The Recession of 1937-8 and the Potential Recession of 2012

Here we go again with the same dumb policies (austerity) from the same dumb congresspersons (Republicans).

There is a similarity between the current situation and that of 1936. There was a mistaken impression then that the vigorous 10.58% annual compound growth rate of the 1933-36 recovery meant that the economy was no longer fragile, and was self sustaining. There have been two periods when banks excess reserves have been abnormally high: in the recovery stages of the Great Depression 1933-41, and 2008-11. Before the recession of 1937-8 the excess reserve ratio, excess reserves divided by time and demand deposits hit a peak of .08555 in January 1936. After the 1937-8 recession it hit .13946 in October 1940. These peaks took years to be reached. In the Panic of 2008-9 the excess reserve ratio went from .00027 in August 2008 to .11104 in May 2009 during what is now known as QE-1. In April 2011 the ratio was .18159 and still rising, far above the Great Depression record.

The recoveries from the Great Depression (beginning in 1933) and the Panic of 2008 have some similarities. All three started from severe downturns, the accumulation of abnormally high excess reserves by the banks, high unemployment, and fiscal and monetary stimulus. In 1937, it was thought that there was no need for additional fiscal and monetary stimulus. The same thinking rooted in the austerity myth exists today. Perhaps in 1937 that might have been true had fiscal and monetary had gone from simulative to neutral, but the actual changes were from simulative to strongly negative. The economy was given three punches in 1936-7.

1. Lower government spending. National Income and Product Account tables show government spending as a percent of GDP for 1930-42 along with some other years. Roosevelt campaigned on a balanced budget plank in 1932 and, sensitive to complaints about deficits (sounds like Obama), lowered government spending on goods and services from 21.74% of GDP in 1936 to 19.81% in 1937, even lower than Hoover in 1931 and 1932.

2. Higher taxes in 1937. Personal tax collections and personal income before taxes (PI). Dividing gives the realized average tax rate. The personal rate rose from 1.90% to 2.56%. Regarding corporate income tax rate, calculating the tax rate by using actual collections includes the effect of loopholes which is why the realized rate does not equal the statutory rate (loopholes are a huge problem currently but we do not seem to have the political will to get rid of them). The realized corporate rate did not increase in 1937 but an important element is missing, social security taxes. Collections for social security began in 1937, 1% of wages from the worker and 1% from the firm.

3. Decline of the money stock. The St. Louis Fed FRED database shows that from March to December 1937 M2 dropped 3.25% (and M1 dropped 6.48% from March to November. A once great indicator, M1 has become obsolete with the advent of interest on checking, sweep accounts, etc.). While 3.25% may not seem to be much of a drop it is almost 6 times bigger than any drop since (.44% Jan-May 1948/ .56% Jan-Feb 1970/ .43% Nov-Apr 1992-3/ .54% Aug-Nov 2003).

Because the fiscal and monetary restraints occurred simultaneously it is not clear whether the 1937-8 recession was caused by the monetary restraint, the fiscal restraint, or both. But in a sense it does not matter because in 2011 it appears that the Republican led Congress is going to re-enact 1936-37 restraints with a cut in government spending, an increase in at least some taxes (hopefully closing loopholes in our crazy 55000 page tax code), and ending the QE-2 monetary stimulus program. Again the assumption is being made that the economy is strong enough to be self sustaining and that the bicycle training wheels can be taken off. Note: Peter Schiff says that QE-2 is not a training wheel, it is the only wheel.

There are doubts about sustainability. The current U.S economy is not normal. It has two features in common with 1936-7, zero short term rates, and huge excess reserves at the banks.