FDR Made the Depression Great Again

How the blue eagle, symbol of a 1933 law, had its wings clipped

By Jason Taylor. He is an economics professor at Central Michigan University and author of “Deconstructing the Monolith: The Microeconomics of the National Industrial Recovery Act.” Excerpts:

"The tragedy is that during Roosevelt’s first months in office the U.S. economy made tremendous strides. Between March and July 1933, employment, production and spending all increased sharply. The nation seemed to be on a highway to recovery, largely thanks to Roosevelt’s policies.

But what good policy giveth, bad policy taketh away. In June 1933 Roosevelt signed the National Industrial Recovery Act (NIRA), which required firms to meet with competitors and construct a “code of fair competition.” Over two years, 557 codes were implemented in industries ranging from steel to fishing tackle.

These codes permitted collusive actions that would otherwise violate antitrust law. Businesses that were found violating the codes—say, charging a price below the code-specified one—could face hefty fines and imprisonment. For their membership in government-enforced cartels, firms were forced to raise hourly wages."

"Companies that violated the act’s labor or cartel rules were barred from publicly displaying the Blue Eagle. FDR urged Americans to boycott them."

"Companies responded to forced wage increases by scaling back employment. And colluding firms did what cartels generally do—they restricted output and raised prices."

"While manufacturing output rose an unprecedented 78% between March and July 1933, it fell sharply after the Blue Eagle’s arrival. By November two-thirds of the recovery gains were lost. Output didn’t pick up until a year later, when business owners, irritated by the Blue Eagle, quit “doing their part” and openly violated the codes, overwhelming the enforcement offices.

By the time the Supreme Court ruled the NIRA unconstitutional in May 1935, even Roosevelt had acknowledged privately that this “whole thing is a mess.” After the Blue Eagle’s demise, the nation’s recovery resumed and manufacturing output rose 50% over the next 18 months."

‘Not Accountable’ Review: Unelected Legislators

Fearful of angering public-employee unions, politicians bend to their will at taxpayer expense. Can this arrangement be challenged in court?

By John Ketcham. He reviews Not Accountable: Rethinking the Constitutionality of Public Employee Unions by Philip K. Howard. Ketcham is a fellow and director of state and local policy at the Manhattan Institute. Excerpts:

"In 2008, six years after securing control over New York City’s public schools, Mayor Michael Bloomberg and schools chancellor Joel Klein put forward a program to tie teacher tenure to student performance. The goal was to reward the best-performing teachers with job security, encourage better student outcomes, and hold teachers accountable for demonstrated results. To most New York residents, it surely sounded like a good idea.

To New York’s teachers’ unions, however, the program was utterly unacceptable. Union leaders lobbied Albany, threatened state lawmakers (who could pass legislation binding the mayor) with the loss of political support, and walked away with a two-year statewide prohibition on the use of student test performance in tenure evaluations. In short, the union thwarted the mayor’s authority over the city’s schools and commandeered the state’s legislative power.

In this case and many others, a public-sector union served its own interests at the expense of the public’s."

"public unions—that is, unions whose members work for the government—are forbidden by the Constitution. The argument, he notes, would have been familiar to President Franklin Roosevelt and George Meany, the longtime president of the AFL-CIO, both of whom championed private-sector labor but believed that public workers—teachers, fire fighters, policemen, civil-service employees—had no right to bargain collectively with the government."

"a world in which inefficiency is “mandated by contract,” and out-of-control, unfunded pension liabilities threaten service cuts. Meanwhile, arbitration stymies accountability, and a morass of work rules “add up to personnel policies where there’s always a reason not to do what’s needed.” Nothing much gets done, he says, because elected executives “no longer have effective authority over the operations of government.”

Armed with vast revenue from members’ dues, nearly all such unions operate from the same playbook: elect pliant public officials as their future bosses; negotiate with those officials for more favorable pay, work rules and fringe benefits in the next round of collective bargaining; and push for laws that expand the government workforce and make reform impracticable. Political leaders intrepid enough to propose legislative fixes can expect fierce resistance and, with few exceptions, defeat at the hands of labor-aligned lawmakers and union-backed primary challengers."

"He sees political authority being usurped by union authority—or, to put it another way, politicians giving over essential governing choices to unions. In response, he cites the “nondelegation doctrine,” a legal theory positing that a branch of government can’t delegate its core powers and responsibilities to a private entity. This doctrine, a sibling of the one often raised when Congress tries to give broad legislative discretion to the executive branch’s administrative agencies, applies, he says, to public-sector unions: If these unions wield an effective veto over government operations—a private entity obstructing legislative or executive powers—then they contravene the constitutional assignment of public responsibilities."

"It requires that the U.S. guarantee to each state a republican form of government. By taking away key decisions from elected officials, Mr. Howard says, public unions obstruct republican government. He also quotes Federalist 39, where James Madison describes a republican form of government as one that requires political officials to serve for a limited term of office and remain subject to removal through the ballot box. Structural union controls—in statutes and collective-bargaining agreements—evade such accountability by persisting across terms, impervious to executive authority. Worse still, laws in many jurisdictions allow unelected arbitrators to resolve public-sector labor disputes through binding decisions, permitting lawmakers to evade their constitutional role and avoid making difficult trade-offs."

The wrong way to think about moral hazard

By Scott Sumner.

"I am continually amazed at the amount of nonsense that I’ve been reading on the subject of moral hazard. Here are a few examples:

1.  Moral hazard played no role with SVB because the shareholders and bondholders were wiped out.  (nonsense)

2.  Moral hazard isn’t an issue because average people don’t think about the safety of a bank when making deposits.  (nonsense)

3.  Moral hazard isn’t an issue because average people are unable to evaluate the risk of various banks.  (wrong)

4.  A run on bank deposits could cause a recession.   (wrong)

If you see anyone making the first two arguments above, just stop reading.  They literally do not know what moral hazard is.  The fact that a business failed and the owners lost everything has no bearing on the issue of moral hazard.  Here’s Matt Levine:

Schematically, a bank consists of shareholders taking $10 of their own money and $90 of depositors’ money and making some bets (home loans, business loans, bond investments, whatever) with that combined pile of money. If the bets pay off, the shareholders get the upside (the depositors just get their deposits back). If the bets lose, the shareholders lose money (the depositors get their money back before shareholders get anything). If the bets lose really big — if the bank bets $100 and ends up with $50 — then the shareholders lose all their money, but the depositors get their money back: If the bank is left with only $50, the government gives the depositors the other $40.

If you are a rational bank shareholder (or, more to the point, a bank executive who owns shares and gets paid for increasing shareholder value), this structure encourages you to take risk. If you bet $100 on a coin flip and you win, the bank has $200, and the shareholders keep $110 of that, a 1,000% return. If you lose, the bank has $0, and the shareholders lose $10 of that, a -100% return. The expected value of this bet, for the shareholders, is positive. The expected value for the depositors is neutral: Either way they get their $90 back, either from the bank or from the government. The expected value for the government is negative: If the bank wins, the government gets nothing; if the bank loses, the government pays the depositors $90. But the shareholders — really the executives — are the ones who get to decide what bets to take.

Deposit insurance gives bank executive an incentive to take socially excessive risks.  In some cases the risks won’t pay off.  But that doesn’t mean executives don’t have an incentive to take excessive risks.  

Things didn’t pan out for SVB.  But that doesn’t mean their executives made an unwise gamble.  It’s very possible that SVB’s strategy had a very high expected payoff, and they were simply hit by bad luck (rising interest rates.)  Of course from a social perspective their decisions may have been bad, but not necessarily from a private perspective.  “Heads I win, tails part of my losses are borne by taxpayers”.  Of course I’d take more risk with those odds.

And yet despite this clear explanation of how moral hazard works, Matt Levine follows a description of how SVB went bankrupt with this head scratcher:

And so the question is: Is that moral hazard? Well, not for shareholders and executives and bondholders.

No!  The fact that things didn’t work out for the executives doesn’t have any bearing on the question of whether moral hazard distorted decision-making at SVB.

The second misconception above also illustrates a basic lack of understanding of moral hazard.  Yes, people don’t tend to pay attention to bank balance sheets when making decisions on where to put their money.  But that’s exactly what you’d expect to happen if moral hazard were a major problem.  People would stop caring about bank risk, and highly risky banks would understand that they could attract deposits every bit as easily as conservative, well-run banks.  Clueless depositors are not evidence of a lack of moral hazard; they are evidence that moral hazard exists.

At this point people often shift their argument.  They say, “Yes, it’s unfortunate that depositors don’t discipline banks, but you certainly cannot expect average people to evaluate the safety and soundness of large complex banks.”  Really?  Are these claims also true?

1. Most average people don’t read academic papers and attend lectures at lots of universities, hence you cannot possible expect average people to know that Harvard and Stanford are better that South Dakota State and Western Michigan University.

2.  Most people are not able to evaluate the quality of carburetors, anti-lock brakes, and fuel injection mechanisms, so they couldn’t possibly be expected to know that a Mercedes is better than a Ford.

3.  Most people are not able to evaluate the quality of surgeons, so they cannot possible be expected to know that Johns Hopkins is better than Missouri Valley Hospital.

Yes, modern Americans pay little or no attention to the relative safety of various banks.  Why should they?  But I assure you that back in the 1920s people cared a great deal about bank safety.  Banks knew this, and managed their balance sheets far more conservatively than do modern banks.  That’s why big city banks used to look like massive Greek temples; they had to convince depositors that they had the capital to survive hard times.  The vast majority of big banks survived the Great Depression.  US GDP in 1929 was about $100 billion and deposit losses during the Great Depression were $1.3 billion.   Today, a 50% fall in NGDP (as in 1929-33) would wipe out almost our entire banking system.  Modern bankers are far more reckless “despite” regulation.  The negative effects of deposit insurance are far more important than the positive effects of regulation.

When people think about moral hazard, they often exhibit a lack of imagination.  If you read a great deal of history, you often find yourself asking, “How could people have behaved that way?  What were they thinking?”  Take an example from the 19th century.  One aristocrat insults another at a well-attended dress ball.  How would you react?  Now think about how you would react if you had been born in 1820.  You might respond to the rude comment with a challenge to a duel.  Pistols at 20 paces, 6am the following morning.  We can’t imagine living this way, because we never experienced this world.

A world without deposit insurance is not that far away.  When I was 10 years old (1965), Canada had no deposit insurance and got along just fine.  People who live in that sort of world know how to behave.  They know enough to put their money in safe banks, not reckless banks.  I wish Canada had never adopted deposit insurance.  (I suppose their decision to do so represented the misguided big government liberalism of the late 1960s.)

Of course, the US system is much different from the Canadian system.  Prior to FDIC, we had lots of bank failures.  This was due to the almost incredibly undiversified nature of our system, which resulted from some pretty insane branch banking restrictions.  Here’s Elmus Wicker:

The number of commercial banks in the United States nearly tripled during the first two decades of the 20th century, reaching 30,000 in 1920. The vast majority of these were unit banks as required by their national and many state charters. Illinois had nearly 2,000, and Nebraska, with a population of 1.3 million, had a bank for every 1,000 residents. Failures averaged about 70 banks per annum, or one of every 300 existing banks, during those two decades. The agricultural depression of the 1920s raised the failure rate to more than 600 banks per annum, or one of 50. Failures showed few signs of abating as the decade drew to a close, and the banking system, especially in rural America, entered the Great Depression in a fragile state.

LOL at Nebraska.  Given the large size of families back then, that’s roughly one bank for every 250 families!

Contrary to widespread opinion, (even among many economists), the bank failures of this period did not lead to much contagion.  The only real “panic” occurred for entirely different reasons, when there was (well-justified) fear that the US would leave the gold standard.  Otherwise, lots of inefficient small banks failed and life went on.

The Canadians were much smarter.  They allowed large well-diversified banks, and thus have looked on with bemusement as the US reels through one banking crisis after another.  Here’s the Financial Post:

Despite investor jitters, concerns for the Big Six were limited. Unlike SVB, which catered to a niche market funding tech start-up companies, Canada’s big banks dominate their home market and are diversified across industries and business lines.

“From a Canadian perspective, not only should the failure of SVB not have significant negative implications for our banks, but this crisis should actually be viewed as further vindication of the Canadian banking model, which is dominated by a few large and diversified players,” Bank of Nova Scotia analyst Meny Grauman said in a March 13 note.

In the US, both left and right wing politicians favor the smaller banks.  Big is viewed as bad.  Matt Yglesias is one of the few progressives that understands the value of big banks, and today he has an excellent post on the issue:

America needs more giant banks

The moral of Silicon Valley Bank’s collapse is that the real danger comes from the medium-sized ones

How do we get to Yglesias’s utopia?  Abolish deposit insurance (he wouldn’t agree).  You’ll see a massive shift of deposits toward the larger, more diversified banks, making our system resemble the Canadian system.

Most people, and even most economists, know nothing about our banking history.  They’ve never bothered to read Elmus Wicker, Larry White, George Selgin, or any of the other experts.  They get their ideas from films like “It’s a Wonderful Life.”  They view our banking system as a fragile house of cards that would collapse without FDIC.  (Funny how the Canadian house of cards avoided any major problems in the century before 1967.)  Actually, it’s a house of cards created by FDIC.

The final misconception involves the effect of banking crises on the macroeconomy.  It’s true that banking crises are often associated with recessions, but not always.  Industrial production soared 57% between March and July 1933, despite many of America’s banks being shut down to check their balance sheets.  In fact, in a fiat money system causality generally goes from the business cycle to banking distress, not the other way around.  The US entered recession in December 2007.  The recession got much worse after June 2008.  The banking crisis occurred in late September 2008.  

As long as the Fed adjusts monetary policy to keep expected NGDP growth at a healthy level, bank failures should have no significant impact on economic growth.  In any case, creating moral hazard doesn’t prevent banking crises, it simply pushes the problem into the future.

FDR opposed deposit insurance, as he (correctly) feared it would create moral hazard.  Unfortunately, Congress refused to listen to his good advice.

PS.  Some other misconceptions: 

“FDIC fees are not a tax on the public.”  Yes, they are. 

“We aren’t bailing out bank executives”.  No, we are not bailing out SVB executives, but we are (implicitly) bailing out their competitors."