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The Great Depression (1929-1941). Housekeeping. Midterm on Wed October 9 11:35-12:50 pm Law School Auditorium (NOT Dunham Lab) TF office hours Review sessions Mon and Tues night (see class web site). Final questions?. Key Elements in the Great Depression 1929-1933.
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The Great Depression (1929-1941)
Housekeeping Midterm on Wed October 9 11:35-12:50 pm Law School Auditorium (NOT Dunham Lab) TF office hours Review sessions Mon and Tues night (see class web site). Final questions?
Key Elements in the Great Depression 1929-1933 • Started as asset price bubble and burst in 1920s • Gold standard hamstrung central banks from expansionary actions. • Collapse of investment and international trade after 1929 • Multiple bank failures through 1933 (standard panic model) • Unclear why so deep and persistent: low level equilibrium? • No effective fiscal policy until 1940 • Trough finally reached in 1933, but no sharp recovery • Recovery came only with fiscal expansion in World War II
Tales of the labor market in recession/depression: “I’d get up at five in the morning and head for the waterfront. Outside the Spreckles Sugar Refinery, outside the gates, there would be a thousand men. You know dang well there’s only three or four jobs. The guy would come out with two little Pinkerton cops: “I need two guys for the bull gang. Two guys to go into the hole.” A thousand men would fight like a pack of Alaskan dogs to get through. Only four of us would get through.” Studs Terkel, Hard Times.
Growth in Key Indicators H = high powered money. Periods are: • Pre-crash boom • From crash to Britain’s leaving gold in October 1931 • From gold crisis to trough Note: rates of change at annual rates.
Alternative views of the sources of the GD Classical theories: • Basically a variant on real business cycles • Complicated story for another time. Bottom line is that it 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
IS interpretation of the depression interest rate (r) IS1929 IS1933 MP Y1929 Y1933 0 Real output (Y)
I. The Expenditure Approach: IS Shocks Were shocks in the IS curve responsible? • Foreign trade, government spending and taxes were too small to cause depression • No apparent exogenous consumption shock • Investment decline was the major shock. • Panics, high risk premiums, low output, unstable dynamics • Shift to “bad investment equilibrium” clearly at work
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. financial market stability (asset prices, panics, liquidity) 2. exchange rates (gold standard and convertibility) 3. macroeconomy (inflation, output, and employment) • Fed was primarily concerned about (#1) speculation in 1928-29 and tightened money at that point. • When depression was underway, Fed was primarily concerned with defending the gold standard (#2) 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 (#3).
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)
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)
Problem with monetarist interpretation of Depression Tobin wrote severe critique of Friedman and Schwartz. Problems: • While it is true that M1 fell, it is likely to be a consequence rather than a cause of the Depression (Tobin). • Interest rates fell rather than rose (much like today). • While Fed might have done more, hard to see how they caused the Depression
Interest Rates 1920-39 Problem with monetarist interpretation: Safe interest rates fell in GD!!!
Fed interest rates: Great Depression and Great Recession
Bad equilibrium view of Great Depression A final approach: • Began with asset price bubble and high leverage. • Then had huge IS shock due to risk, panics, deflation, and the result was high risky real interest rates. • This forced economy into a liquidity trap (like today), so that monetary policy was ineffective. • Government was too small to have effective fiscal policy. • Got locked into “bad equilibrium” of deflation, high risk premiums, fear, low investment, and low spending. • And that lasted until 1940!
IS1929 interest rate (i) IS1933 MP1929 = MP1933 MP1939 Y1929 Y1933 0 Y1939 Real output (Y)
The Roosevelt Presidency (1933-1945) “We have nothing to fear but fear itself.”
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!
IS1945 • Stimulus was 25% of GDP. • Equivalent to $4 trillion/year stimulus package interest rate (i) IS1939 WW II Y1945 MP 0 Y1939 Real output (Y)
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.
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 “bad depression equilibrium” • Size of WW II stimulus suggests that no ordinary monetary or fiscal policy could have quickly ended the depression. • Can it happen again? To answer need to understand how macroeconomic theory and institutions have evolved.
