The Great Depression and the Current Economic Crisis: Similarities and Differences
[28.11.2009, Gene Smiley, CONSERVATIVE LETTERS]

Conservative Letters

The Great Depression and the depression like recovery during the 1930s are tragic testimonials to the harm misguided government interference can do and to the damage that money manipulation can bring about.

Though the Great Depression at the beginning of the 1930s was a worldwide event, in the United States it was longer and deeper than in most other countries. The recovery beginning in the second quarter of 1933 was extremely slow and, in fact, incomplete at the beginning of World War II.

Most analyses now place the sources of the Great Depression in the inflation of World War I and the creation of a “gold exchange” international monetary system in the 1920s to replace the gold standard. The new system no longer automatically brought about equilibrating adjustments. By the end of the 1920s, Great Britain’s overvalued currency, France’s undervalued currency and the buildup of gold reserves in the United States and France led to a worldwide contraction.

Policies initiated by President Hoover brought about a much deeper and longer contraction in the United States. Hoover saw the contraction as a fall in the demand for products and services. To counteract this he encouraged firms to maintain money wage rates and let their profits decline in order that workers could continue purchasing. He dramatically raised taxes in order to reduce the burgeoning federal deficit. To aid farmers he approved programs to fix grain prices and approved the Smoot-Hawley tariff that tried to protect nearly all American producers—not just farmers.

But Hoover misunderstood what an economic contraction was. There is no reduction in the resources and technology; there is no reduction in the desires of consumers and businesses for goods and services. The problem is that the system that coordinates all of the economic activity had been disrupted—the price system has been disrupted and the recovery requires that prices be allowed to adjust to re-coordinate economic activity. Hoover’s policies delayed these adjustments. This, in combination with the three-year long decline in the money supply due to the Federal Reserve System’s failure to stem the banking crises, the buildup of bank reserves and the buildup of consumer and business cash holdings led to the Great Depression in the United States.

President Roosevelt’s banking holiday at the beginning of March 1933 stopped the contraction of the banking system and the money supply and brought some stability to the monetary system. If Roosevelt had done nothing else and had allowed markets to continue to adjust the United States might well have recovered from the depression in a couple of years.

But Roosevelt was elected with an agenda and his administration pursued it with a vengeance. They believed that unrestrained free markets had resulted in widespread “overproduction.” They initiated the New Deal to cartelize American industry and agriculture, control prices and investment, spread the work and reduce production to eliminate overproduction—all under federal government oversight. These programs virtually stopped the recovery in its tracks by the end of 1933. Little recovery then occurred until crucial New Deal programs were declared unconstitutional in mid-1935 and early 1936. The recovery of the economy from late 1935 into early 1937 was stopped by the 1937-1938 Depression brought on by the Federal Reserve System’s doubling of bank reserve requirements, Roosevelt’s new taxes and sharp increase in wage rates without increases in demand or productivity.

The Great Depression and the depression like recovery during the 1930s are tragic testimonials to the harm misguided government interference can do and to the damage that money manipulation can bring about.

The sources of the current contraction in the United States do not lie in the private sector. Following the terrorist attacks of September 11, 2001 the Federal Reserve System pumped reserves into the banking system bringing the federal funds rate to one percent where it was held for nearly two and a half years. This monetary policy initiated a huge expansion in the housing sector—a “housing bubble.”

Why did the Federal Reserve System keep interest rates so low for so long? The recovery—beyond the housing sector—was much slower than what the Fed wanted or expected. As discussed above a contraction comes about because something disrupts the price system. In this case it was the terrorist attacks and the resulting adjustments to those and the threat of future attacks. But monetary policy is not designed to facilitate such adjustments.

The Federal Reserve System could not continue to pump reserves into the banking system. So, from early 2004 to early 2006 the Fed increased the target federal funds rate to a more normal 5 percent. This increase spelled the end of the Fed’s housing bubble. Lenders were in trouble and the innovations in securities fostered by the Fed’s low interest rate policy became a ticking time bomb—a time bomb that exploded in the fall of 2008.

Clearly, little has been learned in the years since the Great Depression. Blinded by their Keynesian spectacles, both the Bush and Obama administrations, like Hoover, concluded that the problem lies in inadequate demand. They expected to stimulate the economy by gigantic increases in federal, state, and local spending. But we’ve seen this before in Roosevelt’s PWA, WPA, CCC and other “alphabet” programs of the New Deal.

The federal government decided to “bailout” failing banks and failing companies such as AIG, GM and Chrysler, much like the 1930s RFC. But, in the 1930s the RFC largely lent to banks and let the other companies face their fortunes in the markets—not like the bailouts, takeovers and destruction of bondholders’ property rights that has occurred since last fall.

And now we’re in the midst of an ongoing bitter discussion about creating some kind of national healthcare program. Again the contraction simply provided a convenient opportunity to expand the scope of federal government control in this area just like in the 1930s and we see reflections of Roosevelt’s New Deal programs to cartelize American industry and of the Wagner Act, the Minimum Wage Act and of the Social Security Act.

The likely effect of all this, as during the 1930s, will be to retard the economic recovery.

Gene Smiley is currently a Professor Emeritus of Economics at Marquette University.

Article is an abstract of the lecture presented at the Conservative Economic Quarterly Lecture Series (CEQLS) held by the Conservative Institute of M. R. ©tefánik in Bratislava on November 23, 2009.

The lecture is available also as a video here.

Article was published in Slovak language in Conservative Letters 09/2009, a newsletter of the Conservative Institute.

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