--- 1) capital accumulation: the growth over time of the economy's capital stock (factories, offices, new machines; plus infra-structure improvements); 2) the growth and any improvement in the skills and quality of the labor force, including formal education and on-the-job training; 3) technological progress --- advances in knowledge, some embodied in machines and some as more efficient managerial know-how in running business firms and public agencies; and 4) the economy's wider institutional and policy framework. The key to these latter, largely societal and political influences? Essentially, institutions that encourage transparency, honesty, and accountability, whether in the public or private realm, coupled with an ever greater ability of larger numbers of people in firms and organizations to cooperate spontaneously for common purposes. And, in turn, public policies that create incentives to savings, investment, education and training, hard work, and entrepreneurial risk-taking.
--- Taken together, good institutions and policies ensure that an economy's investment in capital and the uses and skills of the labor force as it grows will be undertaken productively --- efficiently --- in contrast to the huge waste of capital and labor inputs, say, in the Soviet and other Communist economies or in much of Africa, the Middle East, parts of the former Soviet Union, and still much of Latin America today. (Corruption and nepotism are good indicators of massive waste in investment capital and the misuse of labor resources; so, too, is the size of the underground economy --- all activities, from gangsterism to tax evasion, not included in official national income statistics and not subject to taxation. In much of Africa and Latin America --- no doubt too the Arab Middle East --- the underground economy has been estimated to be 50% or more of officially reported GDP. See the gordon-newspost article on this.
--- Note something else. A decent social security safety-net --- unemployment insurance, retirement insurance, public health and medical services to supplement private insurance, and trade-adjustment assistance for workers who lose their jobs owing to import-competition and seek retraining for new jobs --- is not only humane, but will also encourage flexible labor markets: above all, thanks to the safety net, laid-off or excess workers will be more willing to move out of declining industries into new, more promising industries and firms even if in different regions of the country. This is true for trade-adjustment assistance, which has helped eased the lot of US workers who have lost jobs to trade-competition: see the July 28th, 2003, New York Times article on this.
--- Can a safety net be overdone? Sure. For one thing, the taxes on business firms can be overly burdensome --- a big problem for German owners and managers, where, until the recent changes, social security taxes would add almost 38% to German wages (far higher than the EU average). For another ting, if declining industries are heavily subsidized or protected, or unemployment insurance and welfare too generous and long-lasting, then labor markets will tend to be rigid. The result? The indispensable processes of creative destruction --- letting old and uncompetitive industries shrink or go bankrupt in order to free capital, managerial talent, and skilled workers for newer, more promising industries that embody the most recent technologies --- will be all the more hampered. This is the problem of Japan's economic stagnation writ-small, the blockage of fundamental structural change in the economy. It's also a big problem for most of the EU countries. And both the EU and Japan face the looming prospect of having to support ever larger numbers of retirees living for decades after retirement with an ever smaller work force . . . with ever greater taxes on their incomes.
--- In the long-run, if an economy has good public and private institutions and sound public policies that embody brisk incentives for investment and savings and risk-taking and education and training on the one hand, and that on the other allocate capital and labor resources productively --- efficiently --- then the long-term development of the economy will hinge essentially on the growth of knowledge and its applications: that is, on technological progress.
 More to the point for macroeconomic policymaking, Aggregate Demand --- private consumption, business investment, government consumption and investment, and a smaller trade deficit --- has to be boosted more than it has since the end of 2001 by expansionary monetary and fiscal policies. That way, the actual performance of this and next year's GDP would come closer to the long-term growth path of the economy, its Potential Output. That way, too, far more jobs will be created and bring the economy closer to sustainable full employment. Fortunately, a series of encouraging signs, emerging the last few months, have converged and look like notably speeding up the US growth rate the rest of this year and into the future.
What, more specifically, are those encouraging signs?
Essentially, a swarm of good news about almost all the key leading indicators in our economy: consumer spending, residential sales and construction, the stock market, signs of revived business profits and the start of new investment orders, long-term confidence among the public about our economic future, and the relatively cheap dollar. Manufacturing also appears to be recovering swiftly in the early summer of 2003 too. Come to that, in late July 2003 --- maybe the most encouraging sign of all --- jobless workers applying the first time for unemployment insurance were at a 5-month low, an indicator that the growth in unemployment is stabilizing and maybe even declining slightly. Added to this are two looming stimuli to faster GDP growth: on one side, the Bush tax cuts and the huge record Federal deficit that they will cause this year, with around $400 billion pumped into the economy thanks to government spending not covered by tax receipts; and on the other side, the Federal Reserve's commitment to keep interest rates low and find added ways, if need be, to speed up the US economy's growth rate.
Against all this, we noted at the end of the last article that there were four possible dangers that might prevent these fiscal and monetary stimuli from working their magic. Specifically:
 deflation --- a persistent, self-reinforcing fall of general priceses;
 the possibility of a liquidity trap, which makes monetary policy ineffectual in jump-starting growth in amid deflation or in recessionary conditions generally;
 leakages from tax cuts and government deficits that offset some or all of their stimuli-effects, above all the worry about crowding-out and the Ricardian theory that households are so foresighted that they will nullify the tax cuts by increasing their savings . . . anticipating that the rising national debt and interest payments on it will require future tax rises of an equivalent amount;
 worries that the rest of the world, especially the EU and Japan and the rest of Pacific Asia --- all dependent in large degree on export-led growth --- are themselves not doing enough to generate home-fostered economic growth and are waiting for the US economy to revive and boom . . . a danger that will offset the cheaper dollar, among other things, and limit the US economy's ability to grow faster through exports to them.
How Serious Are These Four Dangers?
The off-the-top answer: it depends on the particular danger, but generally all four are likely to prove either false alarms or not very threatening. The current article will treat deflation and the reality and menace of any liquidity trap. The two remaining dangers just listed,  and , will be evaluated in the next article here.
Danger One: The Threat of Deflation
 Deflation Defined
Deflation, remember, refers to a persistent and general decline in the price level of an economy, and if it occurs and is serious, it can be a problem --- can, in fact, turn into a serious, self-reinforcing nightmare in which households that owe money on mortgages and cars and other big-ticket items find that their incomes are declining, yet they still owe $1500 monthly on the mortgage signed in the robust growth era of the late 1990s, $450 on two cars, and $400 monthly on their Visa cards. Even if they can come up with the money on falling incomes, households in these circumstances will have less money available to spend on anything else --- in the upshot, prices falling even more on all these other items. Aggravating the problem could be a loss job if somebody is working for a firm that can't cut its costs fast enough --- wages included --- and hence has to lay off at least some workers if profits and margins are to be kept from collapsing. Even if others employed in that firm (or others) keep their jobs, they might also try to cut back their spending too, fearful that will need a savings-cushion lest they lose their jobs in the future. At some point --- as happened briefly in the California recession in the early 1990s when the real estate market in Southern California was particularly hurt by both the national decline in GDP and big cutbacks in defense spending in the aerospace industry --- defaults on homes and largely empty office buildings could occur. In the 1930s, it was much worse. Faced with collapsing prices for their products, millions of farmers and their families lost their farms and began migrating to cities or to California, regarded as the land of promise.
Similarly, in a deflation, stock market prices will fall, and since over half of Americans were in the stock market through pension schemes in the late 1990s, those still holding equities will feel less wealthy and likely cut back their spending too. Along with falling consumer spending, then, business investment would likely fall too. For that matter, even households where jobs and incomes are secure might cut back on their spending too, hopeful that the new condo or car they want to buy will be even cheaper a year into the future. On all these counts, then, a persistent and general decline in the price level could be a serious danger if it occurred.
But will it occur?
 Why Deflation, Even If It Occurs, Isn't Menacing in Certain Circumstances
The answer to the question left hanging fire a moment ago? Put tersely, in the US economy, deflation isn't likely --- nor in most of the EU or in Asia either.
, it's true, has suffered from deflation for five or six years now, the price level falling about 1.0% or so on an average each year since 1997, and its economy continues to stagnate as far as the growth of GDP and jobs goes. Still, in the Japanese case, it's unlikely that the stagnation can be directly traced in large part to deflation --- rather, to ineffective policymaking to kick-start the Japanese economy, plus a mountain of market inefficiencies that have emerged in that country for decades . . . including huge banking debts and surplus output in semi-competitive industries and protections and subsidies for non-competitive manufacturing industries and agriculture. The Federal Reserve itself in this country commissioned a study
last summer to look at the reasons for the failure of Japanese monetary and fiscal policies to pull the economy back from its stagnation --- GDP growth not even averaging 1.0% a year since 1997, with the economy looking like it might begin to grow faster only to stumble and fall back into a shallow on-and-off recession again.
The reasons? One of them is that the stock-market crash in Japan in the early 1990s was far worse than here after 2000. Another: there was a huge real-estate balloon as well --- at one point around 1990, one block in central Tokyo was valued in dollar terms more than all of Manhattan! --- that exploded simultaneously. A third reason: we just mentioned it, the huge debts of Japanese banks, which they tried to conceal and still do, almost always with the help of the Japanese government. Above all, though, is a fourth reason: poorly timed and ineffectual policymaking has marked the Japanese government's handling of emergent stagnation and deflation in the early and mid-1990s. (For an illuminating study of how the one-party dominant system of government in Japan --- the LDP in power for half a century now, in the thrall of powerful interest groups fearful of changing the status quo in that country --- has failed to tackle the structural inefficiencies in the economy, including the huge banking debt, see Robert Dugger and Angel Ubide, "Structural Traps, Politics, and Monetary Policy" (May 28, 2002). They also note how increasingly risk-averse the Japanese have become as the population has aged, reinforcing the problems of moving from the status quo.)
So if Japan has stagnated, the causes aren't just due to deflation --- itself fairly mild. Yes, a fall yearly of a price level of 1.0% can be adjusted to by economic actors and the economy still grow vigorously. The evidence?
, the US economy
in the late 19th century: it suffered from a similar price decline annually for over 25 years, 1870 - 1896 --- 1.2% annual decline --- and there were some banking crises and slumps, but the key fact remains this: the GDP rose around 4% each year annually, one of the most vigorous growth periods in US history, and for that matter per capita income grew almost 1.6% a year. No less remarkable, though farmers were hurt and falling agricultural prices generated a populist backlash movement, the US economy industrialized at a very fast pace. Steel production alone quadrupled; sugar production rose three-fold; cigar production leapt forward at the same pace. That's a far cry, obviously, from the 24% fall in prices in the US economy at the start of the Great Depression between 1929 and 1934, with a huge surge in unemployment to over 20% of the US work force, the collapse into bankruptcy of thousands of banks, and a severe decline in money supply of 25-30%.
Another piece of evidence
. It too has suffered from deflation since the start of the Asian financial crisis of mid-1997. How severe isn't clear: official Chinese figures for the economy --- including prices, unemployment, and GDP --- seem manipulated, something even the former Prime Minister Zhu Rongji complained about. Still, the economy has clearly grown and clearly continued to benefit from a large inflow of multinational investment. (For a scholarly treatment, look at the impressive article --- based on field work in China --- by Thomas Rawski
Back to the US
. Not only has deflation not started in the US --- the core CPI index (minus food and energy) --- rose 0.3% last month, after holding steadily the previous two months. All in all, the US price level will probably record an uptick of between 2.0 - 2.5% at the end of the end, the range that the Federal Reserve apparently regards as most conducive to business and consumer confidence. As for other countries, only Germany among the major economic powers is threatened by an onset of deflation . . . and mainly for three reasons:  high interest rates that are controlled by the new European Central Bank, which have helped push that country --- which has the worst growth record in the EU the last decade anyway --- back towards its second recession in three years;  the surging value of the euro, which has cheapened import prices calculated in dollar-terms and hurt Germany's dependence on export-led growth; and  a small mountain of market inefficiencies that makes the Germany economy resemble more and more Japan's.
 Why A Falling Price Level Isn't Necessarily Bad, and May Be Desirable
Remember, deflation to be serious has to be persistent and general and self-reinforcing, assuming it gets underway. When, by contrast, it's reported that the Producer Price Index in the US fell slightly last month (May), that's misleading.
For one thing, almost all the falling price level was due to energy --- especially petroleum, with oil having soared in the three years before (in a fluctuating manner). Hence a sharp reduction in oil and gasoline and eventually a fall in the costs of manufacturing that uses petroleum inputs isn't something to worry about . . . exactly the contrary. It's conceivable, indeed, that the price of oil could continue to fall in world markets and undermine OPEC's ability to manipulate the price level in the short- and mid-term --- in the long-term, it can't control it and didn't in the 1980s and most of the 1990s --- and that would be desirable too. It would hurt profits and employment in certain oil producing states and maybe --- though less certain --- in petroleum-refineries and other related industries in this country and Europe and Asia; but that would free more consumption for buying other goods and services and lead at most to some adjustments as laid-off workers here and abroad moved to growth industries.
For another thing, the fall in petroleum prices can't constantly fall, say, $25 a barrel from $33 dollars a few months ago, bringing it hypothetically down to $8 --- because even a three-fourths reduction of raw oil after that would reduce prices only by $6. (See Everett Ehrlich
, an economist who was a former Undersecretary of Commerce in the Clinton administration.) And yet, conceivably again, a huge and desirable collapse in the price of oil that would help consumers all around the world save in a few small Arab oil producing countries --- with less fall-out in bigger economies like Russia's or Indonesia's --- could keep the PPI (Producers' Price Index) falling for months into the future overall.
More evidence underpinning this conclusion can be cited from the fate of the computer industry in this country and elsewhere. Hard as it might be to grasp, computer prices fell over 90% throughout the 1990s, and far from hurting the global economy or the economies of almost all countries, the fall --- a result of rising productivity and head-spinning technological advance --- was a boon to economic growth. (The exception is in certain economies like Japan and the Far East where there's a glut of DRAM and other component parts; and even then, Japan's problems of a glut aren't confined to computer components, but encompass several industries and reflect its high levels of protection and subsidies and ways of financing corporate manufacturers that blunt the impact of falling profits that would have led American and other firms to cut back on production years earlier and either move on into related areas of manufacturing or go broke and free labor, talent, and capital for use in entirely different industries.)
In fact, if rising productivity were a culprit and something to worry about, then --- as Everett Ehrlich reminded us last week --- the US and other industrialized countries would have faced uninterrupted price-falls and persistent deflation ever since the industrial revolution. The fact is, prices have declined in some industries and gone up in others, even as real wages --- 65% or so of manufacturing costs on an average (even higher in service industries) --- have risen on an average over those two centuries or so and produced our affluent living standards.
 To Summarize:
Persistent and general deflation is something to worry about, but it has to be severe to be a real menace, and a persistent and general low-rate of deflation --- say, 1.2% as in the US in the late 19th century or in China today --- hardly prevents high rates of growth of GDP or jobs. The worst fall-out --- if deflation of a mild sort were to set in --- would be on those who have contracted in the past when prices and incomes were rising steadily in a mild inflationary economy of 2-3% a year. New contracts could be written with price deflation in mind: each year, if the general price level as measured by the CPI, say, were to fall 1.2% a year, could reduce the burden of monthly payments on mortgages or other consumer durables by 1.2% a year too.
A question immediately prompts itself here:
 Is the US Likely To Suffer Deflation at All?
We've already noted that deflation isn't likely to start here. If anything, the CPI has risen recently, and overall the general price level in the US is likely to end the year in the 2.0 - 2.5% range. That's a fairly confident prediction [a prediction about inflation, note, that the Nobel prize-winning economist, Robert Solow, has affirmed since the buggy prof mentioned it two days ago.] What we haven't stressed is a triad of theoretical reasons for this confidence. Historically, to put this tersely, we know of no economy that has slid into a deflation, even a mild one, where . . .
(1) interest rates are at a record low for thirty or forty years;
(2) a huge governmental deficit is already starting, it appears, to lead to rising sales and profit-expectations (a major reason for the big jump in the US stock market this last week);
(3) the currency of the country has fallen on a trade-weighted basis of around 10%. All three, especially the first two, are big stimuli to GDP growth, and the Federal Reserve stands ready to ensure that it doesn't emulate the lackadaisical finagling of monetary policy of Japanese policymakers during the early and mid-1990s in that country.
Wait though! Might there be a hitch here?
In particular, can monetary policy work to offset a deflation if there's a liquidity trap --- the structural condition, it's said, of the US and other economies in the 1930's Great Depression, when interest rates were brought down to record lows, yet failed to reverse the fall in prices, GDP, and unemployment?
Our response requires a brief excursion into this alleged danger. As we'll see, it was first highlighted by the pioneer of macroeconomics --- John Maynard Keynes, the brilliant British economist --- who highlighted the danger, claimed it existed, noted that it was the equivalent of the failure of monetary policy to stimulate a severely depressed economy, and argued in favor of fiscal stimuli of the sort that the Roosevelt administration had hit upon early in the first two or three years of the New Deal (1933-1934), only to shy away from similar fiscal stimuli after 1935 and hence to let the unemployment begin to rise again --- the level of unemployment staying unusually high until WWII started and a huge burst of defense spending brought the economy quickly to full employment (including, of course, military service).
Danger Two: A Liquidity Trap
An economy has allegedly stumbled into a liquidity trap when deflation exists and key nominal interest rates --- the rates without taking into account either inflation (a rise in the general price level) or deflation (a fall) --- are near to zero or at it, yet monetary stimuli seem wholly ineffective in stopping the price fall and jump-starting economic growth. The Central Bank can't, of course, bring key nominal rates below zero --- in that case, lenders would be paying borrowers to take their money --- and so there seems to be something wrong with the way in which monetary policy is supposed to work.
1. The causes of ineffective monetary policy can be fourfold:
Consider each in quick serial form:
 The broad money supply has shrunk ---- as it did in the US between 1929 and 1933, when prices fell 25%, the money supply fell by a slightly larger rate, and unemployment jumped from 3.0% to 25%, a condition of severe Depression;
 Even if the money supply hasn't shrunk, the monetary transmission mechanism --- bank loans, with their multiplier effect --- isn't working. In that case, even though banks may be getting more deposits because Central Bank has bought short-term Treasury securities from the public and has written checks to John Q and Mary J --- who then deposit the checks in the Bank of America or Chase Manhattan --- aren't lending out more to business firms. In that case, there's no multiplier effect. Meaning? No money expansion as there should be in a fractional reserve system, in which banks, say, have to keep only 10% of their deposits on hand as Reserves in order to lend out the other 90%. This creates a multiplier effect of $1/.10 for every dollar lent out in the banking system around the country;
 The monetary transmission mechanism can break down too because business firms --- faced with deflation --- balk at borrowing money for new business investment in the form of inventory or new machines or plants, and hence don't go to their banks and ask for more loans. In a deflationary economy, after all, they will have to pay off a loan taken out in 1929 dollars with fewer dollars coming in this year or next as their prices and costs fall . . . always assuming they have enough business, as unemployment rises, to maintain their profits and margins.
 As an added reason why the monetary transmission-mechanism might break down, households as consumers --- including John Q and Mary J despite their new money deposits in the Bank of America and Chase Manhattan --- decide to withdraw from their deposits and "hoard" the money. This is a new demand for holding money --- above and beyond a desire to hold some money for immediate purchases or for precautionary reasons (people are uncertain about the economy) --- that Keynes, rightly called by Milton Friedman (the father of modern monetarism), the first monetarist, first identified in the middle of the Great Depression of the 1930s. It helps explain why the money multiplier-mechanism broke down in those days, at least in part: the public preferred increasingly to hold (hoard) more money, rather than spend it or keep it in banks as checking deposits or invest it in interest-earning assets like savings accounts or secure Treasury bonds.
--To clarify briefly (we'll do this in more detail later): Suppose John Q and Mary J don't have confidence in the banking system, at any rate the banks in their locality . . . maybe because of numerous bankruptcies (a reality in the 1930s). What then might they do if they've sold Treasury bonds bought in 1928 back to the Federal Reserve, which is offering a higher price in order to expand the money supply? Well, in that case --- worried about their local Bank of America or Chase Manhattan going bankrupt (especially when, as in the first three years after the Depression started in 1929, there was no Federal Deposit insurance) --- they might no sooner get their new checks from the Federal Reserve than they cash the checks for money at their banks and then it home and . . . well, either stuff it under their mattresses, or store it in safety deposit boxes, or put it in home safes.
On the face of it, this seems irrational, no? Why hold money above and beyond the need for immediate consumption purposes or to look around for an interest-earning asset (a Treasury bond, a company equity, a corporate bond or a bank savings deposit as opposed to a checking deposit: remember, interest payments on checking deposits only started in the US in the 1980s)? But recall: if people have no confidence in the banking system --- thousands of US banks, recall, collapsed in the early 1930s and there was no government insurance on checking or savings deposits at all --- and if they find the return on government or private corporate bonds near zero and if, further, they have been burned on the stock market because a ballooning market collapsed by a third as it did in 1929, then people might prefer to hold the money given the alternative and the risks).
To repeat, then, a liquidity trap exists when monetary policy, seeking to end a recession --- including one as was the case in the US in the 1930s with deflation and a monstrous surge in unemployment --- seems unable to start GDP growing fast enough to overcome the unemployment and end any deflation. Nominal interest rates are already at or near zero, but the money transmission-mechanism --- the money multiplier --- has broken down or possibly reversed (the case, as we'll see, between 1929 and 1933 in the US). (Restated in somewhat more technical terms, the equilibrium nominal interest rate that would encourage enough investment and spending to increase GDP growth and bring about full employment might be well below zero . . . something that can't happen (though of course an inflationary expansion of the money supply, as we now know, can easily turn the real interest rate negative. In slightly more technical terms for those of you who remember your basic macroeconomics, the nominal interest rate that would equilibrate the IS and LM curves at full employment might have to be below zero. [In the Keynesian scheme as modified by a former professor of mine, John Hicks --- who won a Nobel prize for economics three decades after he developed the scheme, and for other reasons --- the IS-LM model allows you to derive the Aggregate Demand curve for the economy ---specifically, its position and slope --- when the general price level of the economy is allowed to vary. It's the same relationship between the general price level and the economy's output that the quantity theory of money can also explain as shaping the slope and position of the Aggregate Demand curve.)
2) Did the US Actually Suffer from A Liquidity Trap in the 1930s Great Depression?
Note the wording above in italics when we talked about a liquidity trap at the outset of the previous section: allegedly, seems. That's because there's a big controversy among economists as to whether the US was ever in a liquidity trap in the 1930s (or for that matter, any economy now or in the past).
The debate, ongoing with unflagging energy for four decades now --- ever since the pioneer monetary work of Milton Friedman on the US monetary history in the late 1950s --- pits New Classicists against Keynesians, with monetarists at the University of Chicago around Friedman and elsewhere, striving to disprove the Keynesians interpretation. (New Keynesians, including our current Council of Economic Advisers' Chairman, Gregory Mankiw of Harvard, will be dealt with in a moment or two as well.) To explain:
1) New Classicists
On the one side, New Classicists --- a term for four different "free market" adherents: monetarists first in the 1950s and 1960s, followed by the emergence of rational expectations, supply side theorists, and real business cycle theory --- claim that markets are self-adjusting and that they will not fall into serious deflation, let alone a liquidity trap, provided the central bank adheres to a rule-based expansion of the money supply, say 2.0% each year, if that's the underlying long-term growth potential of the economy at full employment . . . the latter defined by the natural rate of unemployment, which we've repeatedly discussed.
What caused the Great Depression then?
As New Classicists see it, monetary policy was erratic and a big cause of turning a slight recession after the 1929 stock market collapse into the galloping deflation and unemployment. Their evidence? The broad money supply of the economy fell 25-30% in the 1929 – 1933 period. Small wonder, then, that the US economy experienced a 25% deflation and a leap in unemployment from 3.0% to 25%. The Federal Reserve's disastrous policies were responsible. Monetary policy wasn't ineffectual; it was misconceived and misapplied, with disastrous consequences. All that the Federal Reserve needed to do was prevent the money supply from shrinking. And for that, nothing more is needed than for the Federal Reserve to avoid discretionary monetary policy. Instead, if the potential output of the economy --- its long-term growth rate with full employment and without inflation, which is determined wholly by supply side inputs of capital investment, labor force growth and quality, energy and resource availability, and technological progress --- is 2.5% a year, then the Federal Reserve need do no more than accommodate that 2.5% by expanding the money supply 2.5%. (Most monetarists, it's fair to add, don't follow Friedman in eschewing discretionary monetary policy in certain circumstances when the economy is struck by a severe dislocation. Thus in 1987, the US stock market experienced another big collapse ---- by a third, similar to the 1929 plunge in stock values. What happened? The Federal Reserve under Alan Greenspan immediately injected large amounts of liquidity into the banking system and the public's hands, and the result was that GDP growth for the year remained strong.)
On the other side are Keynesians
: they find that markets are marked by systematic failures, in the case of the Great Depression by a sub-optimal equilibrium of 20-25% unemployment, and that therefore only active and corrective fiscal policies would stimulate the economy because of a liquidity trap --- the failure of monetary policy to do the job. In the 1930s, Keynes argued this vigorously. Monetary policy was a dud, ineffectual in a big recession with deflation; only fiscal stimuli would work. Keynes, note, was especially keen on pushing the fiscal line because governments, including the US in both the Hoover and to an extent FDR era, believed in the virtues of a balanced budget that further aggravated the economy's slump and unemployment levels.
And where do New Keynesians like Gregory Mankiw, our new head of Bush's Council of Economic Advisors, come in?
They no longer adhere to the original Keynesian belief that monetary policy was or is ineffectual in any circumstances. Since roughly the late 1970s, they are even willing to agree that it's more potent in stimulating an economy in recession, or alternatively restraining inflation, than fiscal policies. That said, they continue to see the market economy of the US --- to stay with this country only --- as subject to systematic market failures that, at least in the short-run, require more discretionary monetary policy at times and, if need be, fiscal stimuli to match if the economy seems to be growing short of potential output.
From this viewpoint, ironically as it might seem, the Bush Jr. administration is New Keynesian in its faith in tax cuts and fiscal stimuli (the budget deficit) are a big supplement to economic growth this year and next . . . in the run-up to the 2004 election. An exaggeration? Hardly. In fact, as we pointed out, the new chairman of the Bush Council of Economic Advisers --- Gregory Mankiw of Harvard --- is widely considered the most influential of New Keynesian theorists . . . a pivotal figure who has absorbed most (not all) the theoretical lessons of the new classicsts, Friedman and monetarism, Robert Lucas and Thomas Sargent and Robert Barro and rational expectations, supply-side views of long-term growth, and even some real business cycle theory, that requires all tax, regulatory, and macroeconomic policymaking to be conditioned on they impact the expectations of rational business firms and consumers and hence on savings, investment, and consumption responses. (For an amusing article on how NYU, seeking to emulate its success in creating one of the best law school programs in the country, is seeking to do the same in economics and its business school by bringing in big-name economists at fabulous salaries --- Thomas Sargent lately of Stanford the most prominent and a sure-fire Nobel prize-winner in the future, with a salary of over $200,000 a year --- see "Ivy Envy" )
3) New Keynesians vs. New Classicists
New Keynesians generally adhere to the belief, worked out by the rational expectations theorists (following Friedman, but for different reasons), that policymaking by the government, including monetary and fiscal policies, should be largely rule-bound. That said, what distinguishes Mankiw and New Keynesians is that they still adhere to a Keynesian view that short-term cyclical dislocations in the market economy require at times discretionary monetary policy and fiscal stimuli, even though the long-term tendencies of the US economy (as a flexible, resilient market economy) is towards self-adjustment in dealing with dislocations.
By contrast, New Classicists doubt that fiscal stimuli work at all, for reasons we'll discuss later; they also dislike discretionary policy --- both rational expectations theorists and even more real business cycle theorists doubt that monetary policy will work either, at least if it's anticipated by firms and consumers; and real business cycle theorists go further still and argue that the ups and downs of actual GDP year to year that cause the business cycle have nothing to do with aggregate Demand at all, hence with anything to do with things that the government can offset through either fiscal or monetary policymaking: rather with the impact of technological progress and its dislocations that the government can't or shouldn't try to offset.
So New Keynesians still differ from New Classicists. Their main difference is over their varying faith in market failures and government failures in the workings of complex economy.
New Classicists, like classical and neo-classical economists of the 19th and early 20th century, believe that markets are inherently self-adjusting and that if they get mucked up, it's essentially because of bad government and bad central bank policymaking: excessive regulations; excessive taxes that harm incentives to save, invest, gain training, take a long-view, work hard; misguided welfare policies; erratic, discretionary monetary policies, on one side, and misguided and ineffectual fiscal stimuli on the other, for dealing with unemployment and recessions. New Keynesians --- despite their willingness to acknowledge the powerful role of monetary policymaking, the need for rules generally, and the need too to consider the impact of all government policies carefully on the expectations and incentives of private economic actors (firms, individual consumers, individual workers, individual savers and investors) --- still see the private economy as prone to erratic cyclical ups and downs at times, maybe due to dislocations like stock market collapses or energy cartels (OPEC and the 1970s) or wars or droughts, that require more active monetary and at times fiscal stimuli as offsets . . . just as they have less faith in the inherent short-term self-adjusting tendencies of the economy and hence believe that more regulations and macroeconomic policymaking are desirable.
And of course, at the heart of the dispute between the New Keynesians and the New Classicists, is a differing view about capitalism and markets and the role of government . . . which is to say that the former are generally on the left and the latter on the political right. And the underlying ideological conflict, which of course is far narrower than the capitalist-socialist-fascist conflicts of the interwar or pre-1914 period, is fought out in theoretical form through statistical modeling and various interpretations of data sets.
3) How the Debate About the Great Depression Reflects These Underlying Ideological Outlooks
Needless to say, the debate about the Great Depression --- its causes, its prolongation --- can't be separated from these underlying political world-views that pit the left against the right, any more than any other big debate in economics can be insulated from them. However refined the statistical modeling and the vigor and imagination of the economists looking at the data of the 1930s, the theoretical controversy continues and will no doubt persist into the future as far as we can see . . . and for the reasons mentioned in an early buggy professor article here: economics isn't a full-fledged science in the sense of the natural sciences, it never will be, and even major theoretical debates in the natural sciences aren't resolved in the simple straightforward ways textbooks about science used to inform us. We've learned that from the combined work of Quine, Davidson, Putnam, Sellars, and Kuhn --- despite some differences among them --- which in effect revives the earlier work of the great pragmatist pioneers, Peirce, James, and Dewey (with their own differences). It's not a matter of simpleminded relativism of the sort championed by simpleminded obscurantists of the post-modernist vintage. It's what we know about such matters as truth and science and how sciences and all forms of human knowledge operate.
Consider the inconclusive nature of the debate about the Great Depression:
 Keynesians of all stripes tend not to see the shrinkage of the money supply between 1929 and 1933 as the major cause of the plunge in GDP and employment, or for that matter even of the decline in the price level --- deflation. As they see it, consumption fell sharply as a result of the ballooned stock market crash, along with that of a ballooning housing market in the 1920s: people felt far less wealthy and hence cut back on their purchases of big-ticket items. Faced with declining purchases, business investment then nosedived, and that plunge accentuated the fall in GDP and employment. In concrete terms, private consumption fell from $140 billion to $113 in the four years after 1929, and didn't recover the 1929 level until 1937; business investment --- $40.4 billion in 1929 --- collapsed by almost 90% in the four years that followed, ending in 1933 at $5.3 billion, an astonishing fall. As for deflation, it was a result largely of excess capacity: manufacturing firms, confronted with falling demand for all their production output that they had built during the 1920s boom, had to lower their prices sharply the moment their sales fell off to their business-customers or end-consumers. In turn, the worldwide nature of the Depression --- including the high dollar fixed in terms of gold --- led to the collapse of export markets for US factory goods. No less unfortunate, the US effort to gain relief from imports in the form of new tariff legislation led to competitive devaluations against the US $, especially after FDR devalued the dollar once he came into office . . . a policy that did at least stop deflation, by making US imported goods much more expensive. And to top it off, the Hoover administration followed a balanced budget policy and raised taxes in 1932 that hit low and middle-income Americans especially hard, reducing consumption even further.
As a general thing, then, Keynesians and their New Keynesian offshoots tend to see a broad collapse of aggregate demand that reflected a combination of structural problems in the US economy --- excess capacity, the collapse of a ballooning stock market and housing market --- to which consumers and business firms responded by cutting back consumption and investment sharply . . . plus bad policymaking by the government. New Keynesians don't deny that the Federal Reserve failed to do enough to offset the deflation and falling GDP and employment. They can hardly do this, given all the work that Friedman's key book of the late 1950s inspired --- work that keeps piling up, a tiny mountain of it on the Great Depression that emphasizes the falling money supply of about 25-30% in the 1929-1933 period ---- but they tend generally to see this as an accentuating factor, not The Big Cause, let one the sole one. And they note that if consumption fell off sharply, this signified "hoarding" by households: dollars not spent but not put into the banking system either . . . mainly because 9000 banks had collapsed and the public had little confidence in the banks that did survive (until the Roosevelt administration guaranteed savings accounts in 1933).
 The monetarist case is straightforward and simple to grasp, at least on the surface: There was no liquidity trap in the 1930s or for that matter anywhere, any time, any place --- the whole notion for monetarists and most new classicists is a Keynesian myth. The Great Depression should never have happened if the Federal Reserve had acted responsibly. It didn't. It behaved erratically and let the money supply fall drastically after 1929. Specifically, it let the money supply, M1 (currency plus demand deposits --- checking accounts) fall from $26.6 billion in 1929 to $19.9 by 1933. In the process, deflation occurred and turned a normal recession after a stock market collapse into a serious matter of falling prices, bankruptcies, nosediving unemployment, and great uncertainty and falling profits that severely undermined business investment. (Sidebar note: for many New Classicists, recessions even have a functional or benign purpose: they force uncompetitive firms into bankruptcy and hence --- by freeing capital and labor and talent to move into more dynamic growth industries or more competitive firms in the old industries --- further the process of "creative destruction," an idea associated originally with the Austrian School, including Joseph Schumpter and his thesis of "creative destruction")
That seems persuasive, no?
Well, in that case, there wouldn't be a theoretical debate still over what happened in the Great Depression. Dig deeper --- here, I'll rely on the excellent macroeconomics textbook by Gregory Mankiw himself (Macroeconomics, 4th edition, 2000, pp. 492-494) --- and you run into complications for the strict money-supply thesis . . . which, to repeat, stresses that the Federal Reserve misbehaved seriously during the four years after the 1929 Stock Market crash, allowing the money supply to shrink rather than adhering to a rule-bound policy of increasing the money supply annually in line with the long-term growth rate of the US economy at the time (around 3.0% a year). Or, alternatively, noting the price deflation after the first several months, offsetting it with enough money injection into the economy through its normal instruments of policy --- open-market operations of buying government bonds held by the public, lowering the discount rate at which banks can borrow from the Fed, or if need be reducing the reserve requirements of banks so that they could lend out even more of the deposits they still had in large amount.
A Problem in Assessing the Historical Record
The trouble is, as Gregory Mankiw notes in his impressive Macroeconomics
(5th ed, Worth: 2003), pp. 487 ff, there are three variables that determine the money supply (M1, or M2 which adds savings accounts and CD's and some other money-market accounts):
 the monetary base
: the total number of dollars held by the public as currency and by the banks as reserves. The Fed can clearly and directly control this total.
 the reserve-deposit ratio
: this refers to the fraction of deposits that banks have to keep on hand --- hold in reserve --- as a limit on their ability to lend out money obtained by their customers' deposits (which are liabilities on the bank's books). The reserve-deposit ratio is only partly controlled by the Fed: it can raise or lower the legal minimum of the reserves (now at 11.0%, which gives a multiplier effect of nine-fold on any loans made to business firms or households for buying houses or cars or other durables). In addition, banks will hold more of their deposits on reserves according to their business policies and their reading of the economy's general health, in localities where they operate or nationally.
 the currency-deposit ratio
: this refers to the amount of currency people hold as compared with their checking deposits in banks --- which essentially can refer as well to saving deposits up to $100,000, the total guaranteed by Federal Deposit Insurance, remember. People generally hold some currency for purchases, but how much they hold can rise sharply as it did in the first four years of the Great Depression, and for two reasons: lack of faith in the banking system, especially when there wasn't such deposit insurance by the government, and growing uncertainty about the economy and their future earning power. The latter, a precautionary preference for holding liquid money, merges with the former -- a hoarding propensity --- that didn't really cost people much in the form of lost interest on buying Treasury bonds or putting the money into saving accounts, given that the interest rate on these was very low anyway.
It's worth noting that  and  above refer to the "transmission mechanism" by which increases or reductions in  the monetary base --- the latter alone directly controlled by the Federal Reserve --- are multiplied or not by a fractional reserve banking system. It's the transmission mechanism that captures the nature of the "money multiplier" and money creation of a wider sort in the economy (or vice versa in an inflationary climate when the Fed seeks to shrink the money supply). Well, what happened in the Great Depression indicated that the transmission mechanism broke down.
More specifically,  the monetary base --- currency held by the public and by banks as reserves --- actually rose between 1929 and 1933. Yes, rose: from $7.1 billion to $8.4 billion. That was a rise of 18%. Why then did the money supply itself fall some 28%? Quite simply because the "money multiplier" --- a combination of  and  --- fell 38%. And it fell for the reasons we mentioned: First, banks that survived bankruptcy the first year or two of the Depression became increasingly cautious and kept far more money-deposits in the form of reserves than they were required:
, the public's confidence in the banking system was sharply reduced by the large number of bank failures after 1929 --- remember, 9000 or so in number --- and the result was that the public withdrew large amounts of their deposits and "hoarded" the money. In the upshot, the banks' reserves were sharply reduced as well. In turn, as their reserves fell, banks had no alternative but to call in lots of outstanding loans that lots of farmers, house-buyers, and business firms couldn't pay off, resulting in their bankruptcy. The net effect here, as Mankiw notes, was a "reversal" in the process of normal money creation.
, the reversal of money creation was then aggravated by the banks themselves. Faced with uncertainty and worried about a run on their deposits --- remember, until 1933 there wasn't any government insurance should their be a panic-run by their depositors --- bankers became increasingly cautious and kept reserves above the legal minimum. The outcome? Quite simply, bankers lent out less money than they could have, even to some credit-worthy consumers or business-firms.
Given all this, we're back to the key question about deflation, a liquidity trap, and the role of the Federal Reserve in the Great Depression: Tersely put, can the Federal Reserve be blamed for the sharply fall in the money supply when it was the money transmission-mechanism that was largely at fault? The answer's not straightforwardly simple.
As Mankiw notes, the monetary base that the Fed directly controlled didn't itself fall. Oppositely, though, he notes too that the Fed could have first and foremost lent out far more money to the banks that went bankrupt owing to panic runs on their deposits by frighened depositors. And secondly, the Fed could have expanded the monetary base even more vigorously to offset the declining money-multiplier.
4) IS THE DEBATE ONLY ACADEMIC? YEP, MOST LIKELY.
Fortunately, for the US public, the theoretical debate about the Great Depression seems mainly academic. Whether a liquidity trap ever existed in the 1930s may divide New Classicists and New Keynesians 60 or 70 years later, but for the rest of us, the specter of a liquidity trap emerging here in the US in 2003 --- and mainly because a key interest rate, overnight bank lending, is at an unusually low level (probably destined to fall below 1.0% after the next Federal Open Market Committee meeting next week) --- seems far-fetched, something of an urban myth on the left fringes of the economics profession. Consider two pivotal reasons
If the money transmission-mechanism broke down in the early 1930s after the 1929 Stock Market crash --- actually reversing itself and falling 38% in the next four years --- then at least one key part of that faulty transmission mechanism, a flight out of bank deposits into hoarded currency, has been fixed by Federal Deposit insurance. That will almost certainly prevent any collapse of confidence again in the banking system. That in turn will let monetary policy work more effectively . . . even if the Fed can't prevent bankers from becoming cautious and raising their reserves above the 11% legal minimum.
To make sure you understand this, recall from the earlier analysis that high-powered money, the monetary base of the money supply --- the total number of dollars held by the public and by the banks as reserves --- actually rose 18% in that four year period between 1929 and 1933. What caused the money supply to plunge 28% lay elsewhere, in the reversal of the transmission-mechanism. It reversed under the impact of a double whammy:  a big leap in the currency-deposit ratio by about 250% --- a sign of hoarding by the public, owing to its lack of confidence in the banking system --- and  a 50% leap in the reserve-deposit ratio. These dual whammy-blows caused the big fall in the money supply of 28% in that four year disastrous period; in turn, serious deflation was allowed to get underway --- with the price level falling 25% between 1929 and 1933, clear signs of plunging consumption and business investment. Small wonder that in the process real GDP nose-dived a good 44% and unemployment leapt from 3.2% to 25.2%)
Note in passing another relevant point about the banking system here: the general efficiency and soundness of our banking system these days. In particular, not only will Federal Deposit Insurance very likely counteract any public collapse of confidence in the banking system of the 1930s sort, but additionally the speed with which the US government cleaned up the Savings & Loan banking crisis of the late 1980s --- the bad debt of which amounted to about 1.5% of our GDP --- indicates that the government will in all probability prevent any future debt problem to get out of hand.
By contrast, to grasp the US success here, note that total bad debt in the Japanese banking system
seems to be anywhere between 25% and 50% of that country's GDP of $3.6 trillion. That debt continues to undermine the entire banking system. Worse, the government keeps flirting with various kinds of salvation schemes that never allow the worst banks to go bankrupt, followed by these sanitizing measures: the government taking over the most promising of the non-performing debt --- as happened in this country, with those assets sold off to better situated banks or other buyers at discounted rates --- and then helping to refinance the better banks. On current trends, only drastic structural reforms of the whole financial system, banks included, will restore the public's confidence in the banking system and probably, for that matter, in the Japanese stock market and government bonds, now earning virtually nothing for bond-holders . . . including those in or near retirement. (China's banking debt, to continue our comparisons, is almost certainly on the same percentage order of GDP as Japan's . . . despite efforts by the Communist government to conceal it. And even more than in Japan, the big state banks in that country have wasted a large part of the public's savings in propping up uncompetitive firms --- all, in the Chinese case, owned by the state.)
There is also a large array of policies that the Federal Reserve can follow that could keep the US economy from stumbling into a fall in the money supply and a re-creation of the 1930s sharply falling price level even if a key interest rate is near zero . . . this, even though banks themselves in this country might become cautious and increase their reserves over and above the legal minimum. The use of these policies, note, isn't just speculative on our part. On the contrary, The Federal Reserve in New York and its regional offices have already thought hard about this (for one serious study, nicely summarized, see a recent paper pout out by the Federal Reserve of Dallas on these weapons). Specifically, the Fed could
increase its purchases of short-term Treasury bonds: that would put more money directly into the hands of the public's bank deposits and raise the total reserves of the banking system --- an increase in the monetary base. The limit here is the zero-bound nominal interest rate on such short-term bonds (it can't go below zero).
start buying long-term Treasury bonds, something it hasn't done before, but has the legal right to do.
if need be, have the laws changed that limit the Fed's ability to buy and sell Treasury securities only, so that it could directly expand the public's deposits and bank reserves (the monetary base of the money supply, remember) by buying home mortgages (Ginnie Mae and Freddie Mac holdings) or even corporate bonds. (It may even be legal under existing laws to buy the mortgages, or so a recent study put out by the Federal Reserve of Dallas noted).
start "monetarizing" the $400 billion deficit of the federal government this year, which would in effect be a form of money printing.
The advantages of the latter policy --- monetarizing government debt should deflation start and the other money-supply stimuli didn't work to offset it and kick-start faster GDP growth: in effect, printing money --- are multiple. Two stand out if, to repeat, the other, more conventional monetary policies didn't work. For one thing, monetarizing the government's new debt for a while wouldn't crowd out private investment . . . something that might happen, partially or wholly, when the Treasury Department sells new Treasury bonds to finance the deficit to the US public (and foreign buyers as well) and hence becomes a competitor for savings with private investors. For another thing, it wouldn't run into the Ricardian view, held by New Classicists, that argues that tax cuts creating such an deficit won't work: a fore-sighted public knows its future taxes will be raised to help pay off the debt and the interest-rate burdens on it, and hence the public will offset the tax cuts and not increase consumption by upping their savings at a corresponding rate in order to meet future tax burdens.
Why would the Fed's buying the US Treasuries sidestep this problem? Well, put bluntly . . . it wouldn't be the public --- you and me --- who would be incurring the new debt and have to pay it off with higher future taxes. No, it would be the Federal Reserve . . . a private entity, remember. True, the Fed's governors would have to consider what might happen to the value of their new Treasury bonds that they bought --- to the tune, if need be, of $400 billion this year alone ---- in the future, assuming that inflation were to rise and erode some or all of the value of those bonds on which the Treasury would be paying the Fed interest worth less each year (as would be the value of the principal). Still, though a real problem, there are ways to get around this, such as having the Treasury sell inflation-adjusted bonds (something it's done for some of its new securities for a few years now).
But what about Japan? Doesn't Its Fate Show That a Liquidity Trap Can Occur Here Again?
The blunt answer: no, Japan's a special case, a country where a mountain of institutional and structural problems, including the huge menace of ongoing banking debt, continues to heap up and fester away . . . with a one-party dominant democratic system doing little more than ensuring that bankruptcies don't occur to big and medium-size firms and farmers no matter how uncompetitive and inefficient they happen to be by international standards. More bluntly yet, Japan's a country where markets have been so gummed up by government regulations and subsidies and other forms of protection for decades now that low interest rates --- virtually zero --- have had a perverse effect: they not only haven't inspired vigorous consumer buying of new residences and cars and the like, let alone kick-start vigorous business investment, they's actually fitted into the Liberal Democratic Party's chief concerns to shore up uncompetitive farmers and business firms by letting them stay afloat even without profitability, thanks to their borrowing, if need be, at near zero interest rates. The alternative --- bankruptcy --- has frightened the LDP and much of the bureaucracy. For that matter, even much of the public too.
But what happens when low-productive, low-return firms and whole industries are allowed to persist no matter how inefficient they are? In blunt, to-the-point terms again, you get an economy like Japan's --- entangled in a self-made thicket of economic decline, full of bad banking debt, spiraling public debt (national debt is about 150% of GDP, compared to around 40-45% here), stagnant GDP growth, rising unemployment, a dispirited nation, an aging risk-averse population, and the clear prospect of falling out of the ranks of the advanced industrial countries.
The latter stark paragraph can be rephrased in more academic terms. Specifically, the Japanese bureaucracy and the LDP have combined for decades to undermine the processes of creative destruction that are essential to vigorous economic growth: above all by letting uncompetitive and low-productivity business firms and whole industries slim down drastically or disappear ouytright in order to free capital, managerial talent, and scientists and engineers and skilled workers for movement into more competitive and promising industries, including brand new ones. Instead, thanks to a legion of regulations, subsidies, and other forms of protection, huge amounts of capital and talent have been locked up in low-productive, low-return industries and firms --- including most of the Japanese retail and wholesale distribution systems --- and all at the expense of modernizing and updating the Japanese economy.
Nor is that all. The cheap Yen --- which the Japanese government has underpinned by lately buying lots of dollars (selling Yen for them) --- further underpins the inefficient, self-entangled status quo. How so? Well, a cheap Yen keeps out exports that would quickly show just how uncompetitive by international standards most of the Japanese economy happens to be: a few very competitive giants, the rest of the economy largely a form of early 20th century semi-developed and highly protected manufacturing and service industries. Small wonder that some economists and financial specialists, both in and out of Japan, regard the country's economy as not caught up in a liquidity trap --- rather, entangled in a swarm of structural traps that politicians, bureaucrats, and near-zero interest rates conspire to keep the economic system imprisoned in its institutional and other teeming anti-market inefficiencies.
So, on all these counts, whether Japan has stumbled into a liquidity trap of the 1930s sort --- or a set of structural traps (or both liquidity and structural traps at the same time) --- has little relevance to the economic prospects of the US, now or in the future. Its economic failures are at most a warning of what can happen to a country of well-educated and at one time risk-taking people when the logic of market competition, openness to new ideas and technologies and products, combines with fear of change and resistance to risks that politicians might only be too happy to cater to, for both ideological and careerist reasons.
TO BE CONTINUED IN PART V OF THIS MINI-SERIES ON THE US ECONOMY
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-- signed, a college student from Penn (and not State!)...