The report issued this morning by the Bureau of Economic Analysis that real GDP grew at only 1.3 percent in the second quarter and revising the estimate of growth in the first quarter down to 0.3 percent is really depressing (pun intended).
This reminds me of 1932. That’s when the Fed engaged in a program of open market purchases that had at most a minimal effect in slowing the downturn and reversing the slide in prices. The program was widely dismissed as a failure and evidence of the impotence of monetary policy in a depression. (Keynes had not yet invented the liquidity trap, but the idea that monetary policy is ineffective in stimulating a depressed economy because the interest rate channel is blocked predates Keynes. People mistakenly think that Keynes invented the “you can’t push on a string” metaphor, but it seems to have originated with Congressman T. Alan Goldsborough.) Scott Sumner has written about this episode in his (unfortunately still unpublished) book on the Great Depression, clearing up a lot of the confusion surrounding the program. It was not until FDR took office in March 1933 and immediately suspended the gold standard, raising the price of gold, that deflation was halted, and reflation and recovery began.
All current monetary policy is doing, intentionally or inadvertently, is inducing banks to hold reserves yielding more interest than Treasury bills. Looking at the amazing growth in bank reserves and the Fed balance sheet, people are amazed that banks are not lending despite all the “high-powered” money that the Fed has created. The current policy, like the half-hearted open market purchases of 1932 is a prescription for failure, but the failure is interpreted not as a failure to adopt an expansionary monetary policy, but as a failure of expansionary monetary policy. In 1933 FDR proved, despite the skeptics, that expansionary monetary policy does work. Why can’t we learn from FDR? Where are all the historians of the New Deal? Why aren’t they pointing out how FDR used monetary policy to start a recovery at the deepest point of the Great Depression?
HT Benjamin Cole
Uneasy Money 
Somewhere along these lines Robert Higgs in June said:
http://blog.independent.org/2011/06/23/the-continuing-puzzle-of-the-hyperinflation-that-hasnt-occurred/
To which the Free Banking blog echoed some of your concerns:
http://www.freebanking.org/2011/06/24/hyperinflated-hyperinflation-reserve-concerns/
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It’s not evident that FDR’s monetary policy was effective either. There’s an interesting argument that only the gold influx from Europe on account of the political instability was sufficient to spur a monetary recovery.
This was of course completely exogenous to FDR’s policies.
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David, it is incredible, but I tend to agree the US economy need FDR (damn, I really hate saying that…). Well, that’s not really correct what the US economy need is Swedish monetary policy – Lars E. O. Svensson or Cassel.
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John, Thanks for the references. I saw Higgs’s discussion when it first appeared, and felt that he was taking a rather naive view of what the Fed was doing.
Juan, I am not sure why there would be any doubt that FDR’s devaluation of the dollar did not produce immediate results. Wholesale prices which had been falling rapidly increased 14 percent between April and July 1933 (not at a 14% annual rate, but 14%). That seems pretty obviously the result of devaluation. The US economy took off like a rocket and stock prices doubled. Unfortunately, FDR foolishly instituted the NRA in July and aborted the recovery. Kindleberger in one of his discussions of the Great Depression dismisses the April July recovery as an inventory recovery. That was nonsense.
Lars, Sometimes you have to take help from wherever you can get it.
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David, I think Lars E. O. Svensson MIGHT just consider the job as Fed chief;-)
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David. You said:
“…but the failure is interpreted not as a failure to adopt an expansionary monetary policy, but as a failure of expansionary monetary policy”.
Precisely! (http://thefaintofheart.wordpress.com/2011/07/30/the-%E2%80%9Clittle-depression%E2%80%9D-just-became-bigger/)
But in “defence” of Bernanke, he was consistent with his “worldview” of the importance of the “credit channel” (see his non monetary causes of the GD). Also, he is a “rabid” inflation targeter (he edited the book that “popularizes” it). And you have to be “symmetric” going about it (which can lead you into trouble when a “supply shock” hits the scene like in the first half of 2008 (oil and commodity prices). His first mistake was to abandon core inflation in favor of headline. The second was to abandon what Hetzel calls LAW (Lean Against the Wind) with credibility (which characterized Volker´s and Greenspan´s tenure, leading to the Great Moderation) and forget, as he always knew, that the level of the FF rate did NOT indicate the stance of MP.
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I’m not sure how FDR’s (and Hoover’s before him) expansion policy “worked”. Yes, there was GDP growth but unemployment remained in the high teens until 1939 when the impending war started sucking up the labor force and finally reducing unemployment. I shudder at the massive malinvestments that the government made on the people’s behalf and I wonder what the market might have made of things had the ham fisted intervention not occurred.
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A comparison between 1932 and 2011:
The price level fell over 10% in 1932. The real interest rate was over 12% and real wages were rising.
The price level is rising at a 3.6% twelve-month rate in June, 2011. Real interest rates are negative out to seven years. TIPS 5-yr inflation spreads are a quite-normal 2%+. Real wages are falling.
The Fed controls the price level. In 2011, the price level is rising briskly, yet employment is stagnant. If 3.6% is not enough, what increase in the price level would you like to see to break the comparison with 1932? If this change in the price level is achieved through higher commodity and import prices, does recent evidence indicate that this would help or harm consumer spending?
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Lars
I would be happy if the Swedish central bank would be led by Svensson. Now our monetary policy is tighter than he wants which I think is a mistake.
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I´m more and more uneasy with US and EU…
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Excellent post. Bernanke is feeble.
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Even if our policymakers accepted that the right thing to do was to let the bubble pop and allow the markets to correct the malinvestments, it would take a level of moral courage to say “no” that I don’t think many of them have.
I’d almost feel sorry for them if I didn’t recognize that they wanted/fought for the offices they hold. Nobody wants to be at the helm of the Titanic when it goes down, but buddy you wanted the job…
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Lars, That would be a great idea. But if a Republican is elected in 2012, we will be lucky to get John Taylor, lucky because anyone else they would select would be worse.
Marcus, You are right, as usual. And thanks for quoting me!
Skeptical Enlightenment, You are mistaken to equate Hoover and FDR. Hoover was committed to the gold standard. FDR broke loose from the gold standard. That was the critical difference. Had FDR not instituted the NRA in the summer of 1933, the rapid recovery that started when he took the US off the gold standard would have ended the depression within a couple of years. Even with the NRA which was nullified by the Supreme Court in 1935, the end of the depression was in sight in 1937 when a severe tightening of monetary policy caused a relapse into the depression that had almost been surmounted.
David, Your comparison explains why we only have 9 percent unemployment today instead of 25 percent. TIPS spreads of 2 percent are not enough given that real interest rates over a two year horizon are negative. Higher expected inflation is needed to get nominal interest rates back up to more normal levels. I would like to see an increase in the price level of 10 percent over a short period of time which would provide relief to debtors and provide increased incentives for businesses to expand output and employment. In 1933 there was a 14 percent increase in wholesale prices in four months which produced the fastest output expansion in US history. Import and commodity prices will increase as well, but labor costs will not increase as rapidly so there will certainly be an incentive to expand output and employment.
Luis, I agree.
Benjamin, Thanks
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Excellent blog. As a student of the Great Depression, I am much intrigued by your comparisons of the 1930s and today, and I find them to be right on target.
I am also intrigued by your (and Scott Sumner’s) contention that the Fed has a lot more ammunition that it is not using. I am open to that argument, but first I’d need it spelled out for me just what the Fed could/should be doing. Help?
Thanks,
Ranjit Dighe
http://moneyandblogging.wordpress.com/
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Mattias, I would not necessarily agree. I think the tightening of monetary policy we are seeing recently from Riksbanken is prudent and must admit that even though I think both the ECB and the Fed could need the advise of somebody Svensson I think that he from time to time come down as being the “permanent dove”. That said, Riksbanken has done remarkably well during the crisis and overall I think Swedish monetary policy is pretty much on track. But that’s just my personal view…
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David,
Think about the dynamics of 10% inflation. In 1932, the profits share of GDP was likely at a trough; real wages at close to peak; commodity prices in the tank. Further, an increase in commodity prices — FDR’s expressed goal — benefited a larger sector of the economy than today.
Today, profits share of GDP is at a peak, wages at trough and flat on a ten year basis. Commodity prices are at peaks. An increase in commodity prices benefits a tiny sector of the economy.
So how would 10% inflation be achieved? What are the dynamics? A maxi-deval would raise food and energy prices disproportionately, lowering the real wages of leveraged middle income households. We saw the effect of this dynamic in 1H11.
Comparing the effects of a deval on a “deflated” economy with our economy today is quite a stretch. I’d be willing to be convinced, just paint out a sectoral narrative of how we get to 10% and who benefits/loses.
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“and provide increased incentives for businesses to expand output and employment. ”
This is one of the things I take issue with. The effect of reducing real wages in 1932 was highly beneficial to depressed business profits, and the effect was an immediate uptick in investment and hiring. In 2011, margins are already at peak; the corporate WACC is exceedingly low. Businesses have every incentive to invest. Would higher margins help? Or would rising commodity inflation actually lower corporate margins? It is quite possible margins peaked in 2q11 due to this effect.
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David, the real mistake here is the hubris of people who believe that they can understand something as complex as the US economy and make “adjustments” they feel would be beneficial just by tweaking the small number of levers they can reach to control. Their actions always have unforeseen and unknowable consequences and those are often worse than the illness they thought they were trying to correct. Markets are self-organizing and attempting to shape them according to political designs has always proven disastrous.
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Well, my face is red with embarrassment! A hat tip for me!
But, actually, i am always whining that you should talk about Japan, not the 1930s USA.
My reasoning is not academic but political. The minute anyone says “FDR,” or “Democrats,” or “stimulus” the reaction starts. Ancient battle lines are reignited, and the 1930s, and the 1960s, and the 1990s are fought over again. Thinking ceases.
But calling the Bank of Japan “overly feeble” and citing Milton Friedman’s and John Taylor’s advice to Japan can at least get the foot in the door.
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Skeptical Enlightenment, In theory I agree with you. However, in practice, I am not sure that we yet know how to craft an institutional system that will not result in inadvertent misalignments of incentives that cause significant departures from full employment and the trend rate of growth of real GDP. Greed is not good, except under a legal (and perhaps moral) framework that is exquisitely crafted and delicately balanced. Without such an optimal institutional framework, things can go terribly wrong. To a large extent we are just feeling are way in the dark in a quest for such an optimal framework, and in the monetary sphere I have very little confidence that we can yet specify that optimal framework that would minimize monetary and macroeconomic disequilibrium. However, at the present time, I am pretty confident that we are erring on the side of too little inflation, even though over the long-term I think that very low or even negative inflation would be better.
Ranjit, The basic idea is that the Fed should announce a price level objective that is about 10 percent higher than the current price level and commit itself to continuing open market purchases of Treasuries until the price level objective is reached. To give the commitment added credibility, the Fed and Treasury should also announce that they will aim at reducing the dollar exchange rate against key currencies by 10 percent until the price level target is met. In addition, the Fed should immediately stop the payment of interest on reserves. Doing so might well allow the price level target to be achieved without any open market purchases indeed the Fed might have to start selling Treasuries to banks to absorb reserves banks wanted to exchange for higher yielding Treasuries.
David, While I think that there are parallels between 1932 and 2011, obviously the situation now is not nearly as dire as it was then at the bottom of the Great Depression. This is only a Little Depression. So the hole that we have to climb out of is not nearly as deep as the 1932 hole. Second, which commodity price index is at a peak? The DJ/UBS index was well below the 2008 peak the last time I checked and I think that commodity prices have fallen since then, so I think that there is plenty of room for commodity prices to rise without causing the profit squeeze that you are worried about. The increase in commodity prices in Q1 2011 was mainly an increase in the price of oil as a result of the Libyan situation, spooking the markets. Prices have since come down, but it caused a serious supply side shock which helped cause a temporary uptick in measured inflation. Upticks in inflation from supply-side shocks should be accommodated not counteracted by monetary policy. As it became clear that the Fed was backing away from even the modest monetary expansion initiated last September inflation expectations began falling in the spring, putting us back where we were last September when Bernanke’s announcement of QE2 gave us an improvement in GDP growth in Q4 2010 and a recovery in the stock market only to peter out in Q! 2011.
If you are worried about the effect of 10 percent inflation on households, you should consider that it would improve household balance sheets and improve cash flows for households now struggling with mortgage payments. From that perspective even a 20 percent increase might not be a bad thing. I have no detailed sectoral narrative to offer. But let me respond to your point about current high margins that businesses have and the implication for business investment. It seems to me that what is holding back investment and hiring is precisely uncertainty about demand which make businesses unwilling to expand because they do not know if they will be able to sell the output without cutting prices. That’s why an expectation of rising prices would encourage both hiring and investment.
David, you seem to have thought a lot about this, what do you think is holding back investment and hiring?
Benjamin, I am thinking about a post about Japan, but I can’t promise yet when it will get done. Stay tuned.
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David,
Put yourself in the place of a middle income household facing your prescription. Inflation expectations rise steeply. The first/most to go up are food and energy prices. The pass-through of that and import prices mean each visit to Walmart costs much more. House prices have an initial leg down as the jump in nominal rates forces underwater ARM mortgage holders into foreclosure. Manufacturing employment improves, but discretionary services employment — a key source of job losses — suffers as discretionary spend falls along with consumer confidence.
In short, add a real wage shock to over-levered households suffering l.t. real wage stagnation, and real spending suffers.
We can debate why inflation is running at 3.6%; what is more evident is that the acceleration in headline inflation has harmed consumer spending in the first half of the year. Also evident is that targeting a 10% higher price level would spike oil to far above $100/bl. How does policy overcome this sectoral “friction”? My point is that the marginal benefit of an increase in corporate margins is much, much lower in 2011 than it was in 1932.
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Don’t get taken down the “greed” river David. Greed is a proper human emotion and what people who appeal to “greed” fail to understand is that in nature greed is balanced by the fear of loss. One of the early stage activities for many free market capitalists is to leverage the power of government for protection from predatory competition. In effect, they remove the fear of loss from the equation, thereby allowing unrestrained greed to adversely affect the market. As Milton Friedman said, no one hates the free market more than the capitalists. So long as we allow the ruling class control, the rent seekers will ply them with graft and the rest of us will suffer the injustice of a manipulated and lessened free market.
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David,
I am with you on the need for a FDR type leader. However, FDR came in with a lot more freedom to innovate given the severity of the times. It is hard to imagine anyone having FDR freedom today. The economy would have to get even worse and the Fed has burned much of its political capital.
By the way, II raised the same question awhile back here: http://macromarketmusings.blogspot.com/2011/05/original-qe-program-smashing-success.html
Mike Konczal followed up with a nice post on FDR here: http://rortybomb.wordpress.com/2011/06/21/president-sets-a-price-level-target-in-a-depression-fdr-1932-edition/
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Skeptical Enlightenment, You may be reading more into my remark than I intended. I don’t attach any moral or value judgment to greed. It is a basic part of our makeup as human beings and I accept it as such. Acting on it in certain circumstances and under certain constraints is praiseworthy and under others it is blameworthy. The genius of a market economy is that forces people to pursue their self-interest or greed in ways that redound to the benefit of others at the same time. But that is not a natural or inevitable result; it depends fundamentally on having an appropriate set of rules and institutions that direct greedy motivations into action the promotes the general well-being of others. People are no less greedy in a collectivist economy, but their greediness leads them to act in ways that don’t promote the well-being of others. But even in a market economy, improperly defined property rights or badly formulated laws and rules can result in greediness leading to anti-social instead of welfare-enhancing consequences That’s all I meant, and I think that we agree on that.
David Pearson, You may be right that food and energy prices will rise faster than prices in general if the price level were to rise, but I think that that is far from a given. The supply of food is not fixed except in the short run, so the rise in food prices will tend to be moderated. Whether and how much energy prices rise depends on many factors other than monetary policy, despite the convenient correlation that the Wall Street Journal likes to assert between monetary policy and the price of gasoline. As for the effect of a rising price level of mortgage rates, the sound money people — and I can’t tell if you fall under that heading or not — also want to raise interest rates, but without cushioning the blow with rising prices. Moreover, long-term rates will not increase much. The sharply rising yield curve will flatten out. Nor can you assume that the pass through of a reduced dollar exchange rate on import prices is dollar for dollar. Increased competitiveness of domestic products will provide some constraint on the increase in the price of imports. There will be some pressure on the currently employed whose wages lag behind the increase in prices, but that will be more than made up by the increase in total wage income as a result of expanding employment. So I think that the scenario that you are suggesting is far from the inevitable result of a significant increase in the price level.
David Beckworth, I agree that FDR was in a unique historical position to accomplish what he did and his model may not be capable of emulation. That may be our misfortune. Thanks for the links, they look really interesting and I look forward to catching up.
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I wholeheartedly agree. Free markets require transparency and an evenly applied legal framework to defend private property and punish fraud. Sadly, we humans tend to build institutions that go far beyond those missions and eventually make a mockery of even those. You or I would be in jail for perpetuating the Social Security system as it exists today.
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Skeptical Enlightenment, To say that you or I would be in jail for perpetuating the Social Security system as it exists today is actually a very trivial and uninteresting point. You and I would be in jail if we started declaring various behaviors to be criminal acts and started prosecuting and punishing people for transgressing the rules that we enacted. You and I would be in jail if we started imposing taxes on and collecting taxes from our neighbors. You and I would be in jail (or worse) if we tried to raise an army. If you have ever entertained ambitions of becoming a state, I advise you to forget about them ASAP.
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The “point” was about the Ponzi Scheme that Social Security has become. Bernie Madoff knows all about those and their consequences to individuals. That’s simple fraud. All of your examples can be reduced to the use of force, which is not available to individuals other than during the commission of a crime.
I recently got in a debate with someone as to whether or not we actually pay back our Federal debit. I made the statement that we never really paid back principal, we’re just maintaining out debt with interest-only payments. He shot back a scathing retort regarding the Clinton surplus years and demanded a retraction based on a CBO report showing “public” debt holding in decline during the Clinton years. I pointed out the lie hidden in those numbers because while yes “public” debt did indeed decline, intragovernment debt increased so wildly that our overall Federal debt continued to increase. Intragovernmental debt is primarily the IOU’s that Congress has been using to replace the Social Security tax surpluses to they could spend that money as general revenue.
I believe that it is a fraud to publicize your debt to Paul, steal money from John to pay Paul, and then report your level of indebtedness as falling by excluding the fruits of your fraud.
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David,
I am wiling to believe that commodity, food and import prices will lag others during a 10% increase in the price level. The question is, which prices then rise more than 10% in your scenario? Most other cpi products contain a higher wage cost component than commodities; hence, for them to rise more than 10% implies real wage gains (a no-no). There’s rents and OER, but with the housing market in such oversupply, a 10% increase seems a stretch. BTW, ARM mortgages are sensitive to short term Treasury yields, not long term.
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Skeptical Enlightenment, I don’t see the fraud involved in Social Security, though there is an element of coercion involved that you or I would not be able to apply if we were trying to market our own competing program of retirement insurance. All the information about social security that you cite is public knowledge. There is no secret about how the program is run. You think it is a bad program, that doesn’t make it fraudulent.
David, Probably some will and some won’t and I don’t have enough specific information to identify which will rise faster and which will rise slower than average. It would depend among other things on the elasticities of demand and supply for the individual products. On ARM mortgages, you are right of course. I meant to say that conventional mortgage rates would probably not rise much, if at all.
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‘Remained in the high teens’ is classic Amity Schlaes sh*t.
If anybody is interested in the truth, start at http://en.wikipedia.org/wiki/Great_Depression_in_the_United_States
See what happened in the USA from 1933 to 1937 (when FDR had a short and disasterous flirtation with austerity).
“I shudder at the massive malinvestments that the government made on the people’s behalf ”
‘Shuddering’? This is a guide – your ‘shudders’?
“and I wonder what the market might have made of things had the ham fisted intervention not occurred.”
We saw that with Hoover.
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Ahhh, an Austrian
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There was nothing laissez-faire about Hoover. He nearly doubled Federal spending. As for FDR, ever heard of the “New Deal”. FDR tinkered with almost every aspect of life in America. Hoover had started the spending binge and FDR kept the gravy training going. In 1929 Federal spending was around 4% of GNP and from 1932 to 1940 Federal spending hovered around 8%.
Just as a point of reference, doubling Federal spending gives me shudders. That’s just a physical reaction to my intellectual recognition of the problem.
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