Thursday, June 20, 2019

Lessons from the Great Depression: What Really Ended the Great Depression? (Part 1 of 3)

Yes, World War II had a lot to do with it, but not for the reasons you’ve been told. It wasn’t massive government wartime borrowing and spending, but rather FDR’s dismantling of his own most radical and anti-business New Deal policies.

Click here to read the original Cautious Optimism Facebook post with comments

4 MIN READ - In this final installment of the Great Depression, we will first discuss the U.S. economy going into World War II, the reasons why unemployment fell so quickly even before Pearl Harbor, economic life for Americans during the war, the great economic boom right after the war, and of course contrasting economic theories explaining the recovery.


By 1935 and 1936 America’s economy was indeed recovering from the terrible Great Depression that had begun in 1929. Unemployment had surged in late 1933 with FDR's National Industrial Recovery Act and its “minimum wage” provisions for businesses to receive the NIRA Blue Eagle seal of approval storefront sticker, but the NIRA was struck down as unconstitutional by the Supreme Court in 1935 by which time most American businesses were abandoning the program anyway.

Congressional mandates to the Federal Reserve to actually start doing its job and buy securities to counter the 1929-1933 deflation were working, and deposit insurance helped price reflation by encouraging Americans to redeposit their cash at the bank which jumpstarted commercial credit. By 1937 the unemployment rate briefly fell to 11% after peaking at 25% in 1933.

However after his 1936 reelection FDR became more radical and more anti-business in his rhetoric, policies, and cabinet appointments. The Wagner Act which granted vast government backing to unions resulted in a doubling of nationwide strike-hours and an inflation of wages above the market-clearing level, thus creating a labor surplus. He signed the Revenue Act of 1936 which hiked the top marginal income tax rate to 79%, introduced the “Soak the Rich” tax, raised capital gains taxes from 17.7% to 22.5%, and levied a new “undistributed profits tax” of up to 27% on corporations.

Paired with a doubling of bank reserve requirements by the Federal Reserve, America plunged into a new depression—the Depression of 1937-38, dubbed America’s first “depression within a depression”—and by June 1938 unemployment had risen to 20% from its July 1937 trough of 11%, an astonishing increase of nine points in just eleven months.

Recovery from the 1937-38 depression was also painfully slow as FDR’s anti-business crusades continued. By the time Poland was invaded in September 1939—more than two years later—U.S. unemployment still stood at almost 16% and in 1940 joblessness was far higher than in 1930.

Yet as the European war intensified in mid-1940 unemployment in America suddenly began to fall rapidly. In early 1941 the jobless rate was 10.5% and by July of 1941, five months before Pearl Harbor, America had reached full employment where it stayed throughout the war all the way to the Recession of 1949-50.

Just as unemployment had spiked nine points in eleven months and plateaued in 1937-38, it fell even more quickly by twelve points in fourteen months from May 1940 to July 1941.


After a decade of uninterrupted double-digit unemployment what caused this abrupt and massive decline in joblessness? The Keynesian school of economics, with help from their partners in the mainstream press, tells us it was massive government borrowing and spending for the war.

According to Keynesians of all stripes FDR’s 1930’s New Deal programs "weren't big enough," inadequate half-measures at best lacking the astronomical scale required to achieve a lasting economic breakout. But once FDR embarked on a historic borrowing and spending spree to fight a world war, raising the public debt to 120% of GDP (a record then and even today), Washington had at last committed to the level of Keynesian stimulus required to get America out of the decade-long slump.

(incidentally Keynesians never mention that Herbert Hoover boosted real government spending by 100% in his own New Deal from 1929-1933 which resulted in 25% unemployment by the end of his term)

Many conservatives also embrace this theory. Hostile to the notion that FDR’s New Deal itself might have worked, they adopt the alternative account that “war spending finally got the economy moving” to discredit FDR’s economic policies.

However not only does embracing a “war spending solved the problem, not the New Deal” explanation effectively affirm Keynesian theory, it’s also wrong. The actual data don’t support this narrative, and it misses the real catalyst that finally produced a permanent recovery.

What are the problems with the Keynesian theory? The first error is simply temporal: the drop in joblessness to full employment was already over before the federal government began to borrow and spend in earnest.

Federal government spending as a share of GDP only rose by one point from 1940 to 1941 (9.78% to 10.95%) before nearly doubling in 1942 to 21.4% and doubling again in 1943 to 41.8%.

(click this URL for core data)

Given that the 1941 fiscal budget year ended in June of 1941, the same month that the jobless rate crossed below 5%, full employment had already been achieved before federal wartime spending had even started ramping up. It’s tough to argue that a final, epic government stimulus package finally squelched the jobs depression when the jobs depression was over before the stimulus ever got started.

Another problem is the nature of government hiring. During the 18 months leading up to Pearl Harbor FDR committed to reconstituting some of America's neglected armed forces, hence military recruitment picked up somewhat. From 1940 to 1941 the military hired a little over a million new personnel—still a far cry from the 12 million who would serve during the war itself—which was about 1.8% of the American labor force of 55.9 million (source: Census Bureau).

However 1.8 percentage points hardly explains a rapid fall in overall unemployment from 16% in September 1939 to less than 4% in July of 1941. Also, to the extent that the million-man boost in military personnel helped lower the jobless rate, the hiring was done by the government and not the private sector. So one can hardly credit military recruitment for the much larger boom in private sector hiring. Even the Keynesians’ treasured consumption multiplier—assuming one accepts it as valid—can’t turn a million government jobs into seven million private sector ones, especially in less than a year.

In Part 2 of this installment we’ll look at the free market explanation for the rapid recovery, a theory that actually aligns with the World War II events timeline.

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