It’s starting to look like 1933 out there. With the stock market in a shambles and the economy slumping, governments are racking their brains, and history, for expensive solutions. But they are not finding what they think they are.
I had the privilege of teaching American history at the University of Ottawa this fall and as usual it was amazing how directly relevant the past was to modern experience. Barak Obama and the jagged racial scar running across American history seemed most pertinent when term started. But when the stock market collapsed, the importance of the Great Depression and various governments responses to it suddenly jumped to the head of the queue – especially the American response.
Policy-makers seem to have drawn sensible lessons from the disastrous post-Great Crash outburst of “beggar-thy-neighbour” trade policies, including the infamous American Hawley-Smoot Tariff, which not only worsened the economic agony but also fostered conditions conducive to war, as nations denied access to resources through trade sought to seize them by force. But something else happened in the 1930s with clear and immediate relevance to the present: Franklin Roosevelt’s New Deal.
It was the United States that produced the most dramatic and, supposedly, most successful response to the Depression: a dramatic expansion of the government especially into social programs. And to this day it is the template for political “leadership” and the instinctive response of politicians to economic trouble, especially those politicians ostensibly opposed to undue American influence on policy.
In April 1932 while seeking the Democratic Party’s presidential nomination, Roosevelt said “The country needs and, unless I mistake its temper, the country demands, bold, persistent experimentation. It is common sense to take a method and try it: if it fails, admit it and try another. But above all, try something.” Since those words could stand as the credo of the vast majority of politicians today (open-minded pragmatists who just happen to turn instinctively to government in any and all crises), it is worth a sustained look at the results of this approach to see whether something similar might work today.
The first point to make is that there were actually two distinct New Deals. Between 1933 and 1935 the Roosevelt Administration and its supporters in Congress busied themselves attempting to impose a cartel structure on the American economy, primarily through the Agricultural Adjustment Act (AAA) for farming and the National Industrial Recovery Act (NIRA) for everyone else from steel-makers to burlesque dancers. The underlying impulse was to restore prosperity by restricting production and raising costs, every bit as bad as it sounds and, mercifully, unconstitutional as well.
Only after the U.S. Supreme Court dispatched the NIRA in the famous May 1935 “sick chickens” case and then buried the AAA in January 1936 did the second and more familiar New Deal emerge. It was based on social programs, aggressive unionization of the industrial workforce and a considerably increased emphasis on public works. It is to that model that politicians are largely turning today, consciously or not. Mostly not.
So it is not irrelevant to note here that neither New Deal “worked,” if by “worked” you mean “restored prosperity”. The depression that began with the stock market crash of 1929 lasted basically until the coming of war in 1941, a slump unprecedented in duration as well as depth. If it was not worsened by an equally deep, long and unprecedented burst of expensive, aggressive, anti-capitalist intervention, it certainly was not brought to an early end by it.
The second New Deal might nevertheless be defended by saying Roosevelt’s great accomplishment was not in ending hard times but in putting in place programs that enabled people to survive hard times, that there is a trade-off between relief and recovery and FDR got the trade-off right. Orthodox economists before 1933 would certainly have endorsed at least the first part of that contention. But it is not the argument made by intellectuals in the 1930s and 1940s and practical people afterward, in defence of the New Deal and its later Canadian knock-off.
The supposedly crucial lesson drawn from the second New Deal by Keynesian academics, liberal politicians and mainstream voters, was that government spending stabilizes a capitalist economy especially if much of it is “structurally counter-cyclical,” that is, if it consists of programs like unemployment insurance that automatically expand in hard times and contract in good ones. And a lingering belief that relief and recovery go hand in hand clearly underlies the amazing volume of contemporary demands for governments to “do something” to stimulate the economy, often by people who cannot for the life of them suggest what exactly the phrase means.
There is not much explicit or implicit enthusiasm for the first New Deal. But even the second New Deal is a highly doubtful analogy for contemporary stimulus and recovery plans for two reasons that relate directly to the curious incoherence of contemporary demands for “action”.
To put the matter bluntly, the welfare state whose construction supposedly ended the Great Depression cannot be constructed again because it already exists. And it wouldn’t help if it could be, since its existence didn’t prevent the collapse of autumn 2008. Nor, for that matter, did it deliver on its earlier promises either.
Precisely because of the supposed Keynesian lessons of the Second New Deal, American, Canadian, British and other politicians and voters established and then massively expanded a welfare state complete with elaborate, deliberately counter-cyclical features, and for decades intentionally ran deficits in hard times (normally by hiking spending though even John F. Kennedy’s famous tax cut was expressly designed to cause a counter-cyclical deficit).
Unfortunately we learned a grim lesson in the stagflationary late 1970s and early 1980s: Keynes was quite wrong. There is no trade-off between unemployment and inflation and no positive economic impact from deficits. It was a painful lesson partly because it’s easier to start running deficits than to stop and partly because the Keynesian consensus was highly congenial to officeholders, activists and voters who wanted social spending on other grounds. But it was learned. And one disquieting feature of the current crisis is that we spent 30 years convincing ourselves governments could not stimulate the economy and now everyone demands that they do it anyway.
The resulting confusion is not harmless. For the key practical difference between modern times and the 1930s is that we cannot respond to our current difficulties by creating an expensive and countercyclical welfare state, on dogmatic or pragmatic grounds, because one already exists. In fact, sensible people today feel grave concern about its long-term sustainability. But even if it were possible to contrive further expensive additions to it, who can persuade themselves that they would achieve a stimulative effect when the existing system has not?
Remember that the downturn of 2008 began in a world in which, under the allegedly compassionate conservative President George W. Bush, on-budget federal spending in the United States skyrocketed from $1.5 trillion in 2001 to some $2.4 trillion in 2008 while running deficits that shocked friend and foe alike, reaching $450 billion before the collapse of the subprime market. And, at the administration’s request, Congress added an enormous and hideously expensive new prescription benefit for seniors to federal health programs already consuming one-fifth of the federal budget. North of the border, Canada’s Conservative government had already raised spending from $209 billion to more than $240 billion dollars in only three years, while the Liberal government of our largest province had cranked spending up from $74 to $96 billion in just four years with more large increases already planned, and both are now drifting helplessly into deficit and calling it prudence. If that is not stimulus enough to prevent a slump, on both sides of the border, what order of magnitude of increased spending would likely be needed?
The incoherence of suggestions and criticisms in the face of this situation reflects the collapse of the old faith in government stimulus but its persistence at an instinctive level. A November 28, 2008 press release from the office of Canadian federal Liberal MP Hedy Fry quoted Ms. Fry hammering the government for being “the only G20 country with no plan and no fund for stimulating the economy” and then promptly cited her colleague Ujjal Dosanjh saying “A deficit is inevitable. We all know that. But it didn’t have to be that way. They [Conservatives] squandered the surplus left by the last Liberal government, spent the $3 billion contingency fund we set aside for times like these and ratcheted up spending, by more than $40 billion a year. This is lousy fiscal management.” So it is wrong to have no stimulus plan and to run a deficit. What, then, are they meant to do?
It is not obvious that anyone has a sensible answer to that question. American president-elect Barack Obama, for example, has promised a vast stimulus package but also ruthless cutting of government waste to reduce spending which, logically, ought to offset the stimulus. Plans change almost daily as politicians thrash, but in early December Mr. Obama announced a so-called plan for a massive infrastructure public works program (which the New York Times said “showcased his ambition to expand the definition of traditional work programs for the middle class, like infrastructure projects to repair roads and bridges”) including everything from broadband access for every child to solar panels and fuel-efficient cooling systems but with no cost estimates, no reasonable idea of what exactly it would contain and no explanation of how that question would be settled in practice. The plan’s only clearly discernable feature was outdated faith in the capacity of government to spend intelligently in a hurry and stimulate the economy in the process.
We seem to face a solid consensus that something no one can specify is obviously urgent. Which calls to mind the line from Jane Wagner’s play The Search for Intelligent Life in the Universe: “All my life, I always wanted to be somebody. Now I see that I should have been more specific.” Or not, since what they found was a foray into the auto business, bailing out two of the Big Three American carmakers with loans and grants in excess of their combined market value in return for restructuring commitments no one understands that immediately prompted Big Steel to put out a hand as well. As C.D. Howe Institute President William Robson (the author’s brother) recently reminded us, “the adage that governments pick winners badly but losers pick governments well applies doubly when governments act in haste.” It is another lesson learned painfully over 30 years then thrown out the window at the first opportunity.
The one fairly detailed plan everyone does seem to have is for governments to increase the volume of dubious lending in the economy in an attempt to stop a temporary crisis from overwhelming the whole private credit structure. And this plan too points us back toward 1933, because before either of the identifiable and intellectually coherent New Deals discussed above came FDR’s famous initial “Hundred Days” that included a wide range of uncoordinated initiatives from cutting federal salaries to taking the United States off the gold standard as a prelude to a crackpot devaluation scheme to the creation of the vast public hydroelectric power Tennessee Valley Authority. (When asked how he would explain the philosophy behind the TVA, FDR said “I’ll tell them it’s neither fish nor fowl, but, whatever it is, it will taste awfully good to the people of the Tennessee Valley.” Which is precisely the sort of sentiment that appeals to the pseudo-pragmatic politicians in our own time, though regrettably they cannot create Ontario Hydro to fight the slump because, like the current welfare state, it has existed for decades.)
Crucially, the “Hundred Days” also included rescuing the banking system by using “wartime powers in peacetime” (under the Trading With the Enemy Act) to impose a national “bank holiday” followed by legislation to restructure the banking system, create federal deposit insurance, and offer enormous emergency public support for troubled farm and home mortgages. That is where it might seem most rational for politicians to turn for lessons: Throw government’s economic weight into an effort, as FDR and the Democratic Congress did, to keep unsound private credit markets from collapsing.
Unfortunately here too the same crucial difference manifests itself. In 2008 governments are deeply structurally involved in financial markets including the bubble that just burst. It’s not just the American government’s irresponsible, deliberate inflating of the subprime bubble over many years. It’s that, more generally, the modern credit system is already underwritten by government regulation, deposit insurance and a vast range of other mechanisms thanks to the “lessons” of the 1930s. And whereas in the 1920s foolish lending overstretched the private credit system, in the 1990s and 2000s it has overstretched this hybrid public-private credit system.
Proposals for government now to move to support failing credit markets are like suggesting propping up the collapsing roof with timbers already employed in precisely that task. Yanking beams out to stick them back in is not just silly in principle. It’s highly dangerous at a highly dangerous moment. (As for proposals afoot in nations from Britain to Iceland to Estonia to nationalize banks, what was bold, untried folly in the 1930s is now tame, tried folly. It’s not an improvement.)
Politicians may almost uniformly share FDR’s self-image of themselves as compassionate and pragmatic, beyond ideology. But Keynes had much the better of an implicit argument with Roosevelt (whom he once met privately and found disappointingly economically illiterate). In contrast to FDR’s belief in experimentation, Keynes wrote that “the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.” Which ironically came to include him.
If instinctive faith in the power of government to bolster the economy by unfocused hyperactivity is not ideology, then to borrow a phrase from hardboiled crime writer Damon Runyon, it will do until some ideology comes along. A true pragmatist would be willing to revisit an implicit faith in the power of expanding government to fend off slumps given contemporary circumstances. Such a person would find some very helpful alternative ideas sitting there waiting for him or her.
They could start with an explanation of economic cycles that has not been exploded by 30 years of failed policy responses. It is the one put forward by the anti-mathematical “Austrian” school of economics associated most prominently with Friedrich Hayek and Ludwig von Mises. In the Austrian view, the underlying cause of economic fluctuations (other than bad policy) is that information is not a “given” but a scarce and valuable good. People make decisions to invest, borrow or buy based on their best guess about their future prospects. At various times they are unduly pessimistic and risk-averse and the economy is sluggish; at others they are optimistic and things start humming. Unfortunately, especially as conditions improve, too many people start making plans that are not individually irrational but that cannot all be accomplished. Too many merchants plan to obtain the same dollar from the same customer, and while each of them could, they all can’t. At some point it dawns on people that they have, in the aggregate, been over-optimistic, so they adjust their expectations. They postpone purchases, borrowing and investments and a series of mutually reinforcing shocks ripple through the economy.
Crucially, in such downturns the problem is not “confidence” in some odd psychological sense. It is a lucid recognition of widespread overconfidence and an adjustment of behaviour to improved information. And it is neither useful nor possible in such circumstances to restore not confidence but overconfidence that has just painfully given way to realism. We must adapt to what is happening, not pretend we have not noticed it.
Some Austrian economists may have read the preceding passage with horror because it failed to acknowledge the pernicious ways in which governments contribute to economic instability by measures that, intentionally or accidentally, deceive people in ways that cause or at least prolong bubbles. I was saving it in order to drive home that, if the Austrian view is sound, most conventional suggestions for mitigating the current crisis are precisely aimed at bolstering bad loans, propping up failing companies and otherwise delaying the inevitably painful readjustment of expectations to reality. All they can do is increase the inevitable pain of doing so. And the longer politicians try to “restore confidence”, the more harm they will do. You can’t unburst a bubble and should definitely not try.
To be fair, politicians do seem to have drawn one correct lesson from the 1930s. They are determined to protect what remains of the international policy architecture put in place after World War II to ensure that nations were not able to pursue the “beggar-thy-neighbour” trade policies that so badly worsened the Depression. But surely we can also preserve the lessons of the 1970s and 1980s. For if we aren’t all Keynesians, what are we? Just fools?
An open-ended series of drastically expensive measures not based on any coherent reasoning may be paraphrased as “When in danger or in doubt, run in circles scream and shout” except in this case you also spend. It should not be hard to understand why confidence is slow to return in financial circles when that is what the authorities and chattering classes have to show for 75 years of reflection on often painful experience.
So here are the key lessons for policy-makers in this crisis: Do not throw good money after bad. You cannot make something out of nothing. It is not 1933 and you are not Franklin D. Roosevelt.
 John Maynard Keynes, The General Theory of Employment, Interest, and Money (San Diego: Harcourt Brace Jovanovich, Publishers, 1964) p. 383.