During times of economic hardship, the media and politicians always speculate about the worst-case scenarios. In July – when oil was upwards of $145/barrel – the topic du jour was whether or not the U.S. was in a recession. Next, as oil and gas prices started to subside and the economic outlook was slightly brighter, the debate was over what the recovery will look like: V or W shaped. Now, with a banking crisis underway, talk of depression is ubiquitous. Depression sells papers, books, and air-time, but the economy is most certainly not entering a depression: the Fed is just too smart for that.
Gary Becker concurs: “First of all, the magnitude of this financial disturbance should be placed in perspective. Although it is the most severe financial crisis since the Great Depression of the 1930s, it is a far smaller crisis, especially in terms of the effects on output and employment. The United States had about 25% unemployment during most of the decade from 1931 until 1941, and sharp falls in GDP. Other countries experienced economic difficulties of a similar magnitude. So far, American GDP has not yet fallen, and unemployment has reached only a little over 6%. Both figures are likely to get quite a bit worse, but they will nowhere approach those of the 1930s.” Point: the output loss and job loss throughout this banking crisis will not come close to the loss in the 1930’s.
But we also have Ben Bernanke, who spent his career engaged in monetary policy research and understands the mistakes made by policy makers during the 1930’s. Here is what he said in his speech, Money, Gold, and the Great Depression, in March 2004 (the text refers also to an influential paper by Milton Friedman and and Anna Schwartz: Monetary History). “The Federal Reserve had the power at least to ameliorate the problems of the banks. For example, the Fed could have been more aggressive in lending cash to banks (taking their loans and other investments as collateral), or it could have simply put more cash in circulation. Either action would have made it easier for banks to obtain the cash necessary to pay off depositors, which might have stopped bank runs before they resulted in bank closings and failures. Indeed, a central element of the Federal Reserve's original mission had been to provide just this type of assistance to the banking system. The Fed's failure to fulfill its mission was, again, largely the result of the economic theories held by the Federal Reserve leadership. Many Fed officials appeared to subscribe to the infamous "liquidationist" thesis of Treasury Secretary Andrew Mellon, who argued that weeding out "weak" banks was a harsh but necessary prerequisite to the recovery of the banking system. Moreover, most of the failing banks were relatively small and not members of the Federal Reserve System, making their fate of less interest to the policymakers. In the end, Fed officials decided not to intervene in the banking crisis, contributing once again to the precipitous fall in the money supply.” RW: And later in the speech, Bernanke argues that international monetary policy measures [to support the gold standard] acted as a conduit to spread the Depression across borders. “First, the existence of the gold standard helps to explain why the world economic decline was both deep and broadly international. Under the gold standard, the need to maintain a fixed exchange rate among currencies forces countries to adopt similar monetary policies. In particular, a central bank with limited gold reserves has no option but to raise its own interest rates when interest rates are being raised abroad; if it did not do so, it would quickly lose gold reserves as financial investors transferred their funds to countries where returns were higher. Hence, when the Federal Reserve raised interest rates in 1928 to fight stock market speculation, it inadvertently forced tightening of monetary policy in many other countries as well. This tightening abroad weakened the global economy, with effects that fed back to the U.S. economy and financial system.” Point: The primary cause of the Great Depression – when the unemployment rate was 25% and GDP declined sharply – was a contraction in the money supply caused by slack monetary policy, a domino of bank failures, and attemps to adhere to the gold standard by raising interest rates around the globe.
Thus, this period of banking crisis will not lead to a Great Depression II: The Fed is determined to grow the money supply in spite of tight lending standards.
The chart illustrates changes in the M2 measure of money supply and its components through the week ending in 9/22/08. Evident in the chart is the money supply's August contration, as noted in the September FOMC minutes when the Fed left interest rates unchanged. However, since August the Fed turned on the fire hose, flushing the banking sector with enough liquidity that the money supply has increased sharply. In just one week (9/15-9/22), the money supply increased $165.5 billion, or 2% of the toal money stock.
Interest rates are also faling in the U.S. and around the world. Yesterday, the Australian central bank lowered its target rate by 1% and I expect that the Fed will lower its target rate by 0.75% at the the next FOMC meeting. Even Trichet hinted at a possible rate cut at the Eurpean Central Bank’s last meeting. Further, exchange rates are fluctuating, and therefore, the U.S. is not inhereting restrictive foreign central bank policy (at least not in the explicit macroeconomic sense). However, that is a mute point because global central banks stand ready to increase liquidity if needed.
The Fed is not making the same – or even similar – mistakes that were made in the 1930’s. Unless the Fed reduced its liquidity measures, we went back to a fixed exchange rate system, and the Fed turned a bling eye to the needs of the banking system, the economy will certainly not fall into the Great Depression II.