Use Lessons from History to Solve Financial Crisis

Good artical on how we got were we are and how to get out - but will the new government have enough good common sense to do the right thing - Learn from history? hmmm Hopefully.

What Would Keynes Do?

Bruce Bartlett, 12.05.08

The government should spend on stuff, not on bad assets.
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, or falling prices. But fixing it will require more than just low interest rates. This was the key insight of British economist John Maynard Keynes, whose theories finally explained how to end the Great Depression. They may be the key to solving today's crisis as well.

The Great Depression was so deep and prolonged for many reasons. Herbert Hoover stupidly signed the Smoot-Hawley Tariff, which crippled international trade and finance, and imposed one of the largest tax increases in American history in 1932, which was exactly the wrong medicine at the wrong time. Franklin D. Roosevelt at least understood that deflation was at the root of the problem, but he thought artificially raising the price of gold and preventing businesses from cutting prices and wages by law was the solution. In fact, it prevented the economy from adjusting, which made the situation worse.

What few people understood at the time was that the Federal Reserve was primarily responsible for the deflation and the only institution that could have done anything about it. As we now know, the Fed's tight monetary policy brought on a financial crisis that began with the stock market crash in 1929. Smoot-Hawley was also a factor, but it wouldn't have been capable of inducing such a crisis if Fed policy hadn't already put financial markets in a fragile condition.

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 didn't. Instead, 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.

http://www.forbes.com/2008/12/04/depression-deflation-velocity-oped-cx_bb_1205bartlett.html?partner=alerts

According to research by economists 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 over that period. 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, who are perpetually in debt, were especially hard hit. In effect, if they took out loans that were worth X number of bushels of wheat and were forced to repay them with the same number bushels, they needed 25% more bushels to repay.

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Both Hoover and Roosevelt tried to stanch the bleeding by buying up bad assets through the Reconstruction Finance Corporation, just as the Treasury is doing today through the Troubled Asset Relief Program. But it was just as unsuccessful as the current Treasury effort; the RFC then and the Treasury today must borrow the money needed to buy financial assets. Thus there is no net increase in liquidity; it is just an exchange--swapping Treasury securities for private securities.

http://www.forbes.com/2008/12/05/briefing-afternoon-jobs-markets-econ-cx_ss_1205markets30.html?partner=usatodaytix&loc=interstitialskip

It does nothing to get at the economy's root problem, which is deflation. One reason 1930s policymakers didn't grasp what was going on is because they didn't have good data. Money-supply figures in those days only measured currency and coin in circulation, but the vast bulk of the money supply consisted of bank deposits. When those evaporated, the Fed simply didn't have the right numbers. It looked mainly at interest rates, which were quite low, leading the Fed to believe credit was easily available.

But real interest rates were actually high, because the rate of deflation is added to market rates. If the market rate is 2% and prices are falling by 10%, the real interest rate is actually 12%.When the rate of deflation exceeds the nominal interest rate, market rates cannot fall enough to compensate because 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.

Since money is essentially a zero-interest security, when interest rates on marketable securities approach zero, the Fed is unable create liquidity by buying Treasuries with new money. It ends up being an exchange of similar assets with no economic effect. What's the difference between a dollar bill and a Treasury bill with a barely positive interest rate (as is the case today)?

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.

Think of it this way: Velocity is the ratio of the money supply to the gross domestic product. If GDP is $10 trillion and money turns over 10 times per year, then $1 trillion in money supply will be sufficient. But if velocity falls to 9, a $1 trillion money supply will only support a $9 trillion GDP. If the Fed doesn't want GDP to shrink by 10%, it will have to increase the money supply by 10%.This is essentially the problem we have today.

Unlike in the 1930s, the Fed is not allowing the money supply to diminish. Also, we have programs like federal deposit insurance to prevent bank deposits from shrinking. 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 nation is fortunate to have Ben Bernanke as chairman of the Federal Reserve Board http://www.forbes.com/2008/12/04/depression-deflation-velocity-oped-cx_bb_1205bartlett.html?partner=alerts.

As an academic economist, he studied the Great Depression in great depth. He also has a keen grasp of the problem of deflation. http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm,

On Nov. 21, 2002 he gave a speech that precisely outlines what the Fed can and must do when confronted by a deflationary situation. The problem today is that velocity is falling faster than the Fed can pump up the money supply by buying financial assets, and very low market interest rates mean there has been little net increase in liquidity as a result of the actions the Fed has taken thus far.

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. As noted earlier, spending just to buy financial assets does very little good. 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 or pay down debts. Thus, rebates just become another form of exchanging assets that add little to spending (and hence velocity).

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.

It must also employ labor, because much of what people spend money on today is in the form of services. This doesn't necessarily mean putting workers on the federal payroll, it just means that, to the extent that the government purchases services, this will also help raise spending in the economy.We will know that the government is spending enough to matter when interest rates start to rise. Although we think of saving as coming in financial form, in reality, saving represents things--labor and raw materials that are used to produce products and services people want.

Once the federal government increases its purchases of goods and services, it preempts resources that private businesses would otherwise use in production. As they compete with each other for those resources, their prices will rise and interest rates will rise. At this point, Federal Reserve policy will become effective again. As prices and interest rates rise, the liquidity trap disappears and money begins circulating more rapidly; i.e., velocity increases. This is what ends an economic crisis.

Unfortunately, it was not until World War II that the federal government spent enough on real resources--because they were needed for the war effort--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. It takes years to get major road projects planned and built. And at the moment we don't need any new office buildings, so our options in that area are limited. We need something today that can affect the economy within months.

Another option might be to harness interest in so-called green products and technology to reduce pollution and increase energy efficiency and launch a program in this area. But again, there is the problem of time. A green technology effort will require years to devise and execute. We don't have years.

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.

Hopefully we won't need another world war to get us out of the fix we're in today. Fortunately, we are in the early stages of a crisis, and downward momentum has not yet set in. By the time Keynes devised his theory, the Great Depression had been going on for six years, and it took a great deal more effort to get the economy out of the deep hole it was in than it would have had the right course been followed when the crisis started. We also 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, because only that can compensate for the fall in private spending that has caused velocity to drop and brought on deflationary conditions. 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. Buying bad mortgages and sending out more rebate checks won't do any good.

Bruce Bartlett is a former Treasury Department economist and the author of/Reaganomics: Supply-Side Economics in Action /and/Impostor: How George W. Bush Bankrupted America and Betrayed the Reagan Legacy .