The Great Depression:1929-1939

Functional MRI showing fear

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Economics during the Thirty Years War, 1914-1945

• Period of rapid but volatile growth up to World War I • Financial turmoil and hyperinflations of the early 1920s• Stability briefly restored in late 1920s• Problems began to surface in the US:

– Real estate and stock market booms in U.S.– Resembled Internet bubble of 1990s in (a) hype, (b) new

financial instruments• Problems began with stock market crash of 1929• Followed by bank panics through 1933• Collapse of investment and international trade after 1929• Government and Fed took hesitant steps to stimulate the

economy• Trough in 1933• Remember that Keynes’s General Theory not published

until 1935 – the birth of macroeconomics.

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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.

Comparison with the Great Recession of 2007-09

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Fear and panic on Wall Street, then and now

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2007 - on1929 - 1933

Stock prices (beginning of period =1)

2007 2008 2009

On Main Street with real GDP …

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Real GDP 2007 -Real GDP 1929 - 1933

Real output (beginning of period =1)

2007 2008 2009

On Main Street with unemployment rate…

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Unemployment rate (1929 - 1940)Unemployment rate (2007 - )

Unemployment rate

2007 2008 2009

The long cycle by components

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Q C I NX G

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Growth in Key Indicators

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

gold3. 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%

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What caused the Great Depression? AS or AD shocks?

• Was the depression caused by AD shocks or AS shocks?

• Looks like standard AD shock.

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Actual GDP/Potential GDP

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Alternative views of the sources of the GD

I. “Expenditure view”: IS or spending shocks

II. Financial market distress:A. “Money view”: Incompetent Fed reduced money

supplyB. [“Golden fetters”: The gold-standard regime

required central banks to act in deflationary manner (an “international LM curve”). We will not discuss.]

C. Risk, Panic, and deflation theories – most resembles 2007-09.

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Real output (Y)

interestrate(i)

IS1929 LM

Y1933

0

IS interpretation of the depression

IS1933

Y1929

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The Expenditure Approach: IS Shocks

Were shocks in the IS curve responsible? From NX, C, G?– Foreign trade, government spending and taxes were too

small– No exogenous consumption shock

From I?– Investment decline was the major shock.– However, the mechanism is unclear:

• Probably endogenous from financial turmoil and overhang from 1920s, from accelerator, and from decline in Tobin’s Q from stock-price shock?

Not a persuasive case for shock to standard IS sources.

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II. Financial Market Background

• 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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Real output (Y)

interestrate(i)

IS

LM

Y*

i*

Monetarism, the Depression, and IS-LM

LM‘

i**

Y**

• The monetarist regime: "Only money matters for output determination.“

• Friedman’s monetarism. For example, in the “Summing Up” in Friedman and Schwartz, Monetary History of the United States:“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)

• We can interpret this as a constant velocity of money, yielding:

• With fixed prices, this then yields a vertical LM curve because there is only one level of output consistent with a given money supply.

II.A. Friedman and Schwartz and the Monetarist Argument

, where is constant velocity of money.SPY =VM V

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Friedman and Schwartz: The Money View of the GD

• F&S view the depression as primarily driven by “incompetent” monetary policy caused by decline in money supply

• F/S argued that Fed:– Could have raised M1 (probably

correct)– Rise in M1 could have

prevented Y fall and nipped GD in bud (very contentious)

• F&S largely ignored the role of maintenance of the gold standard (clearly wrong)

• In IS-LM model, LM curve shifted in (see next slide)

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

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Interest Rates 1920-39

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3-month T-billFed discount rate (low)

Corporate bond rateCommercial paper rate

Inte

rest

ra

te (

% p

er

yea

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

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IIC1. Liquidity trap in the Depression

An alternative approach is that the world economy was in a “liquidity trap” in the depression.

Important insight and nightmare of central bankers: M policy completely ineffective when i gets to 0.

Liquidity trap in US in Great Depression

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1930 1932 1934 1936 1938 1940 1942 1944

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

interestrate(i)

IS

Y*=Y*’

LM LM’

Problem with LT approach:Cannot by itself cause depression.

II.C2. What about risk?

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Risk premium on investment grade bonds

Baa rate minus 10-year T bond rate

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Risk premium on investment grade bonds

Baa rate minus 10-year T bond rate

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Risk Premium Theory of the Depression• Theory that bankruptcies, bank failures, panics increased

the risk premiums on bonds and stocks.

• We can modify our cost of capital as follows:

rr = risky real cost of capital to business (risky interest rate)

= i – π + risk premium = i – π + ρ

• If risk premium rises in recession/depression, this leads to further falls in asset prices and cuts in investments.

• Easiest to incorporate in IS curve as function of i: **

Y = IS(rr, A0) = IS(i – π + ρ, A0)

• Particularly deadly in case of liquidity trap (also, clearly relevant today).

** NOTE ADDED AFTER LECTURE: SEE NEXT SLIDE.

Note added after lecture

Shifting the IS curve is due to substitution. 1. The original IS curve we derived is:

(a) Y = IS(r, A0)

2. But we need to consider risk, so we rewrite it as the following

(b) Y = IS(rr, A0)

where rr = risky real cost of capital to business (risky interest rate) = i – (rate of inflation) + (risk premium) = i – π + ρ3. We substitute the formula for rr into (b):

(b)Y = IS(i – π + ρ, A0)

This gives the IS as a function of the riskfree nominal rate, i.4. Note that if π = ρ = 0, then it is the normal IS curve. However, if

ρ = .05, then this means that i must be .05 lower to get the same real rate relevant to investment, etc. So we lower the IS curve by – π + ρ.

5. Finally, note that with deflation (– π) is a positive number, so it is also a downward shift.

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Real output (Y)

Nominal safe interestrate(i)

IS(i + ρ, A0)

Y1

Impact of Increase in Risk Premium with Liquidity Trap

LM: liquidity trap

Y2

Risk is particularly deadly in liquidity trap because Fed cannot offset.

IS(i + ρ’, A0)

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Real risky rateNominal risky rateNominal riskfree rate

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nat

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cent per

yea

r)Risk and deflation a deadly disease

II.C3. Add deflation to risk ….

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Real output (Y)

IS(i – π + ρ, A0)

Y1

Add deflation to risk …

LM: liquidity trap

Y2

Deflation further shifts down the IS curve

IS(i – π’ + ρ’, A0)

Y3

Nominal safe interestrate(i)

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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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Unemployment rateDefense spending/GDPFederal expenditures/GDP

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WW II

The end of the depression …

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Implication of the Recovery

• Recovery from GD required an increase in high-employment deficit of 20-25 percent of GDP– FE Deficit was around 3-4 % in 1938 with unemployment

rate of 16-18 %– U rate declined to 5 percent in 1942, with FE Deficit of 25

% 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 seduction simplicity of monocausal

approaches.

• Perhaps a complex situation where combination of factors piled up to produce a “perfect storm” of macroeconomics:– bad luck (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 (deflation and liquidity trap)

• Will it happen again? How does 2007-2009 differ from the 1930s?