Time to Test the Theories

The Great Depression may have destroyed economic wealth but it generated much wealth and doctoral titles for generations of economists as they battled each other for the true causes and remedies for the Everest of economics. For simplicity, this battleground could be divided into two main areas of debate and study:

a) What were the precursor conditions to the Great Depression and once identified what steps could have been taken to prevent it from happening
b) Once started how it could have been escaped from

Unfortunately theories on the prevention of the Great Depression have been completely theoretical, perhaps until now, but the work of Milton Friedman has been accepted as the winner in this class. With respect to escaping from the downturn, we know plenty of things which did not work and may actually have made it worse, like the Smoot Hawley Tariff, and what policies, Keynesian deficit spending, that are supposed to have led to end of the it. However, as Keynes's General Theory of employment Interest and Money was not published until 1936 it is not possible to say for certain that government stimulation of aggregate demand did lead to the end of the Depression. Seven years of asset bubble deflation had already occurred so it is entirely possible that the stage had been already reached in the business cycle where pricing power had returned.

The conclusions of a 2002 study by the Federal Reserve on Japan's deflationary experience of the 1990s, that policymakers should become more aggressive in reducing the target rate as it approaches zero, highlighted Milton Friedman's influence. Alan Greenspan's post tech bubble slashing of the interest rates, and Bernanke's 2002 apology to Friedman for the Fed's inaction (ie not undertaking massive monetary pumping), which Friedman's "natural experiments" had shown caused the Great Depression, illustrates that the toolkit the Fed would use to combat Depression/Deflation threats. As Bernanke said in 2002 while to thanking Friedman and Anna J. Schwartz for showing them the light:

"What I take from their work is the idea that monetary forces, particularly if unleashed in a destabilizing direction, can be extremely powerful."

As the sub prime fall out shows the monetary forces were indeed very powerful with loose money creating a housing boom and ultimately bad debts which has led to the virtual collapse of the banking system. So now we know unfortunately that Milton Friedman was dead wrong. All the same Bernanke and the Central Bankers around the world are not ones to be easily discouraged and are continuing with even more monetary pumping. Further, now that it is being noticed that this method is proving ineffectual, governments are resurrecting Keynes with massive government spending to ward off recession. Competition among governments has broken out for which can come up with the best bailout and stimulus package. At least at the end of all of this we shall know if the theories were right but at the moment it is looking like it could be a very costly experiment. The get out clause then for Bernanke and the rest of them will be that it would have been even worse if they hadn't acted but as Greenspan is finding out now if things get really bad then nobody will believe your protestations any longer.