The 1930s: A Paradigm Shift
"The sovereign is completely discharged from a duty, in the attempting to perform which no human wisdom or knowledge could ever be sufficient; the duty of superintending the industry of private people, and of directing it towards the employments most suitable to the interest of society."  
"neither a state nor a bank ever has had unrestricted power of issuing paper money, without abusing that power; in all States, therefore, the issue of paper money ought to be under some check and control; and none seems so proper as that of subjecting the issuers of paper money to the obligation of paying their notes, either in gold coin or bullion. "

The Roaring 20s came to an abrupt close with the stock market crash of 1929 as the US fell into an exceptionally long and severe Depression.  The U.S. economy had suffered through a number of previous severe downturns - 15 recessions between 1873 and 1929 (1873, 1882, 1887, 1890, 1893, 1895, 1899 1902, 1907, 1910, 1913, 1918, 1920, 1923, 1926). The rebounds had tended to be swift and vigorous and growth was strong - between 1874 and 1929 GDP increased 3.5% per year, doubling every 20 years, and GDP per capita grew at 1.5 - 2% per year, doubling every 40 years.   The US had become an urban industrial power by 1929 with 54 percent of its people living in cities (five cities having more than one million inhabitants) and individuals equally likely to be employed in manufacturing as farming.  By the turn of the 20th century there were skyscrapers (1985 in Chicago),  subways (1897 in Boston), and electric power stations (1882) in the nation's cities and soon there would be automobiles.   There were also enormous factories and corporations - with one quarter of the manufacturing workforce employed in factories with more than 1,000 employees.  

The speed of recovery and underlying growth coupled with a belief in the power of the individual and a distrust of government, kept the government out of the macroeconomic policy business.  At that time there was general acceptance of the idea that if you wanted to work, there was work for you, and if you were out of work it was your fault and not the responsibility of the government.  This was captured in the words of Henry Ford in 1931 after the Depression had hit.  As Ford saw things, "the average man won't really do a day's work unless he is caught and cannot get out. There is plenty of work to do if people would do it."

As it turned out, Ford was a bit off the mark as the Depression continued to deepen and many who wanted to work found themselves out of work.   The Depression of the 1930s was different from what the US had experienced before, and although it manifested itself differently in the major countries, it spared few countries.  These were desperate times and they led to desperate measures.  It is certainly the subject of considerable research.  One on-line Depression site provides a brief time-line of events as well as a discussion of the causes and cures.  You may also want to check out some of the headlines from the New York Times. One of my favorites, at least in hindsight, is the "FISHER SEES STOCKS PERMANENTLY HIGH" headline that reports on Yale economist Franklin Fisher's comments that the dramatic stock price rises were justified and that there was no reason for concern.  Once the crash had occurred, you will see a number of headlines suggesting that acceptance of the permanence of the decline was slow in coming.  On the day after the first crash, Franklin Fisher made the second page where the headline read " STOCK SLUMP IS ONLY TEMPORARY."

In Germany the real crisis surfaced in the early 1920s when the country suffered through a classic bout of hyperinflation. This was a time where the delicate system of exchange in which the industrial structure was rooted was upset, where people used wheelbarrows to transport the money needed for basic expenses, where prices rose so rapidly that workers were paid twice a day so that they could spend their money before its value was eroded. As devastating as this collapse of the German system was, it was not unanticipated.  Keynes had warned about the ramifications of the reparation agreement after WW I.

The hyperinflation and collapse of the German economy had two notable impacts.   The German people were receptive to the extreme ideology of Nazism that ultimately led to WW II and German policy makers to this day remain extremely sensitive to inflation. You can see the anti-inflation in the track record on German inflation which has consistently been among the lowest in Europe - a factor responsible for Germany's central position in the European movement towards a common currency.

In England, the abandonment of the gold standard in 1931 followed a protracted period of double digit unemployment, a situation also anticipated by Keynes who raised serious doubts about England's return to the gold standard in 1925. 

In the U.S., the Depression hit late and hard and was generally unexpected as can be seen in the statement of president Herbert Hoover in 1928.

"the greatness of America has grown out of a political and social system and a method of control of economic forces distinctly its own - our American system - which has carried this great experiment in human welfare further than ever before in all history. We are nearer today to the ideal of the abolition of poverty and fear from the lives of men and women than ever before in any land" Oct 22, 1928

But there were some early warning signs of problems.  The 1920 had been very rough on some important sectors in the US economy, most notably agriculture, mining, textiles, shoes, railroads, and shipbuilding.  It was also a time of growing inequality, increasing concentration in industry and rapid growth in labor productivity, declining union membership, and unsustainable increases in stock prices.  During the 20s we also saw the emergence of credit markets that allowed working Americans to buy now and pay later so that spending was able to outpace income.  This certainly helped spur growth in new consumer goods -radios, telephones, refrigerators, and automobiles.   But certainly there were limits to the credit expansion and by the late 20s the construction boom had ended, automobile sales had begun to fall, and business inventories were rising - a traditional leading indicator of the macro economy.  [For a more thorough discussion of the situation in the 1920s you should check out the Main Causes site.  One of the 'stats' noted there that provides a vivid image of the era's inequality is the comparison of Henry Ford's reported income of $14 million with the average income of $750.  By the end of the 1990s when average personal income was approximately $22,000, Henry Ford's earnings would exceed $410 million]. 

As for the magnitude of the collapse, it is nearly impossible today for us to comprehend fully the magnitude of the Great Depression.  One place to look would be some personal accounts of the Great Depression. You may also want to check out the The Federal Writers' Project of the 1930s where the life stories of more than 10,000 men and woman from a variety of occupations and ethnic groups were recorded.  You could also see it in the songs and literature of the time.  The lyrics from "buddy can you spare me a dime" vividly capture the speed and magnitude of the fall experienced by many.

They used to tell me I was building a dream
With peace and glory ahead
Why should I be standing in line
Just waiting for bread?...
Say, don't you remember, they call me Al
It was Al all the time
Say, don't you remember I'm your Pal!
Buddy, can you spare a dime?

One of the more visual images of the depression are the shanty towns that grew up on the outskirts of cities, much like what you see in many of the Latin American cities today.  These "towns" called Hoovervilles after the president, are described by journalist Charles Walker.

Another place would be at a few of the macroeconomic "stats" of the Depression that help convey a sense of the era. Within one year of the stock market's fall, GDP was down nearly 10 percent, unemployment had nearly tripled, and the first banking panic had triggered runs on the banks.  By 1932, GDP decline had average 10 percent per year, unemployment was approaching one-quarter of the labor force, international trade was down by two-thirds, stocks had lost 80 percent of their value, and about forty percent of the nation's banks had closed.  

On the inflation front, there was nothing that approached what we saw in pre - WW II Germany. The onset of the Depression in the U.S. was preceded by a period of deflation following a spike in the inflation rate during WW I, and the inflation rate continued to fall through the first half of the 1930s, bottoming out in 1932 when the price level fell 11 percent.   By 1932 the price level had fallen more than 50 percent from its 1929 level.

It is the unemployment rate, however, that offers us one of the more graphic images of the Depression and clearly indicates that this was a period in economic history on an order of magnitude larger than anything that we have seen since. At its peak, the unemployment rate reached 25 percent and remained above 15 percent for the entire decade. And those who were working were not taking home a BIG paycheck.  According to the Department of Labor, in 1932 wages in PA sawmill were $.05 per hour while women in TN mills earned  $2.39 per 50 hour week

Given these statistics, it is not difficult to see why American policy makers in the post WW II era were more concerned about unemployment than inflation, at least into the 1980s.

With a quarter of the work force unemployed, prices falling at double digit rates, and output down by a third, the pressure was on to find causes and cures.  In the US, Republicans remained committed to laissez-faire policies, a sentiment reflected in president Coolidge's statement, "The business of America is business." Coolidge was not alone on this, but simply one of three post WWI Republican presidents that believed the engine of growth was business and that the role of the government was to help the businesses grow.   In keeping with this philosophy, in the 1920 income taxes were lowered substantially with most of the savings going to those at the high end of the income distribution who were viewed as the creators of wealth. 

This was a decade where the government issued injunctions against striking workers; the Supreme Court took the side of business in disputes concerning unions, minimum wage laws, and child labor;   the Department of Commerce, under the direction of Herbert Hoover, expanded sharply as it took over the task of  aiding business growth;  federal spending was cut to reduce the deficit, more than 90 percent from wartime highs and nearly 40 percent in 1922; and taxes were cut, especially for the wealthy, under the direction of  the Secretary of the Treasury Andrew W. Mellon, one of the nation's richest men.  It came as no surprise that in the midst of a deepening economic crisis, Hoover vetoed legislation for direct federal aid and called in the army to disperse with force a crowd of unemployed veterans that had converged on Washington. One place where the government did intervene was in international trade and in June of 1930 Congress passed the Smoot-Hawley tariff that sharply raised import duties (40 percent). 

The hands-off, balanced budget policies offered by politicians was grounded in the writing of Classical economists.  You could almost see the theoretical underpinning to Hoover's comments in which he describes the self-correcting nature of the market.

Despite the mounting evidence to the contrary, economists and policy makers clung to the belief that the markets would eventually work, that the unemployment problem would be solved by lower wages and that the mounting inventories would be eliminated by slashing prices.  This would take a heavy toll on the weakest individuals and firms, but eventually the tide would turn and economic growth would return.

You can also see here the very real fear of strong government involvement in managing the economy - a recognition that these were tough times, but that the nation should not unleash the awful powers of government intervention.

"This is not an issue as too whether people shall go hungry or cold in then United States. It is solely a question of the best method by which hunger and cold shall be prevented. It is a question of whether the American people...will maintain the spirit of charity and mutual self-help... as distinguished ... from appropriations out of the Federal Treasury for such purposes... If we break down this sense of responsibility and individual generosity ... in times of national difficulty and if we start appropriations of this character we have ... impaired something infinitely valuable in the life of the American people... Once this has happened... we are faced with the abyss of reliance in future upon government charity in one form or another. I am confident that our people have the resources, the initiative, the courage, the stamina and the kindliness of spirit to meet this situation in the way they have met their problems over generations." Herbert Hoover February 1931

This created what Keynes described as a paradox. "The paradox is to be found in the 250,000 building operatives out of work in Great Britain, when more houses are our greatest material need." The Great Depression, coupled with the inability of the prevailing theorists and policy makers to adequately explain the Depression and to design policies to cure it, triggered many responses and opened the door for some 'radical' ideas.  Into the theoretical void stepped John Maynard Keynes who developed a theoretical explanation of the market system's inadequacies that produced the Great Depression.

It was a time for "reconsidering the possibilities of action," for questioning the judgment of those who believed that "there is no means consistent with sound finance and political wisdom, of getting the one [building operatives] to work at the other [building homes]." It was time to question "the statesman who, already burdened with the support of the unemployed, tells us that it would involve him in heavy liabilities, present and to come, which the country cannot afford, if he were to set the men to build the houses."

The ideas of Keynes were not lost on Franklin Delano Roosevelt who had been elected president of the US in 1932.  In his inaugural speech Roosevelt, recognizing the sense of urgency and the need for some action, stated:

"We must act, and act quickly... If we are to go forward we must move as a trained and loyal army willing to sacrifice for the good of a common discipline, because, without such discipline, no progress is made, no leadership becomes effective... I am prepared under my constitutional duty to recommend the measures that a stricken nation in the midst of a stricken world may require.... I shall... wage war against the emergency as great as the power that should be given to me if we were in fact invaded by a foreign foe."

What Roosevelt did not fully comprehend was that Keynes had provided the theoretical basis for launching such a war.  It is now time to return to the 1930s and map of the battle-lines between two very different views of the macroeconomy.  We will begin with an overview of the Classical model - the incumbent.  This is the view that dominated economic thinking and public policy at the outset of the Great Depression and examine the link between policy decisions and the prevailing theory.  Once we have reviewed the outlines of the prevailing view, in the next unit we will examine the views of a challenger that emerged in the 1930s - the Keynesian model.   This model of the macro economy that provides a very different view of the proper role of the government in managing the macro economy, one that was refined in the 1960s.