Did you know that his stated intent to drop some money by helicopter is actually a reference to an essay by Milton Friedman, where he explains the relationship between an increase in money supply and inflation? (Chapter 2 : "Mystery of Money", Money Mischief, Pg. 29)
That chapter is the best short description of monetary policy ever. At least, its the only one I have understood. It sheds a lot of light on the recent actions of the Federal Reserve and Treasury.
Recent economic events can be summarized as follows :
- Economic shocks to the system have reduced the supply of credit (bankrupt banks), demand (What if I lose my job tomorrow, I need to save!!) and increased preference to hold cash.
- As demand reduces , producers start losing money and react by cutting prices, reducing production and reducing jobs.
- Since debt is in $ terms, the real cost of debt goes up.
- This sets up a vicious cycle. Job losses reduces demand even more, and that spurs even higher job losses and more bankruptcies.
What can the Federal Reserve do about this ?
- Flood the system with cash.
- In "normal" conditions this cash is more than what typically people like to hold, so they spend it. This increases demand, leads to higher prices which then would reduce demand, and in aggregate you are back to where to you started, except that everything costs more. The real value of a previous debt goes down proportionally.
- In "worst case" conditions this cash is not spent but held in entirety as everyone is shell shocked. Absolutely nothing changes, and we continue to deflate.
- The Fed is hoping for something in between, where some fraction of the additional cash finds its way into the system, leading to demand coming back, prices going up and the real value of debt going down - reflation essentially.
- Once confidence has come back, try to pull out some of that cash so that inflation does not go out of hand. One problem with doing that is the size of US household and government debt, and overall fiscal and trade deficits. Though China and Japan would be very unhappy, inflating away a moderate fraction of it is key. They shouldn't actually be so unhappy, because in the other scenario they wouldn't get a cent, as the US will be bankrupt baby. I am not exactly sure how they can take possession :).
PS: This speech by Ben Bernanke, as a Governor of the Federal Reserve System, almost exactly explains the rationale for many of the current Fed actions.
