The lessons of 1937

Henry Morgenthau, Jr., one of the worst Treasury Secretaries ever. You have probably heard a lot about 1937, when FDR made his gravest economic policy mistake, and made deep cuts to federal spending (the chief deficit hawk of the day'Henry Morgenthau, Jr. was FDR's treasury secretary), thinking the Great Depression was beaten back. At least, most credible economists and historians see it that way. Paul Krugman recently wrote about Europe's futile chase for the "confidence fairy":

Back in 2009, when there was (briefly) a policy consensus in favor of active fiscal policy to fight the slump, there were many warnings to the effect that we must not repeat the infamous mistake of 1937, in which FDR was persuaded to focus on balancing the budget while the economy was still weak, terminating the recovery from 1933 and sending America into the second leg of the Great Depression.

Amity Shlaes (yes, her), sees it differently:

Will 2013 be 1937? This is the question many analysts are posing as the stock market has dropped after the U.S. election. On Nov. 16, they noted that industrial production, a crucial figure, dropped as well.

Hey, even Amity Shlaes has learned the lessons of ... wait, what? Shlaes says 1937 happened because FDR was not credible as a budget cutter? That cuts were not deep enough. Ay yay yay:

The obvious question is why an announcement by Obama or Roosevelt to cut back just after the election doesn't reassure those who dislike government expansion. [...] The answer is that the markets, which observe a giant march forward and then a step backward, don't believe the step back is permanent. Giants are giants. Expansionists tend to revert to expanding government, as FDR did, most drastically, in World War II. The mandate matters more than the austerity chatter.

Ahhh. The confidence fairy. Shlaes knows this in "her gut," the way Dick Morris knew in his gut that Romney would win in a landslide. But like Morris, Shlaes is full of shit. Marshall Auerback of the Roosevelt Institute explains by taking apart actual alleged analysis, as opposed to listening to your gut:

[T]he FDR revisionists, who disapprove of fiscal policy measures of any kind, have come back. Now they're brandishing the old arguments that 'excessive' government spending risks 'crowding out' private spending, making it impossible for the US government to deal with the recession (because it has run out of money) and hindering the capacity of the private sector to recover because of too much government interference in the 'free market'. These complaints are usually accompanied by a wave of rhetoric condemning the 'business un-friendly' policies of the current Administration, along with dire warnings of a 'national solvency' crisis. After all, fiscal austerians are nothing, if not fully predictable.

Was the 1937 Relapse Caused by Increased Taxes and Unions?

In that context, we have to give some credit to Professors Thomas Cooley and Lee Ohanian, who have taken a more novel approach in their critique of the New Deal. In some respects, they actually validate the case for fiscal policy expansion (although the two authors might not see it that way). Cooley and Ohanian argue that:

'The economy did not tank in 1937 because government spending declined. Increases in tax rates, particularly capital income tax rates, and the expansion of unions, were most likely responsible. Unfortunately, these same factors pose a similar threat today.'

The OMB numbers suggest that spending actually DID decline in 1937 and 1938 (see here) and, contrary to the assertions of Cooley and Ohanian, that decline had a very deleterious impact on economic activity and employment.

Read the whole thing. Ironically, John Maynard Keynes warned of these consequences. In his 1938 private letter to FDR (PDF), Keynes stated:

(1) I should agree that the present recession is partly due to an 'error of optimism' which led to an overestimation of future demand, when orders were being placed in the first half of this year. If this were all, there would not be too much to worry about. It would only need time to effect a readjustment;'though, even so, the recovery would only be up to the point required to take care of the revised estimate of current demand, which might fall appreciably short of the prosperity reached last spring.

(2) But I am quite sure that this is not all. The recovery was mainly due to the following factors:'

(i) the solution of the credit and insolvency problems, and the establishment of easy short-term money;

(ii)the creation of an adequate system of relief for the unemployed;

(iii) the public works and other investments aided by Government funds or guarantees;

(iv) investment in the instrumental goods required to supply the increased demand for consumption goods;

(v) the momentum of the recovery thus initiated.

Now of these (i) was a prior condition of recovery, since it is no use creating a demand for credit, if there is no supply. But an increased supply will not of itself generate an adequate demand. The influence of (ii) evaporates as employment increases, so that there is a dead point beyond which this factor cannot carry the economic system. Recourse to (iii) has been greatly curtailed in the past year. (iv) and (v) are functions of the upward movement and cease'indeed (v) is reversed'as soon as the position fails to improve further. The benefit from the momentum of recovery as such is at the same time the most important and the most dangerous factor in the upward movement. It requires for its continuance, not merely the maintenance of recovery, but always further recovery. Thus it always flatters the early stages and steps from under just when support is most needed. It was largely, I think, a failure to allow for this which caused the 'error of optimism' last year.

Unless, therefore, the above factors were supplemented by others in due course, the present slump could have been predicted with absolute certainty. It is true that the existing policies will prevent the slump from proceeding to such a disastrous degree as last time. But they will not by themselves'at any rate, not without a large-scale recourse to (iii)'maintain prosperity at a reasonable level. [Emphasis supplied.]

In the current climate, with the threat of the austerity bomb, it is important to remember and reiterate the lessons of 1937. I certainly hope the president remembers. This is no time for the federal government to cut spending.