History Repeating

via DeLong:

Christina Romer, CEA Chair, March 9, 2009:

http://www.brookings.edu/~/media/files/events/2009/0309_lessons/0309_lessons_romer.pdf: [M]onetary policy was very expansionary in the mid- 1930s. Fiscal policy, though less expansionary, was also helpful.... 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 December 1936, but was still well below the level predicted by the pre-Depression trend. 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 21⁄2% 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.

The 1937 episode is an important cautionary tale for modern policymakers. At some point, recovery will take on a life of its own, as rising output generates rising investment and inventory demand through accelerator effects, and confidence and optimism replace caution and pessimism. But, we will need to monitor the economy closely to be sure that the private sector is back in the saddle before government takes away its crucial lifeline...

Christina Romer, CEA Chair, June 18, 2009:

Economics focus: The lessons of 1937: [I]t 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.... However, that growth was halted by a second severe downturn in 1937-38, when unemployment surged again to 19%... an unfortunate, and largely inadvertent, switch to contractionary fiscal and monetary policy.... According to a classic study of the Depression by Milton Friedman and Anna Schwartz... 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.... Granting [the Fed]... 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.

Now is also the time to think about our long-run fiscal situation.... 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.... 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...

Hopefully she'll become President of the San Francisco Fed.