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The Great Depression

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The Great Depression

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    8. 8 The Great Depression and The Japanese Slump Monetary Economics (Macro VI) Marcelo Mello Spring - 2010

    9. References Mankiw, N. G., (2006), Macroeconomics, Worth Publishers. Blanchard, O. (2005), Macroeconomics, Prentice Hall. The Economist, several issues. Pictures of the Great Depression, http://history1900s.about.com/library/photos/blyindexdepression.htm Walton, G., and H. Rockoff, History of the American Economy, 10th edition, 2005.

    10. 10 What caused the Great Depression? In 1929 the unemployment rate in the U.S. was 3.2%. In 1933, it was 25.2%... What caused the depression? Shocks to the IS curve? Shocks to the LM curve? As shown below, the Great Depression provides an interesting case study for the IS-LM model.

    11. Data Source The data below is taken from Mankiw, N. G., (2006), Macroeconomics, Worth Publishers.

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    14. 14 The Spending Hypothesis One hypothesis about the causes of the GD is the so-called Spending hypothesis which suggests that the depression was caused by contractionary shifts in the IS curve. Popular view associates the depression with the stock markets crash of 1929. However, the evidence suggests that the recession started before the stock market crash of 1929.

    15. 15 The Spending Hypothesis, cont. Several shocks to the IS curve may have exacerbated the initial reduction in spending. Shock 1: the stock market crash of 1929 may have caused a significant shift in the IS curve: by reducing wealth and increasing uncertainty in the economy consumers were induced to save more rather than continue spending. Over the period 1921-1929 the stock market boomed. Was the crash the end of a speculative bubble?

    18. 18 Shock 2: Boom-bust cycle in housing. Some economists suggest that the decline in spending was associated with a large drop in residential investment. The 1920s were marked by boom in residential investment. Once the “overbuilding” became apparent the demand for residential investment fell substantially. The slow down in residential and non-residential construction began in 1925, and by 1928 was a full-fledge decline.

    19. 19 Shock 3: Another possible reason for the decline in the demand for residential investment was the large drop in immigration in the 1930s. The next slide shows data on immigration arrivals taken from Walton and Rockoff (2005).

    21. 21 Shock 4: Contractionary fiscal policy of the 1930s. The Revenue Act of 1932 increased various taxes on middle and high-income consumers. The top income tax after the Act was signed into law was 63% ($1 million/year) The Act also raised corporate taxes by almost 15%.

    22. 22 Shock 5: Credit-crunch - a large number of bank failures (more on that later) may have exacerbated the fall in investment by not providing enough credit to healthy firms. October 1930: Bank failures in the South and Midwest December 1930: Bank of the United States in NYC failed. This was the largest bank failed by deposits until then.

    23. The Smoot-Hawley Tariff June 1930: the Smoot-Hawley Act was approved in Congress. The Smoot-Hawley Act increased the import tariff on a number of agricultural goods. Was the Smoot-Hawley Act a cause of the depression? Probably, not. But, it certainly didn´t help. In the least, it made a bad situation worse.

    24. 24 The Money Hypothesis This hypothesis places primary blame for the depression on the Fed. The money supply fell 25% from 1929 from 1933. However, the price level also fell by 25% in the 1929-33 period. Thus, M/P remained unchanged – no shift in the LM curve.

    25. 25 Does that mean that monetary events were irrelevant to explain the depression? As shown below, monetary events were very important in explaining the depression. The Monetary Hypothesis is associated with Milton Friedman and his brilliant book “A monetary History of the U.S, 1867-1969, co-authored with A. J. Schwartz.

    26. 26 M1=currency +checkable deposits M1=H*multiplier, where H=monetary base=currency +banks’ reserves. The multiplier depends on how much reserves banks keep in proportion to their deposits, and on the proportion of money people keep in the form of currency as opposed to checkable deposits.

    27. 27 The monetary base, H, increased from 1929 to 1933. This implies that the decrease in M1 came from the decrease in the money multiplier. Why did the multiplier decline so much? Because of a large number of bank failures. From 1929 to 1933 there were 4,000 bank failures in the U.S. (out of 20,000 banks).

    28. 28 Checkable deposits at failed banks became worthless. Moreover, once banks start to go bust people take their money out of the banks. These events caused to the money multiplier to decrease.

    29. 29 According to Milton Friedman, the Fed didn’t cause the depression but it was responsible for the depth of the depression. The Fed should have increased the money supply enough to more than offset the decrease in the money multiplier. This would have shifted the LM and helped the economy get out of the depression (or even avoided the depression). Furthermore, we had the problem of deflation.

    30. 30 Is deflation bad? As P falls, real money balances increases, M/P. This effect causes the LM to shift down, which leads to higher income. The Pigou Effect: Real money balances are part of households’ wealth. As P falls and real money balances rise, consumers feel richer and want to spend more. This would cause an expansionary shift in the IS curve. In reality, the Pigou effect is small and goes unnoticed (because M/P is a small fraction of wealth).

    31. 31 The destabilizing effects of deflation Debt-deflation theory: unexpected changes in inflation redistribute wealth between debtors and creditors. Real debt is defined as Debt/P. If P falls, the debt increase in real terms. This distributes wealth from debtors to creditors.

    32. 32 If firms are indebted, in the face of deflation, they will be reluctant to borrow and invest. It’s a better deal to pay off debts - IS shifts to the left. How does expected changes in prices affect income?

    33. 33 • Recall that r=i-pe. Investment depends on the real interest rate, and the money demand depends on the nominal interest rate. • The IS-LM model: Y=C(Y-T)+I(i-pe,Y)+G M/P=L(i,Y)

    34. 34 Suppose that initially we have pe=0, and that suddenly everyone expects deflation, that is, pe<0. For a given nominal interest rate, the real interest rate must be higher. ? r=i-pe? The increased real interest rate reduces investment. This causes the IS to shift to the left.

    35. 35 Conclusion: What caused the Depression? There were several negative shocks to the IS curve in the 1930s. Furthermore, the Fed’s inaction may have made a bad situation worse. The amount of real money balances, M/P, didn’t change during the GD (which means that the LM curve didn’t shift) but the fact that we had deflation may have caused the IS to shift further to the left.

    36. 36 The Fed should have increased the money supply in an attempt to change inflation expectations. A large increase in the growth rate of the money supply could have reversed inflation expectations, from pe<0 to pe>0. Given that the nominal interest rate was so low, positive inflation expectations would have generated low or negative real interest rates, which would have increased investment shifting the IS to the right.

    37. 37 Finally, policy makers at that time didn’t know about the IS-LM model. Imagine that: raising taxes to balance the budget in the midst of a recession!!! Macroeconomics as a science was at best in its infancy at that time of the Great Depression. In fact, some say that the Great Depression marks the birth of macroeconomics with the publication of Keynes’s General Theory in 1936.

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    46. The Trouble with Japan • After spectacular growth rates since the 1950s, Japan’s growth came to a halt in the 1990s • Average growth from 1973 to 1991 was 4%; from 1992 to 2001 it was less than 1% • Highest unemployment rate since WWII

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    48. 48 What went wrong? Low interest rates in the 1980s set off a borrowing binge Many loans went into real state, where prices were not set by the market but rather by self-serving bureaucrats Anecdotal evidence says that the Gardens of the Imperial palace in Tokyo were worth as much as the entire state of California

    49. 49 Land was used as collateral for almost all bank loans ? borrowing became easy. Stock market bubble: In the 1980s, the Nikkei 225 was 14 times the DJ. In 1980 the Nikkei 225 was 7,000; in 1989 it was 35,000. Bank and Business in Japan are tied together – if one goes bust, so does the other.

    50. 50 Loans were granted on the basis of personal relations rather than efficiency criteria. Politicians were desperate to create jobs, mostly because of cultural aspects. They place most of the laid off workers in the construction sector. So they build roads, bridges, airports, etc., connecting no place to nowhere - but Keynesian fiscal policy.

    51. 51 About 10% of Japan’s work force (6m people) are in construction. Without government support, some estimate that 50% of the industry might collapse. Another 3m people would join the unemployment pool.

    52. 52 The Crash At the end of 2001 the Nikkei 225 stood at slightly above 10,000, less than one-third of its value at the peak. In the 1980s, the Nikkei 225 was 14 times the DJ. In early 2002, it was below the DJ. The bursting of the stock market bubble had a major impact on output. Since 1991, commercial property prices declined by an average of 84% in Japan’s six biggest cities.

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    54. 54 Financial Meltdown Japan’s Banks: too many, too weak, and too burdened by non-performing loans. The government admits that “bad” loans amount to 7% of the GDP. But nobody believes. Rumor has it that the right figure is about 35% of the GDP. Some companies are in dire straits: retailing and construction. High number of bankruptcies

    55. 55 Japan is the world’s second largest economy. Japan’s GDP is approximately 4.5 trillion dollars. That’s approximately 8% of the world GDP. A banking crisis in Japan would be felt internationally. What can be done to prevent the banking crisis and lift Japan out of the recession? First, let’s have a look at fiscal and monetary policy in Japan in the 1990s

    56. 56 Aggregate demand management policies didn’t work in Japan. Why? Fiscal policy was used. High government spending and low taxes generated a string of budget deficits. The public debt GDP ratio increased from 61% of the GDP in 1991, to 130% of the GDP in 2001. It will reach more than 160% of the GDP by the end of 2004, and 185% by the end of 2006.

    57. 57 Fiscal policy did little to lift the economy out of the recession. However, some say that without it, things could have been a lot worse. Monetary policy was used also. But too late, and had very little effect. Why?

    58. 58 The Liquidity Trap What is it? When the nominal interest falls to zero, the central bank cannot reduce it further by increasing the money supply. At i=0, money and bonds became perfect substitutes.

    59. 59 Clearly, it is impossible to have a negative nominal interest rate - if I lend you $100 at a nominal rate of -10%, you pay me back $90??? Negative nominal interest rates imply disequilibrium in the bonds market: money is strictly preferred to bonds, and bonds therefore would be in excess supply.

    60. 60 At a zero nominal interest rate, i=0, “traditional” monetary policy becomes ineffective: Individuals will be willing to hold more money (more liquidity) at the same nominal interest rate. Increases in the money supply will not affect the interest rate. In this case, downward shifts in the LM curve will NOT increase output.

    61. 61 The Liquidity Trap and Deflation Does it matter if the nominal interest rate hits the zero-lower bound? It depends. If i=0 and pe<0, then we are in trouble. Study the Great Depression! Consider the Fisher equation again: r=i-pe

    62. 62 • If i=0, we have that r=-pe, but in the case of Japan individuals expected deflation, that is, pe<0. Therefore the real interest rates are positive. For example, i=0 and pe=-10%, we have that r=10%. • Note that, if i=0, and pe=10%, then r=-10%. That is, when individuals expect inflation, the liquidity trap is not a problem.

    63. 63 Debt-Deflation theory When prices are falling individuals and firms are unwilling to borrow, which reduces aggregate demand. Furthermore, highly indebted individuals and firms face a higher financial burden because their debt increases in real terms as P falls. The above effects increase the number of bankruptcies, causes financial fragility, reduces aggregate demand, aggravating the deflation problem.

    64. 64 How can Japan get out of the recession? There are two urgent problems in Japan. First, the Japanese government must clean up the banking system. Second, it needs to reflate the economy. To tackle the first problem, the government should allow the loss-making firms and banks with lots of “bad loans” to go bust – this measure carries a very high political cost. It is hard to believe that Japanese politicians will pay such a high price.

    65. 65 There are several ways to reflate the economy. The BoJ could announce inflation targets for the economy, for instance. If individuals expect the BoJ to generate inflation, that is, pe>0, then there will be inflation, that is, p>0. This strategy requires a key ingredient: individuals’ expectations The problem is that the BoJ is too conservative, and nobody believes when it says that it wants to generate inflation.

    66. 66 But the wheels do turn … Real GDP increased by 1.3% in 2003, is projected to increase by 2.7% in 2004. Deflation has eased, -0.3% in 2003, 0.0% in 2004, but we may have -0.1% in 2005. The number of bankruptcies in 2003 was down 14% compared to 2002 The burden of bad loans is slowly diminishing.

    67. 67 What can explain the revival of the Japanese economy? China’s economic boom is pushing Japanese exports Corporate restructuring BoJ’s monetary policy has become credibly expansionary

    68. 68 The importance of being credible Toshihiko Fukui took over as the central bank’s governor in 2001, and has promoted a credibly expansionary monetary policy. Basically, the BoJ is committed with a loose monetary policy until consumer price inflation turns positive. His predecessor, Masaru Hayami, probably the world’s worst central banker, once argued that when interest rates hit the zero lower bound monetary policy could not halt deflation. That’s plain wrong.

    69. 69 But not all is well… If China’s economy falters, Japanese exports would be seriously hurt The yen is appreciating against the dollar. Further appreciation would make a dent in Japan’s exports Public debt hit an all-time high of 160% of the GDP in 2004; may reach 185% in 2006. Financial system still fragile, several firms are also in a “zombie” state

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    71. 71 How can we prevent deflation? Deflation can be prevented by avoiding large drops in aggregate demand. This can be attained by using monetary and fiscal policy to support aggregate demand. Also the central bank should set inflation targets so as to preserve a buffer zone for the inflation rate. For instance, the ECB has a target inflation rate of 2%, not zero. Ensure financial stability.

    72. 72 How can the central bank conduct monetary policy when i=0? In emergency situations – press the button. That is, by printing money the Fed can always generate inflation. Thus, when i=0 and pe<0, the central bank increase the money supply to the point where deflation becomes inflation. The fed can inject money in the economy by making low-interest loans to banks and the fiscal authority.

    73. 73 The central bank can lower the rates on bonds of longer term maturities. The central bank can buy domestic government debt (monetization). Exchange rate devaluation – increase the price of imported goods, cause inflation – but this is not such a good option. Cooperation between monetary and fiscal policy – tax-cut financed by money printing. It would stimulate aggregate demand and most likely increase P.

    74. 74 Conclusion Deflation can be very destructive, as we have seen in at least two episodes (the Great Depression and the Japanese Slump). Policy makers are not defenseless against deflation.

    75. 75 During the Great Depression policy makers were incompetent (the Fed didn’t act on time) and ignorant (e.g., contractionary fiscal policy), the same applies to Japan, with one added problem – politicians in Japan are very conservative and avoid taking hard decisions at any cost.

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