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The Great Depression: Getting the Story Right. Nicholas Crafts and Peter Fearon. The 1930s. Deflation, slump and crisis De-globalization: trade wars, collapse of gold standard and of foreign lending

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the great depression getting the story right

The Great Depression: Getting the Story Right

Nicholas Crafts and Peter Fearon

the 1930s
The 1930s

Deflation, slump and crisis

De-globalization: trade wars, collapse of gold standard and of foreign lending

Lessons from the downturn quite well understood; but also much to be gained from looking at recovery

proportion of countries with banking crises 1900 2008 weighted by their share of world income

- 1

- 0.9

- 0.8

- 0.7

- 0.6

- 0.5

- 0.4

- 0.3

- 0.2

- 0.1

- 0

Proportion of Countries with Banking Crises, 1900-2008Weighted by their share of world income

The Great


Share of countries in banking crisis

(left scale)

Emerging Markets, Japan,

the Nordic Countries and US (S&L)

World War I

Percentage of countries

The Panic

of 1907

Capital Mobility

(right scale)

Source: Reinhart & Rogoff (2009)

  • Wall Street Crash caused the Great Depression
  • New Deal was a massive fiscal stimulus
  • Glass-Steagall was evidence-based policy
  • There was a great depression in the UK
how did the depression start
How Did the Depression Start?

Dominance of US economy in 1920s; world’s leading creditor country

1928: Federal Reserve (FED) moved to control stock market speculation

Higher interest rates destabilized domestic and international economy

1929 Wall Street Crash: an effect not a cause

how did the depression spread
How Did the Depression Spread?

Most economies linked by gold standard which was re-adopted during the 1920s

Fixed exchange rate system; countries losing gold expected to deflate

Countries gaining (“hoarding”) gold, e.g. USA and France, sterilized inflows to protect against inflation

golden fetters
Golden Fetters

After 1930, US loans ceased, imports reduced, primary product prices declined; primary producers had to deflate

1931 major financial crisis started in Austria; moved to Germany

No co-ordinated policy response

Britain leaves the gold standard (Sept 1931)

collapse of gold standard
Collapse of Gold Standard

Crisis then moved to USA

1931: 47 members of gold standard club; 1932: only 6 major economies still in

Abandonment of gold was a key to recovery

Those countries that had not devalued became much more protectionist

trade contraction
Trade Contraction

Major contraction in international trade; value and volume both decline

Starting with Hawley-Smoot tariff (1930) protection increased; beggar-thy-neighbour policies

Drive to self-sufficiency in Germany

Major source of trade decline was inability ofcountries to finance imports

us uk comparison
US/UK Comparison

UK did not experience a Great Depression

1932-37 average real GDP growth 4%; no bank failures, rapid recovery but unemployment remained high especially in Outer Britain

Major regime change; UK abandoned gold standard, protectionist tariffs embraced

Recovery fuelled by cheap money; no fiscal stimulus until later 1930s

why so deep a depression in usa
Why So Deep a Depression in USA?

Deflation undermined consumer and business confidence; increased real debt

Rising unemployment and collapse in farm income added to distress

Three waves of bank failures: late 1930; late 1931; winter 1932-33 undermined investment

Policy response entirely inappropriate

new deal recovery
New Deal Recovery

1933-37 real GDP grew at 8% per annum

Gold standard abandoned; banking stabilized; inflationary expectations established

Monetary policy accidentally expansionary

Little fiscal stimulus

Serious new recession 1937-38

devaluation in the 1930s
Devaluation in the 1930s
  • Very good for early recovery; staying on the gold standard made things much worse
  • Regain control of interest rate, change inflationary expectations, lower real wages, increase international competitiveness, improve fiscal arithmetic
  • Pursuit of self-interest (beggar-thy-neighbour) undermines world trade
changes in exchange rates and industrial production 1929 1935
Changes in Exchange Rates and Industrial Production, 1929-1935
  • Finland
  • Denmark
  • Sweden
  • United Kingdom
  • Norway
  • Germany
  • Italy
  • Netherlands
  • Belgium
  • France

Production 1935








Exchange Rate 1935


bad behaviour
Bad Behaviour
  • Fixed exchange rate systems potentially undermined by big balance of payments surpluses
  • Gold hoarding by France and USA put severe deflationary pressure on the gold standard
  • Deficit countries took the strain of adjustment (initially)
regime change
Regime Change
  • US escape from liquidity trap after 1933 based on leaving gold
  • Changed inflationary expectations and reduced real interest rates
  • Needed a new policy framework; ambiguity about this became a problem in 1937
fiscal stimulus
Fiscal Stimulus
  • With interest rates at zero-bound, expect fiscal multiplier to be relatively large
  • On balance, 1930s evidence suggests this is right; values for UK and US of 1.5+
  • In the early 1930s, fiscal policy didn’t fail, it wasn’t tried; Keynesian stimulus later on from rearmament
fiscal consolidation
Fiscal Consolidation
  • Exposes economy to risk of double-dip recession if monetary policy not supportive
  • USA in 1937/8 is perfect unpleasant example
  • Monetary policy was supportive when real interest rates were held down
  • Suggests conventional inflation targeting not appropriate at lower bound

A Recession to Remember:Real GNP in USA

Source: Balke and Gordon (1986)

banking crises
Banking Crises
  • Asset price collapse, non-performing loans, scramble for liquidity, shortage of collateral: credit for investment severely restricted
  • Market failure with asymmetric information
  • Frequent when bank regulation inadequate especially when capital is internationally mobile
  • Imply major decline in economic activity not just ordinary recession and fiscal hangover
  • Easy to understand ex-post; hard to predict
banking crisis impact on potential output
Banking Crisis: Impact on Potential Output
  • Output is permanently reduced (making structural budget deficit worse)
  • Direct and indirect effects: investment and policy response
  • In 1930s USA, New Deal increased U* and collapse in investment meant lower capital stock … but TFP growth remained very strong
  • Y* in 1941 at least 10 per cent below 1929 forecast
resolving the banking crisis
Resolving the Banking Crisis
  • Re-capitalizing and re-regulating banks was key part of Roosevelt’s policy
  • Deposit insurance (and moral hazard) is important legacy of the depression
  • Accompanying bank regulation was politically captured and not well designed but did deliver financial stability for several decades in ‘capital-immobile’ world
concluding thoughts
Concluding Thoughts
  • Once the crisis began, economics informed by economic history has done quite well and we haven’t repeated the worst errors of the early 1930s
  • Failure to predict the crisis both now and then understandable; failure to prevent the crisis may be less forgivable since economics does explain very clearly why banks fail
world industrial production now vs then
World Industrial Production, now vs then

Source: Eichengreen & O'Rourke (2010)