Stimulus and the Depression: The Untold Story
About one-half of President Obama’s proposed $447 billion American Jobs Act consists of payroll tax holidays designed to boost spending and increase hiring. But these temporary policies will do little to jump-start the economy, much as earlier temporary economic Band-Aids, such as the 2009 stimulus, did little to improve the economy.
Proponents justify stimulus spending in part based on the widely held view that government-fueled increases in “aggregate demand” during FDR’s New Deal ended the Great Depression and brought recovery. Christina Romer, former chairwoman of Obama’s Council of Economic Advisers, has argued in op-eds that government should continue to spend for this reason. And in a 2002 speech as a Federal Reserve governor, current Fed Chairman Ben Bernanke claimed that monetary expansion and the turnaround from the deflation of 1932 to inflation in 1934 was a key reason that output expanded.
But boosting aggregate demand did not end the Great Depression. After the initial stock market crash of 1929 and subsequent economic plunge, a recovery began in the summer of 1932, well before the New Deal. The Federal Reserve Board’s Index of Industrial production rose nearly 50% between the Depression’s trough of July 1932 and June 1933. This was a period of significant deflation. Inflation began after June 1933, following the demise of the gold standard. Despite higher aggregate demand, industrial production was roughly flat over the following year.
The growth that followed the low point of the Depression was primarily due to productivity. Productivity is considered a supply-side factor by many economists: It is determined by the technology and regulatory structure of the economy and therefore is largely independent of spending policies.
The growth rate of real per capita output is the sum of the growth rate of per capita labor input and productivity growth. Increasing aggregate demand is supposed to increase output growth by increasing labor input. But between 1932 and 1934, the period that Mr. Bernanke cited in his speech, per capita real gross domestic product (GDP) growth was entirely due to productivity growth, as per capita total hours worked—a standard measure of labor input—was actually, according to our research, lower in 1934 than it was in 1932.
One reason that many believe higher aggregate demand brought about by government spending programs and monetary expansion created recovery is because unemployment did decline between 1933 and 1937. But declining unemployment reflected significant work-sharing in New Deal policies that began in 1933 with the President’s Reemployment Agreement and continued with the National Industrial Recovery Act of 1933 and the Fair Labor Standards Act of 1938.
Work-sharing increased employment by spreading jobs across more people. Spreading scarce jobs was probably desirable. But the key point is that higher aggregate demand didn’t significantly expand the amount of work that was done.
Productivity growth continued to be the major factor for the rest of the 1930s, accounting for about three-quarters of the growth in real per capita output that occurred between 1932 and 1939. But despite rapid productivity growth, the economy remained well below trend because labor input failed to recover. In 1939, labor input as measured by total hours worked per adult was more than 20% below the 1929 level.
Per capita real GDP was about 27% below trend in 1939, with more than three-quarters of this shortfall due to the continuing depression in labor. Our research indicates that New Deal industrial and labor policies, such as the National Industrial Recovery Act and the Wagner Act (the National Labor Relations Act), were the main reasons. The NIRA, for example, fostered monopoly and raised wages well above underlying worker productivity by a quid pro quo arrangement of relaxing antitrust enforcement in exchange for industry paying substantially higher wages.
The Wagner Act substantially increased unionization and union power. This, in conjunction with government’s toleration of sit-down strikes, in which union workers forcibly seized factories to stop production, increased wages further.
In the absence of these policies, we estimate that labor input would have been about 20% higher than it was at the end of the 1930s and would have returned the economy to trend by that time.
Productivity growth is overlooked today. But as in the case of the Great Depression, economic growth since the trough of the Great Recession in June 2009 has been largely accounted for by productivity growth rather than the restoration of jobs. Following the recession’s June 2009 trough, about 80% of real per capita GDP growth is due to growth in output per hour worked. And GDP growth is slowing now because productivity is no longer growing.
The economy began to recover following the New Deal because policy changed for the better. In a 1938 speech President Roosevelt acknowledged that some administration policies were retarding recovery. Economic policy shifted considerably around this time, and the economy boomed. Antitrust enforcement resumed. The fiercely controversial undistributed profits tax, which was retarding investment, was drastically reduced and then eliminated in 1939. The sit-down strike was declared illegal, and employers could fire sit-down strikers.
The policy changes in the late 1930s benefited the economy by increasing competition, by bringing wages more in line with productivity, and by improving the incentives for investing. Many assume that World War II spending singlehandedly brought the economy out of the Depression, but nearly half of the increase in nonmilitary hours worked between 1939 and the peak of the war already had occurred by 1941, well before the major wartime spending took place.
Policy can also improve today. The bipartisan Joint Select Committee on Deficit Reduction will make a recommendation by Nov. 23 to deal with future deficits. It has an outstanding opportunity to initiate broad-based tax reform that adopts the recommendations of most bipartisan tax reform commissions of the last 20 years: a simpler tax code that improves the incentives to hire and invest, broadens the tax base, lowers the corporate income tax, and also eliminates loopholes to equalize tax treatment of capital income. Sensibly addressing our long-run challenges will do more for the economy than continuing the stop-gap measures that have dominated policy-making for the last three years.