The Current Financial Crisis in Spain: What Should We Learn from the Great Depressions of the Twentieth Century?

The Current Financial Crisis in Spain: What Should We Learn from the Great Depressions of the Twentieth Century? Timothy J. Kehoe University of Minnesota and Federal Reserve Bank of Minneapolis 18th Barcelona Lecture Barcelona G.S.E. and Banc Sabadell February 2010 www.econ.umn.edu/~tkehoe

Modeling Great Depressions not Explaining Great Depressions To explain something, I need to understand it. To understand it, I try to model it.

Modeling Great Depressions not Explaining Great Depressions To explain something, I need to understand it. To understand it, I try to model it. My colleagues and I am making progress on modeling Great Depressions. We have not yet arrived at understanding, much less explaining.

Data show that the current financial crisis in the United States is not unprecedented in the postwar period. Furthermore, there are signs that a recovery may be in sight.

S&P 500 (log scale) 10000 1000 100 10 Jan-50 Jan-60 Jan-70 Jan-80 Jan-90 Jan-00 Jan-10

International data show a darker picture.

Source: Eichengreen and O’Rourke

To sum up, globally we are tracking or doing even worse than the Great Depression, whether the metric is industrial production, exports or equity valuations. Focusing on the U.S. causes one to minimize this alarming fact. The “Great Recession” label may turn out to be too optimistic. This is a Depression-sized event. That said, we are only one year into the current crisis, whereas after 1929 the world economy continued to shrink for three successive years. Barry Eichengreen and Kevin H. O’Rourke (June 2009), “A Tale of Two Depressions.”

A September 2009 update on Eichengreen-O’Rourke

World industrial production

World stock markets

World trade

What do the new data tell us? Global industrial production now shows clear signs of recovering. This is a sharp divergence from experience in the Great Depression, when the decline in industrial production continued fully for three years. The question now is whether final demand for this increased production will materialise or whether consumer spending, especially in the US, will remain weak, causing the increase in production to go into inventories, leading firms to cut back subsequently, and resulting in a double dip recession. Global stock markets have mounted a sharp recovery since the beginning of the year. Nonetheless, the proportionate decline in stock market wealth remains even greater than at the comparable stage of the Great Depression. The downward spiral in global trade volumes has abated, and the most recent month for which we have data (June) shows a modest uptick. Nonetheless, the collapse of global trade, even now, remains dramatic by the standards of the Great Depression.

Great Depressions of the Twentieth Century Project Timothy J. Kehoe and Edward C. Prescott www.greatdepressionsbook.com

Cole and Ohanian, “The Great Depression in the United States from a Neoclassical Perspective,” Federal Reserve Bank of Minneapolis Quarterly Review, Winter 1999. Federal Reserve Bank of Minneapolis Conference, October 2000. Special Issue of Review of Economic Dynamics, January 2002. Great Depressions of the Twentieth Century, July 2007.

15 studies by 26 researchers using the same methodology Great depressions 1930s United States, United Kingdom, Canada, France, Germany Recent Argentina (1970s and 1980s), Chile and Mexico (1980s), Brazil (1980s and 1990s), New Zealand and Switzerland (1970s, 1980s, and 1990s), Argentina (1998-2002) Not-quite-great depressions Italy (1930s), Finland (1990s), Japan (1990s)

Kehoe and Prescott define a great depression to be a large negative deviation from balanced growth. They set the growth rate in the balanced growth path to be 2 percent per year, the growth rate of output per working-age person in the United States during the twentieth century.

Real GDP per Working Age Person in the United States, 1900-2009 3.00 800 2.00 400 index (1900 = 100) 200 1.00 trend real GDP 100 0.00 -1.00 50 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 year

Real GDP per Working Age Person in Spain, 1900-2009 9.64 800 8.64 400 index (1900=100) trend 7.64 200 real GDP 6.64 100 50 5.64 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 year

Trend growth: yti ˆ t ˆi y0 , 1.02 Great depression: D [t0 , t1 ] such that t t0 1. There is some t in D in such that yti / yti0 ˆ 1 0.20. t t0 2. There is some t t0 10 such that yti / yti0 1 0.15. 3. There are no t1 , t2 in D, t2 t1 10, such that t 2 t1 yti2 / yti1 1 0.

Great depressions in the 1930s: Detrended output per person 110 100 France Germany Index (1928 = 100) 90 United States 80 70 Canada 60 50 1928 1930 1932 1934 1936 1938

Great depressions in the 1980s: Detrended output per working-age person 110 100 Chile Index (1980 = 100) 90 Brazil 80 Mexico 70 Argentina 60 50 1980 1982 1984 1986 1988 1990

Great depressions methodology Crucial elements: Growth accounting and dynamic general equilibrium model Growth accounting decomposes changes in output per working-age person into three factors: a productivity factor a capital factor an hours-worked factor

Great depressions methodology Crucial elements: Growth accounting and dynamic general equilibrium model Growth accounting decomposes changes in output per working-age person into three factors: a productivity factor a capital factor an hours-worked factor Keynesian analysis stresses declines in inputs of capital and labor as the causes of depressions.

Balanced growth path In the dynamic general equilibrium model, if the productivity factor grows at a constant rate, then the capital factor and the hours-worked factor stay constant and growth in output is due to growth in the productivity factor. Twentieth century U.S. macro data are very close to a balanced growth path, with the exception of the Great Depression and the subsequent World War II build-up.

Balanced growth path 1 Yt 1 Kt 1 Lt A t Nt Yt Nt When At 1 g 1 At Kt Lt and are constant Yt Nt Yt grows at rate g 1, assume g 1 0.02 as in U.S. Nt

Growth Accounting for the United States, 1970-2009 240 220 200 index (1970 = 100) output 180 160 productivity 140 120 hours worked 100 capital 80 60 1970 1975 1980 1985 1990 1995 2000 2005

Growth Accounting for Spain, 1970-2009 240 220 200 productivity index (1970 = 100) 180 160 output 140 120 capital 100 80 hours worked 60 1970 1975 1980 1985 1990 1995 2000 2005

Growth accounting for the United States 1929–1939 140 capital productivity 120 index (1929=100) 100 output 80 hours worked 60 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939

We use a dynamic general equilibrium model to model the responses of households and firms — in terms of capital accumulation and hours worked — to changes in productivity and changes in government policy. We take the path of the productivity factor as exogenous. Comparing the results of the model with the data, we can identify features of the depression that need further analysis. Example: The Great Depression in the United States.

Growth accounting for the United States 140 capital productivity 120 index (1929=100) 100 output 80 hours worked 60 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939

Growth accounting for the United States 140 productivity 120 index (1929=100) 100 80 60 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939

Growth accounting for the United States 140 120 index (1929=100) 100 output 80 60 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939

Growth accounting for the United States 140 120 capital index (1929=100) 100 80 60 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939

Growth accounting for the United States 140 120 index (1929=100) 100 80 hours worked 60 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939

Conclusions A simple dynamic general equilibrium model that takes movements in the productivity factor as exogenous can explain most of the 1929-1933 downturn in the United States. The model over predicts the increase in hours worked during the 1933-1939 recovery. Need for Further Study The decline in productivity 1929-1933 The failure of hours worked to recover 1933-1939

Lessons from Great Depressions Project The main determinants of depressions are not drops in the inputs of capital and labor — stressed in traditional theories of depressions — but rather drops in the efficiency with which these inputs are used, measured as total factor productivity (TFP). Exogenous shocks like the deteriorations in the terms of trade and the increases in foreign interest rates that buffeted Chile and Mexico in the early 1980s can cause a decline in economic activity of the usual business cycle magnitude. Misguided government policy can turn such a decline into a severe and prolonged drop in economic activity below trend — a great depression.

Growth Accounting for Mexico 140 120 capital index (1980 = 100) hours 100 output 80 productivity 60 1980 1985 1990 1995 2000 2005

A Decade Lost and Found: Mexico and Chile in the 1980s Raphael Bergoeing, Patrick J. Kehoe, Timothy J. Kehoe, and Raimundo Soto Similar crises in 1981-1983 more severe in Chile than in Mexico Different recoveries much faster in Chile than in Mexico Why different pattern?

Real GDP per working-age (15-64) person detrended by 2 percent per year 130 120 110 Chile index (1980=100) 100 90 80 Mexico 70 60 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 year

Growth accounting and applied dynamic general equilibrium model Two numerical experiments with model: Base case model: takes series for productivity factor as given. Model with tax reform: takes series for productivity factor as given and imposes tax reform that lowers tax on capital income in 1988 in both countries.

Applied dynamic general equilibrium model The representative consumer maximizes t 1980 t log Ct (1 )log(hNt Lt ) subject to Ct Kt 1 Kt wt Lt (1 t )( rt ) Kt Tt where Tt t ( rt ) Kt is a lump-sum transfer. Feasibility: Ct Kt 1 (1 ) Kt At Kt L1 t .

Calibration First order conditions: 1 1 (1 )(r ) C C t t t 1 t 1 wt . hNt Lt Ct Look at 1960-1980 data Ct Ct 0.98, 1 1 0.45 in Mexico, 0.56 in Chile ; (rt )Ct 1 Ct 0.30 in Mexico, 0.28 in Chile . Ct wt (hNt Lt )

Numerical experiments Base case: t 0.45 in Mexico, t 0.56 in Chile , 1980-2000. Tax reform: t 0.45 in Mexico, t 0.56 in Chile , 1980-1988; t 0.12 in Mexico, t 0.12 in Chile , 1988-2000.

Detrended real GDP per working-age person and productivity factor 140 Chile output 120 index (1980=100) 100 Chile productivity 80 Mexico output 60 Mexico productivity 40 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

Detrended real GDP per working-age person: base case model 140 Chile data 120 index (1980=100) 100 Chile model 80 Mexico data 60 Mexico model 40 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

Detrended real GDP per working-age person: model with tax refrom 140 Chile model 120 Chile data index (1980=100) 100 80 Mexico data 60 Mexico model 40 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

What do we learn from growth accounting and numerical experiments? Nearly all of the differences in the recoveries in Mexico and Chile result from different paths of productivity. Tax reforms are important in explaining some features of the recoveries, but not the differences. Implications for studying structural reforms story: Only reforms that are promising as explanations are those that show up primarily as differences in productivity, not those that show up as differences in factor inputs. Timing of reforms is crucial if they are to drive the differences in economic performance.

Fiscal reforms Chile: tax reforms 1975, 1984 social security reform 1980 fiscal surpluses Mexico: tax reforms 1980, 1985, 1987, 1989 fiscal deficits Important, but not for explaining the differences!

Trade reforms Chile: by 1979 all quantitative restrictions eliminated uniform tariff of 10 percent tariff hikes during crisis — tariff back below 10 percent in 1991 Mexico: in 1985 100 percent of domestic production protected by import licenses nontariff barriers and dual exchange rates Massive trade reforms in Mexico 1987-1994, culminating in NAFTA Timing seems wrong!

Privatization Chile major privatizations 1974-1979 Mexico major nationalization 1982 expropriated banks’ holdings of private companies government controlled 60-80 percent of GDP major privatizations after 1989 Timing seems wrong?

Banking Chile: 1982 and after took over failed banks market-determined interest rates lowered reserve requirements. Mexico: 1982 and after nationalized all banks government set low deposit rates 75 percent of loans either to government or directed by government.

Private credit as a percent of GDP 90 80 Chile 70 percent GDP 60 50 40 30 Mexico 20 10 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 year

Bankruptcy laws Chile had reformed the administration of its bankruptcy procedures in 1978. In 1982 it reformed its bankruptcy laws to look much like those in the United States. Mexico reformed its bankruptcy procedures in a similar way only in 2000. (Maybe not so similarly!)

Business bankruptcies in Chile 500 400 number per year 300 200 100 0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 year

Studying the experience of countries that have experienced great depressions during the twentieth century teaches us that massive public interventions in the economy to maintain employment and investment during a financial crisis can, if they distort incentives enough, lead to a great depression.

Concluding observations

Comparison of the 2007–2010 U.S. recession with the 1981–1983 U.S. recession

U.S. Real GDP 106 104 index (peak = 100) 102 2007 IV 100 98 1981 III 96 94 0 1 2 3 4 5 6 7 8 quarter following peak

U.S. Unemployment Rate 12.0 July 1981 10.0 8.0 percent 6.0 December 2007 4.0 2.0 0.0 0 2 4 6 8 10 12 14 16 18 20 22 24 month following peak

Comparison of the 2007–2010 U.S. recession with the 1981–1983 U.S. recession Using conventional measures — real GDP, unemployment rate — the 2007–2010 recession is not noticeably worse than the 1981– 1983 recession.

Comparison of the 2007–2010 U.S. recession with the 1981–1983 U.S. recession Using conventional measures — real GDP, unemployment rate — the 2007–2010 recession is not noticeably worse than the 1981– 1983 recession. The recovery during the 2007–2010 recession has been slower, and there is still a danger that the current recession could turn into a “double-dip” recession.

Comparison of the crises in the United States and Spain

Comparison of the Crises in the United States and Spain: Real GDP per Working Age Person 108 106 Spain index (2005 I = 100) 104 102 United States 100 98 2005 2006 2007 2008 2009

Comparison of the crises in the United States and Spain Looked at over the past five years, Spanish growth experience compares very favorably with that of the United States.

Comparison of the crises in the United States and Spain Looked at over the past five years, Spanish growth experience compares very favorably with that of the United States. The recovery in the United States seems to have started in 2009 III. The recovery in Spain does not seem to have started yet.

Those who try to justify the sorts of Keynesian policies implemented by the Mexican government in the 1980s often quote Keynes’s dictum from A Tract on Monetary Reform: “The long run is a misleading guide to current affairs. In the long run we are all dead.”

Studying past great depressions turns this dictum on its head: “If we do not consider the consequences of policy for productivity, in the long run we could all be in a great depression.”

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The Current Financial Crisis in Spain: What Should We Learn from the Great Depressions of the Twentieth Century?

by Barcelona Graduate School of Economics (GSE)

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