The Great Depression presented formidable challenges to mainstream economists of the day. The slump following the stock market crash in the autumn of 1929 was not itself that perplexing. Orthodox doctrine then held that downturns in economic activity were part of the business cycle's natural rhythm. The real problem was to account for the economy's failure to right itself. In a well-functioning market system, it was expected that downward adjustments in wages and prices would generate the correctives needed to restore conditions of high production and employment. By late 1931, it was clear that the expectations of the orthodox did not mesh with the observable reality. This observation did not mean that mainstream economists were ready to reject their original "model." For most of them, confidence in its rightness could still be salvaged with the argument that the state of the economy—not the state of economic theory—was out of joint. It could thus be argued that the many impediments to wage-price flexibility—some generated by the market power of businesses and trade unions, some generated by governments—had kept the normal adjustment mechanisms from functioning properly. This intellectual maneuver may have stiffened the morale of economists in the mainstream, but it did nothing to improve their public image.
In the popular estimation, some critics of mainstream economics were also discredited by the flow of events. In the 1920s, two strands of argument were developed that purported to demonstrate that there was nothing inevitable about "so-called" business cycles and that appropriate policy interventions could effectively stabilize aggregate economic activity at a high level. One variant of this approach maintained that expenditures on public works should be timed to compensate for fluctuations in private spending. This strategy formed an important part of the "new era" economics associated with studies inspired by Herbert C. Hoover as Secretary of Commerce. It is important to note that Hoover expected that the overwhelming bulk of expenditures on public works would be undertaken by state and local governments and that the Federal government's primary role was to signal when to open or close the spending tap. (This strategy was indeed deployed in 1930—but without the anticipated results—when Hoover was in the White House.) A second variant insisted that the alleged "laws" of the business cycle could be repealed through the appropriate conduct of monetary policy. The leading spokesman for this position—Irving Fisher of Yale—maintained that variations in the general price level were at the root of fluctuations in production and employment. Hence, it seemed to follow that stabilizing the general price level—a task that could be performed by the Federal Reserve—would stabilize the economy. These vestiges of "new era" thinking did not fare well in face of the events of 1929 through 1931.
Events did, however, enhance the credibility of economists associated with the heterodox school of institutional economics. Those of this persuasion had long been skeptical of the claims of the mainstream regarding the beneficent properties of unregulated markets. In their view, economists sympathizing with a regime of laissez-faire were hopelessly out of touch with the modern economy. The notion that markets were effectively competitive might have had some validity in an earlier, simpler, and less concentrated economic order. The central truth about the current economy was totally otherwise: It was characterized by a fundamental asymmetry inherent in the economy's structure. In one sector—in which large manufacturing firms were predominant—producers had the capacity to administer prices. It was often in their interest as profit-maximizers to raise prices by restricting outputs, which meant that production and employment were inevitably held below their potential. By contrast, the myriad producers in the agricultural sector were inevitably price-takers, not price-makers, and the prices they faced tended to be notoriously unstable. Depression conditions lent some plausibility to the institutionalist position. (These conditions might also have been read as compatible with a Marxist claim that the Depression foreshadowed the imminent collapse of the capitalist system. This interpretation was indeed articulated, but its impact was never more than marginal in the United States.)
Advocates of the institutionalist heterodoxy got a public hearing in the early 1930s, but they also got more. A number of their most prominent spokespersons were invited to walk in the corridors of power in the early days of the Roosevelt administration. Rexford Guy Tugwell, for example, was a member of Roosevelt's "Brains Trust" during the presidential campaign of 1932 and remained a key adviser in the shaping of policy in the First New Deal. Tugwell was amply on record in holding that laissez-faire amounted to "competition and conflict" and that it should be displaced by a regime of "coordination and control"—that is, central planning. This intellectual posture underpinned the supply-restriction programs administered by the newly formed Agricultural Adjustment Administration as well as the "codes of fair competition" that industrial trade associations were expected to prepare (and to submit for governmental approval) in the National Recovery Administration. Tugwell's influence was also noteworthy in the recruitment of economists to staff these emergency agencies, which in turn gave economists a greater presence in the Washington bureaucracy than they had ever before enjoyed.
While most American economists tended to view the world through familiar analytic lenses, there were some notable instances in which economists fundamentally rethought their original positions. Irving Fisher is a case in point. In the 1920s, he had pronounced that the United States was approaching an era of permanent prosperity—a forecast that was to be disastrous, both professionally and personally. By 1932, he had produced an innovative reformulation to explain what had gone wrong. The root of the difficulties, as he then saw matters, could be traced to two diseases: the "debt disease" and the "dollar disease." The American economy of 1929 was fragile because of overindebtedness (a vulnerability that had gone largely unnoticed at the time). But once the dimensions of this problem had been recognized, alarm spread among some creditors and debtors, sparking an initial round of liquidations. A chain reaction followed, involving distress selling, the contraction of bank deposits as loans were paid off or called in, and a consequent collapse in the general price level. The "dollar disease" had exacerbated this situation: That is to say, as prices fell, the real burden of debts increased. Deflation thus became cumulative. Price reductions in response to shrinking demand should thus no longer be seen as part of a normal readjustment leading to recovery. Instead deflation simply generated more deflation, with no end in sight short of universal bankruptcy. The remedy was implicit in the diagnosis: reflating the price level back to its pre-Depression norm and then stabilizing it at that level. Debt burdens would thereby be relieved and liquidations halted. Debtors, with more discretionary income available for spending on goods and services, would spur resurgence in purchasing power that would reinvigorate production and employment.
Economists in the Washington bureaucracy also displayed some analytic originality, particularly in evidence as they groped to understand a sharp downturn in economic activity in the late summer of 1937 which was, in fact, more precipitous than the drop in production in the months immediately following the crash of 1929. The recession of 1937 and 1938 was especially puzzling because it occurred when the economy was still experiencing excess productive capacity and high levels of unemployment. In the post-mortem on this episode, governmental insiders—most importantly, Lauchlin Currie (then on the staff of the Federal Reserve Board)—detected a significant turnaround in "government contribution to spending" between 1936 and 1937. In 1936, the fiscal impact of government had been decidedly stimulative owing to the payout of a bonus to veterans of World War I, a once-and-for-all transaction for which there would be no counterpart in 1937. Governmental fiscal operations in 1937 turned contractionary when payroll taxes to finance the newly created Social Security system were introduced. It had long been understood that governmental budgetary outcomes were influenced by the state of economy, with revenues rising or falling in response to fluctuations in economic activity. It now appeared that changes in taxing and spending by government could influence the level of economic activity. This basic insight is explored in John Maynard Keynes's General Theory of Employment, Interest, and Money, published in 1936. American experience in the recession of 1937 and 1938 appeared to provide empirical validation of that finding.
Analysis of this episode was also a watershed in the thinking of the economist who was to become the leading interpreter of the Keynesian message in the United States. Harvard's Alvin H. Hansen had reviewed Keynes's General Theory unsympathetically when it first appeared. By late 1937, however, Hansen had undergone a conversion experience. His reading of the course of economic events then meshed with Currie's: He was convinced by the Keynesian argument that identified deficiency in aggregate demand as the cause of excess capacity and underemployment. He was further persuaded that—in American conditions—full recovery could not be achieved unless the government mounted an aggressive deficit spending program to compensate for inadequacies in private demand.
Hansen and Currie became the point men in delivering the Keynesian message, and they used the platform provided by hearings before the Temporary National Economic Committee in 1939 to present it at some length. In mid-1939, Currie was elevated to the White House staff as the "economic adviser to the president," a title he was the first to hold. By that time, his commitment to the Keynesian conceptual system was complete. He drew the argumentative threads together in a lengthy memorandum on full employment, which he placed before Roosevelt in March 1940. Though its structure was inspired by the Keynesian framework, the primary remedy he then offered for a deficiency in aggregate demand was not the one that Keynes had emphasized. Unlike Keynes, Currie downplayed deficit spending on public works: Further increases in the national debt were politically sensitive in the American context and should be constrained. The main weight of policy should instead be assigned to government programs in order to shift consumption upward. This objective could be reached, he maintained, by combining a "truly progressive" tax system with redistributive transfer payments and enlarged public outlays for health, education, and welfare. Thus, the "humanitarian and social aims of the New Deal" could be reconciled with "sound economics."
Pearl Harbor precluded the implementation of this policy strategy, but it did not slow the spread of an Americanized version of a Keynesian-style of thinking in the highest echelons in official Washington. Indeed, within the bureaucracy, it approached the status of an orthodoxy. But this thinking was a long distance removed both from the mainstream orthodoxies of the 1920s and from the heterodoxies that had guided the Roosevelt administration's initial approaches to Depression-fighting.
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William J. Barber