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Government Must Stimulate to Avoid a 1937-Style Recession?

Ivan Pongracic Jr.

It is rather unfortunate that the Royal Swedish Academy of Sciences’ Economics Prize Committee chose to award the 2008 Nobel Prize in economics to Paul Krugman. It is not that Krugman did not deserve the prize—his contributions to international trade theory were indeed substantive and valuable. The problem is that by 2008 Krugman had long ceased to be a serious economist, becoming instead a common pundit. Thus the Nobel Prize gave his ideological and highly partisan New York Times column an imprimatur of economic credibility that it certainly does not deserve. Over the past ten years the economic analysis found in his column has regressed to Keynesian caricature, bereft of the depth or subtlety that one would expect from a Nobel laureate. Instead, the purpose of his column is quite clear: to justify expansion of government control of the economy under all circumstances, facts and good economics be damned.

A Broken Record

“That 1937 Feeling” is an excellent example. Krugman argues that the recent signs of economic recovery are very likely deceptive and therefore the government should not even think about easing up on the fiscal and monetary gas pedals anytime soon. He points to the 1937 recession as an example of the awful consequences of premature tightening. For the past year Krugman has insisted that the government’s economic stimuli have been too small and more stimulus is urgently needed. This is just another round of the same-old same-old.

Krugman’s article exhibits the most simple-headed and mechanistic view of Keynesian economics: If the economy is in the doldrums, it must be because aggregate demand is too low, and therefore it is up to government fiscal and monetary policy to raise it to its proper level. The only mistake that the government could possibly make is to not do enough fast enough.

What Krugman fails to tell his readers is that it is widely accepted among modern economists that the 1937 recession was primarily caused by another kind of government mistake. The Fed did indeed start tightening in 1936, but the problem was how it did it. Instead of using open-market operations to gradually increase interest rates in order to contain any inflationary pressures, it chose instead to use its new power (granted by Congress the previous year) to set the banks’ reserve requirements—the percentage of deposits that banks must hold either in their vaults or at the Fed. We now know that changing the reserve requirements is highly disruptive to bank operations and is simply too blunt of a monetary tool—even small changes can have a great impact on money supply. Rushing like fools where wise men fear to tread and clearly oblivious to the destructive potential of this new tool, the Fed engaged in three back-to-back increases in reserve requirements between August 1936 and May 1937, causing a severe tightening of the money supply in a very short time. It is no surprise that the American economy, just as it appeared poised for a modest recovery, was plunged into a serious recession—within the depression!

A Terrible Record

The moral is not that the Fed shouldn’t be tightening now. Rather, it is that when the Fed makes a mistake in monetary policy, the consequences are often dire. And the Fed’s record over the past nearly hundred years is disastrously bad, with even its defenders admitting that it has often been a major destabilizing force in the economy.

Krugman also fails to note that the U.S. government is repeating other mistakes committed in 1935-36: attempting to radically reorganize key economic sectors, pursuing new soak-the-rich taxes, and vilifying businessmen and financiers in the process. The economy may be forced to fundamentally change how the health care sector operates, creating another enormous unfunded liability for the federal and state governments and possibly a major burden on individuals and businesses. The Obama administration has also vigorously pursued carbon cap-and-trade legislation, which would drive up energy costs, potentially by large amounts. On top of this, there has been much talk of completely revamping and tightening banking and financial regulation.

In short, we are in the middle of the most ambitious government-enlargement agenda since probably the New Deal. Does it come as much of a surprise that we are getting similar results?

After pouring massive amounts of money into the economy in the past two years—two fiscal stimuli totaling $952 billion, the $700 billion TARP program, the $102 billion increase in discretionary domestic spending by the federal government in the 2009 fiscal year, and the $1.2 trillion increase in the monetary base by the Fed, all together adding up to nearly $3 trillion, or more than 20 percent of GDP—the economy is still far from healthy. Unemployment is stuck at 10 percent, and nobody is expecting a quick recovery. But we did get the record federal budget deficit of $1.4 trillion (10 percent of GDP) in fiscal 2009, bringing the gross national debt to a record $12 trillion-plus, on track to hit 100 percent of GDP in 2011 and calling into question the future fiscal viability of the U.S. government. Add to the mix the unfunded liability time-bombs of Medicare and Social Security, and it becomes obvious that sky-high tax—or inflation—rates are inescapable. In addition, every one of the proposed government interventions—and many others being bandied about today—is likely to increase taxes on individuals and businesses, as well as significantly escalate regulatory oversight, making it more difficult and riskier to run a business. How many of these acts will pass into law and what forms will those laws take? No one can know. It is easy to see why entrepreneurs, who in the end are the ones creating economic growth and jobs, would be worried enough about the future to simply stop investing.

The dynamic at work here has been labeled “regime uncertainty” by economist and Freeman columnist Robert Higgs in his article “Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed after the War” (The Independent Review, Spring 1997). Higgs defines regime uncertainty as a state of “pervasive uncertainty among investors about the security of their property rights in their capital and its prospective returns . . . [due to] government actions.” Higgs shows how the “Second New Deal from 1935 to 1940” scrambled the rules of the game to such an extent that many entrepreneurs simply withdrew from the economy rather than continue to attempt to create wealth.

Krugman needs to read Higgs’s brilliant and detailed historical and theoretical analysis to understand the real reason we should worry about repeating the 1937 recession: government’s doing too much rather than not enough.

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