Chronicles of a Reverse Helicopter Drop

Ben Bernanke's nickname, "Helicopter Ben," refers to a famous "thought experiment" in economics. What would happen if the government were to rain money down upon us from a helicopter? Milton Friedman pondered this question in "The Optimum Quantity of Money" in 1969. The helicopter drop thought experiment is increasingly mentioned in discussions of unconventional monetary policy possibilities for the Fed, Bank of England, and ECB. Helicopter money was the subject of a speech given by David Miles, External Member of the Monetary Policy Committee of the Bank of England. Forbes calls QE4 "Another Step Towards Helicopter Money."

An earlier version of the helicopter drop thought experiment did not involve helicopters, because they were not invented yet. David Hume, in 1752, asks us to "suppose that,by miracle, every man in Britain shou’d have five pounds slipt into his pocket in one night." (Robert Lucas later criticizes the "magical" quality of this scenario.) Hume reasons that it should have no effect:

Where coin is in greater plenty; as a greater quantity of it is then requir’d to represent the same quantity of goods; it can have no effect, either good or bad, taking a nation within itself: no more than it wou’d make any alteration on a merchant’s books, if instead of the Arabian method of notation, which requires few characters, he shou’d make use of the Roman, which requires a great many.

Yet, Hume notices that in practice, his conclusion doesn't seem to hold. “Tho’ the high price of commodities be a necessary consequence of the encrease of gold and silver, yet it follows not immediately upon that encrease, but some time is requir’d before the money circulate thro’ the whole state, and make its effects be felt on all ranks of people." His observation is based on the experience of France in the 1720s, an experience almost as magical as the five pound miracle.

In a paper with one of my all-time favorite titles, "Chronicles of a Deflation Unforetold," Francois Velde describes and analyzes the French monetary experiment of the 1720s. French currency at the time was gold and silver coins with nominal value set by government decree. The monarch could raise the legal tender value of the coins (augmentation) or lower their value (diminution). Over a seven-month period in 1724, the nominal value of the coins was reduced by 50% through a sequence of diminutions. On one instance, coins lost 20% of their nominal value overnight. This episode served as an experiment testing the neutrality of money. Here is Velde's abstract:

Suppose the nominal money supply could be cut literally overnight by, say, 20%. What would happen to prices, wages, output? The answer can be found in 1720s France, where just such an experiment was carried out, repeatedly. Prices adjusted instantaneously and fully on one market only, that for foreign exchange. Prices on other markets (such as commodities) as well as prices of manufactured goods and industrial wages fell slowly, over many months, and not by the full amount of the nominal reduction. Coincidentally or not, the industrial sector (as represented by manufacturing of woolen cloths) experienced a contraction of 30%. When the government changed course and increased the nominal money supply overnight by 20%, prices responded much more, and the woolen industry rebounded.

By the spring of 1724, the diminutions had cumulatively reduced the value of coins by one third, but without a matching reduction in prices. In other words, money was non-neutral. This of course caused economic troubles including industrial contraction. Policymakers clearly recognized that public expectations were a cause of monetary non-neutrality and a channel of monetary transmission. Following a diminution on April 4, 1724, the finance minister Dodun wrote a letter to be made public (cited in Velde).

The minister explained that the cumulative reduction in coin value had by now reached a third, and the public ought to see the benefit of this reduction in lower prices. This had not yet happened “because merchants and workers, foreseeing that other reductions might happen, used this pretext to increase prices rather than reduce them.” But coins were now at a rate destined to remain “for a long time if not forever, the public has no reason to fear further reductions for now.”

Dodun's letter served as an attempt of "forward guidance," but was not credible; another diminution ocurred on September 22. Today, monetary policymakers still attempt to make use of the power of public expectations. Forward guidance has been especially emphasized since 2011.

On another occasion, Dodun remarked that

...experience has shown us that the prices of commodities and goods is influenced less by the value of coins than by the fear of an impending reduction on coins and uncertainty over their future value, and this same fear and uncertainty would persist and prevent the previous reductions from having their effect...

Dodun's remark sounds familiar. The choice criticism of Fed policy even now is the accusation that it causes uncertainty. John Taylor, for example, argues that the Fed's quantitative easing announcements amplify uncertainty. In a speech I discussed in a previous post, Cleveland Fed President Sandra Pianalto lists "managing uncertainty" as a primary responsibility of the Fed. The American Enterprise Institute cautions that "Economic policymakers must focus not on experimental policy responses, but rather on reducing the high level of economic policy uncertainty by simplifying the tax system and avoiding new initiatives like the Federal Reserve’s QE3."

Dodun mentions not only uncertainty, but also fear. It is the combination of fear and uncertainty that he finds disruptive. Fear, I would argue, has the potential to do more harm than uncertainty, but the two tend to be confused. Unconventional monetary policy, to the extent that it is poorly understood and sometimes unprecedented, may cause uncertainty but it need not cause fear. The Fed can take some steps to address uncertainty through communication, provided they don't toss credibility out the window like Dodun. In a crisis, doing nothing would cause more fear than trying something new. "Avoiding new initiatives" is not the way to reduce fear and uncertainty.