Download Lessons of the Great Depression

Lessons of the Great Depression and
Great Recession for Current Policy
Scott Sumner, Mercatus Center and Bentley University
The consensus view
 “The worst financial crisis in the history of the United
States and many other countries started in 1929. The
Great Depression followed. The second-worst struck in
the fall of 2008 and the Great Recession followed.
Commentators have dwelt endlessly on the causes of
these and other deep financial collapses. Less
conspicuous has been the macroeconomists’ concern
about why output and employment collapse after a
financial crisis and remain at low levels for several or
many years after the crisis.” (Robert Hall, JEP, 2010.)
Timeline of Great Contraction
 August 1929: Depression Begins
 October 1929: Stock market crash
 November 1930: First (small) banking crisis
 Mid-1931: International exchange rate/banking crises
 Early 1933: Gold standard/banking crisis
 Mid-1929 to early 1933: NGDP falls by more than 50%
Cause of Great Contraction
 Negative AD shock, caused by gold
hoarding
 Gold demand rose for three reasons:
1. Private gold hoarding (devaluation fears)
2. Currency hoarding (currency had to be backed by gold)
3. Central bank gold hoarding (higher gold/currency
ratios)
Causal factors in the Great
Depression
The Relationship Between Detrended Industrial Production and
Detrended (inverted) Real Wages, 1929-39, monthly.
Effects of the Great Contraction
 NGDP is the resources available to repay individual,
business and sovereign debt.
 A dramatic decline in NGDP growth will generally
trigger a financial crisis. (E.g. Argentina 2001)
 The crisis will usually be misdiagnosed as a result of
”irresponsible lending”
 Irresponsible lending does often occur, but is generally
just the tip of the iceberg.
Business cycles and asset
prices
Two stock market crashes
1929 and 1987 stock market
crashes compared
 The 1929 and 1987 stock market crashes were almost
identical.
 In both cases stocks fell by about 20% in six weeks,
and then by more than 20% in just one or two days.
 The 1929 crash was followed by the Great Depression.
 The 1987 crash was followed by a boom.
Tight money caused financial
distress
 Tight money (gold hoarding) caused NGDP to
plummet.
 Because most debts are nominal, the sharp fall in
NGDP led to financial distress (albeit far less than a
similar crash would cause today.)
 Financial stress was a symptom of the Depression, but
also led to gold hoarding that worsened the decline.
Musical Chairs Model
 Falling NGDP creates two problems, financial distress
and high unemployment.
 Both problems caused by nominal stickiness: Nominal
debt contracts & nominal wage contracts.
 NGDP is the resources available to pay nominal debts,
and nominal wages.
 When NGDP falls unexpectedly, there is too little
nominal revenue for companies to maintain existing
employment levels High unemployment.
Recovery aborted by wage shocks,
five times
 Four month (nonannualized!) growth rates
for industrial production

July
May
Nov.
Nov.
1933 wage shock
1934 wage shock
1938 wage shock
1939 wage shock
Before
+57.4%
+11.9%
+15.8%
+16.0%
After
-18.8%
-15.0%
+2.5%
-6.5%
What about the Great
Recession?
 NGDP declined about 3%, which was about 8% below
trend.
 The US banking system was far more fragile than in
1929 (Not entirely due to deregulation---system was
also quite fragile in 1980. Moral hazard was also a
problem.)
 Unlike with the Great Depression, financial stress
began before the 2008 recession occurred.
Real GDP: 2007-2010, (monthly estimates from
Macroeconomics Advisors)
Nominal GDP: 2007-2010
The “musical chairs model”
Mishkin’s key lessons for
monetary policy
 1. It is dangerous always to associate the easing or the
tightening of monetary policy with a fall or a rise in
short-term nominal interest rates.
 2. Other asset prices besides those on short-term debt
instruments contain important information about the
stance of monetary policy because they are important
elements in various monetary policy transmission
mechanisms.
 3. Monetary policy can be highly effective in reviving a
weak economy even if short term rates are already
near zero.
Real interest rates on Treasury bonds with a roughly 5 year
maturity; July to November 2008
Commodity prices in 2008
The value of the dollar in late
2008
Other Asset Markets
 Stock prices crashed in late 2008
 Commercial real estate prices started falling
sharply about the same time as NGDP, and long
after the subprime bubble
 Residential real estate prices in the heartland
(Texas, etc.) had been stable during the 2006-08
subprime crash, and started falling in late 2008
along with NGDP
 TIPS spreads (i.e. inflation expectations) fell
sharply.
If you insist on using interest
rates
Friedman on low interest
rates
 “Low interest rates are generally a sign that money has been
tight, as in Japan; high interest rates, that money has been
easy. . . . After the U.S. experience during the Great
Depression, and after inflation and rising interest rates in the
1970s and disinflation and falling interest rates in the 1980s,
I thought the fallacy of identifying tight money with high
interest rates and easy money with low interest rates was
dead. Apparently, old fallacies never die.” (WSJ, Dec. 1997)
Bernanke on monetary
indicators
 The imperfect reliability of money growth as an
indicator of monetary policy is unfortunate, because we
don’t really have anything satisfactory to replace it. As
emphasized by Friedman . . . nominal interest rates
are not good indicators of the stance of policy . . . The
real short-term interest rate . . . is also imperfect . . .
 Ultimately, it appears, one can check to see if an
economy has a stable monetary background only by
looking at macroeconomic indicators such as nominal
GDP growth and inflation.
The housing crash was mostly over before
the unemployment rate began rising sharply.
Jan. 2006: starts = 2,303,000, completions =
2,058,000, average = 2,180,000, U-rate = 4.7%
April 2008: starts = 1,008,000, completions
=1,014,000, average = 1,011,000, U-rate = 5.0%
October 2009: starts = 527,000, completions =
745,000, average = 636,000. U-rate = 10.0%
Kevin Erdmann on US real
estate
 The US has multiple housing markets.
 “Closed access” (15% of population)
 “Contagion cities” (5% of population)
 Intermediate cities (Seattle, Washington DC)
 “Open Access” Most of the country.
 Fundamentals generally explain housing prices during
bubble, except perhaps in the contagion areas.
Housing construction was not
abnormally high in 2006
Bubbles are difficult to spot . . .
. . . especially in foreign
countries
Real housing prices
Share of Treasury debt held by the Fed
Why no recession in Australia?
 Australian growth did slow sharply after 2008, however:
 1996/2 – 2006/2 Aus. NGDP growth = 6.54%
 2006/2 – 2012/2 Aus. NGDP growth = 6.49%
 US growth slowed from 5.5% to 2.6%
 Eurozone growth slowed from 4% to 1.8%
Two examples of fiscal austerity: The US NGDP (red
line) and the Eurozone NGDP (blue line)
Slow Eurozone NGDP growth
depresses bond yields
When the tide goes out . . .
 Bad loans: Subprime mortgages, Greek sovereign
debt
 Declining NGDP growth causes crisis to spread beyond
reckless borrowers. (ordinary mortgages, business
loans, Spanish sovereign debt.)
 European double dip recession causes second
European debt crisis.
Think outside the box
 “Tell me,” the great twentieth-century philosopher
Ludwig Wittgenstein once asked a friend, “why do
people always say it was natural for man to assume
that the sun went around the Earth rather than that the
Earth was rotating?” His friend replied, “Well, obviously
because it just looks as though the Sun is going around
the Earth.” Wittgenstein responded, “Well, what would it
have looked like if it had looked as though the Earth
was rotating?”
Imaginary conversation
 Wittgenstein: Tell me, why do people always say it’s natural
to assume the Great Recession was caused by the financial
crisis of 2008?
 Friend: Well, obviously because it looks as though the
Great Recession was caused by the financial crisis of 2008.
 Wittgenstein: Well, what would it have looked like if it had
been caused by Fed and ECB policy errors, which allowed
nominal GDP to fall at the sharpest rate since 1938,
especially during a time when banks were already stressed
by the subprime fiasco, and when the resources for repaying
nominal debts come from nominal income?