Are the world’s governments capable of keeping the world economy out of a deep and long depression? Three months ago, I would have said yes, without question. Now, I am not so certain.
The problem is not that governments are unsure about what to do. The standard checklist of what to do in a financial crisis to avoid a deep and prolonged depression has been gradually worked out over two centuries: by Bank of England governor Cornelius Buller in 1825; by the Victorian-era editor of The Economist, Walter Bagehot; and by the economists Irving Fisher, John Maynard Keynes and Milton Friedman, among many others.
The key problem in times like these is that investor demand for safe, secure and liquid assets — and thus their value — is too high, while demand for assets that underpin and finance the economy’s productive capital is too low.
The obvious solution is for governments to create more cash to satisfy the demand for safe, secure, liquid assets.
As Keynes liked to say: “Unemployment develops ... because people want the moon” — safe, secure and liquid assets. “Men cannot be employed when the object of desire [that is, money] is something which cannot be produced and the demand for which cannot readily be choked off.”
The solution is “to persuade the public that green cheese [that is, the notes printed by the central bank] is practically the same thing and to have a green cheese factory [that is, a central bank] under public control.”
By buying government bonds for cash, a central bank can satisfy demand and push down the price of cash. When there is no excess demand for cash, there will be no excess supply of the bonds and stocks that underpin and finance the economy’s productive capital. Thus, expansionary monetary policy via standard open-market operations by a central bank is the first item on the checklist of what to do in a financial crisis.
Three months ago, I argued that all but a tiny and unbalanced fringe of economists approve of expansionary open-market operations to keep total nominal spending constant in a downturn, and I was right. I was also right to say that all but a tiny and unbalanced fringe of economists approve of central-bank guarantees of system stability, in order to prevent the risk of a collapse of the payments system from becoming a first-order consideration boosting the demand for cash to unnatural levels.
The problem comes when expansionary monetary policy via standard open-market operations and central-bank guarantees of orderly markets prove insufficient. Economists disagree about when, under what circumstances and in what order governments should move beyond these first two items on the checklist.
Should governments try to increase monetary velocity by selling bonds, thereby boosting short-term interest rates? Should they employ unemployed workers directly, or indirectly, by bringing forward expenditures or expanding the scale of government programs? Should they explicitly guarantee large financial institutions’ liabilities and/or classes of assets? Should they buy up assets at what they believe is a discount from their long-run values, or buy up assets that private investors are unwilling to trade, even at a premium above their likely long-run values? Should governments recapitalize or nationalize banks? Should they keep printing money even after exhausting their ability to inject extra liquidity into the economy via conventional open-market operations, which is now the case in the US and elsewhere?
Three months ago, I said that there was considerable disagreement about these issues, but that two things were certain. First, we do not know enough about when, under what circumstances and in what order governments should resort to these checklist items.
Second, trying a combination of these items — even a confused and haphazard combination — was better than doing nothing. All five of the world’s major economies implemented their own confused and haphazard combinations of monetary, fiscal and banking stimulus policies during the Great Depression, and the sooner they did — the sooner each began its own New Deal — the better.
Japan and Britain began their New Deals in 1931. Germany and the US began theirs in 1933. France waited until 1936. Japan and Britain recovered first and fastest from the Great Depression, while Germany and the US followed well behind, and France brought up the rear.
The conclusion that I draw from this is that we should try a combination of all checklist measures — quantitative monetary easing; bank guarantees, purchases, recapitalizations and nationalizations, direct fiscal spending and debt issues — while ensuring that we can do so fast enough and on a large enough scale to do the job.
Yet I am told that the chances of getting more money in the US for an extra round of fiscal stimulus this year is zero, as is the chance of getting more money this year to intervene in the banking system on an even larger scale than America’s Troubled Asset Relief Program (TARP).
There is an 80 percent chance that waiting until next year and seeing what policies look appropriate then would not be disastrous. But that means that there is a 20 percent chance that it would be. And the US, it should be noted, is the most aggressive and best behaved of all major governments.
J. Bradford DeLong, a former assistant US Treasury secretary in the Clinton administration, is professor of economics at the University of California at Berkeley.
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