NCPA - National Center for Policy Analysis


December 9, 2008

Every day that goes by makes clearer the parallels between the current financial crisis and the one that led to the Great Depression.  Then, as now, the core problem was one of deflation, or falling prices.  But fixing it will require more than just low interest rates.  This was the key insight of British economist John Maynard Keynes, whose theories finally explained how to end the Great Depression.  They may be the key to solving today's crisis as well, says Bruce Bartlett, a former Treasury Department economist.

The problem today is that velocity is falling faster than the Fed can pump up the money supply by buying financial assets, and very low market interest rates mean there has been little net increase in liquidity as a result of the actions the Fed has taken thus far, explains Bartlett:

  • What Keynes figured out is that when conditions such as these exist, the federal government must step in to raise spending in the economy and thereby increase velocity; this means running a budget deficit, but that is only part of the solution. As noted earlier, spending just to buy financial assets does very little good.
  • We also know from the experience with tax rebates in 1974, 2001 and 2008 that this doesn't do any good, either; people mostly save the money or pay down debts, thus, rebates just become another form of exchanging assets that add little to spending (and hence velocity).
  • Keynes argued that the only thing that will really work is if the federal government uses its resources to purchase goods and services; it must buy "stuff" -- concrete, computers, paper, glass, steel -- anything as long as it is tangible; in other words, the government must spend the way households do, by buying things.
  • It must also employ labor, because much of what people spend money on today is in the form of services; this doesn't necessarily mean putting workers on the federal payroll, it just means that, to the extent that the government purchases services, this will also help raise spending in the economy.

We will know that the government is spending enough to matter when interest rates start to rise.  Although we think of saving as coming in financial form, in reality, saving represents things -- labor and raw materials that are used to produce products and services people want, says Bartlett.

Once the federal government increases its purchases of goods and services, it preempts resources that private businesses would otherwise use in production.  As they compete with each other for those resources, their prices will rise and interest rates will rise, explains Bartlett.

At this point, Federal Reserve policy will become effective again.  As prices and interest rates rise, the liquidity trap disappears and money begins circulating more rapidly (i.e., velocity increases).  This is what ends an economic crisis.  Unfortunately, it was not until World War II that the federal government spent enough on real resources -- because they were needed for the war effort -- to make Keynes' theory work in practice, says Bartlett.

Source: Bruce Bartlett, "What Would Keynes Do? The government should spend on stuff, not on bad assets," Forbes, December 5, 2008.

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