Saturday, April 24, 2010

FDR's Folly - and what Obama should learn from it

Franklin Roosevelt has for years been given credit for shepherding the nation through the Great Depression. For decades, FDR’s New Deal policies were believed by many economists to have prevented a total collapse of the United States economy until the markets and industry could recover as they geared up production to supply the US and its allies with war material to fight the Axis powers.

More recently, a close examination of FDR’s programs has revealed that the opposite may be true. In FDR’s Folly, Jim Powell shows that many of Roosevelt’s New Deal programs did far more to hurt the economy and delay recovery than they did to help. Higher taxes, strict regulation, and centralized economic planning all combined to keep unemployment high and the economy stagnant for the entire decade of the 1930s.

The recession that became the Great Depression had its roots in the Federal Reserve’s monetary policy. In 1928 and 1929, the Fed increased interest rates and caused a severe monetary contraction. Powell estimates that the money supply actually decreased by 1/3 (chapter 2).

Powell also notes that many states had banking laws that prohibited banks from having branches. This prevented diversification and made banks weaker. Approximately 10,000 US banks failed between 1929 and 1933 [1]. In Canada, where there were no such restrictions on bank branches, there were no bank failures. Most of the failed banks were rural single-office banks (chapter 4).

Herbert Hoover, who was president when the stock market crashed in 1929, took aggressive steps to save the economy, many of which are similar to steps taken by congress and President Obama over the last few years (chapter 3). Hoover encouraged industry to keep wages high in spite of falling sales and demand. He tried to put people back to work with public works projects and signed the Davis-Bacon Act which required local governments to pay union wages, which helped keep labor costs artificially high. He also backed farm subsidies, which led to overproduction and low prices.

Further, Hoover signed the Smoot-Hawley Tariff in 1930, which raised prices on imported goods. Many other countries retaliated by raising prices on American goods. The Revenue Act of 1932 also raised taxes. Other Hoover policies included restrictions on short sales of stocks and revisions to bankruptcy law that limited the rights of creditors. Hoover’s responses, and Roosevelt’s adoption of many of his policies, turned a recession into the Great Depression.

When FDR became president in 1933, he initiated a series of policies called the New Deal. Many of FDR’s policies took Hoover’s government actions and expanded them. One of FDR’s first actions was to declare a series of bank holidays, in which banks were ordered to close. Powell argues that the bank holidays actually contributed to the bank runs. People knew that the banks were going to be closed. They also knew that, in the days before credit cards, they needed cash. Their response was to rush to the bank and withdraw money while it was open… and solvent.

Another early action of FDR was to sign the Glass-Steagall Banking Act of 1933. This law (repealed in 1999) created a wall between investment banks and commercial (lending) banks. It also established the FDIC to insure bank deposits. The separation of banks prevented diversification and required many of the strongest banks in the country to split into smaller – weaker - parts.

Deposit insurance eased the minds of depositors, but Powell argues that it also made people more risk tolerant. If people knew that their funds were insured by the government, they would pay less attention to what the banks were doing with their deposits. In turn, it encouraged the banks to be more risky with their depositor’s money because they knew that it was guaranteed by the government.

FDR also raised taxes dramatically. The Revenue Act of 1936 increased federal taxes on income, dividends and estates, while limiting deductions. The Undistributed Profits Tax of 1936 raised corporate tax rates and limited deductions for business losses (chapter 6). By the end of FDR’s tenure, the top marginal rates for both personal and corporate taxes were in excess of 90% (chapter 18). These high tax rates discouraged corporate investment and further slowed economic growth.

At the same time that federal tax rates were rising, local and state taxes were also increasing. Many states saw dramatic increases in their income taxes for individuals and businesses as well as higher sales taxes.

Congress actually passed the legislation in 1939 which would have reversed the higher tax trend. The Revenue Act of 1939 would have lowered corporate taxes to a flat 18% and eliminated the Undistributed Profits Tax. However, FDR refused to sign the bill into law.

Another massive New Deal tax increase was passed into law as the Social Security Act of 1935 (chapter 13). As originally passed, Social Security established a payroll tax that would go into an Old Age Retirement Account. Benefits for retirees would begin after January 1, 1942 (although this was later changed to 1940). This was meant to allow funds to build up to pay out benefits, although the program quickly became pay-as-you-go after FDR and congress depleted the trust fund in 1940.

The passage of Social Security slowed the recovery for several reasons. First, it obviously depleted the purchasing power of employees since the tax decreased their take-home pay at a time when wages were already depressed. Since employers were also taxed, it made hiring more expensive and discouraged businesses from adding employees. Finally, it removed money from circulation that could have been spent on goods and services because the tax receipts went into a trust fund for several years before they were paid out to retirees. The ultimate legacy of Social Security is an unfunded entitlement that is expected to go bankrupt by 2037 [4].

Since the US was on the gold standard in the 1930s, FDR could not finance his New Deal programs by unlimited borrowing and printing money as President Obama does. If people saw that inflation was rising, they could exchange their paper dollars for gold. One way that avoided this problem was by amending the Trading with the Enemy Act of 1917 to be effective in times of national emergency. Under the authority of this law, FDR issued an executive order (EO 6102) forcing people to turn in all but a small amount of gold to the government. After seizing the gold, FDR increased the price of gold from the free market price of $20 to $35 per ounce [2].

Another intervention in private contracts was the Wagner Act (chapter 14), which established closed shops and banned company (in-house) unions. The Frazier Lemke Farm Bankruptcy Act of 1934 (chapter 15) limited the rights of creditors in an attempt to stem the tide of farm foreclosures. The Supreme Court ruled in West Coast Hotel v. Parrish (1937) that the government could impose limits on the freedom of contract, such as establishing minimum wage laws. The assault on business was so intense that a 1941 Fortune magazine poll showed that 91% of respondents believed that a dictatorship and a loss of many property rights was imminent (pp. 86).

The New Deal also made use of vast public works projects to stem unemployment. The Civilian Conservation Corps (CCC) and the Public Works Administration (PWA) hired large numbers of Americans for make-work projects. According to Powell (chapter 7), these agencies concentrated their efforts on western swing states where FDR stood to gain the most politically. He also points out that many of the jobs that the government created were for skilled workers. Unskilled workers, who would have had a harder time finding employment, were left out. Additionally, government competition for workers kept wages artificially high, which prevented the market from reaching an equilibrium in which workers could have real jobs.

Another upward pressure on wages came in the National Industrial Recovery Act of 1933 (chapter 9). This law contained a host of centralized economic planning measures. The law set minimum wages and minimum prices as well as production quotas. The law also made it easier for workers to unionize.

The effect of the NIRA was to push wages above market rates. Higher labor costs in a tight economy led many businesses to become more automated, which means that the price and wage controls actually cost many workers their jobs. Blacks were especially hurt because, at the time, they were excluded by many unions. If the company was a closed shop, where employees were required to be union members, blacks were effectively barred from employment.

Eventually, the NIRA was ruled unconstitutional by the Supreme Court [3]. The Supreme Court viewed the NIRA as an unconstitutional delegation of legislative authority to the president and industrial groups. The Court also pointed out that while the constitution grants congress the power to regulate interstate commerce, the NIRA’s codes attempted to regulate and control intrastate and local commerce as well.

There were other New Deal laws that attempted to fix prices and reduce competition as well (chapter 17). The Robinson-Patman Act of 1936 foreshadowed modern demonization of Wal-mart by making it illegal for wholesalers to give large chain stores cheaper prices than small retailers. The Miller-Tydings Retail Price Maintenance Act of 1937 also meant to protect small stores against chains by setting minimum prices. The Civil Aeronautics Act prevented new airline competition requiring licenses for airlines to operate. No new licenses were issued until 1978. The war against competition ultimately hurt consumers by keeping prices higher.

More price controls were found in FDR’s farm policy (chapter 10). The Agricultural Adjustment Act of 1936 included price controls as well as output limits designed to reduce food supplies and prop up prices. Under the Agricultural Adjustment Act, the federal government was responsible for literally destroying perfectly good food at a time when hundreds of thousands of Americans were going hungry.

Ultimately, the AAA was also ruled unconstitutional in 1936, but it was replaced by the Soil Conservation and Preservation Act which reduced the acreage for food crops by paying farmers to grow grasses and legumes. Market orders (quotas) for farmers were revived by the Agricultural Market Agreement Act of 1937.

Another attempt to bail out farmers was the Commodity Credit Corporation, which made loans to farmers using their crops as collateral. If the price of their crops fell, the farmers had the option of keeping their money and forfeiting their crops. This arrangement chiefly benefitted wealthy farmers who owned more land. The Farm Security Administration also made loans to farmers. Powell notes that the FSA concentrated its loans, not in poor areas, but in swing states. Powell also points out that in spite of these programs, farm foreclosures remained high throughout the depression. There were simply too many farmers in the post-WWI period.

Eventually FDR was so angered by the Supreme Court decisions ruling his pet programs unconstitutional that he tried to remake the court (chapter 15). The court-packing scheme, formally known as the Judiciary Reorganization Bill of 1937, would have allowed FDR to add more (friendly) justices to the Supreme Court. The bill ultimately failed, but the justices, particularly Hughes and Roberts, were apparently so intimidated that they stopped opposing New Deal laws. Many New Deal programs were blatant violation of the commerce and general welfare clauses of the Constitution, as well as the 9th and 10th amendments.

One of the most celebrated organizations of the New Deal era was the Tennessee Valley Authority (chapter 11). The mission of the TVA was build dams and bring electricity to rural communities. While it was long considered successful, the TVA had its down side. For example, the TVA took property from private utilities and individuals through eminent domain. Powell also found that TVA states were slower to exchange agricultural economies for more profitable manufacturing jobs. The lower wages found in farm states reduced the demand for electricity.

Another perceived benefit of the TVA was flood control. The dams built by the TVA were supposed to help control the natural cycle of flooding by rivers. However, Powell points out that areas permanently flooded by TVA lakes covered an even larger area than that typically flooded by the rivers.

With the unprecedented expenditures aimed at reviving the economy, what was the result of the New Deal spending? FDR’s Secretary of the Treasury, Henry Morgenthau, said it best when he told the House Ways and Means Committee in 1939, “We are spending more money than we have ever spent before, and it does not work…. I say after eight years of this administration, we have just as much unemployment as when we started and an enormous debt, to boot” [5].

In fact, in 1938 the United States had entered a depression within a depression (chapter 16)! New Deal policies favored labor unions resulting in increased labor costs as well as disruptions from strikes. In response, many businesses replaced their workers with machines. Tax increases decreased the amount of money available to both businesses and consumers. In 1942, the government started income tax withholding in order to get money into the government’s hands faster.

If the New Deal programs exacerbated the Great Depression, what did help the US recover? Conventional wisdom has been that World War II and the massive production needed by the Allies ended the depression. In reality, this spending was similar to the stimulus bill of our own day. It did put people to work for a limited time, but at the cost of a skyrocketing national debt. And when the government spending stopped, the jobs went away.

As the Wall Street Journal noted, both FDR and his successor, Harry Truman, wanted more New Deal policies after WWII [6]. This new New Deal would have included federal health care, government subsidies for housing, more make-work project, and “the right to a useful and remunerative job.”

Instead, led by Georgia Senator Walter F. George, then chairman of the Senate Finance Committee, congress cut taxes. The top individual tax rate was reduced from 94% to 86.45% and the amount exempt from taxation was increased. This change meant that an additional twelve million Americans paid no income tax at all. Further, the excess profits tax was repealed and corporate tax rates were reduced from 90% to 38% [6]. Additionally, FDR’s price controls were eliminated.

Senator George’s claim that the tax bill “will so stimulate the expansion of business as to bring in a greater total revenue” [6] proved correct. The US began collecting more revenue than it had when tax rates were higher and budget deficits turned to budget surpluses. Unemployment rates fell to a fraction of what they had been during the 1930s.

Powell points to other instances in which cuts in taxes and government spending helped heal economic problems (chapter 19). During the Panic of 1837, Martin Van Buren cut spending and taxes. In 1892, Grover Cleveland cut government spending to resolve a decline in prices. In 1920, Warren G. Harding faced the sharpest price decline prior to the Great Depression. Prompted by Treasury Secretary Andrew Mellon, he resolved it by cutting government spending.

There have been other instances of tax and spending cuts stimulating economic growth. Tax rates were cut by Presidents Kennedy, Reagan, and Bush and in each case led to a period of economic growth and increased tax revenues [7]. Other presidents, such as Lyndon Johnson, Richard Nixon, Jimmy Carter, and our own Barack Obama found that high levels of taxes and regulation led to economic stagnation, high unemployment, and rising inflation.

We can learn from the economic successes and mistakes of the past. President Roosevelt’s New Deal programs, while well intentioned, were costly and ultimately not only ineffective, but counterproductive. The New Deal programs caused fifteen years of economic stagnation. The US economy did not fully recover from the Great Depression until after WWII when tax rates were cut and freedom returned to the markets. This success was replicated (and foreshadowed) many times in US history by spending and tax cuts in the face of economic problems. If the federal government continues to follow the example of FDR, we can expect a long period of economic stagnation until a future administration is willing to embrace free market concepts.


Powell, Jim, FDR’s Folly. Crown Forum, New York, 2003.

Manassas VA
April 24, 2010

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