Why Did The Great Depression Last So Long?
I.
After being a closed book for decades, economists have revisited the Great Depression using recent developments in economic theory and quantitative methods. This new research is surprising, as it finds that several aspects of the Depression contrast sharply with long-standing explanations.
The conventional view is that the Depression began as a garden variety recession, which then became the Depression through banking crises and the failure of the Federal Reserve to expand the money supply. This view also argues that the recovery from the Depression was on track until 1937, when the Fed raised bank reserve requirements and President Roosevelt reduced fiscal stimulus.
But the immediate depth and the chronic duration of the Depression are inconsistent with traditional explanations. The Depression did not start as a garden variety recession, but rather was immediately severe, as manufacturing output fell 35% in just the first year of the Depression, before the banking panics and the large declines in the money supply.
And the Depression lasted far longer than it should have. After 1933, productivity growth was rapid, liquidity was plentiful, the banking system was stabilized, deflation was eliminated and there was plenty of demand stimulus as the Federal Reserve more than doubled the monetary base (currency and bank reserves) between 1933 and 1939.
But despite all of this, the economy didn’t come close to returning to trend. By 1939, per-capita consumption relative to trend had not recovered at all, and per-capita hours worked had recovered by only 20%. Investment recovered somewhat, but still remained more than 60% below trend.
The Depression clearly persisted throughout the 1930s, with little recovery. But the recovery failure has been overlooked by economists who judge it based on the growth rate of gross domestic product and on changes in unemployment. A number of economists point to relatively rapid output growth and declining unemployment to conclude that the recovery was on track. But unemployment is a particularly misleading indicator of recovery. It doesn’t indicate how much work was restored, as it neither measures job growth nor hours per worker, and it also is impacted by long-term unemployed individuals leaving the labor force.
And judging recovery based on output growth requires a benchmark. Both empirical and theoretical benchmarks indicate that output growth should have been much faster than it was, particularly given the very rapid productivity growth that occurred.
In fact, almost all of the recovery in output is from productivity rather than from growth in hours worked. The depth and the duration of the Depression are simply unparalleled, either before the 1930s or afterward.
What specific factors generate such an enormous Depression, and why did it last for more than a decade? A number of economists are currently researching this question and are focusing their attention on labor markets. This is not only because there was little recovery in hours worked, but also because wages in the industrial sectors of the economy were more than 20% above trend by the end of the 1930s.
And the co-existence of above-market wages and Depression is pathological. Depressions are periods of low employment and low living standards. The normal forces of supply and demand should have reduced wages, which would have lowered business costs and increased employment and output.
What prevented the normal forces of supply and demand from working? The main culprit appears to be government policies that restricted competition. The National Industrial Recovery Act (NIRA) was passed in 1933 with the goal of restoring prosperity, and it gave industry the opportunity to explicitly collude, including sanctioning many arrangements that would previously have triggered antitrust activity, such as forming minimum prices and restricting the expansion of capacity within an industry. Cartels were granted under the NIRA in return for industry sharing some of their newfound monopoly profits with workers through large wage increases.
Many industries passed codes of fair competition under the NIRA, and industry prices and wages jumped following government approval of these codes. Prices and wages in industries that were unable to reach agreement on a code remained low, as did prices and wages in the agricultural sector, which was not impacted by these policies.
While the NIRA was ruled unconstitutional, these policies persisted through the passage of the National Labor Relations Act, which substantially increased union bargaining power and led to further wage increases, including substantial increases just before the 1937-38 recession and through the continuation of lax antitrust enforcement.
These policies started to change at the end of the 1930s, however, and hours worked began to rise. By the end of the 1940s, the National Labor Relations Act was significantly modified by the Taft-Hartley Act, industrial wages were back in line with productivity and per capita hours worked were back to their normal level.
More research by both economists and historians is required to gain a more complete understanding of the Great Depression. But almost certainly a satisfactory accounting of this period will focus on why the normal market forces of competition did not work, particularly in industrial labor markets.
Lee E. Ohanian is an economics professor at the University of California, Los Angeles and director of the Ettinger Family Program in Macroeconomic Research.
II.
Dr. Skousen is an economist at Rollins College, Department of Economics, Winter Park, Florida, and editor of Forecasts & Strategies, one of the largest investment newsletters in the country.
The depression . . . was endemic to the system: the economy was not self-regulating and needed to be controlled.
—David Colander and Harry Landreth[1]
The Great Depression of the 1930s may be a dim memory now, but its impact is still being felt in policy and theory. The prolonged depression created an environment critical of laissez-faire policies and favorable toward ubiquitous state interventionism throughout the Western world. The depression led to the Welfare State and boundless faith in Big Government. It caused most of the Anglo-American economics profession to question classical free-market economics and to search for radical anti-capitalist alternatives, eventually converting to the new economics of Keynesianism and demand-side economics.
Prior to the Great Depression, most Western economists accepted the classical virtues of thrift, limited government, balanced budgets, the gold standard, and Say’s Law. While most economists continued to defend free enterprise and free trade on a microeconomic scale, they rejected traditional views on a macroeconomic level in the postwar period, advocating consumption over saving, fiat money over the gold standard, deficit spending over a balanced budget, and active state interventionism over limited government. They bought the Keynesian argument that a free market was inherently unstable and could result in high levels of unemployed labor and resources for indefinite periods. They blamed the Great Depression on laissez-faire capitalism and contended that only massive government spending during World War II saved the capitalist system from defeat. In short, the depression opened the door to widespread collectivism in the United States and around the world.
Fortunately, free-market economists have gradually punctured holes in these arguments and the pendulum has slowly shifted toward a re-establishment of classical free-market economics. Three questions needed to be addressed: What caused the Great Depression? Why did it last so long? Did World War II restore prosperity? Economic historian Robert Higgs had dubbed these three arenas of debate the Great Contraction, the Great Duration, and the Great Escape.
The Cause of the Great Contraction
Many free-market economists had attempted to answer the first question, including Benjamin M. Anderson and Murray N. Rothbard,[2] but none had the impact equal to Milton Friedman’s empirical studies on money in the early 1960s. His was the first effective effort to destroy the argument that the Great Depression was the handiwork of an inherently unstable capitalistic system. Friedman (and his co-author, Anna J. Schwartz) demonstrated forcefully that it was not free enterprise, but rather government—specifically the Federal Reserve System—that caused the Great Depression. In a single sentence underlined by all who read it, Friedman and Schwartz indicted the Fed: From the cyclical peak in August 1929 to a cyclical trough in March 1933, the stock of money fell by over a third.[3] (This statement was all the more shocking because until Friedman’s work, the Fed didn’t publish money supply figures, such as M1 and M2!)
Friedman and Schwartz also proved that the gold standard did not cause the depression, as some Keynesian economists have alleged. During the early 1930s, the U.S. gold stock rose even as the Fed perversely raised the discount rate and allowed the money supply to shrink and banks to collapse.[4]
The Prolonged Slump
Economic activity and employment stagnated throughout the 1930s, causing a paradigm shift from classical economics to Keynesianism. Friedrich Hayek, the Austrian economist who challenged Keynes in the thirties, was so disheartened about the state of the free-world economy that he abandoned the study of economics in favor of political philosophy.
Why did the depression last so long? Many free-market economists have picked up where Murray Rothbard’s America’s Great Depression left off, at the time Franklin Delano Roosevelt took office in 1933. Gene Smiley (Marquette University) attempted an Austrian perspective on the perverse role of fiscal policy in the 1930s. I summarized the causes of stagnation and persistent unemployment, such as the Smoot-Hawley Tariff, tax increases, government regulation and controls, and pro-labor legislation.[5]
More recently, Robert Higgs of the Independent Institute has made an in-depth study of the 1930s’ malaise and focused on the lack of private investment during this period. According to Higgs, private investment was greatly hampered by New Deal initiatives that destroyed investor and business confidence, the key to recovery.[6] In short, the New Deal prolonged the depression.
What Got Us Out?
In another brilliant study, Higgs attacked the commonly held view that World War II saved us from the depression and restored the economy to full employment. The war gave only the appearance of recovery, when in reality private consumption and investment declined while Americans fought and died for their country. A return to genuine prosperity—the true Great Escape—did not occur until after the war ended, when most of the wartime controls were abolished and most of the resources used in the military were returned to civilian production.[7] Only after the war did private investment, business confidence, and consumer spending return to form.
In sum, it has been a long and hard-fought war to restore the case for free-market capitalism. Finally, through the pathbreaking work of Friedman, Rothbard, Smiley, Higgs, and other scholars, we can now say the battle has been won.
1. David C. Colander and Harry Landreth, eds., The Coming of Keynesianism to America (Edward Elgar, 1996), p. 16.
2. Benjamin M. Anderson, Economics and the Public Welfare (Indianapolis: Liberty Press, 1979 [1949]) and Murray N. Rothbard, America’s Great Depression (Princeton: D. Van Nostrand, 1963).
3. Milton Friedman and Anna J. Schwartz, A Monetary History of the United States, 1867-1960 (Princeton: Princeton University Press, 1963), p. 229.
4. Friedman and Schwartz, Monetary History, pp. 360-361. See also my May 1995 Freeman column, Did the Gold Standard Cause the Great Depression?
5. Gene Smiley, Some Austrian Perspectives on Keynesian Fiscal Policy and the Recovery of the Thirties,Review of Austrian Economics (1987), 1:146-79, and Mark Skousen, The Great Depression, in Peter Boettke, ed., The Elgar Companion to Austrian Economics (Edward Elgar, 1994), pp. 431-439.
6. Robert Higgs, Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed After the War, The Independent Review (Spring 1997), 1:4, pp. 561-590.
No comments:
Post a Comment