Word’s in from political leaders and economists: the Great Depression v2.0 has been averted. The Bank of Canada expects our economy to grow this quarter. Businesses and consumers are reportedly regaining confidence. Even U.S. home resale prices recorded their first monthly gains since the downturn began. “As we return to positive growth, policy-makers are facing difficult decisions,” Timothy Lane, deputy governor of the Bank of Canada, told one audience in Kingston, Ont., recently. “When and how to remove stimulus, how to secure the stability of the global financial system.”
Those making such decisions might want to read up on the 1937 recession. That experience reveals how difficult it can be for government to beat an orderly retreat after fearsome meddling in the economy.
The U.S. economy improved rapidly between 1933 and 1937. Unemployment moved from the catastrophic (25%) to the merely horrible (about 14%). America’s GDP was rising as quickly as China’s is today. Many economists believed the New Deal had done the trick. But it had also been fearfully expensive. President Franklin Roosevelt promised balanced budgets but had yet to deliver one.
With the economy mending, pressure mounted to rein in government spending. Treasury Secretary Henry Morgenthau Jr. had long pressed for a return to balanced budgets. His proto-Keynsian foil, Federal Reserve board chair Marriner Eccles, advocated sustained government stimulus. But by 1936, even Eccles wanted fiscal restraint.
Beginning that year, federal spending was trimmed back. Fearing inflation and the spectre of renewed speculation, the Fed began raising interest rates. It also ordered banks to double their reserves. Meanwhile, the government began collecting social security taxes, but wasn’t yet paying out benefits. Plenty of stimulus disappeared in a hurry.
The swift result: renewed disaster. In September 1937, the economy fell back into a sharp recession that lasted until the following summer. Stocks plunged by more than half. Unemployment surged anew. Corporate profits crumbled. Confidence shattered. And bickering between liberals and conservatives resumed forcefully. Seemingly paralyzed by confusion, Roosevelt didn’t pick sides until 1938.
Some prominent policy-makers of today are mindful of all this — among them Christina Romer, one of President Barack Obama’s economic advisers. In an article published in June in The Economist, she wrote, “The 1937 episode provides a cautionary tale ? if the government withdraws support too early, a return to economic decline or even panic could follow.” Not until full employment is re-established should government withdraw, she suggested.
As in the Dirty ’30s, a dispute brews today between fiscal conservatives and neo-Keynesians. Canadian policy-makers, for now, remain in the latter camp. Federal Finance Minister Jim Flaherty says it’s too soon to revoke stimulus. The Bank of Canada’s Lane agrees. “The incipient recovery depends to a considerable degree on official action,” said Lane. “At what stage will private demand be robust enough to make the recovery self-sustaining? Clearly, we haven’t reached that point yet.”
Even so, some actions to which the 1937 recession is attributed are being considered once again. In late August, Flaherty suggested central banks should pop asset bubbles — a popular sentiment in the wake of the U.S. housing market’s collapse, which many blame on Fed inaction. Yet attempts to stifle speculation in the 1930s contributed to disaster.
Fears over souring public finances remain acute. Heavily indebted even before the recession, the U.S. government is now accumulating record deficits. Like Roosevelt, Obama vowed to slash deficits — in this case, in half before the end of his four-year term in office.
Canada spent more than a decade paying down its national debt; all that progress, at least in nominal terms, will likely evaporate. Parliamentary budget officer Kevin Page warns that unless Ottawa develops a plan for balancing its books this fall, the nation may drift toward even deeper deficits. That could spark a larger crisis fuelled by debt, inflation and renewed job losses.
Determining how and when to de-stimulate the economy could well be the toughest decision facing economic policy-makers. A recent report from TD Bank warned, “There remains the real risk that central banks pull back stimulus too early and cause another leg-down in the economy or withdraw too late and cause inflation to rise significantly.” History won’t be particularly useful in pinpointing the “sweet spot.” But a darker reading of the 1937 experience suggests that in certain circumstances the ideal moment may not exist. Perhaps there are some recessions you simply can’t buy your way out of.
