Pedde: A Depressing Fallacy
By Jonathan Pedde, The Dartmouth Staff
Published on Friday, July 6, 2012
In its decision in National Federation of Independent Businesses v. Sebelius, the Supreme Court ruled that the Commerce Clause does not give the federal government the power to force individuals to purchase health insurance. In doing so, the Court very clearly indicated that the scope of the Commerce Clause is limited. Many people were taken aback by this decision. After all, the Court vastly expanded the scope of the Commerce Clause during the Great Depression. Didn’t the Depression prove, once and for all, that the federal government needs more power to regulate the economy than a pre-1930s reading of the Commerce Clause would allow?
The popular narrative of the Depression is rather straightforward. In the 1930s, free markets failed spectacularly, and as a result of the judiciary’s narrow interpretation of the Commerce Clause, the federal government did not have to tools needed to prevent the catastrophe. Only with a significant expansion of its powers under the Commerce Clause was the federal government able to enact the policies that created and sustained the economic recovery.
But while this narrative may be convenient, it is nonetheless incorrect.
In fact, the Great Depression was primarily the result of a monetary collapse, not the stock market crash. The stock market’s nosedive can at most account only for the acceleration of the economic decline at the end of 1929. Both the start of the economic decline in August of that year and the catastrophic meltdown that began in 1931 were due to policy errors made by the Federal Reserve.
In 1928, despite the absence of inflationary pressures, the Federal Reserve began to raise interest rates, which increased the cost of borrowing money. After Great Britain’s departure from the gold standard in September 1931, people began to suspect that the U.S. might also abandon gold and began to withdraw dollar-denominated deposits en masse from American banks, precipitating numerous bank runs. The Federal Reserve could have prevented the wave of bank failures if it had acted as a lender of last resort. Instead, widespread bank failures caused the money supply and financial intermediation to collapse. By March 1933, prices and economic output had fallen by about a third since 1929.
The federal government possessed the tools needed to prevent the economic catastrophe — it has always had the authority to determine monetary and exchange rate policy. Furthermore, the Federal Reserve was set up in 1913 precisely in order to prevent the kind of financial panics that occurred from 1931 to 1933. If the government had not committed itself to an unworkable system of fixed exchange rates and the Federal Reserve had fulfilled its role as a lender of last resort, the downturn would have been, at absolute worst, no more than a garden-variety recession.
The common belief that New Deal-era policies were responsible for the recovery is also mostly wrong. In fact, many “real business cycle” economists argue that the New Deal was responsible for making the Depression longer than it otherwise would have been. On the other side, many “New Keynesian” economists argue that two federal government policies did contribute to the recovery. First, President Franklin Roosevelt ended the gold standard and explicitly committed to raising the price level to its previous peak, drastically increasing inflationary expectations and reducing real interest rates. Second, the federally directed rehabilitation of the financial system allowed financial intermediation — the flow of lending from savers to borrowers — to recover. However, most New Keynesian economists would probably also agree that the rest of the New Deal — the alphabet soup of new government agencies, policies to reduce competition in product markets, support for labor unions, higher minimum wages — were, at best, largely irrelevant to the recovery and obviously reduced the economy’s potential output in the long run. Put simply, the economic policies that contributed to the recovery only required powers that the federal government already possessed prior to the enactment of the New Deal.
Thus, prior to the 1930s, the federal government already had sufficient powers to prevent the Great Depression. Furthermore, those parts of the New Deal that did, in fact, contribute to the economic recovery were already constitutional prior to the expansion of the Commerce Clause.
Perhaps the federal government really does need more power than is granted by an originalist interpretation of the Commerce Clause. But the Great Depression is not evidence in favor of this proposition.