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In a previous article, "Economic Stimulus: Never Works, Never Has, Never Will," I made clear that Fiscal Policy was doomed to failure for three reasons:

  • Government purchases are inherently less effective than private purchases ("category IV spending"),
  • Stimulus programs breed dependency, not entrepreneurial effort, and
  • Stimulus programs distort incentives to save and invest.

I used the 1937 recession and stock market crash, both of which were more sudden and severe the 1929-1932 period, as proof of my premises.

As it turns out, the 1937 debacle is also relevant to our current discussion of the "fiscal cliff." Many analysts, and certainly many politicians, suggest that next years' "toxic cocktail" of tax increases and spending cuts will lead to a second recession and bear market. A small coterie of pessimists believe the 2008 recession never ended!

Arguments now are very similar to those of 1937. Just as President Obama rails against "oil company subsidies" and "high overseas cash holdings" by American corporations, eight decades ago Roosevelt blamed the continued depression on "monopoly power" and "undistributed corporate profits." Just as Harry Reid hopes to pack the Senate agenda by changing the operating rules, President Roosevelt tried to pack the Supreme Court with judges who would view his N.I.R.A. diktats as constitutional. In both periods interest rates hovered near zero levels.

And the greatest echo of 1937 in all the fiscal cliff arguments? We must not cut government spending; we must instead raise taxes!

"If we cut government spending now the economy will collapse like it did in 1937."

Which is certainly most odd, because if you look at Federal Budget data, you'll see it was not budget cuts, but tax increases that were the primary bite that pushed the economy into a second recession. From 1936 to 1937, Federal spending fell about 8.5%, from 8.2 to 7.5 billion. But tax revenues -- in large part because of the imposition of the payroll tax -- rose from 3.9 to 5.3 billion, almost 36%, or more than four times as much as the spending cuts. In 1938 the ratio was only slightly better: revenues "only" grew three times faster than spending cuts.

Keep in mind the logic of our previous article. This shifted billions of dollars -- that was a lot of money back then, as Senator Dirksen of Illinois would say were he alive today -- from the hands of consumers to the hands of Federal Bureaucrats.

The lesson of history is clear: imposing budget discipline over the next few years should concentrate first and foremost on budget cuts. Draining funds out of the hands of consumers, investors, and small business owners thru direct taxes, or indirect taxes and regulations, will indeed push our economy back into recession.

Thus investors and short term traders should keep an eye on the budget negotiations and see where the bulk of next years fiscal "discipline," will fall. I use the term discipline loosely because we certainly have no chance of slashing spending or the deficit by anything close to the percentages we did back in the 1930s.

Primary emphasis on tax increases will devastate consumer spending and with it broad based market performers like the SPDRs S&P500 Trust Series ETF (SPY), and its cousin, the SPDR Dow Jones Industrial Average ETF, (DIA).

In contrast, primary emphasis on spending cuts will be bullish for shares, broadly. However, sectors and stocks which are favorite recipients of government largesse such as defense firms like Raytheon (RTN) and General Dynamics (GD) are obviously vulnerable. Government research contractors like SAIC corporation (SAI), may also be hurt.

And of course, if the economy tanks next year, taking the market with it, expect endless bleating about "dysfunctional government and gridlock."

That's the biggest laugh of all. Roosevelt had a solid majority in both houses in 1936 and 1937. Did that prevent the second crash?

Source: The Fiscal Cliff... Of 1937