The solution to weak economic growth may be higher interest rates.
That seemingly paradoxical remedy can apply if the cause of the slump is a confidence shock that cheap borrowing costs are failing to reverse, two Columbia University economists said in a report published this week. In such a situation, ultra-easy monetary policy risks making fears of deflation a self-fulfilling prophecy as spenders sit tight.
Post-war American industry put on too much capacity and extended (far) too much credit. We had a nasty credit bubble and prices, including stock prices, went up. A lot.
But between the turn of 1920 and the middle of 1921 there was a truly ugly deflationary collapse as the overheated credit markets blew up and production exceeded the ability of the consumer to buy. Stock prices dropped by about half and the collapse in prices at the producer level came at the fastest rate in American history -- surpassing even that of The Depression!
So did the Federal Government increase spending to stimulate the economy and did The Fed (which existed, I remind you) cut rates?
Exactly the opposite.
The Federal Reserve increased rates and The Federal Government balanced the budget.
The over-levered went bankrupt.
But the market cleared, and 18 months later the economy was back to full employment.
You never hear this deflationary recession talked about in economics class, although you should. The only reason it was not called "A Depression" is that it didn't last long enough to qualify.
There are many lessons in history; lowering interest rates and deficit spending in fact don't work. At their best they can manage to substitute false government-fed demand for a while and blow an even bigger bubble than existed before. But frequently they fail entirely and you get the 1930s or the last two decades in Japan.
On the other hand, if you stop the deficit spending (and thus the debasement of people's capital -- their savings) that comes with it, and you refuse to feed an overlevered lending market with ever-cheaper credit, history says the market clears and then the economy recovers.
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