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The Real Lesson Of The New Deal

This article is more than 10 years old.

One reason why Republicans strenuously oppose the Obama administration's fiscal stimulus plan is because it repeats the errors of Franklin D. Roosevelt. To them, the New Deal was mainly about vastly expanding government spending and deficits, which Republicans believe made the Great Depression worse rather than better. Therefore, doing so again in the present downturn will also lead to failure.

The true New Deal legacy, however, is more complicated. Serious mistakes were indeed made. In particular, the National Industrial Recovery Act was fundamentally ill-conceived and retarded economic recovery. But in terms of fiscal policy, Roosevelt's error wasn't that he spent too much, but that he didn't spend nearly enough.

As economists Milton Friedman and Anna Schwartz proved to the satisfaction of most economists, the core economic problem in the early 1930s was a contraction of the money supply by a third. This caused the general price level to fall by about 25%.

Deflation caused real wages to rise, forcing employers to lay off workers to reduce labor costs; it forced businesses to go bankrupt because they had to sell goods for less than they cost to produce; it magnified the burden of debts as borrowers had to repay loans in dollars worth more than those they were lent; and it increased real interest rates and the real burden of taxation.

But neither Roosevelt nor the Federal Reserve really understood that monetary policy was the root cause of the deflation. Insofar as they did, they thought that the gold standard was the basic problem. In fact, the Fed was not constrained by the gold standard; it simply didn't do its job when it really mattered. (See this paper by economists Michael Bordo, Ehsan Choudhri and Anna Schwartz.)

Consequently, Roosevelt's efforts to staunch the deflation were highly inappropriate. He arbitrarily raised the price of gold from $20.67 per ounce to $35, thinking that this would automatically increase liquidity. It didn't because 1) all the privately owned gold had previously been confiscated by the government and 2) it didn't change Fed policy.

The NIRA imposed a vast system of price controls on the economy to prevent prices from falling. But this was worse than doing nothing because it prevented readjustment, which would have aided economic recovery. Luckily, the experiment with the NIRA was short lived; the Supreme Court found it unconstitutional in 1935.

Eventually, the Fed figured out that it needed to greatly expand the money supply to stop the deflation and end the depression. But at this point, the economy was at a dead stop and couldn't be restarted by monetary policy alone. One reason is that the closure of many banks shut off the transmission mechanism for the injection of liquidity into the economy. With interest rates near zero, there simply wasn't anything the Fed could do. (See this academic paper by Fed Chairman Ben Bernanke.)

John Maynard Keynes and other economists argued that in such circumstances, which economists call a liquidity trap, the federal government had to compensate for the falloff in private spending in the economy by increasing government spending. This was necessary to get the economy moving from a stationary position, at which point money would begin to circulate, Fed policy would again be effective, and prices would start to rise, thus ending the crippling deflation.

Despite a falling price level, there were those who nevertheless viewed any rise in prices as the first step on the road to German-style hyperinflation. Insanely, they argued that the government had no business compensating for any amount of deflation; that somehow it represented the natural workings of the market. The only appropriate response, they said, was for businesses to slash prices and workers to accept massive wage cuts.

It never seems to have dawned on these critics, such as Henry Hazlitt of the New York Times and economist Benjamin M. Anderson of the Chase National Bank, that deflation was a decidedly unnatural phenomenon caused by the Federal Reserve's mistakes, not those of workers and businessmen. Yet the critics expected the entire burden of adjustment to be borne by them as if it was their fault that the nation was in an economic depression.

The critics were also totally opposed to deficit spending. As with Republicans today, they said that federal borrowing would simply draw funds out of productive uses in the private sector to be squandered on make-work government jobs, pork barrel projects of dubious value and welfare programs that would sap the dynamism of the American economy.

Apparently, it didn't occur to these critics that the existence of vast unemployment, closed factories, abandoned farms and extremely low interest rates meant that much of the private sector's resources were simply idle. Borrowing them by running deficits didn't reduce private output because there were no alternative uses available.

Furthermore, an expansive fiscal policy was essential to recovery because without it monetary policy was impotent and deflationary conditions continued. Although Roosevelt had economists like Leon Henderson and Lauchlin Currie around him who perfectly well understood this, he did not heed their advice.

Roosevelt preferred instead the counsel of Treasury Secretary Henry Morgenthau, who argued that the modest budget deficits Roosevelt ran in his first term were exacerbating the economy's problems, rather than being part of the cure. In 1937, Morgenthau was successful in getting Roosevelt to raise taxes and cut spending, and in convincing the Fed to tighten monetary policy because prices were finally starting to rise.

This was, of course, absolutely the wrong policy. The result was an immediate economic setback. (It should be noted that the Great Depression was not a continuous downturn, but actually two severe recessions—one lasting from August 1929 to March 1933, and another from May 1937 to June 1938, according to the National Bureau of Economic Research.)

In the table below, I have done a very simple calculation showing what fiscal policy should have been during the New Deal. I assume that the economy's real productive capacity was at least equal to what it was in 1929 throughout the 1930s. The difference between the actual gross domestic product and what it was in 1929 I assume to be the output gap--a measure of idle resources.

Then I show the federal budget surplus or deficit and a calculation of how much the deficit should have been to compensate for lost gross domestic product. This required making an assumption about the multiplier effect--the number of times federal spending turns over as workers hired by government programs spend their earnings, thereby creating income and employment for other workers and so on.

Actual and Appropriate Federal Deficits, 1930-39

(billions of dollars)

Year

GDP

Output Gap¹

Surplus/Deficit

Appropriate Deficit²

1929

103.6

1930

91.2

12.4

+1.6

-3.1

1931

76.5

27.1

-2.1

-6.8

1932

58.7

44.9

-1.3

-11.2

1933

56.4

47.2

-0.9

-11.8

1934

66.0

37.6

-2.2

-9.4

1935

73.3

30.3

-1.9

-7.6

1936

83.8

19.8

-3.2

-5.0

1937

91.9

11.7

+0.2

-3.0

1938

86.1

17.5

-1.3

-4.4

1939

92.2

11.4

-2.1

-2.8

  1. GDP in 1929 minus actual GDP.
  2. Output gap divided by four.

Source: Department of Commerce, Bureau of Economic Analysis

Economist Brad DeLong of the University of California at Berkeley thinks that the multiplier might have been as high as four in the 1930s because unused productive capacity was so great. The Obama administration is assuming a multiplier of 1.6 for its economic plan.

It's important to remember that the lower the multiplier, the larger the deficit would have had to have been. If one assumes a multiplier of one, then the target deficit would have had to equal the output gap. Therefore, the assumption of a multiplier of four is extremely conservative in terms of calculating the minimum appropriate deficit.

As one can see, the actual federal budget deficit was much too small in every year of the Great Depression. And of course it was disastrous for the government to run a surplus in 1937. Economists are unanimous in their view that this was one of the greatest economic mistakes in history.

Nevertheless, Republicans claim that today's fiscal stimulus is doomed to fail because the deficits of the 1930s didn't end the Great Depression. "We know for sure the big spending programs of the New Deal did not work," Senate Republican Leader Mitch McConnell asserted on Feb. 6.

The implication seems to be that the economy would have recovered faster from the Great Depression if the budget had been balanced. But as my calculations demonstrate, the true failure of the New Deal was that deficits were much too small, not too large.

Ironically, Republicans implicitly acknowledge the truth of this when they argue that "the only thing that brought us out of the depression was World War II," as Sen. John Ensign explained on Feb. 7.

Yet Republicans conveniently overlook the fact that it was massively larger budget deficits--which averaged close to 20% of GDP from 1941 to 1945--that were the principal contribution of the war to economic recovery.

Bruce Bartlett is a former Treasury Department economist and the author of Reaganomics: Supply-Side Economics in Action and Impostor: How George W. Bush Bankrupted America and Betrayed the Reagan Legacy. He writes a weekly column for Forbes.com.