TW: Mark Thoma, a very good economics blogger, pulls together highlights from another economist's, Bruce Bartlett, piece in Forbes. It helps if you are trying to wrap your arms around where we are and more importantly where we need to go policy wise over the next few months. To repeat what has become a mantra on this blog, we need government spending not something else at this point.
From Thoma/Forbes/Bartlett:
"Every day that goes by makes clearer the parallels between the current financial crisis and the one that led to the Great Depression. Then, as now, the core problem was one of deflation... What few people understood at the time was that the Federal Reserve was primarily responsible for the deflation...
In its initial stages, the Fed might have been able to prevent a full-blown depression by being a lender of last resort. It should have been aggressive about buying every financial asset it could lay its hands on and created as much money as necessary to do so. But it ... was passive and, as the value of financial assets collapsed, banks closed and vast amounts of wealth simply vanished.
The money simply disappeared, because there was no federal deposit insurance in those days. According to ... Milton Friedman and Anna Schwartz, the nation's money supply fell by one-third between 1929 and 1933, which induced a 25% fall in price levels...
As prices fell, businesses were forced to sell goods for less than they cost to produce. They couldn't cut costs easily because that meant reducing wages, which workers naturally resisted. Layoffs were the only way to cut costs, but this meant workers didn't have any income with which to buy goods, since there was no unemployment compensation either. This created a downward spiral that proved very difficult to stop. ...
The decline in wealth also reduced spending, and the fall in prices had the effect of magnifying debts. Debtors were forced to repay loans in dollars worth 25% more than those they borrowed in the first place. Farmers ... were especially hard hit. In effect,... they took out loans that were worth X number of bushels of wheat and ... they needed 25% more bushels to repay. ...
When the rate of deflation exceeds the nominal interest rate,... no one is going to lend money at a negative nominal rate; they will just hold on to it. When this happens, we have what economists call a liquidity trap, and the Fed cannot inject liquidity into the economy to stop the deflation. ...
Another problem that policymakers back then didn't grasp is that the money supply's effectiveness depends on how quickly people spend it; something economists call velocity. If velocity falls because people are hoarding cash, it may require a great deal more money to keep the economy operating. ...
This is essentially the problem we have today. Unlike in the 1930s, the Fed is not allowing the money supply to diminish. ... But velocity is collapsing. Banks, businesses and households are all hoarding cash, not spending except for essentials. This is bringing on the deflation that is crippling the economy. ...
The problem today is that velocity is falling faster than the Fed can pump up the money supply by buying financial assets... What Keynes figured out is that when conditions such as these exist, the federal government must step in to raise spending in the economy and thereby increase velocity. This means running a budget deficit, but that is only part of the solution. ...
We also know from the experience with tax rebates in 1974, 2001 and 2008 that this doesn't do any good, either. People mostly save the money...
Keynes argued that the only thing that will really work is if the federal government uses its resources to purchase goods and services. It must buy "stuff"--concrete, computers, paper, glass, steel--anything as long as it is tangible. In other words, the government must spend the way households do, by buying things. ... This is what ends an economic crisis. Unfortunately, it was not until World War II that the federal government spent enough on real resources ... to make Keynes' theory work in practice.
The challenge for Congress and the Obama administration will be to devise a spending program that draws a significant amount of real resources out of the economy fast enough. A massive public building program would be one way, but that will take more time to gear up than we may have. ... We need something today that can affect the economy within months. ...
For what it's worth, Keynes didn't know what to do in this situation, either. He suggested building pyramids and burying bank notes in deep mine shafts that had been filled in. As people tried to dig up the money, they would be forced to employ labor and purchase equipment that would raise spending and thereby growth. In the end, it took the greatest war in history to make Keynes' theory work. ...
We ... have the advantage of important institutions like deposit insurance and much better leadership at the Fed. But in the end, there is a limit to what the Fed can do by itself. At some point, government spending must be the engine that pulls the economy out of recession...
But it must be the right kind of spending. It must draw real resources out of the economy--that is the only kind of spending that will work. ..."
http://economistsview.typepad.com/economistsview/2008/12/what-would-keyn.html
http://www.forbes.com/opinions/2008/12/04/depression-deflation-velocity-oped-cx_bb_1205bartlett.html
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