Archive for January 5th, 2009

1997 and 2003 dejavu?

January 5, 2009

Sample this:

There has recently been a marked increase in concerns of a generalized decline in prices in both industrial and emerging market economies. With Japan, China, and several other Asian economies already experiencing declining prices, the worry has been that deflationary pressures could deepen, and even spread more widely. This is against a background of massive declines in global equity markets; significant excess capacity and widening output gaps; repeated disappointments over the pace of global recovery; geopolitical uncertainties; and the impact on activity of higher oil prices.

Seems like a document written for current times. Not really. Well, it has been picked from this IMF primer on deflation written in 2003. Further,

This is the second time in the past five years that widespread concerns about deflation have come to the fore—the first being during and in the aftermath of the Asian crisis. Public discussion in many countries, including the United States and Germany, has centered on risks of the onset of deflation, with increasing attention levied to such risks by policymakers. These developments are notable given that for over four decades markets and policy makers have been more concerned about inflation than deflation.

Replace the first emphasised ((Emphasis is mine)) line as – This is the third time in the past ten years that widespread concerns about deflation have come to the fore—the first being during and in the aftermath of the Asian crisis and second one in 2003 post dot-com crisis. And the document is as good as for 2008.

Of course the research methodology would change with data updated but am sure the conclusions are going to be very similar. It develops a deflation index for some select countries where Japan, Germany, Hong Kong and Taiwan are noted as the highest probable for deflation in 2003.

It also estimates the deflation via the output and unemployment gap. Under this it estimates how much the gap between output and unemployment  between potential and current would have to be for deflation to occur. The findings are:

  Deflation Onset Persistent Deflation
  Unemployment Gap Output Gap Unemployment Gap Output Gap
United States 2 – 2½ 3-4 3½ – 4 5-6
Germany 1 – 1½ 1-2 2½ – 3½ 2 – 2½
France > 3 4 > 5 > 6
United Kingdom 2 – 2½ 2-3 2-3 4
Italy 5 5 > 6 > 5
Canada 5 >5 6 > 5
Japan 1 2


As seen, for deflation to onset in US in 2003,  unemployment gap would have to be 2-2.5% and outpt gap by 3%-4%, For persistent the figures are 3.5-4 and 5-6 respectively. In Japan deflation had already set in 2003 and for persistent to set in figures are given. in 2003, Germany looked closest to deflation as it required a gap of 1-2% in both.

I haven’t come across any papers on how these countries avoided the deflation threat, except for this Bernanke paper. It shows how US could get out by simply communicating to the public that deflation would be avoided. This implies the threat was at best limited in scope and no where near the Japan’s case. I haven’t come across papers that show the experience of other countries. If visitors are aware of any such research, do let me know.

We are seeing a similar situation now. Be prepared for tons of suggestions/research on zero interest rate policy, whether monetary or fiscal policy should be used, etc etc. Infact quite a bit has already started.

All these events pose a lot of questions for economists and policymakers. Why do we see this deja-vu (see a discussion here as well). You have a crisis; Followed by steep rate cuts ; the steep fall in prices lead to deflation pressures; leads to discussions on zero interest policy/liquidity trap; the crisis eases; investors search for higher yield assets; the economy recovers and lessons of capital infows are forgotten; this leads to a bubble driving all to join the bubble; the bubble bursts and similar things occur.

What is the way out?


What if Japan had helicopter-dropped money on its economy?

January 5, 2009

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?

Mostly Economics listed as a tool for Small Businesses finance

January 5, 2009

Kelly Sonora of Web Design Schools sends me this list of top 100 blogs for small business. The rationale for the list is:

In this economy, everyone’s looking for ways to cut down, and small businesses are no exception. One of the best ways to save money in business is to examine your annual expenses and consider how you can decrease those costs. Thankfully, there are some pretty amazing resources to help you figure out new ways to do just that. Check out what we consider to be the top 100 blogs for resources and inspiration to cutting your small business costs in 2009.

 Mostly Economics appears in the General Business Finance list (see 4th blog on the list).

Mostly Economics: Mostly Economics is full of helpful Indian economic and business research that can help you cut your costs.

ME is pretty happy if it is serving this cause. To be honest, ME couldn’t imagine that it could help small businesses cut costs. What started as a way to keep track of economic research and readings, seems to now be seen as a resource for cutting costs! ME also looked at the peer group and was very happy to be ranked with Freakonomics, the iconic economics blog.

Thanks Kelly for the pointer. Above all, thanks to all the visitors for visiting ME .

PS.By the way, Mostly Economics seems to have lost its ranking quite a bit. As per Econolog, it was 12th on Nov 12, 2008,  reached highest 7th on 25 November . Currently, it has slipped to where it started from – A friendly blog.

American Economic Association annual meeting 2009

January 5, 2009

AEA had its annual meeting for 2009. I came across numerous papers presented at the meeting.  The topics are as exotic as Economics of Malaria to the ongoing financial crisis.

The problem is not all papers are available for a free download. However, papers from prominent economists (Stiglitz, Mishkin, Rogoff, Brunnermeier etc) are. I remember even these papers are not available for a free download a while later.

Assorted Links

January 5, 2009

1. WSJ Blog points schools being added to stimulus plan

2. WSJ Blog points Feldstein is a EMU sceptic and latter says it is big test for EMU

3. Krugman again takes a poke at Kansas Fed Symposium. I always thought it is exceptional as it leads to some great papers. Reading Krugman and this complaint by Bill White of BIS, conveys a different side of the symposium as well

4. Blattman says blogging is harmless

5. Mankiw points to young stars of economics

6. Rodrik says one shouldn’t compare equity markets with GDP. He call it a non-economist blooper and has a category named the same in his blog. Better be careful not to land there.

7. JRV points to inflation adjusted stock returns in India. He also says in a ZIRP world we India needs to lower rates further

8. ACB asks – how about living in a mall?

9. Urbanomics points in search of inflation. It also has a nice post on IMF’s new paper on fiscal policy

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