Strengthening Constitutional Self-Government


Financial Crisis—Yes; Great Depression—No


September 2008

by Burton W. Folsom, Jr.

“We are in the midst of the worst financial turmoil since the Great Depression,” writes Paul Volker, former Federal Reserve chairman. During the week (September 15-19, 2008) that Volker penned these words, we saw the collapse of Lehman Brothers, the federal bailout of AIG, and cries of woe up and down Wall Street. What should we make of all this? It’s too early to tell, but two points are worth noting.

First, the current crisis on Wall Street was precipitated by government manipulations, not the alleged failings of the free market. From January 2001 to June 2004, the Fed sharply lowered the interest rate for federal funds. In response, mortgage rates plummeted from almost 8 percent in 2002 to 4-6 percent (depending on the loan) in 2006.
In that artificial atmosphere, banks issued mortgages left and right to all kinds of buyers and speculators, some of whom were allowed to put down no collateral for risky home loans. Fannie Mae and Freddie Mac, the two government mortgage guarantors, and the Department of Housing and Urban Development (HUD) encouraged the issuing of subprime rate mortgages to low income buyers. Given the amount of capital plowed into flimsy mortgages, it was only a matter of time before the defaulting began to topple the more fragile lending institutions. Without the government intervention, much of it politicized and none of it constitutional, banks would have been more accountable and would have had the usual incentives to make more secure loans.

The second point is that although the current crisis may be, in Volker’s words, “the worst financial turmoil since the Great Depression,” that doesn’t mean the crisis is following the pattern of the Great Depression. Happily, the two disasters are very different.

In the first place, the Fed helped spark the Great Depression by raising interest rates, not lowering them, as the Fed is doing now. Economist Milton Friedman won the Nobel Prize in large part because he showed that when the Fed raised interest rates from 1929 to 1933, that stifled investment and contracted the money supply. The Fed this time is keeping rates low.

Second, the Great Depression was worsened by the Smoot-Hawley Tariff, the largest tariff hike in U. S. history. Foreigners, unable to sell to the U. S. because of the high tariff barriers, refused to buy American exports and U. S. industry closed factories throughout the country. Car and truck sales, for example, were 5.3 million vehicles in 1929 and only 1.8 million in 1933. Tariff walls were an important part of this decline, but today tariffs are much lower and trade from country to country is brisker.

Third, Presidents Hoover and Roosevelt extended the Great Depression by passing large tax hikes on America’s major entrepreneurs. In 1932 Hoover signed a bill raising the tax on top incomes from 24 to 63 percent. Three years later, FDR raised the top marginal income tax rate to 79 percent. When government promises to take about three of every four dollars earned past a certain amount, we can be sure entrepreneurs will not risk investments in that amount. The current top marginal income tax rate is 35 percent, but Senator Obama has pledged to raise that to almost 40 percent if he is elected. He has also suggested raising the capital gains tax. Furthermore, House speaker Nancy Pelosi has floated the idea of a 60 percent top marginal tax rate, so the economy may not be completely safe from analogies to the Great Depression.

The fourth point of dissimilarity is that during the Great Depression, Hoover and FDR did no bailouts, but did do politicized loans, which may have been worse. In the case of the bailout, when the Bank of the United States closed it doors on December 11, 1930—the largest bank failure in U. S. history—that created runs on other banks, and that led to a near collapse of the financial system. Perhaps in this instance, a federal bailout would have been the right decision—though if Hoover had done so it would have created a demand for other bailouts, many of which would have worsened the crisis.

What Hoover and FDR did instead was to start the Reconstruction Finance Corporation (RFC), which was authorized to make “loans,” to struggling banks and industries. The problem here is that in times of crisis all industries would like low interest loans (or gifts, which is what they potentially were). Thus, during the Great Depression, we had politicians and bureaucrats picking winners and losers at the taxpayers’ expense. A few examples illustrate this point. Under the Republican Hoover, the RFC made a $7.4 million loan to the Baltimore Trust Company (the vice-chairman was Republican Senator Phillips Goldsborough), and a $90 million loan to Charles Dawes, who had just resigned as president of the RFC three weeks earlier. Dawes received his loan from Atlee Pomerene, the new RFC president, who also made a $12.3 million loan to the Guardian Trust Company of Cleveland—a bank in which he was a director. When FDR became president, he lost little time shifting the political direction of RFC loans. The redirected RFC, for example, made a $1 million loan to David Stern for his Democrat newspaper, the Philadelphia Record. Just in case Stern still had problems, FDR endorsed an IRS investigation of Moses Annenberg, the editor of the rival Philadelphia Inquirer. Meanwhile, with taxpayers on the hook for these loans, many of which were never repaid, unemployment under FDR persisted at over 20 percent more than six years after Roosevelt became president.

The problem with bailouts, government loans, subprime mortgages, and the very presence of Fannie Mae and Freddie Mac is that their activities, whatever the intentions, are quickly politicized. Thus, we need cries for reform to reduce government intervention, not increase it. Whatever greed and corruption we now have on Wall Street is a mere shadow of the greed and corruption in Washington, where it can be readily and legally sated with trillions of taxpayer dollars.

Burton W. Folsom, Jr. is Charles Kline Professor of History and Management at Hillsdale College. He is the author of the forthcoming New Deal or Raw Deal? (Simon & Schuster, 2008).