What Would Keynes Do?
Bruce Bartlett, 12.05.08, 12:01 AM EST
The government should spend on stuff, not on bad assets.
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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. 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.
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. It does nothing to get at the economy’s root problem, which is deflation.
December 5th, 2008 at 7:03 pm
This history is utter non-sense, filled with both economic and historical fallacies. Rothbard’s America’s Great Depression is the definitive economic history of the period and blows most of these fallacies out of the water.
December 5th, 2008 at 7:51 pm
O.K., O.K., so this Keynes dude says that because we don’t spend fast enough, that the government should start buying the stuff we don’t want and that would make the stuff more expensive so the company who makes it can afford to hire me…
Far out.
But isn’t the government using my money? So, when the government buys a computer doesn’t it really mean that I am buying it? That in a real sense when I am competing with the government for scarce resources I am actually competing with myself – that as myself I am buying the same thing I already bought when I was the government, but paying more to get it because I bid against myself? So, in essence, by bidding against myself and buying twice as much as I need, I increase profits and therefore increase GDP and earn myself a job.
Is this some kind of E-bay scam?
Is that about it? Is that the Keynes solution? Oh, man, that is surreal. That is like…I don’t know… a bad hash dream or something, O.K.? Did the dude do opium?
I don’t know about you, but to me it sounds like there simply HAS to be a loser in the deal somewhere…..
December 5th, 2008 at 8:01 pm
Winston, according to the Keynesians, reinflationistas, CEOs of PIMPCO, and various “economists” (one must be careful using the term when referring to anyone who subscribes to neoclassical econostrology), there are no losers in the Keynesian fantasy land, where money flutters down from the sky. It’s a win-win-win.
Of course, you’re right to feel that something is entirely suspect about this picture. You’re one of the lucky few who chose the red pill.
December 5th, 2008 at 9:06 pm
That’s it, I’m cashing out. Gonna find a cave. If this isn’t a sign of the end of times I don’t know what is.
Bruce Bartlet
A (gasp) Keynesian
Jack
December 5th, 2008 at 10:01 pm
The government, or public sector (i.e tax payers) needs to replace the dearth of private activity in order to create aggregate demand. The establishment of the military industrial complex got us out of the last depression . How many tax dollars has the Pentagon controlled over the last 40 years? NASA? We are headed toward a more planned economy, where government takes a much more active role in creating a more sustainable, less speculative system.
December 5th, 2008 at 11:10 pm
Moss, you’re right. We’re headed for more socialism, although “more sustainable” is a joke. We swing between crony corporatism (Republicans) and crony socialism (Democrats). The only real difference is who gets to be the cronies.
There are very few people who remember what free-market capitalism actually is in this country
December 6th, 2008 at 12:44 am
Medicare for All … Services are part of the mix …
This saves jobs right away, especially in the public sector in states and local governments.
This re-capitalizes business, especially manufacturing, but also any business currently employing many people.
Strings could be attached such as a no layoff rule whereby companies would run 32 hour workweeks paying for 40 supplemented by the paid health insurance. States would be mandated to take any extra money and use it for unemployment benefits and\ or pension fund replenishment.
Medicare for All would also make our businesses more competitive at home and abroad. All the other G7 nations have government sponsored health insurance giving their businesses a subsidy.
We need Medicare for All ASAP …
December 6th, 2008 at 5:02 am
Winston Munn wrote:
“I don’t know about you, but to me it sounds like there simply HAS to be a loser in the deal somewhere…..”
In fact, there are a lot of losers in this deal… they’re called taxpayers.
December 6th, 2008 at 1:07 pm
Overall I suppose another blogger’s suggestion to abolish payroll taxes. They are in general a very bad idea unless very very low.
In the present circumstance their abolition would help both businesses and employees, either of which would help sustain the economy.
«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.»
Of the several disagreeable contentions about the Great Depression and today in Bartlett’s arguments, this is the worst.
The Fed and Treasury are taking non-negotiable paper and exchanging it with quasi-money treasuries at near par. That creates a lot of new spending power…
December 6th, 2008 at 6:25 pm
After finally grokking deflation, I’m a Keynesian, too. (Now. Not 4 months ago. I flip-flopped.) But, as for the “losers” — the taxpayers — why not write checks to each and every fellow American instead of the bankrupt banks that created this mess?
It might seem like we’re simply shuffling money around. But, it still reduces real debt. Individual balance sheets will look better.
Okay, foreign creditors won’t be happy with giving it only to Americans. So, give them some, too. What will they do with it? Since they know better than to buy bogus financial IOU’s from us, they’ll instead buy goods, services, or assets from us. What’s wrong with that?
The bottom line is that an industry of cheats (bankers, brokers, appraisers, realtors, flippers) created a massive amount of liquidity that permeated the economy. The sudden writeoffs are killing the real economy. To stop the bleeding, we should replace that liquidity. But, we shouldn’t give it to the jerks (and their bankrupt institutions) who created the problem in the first place. Ergo, give the money to everyone else but them.
It’s ironic. But, I really think this: we should turn Bernanke’s helicopter metaphor into more of a reality than most of us ever thought, as long as the helicopter travels around Main Street everywhere and never hovers over Wall Street.
December 6th, 2008 at 6:35 pm
I guess I’m agreeing with Blissex in a way.
Oh, an argument to “tax rebates” (or reduced withholding) is “consumers won’t spend it”. But, to that, let me say this:
(a) True, because we’re never given *enough* to have any left over after paying off the debt. We need more. (And if you think “oh, but that will be too much!”, then consider the next point.)
(b) Banks won’t lend it either! They won’t lend until they expect inflation again.
I understand all this printing risks high inflation down the road. Yes, it’s difficult to “get it just right”. But, that should not mean “don’t try”, IMHO, because the consequences of “not trying” are too dire. If inflationary expectations grow too high, we’ll raise rates again. (It’s been done before. And we turned out alright…better than in the early 30’s.)
December 6th, 2008 at 9:25 pm
wunsa-,
be cautious, see:
“”If ye love wealth better than liberty, the tranquility of servitude better than the animating contest of freedom, go home from us in peace. We ask not your counsels or arms. Crouch down and lick the hands which feed you. May your chains set lightly upon you, and may posterity forget that ye were our countrymen.” – Speech at the Philadelphia State House, August 1, 1776
and:
“When designs are form’d to raze the very foundation of a free government, whose few who are to erect their grandeur and fortunes upon the general ruin, will employ every art to sooth the devoted people into a state of indolence, inattention and security, which is forever the fore-runner of slavery.” – Article signed “Candidus,” in Boston Gazette, December 9, 1771
http://www.revolutionary-war-and-beyond.com/samuel-adams-quotes-1.html
December 6th, 2008 at 9:43 pm
Wunsacon,
Over the past few years, artificial wealth was created in enormous amounts – this was expressed as paper profits or paper values – which could only be accessed by equivalent debt creation. Consider one who had $50K in home equity due to price rises of houses – the only way to access those “profits” was to create new debt – either by a second mortgage for the existing owner or a new mortgage for a new owner.
Access to debt is not the same thing as wealth. It is this un-wealth that is disappearing.
Excess, non-serviceable debt (un-wealth) should disappear. It has no value to production. It encourages price instability. Yet, the Keynesian approach is to sustain this non-wealth by government intervention. The bottom line of this approach is to guarantee a new misallocation, rather than allowing markets to determine outcomes.