KWR Special Report

Why History Matters: U.S. Perspective on Growth and Austerity
By Scott B. MacDonald

NEW YORK (KWR) July 25, 2010 - The U.S. and other major countries are diverging on economic policy. While there is a growing debate in Washington over the possibility of further stimulus actions, a number of European governments, including the U.K., Germany and Italy, have implemented austerity measures to curb red ink. This issue of austerity versus further stimulus reflects increasing pressure on governments to find a path out of recession to renewed sustainable growth. For a number of European governments it has become critical to regain investor confidence, considering their need to raise debt in international markets as well as to provide support for troubled banking sectors. But the dilemma remains - in cutting government spending it is questionable as to whether growth will come from the private sector. In the U.S., this question clearly haunts an administration sensitive to the historical record.

Part of the U.S. reluctance to let go on fiscal stimulus is rooted in the American experience during the Great Depression. It is no mistake that the Chair of the Council of Economic Advisers in the Obama administration, Professor Christina Romer, and Fed Chairman Benjamin Bernanke are well-known students of the Great Depression. As such they are sensitive to the fact that U.S. economy suffered two major dips, the first occurring in 1933-34, followed by a subsequent dip in 1937-38. Parallels to the 1930s are over the possibility of a double-dip recession in 2010-11.

By the time the Roosevelt administration was elected into office, the United States was in dire shape. Unemployment stood at 25%, a sustained drought gripped the agricultural heartland of the country, and more than 5,000 banks failed. President Franklin D. Roosevelt moved quickly to stabilize the situation through a massive expansion of the government into the economy. This included turning the government spigot on to create jobs through a number of programs. Although this worsened the fiscal situation, these programs focused on employment generation—much of it via public works such as reforestation, rural electrification, as well as various infrastructure projects. He also presided over bank reform (mainly Glass-Steagall), the creation of the Federal Deposit Insurance Corporation (FDIC), and the Securities Exchange Commission, all earmarked to restore confidence in the financial system.

Roosevelt benefited from gradual improvement in the economy in 1936. By the spring of 1937, the country had finally pulled above 1929 levels of output, a key measure of positive economic growth. Considering the depths of the 1930-34 period, this was a major achievement and there was a sense that the future was a little brighter. On the surface, it appeared that the massive government stimulus was working.

But the economic expansion was short-lived. By year-end 1937, the U.S. economy was heading back down. Industrial production collapsed and the stock market, which had clawed back some lost ground, plunged.

What happened to the U.S. economy? The 'prosperity' of early 1937, which rested on a fragile foundation of mass unemployment and a sluggish construction industry, occurred largely because of the government's deficit spending. Indeed, the actual downturn was triggered by Roosevelt administration cuts in deficit spending, which slowed down off the flow of funds to the state work programs.

Another significant factor was the reluctance of big business to invest. Although the uncertain economic environment made many business leaders cautious, there was also a strong anti-business tone coming out of the White House, especially when Roosevelt sought re-election in 1936. This fit earlier indignation over bankers and businessmen, both blamed for the Great Depression. New York bankers were particularly reviled - something that echoes in the current situation and President Barrack's Obama's comments and indignation over Wall Street “fat cats”, who helped cause the financial panic of 2008.

The situation that presented itself in 1937 was one in which government spending had pumped up the economy, but when it was curtailed, the private sector was unable or unwilling for political reasons to pick up the slack. The net result was another dip in the economy, a sharp and worrisome extension of the Great Depression. This unfortunate development left the government in the position of having to restore some capital flow into the economy. The end game of this would not come until the 1940s with the outbreak of World War II, which provided a massive stimulus to American industry and agriculture.

There are parallels to what the Obama administration is facing in the early 21st century. There is a recovery, but many wonder about its strength and sustainability in the face of high structural unemployment, a depressed housing market, and potential problems elsewhere, and Europe in particular. At the end of 2010, the $787 billion stimulus package is over and a number of Federal Reserve programs will have been wound down. Additionally, the Bush tax cuts end in late 2010 and taxes are scheduled to rise on a local level as local governments struggle with acute budget shortfalls. The municipal bond market could be a flash point next year as austerity measures bite deeper and economic growth slows.

The issue of leadership and confidence building cannot be downplayed, at a time when the economic and investing landscape is dominated by uncertainty and volatility. Obama faces a similar situation as Roosevelt as to whether business will start to pick up the slack from the public sector. Nonfinancial companies in the United States are sitting on close to $2 trillion in cash. However, strong corporate balance sheets have not translated into employment generation. Indeed, many corporate chiefs are reluctant to spend. While part of the reason for this is because of the difficulty in ascertaining the economy's direction, part of it sits with what many businesses describe as a groundswell of cost-raising onerous regulations and new healthcare responsibilities. Indeed, the U.S. Chamber of Commerce in July accused the Obama administration of creating an environment of "uncertainty", which is causing firms to put off hiring. This comment brought snide comments from the White House.

The political sparring between the U.S. Chamber of Commerce and the White House does little to restore business confidence and obscures one of the more poignant reasons why the private sector hasn't come to the stimulus party by adding jobs. Jobs of course are necessary to restore long-term trend growth of 3.5% and along with it consumer confidence. In turn, without a more robust consumer, it is difficult to see many companies willing to spend capital. It is the vicious circle the stimulus package was meant to tip into a virtuous circle; but it hasn't worked yet.

Although there is a considerable debate over Roosevelt's "success" with the American economy, one thing Roosevelt did was to restore hope and a degree of confidence in the country, which helped set the stage for a recovery. The Obama administration faces a different landscape – while the economic crisis is difficult, thus far the descent is far less than in the 1930s. The challenge is to avoid another step down and put the country back on the path of sustainable economic growth. Unlike the late 1930s, it is not likely there will be a major world war to function as a large-scale works program. This means a more well-defined balance needs to be struck between what the country needs and what it can afford.

Roosevelt's focus was on the economy, seeking to put people back to work. Reinforcing this sense of mission, he was expert at conveying his own messages to the American people, often through the famous Fire Side chats. Furthermore, Roosevelt was attacked by both the left and right, but he was a master at manipulating the political stage, with experience from his period as governor of the State of New York and concealing his affliction with polio. With Roosevelt there was no question in who was governing.

With Obama the path has been different - many policy initiatives have been outsourced to Democratic leadership in Congress, leaving the public uncertain as to what the President really wants. The handling of the BP Gulf oil spill also gave the appearance of a White House lacking in forceful leadership and led to comparisons to the Bush administration's bungled handling of Katrina. Health care reform was a key reform measure on Obama's part, but many Americans still wonder over the costs and what this initiative encompasses. Furthermore, in many minds it did not really address what most Americans are more worried about - the economy and jobs. Furthermore, the financial regulation bill which does address these concerns was also poorly communicated so most people have little or no idea what was included within its 2,300 pages. The result was evident in an ABC-Washington Post poll published in mid-July, in which President Obama's approval ratings have fallen to 43%, down from 69% at the start of his presidency.

The U.S. economic landscape is becoming more challenging, with concerns about a double dip recession lurking, acrimonious business - White House relations, and a tough mid-term election in November. It is the tepid response from the private sector that magnifies the shadow of the Great Depression for the Obama administration. For anyone looking back to Roosevelt, to which Obama was earlier benchmarked, it is time to learn how to lead and govern. This means both setting a more positive tone and to better defining its goals and intentions. It also means looking hard at current economic policies and coming up with a new game plan - including targeted help for small and medium-sized businesses as well as more hard and fast targets for reducing the fiscal deficit. Considering the 1930s experience this does not necessarily mean an abrupt turning off public spending.

As Roosevelt clearly understood, confidence is a fickle creature and work is needed to gain and maintain it. That meant governing. This is critical for the U.S., but also how the American economy interacts with its global partners at a time when various parts of the world seem to be moving in different directions.

The November mid-term elections will be an important test for the Obama administration. August will provide a brief lull, but the campaigns begin in September. The economy is likely to be the big issue on the agenda and will encompass everything from jobs, housing, whether to extend the Bush tax cuts, the fiscal situation and any ideas as to further stimulus. To revive flagging Democratic fortunes President Obama must seize this opportunity to exhibit the leadership and focus he exhibited during the campaign that got him elected. An improved track record on the economy would benefit both his presidency and the U.S. public. Failure to take the recovery to the next level - a tough act by any standard - increases the probability of a Republican victory in November and will leave the President looking much less like Roosevelt and more like Herbert Hoover, referred to by one historian as "a study in failure."

While the information and opinions contained within have been compiled from sources believed to be reliable, KWR does not represent that it is accurate or complete and it should be relied on as such. Accordingly, nothing in this article shall be construed as offering a guarantee of the accuracy or completeness of the information contained herein, or as an offer or solicitation with respect to the purchase or sale of any security. All opinions and estimates are subject to change without notice. KWR staff, consultants and contributors to the KWR International Advisor may at any time have a long or short position in any security or option mentioned.

KWR International Advisor

Editor: Dr. Scott B. MacDonald, Sr. Consultant

Deputy Editors: Dr. Jonathan Lemco, Director and Sr. Consultant and Robert Windorf, Senior Consultant

Associate Editor: Darin Feldman

Publisher: Keith W. Rabin, President

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