Lessons From the Great Depression
In the aftermath of the First World War, America entered a decade of rapid economic growth fueled by an increase in potential output due to advancements in manufacturing and electricity as well as an increase in aggregate demand due to expansionary monetary policy. Exuberant consumer sentiment brought rampant speculation to the stock market, generating trillions in wealth for the wealthy and the working class. All this would come to a halt in the third quarter of 1929 when a stock market crash would bring about a decade of economic hardship, financial reform, and influential monetary and fiscal policy.
As investors’ unrealized gains in the stock market evaporated, so too did consumer sentiment. Aggregate demand decreased as borrowers began to settle debts instead of taking on more. This decrease in spending, coupled with a drought and falling food prices caused business owners to lay off employees. As millions of families lost their income sources and tightened their belts, this caused aggregate demand to decrease further, prompting even more layoffs. Amidst this feedback loop, there were several waves of bank runs that bankrupted thousands of banks and credit unions (1). This article will examine the fiscal and monetary policies of the Hoover and Roosevelt administrations that turned Black Thursday into a decade that lives in economic infamy.
Hoover was an advocate of laissez-faire economics. He believed that the central government had no place in the economy. Economic assistance would decrease labour force participation, and so it was up to private businesses to trickle down wealth to the working class. In the fourth quarter of 1929, Hoover met with business leaders and secured promises for them to maintain wages, even if it meant fewer profits for the business. This backfired, as it sent the now recovering stock market into a second selloff in anticipation of decreased future earnings. This selloff would last until 1932, triggering more margin calls and loan defaults. Hoover also enacted expansionary fiscal policy by passing a $160 million tax cut and subsidies for the agriculture and construction industries through Congress in an attempt to close the recessionary gap (2). However, the deflationary cycle of layoff-induced austerity resulting in more layoffs far outweighed the expansionary fiscal policy, and real GDP would continue to plummet until 1933.
Monetary policy under the Hoover administration was also expansionary but lacklustre. Under Roy Young, the Federal Reserve gradually lowered the discount rate from 6% to 1.5% and purchased bonds through open market operations (3). These actions attempted to boost aggregate demand by increasing the transactions demand for money and the money supply. The reason they were unable to contain the economy’s deflationary pressures was that the Gold Standard severely restricted the magnitude of monetary policy. Since the 1830s, the value of a U.S. Dollar was tied to gold at a fixed rate of $20.69 per ounce. Each dollar in circulation must be backed by gold worth at least 40 percent of its value, the modern-day equivalent of a fractional reserve system (4). Hoover and Young were unwilling to abandon the Gold Standard, which severely decreased the amount of “new money” they could inject into the economy.
When Franklin D. Roosevelt took office in March of 1933, unemployment was at an all-time high of 25% (Figure 1) and the country was faced with a fourth wave of bank runs since Black Thursday. During a bank run, bank customers wanted to exchange their demand deposits for hard currency (a.k.a. gold), but the banks and the U.S. Treasury did not have the gold reserves to continue supporting these withdrawals, even with a 40% reserve requirement. To prevent a total collapse of the banking system, Roosevelt announced a four-day bank holiday, preventing any further withdrawals and allowing Congress to pass legislation to begin the transition away from the Gold Standard.
The Gold Reserve Act of 1934 gave the president the power to adjust the gold value of the dollar by proclamation, and the exchange rate was immediately set to $35/ounce. The Act also transferred ownership of all monetary gold to the central government, with individuals being compensated at this new exchange rate (4). All privately held monetary gold effectively was turned into dollars, and the money supply EXPLODED. Consumer spending and real output ticked up, markets rallied, and in hindsight, many see this decision as the beginning of the end of the Great Depression. Sure, the dollar lost its value relative to other currencies, but all that did was make American exports more competitive internationally.
Furthermore, with an influx of gold in the U.S. Treasury and a more favourable exchange rate to dollars, the Federal Reserve under Marriner Eccles was able to carry out expansionary policies at a much larger scale. Starting in 1933, real GDP grew at an average 9% annual rate for four consecutive years (Figure 2). This was put to a halt when in late 1936, the Federal Reserve doubled the reserve requirement on banks to prevent “injurious credit expansion” and a repeat of the late ’20s (5). Combined with increasing tax rates to support the newly created social security. The money supply shrank, interest rates rose, and real output fell even though there was still a recessionary GDP gap. From May 1937 to June 1938, the United States experienced a second recession. The Fed eventually reversed their decision and the Roosevelt administration would go on to adopt expansionary fiscal and monetary policies until their entry into the Second World War.
In hindsight, economists believe the 1937 recession was caused by withdrawing economic stimulus too quickly and could have been prevented by ensuring the economy is well on track to recovery before withdrawing their support. In reality, there is no telling whether such dovish economic policy would have resulted in an inflationary spiral or not because World War 2 was only a few years away and it would change the whole equation. We find ourselves in a very similar situation today, with an economic tug-of-war between deflationary pressures (technological advancements, decreased demand due to the pandemic, supply chain issues resolving) and inflationary fiscal and monetary policies (QE, massive spending bills). As to which side will win this tug-of-war, your guess is as good as anyone's. All the Federal Reserve can do is watch as economic indicators trickle in day by day and pray that the inflationary spiral has not already begun.
In conclusion, both the Hoover and Roosevelt administrations correctly implemented expansionary fiscal and monetary policies in an attempt to close the recessionary GDP gap. However, because of the limitations of the Gold Standard and the necessary compromises with fiscally conservative politicians, the speed and scale of the policies implemented was too little too late. Today, bipartisanship has become a thing of the past and the Gold Standard has been completely abolished for decades. Their policies were positive for the economy, just not positive enough. Our policies are positive for the economy… the only question is whether they are too positive.