One of the main messages in the great work by Milton Friedman and Anna Schwartz, A Monetary History of the United States, 1863-1960, is that the Federal Reserve bears considerable responsibility for the severity of the Great Depression. Poor monetary policy, they argue persuasively, can magnify and prolong economic downturns.
Is there a similarly important policy lesson to be drawn from the Great Recession we’ve just experienced? While much of the recent focus has been on unconventional monetary policy, I believe the main lesson to learn is the importance of fiscal policy in promoting recovery from deep recessions, and how poor fiscal policy can also intensify and extend economic downturns.
Federal Reserve Chair Ben Bernanke, a student of the Great Depression, famously vowed in 2002 at a conference celebrating Milton Friedman’s 90th birthday that the Fed would not repeat the mistakes of the Great Depression, “You're right, we did it,” he said, “We're very sorry. But thanks to you, we won't do it again.” When the Great Recession hit, the Fed did, in fact, mostly avoid these mistakes.
That’s not to say that the Fed’s response to the recession has been perfect. But the Fed did avoid the big error of allowing massive bank failures and declines in banking reserves that were so problematic during the Great Depression, and many people give the Fed credit for avoiding a Great Depression type collapse.
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However, while the Fed’s actions were certainly important and necessary – I would not have wanted to experience a repeat of the Fed’s failures during the Great Depression – the improved policy response from the Fed is not the only reason we avoided Great Depression type problems.
First, when the recession hit this time around, we had a much, much higher level of societal wealth, and hence a much larger cushion to absorb the shocks than we had during the Great Recession.
Second, and importantly, the presence of automatic stabilizers, particularly those that come in the form of social insurance programs, made a big difference to people hit by the recession. Programs such as unemployment compensation and food stamps that did not exist during the Great Depression played a large role in cushioning the blow for the millions and millions of people who lost jobs or were otherwise affected by the severe downturn in the economy.
Third, it’s not as though the Fed created a miracle recovery. Even with the improved monetary policy during the recent downturn, the recession has still been very deep and very prolonged, and the end of our troubles, while perhaps in sight, is still far, far away. So while it’s true that things could have been much worse, it does not appear to be the case that improved monetary policy avoids the severe problems associated with financial panics.
The improved response of monetary authorities and the existence of automatic stabilizers certainly made the downturn far less severe than it might have been, but a big lesson from our recent experience is that these policies alone are not enough to turn the economy around. Help from fiscal policy is needed.
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Fiscal policymakers in Congress deserve more blame and scorn than they have received for their poor response to the recession. Congress failed to implement a fiscal stabilization package that was large enough to address the big problems the economy was facing, and due to Republican opposition it refused to implement additional measures when it became clear the initial package was too small in both size and duration. Congress could have, for example, followed up by putting people to work on infrastructure projects that would have more than paid for themselves just in terms of their value to society, never mind the additional benefits from helping the unemployed.
That failure was bad enough. But even worse is that fiscal policymakers actually began moving in the wrong direction – toward austerity – at a time when just the opposite policy was needed. The result has been a much slower recovery than we might have seen otherwise.
After the Great Depression, the Fed learned from its mistakes, and it has hopefully learned even more from the mistakes it made in responding to our recent troubles. Monetary policy does seem to evolve and improve over time. But what about fiscal policy? Will fiscal policymakers in the US and Europe learn from the big mistakes they made recently – mistakes that have prolonged the recession and imposed permanent harm on some members of society?
As much as I’d like to hope that somehow economists will speak with a strong, unified voice on the usefulness of fiscal policy in deep recessions, a position I believe is firmly supported by the empirical evidence, and that politicians – Republican politicians in particular – would follow their advice, it’s hard to imagine either of those things happening. That means, discouragingly, that the next time a severe recession hits fiscal policymakers will likely fail us once again and leave us with yet another unnecessarily slow, agonizing recovery.
