The New Deal and the Great Depression
Like the folks writing at Mahalanobis, Marginal Revolution and Free Exchange, I was rather surprised to see Berkeley Professor Brad DeLong claim, "A normal person would not argue that the New Deal prolonged the Great Depression." Since Brad is a smart guy, I think it might be time for me to acknowledge my freakiness.
I divide the U.S. Great Depression (1929-1939) into three episodes: (1) the initial downturn (1929-30), catastrophic free fall (1931-32), and slow recovery (1933-39). I believe there were different factors in play in each.
The initial downturn does not strike me as all that remarkable. Had the economy begun to recover in the middle of 1930, as the steady appreciation in stock prices from December 1929 through April 1930 suggested that it might, that episode would not look that different from any of a number of other historical business downturns. The same kinds of forces that produce a typical economic downturn can offer a quite satisfactory account of what happened in 1929-30. Among these, a monetary contraction in 1928-29 likely contributed to that downturn, as did an exogenous drop in consumption and investment spending.
What really distinguished this episode from a typical downturn was not the severity of the initial decline, but the fact that, unlike a typical business cycle, things began to deteriorate quite dramatically after 1930. In my opinion, one of the reasons for that is the collapse of the money supply, which led the economy into a ferocious deflation. I've argued that the gold standard contributed to that, and certainly each country is observed to begin to recover from the Great Depression as soon as it suspended gold convertibility. I also believe that the bank panics played an important role in propagating that second phase, and am quite happy to grant Daniel Gross that New Deal financial innovations such as the FDIC and FSLIC were unambiguously helpful in correcting some of those problems.
After 1933, the economy began to grow again, with real GDP increasing at an average compound rate of 6.7% per year from 1933-1939. However, although growth over this period was strong, the unemployment rate stayed high, and there surely remained substantial excess production capabilities. So, in my mind, the third part of the question of "What caused the Great Depression?" is to explain why did the recovery take as long as it did after the contractionary monetary forces were removed?
What is supposed to help the economy recover is that a substantial pool of unemployed workers should result in a fall in wages and prices that would restore equilibrium in the labor market, as long as the government just keeps the money supply from falling (which, as just noted, the Fed failed most spectacularly at doing during 1931-32). And yet, in the midst of quite significant unemployment, between 1933 and 1934, average hourly earnings increased by over 25% in sectors such as iron and steel, furniture, and cement, and over 50% at lumber mills. How could that be?
Those numbers, by the way, come from a paper by UCLA Professors Harold Cole and Lee Ohanian that appeared in the Journal of Political Economy in 2004. And their answer to the question is that the persistence of so many unemployed workers was due in no small part to the National Industrial Recovery Act of 1933 and the National Labor Relations Act of 1935.
Cole and Ohanian noted that many in the Roosevelt Administration believed that the severity of the Depression was due to excessive business competition that led to wages and prices that were too low. I actually agree, in a perverse sense, with part of that diagnosis-- I see the rapid deflation of 1929-33 as quite destabilizing. But I'm inclined to believe that the way to fix that would have been through a monetary and fiscal expansion rather than trying to lift nominal wages and prices back up by sheer government fiat.
The purpose of the NIRA and NLRA was to promote labor and trade practice provisions so as to limit the extent of competition between firms and competition between workers. Among the NIRA codes that Cole and Ohanian highlight include minimum prices below which firms were not allowed to sell their products, restrictions on productive capacity and the amount that could be produced, and limitations on the workweek. Cole and Ohanian concluded on the basis of model simulations that these kinds of New Deal policies might have accounted for 60% of the persistence in the output gap.
Outside of manufacturing, the Agricultural Adjustment Act of 1933 and Soil Conservation and Domestic Allotment Act of 1936 -- paying farmers not to grow wheat-- were designed with the specific goal of reducing agricultural production in order to raise agricultural prices. State regulatory commissions like the Texas Railroad Commission ordered oil producers to cut back production in an effort to increase oil prices.
The notion that if we can just create more monopoly power for every single sector of the economy, encouraging every sector to produce less so they can raise their wages and prices, that we will then somehow make everybody richer, is so spectacularly wrong-headed that I would be just as dumbfounded to find that Brad De Long believes it as he seems to be by those of us who maintain that some aspects of New Deal policy surely did make the recovery from the Great Depression slower.
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.
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