Just as economists have debated the causes of the financial crisis, they are now debating the causes of the slow, almost non-existent, recovery. Topping my list of causes are the so-called stimulus packages -- which empirical work shows did little to stimulate -- and other government interventions, which have left an overhang of uncertainty impeding private investment.
As my colleagues Gary Becker, George Shultz, Michael Boskin, John Cogan and I explained last summer:
The 2008 tax rebate and the 2009 spending stimulus bills failed to improve the economy. Cash for clunkers and the first-time home-buyers tax credit merely moved purchases forward by a few months. Then there's the recent health-care legislation, which imposes taxes on savings and investment and gives the government control over health-care decisions. ... Hundreds of new complex regulations lurk in the 2010 financial reform bill with most of the critical details left to regulators. So uncertainty reigns and nearly $2 trillion in cash sits in corporate coffers.
The latest entry in the debate over the anemic recovery comes from a recent column by Paul Krugman, which Amity Shlaes responded to earlier this week. He argues that "As the stimulus has faded out, so have hopes of strong economic recovery."
With no empirical evidence connecting the weak recovery to a fading-out of stimulus, Krugman appeals to history, and the year 1937 in particular. After three years of strong economic recovery, with real gross-domestic-product growth of more than 10 percent per year, the U.S. economy slowed and went into a recession in 1937 and 1938. Krugman says it was a "fiscal and monetary pullback that aborted an ongoing economic recovery" and that the same thing is happening in the U.S. today.
The historical analogy to the present is flawed in many ways.
First, regarding fiscal policy, the small decline in government purchases couldn't be a significant cause of the large drop in real GDP growth from 1936 to 1938. Thomas F. Cooley and Lee E. Ohanian explained this in their rebuttal last year to similar points made by Christina Romer, then the chair of the President's Council of Economic Advisers. Here are some numbers: Real GDP growth fell by 16 percentage points from 1936 to 1938 (from an expansion of 13 percent in 1936 to a contraction of 3 percent in 1938). Over the same period, the change in government purchases as a share of GDP fell by 2 percentage points (from 3.5 percent to 1.5 percent). In other words, more than 80 percent of the growth change came from other sources, even taking multiplier effects into account.
The other issues stressed by Cooley and Ohanian are the sharp increase in union power, accompanied by several strikes, and the increase in business taxes, for which they cite Ellen McGrattan's finding that increases in capital-income taxation account for "much of the 26 percent decline in business fixed investment that occurred in 1937-1938."
Moreover, any reduction in government purchases associated with the fading-out of the 2009 stimulus is tiny in comparison with 1937 because the stimulus didn't increase government purchases in any material way. At most, federal-government purchases rose by only 0.2 percent of GDP as a result of the 2009 stimulus, and data show that state and local governments didn't use stimulus grants to increase purchases. Even the much-debated deal on the 2011 budget wasn't able to reduce government discretionary outlays by more than $1 billion this year.
So the fading-out of fiscal stimulus can't explain the weak recovery in 2011 -- even if it could explain the decline in 1937, which is unlikely anyway.
Then there's monetary policy. Monetary economists from Milton Friedman and Anna Schwartz to Allan Meltzer have written extensively about the Federal Reserve's decision to increase reserve requirements in 1937, and they conclude that it was an important cause of the contraction. According to Friedman and Schwartz, monetary-base growth (currency plus reserves) declined from 15 percent in 1936 to 8 percent in 1938. But in the past year the monetary base has shown no slowdown. In fact, monetary-base growth accelerated to 24 percent in the year ending in April from 14 percent a year earlier to finance the second round of quantitative easing. No monetary fade-out there. M2 growth increased to 5 percent from 2 percent. No monetary fade-out there, either.
The claim that the anemic recovery is due to a fade-out of monetary or fiscal stimulus isn't consistent with the facts.
(John B. Taylor, a contributor to the Echoes blog, is the Mary and Robert Raymond Professor of Economics at Stanford University and the George P. Shultz Senior Fellow in Economics at the Hoover Institution. The opinions expressed are his own.)
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