Originally published on January 21, 2009
Milton Friedman and Anna Schwartz’s Monetary History of the US motivated the conventional wisdom about the Great Depression, that is, that it was caused primarily because of low money growth and exacerbated by several other things including attempts to balance the government budget, protectionism via Smoot-Hawley tariffs, and of course the tremendous loss of confidence in banks leading to numerous bank runs.
Nonetheless the solution to the depression was thought to be found in the ideas of John Maynard Keynes, namely a substantial increase in government spending to create jobs in the economy. Most everyone agrees that the depression wasn’t really “solved” until WWII, despite the increases in government spending with Roosevelt’s New Deal. However, these New Deal increases only raised government spending from $9 billion in 1929 to $15 billion in 1939. Due to declining output this represents an increase from 9% to 16% of GDP. Although this looks expansionary, it wasn’t until the advent of WWII that government spending really began to rise. Government spending almost doubled to $26 billion in 1941 and peaked at $105 billion in 1944 at a staggering 48% of GDP. By 1944 the US unemployment rate was finally brought down to 1.2% (from its peak of 24% in 1933 and from 17% in 1939)
Unfortunately though history does not allow us to (easily) run a counterfactual. For example, what would have happened in the ‘30s if there were no substantial increase in government spending but there was a substantial increase in the money supply at the very onset of the depression, perhaps tied together with regulations to restore confidence in banking? Today, economic historians like Barry Eichengreen, contend that it is highly unlikely for us to suffer another great depression because deposit insurance can effectively prevent banks runs and maintain confidence in the financial sector and central bank managers know full well to raise the money supply quickly in response to a crisis in confidence. Possibly if that were done in the 30s, the depression would have been a temporary recession.
In this financial crisis, the FED and Treasury did respond by substantially raising the money supply, extending deposit insurance, and taking control or facilitating the buyout of “too big to fail” financial institutions. So how do we know that these actions will not be sufficient?
Seemingly, the massive increases in government spending in WWII substituted for depressed consumer spending and helped put people back to work. However, there was one other characteristic then that doesn’t hold today, at least not to the same degree. In WWII the Japanese flagrantly attacked the US in the Pacific, while at the same time the advance of the Axis forces in Europe threatened our very existence. It wasn’t too hard under those circumstances to rally workers to support the war cause and to quickly ramp up the defense sector. Suddenly everyone in the country had a central purpose, namely preserve our existence. So today the question to ask is, would a massive increase in government spending, without a clear sense of purpose to galvanize the workforce, have the same stimulating effect on the economy? Or again, would allowing the increase in money supply to work its way through be sufficient to prevent a serious decline?
Truth is, we don’t know. I don’t know, …. nor do the experts proposing it.
Regardless, the economic crisis offers an excuse to greatly expand the role of government in the lives of its citizens. Without the crisis, the new administration could never have done this. With the crisis, all sorts of things become possible. Once a $700 billion bailout was passed this past Fall, it doesn’t sound preposterous to propose another $800 or $900 billion in extra government spending. (Some economists like Krugman propose the stimulus should be even bigger)
Indeed the new administration now has the same kind of blank check in fiscal policy that the last administration had in foreign policy. The 9-11 attack made it politically possible for the US to invade both Afghanistan and Iraq. Both of these excursions have led to obligations that are difficult to disengage from and extend long after the initial actions. So similarly the expansion of government spending will lead to obligations that are difficult to reverse and will extend long after the initial actions.
Lastly, the popular impression is that the current economic crisis was caused in part by individuals and businesses overextending themselves and borrowing more than they could expect to repay in the future. Greed for prosperity led to insolvency. Now, we are proposing to fix the problem by greatly expanding government borrowing within a government that is already seriously overextended. (Had we entered the crisis with a tolerable level of government debt, the concerns would be greatly mitigated) In other words, government is about to do precisely what individuals and others were doing, overextending itself in the name of greed. Only this time it’s greed for social, environmental and presumed “good” government programs that will fuel the frenzy.
