Threat of Another Economic Stumble Is Real

Posted June 22, 2010 at 3:23pm

My parents were Depression babies, their lives transformed by the trauma of the 1930s — deflation, unemployment that reached a staggering 25 percent, years of tough living.

[IMGCAP(1)]Many volumes have been written about the causes of the Depression. Some have dissected colossally destructive policies of tight money and tax increases at the worst possible times leading up to the 1932 election and the Franklin Delano Roosevelt administration, and of course, the very different set of fiscal and monetary policies pursued by the FDR administration, including easing up on money and sharply expanding government spending and the size and scope of government.

This is what we now think of as classic Keynesianism — countercyclical policies to give the economy a massive shot of adrenaline when it is sick instead of the earlier approach, which was akin to the medieval practice of bleeding (call it Theodoric of York economics).

Most people, I suspect, when thinking about the Great Depression, think about the contrast between 1932 and 1933, from Herbert Hoover to Roosevelt. What is most striking now, though, is to think about what followed. From FDR’s inauguration in March 1933 on, the economy did begin a major turnaround. In 1934, the economy grew at a robust 10.8 percent, not enough to erase the Depression, but a major step in that direction. Economic growth continued in 1935 and 1936.

But in 1937, perhaps lulled by the positive movement and by the modest but real appearance of inflation, the federal government turned around its economic policy. Most significantly, Roosevelt took the advice of his Treasury secretary, Henry Morgenthau, and moved to balance the budget after a few years of deficits. Spending was tightened and taxes went up — and the economy went back into a tailspin, shrinking 3.4 percent in 1938 and sending the U.S. back into serious recession, even mini-Depression, a condition that was not really alleviated until World War II provided the massive stimulus to pull the country back to economic health.

Unfortunately, I am becoming convinced that the 1937 experience is a relevant one now. We did stare into the abyss of deflation and depression in late 2008 and 2009. The Troubled Asset Relief Program vote has been much maligned, and may result in several election casualties, but by any objective standard it was a critical step in preventing a total credit freeze that could have toppled the global economy (and will be much, much less costly to taxpayers than conventional wisdom would suggest).

The stimulus package adopted on party-line votes in 2009 was less efficient than it might have been, as much because of compromises made to get to 60 votes in the Senate as anything else, but the failure to do a major stimulus bill at the time surely would have pushed us into very serious recession or worse, and the stimulus that did get enacted helped spur some economic recovery. The economy is doing much better than it did in 2008 and 2009.

But we are nowhere near out of the woods. The danger of deflation is still there. The risk of another stumble in our economy is real, including the continuing fragility of community banks over commercial real estate loans. The global economy remains fragile, with Greece the leading edge of what could become a set of dominoes toppling in Europe as creditors become nervous and raise the premium on loans from several shaky countries, adding to their woes and endangering the euro zone and by extension the rest of us.

American companies have responded with suppleness to the challenge, increasing efficiency without increasing costs so that they sit on mountains of cash — but are not doing anything with it that would add liquidity to the system and provide some juice for the economy because they are still nervous about the next year. Little new hiring is going on, adding to the job deficit in the recovery.

The Federal Reserve, fortunately, knows its history and is not tightening. How is Congress responding to this set of conditions? By letting the urgent need for more stimulus to avoid disaster be supplanted by a combination of knee-jerk ideological and partisan reaction against Obama administration policies joined by the commendable desire to avert a long-term deficit and debt explosion, with medicine that is the wrong kind for our current economic state.

As Ezra Klein, and others, has pointed out, there is a giant fiscal drag on the still-nascent economy caused by states forced to slash spending and/or increase taxes to fit their balanced budget requirements. Most American states cannot pursue their own countercyclical policies to stimulate a sick economy. The states’ fiscal drag in 2011 will amount to $180 billion or more. Even if the 2009 stimulus will have a large part of its impact this year and into the next, it is nowhere near enough to counter that giant fiscal drag.

Unfortunately, the politics are not conducive to a reasoned discussion of economic needs; most voters don’t trust government, and swing voters are real deficit hawks who don’t understand why when rank-and-file Americans are responding to adversity by belt-tightening and discipline the federal government should be throwing money around like drunken sailors. The same is true of many Members of Congress.

But getting lots of money out there is just what the federal government should be doing this year. Instead, we see bickering over a short-term jobs bill and over a measly (in the context of a $13 trillion economy) $50 billion package that would help to counter some of that fiscal drag that could send us right into the abyss. In an ideal world, we would find a bipartisan compromise — a generous short-term stimulus of tax cuts and spending combined with a credible plan to move to meaningful fiscal discipline when we are out of the deflationary woods.

I am glad we have a strong collection of fiscal hawks in Congress; I wish some of them were also students of economic history.

Norman Ornstein is a resident scholar at the American Enterprise Institute.