Policy for an Economic Depression: The New Deal

To professor Arístides Silva Otero, in memoriam.

In the midst of the Great Recession that began in 2008, it seems prudent to recall the economic policy presented when Franklin Delano Roosevelt (1882-1945) ascended to the U.S. presidency in 1933. FDR is the only U.S. president who has been elected four times (he was in power until 1945, when he died), and his New Deal program remains the benchmark for how to deal with a severe economic downturn.

A recent working paper examines the New Deal and corrects many misconceptions about it. The reference is Price V. Fishback and John Joseph Wallis’s “What was new about the New Deal?” from the National Bureau of Economic Research, August 2012.

The first important thing about the New Deal is to realize that it was more conventional than is commonly believed. The New Deal was far from a significant break from all of the rules upon which U.S. policy was based; it was also not a plan inspired by the recommendations of the great English economist John Maynard Keynes (1883-1946). The New Deal worked on existing government programs, and much of what it did was essentially intuitive, avoiding a potential challenge to the Constitution and American political tradition. There has been fierce criticism of the administration that preceded FDR, led by Herbert Hoover (1874-1964), which operated between 1929 and 1933. The truth is that Hoover reacted late to the Great Depression, while Roosevelt capitalized on initiatives that provided a good foundation for the New Deal. In short, Hoover did more than he is given credit for and Roosevelt was less revolutionary than believed.

Something that helps us understand the terrain in which Hoover and FDR operated is the knowledge that they both worked with limited and incomplete information. Following is Sebastian Mallaby, in “Regulators Should Keep It Simple” (Financial Times, Sept. 4, 2012): “At the onset of the Depression, governments confronted a collapse in output without the benefit of knowing what that output was. The U.S. national accounts had yet to be invented, so the Hoover and Roosevelt administrations based policy on shards of evidence: the behavior of stock prices, freight-car loadings, production data from particular companies. The dearth of reliable economic measures provoked a minor revolution. Simon Kuznets led the economics profession in creating statistics for gross domestic product and much more.” (Kuznets, who lived between 1901 and 1985, received the Nobel Prize in 1971.)

Then, there was an abundance of heuristic results that came from the New Deal. It was indeed a learning process, where some programs were rejected and deemed to be unconstitutional. One example was a chapter of the AAA (Agricultural Adjustment Administration), which was to establish a tax on agricultural production, but was repealed in 1935 by the Supreme Court declaring it unconstitutional in the case “United States v. Butler.” The same happened to the National Recovery Administration program, which established regulations on price, quality and working conditions in the industry, by the “Schechter Poultry Case” of 1935. Roosevelt never disobeyed court orders that were contrary to his plan and kept the public concern for freedom in mind, and his government remained within the law.

Roosevelt leveraged what Hoover had done previously and often rewrapped it with new packaging. For instance, Roosevelt had a piece in his program called the Reconstruction Finance Corporation, which acted as a banker for his infrastructure projects. This had already been created by Hoover in 1932. In 1927, the U.S. central government spending, according to statistics made after the fact, comprised 12 percent of GDP. Under Hoover, in 1932, it reached 21 percent. During FDR, that level was not surpassed until World War II — yet another cataclysm — that confronted the Democratic president (in 1942, the central government expenditure reached 28 percent of GDP). According to the authors of the working paper, “…There was a difference in style. While Hoover typically increased spending within existing programs, Roosevelt had a taste for advertising the New Deal programs that were renamed, reorganized or entirely new.”

Certainly, the New Deal established the American welfare state. In Table 2, the working paper provides a brief overview of public aid for pre-Roosevelt citizen welfare; these subsidies were limited to the blind, veterans, widows with children and infrastructure. Roosevelt raised awareness on two needs: providing help from the central government to those affected by the economic crisis and allowing transfers from the central government to the states for this purpose.

Amounts of aid in these programs were far from colossal: In 1929 the income per capita, in U.S. dollars at the time, was $820 dollars in aid. The major programs undertaken by Roosevelt covered only a small proportion of this figure: The Federal Emergency Relief Administration Program (FERA) gave $15.19 dollars per year; between 1934 and 1935, the Civil Work Administration Work Grants gave $8.18 dollars per capita. These New Deal programs often had to reduce the volume of aid to cover more people.

Major changes in the welfare state came from newer regulations and often took what already existed nationally in some U.S. federal states. The Social Security Act, created in 1935 to provide aid for the unemployed, already existed in the state of Wisconsin. Pensions for the elderly, previously existing only for war veterans, were extended to all seniors through Old Age and Survivors Insurance, although it only started paying pensions in 1940. Finally, aid was provided for specific audiences, such as the blind (Aid to the Blind) and children (Aid to Dependent Children). It is noteworthy to say that public health programs such as Medicaid and Medicare came later, in 1967. Social Security was a key and permanent part in the New Deal. In the workplace, the Fair Labor Standards Act of 1938 established the role of government in setting the minimum wage and monitoring conditions in the workplace, preventing child labor and excessive hourly sessions.

However, a key condition to ensure the survival of this new welfare state was how it handled the relationship between the central (national) government and the states. If anything is crucial to understanding Roosevelt’s success, it is how he adapted his New Deal to the American zeal via federalism. The chosen scheme centralized the funding component for those programs associated with welfare with the central government, but gave total administrative discretion to the states to administer. Under FDR’s government, the central government began making never-before-seen transfers to states, lifting three percent of GDP in 1932 to a level of 10 percent in 1934, and increasing participation in central government spending from 32 percent in 1932 to 49 percent in 1936 and 43 percent in 1938.

The central government assumed the financial burden of the programs and was severely controlled in deciding how they would be funded and what the funding could be used for; at the same time, each state administered federal funds sent from the government as it deemed best. Progressives were far from pleased. They believed it should be the central government who directly administered these programs in order for them to be most effective. FDR and his talented programs manager, Harry Hopkins, could certainly meet this demand for the programs they had a hold on, but they never wanted to confront the states regarding the matter. This experience showed that innovation in government is successful if you follow certain rules vigilantly and capture the spirit of citizenship on fundamental values.

Fishback and Wallis strongly emphasized this point: “The pattern of centralized and decentralized administration finances persists today. It is central to the interstate highway system, the structure of Medicare, the essential elements of the system of welfare reform in the nineties that gave greater state control over the administration of aid and recent health care reforms contained in the Affordable Care Act.”

Skillfully, the authors of the working paper capture the difference between the American and European schools of thought: While the U.S. maintains strong finances under centralized control and gives discretion to the periphery, Europe gives discretion to the central government (embodied by the eurozone by Brussels) and gives the cold shoulder to local governments (self-governments in Europe, especially those of the Mediterranean). The U.S. model has worked, while Europeans continue to disagree on how to handle their current economic crisis. The vision of federalism and that of the central government in the U.S. has a tradition dating back to independence and is one that remains unclear in Europe.

What was really original in the New Deal? Fishback and Wallis provide the following answer: “The creation of programs for the AAA paying farmers to remove land from agricultural production, the Social Security program for American workers, the NRA codes for competition, buying and mortgage refinancing by the HOLC and federal funding loans to farms.” I commented on Social Security and mentioned in passing the NRA; the other programs also deserve comment.

In agricultural policy, the New Deal had challenges that have been absent in the current economic crisis. The problems faced were the fall in agricultural prices and the inability of farmers to pay mortgages on their farms. According to the authors of the working paper, “The response of the New Deal in 1933 was to create two new programs: the Agricultural Adjustment Administration (AAA), with aid programs to pay farmers to take out land from production, and the Commodity Credit Corporation (CCC), which gave agricultural loans without recourse [without compromising the goods of the farmer] to place a floor under prices received for certain agricultural products.”

The unusual thing about the program was that it went to an extreme to protect agricultural prices by limiting production — an extreme measure especially in times when there was hunger. The loans to farmers guaranteed a minimum prize in practice but they did so as financial markets do for agricultural futures. The government went from having 12 percent of farm mortgages in 1930, by the Federal Land Bank, to 50 percent by mid-century, under the Farm Credit Administration.

The results of these policies are unclear, since they were accompanied by a period of drought. It appears that farmers took out the worst land from production and improved productivity on the land they left in operation. The policies additionally provided a larger subsidy to big farmers. What seems to have been a positive effect was the displacement of farmers from the poorest areas and the indirect effect on preventing soil erosion — a major achievement, given the sand storms that ravaged the U.S., known as the dust bowl, during the Depression.

The HOLC, or Home Owners’ Loan Corporation, was designed for a similar problem to the current situation in our own Great Recession: mortgages. Between 1930 and 1934, U.S. home prices fell on average 33 percent. In the thirties, those mortgage loans were for a term of three or five years, with a “balloon payment” to repay the entire loan at the end — which never exceeded 60 percent of the value for the property. The usual practice was to renew the loan for another three to five years to reach maturity, but with the Great Depression, banks lacked liquidity and demanded immediate payment of mortgages when they reached maturity. So, between 1932 and 1934, many homeowners entered bankruptcy and had to evacuate their homes. Hoover created the Federal Home Loan Board in 1932, which FDR absorbed into the HOLC and provided as a solution to give banks public debt in exchange for the mortgages. As Fishback and Wallis say, “[i]n essence, the HOLC replaced toxic assets from the books of the lenders and provided bonds that had a very liquid market.” The next thing that the HOLC did was to negotiate directly with its borrowers by widening the period by up to 15 years and setting an annual interest rate of five percent, below the then-current market, which was in the range of six to eight percent. According to the authors: “When the HOLC was created, Congress hoped it would be a proposal with monetary losses. The official government statistics suggest that until the HOLC was deactivated in 1951, purchasing programs and mortgage refinancing lost about $53 million or 2.7 percent from $3 billion dollars in loans it made. This certainly underestimates the true magnitude of the subsidy given to the mortgage market, as the interest costs were lower because of the HOLC bonds issued by the HOLC that were guaranteed by the government. If the HOLC had been created without a state guarantee for the bonds, the interest would have been at least a percentage point higher.”

In 1938, they created Fannie Mae (Federal National Mortgage Association) to provide a secondary market (resale) for mortgages, in which lenders could sell their mortgages and thus attract additional resources to give additional mortgages. Fannie Mae was expected to be able to live without government guarantees until 1968, but the reality is that in 2008, during the Great Recession, it was nationalized.

The positive point that can be taken from this is that instead of giving the banks million-dollar bailouts, their mortgages were purchased directly and existing mortgages to those borrowers were refinanced. Surely it was more practical.

Regarding financial regulation, the New Deal made some good progress. One regulation that has been praised by Milton Friedman and Anna Schwartz was the insurance of deposits, institutionalized by the Federal Deposit Insurance Corporation and the Federal Savings and Loan Insurance Corporation. This calmed an otherwise hectic banking market during the Great Depression, shown by the example of when, the day after reaching the presidency in 1933, FDR had to declare a bank holiday and reopen banks once they had detected which were viable and still operating. The Banking Act of 1933 separated retail bank activities from those of investment banking by the Glass-Steagall Act, which has resurfaced in the current era, and the regulation Q, imposing debt ceilings on interest paid on deposits. In the financial market, the Securities and Exchange Commission was established in 1934 to prevent crime and fraud in financial markets — anecdotally, it can be said that it was led by the father of President Kennedy, “Joe,” with a reputation of being a cheater, and FDR who, with practicality, said that to catch a crook you needed another. The fact is that Kennedy, Sr. did a great job and avoided topics such as insider trading and fixed minimum requirements for new issues.

In sum, if the New Deal era illustrates something that is needed now, it is how to manage economic crises with heterodoxy while adhering to existing laws and institutions. Critics of the program have a gripe that since then, the share of public spending in the economy has grown without containment, exceeding 30 percent in 1962 and rising to 39 percent in 1992, even after a conservative like Reagan. In a true emergency like the Great Depression, we have grown accustomed to having a government that is permanently growing and active in economic policy. The danger is clear; since the New Deal, [government programs] have been denounced as inherently at risk of underhanded maneuvers that come with government aid, with the federal and American libertarian zeal preventing the New Deal from turning into demagoguery and widespread corruption.

A final note to economists: Friends of public spending should note that the article gives corresponding evidence of that particular impact in the New Deal. By 1938, the U.S. government had spent 6.5 percent of GDP on social welfare, a high percentage, even in contemporary eyes, where it is estimated that “an injection of $2 million dollars in social assistance was associated with the reduction of: infant deaths, suicide, deaths from infectious diseases and death from diarrhea, while contributing to a rise in the birth rate to its long-term level. A 10 percent increase in aid to workers was associated with a 1.5 percent reduction in property crime; although this is less than the 10 percent reduction in crime associated with a 10 percent increase in private employment.” The authors also note: “The government work programs appear to have had little or no positive impact on private employment and in some cases appear to have driven private jobs even when unemployment remained above 14 percent.” (In the Great Depression, U.S. unemployment had reached the level that today is seen in Spain, 25 percent.) Another statistic mentioned by the authors is this: “Studies suggest that each additional dollar per capita spent on public works and aid during the period 1933-1939 by county [the Spanish equivalent would be a municipality] was associated with an increase in sales for retailers per capita of almost 43 cents, which could be moved to an increase in the per capita income of almost 80 cents. A study of state panel data between 1930 and 1940 suggests that a dollar increase in per capita spending on public works and aid increased income per capita in every state in the ranges of $0.9 cents to $1.7 dollars, while none of this is statistically significant of 1 USD. This increase in income did not translate into increases in private employment in the states…” The controversy between Keynesians and other schools of economic thought is served.