Transcript The Great Depression 1929

The Great Depression
1929-1933
The Defining Moment
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 appreciated—the
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)
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.”
Some basic numbers
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Peak August 1929, Trough May 1933
Real GDP falls 39%
Real Consumption falls 29%
Prices (GDP deflator) falls 23%
Unemployment rises from 3.2% in 1929 to 21 or
25% (Lebergott/Darby) in 1933 and in 1939 it is
11 or 17%.
• July 1929, there were 24,504 commercial banks
with $49 billion deposits. By December 1932
there were 17,802 banks with $36 billion. After
Bank Holiday March 1933 there are 11,878
banks with $23 billion.
World War I and the World Economy
• 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,
UK=101 France=75 Germany=72 US = 116
• Inflation! Price level = 100 in 1914. In 1918
UK=210 France=213 Germany304 US=164
• Huge climb in Debt/GDP ratios.
Consequences
1. World War I---9.5 million deaths. Loss of a
generation (UK 1m, France 1.4m, Germany 2m,
US 114,000)
2. Destruction of physical capital especially
Belgium and northern France
3. Distortion of patterns of production, trade and
consumption (e.g. high wartime prices for
commodities—boom and collapse in U.S.
4. High cost of war. Estimated $208 billion.
5. Political and economic borders of Europe are
redrawn.
6. Inter-allied war debts and German reparations.
Inter-Allied War Debts ($ billions)
France
4.0
United States
4.7
3.0
3.5
United Kingdom
8.1
3.2
Other Countries
To pay principal and interest, war devastated economies would
have to run balance of payments surpluses.
German Reparations
• 83% of one year’s GDP
• 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”
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 finance—not
London
Return to Gold Standard
• 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 British pound is
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.
• Germany’s hyperinflation---returns to gold at
near purchasing power 1925.
• Major imbalances---brittle equilibrium.
U.S. Economic Prosperity in 1920s
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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)
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)
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
How Did the Depression Begin
in the United States?
U.K. problem of internal and external
balance with overvalued currency
• U.S. expansionary monetary policy begun
in the spring of 1927 to ease pressure on
the British balance of payments following
secret central bank meeting.
• 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.
The Stock Market Boom
• U.S. stock market boom begins March 1928.
Everyone wants to be rich.
• 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.
The Recession Starts
• Economy starts to cool
in Summer of 1929
• Federal Reserve had
started to tighten policy
in 1928.
• Open market sales and
increased demand for
money led to rise in
interest rates
Stock Market Crash Effects
• After the crash of October 1929, the Federal Reserve
(NY Fed) provides open market purchases—flushes
system with high-powered money. Nominal and
expected interest rates fall.
• Romer (1990) crash generates considerable uncertainty
about future income. Thus consumer perishable
purchases remain stable, semi-durables change a little
and durable purchase plunge.
• Temin (1976) argued crash decreased wealth and hence
consumption
• Mishkin (1978) argued that crash shifted household’s
balance sheets towards illiquidity
• If the stock market had a bubble---this is exogenous.
Collapse is an exogenous shock from Wall Street to the
U.S. economy and the rest of the world.
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
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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.
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.
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.
How do Friedman and Schwartz
explain why the Fed did not act?
Why didn’t the Fed act?
• Friedman and Schwartz (1963): Up to end of 1930, no
expansion as see the fall out as a result of stock market
collapse. Banks just being winnowed.
• Beginning in 1931, Friedman and Schwartz argue that Fed
could have expanded but chose not to.
• Benjamin Strong?
• 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 Congress---open market operations of $1 billion.
Until Congress adjourns.
• Eichengreen (1992) argues that Fed was constrained by
the gold standard. Reserves falling after UK goes off gold
in 1931, must retain high interest rates.
• Fed should have acted differently at least up to late 1931.
How is the economy driven into a
severe depression?
Romer (1993) canonical argument
is simple. Basically…..
• Depression is the result of a series of aggregate
demand 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.
The Wage Conundrum---markets don’t seem to clear
How did deflation affect the economy?
• Conventional 19th century view: fall in wages and
prices raises real balances and thus stimulates
investment, countering shock.
• High real interest rate hypothesis: Deflation
affects expectations. Deflation generates
expectations of higher real rate of interest,
raising real rates.
• Debt-Deflation hypothesis: Unanticipated
inflation increased real debt, increasing defaults
and thus depressing supply of credit
Rising Interest
Rates
• 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.
Railroad Shippers Forecast Errors
20
10
percentage error
0
-10
-20
-30
-40
-50
1928
1930
1934
1932
Year and Quarter
1936
1938
1940
• Sources of the onset—1929-1930/1931 contrasts
previous experience
• The decline in consumer spending and fixed investment
that are the key elements that need to be explained.
Effects of Banking Panics
• In addition to monetary collapse, there was a
disruption of intermediation.
• One shortcoming of F&S monetary explanation
is that there is no theory of monetary effects on
the real economy that can explain protracted
non-neutrality.
• 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.
• Major contribution to economic decline 1931 and
1932.
Bernanke’s argument
• Information asymmetries are solved by financial
intermediaries.
• For a competitive banking system, the cost of
credit intermediation is the cost of channeling
funds from savers into hands of good borrowers.
It includes screening, monitoring, and accounting
costs as well as expected losses from bad
borrowers.
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.
Recovery….why?
• Real GDP grows at
10% p.a. 19341937.
• 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.
How was the money supply increased?
• F.D. Roosevelt takes emergency powers granted by
Congress in the 100 days.
• FDR allows the dollar to depreciate—sets 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.
goods—rise in the trade balance.
• Devaluation attracted capital flows from Europe,
especially with Hitler’s 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.
Recession of 1937-1938
• Did the Fed learn its lesson?
• Rising excess reserves held by banks—
Fed 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.
Romer (1992)
New Deal Legislation
• National Industry Recovery Act (NIRA) of 1933 created
the National Recovery Administration (NRA). (Declared
unconstitutional May 1935, but not 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.
• 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.
Some Effects of the Great Depression:
The Defining Moment (1998)
1. Activist Monetary Policy
2. Activist Fiscal Policy---idea of cyclically
balanced budget
3. Insurance and Regulation of the Financial
Sector
4. Agricultural Regulation
5. Growth of Government and shift in Federalism
6. Growth of Unions
7. Genesis of Social Security
8. Smoot-Hawley Tariff of 1929 to the WTO
9. The IMF and World Bank