The Recession and the Lessons of 1937

In the wake of the June 2009 employment numbers, released by the Bureau of Labor Statistics on July 2nd, there have been three competing responses:

(1) The "wait and see" argument, which goes like this: Only a fraction of the allocated $787 billion stimulus has been spent. As more funds are distributed to states, municipalities, and other recipients, particularly over the next 3-4 months, the effects on employment and GDP growth will become increasingly evident. If conditions continue to worsen, say 6-10 months down the line, the situation will be reassessed and additional funds can be requested. After all, the stimulus plan was intended to be an 18 month program.

(2) The "Obama's economic policies are a failure" argument. These are the folks who are opposed to any expansion of government spending or involvement in the economy, even when on the precipice of prolonged depression. These are the same people who have failed to learn the lessons not only of the Great Depression of the 1930s, but also of more recent economic downturns, including the so-called "lost decade" of Japan in the 1990s. Of course, for these people, any government action meant to soften the downturn or reverse its course is simply viewed as either counterproductive or, for the more conspiratorial minded, a socialist trojan horse.

(3) And finally, the "initial stimulus was too small" approach. These folks warned of the inadequacy of a $787 billion stimulus in the face of a much larger shortfall in effective aggregate demand and demanded a more robust stimulus. This view was made prominent by Paul Krugman, Brad DeLong, Joseph Stiglitz, among others.

Well, there are serious problems with both arguments 1 and 2. Argument 1 is based on two assumptions: (1) the economic situation will not deteriorate to such a degree that when the remaining stimulus funds are finally allocated, those funds, and the jobs they actually create, will be adequate to meet the gap in demand; and (2) if, in the event those funds are not adequate, additional funds can be requested from Congress.

Both of these assumptions will, unfortunately, likely be proven false: Assumption 1 is false because the gap in demand continues to widen (and the unemployment rate continues to increase), while the original stimulus projections were based on a peak unemployment of 9.0% in 2009, 8.7% in 2010, and 7.5% in 2011. However, as the adjusted June 2009 BLS report indicates, unemployment continues to rise and is currently at 9.5%. Furthermore, the worse the situation deteriorates, the more likely it becomes that this recession turns into a prolonged slump, perhaps akin to that of Japan in the 1990s, which is not easy or quick to recover from.

Assumption 2 (of argument 1) is by no means a given, and will be made increasingly more difficult given the potential efficacy and traction of argument 2 (above) and the looming 2010 midterm elections. As Paul Krugman wrote back in March of this year, an inadequate stimulus would pose political difficulties, in addition to its economic consequences. Opponents of President Obama's stimulus program, and of government intervention in the economy more generally, can stand up and say "I told you so!" Therefore, it would have been wiser and strategically more sensible--both politically and economically--to insist on a bigger package in March, rather than role the dice on a second, supplemental package at a time when both the economy and the administration's political standing has deteriorated.

Which brings us to argument 2, above, which is already claiming that Obama's economic policies have failed, despite only 3-4 months passing since the stimulus was originally passed, and only a fraction of its funds allocated. I don't have much to say specifically in regard to this argument, as it is almost entirely politically motivated and propagated in the absence of well-reasoned economic understanding. It flies in the face of economic history, including that of the 1930s, which may, before all is said and done, be viewed as the closest antecedent to the current crisis. The one comment I will make is that such views must be opposed and shown to be wrongheaded. It would be a colossal mistake to begin a process of debt reduction, budget balancing, and economic disengagement until the current crisis has subsided. To do so would be to repeat FDR's biggest blunder in which he was pressured into balancing the budget prematurely, even as the policies of the first four years of his administration began to bear fruit. As Christina Romer, chairwoman of President Obama's Council of Economic Advisers and a scholar of the Depression, writes in the Economist:

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.

Therefore, it is becoming increasingly difficult to dismiss those claims made by the proponents of argument 3, above, in light of the continued deterioration in job numbers and growth. Additional stimulus may be necessary and should be fought for sooner, rather than later. Inflation is not what should be concerning policy makers at this juncture, as deflation is staring us in the face (see graph below). Debt reduction and budget balancing should be put on the back burner, as such policies would be currently counterproductive given the strain any increased and sharpened downturn would further put on the deficit. Paul Krugman hits the nail on the head in his latest column, which is, as always, a must read.