The Great Depression(1929-1941)

Housekeeping

Midterm on Wed October 9 11:35-12:50 pm Law School Auditorium(NOT Dunham Lab)

TF office hours Review sessions Mon and Tues night (see class web

site).

Final questions?

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Key Elements in the Great Depression 1929-1933

• Started as asset price bubble and burst in 1920s• Gold standard hamstrung central banks from

expansionary actions.• Collapse of investment and international trade after

1929• Multiple bank failures through 1933 (standard panic

model)• Unclear why so deep and persistent: low level

equilibrium?• No effective fiscal policy until 1940• Trough finally reached in 1933, but no sharp recovery• Recovery came only with fiscal expansion in World War

II

Prelude to the Great Depression: Asset bubble

4

0

50

100

150

200

250

300

1920 1925 1930 1935 1940

The asset bubble of the 1920sStock market wealth/GDP (1918 = 100)

The Great Crash, October 1929

Bank failures and panics, 1931-1933

GDP Gap in Depression

0.6

0.7

0.8

0.9

1.0

1.1

1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939

Actual/Potential GDP

Cumulative loss in postwar recessions (%-years)

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0

5

10

15

20

25

30

35

40

45

50

Cumulative loss of Great Depression (%-years)

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0

50

100

150

200

250

High unemployment for a decade

11

0

5

10

15

20

25

30

1928 1930 1932 1934 1936 1938 1940

High unemployment for a decade

Economic migration

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Tales of the labor market in recession/depression:

“I’d get up at five in the morning and head for thewaterfront. Outside the Spreckles Sugar Refinery,outside the gates, there would be a thousand men.You know dang well there’s only three or four jobs.The guy would come out with two little Pinkertoncops: “I need two guys for the bull gang. Two guys togo into the hole.” A thousand men would fight like apack of Alaskan dogs to get through. Only four of uswould get through.”

Studs Terkel, Hard Times.

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Growth in Key Indicators

Periods are:1. Pre-crash boom2. From crash to Britain’s leaving gold in October

19313. From gold crisis to trough

Note: rates of change at annual rates.

Period H M1 Real M1Ind. Prod.

Real GDP Inflation

1927:10-1929:8 42.7% 1.1% 1.4% 11.6% 3.8% -0.3%1929:8-1931:12 2.0% -8.1% -0.9% -22.4% -6.7% -7.3%1931:12-1933:4 6.5% -10.5% 0.6% -10.2% -11.9% -11.0%

H = high powered money.

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Alternative views of the sources of the GD

Classical theories:• Basically a variant on real business cycles• Complicated story for another time. Bottom

line is that it 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

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Real output (Y)

interestrate(r)

IS1929 MP

Y1933

0

IS interpretation of the depression

IS1933

Y1929

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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 to cause depression– No apparent exogenous consumption shock– Investment decline was the major shock.

• Panics, high risk premiums, low output, unstable dynamics

• Shift to “bad investment equilibrium” clearly at work

Investment accelerator at work

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0

20

40

60

80

100

700 800 900 1,000 1,100

GDP

Inve

stm

en

t1929

1933

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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. financial market stability (asset prices, panics, liquidity)

2. exchange rates (gold standard and convertibility)

3. macroeconomy (inflation, output, and employment)• Fed was primarily concerned about (#1) speculation in

1928-29 and tightened money at that point.• When depression was underway, Fed was primarily

concerned with defending the gold standard (#2) 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 (#3).

• 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)

Friedman and Schwartz and the Monetarist Argument

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Money in the Great Depression

0.4

0.5

0.6

0.7

0.8

0.9

1.0

1.1

1.2

28 29 30 31 32 33 34 35 36

M1 (1929 = 1)Industrial production (1929 = 1)

• 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

Friedman and Schwartz and the Monetarist Argument

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Real output (Y)

interestrate(i)

IS

MP

Y*

i*

Monetarism, the Depression, and IS-MP

MP‘

i**

Y**

Problem with monetarist interpretation of Depression

Tobin wrote severe critique of Friedman and Schwartz.Problems:• While it is true that M1 fell, it is likely to be a

consequence rather than a cause of the Depression (Tobin).

• Interest rates fell rather than rose (much like today).• While Fed might have done more, hard to see how they caused

the Depression

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25

Interest Rates 1920-39

0

2

4

6

8

10

20 22 24 26 28 30 32 34 36 38 40

3-month T-billFed discount rate (low)

Corporate bond rateCommercial paper rate

Inte

rest

ra

te (

% p

er

yea

r)Problem with monetarist interpretation:Safe interest rates fell in GD!!!

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Fed interest rates:Great Depression and Great Recession

0

1

2

3

4

5

6

7

1926 1928 1930 1932 1934 1936 1938 1940

2008 2010 2012

Depression

Today

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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!

Liquidity trap in US in Great Depression

0

1

2

3

4

5

6

1930 1932 1934 1936 1938 1940 1942 1944

US short-term interest rates, 1929-45 (% per year)

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Real output (Y)

interestrate(i)

IS1929 MP1929

= MP1933

Y1933

0

IS1933

Y1929

Y1939

MP1939

The Roosevelt Presidency (1933-1945)

“We have nothing to fear but fear itself.”

The rise of the dictators (1917 - )

World War II (1931-1945)

Military spending takes off…

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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!

35

0

5

10

15

20

25

30

.0

.1

.2

.3

.4

.5

.6

30 32 34 36 38 40 42 44 46 48

Unemployment rateDefense spending/GDPFederal expenditures/GDP

Ger

m invas

tion

Aust

ria,

Cze

ch

Ger

m. in

vas

tion

Pol

and

Ger

m in

vas

ion F

rance

Pea

rl H

arbor

WW II

The end of the depression …

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Real output (Y)

interestrate(i)

IS1945

0

IS1939

Y1945

Y1939

MP

WW II

• Stimulus was 25% of GDP.

• Equivalent to $4 trillion/year stimulus package

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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 “bad depression equilibrium”

• Size of WW II stimulus suggests that no ordinary monetary or fiscal policy could have quickly ended the depression.

• Can it happen again? To answer need to understand how macroeconomic theory and institutions have evolved.