AMERICAN FUTURE

My apologies to the Beatles and I’m not taking about candidate Cain’s 9-9-9 tax plan.

I’m talking about the new New York Times/CBS News poll revealing that only 9 percent of Americans approve of the job Congress is doing. The disapproval toward Congress has risen 22 percentage points since the beginning of the year, when Republicans took control of the House.

• 89 percent of Americans say they distrust government to do the right thing.
• 74 percent say the country is on the wrong track.
• 49 percent say the economy is at a standstill and 36 percent say it is getting worse.
• 56 percent think that President Obama does not have a clear plan for creating jobs.

A great time for Republicans? Not so fast.

• 46 percent approve of  the job President Obama is doing.
• Two-thirds of the public said that wealth should be distributed more evenly. Nearly 9 in 10 Democrats, two-thirds of independents and just over one-third of all Republicans say that the distribution of wealth in the country should be more equitable, even as a majority of Republicans said they think it is fair.
• Two-thirds object to tax cuts for corporations and a similar number prefer increasing income taxes on millionaires.
• 71 percent of the public say that Congressional Republicans do not have a clear plan for creating jobs.
• In February, a CBS News poll found that 27 percent of the public said the views of the Tea Party movement reflected the sentiment of most Americans. In the current poll, 46 percent of the public said the same of the Occupy Wall Street movement.

Regardless of who becomes the Republican nominee, he will — with virtual certainty — run on a platform that will oppose a more even distribution of wealth and higher taxes on millionaires and favor a reduction in the corporate tax rate. Their policies are out of joint with what the public wants. Sure, the nominee will move toward the center. But when he does, the Democrats will have an almost limitless collection of sound bytes with which to reply.

Sorry for the cliche, but Republicans shouldn’t count their chickens before they hatch.

Now that’s a presumptuous title if I ever saw one. Well, maybe not. The policies being followed by the governments and central banks of the U.S. and Europe clearly aren’t solving the economic crisis. The anemic economic recoveries on both sides of the Atlantic have run out of steam and the world’s stock, credit and commodity markets have plunged in anticipation of worse to come. The markets are telling us that time may be running out to preempt another Lehman moment and a further slump in economic activity that would turn recession into depression. Despite rising investor angst and an ever-growing avalanche of weakening economic indicators, there’s no evidence that the individuals in positions to alter the course of economic events are starting to have second thoughts about current fiscal and monetary policies.

How have the advanced industrial countries of the West arrived at what increasingly appears to be a tipping point?

Immediately after Lehman’s failure, fiscal and monetary policies were loosened in true Keynesian fashion. The West didn’t fall into the financial abyss and the recession didn’t turn into a depression.  Asset values recovered and the recession officially ended in June 2009. The economy ended its 18-month stay in intensive care. As it became evident that the world economy would soon be discharged from the hospital, governments, central bankers, economists and the public refocused their attention to the aftereffect of its stay in intensive care:  ballooning public debt. Preventing financial and economic collapse resulted in the shifting of trillions of dollars of debt from the private sector’s to the public sector’s balance sheet. Rapidly rising unemployment reduced government tax revenue and increased government spending. Government debt-to-GDP ratios rose to unprecedented peacetime levels. With economic recovery underway, concern about the future solvency of government rose to the top of the worry list.

Fiscal Policy: Tightened

With fear of public sector insolvency having overtaken fear of depression, economic policy was ripe for change. The change has taken the form of calls for and the implementation of increasingly austere fiscal policies. Austerity, its advocates argue, is the path to economic salvation. In every country, those who would rely primarily on reduced spending and those who would rely primarily on higher taxes on the wealthy have something in common: both assume that heightened fiscal rectitude will reduce their government’s debt-to-GDP ratio. By lowering the perceived risk of future insolvency, they aver, the private sector’s confidence will improve. Facing the future more confidently, consumers will buy more and business will invest more. This positive feedback loop involving consumers and business will create a self-sustaining, accelerating economic recovery. That recovery will create more jobs, leading to reduced government spending on unemployment insurance and related items and increased government tax revenues. The budget deficit will contract, borrowing requirements will diminish, the debt-to-GDP ratio will fall, and the real –as well as the perceived — risk of insolvency will vanish.

The ramifications of faith in fiscal austerity as the exit strategy from hard times extend beyond the economic to include the political sphere. Intrinsic to this exit strategy are political disagreements over the mix of spending reductions and tax increases. The issue of the distribution of austerity’s pain came to the fore during this summer’s debate — I use the word advisedly — in the U.S., which heavily contributed to the downgrading of the credit rating of America’s sovereign debt. More significant than that downgrade was the public’s disgust with the spectacle in the House of Representatives. It can’t be doubted that the extreme partisanship so vividly on display further undermined consumer and business confidence in the ability of the government to come to grips with a sputtering economy. This feedback from the political to the economic realm revealed itself in the aforementioned steep market declines, which can best be interpreted as a discounting of further economic weakness.

It’s as simple as that, or is it? Spending decreases and tax increases have something in common: if everything else remains constant, they both drain purchasing power from the private sector.  The “everything else” is the effect of fiscal austerity on confidence. For austerity to boost consumption, the positive impact on the propensity to consume of a reduction in the perceived risk of insolvency in the long-term must exceed the negative impact of the reduction of purchasing power in the short-term. Said another way, for austerity to have its intended effect, it must result in a decline in the propensity to save. Only if this requirement is met will business have an incentive to accelerate hiring and capital investment.

If, as I anticipate, fiscal austerity has the opposite of its intended effect, the circle will be vicious rather than virtuous. Budget deficits, borrowing requirements, debt-to-capital ratios and insolvency risks (both perceived and real) will increase. Confidence will erode. The evidence, as highlighted by the unfolding Greek tragedy, indicates that the adverse outcome is the likely outcome.  But this conclusion doesn’t rest upon Greece, which might be considered an exceptional case. More significantly, as fiscal impetus has turned into fiscal drag, the economies of both the U.S. and Europe have slowed and are now either on the verge of, or already in, a contraction phase.  If governments react to this development by further tightening fiscal policies, they will assuredly produce a second worldwide recession. Should this occur, the 2010s will be remembered by future generations as the decade of the Second Great Depression. As noted earlier, there is at present no reason for optimism that governments and a broad swath of the public understand the predicament we now face. Absent such an understanding, the likelihood of further contractionary fiscal actions is disturbingly high.

Monetary Policy: Loosened

Three weeks after Lehman’s bankruptcy, the Fed lowered the Fed funds rate (the interest rate banks charge each other for overnight loans) to 1.5 percent from 2 percent. Two more reductions were announced by the end of 2008. At year’s end, the rate had been reduced to zero percent (more accurately, for technical reasons, the rate was 0.00 to 0.25 percent). For the first time ever, banks in the U.S. with insufficient liquidity could borrow from banks having more liquidity than they needed without incurring interest expense. One need not look further than this to appreciate the seriousness of the financial situation as seen by those closest to it. The Fed funds rate is still zero percent.

The European Central Bank (ECB) is the equivalent of the Federal Reserve for the 17 countries that employ the euro as their currency. In the eurozone, the “deposit facility” interest rate has the same role as the Fed funds rate. As shown in the following table, the ECB’s monetary policy has been somewhat less accomodative. Most importantly, it has twice raised the deposit facility rate during 2011. Inflation fears were the stated reason for the interest rate increases. Still, at 0.75 percent, the interest rate is far below the inflation rate.

Overnight Interest Rates, 2008-2011

During the 12 months following the end of the recession, real (inflation-adjusted) U.S. GDP grew at a disappointingly slow 3.3 percent — far below the norm for the first year of a recovery. What made this sub-par performance  particularly worrisome was that it happened while short-term borrowing costs in the private sector, reflecting the zero percent Fed funds rate, were at historically low levels. During the summer of 2010, Fed Chairman Bernanke telegraphed the Fed’s intention to implement a policy — subsequently dubbed “quantitative easing” — aimed at stimulating the economy by driving down long-term interest rates. In a speech delivered on August 26, 2010, he said that one of the options for providing additional monetary accommodation was “to expand the Federal Reserve’s holdings of longer-term securities,” and added that he believed “that additional purchases of longer-term securities . . . would be effective in further easing financial conditions.” By the time this policy was implemented in late 2010, market participants had fully discounted its intended effect by driving down yields on longer-term fixed-income securities.

Chart 1.

Chart 2.

Still, the economy refused to cooperate. Real GDP growth fell to 3.1 percent during calendar 2010, two-tenths of a percentage point lower than it had been during the 12 months ending in June, 2010. Growth continued to decelerate during the first half of 2011. The Fed’s reaction to the persistent and growing weakness in the economy was to announce “operation twist” on September 21. In a press release titled “What is the Federal Reserve’s maturity extension program (referred to by some as “operation twist”) and what is its purpose?,” the Fed explained:

Under the maturity extension program, the Federal Reserve intends to sell $400 billion of shorter-term Treasury securities by the end of June 2012 and use the proceeds to buy longer-term Treasury securities. This will extend the average maturity of the securities in the Federal Reserve’s portfolio.

By reducing the supply of longer-term Treasury securities in the market, this action should put downward pressure on longer-term interest rates, including rates on financial assets that investors consider to be close substitutes for longer-term Treasury securities. The reduction in longer-term interest rates, in turn, will contribute to a broad easing in financial market conditions that will provide additional stimulus to support the economic recovery.

For three years, the Fed’s policy has been to deflate interest rates. What began as the deflation of short-term rates has been extended all the way out the maturity spectrum to include 30-year Treasury bonds. This latest interest rate deflation, while helping borrowers — in particular, home owners with variable rate mortgages and first-time home buyers — entails noteworthy risks. The most significant of these risks is its impact on bank profitability. Banks, of course, borrow short and lend long. Accordingly, the outlook for bank profits is at its best when the yield differential between short- and long-term fixed-income securities is large. Operation twist narrows the differential; it “flattens” the yield curve. This new headwind facing the banks comes at a time when another headwind — the eurozone’s sovereign debt crisis — is intensifying, with no end in sight. U.S. banks have an exposure of $650 billion to the debt of Greek, Irish, Italian, Portuguese, and Spanish governments. With the housing market still in the doldrums and the mounting possibility of having to write-down the value of their holdings of eurozone public debt, the flattening of the yield curve could not have come at a less propitious moment. The Fed is betting that operation twist won’t increase systemic risk in the U.S. financial system. It’s a bet that the Fed had better win.

The Problem — And the Solution

The U.S. and Europe are suffering from the same underlying disease: economies that never really recovered from the financial crisis and which will continue to stumble along or soon experience the long-feared double-dip. The European situation is worse, and far more complex. The American states are married; they have one monetary policy and one fiscal policy. The eurozone countries are engaged; they have one monetary policy and 17 fiscal policies. Adding to their problems is the fact that their engagement documents don’t allow them to voluntarily break their engagement or to have other members of their extended family force them to call off their engagement. This is reason enough to conclude that, if a way out of the worldwide economic crisis is to be found, it will start in the U.S.

By now, it should be obvious that credit cost deflation — reducing interest rates — isn’t going to revive the American economy. It should be equally obvious that budget deflation — reducing government spending and/or increasing taxes — isn’t going to revive the American economy, either. If the U.S. is going to lead the industrialized West out of the economic wilderness, it must fundamentally change its fiscal and monetary policies.

We should reverse both of these policies. Fiscal policy should become expansionary. Monetary policy should become restrictive. The eurozone’s sovereign debt crisis provides us with a window of opportunity to do both.

The arguments against fiscal stimulus and my counter-arguments are as follows:

• Fiscal stimulus doesn’t work — Those who support this argument point to the anemic economic recovery that began four months after the February, 2009, passage of the Obama administration’s $787 billion stimulus package.  Top advisers within the administration wanted a larger stimulus, but political realities prevailed. In particular, Christine Romer, who was then the chairperson of the Council of Economic Advisers argued for a stimulus package of at least $1.2 trillion. As reported in the New Yorker,

The most important question facing Obama that day [in December 2008] was how large the stimulus should be. Since the election, as the economy continued to worsen, the consensus among economists kept rising. A hundred-billion-dollar stimulus had seemed prudent earlier in the year. Congress now appeared receptive to something on the order of five hundred billion. Joseph Stiglitz, the Nobel laureate, was calling for a trillion. Romer had run simulations of the effects of stimulus packages of varying sizes: six hundred billion dollars, eight hundred billion dollars, and $1.2 trillion. The best estimate for the output gap was some two trillion dollars over 2009 and 2010. Because of the multiplier effect, filling that gap didn’t require two trillion dollars of government spending, but Romer’s analysis, deeply informed by her work on the Depression, suggested that the package should probably be more than $1.2 trillion.

Would a $1.2 trillion plus stimulus have launched the economy onto a faster growth trajectory? There’s no way to know for sure; the best I can do is to provide an analogy. The economy is frequently referred to as an engine. An immobilized car needs to be jump-started. If the external power source that’s connected to the car’s battery isn’t powerful enough, the engine won’t start. A more powerful external source will succeed where the less powerful one failed. Returning to the economy, it’s a fallacy to assert that, because a stimulus program of a certain size produced a disappointing result, any stimulus package, regardless of its size, will be unsuccessful.

• Fiscal stimulus is inflationary — In some circumstances, this is true. But not in the current circumstances. Chart 3 shows that the velocity of money — the rate at which money changes hands in the economy — is now falling after a brief, mild acceleration following the implementation of the stimulus program. With a stagnant or contracting economy ahead, it’s more likely that money velocity will decline further than to reverse direction. Another analogy will drive home this point. The Fed has been pouring billions of gallons of gasoline (money) into the gas tank (the economy), but fewer miles (purchases) are being driven (made).

Chart 3.

• The dollar will weaken — Perhaps, but that’s not necessarily a bad thing, as it would improve our export competitiveness. In fact, as shown in Chart 4, the dollar has significantly strengthened against the euro in recent days. Since the last day depicted in the chart, the value of the dollar has climbed further.

Chart 4.

At the beginning of this section, I said that the eurozone’s sovereign debt crisis provides us with a window of opportunity to reverse the directions of our fiscal and monetary policies. Now it’s time to explain why.

To safeguard their wealth from the effects of the crisis, Europeans are selling euros, buying dollars, and using their dollars to buy U.S. sovereign debt — Treasury notes and bonds. Notwithstanding occasional glimmers of hope, the eurozone’s crisis admits to no simple solution and will continue for an extended period of time. Accordingly, our interest rates will remain at or near their current historical lows. This means that federal government interest expense as a percent of GDP will not become a budget-buster. Simply stated, for as long as the eurozone’s sovereign debt crisis continues, the U.S. will not have a sovereign debt crisis. This provides us with an opportunity to implement a very sizable fiscal stimulus program without risking the deleterious side-effects that such a program would normally entail.

Changing our fiscal policy is only a part of the solution. A sizable stimulus program will put more money into more people’s pockets, but will they, in this age of deleveraging, spend it or save it (paying down credit card debt counts as saving)?

Chart 5.

This is where reversing our monetary policy enters the picture. The price of credit has been declining for three years. Consciously or not, this trend has undoubtedly seeped into the minds of American consumers. This credit price deflation provides an incentive to defer major purchases. The best example, of course, is housing. If, in addition to expecting a further erosion of home prices, a family also anticipates that mortgage rates will continue to decline, it has an added incentive to wait.

With the stimulus program boosting economic activity, the Fed should announce that, starting on a certain date and every three or six months thereafter, it will increase the Fed funds rate by a quarter percentage point and reduce its holdings of long-term government securities by a specified amount. Replacing credit price deflation with credit price inflation will provide the incentive to purchase now rather than in the future.

There you have it. My solution to the economic crisis is to implement policies that are the exact opposite of those currently in place. Replacing one without replacing the other won’t suffice. Fiscal stimulus without credit price inflation would put more money into more pockets without providing an incentive to spend. Credit price inflation without fiscal stimulus would further weaken the economy.

Political Realities

I haven’t been looking forward to writing these final words. Setting forth a solution to the economic crisis is one thing; expecting that for now and the foreseeable future it has a snowball’s chance in hell of being enacted is another.  The current momentum favoring fiscal rectitude is irresistible. Public opinion being what it is, opposing it amounts to political suicide. We will continue down the current path until it has been completely discredited. What will it take for public opinion to reverse direction? One way or another and by the end of this year, we will have started to walk down the path, instead of just talking about it. If my analysis is on the money, it won’t be a pleasant walk. Stagflation without the “flation” is the most optimistic scenario I’m willing to countenance. If, as seems more likely, the unemployment rate rises into the double digits as the effects of fiscal stringency accumulate, it will be interesting to see whether either of our political parties changes its mind as election day approaches. The ideological rigidity of the Republicans makes it next to impossible for them to undertake an about-face. So, if either of the parties is to change its mind, it will be the Democrats. For now, all we can do is to wait and see.

“I will not support — I will not support — any plan that puts all the burden for closing our deficit on ordinary Americans.  And I will veto any bill that changes benefits for those who rely on Medicare but does not raise serious revenues by asking the wealthiest Americans or biggest corporations to pay their fair share.  We are not going to have a one-sided deal that hurts the folks who are most vulnerable.”

President Obama is finally acting . . . well, presidential. In his speech today, he takes on Speaker Boehner head-on:

“You know, last week, Speaker of the House John Boehner gave a speech about the economy.  And to his credit, he made the point that we can’t afford the kind of politics that says it’s “my way or the highway.”  I was encouraged by that.  Here’s the problem: In that same speech, he also came out against any plan to cut the deficit that includes any additional revenues whatsoever.  He said — I’m quoting him — there is “only one option.”  And that option and only option relies entirely on cuts.  That means slashing education, surrendering the research necessary to keep America’s technological edge in the 21st century, and allowing our critical public assets like highways and bridges and airports to get worse.  It would cripple our competiveness and our ability to win the jobs of the future.  And it would also mean asking sacrifice of seniors and the middle class and the poor, while asking nothing of the wealthiest Americans and biggest corporations.

So the Speaker says we can’t have it “my way or the highway,” and then basically says, my way — or the highway.  (Laughter.)  That’s not smart.  It’s not right.  If we’re going to meet our responsibilities, we have to do it together.”

While talking about tax reform, he takes on the signers of Grover Norquist’s pledge not to raise any taxes under any circumstances:

“It is wrong that in the United States of America, a teacher or a nurse or a construction worker who earns $50,000 should pay higher tax rates than somebody pulling in $50 million.  Anybody who says we can’t change the tax code to correct that, anyone who has signed some pledge to protect every single tax loophole so long as they live, they should be called out.  They should have to defend that unfairness — explain why somebody who’s making  $50 million a year in the financial markets should be paying 15 percent on their taxes, when a teacher making $50,000 a year is paying more than that — paying a higher rate.  They ought to have to answer for it.  And if they’re pledged to keep that kind of unfairness in place, they should remember, the last time I checked the only pledge that really matters is the pledge we take to uphold the Constitution.”

As to those who claim he’s engaging in class warfare, he retorts:

“Now, we’re already hearing the usual defenders of these kinds of loopholes saying this is just “class warfare.”  I reject the idea that asking a hedge fund manager to pay the same tax rate as a plumber or a teacher is class warfare.  I think it’s just the right the thing to do.  I believe the American middle class, who’ve been pressured relentlessly for decades, believe it’s time that they were fought for as hard as the lobbyists and some lawmakers have fought to protect special treatment for billionaires and big corporations.”

Obama has laid down the gauntlet. No more pulling punches, no more Mr. Nice Guy. It’s going to be a fight to the November 2012 finish.

No doubt about it — when it comes to bumper-sticker-sized slogans, Republicans have it all over Democrats. In fact, I can’t think of a single slogan of this type — or any other type — emanating from the Democrats. Whoever it was that came up with “it’s the economy, stupid” isn’t around anymore, and no one has taken his place. While I’m mindful of the fact that slogans don’t always win elections (“In your heart you know he’s right” didn’t propel Barry Goldwater into the Oval Office), part of the Democrats’ problem as we approach 2012 may simply be that they’re at the bottom of the class when it comes to sloganeering.

The nice thing about “class warfare” and “job-killing” is that they can be used to criticize any and all economic programs proposed by President Obama and Congressional Democrats. They’ve taken the place of the one-word slogans  “socialist” and “communistic” employed by Republicans to discredit programs set forth by Democrats from the 1930s to the 1950s. Well, that’s not quite true: occasionally, Obama is accused of being a socialist. His opponents on the Left take strong exception to this description.

Because of their wide applicability, “class warfare” and “job-killing” can and are repeated time and time again. When Congress is in session, it’s an almost daily event. When primary season is approaching, as it is now, it is a daily event. You’d have to escape the confines of the U.S. to avoid being browbeaten. Regardless of your political persuasion, these slogans have sunk into your subconscious mind. If you’re on the fence, it may tip you to the Republican side — that’s the intent, after all. If you’re against the president, your pre-existing condition is reinforced. If you support the president, you’ll experience a severe case of revulsion, and you’ll accuse — justifiably, in my view — the Republicans, not the Democrats, of instigating class warfare and killing jobs. It is disingenuous to argue, as Representative Paul Ryan did today, that increasing taxes on millionaires to help fund the jobs program “punishes job creation” and incites “class warfare.” During the Clinton era, tax rates for the wealthy were higher than now, millions of jobs were created, and there was no class warfare. Wealthy Americans didn’t wait until the Bush tax cuts to stop playing golf and go to work.

“Class warfare” and “job-killing” are the current examples of pure, unadulterated propaganda. What is the purpose of propaganda, especially propaganda that’s repeated over and over again? It’s to crowd-out serious thinking,  investigation, and consideration of the motives and programs of the propagandists. A media that thrives on 30-second sound-bites — the verbal equivalent of bumper stickers — thrives on it. There’s no equal-time provision for a party that gets an F in sloganeering.

The Democrats suffer from sloganeering-deficit-disorder. It may cost them the presidency.

Sometimes, a single picture tells it all:

Here’s what PIMCO’s Bill Gross has to say about this clearly unsustainable situation:

During this country’s recent economic “recovery,” real corporate profits increased by four times the amount of working wages in dollar terms, and, as the chart below shows, are 50% higher than at the turn of the century while wages remain relatively unchanged, something that has not occurred since this country’s nuptials were concluded over three centuries ago. Is it any wonder that preliminary battlefield skirmishes in Wisconsin and Ohio between labor and capital promise to spread across every state of this land? (Not Texas!) Is it any wonder that Republican orthodoxies favoring tax cuts for the rich and Democratic orthodoxies promoting entitlements for the poor threaten to hamstring any constructive efforts to reduce unemployment over the foreseeable future? We are witnessing romantic love turning into a spiteful, bitter clash between partners in name only. [Emphasis not added]

Of course, it’s not surprising that corporate profits are more volatile than compensation. But there’s world of difference between periods of time when both are rising (as in 2003-2006) and those when profits are rising and compensation is not only not rising but is below that of three years ago. If I were a strategist for Obama, I would do everything in my power to imprint this chart in the minds of voters. The Republicans would cry “class warfare,” that Obama was pitting the poor against the rich. Obama would agree that there was class warfare, but of the rich against the poor. The facts would be on Obama’s side.

As to the unsustainability of  the situation, one need only ask how much longer profits can rise if purchasing power doesn’t increase.

The results of the latest CNN/ORC poll suggest that the public is more inclined to blame the Republican Party and the Tea Party than the Democratic Party for our dysfunctional government.

The poll asked the following question: “We’d like to get your overall opinion of some people in the news. As I read each name, please say if you have a favorable or unfavorable opinion of these people — or if you have never heard of them. (RANDOM ORDER)”

The results are in the following table. If the unfavorable percentage is subtracted from the favorable percentage, the Democratic Party is the clear winner:

• Democratic Party: 0 percentage points
• Republican Party: minus 26 percentage points
• Tea Party: minus 20 percentage points

A picture is worth a thousand words. Shades of gray vs. black-and-white. From the Economist:

Yesterday, I asked whether another 1931 was in the offing. Now I’m asking whether another 1937 is in the offing. It seems like I’m a congenital worrier. I don’t like it, but I can’t help it. How can I be an optimist, when (1) the European Central Bank is increasing interest rates , (2) the Bank for International Settlements is advising central banks to tighten their monetary policies to prevent inflation from accelerating, (3) the European financial contagion in spreading and, most disturbingly, (4) the U.S. is on the verge of implementing substantial budget cuts that will take effect at a time of stagnating employment?

In addition to writing about these current concerns, I took a look at the 1937-1938 recession — the recession within the depression — and drew the following conclusion: changes in fiscal policy — deficit reduction and spending reduction — were major contributors to the decline in industrial production that occurred during the the 1937-1938 recession.

Are “deficit reduction” and “spending reduction” familiar? Of course they are. Both are on their way — and soon. Fortunately (for me, at least), Bruce Bartlett — who held senior policy roles in the Reagan and George H.W. Bush administrations and served on the staffs of Representatives Jack Kemp and Ron Paul — shares my concern that we may soon experience a modern day version of the 1937-1938 recession. Despite our differing political views (I’m a lifelong independent, which he clearly isn’t), we see the situation in a similar, if not identical, light.

I see nothing to argue with in his Economix post, which asks “Are We About to Repeat the Mistakes of 1937?” In the following, the emphases are mine.

It is starting to look like 1937 all over again. As the table below indicates, the economy made a significant recovery after hitting bottom in 1932, when real gross domestic product fell 13 percent. The contraction moderated considerably in 1933, and in 1934 growth was robust, with real G.D.P. rising 11 percent. Growth was also strong in 1935 and 1936, which brought the unemployment rate down more than half from its peak and relieved the devastating deflation that was at the root of the economy’s problems.

By 1937, President Roosevelt and the Federal Reserve thought self-sustaining growth had been restored and began worrying about unwinding the fiscal and monetary stimulus, which they thought would become a drag on growth and a source of inflation. There was also a strong desire to return to normality, in both monetary and fiscal policy.

On the fiscal side, Roosevelt was under pressure from his Treasury secretary, Henry Morgenthau, to balance the budget. Like many conservatives today, Mr. Morgenthau worried obsessively about business confidence and was convinced that balancing the budget would be expansionary. In the words of the historian John Morton Blum, Mr. Morgenthau said he believed recovery “depended on the willingness of business to increase investments, and this in turn was a function of business confidence,” adding, “In his view only a balanced budget could sustain that confidence.”

Roosevelt ordered a very big cut in federal spending in early 1937, and it fell to $7.6 billion in 1937 and $6.8 billion in 1938 from $8.2 billion in 1936, a 17 percent reduction over two years.

At the same time, taxes increased sharply because of the introduction of the payroll tax. Federal revenues rose to $5.4 billion in 1937 and $6.7 billion in 1938, from $3.9 billion in 1936, an increase of 72 percent. As a consequence, the federal deficit fell from 5.5 percent of G.D.P. in 1936 to a mere 0.5 percent in 1938. The deficit was just $89 million in 1938.

At the same time, the Federal Reserve was alarmed by inflation rates that were high by historical standards, as well as by the large amount of reserves in the banking system, which could potentially fuel a further rise in inflation. Using powers recently granted by the Banking Act of 1935, the Fed doubled reserve requirements from August 1936 to May 1937. Higher reserve requirements restricted the amount of money banks could lend and caused them to tighten credit.

This combination of fiscal and monetary tightening – which conservatives advocate today – brought on a sharp recession beginning in May 1937 and ending in June 1938, according to the National Bureau of Economic Research. Real G.D.P. fell 3.4 percent in 1938, and the unemployment rate rose to 12.5 percent from 9.2 percent in 1937.

Economists are still debating the precise causes of the 1937-8 recession. While most say they believe that fiscal tightening is primarily to blame, some disagree. Perhaps it would have been positive if tightening was confined to the spending side of the budget, without the large increase in taxes. Maybe the fiscal contraction would have been benign if the Fed hadn’t tightened monetary policy simultaneously.

Given President Obama’s endorsement of large budget cuts, the only question now appears to be how much fiscal policy will tighten and how fast. If it is back-loaded and mainly involves cuts in transfer programs, the impact on growth may be modest. But if – as I suspect Republicans will demand – the spending cuts are front-loaded and involve reductions in government consumption and investment spending, the impact could be severe.

While it’s unlikely that the Fed will repeat its error of 1936-7 and raise reserve requirements or the federal funds rate, it has already begun de facto tightening by moving from monetary stimulus to a more neutral stance. Moreover, with interest rates on Treasury bills hovering near zero, there is little it can do to stimulate growth on the monetary side.

While the odds of another recession are still low, they are increasing. Given the economy’s fragility, policy makers need to be very careful, because it may take only a small misstep on either the monetary or fiscal side to tip the balance. The experience of 1937-38 should be a warning.

Yes, there’s reason to worry. What if both a 1931 and a 1937 are in the offing?

New York Times columnist David Brooks is, by his own admission, a Republican. A very disgruntled Republican.

In today’s column, Brooks, who certainly ranks as a Washington insider, says that “many important Democrats,” including President Obama and Senate majority leader Reid, “are open to a truly large budget deal.”  Republicans, he asserts, are being offered “the deal of the century”: trillions of dollars in spending cuts in exchange for a few hundred million dollars of revenue increases.

A “normal” Republican party would jump at this deal. Today’s GOP, however, isn’t normal:

But we can have no confidence that the Republicans will seize this opportunity. That’s because the Republican Party may no longer be a normal party. Over the past few years, it has been infected by a faction that is more of a psychological protest than a practical, governing alternative.

The members of this movement do not accept the logic of compromise, no matter how sweet the terms. If you ask them to raise taxes by an inch in order to cut government by a foot, they will say no. If you ask them to raise taxes by an inch to cut government by a yard, they will still say no.

The members of this movement do not accept the legitimacy of scholars and intellectual authorities. A thousand impartial experts may tell them that a default on the debt would have calamitous effects, far worse than raising tax revenues a bit. But the members of this movement refuse to believe it.

The members of this movement have no sense of moral decency. A nation makes a sacred pledge to pay the money back when it borrows money. But the members of this movement talk blandly of default and are willing to stain their nation’s honor.

The members of this movement have no economic theory worthy of the name. Economists have identified many factors that contribute to economic growth, ranging from the productivity of the work force to the share of private savings that is available for private investment. Tax levels matter, but they are far from the only or even the most important factor.

But to members of this movement, tax levels are everything. Members of this tendency have taken a small piece of economic policy and turned it into a sacred fixation. They are willing to cut education and research to preserve tax expenditures. Manufacturing employment is cratering even as output rises, but members of this movement somehow believe such problems can be addressed so long as they continue to worship their idol.

And how have the Democrats have reacted to the Republican intransigence (and, I would add, irrationality)?

Over the past week, Democrats have stopped making concessions. They are coming to the conclusion that if the Republicans are fanatics then they better be fanatics, too.

What will happen if the U.S. defaults?

If the debt ceiling talks fail, independents voters will see that Democrats were willing to compromise but Republicans were not. If responsible Republicans don’t take control, independents will conclude that Republican fanaticism caused this default. They will conclude that Republicans are not fit to govern.

And they will be right.

I wish I were as certain that, in the eventuality of a default, the American people would place the blame where it belongs. As I noted in a previous post, only one in five are in favor of having the debt ceiling raised.

Add the Washington Post’s Robert Samuelson to the growing list of pundits who are fed up with the political discourse regarding the budget deficit. In a column somewhat reminiscent of  a recent op-ed by David Brooks, Samuelson takes both liberals and conservatives to task:

We are now engaged in a messy debate over big budget deficits and the size of government. The struggle nominally pits liberals against conservatives, but this is misleading. The real debate involves reactionaries vs. radicals. Many liberals are reactionaries and many conservatives are radicals.

A reactionary is someone who, says Webster’s Collegiate Dictionary, desires “a return to an earlier system or order.” This defines many liberals. They “pine,” Michael Barone writes in the Wall Street Journal, for “the golden years of the 1940s, ’50s and early ’60s [when] . . . Americans had far more confidence in big government.” Modern liberals want yet-bigger government to enhance social justice. They defend virtually all Social Security and Medicare benefits. Everything can be financed, they suggest, by cutting defense or increasing taxes on the rich.

Conservatives have become radical by seeking “drastic political, economic or social reform.” Their obsession with tax cuts when even today’s taxes don’t cover today’s spending implies radically shrinking government programs that are woven into America’s social fabric. All this ignores a basic conservative tenet: to respect existing institutions and traditions that anchor the social order. Change — especially radical change — is a last resort, not because today’s world is perfect but because efforts to improve it might make it worse.

Both visions are unrealistic. Given an aging population — which boosts Social Security and Medicare spending — government is automatically expanding. Since 1971, federal spending has averaged 21 percent of the economy (gross domestic product); just continuing present programs could easily raise that to 28 percent of GDP by 2021. The liberal-reactionaries can’t smoothly finance that. In 2011, the deficit is already twice the entire defense budget. The richest 10 percent already pay 55 percent of federal taxes. The blanket embrace of all benefits for the elderly — no matter how rich — will require much higher taxes or steep cuts in other programs, including those for the poor.

The conservative-radicals are no better. Since 1971, federal taxes have averaged about 18 percent of GDP. There is no believable plan to reduce federal spending below that level, even with sizable cuts in Social Security and Medicare benefits. So promises of more tax cuts either border on dishonesty or imply huge unspecified spending cuts that would devastate national defense, states and localities, and the poor.

A dilemma of democracy is the difficulty of making changes that, though essential for society’s long-term well-being, are unpopular in the short run. That describes today’s budget deadlock. To be sure, not all conservatives and liberals have become radicals and reactionaries. But many have. If we applied true labels to them — reactionaries and radicals — we would clarify the debate and compel them to deal with the world as it exists, not as they imagine it. Dream on.

Our politicians prefer self-serving fantasies. Americans are misinformed, and consensus becomes harder. Democrats won’t admit the need for major benefit cuts in Social Security and Medicare; Republicans won’t concede the necessity for higher taxes. The result is that our leaders are now playing a game of brinkmanship over raising the federal debt ceiling or defaulting. Liberals say spending cuts now would subvert the recovery; conservatives find that an excuse not to cut. Surely a compromise would be phasing in credible future cuts.