We're coming up on 1937

The long-term pernicious effects of Ben Bernanke's monetary policies have yet to be felt

By Martin Hutchinson 

Five years after the 1929 Wall Street Crash, the US economy was in deep trouble but beginning to enjoy a vigorous recovery from the depths of a very unpleasant depression. The rest of the world, on the other hand, with the notable exception of Britain, was mired in Depression and in several cases Fascism. 

This time around, five years after the Lehman crash, we have avoided the Fascism, but the world economy is recovering only feebly. In the 1930s, the US was again plunged into deep depression in 1937, an indication that policymakers had got it wrong. This time around, different mistakes have been made but the likely outcome appears to be very similar. 

There is still considerable discussion about the policy mistakes that converted the 1929 stock market crash into the Great Depression, but three failures stand out. First, the 1930 Smoot-Hawley Tariff zapped world trade just as it was in a fragile position, causing its volume to decline by 65% from the 1929 peak. 

Second, while the Fed kept interest rates low, they did not adjust properly for the decline in money supply caused by bank bankruptcies from late 1930 onwards. This caused a sharp decline in prices that made real interest rates very high - the debt deflation about which Ben Bernanke has nightmares. 

Third, in early 1932, when the depression appeared to be bottoming out, president Hoover forced through a massive tax increase, raising the top marginal income tax rate from 25% to 63%. Keynesians and Austrians, otherwise opposed in their policy prescriptions, can agree that this was a bad idea, giving the Depression another leg downwards to its unspeakable bottom, with real GDP 25% below its 1929 high. 

After 1933, there is less agreement. In 1933 the government threw darts at the US economy, removing the gold peg and instituting Fascist-type business regulations through the National Recovery Administration. Whether these worked or not, the economy bounced nicely in 1933-36 and seemed headed back to equilibrium, although real GDP was still well below the 1929 level in spite of a greater US working-age population and rapid productivity growth. 

Then recession unexpectedly hit again in 1937, and proved to be deeper than any post-war recession, with GDP falling more than 5% and unemployment rising sharply. Keynesians claim this was caused by a very modest move towards a balanced budget, which included minor further income tax increases and spending cuts, but from what we know now this policy move was too small to have had such an effect. Monetarists claim the Fed inappropriately tightened, raising reserve requirements and draining liquidity from the banking system. This may have been part of the cause, but again the modest cause appears too feeble to have had the large effect. 

My belief is that both those factors may have had an effect, especially in combination, but that the major drag was the effect of New Deal legislation, with the Wagner Act (1935) forcing unionization of major industries, pushing up labor costs (the major auto strikes were in early 1937). Also the institution of Social Security (also 1935) further forced up costs by extracting contributions from January 1937 while not paying any retirement benefits until 1940. 

The combination of a large hidden tax increase (because bearing on most of the workforce) and regulatory cost increases, unlike the other fiscal and monetary factors discussed, looks to me large enough to have caused a second downward lurch that was not shared elsewhere in the world. A further negative factor was the Glass-Steagall Act, which de-capitalized the investment banks, reducing capital raising in the late 1930s to a tiny fraction of its former level. 

Whipping forward to the present day, how does the policy reaction to the 2008-09 crash compare? 

With Ben Bernanke in charge, the Fed avoided its predecessors' mistakes in 1930-32. Of course, while bank bankruptcies in 2009-13 were up on the pre-recession period, the big banks were bailed out. Thus there wasn't a problem of an imploding banking system and a collapsing money supply. Instead, M2 money supply has increased 37% since September 2008, three times as fast as the 12% increase in nominal GDP over the period. The Fed's policy would thus have solved the problems of 1930-32 very nicely, but we don't have the collapsing banks disaster of 1930-32 and at no time except for about a week in September 2008 have we looked like getting it.

We haven't had a repeat of the Smoot-Hawley Tariff. We should keep saying that to ourselves, blessing our good fortune as we do so. It's not that our dozy leaders aren't capable of inventing a new version of Smoot-Hawley if the opportunity presents itself, but fortunately today we have a World Trade Organization and an annual series of G8 and G20 meetings, where global leaders can remind each other why Smoot-Hawleyism is a bad idea. 

In the 1930s, they had only the beginnings of such organizations, and the one true hope for international economic cooperation, the 1933 London Economic Conference, was destroyed by the ineffably economically illiterate Franklin Roosevelt. At the margins, trade has suffered a few dings, notably the disappearance of the Doha Round trade talks, but fortunately the injuries have not so far been serious enough to derail the global economic machine. We must however remain vigilant; even this far into a recovery, protectionism has an irresistible populist appeal if times again get tough. 

We also haven't had Hoover's 1932 tax increase. Of course, when you include state taxes, marginal rates are much higher than they were in the blissful Coolidge years, and government spending is around five times higher as a share of GDP. Still, we can breathe a sigh of relief that during the two years when Nancy Pelosi was in full charge of our destinies, she did not impose a major tax increase but concentrated instead on successfully ruining healthcare, severely damaging banking and attempting to shut down the energy sector to fight global warming. Tax increases have so far been only modest and not very damaging, and unless the electorate goes mad in November 2014 and pines for another dose of Nancynomics, we're fairly safe from them in the next few years. 

We have thus avoided the major mistakes of the early post-1929 years. In consequence we have not had a Great Depression that lopped 25% off GDP. Yippee! Of course, we have made our own mistakes, which will have long-term costs that I'll come to. However it's also worth looking at the errors of the middle 1930s, which caused the very nasty recession of 1937-8, to see if a similar fate awaits us. 

The US moved significantly towards a balanced budget in the early part of this year, with the "Fiscal Cliff" tax increases (the most significant of which was restoring the 2% cut in the payroll tax) and the "sequester" spending cuts. However, much to the surprise and indeed teeth-grinding fury of Keynesians, no new recession has appeared; instead we have gone on growing at the same sluggish pace. That suggests that the budget balancing of 1937 wasn't responsible for that downturn, either. 

Unexpected monetary tightening? Don't make me laugh, with Ben Bernanke in charge. He may reduce somewhat his manic level of US$85 billion bond purchases per month, but while money supply is rising at twice the rate of nominal GDP, as it is currently, it's hard for rational people to believe that a monetary pinch will cause another recession. Mind you, there are a lot of irrational people around, especially on bank trading desks! 

However, two out of the three factors that appear most responsible for 1937 have more or less been repeated. Additional costs have been imposed on industry, this time through global warming theories, imposed by fanatics at the Environmental Protection Agency and other departments. The ethanol mandate for auto engines adds cost to all who use automobile fuel for their business and daily lives; in addition the CAFE (Corporate Average Fuel Economy) standards imposed on the automobile industry will become more onerous as 2025 approaches. 

Wind power subsidies and government handouts to favored industries (yes, I'm looking at you, Tesla Motors!) merely create "malinvestment", and solar power subsidies may even have brought the cost of solar panels down to a level at which they are competitive for power generation (though guys - you need to include an "off switch" in order to avoid electrocuting firemen dealing with a solar paneled roof!). 

However the EPA's attempt to regulate carbon dioxide as a poison gas, thereby shutting down coal-fired power stations, will prove immensely expensive when implemented - I have elsewhere calculated the cost as $27 billion annually, the cost differential between coal and natural gas fired power. Then there's the cost of not building the Keystone pipeline. Those are just the new regulations I can think of, but to me they appear comparable to the Wagner Act, albeit with EPA social misfits replacing union goons. 

As for the imposition of Social Security, we surely have that with Obamacare, which is due to push up the cost of medical insurance by an unspecified but substantial percentage. In the long run, that is unlikely to prove as beneficial as Social Security; in the short run it is likely to impose comparable costs. 

Still, to look on the bright side, we haven't this time de-capitalized the investment banks, thereby closing down the capital markets. On the other hand, the long-term pernicious effects of Ben Bernanke's monetary policies have yet to be felt; five years of negative real interest rates, by suppressing saving and driving capital abroad, have dangerously shrunk the US stock of long-term capital, which will almost certainly stymie future job-creating investment just as effectively as Glass-Steagall stymied that of the 1930s. 
On balance, we may have missed the Great Depression, but we seem all too likely to face a repetition of the 1937 unpleasantness in the near future. All in all, given the amount of past experience to draw upon, government's actions during the last five years do not form an impressive policy track record.