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What are the lessons of 1937?

It is said that profound policy decisions are determining how economic life in the United States will go over the next few years. Liberal economist Paul Krugman has that 1930s feeling

Suddenly, creating jobs is out, inflicting pain is in. Condemning deficits and refusing to help a still-struggling economy has become the new fashion everywhere, including the United States, where 52 senators voted against extending aid to the unemployed despite the highest rate of long-term joblessness since the 1930s.

Many economists, myself included, regard this turn to austerity as a huge mistake. It raises memories of 1937, when F.D.R.’s premature attempt to balance the budget helped plunge a recovering economy back into severe recession...

Alan "Bubbles" Greenspan thinks the U.S. is coming to resemble Greece, so he supports reining in the deficits. Krugman believes the original stimulus was undersized. He thinks we should spend at least that much again ($787 billion) to replace sagging aggregate demand in the private sector with government dollars. The goal is to spur job creation.

Thus it's Greenspan versus Krugman, the Austerians versus the Stimulati. I think of it as the Baltimore Orioles (19-49, 0.279 winning percentage) versus the Pittsburgh Pirates (24-44, 0.353). Mish sides with Greenspan. Calculated Risk votes for Krugman. Barry Ritholtz doesn't vote for Krugman per se; he just thinks Greenspan is an idiot, which is a default vote for Krugman.

Let's go back to 1937. After 4 years of massive government stimulus, fearing continued large deficits and rising inflation, Roosevelt cut back on government spending and the Fed tightened rates.

Rather than viewing [inflation accompanying economic expansion] as a sign of progress, which had caused the stock market to almost double between 1935 and 1936, Roosevelt and the inflation hawks of the day were determined to pop what they viewed as a stock market bubble and nip inflation in the bud. Balancing the budget was an important step in this regard, but so was Federal Reserve policy, which tightened sharply through higher reserve requirements for banks. Between August 1936 and May 1937 reserve requirements doubled.

During 1937, Roosevelt pressed ahead with fiscal tightening despite the obvious downturn in economic activity. The budget deficit fell from 5.5% of GDP in 1936 to 2.5% in 1937 and the budget was virtually balanced in fiscal year 1938, with a deficit of just $89 million.

The result was a huge economic setback, with GDP falling and unemployment rising. For this reason, Obama's economic advisers have been warning for some time that stimulus must be continued until full employment has returned...


After Roosevelt's tightening in 1937, the economy went right back into the dumper, as shown in the estimated unemployment rates (graph above). The jobs situation improves after that, reflecting the preparations for World War II and then the war itself. Krugman explains how it worked to George Will in the short video below.

So what are the lessons of 1937? And how do they apply to us? Although I am not a Great Man, a Krugman or a Greenspan, and I am not encumbered by a life-long course in Economic Indoctrination of any variety, I humbly submit the following—

  • We need a thought experiment. Suppose Roosevelt does not tighten in 1937. Suppose World War II was not a possibility, and thus did not occur. What happens then?

The evidence we have strongly suggests that further government stimulus would have had to go on year after year to prop up the economy. Four years (1933-1936) of deficit spending was insufficient to allow the economy to walk without a crutch. When Roosevelt took the crutch away in 1937, the injured man fell down. How long would large deficits & rising inflation have had to go on? Until 1939? Until 1943? Until 1946? Until 1949? When does it end? That's our first lesson: we don't know.

We don't know, but this scenario does raise the question of exactly how we would have made the transition from a government-supported economy to an economy with a robust private sector had World War II not occurred. We don't have a "pure" historical example to go by, but the experience of Japan after 1989 until the present, at least on my reading, strongly suggests that once you're using the government crutch, you need that crutch forever (or for a very, very long time).

And then there's World War II. That's one hell of way to get out of a Depression. Perhaps we need World War III to save our bacon! As far as I can see, Homo sapiens loves waging wars—if we didn't, why would we wage them so often? A big war would create lots of jobs for sure, just like our "modest" Defense budget does now. In the video above, Krugman refers to World War II as "an enormous public works program." Damn right! If we went whole hog—nuclear—we could also (temporarily) fix the world's burgeoning population problem, thus killing two birds with one stone.

And so this is the second lesson of the late 1930s—if no war, then probably no real recovery by the early 1940s, regardless of whether Roosevelt tightens or not. What might replace World War III in the contemporary case?

One suggestion that makes sense is to wage war on ... ourselves! Which is to say, on our dangerous oil dependency. We could set a goal of reducing American oil consumption from about 19-20 million barrels-per-day now to 14-15 million barrels-per-day in 2020. Over some number of years, depending on what we spend, this would obviously pay for itself. Talk about public works! The Chinese or the Japanese would be happy buy our bonds because at the end there would be more oil for them.

Unfortunately, my eminently sensible suggestion will fall on deaf ears in a Declining Empire—our get up and go has got up and went.

Economists have not thought through what history is telling them. Christina Romer, who works in Obama's White House, wrote the original article called The Lessons Of 1937

[T]he 1937 episode provides a cautionary tale. The urge to declare victory and get back to normal policy following 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 [than in normal times]. If the government withdraws support too early, a return to economic decline or even panic could follow...

[My note: The quote was lifted from Brad DeLong, who is linked in below.]

This is the same Christina Romer who, along with Jared Bernstein, projected the Obama stimulus would have the following effect on jobs—

From Brad DeLong's comment on Romer's article, annotated by me to show where we are. The unemployment shown here is the U3 "official" BLS number

Obviously the $787 billion recovery plan did not have the intended effect on unemployment. The answer to this clear deficiency is always the same among people like Krugman—spend more money! Yet, the lessons of 1937 do not necessarily support that view, as I outlined above.

The reality is that policy-makers and economists have no clue about what's going on, and neither does anyone else. Therefore, they have no clue as to how to fix it. And by the way, how can Krugman manage to be so clueless and so patronizing at the same time? I think the correct answer must be that politics makes you stupid.

Policy-makers and economists want to appear to be doing something. But they have no idea what to do, really. It's just that simple. Whatever "solutions" we implement should provide a wide social-safety net to reduce human suffering. I do agree with Krugman that inflicting pain is not the way to go. That's the only thing I'm sure of.

What do you think? Leave a comment below.

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