What history really teaches

8 October, 2012 at 15:10 | Posted in Economics | Leave a comment

For all those who still don’t grasp the simple fact that demand – and not debt – is the greatest problem of today’s economies, a reading of Christina Romer’s article The Hope That Flows From History is recommended. Economic history and “natural experiments” can sometimes be very instructive:

One reason the Depression dragged on so long was that the rapid recovery of the mid-1930s was interrupted by a second severe recession in late 1937. Though many factors had a role in the “recession within a recession,” monetary and fiscal policy retrenchment were central. In monetary policy, the Fed doubled bank reserve requirements and the Treasury stopped monetizing the gold inflow. In fiscal policy, the federal budget swung sharply, from a stimulative deficit of 3.8 percent of G.D.P. in 1936 to a small surplus in 1937.

The lesson here is to beware of withdrawing policy support too soon. A switch to contractionary policy before the economy is fully recovered can cause the economy to decline again. Such a downturn may be particularly large when an economy is still traumatized from an earlier crisis.

The recent downgrade of American government debt by Standard & Poor’s makes this point especially crucial. It would be a mistake to respond by reducing the deficit more sharply in the near term. That would almost surely condemn us to a repeat of the 1937 downturn. And higher unemployment would make it all that much harder to get the deficit under control.

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