President Obama has been talking tough on deficit reduction, but many left-leaning pundits and economists warn that such rhetoric will prolong the economic slump. MSNBC host Rachel Maddow warned that Obamas proposed partial spending freeze was Herbert Hoovers strategy, while Budget Director Peter Orszag cautioned that FDRs attempt in 1937 to rein in the deficit prolonged the Great Depression. These warnings may also help prolong the economic slump because they are based on faulty history.
It is a complete myth that Herbert Hoover was a do-nothing advocate of laissez-faire. On the contrary, Herbert Hoover was a strong believer in an activist government response to cyclical downturns. He believed in a new economics that said high wages were the solution to business cycles.
After the stock market crash in 1929, Hoover urged the nations biggest employers to keep wage rates high, letting profits and dividends bear the brunt of the downturn. It was Hoovers insistence on maintaining wages that drove unemployment to unprecedented levels.
In financial panics prior to 1929, American presidents had largely minded their own business, allowing wages to fall along with prices. Yes, it was obviously a hardship for workers to accept pay cuts, but these were balanced by a falling cost of living. Yet Hoovers strategy for helping the workers was a disaster: Preventing wages from falling, in the face of plummeting prices for goods and services, meant that labor became relatively more expensive as the Depression wore on. This is why unemployment hit 25 percent by 1933.
In addition to his interference with the labor market, Hoover authorized unprecedented peacetime deficit spending, raising the budget 42 percent during his first two years. He implemented massive public works projects and schemes to raise farm prices. The Reconstruction Finance Corporation disbursed more than $1 billion in 1932a fantastic sum at the timeto bail out financial institutions.
It is true that in 1932, the Hoover administration became concerned about the deficit. But their primary solution was to increase taxes massively, in conjunction with only modest spending cuts. In 1931, the top income-tax rate was 25 percent. One year laterin the midst of the Great Depressionthe Hoover administration increased the top rate to 63 percent, more than doubling the tax rate of the nations most productive individuals in a single year.
Contrary to the pundits, the lesson of the Hoover administration is that an activist, tax-and-spend administration can turn a bad recession into the worst economic calamity in the nations history. The pundits interpretation of the Roosevelt record is almost as misguided.
According to Rachel Maddow, Paul Krugman, and the administrations staff economists, the U.S. economy began recovering nicely when Roosevelt first came into office in 1933 and began running massive deficits. But alas, Roosevelt lost his nerve and agreed to spending cuts in 1937, plunging the economy back into deep depression.
There are many flaws with this interpretation. For one thing, under Hoovers last fiscal year, the federal deficit was 4.5 percent of GDP. Under the first three years of the new Roosevelt administrationwhen things were apparently going swimmingly and unemployment was fallingthe deficit averaged 5.1 percent of GDP.
Are we seriously to believe that a difference of 60 basis points in the federal deficit was the dividing line between 25 percent unemployment under Hoover, and rapid recovery under Roosevelt? Surely there were other factors at work; it was not FDRs willingness to spend recklessly that helped the economy when he first came into office.
Consider also the collapse in military spending after World War II. From 1945 through 1947, the U.S. government went from a deficit of 21.5 percent of GDP to a budget surplus of 1.7 percent. Yet this evaporation of stimulus didnt lead to a second Great Depression. The economy quickly adjusted once the government released resources back into the private sector.
The pundits fail to understand that big government made the Depression last so long in the 1930s. Herbert Hoover and FDR both tried the biggest government interventions in U.S. history to fix the economy, and the result was the worst economy in U.S. history. It shouldnt surprise us that when George W. Bush and Barack Obama repeat the policies, we get similar results.
Robert P. Murphy is a Senior Fellow in Business and Economic Studies at the California-based Pacific Research Institute and the author of The Politically Incorrect Guide to the Great Depression and the New Deal. Contact him at [email protected].