Download understanding the great depression in the united

Prepared for: World Economy and National Economies in the Interwar Slump, Theo
Balderston, Editor (Basingstoke: The MacMillan Press).
UNDERSTANDING THE GREAT DEPRESSION IN THE
UNITED STATES VERSUS CANADA
Pierre L. Siklos*
Department of Economics
Wilfrid Laurier University
Waterloo, Ontario
Canada, N2L 3C5
*
Troy Elyea provided valuable research assistance. I am grateful to the Social Sciences
and Humanities Research Council of Canada, and the Society of Management
Accountants of Ontario (SMAO), for financial support. Part of the research was
conducted while I was Wilfrid Laurier University University Research Professor for
2000-2001. Theo Balderston, the Editor, Angela Redish, Richard Burdekin, Lars
Jonung, Lee Ohanian and LeRoy Laney provided helpful comments on earlier drafts.
Previous versions of this paper were presented at the Western Economics Association
Conference, San Diego, July 1999, and the Stockholm School of Economics, the
Economic History Association, and the Canadian Network in Economic History.
TABLE OF CONTENTS
1.
Introduction
2.
The Gold Standard as a Straightjacket for Monetary Policy
3.
Impulse and Propagation of Shocks Leading to the Great Slump
4.
The Great Depression as a Financial Crisis: Canada versus the US
5.
The Consequences: Reform and Recovery
6.
Concluding Remarks
1
1.
Introduction
It is now recognized that the Great Depression should be viewed as a global
phenomenon with its roots in the Gold Standard so arduously restored in Great Britain in 1925
(Bernanke 1995). Temin (1989) and Eichengreen (1995) provide arguably the best recent
accounts of the Great Depression.
Not surprisingly, the literature on the interwar slump which afflicted much of the world
has generated a vast literature which continues to this day to fascinate economists and social
scientists more generally. Unlike Friedman and Schwartz (1963, 1982), whose masterful works
documented the role of monetary policy to explain both the depth of the Depression and its
propagation outside the United States, Temin (1989) stresses the influence of a large
“economic” shock which was then magnified by an almost slavish adherence to the Gold
Standard. Eichengreen (1995) would not disagree but also would emphasize the breakdown in
international cooperation among government and central bank officials. Others, such as
Kindleberger (1986), might argue instead that the collapse of the post World War I monetary
order produced financial chaos which, like the now much discussed “Asian flu” of the late
1990s, caught on across much of the world.
The interwar era has fascinated many due to the tremendous severity of the economic
collapse, as is documented throughout this volume. Lately, however, interested researchers have
been drawn not only to how the Depression was transmitted worldwide but whether the
combination of economic ideology and politics conspired to generate such a spectacular slump.
Since so much of the debate surrounding the Great Depression centers around financial
issues, their real economic consequences, and the global nature of the event, comparisons across
countries can provide useful insights about the role played by institutional factors. It is precisely
for this reason that a review of the US and Canadian experiences is helpful, not only because of
the obvious close ties the two countries share with each other but also because there were
significant differences in the financial sphere which underscore the role played by the Gold
Standard. Yet, despite the differences, there is one unmistakable similarity: both countries
2
experienced a Great Depression at roughly the same time and of comparable economic
magnitude. As Bernanke (1993) points out, there have been relatively few references to Canada
in various arguments about the causes and cures for the Great Depression.
The rest of this chapter is organized as follows. The following section briefly sets the
stage for a US-Canadian comparison by outlining what motivated the return to a Gold standard
following World War I and why the policy, from a “modern” policy perspective, represents a
“straightjacket”, otherwise referred to as the “cross of gold”. Section 3 explores the origins and
transmission of the powerful and large shock that Temin (1989) argues lay behind the Great
Depression and how this played out in the US and Canada. Some evidence about the relative
predictability of deflation in the US and Canada is presented for the period of the Great Slump as
well as for an earlier large deflation which took place in the early 1920s in both countries.
Section 4 focuses on the financial aspects of the Great Depression. Arguably, this is a crucial
ingredient of the global slump. Section 5 looks at the consequences of the Great Depression for
economic reform and recovery. Section 6 offers a few concluding comments by asking how
recent economic research sheds light on the overarching factors in the Depression. Needless to
say, since the topics of interest are wide-ranging, the present chapter can only selectively survey
the extant literature and, hopefully, whet the appetite of the interested student for a more serious
study of this remarkable era in economic history.
2.
The Gold Standard as a Straightjacket for Monetary Policy
One cannot evaluate the magnitude of the Great Depression without comprehending the
constraints imposed by the Gold Standard. For much of the 19th century commodity money
regimes, such as the Gold Standard, shaped policymakers’ thinking. Not surprisingly then, some
countries were keen to return to it following recovery from World War I. But the decision to
return to Gold was not squarely based on economic considerations. As Winston Churchill who,
as Chancellor of the Exchequer, led the United Kingdom back to gold noted:
“But this [the return to the Gold Standard] isn’t entirely an economic matter; it
is a political decision...” (Gilbert (1977, p. 92)).
3
One of the chief attractions of the Gold Standard among its supporters was that it
operated automatically, leaving no room for political interference in the realms of international
trade and investments. Combined with a commitment to central bank autonomy, the “rules of the
game” insured that currencies could be converted into gold at the stipulated fixed exchange rate.
Indeed, in its purest form, the Gold Standard comes closest to the fixed exchange rate system
discussed in standard macroeconomic textbooks.
Students of modern macroeconomics are taught that the demand for money is a function
of income and the opportunity cost of holding money, usually measured in terms of some
nominal interest rate. Moreover, the demand for money is assumed to be proportional to the
price level, giving rise to the usual quantity theory relation. But in the purest gold standard
system, i.e., one where the only money is gold coinage, the demand for gold is also a function of
the price of gold, relative to those of other goods. This is because gold is a commodity with nonmonetary uses too. We can thus write
M/PG = F(Y, P/PG , θ)
(1)
where M/PG is the money stock (M) deflated by the price of gold (PG ), Y is income, P/PG is the
price of consumer goods (P) relative to gold, and θ is the “cost of holding money”.1 Notice that,
unlike the Quantity theory, there is no reason why a change in P/PG should lead to a proportionate
change in M/PG, holding Y and constant. By fixing the price of gold in terms of money, the price
of goods in terms of money is also fixed, leaving no room for active monetary policy, making it
“knave-proof”.2 The actual process which would guarantee this state of affairs was the “specieflow” mechanism.3 Hence, a country which consumed in excess of production, producing a
balance of trade deficit, would have to export gold to cover its debt. Moreover, the resulting fall
in gold reserves would normally lead to a contraction in the domestic money supply and,
eventually, in the price of goods and services. To the extent that monetary policy can be used, at
least in the short-run, to stimulate economic activity, the Gold Standard can be seen to act as a
straightjacket. Moreover, as Eichengreen (1995) argues, the ideology of the Gold Standard
4
prevented due consideration of alternative policies that might have delivered better economic
outcomes.
The reality of the Gold Standard was, of course, different for a number of reasons. First,
countries such as the UK and the US, which had central banks, could manage the monetary
system by varying the terms under which they could extend credit to the banking system. Hence,
a rise in domestic interest rates could offset the loss of gold reserves from a balance of trade
deficit by attracting short-term capital flows. The higher interest rates would also serve to
depress domestic aggregate demand thereby helping eliminate these pressures which produced
the outflow of gold in the first place. Second, the actual Gold Standard was a fractional system
since only a small portion of the money supply was held in the form of gold. Moreover, a central
bank could resort to the practice of “sterilization”, that is, conduct open market operations.
Hence, for example, a reduction in the money supply from gold outflows could conceivably be
offset by buying government bonds held by banks or the public. Third, prices of goods and
services do not adjust instantaneously to some imbalance between aggregate demand and supply.
Fourth, the adjustment process is also dependent on how mobile capital is. Ostensibly then, the
Gold standard could represent a straightjacket under the rules of the game, as sketched above.
However, these rules were contingent on all of the above factors, including the ability of central
banks and global financial markets to circumvent them as needed (e.g., see Bordo and Kydland
1995).
What then of the US and Canadian experiences? First, it might surprise many that capital
markets in industrial economies were highly integrated at the outset of the Great Depression
making the current notion of “globalization” seem somewhat dated (Bordo, Eichengreen and
Kim (1998)). Dick and Floyd (1992) describe in great detail how Canada operated under the
Gold Standard until the outbreak of World War I and the degree to which capital markets in
Canada and the US were integrated (also see Bordo, Redish and Shearer 1999). In particular,
much of banks’ gold reserves were held in New York where a substantial amount of financial
business was carried out. Indeed, these same authors present convincing empirical evidence to
5
suggest that capital market integration drove adjustment under the Gold Standard in Canada rather
than adjustment in the price of goods and services.4 Table 1 shows the balance of trade, flows of
short-term capital, and movements of gold for the period 1926-37. It is clear, for example, that
the specie-flow mechanism worked differently in practice than in theory. Figure 1 plots the
available data on short-term interest rates in Canada and the US. Whereas the traditional view of
the specie-flow mechanism predicts that they should move in the opposite direction, to satisfy
the condition of equilibrating gold flows from one country to the other, Figure 1 instead reveals
a considerable amount of parallel movements in these rates before and after the Gold Standard
period. Finally, Figure 2 plots the behaviour of the wholesale price index of the two countries
from May 1925, when the UK returned to gold until the Gold Standard collapsed in 1931. This
figure shows commonality of price movements in the two economies, not the inverse relation
predicted by the specie-flow mechanism. (It also disproves the much-touted claim that the gold
standard protected against inflation and deflation). Obstfeld and Taylor (1997) also point out that
capital mobility was high not only between the US and Canada, but across all major economies at
the time. The onset of the Great Depression led to a further contraction of the order of roughly
25% of cross-border flows of capital even between the US and Canada coming on top of an
almost 50% drop in capital flows relative to the 1870-1913 period.5
3.
Impulse and Propagation of Shocks Leading to the Great Slump
The impulse to a business cycle expansion or contraction refers to an event or a
“shock” of some kind which affects economic activity, output in particular, with a lag. This gives
rise to changes in economic variables related to each other in time which is then called the
propagation mechanism. Under this interpretation, the return of the Gold Standard sowed the
seeds of a deflation but the straightjacket policy makers placed themselves in was largely
motivated by the belief that the “credibility” of the Gold Standard rested on the maintenance of a
regime that deemed crucial for delivering economic prosperity in the pre-World War I era. In
Temin’s (1989) view, “major deflationary shocks” were the impulse for the Great Depression
6
and its roots therefore lay in the “ideology of the Gold Standard”. For Eichengreen (1995) the
ideology of the Gold Standard, coupled with a breakdown of international cooperation among key
central banks, produced a slump more severe than any previously recorded. That the shock,
whatever its origins, was large is clear on inspection of Figure 3 which plots industrial
production in the US and Canada as well as the dates of reference cycles constructed on the basis
of various economic indicators and pioneered by economists at the National Bureau of
Economic Research (Burns and Mitchell (1946)). In both Canada and the US, industrial
production roughly doubled between 1921 and 1928 or 1929 followed by a contraction of
approximately the same magnitude between 1929 and 1933, that is, in about half the time it took
industrial production to rise to prior to the collapse.6 The peaks and troughs in the reference
cycles – the former dated the beginning of a recession; the latter the end of a recession – tend to
mirror the downturns in industrial production. Nevertheless, we do see more frequent and shortlived cycles in economic activity before the Great Depression while longer durations are
apparent between recessions and recoveries since the Great Slump.7
Finally, note that, with the exception of the US recession of 1927, Canadian and US
recessions are nearly coincident.8 This would suggest a sequence of recessions, including the
Great Depression, that originated in the US but were quickly transmitted to Canada. The
combination of the Gold Standard and the close economic ties between the two countries would
reinforce the mechanism through which the original shock (i.e., the impulse) was transmitted
internationally, as emphasized by both Temin (1989; see also 1993) and Eichengreen (1995).
There is, however, disagreement on the point. Betts, Bordo and Redish (1996) have explained the
parallelisms between the outset, depth and duration of the depression in both countries as a
reaction to a common supply shock, namely a technical or resource shock originating in both
economies simultaneously, which they did not manage to identify. Cole and Ohanian (1999,
2001) use a “neoclassical” model (of the kind popularized by Lucas 1987), which features a
production function with constant returns to scale consisting of labour and capital as inputs. The
model is then used to assess whether the downward rigidity of nominal wages or the role played
7
by the banking system were sufficient “shocks” to explain a significant portion of the Great
Depression. They conclude in the negative. The strong parallels between the US and Canada
detailed in this chapter may weaken the case for the Cole-Ohanian view as we shall see. More
importantly, the basis for their contention of a weak recovery from the Depression is an unusual
calculation of output performance (op. cit., n. 5) during the 1930s which is not justified by the
authors and seems contradicted by Figure 3. Nevertheless, it is also striking, if not troubling, that
the deflation of the early 1920s was more severe in both the US and Canada while the
contractions experienced in both countries (shown in Figure 3) were considerably smaller in
magnitude, again in both countries.9
These two explanations of the relationship between the US and Canadian depressions
arise because of problems in the econometrics of distinguishing between them. Even a fairly
straightforward model can admit several channels through which the variables of interest are
affected. Hence, empirical testing requires that a priori judgments be made about what are, or
are not, significant channels of influence, and scholars will differ in such judgments.10
Nevertheless,
modern econometric tools at least permit the debate over the origins and
magnitude of the Great Depression to be conducted in a manner that permits critical
assessments, as well as progress, to be made over disgreements about the main outstanding
issues. A number of examples follow to illustrate the point.
Betts, Bordo, and Redish (1996) find against the view that Canada “imported” the Great
Depression from the US (also see Fremling (1985)). Hence, relative price changes under the
Gold Standard, whose role is highlighted in (1), implies that the Great Slump was an event which
occurred simultaneously on a global scale. However, it is important to note that the authors are
unable to identify short-run supply shocks which may have been common to both countries.
Fackler and Parker (1994) and Burbridge and Harrison (1985) use similar techniques and find in
favour of the impulse-propagation explanation of the Great Depression. Further, the shock to the
US economy is thought to have been propagated worldwide (Romer 1993). Cecchetti and Karras
(1994) identify the sources of the Great Depression in the US and conclude, in line with Temin’s
8
(1989) views, that a collapse in consumption, that is, an aggregate demand shock, was largely
responsible for the drop in US output through late 1931. This drop was facilitated by monetary
policy actions during this period, as emphasized by Friedman and Schwartz (1963) and Hamilton
(1987). This was followed by an aggregate supply shock, via an unexpected decline in prices
originating in the banking crises of 1930, 1932 and 1933, which contributed to further declines
in output until 1933. It is important to note that these efforts do not formally allow a direct role
for the impact arising from the high degree of financial integration between the two economies.
As discussed in the next section, it is conceivable that while there was an idiosyncratic shock
which led to deflation almost simultaneously in the US and Canada, the integration of financial
systems, not explicitly accounted for in the foregoing research, may explain the global
transmission of the Great Depression.
Is there any single source which can be identified as setting in motion the Great
Depression? While some popular histories (e.g., Garraty (1986)) point out the role of the stock
market crash of 1929, more recent treatments of this event (e.g., Romer (1990)) suggest
otherwise. First, the empirical connection between the stock market crash, lowered expectations
for economic activity, and hence consumption, appears to be weak at best (e.g., Temin (1976),
Dominguez, Fair and Shapiro (1988)). Moreover, unlike the present day situation, only a small
portion of individuals’ wealth was invested in stocks so that this channel of influence on
consumption is also likely not to have been operative. Yet, the combination of loss of confidence
in financial institutions’ survival, and the fact that banks could underwrite share issues and
thereby incur potential losses on their own account, both stemming from the stock market
collapse, must also surely be an ingredient in the Slump.
Romer (1990) argues that uncertainty about the future is what contributed to the drop in
output. Although uncertainty can manifest itself in various forms, it is usually captured in the
form of some measure of volatility. On this basis it can be shown that real income “uncertainty”
appears to have risen before “uncertainty” in stock price movements.11 Even if uncertainty of
some form is the proximate cause for the global collapse of the 1930s, was there something in
9
either the structure of the Canadian or US economies which can provide additional clues about
the events which transpired during this period? Alternatively, perhaps, was the effect of the
original shock amplified by its sheer unexpected size?
Although both economies were dependent on the production and trading of
commodities, Canada was perhaps relatively more vulnerable. For example, in 1919, the
proportion of the labour force in non-agricultural pursuits stood at 73% in the US and 67% in
Canada. By 1939, the size of the agricultural labour force shrank considerably in both countries
(80.2% in the US; 73% in Canada) but the spread between the two actually grew. Hence, any
underlying economic uncertainty might spread to uncertainty about future commodity prices.
One candidate for the originating source of the Depression could be the pre-depression
and depression-period movement of commodity prices. Figure 4 plots some available
commodity price data for the US and Canada. The general downward trend in commodity prices
until about 1932 is evident in both countries. Despite some stability in commodity prices
between roughly 1925 and 1929, commodities fell by over two-thirds of their value in 1919 or
1920. Indeed, commodity prices fell by over 50% between 1919 and 1921 which alone
constitutes a substantial shock. But modern macroeconomics would not treat even such large
movements in prices as a “shock” if they were anticipated. The reason is that events which are
fully anticipated should not upset individuals’ plans even if, as a result, their incomes fell, and if
the downturn was expected to be temporary. Other than for economic historians, many would be
surprised to know that, in the space of 40 years (from 1876 to 1922), the US experienced 12
years of deflation. During the same period Canada recorded a deflation on an annual basis 18
times.12
To what extent then were price changes during the 1920s, in particular, anticipated?
Cecchetti (1992), Hamilton (1992), and Evans and Wachtel (1993) pose just such a question.
Cecchetti (1992) points out that the historical behaviour of inflation in the US was such that the
deflation of 1930-32 could have been anticipated. A straightforward explanation involves the
notion that inflation and deflation are predictable variables because they are persistent. However,
10
there have been no comparisons of persistence between the US and Canada, nor have there been
any comparisons between the deflations of the early 1920s and 1930s. Persistence means that
inflation depends heavily on its immediate past history. A simple representation of this idea is to
write
π t = α + β π t −1 + εt
(6)
where π t is the inflation rate, α is a constant, β is the degree of persistence in inflation since it
measures how last period’s inflation rate affects current inflation. Finally, ε t measures the error
made in specifying that only past inflation affect current inflation. If we estimate (6) for the US
and Canada we obtain the estimates provided in Table 2. We immediately notice that the degree
of persistence did not change dramatically before and after 1928 in the two countries.13 Thus,
for example, for both the US and Canada a 1% rise in last year’s inflation rate would raise this
year’s inflation rate by roughly ½%, and vice-versa.14 To be sure, other variables might be helpful
in explaining the current behaviour of inflation but we can go a long way by simply assuming that
last year’s inflation rate carries with it considerable momentum. Put differently, asking whether
the behaviour of prices in the 1930-32 period could be answered by using the estimates for the
1919-28 sample to forecast inflation for the years 1930-32. Figure 7 shows the results of this
exercise. Clearly, (6) implies that the deflation was forecastable with essentially a one period
lag. Of course, the term ε t in (6) implies that forecast errors are probable so that some portion at
least of the deflation was a surprise. If so, can a more sophisticated model improve on forecast
accuracy and, if economic agents are assumed to have, in effect, used such a model, would the
deflation have been a surprise? Dominquez, Fair and Shapiro (1988) conclude in the affirmative.
Burdekin and Siklos (1999) also rely on recent advances in econometrics to estimate whether
there may have been a significant change in inflation persistence in several countries using over a
century of data. They find significant breaks in US inflation in 1926 and 1933 while for Canada a
break is found in 1930. Their findings suggest that if economic agents did not revise their model
of inflation, it becomes even more likely that the deflation, to a significant degree, was
unanticipated.
11
Hamilton (1992) also presents evidence that, despite the drop in commodity prices in
the 1920s discussed earlier, markets in the US did not anticipate a deflation of the magnitude
which actually occurred. Quite the contrary. Based on futures markets price data for key
commodities, Hamilton’s analysis suggests that markets were betting at first on price increases.
Futures markets are, of course, nowadays widespread in financial assets but their origins can be
traced long ago to commodity markets. If these markets operate efficiently then a futures
contract represents the market’s estimate of the price of a particular commodity expected to
prevail in the future.15 In symbols,
f j ,t − Et S j ,t +1 = εt
(7)
where fj,t is the futures price for commodity j at time t, Et Sj.t+1 is the market’s forecast,
conditional on information at time t of commodity j’s price in the spot market next period (i.e.,
time t+1) and ε t is a “residual” which is defined to have a zero mean and a constant variance. A
version of market efficiency requires that ε t fluctuate randomly. This hypothesis did not
apparently apply to the markets examined by Hamilton, at least at first.16 Comparable data for
Canada are not available but one can speculate that the US results would hold there as well. Evans
and Wachtel (1993) point to uncertainty about the stance of monetary and fiscal policies to make
the point that the deflation of the early 1930s, which was then followed by inflation, were both
unexpected. Hence, if we view events after both economies reached the bottom, around 1933, as
signaling a regime change then the process driving inflation would have changed. While
proponents of the rational expectations hypothesis would argue that models such as (6) or (7)
are at fault, because they presume that both the underlying relationship and the coefficients
remain constant, Evans and Wachtel (1993) would argue that unexpected forecast errors remain
possible so long as economic agents are unsure, in a probabilistic sense, about what drives future
inflation. In particular, if individuals expect the deflation to end, and inflation to return, then it is
conceivable that the severity of the deflation would be underestimated. While the argument
seems persuasive, it ignores that deflation was a “normal” state of affairs since at least 1870.
Therefore, disagreements persist over whether the deflation of the early 1930s and the
12
subsequent inflation need have been largely unanticipated.17 Nevertheless, the size of the
forecast errors in this period suggest that they accumulate sufficiently over time to translate into
a “large shock”.
Friedman’s well-known theory of permanent income 18 provides additional perspective
on the issue. It predicts that temporary changes in income should have little influence on
permanent income. Hence, a shock to aggregate consumption would be signaled by a large and
protracted fall in income relative to permanent income. Figure 5 shows an estimate of the ratio
of per capita income to permanent income. There are some interesting features in the data. First,
actual incomes are persistently below their long-run or permanent levels throughout the 1919-27
era in both countries. Second, the departures from permanent income are more prominent for the
US than for Canada. Third, measured incomes begin to rise sharply relative to permanent income
in both countries, beginning in 1933. Given the sharp drop in consumption, especially in the
1928-32 period, it is conceivable that the drop is measured to permanent income, which
occurred simultaneously, is symptomatic of an unexpected shock. Since the ratio plotted in
Figure 5 also shows a sizeable drop during the earlier deflation of the 1920s this still begs the
question why a second deflation, temporally close to the first one, was such a surprise. Clearly,
how one interprets individual behaviour, and the channels through which these lead to
macroeconomic consequences of a particular variety, matter a great deal to the outcome of the
debate over the degree to which the deflation was anticipated.
Temin (1989), following Keynes (1931), places relatively more emphasis on the role
of investment as the impulse for the chain of events which led to the Great Depression. An
obvious candidate indicator of the real cost of borrowing money is the real interest rate. The
higher real interest rates can be explained in part by the sheer size of the deflation and, not
coincidentally, by central bank policies more concerned about preventing borrowing for
“speculative” purposes but which, nevertheless, had the effect of choking off borrowing for
more “productive” investments. Although the empirical connection between interest rates and
investment has been found to be multifaceted and complex (e.g., see Romer (1996, chapter 8))
13
the estimates presented in Figure 6, however imprecise, suggest that real interest rates were
exceedingly high by historical standards. As shown in Figure 6 they averaged 5.37% in the US
during the 1922-1930 period19 and 10.95% in Canada in the 1929-32 period. An additional
indicator of future economic activity, much touted in recent financial economics literature, is
the spread between long and short-term interest rates, also plotted in Figure 6.20 The potential
link between the yield spread and future output operates along two dimensions. If short-term
interest rates reflect the stance of monetary policy, then, for given long-term interest rates, a
reduction in the spread would, in time, signal a contraction in economic activity as sectors of the
economy sensitive to interest rates reduce spending. Alternatively, if firms expect future
investment opportunities to improve, they will usually borrow in long-term market for funds. The
resulting increase in the supply of bonds reduces bond prices thereby raising current long-term
yields. As such, a rise in the spread would be associated with a future upturn in economic activity.
As is clear from Figure 6, the spread in the US fell sharply in the years leading up to the Great
Depression (until about mid-1929). In Canada, the only time the spread might give an indication
of a fall in future economic activity is in 1931. Otherwise, the spread presages increases in
future output. Either the message in the spread is misleading, or the differences between the US
and Canadian experiences have their origins in the structure and response of the respective
countries’ financial sectors. We explore this question in the following section.
If the impulse for the Great Slump was the deflation in commodity prices (and the price
level more generally) the role played by “ideology of the Gold Standard”, as Temin (1989)
would perhaps emphasize, is not as clearcut as might appear to be the case at first glance. After
all, Canada’s commitment to the Gold Standard in the interwar years was not as great as in the
US. Moreover, the Act creating the Federal Reserve System prohibited it from inflating the
economy by restricting central bank credit to be no larger than 2 ½ times the gold certificates
held by the reserve banks. There was apparently less concern about the risks and consequences of
deflation. With the price of gold fixed at $20.67/oz., the Fed felt mandated to use tight monetary
policy to offset the potential inflationary effect from the resulting inflow of gold. In the
14
meantime Fed officials looked at the stock market’s performance during the mid-1920s,
together with the expansion of credit, and concluded that monetary policy was becoming too
easy.21 At this point the commitment to the Gold Standard did play a crucial role, especially
given the attitudes of the French, who were fiercely committed to the monetary regime. The
resulting tightening of monetary policy, evident from Figure 6, suggests that a form of
international cooperation did work. Canada’s close financial and economic links meant that it
would inherit the US experience.
Nevertheless, if the impulse to the Depression was a
combination of real factors built upon faulty institutional foundations, modern macroeconomic
analysis also makes it clear that the propagation mechanism was financial in nature.22
Not to be forgotten in all this is the role of the exchange rate. As Eichengreen (1995, p.
240) points out the Canadian dollar ceased to be convertible after 1929. Floating exchange rates
should, at least in theory, have insulated the Canadian economy for an “shock” emanating from
the US. Yet, the $C/$US exchange rate was, in appearance, relatively stable between 1929 and
1931. Bordo and Redish (1990) argue that the Canadian government was intent on ensuring
stability for at least two reasons. First, because of a long historical adherence to Gold Standard
principles; second, because of large $US denominated debt. This state of affairs is somewhat
puzzling since, some research has demonstrated that, during the Great Depression, countries with
flexible exchange rates suffered milder contractions than countries with either fixed exchange
rates or ones who adhered to the Gold Standard (Choudhri and Kochin 1980). While it is
conceivable that credibility and political imperatives provided exchange rate stability it is less
clear why there were deemed preferable over the maintenance of the Gold Standard orthodoxy. In
the absence of credible commitment to exchange rate stability the behaviour of the exchange rate
could reflect a “peso problem”. This refers to the phenomenon, apparently coined by Milton
Friedman, to explain the performance of the Mexican peso during the 1970s which failed to be
devalued despite widespread expectations that it would.23 After all, while average exchange rates
were stable during the period in question, they were also considerably more volatile than in other
years (figure not shown).
15
4.
The Great Depression as a Financial Crisis: Canada versus the US
As noted in the preceding section, deflation meant that real interest rates rose even in
the face of relatively low nominal interest rates.24 But lower prices also raise the real cost to
borrowers of repaying outstanding principal. Prospective borrowers, if they feel that prices are
expected to fall further will also find credit to be expensive. In addition, default rates will be
exacerbated if the deflation is unanticipated leading potential lenders to be scared away from
making loans, thereby producing a severe “credit crunch”, to use the modern term. The foregoing
ingredients are harbingers of a financial crisis and place the banking system at the centre of the
story of the Depression. While Kindleberger (1986) was one who emphasized the role of
financial crises in the present historical context, Bernanke (1983) is credited with working out
the analytical details of how the Great Depression led to a massive failure of the credit allocation
process (also see Bernanke (1995)) based on a hypothesis first put forward by Fisher (1933).
Not to be forgotten is monetary policy. After all, few economists would nowadays disagree with
Friedman and Schwartz’s (1963) view that the sharp contraction in the money supply was the
main causal factor in the chain of events that led to the great contraction. In fact, Hamilton
(1987) makes the persuasive case that the monetary contraction led to an unanticipated deflation,
and hence the financial crisis which ensured, together with the attendant high real interest rates,
the collapse of intermediation services. Figure 8 shows just how massive the monetary
contraction was in both countries. However, a puzzling feature of the data is that Canada’s money
supply peaks over a year earlier than in the US. So far as I am aware, there is no explanation for
this result in the literature.
If monetary policy and the banking system are important ingredients in the story, then do
differences in institutional structure matter? There were two notable differences between the US
and Canadian financial systems. First, until 1935, Canada had no central bank. Second, US
banking laws aimed at preventing banks from forming oligopolies. The Canadian banking system
permitted branch banking while the US system placed severe restrictions on this type of activity,
16
effectively encouraged such behaviour.25 As a result, Bordo, Rockoff and Redish (1994) report
the relatively greater stability of the Canadian banking system over the US one in the sense of a
reputation for soundness (also see Grossman (1994) in this connection). This translates into a
lower probability of failure. Stability is then synonymous with the absence of bank failures. The
importance of this feature lies in the concept of asymmetric information and the particular role
it plays in the financial system. If insiders in the banking system are thought to possess a
relatively better understanding of the state of the financial system than the outsiders (e.g.,
depositors), a shock to a particular bank or segment of the financial system may lead outsiders to
paint all participants with the same brush, thereby prompting a run on the banks. This would lead
to a further contraction of the money supply, through the well-known multiplier process,26
leading to a further diminution of the intermediation process. The consequences of asymmetric
information for the severity of the Great Depression was noted by Mishkin (1978).
While the number of bank offices or branches fell off substantially in both countries,
and bank runs, whose social costs continue to be debated (e.g., Calomiris and Mason (1997)),
figured prominently, the Canadian experience was marked by a contraction in the size and reach
of existing banks (from 18 in 1920 to 10 in 1929), as only one bank, the Home Bank, failed in
1923. Thus, adjustment in Canada occurred mainly via mergers and acquisitions and not
widespread bank failures as in the US.27 It is, among other factors considered, an important
element in the story of the Great Slump because Haubrich (1989) argues that the contraction in
intermediation services did not have a separate impact on Canadian output as did the US crisis in
banking (also see Calomiris (1993)). Hence, whereas the costs of providing intermediation
services should not have risen in Canada they did so in the US and so further exacerbated the
output decline. Yet, banks in Canada (and the US) did engage in portfolio reallocation as loans
declined by over 50% from 1929 until 1936 while holdings of government securities rose about
four-fold over the same period.28 A more satisfactory explanation may be that Canadian
depositors had more confidence than their American counterparts in the efficiency and
productivity of the financial system. As a result, the US banking system was perhaps more
17
“fragile” than the Canadian one. While there is no evidence to support this hypothesis for
Canada, Cooper and Corbae (1997) develop a model to suggest that the US banking system was
fragile at the outset of the Great Depression. So we are still left with the perhaps startling
conclusion that the much-touted stability of the Canadian banking did not make the country
immune to the severity of the Great Contraction. Therefore, other factors must be at play.
How important was the absence of a central bank (i.e., lender of last resort)? Under a
gold standard rule, the automatic nature of the system would suggest the lender of last resort
function is rather unimportant or unnecessary. As we have seen, however, the “rules of the game”
were not strictly followed. In the Canadian context, monetary policy actions were influenced by
government via the Finance Act of 1914, originally meant to assist the agricultural sector
through crisis, but ended up extending loans more generally. The Government of Canada
essentially acted as a lender of last resort, though it was a modest role at best.29 An additional
source of funds for the Canadian banking system were reserves held in US dollars. Hence, while
other countries (e.g., France) resisted treating the US dollar as a reserve currency, Canada did
not.30 Moreover, Bordo and Redish (1987) argue that political considerations, not the desire to
have a lender of last resort after the Gold Standard ended, explain the emergence of a Canadian
central bank in 1935. Indeed, the creation of the Bank of Canada was a direct outcome of reforms
is viewed as one of the ingredients in the recovery from the Great Depression necessitated by the
need for instruments of monetary policy in a world without the automatic constraints provided by
the Gold Standard (Shearer and Clark (1984)). Nevertheless, it is worth noting that in spite of
institutional differences between the US and Canada in the realm of monetary policy, economic
performance in the two countries is similar so it is hard to believe that the transmission of
economic shocks from the US to Canada were insignificant (Siklos (1999)).
5.
The Consequences: Reform and Recovery
If economists are interested in the impulse and propagation of the Great Depression,
they are equally interested in the timing of the recovery from that same event. As shown in
18
Figures 3 and 4 both economic activity in general, and commodity prices in particular, rebounded
quickly and sharply from Depression era lows. As for explanations for this outcome, there is
relatively less debate. Friedman and Schwartz (1963) argue that the deposit insurance in 1934 in
the US marked the turning point. Wigmore (1987) suggests instead that the end of the Gold
Standard in April 1933 marked the beginning of recovery. Since these two events are temporally
close to each other it seems difficult to empirically identify the relative importance of one
impulse over the other.31 Vernon (1994) points a finger at the enhanced role of fiscal policy in
the aftermath of the slump. Eichengreen and Sachs (1985) and Choudhri and Kochin (1980),
place a great deal of emphasis on the exchange rate regime, though neither article considers the
Canadian experience. Cole and Ohanian (1999, 2001), however, are an exception. They argue that
the recovery from the Depression was much milder than expected, and cannot be explained by the
neoclassical approach. They “...conjecture that government policies toward monopoly and the
distribution of income are a good candidate...” for the weaker than expected recovery, a theme
also emphasized by Prescott (1999) who also cautions that international evidence is necessary.
Beyond the initial impetus for change, following the earlier debacle in monetary policy,
lay almost a decade’s worth of reforms that, as Timberlake (1993, p. 274) puts it: “... is almost
too much for mortal mind to assimilate, let alone explain.” The abandonment of the Gold
Standard and the centralization of Federal Reserve power at the Board of Governors, embodied in
the passage of the Banking Act of 1935, were the highlights of monetary reforms of the 1930s.
By contrast, the recovery in Canada was rather more placid with the introduction of the Bank of
Canada being the major milestone. Unlike the US experience, deposit insurance was not
introduced in Canada.32 It is interesting to note that studies referred to earlier which purport to
show that the impulse for Canada’s Depression was not the US experience fail to come to grips
with why Canada’s recovery so closely paralleled that of the US. Was it part of a natural secular
renewal reflecting the depths of the downturn? Was international cooperation, in the form of the
World Economic Conference in June 1933, a factor in the return to growth? In Eichengreen’s
(1995) view, the Conference was an “utter failure”. Rather, the Tripartite agreement between the
19
US, the UK and France, combined with a large US devaluation undertaken by President
Roosevelt, interpreted as a regime change in Temin’s (1989) view, were catalysts in freeing
major economies from their “golden fetters”.
Yet, there are aspects of the recovery that have not been fully investigated. For example,
the apparent asymmetry in business cycles has not been fully explained nor the role played by
institutional considerations or government involvement in the process. It seems clear, however,
that recovery was not as complete in Canada as in the US (e.g., see Figure 3). The incompleteness
of the Canadian recovery might suggest that an important element in its economic performance
originates from domestic sources. Yet, both capital flows (Obstfeld and Taylor (1997, Table
2.1)), and the terms of trade (Safarian (1959, chapter 5)), recovered slowly so the international
transmission of business cycles should not be underestimated.
All studies of the recovery must contend with the “shock” of World War II which, in
historical terms, came shortly after the bottom of the Depression had been reached. In part for
this reason an alternative approach asks: What if policy makers had not been blinded by the
ideology of the Gold Standard? In other words, what if the Great Depression had never happened?
Speculations of this kind require constructing a “counterfactual” experiment. A simple example
is Eichengreen’s (1995, chapter 10) argument that an open market operation (i.e., buying of
government bonds) would have offset the fall in the money supply in 1931-32 in the US. A more
elaborate approach (e.g., Bordo and Eichengreen (1997)) supposes that “stable” monetary
policies in a (fractional) Gold Standard would have averted disaster including the unexpected
deflation of the early 1930s. Unfortunately, the authors are unable to nail down the impact of the
No Great Depression hypothesis on overall economic performance. Instead, they speculate that
the Gold Standard in some form would have lasted beyond World War II. Bordo, Choudhri and
Schwartz (1998) also use a counterfactual experiment to show that an expansionary monetary
policy in the 1931-33 period would have averted not only the banking panics but the consequent
loss of gold reserves would not have been large enough to reduce the gold ratio below the
stationary minimum requirement. Interestingly, none of the counterfactuals consider how an
20
earlier introduction of a large fiscal stimulus may also have avoided the onset of the Great
Slump. One of the most striking examples perhaps of a counterfactual experiment is the one
suggested by Sims (1998). He asks: what would the behaviour of the Federal Reserve, as
represented by movements in interest rates it can control or influence, have been during the
inter-war era (1919-38), a sample that overlaps the period of the Great Depression, if central
bank policy had been conducted along the same lines as in the post World War II era? Sims
concludes that “better” monetary policy could not have prevented the Great Depression. The
surprising result, however, is open to two strong objections. First, the structure of the economy
during the inter-war years cannot possibly be compared with the one prevailing in the post 1945
era. Second, Sims’ approach does not explicitly take into account the fact that the 1919-38
period was marked by a string of financial crises while the post World War II era, for the most
part, was not similarly afflicted.
While interesting, counterfactuals assume that correct monetary decisions would have
been possible. But, as the masterful works of Eichengreen (1995), Friedman and Schwartz
(1963) and Temin (1989) show, one ignores the impact of the intellectual milieu of the era at
some risk. Yohe (1990), Timberlake (1993), and Calomiris and Wheelock (1997) provide
fascinating accounts of how ideology is a notion not easily embedded in any model.
Notwithstanding the internal consistency of the Gold Standard system, simulations also presume
that, if only a better policy option has been presented to decision-makers, the Great Depression
could have been avoided. This type of optimism is not shared by those, such as adherents to the
modern political economy literature, who argue that only clearly spelled out, accountable, and
binding institutional constraints will lead to desirable and credible economic outcomes.
There is, of course, another way out of the dilemma facing policy makers in how much
self-imposed institutional constraints should be placed on them. Thus, for example, if an
autonomous monetary authority – deemed desirable – implements “bad” policy, the fiscal
authorities may simply decide not to “play the game” and introduce policies to offset the
negative outcomes from the prevailing monetary policy. But then there still remains the potential
21
for economic activity to become more volatile than through institutional devices which ensure
that “good” monetary policy is practiced.
6.
Concluding Remarks
Almost seven decades after the end of the Great Depression, economists have learned
much from the Canadian and US experiences about how economic shocks are transmitted across
countries and the role and importance of personalities who make and implement economic
policies.
Is there a consensus then amongst economists about why the Slump took place, why it
was so severe, and the ingredients of the recovery? Eichengreen and Temin (1997) would have us
believe this is so. Contrary to historians, the authors suggest that there “... now prevails a
remarkable degree of consensus among specialists about the causes of the Great Depression”.
They return to the themes listed in the opening section of this paper, namely the ideology of the
Gold Standard and central bankers’ attitudes about the proper policies in the face of economic
shocks. While this much is probably true there is still room for disagreement amongst
economists. Whaples (1995) reports what is, in effect, a lack of consensus on the causes of the
Great Depression. Based on a survey of 178 US members of the Economic History Association
(EHA), only 31% of historians in the EHA agreed or partially agreed with the notion that
monetary forces caused the Depression, while 52% of economists in the EHA agreed with this
principle. By contrast, 61% and 51% of economists and historians, respectively, traced the
impulse to the Great Slump to a real shock. Consensus, if any, appears greater about Temin’s
great shock hypothesis than Friedman and Schwartz’s view. Interestingly, far more consensus
was found concerning the proposition that the right mix of policies could have prevented the
Depression (75% of economists and 78% of historians agreed with this idea). Indeed, this survey
has also suggested that there is disagreement about the extent to which shocks are transmitted
across countries.
22
The foregoing survey of views suggests that it is clearly unsatisfactory to suggest that a
single cause is responsible for such a cataclysmic global event. Nevertheless, what is striking
about the US-Canadian experiences is that, despite differences between the two countries’
financial structures, both countries suffered a tremendous slump. Either institutional structures
are not sufficient to insulate a country from large foreign shocks or the role of institutional
factors, and how economic policy can short-circuit their role in the Depression and its aftermath,
is not yet sufficiently understood. One thing is certain, however. Regardless of how the Great
Depression began and whatever the significance of US shocks on the Canadian economy, the
principal lesson of the interwar years is that, in the area of monetary policy, ideology is no
substitute for good judgement. One can only hope that the availability of better models and data
that permit more objective assessments of the likely future course of the economy, an
institutional by-product of the Great Slump as it happens, reduces the obstacles created by a
slavish adherence to a particular economic ideology.
23
ENDNOTES
1
In its purest form, the cost of holding money is part opportunity cost, part cost of
storing gold reserves, part cost of transacting in gold coins.
2
As argued by one of the supporters of the Gold Standard, Sir John Bradbury, at the time
Churchill was debating whether or not the UK should return to gold.
3
David Hume, the famous 18th century Scottish economist, first described the process.
“Specie” is gold, silver, or other precious metal used as money.
4
Trade and investment ties between the US and Canada were also strong, of course.
During the period in question roughly 2/3 of imports were from the US while
approximately 60% of foreign capital invested in Canada came from US sources. But
ties with the UK also remained strong since over 1/3 of investment in Canada came
from the UK while over 1/3 of Canadian exports went to the UK. Imports from the UK,
by contrast, accounted for less than 20% of Canada’s total imports. Unfortunately, there
are limitations in the available data which make it difficult to determine precisely how
trading patterns were affected by the Great Depression.
5
Thus, financial dislocation, in the form of reduced, though still large, capital flows
suggests one avenue through which the Great Slump may have been transmitted from the
US to Canada. Yet, there is a suspicion that there is more to it than that since Figures 1
and 2 suggest that other forces may also have been at work.
6
While it is hazardous under the circumstance to compare the relative sizes of the two
economies, the sheer size of the US economy is surely a factor by itself. US nominal
GDP over the 1926-37 period was approximately 18 times Canada’s nominal GDP.
7
Indeed, Diebold and Rudesbusch (1990) find substantial differences in the duration of
pre World War I versus post World War II business cycles. I do not discuss the
comparative behaviour of unemployment rates in the two countries. Zagorsky (1998)
shows that existing data, which purport to show significantly lower unemployment rates
in Canada during the Great Depression, are misleading. Each country handled depression
relief workers differently. The US treated these individuals as unemployed, Canada did
not.
8
Peaks in the US business cycle are usually dated 1 to 5 months before those in Canada,
while the dating of troughs is usually 1 month ahead in the US.
9
Indeed, comparisons between the 1920s and 1930s deflations, using a general
equilibrium business cycle model, leads Cole and Ohanian (2001) to suggest that the
Great Deepression remains a puzzle. In contrast, Bernanke (1995) argued that, while
aggregate demand side related questions about the Slump were largely answered, there is
as yet no convincing story about the aggregate supply response to the Depression.
11
Readers wishing a slightly more technical description of the problem are asked to
consult the appendix.
Sumner (1992) suggests that news contradicting the public’s expectations about the
likely degree to central bank cooperation may have contributed to heighten uncertainty
about the future monetary policy. A proxy for “uncertainty” would be the standard
deviation in either a measure of real income (e.g., real GDP) or in a stock price index.
Modern empirical macroeconomics tends to rely on more sophisticated measures of
volatility derived from the variance of the residuals from some regression estimate
24
describing the relationship between economic series of interest. A fuller analysis of this
procedure is, however, beyond the scope of this paper.
12
Based on data in column (2) of Table B.2 in Dick and Floyd (1992).
13
The choice of 1928 is arbitrary in a sense but it has the advantage that it omits the period
most economists would describe as the Great Depression period.
14
Various other tests were conducted, including the pooling of US and Canadian data into
a cross-section time series format. All such tests yielded the same result, namely that
inflation persistence was roughly the same in the US and Canada and approximately the
same in the 1920s as in the 1930s.
15
That is, at the time the contract expires at which time the relevant commodities are
delivered at the agreed upon price.
16
For interested readers, an Appendix figure plots
Hamilton’s data.
t
for the case of corn and oats, using
17
Indeed, using model (2), estimated during the period 1919-28, continues to perform
quite well when forecasts for the 1935-37 period are made.
18
According to this theory, consumers look beyond their current level of income in
determining consumption and savings levels. See Siklos (2001, Chapter 9).
19
The average real interest rate in the US rises to 10.21% if we begin calculations in
1920.
20
Bonser-Neal and Morley (1997) provide a thorough and introductory exposition on the
subject.
21
For example, inflows of gold totaled 1432 millions between 1921-24. Meanwhile, loans
by investment brokers to their clients rose 400% between 1919 and 1928 while
installment credit rose almost 300% between 1919 and 1928. Based on figures in
Historical Statistics of the United States: Bicentennial Edition (1997 CD-ROM), series
X547 and X551 and Board of Governors of the Federal Reserve System (1976), Table
158.
22
An aspect of the debate not discussed here is the role played in the propagation
mechanism by the flexibility of nominal wages. Unlike the apparent downward rigidity in
nominal wages prevalent today, there was little such rigidity in the interwar era.
Bernanke and Carey (1995) point out that Eichengreen (1995), for example, makes only
a passing reference to the development of real wages during this era. See also note 4
above for an explanation of data limitations in the Canadian context.
23
A similar occurrence took place after Canada devalued the dollar in 1949. The Canadian
dollar floated until 1961 over objections by the International Monetary Fund about
violating the Bretton Woods monetary standard. At the time of devaluation the Canadian
dollar was set at 90.9¢ US. In 1961, when the $C was pegged anew the rate was 92.5¢.
24
Obviously, nominal interest rates cannot go below 0% but real interest rates can rise
with the severity of the deflation.
25
Through various regulatory measures meant to significantly raise the cost of entry into
banking. See Siklos (2001, chapter 17). Wheelock (1992, 1995) also provides a
thorough review of the US financial system during this period.
25
26
See Siklos (2001, chapter 16) for a basic introduction to the concept of a money
multiplier.
27
If the adjustment was somehow assisted by a government bail-out then the stability of
the Canadian banking system was a myth. This is the argument of Kryzanowski and
Roberts (1989) but is persuasively refuted by Carr, Mathewson and Quigley (1995).
Kryzanowski and Roberts (1999) reply that when one corrects for the difference
between market value and book value on a bank’s balance sheet, some Canadian banks
during the Depression were technically insolvent.
28
Based on data in Urquhart and Buckley (1983), series J191, J146 and J138.
29
Advances under the Finance Act never exceeded $82 million CDN (in 1929), less than
2% of bank assets at the time. Based on data in Urquhart and Buckley (1983), series
J182 and J198.
30
For this reason, authors such as Rich (1988), and Dick and Floyd (1995), define the
Canadian monetary base to include bank reserves of US dollars.
31
Coe (1998, chapter 3) uses some sophisticated econometric technique and concludes
that the introduction of deposit insurance is the event which launched recovery in the
US.
32
Siklos (2001, chapter 19) discusses the successful lobbying by Canadian chartered
banks to prevent the introduction of deposit insurance in Canada (until 1967).
26
TABLE 1
TRADE, CAPITAL AND MONETARY MOVEMENTS: CANADA, 1927-1937
Year
Current Account
Balance
Capital Account
Balance
Net Official
Monetary
Movements
(Millions of dollars)
Gold Standard Era
1927
1928
1929
1930
1931
Post-Gold Standard Era
1932
1933
1934
1935
1936
1937
-10
-32
-311
-337
-174
+3
+77
+62
-19
+54
+7
-49
-37
+36
-33
-96
-2
+68
+125
+244
+180
+60
+33
+27
+32
-2
-17
-3
-6
+4
+6
+5
+6
Source: Urquhart and Buckley (1983), series G83, G109, and G115. A positive sign implies a
surplus in the current or capital account balances; a negative sign a deficit. A positive
sign in Net Official Monetary Movements means a net inflow of gold; a net outflow
occurs when the sign is negative. After 1935, the figure also includes foreign currency
holdings held by the Bank of Canada.
27
TABLE 2
MODELLING THE BEHAVIOUR OF INFLATION
Dependent
Variable:
Annual
Inflation Rate
US
Independent Variables
Constant
Lagged inflation rate
1919-28
-3.05(5.26)
.64(.07)
1919-37
-2.33(2.92)
.54(.06)
Canada
1919-28
-.17(2.22)
.54(.08)
1919-37
-.96(1.20)
.40(.06)
Source: Inflation is the annual inflation rate calculated as (log P t - log P t-12 ) x 100. The
Wholesale Price Index was used for the US; the Consumer Price Index for Canada.
Lagged inflation is the previous year’s inflation rate. Standard errors (Newey-West
corrected) are in parentheses.
28
FIGURE 1
SHORT-TERM INTEREST RATE MOVEMENTS IN CANADA
AND THE UNITED STATES, 1930-37
Short-term Interest Rate Movements in Canada and the United States
6
Gold Standard
5
Percent
4
3
US
Canada
2
1
0
30
31
32
33
34
35
36
Note: For the US, the yield on short-term government securities. For Canada, the yield on short-term
Dominion of Canada bonds. Data on short-term interest rates for Canada not available prior to 1930.
The Gold Standard is dated as ending in April 1933.
Sources: For the US: Cecchetti (1988). For Canada, Nixon (1937).
29
FIGURE 2
PRICE LEVEL MOVEMENTS IN THE US AND CANADA, 1925-1931
US Wholesale Prices, 1926=100
140
130
100
120
90
110
80
100
90
70
26
Note:
27
28
29
30
Canada Wholesale Prices, 1935-39=100
110
US
Canada
31
Monthly data on Wholesale Price Index Movements, April 1925-August 1931, inclusive. The
Gold Standard was in effect throughout. Although the left hand and right hand side scales differ
the plots are used to make inferences about the changes or the evolution of price changes, not
their levels.
Source: Brecher and Reisman (1957), Table 1 (Canada), Table 16 (US), Appendix A. The series are not
seasonally adjusted.
30
FIGURE 3
BUSINESS CYCLES IN THE US AND CANADA
US Business Cycles
70
Gold Standard >
ends
Index 1947-49=100
60
50
Ind. Ption
40
30
20
20
22
24
26
28
30
32
34
36
Business Cycles in Canada
140
Gold Standard >
ends
Index 1935-39=100
120
100
Ind. Ption
80
60
40
20
Sources:
22
24
26
28
30
32
34
36
Industrial Production: Brecher and Reisman (1957), Table 2 (Canada), Table 11 (US),
Appendix A. Reference cycle dates: www.nber.org (US), and Hay (1967, Table 1) for
Canada. The shaded areas refer to the peak to trough periods (recession).
31
FIGURE 4
SELECTED COMMODITY PRICES IN THE US AND CANADA
Selected Commodity Prices: Canada, 1919-37
100
250
80
200
60
150
40
100
20
Wheat, cents per bushel
Wood, WPI (1935-39=100)
Oats, cents per bushel
Gold Standard >
ends
Oats
Wheat
Wood
50
20
22
24
26
28
30
32
34
36
Selected US Commodity Prices: US, 1920-37
160
100
Gold Standard >
ends
80
120
100
60
80
60
40
Oats, cents per bushel
Corn, cents per bushel
140
Corn
Oats
40
20
20
20
Sources:
22
24
26
28
30
32
34
36
For Canada: Urquhart and Buckley (1983), series K38 (wood products and paper), M228
(wheat), and M233 (oats). For the US: Hamilton (1992). The original data were
trimestrial and annual averages were calculated and plotted above. Also, see notes to
Figure 2.
32
FIGURE 5
THE EVOLUTION OF ESTIMATES OF MEASURED TO PERMANENT INCOME:
US AND CANADA
Ration of Measured to Permanent per capita Income
The Evolution of Estimates of Measured to Permanent Income: US and Canada
0.95
0.90
0.85
0.80
Canada
US
0.75
0.70
Gold Standard
period
0.65
20
22
24
26
28
30
32
34
36
Source: Bordo and Jonung (1987). Appendix 1B explains how their measure of permanent income is
constructed.
33
FIGURE 6
SELECTED FINANCIAL INDICATORS IN THE US AND CANADA
Selected Financial Indicators for the US, 1922-37
40
3
20
2
0
1
-20
0
-40
-1
Great
Depression
-2
22
24
26
28
30
32
Short-term int. rate less inflation
Long-term less short-term yield
4
Spread
Real Int. rate
-60
34
36
25
1.5
20
15
1.0
10
0.5
5
0.0
0
-0.5
-5
Great
Depression
-1.0
Spread
Real Int. rate
-10
29
Note:
Short-term int. rate less inflation
Long-term less short-term yield
Selected Financial Indicators for Canada, 1929-37
2.0
30
31
32
33
34
35
36
37
The spread is the yield on long-term government bonds less the yield on short-term
government bonds. The real interest rate is the yield on short-term government bonds less
inflation in the Consumer Price Index (Canada), Wholesale Price Index (US). Inflation is the
log difference of the chosen price level evaluated over a three month horizon. The real interest
rate calculation assumes investors predicted exactly the inflation rate over the holding period
(assumed here to be three months). The period of the Great Depression is dated 1929 October
- 1933 December.
Sources:
CPI for Canada, series P10000 from Statistics Canada. WPI for the US from Brecher and
Reisman (1957), Table 16, Appendix A. Yield on short-term government securities from
Board of Governors of the Federal Reserve System (1976), 1919-28, and Cecchetti
(1988), Table A1 (US); Nixon (1937), Table VI for Canada.
34
FIGURE 7
ACTUAL AND FORECASTED INFLATION: US AND CANADA, 1930-32
US
Annual inflation (%)
0
-5
-10
Actual inflation
Inflation forecasts
-15
-20
30:01
30:07
31:01
31:07
32:01
32:07
Canada
Annual inflation rate (%)
4
0
-4
-12
-16
30:01
Note:
Actual inflation
Inflation forecasts
-8
30:07
31:01
31:07
32:01
32:07
Inflation forecasts based on the application of estimates of (6) for the 1919-28 sample for
both countries. Estimates are given in Table 2.
Source: Table 2.
35
FIGURE 8
MONEY SUPPLY IN CANADA AND THE US: M2, 1919-37
45000
2400
40000
2200
35000
2000
30000
Great
Depression
1800
20
Note:
22
24
26
28
30
32
Millionsof $US
Millions of $CDN
Money Supply in Canada and the US: M2, 1919-37
2600
Canada
US
25000
34
36
For the US, M2 is the sum of currency held by the public and total deposits (demand and time).
For Canada, M2 is currency and total deposits. The Great Depression is dated 1929-1933.
Sources:
Bordo and Jonung (1987), Courchene (1969), and Metcalf, Redish and Shearer (1998).
36
FIGURE A1
THE BEHAVIOUR OF SPOT AND FUTURES COMMODITY PRICES: US, 1920-37
Futures price less spot price, one period ahead (4 months)
The behaviour of Spot and Futures Commodity Prices: US, 1920-37
80
60
40
20
Fut. less spot(t+4)-OATS
Fut. less spot(t+4)-CORN
0
-20
-40
-60
20
Note:
22
24
26
28
30
32
34
36
Data from Hamilton (1992). Also, see notes to Figure 4.
37
FIGURE A2
THE EVOLUTION OF BANK OFFICES IN THE US AND CANADA, 1919-37
The Evolution of Bank Offices in the US and Canada, 1919-37
35000
4800
US No. Bank Offices
4400
4200
25000
4000
20000
3800
3600
15000
3400
10000
3200
20
22
24
Source: Bordo and Jonung (1987).
26
28
30
32
34
36
Canada - No. Bank branches
4600
30000
No. Bank Off. - US
No. Bank br. - Canada
38
FIGURE A3
EXCHANGE RATE BEHAVIOUR
The Highs and Lows of the Canadian/U.S. dollar Exchange Rate
Canadian dollars per 1 U.S. dollar
1.30
Convertibility >
ends
1.25
1.20
1.15
1.10
1.05
1.00
0.95
20
22
24
26
Average
28
30
32
High
Source: Urquhart and Buckley (1983), series J560, J561, J562.
34
Low
36
39
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44
Appendix – Identifying Shocks in Econometric Models: Basics
Suppose the economist believes that the correct model (called “structural”) linking, say, US
and Canadian output can be represented by the following equations:
C
C
ytC = β10 − β12 ytUS + δ11 y US
t −1 + δ12 y t −1 + ε t
(2)
US
ytUS = β20 − β21 y tC + δ 21 y tC−1 + δ 22 ytUS
−1 + ε t
(3)
where yC is a proxy for output in Canada, and yUS is US output. The terms εt and εt , respectively, are
C
US
residuals, that is, output movements not explained by the other right hand side variables. Hence, if
economic agents are assumed to operate with a model such as (2) and (3) then the residuals capture the
influence of unexpected policies on output. The model hypothesizes that Canada’s output is determined
by its own current and past history and the current and past history of US output.33 Notice that the model
presumes a contemporaneous link between US and Canadian output (i.e., yt C is affected by yt US, and viceversa). When economists attempt to empirically estimate a system of equations such as (2) and (3), they
find it convenient to transform them (i.e., reparameterize) into a reduced-form which eliminates the
contemporaneous effect of yt C on yt US and of yt US on yt C. Why? Simply because equations (2) and (3)
are not reduced form equations where the right hand side variables are all lagged relative to the
dependent variable. Since the details of such transformations are not essential,34 we simply state the
result:
ytC = α10 + α11 y tC−1 + α12 y US
t −1 + ε1t
(4)
C
ytUS = α20 + α21 ytUS
−1 + α22 y t −1 + ε 2t
(5)
If the economist is interested in the coefficients in (2) and (3), but estimates (4) and (5), then 6
coefficients are estimated (α10, α11, α12, α20, α21, α22) when 8 coefficients are of interest (β 10, β 12, β 20,
β 21, δ 11, δ 12, δ 21, δ 22). Clearly, the “structural” parameters cannot be estimated unless we impose some
economically sensible restrictions. For example, it is sensible to suppose that US output affects
Canadian output, but not vice-versa. This would mean β 21=0. The number of structural parameters is
therefore reduced and this solves our problem.35
45
33
To keep the analysis simple I only allow a one period lag. Extensions allowing more lagged
terms would not fundamentally change the arguments to be outlined below.
34
See, for example, Enders (1995, chapter 5) for a description.
35
An additional problem arises because estimation requires that the residuals in (4) and (5) be
“well-behaved” (i.e., uncorrelated with a constant variance). Unfortunately, this requirement
often does not hold since many macroeconomic time series contain trends (e.g., see Figure 2
for the case of wholesale prices in Canada and the US). A common solution is to take first
differences in variables such as yt C and yt US. However, if the econometrician simply estimates
(4) and (5) in first differences then an additional restriction is potentially ignored, namely one
which might link output levels in the two countries (i.e., yt C and yt US), and presumably describes
their long-run relationship.