Wednesday, October 08, 2008

Comment: Do bailouts actually prolong downturns?

There is probably no better historical example to examine this question as the Great Depression, when the government intervened for more than a decade trying to prop up the financial system.

Although the Great Depression is generally seen as starting at the stock market crash of 1929 from at least 1929, small banks and farms had been floundering severely. However, it was not until 1931, when the government started a massive bailout program with the National Credit Corporation (NCC) that things started going downhill very quickly.

In 1932, the NCC was replaced with the Reconstruction Finance Corporation (RFC) and things continued to spiral downward reaching the lowest point during the Depression in 1933.

Yet, the RFC continued its bailout program mostly unsuccessfully until America's entry into World War II, generally seen as the point when shortly afterward the Depression ended completely. During the war, the RFC continued to operate giving out $2 billion a year. From 1932 until 1941, the RFC gave out $9.465 billion, a lot of money in those days.

When the war started, the government drafted many of the employed workers, and hired and trained large numbers of unskilled workers, at its own expense, to work in wartime factories. These policies together with rationing and a greater worker discipline helped the country work out of the lingering unemployment that still plagued the country. The stock market did not recover its pre-crash position though until 1954.

Some groups of economists, like those of the Austrian School, who believe that government intervention only prolonged the problems in the economy. Others, like the Monetarists, believe the Federal Reserve did not act quickly and strongly enough to address the crisis.

During the Depression, the Fed followed a deflationary strategy that kept interest rates high. The current Fed chief, Ben Bernanke, believes more in an low interest rate strategy, an attempt to ease credit, but in effect putting upward pressure on inflation.

Bernanke's views may account for today's cut in interest rates, another attempt by the government to bend over backward in accommodating the credit markets. However, as with the Great Depression, it is impossible to deny that easy credit is responsible for the current economic crisis.

Attempts at propping up the easy credit market, then, only reinforce the causative factors according to one school of thought.

The fact that the stock markets have not reacted positively to the torrent of government measures aimed at propping up the easy credit system probably indicates some doubt over the policy.

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