Are we stumbling into another recession?

June 15, 2011

It's not just history buffs who now study the 1937-38 recession. The question is: Are we stumbling into a similar downturn?

Called "the Roosevelt Recession," the 1937-38 slump interrupted recovery from the Great Depression. It was "a depression within a depression," writes Stanford University historian David Kennedy in his Pulitzer Prize-winning "Freedom from Fear: The American People in Depression and War, 1929-1945." Unemployment rose from a monthly low of 11 percent in 1937 to 20 percent. The economy's output (gross national product) fell 18 percent; industrial production dropped 32 percent.

There are eerie parallels between now and then. Then as now, commodity prices (grains, minerals) were rising rapidly; fears of inflation grew. Then as now, the federal budget deficit was criticized as too large. Then as now, the president was widely perceived as being anti-business.

What caused the recession? President Franklin Roosevelt blamed a "capital strike" by monopolistic companies determined to weaken him. As Kennedy notes, "net new private investment in the mid-1930s was running at only about one-third of its rate of a decade earlier." Roosevelt responded by creating a presidential task force to investigate monopoly power.

For their part, business leaders blamed Roosevelt for poisoning the economic climate. Said one: "Uncertainty rules the tax situation, the labor situation, the monetary situation, and practically every legal condition under which industry must operate."

In reality, the recession's main causes transcended the bad blood between Roosevelt and business. In late 1936 and 1937, both monetary policy (credit conditions, managed by the Federal Reserve) and fiscal policy (the federal budget, managed by the White House and Congress) were tightened.

First: monetary policy. Since 1934, gold inflows from abroad had boosted money and credit. Gold was converted into dollars supplied by the Treasury. In late 1936, the Fed and the Treasury — worried that higher commodity prices signaled general inflation — decided to "sterilize" the gold inflows through the sale of Treasury securities, which would soak up the extra dollars. The Fed also doubled required bank reserves (the money banks had to keep on hand) between August 1936 and May 1937. Both moves restricted money and credit. Bank lending fell 7.5 percent in the year ending June 1938.

Second: fiscal policy. In 1936, Congress approved, over Roosevelt's veto, a bonus for World War I veterans, and the federal deficit ballooned to $4.3 billion. In a then-$79 billion economy, that was historically huge. The situation reversed dramatically the next year. Social Security payroll taxes started, but not benefits; meanwhile, Roosevelt — always a supporter of balanced budgets — endorsed spending cuts and a tax on undistributed corporate profits. By 1938, the deficit had virtually disappeared.

So government blundered into recession. Could it happen again? Economist and New York Times columnist Paul Krugman has argued (in a June 2 column) that, in part, it already has. Concern over the deficit, he contended, made the 2009 "stimulus" package too small. Any new deficit-reduction efforts "will put a further drag on an already weak economy."

But there are also big differences between now and then. The most obvious is that the policy reversals in 1937-38 dwarfed anything now being contemplated. From 1936 to 1938, the federal deficit fell from 5.5 percent of gross domestic product (GDP) to 0.1 percent — a huge swing especially when the economy was tanking. By contrast, today's budget deficits are much larger as a share of GDP, and prospective reductions are much smaller.

Here are the Congressional Budget Office's latest deficit estimates for the Obama budget: 8.9 percent of GDP in 2010, 9.5 percent in 2011 and 7.4 percent in 2012. Moreover, some of the 2012 drop assumes an improving economy, which raises tax revenues and reduces spending on unemployment benefits, food stamps and the like.

Similar caveats apply to Fed policy. Nothing like the 1936-37 doubling of reserve requirements is in the works. True, the Fed's so-called QE2 (the purchase of $600 billion in Treasury bonds) is ending. But Fed Chairman Ben Bernanke has repeatedly said that he expects low interest rates to continue for many, many months. Moreover, he has — so far — dismissed high prices for oil and other commodities as either temporary or the result of supply-demand imbalances. He doesn't expect them to lead to higher, general inflation warranting tighter money.

Still, the parallels are unsettling, because government officials then didn't intend to trigger a slump. As their errors became clear, policies changed. The sterilization of gold inflows ended. Despite favoring balanced budgets, Roosevelt pragmatically shifted to higher spending and repealed the profits tax. By 1939, the budget deficit exceeded 3 percent of GDP. The investigation of monopolistic companies did not corroborate Roosevelt's theory of a "capital strike," historian Kennedy notes. And World War II ended the Depression for good.

Robert J. Samuelson writes a weekly column on economics.
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