Menu
Tax Notes logo

Tax History: A 1937 Fiscal Lesson: Don’t Declare Victory Before the War Is Won

Posted on July 13, 2020

In 1937 Franklin D. Roosevelt made a terrible mistake — one that today’s policymakers should consider as they debate the scheduled expiration of pandemic unemployment benefits, now slated for July 31.

FDR learned his lesson the hard way: When you withdraw expansionary fiscal support prematurely, you can tank a fragile recovery with alarming speed. That’s what happened in 1937 when Roosevelt began to unwind the expansionary fiscal policy of the early New Deal. Convinced that he had vanquished the Great Depression, Roosevelt believed it was time to return to more traditional notions of “sound” public finance.

He was wrong.

To be fair, Roosevelt wasn’t the only one making mistakes in the spring of 1937. So were the governors of the Federal Reserve and policymakers at Treasury, who together orchestrated a severe tightening of the money supply; by most accounts, that monetary shock was more harmful than the fiscal contraction that Roosevelt engineered (trade historian Douglas Irwin has pinned particular blame on Treasury’s “gold sterilization” program).

But Roosevelt’s fiscal austerity, which included both a reduction in spending and a significant tax increase, certainly didn’t help. Indeed, those measures combined to produce a sharp reduction in the federal deficit — not enough to explain the full scale and scope of the subsequent downturn, but definitely enough, in the words of economic historian Christina Romer, to exert “significant contractionary pressure.”

The unfortunate history of 1937 merits a closer look, if only to drive home the lesson for contemporary policymakers tempted to rush the return to fiscal normalcy: Don’t declare premature victory in the battle against a severe economic downturn.

Two-Part Depression

In hindsight, we generally view the Great Depression as a single, decade-long slump. But it was really two severe contractions, punctuated by a rather impressive recovery in the middle.

GDP fell sharply in 1930, 1931, and 1932 at the start of the Depression, and somewhat more modestly in 1933. It then rose by 10.9 percent in 1934, 8.9 percent in 1935, 13 percent in 1936, and 5.1 percent in 1937. “The recovery in the four years after Franklin Roosevelt took office in 1933 was incredibly rapid,” Romer has noted. “Annual real GDP growth averaged over 9 percent. Unemployment fell from 25 percent to 14 percent.”

The string of impressive numbers ended in 1938, when GDP fell by 3.4 percent. In fact, the slump had begun in the summer of 1937, but policymakers remained blissfully unaware of the unfolding disaster until it was well underway. New Deal officials were actually quite pleased with themselves throughout the first half of 1937, none more than Roosevelt himself. In his State of the Union address, FDR had taken pains to remind lawmakers of the improving economic climate while also urging them to avoid complacency. “Your task and mine is not ending with the end of the Depression,” he intoned.

As it happened, the Depression hadn’t reached an end so much as an intermission. By the summer of 1937, a new downturn was well underway, and over the coming months the slump would become obvious to even the most optimistic observers. “We are headed right into another Depression,” warned Treasury Secretary Henry Morgenthau Jr. in a memo to the president. As historian David M. Kennedy recounted in Freedom From Fear (1999), his magisterial history of the Depression and World War II, during just a few months in the second half of 1937, stocks fell by more than a third, corporate profits plunged by almost 80 percent, and overall industrial output dropped by 40 percent. Unemployment, meanwhile, was climbing steadily upward, eventually reaching 19 percent.

As noted above, most historians have blamed the 1937 recession on a blend of unwise monetary and fiscal policy changes. “The fundamental cause of this second recession was an unfortunate, and largely inadvertent, switch to contractionary fiscal and monetary policy,” Romer explained.

In retrospect, the fiscal policies can seem particularly hard to fathom, especially for anyone raised to think of Roosevelt as the original Keynesian big spender. However, he was something of a fiscal conservative, sometimes by inclination and often as a matter of political strategy. Roosevelt understood that fiscal probity had a strong constituency, both among voters and among the lawmakers they elected.

Roosevelt knew that fiscal conservatism was supported by investors and the business community, mainstream academic economists, think tanks, and the majority of the voting public,” wrote political historian Julian E. Zelizer in a 2000 article. FDR therefore consistently made room for fiscal conservatives in his administration. “Ideologically, the president embraced their values,” Zelizer contended. “Politically, he shared the belief that fiscal conservatism enjoyed support from the electorate, Democrats, and business.”

During the early years of Roosevelt’s presidency, fiscal conservatism necessarily took a back seat to the exigencies of the economic emergency. But by 1937, the fledgling recovery had created an opening for conservatives to press their case with a generally sympathetic president. FDR agreed to begin scaling back some of the emergency spending that had been bolstering economic growth since 1933.

In April Roosevelt asked Congress to reduce work relief spending, assuring lawmakers that extraordinary programs were no longer necessary. “While I recognize many opportunities to improve social and economic conditions through Federal action, I am convinced that the success of our whole program and the permanent security of our people demand that we adjust all expenditures within the limits of my Budget estimate.”

Reductions in relief spending were important, but they were small in comparison to another factor that also weighed heavily on the economy. In 1936 Congress had given 3.2 million veterans a large, one-time cash bonus. Passed over FDR’s veto, the veterans’ bonus amounted to 2 percent of GDP. That payment had goosed growth in 1936, but it was gone by 1937. Combine that with FDR’s cuts in relief spending, and the stage was set for a significant reduction in the government’s fiscal support for continued recovery.

Meanwhile, the other side of the fiscal ledger was making matters even worse. Tax receipts were rising sharply, both because of economic growth and as a function of the new Social Security taxes then taking effect for the first time. During that first year of operation, payroll taxes drained some $2 billion from the economy; associated Social Security spending, which might have limited the contractionary effect, wouldn’t begin until 1940.

All together, these spending and tax changes produced a sharp reduction in the expansionary effect of federal fiscal policy. The budget deficit fell from 5.4 percent in fiscal 1936 to 2.5 percent in fiscal 1937. In 1938 the budget was nearly balanced.

Lesson Learned?

The 1937 recession should be a cautionary tale for today’s policymakers as they try to navigate the economic crisis brought on by the COVID-19 pandemic. It highlights the understandable but unwise urge to declare victory and get back to normal as soon as possible.

As I noted in a recent article on coronavirus relief legislation, “The real danger, in the face of economic collapse, is timidity, not audacity.” (Prior analysis: Tax Notes Federal, May 25, 2020, p. 1326.) The early legislative response to the pandemic fares well by this standard; lawmakers worked with impressive speed and considerable bipartisan spirit, all things considered. And while the results were certainly imperfect, they were timely, ambitious, and reasonably effective.

But the early efforts were the easy ones, at least politically. As we draw closer to November’s contentious election, our nation’s stock of social capital is already badly depleted. Politics has eroded some of that capital, but so has the wear and tear of coping with the pandemic itself.

Still, the emergency is anything but over, as leaders of both parties have been quick to acknowledge. So what’s next? Legislative deadlines are fast approaching.

Reasonable people can disagree on which elements of the emergency legislation should be extended — and exactly how those extensions should be structured. But in drafting the next installment of pandemic legislation, lawmakers should bear in mind Roosevelt’s unfortunate rush to normalcy in 1937. It was an expensive error for Roosevelt — and the nation as a whole. For FDR, it further depleted his already diminished store of political capital. For the nation, it prolonged its decade of economic suffering for at least another year or two.

The 1937 episode brings to mind the old proverb: “Haste makes waste, and waste makes want, and want makes strife between the goodman and his wife.” We don’t usually hear that saying quoted in its entirety, but for crisis policymaking, I think it’s useful. Premature declarations of victory are likely to be expensive over the long run, creating not just waste, but true economic want. And want — real, painful, economic suffering — almost invariably brings social strife in its wake. That’s something none of us can afford.

Copy RID