Do Policies that Slash Spending Drag the Economy Down?

BY Paul Solman  December 12, 2011 at 10:22 AM EST

U.S. Capitol; Jewel Samad/AFP/Getty Images
Photo by Jewel Samad/AFP/Getty Images.

Paul Solman frequently answers questions from NewsHour viewers and web users on business and economic news on his Making Sen$e page. Here’s Monday’s query:

Name: Roy Pettis

Question: Aren’t these steps of cutting spending, balancing the budget, etc. the sort of policy decisions that many economists think caused the Great Depression to be so long?

Paul Solman: Yes. This is a very important point. A standard argument in American history classrooms for decades has been that the great double dip of the 1930s — the so-called “Mini-Depression” of 1937-8 — was caused when President Franklin Roosevelt campaigned on a balanced budget in 1936. (I first learned it at the Harvard Business School in 1976.) In a 1938 letter to FDR, the English economist who fathered the notion of stimulus, John Maynard Keynes, warned the president of having made an “error of optimism” and urged him to spend and spend liberally.

Making Sense

The standard thinking has also long been that World War II finally forced the government to do what Keynes advised and, as a result, the country prospered for decades thereafter, despite widespread fears of unemployed millions when the soldiers flooded home from the fronts.

These assumptions have been challenged in recent years, however, with the free-market counter-argument that government itself extended the Great Depression through FDR’s foolish and confused policies, and now government interventionism is again keeping the economy hogtied due to current and future deficits. For the first argument, see our interview with Amity Shlaes and economic historian Eugene White. The deficit argument would require more citations than even this page can accommodate.

The problem with the deficit argument thus far, however, is that it’s predicated on rising interest rates and the notion of “crowding out.” That is: large deficits should lead to rising interest rates, we are the next Greece; etc., etc. The problem with this argument is that interest rates have actually fallen sharply since talk of U.S. default first began and recently, according to economic historian Richard Sylla, fell below their ALL-TIME historic low of 1.85 percent, seen twice in 1941. Greece is paying about 25 percent to borrow money for ten years at the moment; the U.S. is paying 2 percent. Hard to see how that is crippling the economy.

Nor does there seem to be much “crowding out” — government borrowing displacing private borrowing that would otherwise be going on and goosing the economy. In fact, U.S. corporations are sitting on more than $3 TRILLION in cash, according to Reuters correspondent David Cay Johnston‘s calculations. And we have reported often that more than $1.5 trillion has been redeposited by U.S. banks at the Federal Reserve, which pays a measly 1/4 of one percent. Surely, if there were live borrowers out there with any ability to pay, the banks would lend to them instead.

This entry is cross-posted on the Making Sen$e page, where correspondent Paul Solman answers your economic and business questions. Follow Paul on Twitter.