AMERICAN FUTURE

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.

“The markets have highlighted a fundamental shortcoming in Keynes’s ideas: He assumed that governments would always be able to borrow. If they cannot, then Keynesian economics is dead in the water.”

Long-term, large-picture perspectives of our unhappy times are extraordinarily useful and unfortunately rare. I’ve found one in the current issue of Foreign Policy magazine, in an article titled “Life After Debt” by James McDonald. His important article should be read from beginning to end. What follows are the concluding paragraphs.

By the early 2000s, it seemed that the solution for almost every problem in the Western world, personal as well as macroeconomic, was to borrow. Not anymore. The message received from both markets and voters Europe and in America is that the era of ever-higher debt is over.

Indeed, one of the most striking aspects of the eurozone crisis is that bond markets have not discriminated between causes of excessive debt. Greece was denied credit and had to go begging to Brussels for a bailout, not because it had taken part in the real estate bubble but because it had abused entry to the eurozone to enjoy a public borrowing spree. Ireland was denied credit because, even though its public finances were in solid shape, it had allowed its banks to overwhelm them. Italy is perhaps the most remarkable case of all. It is now threatened with loss of credit, not because of any post-euro borrowing, nor because of its current budget deficit (which is not much higher than Germany’s). Rather, it is being punished for sins committed in the 1980s and early 1990s when it built up its public debt to levels that the markets have suddenly decided are unsustainable. What we are seeing, in other words, is a wholesale revision of the rules about debt that have held true for decades.

The markets have highlighted a fundamental shortcoming in Keynes’s ideas: He assumed that governments would always be able to borrow. If they cannot, then Keynesian economics is dead in the water. In the European periphery, the markets have preempted the austerity debate by refusing to lend. But even where markets have not forced the issue, voters have been taking matters into their own hands. Germany may have enacted stimulus measures in 2008, but it followed that by adopting a stringent deficit reduction program in 2009, including a balanced budget amendment to the constitution. Britain’s Conservatives, who had been wandering in the political wilderness for more than a decade, seemed out of the mainstream when they proposed cutting the deficit in 2009. The following year, the party was voted into power amid a debate that changed the political climate so dramatically that all parties were soon proposing relatively similar austerity programs. The United States, the last holdout of fulsome deficit spending under President Barack Obama, lurched sharply rightward in the 2010 congressional election. Now, as in Britain, what originally seemed like a minority opinion in favor of fiscal austerity has become accepted policy, with congressional Republicans bent on slashing the budget at any cost and the White House’s Keynesian voices now drowned out by the administration’s chorus of deficit hawks.

It is not clear that the bond markets or voters who have called an end to Keynesianism have a clear vision of what lies ahead. The former know only that they are no longer willing to lend, the latter that they are no longer willing to borrow. The great debt experiment has left the Western world with a problem that has no easy solution. The outcome is hard to predict, but in the end it is likely to involve the reduction of both private and public debts to levels that the markets consider sustainable — whether by debt write-offs or through inflation. One thing seems clear: For the first time in decades, borrowing will not form part of the solution.

Another opinion that falls into the “things are even worse than you think” category, this time from PIMCO‘s Bill Gross:

Nothing in the Congressional compromise reached over the weekend makes a significant dent in our $1.5 trillion deficit. “Out year” fantasies, as opposed to “current year” realities, is an apt description of the spending cuts that characterize this compromise. The Office of Management and Budget (OMB) estimates that future deficits will be reduced at most by .5%, and if so, it would be welcomed, but that .5% comes with no new taxes and a continuation of the belief that we don’t have to pay for our trespasses. Like many a Banana Republic, we may one day be invoking the Lord’s Prayer, pleading – “Forgive us our debts, as we forgive our debtors,” yet at the same time looking towards the heavens á la Saint Augustine with a fervent “let me be chaste, but let it be tomorrow.”

Treasury Secretary Tim Geithner noted last week that it would be unthinkable that the U.S. would not meet its obligations on time. Now that the timeliness has temporarily been put aside, an investor must logically ask how we will meet our obligations, and how much they really are. In addition to an existing nearly $10 trillion of outstanding Treasury debt, the U.S. has a near-unfathomable $66 trillion of future liabilities at “net present cost.” As shown in the following table from a Mary Meeker “USA Inc.” study, and validated by the Department of Treasury and Congressional Budget Office (CBO) calculations, the combined present cost “payment due” from Medicaid, Medicare and Social Security is over six times our current obligations of Treasury debt. The press and most professional investors are accustomed to measuring “paper” debt as opposed to walking/living liabilities in the form of people. I call these liabilities “debt men walking” because as long as 330 million living Americans require promised entitlements – the $66 trillion that wear shoes are as much of a liability as the $10 trillion on paper. [Emphasis in the original]

 

From the London office of Morgan Stanley comes this observation:

For how long will household indebtedness weigh on spending? There is, actually, some good news from the champions of deleveraging, the US. American households are actually very close to sustainable levels for both debt service and debt in relation to disposable income, our US team thinks: it estimates the former at 11-12% of disposable income; the latter in an 80-100% range. As of 1Q11, these metrics stand at 11.5% and 106.5%, respectively. This informs our view that the consumer sector will not be the headwind to the US economic outlook that many expect it to be.

One of the most often talked-about solutions to the Greek financial crisis is to have the European Central Bank issue eurobonds. Such bonds would carry a lower interest rate than does the sovereign debt issued by the Greek government. This would make it easier for Greece to climb out of the financial hole in which it now resides.

So far, so good. But what about the potential spillover effects of eurobonds?

In an article titled “U.S. Treasury Holders Grin and Bear It,” the Wall Street homes in on China — the largest holder of U.S. government debt. After noting, as have many others, that self-impact considerations make it highly unlikely that the Chinese will decide to dump our securities, the articles says China

has few other options on where to park the bulk of its cash. The key lies in the mainland’s continued reliance on an export-driven growth model, supported by an undervalued yuan. China’s trade surplus is shrinking, yet it was still $46 billion in the last quarter. And in order to keep the yuan stable against the dollar, China’s central bank still has to buy up every cent that enters the country.

Once it has those surplus dollars, the options for investing them anywhere other than U.S. Treasurys are limited. A debt deal in Europe is good news on that front, but the sovereign-debt market remains fragmented, meaning there is no comparably liquid, high-quality euro bond available. [My emphasis]

The linkage is clear: if and when a liquid, high-quality eurobond market comes into existence, the Chinese would have an attractive alternative to U.S. government securities in which to invest. Thus, it is possible that the most desirable solution to the eurozone financial crisis would drive up U.S. interest rates.

From the Congressional Quarterly:

 

Until a couple of years ago, the aggregate (private sector + public sector) debt-to-GDP ratios of the U.S. and the eurozone had been nearly identical. More recently, according to Morgan Stanley (no link), the two ratios have diverged. Here, deleveraging — while modest — is a fairly well-established trend. In the eurozone, deleveraging has only very recently begun (if, indeed, it has begun at all).

Ever since the publication in 2009 (and, perhaps, before) of their This Time Is Different: Eight Centuries of Financial Folly, Carmen Reinhart and Kenneth Rogoff  (R & R) have been the go-to sources on the subject of public sector debt. Today, in a Bloomberg op-ed rather provocatively titled “Reinhart & Rogoff: The Economy Can’t Grow,” the two oracles respond to the many “prominent public intellectuals” who continue to argue that, when it comes to advanced industrial countries, debt phobia is “wildly overblown.”

Specifically, R & R say that “there is a growing perception that today’s low interest rates for the debt of advanced economies offer a compelling reason to begin another round of massive fiscal stimulus.” While they give cursory support to the view that “governments must exercise caution in gradually reducing crisis-response spending,” they think “it would be folly to take comfort in today’s low borrowing costs, much less to interpret them as an ‘all clear’ signal for a further explosion of debt.”

As always, R & R’s opinions are empirically-based:

Several studies of financial crises show that interest rates seldom indicate problems long in advance. In fact, we should probably be particularly concerned today because a growing share of advanced country debt is held by official creditors whose current willingness to forego short-term returns doesn’t guarantee there will be a captive audience for debt in perpetuity.

Those who would point to low servicing costs should remember that market interest rates can change like the weather. Debt levels, by contrast, can’t be brought down quickly. Even though politicians everywhere like to argue that their country will expand its way out of debt, our historical research suggests that growth alone is rarely enough to achieve that with the debt levels we are experiencing today.

The recent upward spikes in interest rates on sovereign debt in several eurozone countries certainly support their contention that bond investors can be myopic and engage in herd behavior. While R & R don’t say so explicitly, it’s clear — to me, at least — that the intent of their op-ed is to counter complacency regarding the future interest rate trend of U.S. government securities. As always, however, timing is everything. As my repeatedly-stated bearish view on the near-to-intermediate term prospects for U. S. economic growth suggests, I don’t believe that we’ll experience an upward spike in U.S. interest rates in the foreseeable future. Of course, in the long term, an ambiguous term if I ever heard one, anything can happen. The only long term certainty, as Keynes famously said, is that we’ll all be dead. From my own experience, being right, but early, is to be wrong.

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?

In my previous post, I noted that the charts in Representative Paul Ryan’s report (“The Debt Overhang and the U.S. Jobs Malaise”) came from John B. Taylor’s blog. What I neglected to say is that Taylor isn’t just anyone. In fact, Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University and George P. Shultz Senior Fellow in Economics at the Hoover Institution. His lengthy and impressive c.v. is here.

It turns out that Professor Taylor engaged in some verbal fisticuffs starting last summer with an even better known professor of economics: Paul Krugman — Nobel prize winner, died-in-the-wool Keynesian, and New York Times columnist. Their disagreement was over the explanation for the slowdown in the U.S. economic recovery that was then underway. Krugman claimed that a diminishing impact from the stimulus package enacted in early 2009 was the culprit. Taylor claimed that stimulus packages don’t stimulate and could therefore not be responsible for the slowdown.

Now we come to the interesting part. In an article posted on the Bloomberg website, Taylor said this about Krugman:

With no empirical evidence connecting the weak recovery to a fading-out of stimulus, Krugman appeals to history, and the year 1937 in particular. After three years of strong economic recovery, with real gross-domestic-product growth of more than 10 percent per year, the U.S. economy slowed and went into a recession in 1937 and 1938. Krugman says it was a “fiscal and monetary pullback that aborted an ongoing economic recovery” and that the same thing is happening in the U.S. today.

Not so, according to Taylor: “the fading-out of fiscal stimulus can’t explain the weak recovery in 2011 — even if it could explain the decline in 1937, which is unlikely anyway.”

It just so happens that I’ve recently done a good deal of research on the 1937-1938 recession — or, as I prefer to call it, the recession within the depression. The results of my work are depicted in the following chart:

[Note: Normalized indices for Federal Spending and Federal Deficit are derived from rolling 12 month totals of reported data; the normalized index for Industrial Production is derived from reported monthly data. The data for all three times series is from various issues of the Federal Reserve Monthly Bulletin published in the 1930s.]

The construction of this chart requires some explanation:

• I chose the Industrial Production Index (IPI) (the green line) as the indicator of trends in the real economy because it was (and still is) issued on a monthly basis. It is therefore a more sensitive indicator that other indicators (such as GDP), as they were (and still are) are issued on a quarterly basis. The IPI peaked in May, 1937, and showed little change through August. Starting in September, it declined at a rapid rate through May, 1938. The peak-to-trough decline in the IPI was 33.98 percent. I re-indexed the IPI so that an index value of 100 was assigned to its May, 1937 peak level.
• The other three times series were re-indexed in the same way.
• The peak level of the federal deficit (the red line) was reached in July, 1937. Between then and June, 1938, the deficit declined by 51.4 percent. The decline in the deficit began two months before the start of the precipitous drop in the IPI. The deficit’s decline ended one month after the IPI’s decline terminated.
• Federal spending (the blue line) peaked in September, 1937, the same month as the start of the rapid decline in the IPI. It had fallen by 7.8 percent when it bottomed in June, 1938, one month after the trough in the IPI.

From my work, the conclusion is inescapable: 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. It is equally evident, that when those fiscal policies were reversed, industrial production recovered. In 1937-1938, the removal and subsequent addition of stimulus worked exactly as Keynesian economics would predict.

Sorry, Professor Taylor.

It’s clear what’s next on my to-do list: using the same methodology, to look at the period following the onset of recession in December, 2007.  Stay tuned.