Let’s Not Repeat the Fiscal Policy Mistakes of the Early 1930s

Passage of the President’s five-year deficit-reduction legislation raises the possibility that we will do what we last did in the early 1930s. We will enact policies that will depress an economy that if anything could use a boost.

Fiscal policy is about to tighten significantly in the name of deficit reduction, while monetary policy may soon become less accommodative in order to avoid a further pickup in the rate of inflation. And there are some people--both in and out of government--who, to complete the analogy with the early 1930s, would rue defeat of the proposed North American Free Trade Agreement.

In 1930, President Herbert Hoover was concerned about restoring business confidence in the wake of the 1929 stock market crash, so he tried to reduce Washington’s budget deficit. The Federal Reserve Board of that era, believing there was too much money around and that it would drive interest rates down to the point where banks would be threatened, cut the money supply by one-third. And the Smoot-Hawley Tariff Act was passed into law in an effort to direct spending away from imports and toward goods made in this country.

Needless to say, these policy errors exacerbated the sluggishness already under way, resulting in what has come to be known as the Great Depression.

I don’t mean to imply that what befell us in the 1930s will recur in the 1990s. Nor do I quarrel with the need for deficit reduction, or for the necessity for monetary policy to guard against a pickup in inflation. I would only point out that neither fiscal nor monetary policy should shift to restraint before the more pressing problems of subnormal growth and weak job creation are addressed.

Boosting economic growth and job creation before cutting the deficit was Bill Clinton’s original game plan when he ran for the presidency, as well as immediately after he was elected. It still makes sense today--even though his stimulus program was not enacted by Congress.

Short of a massive increase in government spending and/or a sizable tax cut (the opposite of what was just enacted by Congress), there is little Washington can do to boost growth in the aftermath of the overbuilding of the 1980s, the huge debts now borne by both business and consumers, state and local government budget binds, the downsizing of our defense sector and recessions among many of our trading partners.

If American consumers were to lift their rate of spending, that would help growth in sales and output, but people aren’t about to spend more as long as they are worried about their jobs.

It may not be politically feasible for Washington to embark on a 1930s-style Works Projects Administration hiring program in order to create jobs, but at the very least the government ought to make hiring less expensive by offering business a tax credit for every full-time, permanent person added to an employer’s payroll. In addition, Washington ought to cut Social Security taxes and modify some recent social legislation. Repealing the Tax Reform Act of 1986 would create more jobs as well by encouraging the flow of venture capital into new business enterprises.

Once job creation picks up, spending will too, leading to a faster rate of economic growth. However, given the drags on growth noted above, the economy will not be strong enough to take more than a gradual dose of fiscal restraint.

This means that deficit reduction should rely on a spending freeze alone, rather than the current legislation, which places a great deal of emphasis on higher taxes. Emphasizing the spending side only runs less of a risk of weakening the economy, since it will not be pulling out large sums of money from the private sector in the form of higher taxes.

If there is any law at all in economics, it’s that you can’t tax your way to prosperity.

More important, raising taxes on upper-income individuals will hurt job creation as well. This is because many of these people own small businesses--the only sector still hiring--and they combine their personal tax returns with those of their firms. Clearly, higher taxes will result in these businesses having less funds with which to expand and add to staff.

Finally, raising tax rates has usually failed to lift tax revenues to the extent the government anticipated. Tax revenues have hovered in a narrow range near 19% of gross domestic product for more than 40 years, regardless of the top tax rate. Whenever taxes were raised, people would find ways to reduce their tax payments, and/or the economy contracted.

Today’s 12-digit budget deficits clearly have resulted from too much spending, not too little tax revenues. Hence the need to freeze overall spending levels.

Some would be concerned about modifying the current deficit-reduction legislation for fear of an adverse reaction from the bond market. After all, the reasoning goes, long-term rates have fallen chiefly in anticipation of passage of the Administration’s economic program; they offer the opportunity for business to raise new funds cheaply.

But business tends to borrow when it sees a good reason for it--not just because rates are low. Borrowing and investing were strong in the high-growth, high-rate environments of the 1970s and ‘80s and weak in the 1930s, when rates were even lower than they are now.

The U.S. economy is at a critical juncture. It needs to be weaned off excessively easy policies, both fiscal and monetary. We’ve grown to depend too much on excess government spending and lots of liquidity.

In order to return to a better state of economic health, Washington must reduce its budget deficit, and the Fed must sop up some of the excess liquidity it has created to keep the government’s borrowing needs from crowding out the private sector.

But both must be done gradually--in order to avoid the mistakes of the 1930s.