Krugman & Today's Policies: This Is Nothing Like 1937

Krugman & Today's Policies: This Is Nothing Like 1937

By Sean Trende - June 26, 2012

Paul Krugman has spent the past three years inveighing against any immediate steps to reduce the growth in government spending on the grounds that we would merely be repeating the mistakes that Fed policymakers made in 1937. In that year, spending cuts and insistence on a balanced budget catapulted the United States into a deep recession, one that essentially spelled the end of the New Deal.

On Monday, Krugman doubled down, claiming that policymakers had progressed past 1937, and that we were risking a repeat of 1931. That was the year things really fell apart, when policymakers failed to contain a banking crisis in Austria, which eventually resulted in the spread of a global contagion, bringing down governments worldwide -- and bringing the Great Depression to its crushing denouement.

The European debt crisis is certainly something to be concerned about, but let’s step back a moment and be clear about something: at least in terms of policy, this is nothing like 1937, much less 1931. And if anything, 1937 tells us more about of the dangers of real-world Keynesian experimentation than anything else.

Before going further, it’s worth noting where I’m coming from on this. In a former life, I served as a research assistant on a two-volume history of the Federal Reserve. My assignment was reading, digesting, and summarizing the Board of Governors and FOMC minutes for the 1930s and 1940s. I remember at the time thinking how unfortunate it was to be assigned the ’30s, such a useless decade. After all, the news in 1997 was all about how we had finally defeated the business cycle, with only minor recessions ahead of us. At any rate, I say this to disclose that I don’t have a degree in economics, but I do know a thing or two about 1937.

At the heart of that year was a trio of policy errors. First is the storyline emphasized by Krugman: the government cut spending. Second, and attracting less attention, it raised taxes as well.

Table 1 illustrates this. After rising 142 percent from 1933 to 1934, falling a hair in 1935, then bumping upward in 1936, government outlays fell 10 percent in 1937, and another 10 percent in 1938. A large part of this was political: Congress had accelerated World War I bonus payments in 1936, substantially juicing GDP; the hangover came in 1937.

On the revenue side, FICA went into effect, as did the Revenue Act of 1937 (which sought to close loopholes from the 1935 “wealth tax”) as did an undistributed profits tax. By the end of 1938, spending was about 4.5 percent higher than it had been in 1934; tax receipts were 228 percent higher than they had been in that year.

But perhaps the biggest mistakes were made at the Federal Reserve Board. The Banking Act of 1935 had given the Federal Reserve the power to require banks to maintain a certain level of cash in reserves; if a bank had a million dollars in deposits, and the reserve requirement was 20 percent, they had to keep $200,000 handy (basically). In essence, higher reserves limited the supply of credit. The idea was that these reserves would provide a backstop on future bank runs, but the reserve requirement also provided another mechanism for controlling the money supply. 

Armed with this new power, the Fed immediately used it. In July of 1936, it raised reserve requirements by 50 percent. In early 1937, it increased the requirements twice, doubling the requirement in less than a year. At the same time, the Fed sought to staunch an inflow of gold from Europe through a “sterilization” policy, where it essentially contracted the money supply to offset the “flight to safety.”

The end result of all this was fiscal and monetary contraction, higher interest rates, and -- arguably -- increased uncertainty about the future stemming from the Roosevelt administration’s increasingly anti-business rhetoric. Unsurprisingly, the economy began to contract. By the beginning of the following year, many of these policies (particularly gold sterilization) had been reversed, and the economy began to grow again.

Compare this with today. Recall that in 1938, spending was roughly equal to what it had been five years earlier. Today, federal spending is 39 percent higher than it was five years ago; to achieve spending reductions equivalent to 1937-38, we would have to cut about $600 billion out of our budget over the next two years. Receipts are actually lower than they were five years ago; since the big drop-off in fiscal year 2009, they have only produced nominal annual increases.

What about what Republicans would like to do? The Paul Ryan plan produces a real spending decrease of 2 percent from FY 2013 to 2014, but after that, spending increases annually. Spending five years from now would be 13 percent higher than it is today -- less than Washington currently projects, and less than needed to maintain all of our current spending commitments -- but also more than the 4.5 percent increase during the mid-'30s. That's not offered as a defense of the Ryan plan; it is just meant to illustrate that even plans accused of being radical differ from what occurred in 1937 and 1938. 

On the monetary side, the Fed might not have loosed everything in its arsenal, but it hasn’t shown much willingness to abandon its zero-interest-rate policy either. Two rounds of quantitative easing and more subtle moves such as Operation Twist signal a continued dedication to maintaining an expanding monetary base.

In short, if Ben Bernanke were to start talking about the need to raise interest rates, or if Congress were talking about massive tax hikes or real spending cuts (as opposed to slowing the rate of projected growth), we’d have real reason to question their policy choices. As it stands, the economy really may fall victim to the European recession, which itself has a multitude of causes (note to future policy wonks: don’t structure an economic system to achieve political goals). But American fiscal and monetary policy seems determined not to follow the trend from 1937-38.

There is one important thing to bear in mind. Policymakers didn’t push for contraction in 1936 and 1937 because they were concerned about the deficit as such; “deficit hawks” aren’t to blame. Instead, they were concerned that the stock market had reached the point where stocks bought at the 1929 peaks were seeing a positive return, and that banks had excess monetary reserves that they could use to speculate in the market. The increased gold supplies warned of the inflation that they (wrongly) believed pushed us over the brink in 1929 (in truth, there was no inflation).

To prevent this, they actively sought to contract the monetary supply. It was a disastrous step, one that led the nation back to 20 percent unemployment.

To put this in modern Keynesian terms, policymakers believed that they were reaching the peak of a business cycle, and that it was time to apply the brakes. In retrospect, this was a foolish reading of the data. But at the time, very smart people were absolutely convinced that they had gotten it right.

This is where Keynesianism in practice becomes so difficult. It’s just very, very hard to gauge how much stimulus you need, and when it’s time to take your foot off the accelerator. Unlike monetary policy, where the fed can sort of nudge the levers this way and that, fiscal policy has to go through the political process. This slows spending down and mucks things up (with decisions such as accelerating the bonus payments in the election year of 1936).

The response to this is usually a variant of “we’ve learned so much since then.” Maybe. That is the optimistic view of progress. The pessimistic view, to which I’m inclined, is to look at how certain people were in the 1930s that they were in the right, and how wrong they turned out to be. Maybe we’ve really progressed since then, or maybe future economists will look back and laugh at us for the certitude we possessed regarding really stupid decisions.

So in short, we’re a long way from a 1937 scenario today. But in a strange way, I dread when things start to get better. That’s when the Fed is going to have to decide whether it is time to dial back its market operations, and the government will have to get serious about debt and deficits. That’s something that will be very, very difficult to get right. Getting it wrong could have severe consequences.  Because if there's a real lesson from 1937, it's that today's policymakers probably don't know nearly as much about how (and when) to adjust economic policy as they (and we) would like to believe.

Sean Trende is senior elections analyst for RealClearPolitics. He is a co-author of the 2014 Almanac of American Politics and author of The Lost Majority. He can be reached at Follow him on Twitter @SeanTrende.

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