The imminent return to Berkeley of our Class of 1957-Garff B. Wilson Professor of Economics Christina Romer from her stint serving as cabinet-rank chair of President Barack Obama’s Council of Economic Advisers has reminded me of this speech she gave at Washington’s Brookings Institution 18 months ago, and of Carlos Santayana’s statement that those of us who do not remember history are condemned to repeat it.
I only wish that those of us who do remember history were not also condemned to repeat it with them:
Christina Romer, CEA Chair, March 9, 2009: [M]onetary policy was very expansionary in the mid- 1930s. Fiscal policy, though less expansionary, was also helpful….
And the economy responded. Growth was very rapid in the mid-1930s. Real GDP increased 11% in 1934, 9% in 1935, and 13% in 1936. Because the economy was beginning at such a low level, even these growth rates were not enough to bring it all the way back to normal. Industrial production finally surpassed its July 1929 peak in December 1936, but was still well below the level predicted by the pre-Depression trend. Unemployment had fallen by close to 10 percentage points—but was still over 15%. The economy was on the road to recovery, but still precarious and not yet at a point where private demand was ready to carry the full load of generating growth.
In this fragile environment, fiscal policy turned sharply contractionary. The one- time veterans’ bonus ended, and Social Security taxes were collected for the first time in 1937. As a result, the deficit was reduced by roughly 21⁄2% of GDP. Monetary policy also turned inadvertently contractionary. The Federal Reserve was becoming increasingly concerned about inflation in 1936. It was also concerned that, because banks were holding such large quantities of excess reserves, open-market operations would merely cause banks to substitute government bonds for excess reserves and would have no impact on lending. In an effort to put themselves in a position where they could tighten if they needed to, the Federal Reserve doubled reserve requirements in three steps in 1936 and 1937. Unfortunately, banks, shaken by the bank runs of just a few years before, scrambled to build reserves above the new higher required levels. As a result, interest rates rose and lending plummeted.
The results of the fiscal and monetary double whammy in the precarious environment were disastrous. GDP rose by only 5% in 1937 and then fell by 3% in 1938, and unemployment rose dramatically, reaching 19% in 1938. Policymakers soon reversed course and the strong recovery resumed, but taking the wrong turn in 1937 effectively added two years to the Depression.
The 1937 episode is an important cautionary tale for modern policymakers. At some point, recovery will take on a life of its own, as rising output generates rising investment and inventory demand through accelerator effects, and confidence and optimism replace caution and pessimism. But, we will need to monitor the economy closely to be sure that the private sector is back in the saddle before government takes away its crucial lifeline…