Christina Romer on the Lessons of 1937

Christina Romer on the Lessons of 1937 June 19, 2009

In the field of economics, Christina Romer is one of the acknowledged leading experts on the Great Depression. It’s worth listening to her insights on the relevance of the Great Depression for today.  Here she is in The Economist, (no left-wing magazine that)!:

“The recovery from the Depression is often described as slow because America did not return to full employment until after the outbreak of the second world war. But the truth is the recovery in the four years after Franklin Roosevelt took office in 1933 was incredibly rapid. Annual real GDP growth averaged over 9%. Unemployment fell from 25% to 14%. The second world war aside, the United States has never experienced such sustained, rapid growth.

However, that growth was halted by a second severe downturn in 1937-38, when unemployment surged again to 19% (see chart). The fundamental cause of this second recession was an unfortunate, and largely inadvertent, switch to contractionary fiscal and monetary policy. One source of the growth in 1936 was that Congress had overridden Mr Roosevelt’s veto and passed a large bonus for veterans of the first world war. In 1937, this fiscal stimulus disappeared. In addition, social-security taxes were collected for the first time. These factors reduced the deficit by roughly 2.5% of GDP, exerting significant contractionary pressure.

Also important was an accidental switch to contractionary monetary policy. In 1936 the Federal Reserve began to worry about its “exit strategy”.After several years of relatively loose monetary policy, American banks were holding large quantities of reserves in excess of their legislated requirements. Monetary policymakers feared these excess reserves would make it difficult to tighten if inflation developed or if “speculative excess” began again on Wall Street…The Fed then doubled reserve requirements in a series of steps. Unfortunately it turned out that banks, still nervous after the financial panics of the early 1930s, wanted to hold excess reserves as a cushion. When that excess was legislated away, they scrambled to replace it by reducing lending. According to a classic study of the Depression by Milton Friedman and Anna Schwartz, the resulting monetary contraction was a central cause of the 1937-38 recession.”

The lesson is clear — fiscal and monetary stimulus had the effect of cushioning the depression, while a premature withdrawal of this stimulus caused a relapse. Today, memories are short. We forget that, just a few short months ago, the world financial system faced imminent meltdown. We forget that growth rates at the end of last year were the worst since the Great Depression. Now, attention is focused on signs of life, and people want business as usual. The worries have switched to the inflationary impact of excess liquidity sloshing around the system, and the sustainability impact of huge fiscal deficits. In other words, it sounds like 1937.

Of course, there will come a time when it is right to be concerned with these things, but is it premature? I will merely draw your attention to the recent work by Barry Eichengreen and Kevin O’Rourke, showing that we are tracking the Great Depression very well at this stage in the game, and the overwhelming aggressive policy response is all that is saving us.

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