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?