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VI The Great Depression: 

VI The Great Depression

VI.1 Basic data: 

VI.1 Basic data

Industrial production 1927-35(1929=100): 

Industrial production 1927-35 (1929=100) Source: Industrial Statistics, 1900-1957, OEEC 1958.

CPI, 1925-1938(1929=100): 

CPI, 1925-1938 (1929=100) Source: Mitchell - International Historical Statistics

Industrial unemployment: 

Industrial unemployment Source: Eichengreen and Hatton, Interwar Unemployment in International Perspective, Dordecht, Kluwer Academic Publishers, 1988.

GNP, USA, 1928-1941: 

GNP, USA, 1928-1941

US: real growth, unemployment, CPI: 

US: real growth, unemployment, CPI

US: real growth and money: 

US: real growth and money

VI.2 Impulse and propagation: 

VI.2 Impulse and propagation

General framework: 

General framework WWI: Suspension of stable economic system Namely suspension of the gold standard Sterling overvalued, mark and franc devaluated Pre-war institutional order destroyed Different basic conditions Higher price and wage rigidity No international policy coordination Trade protectionism The very broad cause of Great Depression: the start of WWI and demise of the pre-war economic system

US economy – 1920s: 

US economy – 1920s Strong economic growth both real GDP and industrial production around 40% in 1920-29 recession only 20-21, deflation with very quick recovery Active FED policies and wrong lessons 1920s: the first application of the active monetary policies recession 1921: successful deflationary policies without paying too much in terms of output decline Wrong lesson after WWI – strong demand for US output from Europe gold standard not yet re-installed Trust in monetary policy overdone

Narrow origins: US economy 1928-29: 

Narrow origins: US economy 1928-29 Two points crucial: US relevant: US money supply and FED actions Ineffective gold standard – world-wide relevancy During 1928 – US: speculative boom on financial markets, by US politicians and bankers considered as unhealthy FED strongly contracted money supply The aim was to stabilize the financial markets Belief that impact on output will be mild It became clear that there will be a break on the stock market The existence of gold standard The general conditions were different to 1921 The deflationary policies were propagated worldwide Monetary policies to maintain gold standard – other central banks contracted as well Balanced budgets Wage and price rigidities, no adjustment as before !(!£

Triggers: business cycle and crash: 

Triggers: business cycle and crash Recession already since August 1929 and it could have been just a normal manifestation of the business cycle October 27, 1929 – stock market crash !!! Popular view – Crash and Great Depression are the same – NOT !!! However, when recession arrived, Crash helped to unleash the avalanche that accumulated after money tightening, making it clear that recession will be deep But still: why a “standard” event transformed into a catastrophe?

Why “Great” Depression?: 

Why “Great” Depression? The depth The US average annual growth 1929-1932 was –8.6%, unemployment in some moments almost 25% The length Despite resumption of growth after 1933, the unemployment in 1941 still 9.9% Global scale: USA, Europe, elsewhere Three hypothesis that attempt to explain what happened

Propagation mechanism (1): 

Propagation mechanism (1) Aggregate demand hypothesis - the length was determined by fall in aggregate demand (fall of spending) due to several factors Reduction in personal consumption – people were spending less Higher uncertainty Stock market crash decreased general wealth Reduction in investment Residential investment fall, due to previous overbuilding Bank failures due to poor regulation, no access to funds for capital investment Austere fiscal policies of Governments Balanced budget policies, gold standard

Propagation mechanism (2): 

Propagation mechanism (2) Money hypothesis – applicable namely to US situation (see Friedman and Schwartz in Literature) The contraction of nominal money Note on money multiplier M = H x money multiplier (see next slide) Decrease of money multiplier, not of monetary base Reasons for the decrease of m.m.: Bank failures, shift from checkable deposits to currency, etc. Limitations of the hypothesis Falling prices  real money increases does not fall much Contraction of nominal money should increase the interest rate x the opposite was observed

Money, US, 1929-1933: 

Money, US, 1929-1933

Propagation mechanism (3): 

Propagation mechanism (3) Deflationary hypothesis – not only US related, very cautious monetary policy in all countries due to the adherence to gold standard Both unexpected and expected deflation matters, as the future debt becomes “more expensive” Unexpected – burden on the debtors  there were many debtors  shift in consumption spending Expected – firms know that they will have to pay more for future debt  decrease in investment spending  decrease in production and demand for money  decrease of nominal interest, but prices falling faster and real interest increases Money hypothesis applies ! Many additional factors – low international coordination, trade restrictions, difficult intermediation between lenders and borrowers (Bernanke 1983), etc.

VI.3 The Recovery: 

VI.3 The Recovery

VI.3.1 New Deal: 

VI.3.1 New Deal Economic background appalling 25% of population suffered by Great Depression, 40% fall of GDP Unprecedented number of bank failures Political conditions: Herbert Hoover (till 1932) – liberal concept Franklin D. Roosevelt (1933-1945) – interventions, but mixed policies, not only New Deal Very mixed ideological background: Institutionalism Inclination towards socialism and Soviet planning Deficit financing At the same time - conservatism

Roosevelt’s team: 

Roosevelt’s team Probably better understanding of the causes of crises Dramatic change in monetary policies March 1933: US banks closed for several days 1933-1941: nominal money growth by 140%, real money by 100% Due to increase in the monetary base, not in the money multiplier Deficit financing accepted as economic policy tool Different personalities, from left-wing socialist to traditionalists New Deal – more as a political slogan than a consistent program

National Recovery Administration (1): 

National Recovery Administration (1) Establish “orderly competition” Relief and public works programs for unemployed National Industrial Recovery Act (NIRA) Codes of behavior for the industries Minimum wages No further wage cut at the high unemployment Rather naive notions, sometimes even against the US Constitution (and against competitive environment)

National Recovery Administration (2): 

National Recovery Administration (2) Agricultural Adjustment Act (AAA) Limit the overproduction Support to the decrease of farmable land Subsidized credits for the farmers Debt relief for farmers Stabilization of the banking sector “Emergency” legislation Federal Deposit Insurance Corporation (FDIC) Tax policies

New Deal – success of failure?: 

New Deal – success of failure? Popular fiction: New Deal as a successful program that ended Great Depression In reality Some policies were indeed proper for the economy in Depression On the other hand – some policies counterproductive and brought another recession in 1937 Even the proper policies can not be generalized as policies for all situations The recession lasted till 1941 (see next slide) The most important factors of recovery: monetary policy and reinstated trust into the banking sector Definitely not a clear success, probably not a failure, just “muddling through”

Great Depression, US, till 1941: 

Great Depression, US, till 1941

VI.3.2 Outside USA (1): 

VI.3.2 Outside USA (1) Different countries – different policies Common decisions after 1931 End of gold standard and floating of the currencies Generally: devaluations and revival of the trade Accomodative monetary policies Governmental intervention, spending and fiscal deficits Germany: political turmoil brought Hitler to power, massive governmental spending (military, infrastructure, etc.)

Outside USA (2): 

Outside USA (2) France: effects from increased trade and devaluation of Franc just after WWI UK: sluggish growth because of overvalued pound after 1925

VI.4 Consequences: 

VI.4 Consequences

Theory: 

Theory The crisis of the classical model Assumption of continuous market clearing vs. the persistent excess supply on the labor market Not able to provide a proper guidance for economic policies In combination with golden standard suggested deflationary policies Insistence on balanced budgets Belief that money is neutral and wages flexible Emergence of new macroeconomic paradigm – Keynes’ General Theory (next Chapter)

Policies - liberal approach: 

Policies - liberal approach Perception that liberal policies failed, denial of Market clearing, quick price-adjustment towards equilibrium Assumption of competitive markets Voluntary unemployment State intervention only in case of public goods and externalities Adam Smith and The Invisible Hand Say’s Law

Policies - interventionist approach (1): 

Policies - interventionist approach (1) New Deal - disregarding whether success of failure, established a completely new approach not only to economic policies, but to the role of the state in modern societies: No internal stability of the private sector Persistent disequilibria, namely in the labor market Market failures There is a need for a public sector to intervene not only in case of public goods and externalities

Policies - interventionist approach (2): 

Policies - interventionist approach (2) Intervention: accepting some problems are a fact and suggesting new policies Rigidity in labor markets  accept an equilibrium with involuntary unemployment Gold standard does not reflect reality  need for exchange rates adjustment, floating Money is not neutral  fight deflation with increase of money supply Say’s law is not valid, there is insufficient aggregate demand  stimulate aggregate demand, emergence of policy of governmental spending Protectionism deepens Depression  removal of trade barriers

Concluding remarks on recovery: 

Concluding remarks on recovery Some policies, consistent with classical model, were very proper, e.g.: Improved regulatory framework for banking and financial markets Anti-trust policies New Deal: Was not the first application of keynesian policies, but rather an eclectic mix, stemming from a desperate search for a change Contained some counterproductive measures (and even some unconstitutional) The real end of Great Depression – WWII The second European Thirty Year War (1914-1945)

Literature to Ch. VI.: 

Literature to Ch. VI. Both Blanchard’s or Mankiw’s textbooks have a paragraph on Great Depression Bernanke, Ben S. “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression.” American Economic Review 73, no. 3 (1983): 257-76. Bernanke, Ben S. "The Macroeconomics of the Great Depression: A Comparative Approach" Journal of Money, Credit & Banking, Vol. 27, 1995 Friedman, Milton and Anna J. Schwartz. A Monetary History of the United States, 1867–1960. Princeton, NJ: Princeton University Press, 1963. Kindleberger, Charles P. The World in Depression, 1929-1939 (1983) Temin, Peter. Lessons from the Great Depression. Cambridge, MA: MIT Press, 1989. Shlaes, Amity. The Forgotten Man, HarperCollins Publishers, New York, 2007