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Four Roads to Dealing withDepression

J. Bradford DeLong

University of California at Berkeley and NBERbrad.delong@gmail.com

http://delong.typepad.com+1 925 708 0467

January 27, 2009

There are four things that we know of that we can try whenever an economyfalls into a depression in an attempt to get it out and to get employment backto its normal level and production back to its “potential” level. Call themfiscal policy, credit policy, monetary policy, and inflation.

Inflation is the most straightforward to explain: the government declares thatthe notes it prints are legal tender, prints up lots of notes, and spends them.The extra cash in the economy raises prices. As prices rise, people don’twant to hold cash money in their pockets or their bank accounts—its valueis melting away every day—so they step up the pace at which they spend,trying to get their wealth out of depreciating cash and into real assets thatare worth something. This spending pulls people out of unemployment intojobs, and pushes capacity utilization up to normal and production up to“potential” levels.

We would rather avoid inflation. It is a very dangerous expedient,undermining standards of value and the ability to engage in economiccalculation, and redistributing wealth at random whim. John MaynardKeynes wrote “there is no subtler, no surer means of overturning the

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existing basis of society than to debauch the currency. The process engagesall the hidden forces of economic law on the side of destruction, and does itin a manner which not one man in a million is able to diagnose…” But wewill resort to inflation before we will allow another Great Depression—wejust would very much rather not go there, if there is any alternative way ofrestoring employment and production to balance.

The standard way of fighting incipient depressions is monetary policy.When employment and output threaten to decline, the central bank buys upgovernment bonds for immediate cash, thus shortening the duration of thesafe assets that investors hold. With less in the way of safe assets that paymoney in the future out there in the financial market, supply and demandmeans that the price of safe wealth in the future rises—which makes it worthmore businesses’ whiles to invest in expanding their capacity, thus tradingaway cash they could distribute to their shareholders today for a bettermarket position in the future that will allow them to reward theirshareholders then. This boost in spending today oriented toward the futurepulls people out of unemployment and pushes capacity utilization up.

The problem with monetary policy is that the globe’s central banks havedone all of it that they possibly can. They have bought so many safegovernment bonds for so much cash that the price of safe wealth in the nearfuture is absolutely flat—that the nominal interest rate on governmentsecurities is zero. Monetary policy cannot make safe wealth in the futureworth any more. And this is too bad, for if we could head off a depressionvia monetary policy alone we would do so, as it is the macroeconomicstabilization policy tool that we know best and that has the least danger ofdisruptive side effects.

What else can we do? The third tool is credit policy. We would like to boostspending right now by getting businesses to invest in projects that don’t justtrade safe cash now for safe profits in the future, but to invest in projectsthat are risky or uncertain. But right now few businesses are able to raisemoney to do so. Risky projects are at a steep discount today because the risktolerance of the private-sector financial market has collapsed, and nobody iswilling to buy assets and take on additional uncertainty out of the fear that

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somebody else knows more than they do—and that what they know is thatyou would be a fool to buy. Here the world’s central banks and financeministries have been trying a great deal of ingenious and innovative policymoves to try to conduct a stimulative credit policy, but so far without a gooddeal of success. We don’t know very much about how to conduct asuccessful stimulative credit policy.

This brings us to the fourth tool: fiscal policy. Have the government borrowand spend, and so pull people out of unemployment and push capacityutilization up to normal levels. There are drawbacks: afterwards there is thedeadweight loss of financing all the extra government debt incurred, andthere is the fear that too-rapid a runup in debt may discourage privateinvestors from building physical assets that are then subject to taxation bythe future governments that will have to amortize the extra debt.

But when you have only two tools left, neither of which is perfect for thejob, the rational thing to do is to try both—both credit policy and fiscalpolicy. And that is what the Obama administration is right now attemptingto do.

References

John Maynard Keynes (1919), Economic Consequences of the Peace(London: Macmillan).

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