How inequality reduction happened 80 years ago

How economic beliefs and political acumen enabled the New Dealers to work wonders

Scientist Peter Turchin’s recent book End Times is about the ending chapters of America’s ongoing secular cycle and what this might entail for our future. It is largely a retelling of his 2016 book Ages of Discord that exchanges math, graphs and tables for narrative, with more examples that I think will have more appeal to less technically inclined readers. It provides a good account of the problems we face and what causes them. When I read Ages of Discord I was dismayed by the lack of detail on the important issue of how American emerged from its last crisis without experiencing a disaster like the Civil War. End Times provides no more illumination. This post is my effort to address this deficit.

I set the stage with some notes on timing of the American secular cycles. Unlike Turchin, I see three American secular cycles, now two. The first is roughly dated 1780-1870, the second ended in 1942, and the third is still in progress. I use the onset of the capitalist crisis as the beginning of the third or crisis phase of the last two cycles. The dates for these were 1907 and 2006. The crisis ends with the resolution phase where the causes of the crisis, such as elite proliferation, are dealt with. The resolution phase of the last cycle began with the 1929 crash that led to the Great Depression and WW II. The resolution of the first cycle began with the 1860 election that led to the Civil War and Emancipation. The resolution of this cycle is yet to begin.

The solution to the core problem of elite proliferation for the first secular cycle crisis was loss of wealth and political marginalization for the losers of the Civil War, This was a conflict between opposing elite factions, like the Wars of the Roses in the 15th century English crisis, the Cavaliers vs. Roundheads in the 17th century British crisis, or the Tories vs Patriot in the 18th century American crisis. The factions were Southern plantation elites, represented by the Democratic party, and Northern capitalist elites, represented by the Republican party.  The former lost the Civil War and were eliminated as elite participants in the national discourse. Emancipation resulted in the loss of sixty percent of their prewar wealth. Their voice at the national level was greatly attenuated: prior to 1860, 9 of 13 men elected president had been Southern elites or Democrats. For the 72 years after 1860, 11 of 13 were Republicans. This solution required a fratricidal war resulting in about three quarters of a million deaths. It can hardly serve as resolution model for this crisis, though, of course, it is a possibility. The forgoing will explore how the resolution of the second American cycle over 1929-42 happened for insight about resolution of our current crisis.

A few years into the last crisis phase (1907-29) came a creedal passion period (CPP), which happened cycle’s crisis phase (2006-?) also. Many of the rabble rousers were immigrants, who had brought their radicalism from Europe, or so it was believed. Similarly, the rise of Donald Trump and his cult during the current CPP has intensified opposition to immigration. Back then rising unrest, wild swings in financial markets, socialist revolutions abroad, and the hysteria of the Red Scare fueled a sense of social and political insecurity amongst capitalist elites that spurred legislation to restrict immigration in the early 1920’s. Unlike last cycle, the financial situation this cycle has been very favorable to elites, and there is no threat from the Left; those dictators in charge of great powers most capable of challenging America, such Putin and Xi, have the admiration of Republican leader Trump and many of his foot soldiers. As a result, there has been no action taken to restrict immigration or to reduce the number of undocumented immigrants into the country.

As radicalization subsided in accordance with the social contagion model, it appeared that 1920’s immigration restriction had been successful, as sociopolitical instability declined. Immigration restriction did nothing to address the capitalist crisis or high inequality. It was the political response to the 1929 crash, not to CPP unrest, as Turchin believes, that brought about cycle resolution, setting the stage for the start a of new cycle a dozen years later.

The Republican party was the political representative for the capitalist elite, while Democrats supported Labor. This is shown by the trends in strike frequency (a proxy for labor power) in Table 1. Under Republican rule, strike frequency fell by an average of 2.5% per year, while under Democrats it rose at an average rate of 5.1%, which is a significant difference (p<0.01).

Table 1. Trends in strike frequency over 1896-1976

The secular cycle in modern times is best seen as a cycle in inequality. Inequality is also a driver of the cycle. It produces elite proliferation and political stress by the mechanism Turchin explains in his 2016 book and I present in chapter 2 of America in Crisis. It also creates financial stress (measured by FSI) as I explain in chapter 4 of America in Crisis. A possible outcome of financial stress is financial crisis, which we experienced in 2008. The 2008 event was resolved in such a way as to preserve the current status quote for American elites. An analogous crisis happened in 1929, but the economists of the day did not know what their 2008 counterparts knew, and so it had much more far-ranging effects.

The post-1929 bear market was financially traumatic. In a 1932 Forbes article, private equity specialist Benjamin Graham noted that a third of the industrial companies on the New York Stock Exchange were trading for less than their liquidation value.  In other words, one third of America’s top corporations were worth more dead than alive―a state of affairs that called into question the justification for capitalism in the eyes of many. The status of capitalist elites depended on belief in the capitalist system, on which the status of capitalists as elites lay. Traumatized investors are not healthy for capitalism. Here was a threat to ruling Republicans and their capitalist elite patrons that could not be dealt with by force, as their plantation elite predecessors had done. The cause of the problem was the very thing that made them elites, economic inequality. To address the cause of the problem was anathema. They had no choice but to ride it out.

Loss of revenue from the developing post-crash depression and increased expenditures for relief had led to an enormous fiscal deficit by 1932. Deficits were widely believed to be inflationary, since similar deficits during wartime had led to inflation (see figure 2 here). There was no inflation then, but once the economy recovered it was expected to happen. These fears led to the 1932 bipartisan tax increase and an additional increase in 1935. Indeed, economist Roger Babson, who was credited with forecasting the crash, wrote a book in 1937 talking about possible future inflation, showing these fears were still very much present. In fact, a spending pullback due to inflationary fears led to a balanced budget (and recession) in 1938, undoing much of the gains made since 1933. Belief in the deficit-inflation link* again helped with keeping top tax rate very high after WW II, aided by the brief burst of inflation after the war.

The reigning Republican elite’s failure to adequately deal with the Great Depression led to crushing political defeat. Between 1930 and 1937 the Republican Party lost control of the Presidency and its share of Congress fell from about 60% to 20%. Democrats went on to hold the executive branch for twenty years after 1932, and for the next 62 years they controlled the Senate and House 84% and 94% of the time, respectively. The reason for this failure was Republican resistance to suspending the gold standard. Suspension of the gold standard was done during war time in order to accommodate wartime deficit spending. It is an acknowledgement that large amounts of inflation would come, and with it, collapse of their bond assets. Elites had already suffered massive losses in equity; to submit to the destruction of their bond wealth too was a bridge too far for the capitalist elite.

On the other hand, capitalist elites were willing to accept much higher marginal tax rates on themselves to reduce deficits because they believed that these could eliminate the threat of inflation and the need for suspending the gold standard. Hoover was defeated and Roosevelt elected who moved to suspend the gold standard. Despite elite fears of of the consequences of the end of the gold standard, the results were pretty mild, by the early 1940’s elites were nearly back to where they had been before the crash. Despite all the concern about suspension of the gold standard and massive tax hikes on the economy, unemployment fell by a third during Roosevelt’s first term and he was re-elected by a landslide in 1936.

In other words, the deep concern about abandoning the gold standard had been misplaced, but the consequences remained. Republicans were shut out of power and the belief in high tax rates to suppress inflation remained. When WW II broke out, even higher top tax rates (ca. 90%) were inaugurated with little opposition. The Hoover of the current cycle, President Obama, did not make this mistake. The policy response was a series of operations designed to prevent the financial crisis from fully playing out as it had for Hoover. This involved large-scale government interventions into the economy and financial markets that would amount to more than 5 trillion dollars before it finished. It consisted of targeted assistance for distressed financial firms and local governments, spending on economic development, and Federal Reserve Quantitative Easing (QE) operations. These actions served to maintain the status quo for elites and forestall a crisis resolution.

In 1940, Roosevelt won an unprecedented third presidential term. This established a Democratic dispensation that made the New Deal unassailable when Republicans came back to power under Eisenhower. This dispensation locked in Democratic policy preferences until 1960’s Democrats chose to weaken the New Deal Order, after which Republicans were all too eager to dismantle it. The establishment of a Democratic dispensation politically neutered the capitalist elite, solving the elite proliferation problem that leads to secular cycle instability. However, it did not prevent a repeat of the crisis problems since inequality remained high.

Inequality reduction was achieved by creation of an economic environment in which SC economic culture was adaptive. Three factors were needed to accomplish this: high marginal tax rate on high incomes, pro-labor policy, and strong economic stimulus to produce lots of new economic activity created under the new policy regime.

The first of these was high tax rates. It should be stressed that the way high tax rate works is not by raising revenue. Sufficient revenue is needed to ensure the balanced budgets required for the SC economy to work properly (see discussion around Figure 1 here). But this is mostly achieved through broad-based taxation at lower, flatter rates (over half of revenue was raised from payroll, corporate, or excise taxes with much lower rates). The purpose for high top tax rates is to change the business executive incentive structure away from financial strategies to boost share prices (SP culture) and towards business strategies to grow sales, market share, new product development, and other ways to build a bigger, better company than the competition (SC culture).

The second was pro-labor bias. Democratic pro-labor bias over 1912-1968, as shown by Table 1, probably reflects the Democratic embrace of the Populist program in 1896 and the continued prominence if William Jennings Bryan in Democratic politics (he had been the party nominee in 1896, 1900, and 1908, and had served as Secretary of State under Wilson). In any case Democrats under Roosevelt were favorably inclined to Labor as shown by the passage of the Wagner Act in 1935.

The third was economic stimulus, which seems to have served as a trigger for the collapse of inequality and the creation of SC culture, because it was WW II that produced a sharp decline in inequality, indicating the rise of SC culture, which continued for decades afterward.

The country had been attacked by Japan, and their ally Germany had declared war on America, so even isolationist Republicans saw the need for war, for a war economy, and for the high taxes and other policies needed to see it through. But the war itself was not the key thing. Although it provided the stimulus needed to get people back to work, so did WW I, and it failed to produce a sustained reduction in inequality: top 1% income share dipped during WW I but had recovered by 1926. Unlike with WW I, wartime inequality reductions did not go away after the war. One reason for this was that the high tax regime remained for two decades after the war. Another was deliberate wartime economic policy by the New Dealers specifically intended to produce a fairer society.

Strong growth with minimal inflation was accomplished during WWII via wage and price controls through the National War Labor Board (NWLB) and the Office of Price Administration. The New Dealers designed wage policy so that increasing the wages of low-income workers was easier than increasing wages of high-income workers:

In accordance with this policy, the NWLB decided in February 1943 that wage rates could be raised up to 40 cents an hour ($12.60 in 2021) without obtaining approval. The permissive minimum was raised to 50 cents an hour ($15 in 2021) in November 1944 and, finally, to 55 cents an hour ($16 on 2021) in August 1945. To make its substandard policy consistent with its wage rate brackets, the NWLB permitted wages below the substandard rate to be increased to that level. However, increases at higher wage rates had to be tapered progressively to zero at 70 cents per hour. In other words, no wage rate increases were permitted on the basis of the substandard policy for rates of 70 cents an hour ($22 in 2021) or more. The net effect of this procedure, as in the case of the Little Steel Formula and the wage-rate bracket policy, was to raise the level of the lowest paid workers relative to others (material in parentheses added).

The policy was successful, significant wage compression was achieved. The GDP had expanded by a third from 1941 to 1946. This means a quarter of the economy had been created during the war and so operated in accordance with the New Dealer war policy. More had formed under the high-tax and pro-Labor 1930’s. In contrast, fully 91% of the pre-war economy remained when Republicans returned to power in 1921. They had sought “a return to normalcy” (restoration of the prewar order), and achieved it, restoring pre-war inequality in just five years. This analysis suggests it was the extent of economic transformation achieved by the New Dealers that was the key to achieving the inequality turnaround and successful resolution of the last secular cycle crisis without an internal war or state collapse.

When Republicans returned to power in 1953 top tax rates had been at or above 75% for eighteen years, more than long enough to establish high top tax rate as a norm. Fully 70% of the economy had formed under the New Deal regime, and the way it operated (i.e. SC culture) had also become the norm. Eisenhower acknowledged this reality in a letter to his brother:

But to attain any success it is quite clear that the Federal government cannot avoid or escape responsibilities which the mass of the people firmly believe should be undertaken by it. The political processes of our country are such that if a rule of reason is not applied in this effort, we will lose everything–even to a possible and drastic change in the Constitution. This is what I mean by my constant insistence upon “moderation” in government. Should any political party attempt to abolish social security, unemployment insurance, and eliminate labor laws and farm programs, you would not hear of that party again in our political history. There is a tiny splinter group, of course, that believes you can do these things. Among them are H. L. Hunt (you possibly know his background), a few other Texas oil millionaires, and an occasional politician or business man from other areas. Their number is negligible and they are stupid.

The trend reversal in inequality in 1929 did not occur because elites chose to give up a large portion of their wealth and influence for the sake of stability, as Turchin suggests in End Times. Rather, the Republican representatives of the capitalist elite mishandled the 1929 crash. They believed it would be self-correcting, as the three previous financial crises in 1873, 1893, and 1907 had been and so did not believe extreme action like suspending gold convertibility was warranted. The Democrats at that time still represented Southern agrarian interests, who benefited from inflationary policy. They also sought the votes of the Northern working poor who would benefit from job-creating stimulus. The wealthy and comfortable middle classes mostly voted Republican, so Democrats had every reason to support inflationary stimulus.

Thus, Democrats were free to pursue inflationary policies like an explicit devaluation of the dollar relative to gold in January 1934. Inflation-promoting policy began in the first week of the Roosevelt administration, leading to an immediate turnaround in the trend in agricultural prices. The economy turned around at the same time, with economic growth and falling unemployment ensuing after the new administration began in March 1933. Thus, Roosevelt delivered to his base and earned the wrath of the capitalist elites, some of whom attempted a coup a few months into the administration. The 1934 election confirmed the perception that Democrats had delivered; Republicans lost 14 seats in the House and 10 seats in the Senate, when typically, the opposition party gains seats. In 1936, Roosevelt highlighted how the enemies of working Americans were also his enemies,

We had to struggle with the old enemies of peace—business and financial monopoly, speculation, reckless banking, class antagonism, sectionalism, war profiteering. They had begun to consider the Government of the United States as a mere appendage to their own affairs. We know now that Government by organized money is just as dangerous as Government by organized mob. Never before in all our history have these forces been so united against one candidate as they stand today. They are unanimous in their hate for me—and I welcome their hatred.

and went on to win a landslide victory three days later. These victories created enormous Democratic majorities in Congress.

Democrats took a “shellacking” in the 1938 election (Republicans gained 88 House and 15 Senate seats) because of the recession their policy had created. Yet they retained sizable majorities in Congress. In 1940 Roosevelt won a third term and his party retained its dominant position in Congress. What this meant was the New Dealers had been in charge for nearly nine years when the need arose for effective economic policy to achieve victory in WW II. Roosevelt’s experienced team faced little opposition from Congressional Republicans and they had the policy chops to do the job well as shown by the remarkable results they achieved both during the war and after. A comparison of economic statistics for the 1916-29 and 1940-73 periods illustrates this. The first period saw per-capita GDP growth of 1.8% and real wage growth of 1.4% and 2.3% for unskilled and production workers, respectively. The corresponding figures for the second period were 3.0%, 2.4% and 2.6%. The New Dealers achieved superior results over a longer period of time.

I should point out that though the political struggle between elite factions had been decisively won by Democrats in 1934, the underlying problem of inequality was only solved by adroit policy during WW II, which also resulted in the deaths of more than 400 thousand Americans. Without the war would the New Dealers have been successful? I think not.  After all, just three years before the war, they had plunged the country into recession because of unwarranted inflation fears. Such a party simply could not spend the sums needed for stimulus without a war to justify it. And yet, without those inflation fears there would have been no New Deal at all. Hoover would have won reelection as his counterpart Obama did in this cycle and high inequality would continue on, as happened this time.

It is straightforward to propose a set of policy prescriptions that if taken would likely resolve the cycle positively in a peaceful manner. But these policies would be strongly opposed by the entirety of the Republican party and a goodly share of Democrats, if not most of them. The reason why is the political evolution of the parties since the last crisis phase. The 1920’s Democrats share some commonalities with today’s Republicans. Both parties still represent the losing faction of the last cycle: Southern elites for the 1920’s Democrats and the capitalist elite and the (nonliberal) prosperous middle class for the Republicans. They both added the same second constituency in the intervening years: the white working class. Republicans also gained Southern elites after the 1964 Civil Rights Act.

The parties of the previous winners in the two cycles are different. The 1920’s Republicans were largely the party of capitalist elites and the middle classes that they had always been. Today’s Democrats are different, their victory led to the rise of a second category of elites, the credentialed elite or “mandarins.” (See the shift in party alignment of college-educated voters over time.) Modern Democrats are the party of the mandarins and nonconservative people of color. Since many mandarins are rich, they share with the capitalist elite the status of financial elites and so would resist any effort to reduce their wealth. This is why a repeat of the inequality reduction mechanism of last cycle would be so difficult. No matter which party holds the dispensation, there is no constituency for the much higher taxes on the rich needed to evolve something like SC culture. The same is true for the wealth taxes suggested by Thomas Piketty.

*As the balance model shows, inflationary fears were unwarranted. Though deficits did drive NAIRU higher, unemployment remained well above it, resulting in low inflation (2.7%) over 1934 through 1937. But policymakers of the time did not know this.