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28 The Great Depression: Unemployment rate (%) A focal event in US economic history 24 20 16 12 8 Keynes 4 1 1928 1930 1932 1934 1936 1938 1940 Housekeeping Midterm on Wed October 13 11:35-12:50 pm Sterling Chemistry Lab 110 (NOT Dunham Lab) Remember open TF office hours and review sessions (see class web site). Final questions? 2 Gilded era of the 1920s Stability restored to U.S. economy in 1920s after WW I. Problems surfaced with real estate and stock market booms. The Great Crash, October 1929 Key Elements in the Great Depression 1929-1933 • • • • • • • • • Started as standard recession and deflation Remember world was on gold standard (fixed exchange rate system) Multiple bank failures through 1933 (standard panic model) Breakdown of Gold Standard, particularly with Britain’s leaving gold in 1931. Collapse of investment and international trade after 1929 Government and Fed took hesitant steps to stimulate the economy – Federal government wanted to balance the budget (like several candidates today…) – Fed was serving too many masters (more on this later) Output kept falling, and unemployment kept rising Trough finally reached in 1933, but no sharp recovery Remember that Keynes’s General Theory not published until 1935: macroeconomics was born a decade too late. 5 Fear and panic on Wall Street, then and now 180 Great Depression (1928-1933) Great Recession (2007-2010) 160 140 120 100 80 60 40 20 1928 1929 1930 1931 2007 2008 2009 2010 1932 1933 6 Bank failures and panics, 1931-1933 Real GDP (peak = 100) 108 104 100 96 92 88 84 80 76 Depression Recession 72 68 1929 1930 1931 1932 2007 2008 2009 2010 1933 8 On Main Street with unemployment rate… 30 25 20 15 10 5 0 26 27 28 2007 29 30 31 2010 32 33 34 35 36 37 9 Over-farming the marginal lands and the Dust Bowl Economic migration Migrant worker High unemployment for a decade Tales of the labor market in recession/depression: “I’d get up at five in the morning and head for the waterfront. Outside the Spreckles Sugar Refinery, outside the gates, there would be a thousand men. You know dang well there’s only three or four jobs. The guy would come out with two little Pinkerton cops: “I need two guys for the bull gang. Two guys to go into the hole.” A thousand men would fight like a pack of Alaskan dogs to get through. Only four of us would get through.” Studs Terkel, Hard Times. 14 Growth in Key Indicators Period 1927:10-1929:8 1929:8-1931:12 1931:12-1933:4 H M1 Real M1 Ind. Prod. 42.7% 2.0% 6.5% 1.1% -8.1% -10.5% 1.4% -0.9% 0.6% 11.6% -22.4% -10.2% Real GDP Inflation 3.8% -6.7% -11.9% -0.3% -7.3% -11.0% H = high powered money. Periods are: 1. Pre-crash boom 2. From crash to Britain’s leaving gold 3. From gold crisis to trough Note: rates of change at annual rates. 15 Alternative views of the sources of the GD I. I. AS theories: exist but are in my view defective AD theories “Expenditure view”: IS or spending shocks Financial market distress: LM or financial shocks 16 IS interpretation of the depression interest rate (i) IS1929 IS1933 LM Y1929 Y1933 0 Real output (Y) 17 I. The Expenditure Approach: IS Shocks Were shocks in the IS curve responsible? From NX, C, G? – Foreign trade, government spending and taxes were too small – No exogenous consumption shock From I? – Investment decline was the major shock. – Mechanism is unclear, but probably due to shift to “bad equilibrium” (panics, risk, high risk premiums, low investment. A variant of the IS curve shift.) 18 II. Financial Market Background • Central banks generally have to serve three masters in different mixes over time. This was the Fed’s trilemma in 1928-33. 1. exchange rates (gold standard and convertibility) 2. macroeconomy (inflation, output, and employment) 3. financial market stability (asset prices, panics, liquidity) • Fed was primarily concerned about (#3) speculation in 1928-29 and tightened money at that point. • When depression was underway, Fed was primarily concerned with defending the gold standard (#1) until 1933 and didn’t expand M sufficiently. • From 1933 on, after US depreciated and others left gold, Fed was divided about how strongly to stimulate the economy because of poor macro understanding (#2). 19 Money in the Great Depression 1.2 1.1 1.0 0.9 0.8 0.7 0.6 0.5 0.4 28 29 30 31 32 33 34 35 M1 (1929 = 1) Industrial production (1929 = 1) 36 20 Friedman and Schwartz and the Monetarist Argument • Classic study of the Great Depression is Milton Friedman and Anna Schwartz, Monetary History of the United States, which held the “monetarist” view. “Throughout the near-century examined, we have found that: Changes in the behavior of the money stock have been closely associated with changes in economic activity, money income, and prices. The interaction between monetary and economic change has been highly stable. Monetary changes have often had an independent origin; they have not been simply a reflection of economic activity.” (p. 676) • F&S view the depression as primarily driven by “incompetent” monetary policy caused by decline in money supply. • Argue that rise in M1 could have prevented Y fall and nipped GD in bud • While it is true that M1 fell, it is likely to be a consequence rather than a cause of the Depression (Tobin). Monetarism, the Depression, and IS-LM interest rate (i) LM‘ LM i** i* IS Y** Y* Real output (Y) 22 Interest Rates 1920-39 Problem with LM/monetarist interpretation: Safe interest rates fell in GD!!! Interest rate (% per year) 10 8 6 4 2 0 20 22 24 26 28 30 3-month T-bill Fed discount rate (low) 32 34 36 38 40 Corporate bond rate Commercial paper rate 23 The Fed Discount rate during the Great Depression Federal Reserve Discount Rate 7 6 5 What in the world were they thinking? 4 3 2 1 0 26 27 28 29 30 31 32 33 34 35 36 37 24 Great Depression and Great Recession 7 Discount rate (1926-1937) Fed funds rate (2005-2010) 6 5 4 3 2 Compare then and now! 1 0 26 27 28 2007 29 30 31 2010 32 33 34 35 36 37 25 Bad equilibrium view of Great Depression A final approach: 1. Had a huge IS shock due to risk, panics, and sent economy into a “bad equilibrium” with high risky real interest rates. 2. This forced economy into a liquidity trap (like today), so that monetary policy was ineffective. 3. Got locked into “bad equilibrium” of deflation, high risk premiums, fear, and low spending. 4. And that lasted until 1940! 26 6 US short-term interest rates, 1929-45 (% per year) Liquidity trap in US in Great Depression 5 4 3 2 1 0 1930 1932 1934 1936 1938 1940 1942 1944 interest rate (i) IS1933 IS1929 LM1929 = LM1933 LM1939 Y1929 Y1933 0 Y1939 Real output (Y) 28 The Roosevelt Presidency (1933-1945) “We have nothing to fear but fear itself.” The New Deal Programs (WPA Sleeping Giant Tower) Recovery from the Great Depression • The end of the Great Depression: – Military mobilization for World War II led to ENORMOUS increase in G starting in 1940. – Recovery took off in 1940. • This Standard IS shift … no puzzle here! 31 The rise of the dictators (1917 - ) World War II (1931-1945) Military spending takes off… The end of the depression … 30 .6 15 10 Pearl Harbor Germ invastion Austria, Czech 20 .5 Germ invasion France 25 Germ. invastion Poland WW II .4 .3 .2 5 .1 0 .0 30 32 34 36 38 40 42 44 Unemployment rate Defense spending/GDP Federal expenditures/GDP 46 48 35 interest rate (i) IS1939 IS1945 WW II LM Y1945 0 Y1939 Real output (Y) 36 Can you see why macroeconomists emphasize the importance of fiscal policy in the current environment? “Our policy approach started with a major commitment to fiscal stimulus. Economists in recent years have become skeptical about discretionary fiscal policy and have regarded monetary policy as a better tool for short-term stabilization. Our judgment, however, was that in a liquidity trap-type scenario of zero interest rates, a dysfunctional financial system, and expectations of protracted contraction, the results of monetary policy were highly uncertain whereas fiscal policy was likely to be potent.” Lawrence Summers, July 19, 2009 Implication of the Recovery • Recovery from GD required an increase in high-employment federal deficit of 20-25 percent of GDP – Would be equivalent of $3 trillion deficit today! • The magnitude of the fiscal shock required for recovery suggests that no minor M or F expansion would cure GD quickly. 38 Summary • The depth and severity of the Great Depression remains one of the continuing debates of macroeconomics. • Probably no simple approach can explain the entire story – Warning: avoid the seduction simplicity of monocausal approaches. • Perhaps a complex situation where combination of factors piled up to produce a “perfect storm” of macroeconomics: – bad luck (boom of 1920s and bust of 1929) – poor institutions (gold standard and fragile banking system) – poor international coordination (legacy of WW I) – inadequate understanding of macroeconomics (before Keynes’s theory) – inept policy response (cling to gold standard, no fiscal response) – bad dynamics (panic, high risk premia, deflation, and liquidity trap) • Can it happen again? To answer need to understand how macroeconomic theory and institutions have evolved. 39