Economics: Are We About to Repeat the Mistakes of 1937?

It is starting to look like 1937 all over again. As the table below indicates, the economy made a significant recovery after hitting bottom in 1932, when real gross domestic product fell 13%. The contraction moderated considerably in 1933, and in 1934 growth was robust, with real G.D.P. rising 11%. Growth was also strong in 1935 and 1936, which brought the unemployment rate down more than half from its peak and relieved the devastating deflation that was at the root of the economy's problems.

By 1937, President Roosevelt and the Federal Reserve thought self-sustaining growth had been restored and began worrying about unwinding the fiscal and monetary stimulus, which they thought would become a drag on growth and a source of inflation. There was also a strong desire to return to normality, in both monetary and fiscal policy.

On the fiscal side, Roosevelt was under pressure from his Treasury secretary, Henry Morgenthau, to balance the budget. Like many conservatives today, Mr. Morgenthau worried obsessively about business confidence and was convinced that balancing the budget would be expansionary. In the words of the historian John Morton Blum, Mr. Morgenthau said he believed recovery depended on the willingness of business to increase investments, and this in turn was a function of business confidence, adding, In his view only a balanced budget could sustain that confidence.

Roosevelt ordered a very big cut in federal spending in early 1937, and it fell to $7.6 billion in 1937 and $6.8 billion in 1938 from $8.2 billion in 1936, a 17% reduction over two years.

At the same time, taxes increased sharply because of the introduction of the payroll tax. Federal revenues rose to $5.4 billion in 1937 and $6.7 billion in 1938, from $3.9 billion in 1936, an increase of 72%. As a consequence, the federal deficit fell from 5.5% of G.D.P. in 1936 to a mere 0.5% in 1938. The deficit was just $89 million in 1938.

At the same time, the Federal Reserve was alarmed by inflation rates that were high by historical standards, as well as by the large amount of reserves in the banking system, which could potentially fuel a further rise in inflation. Using powers recently granted by the Banking Act of 1935, the Fed doubled reserve requirements from August 1936 to May 1937. Higher reserve requirements restricted the amount of money banks could lend and caused them to tighten credit.

This combination of fiscal and monetary tightening — which conservatives advocate today — brought on a sharp recession beginning in May 1937 and ending in June 1938, according to the National Bureau of Economic Research. Real G.D.P. fell 3.4% in 1938, and the unemployment rate rose to 12.5% from 9.2% in 1937

For more, see Are We About to Repeat the Mistakes of 1937? by Bruce Bartlett, July 12, 2011 at Economix.