How Social Security Prolonged the Depression: Echoes

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By Joseph J. Thorndike

Social Security began its life as a tax increase, not a spending program. In 1937, the federal government started collecting a 2 percent payroll tax, but benefits didn't start flowing until 1940. For more than three years, Social Security siphoned money from consumers' pockets into government coffers while offering almost nothing in return.

This transfer helped tip the nation into a new recession. From 1934 to 1936, the economy had been growing smartly as the nation began to claw its way out of the Great Depression. But in August 1937, progress came to a halt, with industrial production, corporate profits and the stock market all sinking like stones.

"We are headed right into another Great Depression," the Treasury secretary, Henry Morgenthau Jr., declared. "This cruel process has already begun."

The "Roosevelt Recession" can be blamed on a pair of unforced errors by policy makers. Tighter monetary policy played a key role. But fiscal policy was crucial, as the Roosevelt administration pursued a new austerity program designed to shrink deficits.

President Franklin D. Roosevelt took advantage of the relative prosperity of 1936 to scale back federal spending drastically. At the same time, tax revenue was on the rise, thanks in large part to the payroll tax. As a result, the budget deficit shrank, dropping from 5.5 percent of gross domestic product in 1936 to just 2.5 percent in 1937. The next year, it almost disappeared entirely. Great news for fiscal hawks, but not for the economy.

Writing in the New Republic, the economist George Soule complained that government "has now stopped priming the pump and is instead taking some water out of the spout." Social Security taxes were a big part of the problem. "Certainly it is unjust to make workers pay for their future security against unemployment and old age by losing their jobs now," Soule wrote. "And that is precisely the result that the present social-security program is bringing about."

Many New Dealers were inclined to agree.

"The Social Security law pulled potential buying power out of the pockets of the very people most likely to spend if they had not been taxed," recalled Randolph Paul, a key White House adviser on fiscal policy. Roosevelt himself admitted to reporters that fiscal contraction, including collection of the new payroll taxes, was one of several "contributing factors" slowing the economy.

Most historians have come to agree. In his famous assessment of New Deal fiscal policy, economist E. Cary Brown concluded that a combination of lower spending and higher taxes managed to reduce aggregate demand by 2.5 percent of gross national product during 1937. Brown cited the payroll tax, in particular, for its "pronounced effect" on aggregate demand. And no surprise: Social-insurance taxes increased from 0.1 percent of GDP in 1936 to 0.7 percent in 1937. By 1938, they accounted for 1.7 percent -- more than either the individual or the corporate income tax, each of which was raised to 1.4 percent that year.

Today, as lawmakers ponder a variety of entitlement reforms designed to protect the nation's long-term solvency, it's worth bearing in mind the dangers of ill-timed austerity.

(Joseph J. Thorndike is a contributor to the Echoes blog. The opinions expressed are his own.)

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-0- Jun/07/2011 16:39 GMT