1937 Again?

Predictably, talk of deficit reduction and the Fed’s exit strategy from easy money have raised fears that we may repeat the errors of 1937. As my new Forbes column explains, the 1937-38 recession was brought about by sharply tighter fiscal policy–the budget went from a deficit of 5.5% of GDP in FY1936 to virtual balance in FY1938, an extraordinary tightening of fiscal policy over a very short period of time. (Shows what you can do when there are no entitlement programs to deal with.) At the same time, the Fed doubled reserve requirements, thus sharply tightening monetary policy. The result was that after several years of solid real growth, real GDP fell 3.4% in 1938.

While it is true that there are some right wingers who have opposed fiscal stimulus from the beginning and presumably would cancel the unspent stimulus if they could, there is no serious effort underway to do so. On the other hand, I don’t see much in the way of additional stimulus, which some economists believe is necessary to forestall a relapse this year. But some new stimulus will undoubtedly still find its way into the regular appropriations bills.

As far as Fed policy is concerned, I see no evidence of tightening and belive that it will be very slow and deliberate about doing so once it starts. I think the odds that the Fed will stay too easy for too long are much greater than that it will tighten too much, too soon.

Therefore, I conclude that repetition of the mistakes of 1937 is very unlikely.

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