Sunday, May 17, 2009

It is Not 1936 Again

Alan Blinder is an American economist, a chair professor in the Economics Department of Princeton University and co-director of Princeton’s Center for Economic Policy Studies. On Saturday, he published an op-ed piece in the New York Times titled It's No Time to Stop This Train. Let's review some of the points that he makes in this essay. His words are in bold.

CONTRARY to what you may have heard from some doomsayers, 2009 is not 1930 redux. What we must guard against, instead, is 2010 or 2011 becoming another 1936.

OK I am listening.

Realistically, there is little danger that the economy is heading toward a repeat performance of the Great Depression — when real gross domestic product in the United States declined 27 percent and unemployment soared to 25 percent. What we have is bad enough: our worst recession since the 1930s. But unless our leaders behave unbelievably foolishly, we will not repeat the tragic slide into the abyss of 1930 to 1933 — for two main reasons.

I am still listening.

First, our economy has many built-in safeguards that did not exist back then — like unemployment insurance, Social Security and federal deposit insurance, to name just three. These programs serve as safety nets that cushion the fall. And while they are certainly not strong enough to prevent recessions, they should be enough to prevent another depression.

The economy is structurally different than it was in 1930 - no argument there. This means that the economy will not act precisely as it did in 1930. This, however, is no guarantee that there will not be economic collapse - this just guarantees that if there is an economic collapse, it is likely to be somewhat different. We could spend more time arguing this point but Blinder says that his next point is more important so let's move on...

The more important reason is that Barack Obama, Timothy F. Geithner and Ben S. Bernanke are not Herbert Hoover, Andrew Mellon and Eugene Meyer. (Who’s that? Mr. Meyer was the Federal Reserve chairman from September 1930 to May 1933.) In stark contrast to the laissez-faire crowd that ruled the roost in 1930 and 1931, our current economic leaders are not waiting for the sagging economy to right itself. Rather, they have taken numerous extraordinary steps already — and stand ready to do more if necessary.

Again, like reason number one above, there is no argument here. The political actions taken during this economic crisis have not and will not be the same as those actions taken during the great depression. This means that the outcome will probably be materially different. This does not mean that this outcome will be better or that it will be worse - it just means that it will be different.

That’s the good news. But even if another depression is next to impossible, there is still the danger that next year, or the year after, might turn into 1936. Let me explain.

From its bottom in 1933 to 1936, the G.D.P. climbed spectacularly (albeit from a very low base), averaging gains of almost 11 percent a year. But then, both the Fed and the administration of Franklin D. Roosevelt reversed course.

In the summer of 1936, the Fed looked at the large volume of excess reserves piled up in the banking system, concluded that this mountain of liquidity could be fodder for future inflation, and began to withdraw it. This tightening of monetary policy continued into 1937, in a weak economy that was ill-prepared for it.

There are a couple of assumptions made here. First, Dr. Binder assumes that the strong economic growth from 1933 to 1936 was sustainable. Has he considered the possibility that the economy was goosed during this time period in an unsustainable fashion? If not, why not? We know that the FDR's New Deal was initiated from 1933 to 1935. Is it wild to speculate that these programs may have caused unsustainable distortions in the economy? Second, he assumes that tightening monetary policy in 1936 was the wrong choice and that not tightening would have been been the right choice. Has he considered the possibility that there was no right choice under the circumstances. If not, why not?

About the same time, President Roosevelt looked at what seemed to be enormous federal budget deficits, concluded that it was time to put the nation’s fiscal house in order and started raising taxes and reducing spending. This tightening of fiscal policy transformed the federal budget from a deficit of 3.8 percent of G.D.P. in 1936 to a surplus of 0.2 percent of G.D.P. in 1937 — a swing of four percentage points in a single year. (Today, a swing that large would be almost $600 billion.)

Thus, both monetary and fiscal policies did an abrupt about-face in 1936 and 1937, and the consequences were as predictable as they were tragic. The United States economy, which had been rapidly climbing out of the cellar from 1933 to 1936, was kicked rudely down the stairs again, and America experienced the so-called recession within the depression. Real G.D.P. contracted 3.4 percent from 1937 to 1938; the total G.D.P. decline during the recession, which lasted from mid-1937 to mid-1938, was even larger.

The moral of the story should be clear: Prematurely changing fiscal and monetary policies — from stepping hard on the accelerator to slamming on the brake — can be hazardous to the economy’s health.

Agreed. Rapidly goosing the economy and then abruptly stopping causes economic problems. Maybe we just should not goose it in the first place. Is that option on the table?

Wow, we’ve learned a lot since the ’30s, right? Well, maybe not. For the echoes of 1936 are being heard right now, even before the current recession hits bottom. If you’ve been paying attention, you know that a number of critics of the Fed are sounding alarms over the huge stockpile of excess reserves it has created — more than $775 billion at last count. What these critics are fretting about now is exactly what goaded the Fed into action in 1936: that the vast pool of loose money will ultimately be inflationary. The clear inference is that some of it should be withdrawn before it’s too late.

Will loose money not ultimately lead to inflation? Yes or no? Dr. Blinder never attempts to answer the question. I would argue that the loose economic policies should not have been implemented in the first place.

On the fiscal side, many of President Obama’s critics are complaining vociferously about the huge federal budget deficits. Try to ignore, if you can, the sheer hypocrisy of many Congressional Republicans who, having never uttered a peep about the huge deficits under George W. Bush, are suddenly models of budget probity. But whatever the motives, the worries of today’s deficit hawks sound eerily reminiscent of Roosevelt in 1936 and 1937.

In general I try to ignore politicians - period. Why does Dr. Blinder choose only these hypocritical individuals as the basis for dissent? Why not point towards those that are sounding the alarm that are not politically affiliated? Why not point towards Ron Paul, a Republican Congressman who has always been for fiscal and monetary conservatism from the 1970s into the latest Bush presidency and up to today? Probably because it is easier to whitewash all those who disagree with you as hypocrites instead of arguing the case itself. It is the oldest crutch in debate.

FORTUNATELY, Mr. Bernanke is a keen student of the Great Depression who will not allow the Fed to repeat the errors of 1936-37. But his critics, both inside and outside the Fed, are already branding his policies as dangerously inflationary, and no Fed chairman wants to be called an inflationist.

Again, I agree that Dr. Bernanke is aware of the policies enacted in 1936 and will not repeat those policies. Different policies will likely lead to different results. Why does one assume that these results will necessarily be better or worse than those results?

Similarly, I hope and believe that President Obama will not transform himself from the spendthrift Roosevelt of 1933 to the deficit-hawk Roosevelt of 1936 — at least not until the economy is back on solid ground.

How do we know when we are back on solid ground? If the economy grew on average 11% annually from 1933 to 1936, and that was not solid ground, then when will we know it is time to change course? Are you telling me that if the economy grows by the same amount through 2012 that we should continue with current record deficits and quantitative easing? Does that sound insane to anyone else besides me?

That said, a growing flock of budget hawks are already showing their talons. They will have their day — but please, not yet.

The budget hawks that Blinder is referring to are most likely Republican Congressmen. Through eight years of Bush spending excesses they did nothing (besides Ron Paul). They have more in common with vultures than hawks. Let's get that insult into the lexicon - hypocritical Republican budget hawks shall now be referred to as vultures.

To avoid a replay of the policy disasters of 1936-37, both the Fed and our elected officials must stay the course. Mark Twain once explained that, while history does not repeat itself, it often rhymes. We don’t want any rhymes just now.

At this point you most likely realize that I completely disagree with Dr. Blinder's view. What he is arguing is thus:

In situation A, we enacted policy B which lead to outcome C. Because outcome C was bad, we want to avoid policy B. Therefore, in situation A2 (somewhat similar to A), we will enact policy Y which will lead to outcome Z. Because Y is different from B (different policy), Z must be better than C (better outcome).

In reality, all Dr. Blinder is guaranteeing is that Z must be different from C (different outcome). Different does not mean better! He has refuted none of the inflationary warnings being fired by dissenters.

In the end, Dr. Blinder has nothing to worry about in regards to a repeat of 1936. I have little doubt that any such tough fiscal and monetary policies will be enacted. I mean, really, does he honestly think that Obama will try to balance the budget any time soon? No chance there.

The outcome of this economic crisis will not be 1936. It could be better and it could be worse. A lot worse. Read this description of the hyperinflation episode in Weimar Germany in the 1920s. In that context, maybe FDR made the right choice in 1936. Of course, we will never know what could have been we only know what happened. I have been on the inflationary/deflationary fence for quite some time now but I think I am ready to jump off and lump myself in with the inflationists. Any deflationists care to offer an opposing view?
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