Last year the New York Times ran an interesting piece comparing the US deficit-reduction effort to the 1937 ‘recession within a depression’:
By 1937 an economic recovery seemed to be in full swing, giving policy makers every reason to believe the economy was strong enough to withdraw government stimulus. Growth from 1933 to 1936 averaged a booming 9 percent a year (rivaling modern-day China’s), albeit from a very low base. The federal debt had swelled to 40 percent of gross domestic product in 1936 (from 16 percent in 1929.). Faced with strident calls from both Republicans and members of his own party to balance the federal budget, President Franklin D. Roosevelt and Congress raised income taxes, levied a Social Security tax (which preceded by several years any payments of benefits) and slashed federal spending in an effort to balance the federal budget. Income-tax revenue grew by 66 percent between 1936 and 1937 and the marginal tax rate on incomes over $4,000 nearly doubled, to 11.6 percent from an average marginal rate of 6.4 percent. (The marginal tax rate on the rich — those making over $1 million — went to 75 percent, from 59 percent.)
The Federal Reserve did its part to throw the economy back into recession by tightening credit. Wholesale prices were rising in 1936, setting off inflation fears. There was concern that the Fed’s accommodative monetary policies of the 1920s had led to asset speculation that precipitated the 1929 crash and ensuing Depression. The Fed responded by increasing banks’ reserve requirements in several stages, leading to a drop in the money supply.
The results were disastrous…
The Dow Jones industrial average dropped 49 percent from its peak in 1937. Manufacturing output fell by 37 percent, a steeper decline than in 1929-33. Unemployment, which had been slowly declining, to 14 percent from 25 percent, surged to 19 percent. Price declines led to deflation.
But no-one agrees why:
The possible causes of the ensuing stock market plunge and steep contraction in the economy provide fodder for just about everyone in the current political debate. Republicans can point to the Roosevelt tax increases. Democrats have the spending reductions…
The Nobel-prize winning economist Milton Friedman blamed the Fed and the contraction in the money supply in his epic “Monetary History of the U.S.”
Well, we may soon be able to eliminate at least one of those possibilities. With the “fiscal cliff” looming, the US economy is going to have to withstand both tax rises - the end of the Bush tax cuts - and the ‘big, dumb spending cuts’ resulting from last year’s stupid automatic debt-reduction deal.
What it won’t have to withstand, though, is a contracting money supply. Far from it, thanks to the unprecendented third round of quantitative easing announced by the Federal Reserve this week.
If, as seems likely, the US recovery takes a severe hit after the fiscal cliff, it won’t settle the debate over tax cuts v spending rises. But it will help settle the debate over fiscal policy versus monetary policy. Or, to put it another way, it won’t settle the split between Democrats and Republicans, but it might give some clarity on the disagreement between Keynesians and Friedmanites.