Transcript Great Depression

The Great
Depression
1
The Great Depression

The worst economic contraction was the Great Depression
of the 1930s.
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
Real GDP fell nearly 30% from the peak in August 1929 to the
trough in March 1933.
The unemployment rate rose from 3% to nearly 25%.
Thousands of banks failed, the stock market collapsed, many
farmers went bankrupt, and international trade was halted.
There were really two business cycles in the Great Depression.
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A contraction from August 1929 to March 1933, followed by an expansion
that peaked in May 1937.
A contraction from May 1937 to June 1938.
By May 1937, output had nearly returned to its 1929 peak, but
the unemployment rate was high (14%).
In 1939 the unemployment rate was over 17%.
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American Business Cycle
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Recessions were common from 1865 to 1917,
with 338 months of contraction and 382 months
of expansion.
Compare it with 56 months of expansion and
only 122 months of contraction from 1945 to
2001.
The longest contraction on record was 65
months, from October 1873 to March 1879.
The longest expansion was 120 months between
March 1991 and March 2001.
http://www.nber.org/cycles/
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http://www.dallasfed.org/research/swe/2005/swe0502.pdf
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Source: http://econ161.berkeley.edu/TCEH/Slouch_Crash14.html
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Permanent Components
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The United States Business Cycle, 1890-1940
Source: http://econ161.berkeley.edu/TCEH/Slouch_Crash14.html
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The United States Business Cycle, 1950-1990
Source: http://econ161.berkeley.edu/TCEH/Slouch_Crash14.html
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http://oregonstate.edu/Dept/pol_sci/fac/sahr/pc166514.htm
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http://oregonstate.edu/Dept/pol_sci/fac/sahr/pc1915ff.htm
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http://oregonstate.edu/Dept/pol_sci/fac/sahr/pl1665.htm
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What Happened During
the Great Depression?
Huge increase in unemployment rate, of course, means a huge decrease in Y.
Among the components of GDP, investment dropped precipitously. Government
spending did not compensate for the expenditure drops, at all.
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What Happened During
the Great Depression?
Real money balances were relatively constant. Nominal interest rates
dropped but deflation meant real interest rates were high.
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Roaring Twenties
Extensive innovations in technology and
business practices.
 Rapid growth in American economic
dominance.
 Euphoria.
 Stock market rise (by 9/29 it was 40%
above its fundamental value).
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Crash of October 1929
The urban legend is: stock market crashed
in October 1929 and that triggered the
Great Depression.
 The Stock Market Crash was not the
cause but the effect of economic downturn
and monetary policy of the Fed.
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Economy before 10/29
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The US economy was already slowing
down by the fall of 1929 largely as a result
of monetary tightness.
Industrial production started to decline in July
 Construction permits fell sharply in August
and September.
 Automobile sales dropped sharply in October
 Interest rates in US and abroad were rising
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http://www.federalreserve.gov/boarddocs/speeches/
2002/20021015/default.htm#pagetop
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Stock Market Non-Crash of ‘29
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Stock prices did not collapse in 1929 but only
began to plummet when the depth of the general
economic decline became apparent.
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Stock prices in April 1930 were still about the same
level as in January 1929; and someone who bought
stock in early 1928 and sold in October 1930 would
have almost broken even.
Only as the bad economic news kept rolling in, in the
fall of 1930, did stock prices finally fall below 1928
levels.
http://www.federalreserve.gov/boarddocs/speeches/2002/2
0021015/default.htm#pagetop
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Monetary Tightening
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In 1928, while the inflation rate was actually
slightly negative and the economy was only
barely emerging from a mild recession, the Fed
began to raise interest rates.
The New York Fed's discount rate, at 3.5 percent
in January 1928, reached 6 percent by August
1929, its highest value since 1921.
Rates on term stock-exchange loans peaked in
that month at almost 9 percent, and the rate on
call loans exceeded 10 percent in early August.
For short periods the rates on these loans
sometimes spiked above 20 percent.
http://www.federalreserve.gov/boarddocs/spee
ches/2002/20021015/default.htm#pagetop
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Why Did the Fed Tighten?
To prick the stock market bubble.
 As early as the mid-1920s, various
policymakers and commentators
expressed concern about the rapidly rising
stock market and sought so-called
corrective action by the Federal Reserve.
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http://www.federalreserve.gov/boarddocs/speeches/2
002/20021015/default.htm#pagetop
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Money Supply
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Deflation, like inflation, tends to be closely
linked to changes in the national money
supply, defined as the sum of currency
and bank deposits outstanding, and such
was the case in the Depression. Like real
output and prices, the U.S. money supply
fell about one-third between 1929 and
1933, rising in subsequent years as output
and prices rose.
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Source: http://econ161.berkeley.edu/TCEH/Slouch_Crash14.html
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Milton Friedman and Anna J. Schwartz
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A Monetary History of the United States,
1867-1960 (1963).
Four errors by the Fed.
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Tightening from 1928 on.
Sticking to gold standard and raising interest
rates when USD was “attacked.” (1931)
Stopped easing monetary policy in 1932
because nominal interest rates were low.
Ignored the problems in the banking sector.
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Monetary Tightening in 1928
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Commodity prices were declining sharply, little
hint of inflation.
Fed was concerned that bank lending to brokers
and investors was fueling a speculative wave in
the stock market. When the Fed's attempts to
persuade banks not to lend for speculative
purposes proved ineffective, Fed officials
decided to dissuade lending directly by raising
the policy interest rate.
http://www.federalreserve.gov/boarddocs/speeches/2004/
200403022/default.htm
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Gold Standard
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Fixed exchange rates are subject to speculative
attack if investors doubt the ability of a country to
maintain the value of its currency at the legally
specified parity.
In September 1931 scared speculators
exchanged British pounds for gold in return.
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Faced with the heavy demands of speculators for
gold and a widespread loss of confidence in the
pound, the Bank of England quickly depleted its gold
reserves. Unable to continue supporting the pound at
its official value, Great Britain was forced to leave the
gold standard, allowing the pound to float freely, its
value determined by market forces.
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Gold Standard
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With the collapse of the pound central banks as
well as private investors converted a substantial
quantity of dollar assets to gold in September
and October of 1931, reducing the Federal
Reserve's gold reserves.
The speculative attack on the dollar also helped
to create a panic in the U.S. banking system.
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Fearing imminent devaluation of the dollar, many
foreign and domestic depositors withdrew their funds
from U.S. banks in order to convert them into gold or
other assets.
The worsening economic situation also made
depositors increasingly distrustful of banks as a place
to keep their savings and bank panics proliferated. 25
Fed’s Dilemma
To keep the gold standard means to protect
the dollar by raising interest rates and
making dollar attractive to hold.
 To support the banking system means to
provide funds to the banks under attack and
be lender-of-last-resort by flooding the
system with money and keeping interest
rates low.
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Fed’s Dilemma
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Fed decided to ignore the plight of the banking
system and focused only on stopping the loss of
gold reserves to protect the dollar.
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The attack on the dollar subsided and the U.S.
commitment to the gold standard was
successfully defended.
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Fed chose to tighten monetary policy despite the
fact that macroeconomic conditions--including an
accelerating decline in output, prices, and the
money supply--seemed to demand policy ease.
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Easing or Not Easing
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Congress began pressure the Federal Reserve to ease monetary
policy. The Fed increased money supply between April and June of
1932.
Interest rates fell and the decline in prices and economic activity
halted. Some Fed officials viewed the Depression as the necessary
purging of financial excesses built up during the 1920s. Other
officials, noting the very low level of nominal interest rates,
concluded that monetary policy was in fact already quite easy and
that no more should be done.
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The ongoing deflation meant that the real cost of borrowing was very
high because any loans would have to be repaid in dollars of much
greater value. Thus monetary policy was not in fact easy at all, despite
the very low level of nominal interest rates.
When the Congress adjourned in July 1932, the Fed reversed the
policy. By the latter part of the year, the economy had relapsed
dramatically.
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Banking Sector
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As depositor fears about the health of banks grew, runs
on banks became increasingly common. Deposit
insurance was virtually nonexistent, so that the failure of
a bank might cause depositors to lose all or most of their
savings.
A series of banking panics spread across the country,
often affecting all the banks in a major city or even an
entire region of the country.
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Banking Sector
Between December 1930 and March
1933, when President Roosevelt declared
a "banking holiday" that shut down the
entire U.S. banking system, about half of
U.S. banks either closed or merged with
other banks.
 Surviving banks, rather than expanding
their deposits and loans to replace those
of the banks lost to panics, retrenched
sharply.
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Banking Crisis
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Because bank deposits are a form of money, the
closing of many banks greatly exacerbated the
decline in the money supply.
People hoarded cash. Hoarding effectively
removed money from circulation, adding further
to the deflationary pressures.
Shutting down of the U.S. banking system also
deprived the economy of an important source of
credit and other services normally provided by
banks.
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Bank Panics
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“Many of the banks that failed during the
panics appear to have been at least as
financially sound as banks that were able
to use alternative resolution strategies.
This result supports the idea that the
disruptions caused by the banking panics
may have exacerbated the economic
downturn.” Mark Carlson
http://www.federalreserve.gov/pubs/feds/2008/200807/200807pap.pdf
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Source: http://econ161.berkeley.edu/TCEH/Slouch_Crash14.html
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Bank Consolidation and
Number of Banks
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Shrinking of Banks
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There were 12,343 commercial banks and 2815
savings institutions in 1990. On March 31, 2009
there were 7037 commercial banks and 1209
savings institutions.
Number of failed institutions were in the single
digits in the years 1995-2007. 878 institutions
failed between 1990 and 1994. 25 institutions
failed in 2008 and 21 in Q1 of 2009.
http://www.fdic.gov/bank/statistical/stats/2009mar/FDIC.pdf
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Great Depression
Governments tried to balance budgets,
further slowing down the economy.
 Huge deflation made bank collateral
worthless in defaults.
 Bank failures triggered bank panics.
 Financial system ground to a stop.
 Falling prices provided incentives to
postpone investment.
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Great Depression
Gold standard restricted countries to
expand money supply only when they
acquired gold as a result of trade
surpluses.
 Those countries that abandoned the gold
standard (Scandinavian countries, Japan)
slipped away from the Great Depression.
 To acquire gold, countries passed
protectionist policies (Smoot-Hawley in
US).
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Gold Standard and Trade
Smoot-Hawley was passed in June 1930.
 Eichengreen and Irwin show that those
countries that clung to the gold standard
resorted most to protectionism.
 http://papers.nber.org/papers/w15142
 http://www.economist.com/businessfinanc
e/displaystory.cfm?story_id=14082148
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Trade Shrank to 1/4th Between
Jan. 1929 and Mar. 1933
Dec
Jan
3000
2500
Feb
2000
Nov
Mar
1500
1000
500
0
Oct
Apr
Sep
May
Aug
Jun
Jul
Imports of 75 Countries. Source: E. Ray Canterbury, A Brief History of Economics,
(World Scientific, Singapore: 2001), p. 209.
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Ideologies/Policies That
Exacerbated the Great Depression
Gold Standard
 Classical theory
 Fiscal Conservatism (Balanced Budgets)
 Smoot-Hawley Protectionism
 Tight Money (high interest rate) from bank
failures
 What is it? How does it operate? How did
it contribute to the downfall?
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http://www.economist.com/specialreports/
displayStory.cfm?story_id=14530093
Friedman suggested, the economy can grow faster
than normal for a period until it reaches the point
where it would have been without the crisis, when it
reaches its full potential again.
If the shortfall in demand persists it can do lasting
damage to supply, reducing the level of potential
output (scenario 2) or even its rate of growth
(scenario 3). If so, the economy will never recoup
its losses, even after spending picks up again.
In a recession firms shed labour and mothball
capital. If workers are left on the shelf too long,
their skills will atrophy and their ties to the world of
work will weaken. When spending revives, the
recovery will leave them behind. Output per worker
may get back to normal, but the rate of employment
will not.
World Economic Outlook: cost of 88 banking crises over the past four decades. On
average, seven years after a bust an economy’s level of output was almost 10%
below where it would have been without the crisis.
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Regulatory Legacy of Depression
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The experience of the Depression helped forge a
consensus that the government bears the important
responsibility of trying to stabilize the economy and the
financial system, as well as of assisting people affected
by economic downturns.
Dozens of our most important government agencies and
programs, ranging from social security (to assist the
elderly and disabled) to federal deposit insurance (to
eliminate banking panics) to the Securities and
Exchange Commission (to regulate financial activities)
were created in the 1930s, each a legacy of the
Depression.
http://www.federalreserve.gov/boarddocs/speeches/2004/200403022/default.htm
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Historical Development of the
Banking Industry
ici
Outcome: Multiple Regulatory Agencies
1.
2.
3.
4.
Federal Reserve
FDIC
Office of the Comptroller of the Currency
State Banking Authorities
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http://delong.typepad.com/sdj/2009/03/delonglessons-from-the-new-deal-for-today.html
1.
2.
The government should not sit on its
hands.
Prudent policy has to rely on all the tools
1.
2.
3.
4.
3.
Monetary policy
Quantitative easing
Fiscal policy
Banking policy
Don’t let debates over reform block
policies for recovery
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