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The Great Depression of the1930s: Lessons for Policy Today Nicholas Crafts Economic History Seminar Bank of Spain October 6, 2016 The Great Depression of the 1930s • Deflation, slump and crises • Collapse of gold standard • Life at the ZLB • Strong recoveries The Great Depression in the Advanced Countries Real GDP Price Level Unemployment Trade (%) Volume 1929 100.0 100.0 7.2 100.0 1930 95.2 90.8 14.1 94.8 1931 89.2 79.9 22.8 89.5 1932 83.3 73.1 31.4 76.5 1933 84.3 71.7 29.8 78.4 1934 89.0 75.3 23.9 79.6 1935 94.0 77.6 21.9 81.8 1936 100.6 81.4 18.0 85.7 1937 105.3 91.5 14.3 97.4 1938 105.4 90.4 16.5 87.0 Myths (1) • The Wall Street Crash caused the American Great Depression • There was a great depression in the UK in the 1930s • Rearmament rescued the UK from depression Myths (2) • Roosevelt’s New Deal was a massive fiscal stimulus • The Glass-Steagall Act was evidencebased policy • The United States was mired in secular stagnation in the 1930s The USA in the 1930s Real GDP GDP Deflator Unemployment Stock Market (%) Prices 1929 100.0 100.0 2.9 100.0 1930 91.4 96.4 8.9 69.4 1931 85.6 86.3 15.6 35.8 1932 74.4 76.2 22.9 30.8 1933 73.4 74.2 20.9 46.2 1934 81.3 78.4 16.2 45.8 1935 88.6 79.9 14.4 63.1 1936 100.0 80.7 10.0 79.8 1937 105.3 84.1 9.2 50.5 1938 101.6 81.7 12.5 61.7 Impact of Wall Street Crash on Real Economy • Probably an exogenous component in stock price declines which might have been but wasn’t neutralized by Fed policy response (cf. 1987, 2000) • Transmission mechanism might be via wealth effects, uncertainty effects, balance-sheet effects • Wealth effect on consumption quite small (Temin, 1976) • Uncertainty channel deserves much closer scrutiny (Baker et al., 2015) The Banking Crisis in USA • 1/3 American banks failed • Bank failures not random but reflected ex-ante balance-sheet weakness (Calomiris & Mason, 2003a) and weak regulation (Mitchener, 2007) • Bank failures led to credit crunch that greatly exacerbated the effects of monetary contraction on output (Bernanke, 1983) • Banks had to re-establish low default risk through reduced lending and dividends; adverse impact on supply of credit (Calomiris & Wilson, 2004) Understanding the Role of Financial Crisis in the Downturn Bernanke (1983) • Key aspect is loss of financial intermediation services; it’s a severe credit crunch that affects real economy through supply of loans • Bernanke’s regression demonstrates that adding bank failures helps account for the output decline that money supply per se does not seem to explain • It’s a black box that needs evidence on bank behaviour to be more persuasive but suggests that effective LOLR might have made a big difference Banking Crisis and Investment (Calomiris & Wilson, 2004) • Regression analysis of behaviour of New York banks • Bank lending in early 1930s constrained by capital losses, high (adverse selection) costs of issuing equity and need for liquid assets • Deposit default risk reduced by shrinking loans and holding more reserves; high risk penalized by withdrawals • Increased costs of equity rather than reduced quasirents from loans promote big reductions in lending – adverse impact is on supply of loans An Effective LOLR Was Missed: Evidence from Mississippi (Richardson & Troost, 2009) • Northern (southern) ½ of state in St Louis (Atlanta) Fed district • St Louis (Atlanta) was passive (active) in 1930/1 • ‘Quasi-experiment’ shows that aggressive Fed LOLR policies could have big impact; providing liquidity reduced bank failures which averted reduction of credit supply and decline of economic activity • % banks suspending (failing): 39.2% vs. 14.2% (18.6% vs. 7.1% in the period of policy difference, otherwise similar Investment Banking and Failure Risks (White, 1986) • Much higher survival rate for banks with security affiliates suggests that they offered diversification and economies of scope advantages • Having a security affiliate did not reduce capital adequacy or weaken liquidity • Return relative to risk looks much better for banks with a security affiliate; imposing separation of investment and commercial banking potentially has efficiency costs • Glass-Steagall Act not evidence-based policy New Deal and Recovery • Alphabet soup of New Deal initiatives well known • New Deal did not, however, raise aggregate demand by much (Fishback, 2010) • Did have adverse labour-market implications (Bordo et al., 2000;Cole & Ohanian, 2004) • But was perhaps central to changing inflationary expectations and escaping the liquidity trap (Eggertsson, 2008); mentions of inflation spike in April-May 1933 (Jalil and Rua, 2015) Fiscal Stimulus • New Deal was not a big fiscal stimulus – perhaps about 2.5%GDP (Peppers, 1973) • In the mid 1930s, fiscal-policy stimulus didn’t fail, it wasn’t really tried; however, size of fiscal multiplier not clear • Roosevelt was definitely not a convinced Keynesian and by 1937 was seeking to balance the budget even though D/Y below 0.5 How Big Was the Fiscal Multiplier? • Not clear: wide range of estimates many of them using very dubious methods • Might expect it to vary over time; prima facie, reasons to think it could have been large in some years (ZLB, U) • Recent estimates include Gordon & Krenn (2010) at 1.8 but Ramey & Zuchairy (2014) only 0.8 • NB: the key issue is how far output increases reflect expect future government spending (Ramey, 2011) so need a strategy to exploit ‘fiscal news’ The End of One Big Deflation (Temin & Wigmore, 1990) • Need to explain lower turning point at a time when money supply not rising • Expectations of future monetary policy are influenced by regime change in April 1933 when USA leaves gold; this was the big signal that the Hoover regime was over and markets responded very positively • Policy changes allows real interest rates to be reduced even though nominal rates are at lower bound • Classic solution to liquidity trap is credibly to commit to inflation (Svensson, 2003); this is what the New Deal does (Eggertsson, 2008) Inflationary Expectations: the Narrative Record (Jalil & Rua, 2016) • Use daily newspapers to count mentions of ‘inflation’; big spike in April-May 1933 after USA leaves gold standard and after Thomas Amendment • Event-study analysis shows that inflationary news shocks raise stock prices and lower dollar • Adding a regime-shift dummy (April-July 1933) to Bernanke (1983) regression suggests industrial output growth raised by 7 percentage points per month • NB: Fed no longer independent Secular Stagnation • Hansen (1939) famously thought this was the key problem facing the United States • Low trend growth prospects (adverse demography, slow technological progress) implied low investment demand and would lead to prolonged (Keynesian) unemployment • Hansen (1951) thought this could be solved by deficit-financed government expenditure Why Was Alvin Hansen Wrong? • Regime change stimulated strong recovery post-1933 (Eggertsson, 2008) • USA had strong TFP growth from the 1920s through the 1960s (Field, 2011) • Unemployment tends to U* in long-run and the positive shock of WWII offset hysteresis effects (Mathy, 2015) A Revised View of U.S.TFP Growth Over Time (Bakker et al. (2015) • Estimates of TFP growth for the PDE through the 20th century on a consistent basis • TFP growth in the 1930s is lower than in 19481973; contrary to Field (2003) the1930s is not the ‘most technologically progressive decade’ • Nevertheless, TFP growth in the 1930s was very strong and broadly based – quite different from the ‘productivity puzzle’ of today TFP Growth in the U. S. Private Domestic Economy, 1899-2007 (% per year) 1899-1909 0.92 1909-1919 0.68 1919-1929 1.68 1929-1941 1.87 1948-1960 2.00 1960-1973 2.23 1973-1989 0.48 1989-2000 0.98 2000-2007 1.45 Source: Bakker et al. (2015) Whence Came TFP Growth before WWII? • Key feature of the 1930s is very broadly-based TFP growth; Gordon’s key clusters perform strongly but do not dominate • Taken together, the ‘great inventions’ outdo ICT but the strength of other sectors is remarkable to modern eyes • Rapid TFP growth pre-dates the 1930s; Gordon’s emphasis on positive Great Depression and WW2 shocks is misplaced TFP Growth and TFP Contribution to Labor Productivity Growth in PDE (% per year) Bakker et al. (2015) 1919-29 1929-41 TFP Growth Contribution Rate TFP Growth Contribution Rate PDE 1.68 1.68 1.87 1.87 Manufacturing 4.5 1.25 2.3 0.67 Non-Manufacturing 0.6 0.43 1.7 1.20 ‘One Big Wave’ Sectors 2.6 0.60 3.1 0.74 Electricals 2.6 0.07 4.9 0.15 Wholesale & Retail Trade 0.9 0.12 3.4 0.46 Early 20th-Century National Innovation System • Traditional accounts rightly stress college and highschool education (Acemoglu, 1998; Goldin & Katz, 2008) • Second key aspect which deserves more attention is prowess at ‘creative destruction’ • Micro evidence show firms with market power innovating strongly to maintain rents (Nicholas, 2003) • Macro evidence using DEA techniques shows lagging British and German manufacturing productivity performance with a persistent inefficiency handicap (Timmer et al., 2016; Woltjer, 2013) The UK in the 1930s Real GDP GDP Deflator Unemployment Stock Market (%) Prices 1929 100.0 100.0 8.0 100.0 1930 99.9 99.6 12.3 80.5 1931 94.4 97.2 16.4 62.8 1932 95.1 93.7 17.0 60.2 1933 96.0 92.5 15.4 74.3 1934 102.8 91.7 12.9 90.3 1935 106.6 92.6 12.0 100.0 1936 109.9 93.1 10.2 115.9 1937 114.7 96.6 8.5 108.0 1938 118.2 99.3 10.1 88.5 The UK Downturn • Relatively short and mild (not a depression) • Fits the international pattern: early devaluation, no banking crisis • Unemployment is the reason that the 1930s are seen as ‘traumatic’ • Strong growth after 1933 but cyclical recovery driven by fiscal and monetary stimulus rather than trend improvement Unemployment Rates for Insured Workers (%) 1924 1929 1932 1937 London 9.0 5.6 13.5 6.4 South East 7.5 5.6 14.3 6.7 South West 9.1 8.1 17.1 7.8 Midlands 9.0 9.3 20.1 7.3 North West 12.9 13.3 25.8 14.0 North East 10.9 13.7 28.5 11.1 8.6 19.3 36.5 23.3 Scotland 12.4 12.1 27.7 16.0 UK 10.3 10.4 22.1 10.8 Wales Source: Garside (1990) Devaluation in the 1930s • In absence of coordinated monetary expansion, very good for early recovery; staying on the gold standard made things much worse • Regain control of interest rate, change inflationary expectations, remove need for money wages to fall, increase international competitiveness, improve fiscal arithmetic • This policy space allows regime change Dates of Changes in Gold Standard Policies and Economic Recovery (Bernanke & James, 1991: Maddison, 2003) Return to 1929 Income Level Devaluation Belgium 1939 03/1935 Denmark * 09/1931 France 1939 09/1936 Germany 1935 * Italy 1938 10/1936 Netherlands 1949 09/1936 Norway 1932 09/1931 Sweden 1934 09/1931 Switzerland 1946 09/1936 United Kingdom 1934 09/1931 United States 1940 04/1933 The 1930s UK Recovery: 1st Phase • Started during fiscal consolidation which reduced structural deficit by 4%GDP between 1930 and 1934 • Strong growth 1933-35 based on monetary stimulus which offset negative impact of fiscal policy • Exit from gold standard plus cheap money; housing investment led the recovery • NB: no banking crisis The ‘Cheap Money’ Policy • Was a coherent framework arrived at by mid-1932 at ZLB with HMT not B of E in charge • Aim to raise the price level and to underpin this by holding exchange rate at $3.40 then FFr. 88 • Short term interest rates kept at lower bound and real interest rates fell • Credible because it was clearly in HMT’s interests as a route to recovery that did not open Pandora’s Box and improved fiscal arithmetic The ‘Managed Economy’ Strategy of the 1930s • Post-1932 dirty floating, cartels, tariffs understandable as damage limitation and as a way to restore profitability and raise prices • This implied a major reduction in competition which lasted well into the post-war period (cf. Eggertsson, 2012) • The reduction in competition reduced productivity growth both before and after WWII (Crafts, 2012) The 1930s UK Recovery: 2nd Phase • From 1935 onwards, rearmament central; large exogenous fiscal shock with short-term interest rates held constant • This was a de facto Keynesian policy • Probably raised real GDP by about 3-4% in 1938 but fiscal multiplier only 0.5-0.8 (Crafts & Mills, 2013) • Explanation for ‘low’ multiplier may be high D/Y Revisiting the Interwar Multiplier Crafts and Mills (2013) (2015) • Model-dependent results from macro literature suggest ‘let the data speak’ • Used time-series analysis of new quarterly data from Mitchell et al. (2012) applying the ‘defense news’ approach developed by Ramey (2009, 2011) and adopted by Barro & Redlick (2011) • Tested a variety of alternative specifications but fiscal multiplier always < 1 Fiscal Sustainability: Δd = 0 • Δd = -b + d(i – π – ΔY/Y) so required primary budget surplus is b = d(i - π – ΔY/Y) • Required primary budget surplus rises with higher debt to GDP ratio and higher real interest rate but falls with faster growth rate • If the real interest rate is smaller than the real growth rate, then fiscal sustainability is consistent with a primary budget deficit Reducing d in Interwar UK • Proved extremely difficult despite prevailing balanced budget orthodoxy; b averaged 6.2% but d in 1938 same as in 1921 • (r – g) is a massive headwind pre-1932 • ‘Displacement effect’ of WWI used to finance welfare state not sinking fund (cf. 19th Century) • Price deflation in the context of returning to gold a major handicap in the 1920s; leaving the gold standard transformed the fiscal arithmetic Fiscal Sustainability Data, UK 1921-1929 b i π g d b* 1921 5.10 4.41 -10.52 -4.71 1.472 28.92 1922 7.38 4.45 -16.05 4.11 1.668 27.34 1923 8.92 4.52 -8.01 3.40 1.763 16.10 1924 7.60 4.58 -1.39 5.10 1.726 1.50 1925 6.46 4.59 0.27 2.89 1.633 2.34 1926 6.10 4.85 -1.41 -4.59 1.717 18.63 1927 6.89 4.57 -2.36 8.22 1.635 -2.11 1928 7.53 4.75 -1.12 1.17 1.613 7.58 1929 7.00 4.85 -0.34 3.43 1.584 2.79 Fiscal Sustainability Data, 1930-1938 b i π g d b* 1925-9 average 6.80 4.72 -0.99 2.22 1.636 5.85 1930 6.15 4.75 -0.40 -3.72 1.592 14.12 1931 5.41 4.51 -2.40 -2.37 1.698 15.76 1932 7.25 4.49 -3.58 0.65 1.736 12.88 1933 7.42 3.90 -1.40 4.74 1.792 1.00 1934 6.76 3.58 -0.68 4.78 1.731 -0.90 1935 5.68 3.64 0.87 4.26 1.650 -2.46 1936 4.95 3.59 0.55 4.15 1.587 -1.76 1937 3.89 3.67 3.73 3.17 1.472 -4.75 1938 1.56 3.62 2.77 0.42 1.438 0.62 1933-8 average 5.04 3.67 1.67 3.59 1.612 -1.38 1930s’ Fiscal Arithmetic • Using the standard ex-post fiscal sustainability formula (Abbas et al., 2011), about 2/3 of the fall in d post 1933 came from budget surpluses • After exit from the gold standard in an era of limited capital mobility, the growth/interest rate differential did the rest (ΔY/Y > r) • Attraction for HMT (and hence credibility) of cheap money policy is obvious • NB: from 1934-1937, b* was negative so rearmament was compatible with fiscal sustainability Self-Defeating Austerity • Means that selected fiscal indicator deteriorates rather than improves when government expenditure is cut and/or taxes are raised • Most often discussed in context of public debt to GDP ratio (d) and would mean Δd/ΔG < 0 • NB: well-known that path of d is probably not monotonic under austerity (Boussard et al., 2012) so need to distinguish short-run and long run impacts Deficit-Financed Expenditure • The debt to GDP ratio (d) will fall if ΔD/ΔY < D/Y • This will require that (1 - τμ)/μ < d or equivalently that μ > 1/(d + τ) • However, any increase in Y is temporary but any increase in D is permanent 1930s: Getting the Fiscal Story Right • Frequently suggested we should not repeat 1930s’ mistakes • Procyclical fiscal policy attacked by Keynes • Rearmament seen as major boost to recovery and indictment of earlier fiscal policy • d fell as rearmament surged after 1935 • So was austerity ‘self-defeating’ in the 1930s? Self-Defeating Austerity in the 1930s? (Crafts & Mills, 2015) Assuming τ = 0.44, d = 1.7, μ = 0.5 – 0.8 • μ > 1/τ definitely was not met, cf. Keynes (1933) • μ > 1/(d + τ) may have been met, depending on lags • Low μ makes it much less likely Lessons • Preventing collapse of banking system is paramount • Regime change is the key to recovery in a ‘depressed economy’; easier with ‘subservient central bank • Avoiding price deflation is imperative • Fiscal multiplier is not always big at ZLB • Major crisis does not necessarily imply long-run secular stagnation