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Stay the Course

The debate over economic policy has taken a predictable yet ominous turn: the crisis seems to be easing, and a chorus of critics is already demanding that the Federal Reserve and the Obama administration abandon their rescue efforts. For those who know their history, it's déjà vu all over again - literally.

For this is the third time in history that a major economy has found itself in a liquidity trap, a situation in which interest-rate cuts, the conventional way to perk up the economy, have reached their limit. When this happens, unconventional measures are the only way to fight recession.

Yet such unconventional measures make the conventionally minded uncomfortable, and they keep pushing for a return to normalcy. In previous liquidity-trap episodes, policy makers gave in to these pressures far too soon, plunging the economy back into crisis. And if the critics have their way, we'll do the same thing this time.

The first example of policy in a liquidity trap comes from the 1930s. The U.S. economy grew rapidly from 1933 to 1937, helped along by New Deal policies. America, however, remained well short of full employment.

Yet policy makers stopped worrying about depression and started worrying about inflation. The Federal Reserve tightened monetary policy, while F.D.R. tried to balance the federal budget. Sure enough, the economy slumped again, and full recovery had to wait for World War II.

The second example is Japan in the 1990s. After slumping early in the decade, Japan experienced a partial recovery, with the economy growing almost 3 percent in 1996. Policy makers responded by shifting their focus to the budget deficit, raising taxes and cutting spending. Japan proceeded to slide back into recession.

And here we go again.

On one side, the inflation worriers are harassing the Fed. The latest example: Arthur Laffer, he of the curve, warns that the Fed's policies will cause devastating inflation. He recommends, among other things, possibly raising banks' reserve requirements, which happens to be exactly what the Fed did in 1936 and 1937 - a move that none other than Milton Friedman condemned as helping to strangle economic recovery.

Meanwhile, there are demands from several directions that President Obama's fiscal stimulus plan be canceled.

Some, especially in Europe, argue that stimulus isn't needed, because the economy is already turning around.

Others claim that government borrowing is driving up interest rates, and that this will derail recovery.

And Republicans, providing a bit of comic relief, are saying that the stimulus has failed, because the enabling legislation was passed four months ago - wow, four whole months! - yet unemployment is still rising. This suggests an interesting comparison with the economic record of Ronald Reagan, whose 1981 tax cut was followed by no less than 16 months of rising unemployment.

O.K., time for some reality checks.

First of all, while stock markets have been celebrating the economy's "green shoots," the fact is that unemployment is very high and still rising. That is, we're not even experiencing the kind of growth that led to the big mistakes of 1937 and 1997. It's way too soon to declare victory.

What about the claim that the Fed is risking inflation? It isn't. Mr. Laffer seems panicked by a rapid rise in the monetary base, the sum of currency in circulation and the reserves of banks. But a rising monetary base isn't inflationary when you're in a liquidity trap. America's monetary base doubled between 1929 and 1939; prices fell 19 percent. Japan's monetary base rose 85 percent between 1997 and 2003; deflation continued apace.

Well then, what about all that government borrowing? All it's doing is offsetting a plunge in private borrowing - total borrowing is down, not up. Indeed, if the government weren't running a big deficit right now, the economy would probably be well on its way to a full-fledged depression.

Oh, and investors' growing confidence that we'll manage to avoid a full-fledged depression - not the pressure of government borrowing - explains the recent rise in long-term interest rates. These rates, by the way, are still low by historical standards. They're just not as low as they were at the peak of the panic, earlier this year.

To sum up: A few months ago the U.S. economy was in danger of falling into depression. Aggressive monetary policy and deficit spending have, for the time being, averted that danger. And suddenly critics are demanding that we call the whole thing off, and revert to business as usual.

Those demands should be ignored. It's much too soon to give up on policies that have, at most, pulled us a few inches back from the edge of the abyss.

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