Download Real Business Cycle Models of the Great Depression

Université catholique de Louvain
Département des Sciences Economiques
Thèse présentée en vue de l’obtention du grade de
Docteur en Sciences Economiques
Real Business Cycle Models of the Great
Depression
Luca Pensieroso
Juin 2007
Composition du jury:
Michel De Vroey (Université catholique de Louvain) (directeur)
David de la Croix (Université cahtolique de Louvain)
Franck Portier (Université des Sciences Sociales Toulouse 1)
Henri Sneessens (Université catholique de Louvain)
Raf Wouters (Banque Nationale de Belgique)
i
Ai miei genitori.
ii
Acknowledgements
Eventually, five years after I first arrived in Louvain-la-Neuve, I see the
end of my graduate studies. With them, a period of my life comes to the
end, while a new one, whose story is still to be written, is already on the
horizon.
Before drawing the final line, it is time to thank all the people that made
this achievement possible.
My first thought goes to my supervisor, Michel De Vroey. He believed
in me since I was a Master student. Tough but fair, he taught me to question my certainties, often to discover that they were more based on ideological a-priori than on purely rational basis. He has been the best supervisor I could ever wish.
I would like to thank the other members of the Jury, David de la Croix,
Franck Portier, Henri Sneessens and Raf Wouters for their interesting remarks on this thesis. Their suggestions resulted in appreciable improvements of this work.
The Department of Economics of the Catholic University of Louvain is
an ideal working place, where the rigour of scientific research meets with
the pleasure of an informal and lively ambience. I would like to thank all
the professors, the staff and the students for their precious daily cooperation.
A special thank goes to Raouf Boucekkine and David de la Croix. They
were ready to fund a young Italian economist with a heterodox background, showing a laudable open-mindedness, and trusting his capabilities as researcher. I hope to have been able to pay them back with the
valuable research they expected from me.
Part of this work was carried out at the GREMAQ - University of Toulouse
iv
1. I would like to thank Franck Portier for inviting me, and Aude Schloesing
for the excellent organization of my visiting. Matteo Bassi, Sara Biancini,
Wolfgang Heisen and Dörte Klaus, among others, made my staying in
Toulouse enjoyable.
The story of a PhD thesis is also a story of days (and nights) spent on
apparently unsurmountable problems. If I have not got depressed, it also
because I could count on the support of many colleagues, or friends, as I
should say. My memory goes to the days of the Master, at the Saturdaynight dinners organized by Augusta Badriotti; to the countless (and endless) discussions of economic theory, methodology and policy with Gabriele
Cardullo, Mario Denni, Giulio Nicoletti and Alessandro Sommacal; to the
unforgettable “olehh!” said by Cecilia Vergari; to the nights spent on
Game Theory with Alessandro, secretely waiting for the phone calls of
our respective girlfriends to give us a pause; to the 19-hours non-stop immersion in Business Cycle Theory with Mario before the Macro II exam; to
the “Mundialito” football-tournament, where the Italian Master students
showed their taste for epics with their “Belli Masteronzi” team, lead by
their captain Oscar Amerighi . . . Other faces, other places, other names
cross my mind, all equally important, just too many to mention them
all: Anna Batyra, Mauro Bambi, Carmen Camacho, Gianfranco Casanova,
Gül Ertan, Filomena Garcia, Antonio Minniti, Giordano Mion, Andrea Silvestrini, Marie Vander Donckt, Benteng Zou. . . Thank to all of you, guys,
from the deepest of my heart.
When you leave your country and go abroad for several years, you
would like the hypothesis of ceteris paribus to hold at home. This is not
always the case. But it was so for my best friends ever: David, Francesca
and Antonello. Grazie, ragazzi.
Dulcis in fundo, the final lines are for my family. To my sister Barbara
goes a big thank for her joie de vivre, for all those chats that had the incredible property of making me feel better, no matter how hard were the
times. My fiancée Alessandra has been the love, joy and support of my
life for all these long years. To her goes my love and my deepest gratitude.
Finally, I have always thought that I own to my parents much of what I am
today. This work is dedicated to them, to the memory of my father, and to
the love and care of my mother.
Preface
When I started this project, my orientation towards this new trend in the
literature was admittedly rather critical. I had the feeling that RBC authors
had gone too far. One thing is to apply dynamic optimization and the
equilibrium method to the mild post-war business cycles. A completely
different thing ought to be the analysis of the Great Depression, an event
characterized by pervasive political and financial turmoils, with evident
disruptions in the exchange system. Isn’t that to commit a hybris sin, I
asked myself?
If this was my mood at the start of this work, I have been gradually
realizing that things were more complex than that. Modelization had its
own advantages, often allowing to assess the quantitative contribution of
existent competing explanations. The crude and aseptic data analysis provided for by RBC authors shed new lights on the event, reminding us that
even statements that are apparently obvious need to be proved. Indeed,
in the process of proving them, it often happens to realize that those statement were not so obvious, after all. In one word, the application of the
RBC methodology to the analysis of the Great Depression put a renewed
accent on the discipline-aspect of the theory, which consists in forcing the
economist to take into account the general equilibrium effects of any supposed explanation of the Great Depression.
Moreover, the fact of building models geared towards quantitative assessments makes results open to direct contest, which is not immediately
the case for narrative historical accounts.
On the other hand, I keep on thinking that too narrow a focus on the
modeling aspect is often detrimental to the general understanding of the
phenomenon. Models are built on exclusions, as economists focus their
vi
analyses on those aspects deemed to be crucial. Other aspects, which may
be important as well, are often overlooked, not least for the sake of analytical tractability. Here is where history matters. Having “the broad picture”
in mind may indeed help to be cautious in deriving implications from economic models.
To conclude, using a metaphor from Alan Blinder,1 I still think that the
explanation of complex economic facts like the Great Depression of the
1930s is as much an art as it is a science. What I have learned in those
years spent working on the Great Depression is that while practising the
dark art, science is rather useful.
1
See Blinder (1997), p. 17
Contents
1
Introduction
2
A Critical Survey
2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.2 Assumptions and methodology . . . . . . . . . . . . . . . . .
2.2.1 Assumptions . . . . . . . . . . . . . . . . . . . . . . .
2.2.2 Dating the Depression . . . . . . . . . . . . . . . . . .
2.2.3 Methodology . . . . . . . . . . . . . . . . . . . . . . .
2.2.4 The “normality view”: history and economics . . . .
2.2.5 The national dimension of the phenomenon . . . . .
2.3 The US Great Depression . . . . . . . . . . . . . . . . . . . . .
2.3.1 Cole, Ohanian and Prescott on the Great Depression
2.3.2 Other RBC models of the Great Depression . . . . . .
2.3.3 A sunspots neoclassical interpretation of the US Great
Depression . . . . . . . . . . . . . . . . . . . . . . . . .
2.4 Great Depressions worldwide . . . . . . . . . . . . . . . . . .
2.4.1 The critique of the “consensus view” . . . . . . . . .
2.4.2 Case studies . . . . . . . . . . . . . . . . . . . . . . . .
2.5 A critical perspective . . . . . . . . . . . . . . . . . . . . . . .
2.6 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5
5
7
7
8
9
10
11
12
14
23
The Abandonment of the Abstentionist Viewpoint
3.1 Introduction . . . . . . . . . . . . . . . . . . . .
3.2 Lucas on the Great Depression . . . . . . . . .
3.2.1 The Lucas and Rapping (1969) paper . .
3.2.2 Rees’s criticism . . . . . . . . . . . . . .
49
49
50
50
51
3
1
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
30
32
32
34
40
45
viii
3.3
3.4
3.5
3.6
3.7
3.8
4
CONTENTS
3.2.3 Lucas’s reaction . . . . . . . . . . . . . . . . . . . . . .
3.2.4 Lucas’s subsequent standpoint . . . . . . . . . . . . .
Prescott on the Great Depression . . . . . . . . . . . . . . . .
3.3.1 Prescott’s early view . . . . . . . . . . . . . . . . . . .
3.3.2 Prescott’s present standpoint . . . . . . . . . . . . . .
Explaining Prescott’s change of mind . . . . . . . . . . . . . .
Cole and Ohanian on the US Great Depression . . . . . . . .
An assessment . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.6.1 The originality of Cole and Ohanian’s analysis . . . .
3.6.2 One or several great depressions? . . . . . . . . . . .
3.6.3 Contrasting the approaches of equilibrium macroeconomics and economic history to the Great Depression . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Lucas after Cole and Ohanian . . . . . . . . . . . . . . . . . .
Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The Belgian Great Depression
4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . .
4.2 A look at the data . . . . . . . . . . . . . . . . . . . . . .
4.3 History of interwar Belgium . . . . . . . . . . . . . . . .
4.3.1 1920-1926 . . . . . . . . . . . . . . . . . . . . . .
4.3.2 1926-1930 . . . . . . . . . . . . . . . . . . . . . .
4.3.3 1930-1935 . . . . . . . . . . . . . . . . . . . . . .
4.3.4 1935-1939 . . . . . . . . . . . . . . . . . . . . . .
4.4 The Data through the lens of the theory . . . . . . . . .
4.4.1 Detrending . . . . . . . . . . . . . . . . . . . . .
4.4.2 Total factor productivity . . . . . . . . . . . . . .
4.5 A baseline RBC model of the Belgian Great Depression
4.5.1 The model . . . . . . . . . . . . . . . . . . . . . .
4.5.2 Calibration . . . . . . . . . . . . . . . . . . . . . .
4.5.3 Simulation . . . . . . . . . . . . . . . . . . . . . .
4.5.4 Comments on the results . . . . . . . . . . . . .
4.6 War expectations and investments . . . . . . . . . . . .
4.7 Money and sticky wages . . . . . . . . . . . . . . . . . .
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
52
53
55
55
56
59
60
65
65
68
70
74
75
77
77
79
85
85
87
88
89
89
89
91
92
92
94
94
97
98
102
CONTENTS
4.7.1 The model . . . . . . . . . . .
4.7.2 Calibration . . . . . . . . . . .
4.7.3 Simulation . . . . . . . . . . .
4.7.4 Comments on the results . .
4.7.5 Asymmetric wage rigidity . .
4.7.6 TFP shocks and sticky wages
4.8 A small-open-economy RBC model .
4.8.1 The model . . . . . . . . . . .
4.8.2 Calibration and simulation .
4.8.3 Extension: shocks on r∗ . . .
4.9 Conclusions . . . . . . . . . . . . . .
4.10 Appendix: Data . . . . . . . . . . . .
5
ix
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
105
108
111
112
116
126
126
127
132
136
137
139
Prospects for Future Research
5.1 The Belgian case: an open-economy perspective . . . . . . .
5.2 Involuntary unemployment and the Great Depression . . . .
5.3 Expectations and the recovery from the US Great Depression
145
145
146
148
Bibliography
153
List of Figures
165
List of Tables
169
x
CONTENTS
Chapter 1
Introduction
To understand the Great Depression is the Holy Grail of macroeconomics (Bernanke (1995), p. 1).
So far, for all the bravery of the knights, the quest has proved to be
challenging, and the task is not yet fully attained. In the span of almost
eighty years, several theories claimed to have clinched the matter. Inexorably, each time that claim proved to be wrong, or partial at least. Each
time new theoretical developments, or new data successfully challenged
the dominant story. What is more, each time the change in the perspective
under which the economists looked at the Depression signaled a shift in
the dominant paradigm in macroeconomics.
This thesis deals with a new stage of the quest. Few years after Eichengreen (1992)’s synthesis between the Keynesian and monetarist explanations was believed to have provided the final word on the Depression history, Harold Cole and Lee Ohanian brought it all up for discussion. In
daring to face the Great Depression by means of a full-fledged neoclassical model in the real business cycle (RBC) tradition, they broke what
was perceived by many authors as a taboo (Prescott (2002)): for the first
time in the history of macroeconomics, an analytical neoclassical model
entered the battlefield of the Great Depression, once considered a theme
defying any equilibrium explanation. What is new about the RBC explanation of the Great Depression? Are we witnessing the setting of a new
dominant paradigm in macroeconomics? How did the paradigm need to
2
Introduction
be emended in the endeavour to tackle the Depression issue?
This thesis elucidates the fundamentals of RBC modeling on the Great
Depression; investigates its origin back in the history of the new classical
revolution; provides some critical thought on its whereabouts; presents
the analysis of the Belgian case through the lens of RBC theory.
As it is natural for the questions at stake, this work is on the border line
between history of theory and economics.
The first two chapters are more on the history side. Chapter 2 critically reviews the RBC interpretation of the Great Depression, clarifying
its theoretical and methodological foundations, and paving the way for
an assessment of its contribution. The focus of the chapter is on the outstanding methodological innovation brought about by the attempt to cast
the Great Depression within an “equilibrium” framework. While such
an attempt deserves to be hailed, many problematic issues are put to the
fore. What does total factor productivity (TFP) means in historic accounts?
How reliable are linearized models to grasp output decreases as important
as those observed during the 1930s? Could economic theory do without a
causative perspective, and be content with the ability to mimic a given set
of data, in tackling historical issues like the Great Depression? These and
other questions are singled out in the chapter.1
Chapter 3, which is coauthored with Michel De Vroey, documents and
assesses the reversal of opinion by new classical macroeconomists about
the ability of their methodology to explain the Great Depression. We show
that in the 1970s and 1980s Lucas and Prescott took an abstentionist stance.
They maintained that, because of its exceptional character, an explanation
of the Great Depression was beyond the grasp of the equilibrium approach
to the business cycle. However, while Lucas stuck to this view, Prescott
changed his mind at the end of the 1990s, breaking his earlier self-imposed
restraint. We argue that such a reversal of opinion has been made possible by the progressive evolution of RBC theory in the last decades, from a
strictly Walrasian framework to a general method of analysis that encompasses also non-Walrasian features, like imperfect competition and price
1
A slightly modified version of this chapter was published in the Journal of Economic
Surveys, 21, 110-142.
3
stickiness.
In this chapter we also produce a first assessment of RBC models of
the Great Depression. We claim that the fact of having constructed an
equilibrium model of the Great Depression constitutes a methodological
breakthrough. However, as far as substance is concerned, we argue that
the contribution of real business cycle literature on the Great Depression
is slim, and does not gain the upper hand over the work of economic historians.2
If the first two chapters are more on the history side, chapter 4 is definitely on the economics side. This chapter casts the Belgian Great Depression of the 1930s within a dynamic stochastic general equilibrium (DSGE)
framework. After a brief detour in the data and history of the interwar
Belgium, I show that a TFP shock within a standard RBC model gives
unsatisfactory results. Given the enormous drop in investments, and the
international political environment of the time, I investigate whether fears
of the outbreak of a war could play a role in accounting for the Depression, particularly for what concerns its protracted character. The exercise
shows that this is not likely the case, as introducing war expectations in
the baseline model produces little improvement.
Simple growth accounting suggests that the onset of the Great Depression is almost entirely accounted for by a big drop in hours worked. This
observation, together with the data on nominal and real wages and the
evidence on monetary turbulence put forward by historians, lead me to
explore the performance of a DSGE model with sticky wages à la Taylor
and monetary shocks. Results confirms that high real wages due to a sudden big deflation might have been the transmission mechanism explaining
the onset of the Great Depression in Belgium. However, the model fails to
account for the absence of recovery after the 1935 devaluation, a failure it
shares with all the other model considered in this chapter.
In view of the peculiar small-open-economy characteristic of Belgium,
the chapter concludes with a first extension to the open-economy dimension, though with no appreciable gain in terms of explanatory power.
2
A slightly modified version of this chapter was published in Contributions to Macroeconomics, 6, issue 1, article 13.
4
Introduction
Chapter 2
A Critical Survey
2.1
Introduction
The Great Depression of the 1930s was undoubtedly the most important
economic crisis ever witnessed in the twentieth century. Its extension and
duration convinced several contemporary observers that it might well signal the approaching collapse of the capitalist production system.
The Great Depression plays an outstanding role in the history of ideas.
Keynes’s General Theory, in effect, dates to 1936, and the Great Depression
unquestionably paved the way for Keynes’s work.
The Keynesian approach to economic theory concentrates on the concept of market failure, as opposed to the classical laissez faire theory. Consequently, in the eyes of most contemporary observers, the experience of the
Great Depression seemed to confirm the correctness of Keynes’s intuition,
that, in the short run at least, a capitalist economy does not gravitate towards full employment. The Keynesian approach to economics remained
the mainstream theory until the end of the 1960s, when it was first challenged by Friedman and the monetarists, and subsequently replaced by
new classical macroeconomics. The new theory is an “equilibrium” business cycle theory, meaning that the analysis is cast in a Walrasian framework, and grounded on individual rational choices. The main message of
this new trend in economic literature, with respect to the history of economic thought, is that there is no need to resort to any market failure idea
6
A Critical Survey
in order to provide a thorough explanation of the business cycle. A properly defined neoclassical model can provide a plausible explanation of the
phenomenon.
Nevertheless, even after the Keynesian model had lost its predominance and been replaced by new classical macroeconomics, the Great Depression still appeared to be an example of market failure, whose causes
were mainly attributed to the complex social and institutional situation after World War I (Kindleberger (1973); Eichengreen (1992)), and whose end
could be ascribed to the intervention of public authorities (Romer (1992);
Vernon (1994). New classical macroeconomists themselves considered the
Great Depression a phenomenon somehow beyond the reach of equilibrium theory. In particular, Lucas, whose distinctive contribution to economic theory consists of having stated that all cycles were alike and could
be studied as equilibrium phenomena (Lucas (1977)), wrote:
The Great Depression. . . remains a formidable barrier to a completely unbending application of the view that business cycles
are all alike. (Lucas, 1980, p. 273)
If the Depression continues, in some respects, to defy explanation by existing economic analysis (as I believe it does), perhaps
it is gradually succumbing under the Law of Large Numbers.
(Lucas (1980) p. 284)
However, at the end of the 1990s, attempts to overcome this limitation
saw the light of day: a new interpretation of the Great Depression, which
tried to explain it within a real business cycle (RBC)1 framework, began to
1
Throughout this article, I will use the epithets RBC and New Classical as synonymous. The focus here is on the methodological aspect of tackling the Great Depression
within a neoclassical equilibrium framework. In view of this methodological focus, the
distinction between real or monetary shocks is less important than the general method
of analysis. This is also the reason why I do not make any a priori distinction between
RBC and Dynamic Stochastic General Equilibrium (DSGE) models (DSGE being the most
recent label adopted in the literature to denote such models). I will, however, refer to a
similar distinction when discussing a specific methodological aspect, namely whether the
models considered are or are not involved in causal perspectives. Preference is given to
the RBC nomenclature.
2.2 Assumptions and methodology
7
gain ground. Instead of viewing the Great Depression as a phenomenon
lying beyond the grasp of the equilibrium discipline, authors working in
this direction believe that the new classical methodology and theory might
be able to tackle it.
The aim of this paper is to present a critical review of this RBC interpretation of the Great Depression, by singling out its theoretical and
methodological foundations. The paper will be organized as follows. In
Section 2.2, I will explain some methodological premises for the application of RBC theory to the Great Depression. In Sections 2.3 and 2.4, a
review of existing RBC papers about the US and international Great Depressions will be presented. Section 2.5 provides some critical remarks,
and indicates guidelines for future research, while Section 2.6 summarizes
the argument.
2.2
2.2.1
Assumptions and methodology
Assumptions
The distinctive feature of RBC theory is its attempt to explain cyclical fluctuations of income and employment by two fundamental hypotheses: the
“equilibrium hypothesis” and the “exogenous shock hypothesis”.
The “equilibrium hypothesis” is the postulate that an economic cycle
can be studied as an equilibrium phenomenon, or, in other words, that it
can be studied in a framework postulating market clearing and agents’ optimizing behaviour (Lucas (1977)). Under this assumption, business cycles
are the aggregate result of the optimum response of individuals to changes
in the economic environment (Hartley, Hoover, and Salyer (1997)).
I will label as “exogenous shock hypothesis” the assumption that the
source of any economic cycle is exogenous to the growth process. In an
RBC perspective, the economic cycle is conceived as a stochastic oscillation around a trend. Such a trend is determined by savings, demography
and technology, as in Solow (1956).2 This hypothesis characterizes the con2
For surveys of the RBC literature see, inter alia, Hartley, Hoover, and Salyer (1997),
Mankiw (1989), Plosser (1989), Ryan (2002) and Stadler (1994).
8
A Critical Survey
ception of economic cycles within the RBC framework as being due to exogenous shocks to the fundamentals of an economic system, as opposed to
theories in which fluctuations are endogenous or to “animal-spirit” driven
theories, in which fluctuations result from the indeterminacy of the longrun growth path.
This conception of economic cycles has important implications for the
definition of depressions. Researchers in the RBC tradition define a depression as a period in which the rate of growth of the economy is suddenly and significantly below that which it would have been if the exogenous random shock that hit the economy had never occurred. As to
the notion of a Great Depression, Kehoe and Prescott (2002) consider, as a
“working definition”, that a recession is a Great Depression if output falls
cumulatively by more than 20% with respect to its trend level, dropping
by more than 15% in the first decade of the depression. These numbers
serve to give a quantitative definition of the borderline between a business cycle, and a business cycle that has become a Great Depression. Of
course they contain a good dose of arbitrariness, and although they may
be reasonable, no theoretical meaning should be attributed to them.3
2.2.2
Dating the Depression
It might be thought that the dating of the Depression would be an issue
on which consensus existed, but this is not the case. As a matter of fact
RBC theorists have changed the general way of thinking on this issue.
Traditionally, economists tended to consider the Great Depression as starting with the stock market crash of 1929, and ending with the election of
Roosevelt in 1933 (Robbins (1934); Friedman and Schwartz (1963); Temin
3
Moreover, these definitions produce some odd results. Kehoe and Prescott (2002)
argue that Switzerland has been experiencing a Great Depression since 1973, on the
grounds that detrended output per person of working age fell by more than 30% between 1973 and 2000, with a decline of more than 18% between 1973 and 1983. Anyone
can witness, however, that life in Switzerland in the last 30 years has had very little in
common with life in the USA during the 1930s!
2.2 Assumptions and methodology
9
(1989); Eichengreen (1992)).4 However in an RBC interpretation, the Great
Depression is defined as covering the entire decade of the 1930s. This results from the definition of a Great Depression given above: US de-trended
output dropped more than 35% in 4 years, while in 1939 it was nearly 27%
below its 1929 de-trended level (Cole and Ohanian (1999)). As Prescott
(1999) points out, this change in the timing of the event shifts the nature
of the central question to be addressed from “Why was there such a big
decline in output and employment between 1929 and 1933?” to “Why did
the economy remain so depressed for the entire decade?” In other words,
according to RBC theoreticians, a new issue should be added to the “traditional” question of what caused the Great Depression, namely, “What
explains the slowness of the recovery phase?”
2.2.3
Methodology
As to methodology, RBC theorists tread in Lucas’s footsteps by arguing
that the central purpose of a theory of the economic cycle is to make the artificial, modelled economy reproduce the actual behaviour of a real-world
economy (Lucas (1980)). Elucidating the origin of a particular cycle is perceived as secondary. The logic of this methodological premise must be
traced back to the fundamental hypotheses we have singled out. If any
economic cycle starts with an exogenous shock, studying the specific characteristic of this shock serves little purpose for the task of elaborating a
general theory of the business cycle. It is much more important to understand the regularities that will ensue after the shock occurs.
RBC theoreticians build models in the Solow–Ramsey tradition, modified to allow for stochastic shocks that hit the economy at random. Any
4
Here I refer to the dating of the event called the “Great Depression”, not to the dating of its alleged causes. In effect, many of the authors quoted in the text consider the
causes of the Great Depression to be rooted in events that occurred well before 1929.
Eichengreen (1992) and Friedman and Schwartz (1963) are examples. An exception to
this general tendency to date the Great Depression between 1929 and 1933 is Galbraith
(1995), who criticises this idea from a post-Keynesian point of view, asserting that the
Great Depression never ended, but was swept away by the outbreak of the Second World
War.
10
A Critical Survey
stochastic shock of this nature is called an “impulse mechanism” of the
business cycle. The typical impulse mechanism considered in standard
RBC models is a technological shock, represented as an autoregressive
stochastic shock on the total factor productivity (TFP). TFP is a parameter
of the production function, which embodies a broad concept of efficiency
in combining inputs to obtain output.5
Having defined the impulse mechanism of the business cycle, RBC theoreticians compute the equilibrium reaction to the impulse mechanism.
That is, they study the qualitative and quantitative response of the model
economy to the random shock, on the basis of the set of relationships postulated by the model that allows them to identify a “propagation mechanism” for the shock. Such a propagation mechanism is standard in all the
models reviewed here, and is typically based on both the intertemporal
substitution in leisure and consumption, and the intratemporal substitution between labour and leisure.
This simulation technique requires the model to be calibrated, that is, a
numerical value must be assigned to each parameter on the basis of econometric estimates, or, if reliable econometric data are absent, on the basis of
economic plausibility. If the perturbed model economy “reproduces” aggregate fluctuations reasonably well, it can be considered as a plausible
theory of the cycle. That is, the ability of an artificial model to reproduce
a set of stylized facts after being hit by an exogenous random shock is
the methodological litmus test by which the robustness of the theory is
judged.
2.2.4
The “normality view”: history and economics
RBC’s methodological premises have important implications for the analysis of historical events such as the Great Depression. In the RBC approach, economic theory and economic history are perceived as pertaining
to different, though possibly complementary, realms. Economic theory, as
stated above, is concerned with regular co-movements in the behaviour
of economic variables. Economic history, on the contrary, is a different
5
Solow (1957). See Hulten (2000) for a review of TFP.
2.2 Assumptions and methodology
11
branch of social science, naturally inclined towards considering singularities. In this way, a specific event is amenable to economic theory if, during
that event, economic variables co-moved as predicted by the theory. If,
however, the event is peculiar, it should simply be left to historians, and
considered beyond the grasp of economic theory.
Once this consequence of their methodological assumptions is spelt
out, the breaking of the earlier limit to equilibrium theory assumes new
connotations. To all intents and purposes, it amounts to considering the
Great Depression as a business cycle, possibly of greater than usual magnitude; the alternative view is that the Great Depression was a singularity.
That is, in assuming that the Great Depression is amenable to RBC theory and method, these authors implicitly assume that during the Great
Depression economic aggregates behaved as in any other business cycle,
although with greater variance in their oscillation. In this paper, I will refer
to this implicit assumption as the “normality view”.
2.2.5
The national dimension of the phenomenon
The RBC interpretation of the Great Depression differs from previous interpretations in the role assigned to the international political and economic environment during the 1930s. While earlier leading authors (Kindleberger (1973); Eichengreen (1992); Bernanke (1995)) stressed the international dimension of the Great Depression, and went so far as to say that a
full understanding of that phenomenon could not be reached without considering the international dimension, RBC researchers reversed this position by concentrating their analysis on isolated country studies. Several
reasons for this change of perspective may be given:
• The first work on the Great Depression from an RBC perspective is
the paper by Cole and Ohanian (1999), which is strictly concerned
with the Great Depression in the USA. Data prove that the Great
Depression hit harder in the USA than in other industrialized countries; output fell relatively more, and the state of depression of the
economy lasted longer than in any other country. This evidence persuaded the authors to assume that the shock that affected the US
12
A Critical Survey
economy must have been far bigger than the shocks that affected
other economies and, in addition, that the slowness of the US recovery was probably due to some idiosyncratic shock, since other countries recovered earlier. Moreover, the USA is notoriously an almost
closed economy as far as international trade is concerned. Consequently, a national dimension appeared to them sufficient to analyse
the US Great Depression.6
• From a methodological point of view, the mathematical formalization that is typical of RBC research forces the economist to leave out
many aspects of reality in order to concentrate on the aspects that
are considered essential. Given that RBC models explain recessions
by means of a shift in the labour-demand schedule (Mankiw (1989)),
exogenous shocks to TFP (i.e. exogenous variations in the Solow
residual) are an easy way to reproduce such a shift, while keeping
the model sufficiently compact. This implies that the international
dimension need not be the main focus of the analysis.
2.3
The US Great Depression
RBC models of the US Great Depression can be split into two classes. The
first includes Cole and Ohanian (1999), Cole and Ohanian (2000), Cole and
Ohanian (2004) and Prescott (1999). In this interpretation, the explanation
of the plunge of the early thirties (that is, the historical identification of
the shock that caused the Great Depression) is considered methodologically less interesting than the explanation of its long duration (that is, why
the Great Depression did not behave in the same way as business cycles
observed in the post-war period). The causes of the productive collapse
of the USA economy in the 1930s are mostly traced back to some exogenous supply shock, embodied for simplicity in a parameter of the pro6
This is also the position held by Romer (1993). Although working from a different
basis, she argues that the Great Depression in the US was due to a mixture of bad monetary policy and aggregate demand shocks, both with idiosyncratic characteristics specific
to the American case.
2.3 The US Great Depression
13
duction function (TFP). As for the protracted character of the depression,
these models charge New Deal policies with having been responsible for
it. These policies produced substantial distortions in the economy, thus
impeding the otherwise inevitable recovery.
The second class of models includes all the other RBC papers on the
Great Depression. These models are more interested in the traditional
question of what caused the Great Depression. To this end, they resort to
a variety of variables (monetary shocks and sticky wages in Bordo, Erceg,
and Evans (2000); preference for liquidity in Christiano, Motto, and Rostagno (2004); exogenous demand shocks in Weder (2006)). As to the long
duration of the Great Depression, all these authors accept the implications
of the “normality view”: either the Great Depression would have been a
normal business cycle of greater magnitude had distorting State interventions been absent (Bordo, Erceg, and Evans (2000); Christiano, Motto, and
Rostagno (2004)); or the Great Depression was a normal business cycle of
great magnitude that lasted a long time because the shock producing the
cycle was extremely long lasting (Weder (2006)).
Other papers exist, the classification of which under the RBC label is
more uncertain. Sunspots models are a case at hand.7 In sunspots models, there is multiplicity of equilibria. Business cycles are defined as the
economy’s swinging from one equilibrium to the next. Such swinging
7
In the taxonomy adopted here, it is doubtful whether this last class of models should
be included in the RBC category. First, expectation shocks are neither exogenous nor
endogenous, in the sense that their nature is ambiguous. On the one hand, the very
concept of “animal spirits” suggests that variations in expectations should be considered
as an exogenous shock. On the other hand, it defies credulity to assume that people
form expectations without looking at reality, or framing it in some causal perspective,
i.e. in a model. In this sense, the shock must be at least partially endogenous. Secondly,
be that as it may, by definition expectation shocks are not shocks to the fundamentals
of the economy, which we have assumed to be a distinctive feature of RBC theory. The
counterargument that leads me to include sunspots models in my taxonomy of RBC is
that they are “equilibrium” models à la Lucas, they use the Slutzky intuition of business
cycles as summation of random shocks, and they distinguish between the impulse and
transmission mechanisms of the business cycle. Being unable to choose whether or not
to include sunspots models in the RBC category, I have decided to include at least one of
them for the sake of completeness.
14
A Critical Survey
movements are determined by self-fulfilling (rational) expectations. The
Great Depression appears as a demand-driven phenomenon arising from
people’s unexplained, though plausible, pessimistic behaviour. I will review one paper in this tradition, that by Harrison and Weder (2002), in a
separate subsection.
2.3.1
Cole, Ohanian and Prescott on the Great Depression
The RBC interpretation of the US Great Depression stems from the work of
two leading authors, Harold Cole and Lee Ohanian. Initially, they focused
on the standard issue of explaining the origins of the Great Depression.
This inquiry led to a rather frustrating result. Neither the standard RBC
story of technological shocks, nor other standard real and monetary factors, could properly account for both the observed magnitude and the long
duration of the Great Depression. Cole and Ohanian soon turned their attention to the protracted character of the Great Depression, a theme that
eventually proved more congenial to RBC methodology and theory. The
distorting elements of some New Deal policies helped to explain why the
economy remained depressed for so long. This position has been authoritatively espoused by Prescott, who, in a short comment article in 1999,
gave a clear picture of the basic elements of the RBC interpretation of the
Great Depression. As it is representative of the whole of this stream of literature, I will start by discussing Prescott’s paper, and turn my attention
to Cole and Ohanian’s article in a second step.
Prescott’s assessment
According to Prescott (1999), the RBC interpretation of the US Great Depression consists of two building blocks. First, some of the exogenous factors usually described in terms of shocks to TFP caused a strong recession
at the end of 1929. Second, misconceived economic policies, attempting to
improve the disastrous economic performance of that time, impeded the
normal adjustment of market forces. These policies introduced strong distorting elements into the US economy: by increasing de jure the real wage
2.3 The US Great Depression
15
rate, they lowered the normal employment level and the growth path. In
Prescott’s words:
In the Great Depression, employment was not low because investment was low. Employment and investment were low because labour market institutions and industrial policies changed
in a way that lowered normal employment. (Prescott (1999), p.
27)
The interest of Prescott’s comment is that it highlights the basic elements of the RBC methodology, which I have spelt out in Section 2.2.
A dividing line is drawn between the realm of history, which includes
the historical identification of shocks, and the realm of economics, which
studies the propagation mechanism of the business cycle. In Prescott’s
methodological approach, the origin of a shock (i.e. the concrete historical
determination of the impulse mechanism of the business cycle) is outside
the scope of economics. What is more puzzling for an economist is the explanation of the slowness of the recovery. By sticking to this view, Prescott
reduces the explanation of the Great Depression to the explanation of the
1934–1939 episode. The following quotation illustrates this point.
The fundamental difference between the Great Depression and
business cycles is that market hours did not return to normal
during the Great Depression. Rather, market hours fell and
stayed low. In the 1930s, labor market institutions and industrial policy actions changed normal market hours. I think these
institutions and actions are what caused the Great Depression.
(Prescott (1999), p. 27)
The point is that this method of analysis might make sense, from a
theoretical point of view, when the development of a general theory of
the business cycle is considered. In that case, the theory can conceivably
be more concerned with the regularities of the business cycle (that is, in
how a business cycle arises from an exogenous shock) than in studying
the peculiarities of each particular shock. However, things should be different when a specific event, such as the Great Depression, is analysed.
16
A Critical Survey
In that case, explaining the Great Depression must be tantamount to explaining both its onset and its long duration. By sticking to the “normality
view”, and trying to cast the Great Depression within the RBC framework,
Prescott is led instead to overlook a priori any explanation of the plunge
of the early 1930s, a standpoint which is not acceptable from an historic
point of view. All the more so in that, as shown by Ohanian (2002), in
the specific case of the Great Depression, the exogenous shock required
to reproduce the data is abnormally large (the next Section illustrates this
point). It is important to make the point that at least this abnormal dimension deserves more detailed historical analysis.
Cole and Ohanian on the onset of the Great Depression
Cole and Ohanian’s early work was mainly negative, consisting of showing that, when closely scrutinized, earlier explanations of the Great Depression are unsatisfactory. In their 1999 paper, they started by describing
the behaviour of the main detrended macroeconomic aggregates during
the decade 1929–1939; subsequently, they tried to identify, from among the
many different explanations in the literature purporting to explain business cycles, the models that best fit these data. Cole and Ohanian (1999)
found that stochastic shocks to the growth rate of the TFP could explain
roughly 40% of the 1929–1932 drop in output. They obtained this result by
taking a suitable specification of the model, and feeding in the observed
level of TFP as a measure of technological shock.
An interesting point, highlighted by Ohanian (2002), is that the drop
in measured TFP during the Great Depression, although not sufficient to
reproduce in the model the magnitude of the decline in output, was still
relatively high when compared with the drops in measured TFP that have
normally accompanied recessions in the post-World War II period. This
feature means that the behaviour of the TFP during the 1930s was peculiar, for reasons still to be elucidated (see Ohanian (2002) for further discussion).
Alternative “real” explanations, such as shocks to international trade,
public expenditure and distorting taxes, are presumed to have had a lesser
2.3 The US Great Depression
17
impact, if any, on the crisis. For international trade, Cole and Ohanian
(1999) note that the United States was at that time a relatively closed economy. Moreover, the presence of tariffs suggests that US imports might
have had a high elasticity of substitution with domestic intermediate goods.
Consequently, international trade disruptions had no appreciable or enduring negative effects on the US Great Depression. As to public expenditure, Cole and Ohanian (1999) report data showing that detrended public
expenditure in the USA remained above the trend level during almost the
entire decade. So a negative crowding-out effect of public expenditure has
to be dismissed. As far as taxes are concerned, Cole and Ohanian (1999)
ran two further simulations using data on the average marginal tax rates
on factors’ income: the first with the 1929 average tax level, and the second
with the 1939 average tax level. In the second simulation the steady-state
level of labour input was 4% lower than in the first. The authors therefore concluded that negative fiscal policy shocks did not have appreciable
effects on the 1929–1933 crisis, but that they can explain some 20% of the
weak 1934–1939 recovery.
“Monetary” shocks, financial disruptions and nominal rigidities are
also considered to have had little impact on the Great Depression. Cole
and Ohanian (2000) reviewed the main mechanisms identified by economists
to explain possible real effects of monetary policy during the 1930s, namely
the Lucas and Rapping (1969) unexpected deflation model, the debt deflation model of Fisher (1933), the sticky-wage hypothesis and theories centred on the role of banking disruptions induced by deflation (Bernanke
(1983)). By comparing deflation in 1929–1933 to that in 1920–1921, the authors first excluded Lucas and Rapping’s and then Fisher’s hypotheses.8
8
Their objection to the first theory is that deflation was more widely anticipated in the
1930s than in the 1920s because the nominal interest rate was lower during the 1930s.
This weakens Lucas and Rapping (1969)’s propagation mechanism, which is based on
unexpected deflation. As to Fisher (1933)’s debt deflation model, they note that, although
the level of private debt as a proportion of output was higher in 1929 than in 1920, output
dropped more sharply during the 1930s than during the 1920s, despite deflation being
less severe. Prices went down by 19.4% in 1920–1922 and by 11.5% in 1929–1931, whereas
detrended real income dropped by 3.8% in the 1920–1922 and by 22.4% in the 1929–1931
period. See Cole and Ohanian (2000), p. 6, Table 3.
18
A Critical Survey
To test the sticky-wage hypothesis, Cole and Ohanian (2000) built a two
macrosector general equilibrium model, in which a final good is produced
by means of two different types of intermediate goods. Each intermediate
good is produced by means of capital and labour. There are two sectors
producing intermediate goods: one, n, is a competitive sector, with wages
set at the market-clearing level; the other, m, is a noncompetitive sector,
where wages are fixed above the market-clearing level. Both sectors use
the same constant returns to scale Cobb–Douglas technology. The final
goods sector uses a constant elasticity of substitution (CES) technology.
Both capital and labour are assumed to be immobile. The preferences of
the representative household are specified through a logarithmic utility
function. The household can allocate its working time between the two
sectors, and it is assumed that wage fixity in the noncompetitive sector
is perceived as a nonrecurring phenomenon (i.e. the model assumes that
each wage shock occurring in any of the Depression years is completely
unexpected).9 The model was calibrated using, as far as possible, standard
values from the RBC literature for the parameters. A calibration for the
model-specific parameters is also provided. The values of these parameters were chosen by considering the manufacturing sector as the empirical
counterpart of the noncompetitive sector in the model. Running two simulations, one with a benchmark model without nominal wage rigidities,
and the other with the model as described above, and comparing their
results with the data, Cole and Ohanian conclude:
These results suggest that the high wage was not the primary
cause of the Great Depression . . . This wage accounts for about
a 3 per cent decline in output at the trough of the Great Depression, compared to an actual 38 per cent decline. Increasing the
size of the distorted sector to 50 per cent, or reducing the substitution elasticity to 0,1 did not significantly change the result.
(Cole and Ohanian (2000), p. 20)10
9
This is a technical assumption needed in order to be able to compute the equilibrium
in the simulation recursively.
10
The economic rationale for this result is as follows. In this two-sector model, wage
2.3 The US Great Depression
19
Cole and Ohanian (2000) also exclude the possibility that wages might
be significantly underestimated, and argue that in fact the contrary is likely
to be true. Referring to Margo (1993), they assert that wages were probably also well below the trend line in the manufacturing sector, because of
the compositional bias in favour of high-skilled workers that affected the
US economy in the 1930s.11
As to the analysis of banking shocks, Cole and Ohanian (2000) first defined banking shocks as bank closures affecting the information capital.
Then they built a model in which information capital was used by banks
as input, together with deposits, to obtain a “banking output”. This banking output appears, in the end, as an input to the production of the final
good. Both these productive processes are assumed to be constant returns
to scale. This model is built so that, in each sector, the ratio of inputs
to outputs is equal for all inputs. Consequently, the loss of information
capital relative to output due to bank closures is equal to the fraction of
deposits on output loss due to bank closures. As the US data reported by
Cole and Ohanian (1999) show this to have been pretty low during the
rigidity has both a direct and an indirect effect on employment. In the distorted sector, m,
firms employ labour up to the point where the marginal product of labour equates to the
real wage. Because, by definition, the real wage in this sector is above the market-clearing
level, production in the distorted sector will be below its potential level. It follows that
part of the labour force potentially employable in the distorted sector will remain unemployed. Such a direct effect is clearly negative. To understand the indirect effect, it is
worth considering that output in the distorted sector is an input in the production of the
final good. Cole and Ohanian (2000) assume that technology is such that Ym and Yn are
imperfect complements in the production of the final good, rather than substitutes. This
means that, as Ym diminishes, its relative scarcity will increase, and so will its relative
demand. Firms cannot substitute Yn for Ym beyond a certain level. Thus ppm
, the relative
n
price of the distorted sector, must increase. According to the authors, this means that,
m
given a monetary wage wm , the real wage wpm
will decrease. In other words, the real
wage will decrease in spite of the nominal rigidity, thus producing an upward shift in the
value of the marginal product of labour (i.e. the marginal product of labour multiplied
by the price of output schedule). Thus the indirect effect would tend to counteract the
direct one.
11
This point is actually controversial. For instance, Bordo, Erceg, and Evans (2000) argue that data at the industrial level suggest that there was no significant skill composition
bias.
20
A Critical Survey
Great Depression, the authors conclude that, because the loss of information capital was also low during the Great Depression, it only affected the
economy slightly.
Cole and Ohanian on the long duration of the Great Depression
According to standard RBC theory, the Great Depression should have ended
much earlier than it actually did. Once the effects of the TFP negative
shock were exhausted, the economy should have returned to its steadystate growth path. In Cole and Ohanian (1999)’s simulations, output would
have recovered to its trend level by 1936, if the measured shocks to TFP in
the 1930s had been the sole impulse mechanism for the economic cycle.
The TFP returned to its trend level that year. However, detrended data
show that in 1939 output was still a good 25% below its trend level. This
observation led Cole and Ohanian (1999) to argue that the Great Depression was not only the result of a temporary shock that caused a fluctuation
around the trend-growth path, but was also rather the outcome of a mixture of a temporary shock and some permanent shocks that caused the
growth path itself to shift downwards. At the end of their paper, Cole and
Ohanian (1999) suggest that a likely culprit could be the New Deal policies
introduced after 1933.
While this line of research is only alluded to in Cole and Ohanian
(1999)’s paper, the link between New Deal policies and the Great Depression is the central object of their subsequent research (see Cole and Ohanian (2004) and an earlier and more detailed working paper version, Cole
and Ohanian (2001)). Their basic claim is that New Deal competition and
labour market policies are to blame for the duration of the Great Depression. In particular, they consider two important reforms: the National
Industrial Recovery Act (NIRA),12 and the National Labour Relations Act
12
The NIRA was enacted in 1933 and declared unconstitutional by the Supreme Court
in 1935. The act aimed to ensure that all sectors were covered by “codes of fair competition”, which would put an end to substantial price deflation and increase workers’
income, so promoting greater consumption expenditure. The NIRA also suspended antitrust laws, and encouraged cooperation between firms, and collusion in price setting; it
heavily discouraged price competition, requiring administrative approval for price cuts.
2.3 The US Great Depression
21
(NLRA).13 These measures had a relatively high coverage in the economy:
about 52% of total employment was in sectors covered by the NIRA, while
this figure reached 77% in the private nonfarm sector (Cole and Ohanian
(2001), p. 67, Table 2). Cole and Ohanian (2004) present a model to show
that the rise in prices and wages actually curbed the recovery in production, rather than boosting it (as Roosevelt’s economic advisers thought
it would).14 The model is explicitly oversimplified insofar as it assumes
NIRA and NLRA to be the same thing, and does not consider the effects
of other New Deal policies. This is done in order to predict output for the
whole 1934–1939 period more easily.
The codes, though different for each sector, had to be negotiated under the guidance of
the National Recovery Administration, and required the approval of the President. Cole
and Ohanian (2001) stress that Roosevelt’s political inclinations, as well as the deep conviction of his advisers that an increase in prices and nominal wages would be the best
way to counteract the Depression, led him to guarantee approval to those codes that included collective bargaining over wages, and minimum wages for low-skilled workers.
13
The NLRA was enacted in 1935, and its constitutionality was upheld by the Supreme
Court in 1937. It gave workers the right to organize themselves into trade unions independent of their employers; it prohibited discrimination based on union affiliation, as
well as coercive enrolment in companies’ unions. The Act also established a National
Labour Relations Board (NLRB), which had the authority to guarantee the legal enforcement of wage agreements.
14
It is very interesting to note that the view that the NIRA policy probably had a negative impact is not the prerogative of RBC theory. J.M. Keynes, in an open letter to Roosevelt published in The New York Times in 1933, expressed his disagreement with this
policy as a means of producing a recovery. He argued that the fact that an increase in
prices and monetary wages generally characterizes the recovery periods does not mean
that it causes the recovery to happen. So, in Keynes’s view, the US administration had
confused causes with effects. In Keynes’s opinion the NIRA was probably an obstacle
to recovery, because it increased the costs of production, whereas the appropriate measure for ending the recession was a policy of large government expenditure, financed by
long-term public debt, together with a monetary policy that fixed low nominal interest
rates. Keynes’s diagnosis was that people were not spending money, and that this was
causing the cumulative deflation that resulted in depression. To restart a virtuous circle
of development, people had to be induced to spend. If this were not possible, a good
surrogate for the missing private expenditure would be government expenditure. In the
end, the increase in the aggregate demand would generate an increase in the general level
of prices.
22
A Critical Survey
The benchmark specification of the model is a multisector version of
a standard real business cycle model, in which a final good in period t
is produced using a variety of intermediate goods. These intermediate
goods are produced by different industries, each belonging to a sector. All
the production technologies exhibit constant returns to scale. Labour is assumed to be perfectly mobile across industries and sectors, whereas capital is considered sector-specific. Households are supposed to maximize a
logarithmic utility function in which labour is assumed to be indivisible.
To model New Deal policies in this setup, Cole and Ohanian (2004)
modified the model in three ways. First, they assumed that, in the economy, a fraction χ of the sectors producing intermediate goods forms a
cartel. In these sectors there is, therefore, a rent to be shared between
workers and firms arising from the monopolistic extra profits. Second,
they assumed that, as a consequence, wages in these cartelized sectors are
the result of bargaining between workers and firms; the relative bargaining power of the two parties is embodied in a parameter ω that gives the
probability of a firm gaining monopolistic extra profits without accepting
workers’ wage demands. The cartelized sector behaves in the same way in
an “insider–outsider” model, where all insider workers are paid the same
wage. Third, Cole and Ohanian assumed that there are frictions in the
labour market, which allow for flows of workers between the competitive
and the cartelized sectors. Considering that jobs in the cartelized sectors
are better paid, workers prefer to move to these sectors rather than to similar jobs in the competitive sectors. A search process for these jobs therefore
ensues.
These three modifications were intended to emphasize the characteristic of the New Deal policies that Cole and Ohanian consider essential: a
connection between collective bargaining (allowing de facto for the greater
bargaining power of unions and workers) and price control by cartelized
firms. They also reproduce the “equal pay for equal work” principle, a
cornerstone of union policy in the 1930s. Calibrating and simulating their
model, Cole and Ohanian fed in the sequence of observed TFPs as measures of technological shocks, and compared the results of the cartel modification with the competitive benchmark, both relatively and in terms of
2.3 The US Great Depression
23
reproducing the actual data.
Their main result was that cartelization caused a greater drop in output
the greater the bargaining power of workers, i.e. the lower the calibrated
value for the parameter ω, and, ceteris paribus, the higher χ (the share of
the economy involved in such a policy). However, the effects of varying
ω were much larger than those induced by variation in χ; as Cole and
Ohanian observe:
The key depressing element of the policy is not monopoly per
se, but rather the link between wage bargaining and monopoly.
(Cole and Ohanian, 2004, p. 805)
As far as a comparison with the actual data is concerned, while the
competitive model failed to reproduce the observed trend of economic aggregates during the recovery, the cartel model made predictions that were
considerably closer to the facts. On the basis of the figures obtained, Cole
and Ohanian (2004) argue that the cartel model is able to explain a good
60% of the slow recovery. The rationale for this result is that the negative effects of higher wages and lower production propagated from the
cartelized sectors to the competitive sectors, insofar as the reduced output
in the cartelized sectors tended to lower wages and employment in the
competitive sectors where, moreover, people were looking for better paid
jobs in the cartelized sectors. So, they conclude,
. . . New Deal labor and industrial policies did not lift the economy out of the Great Depression. . . Instead, the joint policies
of increasing labor’s bargaining power, and linking collusion
with paying high wages, prevented a normal recovery by creating rents and an inefficient insider–outsider friction that raised
wages significantly and restricted employment. (Cole and Ohanian (2004), p. 813)
2.3.2
Other RBC models of the Great Depression
The debate about sticky wages
Cole and Ohanian (2000)’s conclusion that sticky wages were irrelevant
24
A Critical Survey
in accounting for the onset of the US Great Depression is far from uncontroversial. Empirical evidence on cross-sectional international data (presented by Eichengreen and Sachs (1985)) suggests that currency-devaluating
countries experienced relatively lower real wages and higher industrial
production, a finding consistent with the sticky-wage hypothesis.15 On
the other hand, Christiano, Motto, and Rostagno (2004) point out that
. . . There just does not seem to be a tight negative relationship
between the real wage on the one hand, and output and employment on the other. (Christiano, Motto, and Rostagno (2004),
p. 11)
This point is also debated theoretically among RBC authors. Bordo,
Erceg, and Evans (2001) and Gertler (2001) argue that Cole and Ohanian
(2000)’s result follows from the unjustified assumption of perfect wage
flexibility in the non-manufacturing sector. As Gertler (2001) points out,
this model excludes nominal wage rigidity by definition, and thus excludes the decrease in the aggregate demand for labour that is necessary
if the sticky-wage hypothesis is to produce real effects. Moreover, Bordo,
Erceg, and Evans (2001) emphasize that there is no justification for this
choice, either theoretically or empirically, because it is based on a questionable extension of the wage flexibility observed in the farming sector to the
whole non-manufacturing sector. According to Bordo, Erceg, and Evans
(2001), imposing noncompetitive wages in the non-manufacturing sector –
even lower, perhaps, than the manufacturing sector’s wages – completely
reverses Cole and Ohanian (2000) results.
In an earlier article, Bordo, Erceg, and Evans (2000) showed that the
sticky-wage hypothesis could provide an explanation of the onset of the
Great Depression within an RBC framework. They built a simple onesector real business cycle model with monetary shocks and fixed wages
à la Taylor (1980). Running a simulation on this model, they found that
it could “explain” approximately 70% of the 1929–1932 drop in output, a
15
Expansionary monetary policy generates price inflation; provided that nominal
wages are rigid, real wages will go down. This will produce an increase in labour demand and hence in output.
2.3 The US Great Depression
25
result in sharp contrast to Cole and Ohanian’s result. However, Bordo,
Erceg, and Evans (2000) admitted that their results clearly show that on
its own the sticky-wage hypothesis can account neither for the recovery
phase of the US Great Depression (characterized by a strong monetary expansion (Romer (1992)), nor for the final year of the recession, 1932–1933.
According to them, some financial disruption of the kind envisaged by
Bernanke (1983) might have been responsible for the crisis in the final year.
They suggest a more detailed explanation for the recovery phase, built on
Cole and Ohanian (1999)’s early suggestion about the possible distorting
role of New Deal policies. In particular, they focused (as Cole and Ohanian did a year later) on the NIRA. Bordo, Erceg, and Evans (2000) then
modified the process of wage formation in their model by splitting it into
two processes: a Taylor setting, for the period 1929:3–1933:2;16 and a level
of wages fixed to their 1933:2 level later on. This modified model shows
that
As long as real wages were legislatively mandated at levels
well above the marginal product of labour that would prevail
at full employment, monetary expansion alone could not lead
to recovery. (Bordo, Erceg, and Evans (2000), p. 1461)
Christiano, Motto, and Rostagno (2004)
A further development in the application of RBC methodology to the Great
Depression is the recent work by Christiano, Motto, and Rostagno (2004).
This paper attempts to build a “realistic” dynamic stochastic general equilibrium model able to tackle contemporary policy questions. The authors
consider the US Great Depression as the toughest possible test for such a
model. Christiano, Motto, and Rostagno (2004)’s main conclusion is that
while the Great Depression was certainly the result of many joint shocks,
it is mainly attributable to two factors: a “preference for liquidity shock”
(which induced a shift away from demand deposit towards money, thus
in large part causing the onset of the depression); and the increased market power of workers during the New Deal (which explains why, during
16
Quarterly data are used here.
26
A Critical Survey
the recovery phase, employment was still so low, thereby shedding some
light on why the recovery phase itself was so slow).
These results are obtained by means of a very complex RBC model. Its
basic structure is as follows. It is assumed that a final good Yt is produced
by a perfectly competitive representative firm, using a number of intermediate goods Yj,t . These intermediate goods are produced by monopolists who set their prices Pj,t subject to Calvo (1983)-style friction. The
intermediate-good firms need labour lj,t and capital Kj,t for their productive activity. They buy working hours from households, paying a wage
rate Wt . They rent capital from entrepreneurs, paying a rental price of
capital P rtk for capital services. Moreover, each intermediate-good firm
must finance in advance fractions ψk and ψl of capital and labour services,
respectively. They do this by asking for loans from banks, and paying a
net interest rate of Rt . Entrepreneurs buy capital x from capital producers,
paying for it at the price Qk̄0 ,t . In order to pay these amounts they use their
net worth Nt and they borrow Bt = Qk̄0 ,t − Nt from banks, paying a gross
interest rate Zt . At the end of the period, they sell the undepreciated capital back to capital producers, at the same price Qk̄0 ,t . Entrepreneurs can be
bankrupted during each period with a probability 1 − γt , which also represents the fraction of the new entrepreneurs entering the market during
each period.
Capital producers produce units of new capital good x0 by means of
previously installed capital x and investment goods It . They buy investment goods from the final-good sector, paying them Pt . Banks use capital and labour to “produce” their services and hoard reserves. They buy
working time ltb from households, and rent capital Ktb from entrepreneurs,
paying Wt and P rtk , respectively. They hold demand deposits Dtf and
Dth from firms and households, respectively, paying them an interest rate
of Rta . They also hold time deposits, Tt , from households, which pay a
e
non-state-contingent expected rate of return Rt+1
. Finally, households consume an amount Ct of the final good, paying Pt per unit; they hold highpowered money M b ; they pay lump-sum transfers to entrepreneurs, in
order to guarantee free entry to entrepreneurship and they receive lumpsum transfers corresponding to the net worth of entrepreneurs leaving the
2.3 The US Great Depression
27
economy.
Households are modeled as maximizing a complex utility function encompassing, inter alia, habit persistence, shocks to the preference for leisure
and shocks to liquidity preference. Households are assumed to be able to
exert some monopoly power over labour, so that they set wages within a
Calvo contract setting. There is also a non-modeled Government, which
buys Gt unit of the final good, at the price of Pt per unit.
Next, Christiano, Motto, and Rostagno (2004) introduce eight exogenous shocks and study their joint and individual impact on the model,
comparing their outcomes with data for the US Great Depression. These
shocks affect the monopoly power of intermediate-good firms, the monopoly
power of wage earners, households’ preference for currency versus demand for deposits, the preference for liquidity, productivity shocks for
intermediate goods, the survival probability of the entrepreneur, the relative value of excess reserves in the banking sector and the willingness of
entrepreneurs to take risks. These shocks are drawn from stochastic processes, and estimated with a maximum likelihood procedure. Christiano,
Motto, and Rostagno (2004) assume that the shocks influence the rate of
growth of money, because of the monetary authority reaction function.
After having estimated all the parameters and calibrated the model,
Christiano, Motto, and Rostagno (2004) ran a simulation, including estimated values for the shocks. They found that their model reproduced key
features of the data properly. As anticipated at the beginning of this section, they also found that two shocks are crucial in explaining the Great
Depression in the United States: preference for liquidity and workers’
market power. While workers’ market power resembles the traditional
high-wages story, which we have discussed above, the preference for liquidity deserves some further explanation. An exogenous shock to the
preference for liquidity leads to a decrease in the ratio between demand
Dh
deposits and money demand, Mtt , in consumption and in time deposits.
The aggregate M1 falls, causing the interest rates to increase. The higher
interest rates cause an increase in the debt burden and a decrease in the
rental price of capital,17 leading to a higher probability of bankruptcy for
17
Because consumption demand decreases.
28
A Critical Survey
entrepreneurs. As a consequence, entrepreneurs drop their demand for
capital goods, and so capital-goods producers lower their level of production. Their prices, therefore, go down. The fall in the price of capital worsens the drop in investments, because it causes the net worth of
entrepreneurs to diminish.
At the end of the paper, Christiano, Motto, and Rostagno (2004) modeled a counterfactual example in which the monetary authority actively
reacts against the shocks, allowing the growth rate in the monetary base
to overcompensate for the reduction due to the eight shocks. This led them
to argue that, had an appreciably more expansive monetary policy been in
place in the 1930s, the size and duration of the Great Depression would
have been much less.
Weder
The last papers to be considered in this section are both by Weder, who
has produced two accounts of the same idea (Weder (2001); Weder (2006)).
The two papers share the same model, but differ in the narrative part,
which is much more developed in the earlier one. I will mostly refer to the
more recent (2006) paper, while occasionally referring to the earlier (2001)
paper. In these papers, a dynamic stochastic general equilibrium model
of the RBC type is modified to allow exogenous shocks to the aggregate
demand for consumption to be the only impulse mechanism of the business cycle. The aim is to evaluate the impact of the consumption shock
on the Great Depression quantitatively, by simulating the model. As for
the methodological concern, the model is in the RBC tradition. Nevertheless, it has a clearly Keynesian flavour, all the more so in that Weder (2001)
defines his model as an RBC formalization of Temin (1976)’s view of the
Great Depression as a phenomenon mainly caused by a contraction of the
autonomous components of aggregate demand for consumption.
In Weder’s model, households are thought of as maximizing a logarithmic utility function with a random variable affecting the subsistence level
of consumption. The model also includes variable capital utilization, “organizational synergies” and increasing returns to scale in the production
2.3 The US Great Depression
29
function. Weder (2006) identifies the preference shifter econometrically.18
He calibrates his model, largely on the basis of Cole and Ohanian (1999),
and runs a simulation. It turns out that the model with increasing returns
matches the trend in US output, “explaining” around 59% of the collapse,
and almost all of the slow recovery and the 1937–1938 recession.
An interesting point, which is developed in Weder’s (2001) paper but
abandoned in the drier (2006) one, is the explicit comparison between
Weder’s model and the competitive and cartel models discussed by Cole
and Ohanian (2001). Weder (2001) points out that his model can mimic the
onset of the Great Depression as well as the slowness of the recovery (reproducing about 80% of the variance in the data correctly), whereas Cole
and Ohanian (2001)’s competitive model can explain only about 40% of the
onset of the depression, and very little of the recovery phase. Moreover,
Cole and Ohanian (2001)’s cartel model can only explain 50–60% of the recovery phase. In addition, Weder argues that his model can reproduce the
1937 recession, which other models cannot.
To investigate further which model “explains” the data in a statistically
more appropriate way, Weder (2001) runs a regression of actual US output
on the “predicted” output of three models (his own, Cole and Ohanian
(2001)’s competitive model and Cole and Ohanian (2001)’s cartel model).
He finds that the predictions of his model are statistically more significant
than those of the other two. When output from his model is added to the
regression, the other two lose any explanatory power, meaning that the
null hypothesis (that they do not explain US output at all) cannot be rejected. When only the recovery period is considered, the “explanatory”
powers of his model and Cole and Ohanian’s cartel model are equally statistically significant. For both models the null hypothesis is rejected at 1%
significance level, with regression coefficients of 0.57 and 0.41 for the cartel
18
Weder first derives a Euler equation from the first-order conditions for the household’s utility maximization problem. He then linearizes the Euler equation, taking a
Taylor approximation of it. Finally he uses ordinary least squares to regress the formula
he obtained on the data, and takes the residual from the regression as the preference
shifter. The dynamic process of this preference shifter is then found econometrically to
ˆ t = ξ1 ∆
ˆ t−1 + ξ2 ∆
ˆ t−2 + dt . Weder (2006)
be second-order autoregressive, of the kind ∆
c
dt 1939
uses this AR(2) to compute a shock series { c }1930 from the data.
30
A Critical Survey
and the demand-driven model, respectively. Weder (2001) concludes that:
Judging the overall performance, the demand-driven model
fares at least as good [sic] as its considered contenders. (Weder
(2001), p. 18)
2.3.3
A sunspots neoclassical interpretation of the US Great
Depression
All the models reviewed above fit the definition of RBC models developed
in Section 2.2, in that they respect the equilibrium discipline, and business
cycles are assumed to arise from exogenous shocks to the fundamentals.
A slightly different approach to the Great Depression was proposed by
Harrison and Weder (2002). In this paper the authors stuck to the equilibrium hypothesis, but business cycles were assumed to be driven by animal
spirits (or sunspots), i.e. self-fulfilling expectations not related to the fundamentals of the economy.
This model is a variation on Weder (2001)’s theme. Instead of assuming an exogenous shock to preferences, and setting parameters to solve the
dynamics for a saddle path, Harrison and Weder (2002) set the parameters
so as to allow for bubbles. The possibility of animal-spirit-driven business
cycles arose in their model because they assumed sufficiently increasing
returns to scale to ensure the existence of multiple equilibria. A high degree of increasing returns to scale actually ensures that optimistic or pessimistic expectations will be self-fulfilling. Consumers will move savings
accordingly, labour supply will shift and capital utilization will vary. Variations in capital utilization will mean variations in labour demand up to
the new equilibrium, at which point expectations will actually have been
fulfilled.
Harrison and Weder (2002) identified non-fundamental shocks to the
“degree of confidence” by means of a vector auto-regression (VAR) model.
They assume that the interest rate spread between high-risk and low-risk
bonds is a reasonable proxy for the degree of confidence. Running two
alternative versions of the VAR, plus a Granger causality test, they claim
2.3 The US Great Depression
31
that residuals from the VAR specification, in which the spread of interest
rates is the “most exogenous” shock to the system, do Granger-cause output.19 Subsequently, they used the sunspot shock series generated by this
procedure to compute the output, consumption, investment and productivity series implied by the model.
The findings fit the data well. Provided the increasing returns to scale
are large “enough”, the model reproduces stylized facts better than Cole
and Ohanian’s competing models. Both the sharpness of the downturn
and the slowness of the recovery are accounted for by sunspots shocks.
Moreover, Harrison and Weder’s model reproduces the 1937–1938 recession, which all the other models fail to do.
These results led them to give the following account of the Great Depression:
The 1929 stock market crash was followed for about a year by
what appeared to be the start of a normal recession. Only later,
during the summer of 1930, did confidence began to deteriorate dramatically. Hence the recession was transformed into a
depression. In 1932, faith in the economy hit bottom; and the
continuing sequence of pessimistic animal spirits are a prime
candidate in the quest to explain the subsequent stagnation
that only ended with the onset of World War II. (Harrison and
Weder, 2002, p. 26)
Extending the analysis, Harrison and Weder tested their model over
a longer period starting from the end of Great Depression and ending in
2000. Results in this case were poor. They concluded that
demand shocks [that is sunspots] were either less important or
smaller in the postwar period or were partially neutralized by
active fiscal and monetary policies. (Harrison and Weder, 2002,
p. 25)
19
In the sense that the null hypothesis that the residuals do not Granger-cause output
is rejected at a confidence level between 5% and 2%, depending on whether 4 or 8 lags
are used (Harrison and Weder (2002), Table 3, p. 17)
32
2.4
A Critical Survey
Great Depressions worldwide
The RBC interpretation of the Great Depression outside the USA is made
up of two elements. The first is a critique of what RBC theorists call
the “consensus view”,20 stressing the role of deflation and nominal wage
stickiness in the diffusion of the depression from the USA to the rest of
the world. The basic idea of the “consensus view” is that adherence to
the gold exchange system induced restrictive monetary and fiscal policies in the presence of serious deficits in the balance of trade, or in order to avoid them. These policies are normally deflationary, and deflation
causes unemployment, unless nominal wages decrease. The second element is a case-study analysis of a number of countries, applying an identical methodology and theoretical setup to each country. These studies,
it is claimed, demonstrate that idiosyncratic shocks to TFPs and countryspecific economic policies provide a fairly good explanation for the Great
Depression in each country, without any reference to an international dimension.
2.4.1
The critique of the “consensus view”
The arguments presented by Cole, Ohanian, and Leung (2005) for rejecting
the “consensus view” are empirical and mainly based on the signs of the
correlations between log deviations from the trend-lines of real wages and
output, and prices and output. According to these authors, if the “consensus view” were right, there should be a positive correlation between
the rates of growth of prices and real output, and a negative correlation
between the rates of growth of real wages and real output. In other words,
pinning things down to a traditional labour supply and demand graph, we
should observe an upward and leftward movement along the labour demand schedule, with increasing real wages and decreasing employment.
Studying cross-sectional data on 17 OECD countries, Cole, Ohanian,
and Leung (2005) noted that when regressions were performed on the
20
The term “consensus view” is used by Cole, Ohanian, and Leung (2005) to refer to
papers by Bernanke (1995), Bernanke and Carey (1996) and Eichengreen and Sachs (1985).
2.4 Great Depressions worldwide
33
cross-sectional averages for 1929–1932, the correlation between the log deviations of prices and real output turned out to be slightly negative, while
the correlation between the log deviations of real wages and real output
was moderately positive. This observation led them to conclude that the
cause of the international Great Depression could not be sought in a movement along the labour demand curve, but rather should be found in a
movement of the labour demand curve. To model this hypothesis, they
considered an RBC model with money à la Lucas. In this model, the economy can be hit by two shocks: a monetary shock, causing a movement
along the labour demand curve, and a productivity (TFP) shock which
shifts the labour demand curve. Cole et al. calibrated the parameters of
the model so that the two shocks taken together reproduced the data set
as exactly as possible. They then tried to work out, for different orthogonalizations21 of the two shocks, how much of the movement of the total
quantities during the Great Depression could be explained by each factor. They found that a country-specific TFP shock orthogonal to deflation
could explain two-thirds of output variation in each country, while monetary shocks explained the remaining third. Moreover, their artificial series
of TFP shocks matched the small amount of data available for economywide productivity during the 1930s.22 On the other hand, the same simulation carried out with only the monetary shock (that is without TFP shocks)
produced a strong negative correlation between real wages and real output (in log deviation terms), which is at odds with the cross-sectional evidence.
On the basis of this analysis, Cole, Ohanian, and Leung (2005) concluded that an RBC account of the international Great Depression should
be based on a shock that works like a productivity shock, that is orthogonal to deflation, and that looks like a productivity shock in the data. They
21
Two random variables x and y are said to be orthogonal if their cross moment E(xy)
is zero. In the present case, the favoured procedure is one that orthogonalizes the TFP
shock on deflation. This means that the authors regress TFP on deflation, and then subtract the value of TFP obtained by the regression from the actual TFP value. In this way
the residual TFP is not correlated with deflation, as the effect of deflation on TFP has
already been taken into account by the regression.
22
These data refer to the USA, Canada, the UK and Australia.
34
A Critical Survey
suggest that natural candidates for such a shock are the financial disruptions stressed by Bernanke (1983), the decrease in “information capital”
hypothesized by Ohanian (2002) and policy interventions that obstruct the
normal working of the market forces, as in Cole and Ohanian (2004).
The analysis presented by Cole, Ohanian, and Leung (2005) deserves
some critical discussion. The 1929–1932 data show that a positive log deviation from the trend of real wages was accompanied by a negative log
deviation from the trend of output in 13 of the 17 countries considered.
This means that the relationship between real wages and output was negative in the vast majority of countries. True, the interpolation of the plotted
data gave an upward-sloping line. But the observations in the plot were
highly dispersed, so that the R2 was very low. Moreover, considering that
the countries under consideration differed substantially in this period, the
fact that an international increase in the rate of growth of wages was accompanied by a diminishing rate of decrease in output does not necessarily mean that as long as real wages increase in each country, we should
expect a parallel increase in real output. Many other factors that have not
been taken into account here could influence the results – for example, internal political factors (such as the role of unions and of socialist parties),
international political factors (such as war reparations and war debts) and
exchange problems in connection with problems in the balance of trade.
2.4.2
Case studies
The case study analyses are all contained in a special issue of the Review of
Economic Dynamics. Four of them, concerning, respectively, Canada, Germany, France and the United Kingdom in the 1930s, will be considered
here.23
23
For the sake of completeness, the other papers in the issue concern Italy’s mild depression of the 1930s, Japan’s crisis in the 1990s and analyses of South-American countries’ depressions in recent years. I omitted Italy, because the Italian depression was
smaller than the others and a bit peculiar (Perri and Quadrini (2002)). Instead I have
focused on Canada, to compare it with the United States.
2.4 Great Depressions worldwide
35
Canada
Amaral and MacGee (2002) carried out a comparative analysis of the Great
Depression in Canada and the USA, using an RBC model that is formally
equivalent to that used by Cole and Ohanian (1999). Their principal result is that an exogenous shock to TFP could reproduce about 50% of the
Canadian depression. This shock also performed well in accounting for
the slow recovery. Moreover, building on arguments by Cole and Ohanian (2000), they excluded the possibility that monetary factors could have
played a major role in causing the Canadian Great Depression. Finally,
they tested the importance of terms-of-trade shocks in explaining the depression. During the 1930s, Canada’s economy was small, and trade constituted a high proportion of GDP; trade shocks were certainly appreciable
at that time. The test was done by running a simulation on a two-country
RBC setup, under the limiting assumption that inputs are non-tradable
goods. The results show that terms-of-trade shocks are unable to account
for the Great Depression in Canada.
The comparison between Canada and the USA is interesting, although
puzzling. It shows that, in spite of some similarities in the general economic trend between the two countries, the USA experienced a recovery
starting in 1933, while Canada did not. The US recovery was characterized by a strong TFP recovery. TFP, in effect, came back to its trend level
by 1937 in the USA, while it remained below the trend level throughout
the 1930s in Canada. Interestingly enough, the time of recovery coincided
with the implementation of New Deal policies in the US, while Canada
had no such policy. On the other hand it is surprising to note that, while
all the aggregate variables suggest that from 1933 onwards the USA was
on the path to recovery (unlike Canada), the total hours worked increased
more rapidly in Canada than in the USA during this time.
Amaral and MacGee (2002) tried to solve these problems by using Cole
and Ohanian (2001)’s ideas; they argue that New Deal policies in the USA
affected labour employment negatively, and therefore measured TFP (which
is a residual) tended to be, ceteris paribus, higher in the USA.
In my opinion this explanation conceals some logical pitfalls. Amaral
36
A Critical Survey
and MacGee (2002) argue that the economy in the USA recovered earlier
than in Canada, because TFP in the USA recovered earlier than in Canada.
Such a faster recovery, they suggest, did not create higher employment
in the USA than in Canada, because New Deal policies independently affected the labour market in the USA. So, contrary to expectations, Canadian employment recovered earlier than the US employment. So far, the
argument works. But then Amaral and MacGee (2002) add that the higher
trend of TFP in the USA could depend upon the lower trend in employment! This introduces a circularity in the argument. It might safely be
concluded that New Deal policies were the instrument that dragged the
USA economy out of the depression because, paradoxically, by allowing
for higher unemployment, they allowed for higher TFP, which, in the RBC
framework, is the driving force of the economy. This paradox suggests that
explanation does not withstand closer examination, leaving the puzzle of
why employment recovered earlier in Canada than in the USA unresolved.
Germany
While the USA was the epicentre of the Great Depression, Germany was
certainly the European country that experienced the worst depression in
the early 1930s. In their paper analysing the Great Depression in Germany
from an RBC perspective, Fisher and Hornstein (2002) first observed that
detrended US and German data are quite similar in terms of rates of variation, so that, in their opinion, the two phenomena are comparable. Interestingly enough, Germany recovered to its 1928 trend level in 1937, while
the USA was still depressed at that date. The paper claims that one or
more real shocks could account for the behaviour of the German economy,
without any need to refer to monetary shocks or international constraints.
Fisher and Hornstein (2002) considered three real shocks that seemed to
them to be in accordance with the data: real wages, TFP and fiscal policy.
Until 1933 Government policies and union strength caused real wages to
increase. In their model, such an increase in real wages could explain the
fall in hours worked per working-age person. However, as real wages began to decrease after 1933, the high-wages hypothesis could not account
2.4 Great Depressions worldwide
37
for the slowness of the recovery. The predictive capacity of the model
improved when fiscal policies (restrictive up to 1932, and very expansive
after Hitler seized power and public expenditure on the military increased
massively) and exogenous variations in TFP were added to the model. On
the other hand, the model incorporating all three shocks overestimated
the magnitude of the fluctuations. In their conclusions the authors suggest that endogenizing TFP by means of the concept of capacity utilization
could improve the results of their simulations.
The logic of these results is the usual explanation of a standard RBC
model with government expenditure and distorting taxation. An exogenous TFP negative shock, together with a deflationary fiscal policy in the
early 1930s, contributes to explaining the onset of deflation. The labour
demand curve shifts downwards. Nominal wages rigidities and unions
explain the increase in real wages, and therefore the transformation of deflation into a recession. There is a move along the new labour demand
curve. With the change in the government, and the accession of Hitler to
power, fiscal policy becomes expansive, while prices and nominal wages
are controlled, mainly through the abolition of unions. High government
expenditure causes a strong crowding-out effect, with public consumption
subtracting resources from the private sector. This induces an appreciable
“wealth effect”, because people, feeling poorer, are now willing to work
more. The labour supply curve shifts rightwards, which explains the recovery in production.
France
If the German Great Depression can be cast in an RBC framework (as argued by Fisher and Hornstein (2002)), the French case (analysed by Beaudry
and Portier (2002)) has proved to be a much harder task. According to
what Beaudry and Portier (2002) call “the conventional wisdom”, the Great
Depression in France was a relatively minor episode, mainly due to monetary factors. France was largely isolated from the Great Depression until roughly 1932, thanks to an undervalued French franc. When the UK
and USA left the gold standard and devalued their currencies, in 1931
38
A Critical Survey
and 1933, respectively, French production for export started to decrease
and precipitated France into a recession that was significant, although less
dramatic than in other countries. At the trough of the recession the French
unemployment rate was about 5%. Deflationary policies put into effect by
Prime Minister Laval in 1935 worsened things. The recovery was finally
due to the devaluation of the franc in 1936, after the leftist Popular Front
won the elections.
Against this view, Beaudry and Portier (2002) note that if we look at
detrended data, a different picture emerges, which is much more comparable with Cole and Ohanian (1999)’s analysis. In terms of detrended
data, the depression in France began in 1930, and there was no recovery
during the 1930s: assuming 1929=100, detrended output in 1939 was 67.5.
Moreover, there was no acceleration of the depression after 1933. Finally,
international trade only accounted for a small proportion of French output
at this time, and for reasonable values of the elasticities of substitution for
intermediate goods, an international trade shock can only account for a
small part of the fall in output in the model.
Having established the similarity between the French and the US Great
Depressions, Beaudry and Portier (2002) checked whether Cole and Ohanian (1999) main explanation for the US Great Depression (namely an exogenous drop in TFP, followed by distorting economic policies) also works
for France. They found that the shock to TFP fails to explain the magnitude
of the detrended output drop. Moreover, they found it to be misleading as
far as the long duration of the depression is concerned.
Disappointed with the traditional RBC model, Beaudry and Portier
(2002) examined whether a business cycle model derived from a vintage
capital endogenous growth model performed better. They introduced the
embodiment hypothesis (that is, a hypothesis stating that technological
improvement only affects new capital goods, i.e. investments, rather than
the whole capital stock) into the RBC setup, and supposed that the impulse
mechanism of the business cycle was a shock to the input side. Simulations run under these conditions showed a much better fit to the data. The
rationale for this result is intuitive. If technological progress is embodied
in new investment goods, the drop in the investment to output ratio will
2.4 Great Depressions worldwide
39
have an indirect effect on the rate of technological progress achieved (that
is, on the technological progress that is applied to the production of goods
and services). In this way, a recession caused by a reduction in the use of
inputs will tend to self-replicate.
In order to explain the source of these variations in investments and
employment, Beaudry and Portier (2002) argued in favour of some institutional change lowering the steady-state level of total hours worked and
the capital to output ratio. In this respect, following Cole and Ohanian
(2001), they suggested that a likely culprit for the protraction of the depression after 1936 is the formation of a leftist government in 1936 that
reduced by law the number of hours worked for a given wage (i.e. increased the real wage rate). According to Beaudry and Portier (2002), the
French depression was merely a normal adjustment process to a lower
steady-state growth path induced by institutional modifications.
United Kingdom
The last case study I want to consider in this section is the analysis of
the Great Depression in the United Kingdom from an RBC perspective by
Cole and Ohanian (2002a). In this paper the authors undertook a growthaccounting exercise, leading them to exclude the view that a TFP shock
could adequately account for the 20-year-long depression in the United
Kingdom. Detrended data show that both TFP and capital input increased
between 1920 and 1938, while labour input decreased markedly, compared
to the pre-World War I average. Moreover, they argue that Keynes (1931)’s
position on the relationship between exchange rate policy, exports and recession was inconsistent with the available data.24 They argue that the
restrictive exchange rate policy (i.e. the adoption of the gold standard
system with the British pound pegged to its pre-War level) dates to 1925,
while, using their definition, the recession began far earlier, in 1919. Moreover, in modern RBC-style models, monetary shocks do not have a prop24
Keynes (1931) basic idea was that gold standard constraints forced British policy
makers to adopt a strongly deflationary policy, in order to achieve equilibrium in the
balance of trade. This was necessary because the high value of the pound caused difficulties in the export sector.
40
A Critical Survey
agation mechanism strong enough to account for such a long-lasting depression.
Having excluded the monetary origin of the British depression, Cole
and Ohanian proposed an alternative explanation, based on a series of
circumstances affecting the labour supply. On the one hand, the diminishing competitiveness of the British economy in producing some traditional
export goods led to changes in the structure of production, and to a necessary relocation of the highly concentrated British industrial firms. On the
other hand, the contemporaneous adoption of a postwar policy of housing
subsidies increased the opportunity cost of moving house, thereby deterring households from following job vacancies around the country. As a
third factor, Cole and Ohanian (2002a) consider the existence of a “generous” unemployment benefit scheme. According to this view, the Great
Depression in the United Kingdom can be attributed to contingencies and
policies causing a leftward shift in the labour supply schedule.
2.5
A critical perspective
The task of tackling the Great Depression from an RBC perspective represents an outstanding methodological innovation, in that an earlier selfimposed limit to equilibrium theory has been breached. In this respect,
Cole, Ohanian and Prescott should be credited with initiating this line of
research.
For better or worse, the Great Depression is a powerful litmus test for
RBC theory and method. At stake is whether specific historical events
such as the Great Depression are amenable to RBC theory, or whether there
are some theoretical or methodological limits to its scope. A broader perspective is then implied, which goes beyond the case study of the Great
Depression, and involves the whole literature on RBC. At this juncture no
definitive conclusion can be drawn. Therefore I will limit myself to a few
tentative observations.
The general picture that emerges from this survey is that the account of
the Great Depression given by RBC authors has two basic characteristics.
First, they consider a strictly national phenomenon. Second, they view the
2.5 A critical perspective
41
Great Depression as a business cycle in the RBC sense, although peculiar
in both its magnitude and duration. They explain its onset by means of
some exogenous shock, while its protracted character is explained by some
additional shock, or by the high persistence of the exogenous shock itself.
This vision stands in sharp contrast to the accepted wisdom of economic historians. Eichengreen and Temin (2000), for example, stress the
role of Gold Standard policies in causing the onset of the Great Depression and its widespread diffusion around the world. More generally, all
the historians who have studied the period stress the role of both international monetary constraints and some tension-widening socio-political
situations (broadly related to the Russian communist revolution and the
consequent emergence of strong leftist parties).25 For them, the international dimension is crucial for the correct understanding of any national
situation. Historical analysis tends to consider the Great Depression as a
specific outcome of a set of historically specific causes; it does not share
the “normality” perspective at all.
Assessing which of these competing views is correct is a hard task,
which I am unable to undertake at the present stage. What can be observed here is that, at first sight, the arguments adduced to support the
new RBC approach do not seem robust enough to subvert the accepted
historical wisdom. While the empirical argument advanced by Cole, Ohanian, and Leung (2005) is lacking definitive evidence, the insights that led,
for example, Romer (1993) and Cole and Ohanian (1999) to analyse the US
Great Depression in a national perspective (i.e. the observation that the
USA was an almost closed economy that experienced a bigger and longer
depression than other countries) do not apply to other countries such as
France or Germany. On the other hand, it must be admitted that the RBC
case studies of the USA and other countries reviewed above are the first
attempt to submit the Great Depression in different countries to the same
methodological inquiry. Beyond its undeniable heuristic value, such an attempt might prove useful in providing new insights and perspectives, so
improving our understanding of the period under examination. Further
research comparing the RBC interpretation of the Great Depression world25
See, inter alia, Eichengreen (1992) and Hobsbawm (1996).
42
A Critical Survey
wide with the work of leading economic historians is highly desirable to
clinch the matter.
My main critical observations on the research by Cole, Ohanian and
Prescott concern their methodological premises. These authors stuck strictly
to the methodology highlighted in Section 2.2, erecting a borderline between the realms of history and economics. In their view, economics is basically concerned with the elaboration of models, and trying to reproduce
a given set of data by the model’s response to an unidentified exogenous
shock. On the contrary, history has the role of giving both content and
meaning to the exogenous shock. The acceptance of the normality view in
this methodological context implies that, for the economist, the real question at stake is the long duration of the Great Depression, its onset being,
as clearly stated by Prescott (1999), but a minor issue.
This methodological stance suffers from drawbacks when applied to
the interpretation of the Great Depression. In view of the improvement in
our general knowledge of the Great Depression, resorting to an exogenous
TFP shock in order to explain its onset is not satisfactory, certainly not as
satisfactory as the rich historical accounts already available (for example,
Kindleberger (1973) and Eichengreen (1992)). TFP is nothing more than a
black box for analytical purposes (Hulten (2000)). Summers (1986)’s acute
criticisms undermine Prescott’s argument that the exact origin of a shock
is a secondary issue, provided that the model can mimic a given set of
data.
Extremely bad theories can predict remarkably well. . . Many
theories can approximately mimic any given set of facts; that
one theory can, does not mean that it is even close to right.
(Summers (1986), p. 24)
Summers (1986) emphasizes that the history of scientific thought is full
of plainly wrong theories that nevertheless fitted the data well (for example, the cases of Lamarckian biology and Ptolemaic astronomy).
Be that as it may, the TFP story also presents some internal consistency
problems. Consider the analysis of the USA. While in Cole and Ohanian’s
simulation, the drop in TFP explains only 40% of the contraction phase,
2.5 A critical perspective
43
such a drop is abnormally large when compared with the behaviour of
TFPs in the post-war era (Ohanian (2002)). This feature leads Cole and
Ohanian up a blind alley. If the abnormal dimension of the drop in TFP is
due to some measurement error, then the true TFP drop during the 1930s
must have been much less. This implies that a TFP-driven RBC model will
explain much less than 40% of the output drop. Moreover, a lower TFP
drop would mean that inputs must have decreased more, thus increasing
the puzzle of why the level of employment of the labour force and the
degree of utilization of capital were so low. If, on the contrary, the value
of the TFP drop in the 1930s is reliable, as Ohanian (2002) suggests when
referring to an “organizational capital” concept,26 then the puzzle becomes
why output decreased so little. If the post-war ratio between TFP and
output drop were maintained, output would have decreased much more.
To summarize, if the Great Depression were merely a business cycle, it
must show the typical regularities of business cycles, including similarities
between the variations of outputs and TFPs.
A further aspect of the application of RBC methodology to the Great
Depression worthy of notice is the indeterminateness of results. Small
modifications in models sharing the same fundamental transmission mechanisms induce big variations in the results. Such modifications mostly involve unverifiable assumptions, such as the presence of taste shocks, the
degree of nominal stickiness and so forth. As an example, consider the
sticky-wages story, which, according to Bordo, Erceg, and Evans (2000), is
the cause of the onset of the US Great Depression, although Cole and Ohanian (2000) consider it totally irrelevant; or the quantitative equivalence
between demand-shock- driven and supply-shock-driven explanations of
the US Great Depression (Weder (2001) vs. Cole and Ohanian (2001)). This
last point deserves some attention because the quantitative dimension of
RBC theory has always been thought of, by its proponents, as one of its
26
Ohanian (2002) suggests that diminished efficiency in combining inputs to produce
output might be understood as a general efficiency drop due to widespread failures in the
economy. Surviving firms had to look for new suppliers and new customers. Moreover,
firms’ responses to sudden crashes are sometimes to adopt new technology, which might
cause temporary efficiency decreases due to its adoption costs.
44
A Critical Survey
major strengths, allowing as it does for the comparative evaluation of different theories on a quantitative basis. This has been viewed as a big step
forward in economic theory, leading towards improved scientific rigour.
In theory, the economist analyses each hypothesis by means of the benchmark model, and then chooses the one that best fits the data. However,
the ambiguous results reported here for the Great Depression suggest that
RBC methodology does not provide suitable criteria for choosing among
competing theories. In other words, the researcher has no means to assess
which theory is correct, among those with comparable data-mimicking
ability. This weakness of the verification technology is a big flaw in RBC
theory, and lends credence to Summers (1986)’ arguments.
In the context of the analysis of the Great Depression, another technical issue arises. Most RBC models are solved numerically or by means of
linearization around the steady state. Numerical solution is a useful tool
allowing a computer to approximate, by numerical iteration, a stochastic
dynamic system that is otherwise insoluble. The attractiveness of the tool
is that it allows the researcher to elaborate more complex models (think
of Christiano, Motto, and Rostagno (2004)). Its drawback is that the economic interpretation of the results is far from obvious, relying more on
the narrative intuition of the economist than on Lucas’s celebrated discipline. As to linearization around the steady state, it is a well-known fact
in economic dynamics that the properties of a linearized system are approximately valid only near the steady state. If the suggestion that the US
economy was in a steady state in 1929 seems acceptable, it is surely not
true that the US economy was anywhere near a steady state in 1931–1939.
In this case, a linear approximation may lead to highly misleading results.
As far as the normative aspect is concerned, the general approach of
RBC theory to economic policy is markedly laissez faire, as the following
quotation from Mankiw (1989) illustrates.
Since real business cycle theory describes economic fluctuations as a changing Walrasian equilibrium, it implies that these
fluctuations are efficient. (Mankiw (1989), p. 83)
This standpoint naturally applies to the Great Depression case. As far
2.6 Conclusions
45
as the US Great Depression is concerned, there is widespread agreement
among RBC authors on the negative impact of New Deal policies, which
are seen as causing the exceedingly long duration of the Great Depression.
Weder (2006) and Harrison and Weder (2002) are the exception, insofar as
they consider the Great Depression to be a demand-driven phenomenon,
which required some policy intervention. Bordo, Erceg, and Evans (2000)
and Christiano, Motto, and Rostagno (2004) take somewhat intermediate
positions. On the one hand, these two papers see the NIRA as a concomitant cause of the long duration of the Great Depression. On the other hand,
they argue that a more expansive monetary policy would have allowed
nominal rigidities to be overcome, thus possibly making the depression
much less severe. As to the analysis of the Great Depression worldwide,
the pro-laissez faire stance is even more marked than it is in the analysis
of the United States:
. . . Government policies that affect TFP and hours per workingage person are the crucial determinants of the great depressions
of the 20th century. (Kehoe and Prescott (2002), p. 15, added
emphasis)
The traditional Keynesian view that New-Deal-like policies, devaluation and public expenditure on armaments dragged the world economy
out of the Great Depression is thus turned upside down by RBC authors.
In the RBC view, economic policy is viewed as the principal cause of the
event called the Great Depression. This position echoes the old “liquidationist” view held in the 1930s (in their policy implications, if not in
their analyses) by outstanding contemporaries such as Hayek, Robbins
and Schumpeter (Bernstein (1987); De Long (1990)). A comparative analysis of this stream of literature and RBC theory could clarify whether RBC
models of the Great Depression bring new insights to the vexed question
concerning the role and effectiveness of economic policy during the 1930s.
2.6
Conclusions
The Great Depression has been considered for years as the main exception
to Lucas’s claim that “all cycles are alike” and therefore call for the same
46
A Critical Survey
theoretical explanation. In this paper, I have reviewed some recent attempts by RBC authors to bridge this gap between the new classical equilibrium method and the explanation of the Great Depression. While it is
too early to draw definitive conclusions, some suggestions for future research have been identified in Section 2.5.
RBC theory defines business cycles in terms of regularities in the relative behaviour of economic aggregates. Events are amenable to the theory
insofar as they show such co-movements in these variables. In this sense,
the very fact of trying to tackle the Great Depression with RBC theory is
tantamount to assuming that the Great Depression was a business cycle in
the RBC sense. I have called this assumption the “normality view”.
The normality view has important implications, as it is the conceptual
basis for the change of the dating of the Great Depression. Before the RBC
interpretation, people spoke of a Great Contraction in 1929–1932 and of
a recovery in the New Deal era. Explanations were highly differentiated,
but the dating was a matter of accepted wisdom. RBC authors, however,
interpreted the Great Depression as the whole 1929–1939 period, as output
did not recover its trend level during this time, whereas TFP had already
recovered by 1936. The normal co-movement between TFP and output
implies a recovery that did not actually occur. Therefore, the Great Depression becomes the whole decade, and the “puzzle” to be solved is why
output remained below its trend level for so long. This view is completely
new, and the fact of having brought it to the forefront has an intrinsic
heuristic value. Cole and Ohanian in particular must be credited for this.
However, the normality view is by no means an uncontroversial assumption. Many historians have taken the opposite view, namely that the
Great Depression has deep roots in specific historic circumstances and institutional factors. In other words, it was a single event.
The contrast between these competing viewpoints is intensified by the
methodological stance of RBC theory. Business cycles are conceived of as
the equilibrium reaction of a modelled economy to some kind of exogenous random shock. The exact identification of the content of the shock is
a minor issue with respect to the comprehension of the propagation mechanism. Taking this reasoning to extremes, an inquiry into the cause of any
2.6 Conclusions
47
business cycle is seen as outside the domain of economic science, a theme
to be left to historians. The application of such a methodology to the Great
Depression, however, takes the theory into difficult territory. Because of
the method of analysis, the substantive contribution of RBC literature to
our general knowledge about the Great Depression is, at most, limited.
None of the papers using TFP technology contribute at all. Others, recasting old ideas such as preference for liquidity, sticky wages and animal
spirits in the new classical framework, may be credited with translating
old concepts into the new accepted scientific language. This is definitely a
feat. But is this enough to talk of a new interpretation of the Great Depression?
RBC methodology puts renewed stress on the quantitative dimension
of the analysis and on empirical verification when undertaking the task of
analysing historic events such as the Great Depression. This is an important discipline, and subsequent research should take it into account. The
theoretical no-compromise approach and the constant reference to empirical evidence should allow researchers to discriminate between good theories and bad theories. Unfortunately, the results of RBC models of the
Great Depression are actually quite poor, despite the valuable quantitative
effort. As shown in this review, many competing theories of the Great Depression have been advanced, each mimicking the data to a similar extent.
The point is that the RBC method does not allow us to discriminate among
theories with the same data-mimicking ability. This is a big problem that
needs to be addressed in the future.
48
A Critical Survey
Chapter 3
The Abandonment of the
Abstentionist Viewpoint
3.1
Introduction
Macroeconomics experienced radical changes in the last quarter of the
twentieth century. The most important was the dethroning of the Keynesian IS-LM paradigm and its replacement by a new paradigm centered
on the study of growth and the business cycle, rather than unemployment.
This started as new classical macroeconomics with Lucas’s work, to be recast as real business cycle theory by Kydland and Prescott. At present,
it also goes under the names of neoclassical growth theory and dynamic
stochastic general equilibrium models.1
The aim of this paper is to describe and assess one of the features of this
approach: the way it deals with the Great Depression, probably the single
most dramatic business cycle event of the twentieth century. The new approach started as an equilibrium theory of the business cycle - equilibrium
1
Throughout this paper we shall treat these labels as synonymous. In doing so, we
are sticking to the convention of considering the “real business cycle” label as indicative
of an “approach to modeling” (Romer (2001)) rather than a set of models. We admit that,
while terminology is not yet firmly established, it is becoming ever more evident that a
distinction should be made between the global approach, for which the name “dynamic
stochastic general equilibrium” might be appropriate, and the different classes of models
within it (which include real business cycle models à la Kydland and Prescott).
50
The Abandonment of the Abstentionist Viewpoint
meaning optimizing behavior and market clearing. Can such an approach
come to grips with the Great Depression? Our paper does not aim to address this issue straight on. Rather, we want to focus our attention on the
evolution of opinion and research activity that took place within the community of real business cycle theorists with respect to the Great Depression. In the 1970s and 1980s Lucas and Prescott, the two towering figures
of the new approach in macroeconomics, took what could be called an abstentionist stance. They maintained that, because of its exceptional character, an explanation of the Great Depression was beyond the grasp of the
equilibrium approach to the business cycle. However, while Lucas stuck
to this view, Prescott changed his mind at the end of the 1990s, breaking
his earlier self-imposed restraint. Real business cycle theory, he ended up
by stating, had succeeded in its endeavor to elucidate the Great Depression. The authors credited with this breakthrough were Harold Cole and
Lee Ohanian.
We shall start our inquiry by exploring the abstentionist stance. In a
second step, we shall document Prescott’s change of opinion. Next, we
examine Cole and Ohanian’s work, which led Prescott to this change,
and assess its contribution. We continue by drawing a contrast between
the real business cycle and the economic history approaches to the Great
Depression. Finally, we briefly discuss whether the new developments
brought about by Cole and Ohanian have led Lucas to forego the abstentionist viewpoint.
3.2
Lucas on the Great Depression
3.2.1
The Lucas and Rapping (1969) paper
The Lucas and Rapping (1969) paper, “Real Wages, Employment, and Inflation”, which provides the micro-foundations for an analysis of the labor
supply, is rightly credited with having initiated the move that led to real
business cycle theory. It is also the paper to start with in our attempt to
3.2 Lucas on the Great Depression
51
elicit Lucas’s position on the Great Depression.2
At the time, Lucas and Rapping were barely aware of the full implications of the assumptions they adopted. In particular, they did not view
their market-clearing assumption as clashing with Keynesian theory. Nevertheless, they felt the need to reconcile the existence of unemployment
with market clearing. Their solution was to question the usual interpretation of census data on unemployment, according to which most unemployment was involuntary, and to declare that, outward appearances to
the contrary notwithstanding, these people were voluntarily unemployed
(Lucas and Rapping (1969): 748).
No discussion of the Great Depression per se is to be found in Lucas
and Rapping’s paper. They did not claim to have a market-clearing model
of the Great Depression. Nonetheless, this was the implicit conclusion
of their work, since they tested their model against US time series data
covering the years 1930-65 (including the depression years) and claimed
that it performed relatively well from an econometric point of view.
3.2.2
Rees’s criticism
The Lucas and Rapping paper made a great stir. One of the economists
who reacted against it was Albert Rees, a labor economist formerly at
Chicago, and at that time at Princeton. His comment (Rees (1970)) is of
particular interest for our inquiry, because it raised the issue of the relevance of Lucas and Rapping’s model for the Great Depression. In particular, Rees was shocked by the implication of Lucas and Rapping’s model
that unemployment in the Great Depression was voluntary:
In assessing the reasonableness of [Lucas and Rapping’s] view,
it should be recalled that it is set forth in a paper that fits an
2
This paper was a joint venture by Lucas and Rapping. However the latter gradually
lost interest in this line of research, so that the authors’ rejoinder to Rees (1970), though
co-signed by both of them (Lucas and Rapping (1972)), was in fact single-authored by
Lucas, as he mentions in his Professional Memoirs (Lucas (2001)). Except when specifically discussing the 1969 paper, we will therefore refer to Lucas’s views rather than to
Lucas and Rapping’s views.
52
The Abandonment of the Abstentionist Viewpoint
econometric model to U.S. data for the period 1930-65, which
includes all of the Great Depression of the thirties. Some measured unemployment may be essentially voluntary in the case
of pockets of unemployment during conditions of general prosperity. . . However, to extend this view to conditions of general
deficiency in demand involves an aggregation fallacy. When all
markets are depressed in varying degrees, a few of the unemployed might still be able to find work by shifting their location
or trade, but it is surely not true that all of them could do so at
once. . . Though scientific discussion is supposed to be dispassionate, it is hard for one old enough to remember the Great
Depression not to regard as monstrous the implication that the
unemployment of that period could have been eliminated if
only all the unemployed had been more willing to sell apples
or to shine shoes (Rees (1970): 308).
Beyond doubt, Rees had what seemed at the time a strong point. Lucas
and Rapping’s model assumed market clearing. That is, it assumed away
involuntary unemployment. If it is believed that the voluntary/involuntary
unemployment distinction makes any sense, the Great Depression is the
period par excellence for which the notion of involuntary unemployment
is relevant. Arguing that the massive unemployment that existed at the
time was composed of voluntarily unemployed persons stretched credibility. Hence Rees’s claim that any model excluding market non-clearing
as a matter of premise was ill suited for studying the Great Depression.
3.2.3
Lucas’s reaction
Lucas’s reaction to Rees’s criticism was twofold. On the one hand he refused to enter into a discussion on the voluntary or involuntary nature of
unemployment.3 However he accepted the standard Keynesian argument
3
Lucas’s definitive position on the subject of involuntary unemployment, namely that
this notion should be dispensed with altogether, is set out in a later article (Lucas (1978)).
For a discussion of this point, see De Vroey (2004).
3.2 Lucas on the Great Depression
53
that the Great Depression was due to a deficiency in aggregate demand.4
On the other hand, he agreed to delve deeper into the issue of the relevance
of Lucas and Rapping’s model for the Great Depression. Here, stepping
back from their previous conclusion, he admitted that the model failed to
explain the data from 1934 to World War II.
Rees also raises the important empirical question of whether
our theory does succeed in accounting for labor-market behavior during the period 1929-39. Further study on our part indicates that Rees’s skepticism on this point is well founded:
our hypothesis accounts for much, but not all, of the observed
labor-market rigidity during this period (Lucas and Rapping
(1972): 186).
Lucas was enigmatic about the reasons behind the failure of the model,
contenting himself with noting that it considered only one source of rigidity (adaptive expectations), while others might have been at work as well.
In a footnote, he hinted at Alchian (1970)’s conjecture that recovery was
delayed by the succession of New Deal price- and wage-fixing measures,
a claim that Cole and Ohanian were to take up again some thirty years
later.
3.2.4
Lucas’s subsequent standpoint
Lucas returned to the issue of the Great Depression on several occasions,
mainly in interviews or book reviews, although never in any detail. In
these pieces he repeatedly expressed the view that real business cycle models, which he otherwise fully endorsed, were unable to explain the Great
Depression. This job, he constantly claimed, had been done by Friedman
and Schwartz:
4
“The only aggregative economic policy implication we see for events like the Great
Depression are the standard ones: if possible, avoid the aggregate-demand shifts which
cause them; failing this, pursue corrective demand policies to make them as brief as possible.” (Lucas and Rapping (1972): 187).
54
The Abandonment of the Abstentionist Viewpoint
The Great Depression, however, remains a formidable barrier
to a completely unbending application of the view that business cycles are all alike (Lucas (1980): 273).
. . . The magnitude of the Great Depression dealt a serious blow
to the idea of the business cycle as a repeated occurrence of the
“same” event. . . The Depression continues, in some respects, to
defy explanation by existing economic analysis (Lucas (1980):
284).
Viewed as positive theory, real business cycle models do not
offer a serious alternative to Friedman and Schwartz’s monetary account of the early 1930s. . . There is no real business cycle
model that can map these shocks into anything like the 40%
decline in real output and employment that occurred between
1929 and 1933 (nor, indeed, does anyone claim that there is).
Even if there were, imagine trying to rewrite the Great Contraction chapter of A Monetary History with shocks of this kind
playing the role Friedman and Schwartz assign to monetary
contractions. What technological or psychological events could
have induced such behavior in a large, diversified economy?
How could such events have gone unremarked at the time, and
remain invisible even to hindsight? (Lucas (1994): 13).5
In short, Lucas’s stance is that the real business cycle method is fine for
periods of plain sailing but ill suited to more dramatic events such as the
Great Depression:
In Kydland and Prescott’s original model, and in many (though
not all) of its descendants, the equilibrium allocation coincides
with the optimal allocation: fluctuations generated by the model
represent an efficient response to unavoidable shocks to productivity. One may thus think of the model not as a positive
theory suited to all historical time periods but as a normative
5
Other references are Lucas (1987): 87, Klamer (1984): 41-42, Snowdon and Vane
(1998): 125 and McCallum (1999):284.
3.3 Prescott on the Great Depression
55
benchmark providing a good approximation to events when
monetary policy is conducted well and a bad approximation
when it is not. Viewed in this way, the theory’s relative success in accounting for post-war experience can be interpreted
as evidence that post-war monetary policy has resulted in nearefficient behavior, not as evidence that money does not matter
(Lucas (1994): 13).
3.3
3.3.1
Prescott on the Great Depression
Prescott’s early view
To the best of our knowledge, Prescott’s first remark about the Great Depression dates from 1983 and is to be found in a Federal Reserve Bank
of Minneapolis Working Paper discussing the methodology of the then
nascent real business cycle theory. In this paper, Prescott examined four
objections that can be raised to this theory. One of these is directly related
to our inquiry:
How can a theory claim to explain the business cycle if it cannot
explain the Great Depression? (Prescott (1983): 11).
Prescott’s answer was straightforward. He plainly admitted that the Great
Depression was beyond the reach of the equilibrium model of the business
cycle. To him, this restraint was virtuous because it showed that the practitioners of the new approach were aware of its limits. Equilibrium models
of the business cycle, he argued, worked only for empirical cases where
the political and financial context was stable:
The answer to question (b) is simply that competitive equilibrium theory is not suited to modeling economic fluctuations
in periods of great political and financial institution instability.
The inability of either the equilibrium monetary or the technology shock theories to explain the Great American Depression
56
The Abandonment of the Abstentionist Viewpoint
is evidence of the discipline of the methodology. If any observation can be rationalized with some approach, then that approach is not scientific (Prescott (1983): 12).
Prescott stood by this point of view for several years.6 This is witnessed by his reaction to Summers’s rejoinder to his “Theory ahead of
measurement” paper (Prescott (1986)). One of Summers’s points was that
no equilibrium theory could deal with events like the Great Depression,
because of the pervasive disruptions to the exchange system that characterize such periods.7 In contrast to the generally flamboyant tone of his
response, Prescott remained subdued on this point, taking the same line
as in his 1983 paper:
Summers has perhaps misread some of my review of real business cycle research. There I do not argue that the Great American Depression was the equilibrium response to technology
shocks as predicted by the neoclassical growth model. I do not
argue that disruptions in the payment and credit system would
not disrupt the economy (Prescott (1986): 29).
3.3.2
Prescott’s present standpoint
Prescott did not return to the matter of the Great Depression until his 1996
interview with Rolnick for The Region, a journal of the Federal Reserve
6
Prescott was not alone among the founders of the new approach in holding such an
abstentionist view of the Great Depression. For example, Sargent stated, “I do not have a
theory, nor do I know anybody’s else’s theory, that constitutes a satisfactory explanation
of the Great Depression” (Klamer (1984): 69).
7
“Between 1929 and 1933, the gross national product in the United States declined
50%, as employment fell sharply. . . I submit that it defies credulity to account for movements on this scale by pointing to intertemporal substitution and productivity shocks. . . It
seems clear that a central aspect of depressions, and probably economic fluctuations more
generally, is a breakdown of the exchange mechanism. Read any account of life during
the Great Depression in the United States. Firms had output they wanted to sell. Workers
wanted to exchange their labor for it. But the exchanges did not take place. To say the
situation was constrained Pareto optimal given the technological decline that took place
between 1929 and 1933 is simply absurd, even though total factor productivity did fall.
What happened was a failure of the exchange mechanism.” (Summers (1986): 26).
3.3 Prescott on the Great Depression
57
Bank of Minneapolis (Rolnick (1996)). Here, he departed from his earlier
abstentionist view. While still referring to the political turmoil of the time,
he maintained that, after all, the Great Depression was amenable to the
real business cycle approach. Moreover, he now distanced himself from
Friedman and Schwartz’s interpretation (Rolnick (1996): 6).
It did not take long for Prescott to fully turn away from his earlier
position. His new views are to be found in two papers, which are commentaries on other authors’ work rather than original research. The first
is a short piece published in the Federal Reserve Bank of Minneapolis Quarterly Review in 1999, entitled “Some Observations on the Great Depression” (Prescott (1999)), which comments on Cole and Ohanian’s article
“The Great Depression in the United States from a Neoclassical Perspective” (Cole and Ohanian (1999)). The second article, written jointly with
Timothy Kehoe, is an introduction to the 2002 special issue of The Review of
Economic Dynamics resulting from a conference held at the Federal Reserve
of Minneapolis in October 2000 (Kehoe and Prescott (2002)). Both articles
start with an expression of surprise:
Why hasn’t growth theory been used to study the Great Depression? Perhaps because economists are reluctant to use standard theory to study an event that historically was treated as an
aberration defying an equilibrium explanation (Prescott (1999):
25).
The general equilibrium growth model is the workhorse of modern economics. . . Until recently, however, it has been taboo to
use the growth model to study great depressions. This volume
breaks this taboo (Kehoe and Prescott (2002): 2).8
Prescott’s earlier argument that real business cycle theory should refrain from trying to explain the Great Depression was now rejected. According to Kehoe and him, the conventional view that “great depressions
are unique events that occurred in the interwar period and are of historical interest only” ought to be dismissed. Instead, they claimed that several
8
The idea that a taboo needed to be broken is also evoked in Prescott’s Richard Ely
Lecture, “Prosperity and Depression” (Prescott (2002): 1).
58
The Abandonment of the Abstentionist Viewpoint
other “great depressions” occurred in the 20th century, most of them close
to the present time.
This claim went along with a definitional change. The standard definition was that the term “Great Depression” designated the period between
the end of 1929 and 1933. In contrast, Kehoe and Prescott proposed a
quantitative definition resting on two conditions:
To be a great depression, a negative deviation from trend must
satisfy two conditions. First, it must be a sufficiently large deviation. Our working definition is that a great depression is a
deviation at least 20% below trend. Second, the deviation must
occur rapidly. Our working definition is that de-trended output per working-age person must fall at least 15% within the
first decade of the depression (Kehoe and Prescott (2002): 9).9
If this definition is adopted, other twentieth century great depressions
emerge:
Argentina, Brazil, Chile and Mexico had depressions in the
1980s that were comparable in magnitude to those in Canada,
France, Germany and the United States in the interwar period. . . In
recent times, New Zealand and Switzerland - rich, democratic
countries with market economies - have experienced great depressions. If the current Japanese depression continues a few
more years, it will become a great one (Kehoe and Prescott
(2002): 2).
The suggested definitional change implied that the Great Depression of
the 1930s covered the entire decade 1929-39, since output remained below
trend for the whole of that period. As will be seen below, this definition
led to two distinct puzzles: first, the onset of the decline, and, second, the
weak recovery from it (i.e. the 1929-33 and the 1934-39 periods). The merit
9
Kehoe and Ruhl later added a third condition, that “there is no significant recovery
during the period in the sense that there is no sub-period of a decade or longer in which
the growth of output per working-age person returns to the trend” (Kehoe and Ruhl
(2005): 762).
3.4 Explaining Prescott’s change of mind
59
of Cole and Ohanian’s work, according to Prescott, was to have shifted
the attention from the former to the latter issue, now considered the most
important (Prescott (1999): 26). Prescott also adhered to their conclusion
as to the cause of the weak recovery, as he stated forcefully in the last
paragraph of his 1999 article:
In the 1930s, there was an important change in the rules of the
economic game. This change lowered the steady-state market
hours. The Keynesians had it all wrong. In the Great Depression, employment was not low because investment was low.
Employment and investment were low because labor market
institutions and industrial policies changed in a way that lowered normal employment (Prescott (1999): 27).
3.4
Explaining Prescott’s change of mind
A 180 degree turn occurred between Prescott’s early remarks pointing to
the inability of the real business cycle approach to explain the Great Depression and his later (and present) standpoint. Two related factors may
explain this change.
First, Prescott’s reversal of opinion must be understood in the broader
context of the evolution of the real business cycle research program. The
last fifteen years have witnessed a progressive breaking away of real business cycle theory from the strict Walrasian principles which characterized
it at its onset. This is a testimony to the resilience and adaptability of
the methodology created by Kydland and Prescott. Indeed, as Romer
(2001) aptly put it when drawing a distinction between real business cycle models and real-business-cycle-style models, “what distinguishes the
real-business-cycle research program is its approach to modeling”, rather
than the Walrasian/non-Walrasian divide (Romer (2001): 210). This means
that categories which were alien to the first generation of real business cycle theorists - imperfect competition, price sluggishness, monetary shocks
- are no longer so. This evolution may make the theory more suitable for
analyzing periods such as the Great Depression.
60
The Abandonment of the Abstentionist Viewpoint
The second reason is the fact that Cole and Ohanian just came out and
did it: they came to grips with the Great Depression within a real business
cycle perspective, and their work enticed Prescott to change his view.10
It must soon have occurred to Prescott that Cole and Ohanian’s breakthrough was good news for the real business cycle approach, which claims
to provide a general theory of business cycles. For, Prescott’s early opinion to the contrary notwithstanding, the admission that one of the most
important depressions in history and certainly the best publicized one lay
beyond the grasp of the theory could not but appear as a sign of weakness. In Obstfeld and Rogoff’s terms “a theory of business cycles that has
nothing to say about the Great Depression is like a theory of earthquakes
that explains only small tremors” (Obstfeld and Rogoff (1996): 627). After
Cole and Ohanian, such attacks lost their sting.
To gauge Prescott’s reversal of opinion, we need to assess Cole and
Ohanian’s work. This is the task undertaken in the next two sections.
3.5
Cole and Ohanian on the US Great Depression
Cole and Ohanian were the first authors to look at the Great Depression
through the lens of neoclassical growth theory.
We use neoclassical growth theory to study macroeconomic
performance during the 1930s the way other economists have
used the theory to study post-war business cycles. We first
identify a set of shocks considered important in post-war economic declines: technology shocks, trade shocks, and monetary shocks. We then ask whether those shocks, within the neoclassical framework, can account for the decline and the recovery in the 1930s. This method allows us to understand which
data from the 1930s are consistent with neoclassical theory and,
10
In private correspondence both Ohanian and Prescott have upheld this thesis.
3.5 Cole and Ohanian on the US Great Depression
61
especially, which observations are puzzling from the neoclassical perspective (Cole and Ohanian (1999): 2).
Cole and Ohanian’s central message can be grasped by looking at Figure 3.1, in which we have graphed de-trended data from their 1999 paper
for US output, total factor productivity (TFP), total employment and real
wages in manufacturing and non-manufacturing sectors.11
120
110
100
trend=100
90
80
70
60
50
40
1929
1930
Real Output
1931
TFP
1932
1933
Real wages: Manufacturing
1934
1935
1936
Real wages: Non-Manufacturing
1937
1938
1939
Total Employment
Figure 3.1: Detrended data. US 1929-1939. Source: Cole and Ohanian
(1999)
One of Cole and Ohanian’s original claims was that the Great Depression
must be viewed as a ten-year episode, because de-trended output (the blue
11
TFP is defined as “any exogenous factor that changes the efficiency with which business enterprises transform inputs into outputs” (Cole and Ohanian (1999): 5).
62
The Abandonment of the Abstentionist Viewpoint
line in Figure 3.1) remained below the trend line for the whole decade.
Figure 3.1 also illustrates the strong pro-cyclical behavior of TFP (the pink
line). After dropping by almost 18% from 1929 to 1933, it returned to its
trend level in 1936. Considering a standard real business cycle model,
Cole and Ohanian fed in measured TFP as the impulse mechanism of the
business cycle. Their growth accounting exercise led to a twofold result.
First, the behavior of the measured TFP accounted for about 65% of the initial decline in de-trended output.12 Second, it had almost no explanatory
power for the post-1933 years. Using the same growth accounting technique, Cole and Ohanian examined whether the behavior of output could
be traced back to the other variables invoked in competing explanations of
the Great Depression - fiscal policy, international trade restrictions, monetary tightening, financial intermediation disruptions, changes in reserve
requirements, and the rigidity of nominal wages. The result was negative:
none of them, they claimed, stands up to scrutiny.
To Cole and Ohanian, the most intriguing result was the lack of a
marked recovery in output and employment (the yellow line in Figure
3.1) from 1933 onwards, despite the normal growth in productivity, rapid
growth in money supply, and the end of runs on the banks. That is, while
the onset of the Great Depression witnessed strongly negative real and
monetary shocks, the post-1933 period did not. Hence their contention
that the main puzzle raised by the Great Depression lay in understanding why the US economy remained depressed until the outbreak of WWII
rather than in elucidating its onset. They concluded their analysis by suggesting that another negative shock must have hit the economy in the mid1930s. New Deal labor market legislation was their main suspect.
The aim of Cole and Ohanian’s 2002 and 2004 articles was to clinch this
last point analytically. Cole and Ohanian (2002b) claimed that a distortion
occurred in the labor market, driving a wedge between the real wage and
the marginal rate of substitution between consumption and leisure, so that
the former exceeded the latter. Positing that agents were in individual
12
The actual figure in Cole and Ohanian (1999) is 40%. The 65% figure reported in the
text was suggested to us by Lee Ohanian, and appears in a revised version of the paper
forthcoming in the Federal Reserve Bank of Minneapolis volume on Great Depressions.
3.5 Cole and Ohanian on the US Great Depression
63
equilibrium in 1929, Cole and Ohanian investigated whether this was still
the case in 1939. Their answer was “no”:
Three of the four [first order] conditions are distorted. The
marginal rate of substitution between consumption and leisure
is 41 percent be-low the wage rate, and factor prices differ considerably from their implied marginal products. The wage rate
substantially exceeds the marginal product of labor, and the
return to capital is below the marginal product of capital. . .
Taken together, these data suggest that some factor raised the
wage above its market-clearing level, and that this high wage
prevented households from satisfying their marginal rate of
substitution condition (Cole and Ohanian (2002b): 30).
In their 2004 paper, Cole and Ohanian focused their attention on one
specific New Deal policy measure, the National Industrial Recovery Act
(NIRA). This allowed firms to set prices cooperatively within the same
industry, conditional on their accepting collective bargaining with unions
over wages. Moreover NIRA codes of “fair competition” prescribed a minimum wage per industry that was typically above the previous prevailing
wage rate. Cole and Ohanian provided evidence that this enhanced high
wages in the US economy. As can be seen from Figure 3.1, the data confirm that wages in manufacturing, which was 80% covered by NIRA, were
above the trend line for the whole decade, with a marked increase in 1933,
the year in which the NIRA was signed. On the contrary, Figure 3.1 also
shows that real wages in non-manufacturing sectors, which were not covered by the NIRA, remained below the trend line throughout the decade.
Cole and Ohanian’s 2004 article also provided a quantitative analysis of
the role of New Deal policies in causing the weak recovery. To this end
they built a multi-sectoral model with imperfect competition and wage
bargaining between firms and insider workers. The cartel sector works on
an insider/outsider pattern. Insiders set the wage and the employment
level, conditional on firms’ reservation profits. Whenever firms agree with
workers, they are allowed to collude over production. This last assumption, Cole and Ohanian claimed, captures the central feature of the NIRA
64
The Abandonment of the Abstentionist Viewpoint
(Cole and Ohanian (2004): 781). Insiders are thereby able to raise the cartel wage above the market-clearing level.13 Hence, a distortion occurs in
the labor market, with the real wage rate exceeding the marginal rate of
substitution between consumption and leisure. Although they did not use
the term, this is nothing other than involuntary unemployment according to its standard definition, a state of affairs where agents would like to
participate in the labor market yet, for some reason, are unable to do so.14
Thus, the very result that Lucas and Rapping decided to exclude from
their model, incurring Rees’s wrath, now re-entered the picture, although
hardly to vindicate a Keynesian standpoint. The main quantitative result
of Cole and Ohanian’s model was that:
New Deal cartelization policies are a key factor behind the weak
recovery, accounting for about 60% of the difference between
actual output and trend output (Cole and Ohanian (2004): 781).
On a broader level, they concluded their 2004 article with the statement
that:
New Deal labor and industrial policies did not lift the economy
out of the depression as President Roosevelt had hoped. Instead, the joint policies of increasing labor’s bargaining power
and linking collusion with paying high wages prevented a normal recovery by creating rents and an inefficient insider-outsider
friction that raised wages significantly and restricted employment (Cole and Ohanian (2004): 813).
13
Cole and Ohanian claim that monopoly per se is not responsible for the low level of
employment. In effect, whenever monopoly is present without labor bargaining power,
the cartel wage turns out to be close to the competitive wage and the reduction in output is small. Thus, the combined presence of monopoly and labor bargaining power is
required in order to obtain the weak recovery result.
14
It is true that in Cole and Ohanian’s model agents who are rationed in the cartel sector
end up in another activity (search, domestic labor or the competitive labor market), which
they choose optimally. However such a result has also been obtained in dual market
models (see, for example, Akerlof and Yellen (1986): 3; Hahn (1983): 225).
3.6 An assessment
3.6
3.6.1
65
An assessment
The originality of Cole and Ohanian’s analysis
Our first task is to ponder the originality of Cole and Ohanian’s work.
To this end, we shall examine, first, whether their analysis enriches our
understanding of the Great Depression (as concerns both its onset and its
protracted character), and, second, whether they inaugurated a new way
of approaching it.
As far as the unfolding of events leading to the Great Depression is concerned, Cole and Ohanian’s positive contribution is, as they themselves
admit, almost non-existent.15 TFP may account quantitatively for 65% of
the drop in output, but qualitatively it is highly unsatisfactory, as it traces
everything back to an undetermined exogenous shock.16 Thus, as far as
the onset of the Great Depression is concerned, Cole and Ohanian’s analysis can hardly compete with the existing historical explanations (Kindleberger (1973); Friedman and Schwartz (1963); Eichengreen (1992); Romer
(1990); Romer (1992); Romer (1993); De Long (1997), to name but a few).
However, Cole and Ohanian’s main investigation bears on the weak
recovery from the Great Depression. Two remarks are in order here. First,
their characterization of the weak recovery brings out only one side of the
picture, as aptly encapsulated by Christina Romer:
The recovery of the United States from the Great Depression
has been alternatively described as very fast and very slow. It
was very rapid in the sense that the growth rate of real output
was very large in the years between 1933 and 1937 and after
1938. . . The recovery was nevertheless slow in the sense that
15
See Ohanian (2002). In the introduction to this paper, Ohanian notes, “The Depression remains one of the most important and enduring mysteries in macroeconomics, and
identifying the causes of this productivity decrease may shed new light on this mystery”
(2002: 12). Yet at the end of the article, he writes “I conclude that the Great Depression
productivity puzzle remains largely unsolved” (2002: 14).
16
Cole, Ohanian, and Leung (2005) offer some hints on the possible nature of productivity shocks, but leave the subject for future research.
66
The Abandonment of the Abstentionist Viewpoint
the fall in output in the United States was so severe that, despite the impressive growth rates, real GNP did not return to its
pre-Depression level until 1937 and its pre-Depression growthrate path until around 1942 (Romer (1993): 34-5).
One aspect of this strong recovery, emphasized by Temin and Wigmore
(1990), is the significant increase in investment that occurred from 1933 onwards and which was a distinctive feature of the US economy. Figure 3.2
illustrates the extent to which this recovery in investment occurred only in
the US. In Temin and Wigmore’s view, the New Deal and the devaluation
of the dollar acted as signals of a regime shift. More optimistic expectations and hence increased investment ensued.
Our second remark is that Cole and Ohanian are hardly the only authors to have criticized the NIRA policy. Attacking the latter has been
a staple of defenders of laissez-faire from the Chicago economist Simons
(1934) to the present day (Powell (2003); Smiley (2002); Hall and Ferguson (1998)).17 Even Keynes (1933) was dismissive of it. Actually, most
economists agree that this particular policy, as distinct from other New
Deal policies, was inadequate.18 To limit ourselves to one account, Eichengreen, a leading Great Depression analyst, wrote:
The National Industry Recovery Act. . . contributed, perversely,
to the slow recovery of American output and employment (Eichengreen 1992: 344).
So, our conclusion on the onset of the Great Depression must be extended to the topic of the protracted character of the crisis: Cole and Ohanian’s novelty in terms of substance is slim.
17
Hawley (1966) is a classical piece assessing the effects of the NIRA.
Weinstein (1981) anticipates both Eichengreen (1992) and Cole and Ohanian (2004).
Weinstein’s main point is that the NIRA produced a threefold negative effect. First, the
policy sterilized the large post-1933 gold inflow. Second, it depressed employment by
imposing mandatory wages that were higher than the market-clearing equilibrium. Finally it increased inflation, thereby decreasing real balances and therefore consumption
and investments.
18
3.6 An assessment
67
Their real contribution is methodological. Previous authors had discussed the NIRA policy in a qualitative way. Their view was, typically,
that, while the policy in itself was a failure, its impact on the overall recovery was hard to assess, because of the presence of countervailing factors.
In contrast, Cole and Ohanian analyzed the policy on the basis of a general
equilibrium model geared towards empirical measurement. Hence, they
were able to make a quantitative assessment, namely that the NIRA policy
accounts for 60% of the slow character of the recovery.
260
240
1932 III = 100
220
200
180
160
140
USA
120
France
Germany
100
1932 - III
1932 - IV
UK
1933 - I
1933 - II
Quarters
UK
1933 - III
Germany
France
USA
Figure 3.2: Production of Investment Goods. Source: Temin and Wigmore
(1990)
To conclude, Cole and Ohanian’s main contribution is to have inaugurated a new way of tackling the issue of the Great Depression. The theoretical breakthrough made by Lucas, Kydland and Prescott consisted of
68
The Abandonment of the Abstentionist Viewpoint
dismissing the view that business cycles were not amenable to equilibrium
analysis. Cole and Ohanian’s contribution is of the same order. Previously
it was believed that no abstract quantitative model of the Great Depression could be constructed. They must be credited with having disproved
this view.
3.6.2
One or several great depressions?
Kehoe and Prescott (2002) claim that several “great depressions” occurred
in the twentieth century. This claim follows from their definition of a great
depression, according to which a 20% cumulative fall in output below
trend, with a 15% fall in the 10 first years, constitutes a great depression.
In our eyes, such a definition has little to commend it. Ten years is too
long a period. In the 1930s it took only one year for detrended output to
fall by 15% (and the overall fall between 1929 and 1933 was almost 40%).
Kehoe and Prescott’s definition is too wide. This is particularly clear when
it is observed that their criterion leads them to assert that countries such as
New Zealand and Switzerland are presently enduring great depressions.
A rapid glance at Figure 3.3 should make it is obvious that the present situation in these countries is not remotely comparable with the situation of
the United States in the 1930s.19 There is something qualitatively different
about the Great Depression, just like there was something qualitatively
different about WWI, WWII, and about stagflation in the 1970s.20 With
Kehoe and Prescott’s definition the specificity of the Great Depression is
lost.
Kehoe and Prescott’s stress on the weak recovery aspect in their definition of a great depression may also lead to a confusion between the
explanation of the causes of the Great Depression and the causes of its
protracted character. In our view, Prescott falls prey to such a mistake
when he says:
19
On this, see Abrahamsen, Aeppli, Atukeren, Graff, Muller, and Schips (2005).
The results presented here are not intended to be directly comparable to those used
by Kehoe and Prescott (2002), since, unlike theirs, the output data used here has not been
detrended.
20
3.6 An assessment
69
In the 1930s labor market institutions and industrial policy actions changed normal market hours. I think these institutions
and actions are what caused the Great Depression (Prescott
(1999): 26).21
If the changes that Prescott has in mind include the effects of the New
Deal, they can in no way be viewed as having caused the Great Depression. Sticking to his definition of a great depression allows him to focus
his attention on the causes of the long duration of the depression, thereby
neglecting the task of explaining the plunge in output in the early 1930s.
Great Depression
1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 1941 1942 1943 1944
14000
25000
10000
15000
8000
6000
10000
4000
1990 International Stone-Geary $ (US)
1990 International Stone-Geary $ (CH, NZ)
12000
20000
5000
2000
0
0
1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994
Post-war
Switzerland
New Zealand
United States
Figure 3.3: Real GDP per capita. Source: Comin and Hobijn (2004)
21
“From the perspective of growth theory, the Great Depression is a great decline in
steady-state market hours. I think this great decline was the unintended consequence of
labor market institutions and industrial policies designed to improve the performance of
the economy” (Prescott (1999): 27).
70
3.6.3
The Abandonment of the Abstentionist Viewpoint
Contrasting the approaches of equilibrium macroeconomics and economic history to the Great Depression
Cole and Ohanian’s work has broken the monopoly that economic history
had over the Great Depression. Two competing approaches are now on
the ground, neither of which can be considered, as a matter of principle,
superior to the other. Our aim in this section is to briefly bring out their
methodological differences.
The singularity of the Great Depression
The standard view of a depression is that it constitutes a particular phase
in the business cycle, characterized by the fact that output remains (significantly) below the trend line. In turn, a business cycle is defined as being
composed of four elements: the depression or decline, the trough, the recovery and the peak. In short, a business cycle is a set of peak-to-trough
movements. To Cole and Ohanian, the Great Depression is yet another
depression, its uniqueness lying solely in its amplitude.
Lucas (1977) claims that the fact that all business cycles manifest the
same sequence of movements and time lags is the very feature that allows
a general theory of the business cycle, abstracted from the particularities
of individual cycles, to be constructed. This is why this literature gives so
little attention to the causes of any given depression.22
It remains true, nonetheless, that all business cycles - and their components - are a mix of singularity and recurrence. Real business cycle theory just assumes that the singularity dimension can be overlooked for the
22
Moreover, according to Prescott, identifying causes is more or less impossible because a “shock” may consist of the aggregate of a series of small, barely identifiable,
events. As he stated in an interview with The Region, “We don’t have a theory of what
causes economy-wide productivity to change. We can measure how big the changes are,
and we can use dynamic theory to predict the consequences of these random changes.
Now the question is: Can we identify specific shocks? My answer is no. We can’t even
identify why total productivity of labor and capital is four or five times higher here than
in India. Given this, how can we hope to identify why this productivity grew by 2 percent
less than expected over some two-year period? Such an occurrence is all that is needed
to induce a recession” (Rolnick (1996): 8).
3.6 An assessment
71
sake of theoretical analysis. So the appropriateness of applying the realbusiness-cycle toolbox to the Great Depression hinges on the assumption
that in this episode too the recurrence is more important than the singularity. If the reverse is true, the appropriateness of the business cycle framework for tackling the Great Depression has to be questioned.
The alternative viewpoint is that the Great Depression was not a depression in the standard sense (i.e. in the sense that slumps are necessarily
followed by recoveries after some “liquidation” has come to an end).23 A
system-failure phenomenon, analogous to that which occurred with the
downfall of the former communist regimes, may have been at work. In
this view, the 1929-33 events brought the economy to a state of affairs
where any speedy recovery through private-sector adjustments was excluded. To vanquish the threat of a system collapse, a strong signal announcing a change in regime was needed. The New Deal constituted such
a signal. This anti-liquidationist vision is well captured in the following
observation:
The devaluation of the dollar [by the Roosevelt administration]
was the single biggest signal that the deflationary policies implied by adherence to the gold standard had been abandoned,
that the iron grip of the gold standard had been broken. Devaluation had effects on prices and production throughout the
economy, especially on farm and commodity prices, not simply
on exports and imports. It sent a general message to all industries because it marked a change in direction for government
policies and for prices in general. The elements of the New
Deal emerged in the course of 1933; the devaluation of AprilJuly 1933 was the proximate cause of the recovery (Temin and
Wigmore (1990): 485).
The case for and against fully articulated models
Real business cycle theorists are rightly proud of proposing an analysis of
the Great Depression based on fully articulated models, which are micro23
See De Long (1990).
72
The Abandonment of the Abstentionist Viewpoint
founded, have a claim to internal consistency and provide quantitative
results open to direct contest. In contrast, economic history does not provide such models. Rather it mixes discursive economic reasoning with
historic considerations of a different order, including, but not limited to,
statistics and econometrics. Even if impressive progress has taken place
between the early analyses (such as Kindleberger (1973)’s classical book)
and modern studies, this hybrid character still remains.
Ohanian pointed out the superiority of the fully articulated modeling
strategy when interviewed in the Economic Dynamics Newsletter:
General Equilibrium theory is important for understanding the
Depression. There are a lot of stories about the Depression, but
without an explicit general equilibrium model you don’t know
if the stories hold water. One of the benefits of general equilibrium theory is that it forces you to look beyond the direct
effects of shocks, and assess the indirect effects. Hal [Cole] and
I are writing a paper for the NBER Macro Annual that uses general equilibrium models to study the two most popular shocks
for 1929-33: the money stock decline and bank failures. Using
general equilibrium models, we found that many of the indirect effects of these shocks offset the direct effects, or were at
variance with the data. (Ohanian (2000): 6).
But there is another side to the picture. While presenting undeniable
advantages over the narrative approach, the modeling approach also has
drawbacks of its own. Ohanian is right in observing that many stories
are available. The problem is that not all of them can be translated into
models. Models are based on exclusions. But what if the excluded factors
are crucial components of the explanation? Let us mention two obvious
contenders for explaining the onset of the Great Depression that are absent from Cole and Ohanian’s model. The first, which has already been
mentioned above, is the idea that the Great Depression witnessed a failure
in the exchange mechanism. The second, favored by Eichengreen (1992)
and Eichengreen and Temin (2000), is the role played by the gold standard
mechanism. As these authors argue powerfully, in the wake of WWI this
3.6 An assessment
73
institutional mechanism ceased to function well, and governments and
central banks did not know how to fix it. According to Eichengreen and
Temin (2000), any analysis omitting this dimension is doomed to fail to
provide a satisfactory explanation of the Great Depression.24
The meaning of ”explanation”
While both equilibrium economics and economic history aim at explaining the Great Depression, it is evident on reflection that the term ”explanation” does not have the same meaning in each case.
To practitioners of equilibrium macroeconomics, “to explain” means
to be able to construct an artificial model economy which, when subject
to a suitable exogenous shock and properly simulated, behaves like the
observed real-world economy. This is what Cole and Ohanian have in
mind when they claim that TFP explains 65% of the observed data.
To the economic historian, however, the “explanation” term has a stronger
meaning. It implies drawing causal inferences, digging out the possibly
inter-related fundamental causes of an event. This causal perspective may
mean resorting to an array of factors which are not always suitable for inclusion in a formal model. Think for instance of Friedman and Schwartz
(1963)’s claim that the course of the Great Contraction in the United States
might have been different had Governor Strong not died prematurely.
Whenever explaining in this sense is at stake, the discourse is bound to
be loose. Yet what is lost in rigor can be compensated for in ability to
address the heart of the matter.
This difference in the meaning of an explanation is related to the contrast pointed out above. Some commentators praise Cole and Ohanian for
having produced good results while excluding many variables that a priori might be considered important, such as the gold standard. Such praise
is only justified if the less demanding definition of explanation has been
adopted. Against the more demanding conception, another conclusion
emerges. The fact that a model fares well without taking into account the
factor that is deemed crucial for a causal explanation casts doubt on the
24
This point is also made by Gertler (2001) in his discussion of Cole and Ohanian (2000).
74
The Abandonment of the Abstentionist Viewpoint
basic adequacy of this model.
3.7
Lucas after Cole and Ohanian
A final point to be tackled relates to Lucas’s standpoint. We have seen
that Prescott has fully endorsed Cole and Ohanian’s work, becoming 100%
positive about the amenability of the Great Depression to the real business
cycle methodology. But what about Lucas? Has he followed suit?
A recent interview with Lucas by Randall Parker on the subject of the
Great Depression sheds some light on this question (Parker (2006)).25 The
first impression conveyed by this interview is the contrast between the
attitudes of Prescott and Lucas. While the former is bluntly assertive, the
latter has no qualms about expressing his hesitations.
Lucas is highly complimentary about Cole and Ohanian’s work. He
praises them for having quantified the effects on the real economy of measures taken under the New Deal. He also praises them for “having the
guts to just look at this [New Deal] period and say ‘none of these theories
I can take off the shelf make any damn sense here. Let’s start over”’.26
Lucas also agrees with Cole and Ohanian’s explanation of the protracted character of the Great Depression. However, we do not think that
this amounts to an abandonment of his earlier abstentionist viewpoint. In
spite of his agreement with their analysis of the second period of the extended Great Depression, Lucas parts company with Cole and Ohanian as
to the possibility of explaining the onset of the Great Depression within
the real business cycle framework. To him, the monetary explanation à
la Friedman and Schwartz remains compelling, and he finds the idea that
productivity shocks caused the depression hard to swallow:
25
We are grateful to Professors Parker and Lucas for having provided us with the text
of this interview in advance of its publication.
26
We agree with the first of these assessments yet disagree with the second. That the
NIRA might have had harmful effects is a view that many authors have put forward,
Friedman and Schwartz among them. Therefore, it would be more correct to state that
Cole and Ohanian improved on an existing discursive claim by transforming it into a
fully articulated model and quantifying it without introducing a new explanatory factor.
3.8 Conclusions
75
I told Prescott I’d hate to have to rewrite the Friedman and
Schwartz book where the role Friedman and Schwartz assigned
to monetary collapses is assigned instead to productivity shocks.
Where is the productivity shock that cuts output in half in that
period? Is it a flood or a hurricane? If it really happened,
shouldn’t we be able to see it in the data?
Lucas admits that Prescott and real business cycle economists have
pushed him “a way over to thinking that a lot of the more modest recessions
can be accounted for in real terms” (our emphasis). Yet he believes that
this conclusion does not extend to the Great Depression. For him, the latter “stands out as a kind of singular economic event”. This is the same
position as he held in 1994 (see Section 3.2.4 above). Thus, we are led to
conclude that Lucas still holds an abstentionist viewpoint.
3.8
Conclusions
Cole and Ohanian must be credited with having started to use the tools
of modern economic theory to investigate the Great Depression. The task
was worth a try, and having been able to construct a model is no mean feat.
However, as far as substance is concerned, we must reserve judgment. As
far as the onset of the Great Depression is concerned, Cole and Ohanian’s
model has not gained the upper hand over the complex and subtle explanations to be found in the writings of the many economic historians who
have studied this event. As far as the recovery is concerned, it seems to
us that the matter remains open. At this juncture, we are unable to decide
whether their weak recovery claim is stronger than the opposing claims.
At stake in the assessment of real business cycle models of the Great
Depression is a territorial dispute between new classical economic theory
and economic history, hinging on whether there are limits to the modeling
strategy in economics. If Prescott’s standpoint amounts to a claim that
the work of economic historians is pre-scientific and should be replaced
by abstract models, we definitely disagree with him. However, we feel
that the clash between the two approaches can have positive effects. On
76
The Abandonment of the Abstentionist Viewpoint
the one hand, it is beneficial that historians will be forced to react to Cole
and Ohanian’s quantitative results. On the other hand, the confrontation
of their work with that of historians may help modelers to become more
aware of the limits of the modeling approach.
Chapter 4
The Belgian Great Depression
4.1
Introduction
Following the seminal work of Cole and Ohanian (1999), recent studies
have started to apply general equilibrium analysis to the Great Depression
of the 1930s.1 The aim of this stream of research is to deepen our historical
knowledge of the period, by putting the quantitative tools provided for by
modern macroeconomics at the service of historic analysis.2
This paper follows in the footsteps of this literature, casting the Great
Depression in Belgium within a dynamic stochastic general equilibrium
(DSGE) framework.
A typical aspect of this literature is its focus on a purely national dimension. Among all the papers interpreting the Great Depression by means
of a DSGE model, only two - Cole, Ohanian, and Leung (2005) and Perri
and Quadrini (2002) - take a worldwide perspective. Even studies concerning notoriously open economies such as France (Beaudry and Portier
(2002)), Germany (Fisher and Hornstein (2002)) and the United Kingdom
(Cole and Ohanian (2002a)) took a closed-economy perspective. If a priori
such a stance appears unwarranted, it is nonetheless true that the above
mentioned analyses still delivered useful insights, while keeping models
1
Major contributions in this field are Cole and Ohanian (2004), Christiano, Motto, and
Rostagno (2004), Kehoe and Prescott (2002), Prescott (1999) and Weder (2006), to name
but a few. Pensieroso (2007) provides a critical survey of this literature.
2
On the clash between economic history and new classical macroeconomics on the
Great Depression, see De Vroey and Pensieroso (2006).
78
The Belgian Great Depression
relatively simple. On this ground, although the closed-economy assumption may be difficult to retain for Belgium, it is useful to proceed stepwise
for analytical convenience, first a closed-economy analysis, and then the
exploration of the open-economy issues. This paper deals mainly with the
former, leaving the open-economy issues for future research. However, a
brief detour in the open-economy field is provided in the last section as a
robustness check.
The paper is organised as follows. In section 4.2, I look at selected data
on interwar Belgium. Section 4.3 provides some basic facts about the Belgian interwar history. In section 4.4, I detrend the data so as to make them
compatible with the theory. Section 4.5 derives and simulates a basic real
business cycle (RBC) model with productivity shocks, to account for the
Great Depression in Belgium. Section 4.6 extends the analysis by introducing war expectations in the baseline model. Results suggest that, in
a perfect-competition, flexible-price framework, the contribution of either
productivity shocks or war expectations for explaining the depression is
slim. Therefore, in section 4.7, I consider a simple DSGE model with nominal wage stickiness and monetary shocks. Results show that the introduction of nominal wage staggering and monetary shocks improves on
the results, with the model able to account for all the observed drop in
detrended output, consumption, investments and labour input. The sluggishness of the recovery, instead, remains largely unexplained. The role of
TFP shocks in this new environment is also explored. Its contribution is
again found to be minor. Section 4.8 removes the closed-economy assumption for the basic RBC model. Although the framework is admittedly oversimplified, results almost overlap with those for the closed-economy. This
finding suggests that, in the perfect-competition, flexible-price RBC model
at least, the tiny additional explanatory power gained by considering an
open-economy model is not worth the price of having an analytically less
tractable model. Finally, section 4.9 draws some conclusion, and provides
guidelines for future research.
4.2 A look at the data
4.2
79
A look at the data
In this section I will show selected data on the Belgian interwar economy.
The appendix describes data sources and derivation in details.
90000
80000
Million BF (1936-38 Prices)
70000
60000
50000
40000
30000
20000
10000
0
1920
1921
1922
1923
1924
1925
1926
1927
1928
1929
1930
1931
1932
1933
1934
1935
1936
1937
1938
1939
Year
I_pr
GNP (Market Prices)
C
G_c
X
M
Figure 4.1: Output and expenditures. Source: Buyst (1997)
Figure 4.1 reports real data on output and its components. The GNP
(Y ) growth witnessed two accelerations, in 1922-24 and 1928-30. The Great
Depression hit in Belgium in 1931, later than in most other countries. Output decreased until 1934, recovered until 1937, then decreased again. Consumption followed a comparable but a bit smoother pattern. Figure 4.2
shows investments, imports, exports and public consumption as shares
of GNP. Investments’ share witnessed a swinging pattern, with a marked
downward tendency: decreasing until 1926, increasing until 1929, then
decreasing again. In 1939, the investment share over GNP was just 8.4%,
80
The Belgian Great Depression
compared with a value of 19.7% in 1920. Exports share was sharply increasing until 1928, then decreasing until 1932, then increasing again until
1937. Imports’ share was basically increasing until 1931, and then from
1932 to 1937. It witnessed two big drops in 1932 and 1938. It is worth
highlighting that the income shares of exports and imports are relatively
high, reaching a level as high as 30%. Trade balance (e.g. exports minus
imports) was in deficit all over the 1920s but for 1926-1928. It was in deficit
again in 1929-1935, to witness then a moderate surplus till the end of the
decade. Public consumption’s (Gc ) share of GNP was slightly decreasing
till 1927, to slightly increase afterwards. As shown in figure 4.3, the share
of private consumption over GNP increased sharply from 1920 to 1922, to
steadily decrease thereafter till 1929. It then went up again until 1932, to
witness later on a swinging pattern with a slightly decreasing trend.
40.0
35.0
30.0
%
25.0
20.0
15.0
10.0
5.0
0.0
1920
1921
1922
1923
1924
1925
1926
1927
1928
1929
1930
1931
1932
1933
1934
1935
1936
1937
1938
1939
Year
I/Y
G_c/Y
X/Y
M/Y
Figure 4.2: Expenditures over output. Source: Buyst (1997)
4.2 A look at the data
81
Figure 4.4 reports monthly data on real interest rates and unemployment rates. Real interest rates were positive and high in the early 1920s
and then in the midst of the depression years. They were instead low and
even negative in the mid-twenties and in 1936-37.
As for unemployment, Belgium seems to have experienced a full employment growth in the 1920s, apart from 1920-21, when recovery from the
war was not yet fully attained. After 1930, unemployment rapidly gained
momentum. It reached peaks of 28% around 1935, witnessing just a mild
and slow recovery after 1935, to worsen again in 1938-39.
88.0
86.0
84.0
82.0
%
80.0
78.0
76.0
74.0
72.0
70.0
1920
1921
1922
1923
1924
1925
1926
1927
1928
1929
1930
1931
1932
1933
1934
1935
1936
1937
1938
1939
Year
C/Y
Figure 4.3: Consumption over output. Source: Buyst (1997)
Figure 4.5 shows 1930-based indexes of real and monetary wages. Monetary wages were sharply increasing all over the 1920s, to reach a peak in
1930. Then they decreased during the depression, reaching a trough in
82
The Belgian Great Depression
1935, when they had decreased cumulatively a good 24 %. Thereafter,
they increased again until the outbreak of the war. Real wages followed a
different pattern. They were almost constant and then slightly decreasing
up to 1927, to become appreciably increasing thereafter. In the midst of
the depression, real wages kept on being approximately constant, slightly
above their 1930 value. After 1935, they increased again until 1939.
40
30
20
lug-39
gen-40
lug-38
gen-39
lug-37
gen-38
lug-36
gen-37
lug-35
gen-36
lug-34
gen-35
lug-33
gen-34
lug-32
gen-33
lug-31
gen-32
lug-30
gen-31
lug-29
gen-30
lug-28
gen-29
lug-27
gen-28
lug-26
gen-27
lug-25
gen-26
lug-24
gen-25
lug-23
gen-24
lug-22
gen-23
lug-21
gen-22
0
gen-21
%
10
-10
-20
-30
-40
Month-Year
r
u
Figure 4.4: Real interest rate and unemployment rate. Source: my elaboration on Banque Nationale de Belgique (1943a) and Banque Nationale de
Belgique (1943b)
Figure 4.6 shows the retail price index on monthly bases, as well as
its monthly rate of variation. Belgium witnessed an appreciable deflation
in 1920-21, followed by period of steep increases in the price index up to
1925. After mid-1926, prices literally jumped up, possibly a consequence
4.2 A look at the data
83
of the monetary stabilisation carried out in that year. Thereafter, inflation
follows the same path as in 1923-26, until 1930. As the Great Depression hit
Belgium, the sharp deflation typically associated to it followed. Deflation
endured up to 1935, year of the devaluation of the Belgian franc.
To better appreciate the possible role of monetary variables, I reported
data for nominal money supply (M1), together with the annual price index
in figure 4.7. From this graph we get that money supply was increasing
till 1931, then sharply decreasing till 1934, then increasing again. The behaviour of the real money supply can be deduced by comparing the nominal money supply index with the price index. The exercise shows that, as
far as the Great Depression is concerned, the real quantity of money decreased in 1932, in 1934 and in 1937, as in those years the nominal quantity
of money dropped more than the price level.
120
100
1930=100
80
60
40
20
0
1920
1921
1922
1923
1924
1925
1926
1927
1928
1929
1930
1931
1932
1933
1934
1935
1936
1937
1938
1939
Year
Nominal Hourly Wages
Real Hourly Wages
Figure 4.5: Nominal and real wages. Source: Goossens, Peeters, and
Pepermans (1988)
84
The Belgian Great Depression
1000
0.1
900
0.08
700
0.02
600
feb-39
feb-38
ago-38
feb-37
ago-37
feb-36
ago-36
feb-35
ago-35
feb-34
ago-34
feb-33
ago-33
feb-32
ago-32
feb-31
ago-31
feb-30
ago-30
feb-29
ago-29
feb-28
ago-28
feb-27
ago-27
feb-26
ago-26
feb-25
ago-25
feb-24
ago-24
feb-23
ago-23
feb-22
feb-21
ago-22
-0.02
ago-21
feb-20
0
ago-20
Montly price variation rate
0.04
April 1914=100
800
0.06
500
400
-0.04
-0.06
300
Month-Year
Monthly rate of inflation
Retail price index
Figure 4.6: Monthly retail price index and inflation. Source: Banque Nationale de Belgique (1943a) and Banque Nationale de Belgique (1943b)
Figure 4.8 reports data on nominal exchange rates between the Belgian
franc and the British, American and French currencies. The Belgian franc
depreciated against the pound for all over the 1920s, till 1927. It stayed
then four years constant, to appreciate from 1931 to 1934. Thereafter it depreciated again till the end of the decade. The exchange rate between the
Belgian franc and the dollar followed a similar though less accentuated
path. In this case, appreciation of the franc in the 1930s started later in
1933. Finally, the Belgian franc depreciated against the French franc from
1919 to 1923, to appreciate until 1926. It jumped then in 1927, depreciating of 40%, to stay constant until 1934. Here it witnessed a second jump,
followed in 1936 by a sharp appreciation.
4.3 History of interwar Belgium
4.3
85
History of interwar Belgium
In this section I shall briefly outline the basic economic and political events
that shaped Belgian interwar history.3
4.3.1
1920-1926
Contrary to other European nations, Belgium had a low debt burden to
cope with after world war I. In fact, having experienced German occupation throughout most of the war, Belgium found itself in the impossibility
of issuing internal debt for war financing. This is why initially the Belgian
economy skipped the typical debt-driven post war hyperinflation which
hit other countries.
The 1920-1926 period witnessed a marked post-war growth in an environment characterised by inflation, a floating exchange rate, low unemployment rates and steady real wages.
According to the historians, the division of the reconstruction burden
between labour and capital income was controversial, a trait that Belgium
shared with many European countries immediately after the war. Much
like the French, the Belgians tried to avoid the problem by pretending to
believe that Germany would pay for the reconstruction of their economy,
as it was obliged to that by the Versailles Treaty. By sticking to this conviction, they produced big government deficits, financing both the reconstruction and a new social legislation by issuing public debt’s short run
bonds. Actually this deficit spending was concealed by the fact that, at
that time, the Belgian government kept two budgets, one, which was more
and less always balanced, for ordinary expenses, and another one, whose
liabilities were supposed to be paid by the Germans, for extraordinary expenses. After the French invasion of the Ruhr failed (1923), this double
accounting trick did not work anymore. Investors realised that Germany
would never pay for the Belgian reconstruction and started to withdraw
3
Sources are Baudhuin (1946), Cassiers (1989b), Cassiers (1995), Eichengreen (1992),
Goossens (1988), Goossens, Peeters, and Pepermans (1988), Hogg (1986), Mommen
(1994), and Vanthemsche (1987).
86
The Belgian Great Depression
their money. The Belgian franc depreciated from 30 BF/£ in 1919 to 96
BF/£ in 1925.
140
130
120
110
1929=100
100
90
80
70
60
50
40
1925
1926
1927
1928
1929
1930
1931
1932
1933
1934
1935
1936
1937
Year
P
M1
Figure 4.7: Nominal money supply and retail price index (base 1914).
Sources: Banque Nationale de Belgique (1943a) and Banque Nationale de
Belgique (1943b) and Hogg (1986)
Inflation raised. If the exchange rate were to be stabilised and the gold
standard restored, new taxes had to be issued, to control for the public
debt, thus restoring investors’ trust. After a first failed attempt in 1925,
the franc was finally stabilised in 1926. The new government was able
to take draconian fiscal measures, in order to restore budget balance, including the levying of new taxes on land and luxury consumption, and
the restructuring of the railways system. Under these new conditions, an
international loan was obtained, which allowed the National Bank to stabilise the franc at the rate of 175 BF/£.
4.3 History of interwar Belgium
4.3.2
87
1926-1930
In the period between 1926 and 1930, the Belgian economy witnessed high
growth rates. However, there is some evidence that such a growth was
not evenly distributed among sectors. In particular, the wholesale and the
retail price indexes followed different patterns, with the ratio of the former
over the latter sharply decreasing. According to Cassiers (1995), such a
feature reveals that the price in francs of tradable goods stopped growing
soon after the stabilisation of the franc, whereas domestic prices kept on
increasing. This led to a decline of profitability in the export sector. This
observation is reinforced by the fact that real wages grew of about 20%
between 1927 and 1930. This notwithstanding, unemployment rates were
remarkably low until the end of 1930.
200
BF for 1 unit of foreign currency (yearly average)
180
160
140
120
100
80
60
40
20
0
1919 1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939
Year
BF/£
BF/$
BF/FF
Figure 4.8: Selected exchange rates, 1919-1939. Source: Baudhuin (1946).
88
The Belgian Great Depression
Another feature of the period is the marked surge in banking and financial activities. The stock exchange prices grew up on average of 246%
between August 1926 and May 1928, apparently fueled by a generalized
distrust in public securities. Banks liabilities increased by 50% between
1927 and 1930, without a comparable increase in their capitalization. After the stabilisation, a heavy inflow of gold followed, which induced the
National Bank to sterilisation policies.
In synthesis the 1926-1930 was a period of boom in the domestic and financial sectors, while profitability in the export sector dampened because
of the combination of decreasing output prices and increasing unit labour
costs.
4.3.3
1930-1935
In 1931, the United Kingdom, one of Belgium’s biggest commercial partners, exited the gold standard and devaluated the pound, imposing also
trade restrictions on steel and other goods that hit Belgium heavily. Belgian exporters reacted as price-takers agents typically do, i.e. by accepting
to sustain losses instead of losing market shares. The export volume therefore fell much less than its value in Belgian francs.
As Great Britain exited the gold standard, Belgian authorities implemented deflationary policies in order to smooth down the differential between domestic and external prices. Income tax, indirect taxes and tariffs
were all increased. The real tax burden, which was 11.7% in 1930, jumped
to 15.3% in 1932 and 16.4% in 1934. Public expenditures on salaries, pensions and unemployment benefits were reduced. Nominal wages went
down but not enough to prevent real wages to increase. Unemployment
rate jumped from 4% in 1930 to above 20% in 1932. The fragile bank system entered a liquidity crisis soon after 1933. In 1934 the Banque Nationale
Belge du Travail declared solvency problems. The National Bank reduced
the official discount rate so as to inject liquidity into the system. But this
policy to save the financial system went openly against gold standard
rules, as big gold outflows were being observed, to which the National
Bank should rather have reacted by increasing the discount rate. Investors
4.4 The Data through the lens of the theory
89
started liquidating deposits, as they anticipated a devaluation of the franc.
This worsened the bank crises and made devaluation eventually unavoidable. After one year of political and financial turmoil, on April 1935 the
Belgian government devaluate the franc by 28%. The amount was thought
of as to regain competitive prices abroad, yet avoiding a competitive devaluation that could have caused commercial retaliations from the United
Kingdom.
4.3.4
1935-1939
Devaluation was followed by a big credit expansion, which gives room
to a recovery till 1937. Pressure on aggregate demand caused inflation to
gain momentum. Yet installed capacity was apparently so underutilised
that overall inflation remained under control. Mutatis mutandis, the same
is true for real wages, which were kept under control, though they witnessed an increasing pattern. The Belgian authorities were initially able to
resist the 40 hours-week movement, contrary to what happened in France.
Unemployment remained very high, if compared with 1930. Finally, currency devaluation notwithstanding, trade account did not improve. In
facts, exports were stagnating, whereas imports increased, possibly due to
the upsurge in aggregate demand. Strong capital inflows helped to keep
the balance of payment favourable.
4.4
4.4.1
The Data through the lens of the theory
Detrending
According to RBC theory, business cycles are defined as deviations from
the long run trend. This means that to be able to look at the Great Depression in Belgium from a Neoclassical perspective, I first need to net the
data of their long-run trend.4 Following Cole and Ohanian (1999), I have
4
It is worth highlighting that detrending is hardly a neutral technique, in the sense
that by construction the choice of the trend value can influence the magnitude and even
the presence of cyclical oscillations.
90
The Belgian Great Depression
assumed that the economy grows in the long-run as predicted by the simple Solow-Ramsey framework, so that all per-capita variables grow at the
same constant rate, which is the exogenous growth rate of technology.
110
100
90
1929=100
80
70
60
50
40
30
20
1929
1930
1931
1932
1933
1934
1935
1936
1937
1938
1939
Year
I
C
Y
TFP
Figure 4.9: Detrended per capita data. Source: my elaboration on Buyst
(1997)
Using data from Comin and Hobijn (2004), I computed the average rate
of growth for the Belgian real GDP per capita in the period 1900-1994 (g),
excluding world wars I and II, and the Great Depression (1929-1939) as
well. It turned out to be equal to 3.02%. This is assumed to be the long run
constant growth rate. Next I collected data on the Belgian working-age
population (i.e. the 15-65 demographic cluster) from the Belgian official
demographic statistics (Ministere des Affaire Economiques (1943)) and I
expressed GNP in per capita terms (Y /N = y). Hence, I detrended the y
4.4 The Data through the lens of the theory
91
series, assuming 1929 as base-year (i.e. 1929 = t0 ), and using the following
formula
yt
ỹt = (t−t0 ) ,
(4.1)
γ
where γ = 1 + g. The same procedure is followed for detrending all the
macroeconomic aggregates.
Results are shown in figure 4.9. Output per capita dropped of a good
20% after 1930, and remained at about this level, with a further decrease
in 1938-39. In line with Cole and Ohanian (1999)’s claim as to the US Great
Depression, Belgium did not recover before the outbreak of world war II.
Investments per capita were constantly decreasing, to reach the trough
of almost 64% below trend in 1939.
Consumption per capita was below trend during all the depression
years, showing a slight downwards tendency.
4.4.2
Total factor productivity
Figure 4.9 also shows detrended total factor productivity (TFP). TFP was
computed using a Cobb-Douglas production function
yt = est ktα (xt lt )1−α ,
where lowercase variables stands for per capita, k is capital, l hours worked.
Non-detrended TFP is given by est xt1−α . x is the labour-augmenting technological progress, whose growth at the rate g gives the deterministic
trend of the economy. es is the stochastic component of TFP, i.e. its deviations from trend, and therefore what remains after detrending TFP.
As shown in figure 4.9, TFP was on trend till 1931, to progressively fall
thereafter up to 10% below trend in 1934, with no apparent recovery to
the trend before the outbreak of the war. An interesting feature of TFP’s
behaviour in Belgium is that, though it did never recover its trend level
during the late 1930s, yet it got near its trend growth rate from 1936 onwards. This is evident from a glance to figure 4.10, where, making 100 both
values in 1929, I graphed the deterministic trend of TFP together with its
observed value.
92
The Belgian Great Depression
Next step is to assess whether, in a RBC model with exogenous TFP
shocks, the observed TFP behaviour is sufficient to account for output
movements in Belgium during the Great Depression. I undertake this task
in the next session.
135
130
125
1929=100
120
115
110
105
100
95
1929
1930
1931
1932
1933
1934
1935
1936
1937
1938
Year
Actual TFP
Trend TFP
Figure 4.10: TFP: deterministic trend versus actual values. Source: my
elaboration on Buyst (1997)
4.5
A baseline RBC model of the Belgian Great
Depression
4.5.1
The model
I assume perfect competition and complete markets. I consider a closed
economy populated by an infinitely living representative household, who
4.5 A baseline RBC model of the Belgian Great Depression
93
solves the following maximization problem:
max
{ct ,lt ,kt+1 }∞
t=0
Et
∞
X
β t [ln(ct ) + φ ln(1 − lt )],
(4.2)
t=0
under the constraints:
ct + kt+1 ≤ (1 − δ)kt + yt ,
yt = est ktα (xt lt )1−α ,
st = ρst−1 + vt ,
xt = γ t x0
0 < ρ < 1,
k0 = given,
s0 = given.
In this model, I have assumed a log-log, time separable utility function.
The parameter β is the household’s discount rate. φ is the relative weight
that leisure holds in the utility function. δ is the capital depreciation rate
due to technical obsolescence and physical disruption. I have assumed
that detrended TFP, st , follows an AR(1) process with ρ being its AR(1)
coefficient, and vt being a zero-mean i.i.d. innovation.
The first order conditions of this problem are given by

γ

1
1 
= Et β
1 − δ + αest+1
c˜t
c̃t+1
k̃t+1
lt+1
!α−1 
γ k̃t+1 = (1 − δ)k̃t + est k̃tα lt1−α − c̃t ;
φ
1
= est (1 − α)
1 − lt
c̃t
k̃t
lt
 ;
(4.3)
(4.4)
!α
;
(4.5)
plus a transversality condition. x̃ means detrended x.
In such an economy there exist a stationary state growth path for all
the detrended variables.
94
The Belgian Great Depression
4.5.2
Calibration
In order to simulate the modeled economy, I need to calibrate the parameters of the model. Table 4.1 illustrates my choices.
β
γ
δ
α
φ
ρ
0.96
1.03
0.1
0.33
1.78
0.99
Table 4.1: Parameters’ calibration
The unit period is the year. The parameters β, δ and α are fixed accordingly, as in Cole and Ohanian (1999). The deterministic growth rate
of the economy is derived as explained in section 4.4.1. The parameter φ
is calibrated so that hours worked l be 1/3 in steady state. The autocorrelation parameter ρ is estimated by regressing the logarithm of detrended
TFP (i.e. st in the model) as an autoregressive process of order 1.
4.5.3
Simulation
I assume the model economy to be at the steady state in 19295 . I feed in the
residuals from regressing the logarithm of detrended TFP as AR(1) as the
unexpected shock vt . Figures 4.11 and 4.12 present the dynamic response
of the model to the shock.
The model reproduces about 35% of the 1929-1934 output drop. It
shows no signs of recovery after 1934, a feature in full accordance with
the data.
5
Note that the assumption that the economy was in steady state in 1929 may be plausible, but it is not a-priori justifiable.
4.5 A baseline RBC model of the Belgian Great Depression
95
Detrended Y
110
100
90
80
70
60
50
40
1929
1930
1931
1932
1933
Model
1934
1935
1936
1937
1938
1935
1936
1937
1938
Data
Detrended C
110
100
90
80
70
60
50
40
1929
1930
1931
1932
1933
Model
1934
Data
Figure 4.11: Simulation: RBC model versus actual economy
96
The Belgian Great Depression
Detrended I
110
100
90
80
70
60
50
40
1929
1930
1931
1932
1933
1934
Model
1935
1936
1937
1938
1935
1936
1937
1938
Data
L
110
100
90
80
70
60
50
40
1929
1930
1931
1932
1933
Model
1934
Data
Figure 4.12: Simulation: RBC model versus actual economy
4.5 A baseline RBC model of the Belgian Great Depression
97
The model performs similarly in accounting for consumption. Its 19291934 drop is accounted for by little more than 31%. From 1934 onwards
consumption stays constant in the model, while it kept on decreasing slightly
in the data. As a result, in 1938 the model accounts for just 28% of the consumption drop.
As for investments, the model is able to replicate 37% of their 1929-1934
drop. Things worsen when we consider 1938, with the model accounting
for a mere 14% of investments’ behaviour. This is because in the model
investments recover after 1934, though not at the trend level, whereas in
the data they dropped even more.
As far as hours worked are concerned, the model accounts for a slim
5% of their 1929-1934 drop. In 1938, it accounts for virtually nothing of
hours behaviour.6
4.5.4
Comments on the results
According to the exercise I performed above, TFP shock is not a likely culprit for explaining the Great Depression in Belgium. First, there is a timing
problem. Detrended data in figure 4.9 shows that the economy entered the
Great Depression in 1930, one year later than elsewhere. On the contrary,
we can see in the same graph that TFP stayed at trend - and even slightly
above trend - until 1931. It dropped 10% below trend between 1932-1934,
to stay basically constant thereafter.
This translates in a problem of both direction and dimension of TFP
movements. In my simulation, as a consequence of the above mentioned
6
Assuming that the utility function is logarithmic in leisure is tantamount to assuming
that the intertemporal elasticity of substitution of labour supply σ is equal to 1, in a CES
specification like
1
U (ct , lt ) = ln ct + φ
(1 − lt )1− σ
.
1 − σ1
As typical estimates for σ range around [0.4, 1] (Cahuc and Zylberberg (2004)), such an
assumption is fair to the RBC transmission mechanism, in that, if anything, it overestimates the transmission of the TFP shock. For the sake of completeness, I run two further
simulations, one with σ = 0.4 and the other with σ = 1.25. The latter value is chosen to
be the threshold superior limit, as in Merz (1995). Results do not change appreciably.
98
The Belgian Great Depression
TFP behaviour, output, consumption and investments increase until 1931,
to decrease only later on, a pattern at variance with the data.
A third problem relates to the quantitative side. Simulation’s results
are rather poor, with the model barely able to account for a small percentage of the variables’ behaviour. This is particularly true as far as labour
input is concerned.
These results suggest two directions for further inquiries. The first has
to do with the investment dynamics. A better accounting of the big drop
we observe in detrended investment can mark an appreciable improvement over the TFP-driven explanation I dealt with here above. This is
particularly true for what concerns the 1934-38 years, as in those years the
discrepancy between the RBC model and the data is major.
The second line of research relates to the behaviour of the labour input.
As TFP was above trend in 1930-31, and given the time-to-build assumption that fixes capital in any period t, simple growth accounting suggests
that hours’ behaviour is crucial for explaining the onset of the Depression.
The next two sessions are devoted to the task of individuating and
modeling those additional shocks that may be behind the depicted behaviour of the production factors.
4.6
War expectations and investments
A striking aspect of the Belgian Great Depression is the dimension of the
detrended investment drop. A possible explanation of such a drop can
be that somewhere in the 1930s agents started to expect a war, thereby reducing capital accumulation. Baudhuin (1961) argues that already in 1936,
when Germany re-militarized the Rhein region, worries about a possible
war started being murmured. These murmurs got plain voice after the
annexion of Austria in 1938.
To see whether war expectations may play a role in explaining investment dynamics, I simulated the same basic RBC model of section 4.5.1,
introducing two differences. First, I assumed zero unexpected TFP shock,
in order to isolate the effect of war expectation. Second I imposed an expected exogenous variation in the rate of capital depreciation δ for the
1940-45 years. The idea is to translate the anticipated physical destruction
4.6 War expectations and investments
99
of the stock of capital in a variation of the depreciation rate. I have chosen
two benchmark values for δ: 0.1387, which is the one I have computed in
deriving the capital series to account for the destructions induced by WWI
(see appendix); and a maximum value of 0.5, which means that half of the
capital stock goes destroyed each year. Results are shown in figures 4.13
and 4.14.
If in 1929 agents had perfectly foreseen WWII, expecting a degree of
destruction in the stock of capital equal to that experienced in the “Great
War”, as WWI was known, then the simulated model can account for
about 4% of the investment drop in 1938. Output decrease in the model
account for 8% of output drop in 1938. Consumption in the model stays
constantly slightly above the trend, thus not accounting at all for the observed behaviour in the data. The same is true for hours worked, but for
the fact that this variable shows a slightly decreasing path, accounting in
1938 for merely about 1.5% of the observed slump in actual hours worked.
If the maximum value δ = 0.5 is chosen for simulation, than the model
can account for a greater proportion of output, investment and hours drop
in 1938, respectively of 37.5%, 74% and 53%. Consumption shows instead
a counterfactual behaviour, increasing steadily up to 2% above trend.
This exercise shows that in this type of models, war expectations could
play a role in explaining investment dynamics only if the dimension of
the expected disruptions induced by the war were very big. In the model,
this translates in an expected loss of capital stock that is much bigger than
that caused by WWI. Historically, this seems not plausible. People could
well have being judging increasingly probable a war, starting, say, from
1936. Yet it is highly improbable that they were expecting something as
ruinous as being four-five times WWI. Moreover, if introducing “realistic”
war expectations in the model is likely to slightly improve on the results
based on TFP shocks, for what concerns inputs and output, yet the model
would fare slightly worse as far as consumption is concerned.
100
The Belgian Great Depression
Detrended Y
110
100
90
80
70
60
50
40
1929
1930
1931
Model - TFP
1932
Data
1933
1934
Model - Exp War
1935
1936
1937
1938
Model - Exp War delta WWI
Detrended C
110
100
90
80
70
60
50
40
1929
1930
Model - TFP
1931
1932
Data
1933
1934
Model - Exp War
1935
1936
1937
1938
Model - Exp War delta WWI
Figure 4.13: Simulation: RBC model with unexpected TFP shocks, actual
economy and RBC model with war anticipation
4.6 War expectations and investments
101
Detrended I
110
100
90
80
70
60
50
40
1929
1930
1931
Model - TFP
1932
1933
Data
1934
1935
Model - Exp War
1936
1937
1938
Model - Exp War delta WWI
L
110
100
90
80
70
60
50
40
1929
1930
1931
Model - TFP
1932
Data
1933
1934
Model - Exp War
1935
1936
1937
1938
Model - Exp War delta WWI
Figure 4.14: Simulation: RBC model with unexpected TFP shocks, actual
economy and RBC model with war anticipation
102
The Belgian Great Depression
All in all, war expectations could be a useful refinement of the model, but
they do not seem decisive in accounting for the Belgian Great Depression.
4.7
Money and sticky wages
Results with the benchmark RBC model suggest that an explanation of the
onset of the Great Depression in Belgium must rely on explaining the behaviour of the labour input mainly. In facts, detrended output decreased
already in 1930, whereas TFP stayed above the trend till 1931, to start decreasing only later on.
25
Unemployment rate 1921-1939
20
15
10
y = -0.5895x + 12.49
R2 = 0.5335
5
0
-15
-10
-5
0
5
10
15
20
25
-5
Nominal hourly wages annual variation rate 1921-1939
Figure 4.15: Phillips curve, Belgium 1921-1939. Source: Goossens, Peeters,
and Pepermans (1988)
4.7 Money and sticky wages
103
As real wages were actually increasing up to 1932, data seem to suggest
that high real wages might be a culprit for explaining hours’ behaviour. At
the same time, nominal wages were sharply decreasing between 1930 and
1935. This suggests that nominal variables must be taken into account as
well. As price level dropped by 25% in the same period (figure 4.7), a possible story is that nominal wages had some staggering, so that prices decreased more than nominal wages, resulting in increased real wages and,
consequently, in unemployment. This is the position held for instance by
Goossens (1988). This explanation would imply the existence in the data
of a downward sloping Phillips curve, i.e. a negative relation between
the variation rate of monetary wages (or inflation) and the unemployment
rate. Cassiers (1989b) argues such a relation is indeed evident for Belgium
in the 1929-1932 years. In figure 4.15, I plotted a standard Phillips curve
for the 1921-1938 period. The figure suggests the existence of an inverse
relation between the two variables.7
If, according to this evidence, sticky wages may be a plausible propagation mechanism for the Great Depression in Belgium, we still have to
identify a source for deflation. According to the historians of the period,
a major role in this respect was played by exchange-rate problems in the
context of the Gold-Standard regime. When in 1931 Great Britain devaluated the pound, so the story goes, the Belgian franc got overvalued, forcing domestic authorities to deflate the economy in order to keep market
quotas intact for the export sector. In that context of exchange-rate pegging, money supply had become quasi-endogenous, as it adjusted to the
trade balance following pre-determined rules. This means that the Belgian
Central Bank had to move the discount rate and the monetary base in order to keep the value of the Belgian Franc stable, whenever trade balance
showed a surplus or a deficit. In the event of a unilateral devaluation by
an important commercial partner, the monetary authority had to sterilize
7
I repeat the same exercise in figure 4.16, substituting the inflation rate to the nominal
wages variation rate. Though the scatter again suggests a negative relation between the
two variables, the evidence here is less conclusive than in the previous graph. This can
be interpreted as evidence that monetary wages and CPI followed different patterns, as
the latter could have been more influenced by exchange rate troubles.
104
The Belgian Great Depression
the subsequent gold inflow, and to deflate internal prices in order to keep
competitiveness on foreign markets. This direct link between exchange
rate and money supply in a Gold-Standard regime suggests that, in the
task of modeling the nominal shock that we may want to hold as responsible for the onset of the Belgian Great Depression, we can use exogenous
monetary shocks as a proxy for exchange-rate variations. The use of this
shortcut is also supported by the data on nominal money. There was indeed a monetary contraction starting from 1931 (see figure 4.7).
25
Unemployment rate 1921-1938
20
15
10
5
y = -0.4373x + 10.31
R2 = 0.4056
0
-15
-10
-5
0
5
10
15
20
25
30
-5
1914-based CPI index annual variation rate 1921-1938
Figure 4.16: Inflation-Unemployment trade-off, Belgium 1921-1938.
Sources: Banque Nationale de Belgique (1943a), Banque Nationale de Belgique (1943b) and Goossens, Peeters, and Pepermans (1988)
At the light of these arguments, I shall investigate the role of nominal
shocks and sticky wages, in a closed-economy monetary model with contractstaggering. For all its being but a rough shortcut, by means of this trick
4.7 Money and sticky wages
105
I shall be able to produce a first assessment of the role of sticky wages
and nominal shocks, while retaining a simple model. Moreover the use of
a closed-economy model shall make the result directly comparable with
those of section 4.5.
4.7.1
The model
I modify the model of section 4.5.1 to introduce sticky wages and monetary
shocks. I have taken inspiration from Bordo, Erceg, and Evans (2000), who
carried out a similar analysis for the United States.
First, I assume fixed labour supply.
Second, I postulate a nominal wage rigidity à la Taylor (1980).8 In this
setting, workers are divided into two cohorts, each one fixing her nominal
contract-wage for two years. The contract scheme is such that, say, cohort
one fixes her contract in t for periods t and t + 1, while cohort two fixes
her contract in t + 1 for periods t + 1 and t + 2. Then cohort one will fix her
contract in period t + 2 for periods t + 2 and t + 3, and so on and so forth.
Thus in each period t, there will be two different contracts, the one of the
cohort who fixed it in period t − 1 and the one of the cohort who fixes it in
period t. Calling χt the contract set in period t, the average nominal wage
in period t will be
1
1
2
Wt = χt2 χt−1
Each contract is fixed according to the following rule.
1
ξ
lt
lt+1
ln (χt ) = [ln (Wt ) + Et (ln (Wt+1 ))] +
ln ¯ + ln
.
¯l
2
2
l
(4.6)
(4.7)
The meaning of equation 4.7 is that, when negotiating contracts, rational
agents set them at the geometric mean of current average wage and expected future average wage, as they know they will not be able to modify
the contract next period. The last term on the right hand side makes contracts depend upon general labour market conditions: the contract will
8
I use Taylor-staggering, as Bordo, Erceg, and Evans (2000) do, because it is the simplest way to make my point on the possible role of sticky wages, in presence of monetary
shocks. Nonetheless, I admit that a proper micro-foundation for wage stickiness would
make the model more robust.
106
The Belgian Great Depression
be positively (negatively) influenced by the hours worked being higher
(lower) than a benchmark level ¯l, which is the steady-state level, when
wages are perfectly flexible and labour supply is endogenous.
By substituting equation 4.7 in equation 4.6, and assuming perfect foresight, I get
1
ξ
lt
lt+1
lt−1
1
2 ln ¯ + ln
+ ln
,
ln(Wt ) = ln(Wt+1 ) + ln(Wt−1 ) +
¯l
¯l
2
2
2
l
(4.8)
which gives the expression of the average wage in time t as a function of
past and expected future values of the average wage, and of past, present
and future conditions on the labour market.
Finally, I assume that agents draw utility from holding real money balances. The timing assumption is that agents draw utility from the real
t
quantity of money mt = M
that remains at the end of period t, after purPt
chasing consumption goods.9
Therefore the problem of the representative household will be
max
{ct ,mt ,kt+1 }∞
t=0
Et
∞
X
β t [µ ln(ct ) + (1 − µ) ln(mt )],
t=0
under the constraints:
ct + kt+1 + mt ≤ (1 − δ)kt + yt +
mt−1
+ τ,
1 + πt
yt = est ktα (xt lt )1−α ,
st = ρst−1 + vt ,
xt = γ t x0 ,
0 < ρ < 1,
ζt = ln (Mt ) − ln (Mt−1 ),
ζt − ζ̂ = θt
θt = ηθt−1 + νt ,
Pt − Pt−1
,
πt ≡
Pt−1
9
See Carlstrom and Fuerst (2001) for alternative timing assumptions.
(4.9)
4.7 Money and sticky wages
107
k0 = given,
s0 = given,
θ0 = given
where vt and νt are zero-mean i.i.d. innovations; τt is a lump-sum nominal
transfer paid by the government when it issues money, which in equilibmt−1
, in order to get govrium must be equal to the seignorage, mt − (1+π
t)
ernment budget balance; ζt is the growth rate of per-capita money stock,
which is assumed to follow and AR(1) process, with ζ̂ and η given parameters. I assume complete markets, perfect competition in the good market
and perfect foresight.
Computing the first order conditions for this problem, and detrending
all the variables, the relevant equations for characterising a solution are

γ

k̃t+1
lt+1
1
1 
1 − δ + αest+1
= Et β
c˜t
c̃t+1
γ k̃t+1 = (1 − δ)k̃t + est k̃tα lt1−α − c̃t − m̃t +
!α−1 
 ;
(4.10)
m̃t−1
+ τ̃ ;
γ(1 + πt )
(4.11)
1−µ
µ it
=
;
m̃t
c̃t 1 + it
α−1 1−α
1 − δ + αest+1 k̃t+1
lt+1 =
ln(w̃t ) =
1 + it
;
1 + πt+1
(4.12)
(4.13)
1
1
1
1
ln(w̃t+1 ) + ln(1 + πt+1 ) + ln(w̃t−1 ) − ln(1 + πt ) +
2
2
2 2
lt+1
lt−1
ξ
lt
+ 2 ln ¯ + ln
+ ln
; (4.14)
¯l
¯l
2
l
w̃t = (1 − α)est k̃tα lt−α ;
(4.15)
plus a transversality condition.
The first two equations are the usual Euler condition and the resource
constraint, respectively. Equation 4.12 is the money demand, which turns
108
The Belgian Great Depression
out to be a function of current consumption and the nominal interest rate
it .10 Equation 4.13 is the Fisher equation, stating that nominal interest rates
must be equal to the real interest rate, i.e. the marginal product of capital,
plus the expected inflation rate.11 Equation 4.14 gives the rule of formation
of detrended real wages w̃. It comes from detrending equation 4.8. Its
role in the model is to determine hours worked, via the labour demand
(equation 4.15).
4.7.2
Calibration
Table 4.2 shows the parametrization of the model. The unit period is the
year.
The parameters α, β, γ, δ and ρ are the same as in section 4.5.2.
β
γ
δ
α
ξ
ρ
η
µ
ζ̂
0.96
1.03
0.1
0.33
0.0148
0.99
0.14
0.5
0.05
Table 4.2: Parameters’ calibration
The parameter ζ̂ is the average annual growth rate of nominal money
supply. The typical value for this variable is 0.05 (Walsh (2003)). To check
for its adequacy for Belgium in the period under exam, I estimated ζ̂ by
10
A clarification on timing. I define it as the nominal interest rate paid in period t + 1
to the owners of bonds issued in period t.
11
The Fisher equation reported in the text can be formally derived by adding bonds
as a choice variable in the model. Given that bonds play no other role in my model, I
have dropped them, and just added the Fisher equation as an exogenous definition of the
nominal interest rate.
4.7 Money and sticky wages
109
running the following AR(1) on the available data for the interwar period:
ζt = (1 − η)ζ̂ + ηζt−1 + νt .
The result is ζ̂ = 0.047.12
The parameter η is estimated by regressing θt as an AR(1) without drift.
The relative weight of consumption and real balances in the utility
function plays no role in the dynamics, so there is no need to calibrate
it. I choose µ = 0.5.
0.3
0.25
0.2
0.15
0.1
0.05
0
1927
1928
1929
1930
1931
1932
1933
1934
1935
1936
1937
-0.05
-0.1
-0.15
-0.2
-0.25
Ni
Figure 4.17: Estimated monetary shock νt
12
Bordo, Erceg, and Evans (2000) run a similar regression on quarterly U.S. data, limited to the period 1922:2-1928:4. Adjusted on yearly basis, their estimations gives a value
of 0.02 for ζ̂.
110
The Belgian Great Depression
The trickiest parameter to calibrate is ξ. This parameter gives the elasticity of nominal contracts to labour market conditions. An high value of ξ
means a relatively lower degree of wage rigidity: nominal contracts react
more fast to hours worked being above or below the steady state value.
Viceversa, a low value of ξ implies an higher degree of rigidity. Estimates
on quarterly U.S. data by Bordo, Erceg, and Evans (2000) gave ξ = 0.0037.
This value was chosen by the authors as the one that minimises the average square difference between the observed and the simulated real-wage
series. Their estimation was run on the period 1929:4-1933:2. Given that
I have yearly data, I have chosen the benchmark ξ to be four times their
estimation. Then, I have run a sensitivity analysis as follows. I have compared the growth rates of the series implied by the model with that of the
data for threshold values of ξ. These values are chosen as to be two times,
four times, one-fourth and one-eightieth the benchmark value.
The model was simulated after feeding in the series of the estimated νt .
This is the series of the residuals from regressing θt , the deviation of the
growth rate of nominal money supply from its long-run average value, as
an AR(1). It stands for unexpected monetary shock, and it is plotted in
figure 4.17. Productivity shocks were set to zero.13
Figure 4.18 shows the results of this sensitivity exercise. It is clear from
it that the choice of ξ within the range of numbers considered does not
affect results in any important way. The figure also shows that my benchmark value of 0.0148 is a conservative one, with respect to the observed
wage rigidity. This guarantees that, if anything, the approximation will
run against the objective of this model, which is to account for the Great
Depression in Belgium by means of wage rigidities and monetary shocks.
13
I shut down productivity shocks because, as the data suggest that nominal shocks
might have been important, I want to isolate the effect of purely nominal shocks first,
without confusing them with other sources of fluctuations. Section 4.7.6 takes productivity shocks back into account, and shows that nominal shocks were indeed crucial.
4.7 Money and sticky wages
4.7.3
111
Simulation
I assume the model economy to be in steady state in 1929. I feed in the
monetary shock series as explained before, and I set TFP shocks to be zero.
Figures 4.19, 4.20 and 4.21 show the dynamic response of the model to
the unexpected monetary shock, and compare it with the dynamics of the
data.
Detrended W
120
115
110
105
100
95
90
85
80
1929
1930
Model (csi = 0.0148)
1931
Data
1932
Model (csi = 0.0592)
1933
1934
Model (csi = 0.0037)
1935
1936
Model (csi = 0.0296)
1937
Model (csi = 0.00185)
Figure 4.18: Sensitivity analysis for calibrating ξ: model wages versus actual series.
The model reproduces about 115% of 1929-1934 the output drop. Simulated output jumps back near to trend in 1935-36, to witness a 10% further
drop below the trend in 1937. On the contrary, in the data detrended output stagnated around 20% below trend in 1935-1937.
112
The Belgian Great Depression
The model predicts slightly more than 100% of the 1929-1934 consumption drop. As far the 1935-1937 period is concerned, the model differs from
the data much in the same vain as output does.
Investments drop is overestimated by the model, which accounts for
about 110% of the actual drop between 1929 and 1934. Again, the model
witnesses a recovery after 1935 which is not in the data.
The same pattern is to be observed as far as hours worked is concerned.
At the trough of the depression, the model’s hours are 35% below trend,
whereas in the data they were “only” 21% below trend. The model shows
a recovery in 1935-1936 which is not in the data. However, it matches the
1937 value.
Figure 4.21 show that the model fits reasonably well the behaviour of
real cash balances, whereas it witnesses some problems as far as the inflation rate is concerned. In particular, the model dramatically overestimates
the 1935 value.14
4.7.4
Comments on the results
The exercise performed above shows that monetary shocks with nominal
sticky wages provides a step in the right direction for an explanation of
the slump in the early 1930s. This goes in the direction put forward by the
historians.
The improvement on the simpler RBC model of section 4.5 is appreciable, especially for what concerns the behaviour of investments and hours
worked.
There are still three aspects under which the model is not satisfactory.
First, the model predicts an initial increase of detrended output in 1930,
which is at variance with the data.
14
For the sake of comparison, the price levels in figure 4.21 are built upon the inflation
rate, using the formula
Pt+n = Pt
n
Y
j=0
(1 + πt+n−j ) , for n = [1, 2, . . .],
4.7 Money and sticky wages
113
Detrended Y
110
105
100
95
90
85
80
75
70
65
60
55
50
45
40
35
1929
1930
1931
1932
1933
Model
1934
1935
1936
1937
1934
1935
1936
1937
Data
Detrended C
110
105
100
95
90
85
80
75
70
65
60
55
50
45
40
35
1929
1930
1931
1932
1933
Model
Data
Figure 4.19: Simulation: model with sticky wages and monetary shocks
versus actual data
114
The Belgian Great Depression
Detrended I
120
115
110
105
100
95
90
85
80
75
70
65
60
55
50
45
40
35
1929
1930
1931
1932
1933
Model
1934
1935
1936
1937
1934
1935
1936
1937
Data
L
115
110
105
100
95
90
85
80
75
70
65
60
55
50
45
40
35
1929
1930
1931
1932
1933
Model
Data
Figure 4.20: Simulation: model with sticky wages and monetary shocks
versus actual data
4.7 Money and sticky wages
115
Detrended M/P
115
110
105
100
95
90
85
80
75
70
65
60
55
50
45
40
35
1929
1930
1931
1932
1933
Model
1934
1935
1936
1937
1934
1935
1936
1937
Data
P
115
110
105
100
95
90
85
80
75
70
65
60
55
50
45
40
35
1929
1930
1931
1932
1933
Model
Data
Figure 4.21: Simulation: model with sticky wages and monetary shocks
versus actual data
116
The Belgian Great Depression
Second, it overestimates output and investment dynamics in 1929-1934,
meaning that either the propagation mechanism is too strong, or the impulse mechanism was mismeasured, i.e. I fed in a monetary shock that
was too big.
The third unsatisfactory aspect of the model is that it fails to explain
the 1935-1937 absence of recovery. A first interpretation of this finding is
that I mismeasured the monetary expansion due to the 1935 devaluation.
The sudden upsurge in 1935 estimated νt in figure 4.17 and the abnormal
model inflation dynamics in figure 4.21, both suggests this might be the
case. Another possible interpretation is that the model assumes a symmetric wage staggering. That is, wages are assumed to be be as sticky
downwards as they are upwards. Therefore, the big monetary expansion
led by the devaluation of 1935 causes inflation to increase in the model,
thereby dragging real wages downwards. In facts, what we observe in the
data (figure 4.18) is rather the contrary: after 1935 detrended real wages
suddenly increased further above the trend.
4.7.5
Asymmetric wage rigidity
As suggested here above, a possible interpretation of the inability of the
sticky-wages model to account for the 1935-1937 absence of recovery is
that we may need a model in which nominal wage rigidity is asymmetric,
with wages being rigid downwards, but flexible upwards. This interpretation may find support from historical evidence suggesting that in 1936 a
wave of strikes spreading from the near France shacked the country, with
an appreciable, if not enduring, effect on increasing nominal wages (Baudhuin (1961)).
To verify such an hyothesis, I have carried out the following experiment. I have split the 1929-1937 period into two subperiods. In the first
one, covering the 1929-1934 years, I have assumed the same model as in
the previous section, with Taylor-wage-staggering and monetary shocks.
In the second period, covering the 1935-1937 years, I have assumed a competitive labour market, with endogenous labour supply and monetary
shocks. The leisure choice appears in the utility function in log-additive
where Pt = 100 and t = 1929.
4.7 Money and sticky wages
117
terms.
Results are shown in figures 4.22, 4.23, 4.24 and 4.25.
The exercise does not confirm the hypothesis that asymmetric wage
rigidity could have played a role. The dynamics of the model with competitive wages since 1935 is only slightly less accentuated than that with
Taylor-staggering. The reason for the qualitative behaviour of the modeleconomy is that by construction the model-economy is always on a saddlepath converging to the steady state. This means that if the economy is
far below the steady state, mechanisms do exist for convergence to be
achieved, in the absence of shocks. In particular, the starting point in 1934
was characterized by capital, output and consumption below- and real
wages above the steady state. This means that investments must “overshoot” to build up new capital stock, while workers will substitute the
relatively expensive leisure for consumption.15
In conclusion, it seems that an additional negative shock is required to
account for the 1935-37 absence of recovery.
15
Simulations with the same model and zero monetary shocks produce identical results, meaning that, in the model-economy with competitive wages, positive nominal
shocks play no role for the recovery. On the contrary, if I shut down the monetary shock
for the same period in the Taylor scenario, the recovery is much smoother. The reason is
that it takes time for wages to adjust, while nominal disturbances still have a (tiny) autoregressive component. As expected, if I assume that the economy was in steady state in
1934, then the big positive monetary shock of 1935 has important real effects in the model
with Taylor-staggering.
118
The Belgian Great Depression
Detrended Y
110
105
100
95
90
85
80
75
70
65
60
55
50
45
40
35
1929
1930
1931
1932
Model
1933
Data
1934
1935
1936
1937
1935
1936
1937
Model - comp w since '34
Detrended C
110
105
100
95
90
85
80
75
70
65
60
55
50
45
40
35
1929
1930
1931
1932
Model
1933
Data
1934
Model - comp w since '34
Figure 4.22: Simulation: model with monetary shocks, sticky wages till
1934 and competitive ones thereafter versus actual data
4.7 Money and sticky wages
119
Detrended I
120
115
110
105
100
95
90
85
80
75
70
65
60
55
50
45
40
35
1929
1930
1931
1932
Model
1933
Data
1934
1935
1936
1937
1935
1936
1937
Model - comp w since '34
L
115
110
105
100
95
90
85
80
75
70
65
60
55
50
45
40
35
1929
1930
1931
1932
Model
1933
Data
1934
Model - comp w since '34
Figure 4.23: Simulation: model with monetary shocks, sticky wages till
1934 and competitive ones thereafter versus actual data
120
The Belgian Great Depression
Detrended M/P
115
110
105
100
95
90
85
80
75
70
65
60
55
50
45
40
35
1929
1930
1931
1932
Model
1933
Data
1934
1935
1936
1937
1935
1936
1937
Model - comp w since '34
P
115
110
105
100
95
90
85
80
75
70
65
60
55
50
45
40
35
1929
1930
1931
1932
Model
1933
Data
1934
Model - comp w since 34
Figure 4.24: Simulation: model with monetary shocks, sticky wages till
1934 and competitive ones thereafter versus actual data
4.7 Money and sticky wages
121
Detrended W
125
120
115
110
105
100
95
90
85
80
75
70
65
60
55
50
45
40
35
1929
1930
1931
1932
Model - Money
1933
Data
1934
1935
1936
1937
Model - comp w since '34
Figure 4.25: Simulation: model with monetary shocks, sticky wages till
1934 and competitive ones thereafter versus actual data
122
The Belgian Great Depression
Detrended Y
110
105
100
95
90
85
80
75
70
65
60
55
50
45
40
35
1929
1930
1931
1932
1933
Model - Money
Data
1934
1935
1936
1937
1935
1936
1937
Model - TFP
Detrended C
110
105
100
95
90
85
80
75
70
65
60
55
50
45
40
35
1929
1930
1931
1932
Model - Money
1933
Data
1934
Model - TFP
Figure 4.26: Simulation: model with sticky wages and monetary shocks,
actual data and model with sticky wages and TFP shocks
4.7 Money and sticky wages
123
Detrended I
120
115
110
105
100
95
90
85
80
75
70
65
60
55
50
45
40
35
1929
1930
1931
1932
1933
Model - Money
Data
1934
1935
1936
1937
1935
1936
1937
Model - TFP
L
115
110
105
100
95
90
85
80
75
70
65
60
55
50
45
40
35
1929
1930
1931
1932
Model - Money
1933
Data
1934
Model - TFP
Figure 4.27: Simulation: model with sticky wages and monetary shocks,
actual data and model with sticky wages and TFP shocks
124
The Belgian Great Depression
Detrended M/P
115
110
105
100
95
90
85
80
75
70
65
60
55
50
45
40
35
1929
1930
1931
1932
1933
Model - Money
Data
1934
1935
1936
1937
1935
1936
1937
Model - TFP
P
130
125
120
115
110
105
100
95
90
85
80
75
70
65
60
55
50
45
40
35
1929
1930
1931
1932
Model - Money
1933
Data
1934
Model - TFP
Figure 4.28: Simulation: model with sticky wages and monetary shocks,
actual data and model with sticky wages and TFP shocks
4.7 Money and sticky wages
125
Detrended W
125
120
115
110
105
100
95
90
85
80
75
70
65
60
55
50
45
40
35
1929
1930
1931
1932
Model - Money
1933
Data
1934
1935
1936
1937
Model - TFP
Figure 4.29: Simulation: model with sticky wages and monetary shocks,
actual data and model with sticky wages and TFP shocks
126
4.7.6
The Belgian Great Depression
TFP shocks and sticky wages
This section serves the purpose of showing how the monetary model with
sticky wages would fare, were TFP shocks the only impulse mechanism at
work during the Belgian Great Depression.
The contribution of this exercise is to disentangle whether the Great
Depression was really a monetary phenomenon, or rather whether if nominal wage stickiness is assumed, TFP shocks and monetary shocks have
comparable data-mimicking abilities.
In order to carry out this exercise, I set monetary shocks to zero and I
feed in the TFP shocks as in section 4.5. Results are shown in figures 4.26,
4.27, 4.28 and 4.29.
As can be easily seen from the graphs, TFP shocks perform worse than
monetary shocks in accounting for the onset of the Great Depression. Indeed, the presence of Taylor staggering in nominal wages does not produce appreciable improvements on the transmission mechanism of TFP
shocks, with respect to the baseline model of section 4.5. Like the latter,
the model performs relatively better than the monetary one in accounting
for the 1935-37 years. As expected, the model produces counterfactual inflation dynamics, and a poorer fitting of the real cash balances. However,
such a feature is meaningless, as those variables are strictly dependent on
the behaviour of the money supply. Given that I have constrained the
growth rate of money supply ζ to be equal to ζ̂, by setting θ = 0, it is no
surprise that the fitting is worsened.
My conclusion from this exercise is that wage stickiness may be an important transmission mechanism in a model with monetary shocks, but
plays no appreciable role in one with TFP shocks.
4.8
A small-open-economy RBC model
So far, the argument has run within a closed-economy set up.
For all its being in line with the literature on RBC models of the Great
Depression, still such a perspective contrasts with the common wisdom
among historians, who maintain that the Belgian Great Depression is bet-
4.8 A small-open-economy RBC model
127
ter understood once the small open economy dimension is taken into account (Cassiers (1989a)). A robustness check seems therefore in order. This
section illustrates how results are likely to be modified once we extend the
analysis to encompass the open-economy dimension. As a complete analysis of the open-economy scenario falls beyond the limits of the present
work, I shall limit myself to a very basic RBC model, ignoring the complications coming from money and price stickiness, and from exchange rates
as well.
4.8.1
The model
The model draws on Mendoza (1991), and is a modified version of that
of section 4.5. It is assumed that the economy can exchange assets with
the rest of the world. These assets pay a constant real interest rate r∗ .
The small-open-economy assumption implies that the domestic economy
cannot influence the value of r∗ . Therefore, in a deterministic set-up a
no-arbitrage condition must exist: ex-ante, the domestic real interest rate,
which is equal to the marginal product of capital, ought in turn to be equal
to r∗ . The obvious implication is that, if an ex-ante discrepancy between
r and r∗ is observed, capital and hours worked have to adjust until the
no-arbitrage condition is again satisfied. A crucial assumption is that foreigners cannot own domestic physical capital. Labour is immobile, and
markets are incomplete, in the sense that no contracts contingent on the
realization of the shocks exist. Of course, the presence of lending and borrowing on the world market provides agents with some insurance.
Let bt be the value of per capita net foreign assets held by the representative household at the end of period t − 1. Following Obstfeld and Rogoff
(1996), I define the current account balance in period t, CAt , as:
CAt ≡ bt+1 − bt .
Therefore, in this model the current account is the variation of the net
claims of a country over the rest of the world.16
16
This concept corresponds to the traditional concept of current account balance as net
128
The Belgian Great Depression
The presence of assets adds a variable to the optimization problem
faced by our representative household, e.g. how many assets to hold at
the end of the period, given his initial dotation.
Thereby, the model of section 4.5 becomes:
max
{ct ,lt ,kt+1 ,bt+1 }∞
t=0
Et
∞
X
β t [ln(ct ) + φ ln(1 − lt )],
(4.16)
t=0
under the constraints:
ct + kt+1 + bt+1 ≤ (1 − δ)kt + yt + (1 + r∗ )bt ,
yt = est ktα (xt lt )1−α ,
st = ρst−1 + vt ,
xt = γ t x0
0 < ρ < 1,
k0 = given,
b0 = given,
s0 = given.
I assume perfect foresight. Computing the first order conditions of this
problem, and detrending all the variable, the relevant equations for characterising a solution are:
1
β
1
= (1 + r∗ )
;
c˜t
γ
c̃t+1
(4.17)
exports. To see that, decompose the budget constraint
ct + kt+1 + bt+1 = (1 − δ)kt + yt + (1 + r∗ )bt
into
kt+1 = (1 − δ)kt + it
it = yt − ct + r∗ bt − CAt .
As the first three terms on the right-hand side corresponds to national savings, and remembering from national accounts that I − S = M − X, where M stands for imports and
X for exports, it follows that CA = X − M , where everything is expressed in per capita
terms.
4.8 A small-open-economy RBC model
1 − δ + αest+1
k̃t+1
lt+1
129
!α−1
= 1 + r∗ ;
γ(k̃t+1 + b̃t+1 ) = (1 + r∗ )b̃t + (1 − δ)k̃t + est k̃tα lt1−α − c̃t ;
φ
1
= est (1 − α)
1 − lt
c̃t
k̃t
lt
(4.18)
(4.19)
!α
;
(4.20)
plus transversality conditions. What is new here, with respect to the previous model, is the no-arbitrage condition in equation 4.18, whereas equations 4.17 and 4.19 give the open-economy version of the Euler equation
and the budget constraint respectively.
It is well known in the literature that this model presents stationarity
problems (Correia, Neves, and Rebelo (1995), Kim and Kose (2003)). The
reason is that in steady state the Euler equation 4.17 usually determines
r. If instead both r and β are given, then the Euler equation plays no role
anymore: any initial level of net assets is compatible with the deterministic steady state. Moreover, in a stochastic environment like the one I am
considering here, net assets will follow a unit root process, e.g. any shock
will hold permanent effects.
Many ways exist to solve for this problem (Schmitt-Grohé and Uribe
(2003)). I chose to impose a risk-premium on the real interest rate paid
or received by the domestic economy. The idea is that the lower is the net
asset holding of the country, or, when b is negative, the higher is its foreign
debt, the higher will be the interest rate it has to pay to borrow more. So,
in the model above, I shall substitute r∗ with
rt = r∗ + ψ(e−bt − 1).
(4.21)
This trick stationarises the model, as now the steady state level of b is
determined by the Euler equation, and turns out to be a function of r∗ and
ψ only.
130
The Belgian Great Depression
Detrended Y
110
100
90
80
70
60
50
40
1929
1930
1931
1932
1933
Open-Economy
1934
Data
1935
1936
1937
1938
1936
1937
1938
Closed-Economy
Detrended C
110
100
90
80
70
60
50
40
1929
1930
1931
1932
1933
Open-Economy
1934
Data
1935
Closed-Economy
Figure 4.30: Simulation: RBC open-economy and closed-economy models
versus actual economy
4.8 A small-open-economy RBC model
131
Detrended I
120
110
100
90
80
70
60
50
40
1929
1930
1931
1932
1933
1934
Open-Economy
Data
1935
1936
1937
1938
1936
1937
1938
Closed-Economy
L
110
100
90
80
70
60
50
40
1929
1930
1931
1932
1933
Open-Economy
1934
Data
1935
Closed-Economy
Figure 4.31: Simulation: RBC open-economy and closed-economy models
versus actual economy
132
4.8.2
The Belgian Great Depression
Calibration and simulation
The model is calibrated as in section 4.5. The parameter ψ is calibrated so
that the model matches the standard deviation of CA
during the 1930s.
y
∗
The steady-state world interest rate is given at r = βγ − 1. I assume the
economy to be in steady state in 1929. In the model, the steady-state value
of current account is assumed to be 0, as well as the initial and steady-state
values of net foreign assets. I feed in TFP shocks as in section 4.5.17 Results
are shown in figures 4.30, 4.31 and 4.32.
β
γ
δ
α
φ
ρ
ψ
r∗
0.96
1.03
0.1
0.33
1.78
0.99
0.465
γ
−1
β
Table 4.3: Parameters’ calibration
As evident from the graphs, no appreciable improvements on the closedeconomy RBC model of section 4.5 are observed. The two models hold the
same explanatory power as to output, consumption and labour dynamics.
The open-economy one fares slightly better in accounting for the investment drop, at the price of having a too much volatile investment behaviour
after 1934. Such a feature is in full accordance with standard results in the
literature: small-open-economy RBC models tends to accentuate investment volatility (Mendoza (1991)).18
As to the behaviour of the current account, the model performs rather
17
It is worth noticing that in an open-economy model context, TFP shocks encompass
terms of trade variations, as aptly argued by Mendoza (1991).
18
Indeed, the typical model encompasses adjustment costs on capital, which I refrain
from for the sake of comparability with the previous models. Intuitively, the presence of
adjustment costs on capital will kill the excess volatility showed by the model in the end
of the decade. At the same time, it is likely to worsen the predictive capacity of the model
as to the initial drop.
4.8 A small-open-economy RBC model
133
poorly. It predicts a countercyclical behaviour of current account over output that is evidently at variance with the data. As this may be due to the
assumption of a balanced steady-state current account, it can be useful to
compare trends instead of levels. So, in figure 4.32, I also reported an additional line, which is the shifted data line, normalised so that the value
of current account over output be zero in 1929. In comparing it with the
model line, we see that both the direction and the amplitude of the variations of the current account ratio are at variance with model’s results.
This simple exercise shows that, while elaborating on this oversimplified RBC open-economy model may lead towards interesting new results,
yet the analysis presented in this paper proved to be robust enough to the
closed-economy hypothesis.
CA/Y
0.1
0.08
0.06
0.04
0.02
0
1929
1930
1931
1932
1933
1934
1935
1936
1937
1938
-0.02
-0.04
-0.06
-0.08
-0.1
Model
Data
Data 1929=0
Figure 4.32: Simulation: RBC open-economy and closed-economy models
versus actual economy
134
The Belgian Great Depression
Detrended Y
120
110
100
90
80
70
60
50
40
1929
1930
1931
Open-Economy
1932
1933
Data
1934
Closed-Economy
1935
1936
1937
1938
1937
1938
Open-Economy + r-shock
Detrended C
110
100
90
80
70
60
50
40
1929
1930
1931
Open-Economy
1932
1933
Data
1934
Closed-Economy
1935
1936
Open-Economy + r-shock
Figure 4.33: Simulation: Comparative effects of international interest rate
shocks
4.8 A small-open-economy RBC model
135
Detrended I
300
250
200
150
100
50
0
1929
1930
1931
1932
1933
1934
1935
1936
1937
1938
-50
-100
Open-Economy
Data
Closed-Economy
Open-Economy + r-shock
L
110
100
90
80
70
60
50
40
1929
1930
1931
Open-Economy
1932
1933
Data
1934
Closed-Economy
1935
1936
1937
1938
Open-Economy + r-shock
Figure 4.34: Simulation: Comparative effects of international interest rate
shocks
136
The Belgian Great Depression
Extension: shocks on r∗
4.8.3
One may speculate if adding an additional source of fluctuations, one
more directly linkable to the international dimension than TFP, can improve on the results obtained so far. To verify this conjecture, I run the
same simulation as above, but assuming that the world interest rate, r∗ ,
was subject to an exogenous external shock, t .
rt∗ =
γ
− 1 + t .
β
The shock series is obtained as the difference between the “theoretical”
r∗ used in the previous simulation and the ex-post real interest rate observed for Belgium in the data. The shock t is assumed to be 0 in steady
state.
CA/Y
0.5
0.4
0.3
0.2
0.1
0
1929
1930
1931
1932
1933
1934
1935
1936
1937
1938
-0.1
-0.2
-0.3
-0.4
-0.5
Model
Data
Data 1929=0
Model + r-shock
Figure 4.35: Simulation: Comparative effects of international interest rate
shocks
4.9 Conclusions
137
The results of this exercise improve on the previous ones as to the behaviour of output and the labour input, particularly for what concerns the
1933-34 years (see figures 4.33, 4.34 and 4.35). However, the price of such
an improvement is an abnormal volatility of investments and the current
account, which at variance with the data. This sheds some shadow on the
overall reliability of the results, and lead me to stick to my previous conclusion that, prima facie at least, the closed-economy analysis presented in
this paper is relatively robust.
4.9
Conclusions
This paper gives partial support to the accepted wisdom among historians, that sees the Great Depression in Belgium as essentially a monetary
phenomenon, due to an external shock and propagated via sticky nominal
wages.
Results show that a DSGE model with nominal wage staggering à la
Taylor and monetary shocks gives a reliable way of modeling the onset
of Great Depression in Belgium. On the contrary, TFP shocks’ contribution appears to be slim, no matter whether cast in a perfect-competition,
flexible-price model or in a sticky-wage environment.
Introducing war expectations in the baseline RBC model produces little
improvement on the results.
None of the models considered in this paper is able to account for the
absence of recovery after the 1935 devaluation. Further research is therefore necessary for a better understanding of the second half of the 1930s in
Belgium.
As explained in the text, I used monetary shocks as a shortcut for exchange rates problems. If such a perspective is arguably a good first approximation, still a more complete analysis of the Belgian Great Depression should go beyond the shortcut, and face the open-economy issues.
Data show that Belgian imports and exports over income were as high as
30% in the interwar period. We know from historians that Belgian industries typically concentrated in the production of highly-standardised semimanufactured goods for foreign markets (Hogg (1986), Mommen (1994)).
138
The Belgian Great Depression
Hence, it is safe to say that Belgium showed all the characteristics of the
typical small open economy. Moreover, Belgium had an important bilateral relationship with the United Kingdom. These two characteristics, to
be a small open economy and the importance of bilateral trade with the
United Kingdom makes the Belgian case suitable to be analysed within
two different frameworks in international macroeconomics. One is the
small-open-economy version of the standard RBC model. Originally advanced by Mendoza (1991) in a pure RBC perspective, such a framework
has recently been enriched by Galı̀ and Monacelli (2005) in a New Keynesian fashion, merging money, nominal frictions and monopolistic competition with the small-open-economy RBC model. In section 4.8, I made a
first step towards this direction, by considering a baseline open-economy
version of the standard RBC model. Results were not satisfactory, as no
new clue on the Belgian Great Depression was gained. This was possibly due to the assumed oversimplified theoretical structure, that excluded
monetary phenomena.
Alternatively, one can think of using a two-country framework for modeling Belgium and the United Kingdom in the 1930s. This class of models
has been pioneered in modern macroeconomics by Backus, Kehoe, and
Kydland (1992) within a pure RBC set-up. It was then extended to a
New Keynesian framework by Obstfeld and Rogoff (1995), and nowadays
many versions of them exist.19
These extensions are left for future research.
19
See Lane (2001) for a survey.
4.10 Appendix: Data
4.10
139
Appendix: Data
Real Interest Rate
Nominal interest rates are monthly nominal returns on Belgian irredeemable
bonds, expressed on a yearly basis (iy ). Real interest rates are computed in
the following way. Using the monthly retail price index, I have computed
a monthly rate of inflation. Then, I have calculated a monthly-based interest rate im according to the simple no arbitrage rule
(1 + iy ) = (1 + im )12 .
(4.22)
Next, I have figured out a series for the monthly-based real interest rate
(rm ), assuming a static version of the Fisher equation,
it = rt + Et−1 πt ,
(4.23)
with Et−1 πt = πt . Finally, I have used equation 4.22 to obtain an yearlybased monthly series for the real interest rate (ry ).
The series so obtained covers the period 1920:1-1940:2. It shows high
volatility, and seasonal components. In order to smooth down the series
and to get rid of seasonality, I have computed a new series r̃y as a 12periods-moving average of ry . The new series covers the 1921:1-1940:2
subperiod, and is the one graphed in figure 4.4.
Unemployment Rate
Monthly unemployment rates are computed in the following way. I took
data from the Banque Nationale de Belgique regarding monthly total working days lost per 1000 insured and per week. Dividing each number by 10,
I obtained the monthly working days lost because of unemployment per
100 insured and per week. To get a percentage referring to men rather
than to weeks, I divide that amount by 6, the number of working days in
a week. This procedure gives but a rough measure of unemployment for
several reasons. First, according to the Banque Nationale de Belgique, at
December 31st, 1930, the total number of employed was 1,850,272, whereas
140
The Belgian Great Depression
that of insured worker was just 695,045. Secondly, my procedure measures
unemployment implicitly as if all the unemployed were so for all the week
and the month long, which was not always the case, of course.
Money
Hogg (1986) provides series on monetary base, money multiplier and the
aggregate M1. While the series for monetary base is complete, the ones
for money multiplier and the aggregate M1 miss the 1934 value. I have
reconstructed this value as follows. I took the 1934 money multiplier to be
the average between the 1933 and the 1935 values. Then I multiply the so
computed multiplier by the 1934 monetary base, to get the 1934 value for
M1.
Labour
I have not a complete series of labour and employment data for the interwar era. Maddison (1995) reports data on total employment, labour force,
annual hours worked per worker, and total hours worked for the years
1913, 1929, 1938, 1950, 1960, 1973, 1987. Moreover, unemployment rates
from 1921 to 1938 and from 1950 to 1989 are also reported. I have used
these data to build an artificial series of total employment in the following
way. Taking the two values of labour force in 1913 and 1929, I have comlf
puted a constant compounded rate of growth of the labour force g(13,29)
using the formula
r
(1 + g) =
n
xn
.
x0
(4.24)
I have repeated this exercise for each two subsequent values, so as to
lf
lf
lf
lf
obtain g(29,38)
, g(50,60)
, g(60,73)
, and g(73,87)
. Then, I have assumed that the
labour force lf evolved at a constant pace in each subperiod. Thus, for
instance, the labour force in 1914 will be
lf
).
lf14 = lf13 (1 + g(13,29)
(4.25)
4.10 Appendix: Data
141
This artificial series of the labour force is then used to obtain a total
employment series (L), the variable we are interested in, by using the unemployment rate (u). This is done using this standard formula
L = (1 − u)lf,
(4.26)
which uses the fact that employment and unemployment rates are defined as the ratios of the number of employed and unemployed, respectively, over the labour force, and therefore are complements to 1.
As it is clear from this account, the information I got about the numbers
of employed is basically driven by the unemployment rate.
25
20
%
15
10
5
0
1921
1922
1923
1924
1925
1926
1927
1928
1929
1930
1931
1932
1933
1934
1935
1936
1937
1938
Year
u Mad
u_comp
u Gos
Figure 4.36: Unemployment rate: a comparison of different estimates.
Sources: u Mad, Maddison (1995); u comp, yearly geometric mean of the
monthly rate in figure 4.4; u Gos, Goossens, Peeters, and Pepermans (1988)
In order to have an idea of the bias I am introducing by means of this
procedure, I compared the artificial series with the data provided by the
142
The Belgian Great Depression
Belgian Planning Bureau for the period 1953-1988.20 Results showed a similar behaviour between the two series. The artificial series tends to fit the
actual one in the mid-sixties and in the late eighties, and to underestimate
total employment in the remaining years.
After this robustness check, I have run again the above mentioned
computations, substituting the unemployment rate taken from Goossens,
Peeters, and Pepermans (1988), for that used by Maddison. This was done
because Maddison’s numbers seem to underestimate the unemployment
rate. Figure 4.36 reports data from different sources. The underestimation
appears evident, especially during the 1930s.
To get hours worked, I took the employment series, I multiplied it
first by 48, the maximum legal working hours per week, and then by 50,
the numbers of per year working weeks in 1929, according to Maddison
(1995).
As to the working age population, available data cover only the years
1920, 1930, 1935, 1939. I interpolated such data to obtain a series (N ).
Capital
To the best of my knowledge there exists no complete capital series for the
Belgian economy in the interwar period. This means that I have to rely on
some estimation.
The standard procedure is to estimate capital by using the perpetualinventory method, that is the relation
Kt+1 = (1 − δ)Kt + It
(4.27)
A problem with this method is how to give a reliable estimate of the
initial value K0 . My choice was to deduce K0 from Neoclassical growth
theory. From the law of motion of capital, we know it must be true that
(1 + n)Kt+1 = (1 − δ)Kt + It ,
(4.28)
where n stands for the growth rate of population, that we assume to be
constant in the long run. Calling g the constant growth rate of capital, and
20
I thank David de la Croix for providing me these data.
4.10 Appendix: Data
143
solving equation 4.28 for Kt we got
It
.
n+g+δ
Kt =
(4.29)
100000
90000
80000
Million of bf 1936-38
70000
60000
50000
40000
30000
20000
10000
8
6
4
2
0
8
6
4
0
19
4
19
3
19
3
19
3
19
3
19
3
19
2
19
2
2
19
2
8
6
4
2
0
8
6
4
2
0
19
2
19
2
19
1
19
1
19
1
19
1
19
1
19
0
19
0
19
0
19
0
19
0
0
0
Year
K
K corr
Figure 4.37: Capital before and after correcting for WWI. Source: my elaboration on van Meerten (2003)
Given that Neoclassical theory tells us that along the balanced growth
path the growth rate of capital is the same as the growth rate of output,
I assumed g to be the constant growth rate of output estimated in section
4.4.1. Then I took data on investments from van Meerten (2003), which has
a long 1900-1960 series expressed in 1936-38 Belgian francs, that is therefore comparable with the other data I used in this study. I assumed δ = 0.1
and then applied formula 4.29 to get an estimate of capital in 1900. In doing that, I am implicitly assuming the economy was in steady state in 1900.
From this initial value, I computed a capital series by means of equation
4.27.
144
The Belgian Great Depression
To take into account the effect of the first world war, I did the following.
According to Encyclopedia Britannica Belgium lost between 16 and 20% of
its wealth during the war. I took this to mean that the capital stock in
1919 was 20% less than what it would have been had been no war. Then I
solved the following equation for δ:
K19 = K13 (1−δ)6 +I13 (1−δ)5 +I14 (1−δ)4 +I15 (1−δ)3 +I16 (1−δ)2 +I17 (1−δ)+I18 .
In this way I am considering physical destructions brought about by the
war as an exogenous increase in the constant depreciation rate of capital.
Figure 4.37 shows my estimation and the significance of the correction
operated.
Chapter 5
Prospects for Future Research
After the work of Cole and Ohanian (1999), the Great Depression of the
1930s is again on top of research agendas. The possibility of applying
the modern macroeconomics toolbox to the different aspects of the phenomenon has opened exciting new perspectives. On the other hand, the
increasing specialization of economists in abstract analytical models calls
for a renewed effort in reflexive works. My ambition for the future is to be
able to contribute to both.
5.1
The Belgian case: an open-economy perspective
A first extension of the present work is to enrich the admittedly poor openeconomy dimension of the Belgian-case analysis, as indicated in the conclusions section of chapter 4. The value-added of such an expansion is
twofold. First, the very nature of the Belgian economy calls for an openeconomy analysis, if only for a robustness check of the closed-economy
one. Second, the fact of tackling the Great Depression by means of an
enriched model, encompassing the open-economy dimension as well as
nominal rigidities, will make the analysis more directly comparable with
those of renown historians of the period, like Cassiers (1989a), Eichengreen (1992) and Feinstein, Temin, and Toniolo (1997). Though limited to
the Belgian case, such a possibility is of high interest, as the comparison
146
Prospects for Future Research
between modern macroeconomics and economic history on the Great Depression is currently on the frontier of research in the profession.
The direction that the research will take after the analysis discussed
in chapter 4 will obviously depend upon the results. Methodologically,
DSGE modeling is data-driven, indeed. My guess is that an exploration
of the monetary dimension is likely to enrich our understanding of the
phenomenon. In chapter 4, I showed that, in a closed-economy set-up,
the introduction of monetary shocks and nominal wage rigidities improve
on the standard RBC story. Given the direct link between monetary policy,
trade balance and exchange rate in a Gold-Standard regime, I would argue
that a monetary model with exchange-rate shocks can be a suitable model
to analyze the Great Depression in Belgium. I particular, such a model
can be of help in clarifying the conundrum of the 1935-1937 years, whose
explanation is still wanting.
5.2
Involuntary unemployment and the Great Depression
A second extension concerns the unemployment theme.1 Unemployment
is obviously an important feature of the real world. Yet this concept, in its
layman meaning of a non-chosen and unpleasant status for the individual, has proved to be difficult to treat within the Neoclassical paradigm
(De Vroey (2004)). In particular, RBC theory treads in Lucas’ footsteps,
assuming market clearing and optimising behaviour as the framework in
which to cast economic facts. Non-chosen statuses, i.e. disequilibrium
outcomes, are typically assumed away, and business cycles are considered
as changing-in-time Walrasian equilibria (Mankiw (1989)). In principle,
involuntary unemployment plays no role in this picture.
Nonetheless, most economists would agree that historical episodes may
exist for which involuntary unemployment should be an important part of
the picture. The Great Depression of the 1930s stands prominently among
them.
1
This is a joint project with Michel De Vroey.
5.2 Involuntary unemployment and the Great Depression
147
Hence my plan to reconsider the issue.
The starting point shall be to give a new foundation to the involuntary
unemployment concept. Admittedly, Lucas’s criticism to the overall validity of this notion is well founded. According to him, once unemployment
is viewed as an activity within a set of available activities, the “involuntary” modifier loses any sense: agents who end up unemployed have just
preferred unemployment against other possibilities (Lucas (1978)). The
problem then is whether it is possible to re-found the concept while abiding by Lucas’s methodological premises. The way I would like to explore
builds on De Vroey (1999). According to his definition, involuntary unemployment is a state of affairs in which an individual cannot choose any
other socially respectable activity but unemployment. In other words, this
individual faces a singleton choice that constraints him in an unemployment status. It is clear that under this definition involuntary unemployment strictu sensu is rarely observable. In practise, feasible alternatives to
being on the dole, no matter how poor they may be, always exist. However, we can think of situations in which the set of individual choices contains so few elements that, compared to normal, the actual choice of the
individual is approximately a forced one. If we assume that the number
of possible alternatives in the choice-set of the individual varies within the
business cycle, increasing during a boom, and decreasing during a slump,
then a new interpretation of involuntary unemployment during the Great
Depression emerges. The Great Depression would be characterized by a
generalised dramatic restriction in the number of feasible alternative activities. Possibly nobody would be involuntarily unemployed, strictly speaking. Still, many people would have come closer to that extreme situation.
Once this conceptual reconstruction is established, the next step would
be to return to studies of unemployment in the 1930s like Baily (1983),
Margo (1991) and Margo (1993), in order to assess whether they can fruitfully be reinterpreted in the light of these categories.
Next, I shall look for factual evidence about shrinking choice-sets during the Great Depression. Economic statistics might be of little help in this
respect. But my hunch is that such evidence might be sought for in the
works by sociologists and psychologists on living conditions during the
148
Prospects for Future Research
Great Depression. Abundant material of this sort exists. An example at
hand is the study by contemporary sociologists of the case of the Austrian
town Marienthal during winter 1931-1932. In this town almost the entire
population fell unemployed, when the firm who employed most of them
went bankrupted (Garraty (1976)). Another example is the survey on unemployed workers in Greenwich, London, in summer and autumn 1931
(Feinstein, Temin, and Toniolo (1997)). Both studies focus on the dismal
status of despair and discouragement induced onto workers by the long
spell of unemployment.
This sort of evidence should be placed side by side with complementary evidence provided by economists, for instance the one proposed by
Simon (2001). Comparing advertisements in the New York Times by people offering and demanding labour during the Great Depression, Simon
argues that workers were plausibly constrained from the demand-side of
the market, being, so to speak, outside their labour supply curve. His argument is based on the fact that job seekers were offering their services for
earnings that were much lower than what employers actually offered for
comparable positions.
Rehabilitating involuntary unemployment as a legitimate concept for
macroeconomic analyses of the Great Depression may lead to the raising
of many interesting issues. In particular, such a rehabilitation can be of
help in assessing whether the current RBC literature is doing a fair job
when it comes to the Depression issue, or rather whether we need to look
elsewhere, possibly to the new generation of models encompassing such
a feature, like the recent one by Blanchard and Galı̀ (2006).
5.3
Expectations and the recovery from the US
Great Depression
The third extension to the present work I would like to pursue concerns a
new assessment of the role of New Deal policies in the United States.2
Until recent years, historiography about the US Great Depression has
2
This is a joint project with Mauro Bambi.
5.3 Expectations and the recovery from the US Great Depression
149
been relatively uncontroversial. Indeed, if the cause of the Great Depression was debated, still there was an accepted wisdom about the main
shape of the picture. The Great Contraction, so the argument runs, started
after the Great Crash in Wall Street. A startling combination of bad monetary policies, debt-deflation, lack of international cooperation and bank
failures jointly contributed to the slump. After Roosevelt seized the power,
the devaluation of the dollar and the whole of the New Deal policies started
dragging the American economy out of the depression. Eventually, the
Great Depression was swept away by the outbreak of World War II.3
As shown in this thesis, this picture has been crushed by the emergence of a new stream of economic literature that cast the Great Depression
within a DSGE framework. While so far this new literature has produced
few new insights as to the onset of the Great Depression, the contrast with
the previous accepted wisdom could not have been greater, for what concerns its protracted character. The new vision is that, far from prompting
out a recovery, New Deal policies were instead the principle obstacle to it.
According to this standpoint, New Deal policies is the answer to the question: “Why did the American economy remain depressed for so long?”.
This radical change of perspective amounts at rehabilitating the so called
“liquidationist” stance, a view held in the 1930s by great economists like
von Hayek, Robbins and Schumpeter, and discarded subsequently after
the Keynesian revolution.4 According to this view, depressions are the
necessary consequence of the liquidation of bad investments, i.e. investments that seemed profitable ex-ante, but turned out to be not so ex-post.
A direct consequence of the liquidationist standpoint is that any governmental intervention to cure a depression is deemed to be harmful, let alone
effective.
However, as shown in chapter 3, an alternative “anti-liquidationist”
perspective on the Great Depression still exists.5 According to this view,
the 1929-1932 contraction brought the economy to a state of affairs where
3
See De Long (1997), Eichengreen (1992) and Friedman and Schwartz (1963), to name
but a few.
4
See Bernstein (1987) and De Long (1990).
5
See Summers (1986), and, more specifically, Temin and Wigmore (1990)
150
Prospects for Future Research
any speedy recovery through the private sector alone was excluded. The
idea is that a system failure was at work at the time, similar to that which
happened during the collapse of communist regimes in Eastern Europe
in the 1990s. In this context of a cumulative deflation leading towards a
system collapse, so the story goes, New Deal policies acted as sign of a
regime shift.
The contrast between this standpoint and that of Cole and Ohanian
(2004) is great. While the latter see New Deal policies as the element impeding a recovery that otherwise would have been there, Temin and Wigmore (1990) hold the opposite judgement. They think that New Deal policies, and the dollar devaluation in particular, dragged the American economy out of what was a cumulative depression, with no obvious recovery
coming up.
The aim of this research is to produce a model of this anti-liquidationist
view of the Great Depression, and to compare it with the RBC models
analysed in this work.
This project is admittedly challenging. The anti-liquidationist view rejects the RBC idea that the Great Depression was the results of several
negative persistent shocks. The basic intuition behind the reasoning by
Temin and Wigmore (1990) is that a “Great Depression” is in some sense
one of the possible equilibrium towards which a capitalistic economy may
indeed converge, in force of history-specific conditions.
In order to translate this standpoint from a narrative to a theoretical
dimension, I shall explore models with global indeterminacy. Global indeterminacy means that the model-economy is characterized by multiple
long-run equilibria. The actual selection of one among them depends on
agents’ expectations, and it is therefore related to the short-run dynamics,
when expectations are effectively formed. So, I shall interpret the Great
Depression as the transitional path towards a new “lower” equilibrium.
As the focus will be on the recovery aspect, I will not enter into the issue
of what can explain such an initial shift from one equilibrium to the other,
at least initially. I will rather explore the possibility that the dollar’s devaluation policy was able to revert the ongoing convergence to the “lower”
equilibrium, by pinning down expectations on a new “higher” one. Such
5.3 Expectations and the recovery from the US Great Depression
151
a path may well be lower than the initial equilibrium path, or the transitional dynamics be relatively slow. This would fit with the RBC result
concerning the absence of recovery. Only, in this set-up the alleged absence of recovery would turn out to be an optical illusion. The observed
path would not depend on policy interventions that impeded the otherwise unavoidable recovery. On the contrary, such a path would represent
a policy-induced reversal of what was a declining path after 1929.
152
Prospects for Future Research
Bibliography
A BRAHAMSEN , Y., R. A EPPLI , E. ATUKEREN , M. G RAFF , C. M ULLER ,
AND B. S CHIPS (2005): “The Swiss Disease: Facts and Artefacts. A Reply
to Kehoe and Prescott,” Review of Economic Dynamics, 8, 749–758.
A KERLOF, G., AND J. Y ELLEN (eds.) (1986): Efficiency Wage Models of the
Labor Market. Cambridge University Press, Cambridge, UK.
A LCHIAN , A. A. (1970): “Information Costs, Pricing and Resource Unemployment,” in Microeconomic Foundations of Employment and Inflation
Theory, ed. by E. Phelps. Norton and Company Inc., New York.
A MARAL , P. S., AND J. C. M AC G EE (2002): “The Great Depression in
Canada and the United States: A Neoclassical Perspective,” Review of
Economic Dynamics, 5, 45–72.
B ACKUS , D. K., P. J. K EHOE , AND F. E. K YDLAND (1992): “International
Real Business Cycles,” Journal of Political Economy, 100, 745–775.
B AILY, M. (1983): “The Labor Market in the 1930s,” in Macroeconomics,
Prices and Quantities: Essays in Honor of Arthur Okun, ed. by J. Tobin.
Washington, DC.
B ANQUE N ATIONALE
Belges, 1919-1928.
DE
B ELGIQUE (1943a): Statistiques Economiques
(1943b): Statistiques Economiques Belges, 1929-1940.
B AUDHUIN , F. (1946): Histoire Economique de la Belgique 1914-1939. Etablissements Emile Bruylant, Bruxelles.
154
BIBLIOGRAPHY
(1961): Belgique 1900-1960: Explication Economique de Notre Temps.
Editions J. Duculot, Gembloux.
B EAUDRY, P., AND F. P ORTIER (2002): “The French Depression in the
1930s,” Review of Economic Dynamics, 5, 73–99.
B ERNANKE , B. S. (1983): “Non-Monetary Effects of the Financial Crisis in
the Propagation of the Great Depression,” American Economic Review, 73,
257–276.
(1995): “The Macroeconomics of the Great Depression: A Comparative Approach,” Journal of Money, Credit and Banking, 27, 1–28.
B ERNANKE , B. S., AND K. C AREY (1996): “Nominal Wage Stickiness and
Aggregate Supply in the Great Depression,” Quarterly Journal of Economics, 111, 853–883.
B ERNSTEIN , M. A. (1987): The Great Depression. Delayed Recovery and Economic Change in America, 1929–1939. Cambridge University Press, Cambridge UK.
B LANCHARD , O., AND J. G AL Ì (2006): “A New Keynesian Model with Unemployment,” Working Paper Research 92, National Bank of Belgium.
B LINDER , A. S. (1997): “What Central Bankers Can Learn from Academics
- and Vice Versa,” Journal of Economic Pespectives, 11, 3–19.
B ORDO , M. D., C. E RCEG , AND C. E VANS (2001): “Comments on Cole and
Ohanian,” in NBER Macroeconomics Annual 2000, ed. by B. S. Bernanke,
and K. Rogoff. National Bureau of Economic Research, MIT Press, Cambridge, USA.
B ORDO , M. D., C. J. E RCEG , AND C. L. E VANS (2000): “Money, Sticky
Wages and the Great Depression,” American Economic Review, 90, 1447–
1463.
B UYST, E. (1997): “New GNP Estimates for the Belgian Economy during
the Interwar Period,” Review of Income and Wealth, 43, 357–375.
BIBLIOGRAPHY
155
C AHUC , P., AND A. Z YLBERBERG (2004): Labor Economics. MIT Press, Cambridge, USA.
C ALVO , G. (1983): “Staggered Prices in a Utility-Maximizing Framework,” Journal of Monetary Economics, 12, 383–398.
C ARLSTROM , C. T., AND T. S. F UERST (2001): “Timing and Real Indeterminacy in Monetary Models,” Journal of Monetary Economics, 47, 285–298.
C ASSIERS , I. (1989a): Croissance, Crise et Régulation en Economie Ouverte: La
Belgique entre les Deux Guerres. De Boeck Université, Bruxelles.
(1989b): “Hourly Wage Statistics in Belgian Industry, 1919-1939,”
in The Economic Development of Belgium since 1870, ed. by H. V. der Wee,
and J. Blomme, pp. 369–395. Elgar, Cheltenham, 1997.
(1995): “Managing the Franc in Belgium and France: The Economic Consequences of Exchange-Rate Policies, 1925-1936,” in Banking, Currency and Finance in Europe between the Wars, ed. by C. Feinstein.
Clarendon Press, Oxford.
C HRISTIANO , L., R. M OTTO , AND M. R OSTAGNO (2004): “The Great
Depression and the Friedman-Schwartz Hypothesis,” Working Paper
10255, National Bureau of Economic Research.
C OLE , H. L., AND L. E. O HANIAN (1999): “The Great Depression in the
United States from a Neoclassical Perspective,” Federal Reserve of Minneapolis Quarterly Review, 23, 2–24.
(2000): “Re-Examining the Contributions of Money and Banking
Shocks to the U.S. Great Depression,” Research Department Staff Report
270, Federal Reserve Bank of Minneapolis.
(2001): “New Deal Policies and the Persistence of the Great Depression: A General Equilibrium Analysis,” Working Paper 597, Federal
Reserve Bank of Minneapolis.
(2002a): “The Great UK Depression: A Puzzle and a Possible Resolution,” Review of Economic Dynamics, 5, 19–44.
156
BIBLIOGRAPHY
(2002b): “The US and UK Great Depressions through the Lens of
Neoclassical Growth Theory,” American Economic Review, 92, 28–32.
(2004): “New Deal Policies and the Persistence of the Great Depression: A General Equilibrium Analysis,” Journal of Political Economy,
112, 779–816.
C OLE , H. L., L. E. O HANIAN , AND R. L EUNG (2005): “Deflation and the
International Great Depression: A Productivity Puzzle,” Working Paper
11237, National Bureau of Economic Research.
C OMIN , D., AND B. H OBIJN (2004): “Cross-Country Technological Adoption: Making the Theories Face the Facts,” Journal of Monetary Economics,
pp. 39–83.
C ORREIA , I., J. C. N EVES , AND S. R EBELO (1995): “Business Cycles in a
Small Open Economy,” European Economic Review, 39, 1089–1113.
D E L ONG , J. B. (1990): “”Liquidation Cycles”: Old-Fashioned Real Business Cycle Theory and the Great Depression,” Working Paper 3456, National Bureau of Economic Research.
(1997): Slouching Towards Utopia?
The Economic History
of the Twentieth Century. http://www.j-bradforddelong.net/
TCEH/Slouch Old.html.
D E V ROEY , M. (1999): “From Labor Rationing to (Involuntary) Unemployment: A Conceptual Elucidation,” Eastern Economic Journal, 25, 315–
330.
D E V ROEY , M. (2004): Involuntary Unemployment: The Elusive Quest for a
Theory. Routledge, London.
D E V ROEY , M., AND L. P ENSIEROSO (2006): “Real Business Cycle Theory and the Great Depression: the Abandonement of the Abstentionist
Viewpoint,” Contributions to Macroeconomics, 6, issue 1, article 13.
E ICHENGREEN , B. (1992): Golden Fetters: The Gold Standard and the Great
Depression, 1919-1939. Oxford University Press, Oxford.
BIBLIOGRAPHY
157
E ICHENGREEN , B., AND J. S ACHS (1985): “Exchange Rates and Economic
Recovery in the 1930s,” Journal of Economic History, 45, 925–946.
E ICHENGREEN , B., AND P. T EMIN (2000): “The Gold Standard and the
Great Depression,” Contemporary European History, 9, 183–207.
F EINSTEIN , M., P. T EMIN , AND G. T ONIOLO (1997): The European Economy
between the Wars. Oxford University Press, Oxford.
F ISHER , I. (1933): “The Debt-Deflation Theory of Great Depressions,”
Econometrica, 1, 337–357.
F ISHER , J. D. M., AND A. H ORNSTEIN (2002): “The Role of Real
Wages, Productivity, and Fiscal Policy in Germany’s Great Depression
1928–37,” Review of Economic Dynamics, 5, 100–127.
F RIEDMAN , M., AND A. J. S CHWARTZ (1963): A Monetary History of the
United States, 1867-1960. Princeton University Press (for NBER), Princeton.
G AL Ì , J., AND T. M ONACELLI (2005): “Monetary Policy and Echange Rate
Volatility in a Small Open Economy,” Review of Economic Studies, 72, 707–
734.
G ALBRAITH , J. K. (1995): Money: Whence It Came, Where It Went. Houghton
Mifflin Co.
G ARRATY, J. A. (1976): “Unemployment during the Great Depression,”
Labor History, 17, 133–159.
G ERTLER , M. (2001): “Comments on Cole and Ohanian,” in NBER Macroeconomics Annual 2000, ed. by B. S. Bernanke, and K. Rogoff. National
Bureau of Economic Research, MIT Press, Cambridge, USA.
G OOSSENS , M. (1988): “The Belgian Labour Market during the Interwar
Period,” in The Economic Development of Belgium since 1870, ed. by H. V.
der Wee, and J. Blomme, pp. 417–429. Elgar, Cheltenham, 1997.
158
BIBLIOGRAPHY
G OOSSENS , M., S. P EETERS , AND G. P EPERMANS (1988): “Interwar Unemployment in Belgium,” in Interwar Unemployment in International Perspective, ed. by B. Eichengreen, and T. J. Hatton, pp. 289–324.
H AHN , F. (1983): “Comment on Axel Leijonhufvud’s ”Keynesianism,
Monetarism and Rational Expectations: Some Reflections and Conjectures”,” in Individual Forecasting and Aggregate Outcomes: Rational Expectations Explained, ed. by R. Frydman, and E. Phelps, pp. 223–230. Cambridge University Press, Cambridge, UK.
H ALL , T. E., AND J. D. F ERGUSON (1998): The Great Depression: An International Disaster of Perverse Economic Policies. University of Michigan Press,
Ann Arbor.
H ARRISON , S. G., AND M. W EDER (2002): “Did Sunspot Forces Cause the
Great Depression?,” Discussion Paper 3267, Centre for Economic Policy
Research.
H ARTLEY, J. E., K. D. H OOVER , AND K. S ALYER (1997): “The Limits of
Business Cycle Research: Assessing the Real Business Cycle Model,”
Oxford Review of Economic Policy, 13, 34–54.
H AWLEY, E. (1966): The New Deal and the Problem of Monopoly. Princeton
University Press, Princeton.
H OBSBAWM , E. J. E. (1996): Age of Extremes: the Short Twentieth Century
1914–1991. Abacus, London.
H OGG , R. L. (1986): Structural Rigidities and Policy Inertia in Inter-war Belgium. Royal Academy of Belgium, Bruxelles.
H ULTEN , C. R. (2000): “Total Factor Productivity: A Short Biography,”
Working Paper 7471, National Bureau of Economic Research.
K EHOE , T. J., AND E. C. P RESCOTT (2002): “Great Depressions of the 20th
Century,” Review of Economic Dynamics, 5, 1–18.
K EHOE , T. J., AND K. J. R UHL (2005): “Is Switzerland in a Great Depression?,” Review of Economic Dynamics, 8, 759–775.
BIBLIOGRAPHY
159
K EYNES , J. M. (1931): Essays in Persuasion. Macmillan, London.
(1933): “The New Deal,” The New York Times, December, 16th,
reprinted in Collected Writings of Keynes, London 1981-1982, vol.
XXI, pp. 289-297, or available online at http://newdeal.feri.org/
misc/keynes2.htm.
K IM , S. H., AND M. A. K OSE (2003): “Dynamics of Open-Economy
Business-Cycle Models: Role of the Discount Factor,” Macroeconomic Dynamics, 7, 263–290.
K INDLEBERGER , C. P. (1973): The World in Depression. University of California Press, Berkley.
K LAMER , A. (1984): The New Classical Macroeconomics: Conversations with
New Classical Economists and their Opponents. Harvester Press, Brighton.
L ANE , P. R. (2001): “The New Open Macroeconomics: A Survey,” Journal
of International Economics, 54, 235–266.
L UCAS , R. E., AND L. A. R APPING (1969): “Real Wages, Employment, and
Inflation,” Journal of Political Economy, 77, 721–754.
(1972): “Unemployment in the Great Depression: Is there a Full
Explanation?,” Journal of Political Economy, 80, 186–191.
L UCAS , R. E. J. (1977): “Understanding Business Cycles,” in Studies in
Business Cycle Theory, pp. 215–239. MIT Press, Cambridge, USA, 1981.
(1978): “Unemployment Policy,” in Studies in Business Cycle Theory,
pp. 240–247. MIT Press, Cambridge, USA, 1981.
(1980): “Methods and Problems in Business Cycle Theory,” in
Studies in Business Cycle Theory, pp. 271–296. MIT Press, Cambridge,
USA, 1981.
(1987): Models of Business Cycle. Basil Blackwell, Oxford.
160
BIBLIOGRAPHY
(1994): “Review of Milton Friedman and Anna J. Schwartz’s ‘A
Monetary History of the United States, 1867-1960’,” Journal of Monetary
Economics, 34, 5–16.
(2001): Professional Memoir. http://home.uchicago.edu/
%7Esogrodow/homepage/memoir.pdf.
M ADDISON , A. (1995): L’Economie Mondiale 1820-1992: Analyse et Statistiques. OECD, Paris.
M ANKIW, N. G. (1989): “Real Business Cycles: A New Keynesian Perspective,” Journal of Economic Perspectives, 3, 79–90.
M ARGO , R. A. (1991): “The Microeconomics of Depression Unemployment,” Journal of Economic History, 51, 333–341.
(1993): “Employment and Unemployment in the 1930s,” Journal of
Economic Perspectives, 7, 41–59.
M C C ALLUM , B. (1999): “An Interview with Robert E. Lucas Jr,” Macroeconomic Dynamics, 3, 278–291.
M ENDOZA , E. G. (1991): “Real Business Cycles in a Small Open Economy,” American Economic Review, 81, 797–818.
M ERZ , M. (1995): “Search in the Labor Market and the Real Business Cycle,” Journal of Monetary Economics, 36, 269–300.
M INISTERE DES A FFAIRE E CONOMIQUES (1943): Démographie de la Belgique. Bruxelles.
M OMMEN , A. (1994): The Belgian Economy in the Twentieth Century. Routledge, London.
O BSTFELD , M., AND K. R OGOFF (1995): “Exchange Rate Dynamics Redux,” Journal of Political Economy, 103, 624–660.
(1996): Foundations of International Macroeconomics. MIT Press,
Cambridge, USA.
BIBLIOGRAPHY
161
O HANIAN , L. E. (2000): “Economic Dynamics Interviews Lee Ohanian on
the Great Depression,” Economic Dynamics Newsletter, Review of Economic
Dynamics, 1 (2).
(2002): “Why Did Productivity Fall So Much During the Great
Depression?,” Federal Reserve Bank of Minneapolis Quarterly Review, 26,
12–17.
PARKER , R. (2006): The Economics of the Great Depression: A Twenty-First
Century Look Back at the Economics of the Interwar Era. Edward Elgar, Cheltenham, forthcoming.
P ENSIEROSO , L. (2007): “Real Business Cycle Models of the Great Depression: A Critical Survey,” Journal of Economic Surveys, 21, 110–142.
P ERRI , F., AND V. Q UADRINI (2002): “The Great Depression in Italy: Trade
Restrictions and Real Wage Rigidities,” Review of Economic Dynamics, 5,
128–151.
P LOSSER , C. I. (1989): “Understanding Real Business Cycles,” Journal of
Economic Perspectives, 3, 51–77.
P OWELL , J. (2003): FDR’s Folly: How Roosevelt and His New Deal Prolonged
the Great Depression. Crown Forum, New York.
P RESCOTT, E. C. (1983): “Can the Cycle Be Reconciled with a Consistent
Theory of Expectations? Or, a Progress Report on Business Cycle Theory,” Working Paper 239, Federal Reserve Bank of Minneapolis, in collaboration with A. Guenther, P. Kehoe and R. Manuelli.
(1986): “Response to a Skeptic,” Federal Reserve Bank of Minneapolis
Quarterly Review, 10, 28–33.
(1999): “Some Observations on the Great Depression,” Federal Reserve Bank of Minneapolis Quarterly Review, 23, 25–31.
(2002): “Prosperity and Depression,” American Economic Review,
92, 1–15.
162
BIBLIOGRAPHY
R EES , A. (1970): “On Equilibrium in Labor Markets,” Journal of Political
Economy, 78, 306–310.
R OBBINS , L. (1934): The Great Depression. Macmillan, London.
R OLNICK , A. J. (1996): “An Interview with Edward Prescott,”
The Region, September, http://www.minneapolisfed.org/pubs/
region/96-09/prescott.cfm.
R OMER , C. (1990): “The Great Crush and the Onset of the Great Depression,” Quarterly Journal of Economics, 105, 597–624.
(1992): “What Ended the Great Depression?,” Journal of Economic
History, 52, 757–784.
(1993): “The Nation in Depression,” Journal of Economic Perspectives, 7, 19–39.
R OMER , D. (2001): Advanced Macroeconomics. McGraw-Hill, New York.
RYAN , C. (2002): “Business Cycles: Real Business Cycle Approach,” in An
Encyclopedia of Macroeconomics, ed. by B. Snowdon, and H. R. Vane. Elgar,
Cheltenham.
S CHMITT-G ROH É , S., AND M. U RIBE (2003): “Closing Small Open Economy Models,” Journal of International Economics, 61, 163–185.
S IMON , C. J. (2001): “The Supply Price of Labor during the Great Depression,” Journal of Economic History, 61, 877–903.
S IMONS , H. C. (1934): “A Positive Program for Laissez Faire: Some Proposals for a Liberal Economic Policy,” in Economic Policy for a Free Society.
Chicago University Press, Chicago, 1948.
S MILEY, G. (2002): Rethinking the Great Depression. Ivan R. Dee, Chicago.
S NOWDON , B., AND H. R. VANE (1998): “Transforming Macroeconomics:
An Interview with Robert E. Lucas Jr.,” Journal of Economic Methodology,
5, 115–145.
BIBLIOGRAPHY
163
S OLOW, R. M. (1956): “A Contribution to the Theory of Economic
Growth,” Quarterly Journal of Economics, 70, 65–94.
(1957): “Technical Change and the Aggregate Production Function,” Review of Economics and Statistics, 39, 312–320.
S TADLER , G. W. (1994): “Real Business Cyle,” Journal of Economic Literature, 32, 1750–1783.
S UMMERS , L. H. (1986): “Some Skeptical Observations on the Real Business Cycle Theory,” Federal Reserve Bank of Minneapolis Quarterly Review,
10, 23–27.
TAYLOR , J. B. (1980): “Aggregate Dynamics and Staggered Contracts,”
Journal of Political Economy, 88, 1–23.
T EMIN , P. (1976): Did Monetary Forces Cause the Great Depression? Norton,
New York.
(1989): Lessons from the Great Depression. MIT Press, Cambridge,
USA.
T EMIN , P., AND A. W IGMORE (1990): “The End of One Big Deflation,”
Explorations in Economic History, 27, 483–502.
M EERTEN , M. (2003): Capital Formation in Belgium, 1900-1995. Leuven
University Press, Leuven.
VAN
VANTHEMSCHE , G. (1987): “The Economic Action of the Belgian State during the Crisis of the 1930s,” in The Economic Development of Belgium since
1870, ed. by H. V. der Wee, and J. Blomme, pp. 337–356. Elgar, Cheltenham, 1997.
V ERNON , J. R. (1994): “World War II, Fiscal Policies and the End of the
Great Depression,” Journal of Economic History, 54, 850–868.
WALSH , C. E. (2003): Monetary Theory and Policy. MIT Press, Cambridge,
USA.
164
BIBLIOGRAPHY
W EDER , M. (2001): “The Great Demand Depression,” Discussion Paper
3067, Centre for Economic Policy Research.
W EDER , M. (2006): “The Role of Preference Shocks and Capital Utilization
in the Great Depression,” International Economic Review, 47, 1247–1268.
W EINSTEIN , M. M. (1981): “Some Macroeconomic Impacts of the National Recovery Act, 1933-1935,” in The Great Depression Revisited, ed.
by K. Brunner. Martinus Nijhoff, Boston.
List of Figures
3.1
Detrended data. US 1929-1939. Source: Cole and Ohanian
(1999) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
61
Production of Investment Goods. Source: Temin and Wigmore (1990) . . . . . . . . . . . . . . . . . . . . . . . . . . . .
67
3.3
Real GDP per capita. Source: Comin and Hobijn (2004) . . .
69
4.1
Output and expenditures. Source: Buyst (1997) . . . . . . . .
79
4.2
Expenditures over output. Source: Buyst (1997) . . . . . . . .
80
4.3
Consumption over output. Source: Buyst (1997) . . . . . . .
81
4.4
Real interest rate and unemployment rate. Source: my elaboration on Banque Nationale de Belgique (1943a) and Banque
Nationale de Belgique (1943b) . . . . . . . . . . . . . . . . . .
82
Nominal and real wages. Source: Goossens, Peeters, and
Pepermans (1988) . . . . . . . . . . . . . . . . . . . . . . . . .
83
Monthly retail price index and inflation. Source: Banque
Nationale de Belgique (1943a) and Banque Nationale de Belgique (1943b) . . . . . . . . . . . . . . . . . . . . . . . . . . .
84
Nominal money supply and retail price index (base 1914).
Sources: Banque Nationale de Belgique (1943a) and Banque
Nationale de Belgique (1943b) and Hogg (1986) . . . . . . . .
86
3.2
4.5
4.6
4.7
4.8
Selected exchange rates, 1919-1939. Source: Baudhuin (1946). 87
4.9
Detrended per capita data. Source: my elaboration on Buyst
(1997) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
90
4.10 TFP: deterministic trend versus actual values. Source: my
elaboration on Buyst (1997) . . . . . . . . . . . . . . . . . . .
92
166
LIST OF FIGURES
4.11 Simulation: RBC model versus actual economy . . . . . . . .
95
4.12 Simulation: RBC model versus actual economy . . . . . . . .
96
4.13 Simulation: RBC model with unexpected TFP shocks, actual
economy and RBC model with war anticipation . . . . . . . 100
4.14 Simulation: RBC model with unexpected TFP shocks, actual
economy and RBC model with war anticipation . . . . . . . 101
4.15 Phillips curve, Belgium 1921-1939. Source: Goossens, Peeters,
and Pepermans (1988) . . . . . . . . . . . . . . . . . . . . . . 102
4.16 Inflation-Unemployment trade-off, Belgium 1921-1938. Sources:
Banque Nationale de Belgique (1943a), Banque Nationale
de Belgique (1943b) and Goossens, Peeters, and Pepermans
(1988) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
4.17 Estimated monetary shock νt . . . . . . . . . . . . . . . . . . 109
4.18 Sensitivity analysis for calibrating ξ: model wages versus
actual series. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
4.19 Simulation: model with sticky wages and monetary shocks
versus actual data . . . . . . . . . . . . . . . . . . . . . . . . . 113
4.20 Simulation: model with sticky wages and monetary shocks
versus actual data . . . . . . . . . . . . . . . . . . . . . . . . . 114
4.21 Simulation: model with sticky wages and monetary shocks
versus actual data . . . . . . . . . . . . . . . . . . . . . . . . . 115
4.22 Simulation: model with monetary shocks, sticky wages till
1934 and competitive ones thereafter versus actual data . . . 118
4.23 Simulation: model with monetary shocks, sticky wages till
1934 and competitive ones thereafter versus actual data . . . 119
4.24 Simulation: model with monetary shocks, sticky wages till
1934 and competitive ones thereafter versus actual data . . . 120
4.25 Simulation: model with monetary shocks, sticky wages till
1934 and competitive ones thereafter versus actual data . . . 121
4.26 Simulation: model with sticky wages and monetary shocks,
actual data and model with sticky wages and TFP shocks . . 122
4.27 Simulation: model with sticky wages and monetary shocks,
actual data and model with sticky wages and TFP shocks . . 123
LIST OF FIGURES
4.28 Simulation: model with sticky wages and monetary shocks,
actual data and model with sticky wages and TFP shocks . .
4.29 Simulation: model with sticky wages and monetary shocks,
actual data and model with sticky wages and TFP shocks . .
4.30 Simulation: RBC open-economy and closed-economy models versus actual economy . . . . . . . . . . . . . . . . . . . .
4.31 Simulation: RBC open-economy and closed-economy models versus actual economy . . . . . . . . . . . . . . . . . . . .
4.32 Simulation: RBC open-economy and closed-economy models versus actual economy . . . . . . . . . . . . . . . . . . . .
4.33 Simulation: Comparative effects of international interest rate
shocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4.34 Simulation: Comparative effects of international interest rate
shocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4.35 Simulation: Comparative effects of international interest rate
shocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4.36 Unemployment rate: a comparison of different estimates.
Sources: u Mad, Maddison (1995); u comp, yearly geometric
mean of the monthly rate in figure 4.4; u Gos, Goossens,
Peeters, and Pepermans (1988) . . . . . . . . . . . . . . . . .
4.37 Capital before and after correcting for WWI. Source: my
elaboration on van Meerten (2003) . . . . . . . . . . . . . . .
167
124
125
130
131
133
134
135
136
141
143
168
LIST OF FIGURES
List of Tables
4.1
4.2
4.3
Parameters’ calibration . . . . . . . . . . . . . . . . . . . . . . 94
Parameters’ calibration . . . . . . . . . . . . . . . . . . . . . . 108
Parameters’ calibration . . . . . . . . . . . . . . . . . . . . . . 132