Posner's A Failure of Capitalism -- VII

This is the second of two posts on chapter five of Failure.

As I noted in the preceding post, Judge Posner asks, after reviewing the stimulus program, whether it is "an $800 billion mistake?" He answers this question in a roundabout way.

He acknowledges that much of the "stimulus" will not be aimed primarily at stimulating economic activity but will instead be an enactment of President Obama's legislative agenda. Judge Posner then proceeds through a lengthy discussion of the "monetarist" and "Keynesian" views of the Great Depression and of solutions to depressions generally. The monetarist solution (in which the Fed increases the money supply through the banking system in order to stimulate economic activity) is problematic because, as previously mentioned, the current situation is so bad that banks are mainly "hoarding" the additional money in order to build their reserves, not lending it. To get beyond this hoarding, the Fed would have to pump so much new money into the banks that, when the depression finally ends and the Fed starts to contract the money supply (as will be necessary to prevent wild inflation), "a severe recession will be unavoidable." Thus, Judge Posner concludes, the monetarist solution alone will not remedy the depression "at a tolerable cost."

The fear in the background, as he explains in this chapter, is that the economy will enter a deflationary spiral. Deflation is a situation in which the general level of prices persistently decreases. This frightens economists because deflation makes it economically rational not to spend money. Since prices are dropping generally, money gains in value simply by being stuffed in a mattress for a few months. People don't need to put their money to work in order to earn a return. Accordingly, the economy contracts and contracts.

After painting this bleak picture, Judge Posner observes that "[e]ventually deflation will bottom out. As income shrinks, consumers will cease to be able to hoard cash; they will have to start spending everything they have." This will start a "virtuous cycle" of increased spending, increased production, and increased employment. "But the progress of recovery will be protracted because it will begin from a very low level."

Judge Posner now comes back to his question whether the stimulus is a mistake. He has concluded that the monetarist solution is not likely to prevent a deflationary spiral "at a tolerable cost." As a result, Keynesian deficit spending (i.e., the stimulus program) is also needed to prompt economic activity. Although he doesn't use these words, he in effect says that we have no choice.

He further points out that, even if the stimulus "will do nothing to speed recovery from the depression, there would still be a compelling argument for it. . . . "

Suppose that President Obama were to tell the American public: "We're trying to avert or ameliorate a depression by pumping up the money supply, but it may not work, in which event we'll find ourselves in a deflationary spiral that may resemble what happened to the United States in the 1930s and Japan in the 1990s. And then we'll just have to tough it out because our toolbox will be empty." (This is what, in effect, some conservative economists would like him to say.) His statement would guarantee a severe depression, because people would react by curtailing their consumption further, accelerating a deflationary spiral that would carry the economy to a lower level and keep it there for years.

The government must instead, for psychological reasons, express optimism and be seen to be doing something.

I don't have the time to review other interesting passages in this chapter, other than to mention them. Judge Posner argues that the monetarist solution "is potentially more socialistic" than the Keynesian one, because under the former, the Fed has found itself needing to buy stakes in businesses. He also looks at Congress's attempt to reduce the number of residential foreclosures by amending the bankruptcy code. In his view, that is not a good plan. Instead, while his preference would be no mortgage relief at all, he suggests a moratorium on foreclosures or a Columbia-devised plan in which certain lien-holders would be compensated with government funds for consenting to modification of mortgage terms.