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The Great Depression (1929 – 1941) 1 Paper topic • • • • • • • • Last problem is short paper (1000 words + tables, figures) Due in reading week (December 10) Broad latitude on particular topic, but must be macro Get approval from TF or me for topic Examples (verbally, but will be in posted assignment) Good style is important References must be acceptable (not Internet junk) Don’t wait until last moment. Gilded era of the 1920s Stability restored to U.S. economy in 1920s after WW I. Problems surfaced with real estate and stock market booms. The Great Crash, October 1929 Key Elements in the Great Depression 1929-1933 • • • • • • • • • • Started as asset price bubble and standard recession Remember world was on gold standard (fixed exchange rate system) Multiple bank failures through 1933 (standard panic model) Breakdown of Gold Standard, particularly with Britain’s leaving gold in 1931. Collapse of investment and international trade after 1929 No effective fiscal policy until 1940 Fed took hesitant steps to stimulate the economy – Federal government wanted to balance the budget (like several candidates today…) – Fed was serving too many masters (more on this later) Output kept falling, and unemployment kept rising Trough finally reached in 1933, but no sharp recovery Remember that Keynes’s General Theory not published until 1935: macroeconomics was born a decade too late. 5 Bank failures and panics, 1931-1933 GDP Gap in Depression Actual/Potential GDP 1.1 1.0 0.9 0.8 0.7 0.6 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 GDP Gap in Depression and Recession Actual/Potential Output 1.1 Great Depression Great Recession (2007 - 2012) 1.0 0.9 0.8 0.7 0.6 29 30 31 32 33 34 35 36 37 38 39 8 High unemployment for a decade Unemployment rate (% of labor force) 30 25 20 15 10 Great Depression Today's recession 5 0 1930 1932 1934 1936 1938 1940 2008 2009 2010 2011 10 Growth in Key Indicators Period 1927:10-1929:8 1929:8-1931:12 1931:12-1933:4 H M1 Real M1 Ind. Prod. 42.7% 2.0% 6.5% 1.1% -8.1% -10.5% 1.4% -0.9% 0.6% 11.6% -22.4% -10.2% Real GDP Inflation 3.8% -6.7% -11.9% -0.3% -7.3% -11.0% H = high powered money. Periods are: 1. Pre-crash boom 2. From crash to Britain’s leaving gold in October 1931 3. From gold crisis to trough Note: rates of change at annual rates. 11 Alternative views of the sources of the GD Classical theories: Basically a variant on real business cycles Longer story, but can’t explain the major movements Keynesian theories: • Expenditure view: IS or spending shocks* • Financial market distress: MP or financial shocks* • Low-level equilibrium trap* • All of the above*** 12 IS interpretation of the depression interest rate (i) IS1929 IS1933 MP Y1929 Y1933 0 Real output (Y) 13 I. The Expenditure Approach: IS Shocks Were shocks in the IS curve responsible? – Foreign trade, government spending and taxes were too small – No exogenous consumption shock – Investment decline was the major shock. • Mechanism is unclear, but probably due to shift to “bad equilibrium” (panics, risk, high risk premiums, low investment, unstable dynamics ?) 14 II. Financial Markets and the Depression • Central banks generally have to serve three masters in different mixes over time. This was the Fed’s trilemma in 1928-33. 1. exchange rates (gold standard and convertibility) 2. macroeconomy (inflation, output, and employment) 3. financial market stability (asset prices, panics, liquidity) • Fed was primarily concerned about (#3) speculation in 1928-29 and tightened money at that point. • When depression was underway, Fed was primarily concerned with defending the gold standard (#1) until 1933 and didn’t expand M sufficiently. • From 1933 on, after US depreciated and others left gold, Fed was divided about how strongly to stimulate the economy because of poor macro understanding (#2). 15 Friedman and Schwartz and the Monetarist Argument • Classic study of the Great Depression is Milton Friedman and Anna Schwartz, Monetary History of the United States, which held the “monetarist” view. “Throughout the near-century examined, we have found that: Changes in the behavior of the money stock have been closely associated with changes in economic activity, money income, and prices. The interaction between monetary and economic change has been highly stable. Monetary changes have often had an independent origin; they have not been simply a reflection of economic activity.” (p. 676) • F&S view the depression as primarily driven by “incompetent” monetary policy caused by decline in money supply. • Argue that rise in M1 could have prevented Y fall and nipped GD in bud Monetarism, the Depression, and IS-MP interest rate (i) MP‘ MP i** i* IS Y** Y* Real output (Y) 17 Interest Rates 1920-39 Problem with monetarist interpretation: Safe interest rates fell in GD!!! Interest rate (% per year) 10 8 6 4 2 0 20 22 24 26 28 30 3-month T-bill Fed discount rate (low) 32 34 36 38 40 Corporate bond rate Commercial paper rate 18 Bad equilibrium view of Great Depression A final approach: 1. Began with asset price bubble and high leverage. 2. Then had huge IS shock due to risk, panics, deflation, and the result was high risky real interest rates. 3. This forced economy into a liquidity trap (like today), so that monetary policy was ineffective. 4. Government was too small to have effective fiscal policy. 5. Got locked into “bad equilibrium” of deflation, high risk premiums, fear, low investment, and low spending. 6. And that lasted until 1940! 19 interest rate (i) IS1933 IS1929 MP1929 = MP1933 MP1939 Y1929 Y1933 0 Y1939 Real output (Y) 20 Recovery from the Great Depression • The end of the Great Depression: – Military mobilization for World War II led to ENORMOUS increase in G starting in 1940. – Recovery took off in 1940. • This Standard IS shift … no puzzle here! 21 The rise of the dictators (1917 - ) World War II (1931-1945) Military spending takes off… The end of the depression … 30 .6 15 10 Pearl Harbor Germ invastion Austria, Czech 20 .5 Germ invasion France 25 Germ. invastion Poland WW II .4 .3 .2 5 .1 0 .0 30 32 34 36 38 40 42 44 Unemployment rate Defense spending/GDP Federal expenditures/GDP 46 48 25 interest rate (i) IS1939 IS1945 WW II Y1945 0 Y1939 MP Real output (Y) 26 Professor Summers again on policy in the liquidity trap: “Our policy approach started with a major commitment to fiscal stimulus. Our judgment was that in a liquidity trap-type scenario of zero interest rates, a dysfunctional financial system, and expectations of protracted contraction, the results of monetary policy were highly uncertain whereas fiscal policy was likely to be potent.” Lawrence Summers, July 19, 2009 Implication of the Recovery • Recovery from GD required an increase in high-employment federal deficit of 20-25 percent of GDP – Would be equivalent of $3 trillion deficit today! • The magnitude of the fiscal shock required for recovery suggests that no minor M or F expansion would cure GD quickly. 28 Summary • The depth and severity of the Great Depression remains one of the continuing debates of macroeconomics. • Probably no simple approach can explain the entire story – Warning: avoid the seductive simplicity of monocausal approaches. • Perhaps a complex situation where combination of factors piled up to produce a “perfect storm” of macroeconomics: – began with asset price bubble (boom of 1920s and bust of 1929) – poor institutions (gold standard and fragile banking system) – poor international coordination (legacy of WW I) – inadequate understanding of macroeconomics (before Keynes’s theory) – inept policy response (cling to gold standard, no fiscal response) – bad dynamics (panic, high risk premia, deflation, and liquidity trap) • Can it happen again? To answer need to understand how macroeconomic theory and institutions have evolved. 29