Weekly Market Update: Week of October 4, 2010
Because of its duration, the recession that ended last year was compared so frequently to the Great Depression that it earned the moniker the “Great Recession.” Even in its aftermath, there are similarities to the Great Depression, most notably prolonged high unemployment.
When the Great Depression officially ended in March 1933, unemployment was an incredible 25% and took eight years before it dropped below 10%. While the current rate of unemployment in the wake of the Great Recession is lower (9.6% for September), there are similar concerns that it could take years before we return to unemployment levels normally associated with full economic output (about 5%).
One setback along the path of reducing unemployment in the 1930s was a second recession which occurred in 1937-38. While much shorter and less severe than the Great Depression, it added approximately three years to the recovery period. So with recent economic data suggesting the current recovery may be weakening, there is considerable debate over whether we risk a replay of a 1937-38 style recession and, if so, what lessons can we learn to prevent a similar setback today.
The 1937-38 Recession
The most fascinating aspect today about the 1937-38 recession is that while economists still debate what exactly caused it, there is a broad consensus that it was a recession that could have been avoided with better economic policy. In that respect, it was an especially unfortunate blunder for the economy that—by 1936—was demonstrating a strong and sustained rebound from the Great Depression.
The arguments for what caused this recession fall into one of three broad categories. The first argument is that it was driven by a shift in monetary policy that caused a credit contraction in 1937. The second argument is it was caused by a premature end to fiscal stimulus (i.e., deficit spending by the government) before the private sector was strong enough on its own to sustain economic growth. And the third argument is that it was triggered by significant (and populist) regulatory and legislative reform programs enacted by the Roosevelt administration, which led to uncertainty and fear on the part of business and a reluctance to continue hiring and investing.
What’s interesting about these arguments is they are also in the news today as criticisms or concerns regarding current economic policy. For example, some are arguing the Federal Reserve (Fed) should reverse course and begin a slow, gradual but deliberate tightening of monetary policy to reduce the longer-term risk of high inflation. There is also considerable debate over whether trillion dollar budget deficits and stimulus programs should be ended—or extended. And many have questioned whether businesses have been reluctant to hire and banks reluctant to lend due to uncertainty over the consequences and costs of major new legislative and regulatory initiatives such as the health care overhaul bill and the Dodd-Frank Wall Street Reform and Consumer Protection Act.
The 1930s in Review
The chart below illustrates three economic indicators over the 1930 to 1941 time frame: annual GDP (gross domestic product) growth based on nominal dollars (nominal dollars are not adjusted for the effects of inflation); the average annual civilian unemployment rate; and the federal government budget surplus or deficit as a percent of GDP. The data for 1938 have been placed in a dashed oval to highlight the impact of the 1937-38 recession on these three economic indicators.
The chart illustrates the severity of shrinkage in GDP from 1930 to 1932 before a robust recovery which led to four years (1934-37) of GDP growth averaging 12% a year. Unemployment, which peaked at 25% in 1933, declined substantially to 14.3% by 1937. During this same period, the government ran a deficit of approximately 5% of GDP—modest by today’s standards but substantial in those days given that balanced budgets were considered an important fiscal policy and goal of the federal government.
However, 1938 was a different story as the effects of a sudden recession took hold. The economy contracted at a -6.3% rate for the year and the unemployment rate jumped to 19%—reversing its four-year downward trend. The dashed line for the unemployment rate, which begins at 1937 in the chart above, illustrates what the unemployment rate could have been from 1938-41 (based on the rate of declines seen from 1933-37) had this recession not occurred. By 1941, it would have been closer to 5% than the actual 9.9% for that year.
Assessing Possible Causes
In hindsight, it was probably a combination of factors captured in the three arguments above that caused the 1937-38 recession. Here are a few of the events based on monetary, fiscal and regulatory changes that led up to the recession:
- 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.1 After its passage, real wages increased substantially but so did the number of worker stoppages and strikes.
Lessons for Today
It’s highly unlikely we risk repeating the mistakes noted above based on monetary policy. The Fed has sent strong and consistent signals that it is committed to maintaining low short-term rates and stimulative monetary policy for the foreseeable future. Likewise, most expect the pace of regulatory and legislative change to slow over the next two years regardless of the results of the November elections. While it is highly unlikely that any of recently passed bills such as financial sector reform and health care will be reversed, there could be some modifications to ease burdens on important groups such as small businesses.
However, the future fiscal policies of the government could well change as a result of this November’s elections. Substantially reducing the current deficit without any substantial increase in taxes can only be accomplished by drastic cuts in spending—notably discretionary spending such as fiscal stimulus programs. If this occurs, the question will be whether the private sector has recovered sufficiently to maintain the current economic recovery. Those opposed to balancing the budget note one lesson which can be inferred from the 1930s: Government stimulus was inadequate and the economy only truly recovered with the type of deficit spending required by World War II.
As for tax policy, there is an interesting parallel between what the Roosevelt administration implemented in increasing marginal rates for the wealthiest Americans and the current debate over whether to extend the Bush tax cuts for those households earning over $250,000 on an adjusted gross income basis. While households in this category represent only 2.1% of all personal tax filings, they account for approximately 45% of total personal federal government income tax revenues (source: the Tax Policy Center). Reverting to the old marginal rate of 39.6% for these individuals could generate substantial new tax revenue. Those arguing against this type of increase note that these individuals are an important element of discretionary spending growth at a time when overall consumer spending remains weak.
In summary, with all that we’ve learned, not just from the recession of 1937-38 but in the 70+ years since, it is extremely unlikely we risk a repeat of this type of recession. However, depending on the outcome of elections in November, there could be substantial shift in the fiscal and taxation policies of the Federal government, especially a shift away from Keynesian policies to those more associated with fiscal discipline and supply side economics.
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1Another act called the National Industrial Recovery Act (or NIRA) was also passed in 1935, giving industries protection from antitrust prosecution and encouraging the creation of pricing cartels so long as firms raised prices (a bid to reverse deflation) and shared their higher profits with workers in the form of higher wages. In some respects, this act was meant to offset the impact of the NLRA by permitting companies to cartelize. However, it was struck down by a Supreme Court decision in 1937.
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