The New Deal, the Current Crisis and the Road Ahead

1. The New Deal, the Current Crisis and the Road Ahead Alexander J. Field Department of Economics Santa Clara University Santa Clara, CA 95053 email: afield@scu.edu The New School New York City May 19, 2009 Access my papers: http://ssrn.com/author=347743

2. Similarities with Great Depression • Although both crises were worldwide in scope, the epicenter in both instances was the United States

3. Similarities with Great Depression • Both economic downturns were preceded by a speculative real estate boom characterized by rising land and house prices and a rising share of GDP devoted to construction. • 1924-27: residential construction exceeded 8 percent of GDP • 2000: 4.6 percent • 2005: 6.2 percent • 2008: 3.4 percent

4. Similarities with Great Depression • Both residential booms followed by a boom in nonresidential structures • Share of nonresidential construction in GDP: • 2000: 3.2 percent • 2004: 2.6 percent • 2008: 3.8 percent

5. Similarities with Great Depression • In both instances the periods preceding the crises featured absent or diminished governmental regulation of the financial sector • Financial innovation • 1920s: mutual funds, consumer installment buying • Current crisis: collateralized debt obligations, credit default swaps • More relaxed attitude toward risky investments and higher leverage on the part of financial institutions • Rise in the relative size of the financial sector and the remuneration and skill intensity of its employees (Philippon and Resheff, 2008)

6. Similarities with Great Depression • The bust part of the financial cycle in both cases saw disruptions in credit markets, with many bankruptcies or near bankruptcies of financial institutions, and big declines in the price of equities, • High stock market volatility • Most of the largest one day stock price increases in the twentieth century took place between 1929 and 1932, as the Dow Jones Industrial Average lost a total of 89 percent of its value.

7. Similarities with Great Depression • In both cases during the upswing, households and firms borrowed, lent, and spent with abandon. • And in both instances, the challenge facing policy makers, at least in the short run, was to cajole, incentivize, and otherwise encourage households and firms to borrow, lend, and spend – just what had gotten them into difficulty in the first place.

8. Similarities with Great Depression • Most importantly, within the United States as well as other countries, the downturns resulted in falling output and employment, and reductions in world trade, although the declines in 2009 do not as yet approach, in percentage terms, those experienced eight decades ago. 

9. Short Run Effects on Productivity • In each instance, while the upswing of the financial cycle supercharged the accumulation of physical capital, particularly structures, its aftermath retarded it. • The upswing of the financial cycle laid the groundwork for a subsequent contraction in physical accumulation, which, amplified by multiplier effects and only partially counteracted by fiscal and monetary policy, contributed in both cases to the decline in aggregate demand that induced recession. • Consequence: short run adverse effects on both labor productivity and TFP.

10. Short Run Effects on Productivity • Between 1890 and 2004, a one percentage point increase in the unemployment rate reduced TFP growth by about .9 percent (Field, 2008) • This is stable across periods in which trend growth rates of TFP are quite different • 1929-33: about 12 percentage points of the roughly 30 percent decline in output attributable to plummeting TFP

11. Short Run Effects on Productivity • 1995-2005: IT productivity boom: 1.46 percent per year TFP growth in private nonfarm economy • 2005-2007: Anemic TFP growth: .36 percent per year • This is before predictable effects of recession are felt • The IT boom productivity boom has now run out of steam • Over the next few years productivity advance will almost certainly be weak or even negative, as it was between 1929 and 1933.

12. Longer Run Effects on Productivity • The years of the Great Depression (1929-41) were the most prolonged period in US economic history in which output remained substantially below potential. • That period was also, the most technologically progressive of any comparable period in U.S. economic history. • TFP Growth in PNE, 1929-41 = 2.31 percent per year (Kendrick) • With cyclical adjustment = 2.78 percent (Field) • Compare with Golden Age (1948-73) = 1.90 percent per year • Or IT boom (1995-2005)= 1.46 percent per year.

13. Longer Run Effects on Productivity • Since the Depression experienced such pronounced productivity advance could we expect boost to longer run growth as a direct consequence of our current recession? • The issue is best approached by thinking of TFP growth across the 1930s as resulting from the confluence of three tributaries.

14. Contributors to TFP Growth: 1929-41 • The continuing high rate of TFP growth within manufacturing, the result of the maturing of a privately funded research and development system. • Spillovers from the build out of the surface road network, which boosted private sector productivity, particularly in transportation and wholesale and retail distribution. • An adversity/hysteresis effect: crisis can lead to new and innovative solutions with persistent effects (silver lining effect; necessity is the mother of invention).

15. Contributors to TFP Growth: 1929-41 • Certain scientific and technological opportunities, perhaps an unusually high number, were ripe for development in the 1930s. They would have been pursued at about the same rate even in circumstances of full employment. Wallace Carothers would still have invented nylon. • Similarly, by the end of the 1920s, automobile and truck production and registrations had outrun the capabilities of the surface road infrastructure. Strong political alliances in favor of building more and improved roads had been formed, and issues regarding the layout of a national route system had been hashed out by 1927. Build out of the surface road network would have continued in the absence of the Depression. • So it is the third effect, the kick in the rear of unemployment and financial meltdown, that is most relevant in terms of a possible causal association between depression and productivity advance.

16. Can we be optimistic? • What doesn’t kill you makes you stronger … • But sometimes it kills you … • Adversity makes some work harder, take more risks … • It causes others to withdraw from the labor force into depression, alcoholism, etc. • Both income and substitution effects operate. • No reason to be optimistic simply on a priori grounds

17. Railroads: Poster Child for Silver Lining Effect • By end of Depression, railroads responsible for a third of all trackage in receivership • Between 1929 and 1941: railroads retired track, cut rolling stock and employees by a third • In 1941 railroads produced more revenue freight ton miles and almost as many passenger miles as in 1929 • Remarkable productivity achievement • Hope for GM and Chrysler?

18. The Road Ahead • Fiscal and monetary response during the Depression was too small to bring us out of the Depression. • Although retardation of equipment accumulation was transitory, not so for structures. • Abandonment of gold brought some modest reflation • Some increase of government spending • Recovery from 1933 to 1937 was extraordinarily rapid, even though it only partially closed the output gap.

20. Capital Income during the Depresion • Many wealthy Americans disliked Roosevelt, even hated him. But that didn’t stop them from making money during his presidency. • The data show that, with one exception, recipients of capital income did terribly under Hoover. The one exception was bondholders: the real value of net interest payments went up almost 22 percent between 1929 and 1932. • For all other types of capital income, particularly proprietors’ income and corporate profits, Hoover’s administration was a disaster. Proprietors’ income fell 56 percent in real terms, and corporate profits fell more than 100 percent – they were negative in 1932 and 1933. • Hoover’s presidency was not great for employee compensation, which declined 24 percent in real terms between 1929 and 1932. • But it was worse, in the aggregate, for those receiving capital income.

21. Capital Income During the Depression • Proprietors’ income and corporate profits recovered sharply after 1933, and surpassed their 1929 levels by 1940. • By 1937, the Dow Index was almost five times the level of its 1932 trough, reflecting the sharp upswing in corporate profits and more optimistic expectations for the future (the stock market’s performance was weaker between 1937 and the end of the war). • Bondholders did not do as well under Roosevelt as under Hoover, but their losses were trivial compared to the huge increases in other types of capital income. • The one bleak spot for capital income recipients across both administrations was rental income of persons, which declined through 1935 and recovered only modestly thereafter. • These statistics are consistent with the generally slower recovery of construction during the Depression.

23. The Response so Far • Fiscal Stimulus package is well motivated, probably too small • Monetary interventions appropriate • Major problem in response to banking system • Larry Summers and Tim Geithner too deferential to Wall Street? • Cognitive capture hypothesis

24. The road ahead • Financial Crises in capitalist systems are endogenous (Minsky) • Combination of greater risk taking on asset side of balance sheet and greater leverage on liabilities makes a system increasingly fragile • A shock that otherwise would not have severe adverse effects on the real economy now has the potential to have a devastating effect

25. The Road Ahead • Leverage must be controlled. Involves more than just interest rate policy • John Taylor (2008) – keeping interest rates too low between 2001 and 2004 caused the housing bubble. Implication: higher rates would have avoided the financial crisis • But: Other countries with tighter short term rates also had a housing bubble

26. The Road Ahead • Acts of regulatory commission as well as omission got us into the current crisis • Brooksley Born – 1998 – proposal to regulate CDSs • Essentially shouted down by Alan Greenspan, Larry Summers, Arthur Leavitt, and Robert Rubin • December 2000 legislation – Commodity Future Modernization Act – prohibits regulation • Geithner and Bernanke are now advocating a somewhat weaker version of what Born proposed

27. Acts of Commission • 2004 decisions by Securities and Exchange Commission under Christopher Cox to remove controls that limited leverage of investment banks to the 10 to 11 range. • Allowed what were then the five large investment banks (Bear Stearns, Goldman Sachs, JP Morgan Chase, Merrill Lynch, and Lehman Brothers) to enter a “Consolidated Supervised Entity” program permitting them to escape the traditional debt to equity limitations, and substituting for it an “alternative net capital rule.” • The consequence was that leverage in these firms soared to 33 to 35 to 1, with generally disastrous results, once house prices stopped appreciating

28. Global Savings Glut Hypothesis • Bernanke – Greenspan view • Fed not responsible because global savings glut drove down long rates, which the Fed doesn’t control. • This view absolves Fed from responsibility • 1920s housing bubble occurred while we were running current account surpluses • Unlikely that large current account deficits/capital account surpluses are the entire explanation

29. The Road Ahead • Revisit Basel II? Financial Institutions have too much discretion regarding how much capital to hold. Sheila Bair’s warning • FDICIA 1991 – responsibilities to take prompt correction action. Some have argued it doesn’t apply to bank holding companies. It doesn’t, but it does apply to the banks they hold. • A step in the right direction: FASB will now prohibit financial institutions from using off balance sheet Special Purpose Entities, which permitted reductions in mandated capital requirements. • A step in the wrong direction: relaxation of mark to market accounting rules. Existing rules already contained restrictions and exceptions for assets that traded infrequently

30. The Road Ahead • Control of leverage not just a matter of open market operations/ interest rate policy • Multiple failure: not just Fed, but OTS, OCC, SEC, CFTC, as well as state insurance regulators, and private sector groups like FASB, bolstered by an ideology that said the market knows best • Need combination of macro prudential regulator responsible for monitoring and controlling systemic risk and micro prudential regulation and supervision responsible for health of individual financial entities. • We do know why this happened. Whether or not we establish an effective regulatory regime in the aftermath of the downturn will influence the frequency and severity of future financial crises/business cycles.