The Helicopter Drop
Why prices could rise 25 to 50 percent in the next five years
When I studied economics in graduate school, we were taught a thought-experiment called the “helicopter drop.” Suppose that GDP, the value of all goods and services produced in the economy, is $1 trillion, and the government drops $100 billion in currency out of helicopter. What happens?
The simplest answer is to note that while the helicopter drop increases paper wealth, the economy is still producing the same amount of output. So it seems likely that when everything settles prices will be 10 percent higher than they were before the Helicopter Drop.
This Helicopter Drop thought-experiment guides my thinking today. I often read about price increases in the economy as if they were idiosyncratic events. An odd lumber shortage here, a strange jump in used car prices there. An article about inflation might go through an entire litany of examples like this without once talking about a Helicopter Drop.
But in 2020, the U.S. Budget deficit was 17.9 percent of GDP (source here) and in 2021 it will be 9.8 percent of GDP. According to the helicopter drop model, this should raise prices by more than 25 percent.
It is important to point out that from 2009 through 2019, the cumulative deficit to GDP ratio was 57.6 percent. But inflation averaged only about 2 percent per year, so that by 2019 prices were less than 25 percent higher, less than half the increase predicted by the Helicopter Drop model.
This could mean that the Helicopter Drop model is completely wrong. Or it could mean that the paper wealth that was created in that decade has not yet been translated into spending. There may be some pent-up inflation from those years on top of the pent-up inflation that has been built in by the last two years of Helicopter Drops.
Over the next five years, if only the last two years of Helicopter Drops ends up in prices, then prices should end up about 25 percent higher, for an average inflation rate of 5 percent. But if some of the pent-up inflation from previous Helicopter Drops shows up, the inflation rate could be closer to 10 percent.
What about the Fed?
Milton Friedman famously insisted that inflation is, anywhere and everywhere, a monetary phenomenon. If that is correct, and the central bank controls the money supply, then can’t our central bank, the Federal Reserve, control inflation?
In fact, things are not that simple. The Helicopter Drop was created by Congress and the President, not by the Fed. Congress and the President ran up the deficits, and the Treasury issued bonds to fund those deficits. The Fed bought some of those bonds (most of them, actually). It paid for them by creating money out of thin air at banks, and paying interest on that money. If you follow the financial pages, you know that bank profits have been doing very nicely, thank you very much.
The Fed cannot undo the Helicopter Drop. It could sell the bonds back to banks and take back the money it created for them, but the banks would still have large balance sheets and plenty of earnings. The paper wealth that Congress and the President created would still be out there, ready to stoke inflation.
It is not that the Fed is totally powerless. It can intervene in financial markets to raise interest rates and cause foreign currencies to depreciate relative to the dollar. In principle, it can keep doing that until inflation grows quiet. The question is how much the Fed would have to do, and whether the resulting economic strain (including higher interest costs in the Federal budget) would be bearable.
I doubt that the Fed will apply the necessary force to quell inflation. You should keep in mind that most economists and financial market participants disagree with me; very few expect to see the sort of inflation that I think is likely.
What about Modern Monetary Theory?
According to Modern Monetary Theory, worries about deficit spending are unwarranted. MMT is hard to pin down. I once reviewed Stephanie Kelton’s The Deficit Myth, and my reading of her book forms my impression of MMT.
When it comes to actual monetary theory, Kelton and I are not too far apart. When the government runs a deficit, I look at it as a Helicopter Drop, whether it is financed with money or bonds. Kelton would seem to agree, saying that money is just the form of government debt that pays no interest.
But when it comes to the relationship between deficit spending on the one hand and real output and inflation on the other hand, Kelton and I are opposites. In her view, as long as there is any spare capacity in the economy (as indicated by the existence of some involuntary unemployment), a Helicopter Drop will increase output, not prices. So in the example with which I began, dumping $100 billion of paper wealth on the economy will, as if by magic, cause another $100 billion of real output to be created. In fact, it might stimulate even more output than that.
A Helicopter Drop could either produce an increase in output (Kelton’s MMT view) or an increase in inflation (my view). Or it could produce a combination of both.
I am old enough to have seen this movie before. When I was a college freshman, in 1971, our textbook assumed that deficit spending raised economic output. In other words, years before Ms. Kelton was born, textbooks were taking her side in the debate.
My freshman economics course taught that inflation was a “cost-push” phenomenon. Just as today we are told that inflation comes from particular shortages, back then we were told that inflation came from particular industries, like auto and steel, where companies pushed up prices and unions pushed up wages.
In our intermediate-level undergraduate course, we were taught that some of a Helicopter Drop (it was not called that) would result in higher output and some of it would result in higher prices. We were told that there was a trade-off between unemployment and inflation—if you wanted to get rid of excess unemployment, you had to be willing to accept a bit more inflation.
In contrast to what we were being taught in the early 1970s, the economy suffered from both high unemployment and high inflation. Rightly or wrongly, this experience is what shapes my outlook for the near future. If you want more of this history, you can read my long memoir.
What about Japan?
In Japan, the ratio of government debt to GDP has been climbing for decades, and it is even higher than ours. Yet Japan has experienced little or no inflation.
My guess is that the reason for this is that Japan’s run-up of government debt was preceded by a gigantic drop in paper wealth, as one of the most spectacular bubbles of all time was popped. The paper wealth that the government has created over the past 30 years has not made Japanese households feel rich, because they lost so much paper wealth when stock prices and real estate prices collapsed in the early 1990s.
What about Bitcoin?
Suppose that you share some of my worries about inflation. Should you buy Bitcoin?
I am not buying Bitcoin. I told you that I am old. The first book I read about money was a best-seller from 1968 called The Money Game. One of the tales the author tells is of an ill-fated speculation in cocoa futures. His take-away is that when other people know more about a market than you do, it is best to stay away from it. That is the way I feel about crypto currencies. I don’t understand them enough to take a position in them.
One good inflation hedge is I-bonds. These are U.S. savings bonds that are indexed to inflation. They can only be purchased by U.S. citizens, and there is a limit of $10,000 per person per year. They earn a rate of return above the inflation rate.
A related instrument is called TIPs, for Treasury Inflation-Protected securities. They, too, are indexed to inflation, but these days they earn a return slightly below the inflation rate.
In principle, the prices of commodities (metals, oil, agricultural products) should go up with inflation, as should stock prices and real estate prices. But the correlation is far from perfect. One problem is that once inflation gets going, interest rates start to go up, and that has an adverse effect on the value of many assets.
The bottom line is that I do not have a way to inflation-proof your savings. I try a little of everything, except Bitcoin.
What “real-world” complexities cause economists to dismiss the helicopter drop as a simplistic model?
Is GDP the right denominator for computing the expected inflation, as opposed to total wealth or value of durable assets? Helicopter money could be used to bid up the price of my house, even though it was "produced" 40 years ago and has not contributed to the GDP calculation since then.
As another thought experiment, if the pandemic shut down 100% of all economic production for 2020 and Americans were living on their savings, would any amount of stimulus cause an arbitrarily large amount of inflation?