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The Great Depression: Getting the Story Right

The Great Depression: Getting the Story Right. Nicholas Crafts and Peter Fearon. The 1930s. Deflation, slump and crisis De-globalization: trade wars, collapse of gold standard and of foreign lending

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The Great Depression: Getting the Story Right

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  1. The Great Depression: Getting the Story Right Nicholas Crafts and Peter Fearon

  2. The 1930s Deflation, slump and crisis De-globalization: trade wars, collapse of gold standard and of foreign lending Lessons from the downturn quite well understood; but also much to be gained from looking at recovery

  3. Contrasts in the Great Depression

  4. - 1 - 0.9 - 0.8 - 0.7 - 0.6 - 0.5 - 0.4 - 0.3 - 0.2 - 0.1 - 0 Proportion of Countries with Banking Crises, 1900-2008Weighted by their share of world income The Great Depression Share of countries in banking crisis (left scale) Emerging Markets, Japan, the Nordic Countries and US (S&L) World War I Percentage of countries The Panic of 1907 Capital Mobility (right scale) Source: Reinhart & Rogoff (2009)

  5. The World in Depression

  6. Myths • Wall Street Crash caused the Great Depression • New Deal was a massive fiscal stimulus • Glass-Steagall was evidence-based policy • There was a great depression in the UK

  7. How Did the Depression Start? Dominance of US economy in 1920s; world’s leading creditor country 1928: Federal Reserve (FED) moved to control stock market speculation Higher interest rates destabilized domestic and international economy 1929 Wall Street Crash: an effect not a cause

  8. Table 1. The Great Depression in the Advanced Countries

  9. How Did the Depression Spread? Most economies linked by gold standard which was re-adopted during the 1920s Fixed exchange rate system; countries losing gold expected to deflate Countries gaining (“hoarding”) gold, e.g. USA and France, sterilized inflows to protect against inflation

  10. Golden Fetters After 1930, US loans ceased, imports reduced, primary product prices declined; primary producers had to deflate 1931 major financial crisis started in Austria; moved to Germany No co-ordinated policy response Britain leaves the gold standard (Sept 1931)

  11. Collapse of Gold Standard Crisis then moved to USA 1931: 47 members of gold standard club; 1932: only 6 major economies still in Abandonment of gold was a key to recovery Those countries that had not devalued became much more protectionist

  12. Trade Contraction Major contraction in international trade; value and volume both decline Starting with Hawley-Smoot tariff (1930) protection increased; beggar-thy-neighbour policies Drive to self-sufficiency in Germany Major source of trade decline was inability ofcountries to finance imports

  13. Table 2: The UK in the 1930s

  14. US/UK Comparison UK did not experience a Great Depression 1932-37 average real GDP growth 4%; no bank failures, rapid recovery but unemployment remained high especially in Outer Britain Major regime change; UK abandoned gold standard, protectionist tariffs embraced Recovery fuelled by cheap money; no fiscal stimulus until later 1930s

  15. Table 2: The USA in the 1930s

  16. Why So Deep a Depression in USA? Deflation undermined consumer and business confidence; increased real debt Rising unemployment and collapse in farm income added to distress Three waves of bank failures: late 1930; late 1931; winter 1932-33 undermined investment Policy response entirely inappropriate

  17. New Deal Recovery 1933-37 real GDP grew at 8% per annum Gold standard abandoned; banking stabilized; inflationary expectations established Monetary policy accidentally expansionary Little fiscal stimulus Serious new recession 1937-38

  18. Devaluation in the 1930s • Very good for early recovery; staying on the gold standard made things much worse • Regain control of interest rate, change inflationary expectations, lower real wages, increase international competitiveness, improve fiscal arithmetic • Pursuit of self-interest (beggar-thy-neighbour) undermines world trade

  19. Changes in Exchange Rates and Industrial Production, 1929-1935 • Finland • Denmark • Sweden • United Kingdom • Norway • Germany • Italy • Netherlands • Belgium • France Production 1935 (1929=100) IP1936=153.9-0.69ER1935 40 60 80 100 120 Exchange Rate 1935 (1929=100)

  20. Bad Behaviour • Fixed exchange rate systems potentially undermined by big balance of payments surpluses • Gold hoarding by France and USA put severe deflationary pressure on the gold standard • Deficit countries took the strain of adjustment (initially)

  21. Regime Change • US escape from liquidity trap after 1933 based on leaving gold • Changed inflationary expectations and reduced real interest rates • Needed a new policy framework; ambiguity about this became a problem in 1937

  22. Fiscal Stimulus • With interest rates at zero-bound, expect fiscal multiplier to be relatively large • On balance, 1930s evidence suggests this is right; values for UK and US of 1.5+ • In the early 1930s, fiscal policy didn’t fail, it wasn’t tried; Keynesian stimulus later on from rearmament

  23. Fiscal Consolidation • Exposes economy to risk of double-dip recession if monetary policy not supportive • USA in 1937/8 is perfect unpleasant example • Monetary policy was supportive when real interest rates were held down • Suggests conventional inflation targeting not appropriate at lower bound

  24. A Recession to Remember:Real GNP in USA Source: Balke and Gordon (1986)

  25. Banking Crises • Asset price collapse, non-performing loans, scramble for liquidity, shortage of collateral: credit for investment severely restricted • Market failure with asymmetric information • Frequent when bank regulation inadequate especially when capital is internationally mobile • Imply major decline in economic activity not just ordinary recession and fiscal hangover • Easy to understand ex-post; hard to predict

  26. Banking Crisis: Impact on Potential Output • Output is permanently reduced (making structural budget deficit worse) • Direct and indirect effects: investment and policy response • In 1930s USA, New Deal increased U* and collapse in investment meant lower capital stock … but TFP growth remained very strong • Y* in 1941 at least 10 per cent below 1929 forecast

  27. Table 3. Growth Accounting Decompositions, United States 1919-1941 (% per year)

  28. Resolving the Banking Crisis • Re-capitalizing and re-regulating banks was key part of Roosevelt’s policy • Deposit insurance (and moral hazard) is important legacy of the depression • Accompanying bank regulation was politically captured and not well designed but did deliver financial stability for several decades in ‘capital-immobile’ world

  29. Concluding Thoughts • Once the crisis began, economics informed by economic history has done quite well and we haven’t repeated the worst errors of the early 1930s • Failure to predict the crisis both now and then understandable; failure to prevent the crisis may be less forgivable since economics does explain very clearly why banks fail

  30. Central bank discount rates, now vs then (7 country average) Source: Alumunia et al (2010)

  31. World Industrial Production, now vs then Source: Eichengreen & O'Rourke (2010)

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