In the comments under my blog on ‘Interest rates and the price system’, Robin Staple asks, “how come, at the moment, a large depression has been avoided, and how come this wasn’t avoided in 1929? Is it not due to increased intervention?” It’s an interesting question and, as I said in the comments, not one that it is easy to give a hard and fast answer to.
As Steve Horwitz points out in this excellent article, there were lots of different policy factors that contributed to the Great Depression. Yes, the Federal Reserve failed to ‘intervene’ when the money supply shrank rapidly just as demand to hold money was rising. The result was a severe, deflationary monetary contraction. That was bad. But just as much if not more of a problem was that the Hoover and Roosevelt governments did intervene to prevent wages and prices from falling. By stopping businesses from adjusting to changed market conditions, the government caused very low investment and very high unemployment, and turned a recession (that is, a necessary remedial phase in the business cycle) into a depression. And of course, these policy mistakes coincided with the rise of protectionism. The combination of all three factors – two interventions and one non-intervention, if you like – is what made the depression so severe.
Applying all that to the current state of affairs, I’d say the following. We haven’t let the money supply collapse. We haven’t tried to prevent prices or wages adjusting to changed economic circumstances. And we haven’t tried to shut down international trade. All those things have helped prevent recession becoming depression, and explain why we’re in a better situation than in the 1930s.
On the other hand, we have repeated one of the mistakes of the Great Depression, which was to ramp up public spending in a misguided attempt to stimulate the economy. Hoover did it, and Roosevelt did it on a grand scale. It didn’t work then, and it hasn’t worked now. All fiscal stimulus ever achieves is to reallocate resources from one part of the economy to another. And since the government is in charge, you’re normally taking from the productive, the wealth creators, and giving to the unproductive, the wealth consumers. That can only hold us back in the long run.
Maybe I need to clarify my point on the money supply. Doesn’t intervention to prevent monetary contraction contradict my whole free market perspective? I’m not so sure. As people like George Selgin and Larry White have pointed out, a free market banking system (with fractional reserves but no central bank) would not allow a massive monetary contraction, but rather would respond organically to an increase in the demand for money by increasing its supply. So perhaps it makes sense for a central bank to try and mimic what would happen in a genuine free market.
Of course, that’s easier said than done: central bankers don’t have the right incentives, and they don’t have the right information. Indeed, since the demand for money (or velocity) cannot be observed directly, and can only be measured by reference to the other parts of the MV=PT equation, manipulating the money supply to offset changes in demand is an extremely tricky – if not impossible – business. But perhaps, in extremis, when a massive bubble has burst, and you are facing a depression, some imperfect monetary intervention is the lesser evil.
So, summing up, I’d say no fiscal stimulus, no attempts to control prices and wages, and no protectionism. Ever. But if you are facing a big monetary contraction, then yes, do something to increase the money supply. Just don’t make a habit of it. And once you’re through the worst, start working out how you can get back to a proper free market monetary-financial system. Otherwise, you’ll just have to go through it all again a few years down the line.