It's been four years since the end of a devastating crash. Unemployment remains elevated, but it has fallen far from its recent heights. The economy, once fueled by rampant speculation and extreme leverage, has pushed past its old levels thanks to a stronger business environment fueled by rising consumer demand. With the darkest days behind him, the president turns his attention toward spending reductions promoted by influential conservatives to stabilize the national budget, as well as tax increases to provide funding for the nation's social-assistance programs.
This might sound familiar -- because it's happened before. The year was 1937, and the economy was about to collapse all over again.
The Roosevelt Recession
President Franklin D. Roosevelt won an overwhelming re-election in 1936 based on the strength of an economic recovery underway since his 1933 inauguration. As he began to lay out a second-term agenda in the spring of 1937, it was easy to see signs of that recovery. The Dow Jones Industrial Average (DJINDICES:^DJI) had risen 260% from Roosevelt's first day in office. Unemployment, which surpassed 25% in the first months of his presidency, had fallen to about 11% shortly after the start of his second term. The real corporate earnings of most large American companies had nearly recovered to their 1929 peak after more than doubling over the course of Roosevelt's first term, and real national GDP had grown as much in those four years as it had during the course of the entire Roaring '20s, surpassing its 1929 high-water mark before Roosevelt had even begun his re-election campaign.
This was almost entirely undone within a year. After peaking in early March of 1937, the Dow fell 49% in 12 months. Unemployment fell below 11% that summer but spiked to 20% a year later. Corporate earnings were cut nearly in half, and industrial output went into a tailspin. According to historian David M. Kennedy, it was a faster economic collapse than that seen during the early years of the Great Depression.
At the time, Roosevelt's economic inner circle contained some prominent fiscal conservatives, including Treasury Secretary Henry Morgenthau. These men wanted a balanced budget, an argument Roosevelt readily accepted once the worst of the Great Depression seemed to have passed. From 1936 to 1938, the government undertook one of the largest spending reductions ever seen in the absence of a war, even while the tax take soared as Social Security taxes were collected for the first time. Spending declined by 17% as total federal receipts grew by 72%. An inflation-fighting policy shift toward monetary tightening at the Federal Reserve only made the decline worse.
Roosevelt reversed course the following year, increasing federal spending by a third in 1939. By the time the United States entered World War II, unemployment had returned to levels not seen since 1930, and the economy was growing at one of the fastest rates in modern history. However, the downturn of 1937 prolonged ultimate recovery for years, and it took a World War to return the country to full employment.
Could the same thing happen again?
History (kind of) repeats itself
The numbers behind the present economic recovery look rather similar to those of Roosevelt's first term. The Dow has nearly doubled since President Obama's first inauguration. Unemployment peaked at 10% several months into his first year in office and has since declined to just less than 8% -- a slower decline from a much smaller peak. Real corporate earnings have nearly recovered to precrash highs, and real GDP has already surpassed its late-2007 level. Unemployment has declined at a slower rate than it did in Roosevelt's first term, but women rarely worked in 1937, and blue-collar jobs in cyclical industries were then a far larger part of the workforce.
Obama is also pursuing several measures that will have a similar effect as Roosevelt's austerity. He has agreed to a firm $1 trillion in spending cuts over the next decade as a result of 2011's debt ceiling deal. The sequester, which is set to start tomorrow once the Office of Management and Budget submits its official notice (due before midnight tonight), contains an additional $1.2 trillion in across-the-board cuts for the next decade. Some commentators, including former Reagan policy analyst Bruce Bartlett, expect it to be short-lived, but some additional cuts beyond the agreed-on $1 trillion could still be in the offing.
Tax hikes are already taking hold as well. The payroll tax cut expired at the end of last year, and that will combine with anticipated Obamacare taxes and the new taxes on high-earners from last year's fiscal-cliff standoff to create a $174 billion tax-related drag on the economy. If the sequester holds up, the total drag on the economy in 2013 will be worth about $304 billion, or 1.9% of GDP, according to The Washington Post's Brad Plumer. Without it, we'll see a $226 billion drag, equal to about 1.4% of projected U.S. GDP this year.
This is nowhere near as bad as the damage caused by Roosevelt's policy shifts. Tax receipts are only expected to rise 18% this year, while government spending remains flat from 2012. That's less than half the growth in tax receipts seen in 1937, a year in which government spending declined by 8% and no one actually saw an immediate benefit from the new Social Security taxes (which were not first distributed until 1940). However, real GDP growth has been less potent during the current recovery than it was during Roosevelt's first term. GDP only barely made it to a positive result in the fourth quarter of 2012 and posted a moderate 2.2% growth rate for the full year. In contrast, real GDP grew 13% in 1936 and continued to grow another 5% in 1937 before falling by 3.4% in 1938.
What lies ahead
The situations in 1937 and in 2013 aren't truly comparable. Seventy-five years ago, much of the working population was on farms or in factories, and families waited in bread lines with no Social Security and had a far less comprehensive system of unemployment insurance. It's hard to compare that to a world in which millions are covered if they lose their jobs and more of the population actually holds or seeks a job in the first place. The recovery started from a far deeper pit in 1932 than it did in 2009, but it's been just as much of a struggle to climb all the way out this time. The government has actually supplied far less of a stimulus boost than it did during the Great Depression -- annual federal spending grew 79% over the course of Roosevelt's first term, but only 9% during Obama's first.
Investors wondering how this combination of tax hikes and spending reductions will affect the economy might use the Dow's performance from 1937 onward as a rough guide. The Dow didn't regain its 1937 high until 1946, and it wasn't until 1949 that it put that level behind it for good. We've spent more time in the shadow of the dot-com peak (adjusted for inflation, the Dow topped out at more than 15,300 13 years ago) than investors of the '30s had spent in the shadow of 1929, and the economy is more stable today than it was in Roosevelt's day. However, the risk of a politically driven downturn appears quite real, as a combination of higher taxes and lower spending doesn't have to be as extreme as it was in 1937 to send a more fragile recovery back over the brink.
Obama might wind up with an FDR-like legacy -- just not in the way he'd like.