Bruce Bartlett Asks: "What Would Keynes Do?"
Some time ago Ezra Klein asked why we economist types were so happy--well, why all we economist types except those of us with offices on the same hall who will miss her company and must teach her and her husband's courses in the spring--at Barack Obama's decision to choose Great Depression and monetary history expert Christie Romer to chair the President's Council of Economic Advisers:
Ezra Klein: [C]an this really be so useful? It's hard to believe that a complex financial crisis in 2008 is so similar to a complex economic crisis in 1929 that you need an incredibly subtle understanding of the latter to effectively apprehend the former. Presumably most economists know enough not to repeat the basic mistakes of the 1930s, and the question is which economists know enough to avoid the possible mistakes of the 2000s. Is there any real reason to assume otherwise?
The problem is that economic theory is not rocket science. It is not like theoretical physics--conducting a relatively few crucial experiments to decide on basic theories and then working out the consequences of those theories from first principles. Economic theory is, instead, crystalized history. We take a bunch of historical episodes that seem relevant to the problems of interest of today. We boil down what seem to be their salient features. And then from the resulting soup and bones we construct simple stylized models that we think help us understand present and future episodes that fall into the same class.
The problem is that right now we have a financial crisis big enough and strange enough that there is only one past historical episode in the same class: the early stages of the Great Depression. And when there is only one, the value of skill at deriving theoretical lessons from the class is at a steep discount and the value of knowing the history is at a premium: better to take the history raw.
Which is why we (OK, them) are cheering the appointment of Christie Romer, reading copies of John Maynard Keynes, Collected Works vol. XXI: Activities 1931-1939: World Crises and Policies 1931-1939, and casting ourselves back into the Great Depression and asking: "What would John Maynard Keynes do?"
And with that let me turn the mike over to Bruce Bartlett at Forbes:
What Would Keynes Do?: 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... falling prices... fixing it will require more than just low interest rates. This was the key insight of British economist John Maynard Keynes....
The decline in wealth also reduced spending, and the fall in prices had the effect of magnifying debts.... 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....
[M]arket 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.... [T]he 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)?...
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.... The nation is fortunate to have Ben Bernanke as chairman of the Federal Reserve Board. As an academic economist, he studied the Great Depression in great depth. He also has a keen grasp of the problem of deflation....
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.... 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....
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....
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....
[T]here 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.... 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.
