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Four Roads to Dealing with Depression J. Bradford DeLong University of California at Berkeley and NBER +1 925 708 0467 January 27, 2009 There are four things that we know of that we can try whenever an economy falls into a depression in an attempt to get it out and to get employment back to its normal level and production back to its “potential” level. Call them fiscal policy, credit policy, monetary policy, and inflation. Inflation is the most straightforward to explain: the government declares that the 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’t want to hold cash money in their pockets or their bank accounts—its value is 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 that are worth something. This spending pulls people out of unemployment into jobs, 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 economic calculation, and redistributing wealth at random whim. John Maynard Keynes wrote “there is no subtler, no surer means of overturning the


existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose…” But we will resort to inflation before we will allow another Great Depression—we just would very much rather not go there, if there is any alternative way of restoring 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 up government bonds for immediate cash, thus shortening the duration of the safe assets that investors hold. With less in the way of safe assets that pay money in the future out there in the financial market, supply and demand means that the price of safe wealth in the future rises—which makes it worth more businesses’ whiles to invest in expanding their capacity, thus trading away cash they could distribute to their shareholders today for a better market position in the future that will allow them to reward their shareholders then. This boost in spending today oriented toward the future pulls people out of unemployment and pushes capacity utilization up. The problem with monetary policy is that the globe’s central banks have done all of it that they possibly can. They have bought so many safe government bonds for so much cash that the price of safe wealth in the near future is absolutely flat—that the nominal interest rate on government securities is zero. Monetary policy cannot make safe wealth in the future worth any more. And this is too bad, for if we could head off a depression via monetary policy alone we would do so, as it is the macroeconomic stabilization policy tool that we know best and that has the least danger of disruptive side effects. What else can we do? The third tool is credit policy. We would like to boost spending right now by getting businesses to invest in projects that don’t just trade safe cash now for safe profits in the future, but to invest in projects that are risky or uncertain. But right now few businesses are able to raise money to do so. Risky projects are at a steep discount today because the risk tolerance of the private-sector financial market has collapsed, and nobody is willing to buy assets and take on additional uncertainty out of the fear that


somebody else knows more than they do—and that what they know is that you would be a fool to buy. Here the world’s central banks and finance ministries have been trying a great deal of ingenious and innovative policy moves to try to conduct a stimulative credit policy, but so far without a good deal of success. We don’t know very much about how to conduct a successful stimulative credit policy. This brings us to the fourth tool: fiscal policy. Have the government borrow and spend, and so pull people out of unemployment and push capacity utilization up to normal levels. There are drawbacks: afterwards there is the deadweight loss of financing all the extra government debt incurred, and there is the fear that too-rapid a runup in debt may discourage private investors from building physical assets that are then subject to taxation by the future governments that will have to amortize the extra debt. But when you have only two tools left, neither of which is perfect for the job, the rational thing to do is to try both—both credit policy and fiscal policy. And that is what the Obama administration is right now attempting to do.

References John Maynard Keynes (1919), Economic Consequences of the Peace (London: Macmillan). 857 words


Four Roads to Dealing with Depression