The battle of 1937

June 24, 2011, 9:57 PM UTC

Is it possible to cut government spending without sending the economy into another tailspin?

Now hardly seems like the time to find out – though try telling that to the tightening-minded Republicans in the House, led by the likes of Eric Cantor of Virginia (pictured at right).

Singing the wrong tune

Already a weak recovery appears to be on the verge of collapse. U.S. output limped ahead at a 1.9% clip in the first quarter. The Federal Reserve, not exactly the most skeptical group, this week cut its 2011 and 2012 forecasts. Ben Bernanke admitted he didn’t know why things aren’t going better.

And yet as poorly as things are going, countless policymakers, wonks and market sages have warned they could be worse. Cut government spending sharply, they say, and you risk a replay of 1937 – when a push to balance the budget ended a recovery and extended the Great Depression.

Back then, a virtue-obsessed Roosevelt administration cut the budget deficit from 5% of gross domestic product to 0.1% in just two years – and workers paid the price. Unemployment surged to 20% from 11% in just 14 months, reversing gains that had been slowly made since the early 1930s trough.

That failed experiment in fiscal fearlessness seems to send an unambiguous message: Don’t try this at home.

But deficit-cutting diehards insist that we have learned the wrong lesson. Cuts needn’t crush the economy, they say, as long as they aren’t too deep.

“There’s nothing on the table that looks anything close to 1937,” says Douglas Holtz-Eakin, a former director of the Congressional Budget Office and an adviser to John McCain’s 2008 presidential run. “You’ll never see a Congress that cuts enough to cause a crisis.”

He says the cuts needed to replicate the 1937 collapse would run into the hundreds of billions of dollars. While another recession would surely spell trouble – lower output would increase the gross debt-to-GDP ratio, which is already registering a troubling 100% — Holtz-Eakin contends modest cuts needn’t cause one.

By his lights a collapse of confidence in the dollar is a greater threat.

“I am not worried about cutting too much,” he said in an interview this month. “I’m nervous that we are headed for a crisis of too much debt and enormous short-term financing needs.”

It is easy to see why he’s nervous about that. Everyone from Bernanke on down has been calling the U.S. deficit habit unsustainable. Even beyond its trillion-dollar budget gap, the United States must roll over some $2.8 trillion in maturing debt this year, and about the same next – which makes it easy to see there is ample room for error.

Yet ironically, the most acute risk of a collapse of economic confidence in the United States lies in the demands made by Cantor and his gang that the deficit be cut without any tax increases. Their stance puts them at loggerheads with the White House — and runs the risk of pushing supposedly safe U.S. debt into default.

No time for experiments

No one will come out of that one looking good, and even the cutback advocate Holtz-Eakin sees this as a perilous place.

“It’s such a bad idea to damage the credibility of the United States,” he says. “I can’t overstate how bad that would be.”

In any case, the case for cutting now is hardly iron clad. Why rush at a time when inflation is ebbing, banks are sitting on their hands and employment as a share of population is at its lowest ebb in three decades (see chart, right)?

A sane idea would be to wait for the economy to actually improve before swinging the ax. But then, who said our political debate had to involve sanity?

The case for cutting spending now “simply makes no sense,” says Brad DeLong, an economics professor at the University of California Berkeley. “An awful lot of Republican economists singing the austerity song would … sing differently if Romney were president.”