To spend or not to spend

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David Leonhardt is out with a great column on the spend-vs.-austerity debate (which Steve and Michael have also rung in on). Leonhardt’s piece provides both historical context and intellectual honesty: there are reasons to think it’s time to cut governmental spending and avoid future problems associated with high levels of sovereign debt, but there are also reasons to think that cutting back on fiscal stimulus right now is ill-timed since the recovery isn’t strong and that such action could retrigger recession. Read that column and you’ll walk away understanding that anyone who tells you that the answer is obvious in either direction is being either ideological or dumb.

Leonhardt does, however, leave out one important point.

The big, visceral worry about cutting back on government spending right now is that we might wind up following in the steps of Great Depression-era policymakers. Leonhardt writes:

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.

This is a legitimate concern. But there is also a big difference between now and then. In the late Depression, policymakers cut back not just on fiscal stimulus, but also on monetary measures to prod along the economy.

Overnight I had an email exchange with Liaquat Ahamed, who recently won a Pulitzer prize for his book about Depression-era central banking. He pointed out:

The problem in 1937 was that not only did Roosevelt tighten fiscal policy as Leonhardt says but, that same year, the Fed fearing that banks were too awash with reserves, tightened monetary policy and raised reserve requirements. It was the combination of a very dramatic fiscal tightening and an equally dramatic monetary tightening all in one year that drove the economy back into recession. The moral that can be drawn from the story of 1937 is that if you are going to tighten fiscally, at least keep your foot on the monetary accelerator.

Now, keeping your foot on the monetary accelerator comes with its own host of potential problems—consider how low interest rates fed the asset bubble that led to the collapse in the first place. Nonetheless, on this point, we seem to be “safe” for now, at least in the U.S. The Federal Reserve can’t seem to say enough about how it’s not planning on raising rates anytime soon.

Although, just to be clear, easy monetary policy doesn’t necessarily supplant fiscal stimulus. Ahamed continued:

That said, my view is that the recovery is still too fragile and unemployment too high to withdraw the fiscal medicine that saved us from a repeat of the Great Depression.