Monday, August 24, 2009

Party Like It's .... 1937

There's a great piece today in the WSJ about how the Federal government is studying the policy train wreck that was 1937 in order to prevent it from happening again. Basically, the government is studying how to take the current punch bowl away without killing the economy. Here are some key points:

The economy was recovering briskly during Franklin D. Roosevelt's first term in the White House. The jobless rate, which had peaked at 25% in 1933, fell to 14% in 1937 -- not exactly cause for celebration but a relief nonetheless.

The comeback stalled in 1937. Banks, nervous about the fragile recovery, were holding huge amounts of cash in reserve at the Fed. Fearing an inflationary surge should the banks decide to lend that money out to businesses and individuals, the Fed -- which had made the mistake of tightening monetary policy soon after the 1929 stock-market crash -- miscalculated again. The Fed ratcheted up banks' reserve requirements three times, starting in 1936. The banks reacted by cutting lending even further.

"There's no doubt that [Fed Chairman Ben] Bernanke is heavily influenced by these two mistakes of the Fed during the Depression and is absolutely intent on not repeating them," says Alex J. Pollock of the American Enterprise Institute, a free-market think tank in Washington.

Compounding the Fed's errors, the federal government tightened fiscal policy. Congress approved a big bonus for World War I veterans in 1936, providing a spark of consumer spending. But lawmakers allowed the subsidy to lapse in 1937. At the same time, the government began collecting the first Social Security taxes, on top of income and capital-gains tax increases that Mr. Roosevelt approved in 1934-35.

Tightening the monetary and fiscal screws sent the economy into free fall again -- the second trough of the W. Unemployment shot up to 19%, prolonging the nation's suffering.

There's a ton of very useful and historically important information here.

1.) GDP dropped from 1929-1933 but returned to 1929 levels in 1937. While unemployment was still high, notice that it did drop a solid rates. Bottom line, by 1937 we were on the right track.

2.) The Fed increased reserve requirements at exactly the wrong time. This point is often lost in history and is an incredibly important point. Politically charged analysis points to 1937 as a reason the government intervention failed. In fact, as classic monetary policy informs us, decreasing the money supply at the wrong time contracts the economy.

3.) In addition, note that tax policy is vitally important. Raising taxes during the middle of an economically fragile time is also incredibly stupid. The best time to raise taxes is when the economy is humming along and has been for at least a year. In addition, you can't just ratchet up tax rates; you have to do it gradually.