The Great Depression:
Getting the Story Right
Nicholas Crafts and Peter Fearon
The 1930s
• Deflation, slump and crisis
• De-globalization: trade wars, collapse of
gold standard and of foreign lending
• Lessons from the downturn quite well
understood; but also much to be gained
from looking at recovery
Contrasts in the Great Depression
UK
USA
Real GDP
-5%
-27%
Price Level
-8%
-26%
Money Supply
-1%
-33%
Bank Failures
None
⅓
Proportion of Countries with Banking Crises, 1900-2008
Weighted by their share of world income
45
The Great
Depression
40
Share of countries
in banking crisis
(left scale)
35
Emerging Markets,
Japan,
the Nordic Countries
and US (S&L)
25
World War I
10
- 0.8
- 0.6
20
15
- 0.9
- 0.7
The Panic
of 1907
- 0.5
Capital Mobility
(right scale)
- 0.4
- 0.3
- 0.2
5
- 0.1
- 0
0
1900
1903
1906
1909
1912
1915
1918
1921
1924
1927
1930
1933
1936
1939
1942
1945
1948
1951
1954
1957
1960
1963
1966
1969
1972
1975
1978
1981
1984
1987
1990
1993
1996
1999
2002
2005
2008
Percentage of countries
30
- 1
Source: Reinhart & Rogoff (2009)
The World in Depression
Myths
• Wall Street Crash caused the Great
Depression
• New Deal was a massive fiscal stimulus
• Glass-Steagall was evidence-based
policy
• There was a great depression in the UK
How Did the Depression Start?
• Dominance of US economy in 1920s; world’s
leading creditor country
• 1928: Federal Reserve (FED) moved to control
stock market speculation
• Higher interest rates destabilized domestic and
international economy
• 1929 Wall Street Crash: an effect not a cause
Table 1. The Great Depression in the
Advanced Countries
Real GDP
Price Level
Unemployment Trade
(%)
Volume
1929
100.0
100.0
7.2
100.0
1930
95.2
90.8
14.1
94.8
1931
89.2
79.9
22.8
89.5
1932
83.3
73.1
31.4
76.5
1933
84.3
71.7
29.8
78.4
1934
89.0
75.3
23.9
79.6
1935
94.0
77.6
21.9
81.8
1936
100.6
81.4
18.0
85.7
1937
105.3
91.5
14.3
97.4
1938
105.4
90.4
16.5
87.0
How Did the Depression Spread?
• Most economies linked by gold standard
which was re-adopted during the 1920s
• Fixed exchange rate system; countries
losing gold expected to deflate
• Countries gaining (“hoarding”) gold, e.g.
USA and France, sterilized inflows to
protect against inflation
Golden Fetters
• After 1930, US loans ceased, imports reduced,
primary product prices declined; primary
producers had to deflate
• 1931 major financial crisis started in Austria;
moved to Germany
• No co-ordinated policy response
• Britain leaves the gold standard (Sept 1931)
Collapse of Gold Standard
• Crisis then moved to USA
• 1931: 47 members of gold standard club;
1932: only 6 major economies still in
• Abandonment of gold was a key to
recovery
• Those countries that had not devalued
became much more protectionist
Trade Contraction
• Major contraction in international trade; value
and volume both decline
• Starting with Hawley-Smoot tariff (1930)
protection increased; beggar-thy-neighbour
policies
• Drive to self-sufficiency in Germany
• Major source of trade decline was inability of
countries to finance imports
Table 2: The UK in the 1930s
Real GDP
GDP Deflator
Unemployment
Stock Market
(%)
Prices
1929
100.0
100.0
8.0
100.0
1930
99.9
99.6
12.3
80.5
1931
94.4
97.2
16.4
62.8
1932
95.1
93.7
17.0
60.2
1933
96.0
92.5
15.4
74.3
1934
102.8
91.7
12.9
90.3
1935
106.6
92.6
12.0
100.0
1936
109.9
93.1
10.2
115.9
1937
114.7
96.6
8.5
108.0
1938
118.2
99.3
10.1
88.5
US/UK Comparison
• UK did not experience a Great Depression
• 1932-37 average real GDP growth 4%; no bank
failures, rapid recovery but unemployment
remained high especially in Outer Britain
• Major regime change; UK abandoned gold
standard, protectionist tariffs embraced
• Recovery fuelled by cheap money; no fiscal
stimulus until later 1930s
Table 2: The USA in the 1930s
Real GDP
GDP Deflator
Unemployment
Stock Market
(%)
Prices
1929
100.0
100.0
2.9
100.0
1930
91.4
96.4
8.9
69.4
1931
85.6
86.3
15.6
35.8
1932
74.4
76.2
22.9
30.8
1933
73.4
74.2
20.9
46.2
1934
81.3
78.4
16.2
45.8
1935
88.6
79.9
14.4
63.1
1936
100.0
80.7
10.0
79.8
1937
105.3
84.1
9.2
50.5
1938
101.6
81.7
12.5
61.7
Why So Deep a Depression in USA?
• Deflation undermined consumer and business
confidence; increased real debt
• Rising unemployment and collapse in farm
income added to distress
• Three waves of bank failures: late 1930; late
1931; winter 1932-33 undermined investment
• Policy response entirely inappropriate
New Deal Recovery
• 1933-37 real GDP grew at 8% per annum
• Gold standard abandoned; banking stabilized;
inflationary expectations established
• Monetary policy accidentally expansionary
• Little fiscal stimulus
• Serious new recession 1937-38
Devaluation in the 1930s
• Very good for early recovery; staying on the
gold standard made things much worse
• Regain control of interest rate, change
inflationary expectations, lower real wages,
increase international competitiveness, improve
fiscal arithmetic
• Pursuit of self-interest (beggar-thy-neighbour)
undermines world trade
Changes in Exchange Rates and Industrial Production,
1929-1935
Production 1935
(1929=100)
130
•Finland
•Denmark
•Sweden
120
•United Kingdom
110
•Norway
•Germany
100
•Italy
•Netherlands
IP1936=153.9-0.69ER1935
90
80
70
40
60
•Belgium
•France
80
100
120
Exchange Rate 1935
(1929=100)
Bad Behaviour
• Fixed exchange rate systems potentially
undermined by big balance of payments
surpluses
• Gold hoarding by France and USA put severe
deflationary pressure on the gold standard
• Deficit countries took the strain of adjustment
(initially)
Regime Change
• US escape from liquidity trap after 1933
based on leaving gold
• Changed inflationary expectations and
reduced real interest rates
• Needed a new policy framework;
ambiguity about this became a problem in
1937
Fiscal Stimulus
• With interest rates at zero-bound, expect
fiscal multiplier to be relatively large
• On balance, 1930s evidence suggests this
is right; values for UK and US of 1.5+
• In the early 1930s, fiscal policy didn’t
fail, it wasn’t tried; Keynesian stimulus
later on from rearmament
Fiscal Consolidation
• Exposes economy to risk of double-dip
recession if monetary policy not supportive
• USA in 1937/8 is perfect unpleasant example
• Monetary policy was supportive when real
interest rates were held down
• Suggests conventional inflation targeting not
appropriate at lower bound
A Recession to Remember:
Real GNP in USA
1929 III
1933 I
1936 I
1936 II
1936 III
1936 IV
1937 I
1937 II
1937 III
1937 IV
1938 I
1938 II
1938 III
1938 IV
100
68.4
85.2
90.6
93.2
96.3
95.9
98.4
98.0
91.0
87.1
88.6
93.7
97.4
Source: Balke and Gordon (1986)
Banking Crises
• Asset price collapse, non-performing loans,
scramble for liquidity, shortage of collateral:
credit for investment severely restricted
• Market failure with asymmetric information
• Frequent when bank regulation inadequate
especially when capital is internationally mobile
• Imply major decline in economic activity not just
ordinary recession and fiscal hangover
• Easy to understand ex-post; hard to predict
Banking Crisis:
Impact on Potential Output
• Output is permanently reduced (making structural
budget deficit worse)
• Direct and indirect effects: investment and policy
response
• In 1930s USA, New Deal increased U* and collapse in
investment meant lower capital stock … but TFP growth
remained very strong
• Y* in 1941 at least 10 per cent below 1929 forecast
Table 3. Growth Accounting Decompositions,
United States 1919-1941 (% per year)
ΔY/Y
ΔK/K
ΔL/L
ΔA/A
Δ(Y/L)/(Y/L)
1919-29
3.08
2.69
1.10
1.44
1.96
1929-41
2.52
0.04
0.27
2.03
2.25
1919-29
4.06
2.93
1.73
2.04
2.30
1929-41
2.36
-0.14
-0.02
2.34
2.38
GDP
Private NonFarm
Resolving the Banking Crisis
• Re-capitalizing and re-regulating banks was key
part of Roosevelt’s policy
• Deposit insurance (and moral hazard) is
important legacy of the depression
• Accompanying bank regulation was politically
captured and not well designed but did deliver
financial stability for several decades in ‘capitalimmobile’ world
Concluding Thoughts
• Once the crisis began, economics informed by
economic history has done quite well and we
haven’t repeated the worst errors of the early
1930s
• Failure to predict the crisis both now and then
understandable; failure to prevent the crisis
may be less forgivable since economics does
explain very clearly why banks fail
Central bank discount rates, now vs then
(7 country average)
2008
1929
6
5
4
3
2
1
0
0
5
10
15
20
25
30
Source: Alumunia et al (2010)
35
40
45
50
World Industrial Production, now vs then
100
95
90
85
80
75
70
65
60
0
5
10
15
20
25
April 2008=100
30
35
June 1929=100
Source: Eichengreen & O'Rourke
(2010)
40
45
50