March 8, 2021

Common Sense: Aftershock to Economy Has a Precedent That Holds Lessons

 The events of the last few weeks — gridlock in Washington, brinksmanship over raising the debt ceiling, Standard Poor’s downgrade of long-term Treasuries, renewed fears about European debt and a dizzying plunge in the stock market — bear an intriguing resemblance to some of the events of 1937-38, the so-called recession within the Depression, with a major caveat: it was a lot worse back then. The Dow Jones industrial average dropped 49 percent from its peak in 1937. Manufacturing output fell by 37 percent, a steeper decline than in 1929-33. Unemployment, which had been slowly declining, to 14 percent from 25 percent, surged to 19 percent. Price declines led to deflation.

 “The parallels to what is happening now are very strong,” Robert McElvaine, author of “The Great Depression: America, 1929-1941” and a professor of history at Millsaps College, said this week. Then as now, policy makers were struggling with how and when to turn off the fiscal stimulus and monetary easing that had been used to combat the initial crisis.

Are we at similar risk today? David Bianco, chief investment strategist for Merrill Lynch Bank of America, told me this week that “the market is collapsing faster than any fundamentals would warrant.” The possibility that the United States faces a recession as bad as 1937’s seems far-fetched. Nonetheless, the risk of another recession has soared, by Mr. Bianco’s estimate, to an 80 percent probability, one that would be worse than the 1991 recession. He noted that there had been only three instances when such a steep market decline was not followed by recession: 1966, 1987 (after the October stock market crash) and 1998 (after the implosion of Long Term Capital Management.) “Confidence is shaken and rapidly falling,” he said, a problem worsened by falling stock prices.

By 1937 an economic recovery seemed to be in full swing, giving policy makers every reason to believe the economy was strong enough to withdraw government stimulus. Growth from 1933 to 1936 averaged a booming 9 percent a year (rivaling modern-day China’s), albeit from a very low base. The federal debt had swelled to 40 percent of gross domestic product in 1936 (from 16 percent in 1929.). Faced with strident calls from both Republicans and members of his own party to balance the federal budget, President Franklin D. Roosevelt and Congress raised income taxes, levied a Social Security tax (which preceded by several years any payments of benefits) and slashed federal spending in an effort to balance the federal budget. Income-tax revenue grew by 66 percent between 1936 and 1937 and the marginal tax rate on incomes over $4,000 nearly doubled, to 11.6 percent from an average marginal rate of 6.4 percent. (The marginal tax rate on the rich — those making over $1 million — went to 75 percent, from 59 percent.)

The Federal Reserve did its part to throw the economy back into recession by tightening credit. Wholesale prices were rising in 1936, setting off inflation fears. There was concern that the Fed’s accommodative monetary policies of the 1920s had led to asset speculation that precipitated the 1929 crash and ensuing Depression. The Fed responded by increasing banks’ reserve requirements in several stages, leading to a drop in the money supply.

The possible causes of the ensuing stock market plunge and steep contraction in the economy provide fodder for just about everyone in the current political debate. Republicans can point to the Roosevelt tax increases. Democrats have the spending reductions, which coincides with Mr. McElvaine’s view. “It appears clear to me that the cause was policies put into effect in 1936-37, mainly cutting spending when F.D.R. believed his re-election was secured,” he said.

The Nobel-prize winning economist Milton Friedman blamed the Fed and the contraction in the money supply in his epic “Monetary History of the U.S.” And the stock market itself may have been a culprit, falling so steeply that it wiped out the wealth effect of rising prices, undermined confidence and brought back painful memories of the crash. But taken together, they suggest that policy makers moved too quickly to withdraw government support for the economy.

In the current context, it’s hard to blame the Fed for being too restrictive in its monetary policy, as the Fed was in 1937. If anything, critics fault it for being too accommodating, raising many of the same issues that led the Fed to tighten in 1937. Ben S. Bernanke, the Fed chairman, is a student of Depression history and is well aware of Mr. Friedman’s monetary analysis. “He won’t make the same mistake,” Jeremy Siegel, professor of finance at the Wharton School of the University of Pennsylvania, said.

The Fed’s pledge this week to keep interest rates near zero not just for a vague “extended period” but for a full two years rendered two-year Treasuries virtually risk-free and depressed their yields to a record low of 0.19 percent. This should lead investors to seek income from riskier assets, leading to lower interest rates across the spectrum, including mortgage rates.

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