Is Obama Repeating the Mistake of 1937?

With the announcement that Obama plans to freeze non-defense discretionary spending in his new budget, I can safely predict a blizzard of liberal attacks drawing a comparison to 1937, when Franklin Roosevelt sharply tightened fiscal policy and brought on an economic downturn. In anticipation of something like this, I wrote a Forbes column two weeks ago on this very topic, which I reprint below.

According to press reports, the Obama administration plans to put forward a budget on Feb. 1 containing significant deficit reduction measures. Some liberal economists are warning that it is grossly premature to implement deficit reduction. Indeed, they believe that additional fiscal stimulus is necessary to prevent a double-dip recession. They argue that there is a danger we will make the same mistake that Franklin Roosevelt made in 1937, which crippled the economy’s recovery.

To evaluate the relevancy of 1937 to current economic and fiscal conditions we first need to review a little history of the Great Depression. First of all, it’s important to remember that what we call the Great Depression was not a continuous downturn; it was really two back-to-back recessions. According to the National Bureau of Economic Research, the first ran from August 1929 to March 1933 and the second from May 1937 to June 1938.

According to current Commerce Department data, real gross domestic product fell sharply in 1930, 1931 and 1932, and modestly in 1933. But GDP rebounded strongly in 1934, growing 10.9% that year, 8.9% in 1935, 13% in 1936 and 5.1% in 1937. But in 1938, real GDP fell 3.4%.

For many years, economists thought this “secondary recession” was inherent in the nature of the business cycle. Today, however, economists generally believe that the only thing that caused the 1937-38 downturn was disastrously bad government policy.

Although right-wingers like to portray FDR as a giddy big spender whose profligate ways made the depression worse, the truth is that he was by nature quite conservative, fiscally. Indeed, when running against Herbert Hoover in 1932 Roosevelt was unsparing in his criticism of Hoover’s spending and deficits. As he put it in an Oct. 19, 1932 speech:

“I regard reduction in federal spending as one of the most important issues of this campaign. In my opinion it is the most direct and effective contribution that government can make to business. In accordance with this fundamental policy it is equally necessary to eliminate from federal budget-making during this emergency all new items except such as relate to direct relief of unemployment.”

Roosevelt vowed that every member of his cabinet would be required to support the economic plank of the Democratic Party’s 1932 platform, which said, “We advocate an immediate and drastic reduction of governmental expenditures by abolishing useless commissions and offices, consolidating departments and bureaus, and eliminating extravagance to accomplish a saving of not less than 25% in the cost of the federal government.”

While it is true that spending and deficits rose sharply once Roosevelt took office, the fact is that they never rose sufficiently to offset the fall in private spending that was at the heart of the Great Depression. This was proven to the satisfaction of most economists in a 1956 article by economist E. Carey Brown, “Fiscal Policy in the Thirties: A Reappraisal.” According to my calculations, the deficits of the 1930s should have been at least five times larger than they were.

Treasury Secretary Henry Morgenthau, in particular, was always disturbed by the deficits. Rather than promote recovery, as most economists believed, he thought that they retarded it by sapping business confidence. As historian John Morton Blum explains, Morgenthau “was sure that private investors would not risk their capital when economic conditions were uncertain. He was sure that federal deficits created uncertainty by causing fears of immediate inflation and future taxation.”

In early 1937, Roosevelt was preparing his budget for the next fiscal year, which began on July 1 in those days. Strong growth in the economy and tax increases over the previous three years, especially the institution of a new payroll tax for Social Security, had caused tax receipts to almost double from 2.8% of GDP in 1932 to 5% in 1936. Projections showed that budget balance was within reach with only a modest reduction of spending.

Roosevelt was also concerned about the reemergence of inflation. After falling 24% between 1929 and 1933, the Consumer Price Index rose by a total of 7% over the next three years and signs pointed to even higher prices in 1937. Indeed, the CPI rose 3.6% that year.

Rather than viewing this as a sign of progress, which had caused the stock market to almost double between 1935 and 1936, Roosevelt and the inflation hawks of the day were determined to pop what they viewed as a stock market bubble and nip inflation in the bud. Balancing the budget was an important step in this regard, but so was Federal Reserve policy, which tightened sharply through higher reserve requirements for banks. Between August 1936 and May 1937 reserve requirements doubled.

During 1937, Roosevelt pressed ahead with fiscal tightening despite the obvious downturn in economic activity. The budget deficit fell from 5.5% of GDP in 1936 to 2.5% in 1937 and the budget was virtually balanced in fiscal year 1938, with a deficit of just $89 million.

The result was a huge economic setback, with GDP falling and unemployment rising. For this reason, Obama’s economic advisers have been warning for some time that stimulus must be continued until full employment has returned. As Council of Economic Advisers chair Christina Romer wrote in The Economist last June:

“The 1937 episode provides a cautionary tale. The urge to declare victory and get back to normal policy after an economic crisis is strong. That urge needs to be resisted until the economy is again approaching full employment.”

More recently, economist Paul Krugman warned that the Fed’s talk of an early “exit strategy” from easy money sounds suspiciously like that which led it to tighten prematurely in 1936. He believes that the good economic news of recent months does not yet constitute proof that a sustainable recovery is underway and that the danger of a relapse this year is strong as stimulus spending wanes.

Nevertheless, the pressure to at least begin the process of normalization is overwhelming. The Fed has talked openly about new procedures to soak up the bank reserves it has created even as those reserves remain largely idle and unlent. And even Democrats and organizations affiliated with them are urging Obama to get the budget on a sustainable path as soon as possible. John Podesta and Michael Ettlinger of the liberal Center for American Progress recently argued that the primary budget (spending less interest on the debt) should be balanced as soon as 2014, with full balance by 2020.

I’m not terribly worried that Congress will reduce the deficit too quickly; too much of the budget is on automatic pilot or effectively off-limits. Entitlement programs like Medicare will continue to grow for years to come and there is no way that defense spending can be reined in as long as we continue to fight two wars in Iraq and Afghanistan, not to mention the likelihood of new domestic security spending in the wake of an aborted terrorist attack on Christmas day. And it’s far more likely that Congress will appropriate new stimulus measures than cut back on those already enacted.

Moreover, the possibility of a tax increase at this point is very remote indeed. Republicans will fight any such an effort even more intensely than they fought health reform, and it’s hard to see any Democrats leading the fight for higher taxes with the party already looking at electoral losses in November. The administration is even backpedaling on plans to allow some of the Bush tax cuts to expire this year. Yet there is no plausible way of significantly reducing deficits in the near term without higher revenues.

For these reasons, I don’t see any possibility of fiscal tightening beyond that which will occur naturally as economic growth automatically reduces spending a bit, and causes revenues to rise as corporate profits revive. I think there is a greater danger of the Fed tightening too much, too soon or that Congress may go overboard with new financial regulations, but hopefully those dangers can be avoided.

One way to achieve fiscal tightening without endangering the recovery would be to enact entitlement reforms now that won’t take effect for some years. Anything meaningful, such as raising the normal retirement age, will have to be phased in over many years anyway. Since entitlements have to be reformed at some point, doing so now would demonstrate resolve to get the budget under control while avoiding near-term fiscal tightening that might be premature.

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