This will be a long post, but a very important one. Doug Terry passed along this analysis from Northern Trust which shows that monetary policy is the most important factor to the economy in the short term. I have said as much on other occasions and pointed out that the rise in the LEI is signaling that the contraction is moderating.
Paul Kasriel, chief economist at Northern Trust, provides some clarity about economic policy during the Great Depression in this report titled, The Great Depression – Just the Facts, Ma’am. Kasriel breaks the depression down into two periods – as many others do – and shows that the rebound from 1933-1937 came despite some pretty horrific policy mistakes:
Given some of the economic policy decisions made in 1930,1931 and 1932, it is quite remarkable that a recovery commenced in April 1933. To wit, in 1930, Congress passed the Smoot-Hawley tariff legislation, effectively a large tax increase on imported goods. In response to this, a number of other foreign governments retaliated by passing their own tariff legislation. As a result, global trade collapsed.
Kasriel then lays out a series of what, in retrospect, seem terrible policies. The New York Fed raised its discount rate by 2% in a one week time frame in October 1931, then reduced it by 1% in two subsequent steps by June 1932. Also in 1932, the top marginal income tax rates were doubled. We all know there were massive bank failures between 1929 and 1933, amounting to a contraction of commercial bank deposits of 37%.
Despite protective tariffs, Fed discount rate increases, personal income tax rate increases and massive bank failures, the first recession of the Great Depression ended in March 1933, the same month in which Franklin D. Roosevelt was inaugurated as president. That is, the business cycle troughed occurred before the “New Deal” policies were implemented.
In 1936, FDR raised taxes again in an attempt to balance the budget. The Fed doubled the required reserves of commercial banks between August 1936 and May 1937 and the economy entered another recession in May 1937.
Kasriel then goes on to explain that New Deal policies did increase government spending but that the spending was monetized by the Federal Reserve. Bank reserves increased dramatically starting in 1933 along with government spending and contracted in 1937 as government spending fell. Kasriel’s argument is basically that it wasn’t the spending that increased GDP at such high rates between 1933 and 1937 (GDP grew at an annual pace of 9.4% in those four years), but the monetization of that spending. In other words, it wasn’t fiscal policy that caused the growth, but rather monetary policy.
Kasriel then concludes:
What does this review of historical facts have to do with the current economic environment? For starters, the policy hurdles that were put in front of an economic recovery in the early 1930s are absent today. The “Buy American” proposal related to the fiscal stimulus program seems to have gone by the wayside. The Fed has no intention of raising interest rates until it is sure the economy has begun to recover. Personal income tax rates are not likely to be raised until 2011. If the top marginal rate is increased then, the increase will be considerably smaller in absolute and relative terms than the tax increases of 1932 or 1936. Today, we have federal deposit insurance, so, for the most part, bank and thrift depositors will not incur losses if institutions fail. In addition, we have income maintenance programs such as Social Security, Medicare, Medicaid, food stamps and unemployment insurance. So, the hurdles that today’s economy has to jump over to enter a recovery would appear to be much lower than the hurdles that were erected between 1930 and 1932.
In addition, the federal government is about to embark on a massive fiscal stimulus program. Will the Fed monetize much of the new debt issued to fund this program? We do not know yet. But if recent history is any guide, the answer is yes. Chart 7 shows that the growth in bank reserves in 2008 was almost 149% – an unprecedented increase. If the federal government embarks on a large spending spree and the Fed “prints” the money to fund the spending, then the pace of real economic activity is bound to increase. How long it will take for higher prices to begin to erode real activity is another question. But never underestimate the initial positive impact on aggregate demand of that powerful combination of increased federal government spending/tax cuts and a central bank running the monetary printing press at a high speed.
It is not my role to endorse government policies. It is my role to forecast the impact of government policies on the economy. I believe that large increases in federal government spending that are monetized by the Fed and the banking system will result in a recovery in real economic activity. When that recovery sets in depends on how quickly the federal government increases its spending and by the magnitude of that increase. We can debate whether tax rates should be cut or federal spending should be increased. We can debate what kinds of spending should be increased. We can debate whether the federal government should increase any of its spending. But the facts of the 1930s appear to be pretty clear – monetized increased federal government spending does result in increased real economic activity in the short run.The economic data are likely to be abysmal through the first half of this year. The popular media will reinforce the gloom of the data. The same pundits who did not see this downturn coming will not see the recovery coming either. My advice to you is to keep your eye on the index of Leading Economic Indicators. If history is any guide, the LEI will signal a recovery well ahead of the pundits.
I believe the trough of the recession has either already happened or is happening now. There are positive signs out there, as I pointed out in my article yesterday, if you are willing to get past the headlines of gloom and doom. Monetary policy, despite what the more dismal of the economists are saying, is not impotent here. We are not in a liquidity trap where monetary policy doesn’t work. Banks are lending, real estate sales in the worst of the bubble states are rising. The leading economic indicators have risen for two consecutive months. Both the ISM surveys have risen from their lows. The pieces of the puzzle for recovery are falling into place.
The stock market rebounded today after severely testing the limits of the intraday lows of November. That is a good, but not definitive sign. The economic statistics will not improve uniformly. Specifically, employment is a lagging indicator and is unlikely to turn higher until the recovery is well underway. The market generally anticipates the improvement in the economy though and the leading indicators are positive signals that should not be ignored.