It's deja vu all over again - Yogi Berra
Bernanke's comments last week elevated to public view a debate over the Bush tax cuts expiring next year. Most of the rate cuts affect people below $250,000 in earnings, so letting it lapse as is would breach one of Obama's core campaign promises. The Sunday NYT headlines a big fight brewing over this. The problem of letting it lapse, however, is much more economic than political, and affects the future path of the stock market.
The Original Double-Dip
The lapse of the cuts amounts to a large tax increase in the middle of a recession, a lesson we should have learned not to do. Back in 1937 FDR tried to return to normalcy after his re-election in 1936, and instead threw the economy back down in a large W shaped recovery - the original double-dip recession. (See chart from WSJ.)
The cluster of mistakes:
- new social security tax ('37)
- "soak the rich" tax ('36)
- surtax on undistributed profits ('36)
- increased bank reserve requirements ('37)
- letting a bonus to veterans lapse ('37)
Of these mistakes, three were tax increases.
The Potential Impact of Tax Increases
Christina Romer made her economics reputation on the impact of taxes on growth, and she "cringes" at the thought of repeating the mistakes of 1937. She became Obama's head of economic advisors, and her policy brief on the 1937 problem can be downloaded here. It is an interesting read since she suggests that fiscal stimulus has a modest impact, while monetary and tax policy have a much bigger impact; and yet the current policies of the administration are the opposite: heavy on fiscal stimulus, sanguine about the coming tax increase, and nearing the end of monetary stimulus. Her reputation-making conclusion on taxes is that each 1% increase in taxes causes a 2-3% decrease in GDP - a huge negative multipler of around 3x (download her paper here):
My purpose is not to rehash the debate over the mistakes of 1937 - there is plenty of that going around. It is useful to appreciate, however, that what passes for conventional wisdom - the Keynesian view of the 1930s as one of a hapless Hoover and a stimulative Roosevelt - is itself revisionist history: Hoover had ramped up Federal spending to deficits of 4.5% of GDP, and FDR kept that relatively constant, averaging 5.1% in the first three years of the New Deal. The economy swung in much broader strokes between 1932 and 1936 than such a minor difference would indicate.
What is clear is that the New Deal did not get us out of the Depression. Unemployment was still above 12% in 1937, and got back to 19% in 1938. Also, government spending did not decrease in 1937, although the deficit did shrink (see chart). The degree to which we fell back down after modest changes in policy throws into question the New Deal narrative, and how effective its fiscal stimulus really was. Certainly it has an impact; but it may not fix things.
This seeming failure to explain the swings in the '30s by fiscal stimulus alone has led many revisionists (beginning with Milton Friedman) to consider the contraction in credit (monetary policy) as a much bigger driver of the 1937 double-dip than any slackening of fiscal stimulus. Yet one of the most troubling analogies to 1937 and today is the dearth of business and consumer lending. Keynes of course called this the Liquidity Trap. Even if the Fed's low interest rate and QE policies of today are theoretically expansive, the monetary fix is not working, and the fiscal stimulus did not work to get us past the Liquidity Trap either. Worse, the recent FinReg bull already has tightened credit even more - for example, the criminalization of rating agencies (a little plum slipped into the bill at the last moment) has caused Ford to have to pull a bond offering as the agencies have stopped rating instruments pending clarity on the new rules.
I wonder if FinReg will go down in the revisionist history of the future as the equivalent blunder in its effect to Smoot-Hawley in the 1930s: the tipping point to a disastrous contraction.
Despite the revisionists, Romer's view that to withdraw stimulus now would repeat the mistakes of 1937 represents the conventional economic wisdom.
The Diminishing Impact of Fiscal Stimulus
In some respects our current environment is very much like 1937:
- Back then, the banks sat on high reserves rather than lending - as now
- Back then, the interventions and meddling of the New Deal (so-called Regime Uncertainty) froze corporations from investing, and they sat on huge stocks of cash - as now
- Back then, the low rates of return made it dis-economical to invest in new plant - as now
In other respects, however, we stand in a very different place:
- In the first wave down from 1929-1933, the over-capacity built by the bubble in the 1920s was worked off, and both production and capacity were in better alignment in 1937 than today
- Growth from 1933-36 was double-digit (above 10%), whereas our growth off the bottom has been in the low single-digits, and we still have very poor capacity utilization
- Although Hoover and FDR ran 5% deficits, the overall size of the Federal spending and debt (as a percent of GDP) were lower then than now
Perhaps most profoundly, back then the economy had not been on continual fiscal and monetary stimulus for decades as we have now. Back then we may truly have had a "multiplier effect", where incremental spending from borrowing led to 1.6x returns; whereas now, as I have analyzed recently in the Peak Debt post, we may be approaching a point where incremental fiscal spending has very little impact on growth. We borrow $1 for each dime of growth so to speak, digging a deeper grave. (See chart, courtesy The Economist.)(For more on multipliers, read this.)
We are in effect in a wartime economy in terms of stimulus, without the war.
And it is not working very well. The political opposition to more stimulus is mounting, just as it did back then (see cartoon). Given an ebbing of stimulus, a tax increase with its 3x de-multiplier would likely push us into another double-dip, especially with Bernanke running out of monetary weapons.
The Impact on Stocks
The WSJ updated their take on 1937 with a discussion of how closely the stock market has tracked the 1937 market (see chart). (This link works without WSJ subscription.) In the two weeks since this chart, the market has continued very close to the 1937 market, and seems poised for the Summer Rally seen in August 1937. Interesting is the timing has shifted right by three months, so adherence to this pattern would see a rally into the November elections:
While the market is a fractal, a one-time event like 1937 should not be considered a precise roadmap to 2010, but at least it shows how a market reacted in a somewhat similar situation. If policy mistakes drive us into the double-dip, the crushing drop after the summer rally is very likely to repeat itself: another 50% drop from the summer high, which I guesstimate at Sp1150 +/- 20 pts. That targets below Sp600, which means below the Mar09 lows. Ouch.
Compare 1937 to 1929 (next chart), and you see the mismatch to 1929. After the crash of '29, we bottomed in November and had a five month rally that went back 50%, then began the sickening slide to the 1932 bottom. After the crash of 2008, we bottomed in November and had a five week rally, then fell to a deeper low in March. Off that low we had a 50% rally, but it took much longer, almost 15 months.
Doug Short has run a constant series of charts comparing various crashes, and even if you line up the bottoms in 1929 and 2009, the 1929 analogy breaks:
This time delta between the 1930 bounce and the Hope Rally has caused the Elliott Wave Theorist to opine that we are unfolding in the same way, just at 1/3 speed. This points to an ultimate bottom in 2016, 3x the time of the drop from '30 to '32. Curiously, the Kondratieff Wave 'false plateau" that preceded the credit bubble in 1929 took 8 years, whereas our recent Great Moderation took 25 years - also a 3x.
While an interesting speculation, this simplistic approach does not really fit Fractal Finance. The 1937 analogy seems to fit better, although imperfectly.
The Road to Recovery
We are left with a troubling question: what policy moves can we count on to get us back to normal? Until we get on that path, the stock market cannot be expected to return to a secular bull market. What policies "work"?
To borrow a phrase from Clinton, it depends upon what the meaning of "work" is.
It is loosely said that the Great Depression ended in 1942 with World War II. Most of the 7M unemployed were absorbed by the military, which grew to 8.6M. The draft ended unemployment, but was not a recovery. GNP rose, but not for the private economy: consumer spending declined, goods were in short supply, civilians were essentially forced to save, and business investment fell. To think it "works" to "fix" the economy by borrowing huge amounts to produce lead & steel that are wasted in the jungles of the Pacific or the beaches of Normandy is abject nonsense.
Even worse are those who wonder where the war is that will get us out this time. Economic debacles tend to end in war, but is not something to be sought just because it might "work".
Many of the justifications for massive stimulus in peacetime claim they "work" as long as we avoid a slide back down. But what if this is not sustainable? It does us little good to try to bridge across a GDP chasm with government life-support if we plunge back down when the life-support is withdrawn. The scary part of 1937 was that the changes in stimulus were modest, and the plunge was huge. At best we end up like Japan, a terminal patient: 20 years of an L-shaped recovery, ever increasing debt, taxes soon less than interest on the debt, and a day of reckoning that is not much further off. Japan seems beyond the point of no return. A good slide presentation on this point can be downloaded here.
Now compare the Japan chart to the next chart, which shows the CBO's forward projection of US debt, and comes with dire warnings over the US's unsustainable path of increased deficits ... we are turning Japanese if we continue on this course. It does not "work" to put us on a path of terminal life support.
The common sense conclusion is a policy bundle "works" if we return to a sustainable path of recovery in the private sector. It doesn't work if we just kick the can down the road. If we slide into a double dip this time too, the Keynesian solutions will have failed again. We will have to find a different set of historical analogies to help us out than the New Deal.
The 1946 Solution
The one analogy year which has so far been overlooked is the remarkable turnaround in 1946. There was grave fear of a return to the Depression after the war. Keynesians and central planners gave dire warnings of the "Depression of 1946" - the one you have never heard about - and urged a continuation of New Deal policies and central management of the economy. These suggestions were completely rejected, and the Depression of 1946 never happened. Instead, the US ended the New Deal: it stopped meddling in the economy, slashed spending by 2/3, canceled war contracts, and ran a budget surplus to begin paying back the huge war debt - the exact opposite of the current convention wisdom. The speed with which government controls over the economy were removed validated the confidence of the private sector and emboldened investors. Rather than return to double digit levels, unemployment among the huge influx of veterans remained under 4.5%. Unshackled from the New Deal, the private economy roared back.
The 1946 story has been recently popularized by Jason Taylor and Richard Vedder in a Cato Institute paper called Stimulus by Spending Cuts: Lessons From 1946 that has run around the blogosphere. The 1946 "Shock of Peace" (a Shock of "De-Stimulus") worked quickly.
While economists, including Nobel winners, are picking up on the policies of 1946 if not the meme itself, and debating the merits of the 1946 analogy, it has not yet emerged into the political debate today about what "works" except as some sort of latter-day Reaganism.
Perhaps the reason is the prescription seems too extreme. Given how heavily the US budget is stuck on entitlements, how would it get cut by as much as 2/3 as we saw in 1946? It may be inevitable that we have to do this, given the unsustainable direction we are currently pursuing, but it would entail more "Change" than the current political leadership could envision (consider for example this speech from James Galbraith). Hence the politicians would rather believe in "Hope", kick the can down the road, and wait for the patient (the US economy) to die before tackling the disease.
There is a plan floating around to make these big changes, and it starts with tackling the big four expenditures (see chart): defense, social security, medicare and medicaid. Without any endorsement of the particulars of it, it at least is an exemplar of how we could do today what they did in 1946, making deep cuts in spending while maintaining the safety net, freeing the economy to grow again.
The initial post on the plan is here.