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The Great Depression
     1929-1933
The Defining Moment
Why “Great” Depression
Ben Bernanke: “To understand the Great Depression is the
Holy Grail of macroeconomics. Not only did the Depression
give birth to macroeconomics as a distinct field of study, but
also---to an extent that is not always fully appreciated—the
experience of the 1930s continues to influence
macroeconomists; beliefs, policy recommendations and
research agendas…..We do not yet have our hands on the
Grail by any means…..”(JMCB, 1995)
Rex Tugwell
   (advisor to Roosevelt)
 “The Cat is out of the Bag.
 There is no invisible hand.
  There never was. If the
depression has not taught us
  that we are incapable of
 education…..We must now
  supply a real and visible
 guiding hand to do the task
     which that mythical,
nonexistent, invisible agency
 was supposed to perform,
       but never did.”
The Prelude 1919-1929
• U.S. enters the war late. (1917-1918)
  effects on U.S. economy relatively small
  compared to European economies.
• Huge damage and disruption to European
  economies.
• Real GDP = 100 in 1913. In 1919,
  UK=101 France=75 Germany=72 US = 116
• Inflation! Price level = 100 in 1914. In 1918
  UK=210 France=213 Germany304 US=164
• Huge climb in Debt/GDP ratios.
Consequences
1. World War I---9.5 million deaths. Loss of a
   generation (UK 1m, France 1.4m, Germany 2m,
   US 114,000)
2. Destruction of physical capital especially
   Belgium and northern France
3. Distortion of patterns of production, trade and
   consumption (e.g. high wartime prices for
   commodities—boom and collapse in U.S.
4. High cost of war. Estimated $208 billion.
5. Political and economic borders of Europe are
   redrawn.
6. Inter-allied war debts and German reparations.
Inter-Allied War Debts ($ billions)
     (Kindleberger,The World in Depression

                                                       France

                           4.0                 3.0


                    4.7                                             3.5
United States               United Kingdom

                                                     8.1

                          3.2

                                                     Other Countries

    To pay principal and interest, war devastated economies would
    have to run balance of payments surpluses.
German Reparations
• John Maynard Keynes (1919) Reparations
  were a “policy of reducing Germany to
  servitude for a generation, of degrading
  the lives of millions of human beings, and
  of depriving a whole nation of happiness.”
  They were “abhorrent and detestable.”
• Étienne Mantoux (1946) Reparations not
  excessive, destructive or uncollectible.
• The French paid in 1815 and 1871---”Le
  Boche Paiera”
The magnitude of reparations
                   Indemnity Percent Share of
                    (billions) of One    Debt
                               Year's   Service
                                GDP     to GDP
France 1815-1819   FF 1.65 to 18 to 21 1.2 to 1.4
                   1.95
France 1871        FF 5.0        25        0.7
Germany1923-1931 DM 50           83        2.5
Vichy 1940-44    FF 479         111        2.6
Germany1953-1965 527 US$        7.7        0.4
Japan 1955-1965  1486 US$       3.0        0.8
Solution---the Dawes Loan 1924
• German Hyperinflation.
• Dawes Loan---begins series of loans---
  U.S. provides funds and funds for
  investment around the globe.
• New York as central of global finance—not
  London
Return to Gold Standard
        “Status Quo Antebellum”
• No problem for U.S.—huge balance of payments
  surpluses and gold
• U.K. deflates and returns to gold in 1925 at old
  parity £1 = $4.86. But overvalued. Depressed
  economy.
• France with near hyperinflation returns to gold in
  1926 at a new parity (old $1= 5FF now $1 = 25.5
  FF) Undervalued currency. Booming economy.
• Germany’s hyperinflation---returns to gold at
  near purchasing power 1925.
• Major imbalances---brittle equilibrium.
Adjustment under restored gold
        standard more difficult
• International capital markets are revived---
  generally free.
• International labor flows almost eliminated
  —immigration restrictions
• Increased protectionism
• Less wage flexibility. Wage now seem
  sticky even with high unemployment
U.S. Economic Prosperity in 1920s
•   No trend inflation
•   High productivity growth
•   1922-1929, GNP grew at 4.7%,
•   Unemployment averaged 3.7%.
•   Fed accommodated seasonal demands
    for credit and attempted to smooth
    economic fluctuations. (2 brief
    recessions)
Some basic numbers
•   Peak August 1929, Trough May 1933
•   Real GDP falls 39%
•   Real Consumption falls 29%
•   Prices (GDP deflator) falls 23%
•   Unemployment Jumps:
    – 3.2% in 1929
    – 25% in 1933 (21%Darby)
    – 17% in 1939 (17% Darby)
• Banking Collapse
    – July 1929, 24,504 banks, $49 billion deposits.
    – December 1932, 17,802 banks, with $36 billion.
    – After Bank Holiday March 1933, 11,878 banks with
      $23 billion deposits.
Key American Role in World Depression
• Based on
  industrial
  production
  GD starts in
  most
  countries at
  the same
  time
• But it is
  larger and
  longer in the
  U.S. Romer
  (1993)
Worst in the U.S.
 • For the U.S.,
   Industrial
   Production
   – Biggest drop in
     first year
   – Biggest drop
     peak to trough
   – Biggest drop in
     the last year.
 • However, turning
   points are very
   similar
Understanding the Great Depression:
            Its Evolution by Phases
                                                                         Real GDP, 1920-1941

1.   Booming Strong Economy in 1920s
                  140

2.   Beginning Shocks, 1928-1929
3.   Aggravating Shocks, 1930-1933
                  130



4.   Rock Bottom and Recovery, 1933-1936
                  120


5.   The 1937-1938 Recession
                  110
6.   The Recovery, 1939-1941
               1929=100




                          100



                          90



                          80



                          70



                          60
                                1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 1941
Understanding the
 Great Depression:
Four Basic Questions                                                   Real GDP, 1920-1941

                        140

1.   Why it Began?
2.   Why so Deep?       130




3.   Duration?          120



4.   Recovery?          110
             1929=100




                        100



                         90



                         80



                         70



                         60
                              1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 1941
Understanding the Great Depression:
           Its Evolution by Phases
1.     Booming Strong Economy in 1920s…but
     a) It’s the Roaring Twenties!
     b) No trend inflation
     c) High productivity growth
     d) 1922-1929, GNP grew at 4.7%,
     e) Unemployment averaged 3.7%.
     f) Fed accommodated seasonal demands for credit and
         attempted to smooth economic fluctuations. (2 brief
         recessions)
     g) BUT: Weak American Agriculture: low prices, high debt,
         weak banks
     h) BUT: Weak Europe: reparations, debts to U.S., slow
         growth, gold standard fragile (overvalued £, UK slumps)
         and (undervalued FF, France booms)
     i) BUT: U.S. Stock market boom halts foreign loans to
         Germany, Eastern Europe and Latin America
Understanding the Great Depression:
           Its Evolution by Phases
1.       Beginning Shocks, 1928-1929
     •     Spring 1927 U.S. expansionary monetary policy to ease pressure
           on the British balance of payments. Critics assert policy too easy,
           and allows stock market boom to ignite
     •     Fed tightens policy in 1928 (discount rate 3 ½ to 5%, and there is
           little increase in total money or credit for 1928-1929.
     •     U.S. stock market boom begins March 1928.
     •     Commercial paper market vanishes
     •     No new lending to Germany, Austria and rest of work in
           1928….Germany slides into a recession.
     •     Fed tries to “jaw-bone” market down. Criticizes brokers loans.
     •     July 1929 raises discount rate from 5 to 6%.
     •     But July-August is peak of business cycle. Recession begins
           Summer 1929
     •     October 1929 U.S. Stock market crash: wealth effect—lowers
           consumption and investment, credit effect—reduces value of
           collateral and hence lending
     •     Smoot-Hawley tariff 1929 by U.S. induces retaliatory tariffs by
           other countries, international trade declines
Understanding the Great Depression:
               Its Evolution by Phases
1.   Aggravating Shocks, 1930-1933
   a) Banking Panics, 1930, 1931, 1933
   –    Failure of the Fed to Pursue Expansionary Policy
   –    Collapse of Gold Standard: Austria, Germany leave the gold
        standard, Britain departs after a run on the pound in September 1931
   –    U.S. begins losing gold, trade deficits and capital flight.
2.   From Rock Bottom to Recovery, 1933-1936
   –    Bank Holiday March 1933
   –    U.S. abandons the Gold Standard March 1933
   –    New Deal Banking and Securities Legislation
   –    Monetary Expansion
   –    Minimal Fiscal Policy
     –     National Industrial Recovery Act (NIRA)
3.       The 1937-1938 Recession
     a)    The Fed Raises Reserve Requirements
4.    The Recovery, 1939-1941
     a) Monetary Expansion
     b) Fiscal Expansion in preparation for war.
Four Basic Questions:
        1. Why It Began?
 2. Why So Deep and 3. So Long?
• Friedman and Schwartz (and others), the
  economy is entering a recession in late
  1929
• The economy is beginning to recover in
  1931 like a normal business cycle
• BUT what makes the recession worse?
• What turns the recession into a
  depression?
The Worsening Depression
• Slight recovery early 1931,then plunge.
• Why?
• Romer (1993) “The source of the continued
  decline in production in the United States was
  almost surely a series of banking panics.”
• Friedman and Schwartz (1963) document four
  panics
  –   Fall of 1930
  –   Spring 1931
  –   Fall 1931---Britain abandons the Gold Standard
  –   First Quarter 1933
• 9000 Banks suspend operations. Depositors
  and stockholders lose $2.5 billion = 2.4% of
  GDP…...not the whole story
Why are there
banking panics?
Why Banking Panics?
• There were no banking panics in Canada.
• Fragmented unit banking system
• Undiversified bank portfolios with high
  regional concentration of loans. Large
  number of bank closures in the agricultural
  states when agricultural prices fall. In
  addition, many hold bonds whose value
  collapsed.
• Many banks become insolvent
• Fear of insolvency feeds the liquidity
  crisespanics.
Effects of Banking Panics
• Money Supply Declines and there is a massive
  rise in realized real interest rates, over 10%.
• Friedman and Schwartz blame inaction of the
  Fed for this decline---and hence for the
  depression.
How do Friedman and Schwartz
  explain why the Fed did not act?
• Up to end of 1930
  – What is the Fed concerned
    about?
  – How does it react to banking
    failures?
• Who was Benjamin Strong?
• New York Fed v. Board of
  Governors?
• What could the Fed have
  done 1930-1931?
• What does Congress do?
Why didn’t the Fed act?
• Beginning in 1931, Friedman and Schwartz argue that Fed
  could have expanded but chose not to.
• In diary of Charles S. Hamlin member of the FR Board, he
  wrote during August 1931 that Open market committee
  voted 11 to 1 against $300 million open market purchase
  of bonds---reduce it to $120 million.
• Governor Mayer of the Board worried about inflation.
• Members of the regional banks did not grasp the extent of
  the crisis.
• Pressure from Congress---open market operations of $1
  billion. Until Congress adjourns.
• After Britain leaves gold in September 1931, gold drain
  starts. Dollars exchanged for gold---Fed’s reserves fall, it
  is afraid that further expansion will lead to greater loss of
  gold----constrained by the gold standard. Reserves falling
  after UK goes off gold in 1931, must retain high interest
  rates.
Understanding the Great Depression:
       Four Basic Questions
    1.   Why it Began?
    2.   Why so Deep?
    3.   Duration?
    4.   Recovery?
Understanding the Great Depression:
           Four Basic Questions
1. Why it Began?
      Business Cycle Peak 7/8-1929, Federal
      Reserve’s tight policy
2. Why so Deep?
      Banking Panics. Inaction of the Federal
      Reserve
•   Duration?
•   Recovery?
How is the economy driven into a
severe depression by the declining
          money supply?

    What is the mechanism of
         transmission?

    Several Explanations……
Romer (1993) basic argument is simple
   • Depression is the result of a series of aggregate demand
     (monetary) shocks that moved economy down an
     upward sloping aggregate supply curve.


Price                          Price
Level                          Level




                      Output                       Output
Romer (1993) basic argument is simple
• Depression is the result of a series of aggregate
  demand (monetary) shocks that moved
  economy down an upward sloping aggregate
  supply curve.
• Result is two problems: (1) unemployment and
  (2) deflation.
• Unemployment:
  – Key point is the upward sloping supply curve. Wages
    and prices not perfectly flexible in 1920s and 1930s.
  – Why did they become less flexible? Some studies
    point to turn-of-the-century change in labor contracts,
    World War I or desire of business to keep demand
    strong.
  – Wage and price stickiness means that aggregate
    demand shocks will have real effects.
The Sticky Wage Conundrum---markets don’t seem to clear
How did deflationary shocks affect the
               economy?
• Conventional 19th century view: fall in wages and
  prices raises stimulate investment, countering
  shock….but not in sticky price world.
• How did the monetary shocks hurt the
  economy?
  – Explanation 1: High real interest rate hypothesis:
    Deflation affects expectations. Deflation generates
    expectations of higher real rate of interest, raising real
    rates and driving down investment
  – Explanation 2: Debt-Deflation hypothesis:
    Unanticipated inflation increased real debt, increasing
    defaults and thus depressing supply of credit
Rising Real Interest              r = i – p(expected)
    Rates—Did the Fed
        understand?
•   Nominal commercial paper
    rate 1927.4 to 1928.4 rises
    from 4.0% to 5.5% and the
    realized real rate from 5.6% to
    9.5%.
•   Rational expectations
    estimates by Romer of the
    expected real interest rate are
    shown to rise----implying
    higher anticipated interest
    rates.
•   Interest sensitive industries
    begin to slow in 1929: building
    permits and automobile
    registrations.
• Sources of the onset—1929-1930/1931 contrasts
  previous experience
• The decline in consumer spending and fixed investment
  that are the key elements that need to be explained.
Romer (1992)
The Risk
 Premium
during the
Depression


Rate Romer uses
Debt Deflation
Hypothesis:
Hamilton looks at
the futures
markets for
predictions of
future prices----
errors random until
1930s when
underestimate
deflation
seriously----don’t
believe that crisis
will continue
Klug, Landon-Lane and White looked at the forecasts of
  Railroad Shippers and found huge cumulating errors in
forecasts of carloadings---businessmen keep thinking that
                               recovery is around the bend.
                       20



                       10



                        0
       p rc n g e r
        e e ta e rro




                       -10



                       -20



                       -30



                       -40



                       -50
                             12
                              98   13
                                    90   13
                                          92       13
                                                    94     13
                                                            96   13
                                                                  98   14
                                                                        90
                                            Y a a dQ a r
                                             e r n u rte
Bernanke’s Contribution—a Third Factor
• In addition to monetary collapse, there was a
  disruption of intermediation.
• Bernanke (1983): banks play special role for
  firms that cannot issue bonds and stocks. When
  banks fail the information and relationships are
  lost and the cost of credit intermediation rises.
  Costs include screening, monitoring, and
  accounting costs as well as expected losses
  from bad borrowers.
• Major contribution to economic decline 1931 and
  1932.
Banking crises an
important
determinant of
loans as much as
industrial      Panic
production.     begins

Liquidation of loans
after stock market
crash
But then credit
declines little even
though IP falls 25%
until banking
crises.
Understanding the Great Depression:
           Four Basic Questions
1. Why it Began?
      Business Cycle Peak 7/8-1929, Federal
      Reserve’s tight policy
2. Why so Deep?
      Banking Panics. Inaction of the Federal
      Reserve—prolonged monetary contraction
•   Duration?----Clearly inaction plays a role
    —what else?
•   Recovery?
What about Fiscal Policy—Deficit
                  Spending?




Price                    Price
Level                    Level




                Output              Output
Fiscal Policy?—Deficit Spending?
                                               Federal Deficit as Percentage of GDP
                                                                                      In 2005---it was -2.6%
          10


           8


           6


           4


           2
Percent




           0
                1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939
           -2


           -4


           -6


           -8


          -10

                                                   Actual GDP        Full Employment GDP
Industrial Policy?
• Specific Intervention in industry?
• National Industry Recovery Act (NIRA) of 1933
  created the National Recovery Administration
  (NRA). (Declared unconstitutional May 1935)
• National Labor Relations Act (1935) that
  promoted unions and Fair Labor Standards Act
  (1938) that set minimum wages in certain
  industries and regulates working conditions.
• NRA established guidelines that raised nominal
  wages and prices and encouraged higher levels
  of employment by work-sharing reductions in the
  length of the work week.
Industrial Policy
• Weinstein (1980), using
  aggregate monthly data on
  hourly earnings in
  manufacturing, he found that
  the NIRA raised nominal wages
  directly and indirectly by raising
  prices. Econometric estimates
  that average hourly earnings
  would have been 35 cents not
  60 cents.
• Result----higher wages create
  more unemployment and
  increase the duration of the
  depression because of higher
  costs to producers---
  counterproductive
• Shift in the Aggregate Supply
  Curve
Did the
Duration have
something to
 do with bad
   monetary
    policy?
      After
 1929-1933,
 had the Fed
  learned its
    lesson?
Recession of 1937-1938
• Did the Fed learn its lesson?
• Rising excess reserves held by banks—
  Fed worries about inflation potential and
  wants to induce lending.
• Uses new tool of required reserves.
  Required reserve ratio doubled.
• Result? Banks raise their excess reserves
  and huge monetary contraction.
Understanding the Great Depression:
           Four Basic Questions
1. Why it Began?
      Business Cycle Peak 7/8-1929, Federal Reserve’s
      tight policy
2. Why so Deep?
      Banking Panics. Inaction of the Federal Reserve.
      Prolonged Monetary Contraction
3. Duration?
      Continued Monetary Policy Mistakes, Fiscal Policy
      not tried. Industrial Policy makes things worse.
•   Recovery? Why?
Recovery, 1934-1937….why?
• Real GDP grows at
  10% p.a.
  1934-1937.
• But real GDP on
  reaches 1929 peak
  in 1937 and trend
  path in 1942.
• What drove the
  recovery.
• Friedman and
  Schwartz (1963)
  and Romer (1992):
  huge increases in
  the money supply.
Real GDP, 1920-1941

           140



           130



           120



           110
1929=100




           100



            90



            80



            70



            60
                 1920 1921   1922   1923 1924   1925   1926 1927   1928   1929 1930   1931 1932   1933   1934 1935   1936   1937 1938   1939   1940 1941
What
Increase
  d the
 Money
Supply?
How was the money supply increased?
• F.D. Roosevelt takes emergency powers granted by
  Congress in the 100 days.
• FDR allows the dollar to depreciate—sets new value for
  gold in 1934: from $20.36 per ounce to $35 per ounce.
• Huge revaluation of big U.S. gold stocks. Treasury
  issues gold certificates equal in value to increase and
  deposits them with the Fed. As government spends
  them, they enter the monetary base. High powered
  money increased 12% between April 1933 and April
  1934.
• Devaluation also improved the competitiveness of U.S.
  goods—rise in the trade balance.
• Devaluation attracted capital flows from Europe,
  especially with Hitler’s rise to power. High powered
  money rises 40% from April 1934 to April 1937.
• Result: real interest rates fall and recovery of investment
  and consumer durable spending.
What drove
the money
supply?
Understanding the Great Depression:
         Four Basic Questions
1. Why it Began?
     Business Cycle Peak 7/8-1929, Federal Reserve’s
     tight policy
2. Why so Deep?
     Banking Panics. Inaction of the Federal Reserve
     Prolonged Monetary Contraction.
3. Duration?
     Continued Monetary Policy Mistakes, Fiscal Policy
     not tried. Industrial Policy makes things worse.
4. Recovery?
     Monetary Expansion
Some Effects of the Great Depression
1. Activist Monetary Policy
2. Activist Fiscal Policy---idea of cyclically
   balanced budget
3. Insurance and Regulation of the Financial
   Sector
4. Agricultural Regulation
5. Growth of Government and shift in Federalism
6. Growth of Unions
7. Genesis of Social Security
8. Smoot-Hawley Tariff of 1929 to the WTO
9. The IMF and World Bank

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The Great Depression

  • 1. The Great Depression 1929-1933 The Defining Moment
  • 2. Why “Great” Depression Ben Bernanke: “To understand the Great Depression is the Holy Grail of macroeconomics. Not only did the Depression give birth to macroeconomics as a distinct field of study, but also---to an extent that is not always fully appreciated—the experience of the 1930s continues to influence macroeconomists; beliefs, policy recommendations and research agendas…..We do not yet have our hands on the Grail by any means…..”(JMCB, 1995)
  • 3. Rex Tugwell (advisor to Roosevelt) “The Cat is out of the Bag. There is no invisible hand. There never was. If the depression has not taught us that we are incapable of education…..We must now supply a real and visible guiding hand to do the task which that mythical, nonexistent, invisible agency was supposed to perform, but never did.”
  • 4. The Prelude 1919-1929 • U.S. enters the war late. (1917-1918) effects on U.S. economy relatively small compared to European economies. • Huge damage and disruption to European economies. • Real GDP = 100 in 1913. In 1919, UK=101 France=75 Germany=72 US = 116 • Inflation! Price level = 100 in 1914. In 1918 UK=210 France=213 Germany304 US=164 • Huge climb in Debt/GDP ratios.
  • 5. Consequences 1. World War I---9.5 million deaths. Loss of a generation (UK 1m, France 1.4m, Germany 2m, US 114,000) 2. Destruction of physical capital especially Belgium and northern France 3. Distortion of patterns of production, trade and consumption (e.g. high wartime prices for commodities—boom and collapse in U.S. 4. High cost of war. Estimated $208 billion. 5. Political and economic borders of Europe are redrawn. 6. Inter-allied war debts and German reparations.
  • 6. Inter-Allied War Debts ($ billions) (Kindleberger,The World in Depression France 4.0 3.0 4.7 3.5 United States United Kingdom 8.1 3.2 Other Countries To pay principal and interest, war devastated economies would have to run balance of payments surpluses.
  • 7. German Reparations • John Maynard Keynes (1919) Reparations were a “policy of reducing Germany to servitude for a generation, of degrading the lives of millions of human beings, and of depriving a whole nation of happiness.” They were “abhorrent and detestable.” • Étienne Mantoux (1946) Reparations not excessive, destructive or uncollectible. • The French paid in 1815 and 1871---”Le Boche Paiera”
  • 8. The magnitude of reparations Indemnity Percent Share of (billions) of One Debt Year's Service GDP to GDP France 1815-1819 FF 1.65 to 18 to 21 1.2 to 1.4 1.95 France 1871 FF 5.0 25 0.7 Germany1923-1931 DM 50 83 2.5 Vichy 1940-44 FF 479 111 2.6 Germany1953-1965 527 US$ 7.7 0.4 Japan 1955-1965 1486 US$ 3.0 0.8
  • 9. Solution---the Dawes Loan 1924 • German Hyperinflation. • Dawes Loan---begins series of loans--- U.S. provides funds and funds for investment around the globe. • New York as central of global finance—not London
  • 10. Return to Gold Standard “Status Quo Antebellum” • No problem for U.S.—huge balance of payments surpluses and gold • U.K. deflates and returns to gold in 1925 at old parity £1 = $4.86. But overvalued. Depressed economy. • France with near hyperinflation returns to gold in 1926 at a new parity (old $1= 5FF now $1 = 25.5 FF) Undervalued currency. Booming economy. • Germany’s hyperinflation---returns to gold at near purchasing power 1925. • Major imbalances---brittle equilibrium.
  • 11. Adjustment under restored gold standard more difficult • International capital markets are revived--- generally free. • International labor flows almost eliminated —immigration restrictions • Increased protectionism • Less wage flexibility. Wage now seem sticky even with high unemployment
  • 12. U.S. Economic Prosperity in 1920s • No trend inflation • High productivity growth • 1922-1929, GNP grew at 4.7%, • Unemployment averaged 3.7%. • Fed accommodated seasonal demands for credit and attempted to smooth economic fluctuations. (2 brief recessions)
  • 13. Some basic numbers • Peak August 1929, Trough May 1933 • Real GDP falls 39% • Real Consumption falls 29% • Prices (GDP deflator) falls 23% • Unemployment Jumps: – 3.2% in 1929 – 25% in 1933 (21%Darby) – 17% in 1939 (17% Darby) • Banking Collapse – July 1929, 24,504 banks, $49 billion deposits. – December 1932, 17,802 banks, with $36 billion. – After Bank Holiday March 1933, 11,878 banks with $23 billion deposits.
  • 14. Key American Role in World Depression • Based on industrial production GD starts in most countries at the same time • But it is larger and longer in the U.S. Romer (1993)
  • 15. Worst in the U.S. • For the U.S., Industrial Production – Biggest drop in first year – Biggest drop peak to trough – Biggest drop in the last year. • However, turning points are very similar
  • 16. Understanding the Great Depression: Its Evolution by Phases Real GDP, 1920-1941 1. Booming Strong Economy in 1920s 140 2. Beginning Shocks, 1928-1929 3. Aggravating Shocks, 1930-1933 130 4. Rock Bottom and Recovery, 1933-1936 120 5. The 1937-1938 Recession 110 6. The Recovery, 1939-1941 1929=100 100 90 80 70 60 1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 1941
  • 17. Understanding the Great Depression: Four Basic Questions Real GDP, 1920-1941 140 1. Why it Began? 2. Why so Deep? 130 3. Duration? 120 4. Recovery? 110 1929=100 100 90 80 70 60 1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 1941
  • 18. Understanding the Great Depression: Its Evolution by Phases 1. Booming Strong Economy in 1920s…but a) It’s the Roaring Twenties! b) No trend inflation c) High productivity growth d) 1922-1929, GNP grew at 4.7%, e) Unemployment averaged 3.7%. f) Fed accommodated seasonal demands for credit and attempted to smooth economic fluctuations. (2 brief recessions) g) BUT: Weak American Agriculture: low prices, high debt, weak banks h) BUT: Weak Europe: reparations, debts to U.S., slow growth, gold standard fragile (overvalued £, UK slumps) and (undervalued FF, France booms) i) BUT: U.S. Stock market boom halts foreign loans to Germany, Eastern Europe and Latin America
  • 19. Understanding the Great Depression: Its Evolution by Phases 1. Beginning Shocks, 1928-1929 • Spring 1927 U.S. expansionary monetary policy to ease pressure on the British balance of payments. Critics assert policy too easy, and allows stock market boom to ignite • Fed tightens policy in 1928 (discount rate 3 ½ to 5%, and there is little increase in total money or credit for 1928-1929. • U.S. stock market boom begins March 1928. • Commercial paper market vanishes • No new lending to Germany, Austria and rest of work in 1928….Germany slides into a recession. • Fed tries to “jaw-bone” market down. Criticizes brokers loans. • July 1929 raises discount rate from 5 to 6%. • But July-August is peak of business cycle. Recession begins Summer 1929 • October 1929 U.S. Stock market crash: wealth effect—lowers consumption and investment, credit effect—reduces value of collateral and hence lending • Smoot-Hawley tariff 1929 by U.S. induces retaliatory tariffs by other countries, international trade declines
  • 20. Understanding the Great Depression: Its Evolution by Phases 1. Aggravating Shocks, 1930-1933 a) Banking Panics, 1930, 1931, 1933 – Failure of the Fed to Pursue Expansionary Policy – Collapse of Gold Standard: Austria, Germany leave the gold standard, Britain departs after a run on the pound in September 1931 – U.S. begins losing gold, trade deficits and capital flight. 2. From Rock Bottom to Recovery, 1933-1936 – Bank Holiday March 1933 – U.S. abandons the Gold Standard March 1933 – New Deal Banking and Securities Legislation – Monetary Expansion – Minimal Fiscal Policy – National Industrial Recovery Act (NIRA) 3. The 1937-1938 Recession a) The Fed Raises Reserve Requirements 4. The Recovery, 1939-1941 a) Monetary Expansion b) Fiscal Expansion in preparation for war.
  • 21. Four Basic Questions: 1. Why It Began? 2. Why So Deep and 3. So Long? • Friedman and Schwartz (and others), the economy is entering a recession in late 1929 • The economy is beginning to recover in 1931 like a normal business cycle • BUT what makes the recession worse? • What turns the recession into a depression?
  • 22. The Worsening Depression • Slight recovery early 1931,then plunge. • Why? • Romer (1993) “The source of the continued decline in production in the United States was almost surely a series of banking panics.” • Friedman and Schwartz (1963) document four panics – Fall of 1930 – Spring 1931 – Fall 1931---Britain abandons the Gold Standard – First Quarter 1933 • 9000 Banks suspend operations. Depositors and stockholders lose $2.5 billion = 2.4% of GDP…...not the whole story
  • 24. Why Banking Panics? • There were no banking panics in Canada. • Fragmented unit banking system • Undiversified bank portfolios with high regional concentration of loans. Large number of bank closures in the agricultural states when agricultural prices fall. In addition, many hold bonds whose value collapsed. • Many banks become insolvent • Fear of insolvency feeds the liquidity crisespanics.
  • 25. Effects of Banking Panics • Money Supply Declines and there is a massive rise in realized real interest rates, over 10%. • Friedman and Schwartz blame inaction of the Fed for this decline---and hence for the depression.
  • 26. How do Friedman and Schwartz explain why the Fed did not act? • Up to end of 1930 – What is the Fed concerned about? – How does it react to banking failures? • Who was Benjamin Strong? • New York Fed v. Board of Governors? • What could the Fed have done 1930-1931? • What does Congress do?
  • 27. Why didn’t the Fed act? • Beginning in 1931, Friedman and Schwartz argue that Fed could have expanded but chose not to. • In diary of Charles S. Hamlin member of the FR Board, he wrote during August 1931 that Open market committee voted 11 to 1 against $300 million open market purchase of bonds---reduce it to $120 million. • Governor Mayer of the Board worried about inflation. • Members of the regional banks did not grasp the extent of the crisis. • Pressure from Congress---open market operations of $1 billion. Until Congress adjourns. • After Britain leaves gold in September 1931, gold drain starts. Dollars exchanged for gold---Fed’s reserves fall, it is afraid that further expansion will lead to greater loss of gold----constrained by the gold standard. Reserves falling after UK goes off gold in 1931, must retain high interest rates.
  • 28. Understanding the Great Depression: Four Basic Questions 1. Why it Began? 2. Why so Deep? 3. Duration? 4. Recovery?
  • 29. Understanding the Great Depression: Four Basic Questions 1. Why it Began? Business Cycle Peak 7/8-1929, Federal Reserve’s tight policy 2. Why so Deep? Banking Panics. Inaction of the Federal Reserve • Duration? • Recovery?
  • 30. How is the economy driven into a severe depression by the declining money supply? What is the mechanism of transmission? Several Explanations……
  • 31. Romer (1993) basic argument is simple • Depression is the result of a series of aggregate demand (monetary) shocks that moved economy down an upward sloping aggregate supply curve. Price Price Level Level Output Output
  • 32. Romer (1993) basic argument is simple • Depression is the result of a series of aggregate demand (monetary) shocks that moved economy down an upward sloping aggregate supply curve. • Result is two problems: (1) unemployment and (2) deflation. • Unemployment: – Key point is the upward sloping supply curve. Wages and prices not perfectly flexible in 1920s and 1930s. – Why did they become less flexible? Some studies point to turn-of-the-century change in labor contracts, World War I or desire of business to keep demand strong. – Wage and price stickiness means that aggregate demand shocks will have real effects.
  • 33. The Sticky Wage Conundrum---markets don’t seem to clear
  • 34. How did deflationary shocks affect the economy? • Conventional 19th century view: fall in wages and prices raises stimulate investment, countering shock….but not in sticky price world. • How did the monetary shocks hurt the economy? – Explanation 1: High real interest rate hypothesis: Deflation affects expectations. Deflation generates expectations of higher real rate of interest, raising real rates and driving down investment – Explanation 2: Debt-Deflation hypothesis: Unanticipated inflation increased real debt, increasing defaults and thus depressing supply of credit
  • 35. Rising Real Interest r = i – p(expected) Rates—Did the Fed understand? • Nominal commercial paper rate 1927.4 to 1928.4 rises from 4.0% to 5.5% and the realized real rate from 5.6% to 9.5%. • Rational expectations estimates by Romer of the expected real interest rate are shown to rise----implying higher anticipated interest rates. • Interest sensitive industries begin to slow in 1929: building permits and automobile registrations.
  • 36. • Sources of the onset—1929-1930/1931 contrasts previous experience • The decline in consumer spending and fixed investment that are the key elements that need to be explained.
  • 38. The Risk Premium during the Depression Rate Romer uses
  • 39. Debt Deflation Hypothesis: Hamilton looks at the futures markets for predictions of future prices---- errors random until 1930s when underestimate deflation seriously----don’t believe that crisis will continue
  • 40. Klug, Landon-Lane and White looked at the forecasts of Railroad Shippers and found huge cumulating errors in forecasts of carloadings---businessmen keep thinking that recovery is around the bend. 20 10 0 p rc n g e r e e ta e rro -10 -20 -30 -40 -50 12 98 13 90 13 92 13 94 13 96 13 98 14 90 Y a a dQ a r e r n u rte
  • 41. Bernanke’s Contribution—a Third Factor • In addition to monetary collapse, there was a disruption of intermediation. • Bernanke (1983): banks play special role for firms that cannot issue bonds and stocks. When banks fail the information and relationships are lost and the cost of credit intermediation rises. Costs include screening, monitoring, and accounting costs as well as expected losses from bad borrowers. • Major contribution to economic decline 1931 and 1932.
  • 42. Banking crises an important determinant of loans as much as industrial Panic production. begins Liquidation of loans after stock market crash But then credit declines little even though IP falls 25% until banking crises.
  • 43.
  • 44. Understanding the Great Depression: Four Basic Questions 1. Why it Began? Business Cycle Peak 7/8-1929, Federal Reserve’s tight policy 2. Why so Deep? Banking Panics. Inaction of the Federal Reserve—prolonged monetary contraction • Duration?----Clearly inaction plays a role —what else? • Recovery?
  • 45. What about Fiscal Policy—Deficit Spending? Price Price Level Level Output Output
  • 46. Fiscal Policy?—Deficit Spending? Federal Deficit as Percentage of GDP In 2005---it was -2.6% 10 8 6 4 2 Percent 0 1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 -2 -4 -6 -8 -10 Actual GDP Full Employment GDP
  • 47. Industrial Policy? • Specific Intervention in industry? • National Industry Recovery Act (NIRA) of 1933 created the National Recovery Administration (NRA). (Declared unconstitutional May 1935) • National Labor Relations Act (1935) that promoted unions and Fair Labor Standards Act (1938) that set minimum wages in certain industries and regulates working conditions. • NRA established guidelines that raised nominal wages and prices and encouraged higher levels of employment by work-sharing reductions in the length of the work week.
  • 48. Industrial Policy • Weinstein (1980), using aggregate monthly data on hourly earnings in manufacturing, he found that the NIRA raised nominal wages directly and indirectly by raising prices. Econometric estimates that average hourly earnings would have been 35 cents not 60 cents. • Result----higher wages create more unemployment and increase the duration of the depression because of higher costs to producers--- counterproductive • Shift in the Aggregate Supply Curve
  • 49. Did the Duration have something to do with bad monetary policy? After 1929-1933, had the Fed learned its lesson?
  • 50. Recession of 1937-1938 • Did the Fed learn its lesson? • Rising excess reserves held by banks— Fed worries about inflation potential and wants to induce lending. • Uses new tool of required reserves. Required reserve ratio doubled. • Result? Banks raise their excess reserves and huge monetary contraction.
  • 51. Understanding the Great Depression: Four Basic Questions 1. Why it Began? Business Cycle Peak 7/8-1929, Federal Reserve’s tight policy 2. Why so Deep? Banking Panics. Inaction of the Federal Reserve. Prolonged Monetary Contraction 3. Duration? Continued Monetary Policy Mistakes, Fiscal Policy not tried. Industrial Policy makes things worse. • Recovery? Why?
  • 52. Recovery, 1934-1937….why? • Real GDP grows at 10% p.a. 1934-1937. • But real GDP on reaches 1929 peak in 1937 and trend path in 1942. • What drove the recovery. • Friedman and Schwartz (1963) and Romer (1992): huge increases in the money supply.
  • 53. Real GDP, 1920-1941 140 130 120 110 1929=100 100 90 80 70 60 1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 1941
  • 54. What Increase d the Money Supply?
  • 55. How was the money supply increased? • F.D. Roosevelt takes emergency powers granted by Congress in the 100 days. • FDR allows the dollar to depreciate—sets new value for gold in 1934: from $20.36 per ounce to $35 per ounce. • Huge revaluation of big U.S. gold stocks. Treasury issues gold certificates equal in value to increase and deposits them with the Fed. As government spends them, they enter the monetary base. High powered money increased 12% between April 1933 and April 1934. • Devaluation also improved the competitiveness of U.S. goods—rise in the trade balance. • Devaluation attracted capital flows from Europe, especially with Hitler’s rise to power. High powered money rises 40% from April 1934 to April 1937. • Result: real interest rates fall and recovery of investment and consumer durable spending.
  • 57.
  • 58. Understanding the Great Depression: Four Basic Questions 1. Why it Began? Business Cycle Peak 7/8-1929, Federal Reserve’s tight policy 2. Why so Deep? Banking Panics. Inaction of the Federal Reserve Prolonged Monetary Contraction. 3. Duration? Continued Monetary Policy Mistakes, Fiscal Policy not tried. Industrial Policy makes things worse. 4. Recovery? Monetary Expansion
  • 59. Some Effects of the Great Depression 1. Activist Monetary Policy 2. Activist Fiscal Policy---idea of cyclically balanced budget 3. Insurance and Regulation of the Financial Sector 4. Agricultural Regulation 5. Growth of Government and shift in Federalism 6. Growth of Unions 7. Genesis of Social Security 8. Smoot-Hawley Tariff of 1929 to the WTO 9. The IMF and World Bank