The Downturn of 192021

1
The Downturn of 1920-21

• 1920-1921 Nominal GNP falls 23.9, Real GNP
  falls 8.7, Prices fall 15.2
• 1929-1930 Nominal GNP falls 12.3, Real GNP
  falls 9.9, Prices fall 2.4

2
Aggregate Demand

• AD C I G NX
• AD Aggregate Demand
• C Consumption
• I Investment
• G Government Spending
• NX Net Exports Exports - Imports

3
Consumption Joseph Schumpeter

• Labor productivity rise rapidly in the 1920s, due
  to improvements in technology.
• Real wages do not rise as rapidly as labor
  productivity, hence the ability to produce goods
  exceeded the ability to purchase these
  commodities. The Great Depression was simply a
  re-adjustment.
• Evidence Number of labor hours required to
  produce a unit of output in manufacturing fell
  40, but nominal wages changed very little
  (prices fell 20 which means real wages did
  rise).
• Corporate profits rose, which meant that income
  was shifted from those that consume to those that
  save.
• Problems Why does consumption collapse after
  1929 after the economic downturn has begun?
• Why do prices not adjust? Prior to this time
  there was very little evidence of rigid prices.

4
Consumer Confidence Peter Temin

• From September of 1929 till June of 1932, about
  179 billion in wealth was lost on the nations 34
  exchanges.
• Stock ownership, however, was limited. Only 5
  million people owned any stock and perhaps
  500,000 owned 75-85 of outstanding stock.
• However, the decline in the stock market may have
  impacted expectations.
• From Temins perspective Consumers revised
  expectations downward in 1930, leading to a
  significant drop in consumption.
• Problems Why would consumers adopt a pessimistic
  model when the most recent experience of the
  nation (1920-1921) suggests the downturn was only
  temporary?

5
Investment John Maynard Keynes

• 1929-33 Gross investment falls to a point where
  dis-investment occurs. In other words, the
  nations capital stock was actually declining.
• Problems Investment began declining after the
  peak in 1926. The biggest portion of investment
  that declined was residential construction.
• Why did residential construction decline? Both
  birth rates and immigration were falling.

6
Government Spending

• 1929 Budget surplus of 1.3 billion
• 1930 Budget deficit of 1 billion (820 million
  more than Treasury Secretary Mellon predicted)
• 1931 Budget deficit rose to 2.7 billion
• After this, the federal government raised taxes
  in 1932, after cutting taxes in 1930. The
  increase in taxes played a role in intensifying
  the recession. It should be noted, though, that
  government spending did not cause the Great
  Depression, it simply led to its
  intensification.

7
Net Exports

• Net exports in 1928 was 1 billion, in 1936 33
  million. WHY?
• International economic decline. In 1929, exports
  rose, but net exports fell as imports rose in the
  U.S.
• Over time, though, U.S. exports fell due to
  weakening demand conditions. Britain financed
  its trade deficit via short-term borrowing. Low
  New York interest rates made London assets more
  attractive. However, when American interest rates
  rose in 1928, the British policy was no longer
  feasible. Rising U.S. interest rates resulted in
  declining demand for U.S. imports
• Smoot-Hawley Tariff legislation
• Problem International trade was still a small
  part of GDP

8
The Monetarist ViewMilton Friedman and Anna
Schwartz

• Cause of the initial downturn Money supply grows
  3.8 in 1927 and 1928
• From 1928-29, via Fed policies to discourage
  speculation, the money supply is lowered so that
  it grows only 0.4.
• Between April, 1928 and November, 1928 the money
  supply fell at a rate of 1 per year.
• If this was unanticipated, then this may have
  been sufficient to cause a downturn in business.
• Note This view was first articulated by Keynes
  at the onset of the Great Depression.

9
Intensification of the Downturn

• Stock Market Crash of 1929
• First Banking Crisis (October 1930 February
  1931)
• Second Banking Crisis (March 1931- August 1931)
• Britain Abandons the Gold Standard
  (September,1931)
• Final Banking Crisis (October 1932 March 1933)

10
Friedmans Argument

• Friedman and Schwartz cite bank failures as the
  primary cause of the Great Depression.
• What caused the bank failures? Public lost
  confidence in the ability of banks to repay
  deposits on demand and chose to substitute
  currency for demand deposits. The failure of one
  bank led to a contagion of fear until more than
  9,000 banks (more than 1/3 of the nations total)
  had failed.
• Had the Fed acted with more vigor in bolstering
  banks, Friedman and Schwartz argue the Great
  Depression could have been avoided.

11
The Austrian View

• The interference in the economy by the Federal
  Reserve and the Federal Government merely
  prolonged the time it took for the economy to
  re-adjust back to full employment.
• Had the government pursued a policy of
  laissez-faire, the economy would have rebounded
  quickly, as it had done in past recessions.
  Government interference hindered the process by
  which the economy liquidates the unsuccessful.
  
• In essence, this is similar to Schumpeters view
  of recession in general.

12
Why did the Fed not do more?

• Contradictions in objectives The Fed may have
  seen the defense of the gold standard as its
  primary objective, not serving as lender of last
  resort to failing banks.
• The dominance of the liquidationist movement on
  the Fed board.
• Death of Benjamin Strong, who in essence invented
  open market operations.
• The Fed policy represented rent seeking by member
  banks. 75 of banks that failed were non-member
  banks and the Fed had argued since its inception
  that the dual system would not work.
• Failure rates among member banks was still
  significantly higher than the 1920s.
• It is not clear how the Fed would target
  non-member banks.
• Rents never appeared for the member banks after
  the failure of a significant number of nonmember
  banks.