Nations Cut Back and Shadow of 1930s Looms
By David Leonhardt The New York Times _ United Daily News pages 7 on Tuesday, July 13, 2010
The world’s rich countries are now conducting a dangerous experiment. They are repeating an economic policy out of the 1930s – starting to cut spending and raise taxes before a recovery is assured – and hoping today’s situation is different enough to assure a different outcome.
In effect, policy makers are betting that the private sector can make up for the withdrawal of stimulus over the next couple of years. If they’re right, they will have made a head start on closing their enormous budget deficits. If they’re wrong, they may set off a vicious new cycle, in which public spending cuts weaken the world economy and beget new private spending cuts.
There is good evidence to support either prediction.
The private sector in many rich countries has continued to grow at a fairly good rate in recent months. Unlike in the 1930s, developing countries are now big enough that their growth can lift other countries’ economies. And in the United States, wages, total hours worked, industrial production and corporate profits have all risen significantly.
On the other hand, the most recent economic numbers have offered some reason for worry, and the coming fiscal tightening in this country won’t be much smaller than the 1930s version. From 1936 to 1938, when the Roosevelt administration believed that the Great Depression was largely over, tax increases and spending declines combined to equal 5 percent of gross domestic product.
Back then, however, European governments were raising their spending in the run-up to World War II. This time, almost the entire world will be withdrawing its stimulus at once. From 2009 to 2011, the tightening in the United States will equal 4.6 percent of gross domestic product, according to the International Monetary Fund. Worldwide, it will equal a little more than 2 percent.
The simultaneous moves have the potential to unnerve consumers, businesses and investors, says Adam Posen, an American expert on financial crises working for the Bank of England. “The world may be making a mistake, and it may turn out to make things worse rather than better,” Mr. Posen said.
But he added, “The chances we’re going to come out of this O.K. are still larger than the chances that we aren’t.”
In the 1930s, John Maynard Keynes’s central insight about depressions – that governments need to spend when the private sector isn’t – was not widely understood.
In 2008, though, policy makers in most countries knew to act aggressively. The Federal Reserve and other central banks flooded the world with cheap money. The United States, China, Japan and, to a lesser extent, Europe, increased spending and cut taxes.
It worked. By early last year, within six months of the collapse of Lehman Brothers, economies were starting to recover.
The recovery has continued this year, and it has the potential to create a virtuous cycle. Higher profits and incomes can lead to more spending – and yet higher profits and incomes. Government stimulus, in that case, would no longer be necessary.
But the parallels to 1937 are not reassuring. From 1933 to 1937, the United States economy expanded more than 40 percent, even surpassing its 1929 high. But the recovery was still not durable enough to survive Roosevelt’s spending cuts and new Social Security tax. In 1938, the economy shrank 3.4 percent, and unemployment spiked.
Given this history, why follow the same course today?
Greece has no choice. It is out of money. Several other countries are worried that financial markets may turn on them, too, if they delay deficit reduction. Spain falls into this category, and even Britain may. Then there are the countries that still have the cash or borrowing ability to push for more growth, like the United States, Germany and China, three of the world’s biggest economies. Yet they are also reluctant.
China, until recently at least, has been worried about its housing market overheating. Germany has long been afraid of stimulus, because of inflation’s role in the Nazis’ political rise. In responding to the recent financial crisis, Europe, led by Germany, was much more timid than the United States, which is one reason the European economy is in worse shape today.
Finally, the idea that rich countries need to cut spending and raise taxes has a lot of truth to it. The United States, Europe and Japan have all made promises they cannot afford.
In an ideal world, countries would pair more short-term spending and tax cuts with long-term spending cuts and tax increases. But not a single big country has figured out, politically, how to do that. Instead, we are left to hope that we have absorbed just enough of the 1930s lesson.