the cheques sent by the Biden plan ($1,200 per adult and up to $3,600 per child, income-tested).
These estimates are based on relatively strong assumptions about the empirical link between a cash transfer and inflation. The proposed amount of the monetary transfer is therefore on the low side, to avoid overshooting the desired target, and corresponds to a first ‘injection’. To be credible, however, the ECB should announce that it will make the necessary number of money transfers to reach its target and that, once the target is reached, it will immediately stop this policy. Defending the ‘proportionate’ nature of helicopter money as well as announcing an exit strategy may from this point of view be easier than for quantitative easing (QE): the central bank can easily terminate the program in case of a return of inflation, without any consequences on the management of the public debt.
In the extreme and unlikely case where the ECB would have to issue five waves of helicopter money in a short period of time, its balance sheet would thus increase by a maximum amount of 10% of GDP. This amount is relatively small compared to the size of its current balance sheet (60% of GDP) and to the scale of the asset purchases that have been necessary to keep inflation close to 1% since 2015 (for a stock that is equivalent to 30% of GDP in 2021). It should also be noted that if the introduction of helicopter money succeeds in bringing the inflation rate back towards its target, it would allow for a more rapid normalisation of monetary policy regarding both asset purchases and interest rates. From this point of view, this monetary instrument might be more acceptable to some countries (e.g. Germany) for which the ECB’s unconventional monetary policy is most problematic.
Table 1 Amount of transfer to achieve a 2% target
Note: For children under 15 the transfer would be half that for adults.
The effectiveness of such a measure on current and future inflation should limit the number of helicopter money drops. It is important to avoid significant costs to the central bank when monetary policy normalises and interest rates are paid on bank reserves to the central bank. The counterparty to the creation of helicopter money cannot bear interest, so it will be costly for the central bank to remunerate the bank reserves created by the helicopter money, if it has to do so. These costs are similar in nature to the current costs due to the ECB's policy of lending to banks at -1% while remunerating bank reserves at -0.5% (Lonergan and Greene 2020). These costs must be anticipated but would be minor in our scenario if a handful of helicopter drops are sufficient to achieve the inflation target and long-term interest rates remain low (Monnet 2021a).
Coordination with fiscal policy
To ensure the full effectiveness of this monetary policy measure, the ECB should ask the European Council to coordinate fiscal responses to the central bank’s policy. This coordination should also be initiated by the European Commission during the European Semester, with approval of the European Parliament (Monnet 2021b). Like any transfer, the sum paid by the ECB will be taxable in each country. The European Council must commit itself to ensure that the member states do not increase their taxes so as not to counteract the immediate impact of the helicopter money on private consumption. In addition to its importance for the effectiveness of the measure on inflation, such coordination will also make it possible to ensure the ‘fiscal neutrality’ of the ECB’s helicopter money policy, i.e. it must not modify the tax structure chosen by each state.
A common criticism of helicopter money that takes the form of direct transfers to households points to the risk of a harmful confusion between monetary policy and fiscal policy. We believe, on the contrary, that transferring money directly to agents falls within the scope of a central bank’s actions. This policy is strictly speaking monetary policy (money creation) and can be conducted essentially in the name of the ECB’s main objective: the inflation target. Moreover, unlike purchases of financial assets, it is less likely to conflict with other objectives of the ECB: financial stability and secondary objectives defined by the EU (notably the fight against inequality). Thus, a direct monetary transfer to households with clear communication in terms of the inflation target and the exit strategy is a last resort policy that maintains a clear boundary between central bank and governmental action.
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1 Transferring money directly to the state is explicitly forbidden in the ECB’s statutes.