1937 and 2011: Tightening policy in a weakening economy

by Jérémie Cohen-Setton on 3rd June 2011

What’s at stake

A slew of economic indicators out in the last few weeks have ratcheted up fears of a much deeper global slowdown than the “soft patch” mentioned in most policy circles. As the world faces higher commodity prices, disruptions stemming from the Japanese earthquake and nuclear castastrophe, while policymakers embrace fiscal austerity, and move towards monetary policy normalisation, a number of bloggers and academics wonder if policymakers are not repeating the 1937 mistake tightening policy too much and too early.

The possibility of a double-dip

Robert Reich points that the US economy was supposed to be in bloom by late spring, but it is hardly growing at all. Expectations for second-quarter growth are not much better than the measly 1.8 per cent annualised rate of the first quarter. The recovery has stalled. It is unlikely that America will find itself back in recession but the possibility of a double dip cannot be dismissed.

The Curious Capitalist
notes that according to the Blue Chip Indicators, which is probably the best survey of economic forecasters, not a single economist is predicting a double dip so far. But when asked about the probability of a double dip, many of them report a significant number: Nigel Gault of IHS Global Insight put the risk of a double dip at 25%. Top Wall Street strategist Ed Yardeni has a double dip at 20%. The ubiquitous Mark Zandi of Economy.com said the chance of a double dip was 17%. Zandi's jobs day partner on CNBC Diane Swonk of Mesirow Financial says 10% to double dipping.

When indicators keep disappointing

Catherine Rampell notes that in light of a streak of bad news — on jobs, auto sales, housing, manufacturing and retailing – many economists have ratcheted down their estimates for gross domestic product in the second quarter. A small selection: Macroeconomic Advisers is now forecasting 2.6 percent annualized growth, down from its forecast of 3.7 percent about a month earlier. Barclays Capital has lowered its forecast to 2 percent, from 3.5 percent. IHS Global Insight is expecting 2 percent. Joshua Shapiro of MFR is predicting (gulp) 1.5 percent, about half of what he’d previously expected.

James Hamilton argues that incoming data over the last two weeks paint a consistent picture that the U.S. economy, which has weakened further. The national income and product accounts updated by the BEA suggested that first quarter GDP growth was even weaker than previously indicated. And the second quarter may be starting out even worse. The National Activity Index maintained by the Federal Reserve Bank of Chicago summarizes a variety of monthly economic indicators. This fell to -0.45 based on indicators of where the economy stood in April. Growth of manufacturing, which had been the economy's bright spot, seems to have slowed last month, with the ISM manufacturing PMI falling to 53.5 for May. House prices are falling again. We've also been getting some troubling new readings on the employment situation. Although new claims for unemployment insurance declined slightly, they have been coming in at a higher rate in May than they did in March or April.

Mark Thoma
argues that the jobs report is very disappointing. The BLS reports: that employment grew by 54,000 and the unemployment rate ticked up from 9.0 to 9.1 percent. Remember that we need between 100,000 and 150,000 jobs per month just to keep up with population growth, and even more than that to reabsorb the millions who are out of work. So, the employment numbers mean that instead of making up lost ground, we lost additional jobs. And, as Calculated Risk notes, if that’s not bad enough, the numbers in previous reports were adjusted downward: The change in total nonfarm payroll employment for March was revised from +221,000 to +194,000, and the change for April was revised from +244,000 to +232,000.

Gavyn Davies
writes that the US employment numbers for May seemed to surprise the markets, but in fact they confirmed what we already knew from a string of earlier data releases, which is that the economy has slowed very markedly in recent months. The debate now is whether this slowdown has been triggered mainly by transitory factors – the fallout from the Japanese earthquake, stormy weather, and a spike in gasoline prices above $4/gallon – or whether it reflects a more fundamental malaise in the economic recovery.

Jeremy Nalewaik has argued that the income-based measure of GDP (referred to as gross domestic income, or GDI) may be a slightly better indicator of business cycle turning points. For example, GDI gave a clearer signal than GDP of a weakening economy in 2007. GDI had been showing a little stronger growth than the GDP indicator in early phase of the current recovery (2009:Q4-2010:Q2), but has been signaling weaker growth than GDP for the most recent quarters (2010:Q3-2011:Q1). The latest BEA numbers report that total U.S. real output was growing at a 1.8% annual rate in 2011:Q1 according to the GDP measure but at only a 1.2% rate according to GDI.

Justin Wolfers using the data presented by Nalewaik argues that this means we continue to overestimate economic activity and because there is no effective policy response, the US is just about half way through a lost decade.

Repeating History

In 1937, on the eve of a major policy mistake, U.S.economic conditions were surprisingly similar to those in the nation today. Gauti Eggertsson provides an account of conditions in 1937 that sound very familiar to the current environment: (1) Signs indicate that the recession is finally over. (2) Short-term interest rates have been close to zero for years but are now expected to rise. (3) Some are concerned about excessive inflation. (4) Inflation concerns are partly driven by a large expansion in the monetary base in recent years and by banks’ massive holding of excess reserves. (5) Furthermore, some are worried that the recent rally in commodity prices threatens to ignite an inflation spiral.

Christina Romer and David Romer argue in a recent lecture at UC Berkeley that the 1937-38 recession was more likely the result of the winding down of New Deal policy than of overly aggressive policy. They point to three shocks on the demand side (fiscal, monetary, expectation) and one possible supply shock as the reasons that have been put forward in the literature to explain the 1937 recession. The fiscal shock, amounting to a bit less of 1% of GDP, was due to the end of the one-time veterans’ bonus and the introduction of Social Security payroll tax. The monetary shock was due to the doubling of reserve requirements designed to decrease excess reserves but which resulted in a contraction of loans as banks wanted to hold excess reserves. Romer and Romer also argue that there was an expectation shock as FDR started to sound less committed to reflation through a series of anti-inflationary communications, which could have raised real interest rates. Romer and Romer also point to supply sides explanations that have been put forward to explain the 1937 recession: the National Relations Act was passed in 1935, which may have led to large inventory accumulation in 1936 in anticipation of strikes and wage increases.

Monetary Policy

Gauti Eggertsson points that a rally in commodity prices was largely responsible for triggering the concerns about inflation. Prices of several commodities more than doubled in the span of only one year. These price increases led many policymakers to express concern about excessive inflation.  Eggertsson is optimistic that policymakers won’t repeat the same mistake today, as economists today generally do not focus on commodity prices without regard to the behavior of the aggregate price index. That might be true for policymakers in the US, but does not seem to be the wisdom on the other side of the Atlantic as illustrated by this op-ed by Lorenzo Bini-Smaghi - incidentally published on the same day than that of Eggertsson – offering arguments for using headline rather than core inflation to drive monetary policy.

Paul Krugman
in reference to Eggertston’s paper argues that he agrees with the parallel with the 1937 situation but disagrees with the conclusion that economists have learned enough to avoid repeating the same mistake. He concludes by saying that we have indeed learned a lot less these past 74 years than you might have imagined. The research staff at the NY Fed wouldn’t repeat the same mistake; but the ECB very probably will, and the Board of Governors is under a lot of political pressure to raise rates.

Lorenzo Bini-Smaghi
gets a smack down treatment from Brad DeLong for confusing the difference between levels and rates of change. LBS writes in his FT op-ed that core inflation is not a good forecaster of future inflation if variations in the prices of agricultural and energy products are not temporary. Brad DeLong responds that core inflation is a good forecaster of future inflation as long as variations in the inflation rate of agricultural and energy products are temporary. If agricultural and energy prices jump and stay at their new levels – which is what is happening – then no problem. It's only if agricultural and energy prices diverge from other prices and the proportional divergence keeps growing and growing and growing – which it isn't.

Fiscal Policy

Zachary Goldfarb from the Wapo initiated a heavy debate about fiscal consolidation in the US with his a portrait of Treasury Secretary Geithner and the light it shed on some internal debates in the administration on fiscal policy. In particular, it presented Secretary Geithner as a fiscal hawk opposing the proposal made by Romer and Summers. Brad Delong has a series of links discussing the issue and ends up more and more convinced that the Romer-Geithner exchange quoted by Goldfarb is unrepresentative of Geithner's position.

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