The Lessons of 1937: Learn From the Roosevelt Recession of 1937 Before Creating the Obama Recession of 2014

Below are three articles that explain an important lesson from the New Deal: cutting the federal budget can prolong a recession or cause another economic collapse if the cuts occur before the economy has recovered. This lesson was learned the hard way in 1937 when after a tremendous recovery from the depression — rapid economic growth and dramatic decline in unemployment — President Roosevelt, who was always concerned about deficit spending, cut New Deal spending and another economic collapse began. In 1938 spending resumed and the economy returned to growth. President Obama and the Congress never provided adequate stimulus and did so primarily through inefficient tax breaks rather than direct spending so the U.S. has had a very weak “recovery” with continued high unemployment and minimal growth. Now they are about to make that error worse by putting in place austerity measures that will take more money out of the economy. They need to learn the lessons of history, especially the Roosevelt Recession of 1937 before they create the Obama Recession of 2014.  KZ

Policymakers Must Learn from the Errors that Prolonged the Depression

By Christina Romer
The Economist, June 18th 2009

AT A recent congressional hearing I cautiously noted some “glimmers of hope” that the economy could stabilise and perhaps start to rebound later in the year. I was asked if this meant that we should cancel much of the remaining spending in the $787 billion American Recovery and Reinvestment Act. I responded that the expected recovery was both months away and predicated on Recovery Act spending ramping up greatly. Only later did it hit me that I should have told the story of 1937.

The recovery from the Depression is often described as slow because America did not return to full employment until after the outbreak of the second world war. But the truth is the recovery in the four years after Franklin Roosevelt took office in 1933 was incredibly rapid. Annual real GDP growth averaged over 9%. Unemployment fell from 25% to 14%. The second world war aside, the United States has never experienced such sustained, rapid growth.

However, that growth was halted by a second severe downturn in 1937-38, when unemployment surged again to 19% (see chart). The fundamental cause of this second recession was an unfortunate, and largely inadvertent, switch to contractionary fiscal and monetary policy. One source of the growth in 1936 was that Congress had overridden Mr Roosevelt’s veto and passed a large bonus for veterans of the first world war. In 1937, this fiscal stimulus disappeared. In addition, social-security taxes were collected for the first time. These factors reduced the deficit by roughly 2.5% of GDP, exerting significant contractionary pressure.

Employment 1920-1940

Also important was an accidental switch to contractionary monetary policy. In 1936 the Federal Reserve began to worry about its “exit strategy”. After several years of relatively loose monetary policy, American banks were holding large quantities of reserves in excess of their legislated requirements. Monetary policymakers feared these excess reserves would make it difficult to tighten if inflation developed or if “speculative excess” began again on Wall Street. In July 1936 the Fed’s board of governors stated that existing excess reserves could “create an injurious credit expansion” and that it had “decided to lock up” those excess reserves “as a measure of prevention”. The Fed then doubled reserve requirements in a series of steps. Unfortunately it turned out that banks, still nervous after the financial panics of the early 1930s, wanted to hold excess reserves as a cushion. When that excess was legislated away, they scrambled to replace it by reducing lending. According to a classic study of the Depression by Milton Friedman and Anna Schwartz, the resulting monetary contraction was a central cause of the 1937-38 recession.

The 1937 episode provides a cautionary tale. The urge to declare victory and get back to normal policy after an economic crisis is strong. That urge needs to be resisted until the economy is again approaching full employment. Financial crises, in particular, tend to leave scars that make financial institutions, households and firms behave differently. If the government withdraws support too early, a return to economic decline or even panic could follow. In this regard, not only should we not prematurely stop Recovery Act spending, we need to plan carefully for its expiration. According to the Congressional Budget Office, the Recovery Act will provide nearly $400 billion of stimulus in the 2010 fiscal year, but just over $130 billion in 2011. This implies a fiscal contraction of about 2% of GDP. If all goes well, private demand will have increased enough by then to fill the gap. If that is not the case, broad policy support may need to be sustained somewhat longer.

Perhaps a more fundamental lesson is that policymakers should find constructive ways to respond to the natural pressure to cut back on stimulus. For example, the Federal Reserve’s balance-sheet has more than doubled during the crisis, drawing considerable attention. Monetary policymakers have made it clear that they believe continued monetary ease is appropriate. Moreover, the Fed’s credit programmes are to some degree self-eliminating: as demand for its special credit facilities shrinks, so will its balance-sheet. But now may also be a sensible time to grant the Fed additional tools to help its balance-sheet contract once the economy has recovered. Some have suggested that the Fed be authorised to issue debt, as many other central banks do. This would enhance its ability to withdraw excess cash from the financial system. Granting such additional tools now could provide confidence that the Fed will be able to respond to inflationary pressures, without it having to create that confidence by actually tightening prematurely.

Fiscal health check

Now is also the time to think about our long-run fiscal situation. Despite the large budget deficit President Obama inherited, dealing with the current crisis required increasing the deficit substantially. To switch to austerity in the immediate future would surely set back recovery and risk a 1937-like recession-within-a-recession. But many are legitimately concerned about the longer-term budget situation. That is why the president has laid out a plan to shrink the deficit he inherited by half and has repeatedly emphasised the need to reduce the long-term deficit and put the debt-to-GDP ratio on a declining trajectory. In this regard, health-care reform presents a golden opportunity. The fundamental source of long-run deficits is rising health-care expenditures. By coupling the expansion of coverage with reforms that significantly slow the growth of health-care costs, we can dramatically improve the long-run fiscal situation without tightening prematurely.

As someone who has written somewhat critically of the short-sightedness of policymakers in the late 1930s, I feel new humility. I can see that the pressures they were under were probably enormous. Policymakers today need to learn from their experiences and respond to the same pressures constructively, without derailing the recovery before it has even begun.

Christina Romer was the chairwoman of Barack Obama’s Council of Economic Advisers when this was written and a scholar of the Depression

Did the New Deal work?

By Phil Ebersole
January 30, 2012

Currently a strong effort is being made to discredit the New Deal by opponents of public works, unemployment insurance and other government programs to revive the economy in recession.

The case against the New Deal is that unemployment never fell to pre-1929 levels until the coming of World War Two. But by other economic measures, the New Deal was in fact a success. The top chart above measures Gross Domestic Product in terms of by what percentage it was higher than its low point in March 1933. The bottom chart above measures industrial production by what percentage it was higher or lower than in October 1929 when the Great Depression began.

The two charts showed that economic recovery began when President Roosevelt took office, and faltered only in 1937 when he decided that his economic recovery program had achieved its goal and did not need to be continued. Full recovery came in the run-up to World War Two.

Now it is impossible to be certain to what degree recovery was due to the New Deal and to what degree it was due to the natural swing of the economic cycle. The only way you could have proof one way or the other would be to have two timelines, one with a New Deal and one without, which is impossible outside science fiction. The case for the New Deal is that economic recovery started to falter in 1937 with President Franklin Roosevelt started to curtail government spending and return to a balanced budget. The only way you could convince me that the New Deal was futile would be to show me a nation that brought about economic recovery through economic austerity.

U.S. Employment 1920-1940


Here is a chart showing the rise and fall of employment during the 1920s and 1930s. Raw employment numbers give an overly favorable impression, because a certain amount of job growth is needed just to stay even—that is, just to keep up with population growth. Even so, the chart shows that the U.S. economy did generate millions of new jobs during the New Deal period.

Here is the perspective of Charles W. McMillion, former associate director of the Johns Hopkins University Policy Institute and a former contributing editor of the Harvard Business Review.

The official U.S. Business Cycle Dating Committee established that the downturn that began in August 1929 ended in March 1933 with the remarkable economic expansion that started within days of FDR’s bold—if trial and error—New Deal programs. By any normal definition, the Great Depression had ended by late 1936, with all major indicators surpassing their previous peaks.

A second cyclical downturn officially began in May 1937 when FDR, always a fiscal conservative, mistakenly thought the economy had become self-sustaining and slashed public spending programs to balance the budget. These harsh and premature spending cuts caused another severe recession that ended after 13 months in June 1938.

Even in this severe downturn, annual GDP did not fall back below its 1929 peak. And although many suffered and most economic measures did fall back below their 1929 levels, not one fell anywhere close to its March 1933 low. For example, although industrial production fell sharply in the 1937-38 recession, at its low point, in April 1938, it remained 49 percent above its level of March 1933.

When the economy again contracted sharply in late 1937 and early 1938, FDR quickly reversed course and rapid growth immediately began again. GDP soared by 10.9 percent in 1939 and industrial production soared by 23 percent. … …

Despite the new record peak in the number of jobs by late 1936, because of population growth and because more people were encouraged to seek jobs, the unemployment rate did remain very high until public spending programs truly exploded with the start of World War II. But even here, it was again vastly expanded government spending, this time to fight the war, that ended high unemployment. … …

Myth and ideology aside, the data show that from 1933 through 1936 the New Deal produced double-digit annual growth in GDP, production, after-tax income and private investment, with strong consumer spending and job growth exceeding their peaks in the 1929 bubble. The Great Depression ended by late 1936.

While a new, severe recession began in May 1937 because FDR prematurely slashed public spending on New Deal programs, rapid growth quickly resumed in late 1938 when funding was restored. … …

Today, the U.S. and the world again face extreme crises similar to those in the early days of the 1930s. The largely unregulated private financial and commercial sector has utterly bankrupted itself. … …

But history has shown that crisis can bring people together in common, public purpose or it can set them against one another. Our circumstances are far too dangerous to leave uncorrected the antigovernment disinformation and myths from the 1930s, and in our own generation. [Emphasis Added]

Click on The “FDR Failed” Myth for McMillion’s complete article for Campaign for America’s Future, which was the source of the top two charts.

Click on Learning from the New Deal’s Mistakes for more on what the New Deal actually did. [Added 1/31/12]

The Real Lesson From the Depression Fiscal Policy Works

New Attacks on FDR’s New Deal Fueled by Old – and Discredited – Ideology

By Marshall Auerback
Roosevelt Institute

If the US government had a dollar every time someone proclaimed to learn the lessons of the Great Depression, we probably wouldn’t have a budget deficit. Usually, these debates turn on the question of fiscal policy and whether in fact, FDR’s New Deal had a discernable role in generating recovery. “Fiscal austerians” have done much to dismiss the economic achievements of the New Deal, some even suggesting that FDR’s fiscal policies worsened the crisis.

For a brief period during 2008, the views of neo-liberals like Alan Greenspan and Robert Rubin were shunted aside. But the FDR revisionists, who disapprove of fiscal policy measures of any kind, have come back. Now they’re brandishing the old arguments that “excessive” government spending risks “crowding out” private spending, making it impossible for the US government to deal with the recession (because it has run out of money) and hindering the capacity of the private sector to recover because of too much government interference in the “free market”. These complaints are usually accompanied by a wave of rhetoric condemning the “business un-friendly” policies of the current Administration, along with dire warnings of a “national solvency” crisis. After all, fiscal austerians are nothing, if not fully predictable.

Was the 1937 Relapse Caused by Increased Taxes and Unions?

In that context, we have to give some credit to Professors Thomas Cooley and Lee Ohanian, who have taken a more novel approach in their critique of the New Deal. In some respects, they actually validate the case for fiscal policy expansion (although the two authors might not see it that way). Cooley and Ohanian argue that:

“The economy did not tank in 1937 because government spending declined. Increases in tax rates, particularly capital income tax rates, and the expansion of unions, were most likely responsible. Unfortunately, these same factors pose a similar threat today.”

The OMB numbers suggest that spending actually DID decline in 1937 and 1938 (see here) and, contrary to the assertions of Cooley and Ohanian, that decline had a very deleterious impact on economic activity and employment. I will address the tax issue presently, but let’s first deal with the “excessive unionization” canard. An objective observer looking at the US in the 21st century would hardly conclude that unions have any real power in the American economy today, any more that we have a “socialist” government dedicated to the promotion of a vast left wing agenda which enhanced union power. Obama has not addressed Labor Law reform and wages haven’t risen in a generation; in fact, last year they fell.

True, the President occasionally does display a social democratic rhetoric, but so far, redistributive policies have primarily benefited financial institutions. Social security benefits are under threat via a new “bipartisan commission” on long term deficits, public health care insurance proposals were eviscerated in the “health care reform” bill, and trade unions outside the public sector have withered over the past 30 years. Cost of living adjustment clauses have largely disappeared since the early ‘80s (although some government benefits like social security retain them), average hourly earnings are virtually flat, and I would not be surprised to see wage deflation before the unemployment rate peaks this time around. US households are paying down debt on a net basis — even credit card debt — and creditors remain reluctant to make new loans. So the odds of a wage/price spiral taking root as a consequence of excessive union power look decidedly low – in fact, close to zero.

On the other question of taxes, I actually have some degree of sympathy with the arguments of Cooley and Ohanian, but largely because functionally, a tax increase works as a countercyclical policy which mitigates the impact of fiscal policy expansion.

Let’s go back to basics. Under a fiat currency regime, such as we have in the US, when the Federal government spends, it electronically credits banks accounts. Taxation works exactly in reverse. Private bank accounts are debited (and private reserves fall) and the government accounts are credited and their reserves rise. All this is accomplished by accounting entries only, but the main point is that spending creates new net financial assets and taxation drains them.

So in one sense, Cooley and Ohanian are right. Tax hikes do cut aggregate demand, much as government spending cuts do. In economic terms, both serve to depress economic activity. We agree with the authors: tax rises at this juncture are a dumb idea. They won’t serve to “reduce” the deficit, because the resultant impact on private sector activity is likely to diminish it and thereby increase the gap between government expenditures and revenues as the economy slows down.

The broader issue of government spending versus tax cuts is a political/distributional argument, and economists (and others) can legitimately argue about the respective multiplier effects of one versus the other. But at least this kind of discussion shifts the debate in the right direction –toward increasing economic activity and, hence, job growth and away from wrong-headed discussions of fiscal austerity and deficit reduction as a primary policy goal of government. FDR ran into trouble only when he moved away from fiscal expansion toward austerity in 1937.

At the outset of the Great Depression, economic output collapsed, and unemployment rose to 25 per cent. Influenced by his “liquidationist” Treasury Secretary, Andrew Mellon, then President Hoover made comparatively minimal attempts to deploy government fiscal policy to stimulate aggregate demand. Further, the Federal Reserve actually sold bonds to push up interest rates in a mindless effort to stem the gold outflows that we occurring as the rest of the world lost confidence in the US economy. So much for the halcyon days of the gold standard!

FDR’s Employment and Wage Strategy Worked

This all changed under FDR. The key to evaluating Roosevelt’s performance in combating the Depression is the statistical treatment of many millions of unemployed engaged in his massive workfare programs. The government hired about 60 per cent of the unemployed in public works and conservation projects that planted a billion trees, saved the whooping crane, modernized rural America, and built such diverse projects as the Cathedral of Learning in Pittsburgh, the Montana state capitol, much of the Chicago lakefront, New York’s Lincoln Tunnel and Triborough Bridge complex, the Tennessee Valley Authority and the aircraft carriers Enterprise and Yorktown.

It also built or renovated 2,500 hospitals, 45,000 schools, 13,000 parks and playgrounds, 7,800 bridges, 700,000 miles of roads, and a thousand airfields. And it employed 50,000 teachers, rebuilt the country’s entire rural school system, and hired 3,000 writers, musicians, sculptors and painters, including Willem de Kooning and Jackson Pollock. So much for the notion that government jobs are not “real jobs”, as we hear persistently from critics of the New Deal!

The reasons for the discrepancies in the unemployment data that have historically arisen out of the New Deal are that the current sampling method of estimation for unemployment by the BLS was not developed until 1940 (for more detail see here). If these workfare Americans are considered to be unemployed, the Roosevelt administration reduced unemployment from 25 per cent in 1933 to 9.6% per cent in 1936, up to 13 per cent in 1938 (due largely to a reversal of the fiscal activism which had characterized FDR’s first term in office), back to less than 1 per cent by the time the U.S. was plunged into the Second World War at the end of 1941.

In fact, once the Great Depression hit bottom in early 1933, the US economy embarked on four years of expansion that constituted the biggest cyclical boom in U.S. economic history. For four years, real GDP grew at a 12% rate and nominal GDP grew at a 14% rate. There was another shorter and shallower depression in 1937 largely caused by renewed fiscal tightening (and higher Federal Reserve margin requirements).

This economic relapse has led to the misconception that the central bank was pushing on a string throughout all of the 1930s, until the giant fiscal stimulus of the wartime effort finally brought the economy out of depression. That’s factually incorrect. Most accounts of the Great Depression understate the effect of the New Deal job creation measures, because they don’t show how much of the decline in official employment was attributable to the multiplier effect of spending on direct job creation. Also, the “work relief” category does not include employment on public works funded by the Public Works Administration (PWA) nor the multiplier effect of PWA spending. The figures tell the story indirectly, however, in the path official unemployment followed — steeply declining in periods when work relief spending was high and either declining more slowly or increasing in periods when work relief spending was cut back. In fact, by the end of 1934, more than 20 million Americans (one out of six!) were receiving jobs or public assistance of one form or another from the “Welfare State”.

Yes, 9.6% unemployment at the end of 1936 was still a big number. But it’s hard to imagine the Democrats being in political peril for the midterms, or witnessing the current abysmal state of Obama’s popularity ratings, if today’s Administration could reduce unemployment by two-thirds in one term in office, as FDR did under any honest measure of unemployment. Suffice to say, unemployment reduction was the singular focus of the Roosevelt Administration; by contrast, today we have “the new normal”, in effect, a faux intellectual argument to justify why we can’t generate higher job growth. It’s a testament to political failure.

In reference to the criticism of FDR’s “high wage” policy by Cooley and Ohanian, it is worth noting that the wage “inflation” which they decry was in reality a product of a deflationary environment in which the general price level fell faster than the money wage level. During the outset of the Great Depression, output generation collapsed in the face of the US federal government’s fiscal inaction and central bank interest rate hikes. This had the strange result of generating a counter-cyclical real wage increase, which in fact was nothing more than a product of depressed nature of the economy, in which overall prices were deflating prices faster than wages (for more information see here).

Overlaying the wage data with the true reduction in unemployment between 1933 to the end of 1936, makes it difficult to mount an empirical case that FDR wage improvements during the Great Depression were damaging to overall economic growth and increasing employment. Even if some sectors were disadvantaged (and that isn’t proven by Cooley and Ohanian) the evidence actually suggests that the rises in real wages were associated with rising overall employment.

Relapse Caused by Austerity Measures

What about the relapse in 1937/38? By 1936 many economists and financial experts (notably FDR’s Treasury Secretary, Henry Morgenthau) feared the country would go bankrupt if the government kept deficit-spending (sound familiar?). And after all, they argued, the government deficits had “pump-primed” the economy. The private sector could now take off on its own and get back to close to the full employment level of 1928-early 1929.

Consequently, Roosevelt ran (in 1936) on a platform that he would try to reduce, if not eliminate, the deficit. He won the election by a landslide — understandably, as the U.S. was out of depression by 1937. True to his campaign promise, government spending was cut significantly in 1937 and 1938, and taxes were raised to “fund” the new Social Security program. By 1938 Roosevelt submitted a budget in which the deficit was virtually eliminated (0.1% of GDP). The resultant economic relapse, based on efforts to balance the budget, exacerbated by a nonsensically tight monetary policy brought on by the Fed, duly followed.

This is unsurprising. Any type of fiscal austerity during a period of economic slowdown, whether via government spending cuts or higher taxes, will indeed depress economic activity.

But the other lesson of the Great Depression is that properly targeted fiscal policy which focuses on job creation can work. The Great Depression was indeed a disastrous human calamity but FDR’s New Deal (including the high wage policies) attenuated the disaster. There is nothing to the claims that the interventions made things worse, other than when Roosevelt himself capitulated to the tired old forces of financial conservatism and fiscal austerianism, and the economy paid the price. Thankfully, FDR was not ideologically wed to the ideas of fiscal austerity and quickly reversed course. It helped, of course, that his Cabinet was well represented by progressive figures such as Frances Perkins, Henry Wallace, Harold Ickes and Harry Hopkins, who overcame the forces of economic conservatism embodied by FDR’s Treasury Secretary, Henry Morgenthau. We need these kinds of progressive forces in current Administration, especially given the recent resignation of CEA head, Christina Romer. It’s time to let go of the old ideology, which created today’s crisis. Here’s hoping that President Obama, like FDR before him, changes course quickly. America is ready for a new New Deal.

Marshall Auerback is Senior Fellow at the Roosevelt Institute.

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