Boom & Bust cycles, the New Deal, and the financial crisis of 2008

A depression is the low part of the business cycle, or the opposite of prosperity.
The business cycle refers to the waves of good and bad times (Boom & Bust) that had plagued industrial economics throughout the 19th century and part of the 20th century. When consumers stopped spending money to buy goods and businesses stopped investing, then money stopped circulating and the nation entered economic paralysis.
(see : 'Past Depressions' available from the Index panel on the right)

During World War I, US federal spending grew three times larger than tax collections. When the government cut back spending to balance the budget in 1920, a severe recession resulted. However, the war economy had invested heavily in the manufacturing sector, and the next decade did see an explosion of productivity. The 1920's saw a return to a  laissez-faire market economy; the top tax rate was lowered to 25 percent and the stock market began its spectacular rise.

laissez-faire is a term used to describe a policy of allowing events to take their
own course with minimal intervention. The term is a French phrase meaning
Let do ('allow to do'). Generally it means an aversion to any infringement of the
right to buy and sell ( today also called 'market fundamentalism' )

The booming economy led in 1929 to a backlog of business inventories which was three times larger than the year before. As a result a recession began in August 1929, two months before the stock market crash. During this two month period, production declined at an annual rate of
20 percent. This decline resulted in the stock market crash which began October 24, followed by Black Tuesday on October 29. Losses for the month amounted to $16 billion, an astronomical sum in those days.

1932 and 1933 were the worst years of the Great Depression. Industrial stocks lost 80 percent of their value since 1930. 10,000 banks failed , or 40 percent of the 1929 total. GNP fell 31 percent since 1929 and over 13 million Americans lost their jobs between 1929 and 1932. In 1933 unemployment did rise to 24.9 percent.
The desperation of many people and especially veterans from WW I resulted in spectacular events, the most dramatic the so-called  Bonus marches in 1932.

Remedies
The most famous remedy to overcome such economic paralysis was proposed by the English economist J. M. Keynes.
Keynes maintained that government must  not be run like a business, because the rational thing for business to do in the midst of an economic downturn is to cut costs, but this is the worst thing to do from the point of view of the national economy as whole as it further reduces spending, resulting in a further spiral into decline.
Instead Keynes proposed increased government spending for such things as relief payments and public works projects during a depression to get the economy rolling again. After a depression ends and prosperity returns deficit spending should then be reversed.
Keynesian economists felt that in order to avoid serious depressions we must avoid extremes in the economic system during prosperity periods. This means that the quantity of check money should not be permitted to increase in a runaway fashion during prosperity, and that the price-fixing activities of monopoly groups should be curbed to avoid upsetting the relationships among the prices for different types of goods. (For an opposing view of Keynesian economics see  Friedrich Hayek)

The Roosevelt administration acted on this idea in an attempt to lift the United States out of the Great Depression of the 1930's. Roosevelt's 'New Deal' introduced certain features which automatically produced government deficits during a depression. The social security system, including unemployment insurance, and the income-tax system both are set up so that government revenues fall off while government expenditures increase as a depression gets under way. These features were called  built-in stabilizers.

Roosevelt began relatively modest deficit spending that arrested the slide of the economy and resulted in some astonishing growth numbers. (Roosevelt's average growth of 5.2 percent during the Great Depression is even higher than Reagan's 3.7 percent growth during his so-called 'Seven Fat Years!') When 1936 saw a phenomenal record of 14 percent growth, Roosevelt rejected Keynes' advice for heavy deficit spending, instead he eased back on the deficit spending, worried about balancing the budget. But this only caused the economy to slip back into a recession in 1938.

( Note: In 1934 Sweden followed a policy of Keynesian deficit spending and became the first nation to recover fully from the Great Depression )

In 1944 Roosevelt signed the GI Bill of Rigths which would provide significant benefits to returning soldiers. This bill was credited with forestalling a widely feared post-war economic depression and led to an unprecedented period of prosperity following World War II. The G.I. Bill is sometimes considered to be the last piece of New Deal legislation.
Despite resistance from the business community most of the New Deal reforms became a permanent part of the U.S.A. The social safety net of the New Deal has cushioned the severity of the cyclical business downturns and prevented a repetition of a full-scale depression.

In order to pay for the New Deal programs Roosevelt raised the top tax rate, and to finance the war economy the top tax rate was raised even more. It remained at 88 percent until 1963, by which time the entire war debt was payed down.
At that time the top tax rate could be lowered to 70 percent. During this period, America did experience the greatest economic boom it had ever known until that time. General income for everybody did raise dramatically. (Unlike the boom of the 1980's when middle class income stagnated but top incomes did raise sharply.)

In the 1980's a renewed scepticism of large-scale government intervention led once more to far reaching deregulations. Keynesian concepts got rejected and his warning about runaway money supply got dismissed.

In a repeat of the 1920's the top tax rate was lowered and the slogan became once again : 'Government is dumb, markets are smart'. The stock market saw again a spectacular rise and for a time the less regulated market forces led to considerable economic successes. (example: the hightech bubble in the 1990's). Blinded by success the money supply got even more increased by so-called derivatives - a development which alarmed some economists. But such warnings got curtly dismissed by most experts of the time as old-fashioned Keynesian politics.
(The legendary investor Warren Buffett called derivatives ' financial weapons of mass destruction.')

In contrast to Roosevelt's tax increases during World War II, the Bush administration tried to
' finance' the Iraq war with tax cuts resulting in a trillion dollar debt. Vice-President Cheney declared famously ' that deficits don't matter anymore'  At the same time the middle class income remained stagnant, which meant that people amassed huge credit debts in order to keep up their expected lifestiles - a situation that proved unsustainable in the long run.

Eventually, the hightech bubble burst, and then the housing market collapsed. Unregulated credit availabilties had induced more and more people to get into unsustainable debts. The journalist Fareed Zakaria wrote that "Household debt had ballooned from $ 680 billion in 1974 to $14 trillion today." He described every city, county and state wanting to preserve its proliferating operations without raising taxes, and doing so by borrowing. He described Federal Reserve chairman Alan Greenspan as having "refused to inflict pain" with higher interest rates.

A typical instrument for enticing credit in the 1990's was the subprime mortgage, ostensibly to make credit available to people who could not get a mortgage otherwise. Many banks, freed from the strict regulations of earlier times, offered loans and mortgages to people who could not afford repayments during an economic downturn.

Unpayable loans became bad assets for banks and when such bad assets accumulated rapidily many banks were unable to offer any credit which led to a
credit freeze in the fall of 2008 and severe economic difficulties. (California,
for instance, warned of a looming state bankruptcy within a month, which
would have meant state employees could not be paid their salaries)

In 1929, during a similar panic, the US government had not reacted for three years resulting in the Great Depression of the 1930's.
In 2008 the US government acted more quickly with large financial government cash infusions to failing banks, ostensibly in order to make credit available to both the public and businesses.

Critics argued that more of the money should have been used to help struggling homeowners avoid losing their homes. To many people it seemed strange to
supply money to the very institutions which had created the crisis in the first place,
instead of using the funds for extended unemployment benefits and public works
programs which would inject money immediately into the failing economy as had
been done under the New Deal in the 1930's.

The new President Obama proposed to stimulate the economy by spending large amounts of capital for infrastructure building (badly neglected since the 1980's) and to initiate a Green Revolution by financing alternative energy sources to reduce dependency from foreign oil supplies and to mitigate CO2 emissions which threatens a looming global climate crises.

Critics charge that spending for large public projects will take too much time and that tax relief would be effective more quickly. However, it's also possible that people - instead of spending their tax savings - would use the money to pay down their enormous credit debts. And it's not clear why enterpreneurs would spend their tax relief money to expand their businesses if there is no market for their goods. Why would automakers expand their capapilities at a time when the car market is shrinking?

On the other hand, money for foodstamps and expanded unemployment benefits would inject money instantly into the economy. And if money is used to build infrastructure, that would provide jobs for something that is badly needed in any case. (Such measures reduced unemployment during the New Deal from 25% to 14% between 1933 and 1937)

As the U.S. Senate designed a bill to stimulate the economy it was revealed that most Democrats accept the Keynesian position that stimulus takes place by government spending replacing temporarely the spending that the private sector is not providing. But Republicans dislike Keynesian economics and think of stimulus more as tax cuts. Senator Mitch McConnell, Republican leader, says "we know for sure that the big spending programs of the New Deal did not work." What got the U.S. out of the Great Depression, he adds, "was the beginning of World War II."

Conveniently left out is the fact that the biggest stimulus ever was the U.S. government spending for the war economy. It was the war wich finally made the opponents of the New Deal accept large deficit spending - the resulting debt was completely payed down in 1963 on account of higher tax rates. (During this period, America did experience the greatest economic boom it had ever known until the oil shock of 1974)

In relation to the debate about taxes and spending it is interesting to note that the US economy grew fastest in the 1950s and 1960s when there was plenty of money for infrastructure and other public investments. In the 1950s America's top tax rates varied between 91 per cent and 92 per cent on incomes over $400,000 per year. In the early 1960s, Kennedy dropped the top rate to 70 per cent. Reagan reduced the top rates to 50% and the Bush tax cuts lowered it to 35 %. ( Opinion: John McCain ).

Successive tax cuts, expenditures for several wars, reduced revenues on account of the recession and stimulus financing resulted in a crushing debt of over 14 trillion dollars by 2011. ( see Milton Friedman's view about deficits). The enormous debt led to a demand for severe spending cuts, but the choice to increase taxes (which are the lowest since 1925) is off the table under the mistaken slogan that tax increases caused the great depression - which is a myth as shown in the diagram Myth and realty.

Even the business magazine 'The Economist' (July 9th 2011) criticised the American reluctance for higher taxes thus: "The vast majority of Republicans, driven on by the cacaphony of conservative media, cling to the position that not a single cent of deficit reduction must come from a higher tax rate. This is economically illiterate and disgracefully cynical"

Finally a commentary from Fareed Zakaria about the issue of the debt crisis in the US :
Fareed's Take: The damage is already done

Addendum:
Who owns America? Hint: It's not China

List of countries by tax revenue as percentage of GDP from Wikipedia.
                      (Click at the arrow under 'Heritage Foundation' to sort countries according to top revenues. It shows that 60 countries have higher tax revenues rates than the USA which has a rate of 26.9% as compared to most developed nations with rates between 30% and 49% !