Stimulus: Can it work like Roosevelt's New Deal?

Why government spending plus easy money could pull US out of recession by year's end.

There's an old saying by economists that once the Federal Reserve gets short-term interest rates down to zero, it can't "push on a string." In other words, the nation's central bank can't do much more to revive the economy from its present financial and economic slump because it can't lower interest rates further. They are now almost zero.

Paul Kasriel, an economist with the Northern Trust Co., in Chicago, has a different string theory. He figures the Fed has been, in effect, printing so much money, regardless of interest rates, that in combination with a massive fiscal stimulus package, the economy should revive by late this year or in 2010. "It depends on how fast the government can shovel out the [stimulus] money," says Mr. Kasriel.

During the Great Depression, it was similarly a combination of major government spending (the New Deal) and easier money that eventually brought a vigorous recovery.

So today, the Fed must in reality finance much of the $787 billion stimulus package or the stimulus won't work, Kasriel says. Without the Fed's support, the nation's actions could be likened to someone spending stimulus money at a store with one hand and taking money out of the store's cash register with the other (via tax hikes or spending cuts).

Certainly Fed policymakers have been pouring gobs of money into the economy. Last year, bank reserves grew almost 149 percent. That's "an unprecedented increase," Kasriel notes.

"Never underestimate the initial positive impact on aggregate demand of that powerful combination of increased federal government spending, tax cuts, and a central bank running the monetary printing press at a high speed," he adds.

A basic challenge remains the scale of today's economic problem, though it's not nearly as bad as the 25.6 percent unemployment rate of May 1933.

United States household net worth is down 25 percent, or $16 trillion from its peak of nearly $63.6 trillion in the third quarter of 2007, estimates Michael Cosgrove, an economist at the University of Dallas, Irving. Stocks are worth $10 trillion less. Household real estate has crashed $5.5 trillion since 2005.

As a result, Professor Cosgrove argues, consumers feel poorer and are spending less, perhaps as much as $300 billion less. Most homeowners can no longer take huge amounts of money out of their home's equity as they did in the past. These factors point to "a long recession," he says.

Another difficulty is the need for further bank rescue. The Obama administration calculates that as much as $2 trillion is needed to clean out the toxic assets held by banks and put them in better shape for lending. The battle in Washington over "nationalization" of troubled banks is in part a dispute over who bears the losses: bank shareholders and bondholders, or the taxpayer.

A byproduct of the political dispute over the stimulus package has been an argument among economists over the effectiveness of President Roosevelt's New Deal.

Economist Kasriel's analysis, presented in an article tltled, "Just the Facts, Ma'am," finds that the stimulus worked. In the four years after Roosevelt took office, ending in 1937, the nation's gross domestic product (GDP – its output of goods and services) grew at a real compound annual rate of 9.4 percent. That's fantastic, close to China's growth rate in recent boom years. But, Kasriel notes, the recovery from the four-year Depression started just at the time Roosevelt took office.

Economists critical of the stimulus package tend to talk of the unemployment rate. For example, Amity Shlaes, an economic historian at the Council on Foreign Relations, notes that unemployment in the Roosevelt era averaged "well above 10 percent."

Economists, though, call the unemployment rate a "lagging indicator." It takes time to ease after an economic recovery starts. During the New Deal recovery, unemployment fell by more than half to 11 percent in July 1937. Then it rose again in a second slump that lasted through June 1938. Kasriel blames this slowdown on major tax increases and tighter Fed monetary policy in 1936 and 1937.

Attempts by some economists to downplay the effect of the New Deal annoy Charles McMillion, a Washington consulting economist. He calls them "antigovernment myths and ideology." He notes that real GDP surpassed its 1929 peak in 1936 and never again fell below it, despite the "trial and error" policies of Roosevelt.

Today the Fed is making an astonishing drive to turn the economy around. The basic money supply grew at a blazing 33 percent annual rate in the fourth quarter of last year. It is acting like a huge commercial bank itself, notes Kasriel, and it has "an infinite amount of capital." It's buying commercial paper, mortgage-backed securities, credit-card debt, etc. This quarter, Kasriel predicts, will be the worst of the current economic contraction. "The streams are beginning to flow," he says.

Let's hope so.