Your humble narrator recently had an article in the Wall Street Journal about the new idea in monetary policy, ‘helicopter money’. An earlier draft had a rather tedious discussion of what it was. Mercifully excised from the printed version, I still thought it might be worth sharing. I’ve little doubt you’ll be hearing more about it soon…
Helicopter money takes its name from a 1969 paper by Milton Friedman called The Optimum Quantity of Money. In it Friedman set out to investigate just that. To analyse how people would adjust their cash holdings to achieve this optimum if the money supply were increased, he conducted a thought experiment in which a helicopter flew over a country dropping newly printed money. The point was simply to model an exogenous increase in the money supply, much as David Hume had in his 1752 essay Of Money. Indeed, Friedman also imagined a furnace destroying piles of cash in an effort to model the effects of an exogenous decrease in the money supply. The key point is that when Friedman wrote about helicopter money, he was not advocating anything like the policies currently bearing that title.
How has it come to this? Since the crash of 2008-2009, developed country economies have been stuck with sluggish growth. Their governments also have historically high peacetime levels of debt and new borrowing. With fiscal policy thus constrained, if stimulus is to be administered it is the central banks who will have to do so using monetary policy. Still others think that fiscal policy would be ineffective in any event. Either way, central banks are, as Mohamed El-Erian has written recently, the only game in town.
But the record of monetary policy’s impact is mixed. In 2002, Bernanke gave a speech frequently cited by advocates of activist monetary policy in which he argued that “under a paper-money system, a determined government can always generate higher spending and hence positive inflation”. But in recent years it hasn’t worked like that. Central banks have churned out new base money and pumped it into the banking system in return for (government) bonds, Quantitative Easing. As a result, in Britain, the monetary base has risen by 516% since May 2006. But, for the most part, this money has just sat on bank balance sheets; they have not used it as the basis for the creation of new credit. Hence, over the same period, broad money has risen by just 53%. The transmission mechanism of monetary policy via the banking system is blocked and increases in base money have not filtered through to increases in spending, also known as nominal GDP or aggregate demand. JK Galbraith’s old quip about expansive monetary policy “pushing on a string” has never been truer.
To look at it another way, consider the equation of exchange from your economics textbooks, one form of which is MV=Py. This says that the money supply (M) multiplied by the velocity of circulation (V) equals the price level (P) multiplied by output (y). Velocity of circulation – how many times in a given period a unit of money is spent – can serve as a useful proxy for the demand for money. If the demand to hold money increases, its velocity (V) falls. Conversely, if that demand falls and people want to swap their money holdings for goods or services, V rises. Velocity is the inverse of the demand for money.
When mortgage backed assets tanked in 2008, banks saw their balance sheets ravaged. They desperately demanded cash to shore them up, their V had fallen, in other words. In an effort to ward off a fall in prices and/or output (Py), central banks offset this by increasing M via low interest rates and QE.
But if the aim is to use increases in M to boost Py then the new money must be given to people whose demand to hold money has either fallen or not risen (their V is constant or rising); to put money in the hands of those who would spend it and boost prices rather than hold it as banks have done. This is where the helicopter comes in.
The success of this policy all depends on whether raising a nominal variable (the price level, P) will also raise a real variable (output, or y), that there is a Phillips’ Curve relationship, in other words. This is the notion of an inverse relationship between inflation and employment, which was long presumed dead among the rubble of the Stagflationary 1970s.
This is a point I intend to return to soon.