Sunday, August 14, 2011

History's Lessons

Government spending accounts for about 20% of GDP in a given year, so curtailing government spending will detract from GDP growth, other things being equal. This is one reason why financial markets are nervous—much of the developed world is experiencing at best modest economic growth.

And yet, the U.S. and many European countries are launching into spending cuts and austerity programs aimed at reining in their debts. While this is desirable from the point of view of long-term economic health, austerity measures that curtail government spending will, by definition, detract from short-term GDP growth. Investors worry that this hit to growth is occurring at a time when the global economy is already weak and could tip us back into recession.

Indeed, University of California Berkeley economist Christina Romer, who was the Chair of the Council of Economic Advisors and a co-author of the Obama stimulus plan, once famously listed six lessons of the Great Depression for policymakers. One of these was “Beware cutting back stimulus too soon.” It is this dictum that the markets fear the government is violating with its newfound focus on austerity measures and fiscal discipline.

Federal Reserve Chairman Ben Bernanke, an expert on the Great Depression, once promised that the central bank would never repeat its 1937 mistake of rushing to tighten monetary policy too soon and prolonging an economic slump.

"Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again," Bernanke said back in 2002 at a conference honoring legendary economist Milton Friedman's 90th birthday.

He has been true to his word, keeping interest rates near zero since late 2008, but cuting government spending may end up having a 1937-type chilling effect on the economy, and there is little Bernanke can do to counter that.

Back in 1937, the U.S. economy had been growing rapidly for three years, thanks in large part to FDR's stimulus spending programs aimed at ending the deep recession that began in 1929. Then the central bank clamped down hard on lending, and federal government cut spending 10 percent. The economy contracted again in 1938. The jobless rate soared.

The seeds of a great depression had been planted in an era of prosperity that unevenly distributed wealth to a few at the top. Pres. Hoover had been in office just months when the nation sustained the most ruinous business collapse in its history. The stock market crashed on October 29, 1929 when frantic traders sold off 16,400,000 shares of stock. The sell off continued and by year's end, the investors in the market had lost some $40 billion. Following the crash, the United States continued to decline steadily into the most profound economic depression of its history. Banks failed, millions of citizens suddenly had no savings, business and shops closed, and most remaining businesses struggled to survive and local governments faced great difficulty with collecting taxes to keep services going.

The initial government response to the Great Depression was ineffective, as President Hoover insisted basic need was to restore business confidence so so business would begin expand production, providing jobs and income to restore the economy to health. But business owners saw no reason to increase production while collapsing demand left unsold goods clogging their shelves. Collapsing economic activity from the late 1920's steadily reduced tax revenues for local, state and federal governments, creating budget deficits.

Convinced that a balanced federal budget was essential to restoring business confidence, Hoover and congress passed budgets mandating cuts to government spending. But in the face of a collapsing economy, this served only to further reduce demand and further tax revenues to run government. As conditions worsened, Hoover’s administration eventually provided emergency loans to banks and industry, created small public works programs, and helped states offer relief. But it was too little, too late. To many, government assistance seemed the only answer, but Hoover was convinced that giving federal aid to the unemployed would undermine recipients’ self-reliance, and he resisted the idea of government aid programs throughout his term.

By the end of Pres. Hoover's first term in the White House the electorate clamored for changes. The Republicans again nominated Hoover, probably feeling that they had no better choice than their deeply unpopular leader. The Democrats nominated Franklin D. Roosevelt.

FDR's energetic, confident campaign rhetoric promoted something specifically for "the forgotten man" — a "New Deal." Roosevelt went on to a decisive victory. At his inauguration in March 1933, Roosevelt declared in his lilting style, "Let me assert my firm belief that the only thing we have to fear is, fear itself — needless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance."

The nation needed immediate relief from the Great Depression, recovery from economic collapse, and reform to avoid future depressions, so relief, recovery and reform became Roosevelt's goals when he took the helm. At his side stood a Democratic Congress, prepared to enact the measures he proposed.

Political Cartoon 1938As historian Jean Edward Smith discusses in his book "FDR", after taking the oath of office in 1933 FDR managed to push through an astonishing number of key initiatives in the first 100 days of his Presidency. Congress also enacted several important relief and reform measures in the summer of 1935 — sometimes called the Second Hundred Days. Legislation signed by FDR include the:

Relief, recovery and reform also affected the social welfare.

Boys in soup kitchen, Dubuque, Iowa The U.S. government could reach out in the widest way to alleviate human misery from the Great Depression — such was the assumption implicit in the New Deal.

Beginning in 1935, Congress enacted Social Security laws (and later amendments) that provided pensions to the aged, benefit payments to dependent mothers, crippled children and blind people, and unemployment insurance.

To fund all the new legislation, government spending rose. The government modified taxes to tap wealthy people the most, who could take it in stride most easily.

The rich, conservatives, numerous businessmen — and those who were all three — vigorously opposed the New Deal. But the election of 1936 triggered a nationwide endorsement of FDR, who carried every state except Vermont and Maine.

What is also striking is how much of the New Deal regime has been dismantled by the conservative movement from 1980 to 2011, and how much of that dismantling has occurred during the eight years Pres. Bush held the White House from January 2001 to January 2009.

Republican dismantling of the Glass-Steagall Act through the Depository Institutions Deregulation and Monetary Control Act and Gramm-Leach-Bliley Act was a major contributor to formation of the the mortgage bubble that bust in late 2008.

The purpose of the Glass-Steagall Act was to control speculation and prohibit a bank from owning other financial institutions which would create a conflict of interest, such as investment banks and insurance companies. The Glass-Steagall Act was enacted in 1933 after excessive risk-taking that contributed to the Great Depression. Jean-Marie Eveillard, of First Eagle Funds, has said: "Glass-Steagall protected bankers against themselves. Bankers are sheep. They don't mind going over the cliff if everyone else goes over the cliff."

The reason banks were giving out such risky loans through the 1920's is that they were able to bundle mortgages as securities as sell them as mortgage backed securities to Wall Street investors. With the ability to both create loans, then underwrite and sell them as mortgage backed "investment instruments under one roof, it is easy for banks to create a ponzi-like scheme. This is exactly what happened during the eight years before the mortgage bubble burst in late 2008.

PBS has a very good history of the repeal of the Glass-Steagal Act on their website.

And now Republicans would finally dismantle Social Security, Medicare and Medicaid.

FDR's "New Deal" was nothing short of a sweeping change from a conservative to progressive view of the roll of government in America. But not as commonly known is the fact that a few key aspects of FDR's policies diluted the positive impact of the New Deal and scuttled further, sharp progress on New Deal legislation in the late 1930s.

From The Left Coaster:

The most significant issues that slowed or reversed New Deal economic progress during FDR's Presidency were Sharp Spending Cuts and Flawed Spending Plan.

Sharp Cuts in Government Spending

In his TNR piece, Brinkley pointed out that:

One of the first acts Congress passed for Roosevelt in 1933 was the Economy Act, which slashed government spending in ways that reduced economic activity. It cut the salaries (and, in some cases, the jobs) of government employees and dramatically reduced payments to World War I veterans, taking $500 million from the economy in a single stroke.

In his book, "FDR", Jean Edward Smith pointed out that the Economy Act was FDR's second measure after the Banking Act, mainly because Roosevelt, at the time, was a strong believer in reducing budget deficits. FDR evidently believed then that budget deficits were partly the cause of the economic stagnation and the banking collapse that led to the Depression. Although he publicly acknowledged in early 1933 that the Economy Act would not help get the country out of depression, he failed to realize that the massive budget cuts in the Economy Act significantly ran counter to the needs of economic expansion. Thankfully, this deflationary act was countered by Roosevelt through inflationary spending and relief measures in the same year.

Yet, FDR would repeat this mistake yet again in 1937 to costly effect. To see why, let us begin with Brinkley's observation that:

Roosevelt's initiatives did not, in the end, lift the country out of the Great Depression. At no time in the first eight years of the New Deal did unemployment drop below 15 percent. At no time did economic activity reach levels comparable to those of a decade earlier; and, while there were periods when the economy seemed to be recovering, none of them lasted very long.

This appears, at least in part, to be incorrect. According to Smith (page 396):

In the spring of 1937 American production pulled above pre-Depression levels for the first time. The New York Times' Weekly Business Index reported output at 110 - 10 percent higher than in the corresponding week in 1929...Unemployment shrank to 12 percent, barely a third of the March 1933 percentage. Subtract the young men in the Civilian Conservation Corps together with those at work in the job creation programs of the PWA and WPA, and the unemployment figure stood at 4 percent. [22*]


*In his 2003 biography of FDR, Conrad Black took issue with the school of historiography that asserts that recovery in the United States lagged behind that of other industrial countries. As Lord Black points out, American employment figures did not distinguish between those who had no job whatever and those working for the WPA, in the public works program, or enrolled in the CCC. All were lumped together as "unemployed". When the relief workers were factored in, American unemployment totals dropped by almost 60 percent...

[NOTE: Also worth reading on the issue of New Deal jobs is Media Matters: "Conservatives cherry-pick 1930s unemployment figures in continued assault on New Deal" and "Conservative media peddle a raw deal"]

Smith goes on to point out that it was in response to the nascent economic recovery that FDR mistakenly assumed that the U.S. economy was on sound enough footing that he could go back to a policy of cutting spending to balance budgets. This proved to be a huge mistake, as Brinkley notes:

In 1937, deluded by a weak economic recovery, Roosevelt (urged on by his Treasury secretary) set out to balance the budget through severe spending cuts. The result was a sudden and dramatic economic downturn--a recession within the Depression that produced some of the highest levels of unemployment and lowest levels of production of the decade.

In the aftermath of the 1937-1938 setback, Roosevelt launched a new $5 billion spending plan to try to shock the economy back to life. This infusion of funds helped undo the damage that the 1937 budget cuts helped to create, spurring a modest recovery that at least got the economy back to the weak and fragile condition of a year earlier.

According to Smith, FDR initially made the situation worse by procrastinating in response to the sharp downturn - largely due to some of the deficit hawks in his cabinet. However, as Smith writes, eventually stung "by continued press reference to the "Roosevelt recession," FDR reluctantly jettisoned the balanced budget approach." The new spending program in 1938 evidently amounted to a special appropriation of $3.4B which allowed the U.S. to recover, by years-end, half of the ground that had been lost. Eventually, World War II provided a huge spending stimulus to bring up the economy further, as Paul Krugman has noted.

Flawed Spending Plan

FDR's implementation of the National Industrial Recovery Act was flawed. Brinkley argues that:

The National Recovery Administration (NRA), created in 1933 to help stabilize the volatile economy, was enormously popular for a time, mostly because it created the illusion of forceful action. The NRA sought to help corporations cooperate with one another in keeping production low and prices up, effectively creating cartels. This effort proved almost impossible to administer: No one in the federal government had any experience or expertise in managing an economic project of this magnitude; control quickly moved to the corporations themselves, with no better results. But the NRA was even worse when it worked as it was supposed to, because its goal was exactly the opposite of what the economy needed: Instead of expanding economic activity, the NRA worked to constrict it. At the same time, the Federal Reserve Board--operating under classical economic assumptions--saw the economic wreckage around it and responded by raising interest rates so as to protect the solvency of the Federal Reserve Bank itself. No one today would even consider high interest rates in a slumping economy, but the Fed of the early 1930s had not absorbed new economic ideas that would later become almost universally accepted. (In fairness, this catastrophic mistake was not a product of New Deal policy, but few New Dealers recognized the magnitude of the error for years.)

In part, Brinkley's assertion here is incorrect. It is true that the production/price control and industry code clauses of the NRA were a nightmare to manage (and were later struck down by the SCOTUS as unconstitutional). However, the other part - spending the appropriated funds through the Public Works Administration (PWA) - was not that difficult. Brinkley's piece missed perhaps the most important reason why the PWA was much less effective than it could have been. The appropriated money was hardly spent due to tight-fisted administration, as Smith points out (pages 343-346):

...the act established two complementary agencies: the National Recovery Administration (NRA) to coordinate economic recovery, and the Public Works Administration (PWA), authorized to spend $3.3 billion in punp-priming construction projects....But FDR made the fatal error of dividing responsibility. To head the NRA, Roosevelt brought in former brigadier general Hugh "Iron Pants" Johnson...For PWA, the president turned to Harold Ickes...Ickes, on the other hand, was pathologically prudent. As he saw it, the problem of the public works program was not to spend money quickly but to spend it wisely. Obsessively tightfisted, personally examining every project in minute detail, Ickes spent a minuscule $110 million of PWA money in 1933...

The failure of the Public Works Administration to provide economic stimulus doomed NRA's recovery efforts from the start. Without a significant infusion of construction money, the NRA could not expand the economy. Johnson labored mightily to create industry codes that would control production, fix prices and regulate working conditions. But without money to prime the pump, he was simply redistributing scarcity...


FDR realized his error and sought to correct it by the end of the year:

As the winter of 1933-34 approached, Roosevelt recognized that Ickes' caution in spending PWA money was creating few jobs...FDR turned to Hopkins. Could he provide temporary jobs for 4 million people? Hopkins said he could if he had the money. Roosevelt ... decided to tap Ickes' underused Public Works budget for the funds....on November 9, 1933, [he] issued an executive order establishing the Civil Works Administration with Hopkins as director [47].

As Roosevelt anticipated, Hopkins moved quickly. He shifted staff from FERA to CWA, raided Army warehouses for tools and equipment, and dragooned the Veterans Administration - the one federal agency with a national disbursement system in place - into becoming the CWA's paymaster. Unlike relief programs, the Civil Works Administration provided jobs. Within ten days Hopkins had put more than 800,000 people to work, 2.6 million by mid-December, and by early January he was well over the 4 million mark. The CWA paid the prevailing minimum wage for unskilled labor, and the work was seasonal. When it went out of existence in April 1934, the CWA had pumped close to $1 billion into the ailing economy. Eighty percent of that had gone directly into workers' wages, with the bulk of the remainder paid out for equipment and material [49]. Less than 2 percent went for administrative overhead - another Hopkins hallmark.

In the bitter winter of 1933-34, with record low temperatures gripping the nation, the CWA laid 12 million feet of sewer pipe and built or upgraded 500,000 miles of secondary roads, 40,000 schools, 3,700 recreation areas, and nearly a thousand airports. It employed 50,000 teachers to keep rural schools open and to provide adult education in the cities. It hired 3,000 artists and writers - and they worked as artists and writers....The CWA did more than provide an overdue cash infusion to the economy; it restored a nation's self-respect. "We aren't on relief any more," said a proud woman in Iowa. "My husband is working for the government." [51]

The United States had not fully put the economic woes of the Great Depression behind it by the time Japanese air and sea forces punched their fist through America's back door at Pearl Harbor in December 1941. Roosevelt introduced a number of major changes in the structure of the American economy through the 1930's, using increased government regulation and massive public-works projects to promote a recovery, but the 1940 census still counted 11.1 percent of U.S. heads of household as unemployed. However, a deep, latent productive capacity existed within American industry and unemployment disappeared as the Great Depression was swallowed up by massive government spending to gear up America's industrial strength to defeat the Axis powers of Japan, Germany and Italy.

In anger, the nation swiftly changed gears from a peacetime to wartime footing that mobilized the populace and numerous industrial sectors. In January 1942, the president called for unheard-of production goals. In that year alone, he wanted 60,000 warplanes, 45,000 tanks, 20,000 antiaircraft guns and 18 million tons of merchant shipping. Labor, farms, mines, factories, trading houses, investment firms, communications — even cultural and educational institutions — were enlisted into the war effort. The nation accumulated big money and generated huge new industries to mass produce planes, ships, armored vehicles and numerous other items.

To achieve the explosive WWII industrial growth, FDR committed the U.S. to massive debt. That massive WWII GDP-Debt Ratio served as a massive government stimulus program that left America as a bright shining star in the post WWII era. America entered the post WWII era with unprecedented manufacturing capacity that served the nation well as wartime manufacturing converted to civilian applications. But the government's economic stimulus programs did not end with the defeat of Nazi Germany and Japan.

Rather than making drastic cuts in federal programs at the end of World War II, President Truman introduced two important spending programs — the Marshall Plan for Europe and the GI Bill for returning service personnel. The GI Bill paid for the education and training of around 8 million young people who then entered the work force to as both innovative producers and strong consumers.

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