It’s what Irving Fisher proposed in the 1930s. It’s what Krugman proposed for Japan in the 1990s. In the latter case, that’s what the authorities (finally) did, and it worked. What is it?
First, we’re not that far yet, inter-bank money markets seem to be getting out of their funk. But if the economy deteriorates so rapidly as to bust up balance sheets of financial institutions faster than the present plan can repair, there is more what they can do.
It’s a bit embarrassing, because that solution is what they are doing in Zimbabwe. It’s what is known as printing money, or at least, flooding the system with money by buying up Treasuries (or other assets) with abandon by the central bank.
In the end, when done at sufficient scale, that will make money so cheap companies and people will start to borrow again and the economy will be revived.
The one danger, as we can see in Zimbabwe, is that a balooning money supply risks creating hyperinflation. But for the moment, this risk is actually pretty low. In a recession, there is enough spare capacity, production will increase first (and asset prices). Which is right what we need.
There might not actually bee too much real printing of money, as this depends whether people prefer cash, and if this action restores faith in the financial system, actually less cash might be needed, and the printing press might be given a break.
It is a risk nevertheless though and the tap should be turned off at the first sign of accelerating inflation, but a risk well worth taking if everything else fails.
- By Justin Fox Last Updated: October 13, 2008: 7:37 AM ET
- (Fortune Magazine) — On Nov. 21, 2002, just two months after leaving Princeton University’s economics department for a spot on the Federal Reserve Board, Ben Bernanke gave a speech in Washington on the topic of deflation. At the time, stock prices had been falling for almost two years straight, inflation was just 2%, and there was widespread worry that it would drop into negative territory. The specter of Japan, beset for a decade by falling prices and economic stagnation, was on the minds of many. In his speech, Bernanke even brought up a far worse deflationary spiral – the Great Depression.
- But his intent was to reassure. “I am confident that the Fed has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief,” Bernanke said. Quoting economist Milton Friedman, he described one such policy instrument – a tax cut accompanied by mass Federal Reserve purchases of Treasuries – as equivalent to a “helicopter drop of money.”
- The helicopter line got a lot of attention, and critics have derided Bernanke as “Helicopter Ben” ever since. But the most important takeaway from his speech was that economists and central bankers had things pretty well figured out. They knew how to prevent a depression – and they had the “tools,” a word Bernanke used a lot.
- Those tools haven’t looked so useful lately. Bernanke is now chairman of the Fed, and together with Treasury Secretary Hank Paulson he has spent the past year battling what is now by almost unanimous agreement the worst financial crisis to hit the world since the one that unleashed the Depression.
- There’s no deflationary spiral, at least not yet. But there is a collapsed U.S. housing market, a global financial system on the brink, and an economy that has gone into a stall. Despite all the tools that Bernanke and Paulson have wielded and in some cases invented to fight the crisis, it keeps getting worse.
- They’ve tried easy money, plus increasingly creative ways to get it into the hands of banks and corporations. They’ve bailed out some struggling financial institutions and let others fail. They’ve persuaded Congress to hand the Treasury $700 billion with which to fight the crisis. And yet stock markets have kept on sliding. Credit markets have remained stuck. Hurt is everywhere.
- Does that mean Bernanke and Paulson have failed? No. They’re not done yet. We’ll leave root causes for another day; here we’re discussing how to get out of this mess.
- There’s still much that Bernanke and Paulson, Congress, and the next President can pull out of the toolbox in coming months, and growing signs that officials are getting ready to employ some seriously heavy machinery. But it is true that the financial excesses now unwinding have turned out to be far vaster and more complicated than all but a few economists ever imagined.
- “Like people in financial markets, we macroeconomists tended to congratulate ourselves too much,” says Barry Eichengreen, a professor at the University of California at Berkeley and a leading scholar of the Depression. Still, Eichengreen doesn’t completely despair. “I doubt that we’ll be able to avoid double-digit unemployment, but I’m still confident we can avoid 24% unemployment like in 1933.”
- Learning from the worst case
- We know: Massive unemployment, depression … economists aren’t known for saying the most comforting things. (Three out of four Americans should be able to keep getting a paycheck! Swell!) But it’s worth delving into the dismal science because economists have played such a huge role over the years in shaping how we respond to financial crises. History’s important too: The terrible first months of 1933 are ground zero for those who study financial panic and economic depression.
- It was a time, as one historian put it, of “near-total banking eclipse.” As lame-duck President Herbert Hoover dithered, depositor runs endangered even the strongest banks. State authorities shut down the banks in New York and Chicago. When Franklin Roosevelt declared a four-day national bank holiday on March 5, a day after he took office, he was merely confirming financial reality.
- The country – and the world – had been through bank panics before. In Britain, for example, the Bank of England was long established as the “lender of last resort” – during bank runs, it would step in and provide otherwise solvent financial institutions with cash to tide them over. In the aftermath of a 1907 bank panic, Congress finally gave the U.S. a central bank, albeit in the decentralized form of the Federal Reserve System.
- After the creation of the Fed, the U.S. economy chugged along panic-free for years. But the Fed was not up to the challenge of ending the wave of bank failures that began about a year after the 1929 stock market crash. By the time Franklin Roosevelt took charge in 1933, it wasn’t just the banking system that was in shambles but the entire economy. Millions of Americans had lost their savings, tens of millions had lost their jobs, borrowing money was mostly out of the question for both businesses and households, and farms and factories were producing a bare minimum.
- A few of F.D.R.’s advisors thought capitalism had failed and wanted him to nationalize the banking industry permanently. The President instead adopted a plan drawn up during the Hoover administration: The strongest banks began reopening, with government endorsement, as soon as the bank holiday ended, while the weakest were shut permanently. Those in between (about 45% of the country’s remaining banks) were put in the charge of government-appointed conservators and recapitalized with government and private money.
- Later came the creation of the FDIC, which insured bank deposits, and a revamp of the Federal Reserve System that pulled power away from the squabbling regional Federal Reserve banks and centralized it in Washington. It was a pragmatic approach to fixing the financial system, not the product of any well-articulated economic worldview. But it worked, mainly by restoring confidence.
- The roots of Bernankeism
- That’s part of the lesson of 1933 – that sometimes just doing something, as long as you do it decisively enough – can end a crisis. But a pair of economic breakthroughs that emerged after the crisis ended have also played a huge role in how officials respond to crisis today. One came from Irving Fisher of Yale, the other from John Maynard Keynes of Cambridge.
- Fisher believed the economy had become stuck in a cycle of debt and deflation: Households and companies borrowed too much and then were forced by some economic shock to start scrimping and selling assets to pay their creditors. This thrift and panic selling drove prices down, in turn making it harder for debtors to avoid default, bringing on more selling, more price declines, and so on in a terrible downward spiral.
- The best way to stop it, Fisher argued, was for the Federal Reserve to forget about just being a lender of last resort and print money – lots of money. (By “printing money” we mean buying Treasury bills and thus driving down interest rates.) And then keep printing it until, to get all jargony, inflationary forces counteracted the deflationary ones.
- Keynes didn’t disagree with Fisher’s account – he just didn’t think such monetary action alone was powerful enough to lift an economy out of the Depression. Instead, he argued, government needed to counteract the ever-more-miserly tendencies of businesses and consumers in a downturn by spending with abandon. It needed to become the spender of last resort.
- You’ve probably heard of Keynesianism – it was behind the $167 billion in tax rebate checks sent out earlier this year and the gigantic deficits the country is sure to run for the next couple of years, no matter who is elected President. Fisher remains in ill repute for his September 1929 claim that stock prices were on a “permanently high plateau,” so nobody talks about Fisherism. But some of his ideas were revived by Milton Friedman in the 1960s – and are now at the core of how central bankers like Bernanke, a student of the Depression, view the world.
- Now what?
- It is today’s bipartisan (if usually unacknowledged) acceptance of the arguments of Keynes and Fisher that explains why economists generally don’t think we’re headed for a repeat of the 1930s. Everything else might go haywire, but the Fed can keep the overall price levels from falling and the government can keep spending going.
- That isn’t the whole story, though. In the heavily regulated environment of the mid-1930s through the early 1970s, financial panics were unheard of in the U.S., and inflation and stagnation were the biggest dangers. But globalization and deregulation began to change that. Several big banks failed in the 1970s, and old-time financial crisis returned to the scene with the 1987 stock market crash – which quick Fed action kept from turning into anything worse.
- Then came the 1990s, a decade replete with panics and crashes around the world. Most occurred in emerging markets, but some rich countries got hit too. In the wake of a stock market and real estate crash, Japan was slow to ease monetary policy and unwilling to shut down insolvent banks, but fended off a depression with years of deficit spending.
- Meanwhile, several Scandinavian countries bounced back quickly (if painfully) from severe banking crises in the early 1990s by taking a page out of F.D.R.’s book. The Swedish government, for example, guaranteed all bank deposits and other debts, then put taxpayer money into troubled banks in exchange for big equity stakes, which it sold when markets recovered.
- That brings us to August 2007, when the gathering collapse of the U.S. housing market first made itself felt in financial markets in general. The Fed responded both by making sure banks had the cash they needed and by pumping up the overall money supply. These measures worked, in that they kept the economy going, albeit fitfully. But they didn’t fix the underlying problem.
- “The tools have been the right tools,” contends Frederic Mishkin, a Columbia University economist who spent two years on the Federal Reserve Board. “The rot that was exposed here was much worse than anybody anticipated.”
- What does Mishkin mean by rot? “This shock has revealed a tremendous problem in the way financial contracting is done and in the way securitization is done,” he says, the core of which was that “nobody cared whether the ultimate holders of the securities got paid back.” That is, mortgage brokers, securitizers, derivatives makers, and credit raters all got paid for making transactions happen, not for making good loans. And so a lot of very bad loans were made.
- When loans go bad, we have long-established procedures in our society for apportioning the losses. For most companies there’s bankruptcy, and for banks since 1933 there’s been the FDIC, which makes sure insured depositors get out whole and then hands out anything that’s left to uninsured depositors and other creditors. In special cases, where it deems the failure of a bank to pose a threat to the overall financial system, the FDIC is allowed to improvise by guaranteeing all creditors, arranging a sale, etc.
- When the problem occurs on a mass scale, though, the case-by-case approach doesn’t work so well. The Fed, Treasury, and FDIC have rescued some ailing financial institutions and let others die – Lehman Brothers being the most famous. European countries facing similar issues have also failed to stick to any clear rulebook. As a result, the providers of the credit that financial institutions need to keep going have turned ever more skittish. That’s why banks are now so loath to lend to each other and increasingly loath to lend to anybody else.
- There are solutions to this. Like F.D.R. in 1933 or the Swedes in 1993, the Treasury Department and the FDIC could quickly sort out which financial institutions are going to live and which have to die, and pour capital into the borderline cases that they want to survive.
- The $700 billion bailout law passed by Congress allows for the money to be used this way, and Treasury Secretary Paulson was moving toward such action when this magazine went to press. He was also floating the idea of guaranteeing all bank debt and insuring all deposits. If done decisively enough, these measures could bring trust and confidence back to the financial system as banks stop trying to guess who might go under next. If coordinated with the efforts of other countries, they could be even more effective.
- That said, more will surely remain to be done. The one big political decision made during the horrible, almost leaderless months of early 1933 was the ratification of the 20th Amendment, which moved Inauguration Day up from March to January. But markets now move at a speed that makes even a week seem like an eternity. Epochal decisions may have to be made during the 21/2 months between Election Day and swearing in. In the end, our fate may be determined as much by politics as economics. To top of page