One of the worst depressions in American history began in mid-1937. At the time, Keynesian ideas were becoming increasingly prominent and many Keynesians blamed fiscal austerity. In fact, there wasn’t all that much fiscal austerity in 1937, certainly not enough to cause a major depression:

Between 2020 and 2022 we had roughly twice as much “austerity” as in 1937, at least in terms of the reduction in the budget deficit. And yet not only did we not have a major depression, we saw some of the strongest job growth in American history. Yes, we began 2022 with employment still a bit below normal, but that was even more true in 1937. And yes, the austerity of 2022 mostly reflected the decision to end COVID relief programs, but much of the austerity of 1937 was the decision to not repeat the big 1936 “bonus” payments to WWI veterans.  

I’m confident that observers can spot a few more differences, but do they actually explain such a dramatic difference in outcome? Do they explain the difference between major depression and extraordinary job growth? And why didn’t the sharp fiscal tightening after WWII lead to the major depression predicted by Keynesian economists at the time? Why didn’t the big 1968 tax increase reduce inflation, as predicted by Keynesian economists? Why didn’t the 2013 austerity produce a recession, as predicted by Keynesian economists?

The answer to all of these questions is quite simple: it’s monetary policy that drives aggregate spending, not fiscal policy. Tight money caused the 1937 depression. It’s time to give up on the theory that fiscal policy drives aggregate demand. The Fed takes fiscal policy into account when it makes its decisions. It tries (not always successfully) to offset the effects.  

The same concept applies to banking problems. It is very possible that we’ll have a recession in late 2023 (recessions are almost impossible to forecast.) But if we do, it won’t be caused by banking turmoil. If the Fed thought credit problems were likely to lead to a recession, they would not be raising interest rates this week. If there is a major recession it will be because the Fed raised rates too much—it misjudged the situation. In contrast, a very small recession might in some sense be intentional—the Fed’s way of reducing inflation.

P.S.  Here’s the unemployment rate. Notice that recessions (grey vertical bars) are easy to spot. Do you see a recession in 2022? Neither do I.