1929-1946 period revisited

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Mr Economy

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Aug 2, 2010, 4:53:00 AM8/2/10

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This post I have to warn is a little long about the period covering 1929-1941. The charts provided come from Federal Reserve data and from various Gerard Jackson articles at Brookenews.com and Frank Shostak articles found at Mises.org. I think its very important to review this period because some economists think that unlimited government spending is the cure to revive an economy and that it takes a war to recover from a really deep depression.

There seems to be so much confusion about the period from 1929-1946 where people believe that the Fed did nothing, Hoover pursued a policy of laisezz-faire, the government did not not spend enough, increased bank reserve requirements in 1937 set back the recovery that started in 1933 and that WW2 got us out of the Great Depression. Well lets look at the this period to see if these statements are correct. The period from 1941-1946 will be discussed in a different post another time.

Prior to crash of 1929 the Fed embarked upon an easy monetary policy which caused a stock market boom in the late 1920s. Because they looked at consumer price indexes where increasing productivity kept prices stable, they did not see inflation as a threat. Only after continued price increases in stocks did it decide to increase the discount rate. Its important to remember that during the late 1920s the discount rate was kept below the broker call rate; the rate to borrow money for the purchase of stocks, so it was profitable for banks to borrow at the discount rate and lend to brokerages for them to lend to people to purchase stocks. In any event the stockmarket eventually crashed as the discount rate was raised.

But after the stock market crashed, the Fed did pursue an easy monetary policy as Chart 1 below shows which led to low interest rates that Chart 2 shows. The only thing it could not control at the time was that if there were bank runs and no banks would lend it wouldn't be able to prevent a bank run if people requested to hold their cash or requested gold coins from banks back then. A little off topic but interesting to note that Canandian banks at the time printed there own banknotes so not many Canadian banks failed. But point to make is that deflation with bank runs can only happen in a fractional reserve system not a 100-percent reserve backed system. In any event as charts below show, monetary policy was loose:

Chart 1

Chart 2

Did Hoover pursue a policy of laissez-faire? Well lets see what Hoover did during the 1929-1932 period:

In 1930 Hoover got passed the Smoot-Hawley Tariff that led to higher prices of critical inputs needed in manufacturing and it caused a reduction in demand for US exports like agriculture. With a larger supply of US agricultural goods available it led to depressed prices. (Also important to note, before Smoot-Hawley was passed and before stock market crashed speculation that Smoot-Hawley was going to pass led to steep corrections in stock prices on a few occasions). So a rising discount rate with increased speculation that Smoot-Hawley would be passed in near future didn't help investor sentiment. Think of Smoot-Hawley as the catalyst back then like Lehman Brothers was in 2008.

With the collapse of agriculture due to Smoot-Hawley, rural banks failed in record numbers. Nine thousand banks closed their doors in the US between 1930 and 1933. The stock market which had regained much of the ground it lost in October 1929 tumbled 20 points on the day in 1930 when Hoover signed Smoot-Hawley into law. The stock market fell almost without respite for the next two years.

Furthermore Hoover increased government spending, increased deficits, increased government subsidies to the agricultural sector that increased supply of agricultural goods further while foreign markets to sell were closed off due to retailatory tariffs imposed on US exports, increased public works spending, doubled the income tax where the top bracked was almost tripled, exemptions were lowered, earned income tax credit was abolished, corporate and estate taxes were raised, new gift, gasoline, and auto taxes were imposed, and postal rates were sharply hiked.

Additionally, Hoover jawboned businesses as early as November of 1929 to keep wages up even as both profits and wages were declining. So consumer prices plunged almost 25 percent between 1929-1933 while real wages on average increased 15%. As chart 3 below shows, wages were above the value of their marginal product during the 1930-1941 period. With wages not adjusting unemployment results which was the case during the 1930-1941 period of high unemployment. The reason being is that in the free market, employers tend to hire laborers up to the point where wages equal the discounted marginal value of their product. The discounted marginal value product is the dollar value of the products workers produce discounted by interest because employers in alot of cases will pay workers ahead of time out of their savings or profits before the product workers create becomes available for sale. So if labor is being paid wages above the value of their product or not earning at least as much revenue as their salary paid, then less workers will be hired or retained.

Chart 3

Now below is chart 4, which depicts the same relationship with PARW which stands for productivity adjusted real wage. As you can see in 1929 with 100 as starting point; as wages were increased above the value of their marginal product unemployment increased. As PARW decreased unemployment decreased. The reason that from 1933 to 1937 it shows a decline in unemployment is partly explained by Roosevelt confiscation of gold from private citizens in which the dollar was devalued to $35 from $25 an ounce for gold. This devaluation had the effect of pumping inflation directly into the system which caused prices of products to rise thus narrowing the disequilibrium between product prices and the value of labors marginal product.

Chart 4

Year	1929	1930	1931	1932	1933	1934	1935	1936	1937	1938	1939
¹PARW	100	113	125	128	130	125	117	114	122	132	134
Jobless rate	3.2	8.7	15.9	23.6	24.9	21.7	20.1	16.9	14.3	19.0	17.2
²Canadian jobless rate	3.1	9.1	11.6	17.6	19.3	14.5	14.2	12.8	9.1	11.4	11.4
GNP		-9.4	-8.5	-13.4	-2.1	7.7	8.1	14.1	5.0	-4.5	7.9
¹Productivity adjusted real wage. ²The Canadian column is particularly interesting in that though Canada had no New Deal her employment record during the 1930s was vastly better than the US's to the extent that on average the US unemployment rate was 3.9 percentage points higher

Now in regards to government spending we see that the government did increase their spending through out the Great Depression as Chart 5 below shows. Chart 6 shows Federal and State spending as percentage of GDP. But no low rate of interest as Chart 7 which lists commercial paper rates and Chart 8 the NY discount rate below shows; will stimulate business spending when there is great business uncertainty like fear of future regulations that will increase costs, higher taxes, tariffs that have closed foreign markets and workers wages that don't adjust to the value of their marginal product. With business uncertainty and less private investment one would think that the average age of capital equipment would increase which did happen as Chart 9 below shows.

Chart 5

Chart 6

	Federal spending as a percentage of GDP	Federal spending + state spending
1929	3.68	12.35
1930	4.34	13.22
1931	5.37	15.93
1932	7.27	21.19
1933	9.05	22.38
1934	9.00	19.40
1935	10.30	20.17
1936	10.94	20.00
1937	9.58	18.74
1938	9.81	20.53
1939	10.04	20.66

Chart 7

Chart 8

Chart 9

Percentage of Metal Working Equipment over 10 Years Old
Year	Percent
1925	44
1930	48
1935	65
1940	70
Source: Benjamin M. Anderson's Economics and the Public Welfare: A Financial and Economic History of the United States 1914-1946, p. 479.

Chart 10

ALFRED Graph

Chart 11

ALFRED Graph

Chart 12

ALFRED Graph

As Chart 10 above shows, GDP decreased from 1929-1933 with increased unemployment even though the government increased spending and ran deficits. Even though government spending on public works created some jobs, unemployment kept increasing because the private sector was not hiring workers due to failure of wages to adjust to product prices, increased regulations adding to increased costs, export markets closed and for fear of future uncertainty.

Its important to consider that even when GDP started to rise again beginning in 1933 the production structure most likely was still shrinking. GDP only counts final consumption spending and leaves out all the intermediate business spending that accounts for almost 2/3 of all total spending in the economy. Gerard Jackson cited the following in his many articles; Professor Higgs calculated that from 1930 to 1940 net private investment was minus $3.1 billion. W. Arthur Lewis calculated that from 1929 to 1938 net capital formation plunged by minus 15.2 percent and Benjamin M. Anderson estimated that in 1939 there was more than 50 per cent slack in the economy. George Reisman wrote that in the Great Depression of the 1930s, corporate saving (undistributed corporate profits) was negative in every year from 1930 to 1936 and again in 1938; personal saving was negative in 1932 and 1933 and barely more than zero in 1934; net investment was negative in the years 1931 to 1935 and again in 1938.

From 1933 to 1937 higher inflation due to some government deficits being monetized and the devaluation of dollar vs gold caused higher prices which helped to narrow the price of goods versus labors' wages. This had the effect of lowering unemployment.

Chart 10 and Chart 12 above shows that the recovery that began in 1933 turned into a recession by 1937. There have been various reasons put forth as to the cause of the recession. However, the real reason that seems to be left out was the upholding of the Wagner Act by the Supreme Court in 1937 that forced businesses to negotiate with politically privileged unions. As Chart 5 shows unemployment increased the same year that the Wagner Act was upheld. Also Chart 3 shows that wages as compared to the price of labors marginal product began to widen again. Gerard Jackson and Jonathan Catalan reviewed the other supposed reasons for the recession of 1937 and came back with the following conclusions:

-Between 1936 and 1937 the Fed reduced reserves from $3 billion to $927 million. Jackson points outs that this overlooks the fact that the reserves were excess reserves eliminated. If they weren't excess reserves then interest rates would have risen which they didn't.

-Money supply was $45.68 billion in 1937 and marginally declined to $45.51 billion ins 1938. Even though there was a slight decline in the money supply, interest rates remained low where commercial paper rates didn't rise above 1%. Additionally there was also an increase in the issuance of new securities.

-Another reason cited for the recession of 1937 was disappearance of gov't deficit. Total federal expenditures in 1937 and for the first 4 months of 1938 was a little over $10 billion while revenue equalled a little over $8.2 billion. So there was still a government deficit. Also Gerard Jackson brings attention to the fact that in 1932 the deficit was $2.7 billion with unemployment at 23.6 percent while in 1937 deficit was 2.8 billion with unemployment at 14.3 percent. So obviously the deficits could not be the cause of the recession of 1937.

-Last explanation given was sterilization of incoming gold. Sterilization only prevented incoming gold from adding to excess reserves. The increased supply of gold still served as base to increase the money supply.

Comparing the 1920-1921 Depression to 1929-1941 Depression

In comparison, during the 1920-1921 Depression the government did not interfere and allowed liquidations of all the malinvestments where wholesale prices declined about 45% but wages only 11%. Here is what Gerard Jackson had to say about period:

"The volume of physical production dropped from 124.5 in 1920 to 103.9 in 1921. Wholesale prices peaked in May 1920 and then plummeted by an astonishing 45 per cent by May 1921. 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. In 1922 the volume of production had risen to 121.6. Although unemployment rose from 1.2 per cent in 1920 to 11.2 per cent in 1921, it fell to 6.8 per cent the following year and then to 1.7 per cent in 1923. Interest rate movements during this period tell an interesting story. The table below show that despite the fact that the fed discount never fell below 4 per cent the recovery was extremely swift."