Paul Krugman: That 1937 Feeling

There's a pretty good chance that the next few economic reports will make it appear that the economy is improving, but those reports may not be as positive as they seem on the surface. Will policymakers "misinterpret the news and repeat the mistakes of 1937?":

That 1937 Feeling, by Paul Krugman, Commentary, NY Times: Here’s what’s coming in economic news: The next employment report could show the economy adding jobs for the first time in two years. The next G.D.P. report is likely to show solid growth in late 2009. There will be lots of bullish commentary — and the calls we’re already hearing for an end to stimulus, for reversing the steps the government and the Federal Reserve took to prop up the economy, will grow even louder.

But if those calls are heeded, we’ll be repeating the great mistake of 1937, when the Fed and the Roosevelt administration decided that the Great Depression was over, that it was time for the economy to throw away its crutches. Spending was cut back, monetary policy was tightened — and the economy promptly plunged back into the depths. ...

As you read the economic news, it will be important to remember, first of all, that blips — occasional good numbers, signifying nothing — are common even when the economy is ... in a prolonged slump. ...

Such blips are often ... statistical illusions. But ... they’re usually caused by an “inventory bounce.” When the economy slumps, companies typically find themselves with ... excess inventories, [and] they slash production; once the excess has been disposed of, they raise production again, which shows up as a burst of growth in G.D.P. Unfortunately, growth caused by an inventory bounce is a one-shot affair unless underlying sources of demand, such as consumer spending and long-term investment, pick up.

Which brings us to the still grim fundamentals of the economic situation. During the good years of the last decade,... growth was driven by a housing boom and a consumer spending surge. Neither is coming back. ...

What’s left? A boom in business investment would be really helpful... But it’s hard to see where such a boom would come from: industry is awash in excess capacity, and commercial rents are plunging in the face of a huge oversupply of office space.

Can exports come to the rescue? For a while, a falling U.S. trade deficit helped cushion the economic slump. But the deficit is widening again, in part because China and other surplus countries are refusing to let their currencies adjust.

So the odds are that any good economic news ... will be a blip, not an indication that we’re on our way to sustained recovery. But will policy makers misinterpret the news and repeat the mistakes of 1937? Actually, they already are.

The Obama fiscal stimulus plan is expected to have its peak effect ... around the middle of this year, then start fading out. That’s far too early: why withdraw support in the face of continuing mass unemployment? Congress should have enacted a second round of stimulus months ago... But nothing was done — and the illusory good numbers we’re about to see will probably head off any further possibility of action.

Meanwhile, all the talk at the Fed is about the need for an “exit strategy” from its efforts to support the economy. One of those efforts, purchases of long-term U.S. government debt, has already come to an end. It’s widely expected that another, purchases of mortgage-backed securities, will end in a few months. This amounts to a monetary tightening, even if the Fed doesn’t raise interest rates directly — and there’s a lot of pressure on Mr. Bernanke to do that too.

Will the Fed realize, before it’s too late, that the job of fighting the slump isn’t finished? Will Congress do the same? If they don’t, 2010 will be a year that began in false economic hope and ended in grief.