In June I asked an important question – are we bound for another depression like Paul Krugman and many commentators have been calling for? And more importantly, are we making the same mistakes that were made in the 30’s that could lead to a severe double dip recession?
For those who aren’t all that familiar, the story behind 1938 generally goes something like this – the US economy was suffering from a massive balance sheet recession and required substantial government aid to maintain economic growth as the private sector absorbed the excesses of the 1920’s. When the government attempted to balance the budget in 1936 they sparked a second leg down. The following chart from American Century Investments shows an excellent depiction of the financial landscape of the 30’s:
As of 1936 the US government was running a deficit that was equivalent to 5% of GDP. Unemployment had fallen from 25% to 14% and GDP had grown at 12% for 4 straight years. Then 1937-38 hit and the unemployment rate spiked to 19% while GDP contracted over 6%. American Century believes there were several causes of the downturn:
- Because some members of Roosevelt’s cabinet—notably Secretary of the Treasury Henry Morgenthau—were uncomfortable with the idea of running a long-term deficit, the administration moved to eliminate it. In 1937 the federal deficit fell to $2.5 billion (or 2.8% of GDP) from the previous year’s $5.5 billion (or 5.5% of GDP) as Roosevelt and Congress slashed spending by 18%. In 1938 spending dropped another 10% from 1937. The government effectively ran a balanced budget that year with a deficit of only $100 million or 0.5% of GDP. (See the “Federal Budget Surplus/Deficit as a % of GDP” line in the chart above for 1938.)
- The Fed began tightening the money supply in 1936. But instead of using open-market operations to gradually increase interest rates in order to contain any inflationary pressures, it chose instead to use its new power (granted by Congress the previous year) to set the banks’ reserve requirements—the percentage of deposits that banks must hold either in their vaults or at the Fed. The Fed engaged in three back-to-back increases in reserve requirements between August 1936 and May 1937 causing a substantial tightening of the money supply in a very short time.
- Several taxes or tax increases were implemented in 1937. The first was a substantial increase in income tax rates for the wealthy due to the Revenue Act passed in June 1936. The top marginal rate was increased from 59% to 75%. Second, President Roosevelt implemented a tax on the undistributed earnings of companies which he argued were shielding income from taxation by refusing to increase dividends. Finally, the new Social Security program with 2% payroll deductions (half was paid by employees and employers) was instituted in January 1937.
- Among many legislative and regulatory changes, one example is the National Labor Relations Act (or NLRA—also called the Wagner Act) which was passed in July 1935 and substantially increased the bargaining power of unions by forcing businesses to recognize and negotiate with them. After its passage, real wages increased substantially but so did the number of worker stoppages and strikes.
We can see right off the bat that the current landscape is quite different in terms of government response. We are running much larger deficits today, monetary policy is likely to remain accommodative and legislative and regulatory changes have done little to fix the world that caused this crisis in the first place. I have never believed the whole “second great depression” theory. We are in, what I believe is simply a prolonged recession – a sustained period of below trend growth that is caused primarily by household de-leveraging. This environment will leave us extremely vulnerable to exogenous risks (housing prices declines, sovereign debt crisis, China slow-down) so the potential for a technical double dip will remain high even though I believe this environment is likely to continue feeling like a recession for several more quarters if not years.
The biggest threat to the current environment is political gridlock and a belief that we need a balanced budget. Thus far, these beliefs have been largely thwarted, however, there remains a shift more and more towards fiscal prudence. The upcoming election is being hailed as a positive sign that the Republicans will add more balance to public policy. I think this is quite possibly a misinterpretation of the realities that we confront. A Republican win likely means a shift towards supply side economics and a move towards fiscal prudence. More belt tightening if you will. That is needed at the private sector level, but is not needed at the public sector level as inflation remains low and there is no risk of solvency for the US government.
The potential for gridlock and little government aid of any form is increasingly likely in this scenario. Monetary policy has proven to be of little use in this environment despite Mr. Bernanke’s continued efforts. In terms of aiding the private sector fiscal policy remains the tool of choice. The one positive of a Republican Congress is that it increases the likelihood of a large scale tax cut of some sort. Warren Mosler has proposed a full payroll tax cut that he believes could be the equivalent of a $1T stimulus bill. I would fully support any such move as I believe we are grossly overtaxed and that the government can certainly afford such a measure. The government has proven itself thoroughly incapable of efficiently spending money so if we are going to consider passing a second form of stimulus it should go directly into the hands of the private sector via a tax cut.
In sum, I see a continued environment of low growth that is consistent with a private sector that is paying down debts and absorbing past excesses. Although the recession is technically over it will likely feel like a recession for several more quarters if not years. This weak economic growth does not mean we are certain to double dip, but it does leave us particularly vulnerable to exogenous risks (housing prices declines, sovereign debt crisis, China slow-down). I do not believe we are in a depression or that we are repeating the mistakes of 1937 (at least not yet), however, there remain substantial headwinds in the current environment and I believe policymakers and investors should continue to err on the side of caution. The risks to the downside remain substantial, but they are not dire given the current landscape.
Source: American Century Investments