Some Inconvenient Facts About Fiscal Austerity
Andrew Mellon's infamous advice to Hoover is as good now as it was in 1932: "Liquidate labor, liquidate stocks, liquidate the farmer, and liquidate real estate."
In 1929 the nation's GNP was $104 billion and by 1932 it had plunged to $59 billion. But there isn't a snowball's chance that changes in Federal spending had anything to do with this huge 43% decline in national output. In the first place, Federal spending in 1929 was just $3.1 billion, or a mere 3% of GNP. It took another 80 years to erect today's leviathan state at 26% of GDP. More importantly, Federal spending wasn't reduced as the economy tumbled into depression during the next three years but, in fact, it grew by 50% to $4.6 billion in 1932. To be sure, there was a debate about whether the resulting shift in Federal finances from a sizable surplus in 1929 to a deficit in 1932 would help or hinder recovery. Yet the plain fact is that Federal finances in these fiscally antediluvian times were a rounding error in the national economy's scheme of things.
By contrast, the statistical source of the $45 billion decline of GNP during the descent into the Great Depression is readily evident, as is the likely train of causation. Between 1929 and 1932, private fixed investment plummeted by an astonishing 94% while durables consumption dropped by 61% and exports by 65%. In dollar terms, the sum of these three components, which had been $33 billion in 1929, dwindled to only $7 billion by 1932. Now that's a depression-scale collapse! Furthermore, this means that nearly three-fifths of the decline in GNP over 1929-1932 was accounted for by private fixed investment, exports, and durables-consumption spending.
This isn't coincidental because these three components were the epicenter of the unsustainable 1920s boom that had been spawned by the Fed's easy-money policies. Exports collapsed in part because of foreign retaliation after the passage of Smoot-Hawley in June 1930, but mainly because America's original experiment in vendor finance of exports failed miserably after the 1929 stock market collapse. During the preceding Wall Street boom, massive issuance of foreign bonds by governments from Peru to Poland and Germany -- that era's equivalent of sub-prime borrowers -- had artificially financed a huge build-up in US exports to countries which otherwise couldn't pay their bills (like China's vendor-financed exports to the US and Europe in the present era). But when the underwriting boom on Wall Street abruptly ended in 1929 (and the price of most of the foreign bonds soon fell to cents on the dollar), export orders in Pittsburg, Detroit, and Kansas City dried up shortly thereafter. Thus, not for the first time did an outbreak of capital market speculation stimulated by central bank largess ultimately result in a devastating liquidation of jobs and production on Main Street.
The 94% annihilation of private fixed investment spending flowed from the same cause. There was a legitimate investment boom in American industry during the 1920s -- especially in capacity to produce the new technologies of automobiles, radio, electric power, and consumer appliances. But by 1929, the Fed had created such a massive bubble on Wall Street that corporations could obtain both equity and debt capital virtually for free. Consequently, industry got massively overbuilt, speculative real estate development was rampant, and inventory accumulation reached precarious levels. Indeed, so great was the over-investment that "payback" time came with a vengeance: During 1932-1934, total private fixed investment including business equipment, structures, and residential housing averaged less than $2 billion per year -- or just 3% of GNP compared to 16% at the 1929 peak.
Finally, Main Street Americans were introduced to the twin wonders of consumer installment credit and stock market margin accounts during the 1920s. When the public's new-found enthusiasm for autos, appliances, and home goods couldn't be funded by these new lines of credit, winnings from the stock market were available to make up the difference. While buying durables and stocks on credit is not an original sin, a central bank policy that caused consumers to plunge off the deep end into unaffordable debt possibly is. In any event, after the music stopped in late 1929, durable goods purchases virtually ceased through the mid-1930s.
In short, the Great Depression had nothing to do with fiscal policy mistakes because the "fisc" in question was self-evidently too small to make a difference. Instead, it was the product of a classic boom and bust cycle that originated in the inflationary finance policies of central banks -- first to fund the carnage of WWI with printing-press money and then to layer on the speculative merriment of the Roaring Twenties.
When viewed in this framework, it's also evident that nostrums about the Great Depression offered by the non-Keynesian catechisms are equally off the mark. The monetarists, following the teachings of Uncle Milton (Friedman), say that the Fed caused the depression. And it did -- but by means of its inflationary monetary policies of 1917-1927, not on account of its stinginess in the provision of money after October 1929. In fact, the Fed was reasonably "easy" in its management of the monetary base after the stock market crash, permitting it to grow by 3% per year during the descent into the Great Depression from late 1929 to January 1933. Thus, the fact that the stock of money fell by nearly 25% during the same period wasn't due to a policy mistake by the Fed in its provision of reserves; rather, the Fed found itself "pushing on a string" in the face of massive loan liquidation owing to defaults and working capital contraction -- the same headwinds thwarting the Fed's hyperactive money string pushing today.
As for the supply-siders, it should be noted that neither Herbert Hoover nor the supply side patron saint, Treasury Secretary Andrew Mellon, committed the heresy of raising the tax burden, either. In 1929 Federal revenues were 3.7% of GNP and declined to 3.2% in 1932. Moreover, with his tax-cutting days of the 1920s long behind him and the reality of a classic boom and bust cycle everywhere evident, the patron saint remained as cogent as ever. In his infamous advice to Hoover in 1932, Mellon admonished: "…liquidate labor, liquidate stocks, liquidate the farmer, and liquidate real estate… ." His advice is as good now as it was then.
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