"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"
"Now 'in the long run' this is probably true.... But this **long run** is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again."
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) - but the rebounds had tended to be swift and vigorous. And economic growth was strong, with GDP increasing 3.5% per year between 1874 and 1929, a rate that would double the economy's size every 20 years. GDP per capita, a better measure of the individual's welfare, grew at 1.5 - 2% per year so that income doubled every 40 years. The US had become an urban industrial power by 1929. 54 percent of its people living in cities (five cities having more than one million inhabitants) and individuals were 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. During this era there was general acceptance of the idea that if you wanted to work, there was work for you. If you were out of work, on the other hand, 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. According to Fisher, the dramatic stock prices rises were justified, and that there was no reason for concern. It was a confidence that died slowly. In the aftermath of the crash, you 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 had 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. It was a time when people used wheelbarrows to transport 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. A story emerging from Berlin and reported in the new York Times on October 30, 1923 gives a good sense of the magnitude of the problem.
"Give me all the food an American dollar will buy," was the order of a prosperous looking stranger in one of the lesser restaurants in Berlin. Such lavish orders are unusual in these days of bad exchange rates, but the waiter recovered from his astonishment and began to serve the guest.
Soup, several meat dishes, fruit and coffee were served. While the guest was smoking his cigar the waiter brought another plate of soup, and later another meat dish.
"What does this mean?" the astonished and satisfied guest asked.
The waiter bowed politely and replied: "The dollar has gone up again."
Another indicator of the severity of the inflation was reported on August 28, 1923 in the New York Times. The German central bank had set the dollar exchange rate at 5,6000,000 marks to the dollar at 1 PM, and by the close of the day the rate had risen to 7,000,000. In the matter of a few hours the buying power of Germans had dropped twenty percent. By the time the hyperinflation had ended in April of 1924 the US dollar was worth 4.2 trillion marks, up from a price of only 2,000 marks a year earlier.
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 world asked Germany to pay their bills for causing the war - and they did by printing money - lot's of it.
And this was not the world's last bout of hyperinflation. One of the most vicious was the hyperinflation in Yugoslavia in the 1990s that helped wreck the Yugoslavian economy. It was triggered by Slobadon Milosovic who attempted to pay for his military "machine." To pay his soldiers and purchase the necessary equipment, Yugoslavia followed Germany's lead and printed lot's of money. Inflation raged for nearly two years, peaking in January of 1994 when it reached 313 million percent a year. At that time there were in circulation 500-billion dinar notes, worth a mere 4.15 German marks when they were printed on December 23, 1993.
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 bias 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. As Steve Henke, former advisor to the vice president of Yugoslavia, saw it, the pattern was simple: "Wreck an economy, then start a war: Its an age-old power preservation ploy." It was what we saw in Germany in the 1930s and Yugoslavia in the 1990s and many countries in between.
In England, the 1930s was to some extent a continuation of the 1920s. The decision to return to the gold standard at the pre WWI price of gold meant England's products were overpriced on the world market. When England's companies could not sell their wares in the international marketplace, they laid workers off and lowered prices which pushed wages down. In the 1920s England experienced deflation nearly every year, and by 1930 the price level had fallen by nearly 50 percent. And people do not lower prices when times are good. The declines accompanied 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. And things did not improve in the 1930s and by 1931 England was forced to abandon the gold standard.
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
The fact is the 1920s were a "Roaring" decade. It was a time the US witnessed three new entertainment technologies - the radio, talking movies, and television. In 1920 KDKA in Pittsburgh was the first station to go on the air and seven years later Warner Brothers introduced the Jazz Singer starring Al Jolsen and Herbert Hoover, then Secretary of Commerce, had demonstrated the ability of TV. His speech in Washington, DC was seen in NYC on a screen that measured two by three inches. As the New Your Times reported on April 8, 1927, "Time as well as space was eliminated." Excitement with the new technologies helped propel the stock market on to dizzying heights.
If you had looked carefully, however, there were some early warning signs of problems. The 1920s 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. 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].
And then there was the stock market. despite the continued advances, not all were confident that the price increases were sustainable. By the mid 1920s there were concerns being raised about the speculative nature of the stock market. An example comes from the New York Times on November 15, 1925.
"...there are times when the rise in [stock] prices...gathers such support from an excited speculative public that eventually the market becomes uncontrollable; that prices of stock lose all relation to earnings and dividends and the business outlook; ...
No market of this kind was ever created without some direct appeal to the speculative imagination.
As for the magnitude of the collapse, it is nearly impossible today for us to fully comprehend 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 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.
"The place is a collection of shanty hamlets. from 150 to 200 men live in the shanties. The place is called by its inhabitants Hooverville. the inhabitants were not, as one might expect, outcasts or untouchables, or even hoboes. They were men without jobs. This pitiable village would be of little significance if it existed only in Youngstown, but nearly every town in the United states had its shanty town for the unemployed, and the same instinct has named them all Hooverville."
The damage done by the Depression was not constrained to the cities. These were difficult times for the rural areas of the country even though the reaction of many to the Depression was to leave the cities and head to the open country where you could live off the land. The situation was captured by John Steinbeck in his book, The Grapes of Wrath.
"And then the dispossessed were drawn west - from Kansas, Oklahoma, Texas, New Mexico: from Nevada and Arkansas families, tribes, dusted out, tractored out. Carloads, caravans, homeless and hungry; twenty thousand and fifty thousand and two hundred thousand. They streamed over the mountains, hungry and restless... The kids are hungry. We got no place to live. Like ants scurrying for work, for food, and most of all for land... and the dispossessed, the migrants, flowed into California, two hundred and fifty thousand, and three hundred thousand. Behind them ... [other] tenants were being forced off [their lands]. And new waves were on the way, new waves of the dispossessed and the homeless, hardened, intent, and dangerous."
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 - the situation depicted in the classic movie that is replayed every Christmas season - It's a Wonderful World. By 1932, GDP decline had averaged 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 when it reached above 20 percent. In the thirties the inflation rate fell through the first half of the decade, 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 - a situation similar to what we had seen in England in the previous decade.
It is the unemployment rate, however, that offers us one of the more graphic images of the Depression and clearly indicates this was a period in economic history on an order of magnitude larger than anything 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 for a 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 until 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 who believed the engine of growth was business, and the role of the government was to help the businesses grow. This could be seen in a number of government policies in the 1920s - 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 under the direction of Secretary of the Treasury Andrew W. Mellon, one of the nation's richest men, taxes were cut, especially for the wealthy. 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) - an effort to protect American companies and workers from cheap foreign labor and a precursor of arguments raised in the 1970s and 1980s.
The hands-off, balanced budget policies offered by politicians were grounded in the writing of Classical economists. You could almost see the theoretical underpinning to Hoover's comments appearing in his memoirs in which the self-correcting nature of the market system is described.
"Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people."
Despite the mounting evidence to the contrary, economists and policy makers clung to the belief that the markets would eventually work, the unemployment problem would be solved by lower wages, and 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. And the war was launched quickly in the first 100 days of Roosevelt's administration and by the end of the decade things had been forever changed, although many of the New Deal's policies did not survive. The government's role in managing the economy would grow substantially - and with this growth came higher spending and a wide array of government legislation introduced as part of the New Deal. This was the period where the US began to provide some security to Americans from the ravages of the macroeconomy - bank deposit insurance to protect workers, Social Security to protect the elderly, and minimum wages to protect low income workers. It was also a time where we saw the government attempt to take more direct control of American industry with passage of the Industrial Recovery Bill. As reported in the New York Times on June 18, 1933, President Roosevelt envisioned the Act as providing for "a great cooperative movement throughout all industry in order (1) to obtain wide re-employment; 92) to shorten the working week; (3) to pay decent wages for the shorter week; (4) to prevent unfair competition, and (5) to prevent disastrous overproduction." Also included in the Act was substantial money for public works and construction projects. With passage of the Agricultural Adjustment Act, meanwhile, Roosevelt attempted to reduce overproduction in agriculture as a means to bolster sagging farm income. And to control the securities and banking industries that were seen by many to be behind the crash, the Securities and Exchange Act of 1934 restricted the activities of investment banks and the Glass-Steagall Act of 1933 separated the businesses of commercial and investment banking. The 1930s also gave us scheduled intercontinental air flights (1939), nylon (1939), which was an instant hit when the first stocking hit the shelf in October, and Disney movies ("Snow White and the Seven Dwarfs" in 1937).
It is now time to turn 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. Once we have outlined the theory we will examine the link between macro policy decisions and the prevailing theory. It is here where you will be introduced to the concept of "crowding-out," the centerpiece of the Classical model. When you are finished this section you should understand why monetary and fiscal policies were seen to be useless as tools for guiding the macro economy.
As the Great Depression continued, pressure mounted to do something. The theoretical underpinnings of the action were provided by an English economist in the 1930s. John Maynard Keynes had watched England suffer through a very long and painful depression in the 1920s and by the 1930s he had developed a "General Theory" to explain the problem - a theory that would rise to challenge and then overthrow the Classical model. In the second section of this Unit we will look at the outlines of this anti-depression model - the Keynesian model. As you will see, this model of the macro economy provides a very different view of the proper role of the government in managing the macro economy. The key concept here is the "multiplier." If the government wants to get the economy moving out of the depression, then all it will need to do is jump start the economy with a little spending and the system will create the jobs and income to return prosperity to the nation. It sounded great, but first let's look at the Classical model.