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Recession of 1949

Congress legitimized the modern role of fiscal policy as an economic stabilizer by passing the Employment Act of 1946. The decade of the 1930s had been a traumatic one in which the unemployment rate had been above 10 percent from 1931 through 1940, and above 20 percent from 1932 through 1935.

The tremendous wartime government purchases of goods and services caused the unemployment rate to fall below 2 percent in 1943, 1944, and 1945. It was generally agreed that a return to the conditions of the 1930s was unthinkable, but it was also feared that the private economy in peacetime would not be able to generate anywhere near the number of jobs required for full employment. Thus, it was felt, the Federal Government would have to take responsibility for maintaining full employment, and an active fiscal policy would have to be a major instrument, perhaps the major instrument, for discharging that responsibility. Although the Employment Act of 1946 as finally passed was substantially modified and compromised from the original bill, it is fair to say that the Act confirmed and institutionalized that view.

After the war ended in 1945, most policymakers were concerned with preventing another Great Depression. But inflation proved to be a much greater concern: Between June 1946 and June 1947 Consumer Price Index (CPI) inflation was 17.6 percent, and from June 1947 to June 1948 it was 9.5 percent. The Fed's priority thus switched from financing the war to restricting inflation, but President Truman and Secretary of the Treasury John Snyder were both strong supporters of the low interest-rate peg in order to protect the value of war bonds. Because the economy operated near full employment in 1947 and 1948, the surpluses in the actual and full-employment budgets were, predictably, quite close. In the recession year of 1949, both surpluses dropped very sharply because of the large rise in Government expenditures. Nevertheless, the reduction of $10.9 billion in the actual budget surplus exceeded the reduction of $7 billion in the full-employment budget surplus by almost 50 percent.

All but $0.5 billion of this $3.9 billion difference was attributable to the different ways actual and full-employment revenues had behaved. Full-employment revenues did fall slightly, by $0.8 billion, because in April 1948 Congress passed a tax cut over President Truman's veto. Yet actual revenues fell by a full $4.5 billion because the 1949 recession had reduced GNP and, hence, total taxes collected.

This difference illustrates the fallacy of judging the thrust of fiscal policy by examining the state of the actual budget. While the reduction in the full-employment surplus shows that the proper fiscal policy for fighting recessing was followed, the fact that a $2.5 billion surplus did remain shows that this policy was not applied in a strong enough dose to prevent the 1949 recession. The $2.6 billion deficit in the actual budget, therefore, gives a misleading indication of how expansive fiscal policy actually was. Rather than regarding that deficit as an unsuccessful attempt to prevent the recession, it is more accurate to view the deficit as having been caused by the recession.

From the point of view of fighting the recession, the incorrect policy had been followed in 1949. The Federal Reserve had continued to conduct open-market operations to support bond prices and interest rates rather than to fight inflation and recession, and stabilize the business cycle. At the end of June 1949, the Federal Reserve stated that henceforth open-market operations would be conducted "with primary regard to the general business and credit situation." The Treasury did not, however, give any sign that it recognized or sanctioned any change in policy. In early 1950 a subcommittee of the Joint Economic Committee of Congress reported on the split between the Treasury and the Federal Reserve and clearly sided with the latter. Both sides preferred to avoid a confror tation and until the middle of 1950 no occasion arose to force the matter.

The outbreak of the Korean War in June, however, meant that they could no longer avoid the critical issue. The War raised the prospects of large new budget deficits and of Treasury's desire to finance those deficits by borrowing at artifically low interest rates. But it also set in motion a large wave of buying by individuals and businesses, a rapid upsurge in prices, and a Federal Reserve desire to fight inflation.

At a meeting between the Secretary of the Treasury and the Chairman of the Federal Reserve Board on August 10, 1950, neither side backed down. Shortly thereafter, the Federal Reserve took a number of actions which forced a confrontation with the Treasury. The Federal (Reserve) OpenMarket Committee decided to peg the interest rate on one year Treasury certificates at 1.375 percent. Soon after, the Treasury announced an issue of certificates bearing a rate of 1.25 percent. The Federal Reserve did not flinch. The rate was held at 1.375 percent although it meant that private investors would not purchase the new Treasury issue.

The Federal Reserve then bought most of the Treasury certificates and partly offset the effect of its purchases on the money supply by selling other securities out of its own portfolio at existing interest rates. This raised a furor in financial circles. It meant that the Federal Reserve had taken over management of the Federal debt. It borrowed money for the Federal Government at interests rates it determined. By February 1951, CPI inflation had reached an annualized rate of 21 percent.