VI. The Great Depression
VI.1 Basic data
Industrial production
1927-35, 1929=100
130
120
110
100
90
80
70
60
50
1927
1928
1929
UK
1930
CND
F
1931
D
1932
I
NL
1933
S
Source: Industrial Statistics, 1900-1957, OEEC 1958.
1934
US
1935
CPI, 1925-1938
(1929=100)
Source: Mitchell - International Historical Statistics
Industrial unemployment
Country
Average
1921-29 1930-38
rate
Difference
Ratio of
difference
to average
USA
7.9
26.1
17.0
18.2
1.07
UK
12.0
15.4
13.7
3.4
0.25
France
3.8
10.2
7.0
6.4
0.91
Germany
9.2
21.8
15.5
12.6
0.81
Source: Eichengreen and Hatton, Interwar Unemployment in International Perspective,
Dordecht, Kluwer Academic Publishers, 1988.
GNP, USA, 1928-1941
US: real growth, unemployment,
CPI
%
30,0
100,0
25,0
90,0
20,0
80,0
15,0
70,0
10,0
60,0
5,0
50,0
0,0
40,0
-5,0
30,0
-10,0
20,0
-15,0
10,0
Real growth
-20,0
1929
1931
1933
Unemployment rate
1935
time
1937
1939
Price level
1941
0,0
%
US: real growth and money
60,0
20,0
15,0
50,0
10,0
40,0
bil.$
5,0
30,0
0,0
-5,0
20,0
Nominal Money
Real growth
10,0
-10,0
-15,0
0,0
-20,0
1929
1931
1933
1935
time
1937
1939
1941
%
VI.2 Impulse and propagation
General framework
• WWI:
– Suspension of stable economic system
• Namely suspension of the gold standard
• Sterling overvalued, mark and franc devaluated
– Pre-war institutional order destroyed
– Different basic conditions
• Higher price and wage rigidity
• No international policy coordination
• Trade protectionism
• The very broad cause of Great
Depression: the start of WWI and demise
of the pre-war economic system
US economy – 1920s
• Strong economic growth
– both real GDP and industrial production around 40% in
1920-29
– recession only 20-21, deflation with very quick recovery
• Active FED policies and lessons
– 1920s: the first application of the active monetary
policies
– recession 1921: successful deflationary policies without
paying too much to output decline
• Problematic lesson
– after WWI – strong demand for US output from Europe
– gold standard not yet generally re-installed
– Trust in monetary policy overdone
Narrow origins: US economy 192829
Two crucial points :
• US relevant: US money supply and FED actions
• Ineffective gold standard – world-wide relevancy
During 1928 – US: speculative boom on financial markets, by US
politicians and bankers considered as unhealthy
• FED strongly contracted money supply
• The aim was to stabilize the financial markets
• Belief that impact on output will be mild
• It became clear that there will be a break on the stock market
The existence of gold standard
• The general conditions were different to 1921
• The deflationary policies were propagated worldwide
• Monetary policies to maintain gold standard – other central
banks contracted as well
• Balanced budgets
• Wage and price rigidities, no adjustment as before 1913
Triggers: business cycle and
crash
• Recession already since August 1929 and it could
have been just a normal manifestation of the business
cycle
• October 27, 1929 – stock market crash
!!! Popular view – Crash and Great Depression are the
same – NOT !!!
• However, when recession arrived, Crash helped to
unleash the avalanche that accumulated after money
tightening, making it clear that recession will be deep
But still: why a “standard” event transformed into a
catastrophe?
Why “Great” Depression?
1. The depth
•
The US average annual growth 1929-1932 was –
8.6%, unemployment in some moments almost 25%
2. The length
•
Despite resumption of growth after 1933, the
unemployment in 1941 still 9.9%
3. Global scale: USA, Europe, elsewhere
Three hypothesis that attempt to explain what
happened
Propagation mechanism (1)
Aggregate demand hypothesis - the length was determined
by fall in aggregate demand (fall of spending) due to
several factors
• Reduction in personal consumption – people were
spending less
– Higher uncertainty
– Stock market crash decreased general wealth
• Reduction in investment
– Residential investment fall, due to previous
overbuilding
– Bank failures due to poor regulation, no access to
funds for capital investment
• Austere fiscal policies of Governments
– Balanced budget policies, gold standard
Propagation mechanism (2)
Money hypothesis
• The contraction of nominal money
• Decrease of money multiplier, not of monetary base
• Reasons for the decrease of m.m.:
– Bank failures, shift from checkable deposits to
currency, etc.
• Open issues of the hypothesis
– Falling prices  real money should increase x did not
happen
– Wages contracted much slower than prices
– Contraction of nominal money should increase the
interest rate x the opposite was observed
– Non-neutrality of money
Money, US, 1929-1933
Money
Real M
mult.
M1
H
1929
26.4
7.1
3.7
26.4
1930
25.4
6.9
3.7
26.0
1931
23.6
7.3
3.2
26.5
1932
20.6
7.8
2.6
25.8
1933
19.4
8.2
2.4
25.6
Propagation mechanism (3)
Deflationary hypothesis – not only US related, very cautious monetary
policy in all countries due to the adherence to gold standard
• Both unexpected and expected deflation matters, as the future debt
becomes “more expensive”
• Unexpected – burden on the debtors, there were many debtors →
shift in consumption spending
• Expected – firms know that they will have to pay more for future
debt → decrease in investment spending → decrease in production
and demand for money → decrease of nominal interest, but prices
falling faster and real interest increases
• Money hypothesis applies !
Many additional factors – low international coordination, trade
restrictions, difficult intermediation between lenders and borrowers
(Bernanke 1983), etc.
VI.3 The Recovery
VI.3.1 New Deal
• Economic background appalling
– 25% of population suffered by Great Depression,
40% fall of GDP
– Unprecedented number of bank failures
• Political conditions:
– Herbert Hoover (till 1932) – liberal concept
– Franklin D. Roosevelt (1933-1945) – interventions,
but mixed policies, not only New Deal
• Very mixed ideological background:
–
–
–
–
Institutionalism
Inclination towards socialism and Soviet planning
Deficit financing
At the same time - conservatism
Roosevelt’s team
• Probably better understanding of the causes of
crises
• Dramatic change in monetary policies
– March 1933: US banks closed for several days
– 1933-1941: nominal money growth by 140%, real money
by 100%
– Due to increase in the monetary base, not in the money
multiplier
• Deficit financing accepted as economic policy
tool
• Different personalities, from left-wing socialist to
traditionalists
• New Deal – more as a political slogan than a
consistent program
National Recovery
Administration (1)
• Establish “orderly competition”
• Relief and public works programs for
unemployed
• National Industrial Recovery Act (NIRA)
–
–
–
–
Codes of behavior for the industries
Minimum wages
No further wage cut at the high unemployment
Rather naive notions, sometimes even against
the US Constitution (and against competitive
environment)
National Recovery
Administration (2)
• Agricultural Adjustment Act (AAA)
– Limit the overproduction
– Support to the decrease of farmable
land
– Subsidized credits for the farmers
– Debt relief for farmers
• Stabilization of the banking sector
– “Emergency” legislation
– Federal Deposit Insurance Corporation
(FDIC)
• Tax policies
New Deal – success of failure?
• Popular fiction: New Deal as a successful program that ended Great
Depression
• In reality
– Some policies were indeed proper for the economy in Depression
– On the other hand – some policies counterproductive and brought
another recession in 1937
– Even the proper policies can not be generalized as policies for all
situations
• The recession lasted till 1941 (see next slide)
• The most important factors of recovery: monetary policy and
reinstated trust into the banking sector
• Definitely not a clear success, probably not a failure, just “muddling
through”
Great Depression, US, till
1941
%
3 0 ,0
1 0 0 ,0
2 5 ,0
9 0 ,0
2 0 ,0
8 0 ,0
1 5 ,0
7 0 ,0
1 0 ,0
6 0 ,0
5 ,0
5 0 ,0
0 ,0
4 0 ,0
-5 ,0
3 0 ,0
-1 0 ,0
2 0 ,0
-1 5 ,0
1 0 ,0
R e a l g ro w th
U n e m p lo y m e n t ra te
P ric e le v e l
-2 0 ,0
0 ,0
1929
1931
1933
1935
tim e
1937
1939
1941
%
VI.3.2 Outside USA (1)
• Different countries – different policies
• Common decisions after 1931
– End of gold standard and floating of the currencies
• Generally: devaluations and revival of the trade
– Accomodative monetary policies
– Governmental intervention, spending and fiscal
deficits
• Germany: political turmoil brought Hitler to
power, massive governmental spending
(military, infrastructure, etc.)
Outside USA (2)
• France: effects from increased trade
and devaluation of Franc just after
WWI
• UK: sluggish growth because of
overvalued pound after 1925
VI.4 Consequences
Theory
• The crisis of the classical model
– Assumption of continuous market clearing vs.
the persistent excess supply on the labor
market
– Not able to provide a proper guidance for
economic policies
• In combination with golden standard suggested
deflationary policies
• Insistence on balanced budgets
• Belief that money is neutral and wages flexible
• Emergence of new macroeconomic
paradigm – Keynes’ General Theory (next
Chapter)
Policies - liberal approach
Perception that liberal policies failed, denial
of
• Market clearing, quick price-adjustment
towards equilibrium
• Assumption of competitive markets
• Voluntary unemployment
• State intervention only in case of public
goods and externalities
• Adam Smith and The Invisible Hand
• Say’s Law
Policies - interventionist approach (1)
New Deal - disregarding whether success of
failure, established a completely new
approach not only to economic policies, but
to the role of the state in modern societies:
• No internal stability of the private sector
• Persistent disequilibria, namely in the labor
market
• Market failures
• There is a need for a public sector to
intervene not only in case of public goods
and externalities
Policies - interventionist approach
(2)
• Intervention: accepting some problems are a fact and
suggesting new policies
– Rigidity in labor markets → accept an equilibrium with
involuntary unemployment
– Gold standard does not reflect reality → need for
exchange rates adjustment, floating
– Money is not neutral → fight deflation with increase of
money supply
– Say’s law is not valid, there is insufficient aggregate
demand → stimulate aggregate demand, emergence of
policy of governmental spending
– Protectionism deepens Depression → removal of trade
barriers
Concluding remarks on recovery
1. Some policies, consistent with classical model,
were very proper, e.g.:
•
•
Improved regulatory framework for banking and
financial markets
Anti-trust policies
2. New Deal:
•
•
Was not the first application of keynesian policies, but
rather an eclectic mix, stemming from a desperate
search for a change
Contained some counterproductive measures (and
even some unconstitutional)
3. The real end of Great Depression – WWII
•
The second European Thirty Year War (1914-1945)
Literature to Ch. VI.
• Both Blanchard’s or Mankiw’s textbooks have a
chapter/paragraphs on Great Depression
• Bernanke, Ben S. “Nonmonetary Effects of the Financial Crisis in
the Propagation of the Great Depression.” American Economic
Review 73, no. 3 (1983): 257-76.
• Bernanke, Ben S. "The Macroeconomics of the Great Depression:
A Comparative Approach" Journal of Money, Credit & Banking,
Vol. 27, 1995
• Friedman, Milton and Anna J. Schwartz. A Monetary History of the
United States, 1867–1960. Princeton, NJ: Princeton University
Press, 1963.
• Kindleberger, Charles P. The World in Depression, 1929-1939
(1983)
• Temin, Peter. Lessons from the Great Depression. Cambridge, MA:
MIT Press, 1989.
• Shlaes, Amity. The Forgotten Man, HarperCollins Publishers, New
York, 2007