The Rollback of QE2, and The Depression You’ve Never Heard Of
You may have heard that the world is ending on Saturday. Suddenly, Ben Bernanke’s monetary policy makes so much more sense!
All kidding aside, it has been quite some time now since the economy tanked and the Fed fired up the printing presses. After injecting trillions in liquidity into the monetary supply, Bernanke followed up the first act with QE2. QE2 was roundly criticized, and my nagging suspicion is that the punditry had already begun to wonder how we would extricate ourselves. Long-term thinking had finally entered the picture.
Well, long-term thinking is firmly entrenched at this point. Amid hints that the Fed will soon be tightening the money supply ever so slowly, by increasing the Fed Funds Target Rate, the financial press is finally speaking up about what the aftermath of the greatest monetary expansion in the history of the world will look like. Some have hinted that it cannot end now that we are this far down the path, but this is hardly worth consideration.
I think it is truly worth wondering how our money, our economy, and our banking system will recover from this. When it seems that all Washington can talk about is budget cuts, how will the economy survive if we are concurrently tightening money? If the end of QE2 is going to squeeze the economy, won’t the economy be exponentially worse if spending is rolled back at the same time? Are we not in for a double-dose of pain, possibly even worse than the great recession of three years ago?
We are at that point in the night where we are sobered up enough to know that we are in for a splitting headache in the morning. Come on, you’ve been there.
Keynes and his eponymous system of economics comes in for a lot of criticism around these parts, but that is not to say that he had no point. It is absolutely possible to affect the economy by messing around with the money supply. My ultimate point is not that Keynesianism has no effect, but that its effects are almost impossible to predict at all, and certainly impossible to predict with any certainty.
Given that that is the case, I do not doubt that Keynesian monetary theory has brought us to where we are, and I find it absolutely unremarkable that the outcome was clearly sub-optimal. And I also do not doubt that there are certain scenarios that the Keynesian system is utterly ill-equipped to handle. I believe we are approaching one.
This is not, however, uncharted territory. Consider the economic depression of 1920-21. What’s that? You’ve never heard of it? That must be why it is called “The Depression You’ve Never Heard Of.” This article by economist Robert Murphy is well worth your time.
Coming out of World War I, the United States had a massive debt load, huge price inflation, and monetary expansion to finance the war effort. In stark contrast to Keynesian prescriptions, the government both slashed spending to the bone and hiked the discount rate to the point where the money supply collapsed by roughly one-third.
And these were not “Washington-style” budget cuts, either, where a “cut” is actually just “a smaller expansion in the future.” The total level of federal spending went from $18.5 billion in 1919, to $6.4 billion in 1920! That’s a 65% reduction! And to top it all off, the budget was slashed another 50% or so to $3.3 billion in 1921!
What resulted was not only not the apocalypse, it was the Roaring 20s, a time of expansion, peace, and general prosperity. It certainly wasn’t easy, though. Unemployment went up to a sky-high 11.7% in 1921 (although I suppose that “sky-high” modifier is less apt in these times of depressing “new normal”), before tapering off to 2.4% in 1923. Certainly, people were displaced from jobs, made to move industries and change careers, and left to wonder whether they would ever get back to where they were just a few years ago. But in the end we were far better for it.
This where I draw my prediction from. When we begin to wean ourselves off the cheap-money gravy train, we will experience pain, and probably more pain than the somewhat normalized world of 2010-2011. Tightening the money supply will again throw the economy into flux. Cutting spending will cut off a source of unearned income for many people who have been made into dependents. Industries will shift. Belts will tighten. People will be uncomfortable.
But the fact is that when you’ve dug yourself into a hole, at some point you have stop digging. While taking a rest at the bottom might be momentarily more comfortable, eventually you have to steel yourself for the long climb out. It will hurt, but in the end, we will be glad we did.
I’m a realist. I believe that the rollback of QE2 is going to cause a lot of short-term pain, but in the long run we need to free ourselves from its yoke.
Assuming we make it past Saturday.