... Romer and Bernanke are playing a dangerous game. They are also operating under false premises. First of all, the Great Depression was not caused by a "lack of aggregate demand" but by the malinvestment brought on by the Fed’s monetary inflation of the 1920s. The reason the depression lasted so long was that the government refused to allow the malinvestment to liquidate.One point which needs a little more elaboration is that the money consumers refuse to spend as they weather the recessionary storm is funding for future investment and consumption. Fiscal and monetary stimulus is a finite process of accelerating future wealth to fund present consumption. The stimulus "works," therefore, but only at the cost of future prosperity.
As for the asset and price deflation of the Great Depression, this was not the result of the Fed’s failure expand the money supply but a result of a drop in the velocity of money – the rate at which money exchanges hands. As Murray Rothbard has illustrated in America’s Great Depression, bank reserves actually increased throughout the Great Depression. However, banks were leery of lending, fearing bank runs and failure. The demand for money was high as people sought safety by holding onto cash; saving and not spending. All of this meant that the price of commodities other than money dropped as people would rather hold onto their money than spend it.
The situation is much similar to what we face today. Unfortunately, because Bernanke believes that the Great Depression could have been avoided if the Fed had inflated aggressively, he has readied an inflationary tsunami. The only thing holding this tidal wave of dollars back is that much of it is still sitting in bank reserves and the velocity of money is still low. Count on Romer and the government to do everything and anything necessary to change that.
Bernanke believes that once the economy takes off again, he will be able to remove the "excess liquidity" from the system by selling the Fed’s assets. Unfortunately, he faces a big problem. Much of the increase in the Fed’s balance sheet is the result of the Fed removing toxic assets from the banking system. Ummm, they are called toxic for a reason; no one wants them. To whom then is Bernanke going to sell them? ...