Monday, February 2, 2009

How To Prevent Another Depression

We are no where near a depression yet, but many people are worrying that we are heading for one. So what can the government do to prevent another depression? According to Brad DeLong we have 4 options. Mark Thoma from The Economist's View looks at DeLong's 4 options in his blog post below.

What can governments do to try to keep the economy out of a depression?:

Depression economics: Four options, by J. Bradford DeLong, Commentary, Project Syndicate: When an economy falls into a depression, governments can try four things... Call them fiscal policy, credit policy, monetary policy, and inflation.

Inflation is the most straightforward to explain: The government prints lots of banknotes and spends them. The extra cash in the economy raises prices. As prices rise, people don't want to hold cash... - its value is melting away every day - so they step up the pace at which they spend... This spending pulls people out of unemployment..., and pushes ... production up to 'potential' levels.

But sane people would rather avoid inflation. It is a very dangerous expedient, one that undermines standards of value, renders economic calculation virtually impossible, and redistributes wealth at random. ... But governments will resort to inflation before they will allow another Great Depression. We just would very much rather not go there, if there is any alternative...

The standard way to fight incipient depressions is through monetary policy. ... The problem with monetary policy is that ... the ... nominal interest rate on government securities is zero. ... And this is too bad, for if we could prevent a depression with monetary policy alone, we would do so, as it is the policy tool for ... stabilisation that we know best and that carries the least risk of disruptive side effects.

The third tool is credit policy. We would like to boost spending immediately by getting businesses to invest... Risky projects are at a steep discount today... No one is willing to buy assets and take on additional uncertainty... Although the world's central banks and finance ministries have been devising many ingenious and innovative policies to stimulate credit, so far they have not had much success.

This brings us to the fourth tool: fiscal policy. Have the government borrow and spend, thereby pulling people out of unemployment and pushing up capacity utilisation to normal levels. There are drawbacks: the subsequent dead-weight loss of financing all the extra government debt..., and the fear that too rapid a run-up in debt may discourage private investors from building physical assets...

But when you have only two tools left, neither of which is perfect for the job - credit policy and fiscal policy - the rational thing is to try both, at the same time. That is what the Obama administration ... and other governments are attempting to do right now.

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