It’s an honor to be on this panel with all these distinguished people. But I’m afraid I was invited because I’m considered soft on bailouts. That’s a terrible reputation to have. What is it they say about poker? “If you look around the table and you can’t tell who the sucker is, it’s you.”

The case for bailouts is usually systemic risk. You do it, not for the bailout-ee, but to limit the collateral damage, damage to the whole “system.” The case against bailouts is that by saving management and owners from the consequences of their excessive risk-taking or bad decisions, you create moral hazard and encourage similar behavior by others.

In most of the so-called bailouts during the Panic of 2008—bunched together in September 2008—the decision-makers were not saved or rescued. Top management, directors and stockholders generally lost their jobs and much of their wealth, and were maligned in Congress and by the press.

They didn’t benefit from a “heads I win, tails you lose” proposition. They had won for a while; then they lost.

Future decision makers under similar circumstances will remember both sides of that coin and not want to go there. Public humiliation is not something you want to emulate.

Mr. Paulson, in fact, seemed eager to fire people at the top who had done no wrong specifically so that he could not be accused of creating moral hazard. The CEOs of Fannie and Freddie were following policies mandated by Congress and were not the same CEOs in place during the earlier accounting scandals. I believe the fired CEO of AIG had been on the job only a few months. And Ken Lewis of Bank of America has learned that no good deeds go unpunished.

Moral hazard did get us into this mess. The making and securitizing of subprime mortgage loans and selling those mortgage bonds all over the world was the mother of moral hazards, since mostly independent unregulated mortgage brokers made the credit decisions and unsuspecting owners of the bonds—misled by their AAA ratings—bore the risk.

Many pundits who were saying “let ‘em fail,” “let ‘em fail” later said letting Lehman Brothers fail was the biggest mistake of the crisis. I tend to agree.

There were a lot of tall dominoes, standing close together. I’m not sure the system could have survived many other failures like Lehman’s, which cost me about 40 percent of my little portfolio.

Given time, I’m sure the Treasury’s TARP program could have been better designed and executed, but under the circumstances I think it’s working pretty well for almost 700 banks caught holding mortgage-backed securities and other assets no longer trading. We only hear of the top nine or the top 19.

I won’t try to defend TARP’s use outside the financial system or the way Congress has used it to fan and pander to our worst populist instincts, to demonize bankers, and as a pretext to expand government power, violate contracts and private property rights. It has been shameful.

The public, egged on by politicians, regards TARP as the Government spending their money to support “evil doers.” Most people have no idea that the Treasury will be able to sell its preferred stock and warrants received from banks, likely at a profit.

There will be losses here and there, on individual transactions and banks, but, overall, I won’t be surprised if taxpayers come out ahead net. The Treasury has earned about 18 percent on the banks that left the program early.

The Federal Reserve’s extraordinary lending last year and security purchases this year are even more likely to earn a net profit for taxpayers. The Fed generally turns over about 90 percent of its earnings to the Treasury’s general fund. Those earnings are rising significantly with the expansion of the Fed’s balance sheet, and those earnings will benefit taxpayers. Even the individual losses here and there, to the extent there will be any, would not be a loss of existing money, but only a loss of the new money created by the transaction—an opportunity cost loss.

Skeptics make much of the Fed’s expansion of bank reserves and money and take it for granted that it will be highly inflationary. Possibly, but I doubt it.

New money must be spent before it can cause inflation. Banks are holding most of their new reserves idle as excess reserves because they are scared to death. And the public has similarly reduced the velocity, or turnover, of money sharply. With the velocity of money collapsing, and credit shrinking, rapid money expansion has not been inflationary. So far, rapid money growth has been needed to forestall deflation.

Despite some pick-up lately, both the Consumer Price Index and the Producer Price Index remain below year-ago levels. Prices for the year are down, not up.

The trick for the Fed will be to adjust money growth as velocity returns toward normal—the exit strategy.

Chairman Bernanke’s study of the Depression has convinced him that tightening monetary policy prematurely is a greater danger than tightening too late. Most pundits on financial TV seem to assume the opposite.

During the Depression the Federal Reserve increased reserve requirements on banks to “mop up” banks’ excess reserves. The banks reacted by contracting credit further. It turned out that the reserves were not considered excess by the banks themselves. They wanted an extra cushion against uncertainty.

Today, the pundits are urging the Fed to make the same mistake—to “mop up’ excess bank reserves before they are used for loans and investments that might create inflation. But the banks are holding those excess reserves voluntarily—for the same reasons they did during the depression, as precautionary balances. Just because they may be excess reserves in a regulatory sense doesn’t make them excess in a more real sense.

While I give passing marks to the Treasury’s capital injections into banks and to the Fed’s direct and indirect lending, I put the massive stimulus program on the other end of the spectrum. It reminds me of hunting wild hogs with a shotgun rather than a rifle. There is a lot of firepower, but it’s diffused–not focused enough. It has probably prevented some layoffs at the state and local levels, but at a huge cost in money, deficits, and debt.

The Fed made loans and the Treasury made investments. The stimulus program, however, was old-fashioned spending. Money spent, money gone.

The deficit as a percent of GDP has tripled and outstanding debt is headed above its recent level of about 40 percent of GDP.

Instead of targeted marginal tax-rate cuts to stimulate the private sector, we face the prospects of repeating a huge mistake made during the depression—raising taxes in a weak economy. Not only the expiration of the Bush tax-rate cuts, but also additional taxes to finance new government programs.

In the 1937-38 period during the depression, the government raised taxes to finance new government programs already put in place. They wanted to balance the budget. We face the prospect of new taxes for existing programs and new programs yet to come.

Another negative feature of the Depression that we seem to be copying is class warfare against business leaders. How that is supposed to help anything is a mystery to me. But, to my knowledge, even Roosevelt didn’t think to have a pay czar.

Another depression-era mistake we’re in danger of repeating is protectionism. We haven’t gone as far as the Smoot-Hawley tariff increase yet, but we are on a slippery slope in that direction, with the violation of the NAFTA agreement on Mexican trucks, tariffs on Chinese tires, and buy-American policies spread all over the stimulus bill.

Will we ever learn?

The second paragraph acknowledges this implicitly when it says “Thailand, South Korea, Russia, and the Philippines have been snapping up dollars this week in order to hold down the value of their currencies.” It goes on to say that Brazil’s finance minister said the country’s currency remained too strong even after Brazil adopted some capital controls to weaken it.

While a majority of pundits on financial TV argue for a strong dollar to boost—or should I say “buck up” the U.S. economy, the rest of the world seems to understand that a weaker domestic currency would help them get out of recession, unless, of course, all or most countries do it and cancel each other out. Such confusion is an important reason countries should adapt domestic policies to domestic needs and let their exchange rate adjust to reconcile those with the outside world. 

Yesterday, rumors were going around that China might soon restore the gradual appreciation of its yuan, which implies a weaker dollar relative to the yuan. That would be helpful both to China and the U.S. since the U.S. trade deficit is largely China’s trade surplus. But wasn’t it just the day before yesterday that China was urging the United States to strengthen the dollar, which would imply a weaker yuan. Consistency is difficult to maintain as blog writers will tell you.

I visited China in 2003 and 2006 and made several speeches and gave several TV interviews. I kept making the point that China’s exchange rate was China’s business, but then I pointed out that holding the yuan down was subsidizing U.S. consumers at the expense of their own. The first part of my message was not really correct since every exchange rate has two sides and affects both parties, but I thought it best to be diplomatic about it. During both periods the U.S. was trying to pressure China to appreciate the yuan, and I was convinced that China would do so only if we quit urging them to publicly.

One of the huge mistakes made early in the Great Depression was the severe Smoot-Hawley trade law, which led to competitive devaluations all over the world and triggered a sharp shrinkage in world trade. We haven’t gone that far yet in our Great Recession, but we are on a slippery slope. Exchange rate manipulation can do harm similar to tariffs and non-tariff barriers to trade. Once we start the game of competitive exchange rate changes it can easily get out of control. Instead, let’s follow Milton Friedman’s advice and keep the float clean.

Then why is it that virtually all the commentary on the dollar on financial TV and in blogs fails to mention the balance of payments when discussing the dollar? The dollar is considered super-important these days while the balance of payments isn’t considered important enough to mention. That’s like saying the price is important, but supply and demand don’t matter.

Instead, a strong dollar is treated as both the evidence of U.S. economic strength and a major cause of it. A weak dollar reflects and causes economic weakness. This relationship is either taken as self evident or is based on historical periods when the economy and the dollar were strong together or weak together. Unfortunately, these conclusions are the opposite of what economy theory teaches.

Other things equal, a primary result of an exogenous weakening of the dollar is an increase in foreign demand for U.S. exports, since they are now cheaper in terms of foreign currencies. A weaker dollar also makes foreign exports (U.S. imports) more expensive in dollar terms. Therefore, the weaker dollar will stimulate U.S. exports and depress U.S. imports. This increase in net exports (U.S. exports minus imports) adds to total spending as measured by GDP. If GDP is at recession levels, a weaker dollar helps pull us out of recession.

I don’t deny that many other economic variables have an influence on these relationships. However, the relative price change brought about by changes in the exchange rate are considered dominant among economists who study the matter.

The positive jolt to domestic GDP caused by a depreciating home currency is well known all over the world. That is why during a global slump such as we are in today we have to guard against competitive devaluations where each country tries to boost its economy through depreciation or devaluation which has the opposite effect on its trading partners. The term of art is “beggar thy neighbor” policies, sometimes called “beggar my neighbor” policies.

While the competitive advantages of currency depreciation are widely understood around the world, most of the talking heads on financial TV seem to believe that the opposite is true for the United States. They imply that a stronger dollar will lead to a stronger economy and a stronger economy will lead to a stronger dollar.

Apparently forgotten is the pressure U.S. officials put on China in the not-too-distant past to let the yuan appreciate, which would effectively depreciate the dollar against the yuan. I wasn’t in favor of pressuring China on that point, but at least those who did understood that a more expensive yuan and less expensive dollar would help restore more balance to trade between those countries. Today’s proponents of dollar appreciation are pulling in the opposite direction. It is amazing to me that China has completely turned the tables on us by arguing that it is us with the weak currency while touting their own artificially weak currency (roughly pegged to the dollar and protected also by exchange controls) as a potential reserve currency.

I’m changing focus now. Pay attention.

While a weaker currency helps a country pull out of a recession, a strong currency is beneficial if there is no recession, or shortage of aggregate demand. A strong currency relative to those of your trading partners helps consumers by making imported goods and services cheaper in the domestic currency. The added competition from imports also lowers the price of many domestically produced goods and services. A strong currency puts pressure on producers, exporters, and potential exporters to remain competitive, which isn’t always possible. Businesses may fail and jobs may be lost.

A strong currency generally harms producers and exporters. To repeat: a strong currency generally helps consumers and harms producers.

So, how do you choose which group to help?

The answer is you don’t. Under our system of market-determined exchange rates, the rules-of- the-game call for hands off. Keep the float clean, not dirty. Government tinkering with a floating currency opens it up to intense lobbying by pressure groups that is best avoided.

In the quandary of whether to favor consumers or producers, importers or exporters, a couple of points should help. One is no matter what we do for a living, we are all consumers. Even those harmed as producers will be helped as consumers. Another question to ponder is this: Who is an economy for, consumers or producers? I think the answer is consumers. This is similar to the question, do we work to eat or eat to work? Or, do we import to export or do we export to import. I think the unstated consensus in a democracy is we work to eat and we export to import. Consumption is the end; production is the means. A more totalitarian government, like China, is usually tempted toward mercantilism, which includes a higher priority on exports than imports.

So, my conclusion is there is a strong argument to be made for a strong currency. It just doesn’t apply in the midst of a deep recession when the main problem is inadequate aggregate demand. Many people who don’t acknowledge that are, in my opinion, trying to avoid sounding “Keynesian.”

I’ve said this many times before. My position on a strong dollar is similar to St.Augustine’s position on chastity in his famous prayer: “Lord, make me chaste, but not just yet.” My prayer is, “Lord give us a strong dollar, but not just yet.”

The front page of today’s Wall Street Journal features a useful breakdown of the third quarter real GDP statistics. On the negative side, it shows that the strength in consumption spending benefited from various temporary government programs: primarily cash for clunkers and the first time home buyers’ credit. Those will eventually go away.

Showing imports as well as exports is almost a breakthrough since commentators typically focus only on exports as a positive to GDP growth. The chart showed exports as contributing 1.5 percentage points of the total increase of 3.5 percentage points. Fair enough. But it also showed imports subtracting 2.0 percentage points, making net exports (exports minus imports) a net drag of 0.5 percentage points.

It’s important to remember that imports are a subtraction from U.S. GDP numbers because the various categories of spending listed have import components that generate income abroad rather than at home. Imports are subtracted to prevent over counting in those other categories.

A very positive detail is the contribution of inventory investments. Inventories have been drawn down in recent quarters, and I was expecting a boost from some rebuilding of inventories in the third quarter. Instead, the boost came from a slower liquidation of inventories than in the previous quarter rather than a rebuilding. (A smaller minus has the effect of a plus.) The reason this is so positive, in my opinion, is that the rebuilding of inventories and its boost to GDP is still in our future. It will likely boost the fourth quarter GDP number; if not, the first quarter. It’s an ace in the hole.

I find it disconcerting that everyone seems to equate an increase in the GDP number as an end to the recession even though everyone expects employment to continue falling for some time. Falling employment is hardly consistent with a recovery in my book.

One might think me a killjoy for raining on the recovery parade, but I do believe too much positive spin on current numbers sets us up for disappointment in the near future. The stock market, in particular, swings up and down on exaggerated news spin. More realistic interpretation of incoming economic data might help the stock market have a slower, but more sustainable, increase.

But just to be clear: a 3.5 percent increase in the third quarter is a good thing.

Amity showed great restraint in writing her book. A scholar with her expertise could have driven the ideological lessons home and saved those of us on a practical mission some time. Instead, she patiently let the characters and the circumstances speak for themselves letting the nuance show through for us to savor.

While I wasn’t totally clueless about the depression, not having lived through it, you see, I must admit that my knowledge of many of the details was limited.

Here’s what I thought I knew going in:

* There was still debate over whether the October 1929 stock market crash caused it, just preceded it, or how big a role it played.

There was general agreement that:

* The Smoot-Hawley tariff was a terrible mistake that made it much worse, and may have made the difference between recession and depression.

* The Fed made it worse by allowing the money supply to shrink.

* Things got better in the mid-thirties, but then worsened again, probably because of policy mistakes.

* Hoover was totally ineffective and did next to nothing to help, while

* Roosevelt was an activist who experimented with cures and generated public hope and was generally successful.

* The depression really didn’t end until WWII.

* The most important change made to prevent future depressions was the FDIC’s deposit insurance.

* The semi-socialist measures of the Roosevelt administration saved capitalism from something far worse.

Here’s what I thought of a couple of things mentioned above:

* I couldn’t really deny the Friedman and Swartz charge that the Fed erred by allowing the money supply to shrink.

* However, I thought insufficient attention had been paid by the economics community to the following factors:

- The shrinkage of the money supply was primarily a by-product of bank failures.

- The world was still on a gold-standard and policymakers were presumably supposed to follow the “rules” of the gold standard game.

- There was no consensus within the economics community on what to do to get out of a depression.

- This consensus would await the publication of Keynes’ General Theory in 1936 and its subsequent popularization and incorporation into economics textbooks.

Here are some of the things I learned by reading the book:

Much of what Roosevelt did on a large scale was begun or done first on a smaller scale by Hoover. Hoover was not sitting on his hands waiting for better times.

Hoover came off better in the book than I expected. Roosevelt came off badly, as expected, based on his economic policies and actions. What I didn’t expect to learn was that Roosevelt was rather petty and vindictive.

The Smoot-Hawley tariff, arguably Hoover’s biggest mistake (expected), came very early (1930) in the first year of his administration without a lot of thought given to it. Protectionism was apparently accepted Republican dogma at the time; so Hoover accepted it almost routinely. (He would try to improve it; not oppose it.)

Hoover’s “economic philosophy” was really an engineer’s view of the world where planning was useful and where problems can be fixed. He was willing to tamper with the machinery up to a point, but he respected the constitution, including the constitution of the gold standard, as limitations on government action.

Roosevelt, on the other hand, had no philosophy to speak of, he cared little about the constitution, and he broke the gold standard with his prolonged devaluation of the dollar. (I had known about the devaluation of the dollar, of course, but I had missed that it wasn’t an immediate thing. Instead, Roosevelt enjoyed setting the price of golf every morning from his bedroom. Different strokes for different folks.)

Roosevelt’s lack of a “North Star” to guide his way made him particularly vulnerable to being pulled in different directions by his staff and “brain trust.” During his administration, policy shifted back and forth between stimulus measures (job creating) and a desire to get back to fiscal rectitude by balancing the budget with large tax increases.

Large and untimely tax increases in the middle of the depression—probably not considered that way then—killed off an incipient recovery.

This should be a huge lesson for us today. Among other potential tax increases implied by various programs under consideration today, we have the pending reversal of the Bush tax-rate cuts looming next year. Could we possibly repeat that mistake?

As for other lessons, for now, I think Chairman Bernanke was very much influenced by this last factor and has resolved to avoid premature “fiscal rectitude.” He considers declaring victory prematurely a bigger danger than waiting too long.

He has already avoided the mistake of allowing the money supply to shrink and have deflation psychology take hold. His critics on that, however, are getting louder and louder, calling for an “end game” sooner rather than later.

One issue involving monetary policy is very much relevant for today: the excess reserves on banks’ (and the Fed’s) balance sheets. As in the 1930s, the banks have more reserves than the law or regulations require them to have—hence the term “excess” reserves. However, also as in the 1930s, banks have good reason to be cautious and remain even more liquid than the law requires. Attempts to “mop up” those excess reserves before they are used in ways that might contribute to inflation could have disastrous results. The fact that banks are holding them voluntarily is proof enough for me that they are “required” reserves in the minds of the bankers and that banks would try to restore them if they were removed by the Fed prematurely.

One final note:  I didn’t realize that our current mob-rule attitude toward successful people that has us cutting executive pay and hauling executives before congressional committees to be humiliated had a counterpart in the 1930s, but, apparently there is nothing new under the sun. Amity has an entire chapter on “Prosecutions” that amounted to political payback. It’s like our leaders are bent on taking the worst lessons from the past.

I had wondered whether Keynes had had much influence on administration policies during the depression since The General Theory came too late. Even though he had earlier influential books, I gather not. My favorite part of Amity’s book was when she describes a meeting that Keynes had with President Roosevelt on May 28, 1934, lasting fifty-eight minutes, about the time of a class-room lecture. Both Keynes and Roosevelt indicated that the meeting did not go well.

The President indicated that “Keynes had left him, disappointingly, with a ‘rigmarole of figures.’ He must be a mathematician rather than a political economist.”

Don’t you just love “rigmarole of figures?”

P.S. I worry that I have done Amity Shlaes, The Forgotten Man, a disservice by my inadequacy in describing it. Even if I haven’t conveyed its merits sufficiently, trust me, it’s great, and well worth your time.

“From May through September, job losses averaged 307,000 per month, compared with losses averaging 645,000 per month from November 2008 to April. Since the start of the recession in December 2007, payroll employment has fallen by 7.2 million.”

As usual, most of the TV commentators gave the impression to their viewers that there was no job creation in September and that there were 263,000 job losses. A typical question was “When are we going to see job creation again?”

The truth is that there were many jobs created in September and in recent months. It’s just that there were more jobs lost. The numbers we get are the net differences between significant numbers of gross job gains and gross job losses. These gross gains and losses are many times the net difference. This detail is worth keeping in mind lest we get the false impression that our dynamic ever-changing and evolving economy is stagnant.

The Bureau of Labor Statistics, in addition to the net changes in jobs, publishes a data series called Business Employment Dynamics. It shows the gross changes that make up the net changes. Unfortunately, the gross changes are published with a lengthy lag.

When I checked on this a couple of years ago before the dramatic declines began, I found that the monthly gross job gains and gross job losses were very roughly 2,400,000 each per month. On average, and very roughly speaking, the net gains would be about that much above 2,400,000 and the net losses would be about that much below 2,400,000.

I adopted the 2,400,000 number as my approximation because it was also convenient to think of it as the length of a 24 inch, or 2 foot, ruler, with each of the 24 inches representing 100,000 jobs. As a guest host on Squawk Box on CNBC once I actually brought two colored 24 inch sticks to demonstrate visually that what makes the news is whether the green job gain stick was an inch or two above or below the red job lose stick. I think I made the point adequately, but the regulars on the set looked a little pale when I brought out my sticks.

The latest published numbers from gross private job gains and losses are for the 4th quarter of 2008 when unemployment was rising rapidly. The gross job gain that quarter came to 6,712,000 while gross job losses totaled 8,467,000, for a net quarterly loss of 1,755,000 private jobs. Dividing these numbers by 3 to convert quarters to months, gross monthly gains were 2,237,333, gross monthly losses were  2,822,333, and net monthly private job losses were 585,000 per month. That last number is the only one emphasized in the media and what most people see or hear. I think most will agree that, while correct, that practice greatly understates the underlying dynamics of the economy.

In terms of my corny sticks with 1 inch equal to 100,000 jobs, gross monthly job gains are just over 22 inches while job losses are just over 28 inches–a six inch difference. Job gains are down two inches while losses are up four inches. They need me and my sticks back on Squawk Box.

This is a corrected version of the original

Of course you can spend your way out of recession, almost by definition. A recession can be defined as a shrinkage of spending and income. More spending is needed to generate more income. Therefore, more spending will do the job.

I think the problem is that spending your way out of a recession is the message of Keynes’s “General Theory of Employment Interest and Money, and people don’t want to be labeled a “Keynesian.” But surely one can cling to his classical economic principles while acknowledging that Keynes had a point, especially during recessions.

In a recession, income declines because spending declines, and spending declines because income declines. It’s a vicious circle that needs to be broken. One option might be tax cuts to increase business spending. Another might be lower interest rates to stimulate spending. Another is to have government spending make up the slack. That will work if it has monetary policy support, i.e. if the government spends newly created money so it doesn’t crowd out private spending.

I don’t necessarily want to be labeled a Keynesian either, but I see no reason to fear acknowledging that he had a point. To say that we can’t spend our way out of a  recession may make a good sound bite, but it has no credibility.

 We hear monthly reports on our trade balance—on how our exports of goods and services match up with our imports of goods and services. What hasn’t seemed to sink in is the fact that both measures are pointed down. Both our exports and our imports have been shrinking, as have the exports and imports of most major trading currencies. World trade is shrinking because of falling aggregate demand. Do we really want to add tariffs to the mix?

 Competitive trade barriers are insidious. So are competitive currency devaluations, with both designed to stimulate domestic demand at the expense of our trading partners. It’s a negative- sum game. Nobody wins.

The good news that employment declined less in August than in previous months is more important than the bad news of the rise in the unemployment rate. As I've noted here previously, the unemployment rate (from the household survey) had not kept up with employment losses and a convergence was over due. It should not be considered new bad news. The unemployment rate will rise further, even if employment losses continue to decline. One reason is that discouraged workers will come into the labor force as their perceived prospects improve. Keep your eye on employment rather than unemployment as a measure of how the economy is doing.

"Are budget deficits inflationary?" was one of his favorite questions on final exams, and he had a precise idea of the components of an "A" answer. Using T-Accounts (Remember the Chicago Fed's Modern Money Mechanics booklet?), the students were supposed to show the alternate ways of financing government spending, including deficits. The answer to the question, you see, depended almost entirely on the method of financing. Another way of saying that is that the impact of fiscal policy depended almost entirely on the accompanying monetary policy.

I'll spare you the T-Accounts and just summarize the conclusions: Government spending financed by taxes was not inflationary (or even expansionary) because the government's new spending was offset by a reduction in private spending. There would be little or no net change in total spending. That did not mean the alternatives of government versus private spending had no other consequences. Professor Waller greatly preferred people spending their own money rather than having the government doing it for them.

Government spending financed by bond sales to private individuals and companies had expansionary/inflationary consequences very similar to a balanced budget. The money the government got to spend was money the bond purchasers no longer had to spend. There was no net change in bank deposits, bank reserves, or the money supply.

Government spending financed by bond sales to commercial banks did increase bank deposits and the money supply and was presumably more expansionary. Commercial banks, however, used up excess reserves in buying the bonds that might have been used making other investments or loans. With the extreme assumption of no excess reserves prior to the deficit financing, the expansion of bank deposits and the money supply would likely be no greater than what would have happened anyway. The expansion in bank deposits that took place was a one-shot deal rather than the beginning of a multiple expansion process since bank reserves were not increased. So, financing government spending with bond sales to the banking system (under normal times with little or no excess reserves) may have been a little expansionary, but no more than would have likely happened anyway.

Government spending financed by bond sales (indirectly) to the Federal Reserve by having the Fed buying bonds in the open market at about the same time as the Treasury was issuing new debt was the most expansionary/inflationary financing method of all. That's because bank deposits initially increase by the amount of the Fed's purchases, but so do bank reserves. The reserve expansion creates sufficient excess reserves to permit the banking system to continue making loans and investments and creating deposit money in the process until the total money created reached a multiple of the purchases-that multiple being the inverse of the required reserve ratio.

In other words, if the Fed buys $10 million (in those days) of Treasury bills and the average marginal reserve requirement of banks was 10 percent, the total deposit expansion of the banking system could be $100 billion.

The previous example amounts, figuratively, to printing money. The Treasury has new money to spend that was not given up by the private sector. Everybody else still has the money they had and the Treasury has more. This is the most expansionary/inflationary method of finance of all. Note that I had the Fed buying the Treasury debt "indirectly" in the open market rather than directly from the Treasury because it is a process easy to abuse. The law restricts such direct purchases. Think "monetary incest."

Professor Waller insisted that an "A" answer to the question had to contain the essence of the above, but it must also contain the following point. Whether the method of financing government spending was expansionary or inflationary depends largely on the state of the economy. The closer the economy is to full employment of labor and other resources, the more likely the new spending with newly created money would cause inflation. An economy in a deep recession with high unemployment of labor and low capacity utilization might be able to produce more goods and services as a result of the new spending. To that extent it would be expansionary, not inflationary, or not as inflationary as it otherwise would be.

It seems to me that contemporary talking heads would do well to review some of these fundamental principles and include some of the important qualifications and caveats into their thinking. We rarely hear of the important role of the financing when we hear of the inflationary consequences of budget deficits. Professor Waller, we need you.