Wednesday, December 10, 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.

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. Spending just to buy financial assets does very little good.

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.

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. 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.

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

For text:

No comments: