Coping with Financial Crisis:
USA in the 1930s
Price Fishback
University of Arizona
Focus
• Long list of contributors to the Great
Depression
• Contributions of Monetary and Fiscal Policy
– To the U.S. Contraction 1929-1933
– To The Recovery, 1933-1937
– To the Second Dip of 1937-1938
2
1930s Monetary Policy Overview
• Mistake-filled Decade: Little Debate
– Deflationary Policy in 1928-1929
– Slow reactions to Bank Failures, 1930-33
– Doubling of Reserve Requirements, 1936-37
• Why?
– Too Much Emphasis on Gold Standard
– Failure to Perceive Tightness of Policy
• Fed did not see impact of deflation on investors’ attitudes
• Fed perceived many troubled banks to be unsound
• Shock Therapy by Leaving Gold Standard
• How Much Causal Effect? 20-80%
3
Fiscal Policy Overview
• Keynesian Stimulus Never Tried
– Large Rise in Government Spending
• Both Hoover and Roosevelt
– BUT Increases in Taxation to Match
– Both Interested in Balanced Budgets
• Macro Discussion:
– 1933 Rise in Spending part of Policy Shock in 1933: Reversing
Deflationary Expectations
• Govt Spending Really more About Differences Across States
• Most Successful Policies at Improving Welfare
– Public Works and Relief Spending on various Measures of
Welfare
– Farm Programs Did more Harm than Good.
4
Monetary Policy
• Friedman and Schwartz, Monetary History of
the United States
• OMOs Too Little,
• Too Late
5
Big Spikes in Failures FED waited until 1932 To
Run Large Purchase of $1 Billion over 5 months
Figure 1
Change in FED Holdings of U.S. Securities, Value of Bank Deposits
Suspended, January 1929-December 1932
500.0
Value of Deposits
Suspended
400.0
OMO bond
Purchases
Millions of Dollars
300.0
200.0
100.0
0.0
-100.0
Jan-30
Apr-30
Jul-30
Oct-30
Jan-31
Apr-31
Jul-31
Oct-31
Jan-32
Apr-32
Jul-32
Oct-32
Jan-33
6
DISCOUNT RATE POLICY
Discount Rate, 1929-1933
7
6
5
Fed Cut Rates Until after Britain
left Gold in 9/31
4
3
2
1
0
7
Why so Recalcitrant?
• Emphasis on Gold Standard support
– Offsetting Gold Flows and not enough attention
domestically
– All Agree played significant role.
– Countries Freed from Gold Standard Recovered
• Temin and Wigmore, Eichengreen, Kindleberger
8
Figure 2
FED Discount Rate, Value of Bank Deposits Suspended, Change in U.S.
Gold Stock, January 1929-December 1932
500
6
400
300
100
5
4
Percent
Millions of Dollars
200
Raising DR to offset outflow
Of Gold
0
-100
3
-200
-300
2
-400
-500
1
Jan-29 Apr-29 Jul-29 Oct-29 Jan-30 Apr-30 Jul-30 Oct-30 Jan-31 Apr-31 Jul-31 Oct-31 Jan-32 Apr-32 Jul-32 Oct-32 Jan-33
Change in U.S. Gold Stock
New York Fed Discount Rate
9
Why Ignore Domestic Problems?
• Real Bills Doctrine
– Let Commercial Activity and Banks
Determine their needs
– Weak Banks Failing
• Fed Did not recognize policy as tight.
• Cut Nominal Discount Rate
• Never Mention Deflation Effect on Real
Interest Rates in their Discussions
10
4.00
1920s Fed was Used to Many Bank Suspensions
of Small, undiversified unit banks, with Small
Deposit Losses
3.50
3.00
% of Banks Suspending
Payments
2.50
2.00
1.50
1.00
% of Assets in
Suspending Bank
% of Deposits Lost
0.50
0.00
1921
1922
1923
1924
1925
1926
1927
1928
11
1929
1930
In 1920s Fed Sees Many Bank Suspensions of
Small, weak unit banks, Deposit Losses Very Low
Even 1931 spike, little spike in Lost Deposits
11.00
% Banks Suspended
10.00
9.00
8.00
7.00
6.00
% Deposits Lost
5.00
% Assets
Suspended
4.00
3.00
2.00
1.00
0.00
1925
1926
1927
1928
1929
1930
1931
1932
12
What the Fed Saw
Discount Rate, 1929-1933
7
6
Loose Policy Except for Rise
to Offset Gold Outflows
5
4
3
2
1
No Mention of Deflation Causing Real Rates to Be High
0
13
What the Borrowers Felt
16
14
Real Discount Rate
Nearly Triple
Next Highest Real Rate
After 1933
12
10
8
6
4
Nominal Discount Rate
2
0
14
Second Dip
Reserve Requirements
• Fed given control under Banking Act of 1935
• In 1936 worried about overheated recovery
• Banks holding excess reserves and worried if lent
them out, inflation would develop
• Doubled Reserve Requirements in 3 steps
• 8/1/36, 3/1/37, 5/1/37
• Banks no trust for Fed as Lender of Last Resort
• Continued to Hold Excess Reserves, Credit Dried
Up
15
Figure 3
Monthly Indices of the Money Supply, Industrial Production of
Consumer Goods, and the Consumer Price Index, (100=1923-1925
140
130
120
110
100
90
80
70
60
50
1919
1920
1921
1922
1923
Money Supply Blue strongly correlated
With Real Output Red
1924
1925
Money Supply
1926
1927
1928
1929
1930
1931
Industrial Production/Consumer goods
1932
1933
1934
1935
1936
1937
1938
1939
Consumer prices
16
Recent Estimates of Impact in DSGE
models
• Build a Dynamic Stochastic General Equilibrium
Model of Economy
– Infinite-Lived Households choosing consumption and
assets
– Firms maximize profits as hire household members
– Capital accumulation process.
– Add inefficiencies: sticky wages, credit limits
– Choose parameters
– Solve and do policy simulations
17
Consensus on Money Effects
• At a minimum it can account for 20 percent of
the problems (Cole and Ohanian)
• Estimates range as high as 70-80 percent
• (Bordo, Erceg, and Evans 2000;
• Christiano, Motta, Restagno 2003)
• Many estimates in between
• Bernanke
• Chari, Kehoe, McGrattan 30-50
18
Microeconomic Evidence
• Tale of two Feds in Mississippi William
McChesney
(Richardson/Troost)
Martin, Sr.
– St. Louis Real Bills
– Atlanta Bagehot’s rule in panics
– Fewer Bank failures in Atlanta district
– Expanded wholesale sales.
19
Shock Therapy
• Eggertsson (2009) Temin and Wigmore (1990)
• Roosevelt Broke Deflationary Expectations in
1933
– Move off Gold Standard
– Fed’s lower Discount Rate and OMOs
– Spending more
– Push for high prices
– Eggertsson model claims explains 80 percent of
recovery
20
Fiscal Policy
• Hoover and Roosevelt Administrations
Increased Outlays
– Hoover the old-fashioned way
• Roads, rivers, harbors, flood control
• Real spending up 88 percent 1929-32
– Roosevelt in many new ways
• Relief, farm programs, new agencies
• Real spending up 68 Percent 1933-1936, Adds another
6% from 1936-1939
Tax Revenues Declined 31-33, Rose Afterward
21
Figure 6
Real Federal Government Outlays, Tax Revenues, and Surplus
in 1958 Dollars, 1929-1939
25.0
20.0
Outlays
15.0
10.0
Revenues
5.0
0.0
1929
1930
1931
1932
1933
1934
1935
1936
1937
1938
1939
-5.0
-10.0
-15.0
Deficit
Real Deficit
Real Government Expenditures
Real Government Receipts
22
Not Keynesian Stimulus
• Find Keynesian Misperception everywhere
• Keynes, Alva Hansen, E. Cary Brown, Larry
Peppers all say it wasn’t
• Essence shown in Figure 7
23
Figure 7
GNP minus 1929 GNP, and Federal Expenditures, Tax Revenues, and
Budget Surplus in 1958 Dollars, 1929-1939
30.0
20.0
10.0
Outlays
Revenues
0.0
-10.0
Deficit
-20.0
-30.0
-40.0
Real GDP in Year –
1929 GDP
-50.0
-60.0
-70.0
1929
1930
Real Deficit
1931
1932
1933
Real Government Expenditures
1934
1935
Real Government Receipts
1936
1937
1938
1939
Real GNP minus 1929 GNP
24
>
Real Action Was in
States, Counties, Cities
• New Studies Show
• 1) Don’t Treat Each Program Same
– Relief and Public Works (positive)
– Farm Payments to Reduce Output (slight negative)
• 2) Some crowding out of private employment as
move from 33-35 to 35-40
• 3) State Level multipliers
– $1 of G leads to $0.8 to $1.4 in income.
– 1.4 to 1.6 for Pub works and Relief. Neg. Farm
25
Tax Rate Infamy: Uncertainty Rules Day
• Smoot-Hawley Tariff
• Income Tax Rate Increases in 1932
– Only Top 5-7 percent of HH paid Income Tax
– Over $1 million 23.1 to 57 (to 68 in 35-36)
– Income Tax Revenues Fell
• Introduced Excise Taxes on oil, pipelines, autos, bank
checks, gasoline
– 48 % of revenue by 1934
– Alcohol Taxes
• Investment Tax with NRA
• Undistributed Profits Tax
• Uncertainty Ruled Day
26
Banking Problems
• State Deposit Insurance Unsuccessful in 1920s
– Attracted weaker banks (adverse selection)
– Insured banks took more risk (moral hazard)
• Unit banks
– Not diversified enough to withstand local shocks
– Explains bad balance sheets when suspended
• Banks, Margins, and Stock Crash
– After 1927, New York Banks broker lending declined
– Slow growth in lending by other American banks
– Most broker loans from foreign banks, private
individuals, corporations
27
1930s Banking Reforms
• Deposit Insurance
• Glass-Steagall
–
–
–
–
–
wall between investment banking and commercial banking
No too big to fail
separates riskier investments from traditional banking roles
BUT repeal of GS not seen by many analysts as current problem
Repeal Allowed Goldman and Morgan Stanley to become banks
• Regulation Q (ended 1978)
– Not interest on checking, ceiling on savings interest
– Way too Conservative
• Separation of S and L and commercial banks
– 1980s problem: premiums too low, lax monitoring
28
1930s Summary
• Monetary Policy Mistakes
– Fed was learning on the job
– Too much focus on gold not enough on lender of last
resort
– Fed not paying attention to deflation impact on real
costs of borrowing
– Measured impact ranges from 20-70 percent
depending on model and scholar
• Fiscal Deficit Policy Not Really Tried
– Real Action is in the Microeconomic Effects of
Expanding Relief and Public Works
29
1930s Supply-Side Effects
• Tariffs a Disaster
• 1932 Income Tax Increase
–
–
–
–
affected less than 10 percent of Households
Most rate rises to levels not too high, BUT
Confiscatory for those over $1 million, 23 to 58 to 67%
Sharp drop in Income Tax Revenues resulted
• Real Tax Problem new Federal Excise Taxes on Leading
new Industries
• Electricity, pipelines, autos, gasoline, etc
• Alcohol Taxes Post-Prohibition
• 1930s Different Tax Mix, 48 % from excise taxes by
1934
30
Fed Policy Then and Now
• 1929-1932 Fed waited 3 years
– as unemployment rose above 10%, then 16%, then
20%
– before making a large open market purchase of $1B.
• In 2008 Fed ran
– large open market operations and drove federal funds
rate close to zero
– before the unemployment rate passed 7 percent
• 2009 Bought huge amounts of mortgage-backed
securities
• To Avoid Second Dip, $600 Billion in QE2
31
To Prevent Shocks from Failures
Borrowed New Deal Playbook
• Bernanke, Paulson, and Geithner propped up
many large institutions
– Bear Stearns
– Fannie (a New Deal Legacy) with Freddie
– AIG
– RFC-style ownership stakes in banks
– Bank Holiday-style
Stress tests
32
Bailouts Seemed to Be Right Move
• Policy Makers Describe Fear that Whole
System going down
• Guarantees Have not been costly
– Except for Fannie and Freddie
• Deficits have been smaller than predicted
(14% predicted, 10% actual) because half of
TARP money not spent, money paid back by
banks
33
Long Run Issues to Address
• Do we want the federal government heavily
involved in financing economy
• Freddie and Fannie
– supposedly private but ultimately backed by govt.
– Major portion of the whole mortgage problem
– now financing over 90 percent of all new home loans
• Bailouts create moral hazard
– Banks take more risks because anticipate bailouts as
protection.
34
Modern Fiscal Policy
• New Deal was not Keynesian Policy
– Deficits too small relative to size of problem
• New Policy is Keynesian.
– Deficit rose from 3.3 % in 2008 to 9.9 in 2009 to
10.6 in 2010
– Uncharted waters.
• Deficits as a share of GDP
– twice the next highest peace-time deficit,
– 3 and 4 and 5 times New Deal Deficits
35
2009 Deficit Response more like what
Keynesian would have done in Depression
1930s Deficit more like expected Response to
2007-2010 problems
WWII
WWI
36
Increasing Debt
• 1930s responding to Unemp range 10-25%
– 10 years to increase Debt/GDP ratio by 28 points
– 16% in 1929 to 44 % in 1939.
• 1907-1910 responding to Unemp range 5-10%
– 3 years to increase Debt/GDP ratio by 28 points.
– 36% in 1907 to 64 % in 2010
37
Did the Fiscal Stimulus Work?
• Most academic short run Macro spending multiplier
estimates are in the 0.5 to 1 range
– $1 of federal spending raises GDP by 50 cents to $1 with
some crowding out. Government replaces some private
activity
• My estimates for 1930s for U.S. states range from 0.8
to 1.4 for general spending
– BUT. These would be highest estimates on record because
1930s had so many unemployed resources
– No positive effect on private employment, some negative
– Focus should be on the microeconomics of each specific
program and not on fiscal multiplier.
38