Will the U.S. Repeat the Great Mistake of 1937?

Since the financial crisis began, public policy makers in the U.S. have by and large stayed the course of stimulus spending and support for struggling corporations, especially banks. However, a substantial minority in Congress, led by the Republican Party but also including conservative Democrats and Tea Partiers, wants to start withdrawing fiscal and monetary stimulus, arguing that the threat to the U.S. economy is largely over. Nothing could be further from the truth. %%DynaPub-Enhancement class="enhancement contentType-HTML Content fragmentId-1 payloadId-61603 alignment-right size-small"%%The nascent, just-starting-to-crawl U.S. recovery is fragile. Not only could a double-dip recession occur, but premature withdrawal of stimulus by Congress (either by repealing fiscal stimulus or by raising taxes) and monetary policy changes by the U.S. Federal Reserve could lead to an economic circumstance that would be far worse than a double-dip.

History Did Not Begin In 1981

Supply-side economics, which preaches low taxes (especially for upper income groups), high defense spending and light regulation, has dominated U.S. public policy and American life since President Ronald Reagan's 1980 election. However, it is not clear that supply-side is the best economic strategy or that one can draw a straight line from tax cuts to prosperity for all. On the contrary, as the financial crisis has demonstrated, supply-side economics -- and the market absolutism associated with it -- is flawed at best, and economic history, far from moving in a straight line, tends to run in cycles, as periods of less government activism are followed by periods of more government activism.

In late 2008, the United States entered a period in which more government intervention was paired with an emphasis on collective action. It doesn't take an MBA from Harvard to realize that the U.S. government has pumped more than $23 trillion in fiscal and monetary stimulus into the economy and financial system to save it from collapse. Further, it isn't hard to see that the crisis occurred because market absolutism -- the theory that the free market, unbridled and left to its own natural forces, is the solution to every economic, social and political problem -- failed. Just as orthodox communism was finally and completely discredited 20 years ago, market absolutism has been discredited as an economic philosophy.

Admittedly, there are counter-arguments to the necessity of government intervention. But as history and economic performance will likely demonstrate, the Fed's extraordinary actions, led by Fed Chairman Ben Bernanke, in conjunction with the bank bailout and related fiscal stimulus supports, prevented the U.S. financial system from veering into the abyss. In particular, the Fed's actions, in coordination with the Bank of England, the European Central Bank, the Bank of Japan, the Swiss National Bank, and other central banks, prevented a global financial collapse that would have plunged the U.S. and global economies into a deeper GDP hole than the 2008-2009 recession.

Dangerous Parallels to 1937

One of the ironies of "tea party"-style criticism and activism that the nation is currently witnessing is that the very actions the faction despises -- the stimulus, the Fed's unprecedented efforts to keep credit markets liquid, the bailout of the banks, General Motors, AIG (AIG) etc. -- stabilized the economic system, enormously benefiting plenty of people and institutions on the right.

Many of these tea partiers and other assorted anti-stimulus critics are now calling for a withdrawal of fiscal stimulus and monetary supports. Their complaints echo those from the mid-1930s, when President Franklin D. Roosevelt's opponents complained that the budget deficit was too large, the dollar had weakened too much, and that excess bank reserves would lead to rising inflation. FDR and the Fed gave in to the pressure, in part due to fears that Democrats were going to be hurt in the Congressional election of 1938. Similarities to the current day are striking. Back then, Congress cut spending and the Fed increased bank reserve requirements by about 50%. The federal budget went from New Deal stimulus-based deficits to essentially a balanced budget in 1938.

And what happened? The premature withdrawal of stimulus and Fed tightening were major factors that tipped the U.S. economy back into recession in 1937. Prices, which had experienced modest support from New Deal programs that increased demand, soon started falling. Deflation took hold, and the U.S. unemployment rate, which had fallen from more than 20% in 1933 when FDR took office to about 10% in 1937, started rising again in 1938. As most economists now agree, the premature removal of stimulus and monetary easing lengthened the Great Depression.

Of course, no two economic eras are identical, but the parallels to the critics of FDR in 1936-37 are eerie. It seems hard to believe that today's critics are fretting over the national debt (it's serviceable), the dollar (it hasn't collapsed), and inflation (so far, it's low) at a time when the nation's unemployment rate is 10% and more than 17.5 million Americans who want full-time work can't find it.

Not only is U.S. unemployment still at double-digit levels, the U.S. economic recovery has barely started: those are hardly conditions that warrant removing stimulus. So the United States needs to stay the course in 2010 regarding both fiscal and monetary stimulus, for the good of the nation -- and for the good of President Obama's critics, whether they know it or not.

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