David Futrelle: You wrote your book, which deals in some detail with the Great Depression, as we sank into a financial crisis very similar to that crisis.
Bruce Bartlett: I think the Great Depression really is the only precedent for what we face. You can't look at any other recession in history for guidance, because every other one was small by comparison, and the Fed could simply reduce interest rates and get things going again. And most of our downturns took place under inflationary conditions.
The current crisis and the Great Depression are the only two that took place under deflationary conditions. In the Depression, the economy fell into what economists call a liquidity trap. The money supply shrunk, banks closed, money wasn't circulating. When you're in a liquidity trap there's no question that the government has to step in with fiscal policy to drive spending in the economy upwards so that money will circulate. You have to have an activist fiscal policy.
Fast-forward to the present time, and a lot of conservative economists said, "Well, we can't be having a repeat of the Great Depression because the money supply did not shrink." But what they forgot is that insofar as the money supply affects the economy, it depends not only on the amount of money but on the velocity, that is the rate at which the money turns over.
DF: And people aren't spending money, banks aren't lending money.
BB: Exactly. For years, spending was inflated because of the housing bubble. People tend to spend anywhere between 5 and 10 cents of each additional dollar of increase in their wealth, so if housing wealth goes up by, say, a trillion dollars, you're going to get perhaps as much as a hundred billion dollars per year of additional spending. And so the decline of many trillions of dollars in housing wealth causes the reverse effect, with people spending less. This decrease in spending reduces velocity, and a decline in velocity is identical economically to a decrease in the money supply.
DF: And the deflation that results from that has been especially pernicious, discouraging people from spending money, because they know that if they wait, things will just get cheaper.
BB: That's absolutely right, most particularly with the housing market. Nobody wants to be a sucker and spend $300,000 for a house today and find out you could have paid $275,000 if you'd waited a week or two.
Now, the Fed tried to compensate, but spending declined too fast. And they ran into the same problem we had in the Great Depression -- a liquidity trap.
The stimulus package may have been oversold by the Obama administration, but the basic principle -- that we needed government spending to get us out of the liquidity trap and make monetary policy effective -- was absolutely correct.
With the benefit of hindsight we can say that the stimulus could have been better targeted, better designed. But you know, the house was on fire, and we were spraying water on the house. And you can't worry about water damage when the house is burning down.
DF: Some liberal economists like Paul Krugman think we need a second stimulus bill.
BB: Maybe there's a case that we should have done more in the first place, but there's certainly no case for doing more now. The lags in implementation are so great that any stimulus enacted today would have no effect until long past the time recovery would have taken place. And don't forget that there's already an enormous amount of money in the pipeline: Only about a third of the $787 billion has actually gone out the door.
It takes awhile to get construction projects and things like that going but once they do get going, you know, they really get going.
I think the makings a of a fairly rapid recovery are very much there. I doubt housing prices are going to turn around very much, but I do think sales will pick up as soon as people perceive that mortgage rates are rising. Nobody wants to borrow for 5 percent when they can get 4.5 percent tomorrow. But if they think it's going to be 6.5 percent tomorrow, they're going to buy as soon as they can.
I think that things over the next year are going to be better than the consensus, and very, very good going into 2012.