A Failure of Capitalism (VIII): The Aftershock of a Depression

by Richard A. Posner

In judging the severity of an economic downturn, one ought to include the costs of fighting it, as well as the costs in lost output and employment that are incurred during the depression. The costs of fighting a depression have two components: the costs of fighting it that are incurred during the depression itself, and the costs incurred after the depression ends--what I call the "aftershock." The difficulty of predicting the form and severity of the aftershock is one of the sources of the uncertainty that I emphasized in blog entries VI and VII in this series.

I want to set aside, as utterly unpredictable, the possible political consequences of the depression and their costs, and focus just on economic losses, and indeed just on the economic losses flowing from (1) the expansion of the money supply by the Federal Reserve and (2) the increase in the annual budget deficit and therefore in the national debt as a result of (a) the fall in tax revenues during the depression, as a consequence of the decline in taxable income of both individuals and corporations, and (b) borrowing by the Treasury Department to finance the government's debt.

The Federal Reserve's balance sheet has risen in the past year (May 2008-May 2009) from $1.3 trillion to $2.2 trillion, an increase in $900 billion in cash plus accounts in federal reserve banks on which banks can draw to make loans or other investments. In other words, the Fed has increased the amount of money by that amount, and it is planning on further increases. But the amount of money in circulation is not rising yet, or at least not rising much. For much of the newly created money is being hoarded by banks (remember how "excess reserves" have grown), other businesses, and individuals. As long as newly created money is not in circulation, that is, is not being used to buy goods and services, it does not create inflation, which is an increase in the ratio of money to output, i.e., in prices. (Imagine getting a dollar from the Fed and putting it under your mattress.)

But suppose that the economy turns up, and the hoarded money is put into circulation, and thus is spent, and in fact is spent faster than the increase in the output of the recovering economy; then prices will rise. The Fed can check this tendency by selling Treasury securities, thus reducing the amount of cash in the economy (because it is selling the securities for cash). But by doing that, it will push up interest rates, because there will be less lendable money. Maybe it will be afraid to do that, because high interest rates slow economic activity. In that event there will be inflation, which can get out of hand, leading ultimately to a Paul Volcker type induced recession: sharp reduction in the money supply between 1979 and 1982, engineered by the Federal Reserve under Volcker's leadership, generated very high interest rates that crushed the inflation that had been rising throughout the 1970s.

At the same time that the Fed in the aftermath of the current depression will be raising interest rates by selling Treasury securities in large quantities to sop up excess cash from the economy, the Treasury may be doing the same thing by selling Treasury securities in great quantity to finance the ballooning federal budget deficits. They will be ballooning not only because of the stimulus package ($787 in Keynesian deficit spending), and bailouts that are not recovered, but also because of the fall in tax revenues during the depression and the increased spending that the Obama Administration plans for health care and other social programs.

Alternatively, the government might raise tax rates to reduce the deficit, rather than borrowing to finance it. That would have a contractionary effect on the economy, just as high interest rates have. The higher interest rates on the public debt would increase the budget deficit, and much of the interest would be paid to foreigners, who currently finance about a quarter of the federal government's debt.

The dependence of the government on foreign lending is not as dangerous as it might seem. The dollar is the international reserve currency, meaning that a great deal of international trade is transacted in dollars. This gives foreign firms and governments an incentive to hold large dollar reserves, which in turn keeps up the demand for dollars even when, by running a negative trade balance, we spend more dollars on imports than we earn on exports. Still, the world's appetite for dollars is limited, which is why the more we borrow, the higher the interest rate we are likely to be charged: we borrow more, and pay higher interest on what we borrow, and this compounds the expense of financing our debt.

When, as it were, the bill is presented for the costs incurred in fighting the depression, it may be too large to pay either by raising taxes or by continued borrowing. At that point the only alternatives will be drastic reductions in government spending, which are likely to be politically infeasible, or inflation. Inflation is a classic method of reducing a debt in real terms, or even wiping it out completely. We may also experience unintended inflation, if the Federal Reserve's efforts to "unwind" its money-creating activities by selling Treasury securities in order to suck cash out of the economy does not succeed for technical reasons. And if as in the 1970s inflation gets out of hand (it peaked at 15 percent before Volcker went to work to break it), a sharp, induced recession may become inevitable. Fear of inflation led to the even sharper recession of 1937-1938, brought on by a reduction in federal expenditures and in the money supply. It could happen again.