*The lessons of 1937
<http://www.economist.com/businessfinance/PrinterFriendly.cfm?story_id=13856176>
* Jun 18th 2009
>From The Economist print edition
*In a guest article, Christina Romer says policymakers must learn from the
errors that prolonged the Depression*
AP [image: AP]
*Christina Romer is the chairwoman of Barack Obama's Council of Economic
Advisers and a scholar of the Depression*
AT A recent congressional hearing I cautiously noted some “glimmers of hope”
that the economy could stabilise and perhaps start to rebound later in the
year. I was asked if this meant that we should cancel much of the remaining
spending in the $787 billion American Recovery and Reinvestment Act. I
responded that the expected recovery was both months away and predicated on
Recovery Act spending ramping up greatly. Only later did it hit me that I
should have told the story of 1937.
The recovery from the Depression is often described as slow because America
did not return to full employment until after the outbreak of the second
world war. But the truth is the recovery in the four years after Franklin
Roosevelt took office in 1933 was incredibly rapid. Annual real GDP growth
averaged over 9%. Unemployment fell from 25% to 14%. The second world war
aside, the United States has never experienced such sustained, rapid growth.
However, that growth was halted by a second severe downturn in 1937-38, when
unemployment surged again to 19% (see chart). The fundamental cause of this
second recession was an unfortunate, and largely inadvertent, switch to
contractionary fiscal and monetary policy. One source of the growth in 1936
was that Congress had overridden Mr Roosevelt’s veto and passed a large
bonus for veterans of the first world war. In 1937, this fiscal stimulus
disappeared. In addition, social-security taxes were collected for the first
time. These factors reduced the deficit by roughly 2.5% of GDP, exerting
significant contractionary pressure.
**
Also important was an accidental switch to contractionary monetary policy.
In 1936 the Federal Reserve began to worry about its “exit strategy”. After
several years of relatively loose monetary policy, American banks were
holding large quantities of reserves in excess of their legislated
requirements. Monetary policymakers feared these excess reserves would make
it difficult to tighten if inflation developed or if “speculative excess”
began again on Wall Street. In July 1936 the Fed’s board of governors stated
that existing excess reserves could “create an injurious credit expansion”
and that it had “decided to lock up” those excess reserves “as a measure of
prevention”. The Fed then doubled reserve requirements in a series of steps.
Unfortunately it turned out that banks, still nervous after the financial
panics of the early 1930s, wanted to hold excess reserves as a cushion. When
that excess was legislated away, they scrambled to replace it by reducing
lending. According to a classic study of the Depression by Milton Friedman
and Anna Schwartz, the resulting monetary contraction was a central cause of
the 1937-38 recession.
The 1937 episode provides a cautionary tale. The urge to declare victory and
get back to normal policy after an economic crisis is strong. That urge
needs to be resisted until the economy is again approaching full employment.
Financial crises, in particular, tend to leave scars that make financial
institutions, households and firms behave differently. If the government
withdraws support too early, a return to economic decline or even panic
could follow. In this regard, not only should we not prematurely stop
Recovery Act spending, we need to plan carefully for its expiration.
According to the Congressional Budget Office, the Recovery Act will provide
nearly $400 billion of stimulus in the 2010 fiscal year, but just over $130
billion in 2011. This implies a fiscal contraction of about 2% of GDP. If
all goes well, private demand will have increased enough by then to fill the
gap. If that is not the case, broad policy support may need to be sustained
somewhat longer.
Perhaps a more fundamental lesson is that policymakers should find
constructive ways to respond to the natural pressure to cut back on
stimulus. For example, the Federal Reserve’s balance-sheet has more than
doubled during the crisis, drawing considerable attention. Monetary
policymakers have made it clear that they believe continued monetary ease is
appropriate. Moreover, the Fed’s credit programmes are to some degree
self-eliminating: as demand for its special credit facilities shrinks, so
will its balance-sheet. But now may also be a sensible time to grant the Fed
additional tools to help its balance-sheet contract once the economy has
recovered. Some have suggested that the Fed be authorised to issue debt, as
many other central banks do. This would enhance its ability to withdraw
excess cash from the financial system. Granting such additional tools now
could provide confidence that the Fed will be able to respond to
inflationary pressures, without it having to create that confidence by
actually tightening prematurely.
*Fiscal health check*
Now is also the time to think about our long-run fiscal situation. Despite
the large budget deficit President Obama inherited, dealing with the current
crisis required increasing the deficit substantially. To switch to austerity
in the immediate future would surely set back recovery and risk a 1937-like
recession-within-a-recession. But many are legitimately concerned about the
longer-term budget situation. That is why the president has laid out a plan
to shrink the deficit he inherited by half and has repeatedly emphasised the
need to reduce the long-term deficit and put the debt-to-GDP ratio on a
declining trajectory. In this regard, health-care reform presents a golden
opportunity. The fundamental source of long-run deficits is rising
health-care expenditures. By coupling the expansion of coverage with reforms
that significantly slow the growth of health-care costs, we can dramatically
improve the long-run fiscal situation without tightening prematurely.
As someone who has written somewhat critically of the short-sightedness of
policymakers in the late 1930s, I feel new humility. I can see that the
pressures they were under were probably enormous. Policymakers today need to
learn from their experiences and respond to the same pressures
constructively, without derailing the recovery before it has even begun.
--
Best Regards,
Jay Shah
"Expect The Unexpected"
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