The Real Lessons of the Great Depression

Since late 2007, more and more commentators have drawn parallels between our current financial crisis and the Great Depression. Nobel laureates and presidential advisors [pdf] confidently proclaim that it was Herbert Hoover’s laissez-faire penny pinching that exacerbated the Depression, and that the American economy was saved only when FDR boldly ran up enormous deficits to fight the Nazis. But as I document in my new book, The Politically Incorrect Guide to the Great Depression and the New Deal, this official history is utterly false.

Let’s first set the record straight on Herbert Hoover’s fiscal policies. Contrary to what you have heard and read over the last year, Hoover behaved as a textbook Keynesian after the stock market crash. He immediately cut income tax rates by one percentage point (applicable to the 1929 tax year) and began ratcheting up federal spending, increasing it 42 percent from fiscal year (FY) 1930 to FY 1932.

But to truly appreciate Hoover’s Keynesian bona fides, we must realize that this enormous jump in spending occurred amidst a collapse in tax receipts, due both to the decline in economic activity as well as the price deflation of the early 1930s. This combination led to unprecedented peacetime deficits under the Hoover Administration – something FDR railed against during the 1932 campaign!

How big were Hoover’s deficits? Well, his predecessor Calvin Coolidge had run a budget surplus every single year of his own presidency, and he held the federal budget roughly constant despite the roaring prosperity (and surging tax receipts) of the 1920s. In contrast to Coolidge – who was a true small-government president – Herbert Hoover managed to turn his initial $700 million surplus into a $2.6 billion deficit by 1932.

It’s true, that doesn’t sound like a big number today; Henry Paulson handed out more to bankers by breakfast. But keep in mind that Hoover’s $2.6 billion deficit occurred because he spent $4.6 billion while only taking in $2 billion in tax receipts. Thus, as a percentage of the overall budget, the 1932 deficit was astounding – it would translate into a $3.3 trillion deficit in 2007 (instead of the actual deficit of $162 billion that year). For another angle, I note that Hoover’s 1932 deficit was 4 percent of GDP, hardly the record of a Neanderthal budget cutter.

The real reason unemployment soared throughout Hoover’s term was not his aversion to deficits, or his infatuation with the gold standard. No, the one thing that set Hoover apart from all previous U.S. presidents was his insistence to big business that they not cut wage rates in response to the economic collapse. Hoover held a faulty notion that workers’ purchasing power was the source of an economy’s strength, and so it seemed to him that it would set in motion a vicious cycle if businesses began laying off workers and slashing paychecks because of slackening demand.

The results speak for themselves. During the heartless "liquidationist" era before Hoover, depressions (or "panics") were typically over within two years. Yes, it was surely no fun for workers to see their paychecks shrink quite rapidly, but it ensured a quick recovery and in any event the blow was cushioned because prices in general would fall too.

So what was the fate of the worker during the allegedly compassionate Hoover era, when "enlightened" business leaders maintained wage rates amidst falling prices and profits? Well, Econ 101 tells us that higher prices lead to a smaller amount purchased. Because workers’ "real wages" (i.e. nominal pay adjusted for price deflation) rose more quickly in the early 1930s than they had even during the Roaring Twenties, businesses couldn’t afford to hire as many workers. That’s why unemployment rates shot up to an inconceivable 28 percent by March 1933.

"This is all very interesting," the skeptical reader might say, "but it’s undeniable that the huge spending of World War II pulled America out of the Depression. So it’s clear Herbert Hoover didn’t spend enough money."

Ah, here we come to one of the greatest myths in economic history, the alleged "fact" that U.S. military spending fixed the economy. In my book I relied very heavily on the pioneering revisionist work of Bob Higgs, who has shown in several articles and books that the U.S. economy was mired in depression until 1946, when the federal government finally relaxed its grip on the country’s resources and workers.

For a fuller exposition, you’ll (naturally) have to buy my book. But here’s the quick summary: Sure, unemployment rates dropped sharply after the U.S. began drafting men into the armed forces. Is that so surprising? By the same token, if Obama wanted to reduce unemployment today, he could take two million laid-off workers, equip them with arm floaties, and send them to fight pirates. Voilà! The unemployment rate would fall.

The official government measures of rising GDP during the war years is also misleading. GDP figures include government spending, and so the massive military outlays were lumped into the numbers, even though $1 million spent on tanks is hardly the same indication of true economic output as $1 million spent by households on cars.

On top of that distortion, Higgs reminds us that the government instituted price controls during the war. Normally, if the Fed prints up a bunch of money to allow the government to buy massive quantities of goods (such as munitions and bombers, in this case), the CPI would go through the roof. Then when the economic statisticians tabulated the nominal GDP figures, they would adjust them downward because of the hike in the cost of living, so that "inflation adjusted" (real) GDP would not look as impressive. But this adjustment couldn’t occur, because the government made it illegal for the CPI to go through the roof. So those official measures showing "real GDP" rising during World War II are as phony as the Soviet Union’s announcements of industrial achievements.

I have only scratched the surface in this article of all the myths surrounding the Great Depression and the New Deal era. For example, we are also constantly told – this time by Chicago economists, not Keynesians – that "we learned in the Depression" that the Fed needs to rapidly expand the monetary base to avert disaster. Oops, turns out that’s bogus too. But you’ll have to buy my book to learn why.