Mostly Economics

Bernanke in his famous deflation speech made reference to “helicopter drop” of money. This “helicopter drop” though was defined by Milton Friedman, it was Bernanke that came to be known as Helicopter Ben .

What does Helicopter drop mean?  It simply means that in times of deflation, Government can simply print money and drop via helicopter to the public (implying throwing monies to public). The excess money would create demand, leading to higher inflation.

This is the simple way but economists don’t like things to be that simple. Infact I learnt there are 2 ways one can transfer money to the public.One way is money financed and other is bond financed.

• Money Financed or Helicopter drop. In this government raises money by issuing bonds which are subscribed by the central bank. The Central bank in turn prints money and passes to the government and government passes the stimulus to the public. This is also called monetisation of deficit
• Bond Financed. In this government simply raises money by issuing bonds to the market and passes on the proceeds to the public. There is no monetisation of deficit and this is called traditional Keynes approach.

I learnt all this in an excellent Laurence Ball paper where the author tries to stimulate what would have happened if Japan had transferred monies using both the methods. He starts the drops from 2003 onwards.

The findings are:

Overall, the results are favorable to the idea of helicopter drops. For base parameter values, a money-financed transfer of 6.6 percent of GDP returns output to potential in a year, and thereafter only small transfers are needed to keep it there. The output recovery ends deflation and the interest rate becomes positive, allowing the central bank to return to a more normal monetary policy.

The helicopter drop also has benign effects on the debt-income ratio. This ratio starts falling as the economy recovers, whereas it would rise without the helicopter drop. Part of this fiscal gain is permanent: a helicopter drop reduces the debt-income ratio in the long run as well as the short run.

There is an important qualification to this success story. The monetization of the fiscal transfer does not mean the transfer is forever free for the government. After the economy recovers, the central bank has to undo its monetary expansion to prevent inflation from rising. This requires contractionary open market operations, which cause a jump in privately held debt. Nonetheless, the overall effect of a helicopter drop is to reduce the debt-income ratio: the decrease in the ratio during the recovery exceeds the increase when the central bank sells debt.

A bond-financed fiscal expansion has different short-run effects than a helicopter drop. The sale of bonds causes a temporary run-up in the debt-income ratio before the output recovery starts to reduce it. In the long run, however, a bond-financed fiscal expansion leads to the same debt-income ratio as a helicopter drop. The reason is that the initial benefit from monetization is offset by the later need to undo monetization.

Hmm. Money financed leads to higher debts later and bond – financed to higher debt initially. However, both lead to similar benefits on output and inflation. But still, money financed is preferred as high debt initially could lead to confidence crisis.

This paper fills the literature which supports fiscal transfers can help come out of liquidity trap (See debate between fiscal and monetary policy here).

Some economists argue that fiscal transfers, whether financed by money or debt, are ineffective for stimulating Japan’s economy. They claim that Japan tried fiscal expansions during the 1990s without success. If this view were correct, it would undermine this paper’s argument for helicopter drops. However, Posen (1998) and Kuttner and Posen (2001) show that fiscal policy is effective in Japan. As noted earlier, Kuttner and Posen (2001) present econometric evidence of a substantial fiscal multiplier. They also discredit the alleged examples of unsuccessful fiscal policy, showing that several “expansion” programs failed because they were not really expansions—they consisted mainly of normal expenditures. When true fiscal expansions occurred, as in 1995, output responded.

Ball also does not agree that monetary policy can generate inflation via the expectations route:

The policies considered in this paper—transfers financed with money or bonds—differ from those discussed in much of the literature on liquidity traps. Papers such as Eggertsson and Woodford (2003) and Auerbach and Obstfeld (2004) analyze models with forward-looking inflation expectations. In these models, central banks can engineer an escape from a liquidity trap through policies that manipulate expectations. Announcing an inflation or price-level target, for example, can raise expected inflation. Higher expected inflation reduces the real interest rate, stimulating spending.

This paper has ignored such policies because, in contrast to fiscal transfers, there is little evidence that they are effective. Policy announcements affect inflation expectations in theory, but not in practice. Empirical work generally finds that inflation expectations are tied to past inflation—they are backward-looking. Expectations do not shift when new policies are announced; they only shift when people see inflation change.

This debate between whether inflation expectations are forward looking or backward looking is quite interesting and am sure monetarists would not agree to what Ball says.

Anyways, an excellent paper which tries to walk the talk. Am not sure whether the walk would have worked?