A good article from Forbes titled What Would Keynes Do? addresses our current financial crisis. To summarize in a sentence, the government must spend massive amounts of money (and buying bad assets doesn’t count) quickly to help increase velocity which will help fight deflation and prevent another Depression. An excerpt:
When the rate of deflation exceeds the nominal interest rate, market rates cannot fall enough to compensate because no one is going to lend money at a negative nominal rate; they will just hold on to it. When this happens, we have what economists call a liquidity trap, and the Fed cannot inject liquidity into the economy to stop the deflation.
Since money is essentially a zero-interest security, when interest rates on marketable securities approach zero, the Fed is unable create liquidity by buying Treasuries with new money. It ends up being an exchange of similar assets with no economic effect. What’s the difference between a dollar bill and a Treasury bill with a barely positive interest rate (as is the case today)?
Another problem that policymakers back then didn’t grasp is that the money supply’s effectiveness depends on how quickly people spend it; something economists call velocity. If velocity falls because people are hoarding cash, it may require a great deal more money to keep the economy operating.
Think of it this way: Velocity is the ratio of the money supply to the gross domestic product. If GDP is $10 trillion and money turns over 10 times per year, then $1 trillion in money supply will be sufficient. But if velocity falls to 9, a $1 trillion money supply will only support a $9 trillion GDP. If the Fed doesn’t want GDP to shrink by 10%, it will have to increase the money supply by 10%.
This is essentially the problem we have today. Unlike in the 1930s, the Fed is not allowing the money supply to diminish. Also, we have programs like federal deposit insurance to prevent bank deposits from shrinking. But velocity is collapsing. Banks, businesses and households are all hoarding cash, not spending except for essentials. This is bringing on the deflation that is crippling the economy.
The nation is fortunate to have Ben Bernanke as chairman of the Federal Reserve Board. As an academic economist, he studied the Great Depression in great depth. He also has a keen grasp of the problem of deflation. On Nov. 21, 2002, he gave a speech that precisely outlines what the Fed can and must do when confronted by a deflationary situation.
The problem today is that velocity is falling faster than the Fed can pump up the money supply by buying financial assets, and very low market interest rates mean there has been little net increase in liquidity as a result of the actions the Fed has taken thus far.
What Keynes figured out is that when conditions such as these exist, the federal government must step in to raise spending in the economy and thereby increase velocity. This means running a budget deficit, but that is only part of the solution. As noted earlier, spending just to buy financial assets does very little good.
We also know from the experience with tax rebates in 1974, 2001 and 2008 that this doesn’t do any good, either. People mostly save the money or pay down debts. Thus, rebates just become another form of exchanging assets that add little to spending (and hence velocity).
Keynes argued that the only thing that will really work is if the federal government uses its resources to purchase goods and services. It must buy “stuff”–concrete, computers, paper, glass, steel–anything as long as it is tangible. In other words, the government must spend the way households do, by buying things.
It must also employ labor, because much of what people spend money on today is in the form of services. This doesn’t necessarily mean putting workers on the federal payroll, it just means that, to the extent that the government purchases services, this will also help raise spending in the economy.
We will know that the government is spending enough to matter when interest rates start to rise. Although we think of saving as coming in financial form, in reality, saving represents things–labor and raw materials that are used to produce products and services people want.
Once the federal government increases its purchases of goods and services, it preempts resources that private businesses would otherwise use in production. As they compete with each other for those resources, their prices will rise and interest rates will rise.
At this point, Federal Reserve policy will become effective again. As prices and interest rates rise, the liquidity trap disappears and money begins circulating more rapidly; i.e., velocity increases. This is what ends an economic crisis. Unfortunately, it was not until World War II that the federal government spent enough on real resources–because they were needed for the war effort–to make Keynes’ theory work in practice.