False Dawn

George Selgin on the New Deal

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Franklin Roosevelt’s New Deal policies had three goals: recovery, relief and reform. George Selgin has produced an excellent new book that focuses on the first of those three goals—recovery. Did New Deal policies succeed in getting the US out of the Great Depression?

The short answer is no. But False Dawn: The New Deal and the Promise of Recovery 1933-1947 is far from being an anti-Roosevelt polemic. Selgin views Roosevelt’s policies as a mixed bag, some of which did indeed aid the recovery. Unfortunately, some of the policies were worse than useless, and actively inhibited the recovery. As a result, the US economy remained deeply depressed as late as mid-1940, when the European War intensified.

I have spent much of my life researching the causes of the Great Depression. Most of this work focused on two issues; the impact of the global gold market on aggregate demand, and the impact of Roosevelt’s high wage policies on aggregate supply. Selgin looks at a much wider range of New Deal policies, and I expect this highly readable book to eventually become the standard reference on the macroeconomic effects of the New Deal.

I’ll divide this post up into three sections: the impact of the New Deal on aggregate demand, the impact of the New Deal on aggregate supply, and why you should read Selgin’s book.

1. The New Deal and Aggregate Demand

Roosevelt had two primary macroeconomic goals. During his campaign, he publicly committed to reflating the price level back up to its 1926 level. In addition, he hoped to boost employment and output back up from the deeply depressed level of early 1933. Surprisingly, however, FDR was skeptical of both of the two most important policy tools now favored by macroeconomists, fiscal stimulus and money printing.

Here is the budget deficit as a share of GDP:

Notice that the budget moved from a surplus in 1929 to a deficit of about 5% of GDP under President Hoover, and then showed no further enlargement until World War II. Contrary to his reputation, Hoover was an activist president. And most of that was actual fiscal stimulus, as the “automatic stabilizers” were quite small back in 1929, when federal spending was barely 3% of GDP.

Many economists are aware that FDR campaigned on the promise of a balanced budget and ended up running budget deficits. I suspect that many of these economists assume that FDR was a closet Keynesian, and that fiscal stimulus was an important part of the New Deal. Selgin shows that this is a myth; FDR was sincerely opposed to deficit spending during peacetime, and did not significantly increase the budget deficit until WWII. Whatever success the New Deal might have had, it was not due to fiscal stimulus.

A better argument can be made in favor of FDR’s monetary policies. But even in this case it was not monetary policy in the modern sense of the term. Instead, monetary conditions improved mostly as a result of three factors:

a. A stabilized banking system

b. Dollar devaluation

c. Gold inflows from Europe

FDR took office on March 4, 1933, in the midst of a severe banking crisis. Selgin showed that the major New York banks were actually in decent shape, it was the Federal Reserve banks that were in danger of insolvency, as nervous investors exchanged currency for gold due to fear of dollar devaluation. Prior to taking office, FDR had been unwilling to commit to keeping the US on the gold standard.

In those days, there was a four-month period between the November election and the inauguration day. Selgin suggests that Hoover and FDR each share some blame for the situation spiraling out of control during this extended interregnum, but the end result probably worked in FDR’s favor. By inauguration day, both economic and financial conditions had gotten so bad that Roosevelt had a relatively free hand to try some pretty radical experiments.

Unfortunately, Roosevelt didn’t seem to have a clear idea as to which experiments would be most effective. The initial bank holiday relied heavily on ideas provided by banking experts who had been struggling to put together a similar plan during the final days of the Hoover administration. FDR strongly opposed federal deposit insurance, and Congress basically forced the president to accept FDIC as part of a broader banking reform package. (FDR was right to worry that deposit insurance would make banks more reckless.)

Roosevelt’s decision to increase the dollar price of gold from $20.67/ounce to $35/ounce did provide a powerful stimulus to the economy. The stimulus would have been even greater if the increase in the nominal (dollar) size of the gold stock had been monetized. But FDR was opposed to anything that smacked of “printing money”, and thus the economy had to rely mostly on increased money velocity during the early stages of the recovery. Fortunately, velocity did increase due to a more stable banking system and higher inflation expectations generated by dollar devaluation.

During the mid to late-1930s, additional monetary stimulus was provided by gold inflows from Europe, which boosted the monetary base. But these gold inflows can hardly be viewed as New Deal policies; rather they reflected the way that the US economy benefited from increased war fears in Europe.

Selgin views FDR’s dollar devaluation as a net positive for economic recovery, despite some reservations about the messy way it was handled. Like most economists, Selgin agrees with Keynes’s remark that George Warren’s gold buying program of late 1933 was something like a “gold standard on the booze”, with its daily adjustments in the federal buying price of gold. I’m one of the few (the only?) economists who have defended the program. But this is a detail. I find Selgin’s overall evaluation to be quite convincing. FDR was able to end the contraction and push nominal spending higher through policies that stabilized banking and devalued the dollar, but also missed a number of opportunities to generate a faster recovery through the use of standard monetary and fiscal policy tools.

In the end, FDR failed to reach his 1926 price level target, indeed the price level remained below pre-Depression levels until WWII. Nonetheless, the boost given to aggregate demand would normally have generated a satisfactory recovery, if not impeded by other factors. Similar nominal growth after the 1920-21 depression did produce a fast recovery. Instead, the 1930s economy remained deeply depressed due to counterproductive supply-side policies, which I’ll consider in the next section.

2. The New Deal and Aggregate Supply

In my work on the Depression, I focused on a single supply-side policy, FDR’s various programs to boost nominal wage rates. But these wage initiatives were part of a much broader attempt to create private sector cartels. The Agricultural Adjustment Act (AAA) tried to restrict farm output and boost prices. The National Industrial Recovery Act (NIRA) tried to achieve the same goal in other industries.

These programs are an almost perfect illustration of the fallacy of “reasoning from a price change”. It is true that depressions caused by a lack of aggregate demand are often associated with falling prices. But that does not mean that a policy of raising prices through supply restrictions will create an economic boom. It would be like arguing that because people who own Rolls Royces are usually wealthy, buying a Rolls Royce is a good way to get rich.

The AAA and the NIRA used a mixture of carrots and sticks to encourage farmers to reduce output and raise prices, while manufacturers were encouraged to reduce both output and hours worked, while sharply increasing hourly wage rates. Today, it may seem bizarre to read theories that the Great Depression was caused by a general “overproduction” that led to falling prices, but this is what happens when you begin reasoning from a price change. You can convince yourself that the solution to a depressed economy is to produce even less!

I don’t know of any economist who has done more than George Selgin to warn people of the fallacy of reasoning from a price change. His book Less Than Zero is one of the best explanations of what can go wrong with price level targeting, and why NGDP targeting is a superior approach to policy. Surprisingly, some modern economists have claimed that the NIRA might have had an expansionary effect by raising inflation expectations. But higher inflation is expansionary when generated by more aggregate demand, not when generated by less aggregate supply.

Selgin emphasizes the negative effects of cartelization programs such as AAA and NIRA, which were probably the single biggest factor holding back the recovery. In percentage terms, prices rose more rapidly after the 1929-33 slump than after the 1920-21 contraction. But the output recovery was far more impressive after 1921. The post-1933 rise in both the wholesale price level and NGDP was more than sufficient to produce a satisfactory recovery, if not interrupted by adverse supply shocks like the AAA and the NIRA.

Notice (below) how industrial production stagnated for two years after the “President’s Reemployment Agreement” was announced in late July 1933. That NIRA policy increased nominal wages by roughly 20% over two months, aborting a promising recovery that had been triggered by dollar devaluation. After the NIRA was ruled unconstitutional in May 1935, a robust recovery resumed until interrupted by another wage shock in late 1936 and 1937, partly related to aggressive unionization drives enabled by the Wagner Act.

The 1937-38 depression was a major setback for FDR. In addition to the wage shock, Selgin points to a wide array of policies that created headwinds for the business community, such as the new “undistributed profits tax” which discouraged firms from using retained earnings to finance investment projects. There was also plenty of hot rhetoric, including administration complaints that a “capital strike” by “economic royalists” was to blame for the 1937-38 depression.

Aggregate demand declined in late 1937 due to policies such as gold sterilization and higher reserve requirements. Even though prices remained well below pre-Depression levels, the price level increases of 1936-37 had led to fears that speculative excess would lead to another 1929. FDR seemed to want the impossible, for prices to return to 1926 levels without any sort of “inflation”.

Keynesians often blame “fiscal austerity” for the 1937 slump, but there’s no evidence that the fiscal contraction was anywhere near big enough to explain one of the deepest recessions of the 20th century. Indeed, contrary to the prediction of many Keynesians, a similar austerity policy in 2013 didn’t produce any slowdown in the economy at all, despite also occurring during a zero lower bound period, when fiscal austerity is supposed to be especially contractionary. And much of the 1937 “austerity” reflected the fact that the special 1936 veteran’s bonus payment, always understood to be a one-off policy, was not repeated again in 1937.

There is much more of interest. I especially enjoyed Selgin’s coverage of the unexpected prosperity in the immediate postwar period, a period that I knew little about.

3. Why you should take this book seriously

I found Selgin’s book to be quite persuasive. But will mainstream economists actually give it a chance? Franklin Roosevelt is generally regarded as a liberal hero, and one of the greatest presidents in US history. In the past, many of the people challenging FDR’s legacy have been right wing cranks. Although Selgin is not a rigid ideologue, he shares my moderate libertarian leanings. So why should a center left economist take this book seriously?

Let’s start from the fact that John Maynard Keynes is arguable the hero of this book. In many key respects, Selgin’s views of the New Deal closely parallel those of Keynes. Keynes also would have preferred that FDR stuck to normal fiscal and monetary stimulus, and eschewed the more radical cartelization policies, as well as the anti-business rhetoric which created uncertainty and reduced what Keynes called the “animal spirits” of the business community.

The second point to consider is that Selgin is not uniformly negative in his appraisal of FDR’s recovery policies—he suggests that banking reform and dollar devaluation did help to boost aggregate demand.

The third point to consider is that Selgin repeatedly emphasizes that his somewhat skeptical take on the recovery aspects of the New Deal do not constitute a negative judgment of the overall program, which included relief and reform. One could easily conclude that the New Deal was a net plus due to lasting reforms such as the Social Security Act and the SEC, as well as relief programs for the unemployed, even if it failed to produce a satisfactory recovery in production and employment.

It’s also worth considering the fact that during the (milder) Great Recession of 2008-09, which is the modern slump that most resembles the Great Depression, neither Democratic politicians nor center-left economists seemed all that interested in creating another New Deal. Instead of cartelization of the economy, they opted for policies rejected by FDR, such as fiscal stimulus and “printing money” (i.e., QE). If FDR’s New Deal was effective, why wasn’t it repeated in 2009?

This book is not at all the sort of polemic that some center-left readers might imagine. It’s perfectly OK to view FDR as a liberal hero who won WWII, saved us from fascism, and helped to create a more humane society though various social insurance programs, and still regard the New Deal as being ineffective in promoting recovery. After all, most other developed economies recovered more quickly than the US, with the notable exception of France, which had an even more dysfunctional NIRA-type program.

Many years ago, some progressives gave James Hamilton a hard time for arguing that the New Deal programs like the AAA and the NIRA were counterproductive. Here’s how he responded:

I openly confess to believing that government policies that were explicitly designed to limit manufacturing, agricultural, and mining output may indeed have had the effect of limiting manufacturing, agricultural, and mining output.

PS. While reading False Dawn, I kept thinking about various aspects of the Roosevelt presidency:

1. A president that rejects classical liberal arguments for free markets and won’t give up on his favorite cartelization policies, despite doubts about their effectiveness even among his supporters.

2. A president who had some major setbacks in the courts and the media, and starts out his second term looking for revenge.

3. A president with a few authoritarian tendencies, like a desire to pack the Supreme Court.

4. A president that likes to needle his critics, to be a troll.

5. A president that blames others for his failures, pointing to dark forces like “economic royalists” and a “capital strike”.

Hmmm . . .