One year later we have the received narrative for the market crack-up of 2008: Exhibit A – The bankruptcy of Lehman Brothers.
And now we know what saved the economy: Exhibit B — Massive liquidity from the Federal Reserve — in contrast to the Great Depression era central bankers who put the squeeze on monetary policy.
Okay. Let’s poke a few holes.
The Lehman bankruptcy, whose anniversary we have been celebrating for the past month, was certainly no heart-warming event. But it wasn’t the straw that broke the camel’s back. University of Chicago economists John H. Cochrane and Luigi Zingales demonstrate that the economy didn’t hit the panic button until former Treasury Secretary Hank Paulson and Fed Reserve chairman Ben Bernanke went to Capitol Hill and yelled “Fire!”
Notice in the graphic (above) that a critical measure of confidence in the banking system — the Libor -OIS spread — didn’t really begin rising to record levels until after Paulson and Bernanke went before Congress to argue for the TARP legislation, which they said was needed to keep the economy from collapsing. Similarly, the price of insurance on Citibank bonds (aka, credit default swaps) didn’t jump to Olympian heights after the Lehman bankruptcy; it was only after the mouths roared before Congress. In general, my experience in covering the market reveals that this is typical. Politics is more often than not the catalyst that roils the markets big time. And credit markets are the leading indicator. That was true in 1987 and it was true in 2008.
Next: Tight money killed the incipient recovery in the 1930s. Economist Arthur B. Laffer begs to differ:
The damage caused by high taxation during the Great Depression is the real lesson we should learn. A government simply cannot tax a country into prosperity. If there were one warning I’d give to all who will listen, it is that U.S. federal and state tax policies are on an economic crash trajectory today just as they were in the 1930s.
And, of course, here’s a graphic to show what happened to just the top federal tax rates during the Depression projected through to 2015. Note: this does not include rising city, state or sales taxes.
I am no big fan of big deficits (and both the NYTimes and Clusterstock both ran pieces similar to mine last week on the dangers of our deep debt hole — Clusterstock featured the same graphic). But now is not the time to raise taxes to either fund new programs or whittle our mountain of debt.
More from Laffer on the tax hikes that began in the Hoover Administration and continued during the Roosevelt years:
…beginning in 1932 the lowest personal income tax rate was raised to 4% from less than one-half of 1% while the highest rate was raised to 63% from 25%. (That’s not a misprint!) The corporate rate was raised to 13.75% from 12%. All sorts of Federal excise taxes too numerous to list were raised as well. The highest inheritance tax rate was also raised in 1932 to 45% from 20% and the gift tax was reinstituted with the highest rate set at 33.5%.
But the tax hikes didn’t stop there. In 1934, during the Roosevelt administration, the highest estate tax rate was raised to 60% from 45% and raised again to 70% in 1935. The highest gift tax rate was raised to 45% in 1934 from 33.5% in 1933 and raised again to 52.5% in 1935. The highest corporate tax rate was raised to 15% in 1936 with a surtax on undistributed profits up to 27%. In 1936 the highest personal income tax rate was raised yet again to 79% from 63%—a stifling 216% increase in four years. Finally, in 1937 a 1% employer and a 1% employee tax was placed on all wages up to $3,000.
Furthermore, state taxes surged as well, from 7.2% of GDP in 1929 to 12.3% in 1932.
Bernanke has declared the end to the recession. Technically, he may be correct. But the economy is in a precarious state: The huge deficit threatens dollar stability and our ability to fund our spending; unemployment means consumers won’t bailout the economy anytime soon. Raising taxes to fulfill the Obama Administration wish-list is tempting but clearly unwise.
In another post I’ll address a critical need: Allowing the economy to correctly price in the housing overhang. And that won’t win any votes.