Chapter 12 of Steve Keen’s Debunking Economics is a critique of a pervasive neoclassical interpretation of the Great Depression (and, by extension, the Great Recession): that the severity of the downturn can be attributed to contractionary monetary policy at the Federal Reserve. As you’d expect, this doesn’t mesh well with the endogenous money theory to which Keen (and I) subscribe, which says that the money supply is largely controlled by private banks.
Keen begins by cataloging Ben Bernanke’s evaluation of the Great Depression, which built on Friedman and Schwartz’ A Monetary History of the United States. From the quotes Keen presents, Bernanke’s offering really seems to be neoclassical economics at its reality denying worst:
the failure of nominal wages (and, similarly, prices) to adjust seems inconsistent with the postulate of economic rationality
[On Minsky’s FIH] I do not deny the possible importance of irrationality in economic life; however it seems that the best research strategy is to push the rationality postulate as far as it will go.
Having said that, the case that the Federal Reserve exacerbated the Great Depression by contracting the money supply does have some substance to it, and is worth discussing.
There is no denying that the Federal Reserve contracted base money at the onset of the Great Depression. But it is a leap to suggest this was the primary cause of the prolonged slump – firstly, the contraction of base money was less than 2% on average. Secondly, there has been one other occasion where base money has contracted nominally (1948-50), and six other occasions where it has contracted when adjusted for inflation. All of these – bar one – were correlated with recessions, but none were correlated with depressions.
Keen presents a graph showing a complete lack of correlation between unemployment and M0:
Instead, there is a much clearer correlation with broader, credit-based measures of the money supply:
From this, it’s quite clear from that the primary cause of the Great Depression was a collapse in aggregate demand, caused by a contraction of credit by private banks. Bernanke and other neoclassical economists are reluctant to accept this conclusion, because it conflicts with the neoclassical vision of the economy as inherently stable, bar perhaps a few frictions, and also renders invalid many of their preferred modelling techniques. For someone like Friedman, the conclusion is simply unacceptable, because it conflicts with his insistence that ‘the government’ is the cause of most significant problems.
The money multiplier, again
Keen catalogues the evidence against the money multiplier story that lies behind Bernanke and Friedman’s interpretation of the Great Depression. In this story, the Central Bank (CB) expands reserves, and private banks then make loans, keeping a fraction of the reserves so that they can accommodate demand for money from customers. These loans are then deposited, and a fraction is kept, and this process continues until no more can be lent out. The amount of loans is that inverse of the fraction banks are required to hold as reserves.
What are the problems with this story? First, the observed reality in banks is that they create loans and deposits simultaneously, and as such do not require reserves before they lend. Second, the change in credit and broader measures of the money supply precedes changes in reserves, rather than the other way around. Third, the failure of monetarism – a disastrous policy used in the 1980s where the CB tried to stabilise money growth, but consistently overshot their target. Fourth, Bernanke’s increases in base money during 2008, which resulted in little to no change in economic activity:
For a more in-depth treatment of the money multiplier by Keen himself, see here.
It is worth noting that it is strictly true that the CB controls base money, and as such some might interpret the endogenous interpretation as one of policy. But the fact is that endogenous money reflects the reality of capitalism: firms need capital before they make sales, and banks must accommodate this to keep the economy moving. The CB – though it has some discretion – simply has to play the role of passively accommodating endogenous activity, otherwise capitalism will not work.
Onto the Great Recession
Keen ends the chapter by documenting a few papers that have attempted to understand the Great Recession – McKibbin and Stoeckel (2009); Ireland (2011); and Krugman and Eggertson (2011). The first two, unfortunately, do not even attempt to create a role for private debt. Instead, the recession is due to a series of external shocks – such as changes in preferences and technology – whilst its length can be attributed to factors such as wage and price rigidity, which get in the way of capitalism’s underlying tendency to stability.
Krugman and Eggertson’s, on the other hand, commendably notices how important private debt seems to be, but only gets as far as modelling it as a special case, in which ‘patient’ agents save, and ‘impatient’ agents borrow. In some ways this observation is true – when money is paid back, it disappears into extremely ‘patient’ agents: banks, who have an MPC of 0. However, banks create rather than save this money, and hence it is added to aggregate demand. This process is, unfortunately, something Krugman says he “just doesn’t get.”
Ultimately, Krugman’s paper is the same story as the others: a one-off event, imperfection, special case, creates a problem in an otherwise stable economy. All three papers fit Bob Solow’s characterisation of New Keynesian models – they fit the data better because economists add “imperfections…chosen by intelligent economists to make the models work better.” All briefly reconsider building new theories from scratch, before simply reasserting the neoclassical core. There really needs to be more soul-searching from economists than this.