For Mr. Grant, the heroes of the narrative are the price mechanism itself and Adam Smith ’s invisible hand. Prices and wages stopped falling “when they became low enough to entice consumers into shopping, investors into committing capital, and employers into hiring.” Hence the book’s subtitle: “1921: The Crash That Cured Itself.”
Does this experience have relevance to policy today? The answer, for Mr. Grant, is a confident “yes.” No fiscal stimulus was administered in 1920-21, and a powerful, job-filled recovery followed. Today our “overmedicated” economy is in its fifth year of a “lackluster recovery.” In the current environment, he believes, we should take a more laissez-faire position.
Perhaps so, but there are important differences between then and now, and there is more to the story. In their definitive “A Monetary History of the United States” (1963), Milton Friedman and Anna Schwartz share Mr. Grant’s essential take on the cause of the 1920-21 recession, describing it as a reaction to an overzealous tightening of monetary policy to fight the post-World War I inflation. But monetary policy, they note, also played a role in the recovery. The discount rate was cut several times in 1921, and the monetary base had stopped falling by the end of the year. Credit conditions eased, the money supply rose and the monetary base started rising sharply in early 1922. Monetary policy caused the downturn, and the recovery occurred when monetary policy changed course. The recession did not cure itself.
Just as important, monetary policy did not cause the recession of 2008. The crisis was precipitated by the unraveling of a housing bubble and excessive leverage by individuals as well as financial institutions, creating a crisis whose remedies are different from 1920-21. To take but one example: Short-term interest rates today have already been reduced essentially to zero, and yet the economy still lags.
So, to Malkiel (who belongs to a very large group) monetary policy did not cause the 2008 recession. That means monetary policy had nothing to do with the large drop in nominal spending that took place.
Friedman would have enlightened Malkiel by:
- Telling him that you cannot escape a (great) recession if the Fed allows nominal spending growth not only drop precipitously but to turn negative.
- Reminding him that interest rates do not define the stance of monetary policy (in fact, if rates are low it means monetary policy has been tight), and
- Sending him to read this (among others) Scott Sumner post