A review of Rethinking the Great Depression, by Gene Smiley

Americans these days are relatively ahistorical in their intellectual interests; in a recent survey 40% of seniors at some of our nation's top universities and liberal arts colleges incorrectly identified the half-century in which the Civil War was fought. Economists are particularly indifferent, even hostile, to historical analysis, and regard economic historians as lesser members of the professional fraternity. The single subject that is an exception to this rule is the Great Depression, an episode that has fascinated economists ever since. For a full decade, the country had double-digit unemployment, falling national wealth, and a sense of national ennui and gloom. Out of that experience came political upheavals that led to the modern American welfare state and, in Europe, to Adolf Hitler and World War II. The Great Depression was the defining economic event of the 20th century. 

Gene Smiley, a professor of economics at Marquette University, has written an engaging, balanced, and perceptive short book that draws upon the vast literature on the Depression to answer the enduring questions: Why did the Depression occur? Why did it last so long? Was the Depression shortened or lengthened by the public policies of the Hoover and Roosevelt administrations? How did the American record in dealing with the downturn compare with other countries? What was the long-term legacy of the Depression for the American economy? Rare for an economist, Smiley writes clearly and largely eschews jargon, telling a story that non-economists can understand, but that appeals also to those with greater technical economic expertise.

Over the last 60 years or so, there have been four kinds of explanations concerning why the Depression occurred. The first is the underspending hypothesis, the Keynesian favorite, which dominated discussion for several decades. According to this view, the Depression arose from underspending on consumer durables and housing in the very late '20s, which, in turn, may have been a byproduct of the maldistribution of income during that roaring decade (a twist favored by John Kenneth Galbraith). The stock market crash had a profoundly negative psychological impact, leading both consumers and investors to be cautious in their spending habits. Underinvestment and underconsumption following the stock market crash led to a need for "fiscal stimulus" in the form of government-induced increases in aggregate demand, preferably from government spending increases, but also from tax reductions. In the Keynesian view, that stimulus was not provided, at least not in sufficient doses. Smiley thinks, correctly in my judgment, that this explanation is fundamentally faulty, and largely ignores it.

A second explanation, which grew in popularity in the 1960s and 1970s, focuses on the money supply and the failure of the Federal Reserve to stem a sharp decline in it, which induced significant deflation, leading to bank failures and the subsequent paralysis of business. This monetarist explanation, championed by Milton Friedman and others, is respected by Smiley, who believes that bank failures and related happenings played a major role in the big economic descent after 1929.

A third explanation builds on old neoclassical notions of the determinants of employment and unemployment, and on the Austrian theory of Ludwig von Mises and Friedrich Hayek. It argues that excessive monetary creation by the Federal Reserve in the 1920s led to artificially low interest rates, which induced a spending boom that set the stage for the 1929 stock market crash. Subsequently, Hoover's and Roosevelt's coercion of American business prevented appropriate wage adjustments from being taken to alleviate unemployment. Other interferences in markets (e.g., price-fixing under the National Industrial Recovery Act) helped prolong the downturn as well. Smiley likes this perspective, and draws on works by Murray Rothbard, Lowell Gallaway, and me in his account of it. For example, he provides rich detail on how the High Wage policy worked in practice, both during the Hoover downturn and the tepid Roosevelt recovery.

The final explanation emphasizes the international dimensions of the downturn, a perspective stressed by Herbert Hoover himself and numerous scholars since. The Federal Reserve's fixation on the maintenance of the gold standard led to policies that were wholly inappropriate, such as in 1931 increasing the discount rate (interest rate) that banks had to pay to borrow from the Fed at precisely the time when appropriate monetary policy (from the domestic standpoint) would have been the opposite. Add to that the folly of the Smoot-Hawley tariff, enacted in 1930, and its subsequent disastrous impact on imports to the U.S., and you have the basis of a severe and prolonged downturn. Smiley loves this explanation, advanced in modern times by Barry Eichengreen and others, and gives it prime billing.

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The three types of explanation that Smiley emphasizes focus on failures of public policy—poor Federal Reserve decisions, inappropriate tariffs (not to mention higher income taxes), government-induced manipulation of wages and prices by presidential "jawboning," laws like the National Industrial Recovery Act, and so forth. The modern literature, well-interpreted by Smiley, has moved dramatically away from the traditional Keynesian story of market failure—of the inability or unwillingness of individuals and businesses to spend enough money to get us out of the Depression. A major intellectual rationalization for modern big government—that it must play an activist role to overcome market-induced spending deficiencies, thereby preventing major downturns—stands largely discredited, not by right-wing ideologues but by scholars of every political stripe investigating nearly every aspect of the Depression. Perhaps unexpectedly, and certainly without much public acknowledgement, the Depression's use as a laboratory to evaluate economic theories has contributed to a sharp decline in Keynesian influence in the economics profession. By masterfully summarizing most of the research and making it accessible to the lay reader in a compelling manner, Smiley provides a great public service.

Smiley's account is quite short, with the actual Depression story discussed in four chapters of about 45,000 words. Though it is not encyclopedic in its coverage, he provides enough detail for the reader to get a good feel for the major problems causing the downturn. For example, economists and historians are nearly universal in their condemnation of the National Industrial Recovery Act and the National Recovery Administration (NRA) run by General Hugh Johnson. Smiley provides more than 15 pages of relentless evidence that the fuzzy, price-fixing cartelization promoted by that ill-conceived legislation worsened the climate for American business. Wages soared in 1933 in the face of high unemployment, forced up by the underconsumptionist mandates of the NRA, which, in turn, thwarted the budding recovery that followed the end of the 1933 banking crisis. Workers were priced out of the market, virtually halting a promising rise in employment. Activist government intervention in the economy—new regulatory agencies like the Securities and Exchange Commission and the National Labor Relations Board, new make-work relief agencies like the Civilian Conservation Corps, new entitlement programs like Social Security—did not speed recovery, but actually retarded it compared with historical American norms (e.g., the 1920-1922 downturn) or those of other countries.

Smiley devotes about a fifth of the book to the Depression's long-term impact on the American people. He points out how many of the nation's leading contemporary problems are related to Depression-era legislation, especially the funding of Social Security benefits. Indeed, this is the 21st century's biggest domestic policy challenge: how to deal with a financially weak Social Security system that reflects a Ponzi-scheme funding system that has its roots in the Great Depression.

Not only was the Depression a tragedy when it occurred, but it spawned a welfare state that has had profound impacts—many negative—on modern society. Deposit insurance, universally hailed as one of the great success stories of the Depression, led to literally hundreds of billions of dollars of liabilities for the federal government during the savings and loan crisis of the 1980s—and that crisis was aggravated by risky lending practices that uniform-rate deposit insurance encouraged. The separation of investment and commercial banking, enacted in haste during the First Hundred Days of the Roosevelt Administration, led to inefficiencies in American banking and declining competitiveness for U.S. financial service firms, which led to its repeal, following the earlier termination of equally inefficient prohibitions on the payment of interest on demand deposits. The promotion of labor unions by New Deal laws (especially the Wagner Act of 1935) unquestionably hastened the demise of much of American manufacturing, as capital fled the high labor costs that unions encouraged. Minimum-wage laws did little to help the poor, but created unemployment for some workers, disproportionately members of minority groups. In short, many Depression-era laws did nothing to end the Depression, but imposed significant long-term costs on American society.

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My quarrels with this book are minor, and in no way detract from my judgment that it is the best short survey of the period for the general reader. I do think Smiley overemphasizes the international causes of the Depression. Imports and exports were only about 5% of national output at the time the Depression began (today, imports are twice as important relatively), so America was more isolated than most nations from external economic shocks. It is true that international concerns affected domestic economic policy, often adversely. Yet the inappropriately tight monetary policy enacted at the time of the mid-1931 European financial crisis came only after the country was well into the Depression—when unemployment rates were already around 15-17%, over half the way to their March 1933 peak.

In my view, the internal interaction between labor and financial markets caused most of the downturn, and ill-advised "reforms" with little international content largely explain the tepid recovery. Hoover's High Wage policy was prompted by the proto-Keynesian view that if employers maintained good wages, consumption spending would not decline much, thus moderating the downturn. This view ignored the Law of Demand, which in this context means that the higher the costs of labor, the more the employers will reduce their staffs. Thus the initial downturn was sharper and longer than would have otherwise been the case.

Unfortunately, the High Wage policy devastated business—sales were falling, but wage costs were not declining much. Profits went quickly from positive to negative. This, in turn, increased the risk of owning debt instruments of American firms. Banks were major corporate creditors. The value of their loan (and bond) portfolios started to decline, raising doubts as to their ability to meet depositor obligations. This led to a decline in the ratio of deposits to currency, beginning in October 1930, that was the single most important factor in the monetary decline. This deterioration of the monetary stock was magnificently described by Milton Friedman and Anna Schwartz in their Monetary History of the United States more than 40 years ago. The international dimension was a secondary cause. 

Europe by and large got out of the Depression faster than the U.S., whereas double-digit unemployment persisted in the United States into the 1940s. The reason is simple: New Deal economic policy was counterproductive. Roosevelt's NRA and Wagner Act institutionalized and extended the high-wage policy so disastrously introduced by Hoover. The intense anti-business attitudes of the president and his associates, so vividly described by Smiley, added to the low level of business confidence and the sluggishness of investment in the later 1930s.

America's Great Depression was largely self-inflicted. Gene Smiley brilliantly describes this tragedy and its long-term consequences.