In 1992, Christina Romer published an article titled "What Ended the Great Depression?" in The Journal of Economic History. In her introduction, Roper explains how America recovered from the Great Depression:
This paper examines the role of aggregate-demand stimulus in ending the Great Depression. Plausible estimates of the effects of fiscal and monetary changes indicate that nearly all the observed recovery of the U.S. economy prior to 1942 was due to monetary expansion [emphasis mine]. A huge gold inflow in the mid- and late 1930s swelled the money stock and stimulated the economy by lowering real interest rates and encouraging investment spending and purchases of durable goods. That monetary developments were crucial to the recovery implies that self-correction played little role in the growth of real output between 1933 and 1942.
Mrs. Romer is now the chair of President Obama's Council of Economic Advisors and was the co-author the administration’s economic recovery plan.
In Romer, Fed Chairman Ben Bernanke has a willing accomplice in his quest to print money, errr…I mean engage in quantitative easing. Like Romer, Bernanke is an expert on the Great Depression. Like Romer, Bernanke believes that the solution to our current economic ills lies in devaluing the dollar through monetary expansion. After all, Bernanke promised Milton Friedman that the Fed would never again refrain from providing liquidity during a downturn like it did during the Great Depression.
It seems as if Romer, Bernanke, et al. are proposing something new and revolutionary — inflate the money supply and devalue the currency. Genius! But there is a big problem. This solution is neither new nor revolutionary. Although it has never before had as fancy a euphemism as "quantitative easing," the practice of monetary devaluation is ancient and is standard government operating procedure. Unfortunately, it has also proven a disaster everywhere it has been implemented.
The Romans tried it. The result was the implosion of Western civilization; a hole out of which it took a millennium for Europe to climb.
The French tried it. Twice, in fact. The first time, in the early 18th century, resulted in a classic speculative bubble. Fortunes were made and then lost in the blink of an eye. The second time, after their revolution, was even worse. In order to combat price inflation — which was causing rioting and civil unrest — the government imposed price controls. Shortages ensued causing more rioting and civil unrest. The French finally gave up and instituted a gold standard.
The Germans tried it after World War One. Their experience was much worse than the French experience but the outcome wasn't quite as bad as the Romans — the Weimar inflation contributed to the rise of National Socialism and the subsequent deaths of over 72 million people. Okay, maybe it was a bad as the Romans.
The Russians have also tried it. As have the Poles, the Hungarians, the Greeks, the Chinese, the Argentineans, the Brazilians, the Chileans, and the Yugoslavians. Oh, and the Zimbabweans are trying it right now.
All of these episodes ended in catastrophe. Of course, the American experience will be different, right? After all, folks like Romer and Bernanke are experts.
German Finance Minister Karl Helfferich was an expert on money, too, and even he could not resist the temptation to crank up the printing press:
To follow the good counsel of stopping the printing of notes would mean refusing to economic life the circulating medium necessary for transactions, payments of salaries and wages, etc. It would mean that in a very short time the entire public, and above all the Reich, could no longer pay merchants, employees, or workers. In a few weeks, besides the printing of notes, factories, mines, railways, and post offices, national and local government, in short, all national and economic life would be stopped.
As it turned out, it was the continued printing of money — and not the cessation — that caused all of these things to occur. But we know better now, right?
No matter what the epoch, the laws of economics remain constant. Prices are information. They relay to entrepreneurs where to best allocate resources in order to satisfy consumer demand. Because it is a society's medium of exchange, money has a universal price; generally, everything is priced in terms of money. Distort the price of money and you throw the entire system into disarray causing what Austrian economists call malinvestment. Resources flow into areas that they should not and away from areas where they should, not because entrepreneurs have lost the ability to make sound decisions, but because the information upon which they rely to make those decisions is corrupted.
Romer and Bernanke are playing a dangerous game. They are also operating under false premises. First of all, the Great Depression was not caused by a "lack of aggregate demand" but by the malinvestment brought on by the Fed's monetary inflation of the 1920s. The reason the depression lasted so long was that the government refused to allow the malinvestment to liquidate.
As for the asset and price deflation of the Great Depression, this was not the result of the Fed's failure expand the money supply but a result of a drop in the velocity of money — the rate at which money exchanges hands. As Murray Rothbard has illustrated in America's Great Depression, bank reserves actually increased throughout the Great Depression. However, banks were leery of lending, fearing bank runs and failure. The demand for money was high as people sought safety by holding onto cash; saving and not spending. All of this meant that the price of commodities other than money dropped as people would rather hold onto their money than spend it.
The situation is much similar to what we face today. Unfortunately, because Bernanke believes that the Great Depression could have been avoided if the Fed had inflated aggressively, he has readied an inflationary tsunami. The only thing holding this tidal wave of dollars back is that much of it is still sitting in bank reserves and the velocity of money is still low. Count on Romer and the government to do everything and anything necessary to change that.
Bernanke believes that once the economy takes off again, he will be able to remove the "excess liquidity" from the system by selling the Fed's assets. Unfortunately, he faces a big problem. Much of the increase in the Fed's balance sheet is the result of the Fed removing toxic assets from the banking system. Ummm, they are called toxic for a reason; no one wants them. To whom then is Bernanke going to sell them?
In addition, the Obama administration, following Romer's advice, is going to have to fund its profligate spending somehow. U.S. treasuries — government debt — were once considered the safest investment in the world. Now, because of the massive debt the federal government is accruing, no one is buying. According to the Treasury International Capital System, capital is now flowing out of the U.S. That leaves one buyer for trillions of dollars of new debt — the Fed. In other words, not only will Bernanke not be able to sell the government debt the Fed already owns, he is going to have to buy oodles and gobs more.
Perhaps Romer and Bernanke are right. Perhaps printing money is the solution. Perhaps this one time the laws of economics will prove malleable. And perhaps donkeys will fly.
If history is any guide, I'm betting on the donkeys.
May 25, 2009