Drawing parallels to the Depression era

The New York Stock Exchange is shown, Tuesday, Aug. 9, 2011 in New York. Stocks tanked again Tuesday as many global markets entered official bear market territory after one of the worst days on Wall Street since the collapse of Lehman Brothers in 2008.(AP Photo/Mark Lennihan)   | Photo Credit: Mark Lennihan

After the grim economic developments of the past few weeks, it's easy to lose hope. Could the Great Recession of 2008 drag on for years, just as the Great Depression did in the 1930s? Adding to the despair is the oft-repeated notion that it took World War II to end the economic nightmare of the 1930s: If a global war was needed to return the economy to full employment then, what is going to save us today?

Look more closely at history and you'll see that the truth is much more complicated and less gloomy. While the war helped the recovery from the Depression, the economy was improving long before military spending increased. More fundamentally, the wrenching wartime experience provides a message of hope for our troubled economy today: We have the tools to deal with our problems, if only policymakers will use them.

Capital flight

As I showed in an academic paper years ago, the war first affected the economy through monetary developments. Starting in the mid-1930s, Hitler's aggression caused capital flight from Europe. People wanted to invest somewhere safer particularly in the U.S. Under the gold standard of that time, the flight to safety caused large gold flows to America. The Treasury Department under President Franklin D. Roosevelt used that inflow to increase the money supply.

The result was an aggressive monetary expansion that effectively ended deflation. Real borrowing costs decreased and interest-sensitive spending rose rapidly. The economy responded strongly. From 1933 to 1937, real gross domestic product grew at an annual rate of almost 10 per cent, and unemployment fell from 25 per cent to 14. To put that in perspective, GDP growth has averaged just 2.5 per cent in the current recovery, and unemployment has barely budged.

There is clearly a lesson for modern policymakers. Monetary expansion was very effective in the mid-1930s, even though nominal interest rates were near zero, as they are today. The Federal Reserve's policy statement last week provided tantalising hints that it may be taking this lesson to heart and using its available tools more aggressively in the coming months.

One reason the Depression dragged on so long was that the rapid recovery of the mid-1930s was interrupted by a second severe recession in late 1937. Though many factors had a role in the ‘recession within a recession,' monetary and fiscal policy retrenchment were central. In monetary policy, the Fed doubled bank reserve requirements and the Treasury stopped monetising the gold inflow. In fiscal policy, the federal budget swung sharply, from a stimulative deficit of 3.8 per cent of GDP in 1936 to a small surplus in 1937.

The lesson here is to beware of withdrawing policy support too soon. A switch to contractionary policy before the economy is fully recovered can cause the economy to decline again. Such a downturn may be particularly large when an economy is still traumatised from an earlier crisis.

The recent downgrade of U.S. government debt by Standard & Poor's makes this point especially crucial. It would be a mistake to respond by reducing the deficit more sharply in the near term. That would almost surely condemn us to a repeat of the 1937 downturn. And higher unemployment would make it all that much harder to get the deficit under control.

Military spending didn't begin to rise substantially until late 1940. Once it did, fiscal policy had an expansionary impact. Some economists argue that the effect wasn't very large, as real government purchases (in 2005 dollars) rose by $1.4 billion from 1940 to 1944, while real GDP rose only $900 million.

Two crucial facts

But this calculation misses two crucial facts: Taxes increased sharply, and the government took many actions to decrease private consumption, like instituting rationing and admonishing people to save. That output soared despite these factors suggests that increases in government spending had a powerful stimulative effect. Consistent with that, private non-farm employment which excludes active military personnel rose by almost 8 million from 1940 to 1944.

The lesson here is that fiscal stimulus can help a depressed economy recover an idea supported by new studies of the 2009 stimulus package. Additional short-run tax cuts or increases in government investment would help deal with our unemployment crisis. What of the idea that monetary and fiscal policy can do little if unemployment is caused by structural factors, like a mismatch between workers' skills and available jobs?

As I discussed in a previous column, such factors are probably small today.

But World War II has something to tell us here, too. Because nearly 10 million men of prime working age were drafted into the military, there was a huge skills gap between the jobs that needed to be done on the home front and the remaining workforce. Yet businesses and workers found a way to get the job done. Factories simplified production methods and housewives learned to rivet.

Here the lesson is that demand is crucial and that jobs don't go unfilled for long. If jobs were widely available today, unemployed workers would quickly find a way to acquire needed skills or move to where the jobs were located.

Finally, what about the national debt? Given the recent debt downgrade, it might seem impossible for the U.S. to embark on fiscal stimulus that would increase its ratio of debt to GDP.

Well, at the end of World War II, that ratio hit 109 per cent one and a half times as high as it is now. Yet this had no obvious adverse consequences for growth or our ability to borrow. This isn't hard to explain. Everyone understood then why the nation was racking up so much debt: we were fighting for survival, and for the survival of our allies. No one doubted that we would repay our debts. We had done it after every other war, and raising taxes even before the attack on Pearl Harbor showed our leaders' fiscal resolve.

Today, we can do much more to aid recovery, including a near-term increase in our debt. But we need to make the reasons clear and make concrete our commitment to deal with the debt over time.

In place of the tepid budget agreement now in place, we could pass a bold plan with more short-run spending increases and tax cuts, coupled with much more serious, phased-in deficit reduction. By necessity, the plan would tackle entitlement reform and gradually raise tax revenue. This would be the World War II approach to our problems.

Equally important, someone needs to explain to the nation and to world markets just why we must increase the debt in the short run. Unemployment of roughly 9 percent for 28 months and counting is a national emergency. We must fight it with the same passion and commitment we have brought to military emergencies in our past.

New York Times News Service

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Printable version | Oct 23, 2020 5:01:50 AM |

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