The Aftershock Threat

One of the reasons, as I explained in my book, for calling our economic crisis a "depression" is that, as was already clear on February 2, when the book was completed, the government was spending trillions of dollars--on top of all the normal expenses of government--to try to arrest the downward spiral and speed recovery. Since then, the expenditures, commitments, and guarantees--all of which represent costs, actual or expected, though many or even most of them will eventually be avoided or recovered--have increased further, and concern has begun to be expressed that the soundness of America's public finance and currency is being undermined by the growing mountain of public debt. The interest rate at which the government borrows to finance the public debt has been rising, and there is even talk, though surely premature, that the government may lose its triple A credit rating!

Remarks by the distinguished macroeconomist Paul Krugman, at a panel discussion of the economic situation published in the current New York Review of Books (June 11), help to bring the problem into focus.

Krugman has been trying for some time, without success, to correct a misunderstanding by the prominent historian (and author of an excellent recent book on the history of banking) Niall Ferguson. Ferguson, who was also on the panel, argued as he has before that the monetary and the fiscal responses to a recession or depression--that is, reducing interest rates by expanding the supply of money, and increasing demand for goods and services by deficit financing of public works--operate at cross purposes. The cost of public works has to be financed by borrowing, and any increase in borrowing raises interest rates and therefore reduces the effectiveness of the monetary response.

Actually, as Krugman pointed out, the monetary and fiscal responses are complementary. The monetary response, we have learned, is inadequate, since, as I keep saying, you can lead a bank to money but you can't make it lend. Essentially the monetary response involves the Federal Reserve's increasing the balances in bank accounts, which increases the amount of money that banks are permitted to lend. But because many banks are still undercapitalized as a result of the collapse of the housing and associated mortgage-credit bubble, because loans in a depression are especially risky, and because the demand for loans is way down since production is down and consumers feel overindebted and so want to save rather than borrow, most of the newly created money is piling up in bank accounts and other safe savings havens rather than being spent.

Moreover, the lower interest rates are, the more difficult it is to persuade the hoarders of cash and cash equivalents to invest their money productively. We want interest rates to be low, to induce borrowing and lending, which increase economic activity. But we don't want then to be so low that there is insufficient inducement for the hoarders to part with their cash. Cash that is hoarded is inert; it does not contribute to economic activity; and so hoarding exacerbates a depression.

The role of fiscal policy, in the form of Keynesian deficit spending on public works (though that is only part of the $787 stimulus program enacted by Congress, the rest being tax reductions and benefits enhancements, which unfortunately are less effective means of fighting a depression because their effect on employment is indirect), is to make up the shortfall in private demand for goods and services by increasing the public demand for them. Construction workers laid off because of the fall in the demand for new residential and commercial buildings can be hired to build public buildings. The result is to reduce unemployment, thus increasing incomes, and increase confidence by other workers that they will not be laid off; and increased incomes and increased confidence in one's economic prospects reduce the propensity to hoard. The net cost to the government should be lower than the aggregate outlay, moreover, because an increase in employment increases income tax revenues and reduces unemployment benefits.

But assuming that there is a net cost to the program, Ferguson is right that the government will borrow more, and that this will raise interest rates--but probably only slightly. For as Krugman points out, the fall in private demand has been matched (not dollar for dollar, however) by a rise in savings, included hoarded cash. The personal savings rate has risen in the last year from 1 percent to more than 4 percent. To quote Krugman, "that saving ought to be translated into investment, but the investment demand is not there." Deficit spending on public works is a way of using the pool of savings to increase investment and therefore employment. "Keynesian policy...takes excess desired savings and translates them into some kind of spending. If the private sector won't do it, the government will."

The relation between savings and (productive) investment can be seen most clearly by imagining that the government decided to finance the public works program by selling "Victory [over Depression]" bonds to the general public. Because the bonds would be safe (the risk of the United States' defaulting on its obligations is effectively zero), most of the hoarders would be quick to buy them in lieu of holding cash that carries no interest at all; and so the government would not have to pay a high rate of interest on the bonds to be able to sell them. The government isn't financing the public works program in this way, but the economic substance may be very similar. If a money-market fund in which a person has placed some of his savings buys government securities to be able to pay interest on its money-market accounts, the person is indirectly financing the government.

Presented by

Richard A. Posner

Richard Posner is an author and federal appeals court judge. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. More

Richard A. Posner worked for several years in Washington during the Kennedy and Johnson Administrations. He worked for Justice William J. Brennan, Jr, the Solicitor General of the U.S., Thurgood Marshall, and as general counsel of President Johnson's Task Force on Communications Policy. Posner entered law teaching in 1968 at Stanford and became professor of law at the University of Chicago Law School in 1969. He was appointed Judge of the U.S. Court of Appeals for the Seventh Circuit in 1981 and served as Chief Judge from 1993 to 2000. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. His academic work has covered a broad range, with particular emphasis on the application of economics to law. His most recent books are How Judges Think (2008), Law and Literature (3d ed. 2009), A Failure of Capitalism: The Crisis of '08 and the Descent into Depression (2009). He has received the Thomas C. Schelling Award for scholarly contributions that have had an impact on public policy from the John F. Kennedy School of Government at Harvard University, and the Henry J. Friendly Medal from the American Law Institute.

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