The Reckoning

2012 As 1937 Redux?

President Franklin D. Roosevelt delivering his final inaugural address, with the Depression far behind him.

Photography by National Archive/Getty Images

One might hope that soon, as the tweedle-dee and tweedle-dum of the GOP race narrows the field, that a smaller number of candidates actually viable in the general election will start speaking something close to sense on economic policy. Iowa’s results have not helped. Mitt Romney, who might otherwise begin a move toward the Obama-rich voters of the American center, will have to continue pandering to the “austerity now!” crowd on the right since he barely bested Rick Santorum and really only just beat libertarian Ron Paul, too.

Why, with all the talk of America’s need to get its spending under control, would radical austerity be a problem? The answer can be structured in many ways, but today we’ll go with a historical lesson, circa 1937. In that year - the fifth of Franklin Delano Roosevelt’s presidency, the US economy had finally matched its size in 1929, the year the stock market bubble popped and the world cascaded into the Great Depression. (The US economy today still has a way to go before it claws back the losses since 2007, but that’s another story).

Back in 1937, the deleveraging process was even longer and harder in every measure than it is today. By 1937, modest growth had returned, and while unemployment remained stubbornly high at just under 10 percent, that was down from a peak in 1932-33 of 25 percent.

At this point, both the Fed and the Roosevelt administration—giving in to orthodoxies that still haunt US economic thought—made terrible, independent errors. FDR acceded to Treasury advisors who declared the recovery self-sustaining and pushed for spending cuts. FDR, by now in complete control of the congressional agenda after a landslide reelection in 1936, duly cut government spending by 10 percent in an effort to balance the federal budget. The Works Progress Administration (WPA), which had employed three million in 1936, was sharply curtailed, as were other “emergency programs.”

The Federal Reserve, meanwhile, had been rattled by recent gyrations in commodity prices, particularly in corn and wheat—crops devastated by the Midwestern Dust Bowl. Acting to tame what it saw as the threat of hyperinflation, the Fed raised interest rates sharply. Various economic schools assign different weight to these two decisions, but the overall math is devastatingly clear. By 1938, joblessness had shot back toward 15 percent, industrial production fell by 37 percent, and the worst double dip in US history had begun.

Could the mistake of 1937 be recurring as we speak? Ben Bernanke, who as chairman of the Federal Reserve bank has a relatively free hand in interest rate policy, has spent his career promising it would never happen. “Regarding the Great Depression - You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again,” Bernanke said back in 2002 at a conference honoring the ninetieth birthday of economist Milton Friedman, godfather of the monetarist school and a man whose scholarly work contends that it was the Fed, not FDR, whose error threw the country back into the Depression.

Yet Bernanke, who has also made the unprecedented promise to the market that the Fed will keep real interest rates below 1 percent until at least 2013, could still repeat the mistake—or rather have it imposed upon him by the more orthodox members of the Fed’s policy-making board, which consists of the chairmen of regional reserve banks. For instance, St. Louis Fed president James Bullard has been agitating for changes in the way inflation is computed to take greater account of spikes in energy and food prices. He also agrees with Dallas Fed president Richard Fisher, an inflation hawk, who has opposed Bernanke’s policy of “printing money” to stimulate the economy—a technique known as quantitative easing or QE. Should these voices come to dominate the Fed’s board of governors, Bernanke could be forced to swallow his promise to Friedman.

The mistake far more likely to be repeated, however, is FDR’s. In this scenario, Congress—prodded by the GOP’s fundamentalist Tea Party faction or a Republican president with no appreciation for the history of financial crises—forces a drastic cut in government spending that turns an anemic recovery into another steep downturn.

In the heat of a presidential primary season the worst political instincts will prevail. If so, the prospect of a default greatly increases, ironically threatening to accomplish exactly the opposite of what Republicans aim for: expanding the federal government. Simon Johnson, a former chief economist of the IMF and now a professor at MIT’s Sloan School of Business, explains that a US debt default would cause the private sector to collapse and unemployment to surpass 20 percent. So while the government would shrink, it would remain the employer of last resort and thus get larger, not smaller. “The Republicans are right about one thing: a default would cause government spending to contract in real terms,” Johnson says. “But which would fall more, government spending or the size of the private sector? The answer is almost certainly the private sector, given its dependence on credit to purchase inputs. Indeed, take the contraction that followed the near-collapse of the financial system in 2008 and multiply it by ten. The government, on the other hand, has access to the Fed, and could therefore get its hands on cash to pay wages.”

The sane way to deal with US debt is to protect growth with a mix of stimulus and prudent cuts to government spending, not by laying off another million or more government employees. Those trims should happen over the course of a decade by attrition with the focus of cuts on things the government can do without - and there are plenty to choose from.

But the drift of the GOP campaign so far looks more likely to produce a UK-style austerity package like the one Tory Prime Minister David Cameron implemented. The results have been predicatable: a steep dive for the UK economy and, almost certainly, a plunge back into recesssion early next year.

We deserve a happier new year than that.

Follow me on Twitter and preorder my book, “The Reckoning: Debt, Democracy and the Future of American Power,” coming in April from Palgrave Macmillan.