The Economic Advisor

Don’t Worry, It May Never Happen

History never repeats itself, exactly. However, perceived parallels can warrant serious discussion. With the recovery no longer in doubt, it has become more fashionable to actually increase the pessimism for future years, assuming that the economy will fall apart again when the historically high stimulus is removed.

Here’s why I refute the validity of this seemingly-logical reasoning:

In the past 80 years (I use this period as the part of the nation’s history with government spending as a major part of the economy), there has never been a fall-off severe enough to call it a “double-dip” except in two instances: 1980-1982, and more importantly, the Recession of 1937, which briefly plunged the nation back into conditions as bad as 1934, which was a bad year indeed, though not as bad as the trough in 1933.

Although technically two recessions, hence a “double-dip,” the 1980-82 recession also has the elements of one recession. For example, Fed Chairman Volcker’s inflation-fighting tightening was nowhere near done in 1980, so one could argue that little changed until inflationary expectations were decisively broken in 1983. Nevertheless, the best reason for downplaying this event is that 1981-1982 was not nearly as steep a downturn as 1980, and seemed more of a continuation of recession than a true, new, hard recession, as 1980 had been. Only by combining the two into one do we get a pattern of prolonged weakness, caused by a Fed determined to wring inflationary expectations out of the system with humongous short-term rates –well over 20% –abetted by a new President who was advised by the Council of Economic Advisors to “get your recession over early in your term”. This almost backfired when Reagan suffered low 35% approval ratings as late as 1983, but the advice was sound if nerve-wracking, since by 1984 America was indeed “better off than we were in 1980″ and therefore Reagan swept to reelection in a landslide.

The Recession of 1937 has been recently analyzed by Francois Velde, an analyst of the Chicago Fed, and Mr. Velde uses standard statistical techniques to show that a huge change in fiscal policy, combined with severely stringent monetary policy, was enough to cause the sudden large drop in industrial production and the concomitant reduction in GDP from May of 1937 to June of 1938.

Roosevelt had always been uneasy with the newfangled Keynesian theories of deficit spending as a palliative for the lack of private spending; as a super-rich, cautious man, it frightened him to even try it. As soon as it was politically acceptable to reverse it, he did, and the fiscal policy took a huge U-turn in 1936, with much higher income tax rates on most wage earners –almost double! –and less spending in an attempt to balance the budget.

Combine that with higher reserve requirements, and an arcane procedure that practically stopped the growth in the monetary base, called “gold sterilization”, and banks stopped lending in the latter part of 1937. The upshot is that excepting this perfect storm of extreme reversals in fiscal and monetary policy, we have never had such momentum change in the economy in modern times.

I believe that despite the conventional wisdom about the removal of stimulus causing a double-dip, it’s really more apprehension than a strong possibility. I therefore give a smaller chance of a double-dip (less than 5% chance of happening in late 2010 or 2011) than I believe the still-fearful markets have discounted.