Deficits and fast money

Posted: Sep 28, 2001 12:00 AM
In the 1930s, the United States suffered its worst economic crisis. Eventually, most economists came around to the idea that what the economy needed was large budget deficits and fast money growth from the Federal Reserve to turn the situation around. But although deficits and money growth did rise gradually during the depression, they did not increase enough to turn around the deflation that was at the root of the economy's problems. John Maynard Keynes, the most prominent economist of his day, proselytized tirelessly for more stimulative monetary and fiscal policies. Not only did he write books and academic articles promoting the idea, but he lobbied government officials and wrote extensively for popular magazines. Yet, by 1940, almost 11 years after the stock market crash of 1929, Keynes was despondent over the failure of the U.S. government to fully embrace his theories and end the Great Depression. Keynes' native country, England, was already at war. But the United States remained on the sidelines. Keynes, like all Englishmen, knew that only U.S. intervention in the war could save England from Nazi domination. Hence, U.S. nonintervention was a deeply personal matter for Keynes. However, it was also a professional matter. Keynes had seen how the onset of war in Europe had finally broken the back of the depression and gotten its economies moving again. He had observed at close hand how Hjalmar Schacht, Adolph Hitler's chief economic adviser, had turned around the German economy by fully applying Keynes' theories there. As John Kenneth Galbraith later wrote, Hitler "was the true protagonist of the Keynesian idea." Consequently, it was deeply frustrating for Keynes to see his nation's enemies benefiting from adoption of his ideas, while its greatest ally continued to wallow in economic depression because it did not fully embrace them. In an article in The New Republic in July 1940, Keynes vented his frustration at an American audience. He concluded that only American entry into the war would end the depression, because only that would lead the government to cast off the budgetary and political constraints that prevented the adoption of monetary and fiscal stimulus on the scale Keynes believed was needed. "It is, it seems, politically impossible for a capitalistic democracy to organize expenditure on the scale necessary to make the grand experiment which would prove my case -- except in war conditions," Keynes wrote. The Second World War did indeed end the Great Depression. Sadly, many people concluded from this that there is something stimulative about war, per se. In fact, of course, war represents nothing but economic waste. Its direct contribution to growth is nothing but an illusion. "War prosperity is like the prosperity that an earthquake or plague brings," Ludwig von Mises once wrote. "The earthquake means good business for construction workers, and cholera improves the business of physicians, pharmacists and undertakers; but no one has for that reason yet sought to celebrate earthquakes and cholera as stimulators of the productive forces in the general interest." Nevertheless, wars do change economic policies, usually for the worse, but sometimes for the better. On the negative side, they almost always lead to sharp increases in taxes, often to levels undreamed of in peacetime. Wars also lead to regimentation of the economy through wage and price controls, and distort investment. But, if the economy is suffering from a severe deflation, as the U.S. economy was in the 1930s, war can bring blessed relief in the form of monetary and fiscal ease. This was Keynes' point. I believe that this history has relevance for today, because the U.S. economy has suffered from a severe deflationary slowdown over the last 20 months. It has desperately needed monetary and fiscal stimulus. But bipartisan support for the so-called Social Security lockbox kept fiscal policy unusually tight, while the Federal Reserve's obsession with nonexistent inflation kept monetary policy too tight as well. Now it appears that substantial monetary and fiscal ease may be forthcoming, as the result of the war against terrorism. Tax cuts that seemed politically impossible a few weeks ago, such as a cut in the capital gains tax, now appear have a good chance of passage in Congress. And the Federal Reserve, as well as foreign central banks, are finally adding the liquidity necessary to end the deflation. It is too bad that it took a crisis to bring it about. No doubt, some bad economic policies will also result from the crisis. Many pork-barrel spending projects seem to have gotten a new and undeserved lease on life, according to Citizens Against Government Waste. New restrictions on travel and the use of products that are thought to have terrorist applications will also have negative economic consequences. It would help if policymakers, in looking for ways to aid the economy, limited themselves to proposals that made sense on Sept. 10, before the World Trade Center attack. If it was a good (bad) idea then, it is probably a good (bad) idea now. Rigid application of this principle will limit the self-inflicted damage from war and promote the fastest possible economic recovery.