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2.7%  Q1 GDP    4.57%  avg. 30-year mortgage     9.5%  Unemployment

Krugman Tells Only Part of the Story of Government's Role in Financial Rescue

Listen: New York Times columnist Paul Krugman owns a Nobel Prize and The Ticker does not. So all props to him.

That said, his column yesterday explaining how Big Government saved the U.S. economy tells only part of the story by omitting the role of monetary policy.

In his column, which you can read by clicking here, Krugman argues that we didn't plunge into a second Great Depression last year because the federal government bailed out financial firms, did not slash spending, built up the deficit and passed a $787 billion stimulus (which Krugman has argued is too small).

He concludes: "The point is that this time, unlike in the 1930s, the government didn’t take a hands-off attitude while much of the banking system collapsed. And that’s another reason we’re not living through Great Depression II."

But by focusing on government spending, Krugman fails to acknowledge the role of the Federal Reserve and monetary policy in heading off this crisis.

Krugman is conflating two "governments." When he's talking about "government" during the current crisis, he's talking about fiscal policy -- programs and spending authorized by Congress and the White House.

But that's not the same "government" of the Great Depression. The biggest influence the much-smaller federal government had on the Great Depression was in monetary, not fiscal, policy.

It was the Fed that took a "hands-off role" in the Great Depression, as Krugman writes, which it decidedly did not do this this time. And the Fed's contribution to alleviating the current crisis doesn't make Krugman's column.

As detailed in Milton Friedman's and Anna Jacobson Schwartz's seminal 1963 "The Great Contraction: 1929-1933," the Fed disastrously refused to turn on the money spigot during the Great Depression and raised interest rates. A monetary contraction -- especially in a time of bank failures and low public confidence -- goes hand-in-hand with reduced production, as consumers and businesses fear deflation.

Click here to see a chart linking monetary supply and GDP during the first half of the past century.

Fed Chairman Ben Bernanke, a student of the Great Depression, believed that the Fed blew it badly back then and was determined not to make the same mistake. So as the crisis loomed and then escalated, Bernanke lowered interest rates and printed more money. It's a move that risks long-term inflation -- too much money in the system makes each dollar worth less -- but compared with the alternative of global financial collapse, Bernanke chose the lesser evil.

So, when Krugman argues that Big Government saved the economy from falling into a second Great Depression and does not acknowledge the role of monetary policy and the Fed, he paints an incomplete picture for readers.

P.S. In a television interview today, Krugman called for a second stimulus plan.

-- Frank Ahrens
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By Frank Ahrens  |  August 10, 2009; 11:48 AM ET
Categories:  The Ticker  | Tags: Ben Bernanke, Paul Krugman, great depression, monetary policy  
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The Post StimulUS plan seems to be working. 477.11 moving up with the Dow -53.81 heading down. Good management is still good. Could break 500 soon. I've held up a few banks in my day. Keep me out of the newspaper though and I'll hold a bank up for you.

Posted by: Dermitt | August 10, 2009 2:15 PM | Report abuse

Dr. Krugman is believed by some astute observers to have his eyes on the Chairmanship of the Frederal Reserve once Dr. Bernake is not reappointed. Thus, the article by Dr. Krugman was designed to say that the current Federal Chairman was not really important in rescuing the Economy. Dr. Bernanke knows the game which Dr. K trying to play for his selfish goal. Readers should keep in mi nd that not all of the Princeton Economists love eachother.

Posted by: eternalvigilance | August 11, 2009 7:39 PM | Report abuse

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