VI. The Great Depression

VI.1 Basic data

Industrial production 1927-35, 1929=100

50

60

70

80

90

100

110

120

130

1927 1928 1929 1930 1931 1932 1933 1934 1935

UK CND F D I NL S US

Source: Industrial Statistics, 1900-1957, OEEC 1958.

CPI, 1925-1938(1929=100)

Source: Mitchell - International Historical Statistics

Industrial unemployment

Country 1921-29 1930-38

Average

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

-20,0

-15,0

-10,0

-5,0

0,0

5,0

10,0

15,0

20,0

25,0

30,0

1929 1931 1933 1935 1937 1939 1941time

%

0,0

10,0

20,0

30,0

40,0

50,0

60,0

70,0

80,0

90,0

100,0

%

Real growth Unemployment rate Price level

US: real growth and money

0,0

10,0

20,0

30,0

40,0

50,0

60,0

1929 1931 1933 1935 1937 1939 1941time

bil.$

-20,0

-15,0

-10,0

-5,0

0,0

5,0

10,0

15,0

20,0

%

Nominal Money Real growth

VI.2 Impulse and propagation

General framework• WWI:– Suspension of stable economic system

• Namely suspension of the gold standard• Sterling overvalued, mark and franc devaluated

– Pre-war institutional order destroyed– Different basic conditions

• Higher price and wage rigidity• No international policy coordination• Trade protectionism

• The very broad cause of Great Depression: the start of WWI and demise of the pre-war economic system

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

Narrow origins: US economy 1928-29

Two crucial points :• US relevant: US money supply and FED actions• Ineffective gold standard – world-wide relevancyDuring 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• It became clear that there will be a break on the stock marketThe 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

Three hypothesis that attempt to explain what happened

Propagation mechanism (1)

Aggregate demand hypothesis - the length was determined by fall in aggregate demand (fall of spending) due to several factors

• 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– Balanced budget policies, gold standard

Propagation mechanism (2)

Money hypothesis• The contraction of nominal money• Decrease of money multiplier, not of monetary base• Reasons for the decrease of m.m.:– Bank failures, shift from checkable deposits to

currency, etc.• Open issues of the hypothesis– Falling prices real money should increase x did not

happen– Wages contracted much slower than prices– Contraction of nominal money should increase the

interest rate x the opposite was observed– Non-neutrality of money

Money, US, 1929-1933

M1 HMoney mult.

Real M

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

Propagation mechanism (3)

Deflationary hypothesis – not only US related, very cautious monetary policy in all countries due to the adherence to gold standard

• Both unexpected and expected deflation matters, as the future debt becomes “more expensive”

• Unexpected – burden on the debtors, there were many debtors → shift in consumption spending

• Expected – firms know that they will have to pay more for future debt → decrease in investment spending → decrease in production and demand for money → decrease of nominal interest, but prices falling faster and real interest increases

• Money hypothesis applies !

Many additional factors – low international coordination, trade restrictions, difficult intermediation between lenders and borrowers (Bernanke 1983), etc.

VI.3 The Recovery

VI.3.1 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• Probably better understanding of the causes of

crises• Dramatic change in monetary policies– March 1933: US banks closed for several days– 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”

Great Depression, US, till 1941

-20 ,0

-15 ,0

-10 ,0

-5 ,0

0 ,0

5 ,0

10 ,0

15 ,0

20 ,0

25 ,0

30 ,0

1929 1931 1933 1935 1937 1939 1941

tim e

%

0 ,0

10 ,0

20 ,0

30 ,0

40 ,0

50 ,0

60 ,0

70 ,0

80 ,0

90 ,0

100 ,0

%

R eal g ro w th U n em p lo ym en t ra te P rice leve l

VI.3.2 Outside USA (1)

• Different countries – different policies• Common decisions after 1931– End of gold standard and floating of the currencies

• Generally: devaluations and revival of the trade

– Accomodative monetary policies– Governmental intervention, spending and fiscal

deficits

• Germany: political turmoil brought Hitler to power, massive governmental spending (military, infrastructure, etc.)

Outside USA (2)

• France: effects from increased trade and devaluation of Franc just after WWI

• UK: sluggish growth because of overvalued pound after 1925

VI.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