BERKELEY – When an economy falls into a depression, governments can try four things to return employment to its normal level and production to its “potential” level. Call them fiscal policy, credit policy, monetary policy, and inflation.
Inflation is the most straightforward to explain: the government prints up lots of banknotes, and spends them. The extra cash in the economy raises prices. As prices rise, people don’t want to hold cash in their pockets or their bank accounts – its value is melting away every day – so they step up the pace at which they spend, trying to get their wealth out of depreciating cash and into real assets that are worth something. This spending pulls people out of unemployment and into jobs, and pushes capacity utilization up to normal and production up to “potential” levels.
But sane people would rather avoid inflation. It is a very dangerous expedient, one that undermines standards of value, renders economic calculation virtually impossible, and redistributes wealth at random. As John Maynard Keynes put it, “there is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose…” But governments will resort to inflation before they will allow another Great Depression – we just would very much rather not go there, if there is any alternative way to restore employment and production.
The standard way to fight incipient depressions is through monetary policy. When employment and output threaten to decline, the central bank buys up government bonds for immediate cash, thus shortening the duration of the safe assets that investors hold. With fewer safe, money-yielding assets in the financial market, the price of safe wealth rises. This makes it more worthwhile for businesses to invest in expanding their capacity, thus trading away cash they could distribute to their shareholders today for a better market position that will allow them to reward their shareholders in the future. This boost in future-oriented spending today pulls people out of unemployment and pushes up capacity utilization.