The Lesson From 1937 Is NOT That Government Shouldn’t Cut Spending During a Recession

by Sep 27, 2013Liberty & Economy0 comments

Those who claim that cutting government spending would worsen the recession often cite 1937 as an argument. The trouble is that this argument makes no sense whatsoever.

Those who claim that cutting government spending would worsen the recession often cite 1937 as an argument. I run into this argument frequently, which goes something like this:

Over all, the picture for America in 2012 bears a stunning resemblance to the great mistake of 1937, when F.D.R. prematurely slashed spending, sending the U.S. economy — which had actually been recovering fairly fast until that point — into the second leg of the Great Depression.

That’s Paul Krugman’s reiteration of it, by the way. The trouble is that this argument makes no sense whatsoever. Just for starters, while it is true that spending in ’37 was less than in ’36, it was still more than in every year prior to that, when the supposed recovery was underway. And the economy rebounded in 1938. But spending was even lower that year. The story doesn’t get much better if looking at the deficit rather than total spending, since the deficit was reduced dramatically in 1938, largely due to increased tax revenues. Here’s a chart of government receipts and outlays:


In the following video, Dr. Frank Hollenback discusses the problems with the 1937 argument:

He has an accompanying recent article at the Ludwig von Mises Institute explaining the true cause of the ’37 recession within a depression:

The depression of 1920 and Roosevelt recession of 1937 show us what happens when excessive monetary printing is followed by tepid tapering.

The 1937 Recession is a perfect example of Austrian business cycle theory. It was severe but short. Output fell by 11 percent and industrial production by 32 percent. Unemployment surged back up from 14 percent to 19 percent.

…The real cause of the 1937 recession occurred much sooner. The die was cast early in 1934 when the United States set the price of gold at an overvalued $35 an ounce. The ensuing gold inflows caused the money supply to explode, increasing 12 percent per year (M2) from 1934 to 1936. A boom ensued with real output growing 10 percent in 1934, 8.9 percent in 1935 and 13 percent in 1936. As Austrians would say, the additional money masqueraded as real savings. Since no real resources had been liberated, a scramble for resources followed. Eventually, many of the investment projects that had been undertaken turned out to be unprofitable and needed to be abandoned. The 1937 recession was necessary and desirable to free up resources from the malinvestments of the previous years. A recession is a realignment of resources closer to what society really wants to be produced. The central bank could have continued printing, extending the illusion of prosperity, but this would have just delayed and amplified the final adjustment.

By late 1936, The Fed started to get worried, and in March 1937 the chairman of he Fed, Martin Eccles, said “[r]ecovery is now under way, but if it were permitted to become a runaway boom it would be followed by another disastrous crash.”

In December 1936, the central bank began sterilizing the gold inflows so they no longer boosted monetary growth.

…The bust was written in the cards. It could not be avoided, just postponed. It is not the bust, but the boom that should be feared. The bust was of short duration, and could have been much worse if the Fed had not pulled the punch bowl then and there.

The real lesson for today is not that the government shouldn’t cut spending or reduce the deficit, but rather:

Recognizing that the economy is still weak, the Fed at its Wednesday meeting yet again declined to begin tapering. When the Fed is finally forced to cut back, interest rates will rise, Wall Street will call for relief, and the economy will slump. This may be delayed with additional printing for a couple of months, but the adjustment will occur and it will be severe, probably much worse than in 2008. However, this time there are no arrows left in the government’s quiver to spend or print its way out of trouble.

As I mentioned, I’ve frequently encountered the 1937 argument, and not just from reading the likes of Paul Krugman. Here’s a fun example: a person going by the moniker “chess.instructor” left a lengthy comment in the customer reviews for my book Ron Paul vs. Paul Krugman: Austrian vs. Keynesian economics in the financial crisis that included the following:

1929-1933: Hoover presidency. Balanced budget. No economic stimulus. Unemployment rises to 25% of U.S. labor force. In Germany, unemployment rises to 50% rate.

1933-1937: First term of Franklin D. Roosevelt. Deficit spending. “Massive” stimulus spending. Unemployment rate drops 40%, from 25% in 1933, to 15% at the beginning of 1937. Inflation is not a problem.

1937: At the beginning of his second term, FDR’s new goal is a balanced budget. Government spending cut. The result is a recession, unemployment rises from 15% to 18%, an increase of 20%. The federal budget deficit is higher than before because the rise in unemployment reduces federal tax receipts more than cuts in federal government spending.

I’ve excluded the rest as it isn’t specifically relevant to the 1937 argument, but here’s the discussion that ensued, with the most relevant parts to the point I want to make here underlined:

Me: For such a long comment, it is astonishing that it doesn’t manage to substantively address a single thing that I wrote in the book. I think it would be more helpful for others if reviewers actually read the book before rating it and try to include relevant remarks. As for the Great Depression, which I don’t discuss in my book, I urge people to read Murray N. Rothbard’s “America’s Great Depression” as an antidote to the above. Available in Kindle edition from the Ludwig von Mises Institute (LvMI) at

D. Burns: Yeah, Murray smashes every piece of nonsense posted here. I second that recommendation. “America’s Great Depression” is one of the finest economic works I have read. I look forward to reading yours as well.

chess.instructor: Did not Hoover’s economic policy of keeping a balance budget result in stedily increasing unemployment from 1929 to 1933, reaching 25% of the U.S. labor force by the end of Hoover’s presidency in 1933? Was this a good thing?

If Hoover had been reelected in 1932, and he maintained his balanced budget policy, how high would the U.S. unemployment rate have risen?

Me: It is difficult to see how a Hoover policy of keeping a balanced budget could be pinned as the cause of unemployment when he didn’t keep a balanced budget, but ran a deficit every year, and increased government spending over his term. Outlays were at 3.6 billion and the deficit at .5b his first year, but those numbers rose to 6.5b and 3.6b, respectively, by his last year in office. How can a policy resulting in nearly doubled spending and 86% increase in the deficit be described as “keeping a balanced budget”?

Unemployment resulted because there was an artificial and unsustainable boom brought on by the Fed’s monetary inflation (prices were stable, but would have been falling due to advances in means of production absent the Fed’s printing), resulting in malinvestment. But rather than allowing a brief recession to restructure the economy and liquidate the malinvestment (compare the 1920-21 recession and the lack of government intervention leading to a quick recovery), both Hoover and Roosevelt administrations intervened to try to prevent a market correction, including by fixing minimum wage prices, which contributed greatly to the high unemployment by pricing lower-skilled laborers right out of the market.

chess.instructor: Hoover’s response to government deficits was to fire government employees which led to further deficits, because the fired workers no longer paid income taxes. Thus, the deficit got even bigger resulting in Hoover firing additional federal employees. This resulted in an acceloration of the economic downturn AND an increase in the federal deficit. Hoover’s motivation in firing federal workers was his attempt to balance the federal budget.

Me: Nonsense. Why, then, again, did government outlays INCREASE every single year of his presidency? Roosevelt’s “New Deal” was just an expansion of policies implemented under Hoover, including attempts to fix wage rates and engage in public works expenditures. Maybe you’ve heard of the HOOVER dam, for instance? Treasury Secretary Andrew Mellon in May 1931: “In this country, there has been a concerted and determined effort on the part of both government and business not only to prevent any reduction in wages but to keep the maximum number of men employed, and thereby to increase consumption.” Contradictory goals, of course, and rather Keynesian in prescription, but the point is clear. It’s true under Hoover there was a reduction of hours in government employ, but without a reduction in pay. In fact some government employees received wage increases. Hoover did not try to balance the budget by decreasing revenue, but by increasing taxes. Despite (or perhaps we should say “because of”) the tax increases, federal revenue declined.

The dude’s next comment was again quite lengthy, and mostly irrelevant to the point I want to make here, but here’s the relevant part:

I agree raising taxes during an economic downturn is a bad idea. Hoover’s policies failed because he did much too little to stimulate the economy. Roosevelt’s policies were successful because of his willingness to spend huge budget deficits, something Hoover was philosophically opposed to. Obama’s stimulus program was less effective because Congress refused to spend the amounts Obama asked for.

Roosevelt’s 1937 budget which was an attempt to balance the budget by cutting government spending, had the opposite result: the deficit got bigger. This is because the spending cuts were dwarfed by the loss in income tax revenue caused by the increase in the national unemployment rate from 15% to 18%.

…The bottom line is Hoover’s economic policies failed for three and a half years to halt the depression which followed the Stock Market crash of 1929. Roosevelt’s economic policies immediately halted the economic slide. Roosevelt’s policies led to steady economic improvement for the first four years of his presidency, with the unemployment rate dropping from 25% to 15%, a reduction of 40%.

In summary, cutting government spending during a severe economic downturn DOES NOT WORK. Instead, recovery from a severe economic downturn happens faster with DEFICIT SPENDING.

And the relevant part of my reply:

It is interesting how you keep changing your story. First you claim “Hoover’s economic policy of keeping a balanced budget” was the cause of increasing unemployment. Then, when I point out Hoover didn’t keep a balanced budget, you still claim that Hoover fired government employees to try to balance the budget. Then, when I point out how Hoover actually engaged in public works projects with an explicit policy of trying to keep maximum employment, you come back with the claim that, well, he just “did much too little to stimulate the economy”, a tacit acknowledgment that everything you tried to claim before was wrong. Hoover’s policies certainly did fail — just not for the reasons you’ve tried to claim.

It is difficult to see how “Roosevelt’s policies were successful”, given the fact of history we call the Great Depression. Again, we can compare the 1920-21 recession and lack of government intervention leading to a quick recovery.

As for 1937, you claim Roosevelt attempted to balance the budget by cuting spending, which only made the deficit bigger. But then you contradict that by saying it was actually the loss of revenue from income taxes due to the high unemployment. In fact, receipts increased from 3.9 billion in 1936 to 5.4 billion in 1937, and up again to 6.8 billion in 1938. Government spending was less in 1937 than 1936, but still higher than every single year prior to that going back to the start of the Great Depression. And the deficit didn’t get bigger, it shrunk from 4.3 billion in 1936 to 2.2 billion in 1937. But then, when the economy turned upward again, the deficit was just .1 billion in 1938!

So the bottom line is that it is exceedingly difficult to see how the actual facts support your case.

See, I told you that would be fun!

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About Jeremy R. Hammond

About Jeremy R. Hammond

I am an independent journalist, political analyst, publisher and editor of Foreign Policy Journal, book author, and writing coach.

My writings empower readers with the knowledge they need to see through state propaganda intended to manufacture their consent for criminal government policies.

By recognizing when we are being lied to and why, we can fight effectively for liberty, peace, and justice, in order to create a better world for ourselves, our children, and future generations of humanity.

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