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Historical Myths and Tired Fallacies

by on February 23, 2011

When I started writing this, I confess that I did not intend for it to get so long. It rather got away from me, and I am now too lazy to go back and edit it down to a proper size. Be warned, it rambles on and on and I’m not sure it is very well written. If anybody likes it, great. If not, you had a fair warning.

One of the popular economic writers I read on an almost daily basis is David Leonhardt. He writes for the NY Times. He’s a good writer, and someone who usually comes off as moderate and balanced.[1] He is obviously well learned on the major economic topics of the day, which is probably how he writes so fluidly about them.

Unfortunately, nobody is perfect, and Leonhardt proves that in his latest column. Bluntly titled, “Why Cuts Don’t Bring Prosperity,”[2] he not only ends up mindlessly repeating one of the more pernicious myths in American history, he also makes an uncharacteristically bad argument against austerity measures during recessionary periods. We will deal with each issue separately.

Herbert Hoover, the Great Liquidationist

There is a popular historical narrative that has buried itself so deep in the collective consciousness of America that even esteemed academics, journalists, and politicians endlessly repeat it, despite it having been proved false an uncountable number of times. The narrative runs something like this:

The roaring ‘20s were a period of greed, speculation, and short-sightedness. In time, the excesses of American capitalism came to a tremendous end on Black Tuesday, 1929 and the country was thrust into a great depression. President Herbert Hoover, following the advice of his Secretary of the Treasury, promptly cut government spending, refused to assist the poor, and allowed the economy to spiral downwards in an attempt to ‘liquidate’ the rottenness out of the system. Only the election of FDR, a few years later, saved us.

Here is Leonhardt’s take on that narrative:

“But no matter how morally satisfying austerity may be, it’s the wrong answer. Hoover’s austere instincts worsened the Depression. Roosevelt’s postelection reversal helped, but he also prolonged the Depression by raising taxes and cutting spending in 1937.”[3]

I am positive that almost every single American citizen has heard this myth, either on the news, in the textbooks, or from teachers. It is repeated ad infinitum. It is also false. The myth seems to have originated with a famous quote by Andrew Mellon, Hoover’s Secretary of the Treasury. He once advised Hoover to,

“Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate….purge the rottenness out of the system…”[4]

It is true that Mellon advised Hoover to do such things, but the problem is that Hoover never did do such things. Hoover, contrary to popular belief, was not some sort of coldhearted conservative, hell-bent on downsizing big government. He was, rather, a man who believed what most progressives at the time believed: that government had a role to play in assisting the market in raising people’s standard of living. Hoover was, above all, an engineer who loved to test the sort of good government could do.[5]

What is true, but often ignored, is that Hoover actually increased spending during his tenure as president. He increased spending and (combined with falling tax revenue) ran the highest peace-time deficits the country had ever seen. Real government spending increased a whopping 45% between 1929 and 1933.[6] Along with the deficits and spending, Hoover also raised taxes dramatically with the passing of the Revenue Act of 1932.[7] Those are not exactly the actions of a man who believes government should step out of the way.

When government spends money it doesn’t simply hand out wads of cash to various people; instead, it oftentimes uses that money to build vast bureaucracies and implement laudable sounding programs. Under Hoover, the government did just that. Hoover created the Federal Farm Board (which transferred millions of dollars into the agriculture industry)[8]; signed into law the Emergency Relief Construction Act (which channeled millions of dollars into banks and small businesses)[9], and pressured businesses to maintain wage rates instead of allowing them to fluctuate according to market conditions.[10] He did a whole host of other things, too, but that short list alone should suffice to blow away the myth that Hoover did nothing, or cut government.

Old myths die hard, but the amount of time this one is hanging on is ridiculous. The record is blatant. It is not hidden away or the product of a revisionist historian. You can read it, in fact, in Hoover’s memoirs. He does not shy away from his record, and neither should anyone else.

Cutting Government Harms the Economy?

Leonhardt’s use of a historical myth is not, sadly, the only problem in his article. The other problem concerns government spending during a downturn. Leonhardt argues that one should not cut government spending during a downturn, and he uses the case of Germany to prove his point. He writes,

“Germany’s economic growth surged in the middle of last year, causing commentators both there and here to proclaim that American stimulus had failed and German austerity had worked. Germany’s announced budget cuts, the commentators said, had given private companies enough confidence in the government to begin spending their own money again.

Well, it turns out the German boom didn’t last long. With its modest stimulus winding down, Germany’s growth slowed sharply late last year, and its economic output still has not recovered to its prerecession peak. Output in the United States — where the stimulus program has been bigger and longer lasting — has recovered. This country would now need to suffer through a double-dip recession for its gross domestic product to be in the same condition as Germany’s.”[11]

Some explanation might be helpful.

Following the American crisis of 2008, most of the world was plunged headlong into a worldwide recession. The response from the majority of governments around the world was to increase government spending in the form of stimulus measures, and to increase the money supply in order to put downward pressure on interest rates.

Germany, though, took a rather more measured position and actually decided to cut government spending. That, at the least, is the typical account. In reality, Germany did implement a moderately sized stimulus program (equal, in fact, to 1.5% of its GDP[12]- the U.S.’s was 2%). As Paul Krugman notes,

Oh, and don’t tell me that Germany proves that austerity, not stimulus, is the way to go. Germany actually did quite a lot of stimulus — the austerity is all in the future.[13]

Germany did respond to the downturn with a stimulus package, but they also promised austerity measures in the future. This can be a useful way of stimulating the economy. Market actors, being naturally forward-looking, respond to future cuts in government spending and taxation. People will begin saving, investing, and hiring today if they know that a year from now government’s burden will have been lessened. Stability is an important component of economic growth, and even promising stability in the future can have positive effects.

Many pundits and economists praised the German response, especially as Germany seemed to be doing better than the U.S. in getting out of the recession. However, as Leonhardt notes, Germany currently isn’t doing quite as well as it had been. So what happened? Can even future cuts to government spending exasperate downturns?

Let’s go back for a moment and review what I consider to be the two overarching macroeconomic explanations for recovery. This is going to be very broad, of course. Although there are numerous macroeconomic theories that fall under these two broad explanations, I feel they all share similar traits.

On the one hand, you have the more or less Keynesian-driven story. Not all of the Keynesian narratives agree on the actual causes of recessions, but they all agree that demand-failures are the real problem. For whatever reason, consumers become uncertain about the future and begin “hoarding” money, which leads to a drop in spending. Businesses, reacting naturally to decreases in sales and burgeoning surplus inventories, begin to lay off employees. The entire process metastasizes throughout the economy. Because nobody is spending, the government is encouraged to step in and pick up the slack by increasing demand through stimulus programs, infrastructure projects, and other methods.

The other camp, broadly speaking, puts more of an emphasis on the causes of the downturn, arguing that you can’t fix something if you don’t know what broke it in the first place. Many economists see central bank induced expansions in the money supply as the primary problem. Increases in the supply of money have the effect of artificially lowering the rate of interest.[14] Normally the interest rate will decrease naturally due to an increase in savings, which banks then loan out to businesses. Businesses take the money they have acquired and embark on new business venture. However, if the interest rate falls without an increase in savings, businesses eventually find that the projects they have started cannot be completed. The savings are not there to finance the undertakings. This leads to a recession as businesses are forced to lay off workers, dump projects, and often times face bankruptcy.

The solution in the aforementioned theory is most often to get the government out of the way and let the market work. The reason for this is relatively straightforward: the cause of the problem isn’t psychological. Uncertain consumers didn’t simply stop spending because they felt something was wrong. Due to the artificial lowering of the interest rate, real resources were misallocated throughout the economy. Businesses invested in projects that they would not have had interest rates followed a more natural path. Labor and capital were employed in areas of the economy they should not have been. The downturn- or recession- is the period during which those resources are rearranged throughout the economy in a more sustainable way.

Looked at this way, government spending will not necessarily assist in those resources being used in ways congruent with consumer demands. A likely possibility is that government spending ultimately ends up prolonging the recession by slowing down the pricing system’s ability to coordinate resources. In other words, those resources that were misallocated will remain misallocated if government attempts stimulus measures.

Going back to Leonhardt’s claims about Germany, we can see that his argument against austerity measures fails miserably. Germany, remember, actually did engage in stimulus spending. If the resource-misallocation theory were correct, it would mean that the stimulus spending was a setback to actual recovery. Despite the future austerity measures, the stimulus spending would already have harmed the economy. One could not expect the austerity measures to work quite so well in the face of further distortions to the economy.

Germany’s problem was not that it engaged in austerity measures; it is that it did no such thing. Krugman is correct- the austerity measures are all in the future. If the present consists of actions that impede recovery, the future is going to be a long time in the coming! Germany’s government spent fairly lavishly and nothing happened. So, too, did the U.S. government. Some people argue that that is because the stimulus funds were too small. Perhaps, but it still doesn’t reflect well on pro-stimulus advocates. The results all makes sense, though, if you believe government spending is the problem.

Leonhardt also goes into Britain’s supposed austerity measures that he says have been even more disastrous than Germany’s. That may be the case- I don’t know. Unfortunately, I don’t have the time or patience at the moment to look into that. Perhaps another day.

[1] He even answered a question of mine about the housing market, which can be read here.

[2] David Leonhardt (2011), “Why Cuts Don’t Bring Prosperity.”

[3] Ibid

[4] Paul Krugman (2009). “The Return of Depression Economics.” New York: Norton, pg. 3

[5] Amity Shlaes (2007). “The Forgotten Man.” New York: HarperCollins, pp. 30-33

[6] Stefan Karlsson (2020), “Herbert Hoover was no Deficit-Cutter.”

[7] Robert Murphy (2009). “The Politically Incorrect Guide to the Great Depression and the New Deal.” Regnery: New York, pp. 52-53

[8] Ibid, p. 56

[9] Amity Shlaes (2007), p. 115

[10] Robert Murphy (2009), pp. 39-42

[11] David Leonhardt (2011)

[12] Richard Tomlinson and Oliver Suess (2009), “Merkel Makes like Obama With German Stimulus Excluding Europe.”

[13] Paul Krugman (2010), “The Real Story.”

[14] Austrians argue, following Knut Wicksell, that there exists a “natural” rate of interest, determined by the aggregate “time-preferences” of individuals in society. When the interest rate diverges from the natural rate, it sets in motion an unsustainable boom that will inevitably come crashing down.


From → Economics

  1. Sam,

    This is great, very impressed with your well researched writing!

  2. seven of nine permalink

    good stuff. Thanks for putting all this info together.

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