Monday, July 13, 2009

Great Depression Comparisons

A few weeks ago, I read an interesting piece in the Economist from Christina Romer, the chairwoman of Barack Obama's Council of Economic Advisers (lessons from 1937)

Basically, it concentrated on the events of 1937 and the double dip recession which occurred.


Most people assume that the Great Depression lasted for the whole 1930s, but, this wasn't the case. Output fell for 3-4 years between 1929-32, but then recovered. By 1936, output was rising strongly. Unemployment was still high, but, it had started to fall.

However, 1937, was a real kick in the teeth as the relatively strong recovery came to an end and the economy went into recession again, causing unemployment to rise above 20%.

This second recession of 1937, was put down to two main factors.
  • A tightening of monetary policy. The Fed doubled the reserve ratio required by banks because they became nervous over inflationary pressure. But, this doubling in reserve ratio led to a tightening of lending.
  • A tightening of fiscal policy. - Tax increases (social security taxes collected for first time) and spending cuts (veteran's bonus allowed to expire).
Interestingly in 1937, there was great concern over the size of the budget deficit and there was strong political pressure to reduce the deficit. Public opinion generally supported moves to reduce the deficit.

However, this switch in policy, combined with a tightening of monetary policy, caused a recession. And the worst event for the budget deficit is a recession. In a recession, the budget deficit will tend to rise - even if you increase tax rates and spending cuts. A return to growth is one of the best ways to reduce the budget deficit.

This does not mean we should permanently run in a budget deficit because of fear of creating a double dip recession. The governments deficit will not be reduced by a return to normal rates of growth. In the medium to long term, the government will need to tackle the structural deficit.

However, they will need to be careful. There will also need to be a careful co-ordination with monetary policy to prevent a sudden tightening which could push the economy back into recession.

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