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January 21, 2010
Tax History: The Limited Lessons of 1937
Joseph J. Thorndike

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There's been a lot of talk lately about 1937. That was the year of the so-called Roosevelt Recession, the second of two back-to-back slumps that we now conflate into a single Great Depression. Some members of the scrivening class seem to think we're poised to repeat "the great mistake," as Paul Krugman describes it: that fateful moment in the middle of the Depression when "spending was cut back, monetary policy was tightened -- and the economy promptly plunged back into the depths."

The worriers aren't all liberals. Martin Feldstein, for instance, thinks the possibility of a renewed recession is real indeed. "There is a significant risk the economy could run out of steam sometime in 2010," he recently warned. The 2009 stimulus bill delivered less than advertised, and what modest lift it did provide seems likely to peter out soon, he said last month.

Worries about renewed recession inevitably give rise to a policy debate. Liberals, in general, call for further stimulus. Conservatives urge less. And a third group -- sometimes described as deficit hawks -- implicitly (if reluctantly) accept the need for expansionary fiscal policy to ward off recession but generally decline to indicate clearly when and if additional stimulus will be needed.

This policy debate -- like the economic conditions from which it arises -- recalls the New Deal era. Historians have generally identified the 1937 recession as a turning point in the development of modern liberalism -- the moment when structural economic reform gave way to Keynesian demand management. But that turning point was no pirouette. Rather, it was part of a long, slow turn shaped more by circumstance than intention.

Tax experts helped guide the fiscal turn of 1937. With one foot in the Keynesian camp but another rooted in the soil of fiscal probity, they offered a middle ground of sorts. Their guidance, while not decisive or even particularly influential with political leaders, proved consistent with economic and political realities. As a result, it presaged the eventual compromise that shaped postwar American fiscal policy.

The Recession

The Great Depression is generally described as a unitary economic slump, but most historians view it as a pair of back-to-back recessions. As Bruce Bartlett noted in a recent article for Forbes, GDP fell sharply in 1930, 1931, and 1932, and modestly in 1933. But it surged by 10.9 percent in 1934, 8.9 percent in 1935, 13 percent in 1936, and 5.1 percent in 1937. Only then did it begin a new decline, falling 3.4 percent in 1938.

In fact, the second recession began in the spring of 1937. Policymakers, as usual, were unaware of the unfolding disaster until it was well under way. New Deal officials were actually quite pleased with economic conditions in early 1937, and Franklin Roosevelt was busy taking credit for them. In his 1937 State of the Union address, he went so far as to warn Congress that "your task and mine is not ending with the end of the Depression."1

By summer, the grim reality was undeniable. Treasury Secretary Henry Morgenthau warned FDR, "We are headed right into another Depression."2 Stocks fell by more than a third, corporate profits sank by 80 percent, and unemployment rose sharply from 9.18 percent in 1937 to 12.47 percent in 1938 (still short of the 1932 peak, when it reached 22.89 percent).3

What caused the downturn? Historians generally blame the Roosevelt administration.4 As Christina Romer, chair of President Obama's Council of Economic Advisers, wrote last year, "The fundamental cause of this second recession was an unfortunate, and largely inadvertent, switch to contractionary fiscal and monetary policy."5

In less than a year, federal policymakers managed to cut spending, raise taxes, and shrink the money supply. Convinced that recovery was under way and eager to balance the federal budget, Roosevelt convinced Congress to reduce spending on public works and relief. Meanwhile, tax receipts had been rising, both as a result of economic growth and the collection of new Social Security taxes (which raised roughly $2 billion from 1937 to 1938). And perhaps most important, the one-time boost provided by payment of the veterans' bonus in 1936 (passed over FDR's veto) disappeared.

The Federal Reserve also did its part to deflate the recovery (or stock bubble, as it saw it). Fed governors doubled reserve requirements between 1936 and 1937, prompting banks to curtail their still anemic lending. The money supply fell accordingly.6

The upshot? The federal deficit fell from 5.5 percent in fiscal 1936 to 2.5 percent in fiscal 1937. In 1938 it was nearly balanced.7 Economic historians blame this ill-timed fiscal probity -- along with the Federal Reserve's monetary contraction -- for the resulting recession. In other words, the recession was an avoidable blunder. Roosevelt (and other politicos) blew it.

The Response

If fiscal contraction was the cause of the recession (or at least a leading culprit), then fiscal expansion must be the solution. That, at least, was the conclusion of many New Dealers, who called for a surge in federal spending (although not, notably, for a cut in federal taxes; as economist Richard Musgrave later pointed out, expansionary tax cuts remained "unthinkable" in the late 1930s, chiefly because they delivered disproportionate benefits to wealthy taxpayers -- not a vital New Deal constituency).8 John Maynard Keynes was not yet the demigod he later became to American liberals, but his ideas were already gaining currency among influential figures in the political establishment.9

Not everyone agreed with the New Dealers' diagnosis and prescription. The spenders were countered by fiscal conservatives in the Democratic establishment. Chief among this latter group was Morgenthau, who insisted that the path of fiscal restraint offered the quickest route back to prosperity. Morgenthau and his fellow budget balancers believed that antibusiness policies had frightened investors and smothered the incipient recovery. They counseled FDR to assume a less combative stance toward the business community, while also returning to the fiscal straight and narrow.

The fight between spenders and budget balancers was not exactly a battle royal, but it was certainly a good tussle. And ultimately the Keynesians won. But to what effect? As historian David Kennedy has observed, "Seldom has so much intellectual and political energy been expended with such slender result."10 Under pressure from the New Dealers, Roosevelt took a modestly expansionary approach to fiscal policy, asking Congress for $3 billion in new spending -- not a huge amount in a $100 billion economy, to be sure, but significant nonetheless. Soon afterward, however, he also tried to mollify his opponents by kicking off a "business appeasement" campaign that featured friendly (or at least, less hostile) rhetoric and a modicum of pro-business policy revision.

And that was about all the president could manage. As he confronted the 1937-1938 recession, FDR was politically hobbled. His unsuccessful "court packing" scheme to remake the Supreme Court (and render it more congenial to New Deal reforms) left him badly battered. His subsequent effort to purge the Democratic Party of its more conservative members (by campaigning against them) only diminished his influence on Capitol Hill. By the end of the 1930s, FDR had his hands full simply defending past victories from conservative assault. The Keynesians may have won the battle for Roosevelt's mind (although even that claim remains dubious), but the president had precious little political capital to spend on his new agenda.

The Revenue

Where did taxes figure in the grand debate between spenders and budget balancers? Not prominently. The great New Deal tax reforms ended in 1936, although legislation in 1937 to close egregious loopholes was politically, if not economically, significant. But 1938 and 1939 saw a rollback in fiscal liberalism, including repeal of the undistributed profits tax, the New Deal's most ambitious tax innovation. Roosevelt more or less ceded tax policy to Congress.

But if the scope of New Deal tax legislation was distinctly modest in the late 1930s, the administration's internal discussion of tax reform was much more vigorous. In particular, tax experts in the Treasury Department embraced the Keynesian prescription for stimulating the economy. "In the opinion of an important body of present-day economists, a business depression is characterized by a lack of balance between saving and investment," explained the department's leading tax economist in a key 1937 memo. Worried about prospects for the future, people saved too much and invested too little. This tendency left large stores of capital and labor unemployed. In such a situation, the government should borrow the nation's unused savings and increase spending immediately, thereby increasing national income and promoting recovery. "In this way," George Haas wrote, "during a period of abnormal unemployment, an unbalance of the Federal budget may be said to help to redress the unbalance of the entire economy."11

Even as they embraced Keynes, however, New Deal tax experts were also drafting plans for raising taxes. While Treasury economists seemed convinced that deficits were an appropriate response to recession in the abstract, they also faced institutional and political constraints on pursuing them in practice. Responding to inquiries from Morgenthau and other senior officials, Treasury tax officials suggested a variety of possible tax increases, should the administration decide they were necessary. Tax officials, by their nature, place revenue adequacy (and fiscal probity more generally) high on their list of priorities. While open to arguments for expansionary deficit spending, they were unable to embrace them completely. Of necessity, they sought a middle way (or a muddled way, depending on your point of view).

As it happened, history was on the side of the tax economists and their half-measures. While Roosevelt pursued expansionary spending in a modest way during 1938 and 1939, these efforts were soon overwhelmed by the onset of World War II, which raised both spending and taxes. Exigency proved more powerful than theory or ideology in shaping the course of federal fiscal policy.

The Result

So what lessons can we distill from the "great mistake" of 1937? Strictly speaking, not many. There's an element of instrumental convenience to the indictment of Roosevelt and his advisers. By faulting past policy, we can construct a useful morality tale for today's debate over fiscal policy and antirecession stimulus.

But the story leaves out one key inconsistency: FDR's optimism in 1937 was not unreasonable. Many observers believed the economy had turned the corner and was headed back to prosperity. And many more believed that fiscal stringency was prudent under any circumstances. Brookings Institution President Henry Glenn Moulton, for instance, insisted in February 1937 that balanced budgets were a necessary part of any "consistent program of further recovery."12 And a January 1937 Gallup poll revealed that most Americans harbored similar thoughts: 52 percent endorsed efforts to reduce the national debt.13

These observers were wrong, of course, as was Roosevelt. But they were not stupid. The challenge facing economic policymakers is to make the right decisions with inadequate (and often misleading) data. Roosevelt might have been right in 1937 to worry that a modest rise in inflation was a portent of worse to come (and therefore an argument for smaller deficits). Likewise, the Federal Reserve might have been right to boost bank reserve requirements. That all of them were, in fact, quite wrong at that historical juncture doesn't mean that fiscal and economic policy should always and everywhere remain expansionary past the point when most people think it should. History doesn't provide that sort of easy guidance.

So sure, if we're on the brink of a renewed recession brought on by slipping aggregate demand, then by all means let's have some additional stimulus. But how will we know if we are in fact standing on the precipice of economic abyss? We won't. We'll just make the best guess we can given the incomplete information we have. Like Roosevelt did.

Let's just hope we get it right.


1 Franklin Roosevelt, annual message to Congress, Jan. 6, 1937, in John T. Woolley and Gerhard Peters, The American Presidency Project, Santa Barbara, Calif., available at

2 David M. Kennedy, Freedom From Fear: The American People in Depression and War, 1929-1945, the Oxford History of the United States, vol. 9 (New York: Oxford University Press, 1999), 350.

3 Unemployment rates during the Great Depression have been the subject of spirited (and politicized) debate. These data are drawn from the best modern series, in my estimation: Susan B. Carter, "Labor Force, Employment, and Unemployment: 1890-1990," Table B, p. 470-477 in Historical Statistics of the United States, Earliest Times to the Present: Millennial Edition, edited by Susan B. Carter, Scott Sigmund Gartner, Michael R. Haines, Alan L. Olmstead, Richard Sutch, and Gavin Wright. New York: Cambridge University Press, 2006.

4 Although some still cling to the notion that the recession was a more or less natural part of the business cycle. See Kennedy, supra note 2, at p. 351.

5 Christina Romer, "The Lessons of 1937," The Economist, June 18, 2009, available at

6 For a recent treatment of this episode, see Thomas F. Cargill and Thomas Mayer, "The Effect of Changes in Reserve Requirements During the 1930s: The Evidence From Nonmember Banks," The Journal of Economic History 66, no. 02 (2006).

7 Office of Management and Budget, "Historical Tables, Budget of the United States Government, Fiscal Year 2010" (Washington: U.S. Government Printing Office, 2009), 24.

8 Richard A. Musgrave, "U.S. Fiscal Policy, Keynes, and Keynesian Economics," 10 J. of Post Keynesian Econ. 171, 174 (1987-1988).

9 On the rising influence of Keynes, see Herbert Stein, The Fiscal Revolution in America, rev. ed. (Washington, D.C.: AEI Press, 1996).

10 Kennedy, supra note 2, at p. 350.

11 George Haas, "Tax Revision Studies: General Statement, Revenue Estimates, Summaries, and Recommendations," Box 63; Tax Reform Programs and Studies; Records of the Office of Tax Analysis/Division of Tax Research; General Records of the Department of the Treasury, Record Group 56; National Archives, College Park, Md.

12 "Recovery Aid Points Listed," Los Angeles Times, Feb. 16, 1937, p. 6.

13 Survey by Gallup Organization, Jan. 27-Feb. 1, 1937. Retrieved Jan. 21, 2010, from the iPOLL Databank, the Roper Center for Public Opinion Research, University of Connecticut, available at