Are the Fed’s Tools Enough to Prevent Another Recession?


Some believe that fending off a pending recession will require all the tools we can muster, including a lot of “infrastructure spending.” Is this really warranted?

We learned some valuable lessons during the Great Depression, or at least there were lessons to be learned, whether we learned them all that well or not. One of the things we did learn is that massive government spending under the New Deal didn’t really do that much for the problem, and if there ever was a time when this was going to work, it was then.

The big issue back then wasn’t even a depression, even though we call the entire decade of the 1930’s a depression, and a great one at that. The actual depression only lasted from 1930-1933, where nominal GDP was cut in half, from $105 billion to $57 billion at the worst of it.

There were two major factors in play during this time, with the first and most damaging being the high level of bank failures. Bank failures depress the economy like nothing else, because this causes a lot of damage to the money supply, and when many banks go under, you can get a massive amount.

This all happened during the early part of the depression, when the Fed sat on their hands and watched this all happen, in spite of one of their primary roles being to step in and prevent this. When we faced the same problem in 2008, we did not make the same mistake again, or we might be back in the 1930s again, or worse, and it could have been a lot worse given that this could have taken down the banking system itself this time.

The second factor during the actual depression was Hoover raising taxes in 1932. If you know how taxes affect the economy, you are probably doing a double take here, as this is like pouring gasoline on a fire. It is hard to imagine why anyone in their right mind would consider such a thing in a time of epic economic crisis, but he took GDP growth from the –6.4% that the Dust Bowl produced, and taxed it all the way up to –12.9%.

In the first 3 years of the New Deal, GDP really took off, with years of 10.8%, 8.9%, and 12.9%. This was actually as far away from a depression as we ever see. Unemployment rates remained high though as all this spending did employ a lot of people but nowhere near enough to make much of a difference on this front. The unemployment rate still averaged 19% during this time, which was down a few percentage points from when the depression was on but was still far away from where we needed to be.

All this spending did stimulate GDP but did so in a more isolated way that obviously did not translate that well to the economy as a whole. We produced more, and increased it at a rate that should even alarm us. However, it didn’t play out that well on Main Street which still had people lining up in droves for bowls of soup so that they wouldn’t go hungry.

There is an important lesson here and it’s that, among all the tools that are out there to stimulate the economy, fiscal spending is the least effective across the board as its effects are not widespread enough. If we were going to rely on fiscal policy a lot, tax cuts across the board and especially corporate tax cuts would have helped everyone in a manner more directly than New Deal spending did.

We might think that we would arrive in the same place or a similar one with each approach if we used them proportionately, but the fact that tax cuts benefit everyone and fiscal spending relies on the trickle-down effect overall, which simply is not as effective, is what sets them apart.

People will claim that cutting corporate taxes involves a trickle-down effect, but that is mistaken, as what happens is that the tax savings flow through to consumers by way of lower prices. Spending money on public works projects, on the other hand, place money in the hands of a small percentage of the pubic with the hopes that this will work its way around. As we see with the New Deal, it didn’t trickle down all that much, and we boosted our GDP numbers but most of the people who were out of work remained out of work.

Governments spend money all the time, and it certainly doesn’t hurt the economy when they do, and this all contributes to aggregate demand and increases aggregate production. If we’re out to use this to fight economic recessions though, it just isn’t the wisest or most effective way to manage these things. You get more bang from your buck by cutting taxes.

Just when things were at least looking up GDP wise, and things were starting to improve on the employment front, with the number at least going down, FDR raised taxes. This actually caused GDP to decrease and a recession to kick in, dropping GDP by 7.8% the next year and by a further 8.4% the year after and sending us into the negative once again.

Unemployment also went back up during this time, which had been the source of all the pain of the era and did not bear increasing. Throughout the decade, unemployment remained high throughout and it took WWII to right this ship as the government struck out.

We can only wonder what would have happened if we used both monetary and fiscal policy more correctly during the Great Depression, but it very likely would only have resulted in a fairly brief recession, much like the one we saw in 2008-09. Instead, this was badly managed overall. We should have instead bailed out the financial sector to whatever extent needed, and used a combination of tax cuts, spending, and expansionary monetary policy to bring things back to where they needed to be.

We’re Faced with Nothing Like This These Days

The issues that we battle today are far less great than with either the Great Depression or the Great Recession, and of a nature that monetary policy from the Fed should be plenty enough to manage it. Getting out of the last crisis did take a concerted effort, with the Fed both cutting rates to zero and using an aggressive amount of quantitative easing, meaning that they bought a lot of treasuries which expands the money supply.

The government also cut taxes and increased spending, which was wise because with a crisis like this, you want to be aggressive with it and use all of your weapons. As it turned out, the effects were pretty modest, in spite of this being called a recession that was great, and we only really saw one bad year, 2009.

Unemployment did rise to 9.9% in 2009, but went down from there and is still going down each year. Looking back, they really handled this situation beautifully and we have had the last decade to look back on this effort and be grateful, as the response was not only effective but very sustained.

We are faced with the challenge of an economic slowdown these days, and the main reason for this is the Fed being guilty of being too aggressive with its rate hikes once things picked up enough. We did see Trump lower taxes during this time, which did help stimulate things, but not so much that this required that this be undone by successive rate hikes by the Fed.

It is actually very fitting that they are retracing their steps now, and provided that inflation remains in the comfort zone, more can be added to look to help us out of this little funk. Given the nature of this problem, there is little reason to believe that this will not be enough.

Hardly anyone talks about the Fed’s ending quantitative tightening, but this matters as well, and takes us toward rather than away from slowdown in the same manner that rate hikes do. Rate hikes and quantitative tightening shrink the money supply and the economy in turn, and if you’re worried that has shrunk too much, or you have shrunk it too much in this case, you need to do the opposite.

The Fed doesn’t just have more rate cuts in its arsenal, it also can use quantitative easing. While monetary policy certainly involves the trickle-down effect to the people at the bottom of the chain, it effects the primary participants directly and on a wide scale, making it cheaper for businesses to borrow and expand, which is what we are after primarily.

While Trump has given with one hand, he has been taking away with the other, although even with all these tariffs the net effect is still positive. The reason is that these tariffs really don’t make that big of an impact upon the economy as a whole, nor do the Chinese ones, and we tend to worry about this more than we should.

Still though, these tariffs do contract the economy like all taxes do, and it would be better if we could get this all settled and see them go away. We know how stubborn President Trump can be though, and we don’t want to be sitting on our hands and hoping here, but monetary policy can easily handle an issue of this not particularly concerning magnitude.

If We Need to Use Fiscal Policy Against Tariffs, Corresponding Tax Cuts Would be Best

If these tariffs were paired with a corresponding tax cut, preferably a corporate one, this would both serve the purpose of providing American businesses with a competitive advantage as well as offsetting the harm that tariffs have on the economy. We might think that we are committing ourselves to too much here given the presumably transitory nature of the tariffs, but tax cuts can be fashioned in such a way as well, and even be used in response to sectors that are harmed by tariffs on the other side. This serves to both help the harm we cause ourselves as well as the harm that China is causing our companies, all in one move.

In a real sense, the way that we fight trade wars is like two cavemen with clubs, with each hitting themselves on the head with it. There are better ways to resolve this, by looking to limit domestic harm while still seeking to address your trade concerns.

Spending this extra money on public works projects certainly wouldn’t hurt, but it just isn’t as efficient of a way to manage this than corporate tax cuts would be. The majority of the people do not understand why corporate tax cuts are beneficial to both the economy as a whole and to them as well, so these things are met with real resistance, and we need to do a lot better job educating the public about the benefits of these things.

In any case, the current economic situation does not require all hands-on-deck like we had in 2008, with rate cuts, quantitative easing, tax cuts, and spending all needed to help out. We do know that we will need to spend a lot of money on public works projects going forward, but we should only look to do so when the time is right, according to its own merits, and not use a little economic slowdown as an excuse.

Fiscal spending is also something that you want to consider when you’re looking to boost employment by hiring all these people to do these projects. This doesn’t work as well as we may think in the face of an economic undertow, but especially would not be that appropriate with today’s full employment, with the unemployment rate even below what you would normally see with no structural unemployment at all.

If we’re looking to spend a lot and create a lot of jobs, we need to ask who will fill these jobs, either the new jobs themselves or ones that end up being displaced. This can actually create a labor shortage where we’re forced to bring in a lot of migrant workers, perhaps even from China, seeking a lot of wages taken out of our economy and sent back home, and ironically worsening our balance of payments with them and sending a lot of what is supposed to be benefiting our economy to other countries to benefit theirs.

If monetary policy turns out to be not enough, we should look to cut corporate taxes first, because this approach produces a wider distribution of the benefits, the lack of which is why the New Deal didn’t work that well. We’re nowhere near this level of threat yet though and it will only be when the Fed undoes its mistakes over the last 4 years that we’ll even know where we are at, and this alone should be plenty enough.

John Miller


John’s sensible advice on all matters related to personal finance will have you examining your own life and tweaking it to achieve your financial goals better.