The Great Depression Was In Large Part FDR's Fault

Bad policy is still bad

The Great Depression was unusual not just for the severity of the economic downturn, but also for its length. I assert that, left to their own devices, wages and prices would have adjusted on their own, as they did in the past. The length of the Great Depression, then, is due to poor economic policy, in particular that of FDR’s administration. With this in mind, the optimal course of action to future downturns is considerably different from what people commonly imagine.

First, why did the Great Depression happen to begin with? We must first understand the implications of a gold currency. The dollar was defined such that $20.67 could buy one ounce of gold, with this being enforced by requiring the government to hold gold reserves to exchange at that price. If the real value of gold fell below that price, people would pull gold out of circulation to act as dollars; and if it rose, people would trade in dollars for gold. Nominal prices are a function of the number of dollars in circulation, so an increase in the real value of gold can occur only through a fall in the nominal price of everything.

The trouble started with France, as many things do. They had spent most of their gold reserves to finance the First World War, and now they wanted them back. The French government directed the Treasury to seek to buy gold reserves; and not only that, but to not issue francs unless fully backed one-to-one with gold reserves. The rest of the world heard a great sucking sound as gold went over the border, and what would lead to the Great Depression started.

This made the price level plummet. If the nominal value of wages or borrowing terms stays the same, then the real value has steeply increased. Companies ran out of money, couldn’t pay their creditors, and folded. Meanwhile, the banks — which were already too small and fragile, as we covered recently — folded, which still further reduced the availability of money. It was a classic demand-driven recession due to sticky wages and prices.

But this story is missing something. We had had the exact same thing happen in 1921 and 1922. The price level plummeted and industrial output fell. It is a forgotten recession, though, because in the end wages and prices readjusted to the new price level and we returned to normal economic output. Prices and wages may be sticky in the short run, but they are not sticky in the long run.

In order for it to last as long as it did, bad economic policy was required. While both Hoover and FDR were responsible, it was ultimately their policies which made the Great Depression great. Starting with Hoover, he mistook the symptoms of loose money (high wages) for the causes. His first course of action was to jawbone large industrial concerns to not cut wages in conjunction with the unions. As a consequence, real wages rose 10 percent — while reducing output and hours worked by 20 percent. He signed the Smoot-Hawley tariff bill, which, while not responsible for the Great Depression, did substantially reduce output and efficiency, and he was also extremely indecisive during the interregnum period. The market believed that FDR would devalue the dollar, and since no one wanted to be caught with the dollars when they were devalued, everyone started trading at the expected new price. This is extremely bad though, because the implied new dollars don’t actually exist, and so unemployment reached its zenith during the early months of 1933. The severity of the crisis is why the Constitution was amended to move the inauguration early, in fact.

FDR’s primary positive action during the Great Depression was devaluing the dollar. The price per ounce was moved up to 35 dollars, with an immediate and massive increase in industrial production. This was also true internationally, with countries recovering from the Great Depression more or less when they moved away from the gold standard. It was also made illegal to hold or trade gold anywhere in the United States.

This recovery was nipped in the bud by the unsound microeconomic policies of the Roosevelt administration. Yet again, they mistook high prices as a cause. Their agricultural stabilization policies are perhaps the clearest example. In order to keep prices high, so that farmers could pay back their loans at high nominal prices, they had a substantial portion of farm output destroyed. Remember that a monopoly increases its profits by not selling a portion of the output which it could sell. This might increase the income of farmers, but can do so only at the cost of lowering total output.

And the Roosevelt administration did this to the entire economy! Wages were set by negotiation for entire industries, with output restricted to keep wages high. Productivity growth would have been sufficient to return the economy to trend by 1936, were it not for the continued meddling of the government in every aspect of the economy. It is striking that the industries which were exempt from the NIRA were the ones which had the least increase in unemployment.

The consequence of this is that we have a badly distorted view of what is needed to prevent recessions. FDR is regarded reverentially nowadays, in part for winning the Second World War, and this gives all of his policies, even the terrible ones, an angelic glow. What we need to understand is that the solution to shortfalls in aggregate demand is not massive fiscal interventions, but good monetary policy. The Federal Reserve then was hampered by being on the gold standard, which limited their possible responses – we today face no such constraint, and the only barrier to provide a sufficient amount of money for the economy is fear itself. The solution to an output gap is a not a massive government jobs program, but simply putting a sufficient amount of money into the economy.