Thursday, April 02, 2009

How to Turn a Recession into a Depression
by William A. Niskanen

Four federal economic policies transformed the Hoover recession into the Great Depression: higher tariffs, stronger unions, higher marginal tax rates, and a lower money supply. President Obama, unfortunately, has endorsed some variant of the first three of these policies, and he will face a critical choice on monetary policy in a year or so.


The Smoot-Hawley Tariff Act was passed by the House in May 1929, before the stock market collapse in October, and was enacted in June 1930 despite the opposition of many economists and several leading businessmen. Tariffs were increased 60 percent on 3,200 imported products, although most imports remained duty free. Moreover, most of the tariffs were in dollars per unit, so the real cost of the tariffs increased with the subsequent deflation. This act provoked 60 other governments to enact retaliatory tariffs. The higher tariffs and the general recession reduced total world trade by about two-thirds by 1933, and the U.S. unemployment rate increased from 7.8 percent when the Smoot-Hawley Act was enacted to 25.1 percent in 1933.

Senator Obama had been a cosponsor of the Fair Currency Act of 2007, which would have authorized a countervailing duty on imported products from a nonmarket economy with an undervalued exchange rate. Although directed primarily against China, it was also broadened to include Canada and Mexico. Approval of this act would surely provoke some form of retaliation; the United States is especially vulnerable to retaliation by China, because we are dependent on China to finance our current account deficit. A statement by Treasury secretary-designate Timothy Geithner during his confirmation hearing increases the prospect that the Obama administration will rule that China has manipulated its currency. During his campaign for the presidency, Obama also proposed opening up NAFTA to renegotiate the labor and environmental standards, and he opposed the several outstanding bilateral trade agreements that had been negotiated but not yet approved. During the congressional deliberations on the 2009 fiscal stimulus bill, however, President Obama expressed caution about any Buy America provision that might provoke trade retaliation.


The Davis-Bacon Act of 1931 required that labor employed on a federally financed construction project be paid no less than the local rates on a similar project. The Norris- LaGuardia Act of 1932 made "yellow dog" contracts, which made an agreement not to join a union a condition for employment, unenforceable in federal courts, and it banned any federal injunctions in nonviolent labor disputes. This was followed by the 1935 Wagner Act—which guaranteed workers' rights to organize unions, collective bargaining, and strikes—and the 1938 Fair Labor Standards Act, which established a federal minimum wage and banned child labor. These acts increased the real price of labor services, especially in the industrial sector, and were an important contributor to the substantial increase in the unemployment rate during the Great Depression.

Senator Obama had been an original cosponsor of the Employee Free Choice Act of 2007, the primary effect of which would be to outlaw secret ballots on the decision to certify a union. Another provision of this proposed law would authorize the government to write the labor contract in newly unionized firms if management and the union have not agreed to an initial labor contract within a specified time. Obama has also been a consistent supporter of higher minimum wages, which increases the unemployment rate of young unskilled workers.


A year before the bottom of the Great Depression, the Revenue Act of 1932 increased the top marginal federal tax rate on personal income from 25 percent to 63 percent, increased the corporate tax rate from 12 percent to 13.75 percent, and doubled the estate tax rate. The Revenue Act of 1936 further increased the top marginal tax rate on personal income to 79 percent and the rate on undistributed corporate profits to 42 percent. These two revenue acts increased federal tax rates more than in any other peacetime period and extended the length of the Great Depression by substantially weakening the incentive to work, save, invest, and increase productivity.

During his presidential campaign, Senator Obama proposed a combination of tax credits for low- and middle-income households, a substantial increase in marginal tax rates for those with an annual household income over $250,000, and several selective changes in business taxation. The top marginal rate on income would be increased from 35 percent to 39.6 percent, the marginal payroll tax would be increased from 1.45 percent to 5.45 percent (plus an equal increase to the employer), and the rate on capital gains and dividends would be increased from 15 percent to 20 percent. A phase-out of the personal exemption and specific deductions would add about 4.5 percentage points to the marginal tax rate (an estimate by the Tax Foundation).

The total marginal tax rate, thus, would be increased from 36.45 percent to 49.55 percent, reducing the after-tax return to additional earnings by about one-fifth; a lot of small business owners and professional couples would be subject to these higher marginal tax rates. Obama has not proposed a reduction in the corporate tax rate, although this rate is now the second highest among the industrial nations. His proposed changes in business taxation are designed to change the composition of U.S. business activity, increasing taxes on oil and gas companies and on U.S. multinationals that defer repatriation of foreign profits in favor of companies that produce renewable energy and increase domestic employment.

Obama's proposed federal tax rates do not look unusual compared to federal taxes before the Reagan-era rate reductions, but they would be a significant increase relative to recent years at a time when many other governments are reducing their personal and business tax rates.

Monetary Policy

In retrospect, the origin of the Great Depression seems surprisingly similar to recent conditions— with one huge exception. The Federal Reserve had increased the money supply from 1921 through 1927 by around 60 percent, contributing to the rapid increase in stock prices. In early 1928, however, the Federal Reserve began a policy of monetary restraint that continued through May 1929, increasing the discount rate from 3.5 percent to 5 percent in three stages. This triggered the stock market collapse in October.

The fall in stock prices and the subsequent general deflation led to a large increase in the demand for money. Following the collapse of the Bank of the United States in December 1930, however, the Federal Reserve increased interest rates again in early 1931. From 1929 to 1933, the money supply declined by around one-third, constrained by the rules of the gold standard, although the Federal Reserve Bank of New York had consistently urged a policy of monetary expansion. During this period, the number of U.S. banks also declined by around one-third due to either failure or merger.

This combination of a large increase in the demand for money and a substantial reduction in the supply of money was the primary cause of the first phase of the Great Depression. This period of monetary contraction ended only in 1933 when President Roosevelt raised the price of gold by 75 percent, permitting a renewed expansion of the money supply. In 1936 and 1937, however, the Federal Reserve doubled bank reserve requirements, leading to the short sharp recession of 1937–38 within the longer period of the Great Depression.

The monetary policy that led to the current recession was similar to the policy that led to the first phase of the Great Depression. The Federal Reserve maintained an expansionary monetary policy from 2001 into 2004, with a federal funds rate lower than the general inflation rate, contributing to both the housing boom and the increase in stock prices. Then from mid-2004 through mid-2007, the federal funds rate was increased by 4.25 percentage points, leading to a decline in residential investment beginning in the spring of 2006 and a decline in the stock market and national output beginning in the fall of 2007.

As in the 1930s, the decline in stock prices and the subsequent deflation greatly increased the demand for money and other financial instruments such as Treasury bills. The major difference from the earlier period is that the Federal Reserve has maintained a very aggressive monetary policy since mid-2007, reducing the federal funds rate by 5 percentage points. Moreover, beginning last fall, the Federal Reserve has purchased a wide range of private and public financial instruments, doubling the monetary base since last August. This dramatic change in monetary policy is primarily attributable to the lessons from Fed Chairman Ben Bernanke's studies of the monetary policy mistakes during the 1930s.

The very rapid increase in the monetary base since last August was, I believe, the correct response to the huge increase in the demand for money and is likely to be much more effective than any fiscal stimulus plan. But it presents a potentially large future danger. At such time as there is a revival of some general inflation and increased confidence in the security of nonmonetary assets, the demand for money will decline to a more normal level relative to total money income.

At that time, the Federal Reserve and the Obama administration will be faced with a very difficult choice—allow a high rate of inflation or raise interest rates fast enough to avoid that outcome. The first option would be the policy of inaction; the second option would require selling most of the financial assets that the Federal Reserve has accumulated in the past few months. My guess is that the time for this difficult choice is not too far off, probably in the next year or two, a guess based on observing that there has already been some increase in stock prices and commodity prices since November. And that will be a difficult time to make this difficult choice. Bernanke's term as Fed Chairman expires in January 2010 and, of course, there will also be a congressional election that fall, reducing the incentives and support for a rapid increase in interest rates. The second option would also present the potential for a W-shaped recession and recovery, extending the period of weak economic growth to avoid a high rate of inflation. In either case, the only way to avoid being faced with such a difficult choice in the more distant future is to correct the conditions that led this recession to be a financial crisis. This would require restructuring the mortgage market such that mortgages and mortgagebacked securities are more liquid and their risks are more transparent.

Other Related Policies

The trade and labor policies of the 1930s were designed to maintain the prices of products and labor services, usually at the expense of the amounts supplied. Other policies had the same objectives and effects. The 1933 National Industrial Recovery Act authorized cartels to maintain prices; until this act was declared unconstitutional in 1935, for example, members of these cartels were subject to fines for discounting. The most egregious of such policies was the Agricultural Adjustment Act of 1933; until this act was declared unconstitutional in 1936, this act authorized payments to farmers to reduce their acreage under cultivation. In effect, these policies established a floor under prices that prevented many product and labor markets from clearing, given the decline in nominal demand. These policies were an important reason why total output did not recover to the 1929 level until 1939, and the unemployment rate at the end of this decade was 17.2 percent.

Several current agricultural programs also have much the same objective and effects. The price of milk is maintained by a government- authorized cartel, the price of sugar by a quota on imports, and the price of corn has been increased by a regulation that requires a substantial production of corn-based ethanol as a motor fuel. I do not know Obama's position on the dairy cartel. During his campaign for the presidency, however, Senator Obama was a strong supporter of both the sugar quota and the ethanol program.

One other policy of both the Hoover and Roosevelt administrations was a substantial increase in federal expenditures for public infrastructure, especially hydroelectric facilities. These programs did not reduce total output but they were clearly not effective, given the combination of other policies, in reducing the depth or duration of the Great Depression. The government of Japan enacted a substantially larger public infrastructure program in the 1990s, also with no effect on ending what turned out to be a decade of very low economic growth. A major provision of President Obama's fiscal stimulus proposal, of course, is a substantial increase in federal expenditures for public infrastructure. Fed Chairman Bernanke was correct to observe recently that "Fiscal actions are unlikely to promote a lasting recovery unless they are accompanied by strong measures to further stabilize and strengthen the financial system."


The most important lesson of this paper is to avoid repeating the policies that increased the depth and duration of the Great Depression, particularly in combination. Unfortunately, some of these policies still have broad political appeal—limiting international trade, strengthening unions, other measures to support the prices of some products and labor services, and higher taxes on the wealthy and the income from capital. One important lesson that we seem to have learned from the 1930s is to avoid reducing the supply of money in response to an increased demand for money. Another important lesson that we have not yet learned is that some government spending for infrastructure may be both popular and valuable but is not very effective in countering a recession.

We have yet to learn the lessons about what caused the current recession and the general financial crisis. The United States had experienced 11 prior recessions since World War II without a general financial crisis, so something new must have happened that caused the current financial crisis. My judgment is that the government policies and private practices that changed the way mortgages are financed are that dangerous new development, but that is a story for another occasion. In this respect, I agree with Chairman Bernanke's recent conclusion that "we should revisit capital regulations, accounting rules, and other aspects of the regulatory regime to ensure that they do not induce excessive procyclicality in the financial system and the economy."

This article originally appeared in the March/April 2009 edition of Cato Policy Report.

1 comment:

Anonymous said...



Experts feel that the residential property prices are likely to stabilise from April onwards, with fear of deflation brooding over the economy. They maintain that the continuous drop in the prices of general goods and services will bring the interest rates down to more affordable levels. This, combined with the recent downward trend in property, may see buyers coming back to the market. The demand has not evaporated. It's waiting to come to the surface, but at the right price, with the right sentiment and with some kind of guarantee that the product will come up in the market, says Pranay Vakil, chairman, Knight Frank India, a global real estate consultancy.

We have various guesstimates ranging from end-2009 to middle-2010 when the slowdown might come to an end, but it must be clearly realised that there is no scientific basis for such estimates. After all, how can one estimate when the 'feel good' factor returns to reverse adverse expectations? Whenever it does, it will offer at least a small rally for some time because of the pent-up demand over the past 18 months, adds Sahni. In anticipation, investors are lapping up property when they believe they can negotiate good deals.

Changed Rules

- Some developers have increased the super area without a corresponding increase in the carpet area, even after the launch of the project.
- Instead of the surety of prices going up, some project launches have seen lower prices than those offered during soft launches.
- Payment for add-ons is not disclosed at the time of the sale.
- Developers now hold on for maintenance income even after project completion.

Before you decide

The prices have been falling and you might be ready to invest in a small city, but should you buy commercial real estate or stick to residential projects? Obviously, the demand and supply position of each sector needs to be examined carefully before you invest. Experts believe that given the demand for residential properties and the smaller investment required here, this sector scores over the commercial and office space. Also, the price correction in the residential sector has been more pronounced in the new launches than in the existing projects.

While investing in smaller areas, it is critical to know the market well. However, timing is equally important if you are buying land purely as an investment; a first-mover advantage helps immensely. Also, while the city suburbs offer affordable opportunities, investments in smaller cities should ideally be within municipal limits. You also need to keep an eye on any new rules and regulations as these can change suddenly. For example, while soft launches almost always meant a low entry price and short-term profits, some developers have now been forced to bring the prices down during the actual launch. Finally, make sure that you take great care while evaluating the size of the property as some developers tend to increase the super area without a corresponding increase in the carpet area.

The bottom line is that some sections of the real estate are still over-priced. Opportunities exist in the smaller cities, but prudent investors should focus on specific sectors or development types when venturing into these markets. The risks and opportunities that exist in the smaller markets are different from those in metros. The risk, when compared to metro cities, arises from lack of enough market information. If you do your homework well, you might find that there are good opportunities waiting to be tapped even now.