Transcript GD_2012_post

The Great Depression (1929 – 1941)
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Paper topic
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Last problem is short paper (1000 words + tables, figures)
Due in reading week (December 10)
Broad latitude on particular topic, but must be macro
Get approval from TF or me for topic
Examples (verbally, but will be in posted assignment)
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References must be acceptable (not Internet junk)
Don’t wait until last moment.
Gilded era of the 1920s
Stability restored to U.S. economy in 1920s after WW I.
Problems surfaced with real estate and stock market booms.
The Great Crash, October 1929
Key Elements in the Great Depression
1929-1933
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Started as asset price bubble and standard recession
Remember world was on gold standard (fixed exchange rate system)
Multiple bank failures through 1933 (standard panic model)
Breakdown of Gold Standard, particularly with Britain’s leaving gold
in 1931.
Collapse of investment and international trade after 1929
No effective fiscal policy until 1940
Fed took hesitant steps to stimulate the economy
– Federal government wanted to balance the budget (like several
candidates today…)
– Fed was serving too many masters (more on this later)
Output kept falling, and unemployment kept rising
Trough finally reached in 1933, but no sharp recovery
Remember that Keynes’s General Theory not published until 1935:
macroeconomics was born a decade too late.
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Bank failures and panics, 1931-1933
GDP Gap in Depression
Actual/Potential GDP
1.1
1.0
0.9
0.8
0.7
0.6
1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939
GDP Gap in Depression and Recession
Actual/Potential Output
1.1
Great Depression
Great Recession (2007 - 2012)
1.0
0.9
0.8
0.7
0.6
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30
31
32
33
34
35
36
37
38
39
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High unemployment for a decade
Unemployment rate (% of labor force)
30
25
20
15
10
Great Depression
Today's recession
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0
1930
1932
1934
1936
1938
1940
2008 2009 2010 2011
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Growth in Key Indicators
Period
1927:10-1929:8
1929:8-1931:12
1931:12-1933:4
H
M1
Real M1
Ind.
Prod.
42.7%
2.0%
6.5%
1.1%
-8.1%
-10.5%
1.4%
-0.9%
0.6%
11.6%
-22.4%
-10.2%
Real
GDP
Inflation
3.8%
-6.7%
-11.9%
-0.3%
-7.3%
-11.0%
H = high powered money.
Periods are:
1. Pre-crash boom
2. From crash to Britain’s leaving gold in October 1931
3. From gold crisis to trough
Note: rates of change at annual rates.
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Alternative views of the sources of the GD
Classical theories:
Basically a variant on real business cycles
Longer story, but can’t explain the major
movements
Keynesian theories:
• Expenditure view: IS or spending shocks*
• Financial market distress: MP or financial shocks*
• Low-level equilibrium trap*
• All of the above***
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IS interpretation of the depression
interest
rate
(i)
IS1929
IS1933
MP
Y1929
Y1933
0
Real output (Y)
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I. The Expenditure Approach: IS Shocks
Were shocks in the IS curve responsible?
– Foreign trade, government spending and taxes were
too small
– No exogenous consumption shock
– Investment decline was the major shock.
• Mechanism is unclear, but probably due to shift to “bad
equilibrium” (panics, risk, high risk premiums, low
investment, unstable dynamics ?)
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II. Financial Markets and the Depression
• Central banks generally have to serve three masters in different
mixes over time. This was the Fed’s trilemma in 1928-33.
1. exchange rates (gold standard and convertibility)
2. macroeconomy (inflation, output, and employment)
3. financial market stability (asset prices, panics, liquidity)
• Fed was primarily concerned about (#3) speculation in 1928-29 and
tightened money at that point.
• When depression was underway, Fed was primarily concerned with
defending the gold standard (#1) until 1933 and didn’t expand M
sufficiently.
• From 1933 on, after US depreciated and others left gold, Fed was
divided about how strongly to stimulate the economy because of
poor macro understanding (#2).
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Friedman and Schwartz and the Monetarist Argument
• Classic study of the Great Depression is Milton Friedman and
Anna Schwartz, Monetary History of the United States, which held
the “monetarist” view.
“Throughout the near-century examined, we have found that: Changes
in the behavior of the money stock have been closely associated with
changes in economic activity, money income, and prices. The
interaction between monetary and economic change has been highly
stable. Monetary changes have often had an independent origin; they
have not been simply a reflection of economic activity.” (p. 676)
• F&S view the depression as primarily driven by “incompetent”
monetary policy caused by decline in money supply.
• Argue that rise in M1 could have prevented Y fall and nipped GD
in bud
Monetarism, the Depression, and IS-MP
interest
rate
(i)
MP‘
MP
i**
i*
IS
Y**
Y*
Real output (Y)
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Interest Rates 1920-39
Problem with
monetarist
interpretation:
Safe interest rates
fell in GD!!!
Interest rate (% per year)
10
8
6
4
2
0
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22
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30
3-month T-bill
Fed discount rate (low)
32
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Corporate bond rate
Commercial paper rate
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Bad equilibrium view of Great Depression
A final approach:
1. Began with asset price bubble and high leverage.
2. Then had huge IS shock due to risk, panics, deflation, and
the result was high risky real interest rates.
3. This forced economy into a liquidity trap (like today), so
that monetary policy was ineffective.
4. Government was too small to have effective fiscal policy.
5. Got locked into “bad equilibrium” of deflation, high risk
premiums, fear, low investment, and low spending.
6. And that lasted until 1940!
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interest
rate
(i)
IS1933
IS1929
MP1929
= MP1933
MP1939
Y1929
Y1933
0
Y1939
Real output (Y)
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Recovery from the Great Depression
• The end of the Great Depression:
– Military mobilization for World War II led to ENORMOUS
increase in G starting in 1940.
– Recovery took off in 1940.
• This Standard IS shift … no puzzle here!
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The rise of the dictators (1917 - )
World War II (1931-1945)
Military spending takes off…
The end of the depression …
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15
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Pearl Harbor
Germ invastion Austria, Czech
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Germ invasion France
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Germ. invastion Poland
WW II
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.3
.2
5
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0
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30
32
34
36
38
40
42
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Unemployment rate
Defense spending/GDP
Federal expenditures/GDP
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48
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interest
rate
(i)
IS1939
IS1945
WW II
Y1945
0
Y1939
MP
Real output (Y)
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Professor Summers again on policy in the liquidity trap:
“Our policy approach started with a major commitment to fiscal
stimulus. Our judgment was that in a liquidity trap-type scenario of
zero interest rates, a dysfunctional financial system, and
expectations of protracted contraction, the results of monetary
policy were highly uncertain whereas fiscal policy was likely to be
potent.”
Lawrence Summers, July 19, 2009
Implication of the Recovery
• Recovery from GD required an increase in high-employment
federal deficit of 20-25 percent of GDP
– Would be equivalent of $3 trillion deficit today!
• The magnitude of the fiscal shock required for recovery
suggests that no minor M or F expansion would cure GD
quickly.
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Summary
• The depth and severity of the Great Depression remains one of the
continuing debates of macroeconomics.
• Probably no simple approach can explain the entire story
– Warning: avoid the seductive simplicity of monocausal approaches.
• Perhaps a complex situation where combination of factors piled up
to produce a “perfect storm” of macroeconomics:
– began with asset price bubble (boom of 1920s and bust of 1929)
– poor institutions (gold standard and fragile banking system)
– poor international coordination (legacy of WW I)
– inadequate understanding of macroeconomics (before Keynes’s theory)
– inept policy response (cling to gold standard, no fiscal response)
– bad dynamics (panic, high risk premia, deflation, and liquidity trap)
• Can it happen again? To answer need to understand how
macroeconomic theory and institutions have evolved.
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