Friday, January 23, 2009

Depression Economics

The Monetarist explanation of the Great Depression focuses on the collapse in the Money Supply which occured in the early 1930s.

Economists like Milton Freidman say the real mistake was allowing banks to go bankrupt causing a decline in the money supply and also loss of confidence in the banking sector. This decline in the money supply caused deflation and a dramatic fall in demand and output.

The current chairman of Federal Reserve Ben Bernanke admitted the Federal Reserve made a huge mistake in the Great Depression, but, it is a mistake they promise not to repeat.

Being true to his word, the Fed and government are doing everything they can with Monetary Policy. Interest rates cut to 0%, bailouts for banks and also increasing the money supply through quantitative easing.

The problem is that even this radical monetary policy seems unable to stem the fall in sales, record rises in unemployment and the huge falls in Output.

This is not just a usual boom and bust cycle it involves the unwinding of a credit and asset bubble.

It is in this scenario of failed Monetary policy, that Keynes advocated expansionary fiscal policy. In other words governments should borrow and spend to offset the fall in private investment and spending.

The problem is that US debt is already high therefore, the Obama team will be nervous about implementing more than a modest fiscal stimulus (the structural budge deficit of the Bush year's will be one legacy of profound regret for all)

Even this moderate fiscal expansion may be insufficient to deal with the extent of the downturn. And then people will criticise the fiscal injection as not working. But, that may miss the point; yes, it may fail to solve the recession, but, the recession would have been even deeper without it.

1 comment:

David said...

For someone not well versed in the history of Political Economy there appears to be a curious paradox. US bond rates are @ 0%, Money Supply is inflating exponentially , yet demand and prices in the 'real' economy appear to be falling and unemployment rising.