Freedomnomics

Article published Friday, September 3, 2010, at Fox News.

Obama Is Repeating the Mistakes of the 1937 Economic Collapse

By John R. Lott, Jr.

Does the 1937-38 economic collapse, the so-called "depression within the Depression" offer any lessons on what we should do now? In 1937, it seemed that things were improving, some light was seen in the Great Depression, but unemployment suddenly jumped from 14.3 percent in June 1937 to 19 percent in June 1938. With the unemployment rate stuck at 9.6 percent, the Obama administration is planning to unveil what would be its third stimulus package. Supporters are pointing to the late 1930s to justify yet another increase government spending.

Today Keynesians are out in full force defending the massive $1.3 plus trillion deficit that we have run since Obama became president, warning that cutting it would lead to a scenario similar to what we saw in the late 30s.

Economist and New York Times columnist Paul Krugman, has this to say in The Times earlier this summer, declaring that those opposing more government spending were pointing us towards disaster: "It raises memories of 1937, when F.D.R.’s premature attempt to balance the budget helped plunge a recovering economy back into severe recession."

Last Saturday, Yale’s self-described "New Deal economist" Robert Shiller made the same point in an interview with The Wall Street Journal, attacking the "concern about the national debt" and advocating more government spending.

Both men point out that the federal deficit declined from $2 billion in 1937 (in inflation adjusted dollars, about $30.3 billion today) to a near balanced budget in 1938.

Some conservatives, such as Newt Gingrich, have recently focused on the new Social Security taxes that started in 1938 as the problem. "If we have large tax increases in January, this economy will sink deeper into recession," Newt Gingrich told Newsmax in late July. "This was exactly the mistake made in 1937 and 1938, and it created a second mini-depression."

Yet, while taxes surely hurt economic growth, there were other major economic events that both these discussions completely ignore. The late Milton Friedman pointed to new banking regulations that went into effect from March through May 1937. President Roosevelt had accused banks of "hoarding" money and his solution was to increase the reserve requirement with the Federal Reserve, dramatically reasoning that the government could make sure that the banks' money was properly spent. Of course, banks had not just been "hoarding" extra reserves for no reason.

Banks had very good reasons not trust the Federal Reserve. When the Federal Reserve was set up in 1913, banks lost crucial tools that they had to stem runs were depositors tried en mass to withdraw money from their accounts. In exchange, the Federal Reserve promised to serve as a lender of last resort to temporarily tide over banks who couldn't cover withdrawals by depositors.

However, in 1929 and later, the Fed reneged on this promise. Banks, left to fend for themselves, were forced to liquidate many assets and build up their cash reserves. When Roosevelt took these cash reserves from banks, the banks dramatically reduced their lending to again build up a cushion that they could control. The money supply shrank, prices plummeted, and unemployment rose in all the ensuing chaos.

What are the general views of economists? After all, economists are famously known to be quite divided on wide range of issues. A recent Wall Street Journal survey during August of 53 prominent, forecasting economists provides something of a guideline. The view of 63 percent of the economists who opposed any more fiscal or monetary stimulus is summarized well by Stephen Stanley of Pierpont Securities: "The economy needs government to get out of the way."

The real lesson from the 1937-38 is that government made the situation much worse by always trying to fix things. Unfortunately, this is precisely what we have seen under Mr. Obama's presidency with the failed stimulus spending and all the regulatory chaos they have created.

John R. Lott Jr. is a FOXNews.com contributor. He is an economist and the author of "More Guns, Less Crime (University of Chicago Press, 2010), the third edition of which was published in May.".

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