by Sylvia Nasar
• • •
Keynes and Fisher both spent the first week of July 1931 in the drought-stricken Midwest. Two dozen monetary experts were meeting at the University of Chicago to discuss the government’s response to what was now being called the Great Depression. Keynes praised the Hoover administration for cutting taxes and signing off on a raft of building projects, among them the Hoover Dam. He complimented the Federal Reserve for cutting interest rates to record lows to prevent deflation. “The depression must be fought by price-raising, not price-cutting,” he told reporters.34 He was still convinced that lowering interest rates would suffice to end the recession, but prudent enough to recognize that not putting all eggs in one basket—“attacking the problem on a broad front, trying simultaneously every plausible means”35—made economic as well as political sense in a situation that no one had foreseen.
Keynes chaired a roundtable that took up the question “Is it possible for Governments and Central Banks to do anything on purpose to remedy Unemployment?”36 Typical midwestern fiscal conservatives, the Chicago economics faculty nonetheless supported the Hoover administration’s policy of more government spending and easier money. Keynes was not the only one to have the insight that shortfalls in demand—the means and desire of households and businesses to spend—caused recessions and that the solution was for the government to make up for them. Indeed, the Chicagoans were decidedly more enthusiastic than was Keynes about Hoover’s public works program and business lending initiative. Keynes had less confidence in the organizational capability of American as opposed to British civil servants.
After he returned to London, Keynes lent his name to the Labour government’s Report of the Committee on Finance and Industry, by Lord Hugh Macmillan, proposing that Britain, the United States, and France join in a concerted effort to expand credit by a number of means, including canceling war debts, making emergency loans, and removing obstacles to trade. Labour’s attempt to restore confidence in the pound by proposing £70 million of spending cuts plus £70 million of tax increases was to no avail. By August 1931, the Labour government had split over the policies proposed by the Economic Advisory Board, and Ramsay MacDonald had resigned as prime minister. A few weeks later, the collapse of the largest Austrian bank, Kreditanstalt, triggered a financial crisis on the Continent and a run on the British pound as European investors frantically raised cash by withdrawing sterling from their London accounts. The Bank of England responded by more than doubling the discount rate to 6 percent.
On September 21, Britain finally took the step that Keynes and Fisher had been advocating all along: devaluing the pound by 30 percent and suspending gold payments. Rather than leaving interest rates at their September high to prevent a further outflow of gold and hard currency reserves and defend the gold value of the pound—a measure that would have forced another round of investment and job cuts—the Bank of England lowered the rate from 6 percent to 2 percent in the first half of 1932.37 In a congratulatory telegram to Prime Minister MacDonald on “the breaking of the gold standard,” Fisher assured him that the step was “not something to be ashamed of.”38
Keynes was reassuring. Vanessa Bell wrote to her sister Virginia Woolf in October, after she and Duncan Grant went to see a movie in London:
Suddenly Maynard appeared on the screen enormously big . . . blinking at the lights & speaking rather nervously & told the world that everything was now going to be all right. England had been rescued by fate from an almost hopeless situation, the pound would not collapse, prices would not rise very much, trade would recover, no one need fear anything. In this weather one can almost believe it.39
It was too late for the Labour government. The general election in October resulted in a landslide for Tories and Liberals. Ramsay MacDonald retained his prime ministership, but Conservatives once again controlled domestic economic policy.
• • •
Despite his financial straits, damaged reputation, and advancing age, the sixty-five-year-old Fisher seemed more energized than depressed by the economic calamity. In 1932 he published an extraordinary number of scientific papers and newspaper pieces. He bombarded the Hoover administration and the Federal Reserve with advice and organized other economists to do the same. His chief objective was to convince President Hoover to take the United States off the gold standard, if not de jure then de facto by having the Federal Reserve do nothing to prevent the foreign exchange value of the dollar from falling. He met with the bankers at the Federal Reserve to urge them to adopt an aggressive program to buy bonds from the banks and the public in order to pump money into the banking system. To his frustration, the “Federal Reserve men thought it would be ‘safer’ if they waited!” as he later complained. “That waiting, in my opinion, cost the country the major part of the depression.”40
In January 1932, Fisher attended a second meeting of monetary experts at the University of Chicago. This time, he organized a telegram urging the president to permit the federal budget deficit to rise, pump reserves into the crippled banking system, slash tariffs, and cancel interallied debts. Thirty-two prominent economists from Chicago, Wisconsin, and Harvard universities signed the statement, in which Fisher pointed out that Sweden, Japan, and Britain were recovering after going off gold the previous year. The signatories reflected the extent to which Fisher and Keynes’s view of the crisis, with its emphasis on its global nature, monetary causes, forecasts of its future course, and the need for concerted monetary intervention, had gained adherents. On the other hand, theirs was still a minority view. In the same month, two Harvard instructors, Harry Dexter White and Lauchlin Currie, had issued a similar manifesto. Calling the depression “an international calamity,” they insisted that the government do more than aid the victims and focus on preventing the slump from worsening:
With the reparations problem involved, economic distress throughout Europe on the increase, with the progressive mal-distribution of gold reserves, the growing loss of confidence in banks, the mounting trade barriers, disorders in Spain, India, and China, the outlook for recovery in the near future is not encouraging . . . In view of . . . the failure on the part of the government to adopt other than palliative measures there devolves upon the economist the responsibility of recommending a course of action which will hasten the approach of recovery.
Calling for massive public spending, the Harvard dissidents referred derisively to “economists who believe that the course of the depression cannot be checked, that political and economic changes are beyond human control.”41 At Harvard apparently these included the entire senior faculty. The third Harvard signature on the manifesto was also that of an instructor.
• • •
By 1932 the depth and global nature of the depression was becoming clear, and Herbert Hoover was on his way to becoming the “most hated man in America.” Bombarded with conflicting advice, the president adopted a grab bag of inconsistent policies to combat rising unemployment. Under attack for cutting taxes and raising spending while the budget deficit continued to widen, Hoover reversed course, raising taxes and cutting spending. Bankers, businessmen, and, indeed, the economics community refused to support such unconventional measures. After a meeting with a Treasury undersecretary, Fisher wrote to Maggie, “I told him he and Hoover should choose some way and go right after it!”42
In truth, there was no consensus anywhere about what government should do. Most governments reacted to falling prices, production, and tax revenues by trying to balance their budgets. The effect of tax increases and spending cuts was to make the slump worse and to trigger further price declines. Banking panics created huge liabilities for governments. Thus, as the economic historian Harold James points out, the action of governments, especially Washington, helped to spread the deflation and depression and made the Great Depression truly global.
Any hope that 1932 would be like 1923, when the American economy had roared back after the steep 1920–21 recession, was soon quashed. Instead of recovering, the economy�
��s slide accelerated. By 1933, stocks were trading at one-fifth of their 1929 values while retail prices had plunged by 30 percent. National output and income had shrunk by one-third. An extraordinary 25 percent of the labor force was out of work. Death by suicide was up sharply, as one might expect. One of the few bright notes was that Americans on the whole were getting healthier and living longer and had a lower chance of dying before their time. Apparently, the 1920s prosperity, with its plethora of opportunities to work and consume, had not been a wholly unalloyed blessing.
• • •
By the time Keynes and the American journalist Walter Lippmann conducted their first transatlantic broadcast in real time in July 1933, Franklin Delano Roosevelt was in the White House. Lippmann concluded the broadcast with an observation calculated to win over his interviewer:
It may be that at the present stage of human knowledge we are not equipped to understand a crisis which is so great and so novel . . . Nowhere in the whole world has there been a prophet of whom it can be said that his teachings were comprehensive and prompt and sufficient . . . It is also a crisis of the human understanding, and our deepest failures have not been failures arising from malevolence but from miscalculation.43
Most economic historians agree that not only did no one predict the Great Depression on the basis of any previous depression, but no one could have predicted it on the basis of any existing theory.44 In retrospect, modern scholars put the primary blame on mistakes by the Federal Reserve, the collapse in confidence and spending by consumers and business, and the wave of selling into falling markets by increasingly panicky investors. But, as David Fettig at the Federal Reserve Bank of Minneapolis has observed,
In the end, if the Great Depression is, indeed, a story, it has all the trappings of a mystery that is loaded with suspects and difficult to solve, even when we know the ending; the kind we read again and again, and each time come up with another explanation. At least for now.45
For those of a scientific bent, being spectacularly wrong is often the most powerful stimulus to fresh thinking. By late 1932, it had become clear that Keynes and Fisher’s theory that price stability was a sufficient condition for economic stability—that is, full employment—was flawed or, at the very least, missing some crucial variable. Neither had a truly satisfactory explanation for the magnitude of the economy’s collapse between 1929 and 1933. Without a compelling theory that accounted for the crisis, no government would have the confidence to take strong, consistent action. Thus, both men were driven to examine their earlier assumptions and to look for forces that they had overlooked or misunderstood.
Fisher thought he had discovered the missing variable: debt. He first proposed a new theory to explain the magnitude of the economic collapse by emphasizing the toxic interaction of excessive debt and rapid deflation at a meeting of economists in New Orleans. “Over-investment and over-speculation are often important,” he told them, “but they would have far less serious results were they not conducted with borrowed money.”46 Public and private debt levels had exploded since World War I, not only in the United States but worldwide.47 American households took on debt to buy cars, appliances, and houses while European governments still owed gargantuan sums from the war.
The initial fall in stock prices was enough to rattle the confidence of heavily indebted businesses and households and overextended banks, who rushed to liquidate their debts and shore up their balance sheets. This led to an initial wave of distress selling—“selling not because the price is high enough to suit you, which is the normal characteristic of selling, but because the price is so low it frightens you”48—and further declines in stock prices, which in turn caused bank deposits to contract. As the supply of money shrank, prices began to slide downward across the board.
Deflation, as a fall in the overall price level, should, in principle, raise real incomes by increasing the purchasing power of a given nominal wage. As the prices of everything from gasoline to shoes fall, a given wage buys more. In his 1911 book The Purchasing Power of Money, Fisher had shown that falling prices could also depress income. The real value of a $1,000 loan is $1,000 divided by the average price level. If prices decline, the real value of the debt increases, impoverishing debtors and enriching creditors. A second effect follows from the redistribution of income from debtors to creditors. Debtors tend to spend more and save less of their income than creditors, one reason they took out a loan in the first place. Thus, their spending falls by more than creditors’ spending increases.
If everyone expected prices to fall in the future, Fisher argued, companies would become reluctant to borrow to invest in new factories and equipment, because they would have to repay the banks later in more valuable dollars. As businesses slashed investment plans, spending on capital goods would fall, as would the incomes of capital goods producers and workers. As income slipped, the demand for money and the nominal rate of interest would both fall. But the nominal rate of interest would fall less than the price level, so the real interest rate would wind up higher. In both cases, falling prices would lead to lower production and higher unemployment.
Fisher’s point was that the effort of businesses to get rid of debts actually resulted in increasing the debt burdens in real terms, a dramatic instance of actions that were beneficial for an individual but harmful in the aggregate. Even businesses that were debt free would find themselves in trouble as the prices they could charge for their products fell faster than the costs of labor and raw materials. The squeeze on their profits would inevitably result in layoffs and production cuts. The rational attempt by banks and individuals to solve their own difficulties by slashing their debt, he emphasized, had the perverse effect of making things worse.
Fisher had already concluded that the immediate cause of the crisis was “the collapse of the credit system under the weight of these debts.”49 Between 1929 and 1933, three banking panics wiped out billions in business, farm, and personal assets—equal to one-third of the nation’s money supply. Yet the Federal Reserve began raising interest rates in the fall of 1931 and did nothing to shore up the banking system, on the grounds that weeding out unfit banks was laying the groundwork for recovery. Fisher blamed lingering war debts, the Smoot-Hawley tariff, and the absence of a strong leader at the Federal Reserve. Benjamin Strong, who as president of the New York Federal Reserve Bank had dominated the Federal Reserve, had possessed a deep knowledge of banking and close ties with the head of the Bank of England. His death at the end of 1928, Fisher was certain, had deprived the relatively untested American central bank of strong leadership—and credibility overseas—just when such leadership was most needed. He told a reporter that “the effect of the economic crisis could have been mitigated ‘by at least 90 percent’ if the Federal Reserve banks had followed the stabilization policy of former Governor Benjamin Strong of the New York Bank.”50
Nonetheless, Fisher’s optimism that greater understanding would ultimately make preventing and mitigating depressions possible was undimmed:
The main conclusion of this book is that depressions are, for the most part, preventable and that their prevention requires a definite policy in which the Federal Reserve System must play an important role. No time should be lost in grappling with the practical measures necessary to free the world from such needless suffering as it has endured since 1929.51
Judging by newspaper headlines of the early 1930s, popular wisdom viewed economics through a biblical lens: recessions were the wages of sin. When good times lasted too long, businesses and individuals threw caution to the wind and behaved badly. Recessions—periods when output, employment, and income contract instead of expand—occurred when private businesses and households unwound past excesses, wrote off bad investments, and behaved with restraint once again. Recessions, in this view, were regrettable but necessary correctives, like a detox program for a drunk. When they occurred, the government had to prevent business and consumer confidence from being damaged further by balancing the budget and g
uarding against excessively easy monetary policy. That, of course, is the platform on which Franklin Delano Roosevelt campaigned.
The Brain Trust around FDR was a group of campaign advisors from Columbia University that included Adolph Berle, a law professor and expert on corporate governance; Rexford Tugwell, an agricultural economist; and Marriner Eccles, a millionaire Western banker. Its members distrusted economic radicals such as Keynes and Fisher almost as much as did the British Labourites, considering them inflationists hardly better than William Jennings Bryan and the silverites of the 1890s. This was unfair. Fisher and Keynes advocated that the Treasury and the central bank stop targeting the gold exchange rate and instead target the overall price level. They wanted, in other words, the monetary authorities in the major economies to let their foreign exchange rates depreciate while preventing deflation of domestic prices. For the Brain Trusters, this was a distinction without a difference. Tugwell recalled, “We were at heart believers in sound money.”52 In their way, Roosevelt’s advisors were as conservative on money matters and as wedded to the Treasury view as was the British Labour Party.
David Kennedy describes FDR’s own brain as “a teeming curiosity shop continuously restocked with randomly acquired intellectual oddments . . . open to all number and manner of impressions, facts, theories, nostrums, and personalities . . . particularly inflation-preaching monetary heretics like Yale’s Professor Irving Fisher.”53 Tugwell recalled, “All the old schemes for cheapening money were apparently still alive, and there were many new ones. The Governor [FDR] wanted to know all about them. We shuddered and got him the information.”54
Inflation’s appeal was political. Two-thirds of the Democratic Party consisted of southern and western farmers who were caught between debt and declining crop prices and were hostile to gold. On the other hand, the prospect of inflation inspired more dread among bankers and businessmen than one would suppose in a year when the average price level had dropped by more than 10 percent and one-third of the nation’s banks had defaulted. Memories of the violent inflations during and after World War I and the deflations that had been necessary to cure them were still too fresh to ignore. FDR was especially hostile to international cooperation to fight the depression.