How did the US economy recover from the Great Depression?

The general idea that the US got out of the crisis only in 1940's after the spending in World War 2 is not quite true. The US economy started recovering in 1930's when the State started applying a wide variety of measures to stem the drop. Indeed, by 1937 Industrial production in the US had reached the levels in 1929. It is important to understand that the measures applied by the Roosevelt Government were not something that necessarily came out of blue. Many policies were in fact, a continuation of Hoover's policies which in turn were influenced by the policies pursued during World War 1.

To understand it, we must understand the nature of crisis (I have explained the background here), it's impact because certain legislation that was passed by Congress during Roosevelt's presidency was prepared during Hoover's time and certain policies were in fact continuation of Hoovers. The reason is that without stabilization of the financial system it was impossible to use an effective fiscal policy. To give a short summary they were paid through increasing growth that gave more tax revenue to the government and enabled it to engage in deficit spending. The Federal Government eliminated the gold standard which led to increasing money supply that ended deflationary pressures, creating FDIC that guaranteed savings which prevented further bank runs, establishment of government owned corporations that bought stocks in failing banks and resolving them to be later bought by up profitable banks and heavy investment in public projects.

The New Deal included three components as Wiki tells us- Recovery, Relief and Reform. It was not possible for providing relief and recovery without reform. The United States was facing an unprecedented economic disaster due to systematic breakdown of the financial system that was caused by failure of banks, deflationary pressure that was exacerbating the pressure of the recession by increasing the value of debt held by financial institutions, businesses and households and collapse of trade because of Smoot-Hawley tariff act that was passed inspite of the fact that the United States was in trade surplus and which reduced global trade from 30 percent of GDP to 10 percent of GDP.

The Banking Act of 1932 allowed the Federal Reserve to act as a lender of last resort by using government securities as a collateral in addition to gold and commercial paper. This was designed to beat deflation. Both the Acts succeeded in their objective. Industrial prices stopped dropping and reached pre crash levels by July 1932. This was why Roosevelt blasted Hoover for excess spending. The Federal Reserve had purchased an enormous amount of government securities reaching around $ 1 billion by the end of April 1932.When the act expired, the economy once again worsened paving the way for the Banking Act of 1933. It was already began to prepared by Hoover's team but passed by Roosevelt.The previous act had led to large scale hoarding of gold and much of it had started going to Europe. The Reserve banks had required holding gold which amounted to 40 percent of paper currency they issued. Foreigners and domestic holders of paper currency were fearing that it would not be redeemed. Many banks were once again in the fear of suffering bank runs. The Federal Reserve governors requested President Hoover to close banks for some period of time but neither Hoover nor President Elect Roosevelt were sure about it.

Ultimately, Roosevelt after coming into office on March 4 acted decisively ordering the closing of banks. The Banking Act of 1933 passed by Roosevelt was closely related to Banking Act of 1932 and Re Construction Finance Corporation Act. The Corporation was established by the Federal Government by selling treasury bonds as a joint stock company which was to finance insolvent banks by lending them money so that they could pay depositors, buying assets which had long term value but had dropped dramatically in the short term which was to serve as collateral etc. This was managed by independent managers. It was modeled on the War Finance Corporation which was established by the Federal Government during World War 1. It's initial capital was $500 Million but was later expanded to $ 1.6 Billion as it borrowed that money from the US treasury and the public. This idea was also applied by Park Chung Hee in South Korea during the 1960's who set up similar policy banks to fund industrialization and which was also very successful.

Hoover's advisers and the governors of Federal Reserve Bank of New York had already put together a plan to restore credibility of the banking system.This was done by increasing money supply by holding the assets of banks as collateral instead of gold. Banks were divided into 3 classes - Class A, Class B and Class C. Class A banks were sound financial institutions, Class B were weakened from the crisis but would be able function and were to re open but continued to undergo a long period of resolution and Class C banks were to be permanently closed. This worked and after the banks were reopened there were more deposits than withdrawals. Currency held by the public had increased by $1.78 billion in the four weeks ending March 8. By the end of March, though, the public had redeposited about two-thirds of this cash. Wall Street gave it's approval with the Dow Jones ending up 8 points at 62.10. Roosevelt ended up increasing the power of RFC by allowing it buy prefered stocks in some banks.The purpose to increase confidence such that they would start lending to businesses and guarantee by government allowed them to invest in more riskier assets rather than just holding safe treasuries. Later, many programs like public works were financed by the government in this way. As the loan re payment began the pressure on the RFC began to reduce. This increased public confidence, boosted industrial production and recovery. By the time the institution was closed in 1957, it had invested around $ 57 Billion through investments in large scale projects and failing banks, working with FDIC (Federal Deposit Insurance Corporation) so that open banks could take over failing banks and lost only $ 5 Million from two banks.

During the period of World War 1, the US Government had set up War Industries Board where there was considerable amount of cooperation between the Government and Enterprises. The experience in particular led to a rather permissive attitude towards Industrial trusts and oligopolies that had come dominate the American economy. There was a view that State intervention in order to bolster competition would lead to a needless wastage of resources. Thus the Government discouraged excessive intervention by the Justice Department and US Trade Commission. This continued even during the first phase of the 'New Deal', where the primary purpose of the Government was to restore production that had fallen at least by 30 percent and Competition was viewed to have failed. In some ways, many policies under Roosevelt were a continuation of the ones under Hoover as I mentioned above. The people who advised Roosevelt and designed the National Industry Recovery Act were influenced by the policies that were pursued in the period post World War 1. Many economists also supported them with the argument that because of 'economies of scale', large scale enterprise were efficient.

For instance, Section 8 of the Agricultural Act allowed the Secretary of Agriculture to engage in agreements with Producers, association of producers and other engaged in handling Interstate or foreign commerce of agricultural commodities. Such acts therefore enabled agreements that were considered to be in "restraint of trade". This was not exactly new. In 1918, Congress passes the Webb Pormene Act which allowed certain degree of exemptions from Anti trust laws to exporters for purpose of selling goods abroad that would compete with foreign manufacturers. The primary purpose of these interventions were to cut costs, improve competitiveness (as opposed to competition) and output.This was hardly unusual though. Finland's forestry sector operated as a cartel from the early 20th century in order to maintain it's competitiveness as it was the country's chief export and there is evidence that it helped the country's economy remained steady even during economic downturns of it's trading partners. The country enacted an anti cartel law in 1958. Much of these laws along with laws on Foreign Investment were only abolished once Finland joined the European Union in 1993. Similarly, the Industrial Rationalization plan imposed by MITI in Japan on the country's small business sector in 1963 allowed it to remain efficient and cut costs.

However by 1936, Roosvelt turned his ears towards those who thought that Competition was key to restoring prosperity. Part of the problem was that under Roosvelt, the Government had tried to maintain the previous cartel like arrangements while at the same time trying to preserve small scale enterprises by preventing large scale firms from cutting prices in order to drive the former out of the market. Many of these economists were actually supported by the pro free market economists of Chicago School like Frank Knight, Jacob Viner and especially Henry Simons. The Chicago school initially were strong proponents of anti trust and viewed it as fundamental part of a well regulated market economy and preferable to State direction and planning. Simons favoured breakup of large monopolies and Nationalization of Enterprises in Industries like Railways where (in his view) that Competition could not effectively be maintained. This ended the era of neglect that lasted from 1915 to 1936.