299. In Meltzer 1976 I point to the role of the 1929 Smoot-Hawley Tariff and retaliation for its effects on trade, but mainly on gold flows. Most research suggesting a small effect ignores the pronounced effect on farm exports, distress, bankruptcies, and bank failures in farm states.
Policy coordination can solve problems of misalignment only if countries are willing to adjust their tax, spending, and monetary policies to benefit their partners. Given the political difficulties that many countries, including France and the United States, faced in adjusting spending and tax policies for domestic reasons, the required cooperation was unlikely.
It was also unnecessary. Exchange rate changes were a readily available substitute. To argue that exchange rate changes led to competitive devaluations misses the point. There is every reason to expect that countries seeking relative advantage through devaluation would have chosen other policies to gain relative advantage, as Germany did.
The main difficulty with Kindleberger’s argument is that it misstates the central problem. The sluggish decline in United States unemployment was mainly a result of domestic policy. The decline in the United States was larger and deeper than in the principal European countries, but the recovery after 1933 was also more robust. Chart 6.9 shows comparative data for real GNP growth in six advanced countries.
The recovery of German GNP, based on armaments and autarky, is the only one that surpasses that of the United States, and only for a few years. Until the policy mistakes of 1937, real GNP growth in the United States seemed certain to pass the 1929 level. Relative to the other developed countries, the United States recovery until 1937 was strong, not weak.
Unemployment rates tell a different story. The reported unemployment rate declined more slowly in the United States than in Europe and was much higher in 1939.300 Insufficient international cooperation cannot explain this difference. Policy mistakes in 1937 are again part of the explanation, but the United States unemployment rate remained relatively high before the 1937–38 recession, despite its relatively strong recovery. Chart 6.10 shows these data.
Wages and Profits
Recent research on wages and employment during the recovery concludes that New Deal wage and labor policy acted as a negative shock to the supply of output by raising wages and encouraging labor unions. In 1933 and 1934, as we have seen, the NIRA established codes that raised wages in many industries. Subsequently the Wagner Act (1935) strengthened trade unions and led to the organization of labor in the steel, automobile, rubber, and other manufacturing industries. Strikes and occupation of plants achieved settlements that recognized unions and further raised wages. In 1938 the Fair Labor Standards Act introduced a minimum wage and maximum hours of work.
300. Correcting for part or all of the relief workers, as in Darby 1976, would alter this statement only slightly. Unemployment in Switzerland and the United Kingdom had fallen to about 6 percent in 1939. Darby’s measure is 9.5, slightly above Sweden.
When demand rose rapidly, as in 1935–36, profits rose despite higher wages. Hourly wages in manufacturing continued to increase in 1937 and 1938 despite the recession and the reduction in hours of work. Chart 6.11 shows that after 1938, growth of profits is much slower absolutely and relative to wages.301 Further, stock prices fell in 1939, 1940, and 1941, and prices of large company shares fell relative to small company shares, suggesting that profits were not expected to increase strongly, particularly at larger companies most subject to government and union pressures.302
301. The profit series from Barger 1942 is not comparable in coverage to the Commerce Department Series, so I have not attempted to combine the two series and have omitted 1939, the transition year.
302. Silver and Sumner (1995) find strong support for the negative effect of wage policy on output. Their findings show considerable difference in the effect of wage growth on growth of industrial production in the 1920s and 1930s. They attribute the large negative effect in the 1930s to New Deal wage policy. As noted above, Weinstein (1981) estimates that NRA codes raised real wages in manufacturing 12 percent a year in 1933 and 1934. Bordo, Erceg, and Evans (1997, charts 14 and 18) show the very rapid rise in real wages and the sluggish increase in hours worked noted earlier.
Chart 6.11 compares rates of change of nominal profits and nominal wages from 1935 to 1941. Note the difference in scales. Growth of profits declined well before the 1937 recession and (based on a different data series) increased more slowly after the recession. The economy entered the recession with rising wage growth and falling profit growth. After the recession, wage growth continued to increase, contributing to the low level of optimism about future profit growth that stock prices reflected at the time.
Productivity growth appears to be a principal factor affecting stock prices, most likely by changing the growth rate of expected future earnings. Chart 6.12 shows that the two series move together from 1933 to 1938. Thereafter they diverge; productivity growth exceeds growth of stock prices after 1938. Stock price changes for this period support the finding in chart 6.11 based on the less reliable profits data. Together the two charts suggest that after the 1937–38 recession, both profit growth and expected future profits fell.
Real wages remained above average productivity through most of 1933–40. New Deal labor policies were a common complaint. If the data for manufacturing in chart 6.13 are representative of the economy, two periods dominate these years. The first, 1933–35, corresponds to the NRA period but also to the start of recovery. The second, 1937–38, includes the wages and hours legislation and mandatory minimum wages. It follows the period of militant union organizing. Following both periods, productivity remained below real wages.
The data on productivity and real wages correspond broadly to the patterns shown by profits after 1936. There are too few observations to precisely separate current and lagged effects of cyclical and New Deal changes. Nevertheless, the evidence is consistent with a number of studies suggesting that New Deal labor legislation increased unemployment rates by raising costs of employing labor (Weinstein 1981; Silver and Sumner 1995; Cole and Ohanian 1999).
New Deal labor policies emphasized demand. Proponents of these policies expected higher wages, and higher incomes, to stimulate demand through the income effect. In labor markets, as in agricultural markets, the policies ignored or minimized the effect of relative price changes, later called supply-side changes.
Political calculation and economic beliefs are not easily separated in the policy process. Particularly after 1936, the president and parts of his administration reinforced the concerns of businessmen with rhetoric suggesting that additional costly changes were more likely than a retreat from the policies that increased costs of production and lowered profits.
For the postwar years 1962 to 1984, Fallick and Hassett (1998), building on Rose 1987, test the hypothesis that unionization is a tax on capital. They find that, on average, union certification is equivalent to a thirty percentage point increase in the corporate tax rate. Applied to the 1930s, this finding suggests that rising unionism, encouraged first by the NIRA and later by the Wagner Act, may explain both rising real wages and the sluggish growth of investment in the 1930s. The possible effect is large; union membership rose from 11 percent of the labor force in 1933 to 27 percent in 1941. The largest jump came in 1937 (Freeman 1998, 292).
Chart 6.13 shows that real wages again rose rapidly in 1941. Yet unemployment fell, and most explanations based on the stifling effect of New Deal policies, taxation, and regulation do not apply to the defense and war period. Nor do they apply to the postwar period, when high rates of taxation and many regulations remained. If New Deal regulations are part of the explanation for the thirties, by the end of the decade their effect was probably more on prices and exchange rates than on profits. And by 1940 the president and most of his administration sought cooperation. Antibusiness rhetoric declined.
Frequent unanticipated changes in policy may have been important also. The New Deal had little cohere
nce and little continuity. Roosevelt was proud of his commitment to experimentation and not much concerned with consistency. The NIRA and the AAA sought to raise prices. The antimonopoly rhetoric and the antitrust drive aimed to prevent price increases or to lower prices. The administration shifted also on balanced budgets, the role of gold, devaluation, and many other issues. Policy changes, reinforced by changing rhetoric, maintained a state of flux in which long-term planning was difficult.303 As Alvin Hansen remarked at the time, “Businessmen avoided as much as possible long-term capital commitments” (quoted in Roose 1954, 174).
In contrast, defense (and later wartime) spending was both larger and expected to continue longer. President Roosevelt’s declaration of an emergency in June 1940 was the beginning of a sustained program. A permanent expansion replaced temporary experiments. Output and employment responded to the permanent change and perhaps to the changes in rhetoric and practice. To manage the defense buildup, the president appointed leading Republicans—Frank Knox and Henry Stimson—to the cabinet, and leading businessmen to the new defense agencies.304 Chart 6.14 shows the increase in real government spending and private investment. The slope of the real investment line increases in 1940 and 1941.
303. Higgs (1997) makes a persuasive case for heightened uncertainty about what the administration intended. There was also concern with what it did, for example, abrogating the gold clause in contracts, regulating small details, and prosecuting even very small businesses that violated the NRA codes or later legislation.
Chart 6.15 shows one measure of the incomplete recovery. Trend real output growth, at the rate calculated for 1922 to 1929 (based on Balke and Gordon’s quarterly data), put 1940 output about 15 percent below the capacity output that would have been achieved if the 1920s trend (2.7 percent) had continued in the 1930s.305 One reason for using the 2.7 percent growth rate is that recovery from the depths of the recession was rapid to the end of 1936, 11 to 12 percent a year. If the economy had avoided the policy errors that produced the 1937–38 recession, real GNP, on this path, would have reached the 2.7 percent trend line by the end of 1938. No doubt this is an overestimate. Growth would likely have slowed as it approached the old trend. Nevertheless, much of the gap between actual and potential output would have closed before wartime spending began.
304. Recall that Harrison met with New York bankers in the summer of 1940. Many of these men led the criticism of New Deal taxes and deficits. Now faced with much higher tax rates and larger prospective deficits, they wanted Harrison to express their interest in financing defense plants.
305. Admittedly this is a relatively high growth rate, well above the approximate 2 percent average generally used as the trend. I have used the higher rate intentionally for the calculation that follows. At 2 percent growth, the shortfall is less than 10 percent in 1940.
The conclusion I draw is that the 1937–38 recession is part of the explanation for the failure of the economy to fully recover. New Deal labor, and other policies, played a role. That these policies did not prevent recovery of profits, employment, and production after 1940 suggests that, if the deep 1937–38 recession had been avoided, the lasting effect of New Deal policies would have been mainly on the price level and the real exchange rate.
Money and Inflation
Money growth had a major role in the recovery and in the 1937–38 recession. Although the Federal Reserve took few actions, gold flows and gold sterilization changed the rates of growth of money and base money. Chart 6.6 (p. 529) plots the relation between quarterly values of growth in real final sales and growth of real money balances. The association is strong, although there are some large exceptions.306 The chart suggests that money growth continued to affect spending during the recovery. The chapter appendix shows some statistical analysis.
Finally, chart 6.16 shows the relation between actual inflation and the inflation predicted for 1930 to 1941 using estimates computed from the 1920s. The prediction captures the thrust of actual inflation, again suggesting that the relation of money growth to inflation remained in the 1930s. The chapter appendix shows the underlying relation.
306. McCallum (1990) shows that an adaptive rule for the monetary base captures the main features of the decline and recovery of nominal GNP.
CONCLUSION
The two outstanding features of economic performance from 1933 to 1941 are the strong recovery of output, interrupted by a deep recession in 1937–38 and the weak recovery of employment and investment spending. Together these features tell a consistent story about economic policy.
The main policy stimulus to output came from the rise in money, an unplanned and for the most part undesired consequence of the 1934 devaluation of the dollar against gold. Later in the decade, German mobilization and annexation of the Rhineland, Austria, and Czechoslovakia, the rising threat of war, and war itself supplemented the $35 gold price as a cause of the rise in gold and money.
The United States was on the gold standard after 1934 in the sense that changes in the monetary base were dominated by gold movements and the Treasury agreed to buy or sell gold at a fixed price.307 At first the Treasury agreed to sell gold only to countries on the gold standard. Later, after few countries remained on the gold standard, it bought and sold gold with other foreign governments and their agencies, but not with United States citizens.
In practice, the Treasury bought all gold offered at the $35 price and issued gold certificates to the Federal Reserve. With market interest rates low and excess reserves accumulating rapidly, the Federal Reserve and the Treasury became concerned about inflation. One response was to return to the gold sterilization policy that the Federal Reserve followed during much of the 1920s. A second response was to remove excess reserves by raising reserve requirements for member banks. In 1935 the Federal Reserve received new powers to increase reserve requirement ratios without presidential approval. In 1936 and 1937 it put the new powers to use.
The two discretionary monetary actions, coming within a brief period and supplemented by the end of the soldiers’ bonus, caused a reversal of the rapid economic recovery. The economy returned to recession in 1937–38.
As in 1920–21 and 1929–33, the Federal Reserve took no responsibility for the recession, denied that higher reserve requirements had contributed, and took no expansive actions until late in the recession. The administration increased relief payments but did not initiate countercyclical policy until spring 1938.308
307. Silver purchases also added to the monetary base, but their contribution was much smaller.
308. Eccles, his principal aide Goldenweiser, and most of the Board denied that the increase in reserve requirement ratios had done more than absorb redundant excess reserves. This view was not unchallenged. A staff memo by Emile Despres later argued the opposite side and urged that a vigorous monetary policy of expansion could be used to end the recession. Goldenweiser opposed this view, and it does not appear to have had any effect on decisions.
The principal force for recovery from the 1937–38 recession came from the decline in prices that raised the real value of the money stock and, later, from the rise in the nominal money stock. As in 1921, both real money balances and real interest rates rose; again the expansive effect of real balances outweighed the contractive effect of real interest rates. With the release of gold from sterilization and a modest reduction in reserve requirement ratios, the nominal stock also rose, followed by a rise in spending.
Although Federal Reserve officials believed that monetary policy was impotent, and this view was widely held in the academic profession, the evidence suggests very strong effects of real money balances on real output during the recovery. (See chart 6.6, for example.) For the period 1933 to 1941 as a whole, there is very little change in monetary velocity. Using Balke and Gordon’s (1986) quarterly data, real GNP and the price deflator rose at a compound annual rate of 6.6 and 2.5 percent, respectively. The monetary base rose at a 9.7 percent annual rate, so monetary base velocity changed relative
ly little over the period.309 This is consistent with the small change in interest rates, particularly long-term rates. (See appendix chart 6.A1.)
Marriner Eccles headed the Federal Reserve Board from 1934 to 1935 and the Board of Governors after March 1936. Eccles was much more interested in fiscal actions, housing, and advising President Roosevelt on these and other issues than in conducting monetary policy. The Federal Reserve took very few discretionary actions. Except for doubling reserve requirements in 1936–37, it was passive through most of these years. Despite the mutual antipathy between Eccles and Treasury Secretary Morgenthau, the Treasury usually led and the Federal Reserve followed.
A main reason the Treasury could lead in monetary matters was that most of the profit from the 1934 revaluation of gold went to establish the Exchange Stabilization Fund. Morgenthau threatened to use the fund, and the Treasury trust funds, to engage in open market operations. The Federal Reserve disliked these actions, disliked being a junior partner, and feared that the Treasury would take over its functions. Morgenthau, on his side, distrusted Eccles and regarded most Federal Reserve officials as bankers of questionable loyalty to the administration. He wanted interest rates to remain low so he could market government debt on favorable terms; and he was willing to use his trust funds as a threat so that he could choose the monetary policy he wanted. These efforts were generally successful.
A History of the Federal Reserve, Volume 1 Page 83