Economic Recovery -- Five Lessons from the Depression

The Washington Consensus is that whatever measures are needed to ensure economic recovery should be taken. This is especially true of the incoming team -- President-elect Obama has made clear he is prepared to undertake a major stimulus program.

How should the U.S. Government best pursue economic recovery? We hear a lot that the country is suffering its worst crisis of confidence since the Great Depression. What did we learn from the Depression? We learned the big lesson from John Maynard Keynes that fiscal policy should be temporarily expansionary. Second, we learned four post-Keynesian lessons featured in speeches by Fed Chairman Bernanke while he was Governor.

Lesson I - Government Spending Is Crucial ("Can't Push on a String"). For Keynes, the main lesson was that monetary policy isn't effective at very low interest rates associated with a crisis of confidence and cash hoarding. With monetary policy ineffective, the only way out was for the government to spend money on new short-term projects.

Keynes built his theory around the importance of the "animal spirits" of investors being crushed by the 1929 crash. With expected returns from investments low, investment fell, creating a decline in economic activity. Businesses avoid investing in real capital and hold more cash. Investors in securities stay in short maturities because they are afraid of being stuck with low-coupon bonds that lose value once rates rise again. These attitudes become a self-fulfilling prophecy, a "liquidity trap". The metaphor used by economics teachers is that the Fed "can't push on a string". Keynes believed that monetary policy could do little in this situation and recommended expansionary fiscal policy -- higher spending without higher taxes, creating temporary deficits to be paid down after recovery. A central bank can (to change the metaphor) prick a bubble but it can't reinflate a popped bubble. So the increased U.S. spending in World War II was viewed by Keynesians as proof that spending enough is the ticket to restoring confidence.

Lesson II - Don't Pop a Bubble (The Fed Did It in 1928). This lesson was taken to heart during the bubble period. Monetarists, notably Milton Friedman and Anna Schwartz in their 1963 book, believe Keynes underestimated the Fed's power. They have argued that the Fed improperly tightened money in 1928. After New York Fed President Benjamin Strong died in early 1928, his less able successors opted to prick the stock market bubble, raising the discount rate from 3.5 percent in January 1928 to 6 percent in August 1929. This tightening drove private short-term lending rates to 9-10 percent (and occasionally above 20 percent). The high rates killed a budding recovery from the previous mild recession and the economy turned back down in August 1929, leading to a stock market decline in the next month and the well-known crash in October. Fed Chairman Bernanke used this description of the origins of the Depression to argue against "popping the bubble" of the stock market in his remarks to the New York Association for Business Economics in October 2002.

Lesson III - Enough Money Will Create Recovery. Milton Friedman argued that a central bank could have done more than Keynes allowed and that the dreaded liquidity trap could in practical terms be dealt with by dropping dollar bills from helicopters. Then-Governor Bernanke in 2003 agreed ("A sufficient injection of money will ultimately always reverse a deflation.") and reasserted the importance of monetary policy by observing that fiscal policy has monetary implications. ("A money financed tax cut is essentially equivalent to the helicopter drop.")

Lesson IV - The Fed Should Help Stop Runs on Banks. Bernanke in 2002 said of the Fed in the 1930s that it "made little or no effort to protect the banking system from depositor runs and panics." The creation of the Federal Deposit Insurance Corporation by the 1933 Glass-Steagall Act was needed because the Fed did not think that protecting small depositors was its responsibility.

Lesson V - The Fed Should Stop a Severe Price Deflation. Bernanke argues that allowing deflation in the 1930s "drove real interest rates sky-high and greatly increased the pressure on debtors." (Real interest rates are figured as the nominal rates minus the expected rate of inflation, so if deflation is expected it adds to the nominal rate.) Asset deflation could have been prevented by the Fed buying longer-maturity government securities, and some even suggested it might be useful for the Fed to have the right to buy private-sector bonds in unusual circumstances. These unusual circumstances were reached yesterday, with the Federal Open Market Committee's announcement that the Fed would not only "implement the Term Asset-backed Securities Loan Facility to facilitate the extension of credit to households and small businesses," but would also "continue to consider ways of using its balance sheet to further support credit markets and economic activity." No stone is being left unturned.