Guest Post: Depression Within A Depression

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Submitted by Jim Quinn of the Burning Platform

Depression Within a Depression

In recent months, worshippers at the altar of Keynes have been
hyperventilating over the possibility Congress will run a deficit of
“only” $1.5 trillion in 2010. They have issued dire proclamations about a
replay of the 1937-1938 Depression within the Great Depression. White
House favorite and #1 Keynesian on the planet, Paul Krugman, declared
that not borrowing an additional $100 billion to hand out to the
unemployed for another 99 weeks would surely plunge the country into
recession again.

    “Suddenly, creating jobs is out, inflicting pain is in.
    Condemning deficits and refusing to help a still-struggling economy has
    become the new fashion everywhere, including the United States, where 52
    senators voted against extending aid to the unemployed despite the
    highest rate of long-term joblessness since the 1930s. Many economists,
    myself included, regard this turn to austerity as a huge mistake. It
    raises memories of 1937, when F.D.R.’s premature attempt to balance the
    budget helped plunge a recovering economy back into severe recession.”
    – Paul Krugman in NYT    
     So did Roosevelt’s attempt to balance the budget in 1937 cause the
    second major downturn in 1938? I’m a trusting soul, but I prefer to
    verify what is being peddled to me by any economist, especially Paul

Ghost of Keynes Past

Today’s Keynesian economists have convinced boobus Americanus
that the Great Depression was caused by the Federal Reserve being too
tight with monetary policy and the Hoover administration not providing
enough fiscal stimulus. Ben Bernanke and Barack Obama used this line of
reasoning to ram through an $850 billion pork-laden stimulus package, as
well as the purchase of $1.2 trillion of toxic mortgages by the Federal

The only trouble is that this storyline is a complete sham.

The fact that colossal stimulus spending, zero interest rates, the
purchase of over a trillion in toxic assets by the Fed, and the loosest
monetary policy in history have done absolutely nothing to revitalize
the economy, has proven that Keynesian policies have been a wretched
failure. This is not a surprise to Austrian school economists.

Keynesian policies failed during the Great Depression, and they are
failing today. An economic catastrophe caused by loose monetary
policies, crushing levels of debt, and appalling lending practices
cannot be solved by looser monetary policies, issuance of twice as much
debt, and government commanding banks (or, in the case of Fannie and
Freddie, “commandeering”)  to make more bad loans.

Ludwig von Mises described what happened in the 1920s and 1930s. His
explanation accurately illustrates the situation in America today.

“There is no means of avoiding the final collapse of a boom
brought on by credit and fiat monetary expansion. The only question is
whether the crisis should come sooner in the form of a recession or
later as a final and total catastrophe of depression as the currency
systems crumble.”

The Roaring Twenties

They don’t call the 1920s roaring because money wasn’t flowing freely
and consumers were practicing frugality. The newly created Federal
Reserve expanded credit by setting below-market interest rates and low
reserve requirements that favored the big Wall Street banks. The Federal
Reserve increased the money supply by 60% during the period following
the recession of 1921. By the latter part of the decade, “buying on
margin” entered the American vocabulary as more and more Americans
overextended themselves to speculate on the soaring stock market.

The 1920s marked the beginning of mass production and the emergence
of consumerism in America, with automobiles a prominent symbol of the
latter. In 1919, there were just 6.7 million cars on American roads. By
1929, the number had grown to more than 27 million cars, or nearly one
car for every household. During this period banks offered the country’s
first home mortgages and manufacturers of everything – from cars to
irons – allowed consumers to pay “on time.” Installment credit soared
during the 1920s. About 60% of all furniture and 75% of all radios were
purchased on installment plans. Thrift and saving were replaced in the
new consumer society by spending and borrowing.

Encouraging the spending, the three Republican administrations of the
1920s practiced laissez-faire economics, starting by cutting top tax
rates from 77% to 25% by 1925. Non-intervention into business and
banking became government policy. These policies led to overconfidence
on the part of investors and a classic credit-induced speculative boom.
Gambling in the markets by the wealthy increased. While the rich got
richer, millions of Americans lived below the household poverty line of
$2,000 per year. The days of wine and roses came to an abrupt end in
October 1929, with the Great Stock Market Crash.

Between 1929 and 1932, the market fell 89% from its high. The
Keynesian storyline is that Herbert Hoover’s administration did nothing
to try and revive the economy. It took Franklin Delano Roosevelt and his
New Deal Keynesian policies to save the country. It’s a nice story, but
completely false. Between 1929 and 1933, when Roosevelt came to power,
the Hoover administration increased real per-capita federal expenditures
by 88%, not exactly austere.

Excessive Consumer Spending

When examining the BEA chart of GDP from 1929 to 1939, some
fascinating similarities with today’s economy leap out. In 1929,
consumer expenditures accounted for 72.3% of GDP, confirming that the
much-commented-upon American consumerism is not a modern development. In
fact, consumer spending peaked at 81% of GDP in 1932 and remained above
70% during the entire depression.

By 1950 consumer expenditures had subsided to 64% of GDP. In 1960,
they had fallen to 63% and edged up to 64% by 1970, where they remained
until 1980. By 1990 they had ticked up to 66% and by 2000 had reached
68%. The modern-day climax appeared to many to have been reached in 2007
at 70% of GDP. But in a replay of the New Deal playbook, where much of
the consumerism was funded by make-work projects and federal transfer
payments, the federal government has thrown billions of dollars at
consumers to buy houses, cars, and appliances. Consumer expenditures as a
percentage of GDP actually rose to 71% in
2009. It should be readily apparent that until consumer expenditures are
narrowed to a level that leads to a sustainable balanced economy, the
current depression will continue indefinitely.

Bureau of Economic Analysis National Income and Product Accounts Table

Table 1.1.6A. Real Gross Domestic Product, Chained (1937) Dollars [Billions of chained (1937) dollars]
   1929   1930   1931   1932   1933   1934   1935   1936   1937   1938   1939 
Gross domestic product 87.3 79.8 74.6 64.9 64.0 71.0 77.3 87.4 91.9 88.7 95.9
Personal consumption expenditures 63.1 59.7 57.8 52.6 51.5 55.1 58.5 64.5 66.8 65.8 69.4
Gross private domestic investment 12.2 8.1 5.1 1.5 2.3 4.1 7.6 9.7 12.2 8.0 10.3
Net exports of goods and services 0.8 0.4 0.2 0.0 -0.1 0.2 -0.5 -0.3 0.1 0.9 1.0
Government consumption expenditures and gross investment 9.2 10.2 10.6 10.2 9.9 11.1 11.5 13.4 12.8 13.8 15.0

The Depression Within the Depression

The Great Depression lasted from 1929 until 1940. What is not well
known is that GDP was at the same level in 1936 as it had been in 1929.
In no small part because GDP soared by 37% between 1933 and 1936. The
unemployment rate in 1929 was 5%. In 1936, even after GDP had recovered
to pre-depression levels, the unemployment rate was still 15%. It spiked
back to 18% in 1938 and stayed above 15% until World War II. Tellingly,
in 1936, private domestic investment was 21% below the level of 1929.

By contrast, government expenditures surged by 46% between 1929 and
1936. With the government creating agencies and hiring people into
make-work projects, private industry was crowded out. The extensive
governmental economic planning and intervention that began during the
Hoover administration was expanded significantly under Roosevelt. The
bolstering of wage rates and prices, expansion of credit, propping up of
weak firms, and increased government spending on public works prolonged
the Great Depression.

The evidence strongly contradicts the notion promoted by Krugman and
other Keynesian worshippers that the supposed 1937-38 Depression within
the Great Depression was caused by Roosevelt becoming a believer in
austerity. In fact, GDP only dropped by 3.5% in 1938 and rebounded by
8.1% in 1939. What actually collapsed in 1938 was private investment,
which fell 34%. By contrast, government spending declined by only 4.5%
in 1938, confirming that Roosevelt did not slash spending. To the extent
that he eased up on the accelerator, it was by cutting back on jobs
programs like those provided by the Works Progress Administration and
the Public Works Administration.

The reason private investment collapsed in 1938 was Roosevelt’s
anti-business crusade. He denounced big business as the cause of the
depression. In March 1938, FDR appointed Yale University law professor
Thurman Arnold to head the antitrust division of the Justice Department.
Arnold soon hired some 300 lawyers to file antitrust lawsuits against
businesses. Arnold launched cases against entire industries, with
lawsuits against the milk, oil, tobacco, shoe machinery, tires,
fertilizer, railroad, pharmaceuticals, school supplies, billboards, fire
insurance, liquor, typewriter, and movie industries.

The Greater Depression and Excessive Debt

Some Conclusions

The mainstream media’s popular narrative about the causes and cure
for the Great Depression invariably start with the storyline that the
stock market crash caused the Great Depression. Herbert Hoover
purportedly refused to spend government money in an effort to
reinvigorate the economy. Franklin Delano Roosevelt’s New Deal
government spending programs allegedly saved America.

This storyline is a big lie.

The Great Depression was caused by Federal Reserve expansion of the
money supply in the 1920s that led to an unsustainable credit-driven
boom. When the Federal Reserve belatedly tightened in 1928, it was too
late to avoid financial collapse. According to Murray Rothbard, in his
book America’s Great Depression, the artificial interference in
the economy was a disaster prior to the depression, and government
efforts to prop up the economy after the crash of 1929 only made things
worse. Government intervention delayed the market’s adjustment and made
the road to complete recovery more difficult.

The parallels with today are uncanny. Alan Greenspan expanded the
money supply after the dot-com bust, dropped interest rates to 1%,
encouraged a credit-driven boom, and created a gigantic housing bubble.
By the time the Fed realized they had created a bubble, it was too late.
The government response to the 2008 financial collapse has been to
expand the money supply, reduce interest rates to 0%, borrow and spend
$850 billion on useless make-work pork projects, encourage spending by
consumers on cars and appliances, and artificially prop up housing
through tax credits and anti-foreclosure programs. The National Debt has
been driven higher by $2.7 trillion in the last 18 months.

The government has sustained insolvent Wall Street banks with $700
billion of taxpayer funds and continues to waste taxpayer money on
dreadfully run companies like Fannie Mae, Freddie Mac, General Motors,
and Chrysler. The government is prolonging the agony by not allowing the
real economy to bottom and begin a sound recovery based on savings,
investment, and sustainable fiscal policies. President Obama continues
to scorn business by creating more burdensome healthcare, financial, and
energy regulations.

Today’s politicians and monetary authorities have learned the wrong
lessons from the Great Depression. The result will be a second, Greater
Depression and more pain for the middle class. The investment
implications of government stimulus programs are further debasement of
the currency and ultimately inflation and surging interest rates. Owning
precious metals and mining stocks, and shorting U.S. Treasuries will
pay off over the next few years. 

Regular Casey Report contributor James Quinn is the head of
strategic planning for one of the world’s most prestigious business
schools and the host of blog.