Magazine | March 14, 2016, Issue

Policy Mixing

The Midas Paradox: Financial Markets, Government Policy Shocks, and the Great Depression, by Scott Sumner (Independent Institute, 560 pp., $37.95)

Did FDR lead us out of the depths of the Great Depression, or did his policies extend it for years? Were his economic policies salutary or destructive? In The Midas Paradox, Scott Sumner answers yes.

The devaluation of the dollar in the spring of 1933, overseen by the president personally, led to a 57 percent increase in industrial production in four months, easily the most rapid increase in U.S. history. Stocks rose even more dramatically. This upswing lasted so briefly because, during the summer, the National Industrial Recovery Act (NIRA) — Roosevelt’s attempt to cartelize American industry — imposed very large wage increases on business. Stocks and industrial production both went into reverse.

Sumner makes a strong case for this story, even arguing that, without the attempt to fix wages in Washington, the Depression might have ended seven years earlier than it did. It might make more sense, he even suggests, to say that a second, hidden Depression began in mid 1933.

Both contemporaries and later researchers missed this story, according to Sumner, but for understandable reasons. Because these policies counteracted each other after the summer of 1933 — labor-market interventions pushing real wages up and stocks and production down, devaluation doing the reverse — the magnitude of their effects was hidden. Studies that focused on either the wage policy alone or the currency policy alone underestimated their importance.

The book is an ambitious attempt to explain the origins and course of the entire Depression. Sumner integrates previous work on the role of the gold-exchange standard, wage shocks, and Federal Reserve policy in the economic history of the 1930s. He adds his own focus on how these events influenced the stock markets — or, to put it another way, what the stock market’s reaction says about these events.

The Midas Paradox builds, as any account of the Depression must, on Milton Friedman and Anna Schwartz’s Monetary History of the United States. That 1963 book revolutionized our thinking about the Depression by diagnosing its cause as tight money from the Federal Reserve. Sumner believes that Friedman and Schwartz were right to see monetary contraction from 1929 to 1933 as the main cause of the calamity, but he places less emphasis than they did on the money supply and more on international flows of gold.

Given the currency arrangements of the time, these flows had a major effect on market expectations about future monetary policy — and these expectations, Sumner argues, powerfully influenced economic behavior. He bolsters his case by noting that one can make more sense of the pattern of decline and advance in stocks and industrial production by tracking gold flows than by looking at changes in the money supply.

Maintaining the gold-exchange system under the circumstances of 1929 required cooperation among the great economic powers, and Sumner convincingly traces the stock-market crash and onset of the Depression to the dawning realization that it would not materialize. The U.S. and, even more, France would keep building their gold reserves, regardless of the deflationary effects this had on everyone else. The gold-exchange standard would have been less destructive if it had been either more or less rigid: if governments were not allowed to hoard gold, or could disregard gold flows altogether.

A dispute over how much the standard constrained the Federal Reserve has inspired a lot of economic-history literature. Sumner takes a moderate line: The constraints were real, but the Fed failed to do all it could within them. He also notes that the constraints worked in part through markets: Monetary expansion would have little effect if traders assumed that the gold outflows would scare the Fed from going very far with it, or if people hoarded gold in response to it.

To my mind, the analysis of 1933 is the high point of the book, and the year turns out to be full of lessons yet unlearnt. To this day many observers look at interest rates and the money supply to gauge the stance of monetary policy. Neither indicator, however, showed much change that year, even as the devaluation showed all the signs of being the most expansionary shift in monetary policy since the Depression began.

Another open question reverberating in our own time is how important financial-industry turmoil was to the broader economy. In March 1933 the banking industry was in the midst of the worst crisis in our history, one that led to a ten-day bank holiday. Yet the stock market treated these events as much less important than the devaluation or the wage spikes — suggesting to Sumner that the distress in the financial sector was more a symptom than a cause of the Depression.

The conflicting economic experiments in the U.S. affected the behavior of other countries. The early success of devaluation put pressure on France to follow suit, but the post-NIRA faltering of our economy relieved that pressure. Later France would adopt its own version of NIRA — which it probably would not have done if the full consequences of the policy in the U.S. had not been masked by the devaluation.

The confusion that resulted from this record affected economists, too, and for decades. Thwarted monetary expansions under the gold-exchange standard influenced Keynes’s conclusion that monetary policy would be ineffective in a slump. Hence his advocacy of the aggressive use of fiscal policy to stabilize the economy.

Much of the book is a catalogue of catastrophic economic mistakes, and Sumner does not shrink from judging these policies harshly. Other historians think that the economy went through several impressive recovery periods during the 1930s; he thinks most of them were weaker than one would expect in a rebound from a deep depression.

But Sumner is at the same time forgiving of the policymakers involved, who faced institutional, political, and even psychological constraints. Devaluation was seen, for example, as a radical step at the time. The book provides another reason for forbearance: How can we hold the officials of the 1930s responsible for all that went wrong when we still do not have a comprehensive understanding of the Depression all these decades later? That understanding is, however, much more complete thanks to this book.

Ramesh Ponnuru — Ramesh Ponnuru is a senior editor for National Review, a columnist for Bloomberg View, a visiting fellow at the American Enterprise Institute, and a senior fellow at the National Review Institute.

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