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Commentary: Can We Avoid Another Great Depression? Government Policies to Limit the Economic Damage

First, let’s recall some basic macroeconomics. For a variety of reasons average prices and wages do not respond immediately to economic conditions. One implication of this is that reduced spending leads businesses to cut production and reduce employment rather than simply lowering prices and wages. As profits and wage incomes fall spending contracts further. Eventually, of course, wages and prices will adjust and economic conditions will return to normal. If the reduction in spending is pronounced, as in the current economy, “eventually” can be a long time off.

One reason it can take a long time for falling wages and prices to restore normalcy is that initially falling prices may have two counter-productive effects. First, if consumers anticipate falling prices, they may put off purchases as they wait for lower prices. This further reduces spending and exacerbates the problem. Second, as profits and wage incomes fall borrowers fall behind on their mortgage and loan payments and more bonds default. This reduces the supply of credit and further reduces the ability of consumers and businesses to spend.

In the current economy, as in the 1930s, both consumers and businesses have reduced spending significantly. Consumers are worried about losing income and paying off debt which prompts them to decrease consumption spending. Business firms are less likely to spend on new plant, equipment and technology when revenues are low and businesses have ample excess capacity. Furthermore, the financial system is compromised by “toxic assets,” bad debts and falling stock prices. Those consumers and firms that want to spend find credit hard to find.

This suggests two courses of action. First, replace the spending that consumers and businesses are not doing with public spending or cut taxes to promote added consumption spending. Second, improve the functioning of the financial system to enable financing of private spending.

The recently enacted stimulus package is intended to increase spending. The logic is, basically, “if people are spending less let’s increase after-tax income to get them spending” and “if businesses are not building new factories, let’s build new bridges.” At the same time, The Federal Reserve System has been lowering short-term interest rates and providing credit directly. Here the idea is to lower the cost of credit and to make it more widely available which, the “Fed” expects, will lead to more spending.

There are no guarantees that these initiatives will work. Cheaper, more available credit will not increase spending if people are so worried about the future that they avoid additional debt. Increased government spending and reduced taxes imply more government borrowing and, at some point, higher taxes to pay for the debt. If people worry about the increased government debt and future taxes, they may cut their spending even more. On the other hand, these initiatives are based on standard macroeconomics and, while they will not generate a speedy recovery, they should keep us out of a repeat of The Great Depression.

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