Mistreating Depression

by John B. Judis | November 25, 2008

Barack Obama announced today that the chair of his Council of Economic Advisors will be Christina Romer, a professor at the University of California, Berkeley, and an expert on government fiscal and monetary policy. As Romer stood beside him at the press conference, Obama uncharacteristically stumbled over his words in introducing her. He seemed to be learning who she was as he spoke--and that may say more about the appointment than the actual words of praise he uttered.

Obama has been criticized for excluding progressive Democrats from his administration. I think that’s nonsense. But in this case, Obama did appoint someone--whether wittingly or not--whose views on the economy appear to place her well to the right of mainstream Democratic economic opinion. I say they appear to do so, because my basis for saying this is not pronouncements that Romer has made on what to do now, but her theories about fiscal and monetary policy.

Start with her views on the Great Depression of the 1930s. The standard account has been that the U.S. economy began to revive from 1934 to 1937, when Franklin Roosevelt’s government hiked public investment and ran budget deficits; that the recovery stalled in 1938 after Roosevelt erroneously put the breaks on the economy and tried to run a surplus; and that the country only recovered from the depression after that because the U.S. began running deficits again and because of growing war orders from abroad; and that the final recovery awaited the massive public defense investment in 1941 and 1942. Gross public investment increased 150 percent from 1940 to 1941, and that’s when unemployment began to plummet.

Romer’s view is that what ended the depression was an expansion in the monetary supply, due to the inflow of gold from abroad. “Fiscal policy, in contrast, contributed almost nothing to the recovery before 1942,” Romer wrote in a 1991 paper for the National Bureau of Economic Research. That’s a view that would lead one to emphasize monetary over fiscal fixes--that is, changes in the federal funds rate and money supply over increases in public investment and cuts in taxes. This policy perspective would seem to de-emphasize or even oppose the kind of massive public investments that Obama now seems to be considering. If so, Romer would be encouraging a strategy that has so far proved ineffective--Fed interest rates are approaching zero and the economy is continuing to crater--and rejecting a measure that might be effective.

In a paper delivered in September 2007, Romer addresses more directly recent government fiscal and monetary policy--but with the same implications. She contends that after World War II, the Truman and Eisenhower administrations developed a “modern” fiscal and monetary policy that was remarkably successful. It stressed a commitment to budget surpluses to prevent inflation and the use of deficits only in the extremity of a recession. During the Kennedy and Johnson years, Romer argues, the U.S. abandoned this approach for one that sought to maintain low unemployment (a four-percent target) through, if necessary, persistent budget deficits. Romer contends that the ’60s model led to the high inflation and unemployment of the ’70s.

According to Romer, fiscal and monetary policy partially returned to the successful strategy of the 1950s after Ronald Reagan’s election in 1980. She cites Federal Reserve chief Paul Volcker’s attempt to kill off inflation through inducing the steepest recession since the 1930s. Since then, government policy toward the business cycle has been ceded to the Federal Reserve, which has contracted the money supply when unemployment has been reduced to a “natural rate” under which it would encourage inflation. This policy, she writes, “particularly on the part of the Federal Reserve, is directly responsible for the low inflation and the virtual disappearance of the business cycle in the last 25 years.”

Here is Romer again on the success of the Fed:

Overall, the story of stabilization policy of the last quarter century is one of amazing success. We have seen the triumph of sensible ideas and have repeated the rewards in terms of macroeconomic performance. The costly wrong turn in ideas and macropolicy of the 1960s and 1970s has been righted and the future of stabilization looks bright.

This was said, it must be stressed, only a year ago, when signs of incipient downturn and financial disaster were already apparent to a good many economists. Romer’s opinions in this case suggest that there may be something wrong with her overall point of view.

I’ll leave it to better minds to pick apart her economic theory. I’ll just make two points about her argument. First, her history is misleading. She singles out the “1950s” as an Eden of economic policy and performance. She acknowledges later that “there were two recessions in the 1950s, and that in 1958 was quite deep,” but even that acknowledgement is insufficient. Yes, it is true if you define the “1950s” literally as 1950 to1959; but there were four recessions from 1948 to 1960. One of the reasons John Kennedy won the election in 1960 was because Americans--once again suffering from a downturn--were sick of repeated recessions and wanted “to get the country moving again.” Kennedy came into office with a mandate to fix fiscal and monetary policy.

The history since then has been considerably more complicated than Romer makes out. Kennedy’s economic policies were by no means unsuccessful. Unemployment fell from seven percent when Kennedy took office to 4.8 percent in November 1964 without provoking a rise in prices. What took place afterwards were disasters--most of which Romer does not mention, but which made Kennedy’s brand of aggressive Keynesianism more difficult to pull off: the Vietnam War (along with Johnson’s reluctance to finance it through tax increases); the growing competitiveness of foreign producers that threatened, and finally undercut, America’s trade surplus; the huge spike in international oil prices (which Romer discounts as a major cause of inflation); the collapse of Bretton Woods; and the peculiar arrangement that the U.S. created with Japan and later China that allows them to run budget and trade deficits without raising interest rates.

None of this suggests that the U.S. should go back to the fiscal strategy of the ’60s--the circumstances now are utterly different. But it does suggest that the answer may not lie in a return to Eisenhower’s fiscal and monetary strategy of the ’50s or to Romer’s version of the post-1980s monetary strategy. If Romer’s views of September 2007 are applied to November 2008, what do we get? Deficits, but with an eye toward surpluses, and an emphasis--going back to her article on the Depression--on monetary rather than fiscal expansion as the solution. If that is, indeed, what Romer advocates, that’s probably not the change we need--or that Obama has promised.

John B. Judis is a senior editor at The New Republic and a visiting fellow at the Carnegie Endowment for International Peace.

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