Download 1 The Great Depression (1929 – 1941

The Great Depression (1929 – 1941)
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Housekeeping
Midterm on Wed October 12
11:35-12:50 pm
DL 220, ML 211, Rosenfeld Hall
as per assignment.
assignment
Remember open TF office hours
and review sessions (see class
web site).
Final questions?
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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
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Key Elements in the Great Depression
1929-1933
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Started as asset price bubble and standard recession
Remember world was on gold standard (fixed exchange rate system)
Multiple
p bank failures through
g 1933 ((standard p
panic model))
Breakdown of Gold Standard, particularly with Britain’s leaving gold
in 1931.
Collapse of investment and international trade after 1929
No effective fiscal policy until 1940
Fed took hesitant steps to stimulate the economy
– Federal government wanted to balance the budget (like several
candidates today…)
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.
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Bank failures and panics, 1931-1933
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Real GDP then and now
[= 100 at beginning of first year]
108
104
100
96
92
88
84
80
76
72
68
I
II
III IV
I
II
III IV
I
II
III IV
I
II
III IV
1929
1930
1931
1932
2008
2009
2010
2011
I
II
III IV
1933
High unemployment for a decade
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Unemployment rate (% of labor force)
30
25
20
15
10
Great Depression
Today's recession
5
0
1930
1932
1934
1936
1938
1940
2008 2009 2010 2011
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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 in October 1931
3. From gold crisis to trough
Note: rates of change at annual rates.
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Alternative views of the sources of the GD
Classical theories: exist but are in my view defective
too long
g a digression
g
to explain
p
why
y at this stage;
g ;
will mention when we do real business cycles
Keynesian theories:
- “Expenditure view”: IS or spending shocks
- Financial market distress: MP or financial shocks
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IS interpretation of the depression
interest
rate
(i)
IS1929
IS1933
MP
Y1929
Y1933
0
Real output (Y)
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I. The Expenditure Approach: IS Shocks
Were shocks in the IS curve responsible?
– 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
bad equilibrium
equilibrium” (panics, risk, high risk premiums,
low investment, unstable dynamics ?)
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II. Financial Markets and the Depression
• 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
2.
(inflation, output
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).
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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
p
as p
primarily
y driven by
y “incompetent”
p
monetary policy caused by decline in money supply.
• Argue that rise in M1 could have prevented Y fall and nipped GD
in bud
Monetarism, the Depression, and IS-MP
interest
rate
(i)
MP‘
MP
i**
i*
IS
Y**
Y*
Real output (Y)
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8
Interest Rates 1920-39
Problem with
monetarist
interpretation:
Safe interest rates
fell in GD!!!
Intterest 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
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IS-MP model for abnormal times:
The liquidity trap
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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
Japan short-term interest rates, 1994-2010
Liquidity trap from 1996 to today:
15 years and
d counting.
ti
10
US in current recession
Federal funds rate (% per year)
20
Policy has
hit the
“zero lower
bound”
three years
ago.
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12
8
4
0
1975
1980
1985
1990
1995
2000
2005
2010
Fiscal policy in liquidity trap
r = real
interest rate
IS
IS’
MP
re
Y = real output (GDP)
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Monetary policy in liquidity trap
interest
rate
(i)
IS1933
MP1933
MP1939
Y1929
Y1933
0
Y1939
Real output (Y)
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Great Depression and Great Recession
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Federal funds rate (2005-2011)
Fed discount rate (1926-1937)
6
5
4
3
2
Compare then
and now!
1
0
1926
1928
1930
1932
2005
2007
2009
2011
1934
1936
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Bad equilibrium view of Great Depression
A final approach:
1. Began with
h asset price b
bubble
bbl and
dh
high
h lleverage.
2. Then had huge IS shock due to risk, panics, deflation, and
the result was high risky real interest rates.
3. This forced economy into a liquidity trap (like today), so
that monetary policy was ineffective.
4. Government was too small to have effective fiscal policy.
5 Got
5.
G llocked
k d iinto “b
“bad
d equilibrium”
ilib i ” off deflation,
d fl i
high
hi h risk
i k
premiums, fear, low investment, and low spending.
6. And that lasted until 1940!
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interest
rate
(i)
IS1933
IS1929
MP1929
= MP1933
MP1939
Y1929
Y1933
0
Y1939
Real output (Y)
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Recovery from the Great Depression
• The end of the Great Depression:
– Milit
Military mobilization
bili ti ffor W
World
ld W
War II led
l d tto ENORMOUS
increase in G starting in 1940.
– Recovery took off in 1940.
• This Standard IS shift … no puzzle here!
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The rise of the dictators (1917 - )
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World War II (1931-1945)
Military spending takes off…
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The end of the depression …
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Germ. invastion Poland
G
WW II
15
10
Pearl H
Harb or
Germ invast ion Austria, Czec h
20
.5
Germ in
nvasion F rance
25
.4
.3
.2
5
.1
1
0
.0
30
32
34
36
38
40
42
44
46
48
Unemployment rate
Defense spending/GDP
F ederal expenditures/GDP
interest
rate
(i)
IS1939
31
IS1945
WW II
Y1945
0
Y1939
MP
Real output (Y)
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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. Our judgment was that in a liquidity trap-type scenario of
d f
l financial
f
l system, and
d
zero interest rates, a dysfunctional
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.
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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:
– began with asset price bubble (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.
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