Monday, December 31, 2012

The fiscal cliff of 1937

With all the current noise regarding the 'fiscal cliff' I thought a look back at when we had a real fiscal cliff would be interesting.

Steve Keen, an Australian economist I've mentioned before recently gave a presentation to members of Congress regarding the Fiscal Cliff of 1937.


In his presentation Mr. Keen describes the mechanism through which a dramatic tax increase coupled with an absolute cut in spending threw the US economy into a recession.  From 1937 to '38 tax receipts when up ~25% and spending was cut ~8%  While in the 1937 spending and taxes were a much smaller percentage of GDP, the large swings in their absolute numbers were enough to decrease the deficit from -2.5% to -0.1% or a change of 2.4% (source: White House)

Additionally the Federal Reserve shrank their balance sheet at the same time:

The wrong time to anti-QE
Source: Federal Reserve

The combination of Fiscal and Monetary tightening pushed the economy back into recession. (Vertical gray lines on above graph.)

Right now we are experiencing a similar situation: The US economy is working off the excesses of a burst credit bubble and federal spending and deficits are at an all time high.   

Spending and Taxes from 1930 on
Source: White House
As you can see above, spending is at at a peacetime high and taxes are near a post WWII low. (Both relative to GDP.) Combine the two and you have the largest peacetime deficit from 1900 onward. (The data from the White House doesn't go back any further than 1900, so there may be another time period before then however I doubt we have experienced peacetime 10+% budget deficits before.)

Today we can see the credit bubble bursting in a chronically high unemployment rate and sluggish GDP growth.  Unlike other downturns, our GDP did not rebound much. 

Source: Federal Reserve

A ~2.5% GDP growth rate after coming out of a recession is quite low as compared to historical norms.

Raising taxes too quickly combined with actual spending cuts on an already slowly growing economy could send us immediately into a recession.  This is what has Wall Street in a current tizzy and is already hitting consumer confidence.

Predictions about the future are tricky, especially when politicians are involved.

How much taxes go up, and if there are any actual spending cuts will determine how much of a fiscal drag hits the economy in 2013.  Right now it's all speculation and I'm not going to try to predict what Congress and the President will eventually agree to, before or after January 1, but there are a few items which appear certain:

  • Taxes will go up, but not as much as 1937 on a percentage basis
  • Spending will most likely not decline on an absolute basis
  • Federal spending is a much larger percentage of the economy than in 1937
  • The Federal Reserve will NOT shrink its balance sheet in 2013

How much taxes will go up and on whom is the unknown and that is what is creating uncertainty in the mind of corporations and individuals.  Until we have clarity both the markets and consumer actions may be volatile.

Additional reading:

I actually wrote about this 2+ years ago as I was studying the history of the Great Depression.

Thanks to
 @mbusigin 1937 fed data
 @AlephBlog When is a 'cut' really a 'cut' in Washington speak (hint, not very often)