The Check Tax

From the NBER Reporter Fall 1995 page 31, summarizing William D, Lastrapes and George Selgin, University of Georgia, “The Check Tax and The Great Contraction”, a paper delivered at the Workshop on Macroeconomic History, Oct 13 In Cambridge, Mass.

“Although its role has been overlooked by monetary historians, a two cent tax on bank checks effective from Jun 1932 through December 1935 appears to have been an important contributory factor to the periods severe monetary contraction. According to estimates by Lastrapes and Selgin, the tax accounted for between 11 percent and 17 percent of the total increase in the ratio of currency to demand deposits and for between 11 percent and 19 percent of the total decline in M1 between October 1930 and March 1933. The contractionary consequences of the check tax had been anticipated by many legislators, but they were unable to prevent the measure from being included in the Revenue Act fl 1931.”

The resulting paper can be found at papers.ssrn.com/sol3/papers.cfm?abstract_id=33320

I have read a fair amount about monetary history and the Great Depression and I do not recall hearing about the check tax.

(This piece is the result of reading and discarding old publications of the NBER.)

The New Deal and recovery

Did FDR prolong the Great Depression? This video says yes.

Some of his policies (primarily getting off the gold standard, which neutralized the Federal Reserve for several years) were key to stopping the decline. But I agree with Ohianian that many others slowed recovery.

Regime uncertainty

Donald Boudreaux contrasts two theories of depression, the Keynesian and one from Robert Higgs:

Perhaps ironically, one of the most powerful challenges to any Keynesian diagnosis of economic ailments also focuses on inadequate investment spending, but from a wholly different perspective. That challenge is today most closely associated with the economist Robert Higgs.

Higgs' careful look at the data on the Great Depression and World War II convinced him that (1) a U.S. economy producing genuine prosperity wasn't restored until 1946, and (2) investors hunkered down, especially from 1935-40, because New Deal regulations -- along with President Franklin Roosevelt's increasingly vocal hostility to enterprise and successful risk-takers -- created too much uncertainty about how government would treat profits and wealth accumulation.

The "regime uncertainty" -- described by Higgs as "a pervasive uncertainty among investors about the security of their property rights in their capital and its prospective returns" -- unleashed by actual and threatened New Deal interventions made private innovation and entrepreneurial effort simply too unattractive. So private investment spending largely ground to a halt during FDR's reign.

Read more: Regime uncertainty - Pittsburgh Tribune-Review http://www.pittsburghlive.com/x/pittsburghtrib/opinion/columnists/boudreaux/s_757981.html#ixzz1Z4O9XdPA

Higg's view is shared by Amity Shlaes in her The Forgotten Man: A New History of the Great Depression.

Both are essentially arguing that the focus should not be on the demand side, as both Keynesians and monetarists have argued, but on the supply side. To understand the reason that recovery was so slow in the Great Depression, and by extension the reason we see so little recovery now, look not to the theories of macroeconomics, but to some of the literature on economic growth and development that argues that secure property rights and an impartial legal system are keys to economic growth.

the welfare state as the modern gold standard?

Robert Samuelson looks at the 1930s and wonders if today's welfare state may not be equivalent to yesterday's gold standard, a policy that no one dares question but also one that can only lead to disaster:

But there is another more sobering reading of the Great Depression. It is that painful and once unthinkable changes are made only under the pressure of acute crisis. One reason that central banks were so passive is that they clung to the gold standard: Relaxing credit policies too dramatically to rescue banks might lead to a loss of gold; people would demand metal to replace paper money. Gold was abandoned in various countries only after it seemed untenable. Similarly, the post-World War I debt problem wasn't "solved" until repayment was impossible. As for Britain's place as global leader, the United States assumed that role only in World War II.

Against that backdrop, today's unresolved problems -- over the welfare state, leadership in the global economy -- become more ominous. They suggest that major adjustments won't be made until they're compelled by some sort of crisis. This possibility defines the present economic drama. Will the recovery encourage conscious changes? Or is recovery providing a false sense of security? The stakes are, of course, enormous, because -- as everyone knows -- the economic suffering of the Great Depression transformed many countries' politics for the worse and led to World War II.

Someone beat me to it

I have thought for several years it would be fun to do a blog that summarizes news from the 1930s day by day, but I do not have the time to do it, at least not now. Someone else does.

Regime uncertainty

A discussion of regime uncertainty at samizdata.net, mostly in the comments. (It is rather unusual for the comments to be more interesting than the main post, but this may be an example.) There is also a link to an article by Robert Higgs that looks at regime uncertainty as a reason the Great Depression lasted so long.

More theories about the Great Depression

There is renewed interest in the Great Depression. Greg Mankiw quotes from a paper by UCLA economist Lee Ohanian:

I conclude that the Depression is the consequence of government programs and policies, including those of Hoover, that increased labor’s ability to raise wages above their competitive levels. The Depression would have been much less severe in the absence of Hoover’s program. Similarly, given Hoover’s program, the Depression would have been much less severe if monetary policy had responded to keep the price level from falling, which raised real wages.

The 1930s would have been a better economic decade had government policy promoted competition in product and labor markets, rather than adopting policies that extended monopoly in product markets, and that set wages above competitive levels which prevented labor markets from clearing.

Over in The Wall Street Journal, Steven Gjerstad and Vernon L. Smith are examining bubbles. They state that experimental economics shows that bubbles are natural in markets, but some bubbles pop with few effects while others have cause substantial damage to the real economy. They note that the popping of the dot.com bubble led to a loss of $10 trillion in assets but caused no damage to the financial system, while the decline in housing prices caused $3 trillion in losses and devastated the financial system.

Part of the answer, they say, was leverage. When the borrowing is by the rich, the losses are absorbed by the rich. But when the borrowing is by the poor, it is absorbed by financial institutions.

According to First American CoreLogic, 10.5 million households had negative or near negative equity in December 2008. When housing prices turned down, many borrowers with low income and few assets other than their slender home equity faced foreclosure. The remaining losses had to be absorbed by the financial system. Consequently, the financial system has suffered a blow unlike anything since the Great Depression, and the source is the weak financial position of the people holding declining assets.

The causes of the Great Depression need more study, but the claims that losses on stock-market speculation and a monetary contraction caused the decline of the banking system both seem inadequate. It appears that both the Great Depression and the current crisis had their origins in excessive consumer debt -- especially mortgage debt -- that was transmitted into the financial sector during a sharp downturn.

Update

A week ago James Hamilton looked at the impact of oil prices on the current economy.

Although the approaches are quite different, they all support a common conclusion: had there been no increase in oil prices between 2007:Q3 and 2008:Q2, the U.S. economy would not have been in a recession over the period 2007:Q4 through 2008:Q3.

Something in addition to housing began to drag the economy down over the later period, and all the calculations in the paper support the conclusion that oil prices were an important factor in turning that slowdown into a recession.

He is not arguing that the housing market has not been the factor that makes the current financial mess special among downturns over the last 50 ears, but that the crisis in the housing market was triggered by the oil-price shock.

On a more positive note, the Federal Reserve Bank of New York is suggesting that, based on the pattern of economic recovery and the yield curve, we may have hit the bottom of this recession.

Fisher in the news

A few days ago economist.com had an article about Irving Fisher, who argued that a feedback cycle involving deflation and debt was a source of the Great Depression.

And he developed his debt-deflation theory. In 1933 in Econometrica, published by the Econometric Society, which he co-founded, he described debt deflation as a sequence of distress-selling, falling asset prices, rising real interest rates, more distress-selling, falling velocity, declining net worth, rising bankruptcies, bank runs, curtailment of credit, dumping of assets by banks, growing distrust and hoarding.

Fisher was also one of the great monetarist, the Milton Friedman of the early 20th century.

Time to delete mark-to-market?

There were rumors on Friday that the mark-to-market rules might be relaxed, and those rumors were credited with the rise in bank stocks.

Which leads to the question, why are those rules still in place? There have been suggestions throughout the financial panic that the mark-to-market rules were one of the things that was accentuating the fall. And if we look at how the Federal Reserve has responded, we can see that this financial panic is like no other. What is different this time? Could it be that the mark-to-market rules have introduced amplifying feedback, making the financial crisis a self-feeding process?

When FDR became president, his administration was a lot like the character in a comedy reacting to a crisis by pushing buttons. FDR pushed a lot of wrong buttons, but he did push one correct button by severing the tie to gold and eliminating the Fed from monetary policy, which had established an amplifying feedback loop in monetary policy. Maybe the mark-to-market button is the right one this time. Certainly it is worth trying. If the U.S. is willing to spend nearly two trillion dollars, the amount of the TARP and the so-called stimulus plan, why would it not also be willing to junk a rule that costs virtually nothing at all to junk? I wonder why the Bush administration was never willing to take this simple step given that they were willing other steps that were far more drastic.

Economics lacks a consensus framework in which to view macroeconomics. A framework of shocks and feedback, in which shocks knock the economy off path and the feedback accentuates the effect of the shock, leads one to focus on items like mark-to-market. The equilibrium approach of Keynesian economics leads to a focus on stimulus packages. If we get both a stimulus package and an elimination of mark-to-market, it may be very difficult to distinguish the effects of each.

Update Feb 16, 2009: Brian Wesbury, chief economist at First Trust Portfolios L.P., argues in a National Review piece, "Untouchable Accounting Rules? Really?", that mark-to-market has been a major contributor to the current crisis because of its procyclical feedback properties, and needs to be eliminated. He points to some history:

Fair-value accounting as we know it today is based on rule FAS 157, which was implemented by the FASB in 2007. But it has a longer history than that. Fair-value accounting existed in the 1930s, which was when we had the Great Depression. In 1938, President Roosevelt suspended those rules, and between then and 2007 the economy had no panics or depressions. Maybe its time we put fair value through the shredder once again.

Stimulus and the Great Depression

The Huffington Post has an article about the two views of the Great Depression,

The dominant story in the public mind is of President Franklin Delano Roosevelt's success. It goes like this. Like Obama, FDR comes to power with the American economy haemorrhaging jobs. He believed that, if private industry is withering, the government has to take up the slack by large public spending programmes. He set millions to work preserving green spaces and rebuilding the country's infrastructure.

The other view is attributed to a small number of right-wing economists in the 1980s.

They argued that the American people had been wrong: the New Deal actually made the Depression worse. By borrowing and spending so much, the government created a climate of uncertainty. This made investors hold on to their money - prolonging the despair. It didn't restore private investment, it "crowded it out".

The author, Johann Hari. then argues the first is correct for two reasons. First, when FDR cut back spending and raised taxes in 1936, we had relapse. Second, it was the spending of WWII that finally ended the Depression.

The article skips the interesting questions that are needed to frame the whole debate. We have had recessions every few years for the past two centuries. Most of them have been mild. Nothing else was close to being as severe or as long-lasting as the Great Depression. Why was it so deep? At the time, many thought it revealed an inherent flaw in capitalism, that it showed that Marx was correct. A large part of the intellectual class that grew up in that era accepted this explanation and became Marxist. But when there was no depression after World War II, despite the predictions of people such as Paul Samuelson, an ardent Keynesian, people had to start looking for other explanations. The most convincing explanation that has emerged is a monetary interpretation, arguing that the Great Depression was special because government policy set up an amplifying feedback loop. As things became worse, government (monetary) policy changed to make it even worse, etc. That loop was not broken until FDR neutered the Federal Reserve by abandoning gold. There remains disagreement among economists as to the importance of the real-bills doctrine and the gold standard in contributing to that feedback loop, but most economists who have looked at the episode with any care now see Federal Reserve policy as key to understanding the decline from 1929 to 1933, and also the sharp recession in 1936-7 when the Fed raised reserve requirements. This explanation was developed and popularized by Milton Friedman and Anna Schwarz, but it can be found far earlier, in, for example, a book by Lauchlin Currie.

Compared with other recoveries, the recovery after 1933 was slow. Why was this recovery so slow? One answer, favored by the left, is that because the fall was so deep, normal resiliency of markets was impaired, and government policy was needed. The New Deal was doing the right thing, but just not enough of it. On the other side, the conservative answer focuses not only on expectations and uncertainty (though not primarily caused by borrowing and spending), but also on interference with markets. When a market has a surplus, either a fall in price or an increase in demand will restore market clearing. If there is no increase in demand, then an attempt to keep price from falling will stop that market from finding an equilibrium. In a system of markets, preventing some markets from adjusting can keep the entire system from re-adjusting. The New Deal interfered with price adjustment in many ways--various programs attacked a symptom of recession (deflation), not the cause (insufficient demand). Hence, it is only natural for economists to argue that some New Deal policies made the problems worse rather than better.

The first rule of medicine is, "First, do no harm." It should also be the first rule of economic policy making. Economists have made a convincing case that government policies during the Great Depression did harm. Hari does not seem to take seriously the possibility that the stimulus package being discussed in Washington could do more harm than good.

(If Johann Hari is correct on what got us out of the Depression, shouldn't he be advocating a massive expansion of the military?)

Update: The Wall Street Journal has an piece dated Feb 2, 2006 by economists Harold Cole and Lee Ohanian that emphasizes the negative role of the New Deal's attempts to micromanage markets.

Obama on the recession

An AP story reports:

President-elect Barack Obama said Thursday the recession could "linger for years" unless Congress pumps unprecedented sums from Washington into the economy.

That is a very Keynesian view, a belief that the economy lacks strong stabilizing forces. I live in the other camp, the camp that thinks that the economy has strong stabilizing forces over a period of a few years, and the greatest danger is destabilization from the government. What is rather odd is that both views look to the Great Depression for support.

Bank or cracker box?

A few days ago a story hit the wires about someone who found $10000 in a box of crackers. It turned out that an elderly woman had put the money there, and then in a mix up somehow the crackers had been returned to the store and put back on the shelves. The line that struck me was this:

The Lake Forest woman, whose identity was not released, had lost faith in her bank and decided the box would be a safer place for the money.

Everyone knows that a box of crackers is a much safer place to keep money than in a bank, right?

The story reminds me of another incident, but one that did not have a happy ending. In the little town that I called home half a century ago, there was an poor old lady noted for her holiness. After we moved away, she became ill and had to go to the hospital. Her fellow parishioners thought they could do a good deed by cleaning out her tiny house and buying her a new bed, which they did. When she came home, she got very agitated when she saw what they had done. It took a while for the do-gooders to come to the conclusion that the little old lady had put her life savings in the old mattress which they had burned.

Rent seeking

Donald Boudreaux writes about the size of government, Blagojevich, and rent seeking. His commentary is in the Christian Science Monitor, but he blogs frequently at Cafe Hayek. Speaking of which, Russell Roberts had a couple of good posts there: a good piece on the source of the housing bubble, and a link to a video from 1933 arguing that inflation was a way to cure the Depression.

Stories of the panic

Steven Landsburg wrote, "Most of economics can be summed up in four words: 'People respond to incentives.' The rest is commentary."

Peter J Walliston has been doing commentary, arguing that the incentives created by the government in its attempt to use markets to pursue social aims are the source of the current financial meltdown.

...U.S. housing policies are the root cause of the current financial crisis. Other players...played a part, but they were only following the economic incentives that government policy laid out for them.

Does it matter how we interpret events such as the current financial mess? Interpretation certainly mattered in the 1930s, when the predominant story was that the Great Depression was a failure of the market. That interpretation justified a many government programs and created a generation of socialist intellectuals. After World War II when decolonization took place, that interpretation led to many of the new nations pursuing socialist policies, with disastrous results.

The story that the current financial mess is the result of deregulation, which is popular in some parts of the press, is also a story that the market failed, and it logically leads to larger government. A story that government involvement led to the current crisis has completely different implications.

A major achievement of Milton Friedman was a convincing argument that the Great Depression represented a failure of government policy. The Federal Reserve pursued a procyclical rather than a countercyclical monetary policy. Without this reinterpretation of the Great Depression, the Ronald Reagan presidency would not have been possible. Keynes was right about the power of ideas.

Back to the great depression

Discussion of the Great Depression is back in the news, and it has prompted a couple of posts at marginalrevolution.com by Alex Tabarrok. I thought the second was clever. Tabarrok notes the neo-Keynesians argue that fiscal policy was at best only mildly expansionary during Roosevelt's first two terms because higher taxes largely counteracted the effects of increased government spending. Tabarrok suggests that if we take into account the supply-side and the uncertainty effects of changing tax policy, the net effect of New Deal policy would have been contractionary. The view that the bulk of the New Deal did little to get the economy out of Depression and may have actually prolonged it is not a popular view on the Left.
Update: Here is another post at marginalrevolution.com about the Great Depression.