Download 19 Big Events: The Economics of Depression, Hyperinflation, and

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BIG EVENTS: THE ECONOMICS OF
DEPRESSION, HYPERINFLATION,
AND DEFICITS
FOCUS OF THE CHAPTER
• In this chapter we revisit the time period which gave birth to modern macroeconomics: the
Great Depression. We examine the role that both monetary and fiscal policies played in its
beginnings, its continuation, and our ultimate recovery from it.
• We also examine the link between money growth and inflation in normal business cycles and in
hyperinflations. A variety of policy responses to hyperinflation are reviewed; the necessity of
stabilizing government budget deficits in hyperinflationary economies is emphasized.
• The U.S. budget deficit is examined in some detail. There is a brief discussion of the national
debt.
SECTION SUMMARIES
1.
The Great Depression: The Facts
The Great Depression began just before the infamous stock market crash of September 1929, and,
fueled by large-scale bank failures that caused an immense decline in the money supply, lasted
until the end of 1941 when the U.S. entered World War II. Unemployment averaged 18.8 percent
between 1930 and 1941, and reached a high of 24.9 percent in 1933. Net investment was negative
between 1931 and 1935. Output fell nearly 30 percent between 1929 and 1933. The consumer
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BIG EVENTS: THE ECONOMICS OF DEPRESSION, HYPERINFLATION, AND DEFICITS
205
price index fell almost 25 percent. The stock market declined an astounding 85 percent between
the crash of September 1929 and June 1932.
Because the federal government in the mid-1930s was worried about balancing the budget,
federal state and local fiscal policies were actually contractionary between 1932 and 1934, exactly
opposite of what was needed. President Roosevelt’s “New Deal,” often credited with pulling the
U.S. out of the Great Depression, actually wasn’t expansionary at all. A number of institutional
changes, however, were made during Roosevelt’s first term: the Federal Deposit Insurance
Corporation (FDIC) was created to supervise banks and insure bank deposits; the Securities and
Exchange Commission (SEC) was established to regulate the securities industry; and the Social
Security Administration was set up so that the elderly would not have to rely on savings to
finance their retirement. These changes were all viewed as potentially stabilizing, and all of them
have persisted to this very day. Many economists, however, give credit to the bombing of Pearl
Harbor and the subsequent entry of the U.S. into World War II for our eventual victory over the
Great Depression.
Due in part to the collapse of the international financial system and the widespread adoption of
“beggar-thy-neighbor” trade policies, the Great Depression was a virtually worldwide
phenomenon. Many countries weathered it much better than the U.S., perhaps because they were
more willing to adopt expansionary fiscal policies.
2.
The Great Depression: The Issues and Ideas
Early Keynesians believed that the depression was a consequence of contractionary fiscal policy,
and argued that the only effective remedy for it was fiscal expansion. They gave very little weight
to monetary factors, claiming that expansionary monetary policy could not have triggered an
economic recovery because the U.S. economy was in a liquidity trap. Interest rates were close to
zero, and they believed that any monetary expansion would be absorbed without significantly
changing them.
Monetarists, notably Milton Friedman and Anna Schwartz, took a different view. They believed
that the Fed’s failure to help struggling banks and to prevent the decline of the domestic money
stock was responsible for the severity of the depression, and made quite a persuasive argument.
Although Keynesian and Monetarist explanations of the Great Depression were originally held to
be at odds with one another, there is no inherent conflict between them. Everyone behaved
ineptly during the 1930s; there is plenty of blame to go around.
It is interesting to note that the stock market crash of October 19, 1989 was much worse in
percentage terms than the crash of September 29, 1929. Unlike the crash that heralded the
beginning of the Great Depression, however, “Black Monday” did not even cause a mild
recession. The Fed acted instantly, allowing a huge drop in the federal funds rate. After a few
days, the economy returned to normal.
206 CHAPTER 19
3.
Money and Inflation in Ordinary Business Cycles
The link between money growth and inflation is not as tight in the short run as it is in the long
run, in part because money growth can affect output in the short run, in part because low levels
of inflation can be a fiscal as well as a monetary phenomenon. To explain the long run theory of
inflation and money growth, we go back to the quantity theory of money:
MV  PY
where M is the money stock, V is the velocity, P is the price level and Y is the output. The above
equation, when written in growth terms is specified as:
mv  π y
In the above equation, m is the money growth rate, v is the change in velocity, π is the inflation
rate and y is the output growth rate. Since, the long run output growth rate is fairly stable (at 3
percent) and so is long run velocity, the money growth rate is reflected for one to one in inflation.
This is consistent with the monetarist view that in the long run all inflation is due to money
growth.
Hyperinflation, therefore, is indisputably a result of excessive money growth. It is an unfortunate
reality that it is easier to create a hyperinflation than it is to stop one.
4.
Hyperinflation
Although there is no consensus on what constitutes a hyperinflation, a working definition is an
annual rate of inflation that exceeds 1,000 percent. Hyperinflationary countries all appear to
suffer from large budget deficits and high rates of money growth. Because inflation increases the
measured deficit, economists often look instead at the inflation–adjusted deficit:
total deficit - (inflation rate  national debt )
This subtracts the component of the interest payments on the debt that are attributed directly to
inflation.
The heterodox approach to stabilization combines monetary, fiscal, and exchange rate policies
with incomes policies; it constitutes a coordinated attack on inflation, and offers the possibility of
deflation without recession. But like all other policies that need to affect people’s expectations in
order to work, this heterodox approach must be credible. For countries with debt-driven
hyperinflation, this often means a strong commitment to debt reduction. Nobody’s going to
believe the government will stop printing money until the problems that made it necessary have
been dealt with.
This highlights a very important fact: that the sacrifice ratio, or the percentage decline in output
resulting from a one percentage-point reduction in the rate of inflation, can be reduced through
BIG EVENTS: THE ECONOMICS OF DEPRESSION, HYPERINFLATION, AND DEFICITS
207
the implementation of credible policies. Central bank credibility can be an immensely powerful
tool.
5.
Deficits, Money Growth, and the Inflation Tax
The government can finance its deficits in two ways: it can either sell bonds, or persuade the
central bank to increase the monetary base. The Fed is said to monetize a deficit whenever it
purchases some of the bonds that the Treasury sells to finance that deficit. If it does not do this,
the fiscal expansion behind the deficit will drive up interest rates; if it does, it runs the risk of
causing inflation. Evidence is mixed on whether the Federal Reserve even partially monetizes
U.S. deficits.
Creating high-powered money serves as an alternative to taxation. The revenue collected
through money creation is referred to as seigniorage. The total amount of seigniorage that can be
collected is given by the formula
inflation tax revenue = inflation tax rate  real money base
As the growth rate of money becomes large, the real money stock falls to zero; the government
cannot collect an arbitrarily large amount of tax revenue simply by printing money. The
“inflation tax” appears to be quite low in industrialized countries, where the money base is small
relative to the size of the economy. Countries with less developed financial sectors, where people
hold large amounts of currency, appear able to generate more revenue by printing money.
6.
Budget Deficits: Facts and Issues
Government expenditures consist of both mandatory and discretionary outlays. Mandatory
outlays consist of spending made under entitlement programs; Medicaid, Social Security, and
Aid to Families with Dependent Children are examples. In the U.S., discretionary spending must
be approved by Congress; it includes defense spending and foreign aid.
Defense spending as a fraction of GDP has declined in the U.S. since the end of the Cold War.
However, recent events like 9/11 and Iraq war have led to a rise in the defense spending.
Entitlement spending is nearly double what it was in the 1960s, and interest payments on the
national debt have become a significant component of government expenditure. Most of the
federal government’s revenues come from taxes. The government’s revenues haven’t changed
very much as a percentage of GDP over the last 30 years; its expenditures have soared. Social
security taxes contribute more to federal revenue today than anytime in the recent past; revenue
from corporate income taxes, as a percentage of GDP, has fallen by half since the 1960s.
Structural deficits measure the size that the budget deficit would be if output were at its fullemployment level. Cyclical deficits are the difference between actual structural deficits. The
deficit is typically broken into two components: the primary, or non-interest deficit, and interest
payments on the public debt. During periods of low inflation, nearly half of the nominal interest
payments on the debt may be offset by inflation.
208 CHAPTER 19
The national debt of the U.S., close to $9 trillion, seems like a great burden. In per capita terms,
however, that amounts to only $28,000 per person. The debt ratiothe ratio of debt to
incomeis less than 1; we could pay back the entire debt using less than 1 year’s output. And
most of it does not even need to be paid back; we owe the bulk to ourselves. Still, foreigners own
an increasingly large portion of the national debt. That portion represents the tax burden that
future U.S. taxpayers will have to carry. Because it places an upward pressure on interest rates,
the debt can also lower investment and may decrease our potential for long–term growth.
7.
Social Security
The U.S. currently uses a pay-as-you-go social security system, in which the taxes paid by those
generations who are currently working are used to fund payments made to retirees. Due to
declines in population growth, at some point in the near future we will either have to raise the
social security tax or reduce the amount of benefits paid to each retiree. The U.S. does not face
this problem alone; a vast number of countries will soon have to address the same problem.
Suggested social security reforms include increasing the age at which people can get social
security benefits, taxing all social security benefits received in excess of contributions, and
reducing cost-of-living increases by changing the way inflation is measured. Other suggestions
include placing a part of the Social Security Trust Fund in a diversified portfolio of stocks and
bonds, and allowing individuals to substitute investment in private retirement accounts for part
of their social security contributions.
KEY TERMS
Great Depression
New Deal
Keynesian revolution
quantity theory of money
velocity of money
hyperinflation
inflation-adjusted deficit
heterodox approach to stabilization
credible policy
credibility bonus
inflationary inertia
sacrifice ratio
government budget constraint
monetization
seigniorage
inflation tax
mandatory outlays
discretionary outlays
entitlement programs
government purchases
transfer payments
primary (non-interest) deficit
debt-income ratio
intergenerational accounting
pay-as-you-go (social security) system
BIG EVENTS: THE ECONOMICS OF DEPRESSION, HYPERINFLATION, AND DEFICITS
209
GRAPH IT 19
This Graph It gives you a chance to look at what happened to output during the Great
Depression. Table 19–1 provides data on U.S. real GDP between 1929 and 1942. Your task is to
find and plot the percentage change in output for each year. You might also try graphing the level
of output, making another chart.
TABLE 19–1
Percent change from
previous year
Year
GDP
1929
790.9
—
1930
719.7
–9.0
1931
674.0
1932
584.3
1933
577.3
1934
641.1
1935
698.4
1936
790.0
1937
831.5
1938
801.2
1939
866.5
1940
941.2
1941
1,101.8
1942
1,308.9
210 CHAPTER 19
20%
15%
10%
5%
Trend GDP = 3%
0%
-5%
-10%
1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 1941 1942
Chart 191
THE LANGUAGE OF ECONOMICS 19
Debts and Deficits
Debts and deficits are frequently confused. Both appear to be in levels, and both seem to be a
problem. What is the difference between them, and how are they related to one another?
The primary difference is that debt is a stock and the deficit is a flow into that stock. Budget
deficits, when they are not monetized, add to the debt. Budget surpluses reduce the debt, as all of
the money that the government does not spend can be used to buy back the bonds the Treasury
has issued on that debt.
It is more useful to look at the debt-income ratio than at the absolute level of the debt. While the
national debt of the United States, for example, is clearly greater than that of Italy in absolute
terms, it represents a much smaller fraction of output. If both countries were to completely pay
off their debts, the U.S. would find it less of a burden: the U.S. national debt, as of 1996, was 69.2
percent of GDP. Italy’s was roughly 121 percent.
REVIEW OF TECHNIQUE 19
Dynamic Expectations
When expectations are based on current or lagged variables, they change over time to reflect the
impact of new information. This Review of Technique works through a simple model with
dynamic expectations.
BIG EVENTS: THE ECONOMICS OF DEPRESSION, HYPERINFLATION, AND DEFICITS
211
Suppose that permanent income is given by the formula:
YP  Y e
where Ye is the average amount of money you expect to earn each year for the rest of your life.
Suppose also that your expectations regarding this stream of income are given by the formula
Ye 
1
2
Y  Y1 
and that consumption, investment, and government spending are as follows:
C  21 YP  21 Y e 
1
4
Y  Y1 
I  1000
G0
Table 19–2 traces out, for a few periods, this process of expectational adjustment and shows the
effect that it has on consumption. We use the national income accounting relationship
Y  C  I  G , or, more precisely,
Y
1
2
Y  Y1   100
to track the way that income changes over time.
Do you see how changes in people’s expectations of future income affect their consumption
patterns?
Table 19–2
Period
Y
Y-1
Ye
C
I
G
0
1,400.00
1,000.00
1,200.00
600.00
1000.00
0
1
1,600.00
1,400.00
1,500.00
750.00
1000.00
0
2
1,750.00
1,600.00
1,675.00
837.50
1000.00
0
3
1,837.50
1,750.00
1,793.75
896.88
1000.00
0
(Note: The function that we have used to represent these expectations is not a realistic one. If we were building a more
careful model, we would want people’s expectations to be formed rationallyto take into account all available
information about the economy.)
212 CHAPTER 19
Crossword
1
5
3
2
4
2
3
4
ACROSS
1 non-interest deficit
2 revenue from inflation tax
3 entitlement spending
4 deficit at full employment
5 very high inflation
DOWN
1 current social security system
2 spending to be approved by the congress
3 deficit covered by printing money
4 great monetary economist
5 mix of fiscal and monetary approach to stabilization.
FILL-IN QUESTIONS
1.
Hyperinflations have historically tended to occur in the aftermath of ______________.
2.
Wage and price controls are referred to as _______________________.
3.
The revenue collected through money creation is called ___________________.
BIG EVENTS: THE ECONOMICS OF DEPRESSION, HYPERINFLATION, AND DEFICITS
213
4.
The creation of high-powered money in order to generate revenues is referred to as an
______________________.
5.
The Fed is said to _____________________ a deficit when it buys some or all of the bonds that the
treasury sells to finance that deficit.
6.
The ___________________ deficit subtracts the component of the interest payments on the
national debt that are attributed directly to inflation.
7.
A ___________________ approach to stabilization consists of the simultaneous use of monetary,
fiscal, exchange rate, and incomes policies.
8.
The government can finance its budget deficits in two ways: it can either _______________ or
______________________________.
9.
Rising markets are called ___________________ markets; falling markets are ___________________.
10.
Countries with hyperinflation often have large, persistent ___________________.
TRUE-FALSE QUESTIONS
T
F
1.
The Great Depression was specific to the U.S.; everyone else was just fine.
T
F
2.
Fault for the Great Depression has been attributed to both bad fiscal and bad
monetary policy.
T
F
3.
Monetary policy was expansionary during the early years of the Great
Depression.
T
F
4.
Fiscal policy was clearly expansionary during the early years of the New Deal
(1932-1934).
T
F
5.
The stock market crash of October 1989 wasn’t nearly as bad as the one of 1929.
T
F
6.
The link between money and inflation is stronger in the short run than in the
long run.
T
F
7.
Wage and price controls are an effective way to halt inflation.
T
F
8.
A heterodox approach to stabilization offers the possibility of deflation without
recession.
T
F
9.
Policy credibility has no effect on sacrifice ratio.
T
F
10.
The U.S. has one of the largest debt-income ratios in the world.
214 CHAPTER 19
MULTIPLE–CHOICE QUESTIONS
1. The length and severity of the Great Depression was the fault of
a. monetary policy
b. fiscal policy
c. neither
d. both
2. The depression of the 1930s was a ___________ phenomenon.
a. U.S.
b. North American
c. western
d. global
3. The Great Depression began in the U.S., in
a. 1929
b. 1931
c. 1933
d. 1935
4. The Great Depression ended in the U.S., in
a. 1935
b. 1939
c. 1941
d. 1945
5. Credit for the end of the Great Depression in the U.S. is given to
a. monetary authorities
b. the “New Deal”
c. U.S. entry into WWII
d. stock market recovery
6. Which of the following agencies was not created by Roosevelt’s “New Deal” reforms?
a. FDIC
b. FOMC
c. SEC
d. Social Security Administration
7. Keynesian theory, during the 1960s, was dubbed the
a. New Economics
b. New Deal
c. Great Depression
d. “beez-neez”
8. Which of the following annual rates of inflation would be called a hyperinflation?
a. 10%
b. 100%
c. 1000%
d. (b) and (c)
9. There is a stronger link between the rate of money growth and the nominal rate of inflation in
the
a. long run
b. short run
c. steady-state
d. no difference
BIG EVENTS: THE ECONOMICS OF DEPRESSION, HYPERINFLATION, AND DEFICITS
215
10. Hyperinflations are usually ended through
a. currency reform
b. reduced budget deficits
c. tight monetary policy
d. all of the above
CONCEPTUAL PROBLEMS
1. Why do you think the U.S. stock market crash of October 1989 didn’t cause another
depression? Were we lucky, or did we do something right?
2. Explain why each of the following situations might lead to hyperinflation. Can you think of
any historical examples in which they’ve done exactly this?
a) A government cannot meet its debt obligations (does not have sufficient revenues to repay
the interest on its debt).
b) A country is assessed war reparations that force its government to run huge budget
deficits.
c)
A government lacks either the power or the necessary infrastructure to collect taxes.
3. How can the creation of high-powered money be a source of government revenue?
4. Do you think that the U.S. national debt is a burden? Do our high levels of debt risk triggering
a hyperflation?
TECHNICAL PROBLEMS
1. How much inflation tax revenue would be generated in a country with a real money base of
$1,000 and an inflation rate of 1000%?
2. How much inflation tax revenue would be generated in a country with a real money base of
$500 and an inflation rate of 1000%?
3. What happens to the real money base, over time, when the growth rate of money becomes
large? Given this, do you think that seigniorage is a good way to generate revenue?