Thursday, December 18, 2008

The Great Depression Analogy

Just a couple of links that warn that the Great Depression analogy might not be right:
Tim Duy: On one hand, using the Great Depression as a guide, the appropriate policy direction appears clear – flood the markets with liquidity, coupled with massive fiscal stimulus. This is the track the policy train is on. I completely understand this policy in a closed economy suffering from insufficient demand relative to supply. But when faced with a large open economy with a substantial current account deficit, the back of my mind screams “caution.” It is an itch I can’t scratch.

In my view, policymakers tend to see the current account deficit as almost an unimportant residual, something that just falls out of the global economy, but tells you little about the economy itself. I tend to view it as representing a fundamental imbalance. I believed that as part of the adjustment of the past year, a combination of import compression and export expansion would eliminate the imbalance, and that the appropriate role of policy was to facilitate and cushion that imbalance.

Naked Capitalism: ... the analogy is to the US in the Depression, which we have said repeatedly before is questionable. The US in the 1920s was the world's biggest creditor, exporter, and manufacturer. Our position then is analogous to China's now. Indeed, Keynes in the 1930s urged America to take even more aggressive measures, and argued that it was not reasonable for the US to expect over-consuming, debt-burdened countries like the UK and France to take up the demand slack. So even though most economists are invoking Keynes, it isn't clear he's prescribe such aggressive stimulus for the US and UK now.

Second, the argument is that the US in the 1930s and Japan in its post bubble era failed to engage in sufficiently large stimulus. That is mere conjecture; there is no way to prove that argument ...

Back to Tim Duy:
... the coming massive US policy response is a desperate attempt to maintain a global economic structure that is fundamentally broken. This is a story I have long championed, but, in recent months, one I was willing to discount given my expectations of an improvement in the current account. Indeed, this seemed consistent with the strengthening of the Dollar. But recent trade data suggests I may have become too complacent with regards to the external dynamic.

The threat, of course, is that the Fed the Fed and Treasury are setting the stage for a disorderly adjustment of the Dollar by ignoring the imbalance. Without the external adjustment in place, pushing rates to zero, flooding the economy with money, and pumping out hundreds of billions of new debt threatens to all pull the rug out from under the Dollar. Even more worrisome, however, is that surplus nations respond with competitive depreciations as they also seek to maintain the fundamental imbalance. We all race to the bottom together.

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