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US policymakers learnt in 1937 that cutting stimulus can lead to a recession

But prolonging a recovery with stimulus could lead to a worse slump later.

US policymakers learnt in 1937 that cutting stimulus can lead to a recession

November 2019

At a ‘Fed Listens’ event held where the US central bank’s policy-setting board meets, Federal Reserve Chair Jerome Powell in October described how the room with “26-foot (eight-metre) ceilings, a monumental marble fireplace and a 1,000-pound (450-kilogram) brass and glass chandelier” had “seen a lot of history since Franklin Roosevelt dedicated this building in 1937”.[1]

That’s probably the most innocuous economic event linking 1937 and the 32nd president. The pairing is more renowned for the ‘depression within a depression’ Roosevelt triggered in his second term when he tightened monetary and fiscal policies after US production surpassed pre-Depression levels.[2]

Under Roosevelt’s direction, the Fed boosted bank reserve requirements by 50% and the Treasury withheld gold inflows from the monetary base, to guard against inflation. Government spending was cut in a quest to eliminate the federal deficit within two years. The result was the third-worst recession of the 20th century. Real GDP dived 10% and industrial production plunged 32% while the jobless rate jumped to 20% as four million people lost their jobs.

Roosevelt’s premature tightening still haunts US policymakers. Avoiding 1937-style missteps was pertinent in 2016 when the economy was healthy enough for the Fed to tighten monetary policy and for the administration of Barack Obama to reduce budget deficits towards 2% of output from a post-crisis peak of 10% of GDP in 2009.

That the US expansion that began in 2009 has entered a record 11th year shows officials have avoided a 1937 rehash. To help ensure no repeat, the Fed this year resumed loosening monetary policy, while Washington’s budget deficit is widening. President Donald Trump’s tax cuts of 2017 have stretched the shortfall beyond 4% of output.

Prolonging an upturn with stimulus is an achievement but it comes with risks. Three leap out. One is that stimulus can delay adjustments an economy might need to thrive over the long term. Today’s US recovery is sluggish and it is at risk if imbalances metastasise. These distortions include record asset prices and government, household[3] and business debt[4] at worrying levels.

A second is the Fed is unable to respond in a meaningful, conventional way to threats. The central bank has cut the cash rate to between 1.5% and 1.75% and its balance sheet is still distended from three bursts of asset buying (or quantitative easing).[5]

The third, flowing from a stranded Fed, is that policymakers might need to double down on fiscal solutions to extend the expansion. The risk with loosening fiscal policy is it might feed doubts about US government finances. Washington’s projected deficits, on top of almost continual shortfalls since 1970,[6] are forecast to boost its debt to 95% of GDP by 2029, the highest ratio since just after World War II.[7] At some point, the public and investors could lose confidence in Washington’s budgeting abilities.

Given the gloomier outlook, US policymakers will be under pressure to prolong an expansion that already contains imbalances. The question they might ask themselves as they view these distortions is whether extending the expansion might lead to an uglier downturn than what they might have evaded so far.

To be sure, any slump comes with social costs best avoided; policymakers had little choice politically but to stimulate the economy when they could. The US’s imbalances aren’t as large as those of the eurozone and Japan, where radical stimulus has largely failed to stir robust growth. It should be noted too, that rather than stimulus, micro-economic reforms that boost productivity would be a better way to raise long-term living standards. But policymakers almost always must do something and stimulus is handy like that.

Now conventional monetary policy is nearing its limits, authorities could be tested on how much fiscal stimulus they can inject without stoking distortions or triggering repercussions that trouble the economy. The longer the recovery, the greater the risk that a coming year might gain infamy for when policymakers realised that endless stimulus leads to a bigger downturn.

Stimulant side effects

Herbert Hoover was president when the Great Depression struck in 1929. In his memoirs, Roosevelt’s predecessor told of the advice of his treasury secretary, Andrew Mellon. “Liquidate labour, liquidate stocks, liquidate farmers, liquidate real estate. It will purge the rottenness out of the system.”[8]

The quote summed up the tightening of fiscal and monetary policies that officials followed in the 1930s, the same type of voluntary deflation known as austerity that Europe pursued during the eurozone debt crisis. Repeated spectacles where austerity misfired by hurting the economy gave credence to the remedies of John Maynard Keynes. The UK economist argued that easing monetary and fiscal policies in tough times and doing the reverse in good times prolongs growth and softens recessions. Such policy activism explains why five of the six longest US expansions of the 34 upturns recorded from the 1850s have occurred since the 1960s.[9]  

While advocating macro management, Keynes was aware of its limits, especially with monetary policy. In The general theory of employment, interest and money of 1936, Keynes warned of the ‘liquidity trap’, a concept that describes situations when uncertainty is so great, low interest rates would fail to generate enough demand to ensure full employment.[10]

‘The reversal interest rate’ is modern term that warns low interest rates can even backfire. A US paper[11] of 2018 with that title cautioned that accommodative monetary policy could reduce lending by tightening capital constraints.[12] While there is no consensus on whether the US is near the ‘reversal rate’ or even that the concept holds, policymakers are questioning if loose macro settings might come with complications that are storing trouble.

One question they are asking themselves is whether emergency steps could be ineffective or even prompt perverse behaviour. On the fiscal side, policymakers are assessing whether prolonged activism might only lead to torpor and damaged public finances.[13] Italy’s budget deficit, for instance, averaged 3.4% of output from 1995 to 2018, which boosted government net debt from 101% to 120% of output. Yet the economy struggled most years.[14] With monetary policy, central bankers are watching for signs that rate cuts towards zero are worrying people so much they save rather than spend.[15]

Another question central bankers are asking themselves is, given that conventional monetary stimulus is finite and nearly exhausted, how will they fight future downturns. Policymakers could come under pressure to adopt radical steps that might boomerang. Many, for instance, are calling for fiscal authorities to resort to the inflation-prone practice of ‘money printing’, when money is whisked up and handed to the public.

Central bankers are also questioning whether loose monetary policy could reduce the pressure on politicians to take the steps economies need to thrive over the long term. They are aware that the European Central Bank calmed the eurozone debt by 2014 and saved the euro. Yet that allowed politicians to duck devising the fiscal, political and banking unions the currency union needs to endure.

Another side effect policymakers are wary of is that stimulus can inflate asset prices and foster risk-taking. The ‘Greenspan put’ described how Fed chief Alan Greenspan repeatedly cut interest rates to insulate the economy from falling stock prices. These cuts rewarded excessive risk-taking, which is often cited as causing the global financial crisis. The pertinent question they ask themselves is: Could this happen again?[16]

Policymakers are asking too if policy activism might make people too dependent on stimulus. Household budgets, for instance, appear unprepared for any meaningful rise in interest rates, however unlikely that might appear.[17]

A sixth question that policymakers are asking is whether prolonged stimulus could feed imbalances that recessions usually correct. The ‘Austrian School’ of economics opposes stimulus because slumps rid economies of ‘malinvestment’. While that’s considered extreme, low rates have led to record household, corporate and government debt in many countries. Policymakers are aware that imbalances typically get corrected one day.

The complications of stimulus don’t argue against heeding the lessons of 1937. They just mean that when policymakers gather in their splendid rooms to ponder options they must ask themselves if they risk creating a world of rarer but perhaps harsher downturns.[18]    

By Michael Collins, Investment Specialist


[1] Federal Reserve. “Opening remarks” Jerome Powell at a Fed Listens event Washington DC, 4 October 2019. federalreserve.gov/newsevents/speech/files/powell20191004a.pdf

[2] Information on the events of 1937 is from ‘FDR’. Jean Edward Smith. Random House trade paperback edition 2008. Pages 396 to 398 and the Federal Reserve history section. ‘Recession of 1937-38’. federalreservehistory.org/essays/recession_of_1937_38

[3] Federal Reserve. US aggregate household debt-to-income ratio is below its high of about 1.2 of 2008 but still high at just under one. See Household debt-to-income ratios in the enhanced financial accounts. 11 January 2018. federalreserve.gov/econres/notes/feds-notes/household-debt-to-income-ratios-in-the-enhanced-financial-accounts-20180109.htm. Consumer debt has risen in recent years. See, the table of consumer credit outstanding. ‘Consumer credit – G.19’ 7 October 2019. federalreserve.gov/releases/g19/current/. It’s worth noting that household debt service payments as a percentage of disposable income are low. See Federal Reserve Bank of St Louis chart. ‘Household debt service payments as a percent of disposable income.’ fred.stlouisfed.org/series/TDSP

[4] Non-financial corporate debt as a percentage of net worth is below the peak of the early 1990s of above 50% but is at 43%. See Federal Reserve Bank of St Louis chart. [4] Non-financial corporate debt; debt as a percentage of net worth (market value). fred.stlouisfed.org/series/NCBCMDPNWMV  

[5] Federal Reserve Bank of St Louis. The Fed’s balance sheet is worth about US$3.6 trillion compared with a peak of above US$4.4 trillion from 2015 to 2018 and with about US$800 billion pre the crisis in 2008. Chart: ‘Assets: Total assets (less eliminations from consolidations): Wednesday level.’ fred.stlouisfed.org/series/WALCL

[6] The US federal government recorded budget surpluses in 1998 to 2001; otherwise the last surplus was in 1969. Prior to that the budget was largely in balance. See Federal surplus or deficit chart from the Federal Reserve of St Louis. fred.stlouisfed.org/series/FYFSD  

[7] Congressional Budget Office of the US. An update to the budget and economic outlook: 2019 to 2029.’ 21 August 2019. cbo.gov/publication/55551

[8] Herbert Hoover. ‘The memoirs of Herbert Hoover – The Great Depression, 1929-1941.’ 1952.

[9] The numbers include the record, unbroken expansion since 2009. National Bureau of Economic Research. ‘US business cycle expansions and contractions.’ The longest expansions measured from trough to trough – a measure that excludes the unbroken expansion from 2009 – are 1991 to 2001 (128 months), 1961 to 1969 (117 months), 1982 to 1990 (100 months), 1876 to 1883 (averages taken) (99 months), and 2001 to 2007 (91 months). nber.org/cycles.html.

[10] Keynes said the liquidity trap occurs when interest rates are so low that people prefer cash to holding a debt and in such cases “the monetary authority would have lost effective control over the rate of interest”. See Paul Krugman’s explanation of the liquidity trap. “Nobody understands the liquidity trap (wonkish).’ 14 July 2010. krugman.blogs.nytimes.com/2010/07/14/nobody-understands-the-liquidity-trap-wonkish/

[11] Markus K. Brunnermeier and Yann Koby. ‘The reversal interest rate.’ NBER working paper No. 25406. December 2018. nber.org/papers/w25406

[12] To quote the paper: “It occurs when banks' asset revaluation from duration mismatch is more than offset by decreases in net interest income on new business, lowering banks' net worth and tightening their capital constraints.”

[13] To cite another example, US academic research finds that low rates are misfiring in that they encourage market concentration by boosting the incentive for industry leaders to gain a sustainable advantage over competitors. This reduces long-term productivity growth. Ernest Liu and Atif R. Martin from Princeton University and Amir Sufi from the University of Chicago. ‘Lower interest rates, market power and productivity growth.’ 1 August 2019. papers.ssrn.com/sol3/papers.cfm?abstract_id=3320551&mod=article_inline

[14] Italy’s GDP in 2018, for instance, was 3.2% below that of 2008. IMF. World Economic Outlook database October 2019. GDP is at constant prices. Government deficit is government net lending/borrowing as a percent of GDP. imf.org/external/pubs/ft/weo/2019/02/weodata/index.aspx

[15] While it’s just one statistic, this effect showed up in the Westpac-Melbourne Institute Index of Consumer Sentiment after the Reserve Bank of Australia cut the cash rate on June 4 to a then record low of 1.25%. Responses collected before the RBA decision scored 106.8 while those gathered afterwards fell to 95.5 – where a result above 100 signals optimism and one below indicates pessimism. Some of the drop can be blamed on the news on June 5 the economy only grew 0.4% in the March quarter. Westpac Banking Corp. ‘Sentiment dips as economy concerns outweigh policy boost.’ 12 June 2019. The survey of consumers was from June 3 to June 7. westpac.com.au/content/dam/public/wbc/documents/pdf/aw/economics-research/er20190612BullConsumerSentiment.pdf.

[16] Stock prices have hit record highs since the Fed relaxed monetary policy and the amount of risky lending (such as so-called leveraged lending) worldwide is rising. The Bank of England is concerned that leveraged loans – generally defined as loans to indebted consumers or businesses – have now reached US$2.2 trillion outstanding worldwide. ‘How large is the leveraged loan market?’ Bank of England. 25 January 2019. bankofengland.co.uk/bank-overground/2019/how-large-is-the-leveraged-loan-market?sf97991689=1

[17] Budget surpluses are a rare part of Keynesian management because they are politically difficult. France, for instance, last posted a government surplus in 1974 and Paris’s public debt now equals 99% of GDP even though the country has the highest tax-to-GDP ratio in the EU of 48.4%.

[18] See Roby Harding. ‘Recessions have become rarer and more scary.’ 3 September 2019. ft.com/content/8a9d12a8-ce31-11e9-99a4-b5ded7a7fe3f

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