The Great Depression in the United States
From A Neoclassical Perspective
Harold L. Cole and Lee E. Ohanian
The Great Depression, 1929 – 1939
• What explains its scale and duration?
• The 1933 – 39 recovery period witnessed significant
increases in money supply, total factor productivity,
the elimination of deflation, no more bank failures
• According to neoclassical theory, output should
have returned to trend around1936.
• But output remained 25%-30% below trend
throughout the 1930’s.
Neoclassical Growth Model (drop time subscripts)
Maximize Σ βtu(c,l)
Maximize discounted utility from consumption and leisure
Subject to y = zf(k,xn) >= c + i Output exceeds c +
investment
n+l=1
Hours of work + leisure = 1
k = (1-δ) k-1 + i kapital stock and δeprec.
x = (1+γ)x-1 Labor productivity γrowth
z = random technology shocks
Introducing fiscal shocks, y = zf(k,xn) >= c + i + g
Introducing money shocks complicates things
Cash in advance assumption: m >= pc
Cole and Ohanian consider the following shocks
• Technology shock  Real Business Cycle?
• Fiscal shock  Tax disincentive to work
• Trade shock  World in depression
• Monetary shock  Lucas-Rapping intertemporal
substitution of leisure for work
• Financial intermediation shock  Bank failures
• Reserve requirements
• Inflexible nominal wages and increased real wages
• Real wages rose in manufacturing
• But real wages declined in other sectors
Technology Shocks? Perhaps initially
Shocks that reduce the productivity of capital and labor.
– Prescott (1986) finds technology shock accounts for 70% of postWWII business cycle fluctuations Real business cycle paradigm
Cobb-Douglas production function
y = zf(k,xn) = zkθ(xn)(1-θ)
θ = 1/3 γ = 1.9 % n growth rate = 1%
z = Actual total factor productivity in each year
• Model predicts a smaller decline in 1929-1933 output than
actually occurred.
• Output should have returned to trend by 1936 per model.
– It actually remained below trend by 25% during the
recovery.
Correction for decline in capital stock during depression
• Use the actual capital stock in 1934—20% below trend.
• Output still should have returned to trend by 1937.
• It did not.
Problem: “Actual” capital stock ignores idle capacity
– There was lots of idle capacity both in descent and
recovery phases of the depression.
– This complicates estimates of total factor productivity
Fiscal Shocks? A little
Decreased government spending increases consumption,
decreasing the marginal rate of substitution of consumption for
leisure Leisure increases  Hours of work decreases
• To explain the depression, government spending should
have decreased
• 1929 – 33: government spending decreased modestly
• After 1933: government spending increased by 12% above
trend. But hours of work remained below trend.
• Taxes rates essentially stayed the same during 1929-33 but
increased for the rest of decade.
• From 3.5% to 8.3% on labor and from 29.5% to 42.5% on capital.
• Feeding this into the model
• Labor input falls by 4%
• Only 20% of the weak recovery is explained.
Trade Shocks? No
• Tariffs caused world trade to fall 65% b/w 1929-1932.
• Lucas(1994) argues that trade was such a small share of US output
that it could not possibly have any explanatory relevance.
• Even if import elasticity of substitution was very low, it
would have only taken a short time for domestic producers
to adjust.
• Trade shocks do not account for output deviation from trend
during the recovery.
• Monetary Shocks? Maybe for the decline
• Friedman and Schwartz: declines in the supply of the money
stock have preceded declines in output for a century
• A large decline in M1 preceded the 1929-33 output decline.
• The real money stock fell less than the nominal money stock.
• 1933 – 1939: The real money stock increased during
recovery
• The variation in real money stock is consonant with the
variation in real output.
 money non-neutrality
something keeps prices from changing in sync with
money supply.
Is non-neutrality an equilibrium outcome?
• Lucas and Rapping (1969) and Lucas (1972): cyclical
fluctuations explained by leisure/labor substitution and
unexpected changes in real wages.
• If real wages are high, workers opt for more labor and less
leisure.
– Rapid decline in money supply led to real wage falling below
expected level in 1930.
» Workers chose more leisure...Gone fish’n’
» Could account for the decline in output, 1929-1933.
– For rest of the decade the real wage was at or above expected level
» This should have resulted in less leisure and more work,
returning output to 1929 level.
» This did not happen.
Money, deflation and debt deflation (per Fisher)?
• Deflation transfers nominal wealth from debtors to creditors
• Debtors’ decrease in net worth leads to reduced borrowing,
reduced business expansion and reduced consumption.
• This could partly explain the 1929-1933 decline
(qualitatively)
• The quantitative aspect for the recovery period remains
unchartered.
Intermediation Shocks? Only briefly
• Bernanke (1983): bank failures  negative changes in output.
• Cole and Ohanian report low loss of output due to this source
• Output reduction (1929-1933) attributable to finance, insurance
and real estate = 4.7%.
Reserve Requirements? Not much
• 1936-37: Reserve reqm’t raised from 10% to 15% to 17.5% to 20%
 Weak recovery to these increases via reduced lending?
• But output rose by 12% during this period.
• The downturn started in 10/1937 or 14 months after first
increase in reserve requirements.
• Interest rate increases were very small and transitory during
this period and for the rest of the decade.
• It is therefore questionable that increased reserve requirements
can explain the weak recovery.
Inflexible Nominal Wages? Real wage too high?
• Manufacturing real wages rose above trend between
1929-1933 and were 16% above trend by 1939.
• Nonmanufacturing wages fell 15% between 1929 1933 and remained 10% below trend in 1939.
 Mixed signals
• Money illusion and nominal contracts can’t explain
the weak recovery
Cole and Ohanian’s Postulate: Blame the New Deal
• National Industrial Recovery Act (NIRA)
– Cartelization of the US manufacturing sector.
– Monopolists earn more by producing less
• Manufacturing wages were set in the same political/
administrative manner.
Qualitatively this shock seems promising in explaining why
output was so much and so consistently below trend from
1934-1939.