1937, 2011: Déjà Vu All Over Again -- Stimulus Wanes, Unemployment Increases

07/19/2011 09:56 am ET | Updated Sep 18, 2011

One of the reasons the United States' economy did so well in the last half of the 20th century is that we ignored ideology in favor of pragmatism. Since ideology gave us first fascism and then communism, and World War II followed by Korea, the Cold War and Vietnam, perhaps ideology just had a bad name.

In the first decade-plus of the 21st century, that is no longer true. Ideology has again become fashionable. And, we are paying for it, dearly.

Josef Stalin did not like genetics or evolution because they contradicted key elements of Communist ideology, and so he elevated a pseudo-scientist, Lysenko, to a position of authority. Implementing the teachings of "Lysenko biology," the Soviet Union experienced a series of famines.

Welcome to the 2011 Republican Party, courtesy of the Koch (pronounced, "coke") Family, who happened to be friends of Uncle Joe. Koch Republicans will tank the economy to pursue their ideological ends; coincidentally, that also happens to favor their financial interests.

But, even FDR succumbed for an interlude to the siren of ideology.

Rarely in economics does one get to observe an experiment that might qualify as real science. That is because there is no "control arm" for a policy, no ability to know that whatever changes occur are likely due to the policy, or would have occurred anyhow, or even with the opposite policy. In 1981, for example, Reagan cut taxes from 70% on the top bracket to 50%. In 1982, he raised taxes by $100B. From 1982 onwards, the deficit ballooned, but 17 million new jobs were created. Was the job growth during the next several years mainly impacted by (A) The tax cut? (B) The tax increase? (C) Deficit spending? (D) All of the Above?, (E) Some of the Above? or, (F) None of the above? Since we there was no "control arm," we cannot know. And, since we cannot know, the space is cleared for ideologues to assert whatever suits their needs and, in the case of right-wing Republicans, their paymasters.

But, there are rare instances that we can know. 1937 is one of them.

The year 1937 provided the unique opportunity for a "control arm" in an economic experiment. Once FDR took office in March 1933, the federal government engaged in deficit spending and government programs that hired people directly. The economy grew and unemployment was reduced. Then, in 1937, FDR decided the recovery was well underway, and he could return to his personal orthodoxy of reducing spending to get the budget close to balance. The economy contracted; unemployment increased again. FDR then reversed course; the economy started growing again, and unemployment declined again.

Thus, we had an "off-switch" under the last days of Herbert Hoover, with severe economic contraction. We then had an "on-switch" in FDRs first 4 years, with economic expansion and reduced unemployment. Not truly believing there was a connection between the "on-switch" of government spending in the Depression and the improved economy, FDR hit the "off-switch" in 1937, and the economy again contracted and unemployment rose. FDR quickly hit the "on-switch" again, and the economy recovered, and was then given a sustained jolt by massive government spending for the Second World War.

That sequence provides as close to a "control arm" in an economic policy experiment as we are ever going to have. It would make sense to heed it.

But, we are not.

In 2011, we are repeating FDR's error of 1937.

Note the political rhetoric this year. For the first several months of 2011, job growth was decent, not robust, but it was there. It appeared that we might see sustained job growth. Republicans swarmed the microphones claiming the tax cuts for the wealthy they had insisted upon as hostage during the Lame Duck session were responsible. Yet, with all that Republican tax cut elixir still in place, unemployment is rising again. Strangely, they are now camera-shy.

Those tax policies are still in full force and effect. Indeed, they had been for the entire period of economic contraction. They did not work then, and they do not seem to be doing very much now.

The major variable that has changed is the stimulus. About $250B of the stimulus was tax cuts for the middle class in 2010. Another ~$250B in 2010 went to state governments to help them retain public workers such as police, firefighters and school teachers. Only ~$250B went to specific projects.

In 2011, there is no more money for state governments, so layoffs have been occurring all across the country. Those people are now unemployed, are not contributing their taxes, and are not contributing very much to overall demand in the economy. Those layoffs are subtracted from whatever monthly gains are made in total employment. Not just that, but communities are increasing class sizes, and reducing police and firefighting departments. None of the those consequences bodes well for the future.

Much of the money for specific projects has been spent, and, as time proceeds, it will wane further.

There is one other variable this time, the ending of "QE2," by which the Federal Reserve keeps long-term interest rates low by purchasing long-term financial assets, and thus indirectly (it hopes) spurs banks to provide credit. But, we have just learned that most QE2 money parked itself on the balance sheets of foreign banks, so it did not do what it was supposed to do.

2011 is repeating 1937. "It's déjà vu all over again" (Yogi Berra).

The lesson from 1937 and 1938 is clear. During major economic contractions, increase government spending to put people back to work. The only reason such spending would not increase GDP and employment is if the money spent by government were matched, dollar-for-dollar, by a decrease in private demand or private hiring, and the only reason for that to happen is if interest rates went sky-high.

But, that has not happened. Had that been the problem in 1937 or 2011, then decreasing public sector spending would have resulted in increased demand and hiring from the private sector. It did not. It caused the economy to contract. That is, we tried the Republican experiment in 1937, and it not only did not work, it demonstrably, "scientifically," made things worse.

Today, interest rates are at historic lows. The QE2 program may have stemmed further deterioration and prevented deflation, but it certainly did not have its intended effect of the banks extending more credit. Tax incentives for small businesses may also have prevented further deterioration but it did not give the economy a big jolt.

If there is insufficient private demand in an economy, as there is in ours, it is important to put money into the hands of the "demand-creators." Job-creators will follow demand, regardless of tax rates. Only high interest rates, that are nowhere on the horizon, would limit job-creator response to increased demand.

The time for economic theories about how people will respond to this or that carrot, or this or that stick, is over. Direct action is required: A massive infrastructure program, directly employing 4M workers for 4 years. It can be paid for by eliminating the Bush tax cuts on the top bracket, and a 0.5% financial activities (FAT) tax, together bringing in $170B annually.

Yet, we will not do it. Unless Democrats have learned the lessons of 1937 and 2011, and it is not clear they have, and then the President is re-elected, and substantial Democratic majorities are achieved in the House and Senate, we will never do it.

But, the earliest that can happen is 2013. That's a very long time to wait if one is unemployed.

And, if we do not do it, we will have a generation of people with education but no work experience; of prematurely "retired" who have not contributed sufficiently to their own social security and old age pension; of prematurely and highly expensive ill elderly; of a deteriorated and antiquated infrastructure; of polluting industries set "free" of regulation in a climate of fear, despoiling our national treasures.

We will be a nation with a mighty military, and a subjugated, poor population. Like the old Soviet Union.

No, things do NOT go better with Koch.