In 2006 a Mr. Alex Grey had posted an insightful comment on one of the financial blogs which we have kept in mind. Here it is in its entirety.
There was definitely a hole in Keynes' theory of the Great Depression. This has thankfully been filled by the article "Fisher, Keynes and the Corridor of Stability" by Robert Dimand (American Journal of Economics and Sociology, Vol. 64, No. 1 (January, 2005), pp. 185-199).
This article is I think the missing link that established that the Keynesian Liquidity Trap that characterised the Great Depression was a result of debt deflation as described by Fisher. This establishes that Friedman and Schwartz's view of the great Depression has the causality reversed - the economic contraction led to the contraction in monetary aggregates, notably M3. The Fed or its the equivalent could do little to avert this.
I think averting the process of debt deflation cannot be accomplished through monetary policy (Bernanke following Friedman believes the opposite). This again points to the contrast between Keynes and Friedman.
Evidence in support of the incorrectness of Friedman's view is seen in the experience of Japan in the 1990s where the government succeeded only in increasing M1 while M3 continued to shrink (see paper by Krugman (1997 on this) and asset prices, notably housing, continued to fall. The reason why monetary policy cannot avert debt deflation is that asset prices are bid up to unrealistically high levels during booms based on the same "animal spirits" that govern investment. When markets turn then so do expectations which cannot easily be reversed and certainly not by monetary policy.
Financial innovation as described by Minsky leads to greater increases in asset prices during booms as it permits greater amounts of borrowed funds to flow into asset markets making asset prices more sensitive to the business cycle. As a result the risks of debt deflation during cyclical downturns increases over time. The reasoning behind this is simple - the ultimate effect of all financial innovation is to increase the level of debt relative to income. At the macro level this entails an increase in the debt to GDP ratio.
Therefore the Great Depression can be viewed as the natural course of the business cycle in economies subject to financial innovation. The full downswing portion of the business cycle can be forestalled by Keynesian counter-cyclical policy however this has to be accompanied by financial regulation. If not, financial innovation risks creating pro-cyclical swings in asset prices that will ultimately swamp Keynesian counter-cyclical policy.
Since 1980 we have witnessed the elimination or substantial reduction in almost all legislation governing the financial sector. This combined with disinflation and financial innovation set in motion a period of sustained increase in private credit relative to GDP. The foregoing suggests that an imminent recession could morph into an economic depression if it triggers debt deflation.
There does seems to be little doubt that Bernanke et al. believe that they can mitigate the process of credit contraction through monetary policy. There is an interesting question about the possible inflationary effects.
It is to be expected that Bernanke et al. have all thought about this, and would seek to mask the short term inflationary effects and the indicators of this very phenomenon described by Alex Grey of a sluggish broader money supply as compared to the narrow measures which are more amenable to monetary policy.
There is it seems a significant wild card which few seem to account for explicitly in the relative values of currencies and their impact on the import prices of economically important commodities.
We will be speaking more about this in the future. One of the slants on this that seems worth considering is the difference between the Japanese economic experience, which so many cite, and the Russian experience, which is qualitatively different and perhaps illuminating of important elements and differences therein.
