From its bottom in 1933 to 1936, the G.D.P. climbed spectacularly (albeit from a very low base), averaging gains of almost 11 percent a year. But then, both the Fed and the administration of Franklin D. Roosevelt reversed course.
In the summer of 1936, the Fed looked at the large volume of excess reserves piled up in the banking system, concluded that this mountain of liquidity could be fodder for future inflation, and began to withdraw it. This tightening of monetary policy continued into 1937, in a weak economy that was ill-prepared for it.
About the same time, President Roosevelt looked at what seemed to be enormous federal budget deficits, concluded that it was time to put the nation’s fiscal house in order and started raising taxes and reducing spending. This tightening of fiscal policy transformed the federal budget… — a swing of four percentage points in a single year. (Today, a swing that large would be almost $600 billion.)
Thus, both monetary and fiscal policies did an abrupt about-face in 1936 and 1937, and the consequences were as predictable as they were tragic. The United States economy, which had been rapidly climbing out of the cellar from 1933 to 1936, was kicked rudely down the stairs again… The moral of the story should be clear: Prematurely changing fiscal and monetary policies … can be hazardous to the economy’s health.
Wow, we’ve learned a lot since the ’30s, right? Well, maybe not. For the echoes of 1936 are being heard right now, even before the current recession hits bottom. If you’ve been paying attention, you know that a number of critics of the Fed are sounding alarms over the huge stockpile of excess reserves it has created… The clear inference is that some of it should be withdrawn before it’s too late.
On the fiscal side, many of President Obama’s critics are complaining vociferously about the huge federal budget deficits. Try to ignore, if you can, the sheer hypocrisy of many Congressional Republicans… But whatever the motives, the worries of today’s deficit hawks sound eerily reminiscent of Roosevelt in 1936 and 1937.
Fortunately, Mr. Bernanke is a keen student of the Great Depression who will not allow the Fed to repeat the errors of 1936-37. But his critics, both inside and outside the Fed, are already branding his policies as dangerously inflationary, and no Fed chairman wants to be called an inflationist.
Similarly, I hope and believe that President Obama will not transform himself from the spendthrift Roosevelt of 1933 to the deficit-hawk Roosevelt of 1936 — at least not until the economy is back on solid ground. That said, a growing flock of budget hawks are already showing their talons. They will have their day — but please, not yet. To avoid a replay of the policy disasters of 1936-37, both the Fed and our elected officials must stay the course. …
We’ll see. I’m not as sure as he is that the desire to get health care reform passed this fall won’t dominate the need to maintain stimulative policies. One of the big objections to health care reform is how we will pay for it (a preliminary CBO estimate suggests it will cost a little over 1 trillion). Suppose the economy continues to stay recessed and the choice becomes health care reform verus another stimulus package. What will be chosen? What should be chosen? (The answer is that one shouldn’t be traded against the other, we should do both since they deal with different problems. One problem is to stabilize the economy in the short-run. The other is to provide health care universally and at the same time rein in health care costs to bring the budget into balance in the longer run. While each stands on its own merits, the politics would be unlikely to allow us to do both, and I’m guessing health care reform will be the administration’s first priority.)
Originally published at the Economist’s View and reproduced here with the author’s permission.
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