A monetary story alternative to Krugman´s fiscal story

Paul Krugman writes “Did The Fed Save The World?”:

Bernanke’s basic theme is that the shocks of 2008 were bad enough that we could have had a full replay of the Great Depression; the reason we didn’t was that in the 30s central banks just sat immobilized while the financial system crashed, but this time they went all out to keep markets working. Should we believe this?

It’s not a hard story to tell — and I very much agree with BB that pulling out all the stops was the right thing to do. You don’t play games at such times.

But I’m not persuaded that the real difference between 2008 and 1930-31 (which is when the Depression turned Great) lies in central bank action, or related bailouts.

It’s true that the 30s were marked by a big financial disruption; one measure (which I learned from Bernanke’s academic work) is the soaring spread between slightly risky corporate bonds and government debt:

Alternative to Krugman story_1

But there was also a big financial disruption in 2008-2009, in fact comparable in size by this measure:

Alternative to Krugman story_2

So really, was putting a limit on the financial crisis the reason we didn’t do a full 1930s? Or was it something else?

And there is one other big difference between the world in 2008 and the world in 1930: big government. Not so much deliberate stimulus, although that helped, as automatic stabilizers: the U.S. budget deficit widened much more in 2007-2010 than it did in 1930-33, even though the slump was much milder, simply because taxing and spending were much bigger as a share of GDP. And that budget deficit was a good thing, supporting demand at a crucial time.

Again, Bernanke and company were right to step in forcefully. But I’d argue that the fiscal environment was probably more important than monetary actions in limiting the damage.

The charts below allow for a different narrative.

Alternative to Krugman story_3

Notice that the “financial disruption” in the Great depression only began 15 months into the economic contraction, being responsible (“propagating”) the second stage of the contraction. When did it end? When FDR delinked from gold and NGDP turned around.

The “financial disruption” in the Great Recession was “front loaded”, with financial disruptions beginning even before the start of the recession. What seems to have “propagated” the financial disruption after mid-2008 was the Fed allowing NGDP to “shrink”. The fact that the “financial rescue services” quickly went into action helped avoid another dive in NGDP as happened in 1931. In other words, “propagation” this time around was avoided. When did the “financial disruption end? When, in addition to rescuing finance houses, the Fed introduced QE1 in March 2009.

Just like FDR´s action in 1933, Bernanke´s action in 2009 reversed the course of “fate”, only in Bernanke´s case, the action was excessively timid.

The main point, however, is that in this version of the comparative stories the “fiscal actor” (big government) does not get to go on stage!

Update: Elsewhere someone called geerussell commented:

Those charts just show the central bank doing its job. In the 1930s by abandoning the gold standard to provide the necessary accommodation. In 2009 by furnishing liquidity and avoiding rate spikes. In doing so they don’t crowd big government off the stage, they keep the stage from collapsing so the show can go on.

If the central bank is doing its job in accommodation though, it can’t “do more” and whether anything happens on the stage or not depends on degree to which the government steps up with the necessary spending and this chartdetermines the pace and quality of NGDP recovery.

The version of his chart is on top:

fiscal-mon story

Despite increasing fiscal stimulus in 2007-09, the real economy is tanking together with nominal spending. When NGDP growth turns up, so does RGDP growth. And note that despite increasingly contrationary fiscal policy in 2011-14, RGDP growth hums along at a stable rate, dancing to the tune of stable NGDP growth.

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