What Got Us Into and Out of the Great Depression?

Robert Higgs, Independent Institute

When scholars consider what got the United States into and out of the Great Depression, they usually begin their analysis in, or shortly before, 1929 and end it in 1941 or thereabouts.  Moreover, they presuppose that the event to be explained is the twelve-year series in which annual real output invariably fell short of the economy’s capacity to produce and that, within this time span, the determinants of each year’s substandard performance consisted of contemporaneous or shortly preceding conditions and events.

This approach tends to mislead us in two important ways. First, it fails to give adequate weight to the events of 1914-1929 that served as preconditions for the onset of the depression and help us to understand why governments responded to it as they did and thereby exacerbated it―that is, scholars too often fail to appreciate that “[t]he origins of the Great Depression lie largely in the disruptions of the First World War” (Temin 1989, 1). Second, the usual analysis mistakenly takes for granted that the Great Depression ended in 1941 or thereabouts and was superseded by a business-cycle boom, often called “wartime prosperity,” whereas in reality, the war years themselves were not a time of genuine prosperity.

An adequate understanding of the Great Depression requires that we view it as contained within a longer series of political and economic events―an Age of Endless Emergencies from 1914 to 1945, or, in Peter Temin’s words, “one long conflict with an uneasy truce in the middle.”  In this light, we perceive World War I to have been the mother of all the great politico-economic disasters during a period of more than thirty years and, in many ways, beyond it, even to our own times.

My overall interpretation of these events proceeds along the following lines. The actions taken and the policies adopted by the warring governments in World War I destroyed the foundations of a highly successful economic order in which all the economically advanced countries had participated for several decades before 1914. After the armistice, the Treaty of Versailles put in place defective and unsustainable economic arrangements, which the leading economic powers sought to keep afloat during the 1920s. The policies adopted in an attempt to patch this system, along with other ill-chosen polices, produced one crisis after another and set the stage for the economic downturn that began in mid-1929. In the United States, as elsewhere, the government responded to the economic bust with a series of policy actions that only exacerbated it, plunging the world economy into the greatest economic catastrophe of modern times. After the economy hit bottom in 1933, the government continued to treat the disease with an outpouring of snake-oil cures that seriously hampered spontaneous recovery, although some improvement occurred in spite of the government’s actions. After World War II began in 1939, if not earlier, the U.S. government turned its attention away from domestic economic nostrums and toward mobilization of the economy for future participation in the war. From mid-1940 until the latter part of 1945, the government imposed a command economy, setting aside essential elements of a genuine market order. “Wartime prosperity,” however, is a myth: the war merely replaced the economic suffering of the 1930s with a new form of privation, in many ways a worse form. Only in 1945-46, with the end of the war and the reconversion of the command economy to a more market-directed economic order, did genuine prosperity resume and persist.

The Old Economic Order and Its Destruction by World War I

No one ever depicted the old economic order any better than John Maynard Keynes, who wrote in 1919 in The Economic Consequences of the Peace:

What an extraordinary episode in the economic progress of man that age was which came to an end in August, 1914! The greater part of the population, it is true, worked hard and lived at a low standard of comfort, yet were, to all appearances, reasonably contented with this lot. But escape was possible, for any man of capacity or character at all exceeding the average, into the middle and upper classes, for whom life offered, at a low cost and with the least trouble, conveniences, comforts, and amenities beyond the compass of the richest and most powerful monarchs of other ages. The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, in such quantity as he might see fit, and reasonably expect their early delivery upon his doorstep; he could at the same moment and by the same means adventure his wealth in the natural resources and new enterprises of any quarter of the world, and share, without exertion or even trouble, in their prospective fruits and advantages; or he could decide to couple the security of his fortunes with the good faith of the townspeople of any substantial municipality in any continent that fancy or information might recommend. He could secure forthwith, if he wished it, cheap and comfortable means of transit to any country or climate without passport or other formality, could dispatch his servant to the neighboring office of a bank for such supply of the precious metals as might seem convenient, and could then proceed abroad to foreign quarters, without knowledge of their religion, language, or customs, bearing coined wealth upon his person, and would consider himself greatly aggrieved and much surprised at the least interference. But, most important of all, he regarded this state of affairs as normal, certain, and permanent, except in the direction of further improvement, and any deviation from it as aberrant, scandalous, and avoidable. The projects and policies of militarism and imperialism, of racial and cultural rivalries, of monopolies, restrictions, and exclusion, which were to play the serpent to this paradise, were little more than the amusements of his daily newspaper, and appeared to exercise almost no influence at all on the ordinary course of social and economic life, the internationalization of which was nearly complete in practice.(1920, 10-12)

As Keynes’s depiction suggests, the main pillars of the old order were unrestricted international travel, trade, and investment, the monetary system known as the gold standard, and reliable but limited government. Under this regime, international trade, mass migration, and investment flourished; nations developed their economic activities in accordance with their comparative advantages; and the people of all the participating countries improved their economic well-being beyond any standard previously achieved by the masses or, in certain regards, even by the upper crust.

With the onset of the Great War, the warring governments pulled down each of these pillars. Blockades, naval warfare, and shipping shortages impeded international trade; foreign investments were cashed in to pay for munitions; the belligerent nations fell back into greater self-sufficiency and hence into diminished real income; the gold standard was suspended (wholly by the European belligerents, partly by the United States), and the national monetary authorities brought about the creation of enormous amounts of new fiat money unredeemable for gold, silver, or other commodities at fixed rates (again, the United States was a partial exception, because it maintained domestic [but not foreign] convertibility), causing tremendous reductions in money’s purchasing power.

Moreover, during the war the governments on both sides abandoned old limitations of their economic intervention and put in place various forms of “war socialism,” a species of central economic planning and resource allocation that gave highest priority to the state’s own demands and restricted the citizens’ traditional economic and civil rights. These governments drafted millions of men into involuntary service in the armed forces, seized hugely increased amounts of taxes, and generally rode roughshod over the old economic order of private property rights, contractual freedom, and extensive personal liberties. If the war itself was a catastrophe, senselessly slaughtering men by the millions and bringing about great suffering for hundreds of millions of others, the economic measures that governments adopted to reallocate resources to war purposes were themselves nearly as disastrous, going far toward wrecking everything that had been built up at such great sacrifice during the previous century of economic progress.

When the armistice took effect on November 11, 1918, the belligerent nations of Europe were economically almost prostrate. Their labor forces and capital stocks had been depleted greatly, their domestic economic organization distorted grotesquely, and their old arrangements for international cooperation by means of trade and investment shattered.

From the Armistice to 1929

To make matters worse, the Versailles Treaty, signed in 1919, required that Germany make huge reparations payments to France, Great Britain, Italy, and Belgium. To earn the wherewithal to make these transfers, Germany needed to sell great amounts of its goods abroad, but doing so was nearly impossible, given Germany’s economic devastation and its direct loss of important territories and other resources to the victorious powers―not to mention the barriers other countries erected to protect their own producers from foreign competition.

It soon became clear that the reparations would be paid only if Germany borrowed large amounts from other countries, and the only lenders capable of providing sufficient funds were the Americans. Therefore, arrangements were made whereby in effect the Germans borrowed from the Americans and then handed over much of the proceeds to the French and the British, who in turn sent some of the money back to the United States to repay loans received during the war.

This scheme held so little charm for the Germans, who got nothing out of it but more debt, that they resorted to engineering a hyperinflation of the German currency in 1922-23 to ease the government’s fiscal woes. Unfortunately for the German people, especially middle-class people, who held monetary assets such as bonds, insurance policies, and bank accounts, this inflationary eruption proved devastating, not only to the economy but, in the longer term, to the moral fortitude of the bourgeoisie, who felt that the rug had been pulled out from under frugal, respectable people. No one described this devastation better than Thomas Mann, who wrote that

there is neither system nor justice in the expropriation and redistribution of property resulting from inflation.  . . . [O]nly the most powerful, the most resourceful and unscrupulous, the hyenas of economic life, can come through unscathed. The great mass of those who put their trust in the traditional order, the innocent and unworldly, all those who do productive and useful work, but don’t know how to manipulate money, the elderly who hoped to live on what they earned in the past―all these are doomed to suffer. An experience of this kind poisons the morale of a nation. ([1942] 1977, 166).

By creating disaffection with the Weimar Republic, the hyperinflation helped to prepare fertile ground for the growth and eventual triumph of Hitler’s party.

After the hyperinflation was stopped, new international lending arrangements were hastily concocted, but each such Band-Aid served only as a temporary means of staunching the bleeding. The reparations regime was simply not viable in the long run; the only question was precisely how it would break down and what would replace it. From the start, the German government “struggled ceaselessly for the reduction and elimination of its reparations obligations” (Temin 1989, 30). After the Germans defaulted in 1923 and the French army occupied the Ruhr district in response, the payments were rescheduled in 1924, scaled down in 1929, then delayed and ultimately, after Hitler came to power in 1933, repudiated along with every other German obligation under the Versailles Treaty.

At the same time that the economically advanced countries were dealing with the reparations problem, they were striving to reconstruct the international financial regime that they had wrecked during the war by suspending the gold standard and issuing vast quantities of fiat money. The general assumption was that the European nations ought to return to the gold standard, and one by one, they did so during the latter half of the 1920s. The monetary system to which they “returned,” however, was not the old pre-war gold standard, but a “gold-exchange” standard that lacked essential attributes of the old system, such as circulating gold coins and domestic convertibility. Murray Rothbard called it “a bowdlerized and essentially sham version of that venerable standard” (1998, 123; see also Timberlake 2007). Unlike the classical system, it was subject to constant “management” by central bankers who sought to achieve new goals, such as price stability or a low rate of unemployment.

When Great Britain finally resumed international convertibility of the pound sterling into gold in 1925, it made a serious mistake by setting the official value of the pound at the old, pre-war parity. Because of the rise in prices that had occurred in Britain during the war, however, the pound in free exchange was no longer worth as much relative to the U.S. dollar as it had been worth before the war. By officially overvaluing the pound (at £1 = $4.86, when the prevailing free-market rate was in the neighborhood of $4.40), the British made their export products―goods priced in terms of the pound sterling―relatively expensive and hence difficult to sell overseas. British export industries, such as coal, steel, textiles, and shipbuilding, suffered accordingly, and workers in those industries, traditionally reluctant to go far afield in search of jobs, endured high rates of unemployment. Many workers subsisted on the infamous “dole.” The British economy languished, and investment funds tended to flow out of the country, especially to the United States, putting even more pressure on the overvalued pound.

To help the British succeed in their resumption of gold convertibility, central bankers in the United States, led by Benjamin Strong, governor of the Federal Reserve Bank of New York, undertook to pursue monetary policies that would reduce interest rates in the United States, thereby diminishing the relative attractiveness of U.S. investments for British investors and causing them to reduce the pressure they would otherwise put on the pound’s exchange value by trading pounds for dollars (Rothbard 1998, 105-65, esp. 120-21).

These U.S. policies, however, also had effects on the U.S. economy. The “momentous decision of forcing a regime of cheap money,” as Lionel Robbins described it, caused the U.S. money stock to grow faster than it otherwise would have grown, kept interest rates lower than they otherwise would have been, and thereby encouraged domestic investors to make certain investments―in structures and other long-lived producer goods―that they otherwise would not have made (Robbins qtd. in Temin 1989, 19). In short, U.S. monetary policies, aimed at assisting the British monetary authorities, had the effect of bringing about “malinvestments” in the United States and thereby distorting the structure of the capital stock in an unsustainable fashion (because structures and other long-lived capital goods will ultimately prove economically unwarranted when they have been made in response to artificially low interest rates, and such projects will go bankrupt).

U.S. central bankers also began to worry in the late 1920s that by keeping interest rates artificially low, their policies were feeding a frenzy to buy corporate shares and creating a stock-market bubble destined to pop with destructive effects on the real economy. Accordingly, in 1928 and more so in 1929, they moved away from their “cheap money” policies, adopting policies of higher interest rates and exerting direct pressure on commercial banks to stem what they viewed as “speculative excesses” and diversions of bank loans from economically sound purposes. Most economists now believe that this change of monetary policy triggered the U.S. economic downturn that occurred in mid-1929 and the stock-market crash that followed later in the year. Others believe that the prior (“cheap money”) policies themselves presaged the downturn, because the malinvestments that those policies had fostered would have to be liquidated sooner or later by means of bankruptcies and reallocations of resources to more sustainable uses, a process marked by economic disruptions and transitional unemployment.

The Great Contraction, 1929-33

Whatever its trigger, however, the economy’s initial recession need not have become a disaster. Many downturns had occurred previously in U.S. economic history, and nearly all of them had been fairly shallow and soon followed by recovery and continued growth. The depression of the mid-1890s had been the most severe macroeconomic bust prior to 1929. At the end of the 1920s, however, many informed observers believed that the economy had entered a “new era” in which government and business leaders understood how to counteract any recession that might occur before it turned into a catastrophe. Unfortunately, the knowledge they imagined themselves to possess in this regard was, for the most part, nothing more than an example of what F. A. Hayek later called the pretense of knowledge―the conviction that government planners, including the monetary authorities, know how to make the world a better place than it would be if people were simply left to their own devices.  In previous economic downturns, hardly anyone had expected the government to take vigorous action to bring about recovery. In the nineteenth century, most people had believed that the government neither knew how nor possessed the constitutional authority to act effectively as an economic savior. They appreciated that “[r]ecessions unhampered by government interventions almost invariably work themselves into recovery within a year or so” (Rothbard 1998, 151).

By 1929, however, the dominant ideology had changed substantially. Many opinion leaders and large segments of the general public had embraced the Progressive faith in activist government. To make matters even worse, the economics profession for the most part had come to believe that the government could and should intervene actively in economic life (Rockoff 1998). These ideological and intellectual changes came as music to the ears of many politicians, who welcomed a plausible excuse to enlarge their powers and to turn the exercise of those enlarged powers to their own advantage. Organized special interests also seized on the new ideas and attitudes as pretexts for the creation of the pensions, subsidies, insurance benefits, protections from competition, bailouts, and other privileges they sought from the government.

As officials at all levels responded to the newly strengthened demands that government “do something” in late 1929 and afterward, the government adopted an enormous number and variety of interventionist measures, spanning every industry, region, and demographic group in the country. Many of these measures simply reestablished under new names the measures that had been used during the war, on the ill-considered ground that these policies and programs had proved successful in a previous emergency (war), so they would prove successful again during the existing emergency (economic depression). As President Hoover himself declared, “We used such emergency powers to win the war; we can use them to fight the depression” (qtd. in Rothbard 2000, 323). So, for example, the defunct War Finance Corporation was revived in 1932 and called the Reconstruction Finance Corporation.

Because the government’s economic rescue programs often worked at cross purposes or interfered with the successful operation of the private competitive economy, they exacerbated the downturn between 1929 and 1933, making it deeper than it otherwise would have been, and they slowed the economy’s recovery after 1933, so that even when the government began to shift the economy onto a war footing in mid-1940, full recovery had not yet been attained―the official unemployment rate in 1940 was 14.6 percent (if we count persons enrolled in government emergency employment programs as employed, the unemployment rate was 9.5 percent). In short, the government’s cures made the disease much worse and slowed the patient’s natural recovery. No wonder the authors of a recent book on the Great Depression blame government officials for “an incredible sequence of policy errors that generated a cataclysmic event reaching around the entire globe” (Hall and Ferguson 1998, xii).

The dimensions of the disaster were shocking. For nearly four years, with only brief and abortive reversals, the economy fell deeper and deeper into the trough. By 1933, real gross domestic product (GDP) had declined by 30 percent. Production of consumer durables fell by 50 percent, producer durables by 67 percent, new construction by 78 percent, gross private domestic investment by almost 90 percent. The real value of U.S. exports and imports dropped by nearly 40 percent. The unemployment rate reached nearly 25 percent, and perhaps one-third of those still working in 1933 were working only part-time. Prices fell on average by about 23 percent. Banks failed in waves, and by the end of 1933, nearly 10,000 of them had gone under. In 1931, 1932, and 1933, the after-tax profits of all corporations added up to less than zero. Rental and proprietary income dropped by more than 60 percent. The stock market hit bottom in 1932, having lost more than 80 percent of its value during the preceding three years. Farm-product prices fell by more than 50 percent, net income of farm operators declined by nearly 70 percent, and thousands of farmers surrendered their homes and farms to mortgage lenders and tax collectors. Three states―Arkansas, Louisiana, and South Carolina―and approximately 1,300 municipalities defaulted on their debts, and many other states and local governments verged on default. The sky, it seemed, really had fallen.

Conditions need not have become so desperate, and on their own they would not have done so. The collapse was worsened by a succession of powerful pushes from government policies ostensibly aimed at alleviating it or some aspect of it. Among the most harmful of these counterproductive policies was approval of the Smoot-Hawley Act in 1930, which “raised tariff rates on imports to the highest levels in the nation’s history” and set in motion a tariff war, a trade-constricting sequence of action and reaction around the trading world (Chandler 1970, 12-13). In late 1929, President Hoover urged employers to maintain real wage rates despite the plummeting decline in demand for their products. Many of the larger employers did so in 1930 and into 1931 and, as a result, unemployment increased much faster than it otherwise would have (Vedder and Gallaway 1993, 74-97). The Revenue Act of 1932, which became fully effective in 1933, “provided the largest percentage tax increase ever enacted in American peacetime history,” administering a stunning blow to already-struggling businesses and households (Chandler 1970, 125; see also 139-40).

Perhaps worst of all, at the Federal Reserve System, which had been created in 1913 to provide emergency liquidity to commercial banks during financial panics, officials stood by while banks failed by the thousands, bizarrely convinced that in the circumstances they had done all that they could and should do to prevent the banking system’s collapse. As a result, the money stock (M2 measure) fell by 32 percent between June 1929 and June 1933. As banks failed and depositors clamored to withdraw their funds from banks and to augment their cash holdings, financial stringency took an enormous toll on businesses and households throughout the country. The vaunted “lender of last resort” had failed spectacularly to perform its designated function, with enormous consequences not only for the banks that relied on it to supply emergency reserves, but for everybody. As Gottfried Haberler concluded, “there can be no doubt that the collapse of the banking system, the bankruptcy of many thousand banks, and the inept and overly timid monetary policy which permitted the money stock to shrink by about one-third was to a large extent responsible for the disaster” (1976, 31-32).

Owing to the foregoing policies and many others that might be mentioned if space permitted, the economic downturn that began in 1929 turned out to be not just another recession but a catastrophe.

The Great Duration

Economists, following the usage of Milton Friedman and Anna Schwartz in their classic study, A Monetary History of the United States, 1867-1960, call the economic collapse in the United States between 1929 and 1933 the Great Contraction. In my own writings, I have added two similar terms to refer to other aspects of the Great Depression―the Great Duration and the Great Escape. The former denotes the depression’s exceptional length, from 1929 to 1941 (when the societal disaster did not actually end, but merely changed its form, as I describe later). The Great Duration is as puzzling as the Great Contraction, in some ways even more so. No previous economic bust had persisted nearly so long. The second-worst one, in the mid-1890s, lasted less than half as long. Except for France, where political conflicts stymied recovery, no other major industrial country took as long as the United States to escape from the Great Depression; all the others had recovered well before World War II began. What accounts for the Great Duration?

In brief, the depression’s exceptional length is attributable to the same general cause that explains the Great Contraction’s exceptional severity: a series of ill-chosen government policies. These policies disrupted and distorted the operation of the competitive economy, created paralyzing fear in the minds of its most essential investors and businessmen, and gummed the gears of the economy’s normal recuperative processes. After some headway had been made toward recovery between 1933 and 1937, new government policies―collecting new taxes, encouraging aggressive labor unionization and, especially, abruptly doubling bank reserve requirements―knocked the economy into a serious “depression within a depression,” setting full recovery back by at least another two years.

Nearly all of the counterproductive policies adopted from 1933 to 1938 reflected the triumph of Progressive ideology and political self-serving over the application of economic rationality to improve economic conditions on a wide scale―which is to say that these policies, regardless of their creators’ beliefs or assurances, were not actually in the public interest. It was a great misfortune for the American people that the New Dealers “turned away from the market toward a managed economy and democratic socialism” (Temin 1989, 97) and that they embraced above all “the conviction that government must play an active role in the economy” (Brinkley 1995, 10). In practice, that conviction was equivalent to the belief that a bull elephant must play an active role in the China shop.

When Franklin D. Roosevelt took office in March 1933, the economy was in the ditch. Roosevelt’s first official act was to issue an executive order to close all the commercial banks in the country, thereby bringing economic activity almost to a complete standstill. By that time, after nearly four years of relentlessly deteriorating economic performance, almost everyone was clamoring for some kind of economic salvation from the federal government. The supplicants did not agree about the form this salvation should take; indeed, all sorts of schemes and proposals blossomed like the proverbial thousand flowers to which Chairman Mao referred during the Cultural Revolution. As John T. Flynn described the scene,

Washington was now full of Great Minds and Deep Thinkers―youthful pundits from Harvard and Yale and Princeton and especially Columbia, with charts and equations; cornfield philosophers from Kansas and California and, of course, the unconquerable champions of all the money theories, including free silver, paper money and inflation. There were advocates of the 30-hour week and of every variety of plan for liberating the poor from their poverty and the rich from their riches. ([1948] 1949, 10-11)

Everyone, however, demanded immediate help of some kind, and many of the petitioners verged on desperation.

In this charged atmosphere, politicians found themselves in paradise, because they could easily rationalize on grounds of “national emergency” the creation of a host of policies to please or calm down countless organized special-interest groups and then reap the return on their political “exchange,” whether it took the form of votes in the next election or cash in a plain brown wrapper. Politicians who normally might have blocked one another’s schemes now found it expedient to organize enormous “log rolls,” rewarding every clamoring special-interest group at once. “The crisis,” historian John Garraty has written, “justified the casting aside of precedent, the nationalistic mobilization of society, and the removal of traditional restraints on the power of the state, as in war, and it required personal leadership more forceful than that necessary in normal times” (1973, 932). In short, as Roosevelt and the Democrats in Congress perceived the situation, it required FDR’s New Deal.

Which is what it promptly got―good and hard. No summary can do justice to the astonishing breadth of the legislative outpouring during Roosevelt’s first term, especially during the congressional sessions of 1933 and 1935, from “a Congress made dizzy by the swiftness and variety and novelty of the demands” the administration sent to Capitol Hill (Flynn [1948] 1949, 11). Jim Powell has written an entire book recently to line up the numerous studies that show, in the words of the book’s subtitle, “how Roosevelt and his New Deal prolonged the Great Depression.” These measures included abandonment of the gold standard, confiscation of everyone’s monetary gold, and abrogation of all gold clauses in contracts, including the government’s own contracts; breakup of some of the nation’s strongest banks by mandating the separation of commercial and investment banking; enactment of a series of soak-the-rich tax laws that discouraged entrepreneurship and capital accumulation and doubled federal taxes as a proportion of GNP between 1933 and 1940; operation of huge make-work programs that served as vote-buying schemes for Democrats and diverted millions of workers from productive private employment; supply reductions and price increases of farm products at a time when millions of poor families were struggling to afford food and clothing; federal government entry into competition with private entrepreneurs in the production and distribution of electricity; establishment of a Ponzi scheme known as Social Security that raised taxes and discouraged private saving; promotion of labor-union monopolies in the sale of labor services, pushing affected wages above competitive market levels and increasing costs for struggling businesses; suppression of competition in a wide range of industries, from petroleum production to coal mining to ordinary retailing, allowing sellers to charge increased prices for a great variety of products, notwithstanding consumers’ diminished incomes; and general subversion of private property rights in ways too numerous to specify. The Roosevelt administration taxed, spent, borrowed, regulated, insured, subsidized, and confiscated on a scale never before seen in the United States in peacetime.

No wonder the recovery was so slow: goaded by special interests and intellectual crackpots and sustained by the public’s desperate cry for salvation, the government had placed itself, in effect, in a state of war against the great cooperative order of the people’s productive efforts and arrangements, sanctifying its destructive efforts with hot-air claims about the achievement of “relief, recovery, and reform.” Powell concludes: “[t]he New Dealers really came to believe that their knowledge, combined with political power, could cure the problems of the world. They thought that by issuing executive orders, passing laws, raising taxes, and redistributing money, they could make society better” (2003, 270).

During the first two years of Roosevelt’s presidency, which historians call the First New Deal, the administration tried to work with nearly all organized political interest groups, including important business groups, such as the Chamber of Commerce and the National Association of Manufacturers. Indeed, the keystone of the First New Deal, the harebrained scheme to cartelize every industry in the country under the terms of the National Industrial Recovery Act, was the brainchild primarily of those business interests (Hawley 1966; Shaffer 1997, 77-104). “It would have been impossible,” Flynn observed, “to invent a device more cunningly calculated to obstruct the revival of business than this half-baked contrivance” ([1948] 1949, 48). Having surveyed the evidence of the National Recovery Administration’s operation and effects, Gene Smiley concurs that “[a]ll the initiatives created under the ‘enlightened management’ of the NRA were inimical to recovery” (2002, 102). As this scheme degenerated into multidimensional squabbling and enforcement difficulties on the way to its death at the hands of the Supreme Court in the spring of 1935, and as Roosevelt himself came under increasing fire from goofy-left challengers such as Huey Long and Upton Sinclair, he decided to change course, switching his emphasis toward more collectivist, anti-capitalist policies during the so-called Second New Deal, which spanned the years from 1935 to 1938 or 1939, when the New Deal in any form had run out of steam.

During the Second New Deal, the president, cheered on by a coterie of enthusiastically anti-capitalist advisers―many of them the youthful acolytes of Louis Brandeis and Felix Frankfurter―frequently lashed out at businessmen and investors, demonizing them as “economic royalists” and blaming them for sabotaging the economy’s recovery. “Roosevelt’s opinions at this moment,” Flynn wrote, “were generally that big business was immoral, that the poor were not getting a fair break and that the depression was the result of the sins of business and that business must be punished for these sins” ([1948] 1949, 101).  Pushing such collectivist measures as the Social Security Act and the National Labor Relations Act, the administration embraced “that easy, comfortable potpourri of socialism and capitalism called the Planned Economy which provided its devotees with a wide area in which they might rattle around without being called Red” (Flynn [1948] 1949, 75). Accepting the Democratic nomination for the presidency in 1936, Roosevelt gave a speech that “was widely regarded as essentially a formal declaration of war against the free enterprise system” (Smiley 2002, 114). The Washington Post called it “the sort of speech which paves the way for fascism” (qtd. in Best 1991, 132).

Although this strategy proved successful politically―FDR was reelected by a landslide in 1936―it had a disastrous effect on the recovery: by creating heightened fears about the security of private property rights, it led investors to refrain from making enough long-term investments to propel the economy back to full prosperity. As Flynn observed, more than seven years after the onset of the depression, “[t]he great investment industries were idle,” and “[w]ithout the revival of investment there could be no revival of the economic system” ([1948] 1949, 99). A leading businessman, Lamont du Pont, described the prevailing state of uncertainty investors faced in 1937:

Uncertainty rules the tax situation, the labor situation, the monetary situation, and practically every legal condition under which industry must operate. Are taxes to go higher, lower or stay where they are? We don’t know. Is labor to be union or non-union? . . .  Are we to have inflation or deflation, more government spending or less? . . .  Are new restrictions to be placed on capital, new limits on profits? . . .  It is impossible to even guess at the answers. (qtd. in Krooss 1970, 200)

Also in 1937, even the milquetoast Treasury Secretary Henry Morgenthau pumped up his courage enough to challenge the president by insisting, “What business wants to know is:  are we headed toward Socialism or are we going to continue on a capitalist basis?” (Flynn [1948] 1949, 119).

After several years of sponsoring the cartelization of U.S. industry across the board, the president abruptly decided to embark on a “trust-busting” jihad in late 1937, even as economic conditions began to slide into the “depression within a depression.” This radical reversal of course only gave businessmen a new reason to worry about the future. Indeed, as The Economist observed on November 6, the president’s policy “might almost have been a concerted program to discourage capital investment” (qtd. in Best 1991, 180). Historian Gary Dean Best concludes: “Instead of improving business sentiment, Roosevelt seemed intent on stamping out any confidence that might remain” (1991, 180).

After net investment had totaled minus $18.3 billion for the years from 1931 to 1935―that is, gross investment fell short of compensating for depreciation by that amount―it revived to positive amounts in 1936 and 1937, only to fall back into the negative range in 1938 before resuming its recovery. For the eleven-year period from 1930 through 1940, net private investment totaled minus $3.1 billion, and only in 1941 did annual net investment finally exceed the 1929 amount. No economy can prosper when it goes more than ten years without adding to its capital stock, and economists of various schools agree that the failure of private investment to recover accounts in great part for the Great Duration.

The regime-uncertainty hypothesis also gains support from public opinion surveys conducted in the 1930s among businessmen as well as the general public and from evidence drawn from the financial markets.  Even as late as November 1941, a Fortune poll of business executives found that almost 93 percent of the respondents expected the postwar regime to be one that would further attenuate private property rights to a greater or lesser degree, and more than 40 percent of them expected a regime in which the government would dominate the economy (Higgs 2006a, 18). Between 1934 and 1936, yields of longer-term corporate bonds increased sharply, relative to the yield on a bond with one year to maturity, manifesting an increased risk premium that investors required on longer-term investments. By 1936, bonds with five years to maturity had a yield that was three times that of a bond with one year to maturity. The yield multiple was more than four for a bond with ten years to maturity, five for a bond with twenty years to maturity, and more than five for a bond with thirty years to maturity. Between the first quarter of 1941 and the first quarter of 1942, however, these bond-yield spreads (risk premia) dropped precipitously, and by early 1943 they had returned to their 1934 levels (Higgs 2006a, 23-24). These bond-yield data show that investors’ confidence in their ability to appropriate the longer-term interest payments and principal repayments promised by the country’s most secure corporations plummeted between early 1934 and early 1936, as the Second New Deal came into prominence. Confidence remained at an extremely low level from 1936 through the first quarter of 1941, after which it improved rapidly, despite the country’s becoming a declared belligerent in the greatest war of all time. This evidence testifies to the terrifying effect the Second New Deal had on investors, and to the stultifying effect it had on the recovery of private investment and, therefore, on the recovery of the entire economy, whose growth depended critically on such revitalized investment.

From the New Deal to Engagement in the War

In 1937, the New Deal began to peter out, as the president alienated many people, even fellow Democrats, by his attempt to pack the Supreme Court and, especially, as the “depression within the depression” set in, canceling much of the previous four years’ gain―the official rate of unemployment in 1938 was 19 percent. In Congress, disaffected Southern Democrats and northern Republicans formed a “conservative coalition” powerful enough to block most attempts to enact new legislation along New Deal lines.

As the president’s political prospects waned domestically, he turned his attention increasingly to the world scene, where a resumption of the war in Europe seemed imminent and, in September 1939, actually occurred. Notwithstanding proclaimed U.S. neutrality, the president immediately took sides with the British, and he worked assiduously, if deviously, for the next two years to maneuver the overwhelmingly reluctant American people into supporting U.S. engagement in the war against Germany. By conducting economic warfare against Japan, a German ally, the Roosevelt administration expected that these provocative actions might incite a Japanese attack and thereby open a “back door” to enter the war in Europe.

The Roosevelt administration accordingly undertook to mobilize the economy for war. The U.S. armed forces were small and the country’s munitions industries ill-developed, though both were potentially very large. The buildup of the armed forces themselves accelerated after enactment of a conscription bill in September 1940. A substantial obstacle to the military-industrial buildup, however, took the form of businessmen’s reluctance to enter into arms contracts with the government. After years of being browbeaten and vilified, many businessmen did not trust the government to treat them fairly and honestly. Hence, “private industry was, on the whole, profoundly reluctant to invest in new [war-related] plants” (Brinkley 1995, 182; for details, see Higgs 2006a, 36-38).

Having no good alternative to placating the suspicious businessmen―after all, New Deal lawyers and economists did not know how to produce steel, copper, aluminum, and the countless other products essential to the operation of the war machine―the administration proceeded to make its peace with them.

Both the attitude and policies of the Roosevelt administration toward business during the New Deal years were reversed when the president found new, foreign enemies to engage his attention and energies. Antibusiness advisers were replaced by businessmen, pro-labor policies became pro-business policies, cooperation replaced confrontation in relations between the federal government and business. . . .  Probably no American president since, perhaps, Thomas Jefferson ever so thoroughly repudiated the early policies of his administration as Roosevelt did between 1939 and 1942. (Best 1991, 222)

In mid-1940, Henry Stimson, a lion of the northeastern Republican establishment, was made Secretary of War, and publisher Frank Knox, who had been the Republican vice presidential candidate in 1936, was made Secretary of the Navy. (Note, however, that “[b]oth Stimson and Knox were eager and ardent supporters of Roosevelt’s war policy” [Flynn (1948) 1949, 208].) A multitude of businessmen―more than ten thousand by mid-1942―often working without compensation or as dollar-a-year men, soon joined the ranks of the government’s bureaucracy preparing the economy for effective participation in the war (Brinkley 1995, 190). Several important laws were enacted or amended to shift the risks of building up the munitions industries from private investors to the taxpayers.

This war-induced reconciliation between the government and the businessmen would eventually prove essential in making possible a resumption of economic prosperity, but such a resumption could not occur during the war because for its duration  all efforts were turned toward producing military goods and placing large, well-equipped armed forces in the theaters of war. New homes, new cars, new refrigerators, and even a decent men’s dress shirt would have to wait.

The Myth of Wartime Prosperity

The standard story, of course, is that the war itself brought back prosperity, that by 1941 or, at latest, 1942 the Great Depression had ended. Although perhaps understandable, because even at the time many people thought along these lines, this view is completely mistaken. It fails to appreciate that the economy during 1941 and 1942 became a command economy and that it continued to operate as such until the reconversion that began in the second half of 1945 and was not completed until, probably, early in 1947 or thereabouts. In a command economy, many standard economic concepts, such as “gross domestic product,” lose their meaning, because they are no longer moored to the realities of voluntary choices within the competitive price system. Even “employment” and “unemployment” lose their usual meaning when the labor market operates under the cloud of massive conscription and extraordinary manpower controls.

So, the most often cited evidence of wartime prosperity, the nearly complete disappearance of unemployment, does not signify “full employment” in the usual sense. In 1940, the unemployment rate (Darby concept, which, unlike the official measure [14.6 percent in 1940], does not count those enrolled in government emergency employment programs as unemployed) was 9.5 percent. During the war, the government pulled the equivalent of 22 percent of the prewar labor force into the armed forces. Voilà, the unemployment rate dropped to less than 2 percent. This disappearance of unemployment reflected not, as Keynesians would have it, the beneficial effects of huge government-budget deficits or, as monetarists would have it, the beneficial effects of huge increases in the stock of money. Instead, the disappearance of unemployment reflected overwhelmingly the direct and indirect effect of the gigantic military conscription―more than ten million men were drafted and many others were induced to join the armed forces before being drafted, in hopes of avoiding service in the infantry. Throwing people into the army to cure unemployment is scarcely what we have in mind when we speak of creating prosperity.

It is true, of course, that measured gross domestic product increased greatly during the war, which would seem to evince economic recovery. However, when we break down the wartime increase in output, we see that it consists entirely of war goods and services; indeed, private consumption and investment declined after 1941 and did not regain their prewar levels until 1946. In short, the wartime “miracle of production” consisted entirely of guns and ammunition—hardly the stuff of genuine prosperity, unless B-17s, machine guns, aircraft carriers, and A-bombs epitomize the substance of the good life.

In sum, although people were employed at a high rate (millions of them involuntarily) during the war and they produced military goods and services galore, the war years were not a time of genuine economic prosperity. Many civilian goods, such as automobiles and important consumer durable goods, were not produced at all or were produced only in sharply reduced amounts, owing to government prohibitions, and scores of ordinary nondurable goods, such as gasoline, tires, clothing, shoes, canned foods, and meats, were in short supply and subject to rationing. Every facet of economic life, from the speed limits on the highways to the availability of women’s hosiery, was subject to extraordinary regulations and controls. We may say that the depression continued from 1941 to 1945, or we may say that a different kind of economic privation occurred in those years. In no event, however, may we say that the war years were a time of genuine economic prosperity.

The Great Escape

Having considered the Great Contraction and the Great Duration, we come now to the Great Escape, the end of a sixteen-year period of economic privation―twelve during the depression proper and four during the war. In one great, glorious push in late 1945 and throughout 1946, the American people returned to something that deserves to be called normal prosperity, the kind they had enjoyed during the 1920s and earlier times. The ease and success of the economic reconversion deserve to be regarded as little short of miraculous, although, strange to say, economists and economic historians have scarcely paused to notice this astonishing event, much less to understand it properly.

During the war, the newly ascendant Keynesian economists had feared that when the war ended and government spending diminished drastically, the economy would plunge back into depression (they did not, as I do, understand the war years themselves to be merely a different kind of depression). However, when the government cancelled the bulk of the munitions contracts, released more than ten million servicemen from the armed forces, and eliminated most of the controls and regulations put in place during the war, mass unemployment did not develop. Indeed, despite the unprecedented rapid reallocation of resources, the unemployment rate rose only to 4 percent in 1947 and 1948. Moreover, as production for military purposes dropped to a small amount, private output leaped upward, rising between 1945 and 1946 by 30 percent, a rate of increase never equaled before or since.

This nearly miraculous economic recovery, which decisively refuted the Keynesian theory used then and later to explain the apparent economic boom during the war (though hardly anybody took notice of that refutation), reflected in great part the substantial lessening of the regime uncertainty that had impeded recovery between 1935 and 1940. During the war, the most zealous New Dealers had been removed from the government or pushed onto the periphery of policy making; “a massive shift of power [occurred] within the federal government away from liberal administrators and toward corporate interests” (Brinkley 1995, 118; see also 145). Dollar-a-year men and military officers had ruled the roost of the wartime command economy, directing all efforts toward feeding the war machine. By their influence in the upper reaches of the wartime bureaucracy and by their reestablished prestige in the eyes of the public, businessmen and investors had greatly diminished the threats that they had perceived to a regime of private property rights in the latter half of the 1930s. As Alan Brinkley has noted, “The wartime experience muted liberal hostility to capitalism and the corporate world” (1995, 7). In 1946, with Roosevelt dead, the New Deal in retreat, and most of the wartime controls eliminated or soon to be scrapped, investors came out in force. To be sure, the federal government had become, and would remain, a much more powerful force for businessmen to reckon with. Nevertheless, the government no longer seemed to possess the terrifying potential that business people had perceived before the war. For investors, the nightmare was over. For the economy, once more, real prosperity was possible.


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