In Trying to Prevent Another Depression, Government Gets it Wrong

Was the Great Depression avoidable? If we could use the transporter room to send Uncle Ben and the Fed team back to 1929, could they have prevented the Great Depression? It would have probably been too late in 1929 to stop the cascade of events which was set up years earlier.

The Great Depression itself was caused by a massive evaporation of wealth - the stock market crash of 1929, bank failures, and unemployment causing repossession of assets. The bubbles which burst in 1929 began growing at the end of WWI, and by 1929 even Superman was not able to stop what came next.

Today’s response to our massive evaporation of wealth centers on keeping the banking system afloat, minimizing unemployment (not letting automakers fail), providing liquidity to the market, lowering interest rates to spur consumption, public works, and free trade. We are using our knowledge of the Great Depression to prevent its reoccurrence.

What happens if one or more of our economic responses actually makes the situation worse? Doing the opposite of what was done in 1929 and the early 30’s may not be right either. I want to center on one issue specifically – foreign trade.

Economists try to paint America as this rising industrial power in the early 20th century riding a wave of exports to Europe. Then a nasty depression hit and the idiots in Congress passed a trade protection act to protect the American worker. All the other countries retaliated, and the world wide depression was made much worse.

We are told that over one half of the drop in trade is due to import tariffs and restrictions imposed in most countries in the world. If only data and logic supported this.

• America was not a great exporting power. In 1929, trade was balanced. The trade protection act was passed in 1930. There was no effect on the trade balance. The chart below is from BEA data.

click to enlarge

• Trade fell because there was no demand. Exports fell from 5.6% of GDP to 3.5% of GDP for most of the Great Depression. [Cost of government rose from 9% of GDP to over 15% of GDP – does this scenario sound familiar?].
• In 1929, the majority of imported and exported items were simply high end products which are the first to be abandoned in bad economic times. Our imports today are low cost, value items.
• Note that despite trade barriers, trade began to recover beginning in 1934.
• If there was demand, either the import duty was paid or the product was produced in America. Economists are intent on proving protectionism added to the economic train wreck. I can find no studies on jobs created because of Smoot-Hawley protectionism. I can, however, demonstrate that the import and export of services (which was not taxed) remained in a tight range relative to the import and export of goods - between 17.3% to 21.9%. This services-to-goods ratio is from 1929 to 1937 but excludes 1931 and 1932 due to data anomalies. This directly contradicts assertions that tariffs had any significant impact to trade during the Great Depression, or the Great Depression itself.
• If you are wondering why economists did not look for positive effects (if any) of the Smoot-Hawley Act, 1000 economists petitioned Congress not to pass the act because they laid their reputations on the line insisting this was the wrong thing to do.

There is no question that free trade lowers the cost of goods and services to everyone. There is also no question that nothing is “free”, and everything has consequences.

Trade is a side show in the discussion of the Great Depression. What we learned in school are mere summaries of very complex situations distorted by the views of the various authors. I picked on trade because it is the easiest to argue, but I also worry that the cost of government expressed as a percentage of GDP was a significant factor in delaying economic recovery during the Great Depression.

I wish all of you a Merry Christmas, and remember the best present of all is happiness.

Disclosures: None.

Comments

[gotnochips:]

And the same to you!

2008 Dec 22 11:46 AM

[bobbobwhite:]

Let every country and industry and business do what it does best and do it globally. Everyone in every country benefits, or should if they are competitive in providing and also consuming the best product for the money no matter where it is produced. That's a true free economy.

Protectionism does not work and will never work over the long run as it is artificial and not realistic and serves to protect only those who are not globally competitive thus do not deserve protection. It is not fair, right, or sensible but is unfair, greedy, isolationist and very wrong for any country and its citizenry.

Support Free Trade Always!

2008 Dec 22 12:36 PM

[carey_jim:]

The biggest problem, as I see it, is that there is no real understanding of what caused the Great Depression, even among scholars and economists.

The stock market crash can't be blamed because only about 6% of Americans owned stock and among those, only about 500,000 people owned more than 80% of all stocks.

As you pointed out, the Smoot-Hawley Act can't be blamed because only about 5% of the American GDP was in foreign trade and the small reduction in GDP caused by the increased tariffs wasn't enough to cause a depression.

The economic boom of the 1920s can't be blamed because that would, theoretically, only produce a recession of a couple of years, possibly like the severe recession of 1920-21.

Economic historians have settled on two major events. The first was the increase in taxes that Hoover signed in 1932 to balance the budget. This increase was forced on Hoover, who was against it, because Roosevelt challenged him, during the 1932 presidential campaign, to balance the budget and Hoover was told that he would certainly lose the election if he didn't raise taxes to balance the budget. (Roosevelt broke his promise to balance the budget and actually increased it by 60% by 1936.)

But if you actually look at the data, you will see that government spending offset most of the loss of private spending.

Also, higher taxes didn't produce a very large drop in business spending, because business spending on new equipment, etc. wasn't that great in the 1920s anyway.

At any rate, there certainly wasn't a big enough decline in business spending to account for such a steep slowdown (25% unemployment and 30% decline in real GDP in three years.)

The gold standard was also blamed because countries were forced to raise interest rates to attract gold which depressed borrowing. But by 1932 the number of countries on the gold standard dropped from 47 to 7 and even though the United States remained on the gold standard, the Roosevelt administration found ways to get around it in practice.

While rising interest rates and increased taxes were factors, it isn't at all clear that they were THE major contributors to the huge and persistent decline that we call the Great Depression.

Many economic historians blame Roosevelt's New Deal because, they point out, after 1935 the Supreme Court ruled virtually all of his measures unconstitutional, and then there was an immediate two year recovery from 1936-37. So it seemed that when they economy was freed of the New Deal, it recovered.

The economy expanded by a very good clip during those two years from 1937-8 but unemployment remained high. It was followed, however, by another steep recession of 1938-39.

It isn't clear the war had anything to do with the end of the Great Depression either but I don't have time to talk about that now.

The real problem seems to be that the consensus of economic historians is that the Great Depression was caused by high taxes and a contraction of the money supply. But this could very well be wrong.

If they are wrong and 1) government spending by raising taxes and 2) lowering interest rates to stimulate consumption (it isn't very far from 0% already) are the only arrows in their quiver, what happens then?

2008 Dec 22 02:42 PM

[CLH:]

Capitalism requires a gut renching correction every 50-70 years. Only time will cure it. Whatever the gov. does will only prolong it. The pain is part of the cure.

Socialism does not correct so after a certain time it collapses.

2008 Dec 22 04:21 PM

[Moon Kil Woong:]

Steven Hansen: Very well thought out article. Sorry for reading it late.

The recession of 2008 may also be equally ponderous in the future. Although historians will cite the housing bubble, how many will recall the ill laid plans by bankers to hedge themselves out of losses by making a $50 trillion derivatives market that was specifically created to avoid any regulation whatsoever. Thankfully, although no one knows the full extent of this shadow market e are at least aware of the CDO and CDS market and how it is eating away at the fabric of our financial strength.

In 1929 who knows what machinations were hatched in the back rooms that went bad. That is the reason that full transparency is a must in order for our economic well being and health. The secondary benefit is for economists and historians; a complete and accurate record of economic calamities.

2008 Dec 23 10:45 PM

[jbgolfer:]

So where does all the money "evaporate" to??? Someone is keeping it...right?


On Dec 22 11:46 AM outofchips wrote:

> And the same to you!

2008 Dec 27 08:54 AM

[Longinvestor:]

Excellent article. It is the first time that I saw data refuting the anti-Smoot-Hawley Act shills.

2008 Dec 28 08:24 PM