The 2008 Federal Budget: Radio: KQED Forum 88.5 FM 9:00 AM Wednesday, February 7, 2007
Boykin User Research

Arnold Kling vs. Brad DeLong on the New Deal

UPDATE: Bruce Bartlett writes:

I just read your WSJ piece and you make one mistake. If Hoover had been re-elected in 1932, Ogden Mills would have been Treasury secretary, not Andrew Mellon. Mills became secretary on Feb. 13, 1932.

Arnold Kling vs. Brad DeLong on the New Deal at the Wall Street Journal's website.

Here are my first drafts for the exercise:

Let me start with our collective best guess about what would have happened in an alternate history--one in which the press discovers and publishes the full details of FDR's polio injuries and irregular family life , and in which in November 1932 Herbert Hoover is reelected to a second term with a narrow margin, and "stays the course" with his first-term economic policies...

In that alternate universe, a group of Harvard economists headed by Joseph Schumpeter were brought down to the White House to advise Herbert Hoover what do about the banking crisis in the winter of 1933. They argued that banks are failing because their fundamentals are unsound, and that it would be improper to rescue bankers who have run their businesses into the ground or depositors who have not been prudent enough at watching the character of the people with whom they have deposited their money. Supported by the articulate Treasury Secretary, Andrew Mellon, they carried they day: "Liquidate labor, liquidate stocks, liquidate the farmes, liquidate real estate," said Mellon. A full-fledged panic would not be a bad thing: It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people..." But the consequence was not people working harder and living a more moral life. Instead, the consequence was an intensification of the Great Depression as the transmission channels analyzed by Ben Bernanke (1983), "Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression," grew much stronger than they were in our actual history.

As more and more banks failed and more and more of the deposits of Americans vanished, the downward spiral of economic activity continued through 1933, 1934, and 1935. Increasing economic uncertainty and fear drove an acceleration of gold outflows from the U.S. accelerated throughout 1933 and 1934. The Federal Reserve--itself under Mellon's, responds by following gold standard orthodoxy: an outflow of gold is a sign that your interest rates are too low and need to be raised. Contractionary open market operations to raise interest rates further reduced the money stock, and this falling-money-stock channels for the intensification of the Great Depression that was stressed by Milton Friedman and Anna Schwartz (1963), A Monetary History of the United States, grew much stronger than they were in our actual history.

As the unemployment rate rose from 25% in 1933 to 33% in 1934 to 40% in 1935, Herbert Hoover vainly tried to restore confidence. "America must cling to the gold standard, for it is our only life raft," Hoover argued. Only confidence that the dollar would stay as good as gold could produce the confidence in the future of America that would induce entrepreneurs to start investing in America once again and so bring about recovery. But as Eichengreen and Sachs were to argue in their 1986 "Exchange Rates and Economic Recovery in the 1930s," Hoover had it exactly backward: no country could even begin to halt the downward spiral that was the Great Depression until it abandoned the gold standard, devalued its exchange rate, boosted its exports, expanded its money stock, and lowered its interest rates.

In 1932 Herbert Hoover had unleashed General Douglas MacArthur to deal with the Bonus March. At his command, Major George F. Patton's 3rd cavalry and other units had driven them with tear gas, swords, and bayonets across the Potomac River bridges and fired their camps, defeating what MacArthur called a communist attempt to overthrow the government of the United States. In 1934 the Bonus Marchers came back--and this time not coming unarmed. In our history Eleanor Roosevelt went down to their camp and had coffee with the Marchers, and Franklin Roosevelt signed up many of them to work on extending U.S. Route 1 through the Florida Keys. Not in the history where Hoover stayed president. Employing marchers by increasing the deficit would destroy confidence, Hoover said. In fact, Hoover declared at the end of 1934, balancing the budget had to take priority over relief, and the federal government would leave all relief expenditures in the hands of the states. Food riots broke out at the start of 1935 in scattered cities.

The Marchers camped in Arlington Cemetery through the winter of 1934-1935. The camp grew, as they were joined by followers of Louisiana's Huey Long, who cried "Share Our Wealth!" and "Nail 'Em Up!" and followers of radio Priest Charles Coughlin, who believed that Herbert Hoover had ruined America in the interest of enriching Wall Street, the international bankers, and the Jews. They placed themselves under the command of retired Marine General Smedley Butler. In March 1935 General MacArthur told President Hoover that he could wait no longer. MacArthur's chief of staff, D.D. Eisenhower, had had grave misgivings in 1932 when MacArthur sent Patton to attack the Bonus Marchers. On March 24, 1935, Eisenhower went to visit General Butler...

[to be continued]

I, at least, think that as far as recovery was concerned the macroeconomic good done by the New Deal vastly outweighed the structural bad. Any reasonable counterfactual involving no New Deal that I can see has things a good deal worse in the middle and late 1930s than they were in our reality.

But there is an argument to be made that an even better New Deal would have been possible, and ought to have been attainable.

Had Milton Friedman been special assistant to and whispering in the ear of Fed Chair Marriner Eccles in 1936-1938, he would have successfully headed off Eccles's boneheaded idea of raising reserve requirements on banks. Then the late 1930s would have been a much happier time. Had FDR given his baton in 1933 to trustbuster Thurman Arnold rather than to cartelizer Hugh Johnson and had the initial round of the New Deal increased rather than decreased the degree of competition in the American economy, then... well, the neoclassical part of my brain thinks that 1934 and 1935 would have been somewhat happier--but the Fundie Keynesian part of my brain thinks that Hugh Johnson's NRA was irrelevant because aggregate demand was a much bigger problem then than aggregate supply.

Arnold Kling, however, wants to talk about the legacy of the institutions and practices created in the New Deal for us today. For example, do we really need a Securities and Exchange Commission in the form it was cast in 1933 and 1934. Back then everybody, unfairly, blamed Wall Street for the Great Depression. Remember Roosevelt declaration in his inaugural address that the "practices of the unscrupulous money changers stand indicted in the court of public opinion, rejected by the hearts and minds of men....The money changers have fled from their high seats in the temple of our civilization."

The New Deal essentially dusted off and implemented the unsuccessful Progressive Era program for the reform of American finance that had been pushed by the likes of Louis Brandeis during the 1900s and the 1910s. And Louis Brandeis was definitely on the side of the upwardly-mobile and the smart and technically competent, as opposed to the side of old wealth and new thrift.

Was dusting-off and implementing Louis Brandeis's generation-earlier plan a very smart idea?There are powerful arguments that in the long run it was not. Financial markets function well for the economy only when they do a good job of seeking out and transmitting information about the likely future of enterprises and industries and getting that information crystalized into prices. This requires that people be incentivized to seek out and uncover important pieces of information by being able to profit handsomely from doing so--which requires that there be a bright visible line between what you can do and what you can't, between legitimate research and illegitimate insider trading.

The SEC as born in the New Deal has always found it relatively difficult to draw such a bright visible line, because its crisis origins have led it to focus on a different problem. You see, financial markets also function well only when they mobilize great masses of savings from scattered individuals by giving them confidence that their investments are liquid in that they can be bought and sold at a fair price. This requires that you not be buying share of a company from a cousin of one of its directors who knows that its market share has collapsed in the current quarter, and not be selling to somebody who knows that the latest sample assayed was extremely encouraging.

Smart financial regulation attains a point of balance. There is not general agreement but at least a general worry that the system the New Deal has left us pays too much attention to the desirability of a level playing field for buyers and sellers, and not enough to the desirability of having truly informed buyers are sellers in the market, and that it gives too much power to entrenched managers and not enough power to insurgent financiers.

It is not possible for even an abnormal person to defend somebody like Chase's Albert Wiggin, who by massively shorting Chase's stock gave himself a mammoth financial incentive to manage the bank as badly as possible, or New York Stock Exchange President Richard Whitney, who reported to Sing Sing in April 1938 for embezzling from the New York Yacht Club as well as others including his own father-in-law. But the neoclassical part of my brain whispers that times of crisis are not the times to design the best institutions for normal times when other and different considerations than those of the then-current crisis should carry greater weight.

Let me agree with Arnold that deposit insurance was badly handled. But let's not lose sight of the fact that even badly-handled as it was, really-existing deposit insurance was a mammoth improvement over no deposit insurance at all. I think that that is a good thumbnail summary of the entire New Deal: badly-handled, but a vast improvement over the preceding system and over the politically-viable alternatives--with the exception, I would argue, of Agriculture Support and the NRA, which did little if any good at immense long-run cost.

But Arnold now wants to hunt other game: "Just as we revere the constitution as the basis for our government and we revere Abraham Lincoln for ending slavery and preserving the union, we are supposed to revere the New Deal as somehow providing the basis for our modern prosperity. Yet the policies of the New Deal are quite a mixed bag.... Social Security, and its offspring Medicare, are going to be the next great financial crisis in this country." Let me protest the phrase "its offspring, Medicare." Medicare and Medicare are Lyndon Johnson's Great Society--not FDR's New Deal. And let me note that whenever I do the math that back in 2000--before Bush II--the long-run non-health program finances of the federal government looked to be in fine shape. At least as I did the math, even factoring in the forthcoming recessionary period 2001-2003, with then-current tax laws the long-run on-budget surpluses significantly outweighed the long-run off-budget Social Security deficits.

It's more accurate, I think, to say that the U.S. federal government has two fiscal problems: (a) the Bush II administration--with its insistence on not paying for the spending it insists on undertaking (including both the Iraq War and Medicare Part D)--and our long-run health financing problem.

And the health programs... One way to look at it is that it is not a problem but an opportunity. If we restricted Medicare and Medicaid to offer to beneficiaries in the future the levels of care that Medicare and Medicaid recipients received in 2000, we wouldn't have a long-run health-care financing problem. We have one because we expect that Medicare and Medicaid will pay for more care in the future than has been possible in the past; because we expect our doctors, nurses, pharmacists, and researchers to learn how to do amazing things; because we expect these amazing things to also be amazingly expensive; and because we expect America to want to provide access to future medical miracles on the basis not of heal-the-rich-sick but of heal-the-sick.

Does our belief that in general medical care should not be rationed according to ability-to-pay spring from the New Deal, or does it have deeper cultural roots?

If I can rephrase Arnold Kling's position, it is that the partial success of the New Deal--the recovery from 25% unemployment to roughly 10% unemployment, the recovery from 50% of 1929 industrial production to approximately 120% of 1929 industrial production before WWII began, and then the production and employment (albeit not private consumption) boom of WWII accompanied by total victory--taught us Americans bad lessons about the role of government, or lessons that will be bad for us in the future.

We now believe, I think Arnold thinks, that it is the government's job to provide for us in our medical care, in our old age, and when things go wrong in our work or family life. As a result, we now save too little, have too few children to support us when we get old, and work too little (because we face substantial marginal tax rates). We would be a better society if people knew that if they didn't save for retirement they would be poor in their old age, that if they didn't save for future medical care needs they would die prematurely, that if they didn't have dutiful chldren they would be alone and unnursed in their old age, and if they did not pile up large lumps of precautionary savings then they would lose their middle-class status if they had a heart attack, lost their job, or got divorced.

I find myself agreeing with Arnold Kling to the extent that I think Social Security would work better as a real forced-saving program than it does as a pure pay-as-you-go program. I agree with Arnold Kling in fearing that the health-care financing system we have grown will lead us to fumble a good deal of the opportunities for extending human happiness that are going to be opened up by biomedical research in the next two generations.

But as for the rest of it... Well, I am reminded of my teacher Shannon Stimson's lectures on early Victorian political economy. She noted that to the Victorians private charity should be ample (because that was what Jesus taught, and to keep the poor from starving in masses the streets) but never comprehensive, so that there would always be a few of the poor visibly starving in the streets, so that the poor would know that charity was not something they could count on, so that the poor had the proper incentive to work, to save, to stay married, to have children and bring them up properly. She tries hard to recover this mode of thought, in which the purpose of the economy is to create morally prudent servants who live in the Fear of the Lord. And her students--hedonists living in the California sun early in the 21st century--find it very strange: the purpose of the economy is obviously to enable people to realize their human potential and to satisfy their needs, wants, and dreams.

We California-sun hedonists will readily admit that moral hazard--people gaming the system and not contributing their share--is a pronounced danger in all kinds of insurance programs, especially social insurance. But consider: America is already on the libertarian end of the spectrum of advanced industrial economies. Further leaps in a libertarian direction would make us more the odd one out. The payoffs in increased savings from making the old and the sick who haven't saved poor would have to be demonstrated to be very large before I would conclude that the big problem with American government is that the incentives facing Americans in the economy are too soft and encourage too much slacking. And I haven't seen that demonstrated yet.


I like J. Bradford DeLong's Journal of Economic Perspectives article and his still unpublished attempt to get at the guts of the economic advice Joseph Schumpeter and others were giving in 1933 John Maynard Keynes called "extraordinary imbecility." An online for-pay version of Joseph Schumpeter et al. (1934), The Economics of the Recovery Program is at Schumpeter and company were fiercely critical of the New Deal. A contemporary review of their book by Princeton's Otto Nathan is here

Wikipedia has good background entries on Huey Long, the Bonus March, and Father Coughlin

For Eichengreen and Sachs on the gold standard and the Great Depression: "Exchange Rates and Economic Recovery in the 1930s"

Ben Bernanke's analysis of the role played by unstemmed financial panics, industrial bankruptcies, and bank closings is Ben Bernanke, Ben, "Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression," American Economic Review, 73, (June) pp. 257-76 at google scholar Ben has a nice speech about money, gold, and the Great Depression

Milton Friedman and Anna Schwartz's account of the role played in the Great Depression by gold-standard and other policies that contributed to the sharp decline in the money supply is in the "Great Contraction" chapter of their Monetary History of the United States Joseph Schumpeter, 1934: "[There is a] ...presumption against remedial measures [like cutting taxes, increasing spending, or lowering interest rates]... [because] policies of this class are particularly apt to...produce additional trouble for the future.... [Depressions are] not simply evils, which we might attempt to suppress, but...forms of something which has to be done, namely, adjustment to...change... [and] most of what would be effective in remedying a depression would be equally effective in preventing this adjustment..."