Tuesday, September 8, 2009

Obama Making Great Depression Mistakes?

According to a report by economists Charles Rowley of George Mason University and Nathanael Smith of the Locke Institute There are "troubling similarities" between the US President's actions since taking office and those which in the 1930s sent the US and much of the world spiralling into the Great Depression. The new pamphlet, published by the Institute of Economic Affairs has been endorsed by Nobel Laureate James Buchanan, who said:
"We have learned some things from comparable experiences of the 1930s' Great Depression, perhaps enough to reduce the severity of the current contraction. But we have made no progress toward putting limits on political leaders, who act out their natural proclivities without any basic understanding of what makes capitalism work."
In particular, the authors, claim that the White House's plans to pour hundreds of billions of dollars of cash into the economy will undermine it in the long run.

To some extent I agree with their analysis. I agree it was a terrible mistake to have
  • Fiscal expansion and higher government borrowing during the Bush years of 2001-06. These years of economic growth should have been a time to reduce government debt, not cut tax and increase the deficit.
  • Reckless Monetary expansion in 2001-07 encouraging a boom in house prices and stock market which led to subsequent bust and credit crunch which caused the most devastating recession since the 1930s.
However, I disagree with their analysis that deficit spending in a recession is harmful.
If excessive government indebtedness is a major source of the problem, why increase the government debt? Why encourage households to go yet further into debt?
If we learnt anything from the Great Depression, it was the necessity for the government to offset the rapid rise in private sector spending. (see: Principles of borrowing to see how the rise in government borrowing has offset the rise in private sector saving)

The great mistakes of the Great Depression were:
  • Allowing so many banks to collapse
  • Pursuing deflationary fiscal policy. Trying to balance the budget through higher taxes and lower spending. This mistake occurred at the beginning of the Great Depression and also in 1937, where a tightening of fiscal policy pushed the US back into a second recession.
Keynesian fiscal policy does not mean we have to increase the size of the public sector in the long run. It does not mean we want to maintain a permanently low saving rates. Keynesian fiscal policy is attempting to stabilise the economy during a period of economic contraction and rapidly rising unemployment.

It is not that we are trying to encourage more private sector debt. We are trying to prevent a too rapid fall in consumer spending which would cause an even larger rise in unemployment. The deficit spending is cyclical. Boosting growth is one of the best ways to increase tax revenues. When the economy is strong enough, the fiscal expansion can be reversed.

True, the burden of debt, is a problem. With an ageing population and increased health costs it will provide a challenge over medium and longer term. But, high government debt is not necessarily as crippling as some would like to exaggerate.

After the war, US debt was over 125% of GDP. Even by 1950, National debt was over 80%, this proved no barrier to the US having two decades of very strong economic growth. (Paul Krugman explains more at - A couple of notes on 40s and 50s)


Julien Couvreur said...

Actually, it is quite the opposite: increased government intervention and spending during the Great Depression only caused more uncertainty and unemployment.

If large government spending was good for the economy, we should have it all the time :-P

You have to remember that any spending by government comes from tax or inflation (a sneaky form of taxation). Whatever it spends cannot be spent by the tax payers. On top of that, it will create fake demand, which does not correspond to the real needs of the people, which means an artificial and misleading configuration of the production structure.
In the case of the current crisis, the most fundamental cause was the US FED trying to stabilize the economy after the dot com bubble. But it only created a larger bubble...

A good read on the topic: America's Great Depression

Anonymous said...

Government intervention didn't cause more unemployment. Also, the war became a convenient factor to increase deficit spending to boost the country's industrial war machine.

Government DO spend all the time. National defence, public works etc etc.

Deficit spending is the key here and that did help in the depression and was absolutely vital to fund war. The paybacks for it were there to see in the post-war prosperity. They even managed to repay $200 billion worth of war bonds.

The larger bubble after the dot com crash came from the interest rates artificially kept low for too long after recovery was achieved during a time of strong growth.

Julien Couvreur said...

Again, if large government spending is good for the economy, we should have it all the time.

You are correct that the FED setting the interest rate too low is a key cause of the current crisis.
What you may be missing is that the FED did the exactly same thing in the 1920s, especially 1927.
There were signs of housing bubble, then the market crashed and banks failed (fractional banking system...). Sounds familiar?

What is different about the Great Depression compared to the previous recessions in the US were:
-the FED started artificially lowering interest rates, causing the recession.
-the government undertook massive intervention, making the recession worse.

The 1920-1921 recession is interesting relative to the second point. Even though unemployment indicators were comparable to the Great Depression, the president chose the sound approach of reducing debt and the size of government. The economy recovered in less than a year.

James Douran said...

Obama made mistakes from the beginning. What's the sense of hiring people who are responsible for the recession into his advisory board?

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