deflation and other lessons from the "New Deal"

Topics: Regulation
26 Nov 2008

From: Ervan

"The New Deal Didn’t Always Work, Either" [0] written by
quasi-Libertarian economist Tyler Cowen [3].

The article is worth reading in it's own right, the summary of it is:
During a recession, government borrowing (keeping taxes low and deficits
high) to stimulate aggregate demand is useful (contrary in part to what
I have been arguing), but particular economic programs, particular
regulations, and spending for the sake only of creating jobs are all
counter productive. Most important: monetary policy has to stabilize
the dollar and banking.

Also interesting is that Obama's new head of the Council of Economic
Advisers, Romer, is agreeing with Milton Friedman's analysis of the
Great Depression [1]. That gives me some hope for Obama.

I would add one thing not mentioned in the article (since I read "A
Monetary History of the United States" some years ago), Friedman's
analysis was that the federal reserve caused the Great Depression not
only by deflating the currency at the wrong point, it had previously
created the inflation that it then overreacted to. This was especially
ruinous in 1929 because the U.S. had been on the gold standard and thus
prices were at least somewhat stable. Yes, they went up and down as
production and gold mining got out of sync with each other, but never
completely out of sync. When the newly created Fed started inflating
the currency pre 1920 it looked to everyone as if aggregate demand were
truly rising. Previously, higher prices had always signaled more demand
and thus a reason to produce more. With everyone rushing to produce
more, people invested in the stock of these growing companies. It was
all a lie because all that was happening was the currency was being
debased and prices were rising without real demand rising. But then, it
was too late, too many people were working to build things we didn't
really want and too much capital was diverted to supporting those
useless things. The fed overreacted sending the country into a
deflationary spiral.

But surfing today, I see that the broad brush data doesn't support this
very well [2]. So, take my summary from a long ago read with some
skepticism.

Taking another step back, I'll take it as a good theory that the Fed was
responsible for the Great Depression, but it also says that (the rich
and smart) traders were not smart enough to see all of the way through
to what was going on. Had they been, they would have been selling all
through 1928 and 1928. Yes, individuals were first exposed to the
concept of making money on the stock market in the 20's. Those amateur
investors were chasing the trend line instead of investing in
fundamentals. We expect such novices to err. But had the professionals
been selling into that buying the stock rise would have been much less
and the desire to chase trend lines much less. In this sense, the
market was not as insightful as it needed to be.

That seems like a metaphor for today. Individuals without investing
expertise invested in real estate by taking leveraged loans (e.g. ARMs
or zero down) and bet on the market going up forever, i.e. chasing the
trend line of real estate values. It's a shame that ordinary people bet
their biggest investment on a flawed strategy, but they should be
allowed to fail nonetheless. But the experts with the big money failed
to see that the mortgage insurance and mortgage bond companies were
leveraged too far on shaky securities out with no backup plan. Those
people should have been smarter and been selling real estate all along
(or betting down the stock of companies that were buying). Yes, I'm
asking them to be smart beyond their narrow specialty and see all of the
way to macro economic cycles. Few were. Like the historical Black
Thursday, the government created false expectations, the masses had
"irrational exuberance" in chasing a trend line they can now invest in,
and the experts weren't visionary enough to buck the trend line.

--------------

[0]
http://www.nytimes.com/2008/11/23/business/23view.html?_r=3&partner=permalink&exprod=permalink&oref=slogin

[1] http://en.wikipedia.org/wiki/A_Monetary_History_of_the_United_States
also noting that Bernanke agrees with Friedman (something Dan L.
recently pointed out to me).

[2]
http://en.wikipedia.org/wiki/Image:US_Historical_Inflation_Ancient.svg

[3] http://en.wikipedia.org/wiki/Tyler_Cowen

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