Sunday, August 29, 2010

Lessons of 1937

Here are some bits from a paper given on March 9, 2009 by Christina Romer, Obama's Chair of the Council of Economic Advisors. It demonstrates that she knew exactly how bad a mistake it would be to create a stimulus that was too small. But Obama went ahead and went for a stimulus which was too small and which "compromised" with Republicans and wasted a third of it on tax cuts which had little or no stimulative effect on the economy. In short, Obama's "stimulus" was a tragedy because it was known at the time that going in with too small a stimulus was a bad idea, but he went ahead and did it...

This discussion of fiscal and monetary policy in the 1930s leads me to a third lesson from the Great Depression: beware of cutting back on stimulus too soon.

As I have just described, monetary policy was very expansionary in the mid-1930s. Fiscal policy, though less expansionary, was also helpful. Indeed, in 1936 it was inadvertently stimulatory. Largely because of political pressures, Congress overrode Roosevelt’s veto and gave World War I veterans a large bonus. This caused another one-time rise in the deficit of more than 1.5% of GDP.

And, the economy responded. Growth was very rapid in the mid-1930s. Real GDP increased 11% in 1934, 9% in 1935, and 13% in 1936. Because the economy was beginning at such a low level, even these growth rates were not enough to bring it all the way back to normal. Industrial production finally surpassed its July 1929 peak in 7 December 1936, but was still well below the level predicted by the pre-Depression trend.19 Unemployment had fallen by close to 10 percentage points—but was still over 15%. The economy was on the road to recovery, but still precarious and not yet at a point where private demand was ready to carry the full load of generating growth.
In this fragile environment, fiscal policy turned sharply contractionary. The one-time veterans’ bonus ended, and Social Security taxes were collected for the first time in 1937. As a result, the deficit was reduced by roughly 2.5% of GDP.

Monetary policy also turned inadvertently contractionary. The Federal Reserve was becoming increasingly concerned about inflation in 1936. It was also concerned that, because banks were holding such large quantities of excess reserves, open-market operations would merely cause banks to substitute government bonds for excess reserves and would have no impact on lending. In an effort to put themselves in a position where they could tighten if they needed to, the Federal Reserve doubled reserve requirements in three steps in 1936 and 1937. Unfortunately, banks, shaken by the bank runs of just a few years before, scrambled to build reserves above the new higher required levels. As a result, interest rates rose and lending plummeted.

The results of the fiscal and monetary double whammy in the precarious environment were disastrous. GDP rose by only 5% in 1937 and then fell by 3% in 1938, and unemployment rose dramatically, reaching 19% in 1938. Policymakers soon reversed course and the strong recovery resumed, but taking the wrong turn in 1937 effectively added two years to the Depression.
Read the paper and weep. It is one thing for a hero to be felled by unknown forces. It is another when the hero knowingly goes into battle unprepared, with too little, and allows his enemies to talk him into "compromises" that are one-sided and simply result in him disarming himself. Obama has made ghastly errors in his "war on the Great Recession" just as he has made ghastly errors with his "double down" surge in Afghanistan.

I think the Obama approach can be summarized by the following video:

Yes... don't let facts get in the way. You know that "recovery is happening" just like these truck drivers know that their truck will fit under the trestle.

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