One of the worst depressions in American history began in mid-1937. At the time, Keynesian ideas were gaining prominence and many Keynesians blamed fiscal austerity. In fact, there wasn’t that much fiscal austerity in 1937, certainly not enough to cause a major depression:
Between 2020 and 2022, we have had about twice as much “austerity” as in 1937, at least in terms of reducing the budget deficit. And yet, not only did we not experience a major depression, but we also experienced one of the strongest job growths in American history. Yes, we started 2022 with employment still a bit below par, but that was even more true in 1937. And yes, the austerity of 2022 mainly reflected the decision to end Covid relief programs, but a large part of the austerity of 1937 was the decision not to repeat the large “bonus” payments of 1936 to veterans of the First World War.
I’m sure observers can spot a few more differences, but do they really explain such a dramatic difference in results? Do they explain the difference between a major depression and extraordinary job growth? And why did the brutal fiscal tightening after World War II not lead to the major depression predicted by Keynesian economists at the time? Why didn’t the big tax hike of 1968 reduce inflation, as Keynesian economists predicted? Why didn’t the austerity of 2013 produce a recession, as Keynesian economists predicted?
The answer to all of these questions is quite simple; it is monetary policy that determines overall spending, not fiscal policy. Lack of money caused the depression of 1937. It is time to abandon the theory that fiscal policy stimulates aggregate demand. The Fed considers fiscal policy when making its decisions. It tries (not always successfully) to compensate for the effects.
The same concept applies to banking problems. It is very possible that we will have a recession at the end of 2023 (recessions are almost impossible to predict.) But if we do, it will not be caused by the banking turmoil. If the Fed thought credit problems were likely to lead to a recession, it wouldn’t raise interest rates this week. If there is a major recession, it will be because the Fed raised rates too much – they misjudged the situation. On the other hand, a very small recession could, in a certain sense, be intentional – the Fed’s way of reducing inflation.
PS. Here is the unemployment rate. Note that recessions (grey vertical bars) are easy to spot. Do you see a recession in 2022? Me neither.