Friday, May 9, 2008

Depression though experiments

Jim Hamilton has written one of the simplest and most direct explanations of what happened with the depression in the form of a thought experiment asking what would have happened if the US went back on the gold standard in 2006. The crucial point, I think, is that financial crises are inherently deflationary because you have sudden increase in the demand for money relative to the demand for other things, particularly financial assets. Money comes to be worth more in relative terms, which is the very definition of deflation.

Naturally, given that Ben Bernanke's entire academic career was founded on studying this phenomenon, the Fed is aware of this problem, and is increasing the money supply enormously, even though this means that the price of gold (which we could replace in Hamilton's story with the price of commodities generally) goes through the roof. The trick I suppose is to just balance the deflationary effects of a financial panic with the inflation of the money supply.

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