The Great Depression 19291933 The Defining Moment

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The Great Depression1929-1933 The Defining
Moment
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Why Great Depression

• Ben Bernanke To understand the Great
  Depression is the Holy Grail of macroeconomics.
  Not only did the Depression give birth to
  macroeconomics as a distinct field of study, but
  also---to an extent that is not always fully
  appreciatedthe experience of the 1930s continues
  to influence macroeconomists beliefs, policy
  recommendations and research agendas..We do not
  yet have our hands on the Grail by any
  means..(JMCB, 1995)

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Rex Tugwell (advisor to Roosevelt)The Cat is
out of the Bag. There is no invisible hand.
There never was. If the depression has not
taught us that we are incapable of education..We
must now supply a real and visible guiding hand
to do the task which that mythical, nonexistent,
invisible agency was supposed to perform, but
never did.
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The Prelude 1919-1929

• U.S. enters the war late. (1917-1918) effects on
  U.S. economy relatively small compared to
  European economies.
• Huge damage and disruption to European economies.
• Real GDP 100 in 1913. In 1919, UK101
  France75 Germany72 US 116
• Inflation! Price level 100 in 1914. In 1918
  UK210 France213 Germany304 US164
• Huge climb in Debt/GDP ratios.

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Consequences

• World War I---9.5 million deaths. Loss of a
  generation (UK 1m, France 1.4m, Germany 2m, US
  114,000)
• Destruction of physical capital especially
  Belgium and northern France
• Distortion of patterns of production, trade and
  consumption (e.g. high wartime prices for
  commoditiesboom and collapse in U.S.
• High cost of war. Estimated 208 billion.
• Political and economic borders of Europe are
  redrawn.
• Inter-allied war debts and German reparations.

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Inter-Allied War Debts ( billions)
(Kindleberger,The World in Depression
France
4.0
3.0
4.7
3.5
United States United Kingdom
8.1
3.2
Other Countries
To pay principal and interest, war devastated
economies would have to run balance of payments
surpluses.
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German Reparations

• John Maynard Keynes (1919) Reparations were a
  policy of reducing Germany to servitude for a
  generation, of degrading the lives of millions of
  human beings, and of depriving a whole nation of
  happiness. They were abhorrent and
  detestable.
• Étienne Mantoux (1946) Reparations not excessive,
  destructive or uncollectible.
• The French paid in 1815 and 1871---Le Boche
  Paiera

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The magnitude of reparations
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Solution---the Dawes Loan 1924

• German Hyperinflation.
• Dawes Loan---begins series of loans---U.S.
  provides funds and funds for investment around
  the globe.
• New York as central of global financenot London

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Return to Gold StandardStatus Quo Antebellum

• No problem for U.S.huge balance of payments
  surpluses and gold
• U.K. deflates and returns to gold in 1925 at old
  parity 1 4.86. But overvalued. Depressed
  economy.
• France with near hyperinflation returns to gold
  in 1926 at a new parity (old 1 5FF now 1
  25.5 FF) Undervalued currency. Booming economy.
• Germanys hyperinflation---returns to gold at
  near purchasing power 1925.
• Major imbalances---brittle equilibrium.

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Adjustment under restored gold standard more
difficult

• International capital markets are
  revived---generally free.
• International labor flows almost
  eliminatedimmigration restrictions
• Increased protectionism
• Less wage flexibility. Wage now seem sticky even
  with high unemployment

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U.S. Economic Prosperity in 1920s

• No trend inflation
• High productivity growth
• 1922-1929, GNP grew at 4.7,
• Unemployment averaged 3.7.
• Fed accommodated seasonal demands for credit and
  attempted to smooth economic fluctuations. (2
  brief recessions)

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Some basic numbers

• Peak August 1929, Trough May 1933
• Real GDP falls 39
• Real Consumption falls 29
• Prices (GDP deflator) falls 23
• Unemployment Jumps
• 3.2 in 1929
• 25 in 1933 (21Darby)
• 17 in 1939 (17 Darby)
• Banking Collapse
• July 1929, 24,504 banks, 49 billion deposits.
• December 1932, 17,802 banks, with 36 billion.
• After Bank Holiday March 1933, 11,878 banks with
  23 billion deposits.

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Key American Role in World Depression

• Based on industrial production GD starts in most
  countries at the same time
• But it is larger and longer in the U.S. Romer
  (1993)

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Worst in the U.S.

• For the U.S., Industrial Production
• Biggest drop in first year
• Biggest drop peak to trough
• Biggest drop in the last year.
• However, turning points are very similar

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Understanding the Great Depression Its
Evolution by Phases

• Booming Strong Economy in 1920s
• Beginning Shocks, 1928-1929
• Aggravating Shocks, 1930-1933
• Rock Bottom and Recovery, 1933-1936
• The 1937-1938 Recession
• The Recovery, 1939-1941

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Understanding the Great DepressionFour Basic
Questions

• Why it Began?
• Why so Deep?
• Duration?
• Recovery?

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Understanding the Great Depression Its
Evolution by Phases

• Booming Strong Economy in 1920sbut
• Its the Roaring Twenties!
• No trend inflation
• High productivity growth
• 1922-1929, GNP grew at 4.7,
• Unemployment averaged 3.7.
• Fed accommodated seasonal demands for credit and
  attempted to smooth economic fluctuations. (2
  brief recessions)
• BUT Weak American Agriculture low prices, high
  debt, weak banks
• BUT Weak Europe reparations, debts to U.S.,
  slow growth, gold standard fragile (overvalued ,
  UK slumps) and (undervalued FF, France booms)
• BUT U.S. Stock market boom halts foreign loans
  to Germany, Eastern Europe and Latin America

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Understanding the Great Depression Its
Evolution by Phases

• Beginning Shocks, 1928-1929
• Spring 1927 U.S. expansionary monetary policy to
  ease pressure on the British balance of payments.
  Critics assert policy too easy, and allows stock
  market boom to ignite
• Fed tightens policy in 1928 (discount rate 3 ½ to
  5, and there is little increase in total money
  or credit for 1928-1929.
• U.S. stock market boom begins March 1928.
• Commercial paper market vanishes
• No new lending to Germany, Austria and rest of
  work in 1928.Germany slides into a recession.
• Fed tries to jaw-bone market down. Criticizes
  brokers loans.
• July 1929 raises discount rate from 5 to 6.
• But July-August is peak of business cycle.
  Recession begins Summer 1929
• October 1929 U.S. Stock market crash wealth
  effectlowers consumption and investment, credit
  effectreduces value of collateral and hence
  lending
• Smoot-Hawley tariff 1929 by U.S. induces
  retaliatory tariffs by other countries,
  international trade declines

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Understanding the Great Depression Its
Evolution by Phases

• Aggravating Shocks, 1930-1933
• Banking Panics, 1930, 1931, 1933
• Failure of the Fed to Pursue Expansionary Policy
• Collapse of Gold Standard Austria, Germany leave
  the gold standard, Britain departs after a run on
  the pound in September 1931
• U.S. begins losing gold, trade deficits and
  capital flight.
• From Rock Bottom to Recovery, 1933-1936
• Bank Holiday March 1933
• U.S. abandons the Gold Standard March 1933
• New Deal Banking and Securities Legislation
• Monetary Expansion
• Minimal Fiscal Policy
• National Industrial Recovery Act (NIRA)
• The 1937-1938 Recession
• The Fed Raises Reserve Requirements
• The Recovery, 1939-1941
• Monetary Expansion
• Fiscal Expansion in preparation for war.

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Four Basic Questions1. Why It Began? 2. Why So
Deep and 3. So Long?

• Friedman and Schwartz (and others), the economy
  is entering a recession in late 1929
• The economy is beginning to recover in 1931 like
  a normal business cycle
• BUT what makes the recession worse?
• What turns the recession into a depression?

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The Worsening Depression

• Slight recovery early 1931,then plunge.
• Why?
• Romer (1993) The source of the continued decline
  in production in the United States was almost
  surely a series of banking panics.
• Friedman and Schwartz (1963) document four panics
• Fall of 1930
• Spring 1931
• Fall 1931---Britain abandons the Gold Standard
• First Quarter 1933
• 9000 Banks suspend operations. Depositors and
  stockholders lose 2.5 billion 2.4 of
  GDP...not the whole story

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Why are there banking panics?
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Why Banking Panics?

• There were no banking panics in Canada.
• Fragmented unit banking system
• Undiversified bank portfolios with high regional
  concentration of loans. Large number of bank
  closures in the agricultural states when
  agricultural prices fall. In addition, many hold
  bonds whose value collapsed.
• Many banks become insolvent
• Fear of insolvency feeds the liquidity
  crises?panics.

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Effects of Banking Panics

• Money Supply Declines and there is a massive rise
  in realized real interest rates, over 10.
• Friedman and Schwartz blame inaction of the Fed
  for this decline---and hence for the depression.

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How do Friedman and Schwartz explain why the Fed
did not act?

• Up to end of 1930
• What is the Fed concerned about?
• How does it react to banking failures?
• Who was Benjamin Strong?
• New York Fed v. Board of Governors?
• What could the Fed have done 1930-1931?
• What does Congress do?

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Why didnt the Fed act?

• Beginning in 1931, Friedman and Schwartz argue
  that Fed could have expanded but chose not to.
• In diary of Charles S. Hamlin member of the FR
  Board, he wrote during August 1931 that Open
  market committee voted 11 to 1 against 300
  million open market purchase of bonds---reduce it
  to 120 million.
• Governor Mayer of the Board worried about
  inflation.
• Members of the regional banks did not grasp the
  extent of the crisis.
• Pressure from Congress---open market operations
  of 1 billion. Until Congress adjourns.
• After Britain leaves gold in September 1931, gold
  drain starts. Dollars exchanged for gold---Feds
  reserves fall, it is afraid that further
  expansion will lead to greater loss of
  gold----constrained by the gold standard.
  Reserves falling after UK goes off gold in 1931,
  must retain high interest rates.

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Understanding the Great DepressionFour Basic
Questions

• Why it Began?
• Why so Deep?
• Duration?
• Recovery?

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Understanding the Great DepressionFour Basic
Questions

• Why it Began?
• Business Cycle Peak 7/8-1929, Federal Reserves
  tight policy
• Why so Deep?
• Banking Panics. Inaction of the Federal Reserve
• Duration?
• Recovery?

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How is the economy driven into a severe
depression by the declining money supply?What
is the mechanism of transmission?Several
Explanations
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Romer (1993) basic argument is simple

• Depression is the result of a series of aggregate
  demand (monetary) shocks that moved economy down
  an upward sloping aggregate supply curve.

Price Level
Price Level
Output
Output
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Romer (1993) basic argument is simple

• Depression is the result of a series of aggregate
  demand (monetary) shocks that moved economy down
  an upward sloping aggregate supply curve.
• Result is two problems (1) unemployment and (2)
  deflation.
• Unemployment
• Key point is the upward sloping supply curve.
  Wages and prices not perfectly flexible in 1920s
  and 1930s.
• Why did they become less flexible? Some studies
  point to turn-of-the-century change in labor
  contracts, World War I or desire of business to
  keep demand strong.
• Wage and price stickiness means that aggregate
  demand shocks will have real effects.

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The Sticky Wage Conundrum---markets dont seem to
clear
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How did deflationary shocks affect the economy?

• Conventional 19th century view fall in wages and
  prices raises stimulate investment, countering
  shock.but not in sticky price world.
• How did the monetary shocks hurt the economy?
• Explanation 1 High real interest rate
  hypothesis Deflation affects expectations.
  Deflation generates expectations of higher real
  rate of interest, raising real rates and driving
  down investment
• Explanation 2 Debt-Deflation hypothesis
  Unanticipated inflation increased real debt,
  increasing defaults and thus depressing supply of
  credit

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Rising Real Interest RatesDid the Fed understand?
r i p(expected)

• Nominal commercial paper rate 1927.4 to 1928.4
  rises from 4.0 to 5.5 and the realized real
  rate from 5.6 to 9.5.
• Rational expectations estimates by Romer of the
  expected real interest rate are shown to
  rise----implying higher anticipated interest
  rates.
• Interest sensitive industries begin to slow in
  1929 building permits and automobile
  registrations.

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• Sources of the onset1929-1930/1931 contrasts
  previous experience
• The decline in consumer spending and fixed
  investment that are the key elements that need to
  be explained.

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Romer (1992)
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The Risk Premium during the Depression
Rate Romer uses
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Debt Deflation Hypothesis Hamilton looks at the
futures markets for predictions of future
prices----errors random until 1930s when
underestimate deflation seriously----dont
believe that crisis will continue
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Klug, Landon-Lane and White looked at the
forecasts of Railroad Shippers and found huge
cumulating errors in forecasts of
carloadings---businessmen keep thinking that
recovery is around the bend.
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Bernankes Contributiona Third Factor

• In addition to monetary collapse, there was a
  disruption of intermediation.
• Bernanke (1983) banks play special role for
  firms that cannot issue bonds and stocks. When
  banks fail the information and relationships are
  lost and the cost of credit intermediation rises.
  Costs include screening, monitoring, and
  accounting costs as well as expected losses from
  bad borrowers.
• Major contribution to economic decline 1931 and
  1932.

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Banking crises an important determinant of loans
as much as industrial production. Liquidation of
loans after stock market crash But then credit
declines little even though IP falls 25 until
banking crises.
Panic begins
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Understanding the Great DepressionFour Basic
Questions

• Why it Began?
• Business Cycle Peak 7/8-1929, Federal Reserves
  tight policy
• Why so Deep?
• Banking Panics. Inaction of the Federal
  Reserveprolonged monetary contraction
• Duration?----Clearly inaction plays a rolewhat
  else?
• Recovery?

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What about Fiscal PolicyDeficit Spending?
Price Level
Price Level
Output
Output
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Fiscal Policy?Deficit Spending?
In 2005---it was -2.6
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Industrial Policy?

• Specific Intervention in industry?
• National Industry Recovery Act (NIRA) of 1933
  created the National Recovery Administration
  (NRA). (Declared unconstitutional May 1935)
• National Labor Relations Act (1935) that promoted
  unions and Fair Labor Standards Act (1938) that
  set minimum wages in certain industries and
  regulates working conditions.
• NRA established guidelines that raised nominal
  wages and prices and encouraged higher levels of
  employment by work-sharing reductions in the
  length of the work week.

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Industrial Policy

• Weinstein (1980), using aggregate monthly data on
  hourly earnings in manufacturing, he found that
  the NIRA raised nominal wages directly and
  indirectly by raising prices. Econometric
  estimates that average hourly earnings would have
  been 35 cents not 60 cents.
• Result----higher wages create more unemployment
  and increase the duration of the depression
  because of higher costs to producers---counterprod
  uctive
• Shift in the Aggregate Supply Curve

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Did the Duration have something to do with bad
monetary policy? After 1929-1933, had the Fed
learned its lesson?
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Recession of 1937-1938

• Did the Fed learn its lesson?
• Rising excess reserves held by banksFed worries
  about inflation potential and wants to induce
  lending.
• Uses new tool of required reserves. Required
  reserve ratio doubled.
• Result? Banks raise their excess reserves and
  huge monetary contraction.

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Understanding the Great DepressionFour Basic
Questions

• Why it Began?
• Business Cycle Peak 7/8-1929, Federal Reserves
  tight policy
• Why so Deep?
• Banking Panics. Inaction of the Federal
  Reserve. Prolonged Monetary Contraction
• Duration?
• Continued Monetary Policy Mistakes, Fiscal
  Policy not tried. Industrial Policy makes things
  worse.
• Recovery? Why?

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Recovery, 1934-1937.why?

• Real GDP grows at 10 p.a. 1934-1937.
• But real GDP on reaches 1929 peak in 1937 and
  trend path in 1942.
• What drove the recovery.
• Friedman and Schwartz (1963) and Romer (1992)
  huge increases in the money supply.

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What Increased the Money Supply?
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How was the money supply increased?

• F.D. Roosevelt takes emergency powers granted by
  Congress in the 100 days.
• FDR allows the dollar to depreciatesets new
  value for gold in 1934 from 20.36 per ounce to
  35 per ounce.
• Huge revaluation of big U.S. gold stocks.
  Treasury issues gold certificates equal in value
  to increase and deposits them with the Fed. As
  government spends them, they enter the monetary
  base. High powered money increased 12 between
  April 1933 and April 1934.
• Devaluation also improved the competitiveness of
  U.S. goodsrise in the trade balance.
• Devaluation attracted capital flows from Europe,
  especially with Hitlers rise to power. High
  powered money rises 40 from April 1934 to April
  1937.
• Result real interest rates fall and recovery of
  investment and consumer durable spending.

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What drove the money supply?
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Understanding the Great DepressionFour Basic
Questions

• Why it Began?
• Business Cycle Peak 7/8-1929, Federal Reserves
  tight policy
• Why so Deep?
• Banking Panics. Inaction of the Federal Reserve
• Prolonged Monetary Contraction.
• Duration?
• Continued Monetary Policy Mistakes, Fiscal
  Policy not tried. Industrial Policy makes things
  worse.
• Recovery?
• Monetary Expansion

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Some Effects of the Great Depression

• Activist Monetary Policy
• Activist Fiscal Policy---idea of cyclically
  balanced budget
• Insurance and Regulation of the Financial Sector
• Agricultural Regulation
• Growth of Government and shift in Federalism
• Growth of Unions
• Genesis of Social Security
• Smoot-Hawley Tariff of 1929 to the WTO
• The IMF and World Bank