cont. ec. issues lecture 3

Contemporary Economic Issues LECTURE 3: 12 MARCH 2017

Government Depression Policy: Laissez-Faire

If government wishes to see a depression ended as quickly as possible, and the economy returned to normal prosperity, what course should it adopt?


Don’t interfere with the market’s adjustment process. The more the government intervenes to delay the market’s adjustment, the longer and more grueling أشد the depression will be, and the more difficult will be the road to complete قسوةrecovery.

If, in fact, we list logically the various ways that government could hamperيعرقل market adjustment, we will find that we have precisely listed the favorite “anti-depression” arsenal of government policy.


(1) Prevent or delay liquidation. Lend money to shaky businesses, call on banks to lend further, etc.

(2) Inflate further. Further inflation blocks the necessary fall in prices, thus delaying adjustment and prolonging depression. Further credit expansion creates more malinvestments, which, in their turn, will have to be liquidated in some later depression. A government “easy money” policy prevents the market’s return to the necessary higher interest rates.

(3) Keep wage rates up. Artificial maintenance of wage rates in a depression insures permanent mass unemployment. Furthermore, in a deflation, when prices are falling, keeping the same rate of money wages means that real wage rates have been pushed higher. In the face of falling business demand, this greatly aggravates the unemployment problem.


(4) Keep prices up. Keeping prices above their free-market levels will create unsalable surpluses, and prevent a return to prosperity.

(5) Stimulate consumption and discourage saving. more saving and less consumption would speed recovery; more consumption and less saving aggravate the shortage of saved capital even further. Government can encourage consumption by “food stamp plans” and relief payments. It can discourage savings and investment by higher taxes, particularly on the wealthy and on corporations and estates. As a matter of fact, any increase of taxes and government spending will discourage saving and investment and stimulate consumption, since government spending is all consumption.

Food Stamps


(6) Subsidize unemployment. Any subsidization of unemployment (via unemployment “insurance,” relief, etc.) will prolong unemployment indefinitely, and delay the shift of workers to the fields where jobs are available.

These, then, are the measures which will delay the recovery process and aggravate the depression they were the policies adopted in the 1929–1933 depression, by a government known to many historians as a “laissez-faire” administration.


Since deflation also speeds recovery, the government should encourage, rather than interfere with, a credit contraction. In a gold-standard economy, such as we had in 1929, blocking deflation has further unfortunate consequences. For a deflation increases the reserve ratios of the banking system and generates more confidence in citizen and foreigner alike that the gold standard will be retained. Fear for the gold standard will precipitate the very bank runs that the government is anxious to avoid.

Banks should no more be exempt from paying their obligations than is any other business. Any interference with their comeuppance via bank runs will establish banks as a specially privileged group, not obligated to pay their debts, and will lead to later inflations, credit expansions, and depressions. And if, as we contend, banks are inherently bankrupt and “runs” simply reveal that bankruptcy, it is beneficial for the economy for the banking system to be reformed.


The most important canon of sound government policy in a depression, then, is to keep itself from interfering in the adjustment process. Can it do anything more positive to aid the adjustment?

1- a government-decreed wage cut to spur employment, e.g., a 10 percent across-the-board reduction. But free-market adjustment is the reverse of any “across-the-board” policy. Not all wages need to be cut; the degree of required adjustments of prices and wages differs from case to case, and can only be determined on the processes of the free and unhampered market. Government intervention can only distort the market further.


2- it can drastically lower its relative role in the economy, slashing its own expenditures and taxes, particularly taxes that interfere with saving and investment. Reducing its tax-spending level will automatically shift the societal saving-investment–consumption ratio in favour of saving and investment, thus greatly lowering the time required for returning to a prosperous economy. Reducing taxes that bear most heavily on savings and investment will further lower social time preferences.

Any reduction of taxes, or of any regulations interfering with the free market, will stimulate healthy economic activity; any increase in taxes or other intervention will depress the economy further.


It might be objected that depression only began when credit expansion ceased. Why shouldn’t the government continue credit expansion indefinitely?

the longer the inflationary boom continues, the more painful and severe will be the necessary adjustment process, Second, the boom cannot continue indefinitely, because eventually the public awakens to the governmental policy of permanent inflation, and flees from money into goods, making its purchases while the dollar is worth more than it will be in future. The result will be a “runaway” or hyperinflation

Inflation


Hyperinflation, on any count, is far worse than any depression: it destroys the currency—the lifeblood of the economy; it ruins and shatters the middle class and all “fixed income groups”; it wreaks havoc unbounded. And furthermore, it leads finally to unemployment and lower living standards, since there is little point in working when earned income depreciates by the hour. More time is spent hunting goods to buy. To avoid such a calamity, then, credit expansion must stop sometime, and this will bring a depression into being.

Preventing Depressions If the government’s proper policy during a depression is laissez faire, what should it do to prevent a depression from beginning?

Since credit expansion necessarily sows the seeds of later depression, the proper course for the government is to stop any inflationary credit expansion from getting under way. This is not a very difficult injunction, for government’s most important task is to keep itself from generating inflation. For government is an inherently inflationary institution, and consequently has almost always triggered, encouraged, and directed the inflationary boom.

Preventing Depressions Government is inherently inflationary because it has, over the centuries, acquired control over the monetary system. Having the power to print money (including the “printing” of bank deposits) gives it the power to tap a ready source of revenue. Inflation is a form of taxation, since the government can create new money out of thin air and use it to bid away resources from private individuals, who are barred by heavy penalty from similar “counterfeiting.”

Private banks, it is true, can themselves inflate the money supply by issuing more claims to standard money (whether gold or government paper) than they could possibly redeem. A bank deposit is equivalent to a warehouse receipt for cash, a receipt which the bank pledges to redeem at any time the customer wishes to take his money out of the bank’s vaults. The whole system of “fractional-reserve banking” involves the issuance of receipts which cannot possibly be redeemed.

Preventing Depressions Instead of preventing inflation by prohibiting fractional-reserve banking as fraudulent, governments have uniformly moved in the opposite direction, and have step-by-step removed these free-market checks to bank credit expansion, at the same time putting themselves in a position to direct the inflation. In various ways, they have artificially bolstered public confidence in the banks, encouraged public use of paper and deposits instead of gold (finally outlawing gold), and shepherded all the banks under one roof so that they can all expand together. The main device for accomplishing these aims has been Central Banking, an institution which America finally acquired as the Federal Reserve System in 1913.

Preventing Depressions Central Banking permitted the centralization and absorption of gold into government vaults, greatly enlarging the national base for credit expansion: it also insured uniform action by the banks through basing their reserves on deposit accounts at the Central Bank instead of on gold. Upon establishment of a Central Bank, each private bank no longer gauges its policy according to its particular gold reserve; all banks are now tied together and regulated by Central Bank action. The Central Bank, furthermore, by proclaiming its function to be a “lender of last resort” to banks in trouble, enormously increases public confidence in the banking system.

Preventing Depressions The government assured Federal Reserve control over the banks by (1) granting to the Federal Reserve System (FRS) a monopoly over note issue; (2) compelling all the existing “national banks” to join the Federal Reserve System, and to keep all their legal reserves as deposits at the Federal Reserve;

and (3) fixing the minimum reserve ratio of deposits at the Reserve to bank deposits (money owned by the public). The establishment of the FRS was furthermore inflationary in directly reducing existing reserve-ratio requirements.

Preventing Depressions The Reserve could then control the volume of money by governing two things: the volume of bank reserves, and the legal reserve requirements. The Reserve can govern the volume of bank reserves (in ways which will be explained below), and the government sets the legal ratio, but admittedly control over the money supply is not perfect, as banks can keep “excess reserves.” Normally, however, reassured by the existence of a lender of last resort, and making profits by maximizing its assets and deposits, a bank will keep fully “loaned up” to its legal ratio.

Banker to Commercial Banks

commercial banks are required to hold more cash on hand and are less able to increase the amount of loans to give consumers and businesses. This reduces the money supply, economic growth, and increases interest rates.

commercial banks are required to hold less cash on hand and are able to increase the amount of loans to give consumers and businesses. This increases the money supply, economic growth, and reduces interest rates.

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Conducting Monetary Policy

Open Market Operations

cont. ec. issues lecture 3

Economy & Finance