Download 3. The Great Depression

IV. The Great Depression
IV.1 Basic data
Industrial production
1927-35, 1929=100
130
120
110
100
90
80
70
60
50
1927
1928
1929
UK
1930
CND
F
1931
D
1932
I
NL
1933
S
Source: Industrial Statistics, 1900-1957, OEEC 1958.
1934
US
1935
CPI, 1925-1938
(1929=100)
Source: Mitchell - International Historical Statistics
Industrial unemployment
Country
Average
1921-29 1930-38
rate
Difference
Ratio of
difference
to average
USA
7.9
26.1
17.0
18.2
1.07
UK
12.0
15.4
13.7
3.4
0.25
France
3.8
10.2
7.0
6.4
0.91
Germany
9.2
21.8
15.5
12.6
0.81
Source: Eichengreen and Hatton, Interwar Unemployment in International Perspective,
Dordecht, Kluwer Academic Publishers, 1988.
GNP, USA, 1928-1941
US: real growth, unemployment, CPI
%
30,0
100,0
25,0
90,0
20,0
80,0
15,0
70,0
10,0
60,0
5,0
50,0
0,0
40,0
-5,0
30,0
-10,0
20,0
-15,0
10,0
Real growth
-20,0
1929
1931
1933
Unemployment rate
1935
time
1937
1939
Price level
1941
0,0
%
US: real growth and money
60,0
20,0
15,0
50,0
10,0
40,0
bil.$
5,0
30,0
0,0
-5,0
20,0
Nominal Money
Real growth
10,0
-10,0
-15,0
0,0
-20,0
1929
1931
1933
1935
time
1937
1939
1941
%
IV.2 Impulse and propagation
General framework
• See previous Lecture III
– End of pre-WWI economic stability
– Since 1925 return to gold standard, but inefficient
operation
• Sterling overvalued, mark and franc opposite
• No international policy coordination
• Protectionism: both as to trade and capital flows
– Pre-war institutional order destroyed, different basic economic
and social conditions
• Higher price and – namelly - wage rigidity
• Traditional view: Great Depression = US crisis, analytical
emphasis on US economy
– Yes, US shocks were primary cause, but …
• Modern analysis: comparative approach, focusing on
simultaneous experience of many countries
US economy – 1920s
• Strong economic growth
– both real GDP and industrial production around 40% in 1920-29
– recession only 20-21, deflation with very quick recovery
• Active FED policies and lessons
– 1920s: the first application of the active monetary policies
– recession 1921: successful deflationary policies without paying
too much to output decline
• Problematic lesson
– after WWI – strong demand for US output from Europe
– gold standard not yet generally re-installed
– Trust in monetary policy overdone
US economy 1928-29
Two crucial points :
• US relevant: US money supply and FED actions
• Ineffective gold standard – world-wide relevancy
During 1928 – US: speculative boom on financial markets, by US politicians and
bankers considered as unhealthy
• FED strongly contracted money supply
• The aim was to stabilize the financial markets
• Belief that impact on output will be mild
• Stock market crash expected, by some even desired
The existence of gold standard
• The general conditions were different to 1921
• The deflationary policies were propagated worldwide
• Monetary policies to maintain gold standard – other central banks
contracted as well
• Balanced budgets
• Wage and price rigidities, no adjustment as before 1913
Triggers: business cycle and crash
• Recession already since August 1929 and it could have been
just a normal manifestation of the business cycle
• October 27, 1929 – stock market crash
!!! Popular view – Crash and Great Depression are the same –
NOT !!!
• However, when recession arrived, Crash helped to unleash the
avalanche that accumulated after money tightening, making it
clear that recession will be deep
But still: why a “standard” event transformed into a
catastrophe?
Why “Great” Depression?
1. The depth
•
The US average annual growth 1929-1932 was –8.6%,
unemployment in some moments almost 25%
2. The length
•
Despite resumption of growth after 1933, the
unemployment in 1941 still 9.9%
3. Global scale: USA, Europe, elsewhere
Aggregate demand vs. aggregate supply
• Since 1929 – profound drop in aggregate demand
– Main factor: mainly drop of money supply, i.e. monetary
shock
– Shock – predominantly exogenous, causality from money
to fall of aggregate demand
– Inefficient gold standard promoted the shocks around the
world
• Compared to pre-WWI, money ceased to be neutral,
i.e. drop of nominal money supply affected real
economy
• Aggregate supply
– Deflation induced financial crisis
– Real wages permanently above market clearing levels,
incomplete adjustment of nominal wage to price declines
IV.2.1 Aggregate demand
Reminder - money multiplier
• Monetary base, directly controlled by central bank: B
= CR + RS
– CR directly issued by central bank (“coined and printed
money”)
– RS are existing reserves, as resulted from the past
• Money supply, overall money available (M1), i.e.
currency plus total demand deposits: MS = CR+DD
• What is the relation between MS and B?
M S CR  DD

B
CR  RS
MS
CR D D  1

B CR D D  RS D D
MS a  1

B ab
 M S  mB , m 
a 1
ab
m – money multiplier, m > 1
Exogenous monetary shock
• Money supply determined by:
– Gold reserves
– Money multiplier plus share of reserves on monetary
base plus share of gold on total reserves:
M1=(M1/BASE).(BASE/RES).(RES/GOLD).GOLD
or money-gold ratio M1/GOLD = (M1/BASE).(BASE/RES).(RES/GOLD)
• → M1 was much larger than just value of gold
reserves (money-gold ratio always > 1)
• Gold reserves slightly increasing, but money–gold
ratio after 1928 sharply declined
Why the exogenous shock?
• In 1929-1931: consciously chosen policies
– See above US attempt to curb strong 1928 speculative
boom, i.e. contractionary FED policy depressed
(BASE/RES) ratio → M1 fall
• After 1931: not deliberate policies any more, but
consequence of waves of bank panics and
exchange rate crisis (as consequence of inefficient
gold standard)
– Sharp decline of money multiplier (people did not trust
the bank deposit, held much more cash)
– Reduction of (RES/GOLD), as due to currency crisis,
central banks substituted gold for foreign exchange
reserves
– Again, M1 falls
Money, US, 1929-1933
M1
H
Money
mult.
1929
26.4
7.1
3.7
26.4
1930
25.4
6.9
3.7
26.0
1931
23.6
7.3
3.2
26.5
1932
20.6
7.8
2.6
25.8
1933
19.4
8.2
2.4
25.6
Real M
Macroeconomic implications (1)
• Causal chain: exogenous shock (policy, bank
panic, exchange rate crisis) → M1 fall → fall of
aggregate demand, followed by
– Output contraction
– Price deflation
– Unemployment
• Crucial – adherence to gold standard
– UK and its trading partners abandoned gold standard
already in 1931 – devaluation of domestic currency
– Other countries followed (US in 1933, I in 1934, F, PL
in 1936)
• The sooner countries left gold standard, the
milder was the impact of Great Depression
Macroeconomic implications (2)
• Reduction in personal consumption – people were spending less
– Higher uncertainty
– Stock market crash decreased general wealth
• Reduction in investment
– Residential investment fall, due to previous overbuilding
– Bank failures due to poor regulation, no access to funds for
capital investment
• Austere fiscal policies of Governments
– Belief in balanced budget policies, gold standard
IV.2.2 Aggregate supply
Debt - deflation
• Monetary shocks on aggregate demand side →
price deflation (decline)
• Impact on the supply side: nominal debtors
under pressure
– Future proceeds not enough to repay the debt,
debtors into bankruptcy, even more output decline,
even more deflation
• If debt-deflation very severe → banks and
financial intermediaries in general threatened
– Again the same dynamic, self-fulfilling negative
implication for further output fall and deflation
• 1931 and on: induced financial crisis
Irving Fisher
• 1867-1947
• American
• Neoclassical Marginalist
Revolution, mathematical methods
• Introduced Austrian economic
school to the USA (Theory of
capital and investment, 18961930), intertemporality
• Quantity theory of money (19111935)
• Loss of credibility during Great
Depression
Nominal wages inertia
• Again starting from monetary shocks on AD
side → deflation
• Price fall → real wage increase above market
clearing → adjustment: decrease of nominal
wage
– In pre-WWI period, with efficient gold standard
and not-organized labor force → nominal wage
declined and equilibrium (stability) regained,
output did not fall
• Money was neutral
– After WWI, labor force more organized and
nominal wages became sticky → deflation led to
unemployment and lower output
• Non-neutrality of money
IV.3 The Recovery
US: New Deal
• Economic background appalling
– 25% of population suffered by Great Depression, 40% fall
of GDP
– Unprecedented number of bank failures
• Political conditions:
– Herbert Hoover (till 1932) – liberal concept
– Franklin D. Roosevelt (1933-1945) – interventions, but
mixed policies, not only New Deal
• Very mixed ideological background:
–
–
–
–
Institutionalism
Inclination towards socialism and Soviet planning
Deficit financing
At the same time - conservatism
Roosevelt’s team policy
• Probably better understanding of the causes of crises
• Dramatic change in monetary policies
– March 1933: US banks closed for several days
– 1933: leaving gold standard
– 1933-1941: nominal money growth by 140%, real money by
100%
– Due to increase in the monetary base, not in the money
multiplier
• Deficit financing accepted as economic policy tool
• Different personalities, from left-wing socialist to
traditionalists
• New Deal – more as a political slogan than a consistent
program
National Recovery Administration (1)
• Establish “orderly competition”
• Relief and public works programs for
unemployed
• National Industrial Recovery Act (NIRA)
–
–
–
–
Codes of behavior for the industries
Minimum wages
No further wage cut at the high unemployment
Rather naive notions, sometimes even against the US
Constitution (and against competitive environment)
National Recovery Administration (2)
• Agricultural Adjustment Act (AAA)
– Limit the overproduction
– Support to the decrease of farmable land
– Subsidized credits for the farmers
– Debt relief for farmers
• Stabilization of the banking sector
– “Emergency” legislation
– Federal Deposit Insurance Corporation (FDIC)
• Tax policies
New Deal – success of failure?
• Popular fiction: New Deal as a successful program that ended Great Depression
• In reality
– Some policies were indeed proper for the economy in Depression
– On the other hand – some policies counterproductive and brought another
recession in 1937
– Even the proper policies can not be generalized as policies for all situations
• The recession lasted till 1941 (see next slide)
• The most important factors of recovery: monetary policy and reinstated trust
into the banking sector
• Definitely not a clear success, probably not a failure, just “muddling through”
• Most crucial – not New Deal, but abandoning of gold standard
Great Depression, US, till 1941
%
3 0 ,0
1 0 0 ,0
2 5 ,0
9 0 ,0
2 0 ,0
8 0 ,0
1 5 ,0
7 0 ,0
1 0 ,0
6 0 ,0
5 ,0
5 0 ,0
0 ,0
4 0 ,0
-5 ,0
3 0 ,0
-1 0 ,0
2 0 ,0
-1 5 ,0
1 0 ,0
R e a l g ro w th
U n e m p lo y m e n t ra te
P ric e le v e l
-2 0 ,0
0 ,0
1929
1931
1933
1935
tim e
1937
1939
1941
%
IV.4 Consequences
Theory
• The crisis of the classical model
– Assumption of continuous market clearing vs. the
persistent excess supply on the labor market
– Not able to provide a proper guidance for economic
policies
• In combination with golden standard suggested deflationary
policies
• Insistence on balanced budgets
• Belief that money is neutral and wages flexible
• Emergence of new macroeconomic paradigm –
Keynes’ General Theory (next Chapter)
Policies - liberal approach
Perception that liberal policies failed, denial of
• Market clearing, quick price-adjustment towards
equilibrium
• Assumption of competitive markets
• Voluntary unemployment
• State intervention only in case of public goods
and externalities
• Adam Smith and The Invisible Hand
• Say’s Law
Policies - interventionist approach (1)
New Deal - disregarding whether success of failure,
established a completely new approach not only to
economic policies, but to the role of the state in
modern societies:
• No internal stability of the private sector
• Persistent disequilibria, namely in the labor market
• Market failures
• There is a need for a public sector to intervene not
only in case of public goods and externalities
Policies - interventionist approach (2)
• Intervention: accepting some problems are a fact and suggesting
new policies
– Rigidity in labor markets → accept an equilibrium with
involuntary unemployment
– Gold standard does not reflect reality → need for exchange rates
adjustment, floating
– Money is not neutral → fight deflation with increase of money
supply
– Say’s law is not valid, there is insufficient aggregate demand →
stimulate aggregate demand, emergence of policy of
governmental spending
– Protectionism deepens Depression → removal of trade barriers
Concluding remarks on recovery
1. Some policies, consistent with classical model, were
very proper, e.g.:
•
•
Improved regulatory framework for banking and financial
markets
Anti-trust policies
2. New Deal:
•
•
Was not the first application of Keynesian policies, but rather
an eclectic mix, stemming from a desperate search for a
change
Contained some counterproductive measures (and even some
unconstitutional)
3. The real end of Great Depression – WWII
•
The second European Thirty Year War (1914-1945)
Literature to Ch. VI.
• Both Blanchard’s or Mankiw’s textbooks have a chapter/paragraphs on
Great Depression
• Bernanke, Ben S. “Nonmonetary Effects of the Financial Crisis in the
Propagation of the Great Depression.” American Economic Review 73, no. 3
(1983): 257-76.
• Bernanke, Ben S. "The Macroeconomics of the Great Depression: A
Comparative Approach" Journal of Money, Credit & Banking, Vol. 27, 1995
• Friedman, Milton and Anna J. Schwartz. A Monetary History of the United
States, 1867–1960. Princeton, NJ: Princeton University Press, 1963.
• Kindleberger, Charles P. The World in Depression, 1929-1939 (1983)
• Temin, Peter. Lessons from the Great Depression. Cambridge, MA: MIT
Press, 1989.
• Shlaes, Amity. The Forgotten Man, HarperCollins Publishers, New York, 2007