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US economy: the Great Depression and interest rates
Gerard Jackson
Economics is a subject plagued with fallacies, ill-informed commentary and historical myths, especially concerning the Great Depression. Without a doubt, the economic tragedy of the thirties was a turning point in economic history and whose ramifications are even now still making themselves felt through misguided economic policies. The two enduring myths of the Great Depression are that the free market failed and that president Hoover deepened the depression by implementing ‘orthodox’ economic policies.Writing on Asia and the possibility of world deflation, Peter Hartcher (Australian Financial Review 19 December 1998), echoed the conventional view, when he asserted that by “acting in complete accord with the economic orthodoxy of the day”, Herbert Hoover created an economic nightmare.
Not a word of this is true. The Great Engineer, as Hoover was sometimes called, had never accepted what the likes of Hartcher call the “economic orthodoxy of the day” or what others correctly call laissez-faire policies. It is indeed a curious irony that the man who laid the foundations for Roosevelt’s New Deal is still labelled by academics and journalists as an advocate of failed free-market policies. It is also a bitter commentary on those who are paid to know better, including certain economists who pretend to be knowledgeable about the US economy of the 1920s and 1930s.
Now the “orthodox” economic prescription for depressions was to allow the market to liquidate the malinvestments that the preceding boom had created — what the classical economists called “disproportionalities” — and allow prices and costs to adjust to proper market conditions. This policy was based on the vital insight that supporting unsound investments and trying to hold prices, especially wages, at boom-time levels would deepen and prolong a depression.* The 1920-21 depression was the last time in American history that the wisdom of this policy was allowed to do its work.
The very short but sharp American post-war economic contraction that lasted from late 1918 to early 1919 was quickly followed by a massive credit expansion that generated the 1919-20 boom that the Federal Reserve belatedly checked by raising the discount rate from 4 per cent in 1919 to 7 per cent in June 1920. This triggered the sharpest and fastest depression in US history. Wholesale prices peaked in May 1920 and then plummeted by 56 per cent, levelling out in June 1921. About 75 per cent of this unprecedented price drop occurred between August and February, a mere 6 months. Despite this severe price fall, average non-agricultural wages declined by only 11 per cent. By August 1921 the economy was on the road to recovery despite the fed discount rate standing at 6 per cent. (It later declined.) Although unemployment leapt from 1.2 per cent in 1920 to 11.2 per cent in 1921, it also fell rapidly, reaching 1.7 per cent in 1923.
What brought about this remarkable recovery was the very “economic orthodoxy” that ill-informed journalists, economic advisors, and academics now sneer at. It was this “orthodox” policy that moved Dr Benjamin M. Anderson to call this economic episode “our last natural recovery to full employment”. (Benjamin M. Anderson, Economics and the Public Welfare, Liberty Press, 1979, First published 1949). The Harding administration pursued a largely laisezz-fair policy during the 1920-21 depression, allowing wages and other costs and prices to fall until the necessary price adjustments and liquidations had been made. Hoover, on the other hand, strongly opposed this policy, proposing large-scale interventionist policies instead.
On his return from Europe shortly after the war, he touted his “Reconstruction Program” that was based on government planning euphemistically called “voluntary” but which relied on “central direction”. From the moment he was appointed Secretary of Commerce in March 1921 he set about trying to intervene in the economy, designing several policies that he thought would help end the depression. Fortunately for America the depression ended before Hoover’s interventionist schemes could do any damage. That the laisezz-fair policy of “leave it alone” ended the depression so swiftly was a lesson Hoover never learnt.
Economics taught that during deflationary periods it was vital that prices, especially money wages, be allowed to adjust to the new monetary conditions. Only by this means could market clearing prices be established. It was clearly absurd to believe that boom-time money wage rates could be maintained during a deflation without causing lasting widespread unemployment. Hoover, however, detested “orthodox” thinking on wage rates, believing instead that living standards were a product of high real wages. He made his rejection of the “old economics” clear in a speech on 12 May 1926:
. . . not so many years ago — the employer considered it was in his interest to use the opportunities of unemployment and immigration to lower wages irrespective of other considerations. The lowest wages and longest hours were then conceived as the means to obtain lowest production costs and largest profits . . . But we are a long way on the road to conceptions. The very essence of production is high wages and low prices, because it depends upon a widening . . . consumption, only to be obtained from the purchasing-power of high real wages and increased standard of living.
This was the “new economics” that Hoover and others now preached and which became the prevailing theory of the time. One could easily be forgiven for thinking that Hoover was a Keynesian before Keynes was. When depression struck in 1929, Hoover, as president, was now free to implement his interventionist (or should I say Keynesian) schemes that gave the world the Great Depression. He reacted swiftly to the crisis, persuading the country’s industrialists to maintain money wage rates at pre-depression levels. Alarmed by these interventionist policies, Secretary of Treasury Mellon urged him to allow the depression to follow its natural course as had all previous administrations. Not Hoover. He scornfully dismissed Mellon and his supporters as “leave-it-alone-liquidationists”. On 3 December, 1929, Hoover marked his annual address to Congress by stating:
I have instituted . . . systematic . . . cooperation with business . . . that wages and therefore earning power shall not be reduced and that a special effort shall be made to expand construction . . . a very large degree of individual suffering and unemployment has been prevented.
Unemployment was then about 3 per cent. Two days later he convened a large conference of business leaders. Urging them to accept his policies he condemned the previous “dog-eat-dog” economics. Not surprisingly the AF & L (American Federation of Labor) hailed Hoover’s policies and “new economics” as an advance of previous policies which had “intensified depressions”. The AF & L also praised his 1930-31 policies of reducing hours of work for government employees without loss of pay; maintaining money wage rates on public works and buildings; raising wages for government employees, etc. In October 1930 William Green presented Hoover to the AF & L annual conference, declared that:
The great influence which [Hoover] exercised upon that occasion [the White House Conferences] served to maintain wage standards — to prevent a general reduction of wages. As we emerge from this distressing period of unemployment we . . . understand and appreciate the value of the service which the President rendered wage earners of the country.
Unemployment now stood at 7.8 per cent. So much for recovery. In May 1931 Secretary Mellon publicly summed up Hoover’s views on wage rates:
In this country, there has been a concerted and determined effort on the part of both government and business not only to prevent any reduction in wages but to keep the maximum number of men employed, and thereby to increase consumption. It must be remembered that the all-important factor is purchasing power, and purchasing power . . . is dependent to a great extent on the standard of living . . . that standard of living must be maintained at all costs.
By the end of 1931 unemployment stood at 16.3 per cent. The tragic result of trying to maintain purchasing power. Nevertheless, in a report to Prime Minister Ramsey MacDonald, Keynes praised Hoover’s wage-fixing job-destroying policies. During his presidential campaign in late 1932 Hoover defended his interventionist program, claiming that
. . . we might have done nothing. That would have been utter ruin. Instead we met the situation with proposals to private business and to Congress of the most gigantic program of economic defence and counterattack ever evolved in the history of the Republic. . . . For the first time in the history of depression, dividends, profits, and the cost of living, have been reduced before wages have suffered . . . They were maintained until the cost of living had decreased and profits had virtually vanished. They are now the highest real wages in the world . . . We determined that we would not follow the advice of the bitter-end liquidationists [“orthodox economists”] . . .
By this time Hoover’s dangerous purchasing power theory of wages had driven unemployment up to 24.9 per cent.
Hoover lost the election to Roosevelt who, nevertheless, continued with Hoover’s policies. The result was the longest and deepest depression in US history. Yet Hoover, the man who denounced proponents of “economic orthodoxy” as “reactionary . . . bitter-end liquidationists”, who supported the 1930 disastrous Smoot-Hawley tariff, who fixed wage-rates, implemented public works, established the Reconstruction and Finance Corporation, restrained competition, drastically raised taxes and government spending; the president who intervened in the economy on an unprecedented scale, breaching every tenet of laisezz-fair economics, is still accused by the historically illiterate likes of Hartcher of having created the Great Depression because he adhered to the “economic orthodoxy of the day”.
As we have seen, this view is a complete reversal of the truth. Hartcher was right about one thing: the Great Depression was not inevitable — but what he and his colleagues cannot grasp is that it was the bitter fruit of the anti-market policies of Hoover and Roosevelt.
Note: How can journalists and others be so wrong? The answer, I regret to say, is our universities. It’s not just journalists who are at fault. Plenty of economic advisors are still pumping out the same nonsense.
*Only the Austrian school of economics has been able to provide a satisfactory explanation of the great depression and the Asian crisis. Unfortunately the Australian media refuses to publish articles based on Austrian analysis. I suspect this is due to Australian journalists’ deep-rooted attachment to Keynesian economics and its rationale for large-scale government spending.
Gerard Jackson is Brookes’ economics editor
BrookesNews.Com
Monday 18 April 2005