Revisiting the 1937 recession

In 1937-38 the US economy experienced a sudden decline that saw unemployment rates spike from 14 percent to 19 percent -- essentially a recession within the Great Depression. Keynesians typically assign blame for the event on a reduction in government spending, and point to the episode as evidence of the foolishness of engaging in austerity measures while an economy is still on the mend.

The following two graphs illustrate the recession's impact:

Writing in today's Wall Street Journal, however, economics professors Thomas Cooley of New York University and Lee Ohanian of UCLA argue that the recession is best understood as the consequence of increases in taxes and labor costs rather than cuts in government expenditures:

Here are the facts: Real government spending, measured in 1937 dollars, declined by less than 0.7% of GDP between 1936 and 1937, and then rebounded in 1938. It is implausible that such a small and temporary decline reduced real GDP by nearly 3.5% in 1938 or reduced industrial production by about one-third.

But in 1936, the Roosevelt administration pushed through a tax on corporate profits that were not distributed to shareholders. The sliding scale tax began at 7% if a company retained 1% of its net income, and went to 27% if a company retained 70% of net income. This tax significantly raised the cost of investment, as most investment is financed with a corporation's own retained earnings.

The tax rate on dividends also rose to 15.98% in 1932 from 10.14% in 1929, and then doubled again by 1936. Research conducted last year by Ellen McGratten of the Federal Reserve Bank of Minneapolis suggests that these increases in capital income taxation can account for much of the 26% decline in business fixed investment that occurred in 1937-1938.

Meanwhile, after the 1935 National Labor Relations Act, union membership rose to about 25% in 1938 from about 12% in 1934. The increase in unionization was fostered by the sit-down strike.

The professors conclude:

There are lessons to be learned from the history of 1937-1938 but they are not the ones being taught. The Obama administration should consider these: Raising business costs by increasing capital income taxes and promoting higher unionization is a mistake that will hurt most those who they should want to help—workers who have lost jobs during this recession.

Lessons that are sure to fall on deaf ears.