We have nothing to fear but a replay of 1937 itself

09/22/2009 8:30 am EST


Jim Jubak

Founder and Editor, JubakPicks.com

The specter of 1937 hangs over the economy and the stock market.

That’s the year that over confidence that the Roosevelt administration had whipped the Great Depression and that it was time to balance the federal budget led to another deep recession that wiped out three years of growth and sent the economy reeling back to the Depression depths of 1934.

The Dow Jones Industrial Average, which had climbed 127% from a low of 85.51 on July 26, 1934 to a high of 194 on March 10, 1937,  would fall by 49% from that peak by March 31, 1938. And since it only takes a 50% loss to wipe out a 100% gain, in March 1938 the Dow was at 98.95 just about the 85.51 that it had been in July 1934.

Thanks to another collapse in 1942 stocks wouldn’t match that 1937 peak until 1945.

A few days ago I wrote a post “Most of the time rallies like this have been followed by a gain over the next 12 months”  (http://jubakpicks.com/2009/09/14/most-of-the-time-rallies-like-this-have-been-followed-by-a-gain-over-the-next-12-months/) arguing that the odds were on an investor’s side since a year after almost all big rallies--like the one going on now—the stock market was still higher in a year.

Almost. The one big exception, the one that delivered a loss big enough to wipe out portfolios, came in 1937.

It’s that “almost” that constantly gives me pause as I look, not so much at the stock market, but at the economy and at what passes for our national discussion of economic policy these days.

The comforting thing about looking back at that economic and investment disaster in 1937 is that we did it to ourselves. Bad policy decisions, not accident or fate, led us over the cliff in that year. So all we have to do to avoid a repeat of the results is to avoid the policy mistakes right?

Disturbingly, there are plenty of signs that we might well be prepared to do it to ourselves all over again.

Let’s look at what happened in 1937 and at the disturbing signs that we could well repeat the same mistakes on our way out of the Great Recession.

1937 was the year, students of the Great Depression know, that everyone from the president to the treasury secretary to the clerks on Wall Street and at Woolworth’s got so confident that the bad times were over that they tipped the country back from recovery to depression.

Unemployment, which had marched downward from its Depression high of 25% to a low of 14.3% in 1937 started to climb again, hitting 19% in 1938. Personal income dropped 15% from its 1937 peak.  And manufacturing output fell 40% from its 1937 peak all the way back to the levels of 1934.

In other words, 1937 is the year that the V-shaped recovery from the depths of the Depression turned into a W. The economic growth of 1934 (17%), 1935 (11%), 1936 (14%) and 1937 (10%) that succeeded the economic collapse of 1930 through 1933, came to grinding halt that year. And in 1938 the U.S. economy actually returned to negative growth with the economy shrinking by 6.2%.

What happened? Buoyed by the economic numbers—and by a landslide in the 1936 election where Roosevelt defeated Republican nominee Alf Landon of Kansas by an electoral college vote of 523 to 8—the Roosevelt administration declared economic victory over the Great Depression.

The declaration was a bit premature. Yes, unemployment was down from the horrifying 25% levels of the worst of the depression but it was still horrendous at more than 14%. The economy had begun to grow again but 1937 GDP was still, at $88 billion, lower that it had been in 1930 (at $97 billion).

But the emergency seemed to be over and many in the New Deal, including Roosevelt’s Secretary of the Treasury Henry Morgenthau, were deeply uncomfortable with the idea of running what looked very much like a permanent deficit. The annual federal budget deficit had peaked at $5.9 billion (yes, I know how quaint these numbers are in the days of trillion dollar deficits) but it was still a shockingly high $5.5 billion in 1936.

You have to do a bit of number crunching to realize exactly how high a $5.5 billion annual deficit seemed then. It represented 7.7% of GDP and a huge 110% of the federal government’s total annual revenue.

In 1937 the Roosevelt administration and the Federal Reserve moved to reverse many of the extraordinary measures they’d taken to fight the Great Depression. In 1937 the federal deficit fell to $2.5 billion from the previous year’s $5.5 billion as Roosevelt and Congress slashed spending by 18%. In 1938 spending dropped still further, by another 10% from the level of 1937.

And the annual deficit just about vanished. The government ran an almost balanced budget that year with a deficit of a mere $100 million.

The Federal Reserve moved in the same direction. After pursing policies that resulted in an average 11% annual increase in the money supply in the prior four years, in the beginning of 1937 the Fed under chairman Marriner Eccles reversed course and began to contract the money supply raising reserve requirements twice, the last time in the spring of 1937.

The result was the disaster I’ve described above. The economy, which had been growing strongly stalled. GDP, which was $89 billion in 1938, grew to just $89 billion in 1939. And the damage wasn’t worse only because Roosevelt forced a change in course so quickly. By April 1938 he had pushed new large scale spending programs, totaling $3.75 billion, through Congress. Legislators later added another $1.5 billion to the pot. Eccles reversed course and started to expand the money supply again.

The annual deficit soared back to $3.2 billion in 1939. That represented 45% of the government revenues that year.

Couldn’t possibly happen again, though, could it? In 1936 Roosevelt and his team didn’t even have an economic theory to justify deficit spending in an economic emergency. John Maynard Keynes’ The General Theory of Employment, Interest, and Money wasn’t published until that year. We’ve now got a Fed chairman who has written and lectured extensively on the mistakes made by his predecessors. And unemployment is still rising. We certainly wouldn’t try to cut the deficit or balance the budget while the ship is still taking on water, right? Right?

I wish I were more certain.

A July CBS News/New York Times poll found that 58% of those surveyed said the government should focus on reducing the budget deficit rather than on spending to stimulate the economy. Granted that number is probably inaccurate to the high side because of the way the question was phrased—How about instead Do you think the government should focus on reducing the budget deficit or making sure that you have a job tomorrow?—but it is still remarkably consistent with earlier polling. In May, the same poll found that a majority of Americans thought that the Obama administration should shift from fighting the Great Recession to reducing the government deficit.

Listen to all the voices—not just here but even more stridently in Europe—calling for a need to restore fiscal discipline. Listen to Congressional speeches calling for the Federal Reserve and the Treasury to exit the “free market” now before it’s too late to save even the bones of U.S. style capitalism and before the Obama administration sells us into, gasp, socialism. (I just wish someone, sometime making this charge would be specific about what kind of socialism he or she is talking about. Are we afraid that this administration wants this country to be Sweden or that it has a hankering for Stalin-era gulags and collective farms where we all start the day singing to the glory of our tractors? There’s just a little difference. Maybe the speakers could wear hats or talk in funny accents to make their definition clear.)

The economists and policy wonks and wonkettes at the New America Foundation symposium I wrote about on Friday, September 18, LINK HERE, actually believe there’s a chance we could do it again. Not by Congress cutting off the funding for the first stimulus package still flowing through the pipes, but by the House and Senate refusing to even consider a second stimulus if the economy looks like it needs one in 2011.

2011 is the year of the Big Test. By that year the money from the first stimulus will have been spent and the economy will either be in the midst of a sustainable recovery or not.

I think anybody who tells you they can predict now whether we’ll have a sustainable recovery underway in 2011 is either out to fool you or is fooling himself.

This isn’t your average recession. This is a great big global recession. Coupled with a great big global financial crisis.

This Great Recession is therefore much more subject to fits and starts and reversals than the average recession because every time the economy starts to run smoothly the banking system stands ready to throw another wrench into the works.

I’m not predicting the return of 1937 in 2011. I don’t think I’ve got the kind of super-X-ray-economic vision to call that one right either. But I would like us not to get carried away by the 57% rally in the stock market (as of the close on September 18) and become convinced that everything is fixed.

I’d like to keep all the available tools on the table until, well, until we see unemployment down to 5% or so (or whatever passes for normal these days), until we see working financial markets for all the stuff that Wall Street invented in the bubble, until we see mortgage foreclosures going down until we see credit card defaults back to pre-crisis levels, and until we see some significant inflation in the economy.

Until then, I’m hopeful, but I’ll be damned if I’m going to get overconfident.

I’d like the 1937 recession to stay buried in the history books where it belongs. But I don’t think there’s any guarantee.

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