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Understanding Fiscal Policy During the Great Depression
My little spat with with Rauchway regarding unemployment during the Great Depression draws in Paul Krugman. Krugman doesn't respond to any of my arguments but he does give us the old line that fiscal policy didn't fail during the Great Depression it wasn't tried.
Now, you might say that the incomplete recovery shows that “pump-priming”, Keynesian fiscal policy doesn’t work. Except that the New Deal didn’t pursue Keynesian policies. Properly measured, that is, by using the cyclically adjusted deficit, fiscal policy was only modestly expansionary, at least compared with the depth of the slump. Here’s the Cary Brown estimates, from Brad DeLong...Net stimulus of around 3 percent of GDP — not much, when you’ve got a 42 percent output gap.
Now there is actually a lot of truth to this but the way in which Krugman, Rauchway, DeLong and others present this point is esoteric and likely to mislead even many economists. What Krugman seems to be saying is that the government didn't spend enough during the thirties (Rauchway, who also cites Cary Brown, says directly "there was never enough spending to achieve the desired effect.") Yet federal spending during this time increased tremendously. So what is really going on? The answer is actually quite simple.
During the Great Depression federal expenditures increased tremendously but so did taxes. Thus, the reason spending was not stimulative was not that spending wasn't tried it's that taxes were also raised to prohibitive levels. But don't take my word for it. Read Cary Brown (JSTOR) whom Krugman, Rauchway, DeLong all cite but none of whom quote at length. Here is Brown:
The primary failure of fiscal policy to be expansive in this period is attributable to the sharp increases in tax structures enacted at all levels of government. Total government purchases of goods and services expanded virtually every year, with federal expansion especially marked in 1933 and 1934. [But] the federal Revenue Act of 1932 virtually doubled full employment tax yields...
...the highly deflationary impact of this tax law has not been fully appreciated...The Revenue Act of 1932 pushed up rates virtually across the board, but notably on the lower and middle income groups....Personal income tax exemptions were slashed, the normal-tax as well as surtax rates were sharply raised, and the earned-income credit equal to 25 percent of taxes on low income was repealed. Less drastic changes were made in the corporate income tax, but its rate was raised slightly and a $3000 exemption eliminated. Estates tax rates were pushed up, exemptions sharply reduced, and a gift tax was provided. Congress toyed with a manufacturers' sales tax, but finally rejected it in favor of a broad new list of excise taxes and substantially higher rates for old ones....
The Revenue Act of 1932 was followed by many further tax increases (e.g. Brown notes "...social security taxes began in 1937 to exert a pronounced effect...") many of them, under pressure from the Huey Long wing, designed to "Share our Wealth." Here is a graph of the highest marginal income tax rate which went from 25% to 79% between 1929 and 1940 and here is a graph of the lowest marginal income tax rate which (from a low base) increased by a factor of 10. (Hat tip to Carpe Diem).
Thus, an accurate portrayal of fiscal policy during the Great Depression - entirely consistent with Krugman - is that we had much greater spending, much greater taxes and not much economic stimulus. And if supporters of the New Deal argue that fiscal policy was only "modestly expansionary" then it's quite reasonable to think that once we take into account the supply side effect of taxes and the increase in regime uncertainty then the net effect might even have been contractionary.
Posted by Alex Tabarrok on November 10, 2008 at 07:45 AM in Economics | Permalink
Comments
Please do keep comments civil and focused on economics. I think everyone would appreciate this. Thank you.
Posted by: Alex Tabarrok at Nov 10, 2008 7:47:47 AM
I guess now everyone will drop the calls for increasing taxes significantly. I am glad to hear of such a happy ending.
Posted by: Tyler Cowen at Nov 10, 2008 7:53:27 AM
Paraphrasing GK Chesterton:
"Capitalism has not been tried and found wanting; it has been found difficult and not tried."
Posted by: at Nov 10, 2008 8:11:30 AM
I guess now everyone will drop the calls for increasing taxes significantly. I am glad to hear of such a happy ending.
Shame on you! That's politics, not economics.
Posted by: at Nov 10, 2008 8:21:32 AM
79%! And later in the century it was 90%. Nowadays you'd think 39.6% is the highest its ever been.
In the Monday Op-Ed column, Krugman does mention the federal tax increases and throws in a line about state/local spending cuts and tax increases.
I think, overall, everyone is agreeing, but quibbling a bit about the phrasing, but where we should really be worrying about phrasing is in the present, not the past.
I think there is a consensus that what currently needs to happen is that gov't spending has to increase and taxes should not. But, we already know that in my states/cities, spending will DECREASE (and taxes may go up), so the Fed. Gov't will have to counteract those local spending cuts as well as spend more on top of that.
Ideally, the gov't would have saved up some surpluses from higher taxes during the good times, but our gov't runs by the philosophy, "things are bad? Cut Taxes! Things are good? Cut Taxes!" Hopefully there is never a Bird Flu pandemic for I fear that too many think tanks would actually write that the cure, once again, was to cut taxes.
So we may not be able to do completely what we ought to do. We do know that s fiscal is more effective the more poorer people get that money because of their higher marginal rates. So the currently planned tax cuts to the lower and middle class seem to be the right idea. Its just that increase for the wealthiest 95% that is open for debate. Be sure to avoid any false equivalences here. we're talking a 4.6%, not 55% of the 1930's and it must be kept in mind that we weren't stocking up reserves from surpluses these past few years like we "should have."
I think most people agree that massive infrastructure spending seems like a good idea too. But, we have to stop this "running a deficit in a boom" problem thats plagued us for the last 30 years (minus the surplus years at the tail end of the 90's). So, it should be made very clear that when things get better, we have to start making a surplus again, which will require both slashes in spending, and increases in taxes.
Posted by: Nylund at Nov 10, 2008 8:27:47 AM
So taxes were raised too high relative to the aggregate demand those government deficits created. But then you cannot argue that FDR cured the Depression, can you?
Posted by: kurt at Nov 10, 2008 8:29:35 AM
"I think most people agree that massive infrastructure spending seems
like a good idea too."
I don't. Most projects seem in and of themselves a waste, if not counterproductive.
" But, we have to stop this "running a deficit in a boom" problem thats plagued us for the last 30 years (minus the surplus years at the tail end of the 90's). So, it should be made very clear that when things get better, we have to start making a surplus again, which will require both slashes in spending, and increases
in taxes."
Yeah, next time we will get central, political spending correct.
Posted by: Paul from Florida at Nov 10, 2008 8:44:17 AM
I thought WWII, and the post-war need for domestic goods, was given the most weight in curing the Great Depression. No?
Posted by: Steve at Nov 10, 2008 8:47:04 AM
Alex,
I don't think Krugman is being "drawn in" to your spat. He is drawn in to the debate between Wilson and Rauchway to which you are a kibitzer...
Posted by: RobbL at Nov 10, 2008 9:03:06 AM
I must be a bad economist, because I do not see a difference between gov't borrowing and spending, and the lender simply spending himself. If the money being spent is not an unprofitable waste of money, they'll figure out that they should spend the money as quickly as politicians. So in order to bring back fiscal sensibility, the government has to waste money like a drunken sailor? Sounds far too much like another version of the Broken Window Fallacy.
Posted by: Russ Nelson at Nov 10, 2008 9:19:48 AM
Given the post-war recession, one could argue that aside from the anomalous wartime economy, the Depression wasn't over until 1950.
Posted by: Cyrus at Nov 10, 2008 9:19:49 AM
Alex - Could you commment some on one aspect of Rauchway's "dissenting" series (e.g. his Take 2) at this link?
They show unemployment trending down from 1932 at more or less a constant rate. Presumably we would not credit FDR's initial measures for progress till 1934 so should we credit the first two data points to Hoover?
Posted by: SLS at Nov 10, 2008 9:22:59 AM
Confirming Alex's point regarding taxes going up during the Great Depression - here's Mark Perry's post showing the changes in tax rates for top income earners and here's his follow up post showing the changes in tax rates for the lowest income earners.
It's as if the government wanted lots of money for something.
Posted by: Ironman at Nov 10, 2008 9:28:44 AM
Problem one. Debates about the New Deal and the Great Depression are interesting but the economy is not yet that bad. Solutions that might have had some impact then, could have very different results now. Regardless of which side is right about the New Deal.
Problem two. Some seem to argue that emergency measures taken by the New Deal should be made a general model of how to make the economy run. The point at which extreme measures should be used is unclear to me.
Problem three: I think Stigler would warn about the dangers of creating or greatly expanding agencies or programs. Too often we create monsters full of unintended consequences.
Problem four; Fiscal stimulus of the type Krugman and others want (public works projects) do not look like much of a solution. One the benefits occur with a lag. But most important, these projects just become pork laden projects deigned to help the politically connected. Look at the typical road project today. Bond and insurance business go to politically connected firms. Labor contracts are gifts to union workers and politically connected minority businesses. Equipment leasing, hauling, disposal, etc all allow opportunities for graft. Not to mention that the projects will be spread around by a political process that cares little about economic returns from the project. Not to mention that draining resources from the private sector seems less then ideal at this time. If Krugman likes he can consider our investment in the auto industry
as a public works project. (BTW I will support a cash infusion for the auto industry if every employee, from top to bottom, agrees to a 25% reduction in salary in return for stock in their respective companies. If they truly believe that they just need a bridge loan to better times, that should be a good deal for the workers.)
Problem five: Using the tax code to social engineer the economy. This is clearly ripe for abuse. Politicians inserting favors for the politically connected or favored. Just make the tax code simple and let people free to find the best use for their money. I am afraid of a President who will use the tax code and regulatory powers to bankrupt firms that he dislikes while using the same power to reward firms that have enough political clout,
Posted by: DanC at Nov 10, 2008 9:37:19 AM
I think Nylund (above) gets closest to the point here by saying "I think there is a consensus that what currently needs to happen is that gov't spending has to increase and taxes should not."
The point that Nylund gets to a moment later that is key is that _overall_ taxes should not increase much, but taxes _for certain groups_ can rise or fall. As the source you cite extensively puts it, "...the highly deflationary impact of this tax law has not been fully appreciated...The Revenue Act of 1932 pushed up rates virtually across the board, but _notably on the lower and middle income groups_".
An overall tax increase (or better, a neutral overall tax reform) can still be stimulative if it concentrates the tax cuts on those with a higher marginal propensity to spend: i.e. the lower and middle income groups.
This is not inconsistent with a) much of what Krugman, Obama and others are saying, that cutting taxes for 95% while raising them at the top end is not the same as a huge tax increase, or b) saying that the demented form of supply side-ism (cutting taxes _for the high income earners_ - e.g. in certain tax cuts of a certain future ex-President - will stimulate the economy and will result in higher tax revenue) is flat-out wrong.
It is entirely consistent with saying that any tax cuts/fiscal measures should be focused on lower-income groups, and genuflecting in the direction of fiscal balance (even if only symbolic) by raising taxes on high-income groups may not be that bad, particularly if the marginal tax rates at that level don't get out of hand.
Posted by: GA at Nov 10, 2008 10:04:48 AM
SLS I do not object to Rauchway's take two. There are different series and both may be appropriate depending on the questions asked.
Posted by: Alex Tabarrok at Nov 10, 2008 10:27:51 AM
Hey, what happened to the infamous "balanced budget multiplier?" that Paul Samuelson et. al. taught generations of students. You know, raising government spending and taxes by equal amounts increases GDP by that same amount! Never mind, of course,that this means people are producing the addition GDP for no bump in their net of tax income.
Posted by: Indiana Norm at Nov 10, 2008 10:28:03 AM
Alex,
I think R. Higgs' "Regime Uncertainty" point you allude in your post deserves a post of its own. I would love to see how Krugman, DeLong, and Rauchway would reply to it.
Posted by: David Beckworth at Nov 10, 2008 10:55:05 AM
And if supporters of the New Deal argue that fiscal policy ...
==
How did we end up sweeping the _1932_ tax hikes into 'fiscal policy of the New Deal' that supporters must cope with?
Meanwhile, on your own calculations and arguments, it looks like the Obama plan skips over obvious objections: his likely tax policy is altogether quite different than Depression Era.
Posted by: Amicus at Nov 10, 2008 11:15:54 AM
Oh, and as for "regime uncertainty", it appears to have worked, at least until the Bush-43 era: it left a long-lasting reminder of what happens when businesses fall short of managing the risk(s) in their investments, by assuming that "labor" will bear the costs of their mistakes.
Posted by: Amicus at Nov 10, 2008 11:41:22 AM
You are right about the tax act of 1932.
But what does this have to do with the New Deal.
It was enacted and had its impact well before FDR took office.
Get your time lines right.
Or is just another example of your analytical mode of reaching a conclusion and feverishly searching for any data point that will support it?
Posted by: spencer at Nov 10, 2008 12:01:15 PM
Krugman's editorial completely misses the important policy point. Is there a variable that the federal government controls that can be used -- Keynesian style -- to reliably manipulate the economy? The answer during the Great Depression was "no."
Posted by: John Goodman at Nov 10, 2008 12:09:13 PM
Writes P. Gauthier:
Does anyone fell dumb for supporting Paulson's plan now that they are taking advantage of the non-review clauses to give 2 trillion dollars to unknown groups?
Tyeler and Alex, you helped support outright thieves...2 trillion would be better spent by giving $26,000 to every household in the country. Instead they stole the money fromt eh people and gave it to the billionaires you serve...good job guys.
The Federal Reserve has still refused to say who they gave $2 trillion to, and what they took as collateral. Bloomberg is suing to find out the answers.
Posted by: Gabe at Nov 10, 2008 12:13:36 PM
I confess I don't know the literature and response on Higgs, but his investment numbers were odd enough on face to cause me to furrow my brows.
Here's from Milton's History:
"During the low level of economic activity in the United States in the second half of the 1930s, foreign private investment in the United States more than doubled. The fastest growth was in short-term investment [!],which more than quadrupled, but every category of foreign investment grew." p. 486
I don't think that changes the basic point that the business climate is important, but it does offer another context to judge the assertion of relative importance.
Google book's online reference:
http://tinyurl.com/5wvuf2
Posted by: Amicus at Nov 10, 2008 12:21:03 PM
1) This is a stimulating debate and exchange, another in the series here at the Marginal Revolution (and elsewhere) on the Great Depression and --- explicitly or implicitly --- the relevance of New Deal policies to our existing financial and economic problems . . . or, in the view of many, not just problems but crisis on a global level.
2) As a general thing, Alex and others who criticize the big tax rise of 1932 --- a year not referred to, I believe, in Alex's post --- are probably right.
Only fair to add, though, that it was Herbert Hoover's administration that raised the marginal tax rate on very rich people --- essentially, those with incomes around $14 million or higher in today's dollars --- from 25% to 63%, while simultaneously raising the tax rate at the margin on low-income Americans from 1% to 4%.
To repeat --- the tax increases were NOT part of the New Deal programs. They were implemented by Herbert Hoover, whose various policies (as one poster here noted rightly) foreshadowed virtually all of the New Deal policies on a more modest scale.
....
Note, if only in passing, though: Hoover had cut taxes in 1929 --- especially on the top income earners. Those cuts, which continued a trend practiced by all Republican administrations in the 1920s to bring down the marginal and average rates that had reached a high level in WWI, didn't do anything to stem the huge decline in GDP after the stock market crash: a decline of nearly a third of US GDP, with serious deflation and soaring unemployment . . . an economic crisis without parallel not just in US, but globally.
And it was the Hoover administration that passed the Smoot-Hawley Tariff increase of 1930 . . . even though Hoover personally knew free trade was a better policy. He had no choice. The Republican Party was the champion of tariff policies for several decades by then. It was the FDR era that began reversing that ill-advised restrictive trade practice, urging free trade from 1936 on.
3) A political interlude. The political horrors that the Great Depression helped to bring about.
The Nazi Party had about 4% of the German vote before 1929. By early 1933, when Hitler came to power legally, that vote rose to 42% in the last free election. All over Europe, by 1933, right-wing militarist or fascist regimes were in power except in Scandinavia, Holland, Switzerland, and Britain . . . with France increasingly in that decade so torn by class-strife and political polarization that it was suffering by 1939 from an incipient civil war. And, further to the east, was the mass-murdering slave-labor Stalinist Soviet Union. And in Asia, Japan had invaded Manchuria in 1932; invaded China in 1936; and was on a course that would inevitably lead to war with the US, Britain, France, and the Dutch in Indonesia.
Somehow, conservatives and libertarians seem unaware these days just horrific the political fall-out of the Great Depression was. Or how bleak it looked from America. With Britain very badly overstretched to deal with these problems in Europe, Asia, the Indian sub-continent . . . at a time when Indian nationalism was also on the rise.)
...
4) Rewind in fast motion now back to the News Deal and the Great Depression era.
FDR only raised taxes slightly . . . mainly, unfortunately, in unintended regressive ways: especially a new payroll tax on the new social security system in 1936-37 that almost certainly did help cause --- along with the Federal Reserve's tightening the money supply --- the short-lived but fairly large recession of late 1937 and early 1938. There was a reduction of about 13% in GDP and a rise in unemplyment from the 1936 low of 9.9% (Darby correction of the official statistics, counting WPA workers) to 12.5%).
FDR did try to impose a new tax on corporate profits, but Congress rejected them in 1937. Otherwise, he did nothing to raise income taxes that he inherited from the Hoover administration.
...
So --- if high marginal or average taxes are to blame in part for prolonging or worsening the Great Depression in the US, it isn't mainly a misguided policy that can be traced back to the New Deal. The responsibility can be traced back to policies introduced by Hoover, and reinforced by the new payroll tax in 1937 . . . plus, it should be added, local and state governments increasing sales and other taxes, desperate as these governments were for revenue.
....
5 ) What FDR can be faulted for --- contrary to Alex's tendencies to criticize the New Deal's tax policies --- is his adherence to fiscal "austerity."
For contrary to the stereotyped view, FDR himself feared deficit spending . . . a fear that was no small part behind Hoover's tax-increases of 1932. And so at most the New Deal moved surplus federal revenues to neutral spending by the federal government and, off and on, slight deficits as a percentage of GDP or in real terms.
And hence, as Krugman and others note, this was a big reduction in any multiplier effects to increase aggregate demand in the midst of the Great Depression.
John Maynard Keynes, visiting FDR, came away from his meeting thinking that FDR --- far from being a disciple of his new theoretical stress on fiscal spending to stimulate GDP growth in the Depression --- was a fiscal conservative.
....
6) Enter the main problem in making sense of what happened in the New Deal era. It was introduced a couple of days ago by Tyler: there was good and even impressive GDP growth between 1933's start and the end of 1940 when we began to rearm in naval and airplane production even before we entered WWII in very late 1941. But, despite such growth, there was still high unemployment: 11.2 in Darby's calculations, and 17.% in the official figures that exclude WPA workers.
Here are the puzzling figures:
GNP --- to use that concept --- grew by 34% between the start of 1933 and 1936.
Despite the brief 1937-38 recession, GNP was 58% higher than in 1933's start. To make sure you grasp how fast that growth was, the growth of GNP in the 5 years of US wartime --- including the 1940 peacetime rearming -- was 56%. In short, however you view it, the New Deal era between 1933 and 1940 witnessed a huge growth rate in national income from the Great Depression trough of 1932 (when, to repeat, it was down 33% or so from the 1929 level).
....
And yet --- the puzzle --- unemployment was still high. Somehow, some way, the big productivity growth that accompanied this bursting GNP growth (and especially after 1937) did not generate job growth anywhere near that rate.
...
7) Note something similar, even if on a much lower level, to conclude this fast, top-skimming survey.
The US recession of 2001 lasted three quarters and was small peanuts in GDP loss. But, surprisingly, though the recession ended by the start of October 2001, job growth lagged noticeably behind the recovery of the economy. So much so that in fact unemployment continued to rise for nearly 20 months after the recovery began: a rise from roughly 5.0% t 6.3%.
And, please note, this was a recovery --- very likely similar to the recovery of US GNP after the 1937-38 recession --- accompanied by major leaps ahead in labor productivity.
.....
Michael Gordon, Aka, the buggy professor
Posted by: the buggy professor at Nov 10, 2008 12:43:12 PM
