The End of One Big Deflation

"An important fact about the Depression that will resonate with people interested in the modern economy is that by 1934 interest rates in the US economy were down to zero – what economists call the zero lower bound. At that point the Federal Reserve doesn’t have the option of more conventional monetary policy, like lowering interest rates further. That’s exactly the same situation we have been facing since the end of 2008. A big question in economics is: Can monetary policy still be helpful once the policy interest rate is at zero? This paper by Temin and Wigmore suggests that it can. One of the ways that monetary actions can have an impact when we’re at zero lower bound is by affecting expectations. If policy makes people expect more rapid output growth or higher inflation, that can raise demand and output today. For example, if I own a business and I see the government taking aggressive action, I might decide to invest today because I expect my sales to be higher in the future. Temin and Wigmore show that going off the gold standard was a very powerful signal that US monetary policy was going to be more expansionary in the future. It seems to have had the effect of raising expectations of growth and inflation. They find that spending and output responded very quickly to that decision. For example, truck sales took off soon after the US went off the gold standard. That particular paper focused on how we got out of the Great Depression. One of the points that it made goes back to what we talked about with Chandler’s book – it provided some empirical evidence that the changes in fiscal policy were pretty small in the Great Depression. So in terms of accounting for what helped to end the Great Depression, the fiscal response mattered but was not very important because it was so small. What I showed in the paper was that there was a very aggressive monetary response – not only going off the gold standard, as Temin and Wigmore discuss, but following up with a big monetary expansion. It was probably the one time in US history when we had a monetary expansion that was orchestrated by the executive branch rather than by the Federal Reserve. In the mid-1930s a lot of gold was flowing to the US because of political tensions in Europe. Because we were back on the gold standard (but at a lower price for the dollar), the Treasury Department had the ability to turn the gold inflow into increases in the money supply. As a result, the money supply grew rapidly after 1934. You can think of this as a very early version of quantitative easing – which economists describe as increasing the money supply even when interest rates are already at zero. I showed that this monetary expansion affected real interest rates by ending expectations of deflation. In the data, interest-sensitive spending – such as business investment and consumer purchases of durable goods – responds to this fall in real interest rates. Interest-sensitive spending was a major engine leading us out of the Great Depression. My study was one of the earlier papers to talk about whether monetary policy can be useful at the zero lower bound. I argued that absolutely it could be. I think the Great Depression provides the best evidence we have that more aggressive monetary policy can help us to recover faster, even in a world of very low nominal interest rates. Many countries are at the zero lower bound today, but it’s not very common at all. The main other time when it happened in a number of countries was in the Great Depression. The other key episode was Japan after their Great Recession, which began in the early 1990s. Japan, for the most part, has stayed at the zero lower bound since the mid-1990s and has never fully recovered. What’s important about the Great Depression in the US is that it’s a case where we were at the zero lower bound and successfully got out of it. What we learned from the Temin and Wigmore paper is that one way out of a recession at the zero lower bound is by changing expectations. To do that, often what is needed is a very strong change in policy – something economists call a “regime shift”. The most effective way to shake an economy out of a terrible downturn when we’re at the zero lower bound is an aggressive change in policy that makes people wake up, say “this is a new day” and change their expectations. What the Fed has done since early 2009 is much more of an incremental change. I think that what the Fed needs instead is a regime shift. A number of economists have suggested that the Fed adopt a new framework for monetary policy, like targeting a path for nominal GDP . If the Fed adopted such a nominal GDP target, they would start in some normal year before the crisis and say nominal GDP should have grown at a steady rate since then. Compared with that baseline, nominal GDP is dramatically lower today. Pledging to get back to the pre-crisis path for nominal GDP would commit the Fed to much more aggressive policy – perhaps more quantitative easing and deliberate actions to talk down the dollar. Such a strong change in the policy framework could have a dramatic effect on expectations, and hence on the behavior of consumers and businesses. Of course the economy has changed over time. Our economic institutions have evolved and the composition of what we produce has changed. But the Great Depression is still relevant, because the economy is not fundamentally different. When I teach my undergraduate course on macroeconomic policy, I argue strongly that the Great Depression is a sensible place to start. The world was similar enough in the 1930s that a lot of the lessons that we learned then are still applicable today. One of the things that we have learned from the Great Recession is that modern economies are still vulnerable to terrible downturns. Even very aggressive monetary and fiscal policy cannot fully offset incredibly large shocks to household wealth and credit. That fact should make us anxious to avoid the kind of bubble and bust period we have just been through. That good policy absolutely matters. The shocks hitting the American economy in 2008 were enormous, in terms of the destruction of wealth and the freezing of our financial system. I firmly believe that the stresses on the US economy in 2008 were much larger than those in 1929 and 1930. So why has this recession, as bad as it has been, not been a second Great Depression or even worse? I think the answer is a much better policy response. But this episode has also shown that policy is very hard to get right. The policy response is inherently based on forecasts, which are subject to great uncertainty. And the political process often puts constraints on what can be done. Moreover, the policy response is limited by our understanding of how policy works and our vision of possible options. The bottom line is that the Great Recession showed us that we have effective tools to fight a terrible downturn. But we also have much to learn about how to use those tools more successfully."