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Posted by on Dec 16, 2008 in At TMV | 0 comments

The “Helicopter Drop” Has Begun

The Fed cut interest rates to effectively 0% today, but that really isn’t important. The problem is that even though money is now (pretty much literally) free for banks to borrow and lend back out, they are having a hard time finding anyone that is a good credit risk and wants it. Even worse, they have to worry about all the existing debt starting to go bad, so creating new loans doesn’t make sense.

Thus comes the “helicopter drop” which is a reference to when Bernanke said that you can prevent deflation because worst case you can fly around in a helicopter dropping money. That is what this sentence from today’s announcement means: “over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets.” As the downturn continues, you can count on the number of things they are “providing support” to to increase.

So what’s this mean practically speaking? Well it means that the Fed is going to buy hundreds of billions if not trillions of dollars worth of bad debt. The idea is that it will keep long term interest rates down and clear the books of banks so they can make more loans. Where are they going to get that money? From nowhere, they’ll just print it.

It all sounds glorious, until the end: “At some point the animal spirits of businesses and consumers (and bankers) will return, and if the Fed doesn’t act quickly to retire most of those hundreds of billions of new dollars it’s been creating, the result will be inflation. But that’s tomorrow’s problem.” Saying the result will be “inflation” if they mess up is a little like saying the sun is “hot.” Fortunately, our economic leaders are very competent so I’m sure there will be no problems.

In all seriousness, what they are trying to do is prevent an economic downturn by expanding out the bad investments over a longer period of time. This sounds OK except when you note that Japan is doing a similar thing and they are now up to two decades with almost no growth, with no end in sight. In effect, their policies are hidden taxes, with the “revenue” going to the financial system to compensate them for bad bets. These policies will have long term consequences but for some reason people care a lot more about a 3% marginal tax de-decrease like Obama has proposed because they can see it.