Another 1937?
Source Louis Proyect
Date 11/08/13/03:00
Aftershock to Economy Has a Precedent That Holds Lessons

Like earthquakes, financial crises seem to be accompanied by
aftershocks, like the one we’ve been living through this week.
They can feel every bit as bad as the crisis itself. But economic
history and academic research suggest they can set the stage for a
sustainable recovery — and eventual sharp stock market gains.

The events of the last few weeks — gridlock in Washington,
brinksmanship over raising the debt ceiling, Standard & Poor’s
downgrade of long-term Treasuries, renewed fears about European
debt and a dizzying plunge in the stock market — bear an
intriguing resemblance to some of the events of 1937-38, the
so-called recession within the Depression, with a major caveat: it
was a lot worse back then. The Dow Jones industrial average
dropped 49 percent from its peak in 1937. Manufacturing output
fell by 37 percent, a steeper decline than in 1929-33.
Unemployment, which had been slowly declining, to 14 percent from
25 percent, surged to 19 percent. Price declines led to deflation.

“The parallels to what is happening now are very strong,” Robert
McElvaine, author of “The Great Depression: America, 1929-1941”
and a professor of history at Millsaps College, said this week.
Then as now, policy makers were struggling with how and when to
turn off the fiscal stimulus and monetary easing that had been
used to combat the initial crisis.

Are we at similar risk today? David Bianco, chief investment
strategist for Merrill Lynch Bank of America, told me this week
that “the market is collapsing faster than any fundamentals would
warrant.” The possibility that the United States faces a recession
as bad as 1937’s seems far-fetched. Nonetheless, the risk of
another recession has soared, by Mr. Bianco’s estimate, to an 80
percent probability, one that would be worse than the 1991
recession. He noted that there had been only three instances when
such a steep market decline was not followed by recession: 1966,
1987 (after the October stock market crash) and 1998 (after the
implosion of Long Term Capital Management.) “Confidence is shaken
and rapidly falling,” he said, a problem worsened by falling stock

By 1937 an economic recovery seemed to be in full swing, giving
policy makers every reason to believe the economy was strong
enough to withdraw government stimulus. Growth from 1933 to 1936
averaged a booming 9 percent a year (rivaling modern-day China’s),
albeit from a very low base. The federal debt had swelled to 40
percent of gross domestic product in 1936 (from 16 percent in
1929.). Faced with strident calls from both Republicans and
members of his own party to balance the federal budget, President
Franklin D. Roosevelt and Congress raised income taxes, levied a
Social Security tax (which preceded by several years any payments
of benefits) and slashed federal spending in an effort to balance
the federal budget. Income-tax revenue grew by 66 percent between
1936 and 1937 and the marginal tax rate on incomes over $4,000
nearly doubled, to 11.6 percent from an average marginal rate of
6.4 percent. (The marginal tax rate on the rich — those making
over $1 million — went to 75 percent, from 59 percent.)

The Federal Reserve did its part to throw the economy back into
recession by tightening credit. Wholesale prices were rising in
1936, setting off inflation fears. There was concern that the
Fed’s accommodative monetary policies of the 1920s had led to
asset speculation that precipitated the 1929 crash and ensuing
Depression. The Fed responded by increasing banks’ reserve
requirements in several stages, leading to a drop in the money supply.

The possible causes of the ensuing stock market plunge and steep
contraction in the economy provide fodder for just about everyone
in the current political debate. Republicans can point to the
Roosevelt tax increases. Democrats have the spending reductions,
which coincides with Mr. McElvaine’s view. “It appears clear to me
that the cause was policies put into effect in 1936-37, mainly
cutting spending when F.D.R. believed his re-election was
secured,” he said.

The Nobel-prize winning economist Milton Friedman blamed the Fed
and the contraction in the money supply in his epic “Monetary
History of the U.S.” And the stock market itself may have been a
culprit, falling so steeply that it wiped out the wealth effect of
rising prices, undermined confidence and brought back painful
memories of the crash. But taken together, they suggest that
policy makers moved too quickly to withdraw government support for
the economy.

In the current context, it’s hard to blame the Fed for being too
restrictive in its monetary policy, as the Fed was in 1937. If
anything, critics fault it for being too accommodating, raising
many of the same issues that led the Fed to tighten in 1937. Ben
S. Bernanke, the Fed chairman, is a student of Depression history
and is well aware of Mr. Friedman’s monetary analysis. “He won’t
make the same mistake,” Jeremy Siegel, professor of finance at the
Wharton School of the University of Pennsylvania, said.

The Fed’s pledge this week to keep interest rates near zero not
just for a vague “extended period” but for a full two years
rendered two-year Treasuries virtually risk-free and depressed
their yields to a record low of 0.19 percent. This should lead
investors to seek income from riskier assets, leading to lower
interest rates across the spectrum, including mortgage rates.

Despite a brief stock market rally after the Fed’s announcement,
Mr. Bianco said he believed investors might be underestimating the
significance of the Fed’s move. “You will see household funding
costs go down. That will be a benefit and should boost
confidence.” At the least, “The Fed has not abandoned us. They’re
doing what they can,” he said.

But monetary policy can only do so much, especially if fiscal
policy is moving in the opposite direction.

Christina Romer, a professor at the University of California,
Berkeley, who has written extensively about the Great Depression,
declared two years ago while chairman of President Obama’s Council
of Economic Advisors: “The urge to declare victory and get back to
normal after an economic crisis is strong. That urge needs to be

Yet both political parties have strapped themselves to the mast of
deficit reduction, one through spending cuts, the other tax
increases. The recent market plunge may reflect not the largely
symbolic S.& P. downgrade of United States Treasuries or worries
about political gridlock, but widespread investor fears that both
approaches risk a renewed recession by withdrawing stimulus from a
fragile economy too soon. No one seriously disagrees that the
budget deficit has to be addressed, either through spending cuts
or tax increases or in some combination of the two. The question
is when.

The good news about the 1937-38 recession, severe though it was,
is that it lasted just a year, from May 1937 to June 1938 by most
calculations. The precipitous 1937 stock market decline and
surging unemployment jolted Washington into action. The Fed
reversed its higher bank reserves policy and cut the discount rate
to 1 percent. In April, President Roosevelt announced a $2 billion
“spend-lend” program and embraced deficit spending. But the tax
increases remained in effect. Economic growth resumed in June 1938
and was stronger than it had been in the 1933-37 period. Stock
prices surged.

Of course, history never repeats itself exactly, and unfortunately
for today’s policy makers, the causes of the 1938 economic rebound
seem less clear than the causes of the recession. While Keynesians
have embraced the Roosevelt stimulus package to support their
arguments for government intervention, others argue it came too
late and was too small to account for the recovery. A Federal
Reserve Bank of Chicago senior economist, François Velde,
concluded that while traditional monetary and fiscal analyses
tended to account for the severity of the 1937 downturn, other
still-unidentified factors are needed to explain why the economy
“rebounded so strongly.”

Still, the sense that Washington was doing something to address
the problems may have played a key role by bolstering confidence,
which was reinforced by rising stock prices.

Historians can’t know if the 1938 recovery, strong as it was,
would have been enough to finally end the Great Depression. World
War II intervened. But nothing today seems nearly as dire as the
problems facing the world in 1938. The 1937 aftershocks had the
effect of galvanizing policy makers who had grown complacent about
the recovery. The result was renewed economic growth, higher
employment, higher wages and productivity — and higher stock
prices. Investors who had the courage to buy stocks at their 1937
lows were looking at a 60 percent gain less than a year later.

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