Evoking the spirit of Keynes

Mark Thoma linked to a May 2008 piece by Bruce Bartlett entitled “What would Keynes do”. It´s a conventional narrative of the “Great Depression” with which he found clear parallels with the situation at the time he wrote the article (May 2008):

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.

I take serious issue with the highlighted words. BB conflates FDR´s expansionary monetary policy, which was very effective, with government interventionist policies, elements of NIRA (National Industrial Recovery Act). But that summary dismissal of monetary policy is needed to support his conclusion:

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. By the time Keynes devised his theory, the Great Depression had been going on for six years, and it took a great deal more effort to get the economy out of the deep hole it was in than it would have had the right course been followed when the crisis started. We also have the advantage of important institutions like deposit insurance and much better leadership at the Fed.

But in the end, there 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, because only that can compensate for the fall in private spending that has caused velocity to drop and brought on deflationary conditions.

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.

The charts clearly show that in the 1930s it was monetary policy (FDR´s decision to delink from gold) that reversed the trend (the stock market had done a turn-about at the time of FDR´s acceptance speech in July 1932).

Bartlett on Keynes_1

And the following chart puts a dent in Bartlett´s argument for the “rescuing capacity” of government purchases (real government consumption & investment spending). Strongly rising government purchases didn´t stop the economy from plunging hard from mid-2008 to mid-2009 (the deepest fall in the post war period). Also, the steep drop in government purchases didn´t stop the economy from gaining some traction. QE1 brought on a moderately expansionary monetary policy, which was just enough to reverse the economy´s trend (but far short of what was needed to get it back to any reasonable trend level).

Bartlett on Keynes_2

Once again, the views of Friedman beat those of Keynes.

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