And here in Germany, a few scholars see parallels to the policies of Heinrich Brüning, the chancellor from 1930 to 1932, whose devotion to financial orthodoxy ended up sealing the doom of the Weimar Republic.

Yet another example of incorrect historical revisionism on Krugman’s part.  This time, factual history is against Krugman’s thesis.  Germany’s collapse in the early 1930s was hinged on debt and the inability of their central bank to pay for it.  As I write in “Garet Garrett’s Invaluable Lesson“,

The late 1920s and early 1930s was a period of fear throughout Europe. Currencies were losing value, governments were building debt, and animosity was again quickly spreading between governments. European central banks were having issues remaining solvent while still providing liquidity to their governments. As a result, they often looked to the New York Fed and a host of private banks in the United States for credit to provide this liquidity.

Ultimately, the solvency of the Bank of England and the Reichsbank depended entirely on the solvency of the US Federal Reserve System. The Fed could only remain solvent as long as the Europeans repaid their debts, and by 1930 it was becoming obvious that these countries were borrowing far more than they could afford to repay.

Germany was the weakest link. Her government, scrambling for funds to pay for war reparations and social programs, borrowed copiously from English and American creditors. Unsurprisingly, the Germans began to borrow to pay for debts owed to the same creditors. Garet Garrett described this as a method by which Americans were repaying themselves for debts owed by others. The long-run consequence was even greater German debt. The principal losers were the American creditors who had lent far too much credit to the Europeans.

The overall consequences were easy to predict. As European central banks became insolvent, they began to default on their debts, catalyzing the collapse of the giant pyramid of credit funded largely through the Federal Reserve Bank of New York.

Theo Balderston, in Economics and Politics in the Weimar Republic,  argues that Germany’s debt problem originated with their inability to pay for war reperations.  I can agree with this analysis.  He further claims that Germany’s major problem at the time was growing wages and shrinking productivity.   But, the Reichsbank made good their ability to finance government reparation of debt and provide liquidity to private investors, and so I am not particularly convinced by any argument that the German government, at the time, was being fiscally austere.

Tracking back a bit, let’s be clear, the Austrians fundamentally agree with Krugman on this point.  Without intervention the economy will tank after an unsustainable boom.  So, let’s not get overly defensive over what Krugman writes in the latest op-ed.

The real argument is whether or not fiscal stimulus can revive an economy.  Krugman’s underlying thesis is that had the German government pursued a more extravagant spending program a revived German economy could have provided the German government the revenue necessary to pay off war reparations and other accumulated debt (coupled with inflation, bringing down the cost of debt in real terms).  This, in effect, would be something similar to what occurred in the United States directly after the Second World War.  But, the American example does not offer as clear of an example as Krugman would like to claim (see Robert Higgs’s Depression, War, and Cold War).

Ultimately, as I said above, the German economy during the 1930s was brought down by debt, not by a lack of government spending.  Whether or not fiscal stimulus can revive an economy in real terms (not just increase GDP by inflating ‘G’ in the equation) has not really been empirically proven, and the fact is that there is no theoretical consensus either.  If government spending does not stimulate an economy then the government is left with only more debt it is unable to repay, because all its spending has only made a private resurgence all the more difficult.

Maybe Keynesians can fall back on the claim that the stimulus wasn’t big enough, but the ideal size of a stimulus seems largely arbitrary to me.  So far, the best guess from Krugman has been along the lines of, ‘It it hasn’t worked it’s because it wasn’t big enough.’  This is not very convincing to a skeptic.

On average, fiscal stimulus makes up a bit less than 10% of total debt increase (3.5% as a percentage of GDP).  Krugman remains bewildered at the G20’s call for fiscal austerity by pointing out that slashing stimulus spending is not bound to have a major impact on debt growth and that such a policy could have long-term harmful side effects.  The latter concern is legitimate, at least if you believe that Keynesian countercyclical fiscal policy is the correct prescription for our current recession, but I feel that Krugman leaves out a few key details.

Krugman accuses this new plan of fiscal austerity of inflicting pain for no gain, because nobody trusts government to decrease long-term spending.  While I don’t think that countercyclical fiscal policy is useful, that’s not something I think is worth covering—William Anderson covers it on his blog, and the topic has already been overworked.  I’d just like to bring up a few points I think Krugman omits.

1. The fact that fiscal stimulus makes up a relatively small percentage of total debt growth is alarming, and goes to show that our current debt problems are much deeper than a secondary effect of the current recession.  There are major institutional problems with long-term government spending.  I cover this in an older Mises Daily: “Garet Garrett’s Invaluable Lesson”.  Krugman hints at this by saying that a major concern is increasing healthcare costs, and he attempts to assuage the reader by pointing to healthcare reform.  This is likely to lead to rising costs, not diminishing costs; see: “Why Not Universal Car Insurance?”.
2. I’m not sure fiscal austerity aims at cutting only stimulus spending.  For the most part, it seems that European governments have aimed at cutting long-term costs by reducing workers’ wages and firing public employees.  Admittedly, Krugman would probably say that all government spending is worthwhile when there is a liquidity trap.  But, if so, there’s no use in pointing out the volume of fiscal spending in relation to debt growth, because all debt growth is fiscal spending at this point.  In other words, it seems that Krugman is trying to confuse his readers into agreeing with him.
3. Krugman writes that other than ‘Euro peripheries’ there is no risk of debt insolvency, because governments can still borrow at very low interest rates.  Low interest rates are maintained by debt monetization.  The Federal Reserve puts downward pressure on interest rates to allow the government to continue to borrow at low rates.  So, while the government can borrow cheaply and accumulate large debt, what happens when interest rates inevitably rise?  What happens when the accumulated debt is now much, much more expensive to service, and then the government tries to pay off long-term spending (which is, by Krugman’s own admission, the majority of current debt growth)?

As aforementioned, I rather not go into the theoretical justification for countercyclical fiscal spending, but I would suggest this Mises Daily by Frank Shostak.

The New York Times published a very good article on the suggestions Ben Bernanke made to the Joint Economic Committee today.  Here are the key quotes,

The Federal Reserve chairman said Wednesday that the government must begin to make “difficult choices” to address its gaping deficits and warned that “postponing them will only make them more difficult.”

The chairman, Ben S. Bernanke, said that a “credible plan” for reining in federal deficits could help long-term interest rates and raise consumer and business confidence. “Although sizable deficits are unavoidable in the near term, maintaining the confidence of the public and financial markets requires that policy makers move decisively to set the federal budget on a trajectory toward sustainable fiscal balance,” he said.

In testimony to the Joint Economic Committee of Congress, Mr. Bernanke did not address monetary policy or say how long the Fed would keep short-term interest rates near zero. When the committee’s chairwoman, Representative Carolyn B. Maloney, Democrat of New York, asked him to elaborate on what it meant for the Fed to keep its benchmark rate there “an extended period,” Mr. Bernanke said the time frame was based on “low resource utilization,” subdued inflation and stable inflation expectations.

Basically, Bernanke is banking on easy credit as a means of stimulating investment and consumption.  I’m not going to lie, Bernanke’s position on stimulus and public expenditure confuses me.  He notably opposed a second stimulus bill, which got him heated criticism from Paul Krugman.  But, any Keynesian economists would tell you that we are currently in a liquidity trap.

I sense a flurry of blog posts from both the Keynesian and the Austrian sides.  I’m already typing my article up.

WASHINGTON (AP) — The U.S. Postal Service is increasing the pressure for dropping Saturday home delivery as it seeks to fend off massive financial losses.

This is what Paul Krugman wrote last year:

Maybe I’m living a sheltered life here in central New Jersey, but I don’t find the Post Office a terrible experience — no worse than Fedex or UPS. (Full disclosure: I worked as a temp mailman when in college.) And nobody likes going to the DMV, but the one on Rt. 1 I go to always seems fairly well managed.

And in general: is dealing with these government agencies any worse than, say, dealing with the cable company?

The prejudice against government seems to have become free-floating, unattached to any actual experience.

The local news is blaming the deficit on a decrease in the volume of mail being moved by the U.S. Postal Service, thanks to an increase in the volume of emails.  However, the USPS has been suffering budget deficits for at least the past decade, and so acting as if it was fiscally inefficient as of only recently is at best disingenuous.   But, alas, nobody is likely to admit that the real problem is the fact that socialized industries just do not work.

Interestingly, the final comment on the local news network was that privatizing the postal system was not on the table.

www.youtube.com/watch?v=985C0uh1HKA

One of the major disputes revolves around the question of whether or not the Federal Reserve took action to provide liquidity to failing banks.  In Free to Chose, Milton Friedman suggests that the decline in money stock between 1929 and 1933 represents the Federal Reserve’s inaction in the face of deflation.[1] Other economic historians have taken a similar stance.  For example, in his book on Roosevelt’s New Deal, Burton Folsom writes, “In the early 1930s, the Fed dithered and let the runs on banks continue.”[2] Murray Rothbard suggests something radically different, in America’s Great Depression, offering statistics on the expansion of controlled reserves by part of the Federal Reserve.  In fact, as early as the last week of October 1929 the Federal Reserve bolstered bank reserved by nearly $300 million, he claims and lowered the rediscount rate by 1½ percent by November.  He goes a long way in explaining why there was a general decrease in the money supply: “…controlled reserves increased by $359 million (with government securities the overriding factor), while uncontrolled reserves fell by $381 million.[3] Regardless if the Federal Reserve did, in fact, attempt to inflate the credit supply as early as late 1929, the fact of the matter that there was a deflation in the money supply between 1929 and 1932 due to a decrease in uncontrolled reserves, which outstripped any attempts to increase the Federal Reserve’s efforts.  The difference is that in the case of today’s recession, under Ben Bernanke the money supply has been growing at an accelerating pace.

Economist Jesús Huerta de Soto makes the argument that a recession can be temporarily avoided if the Central Bank creates money at an accelerating, or exponential, rate.[4] The ultimate conclusion to such a policy is still the inevitable reallocation of resources by the market, but only after a continued illusion of wealth—ultimately, such a policy will also lead to hyperinflation.  Therefore, unless the Federal Reserve suddenly ends the expansion of credit, there is the chance that the illusion of a recovery will be created.

As already explained, there are key differences between the Federal Reserve’s responses to either financial crisis; there is a minor similarity between the Federal Reserve’s policy between 1933 and 1936 and Ben Bernanke’s current fiscal policy.  It is generally accepted that in 1933 the United States economy had bottomed out.  At that time, the Federal Reserve continued its inflationary policy by expanding the money supply.  However, since the economy had bottomed out uncontrolled reserves were not decreasing at greater rates than controlled reserves, leading to a visible increase in the monetary base.  Simultaneously, Roosevelt continued and accelerated Hoover’s public works projects, sparking what was known as the New Deal.  Amongst the two, the latter has been at the forefront for explaining either why a recovery occurred at all after 1933, or why the recovery took so long to complete.  To a large degree, the former has been all but ignored.  However, the latter becomes more relevant when considering that in 1937 the economy suffered another downwards spike, which lasted for two years, largely undoing whatever recovery had taken place between 1933 and 1936 (although, this downturn was not as dramatic as the downturn of 1929–32).

The 1937 downturn, since then called Roosevelt’s Recession, has not been a major topic in any historical overview of the Great Depression.  The majority of books which deal with Roosevelt focus on the New Deal between 1933 and 1936, with only a scant look at the events of 1937 and 1938.  As it turns out, Roosevelt’s Recession of 1937 may be more relevant to the current financial situation in the United States than the Crash of 1929.  This is because we may be headed in the same direction.

Although the 1937 recession is only a minor focal point, that is not to say that economists have not drawn their own conclusions in regards to the causes of this event.  Keynesian economists, such as Paul Krugman and Jeff Madrick cite Roosevelt’s objective to balance the budget,[5] while Keynesians and Monetarists alike blame the Federal Reserves sudden tightening of the money supply.[6] Nevertheless, these opinions have drawn two inevitable conclusions: one, the government must (seemingly) perpetually provide public goods by spending more money than collected through tax receipts, and two, the Federal Reserve should not increase interest rates, or at least should better calculate when to finally allow an increase in interest rates.  Now, the relationship between the period marked between 1933 and 1936 and the current financial situation in the United States should be clear.  Currently, controlled reserves are rising at a rate at which despite any possible decreases in uncontrolled reserves the monetary base is growing exponentially.  Furthermore, there is the risk that Obama will actively support the largest deficit spending programs in the fiscal history of the United States government.  If the conclusions of the 1937 recession are that bringing these two policies to an end will only lead to another recession, the country currently runs a real risk of complete and utter collapse when the people lose faith in both their government and their currency.  Therefore, the recession of 1937 merits a closer look and the pervasive mistakes made by Keynesian and Monetarist economists should be corrected.

Admittedly, of the two schools of thought, the Monetarists are probably closer to the truth.  What they fail to realize is the impossibility of calculating when to end credit expansion.  In two occasions during the Great Depression a sudden end to credit expansion ended in recession: 1929 and 1937.  Furthermore, during other recessions, notably during that of 1921, increases in the reserve ratio requirement as set by the Federal Reserve did not end in a lengthened period of recovery.  Instead, the 1921 downturn was one of the worst in the economic history of the nation, but one of the quickest.[7] It becomes obvious that the issue is not related to the sudden increase in interest rates by the Central Bank.  And so, while the Monetarists remain half-right, an Austrian approach must be made to this era as to provide an accurate lesson to apply to the current recession, and most importantly to correct the dangerous and false lessons as extracted by the Keynesian and Monetarist schools of thought.

Austrian economists are fighting an uphill battle to end the monopoly on money commanded by the Federal Reserve and ever-growing government fiscal interventionism.  Their most powerful case, the 1937 recession, has largely been ignored.  Most publications have avoided the topic altogether, focusing instead on the New Deal.  The only Austrian explanations are largely as a result of the work of Benjamin Anderson, in Economics and the Public Welfare, and Vedder and Gallaway in Out of Work.  A dedicated Austrian explanation of 1937 is in order, as it would severely undermine any pro-centralization arguments provided by rival schools of thought.

As with any historical study of a recession, explaining the downturn of 1937 requires a close examination of the fiscal policies which preceded it.  In this case, in order to show what made the crash of 1937 possible and to disprove Keynesian and Monetarist theories, we must put the events of 1933 through 1936 under a microscope.

Hoover’s response to the October 1929 crash

Although we are concerning ourselves with the events which took place between 1933 and 1936, a brief overview of Hoover’s response to the beginning of the recession in October 1929 is important.  It will show that Roosevelt’s New Deal was not unique, and that a nearly identical program was originally ignited under Hoover’s administration.  This is important because after one has an understanding of the true scale of Hoover’s fiscal spending figures one can deduct that if government spending did not work during the first three years of the 1930s, there is no reason that it should have worked during the next four, either.  In fact, in many ways Roosevelt’s New Deal damaged a recovery by forcing industry to comply with unnecessary restrictions and regulations, disallowing a serious effort to invest.  However, it is also worth noting that the Federal Reserve’s consistent attempts to counteract decreases in bank reserves due to uncontrolled withdrawals also hampered the quick liquidation of unhealthy assets, causing a longer than usual contraction.  Understanding the Federal Reserve’s actions during the first four years of the Great Depression will provide a historical background which explains why the monetary expansion during Roosevelt’s first term and beginning of his second term were not arbitrary.  In other words, the first four years of the Great Depression go a long way in explaining the trends which would continue to exist throughout the Roosevelt administration, up until the beginning of the Second World War in Europe (it was at this time that the United States Armed Forces began a massive mobilization effort to prepare themselves for eventual war across the Atlantic and Pacific Oceans).

The Federal Reserve responded to the bank’s loss of liquidity after the original crash of October 1929 by shoring up bank reserves by adding roughly $300 million to the money supply by November of that same year.  Between October and December controlled reserves had risen by $359 million, while uncontrolled reserves had fallen by $381 million.  As a result, there was an estimated $21 million decrease in bank reserves for the first three months of the Great Depression.[8] 1930 saw the beginnings of an even greater inflationary process, with the New York Federal Reserve reducing the rediscount rate from 4½% in February 1930 to 2% by the end of that same year.  However, again, despite the Federal Reserve’s inflationary measures, the money supply fell by roughly 250 million dollars.[9] Although the Central Bank continued in its effort to pump money into the system it failed in its efforts to create more money than was being lost through the decline in uncontrolled reserves, meaning that throughout 1931 and 1932 there was still a decline in the money supply.  The claim that the Federal Reserve did nothing to counteract the deflating effects of the bust bases its factual evidence on the general decrease in the volume of the money supply.  Monetarists need to take a closer look at the history of the United States’ money supply during this era, and need to account for why the decrease in the money supply was so gradual.

It was not only the Federal Reserve which quickly moved to impede a quick liquidation in 1929.  Hoover too took matters into his own hands, beginning a large fiscal spending program in an effort to relieve unemployment and bolster aggregate demand.[10] Total government outlays in 1932, for example, amounted to $4.659 billion, which was higher than the federal expenditure of 1933 under President Roosevelt ($4.598 billion).[11] During Roosevelt’s presidential campaign, the Democratic candidate consistently attacked Hoover for his high fiscal spending, considering Hoover’s decisions during his four-year term as “reckless and extravagant” and promoting his own objective of balancing the budget.[12] Hoover also did much to regulate the labor market, believing that by maintaining high wage rates the economy would recover.[13] Instead, high nominal wages—despite a decrease in the general price level—caused a massive loss of profit.  For example, the First National City Bank of New York reported that less than six percent of banks surveyed were reporting losses in mid-1929.  This percentage skyrocketed to 29 percent by the third-quarter of 1930.[14] Hoover’s high-wage policy backfired, as a decline in loanable funds helped gross private domestic investment fall by over 65 percent between 1929 and 1931.[15] Hoover’s intervention during his four year term as president served only to exacerbate the economic rut which would be known as the Great Depression.

Roosevelt’s New Deal, which unfolded mainly between 1933 and 1936, was not unique.  As aforementioned, Roosevelt had been an insistent critic of Hoover’s big-spending government programs during the 1932 election campaign.  In fact, Hoover’s final year of spending saw a higher amount of tax money spent than Roosevelt’s first year.  Although, ultimately, Roosevelt’s deficits would be much larger than those of Hoover, it would be fair to state that Hoover was no “laissez-faire” president.  Furthermore, it is clear that there was no lack of effort on part of the federal government and the Federal Reserve to actively intervene to stall the downward plunge the United States economy was experiencing.  Did this intervention help assuage the final effects of the depression?  One could certainly assume that the economy would have bottomed-out in worse condition.  However, when proponents of the New Deal argue that Hoover was laissez-faire they inadvertently recognizing that the economic condition of the country in 1933 was as bad as it could have been. Any attempts to protect Keynesian theory therefore must be subject to suspicion.  Besides, how does one quantify what the state of the economy would have been otherwise?  Indeed, empirically speaking, recessions tended to last for much shorter periods of time when there was a lack of intervention—the little spoken of recession of 1921–22 serves as the perfect example.

New Deal: Fiscal expenditure, money supply, and the Federal Reserve

The policies enacted and carried out by the Franklin Roosevelt administration between 1933 and 1936 had severe consequences on the state of the national economy during that same period and after.  Beforehand unforeseen and unimaginable levels of public spending, and accompanying high taxation, brought about four years of uncertainty, economic stagnation and individual poverty.  It was not until the National Industrial Recovery Act was overturned by the Supreme Court in 1935 that business investment would again pick up, leading to a short period of relatively high economic growth.  This growth spurt suddenly came to an end in the autumn of 1937.  In its place came a renewed period of decline in productivity and an increase in unemployment.  A number of theories have been developed in order to explain this sudden and unforeseen recession.  Most of them are wrong.  In order to understand why these theories are wrong one should have an elementary grasp on the policies of Roosevelt, why they did not help lift the United States out of depression and why they actually contributed to the causes of the 1937 downturn.

Perhaps the most damaging of economic policies—as far as industrial productivity is concerned—was the National Industrial Recovery Act (NIRA), enacted in 1933; it would later be renamed the National Recovery Act (NRA).[16] The NRA cartelized a large number of industries nation-wide and placed minimum prices for the goods and services provided by these industries.  The consequences were dire for those who could only manage to compete against larger companies by decreasing their prices; many small businesses were driven off the market.[17]

For example, under the legislation imposed by the NRA Goodyear, Goodrich and Firestone were able to organize and fix tire prices artificially high.  Since it was illegal to sell tires at a price lower than the price agreed upon in the code provided by the NRA (which was written by the three aforementioned national tire producers, as directed by the government), the large tire corporations did not have to risk losing some of their market share to local tire companies which competed by offering their product at cheaper prices.  For local and small businesses, the effects were incredibly damaging—they simply could not compete, as their product was now too expensive and they could not offer the same services that the larger firms had the infrastructure already built for.  Furthermore, artificially high tire prices also meant that foreign consumers simply substituted American tires for those of another foreign company.[18]

But, tires only constituted a fraction of what the NRA price-fixed.  In fact, the NRA intervened in almost every single major industry in the United States by dictating the prices of the goods being sold (not to go below “production costs”), the price of labor, how a company could conduct business, et cetera.  Small businessmen who tried to avert fiscal disaster by ignoring NRA code were oftentimes imprisoned.  Unsurprising, a large number of small businesses were forced to close, causing the unemployment rate to increase.  The NRA was little more than government-imposed monopolization and cartelization of the most important industries in the national economy.[19] It comes as little surprise that the Supreme Court deemed the NRA unconstitutional in 1935 (nine votes to none).[20] During the three years of its duration, the NRA would be a root cause of much of the uncertainty which precluded entrepreneurs from investing and stalled a systemic economic recovery in the United States.[21]

The New Deal programs were expensive, and this manifested itself in the annual increases in fiscal outlays.  For example, in 1933 the Federal Government spent 4.598 billion Dollars, while in 1934 this increased to 6.541 billion.  By 1936, government spending had soared to 8.224 billion.[22] This caused taxes to increase throughout the Great Depression.  In 1935, the top income bracket ($5,000,000 and above), in the state of New York paid roughly 69.9 of their income in taxes to the Federal Government.[23] By the late 1930s, the average income tax rate for the top income bracket was 79%.[24] As Henry Hazlitt eloquently pointed out in Economics in One Lesson, “taxes discourage production”.[25] High tax rates proved a burden on entrepreneurs, and went a long way in explaining why productivity growth in the United States was as low as it was for what turned out to be the entire length of the Great Depression.

All the while, despite the government-induced repression of entrepreneurship and investment, the Federal Reserve and the Federal Government continued with its expansionary fiscal policy.[26] Several events out of the control of the Federal Reserve also played a part.  Foreign events, such as the rise of Hitler in Germany, catalyzed the return of large gold stocks to the United States between 1934–41.  Member banks who originally imported the gold then sold it to the Federal Reserve for Federal Reserve notes, inflating their reserves and driving interest rates down.[27] It should be remembered, though, that in 1934 the price of gold was fixed at $35 per ounce, instead of the original price of $20.67.[28] Between 1933–37, the money stock increased by 46%, while wholesale prices rose by 31%.[29] Federal Reserve controlled interest rates, such as the rediscount rate, remained relatively level for nearly three and a half years, while credit outstanding remained at an average of $177 million.[30] The rise in the stock of money should be credited to the price-fixing scheme on gold, imposed by the government.  Despite low and constant interest rates,[31] stagnating investment prior to 1936 was due, almost exclusively, to the immense regulation imposed upon business by the NRA.[32]

1937 Recession: Expansion, Malinvestment, Uncertainty and Crash

If the Great Depression lasted as long as it did between 1933 and 1935, it was because of the interventionist policies adopted by the Roosevelt administration.[33] However, the Supreme Court’s decision to rule the NRA unconstitutional in 1935 caused resurgence in investment, and a period of quick growth.  By 1937, gross real domestic product had recovered 96-percent of its pre-1929 value and gross real investment 64-percent.[34] Production of durable goods increased, seeing its first sustained positive growth trend, and the gap between the production of durable and non-durable goods began to close.  The Federal Reserve’s Index of Production (using 1923–25 as the base years) rose to 104 by December 1935, which was a record high since 1930, and remained at over 115 throughout the middle and end of 1936, sometimes shooting even beyond 120.  Industrial production rallied until the third quarter of 1937.[35]

Although the recovery had already taken place for quite some time, 1935 and 1936 signaled the final years of this continuous recovery, and there was a drop in uncertainty.  However, this growth in productivity was outstripped by growth in nominal and real wages, thanks largely to the Supreme Court’s decision to uphold the National Labor Relations Act of 1935 and to the introduction of the Wagner Act.[36]

Real wages had, in fact, decreased sharply in 1935 and 1936, largely aided by the Supreme Court’s decision to overturn the NRA.  This trend proved short lived.  In 1937, for example, wages increased by 11.6-percent, thanks to the Supreme Court’s defense of the National Labor Relations Act, and also to the influence of the Social Security Act.[37] To illustrate the impact of the latter, fringe benefits, or supplements to standard wage bills, rose from 1.4-percent in 1935 to 4.2-percent in 1937.  Accounting for the majority in the rise of the cost of supplements was the required employers’ contributions towards social insurance, which rose from 25 to 71-percent of the total cost of the supplements, by 1938.[38] This was all complemented by the effects of the Wagner Act, which instigated a rise in union activity since 1936.[39]

The 1937–38 recession was catalyzed by a bear market rally in the stock market, starting on 27 August 1937.  The market closed on 26 August at 190.38, falling to 175.09 by the end of 27 August.  By 31 March 1938, the market had fallen to a low of 97.46.  Surprisingly, weekly business figures still pointed towards a positive direction, and sales and productivity figures did not match the worsening situation at Wall Street.[40] What explains this break in the market was ever increasing taxes on profit, reducing incentives to invest in the stock market, as well as the elimination of inside trading, which disallowed quick readjustments to real market values for relevant stocks.  The result was a very “thin” market, where relatively minor decreases in purchasing and selling could cause very dramatic changes in prices.[41] Thus, increases in uncertainty caused by a retreat in the Supreme Court’s fight against Roosevelt’s labor programs managed to instigate an extraordinary fall in the price of stocks.  With the downward market trend and increasing uncertainty, it was due time that the effect of high real wages finally began to set in.  Despite an increase in commercial loans during the onset of the recession, business began to waver due to a decrease in profitability.[42]

We come to find that the main contributing factor behind “Roosevelt’s Recession” was a substantial increase in real wages in 1937, to a large extent caused by increased union activity and by national legislation (such as minimum wage laws).  However, Benjamin Anderson upholds that businesses continued to attempt to maintain these high wages by reducing costs elsewhere.  The growth in industry also continued for quite some time, despite the high wages.  Therefore, although the loss in profitability was what caused a sharp decline in industrial production, gross domestic product and real investment, the direct catalyst for the downturn was uncertainty amongst market investors.  Further, it is difficult to believe that there was such a dramatic drop in industrial output simply as a result of the high costs in labor.  It becomes evident that the money supply played a bigger role in the ensuing recession than is previously accepted.  Although, as explained above, there was limited monetary expansion done by the Federal Reserve System, there was a tremendous increase in the money supply thanks to the government’s decision to increase the fixed price of gold.  The Federal Reserve facilitated the conversion of gold into bank notes for recipient member banks.  The result was a swelling in the size of bank reserves.  This monetary inflation ultimately did create extensive malinvestments, which were kept up even during the initial months of the recession.  But, what seemed profitable during times of low interest rates would no longer after banks began to retract their loans.

There was a substantial decrease in the money supply between late 1937 and the end of 1938.[43] This has been attributed to an increase in reserve requirements by the Federal Reserve.[44] Although Kenneth Roose’s thesis that the increase in the reserve requirements led to a decrease in the price of government bonds,[45] the theory that the increase in reserve requirements led to a contraction of the money supply is much less empirically satisfying.  This was not the first time the Federal Reserve had increased reserve ratio requirements; indeed, they had done so in 1922, and that recession was over with fairly quickly.[46] Joseph Salerno suggests that the monetary contraction was a result of the recession, not a factor of, explained by the idea that banks began to retract on their loans due to increased uncertainty after the initial decline in the stock market and because of falling business profits, due to high artificial wages.[47] In light of evidence provided by Benjamin Anderson, it seems as if Salerno’s explanation is more appealing.  As aforementioned, the volume of commercial loans increased despite an increase in the reserve ratio requirement, as did the volume of brokers’ loans and the total amount of securities being sold.[48] It was only after the initial crash that total amounts of loan began to contract from the peak established in the middle of 1937.[49]

Increasing reserve ratio requirements did not play a major role in influencing the beginning of the 1937 recession.  Rather, as already conclude, it was an increase in the price of labor and in uncertainty due to several decisions being made congruently by the Supreme Court.  It was only after the initial shock of a declining stock market that banks began to curtail the volume of loans pending and the money supply began to contract, revealing a large amount of malinvestments and disallowing businessmen from continuing to pay such high wages to their employees.  The result was a very severe contraction, flying in the face of the vaunted “recovery” taking place between 1933 and 1936.

Dangerous lessons

There are two major alternative theories of what caused the 1937 recession.  Both of them were alluded to in the opening paragraphs of this essay, and one of them was expounded directly above.  The theory of doubling reserve ratio requirements has already been refuted.  The danger of the continued perpetuation of that theory is clear.  We can see the results of the continued widespread belief in the validity of said theory in the actions currently being undertaken by the Federal Reserve, led by Chairman Ben Bernanke.  In an effort to supposedly avoid such an event of occurring again, the Federal Reserve is intent on stimulating the money supply for as long as possible, until the economy fully recovers.  If Austrian theory is correct, however, this will simply cause more malinvestment, cause a secondary dip in productivity and prolong the recession.  The effects of this can already be seen in the Great Depression, where despite great pressure against entrepreneurship by the Federal government there was still growing investment (and malinvestment).  An increase in uncertainty and a resulting contraction of the money supply, along with a loss in profitability due to high wages, led to a major contraction in wealth in late 1937 and 1938.  The effects of the 1937 recession were limited to the limited recovery which had taken place up to that date.  Without such restrictions (at least, the same degree of restrictions) in place today, we may find that the level of malinvestment will much greater than that of 1935–36.  We are risking a much more dangerous “second recession” (otherwise known as the infamous “double dip”).

The second alternative cause was a decrease in the government deficit.[50] Apart from the fact that a drop in government spending did not result in widespread recession after the Second World War, and the fact that Herbert Hoover’s deficits did nothing to assuage the great contraction which took place between late 1929 and 1932, this theory is unsound.  First of all, a reduction in government deficit does not immediately mean that there was an equal reduction in government spending.  In 1936, the annual government deficit stood at $4.3 billion, in contrast to the deficit of $2.193 billion ran during 1937.  However, total government outlays decreased only from $8.228 to $7.580 billion.  Interestingly, the deficit in 1935 was at $2.803 billion, while total federal spending was actually lower than both 1936 and 1937.  Meanwhile, while the economy managed to begin recovery anew by late 1938, the fact remains that the government deficit for 1938 was only 89 million!  What explains a decrease in the deficit between 1935 and 1936 was an immense increase in total receipts; from almost four billion in 1936 to $5.3 billion in 1937.[51] If this is not enough, month by month government expenditures during 1937 and 1938 did not change wildly, and unsurprisingly, the months of surplus saw hikes in expenditures.  The surpluses owed their existence entirely to the fact that these months fell in line with tax months.[52] Given these statistics, it cannot follow that the decrease in the deficit is at fault for the contraction of 1937.  The entire position, in fact, is untenable.

Although it is easy to see that a decrease in government spending, or deficits, was not the cause of the contraction, the belief that it was proves a very dangerous threat.  Christina Romer used the explanation in support of her agenda to keep the current government’s fiscal stimulus rolling.  These gargantuan fiscal packages require the exact same amount in receipts, even if the government operates at a deficit over the short-run.  An increase in government spending will lead to an increase in taxation, which will lead to a decrease in investment and the introduction of economic stagnation.  The myth that a decrease in government spending will lead to economic collapse must be firmly corrected; all empirical evidence suggests that economies run much more smoothly when there is less government spending, in fact.  What these stimulus packages really represent is dirty money being funneled to government cronies, while conveniently stolen from taxpayers blind to the true intent behind the government’s action.

The facts outlined in this essay only lead to one sensible deduction.  A true recovery will only take place in an economy free of the shackles of government intervention and central monetary control.  These tyrannical institutions consistently publish counterfactual evidence in an attempt to solidify their purpose and legitimacy.  They are greatly helped by a vast armada of historians and economists who are either on their payrolls or for some reason have fallen to their false ideas.  Over the long-run, “perfect” (perfect in the sense that the maximization of utility for each individual will be allowed to be sought, not perfect in the sense of maximum efficiency) economic growth is only possible in a society free of coercion; that is, free of government.

It remains important to separate the truth from fallacies.  The events of 1937 prove to be the perfect case study against current institutional programs to aid an “economic recovery”.  This essay has shown how greater government spending will not cause economic growth, while most importantly, a decrease in government spending will not catalyze economic contraction.  Finally, this essay also makes apparent that the Federal Reserve’s monetary policies lead to the creation of illusionary wealth and real destruction of wealth.  Continued easy money schemes will not lead to recovery, only to greater pain.

[2] Folsom Jr., Burton, New Deal or Raw Deal?  How FDR’s Economic Legacy Damaged America, Threshold Editions, New York: 2008; p. 33.

[3] Rothbard, Murray, America’s Great Depression, BN Publishing: 2008; p. 191–192.

[4] Huerta de Soto, Jesús, Money, Bank Credit, and Economic Cycles, Ludwig von Mises Institute: 2009: pp. 404–405.

[5] Murphy, Robert and Madrick, Jeff, Was the New Deal a Raw Deal?

[6] Roose, Kenneth D., Federal Reserve Policy and the Recession of 1937–1938, The Review of Economics and Statistics, Vol. 32, No. 2: May 1950; p. 178.

[7] Vedder, Richard K. and Gallaway, Lowell E., Out of Work: Unemployment and Government in Twentieth-Century America, New York University Press, New York: 1993; p. 61.

[8] Rothbard (2008), pp. 191–192.

[9] Rothbard (2008), pp. 212–213.

[10] Rothbard (2008), p. 193.

[11] Statistics provided by the Government Printing Office.

[12] Folsom (2008), p. 40.

[13] Murphy, Robert P., The Politically Incorrect Guide to the Great Depression and the New Deal, Regnery, Washington, D.C.: 2009; pp. 32–34.

[14] Vedder and Gallaway (1993), p. 113.

[15] Vedder and Gallaway (1993), pp. 122–123.

[16] Folsom (2008), p. 43.

[17] Murphy (2009), pp. 130–131.

[18] Folsom (2008), pp. 49–51.

[19] DiLorenzo, Thomas J., How Capitalism Saved America: The Untold History of our Country, From The Pilgrims to the Present, Three Rivers Press, New York City, New York: 2004; pp. 186–189.

[20] Folsom (2008), pp. 57–58.

[21] Higgs, Robert, Depression, War and Cold War: Challenging the Myths of Conflict and Prosperity, Independent Institute, Oakland, California: 2006; pp. 11–13.

[22] Statistics provided by the Government Printing Office.

[23] Anderson, Benjamin M., Economics and the Public Welfare, LibertyPress, Indianapolis, Indiana: 1979; p. 375.

[24] Folsom (2008), p. 140.

[25] Hazlitt, Henry, Economics in One Lesson, Ludwig von Mises Institute, Auburn, Alabama: 2008; p. 23.

[26] Salerno, Joseph T., Money and Gold in the 1920s and 1930s: An Austrian View, The Freeman: October 1999 (Vol. 49, No. 10).

[27] Anderson (1979), pp. 401–403.

[28] Anderson (1979), p. 346.

[29] Friedman, Milton and Schwartz, Anna, A Monetary History of the United States, Princeton University Press, Princeton: 1963; pp. 497–498.  On p. 500, Friedmand and Schwartz claim that between March 1933 and May 1937, the money stock actually grew by 51%.

[30] Friedman and Schwartz (1963), p. 512.

[31] Anderson (1979), p. 403.

[32] Friedman and Schwartz (1963), pp. 496–497.

[33] Higgs (2006), pp. 11–13.

[34] Higgs (2006), p. 5.

[35] Anderson (1979), p. 427.

[36] Salerno (1999).

[37] Vedder and Gallaway (1993), pp. 130–131.

[38] Vedder and Gallaway (1993), pp. 140–141.

[39] Anderson (1979), p. 437.

[40] Anderson (1979), p. 440.

[41] Anderson (1979), pp. 441–442.

[42] Anderson (1979), pp. 432–433 and p. 440.

[43] Timberlake, Richard H., The Reserve Requirement Debacle of 1935–1938, The Freeman: June 1999 (Vol. 49, No. 6).

[44] Roose (1950), p. 182 and Timberlake (1999).

[45] Roose (1950), p. 178.

[46] Murphy, Robert and Madrick, Jeff, Was the New Deal a Raw Deal?

[47] Salerno (1999).

[48] Anderson (1979), pp. 432–433.

[49] Anderson (1979), p. 434.

[50] This theory was recently restated by Christina Romer in an article for The Economist.  Robert Murphy restated the thesis in his Mises Daily, Christina Romer’s Faulty Depression History.

[51] Statistics provided by the Government Printing Office.

[52] Anderson (1979), pp. 434–435.

Let us use the Austrian theory on the trade cycle to portray the “neo-classical” argument (it should be assumed though that other neo-classical schools of economic thought agree with the Austrian theory).  Simply put, the theory suggests that government-induced (through the Federal Reserve) monetary inflation caused a variety of malinvestments.  In the case of the current recession these malinvestments took place principally in the housing sector (both individual and commercial), although there were malinvestments elsewhere.  These malinvestments were relevant to the capital-goods industry, but since there was also an extension of consumer credit the consumer-goods industry also saw an array of malinvestment.  Krugman is correct in stating that the expanding sectors of the market necessarily drew labor from one sector to theirs.  It would follow that there is a restructuring of the employment market, and therefore if the “hangover theory” is correct then Krugman holds that there should have been “massive” unemployment during the economic boom.

But, Krugman does not consider that while a time of economic boom there is no liquidation of malinvestment because monetary inflation continues to make certain lines of investment seem profitable, during a bust this no longer holds true.  In other words, it is not the restructuring of the labor market which in and of itself creates unemployment.  The origins of unemployment come from the liquidation of malinvestments.  During a time of boom a laborer can quickly and immediately move (if the laborer possesses the right skills) to a new sector because that sector is immediately available.  During a bust there is no alternative job immediately available, and so the laborer is forced into unemployment.

Although Krugman has repeatedly been caught making elementary macroeconomic mistakes in his analyses, this one should have come as a surprise.  This was not an elementary mistake of economic theory.  This mistake came out of a failure to objectively take into account all the factors, and instead blindly (and foolishly) criticize sound economic theory without any real argument.

If one asks why there is no alternative form of employment immediately available during a recession, then another would respond that during a recession there is a psychological impediment to investment.  Recessions which are allowed to take place without government interference (or at least minimal government interference) usually are relatively short (take for instance the recession of 1921 and 1922, which in many ways was worse than the recession turned depression of 1929, but lasted for a much shorter period of time), which shows that the restructuring of industry can take place rather quickly.  But, when government interference casts further shadows on the investment sector and produces economic uncertainty then that restructuring will take much longer, as people prefer to hold on to their money instead of investing it.  This is why, despite the stimulus package, unemployment has continued to increase.

Keynesians assert that business cycles are caused by changes in aggregate spending behavior.

To be fair, most Keynesian economists (probably) no longer believe this.  It’s hard to reconcile this theory with the fact that both in 1929 and 2007 savings were at all time lows, meaning that aggregate demand (or aggregate spending) were at all time highs.  Most Keynesian economists recognize that people were responding beyond their means.  Instead, they suggest that aggregate irrationality on part of the businessmen that led them to overinvest caused the recession, and now an increase of aggregate spending must pull the world back out (even though the rate of savings is still extremely low).

But when the increased supply of housing overwhelmed demand, the euphoria broke and home prices fell.

It’s interesting how they shift the blame from loan sharks to an “increased supply” of houses.

But on the subject of the policies to get us out of the crisis, the Monetarists shine much brighter. Milton Friedman’s monumental work, “A Monetary History of the United States”, argued that whatever caused the Great Depression of the 1930s, the downturn was made much worse by the Fed’s failure to aid the credit markets.

Milton Friedman’s book is monumental in many respects, but in this case Friedman got it wrong.  Two articles have been written on this site on the topic:

1. Hoover’s Response to the October 1929 Crash
2. Credit Inflation During the Hoover Administration (Murray Rothbard)

This, however, does not discount Friedman’s A Monetary History of the United States as a poor book.  It is one of the best books on the subject.  Unfortunately, Friedman did not look at the money supply as objectionally as he could have.  In this case, Murray Rothbard’s America’s Great Depression is a superior book (and deals specifically with the Hoover administartion).

This quote is particularly entertaining:

The Fed was indeed hampered by the Keynesian Liquidity Trap when the central bank set the Fed Funds near zero at the end of last year. But Bernanke initiated policies to mitigate this constraint.

But, a liquidity trap supposedly happens when Federal Reserve operations do not catalyze an increase in the volume of loans.  So, that sentence does not make much sense.  Indeed, the rate of loans continues to fall, despite the Fed’s massive monetary pumping (the real effects of which we will feel very soon).

Finally, Doctor Siegel, don’t kid yourself: fiscal stimuli don’t work.

I found it interesting how respected doctorates in economics are.  Yet, doctorates focus mostly on mathematics as opposed to economic theory.  Most economic theory is learned during your undergraduate years, and even there it is rather light (basic macroeconomics and then whatever you decide to take as electives).  What’s the point?  We are graduating a bunch of  “economists” who have little idea of what economics actually is and do not have a proper grasp of theory.  The less mathematically inclined ones write articles on Yahoo Finance, while the more mathematically inclined ones try to prove their baseless theories by using enough math to confuse those who they are trying to persuade.  The economics profession has been politicized, and the majority of economists don’t know what they’re talking about.

If you do not consider yourself part of this group, then perhaps you should take a look at an alternative school of economics: the Austrian school.