The Great Depression and its Economic Impact

1. W10A • The Great Depression • Some Dates • Interest rates, deflation and FRB lending • MVPY and Wage movements • Investment, Fiscal Policy and debt-deflation • Housing and the Credit Channel • Conclusions

2. The United States Business Cycle Source: DeLong 1997

3. 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)

4. 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.”

5. Source: Checchetti 1997, other dates: May 1931 Credit Anstalt Fails 1931 Austria, Germany, England (Sep 30) off gold 1933 Roosevelt and 1st New Deal: Off gold, NRA and AAA 1936-37 Depression Within Depression 1935 Second New Deal: Banking, Labor, SS, FDA

6. Stabilizing 19th Century Core/Pheripery Interactions Brinley Thomas Core in Boom Periphery in Slump high investment low investment & consumption high consumption high exports to core Core in Slump Periphery in Boom Low investment and Arrival of new immigrants Consumption, but high Building of new housing and RR Exports of capital goods To periphery Broke down with World War I and fall of Gold Standard

7. 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. There are problems when all countries want a surplus. US wound up lending to Austria etc.

8. International Failure 1931 negotiations to support the Credit Anstalt failed. France sought to impose conditions on an international loan that Austria would not accept: a block on an Austrian-German customs union.

9. 1920’s Boom and Bust http://www.creating-wealth.co.nz/history_dow_jones_index.htm

10. DeLong blames FRB “By 1928 and 1929 the Federal Reserve was worried about the high level of the stock market. It feared that the "bubble" component of stock prices might burst suddenly. When it did burst, pieces of the financial system might be suddenly revealed to be insolvent, the network of financial intermediation might well be damaged, investment might fall, and recession might result. It seemed better to the Federal Reserve in 1928 and 1929 to try to "cool off" the market by making borrowing money for stock speculation difficult and costly by raising interest rates. They accepted the risk that the increase in interest rates might bring on the recession that they hoped could be avoided if the market could be "cooled off": all policy options seemed to have possible unfavorable consequences.”

11. Bierman..P/E of 10 was ok “..one of the primary causes was the attempt by important people and the media to stop market speculators. A second probable cause was the great expansion of investment trusts, public utility holding companies, and the amount of margin buying, all of which fueled the purchase of public utility stocks, and drove up their prices. Public utilities, utility holding companies, and investment trusts were all highly levered using large amounts of debt and preferred stock. These factors seem to have set the stage for the triggering event. This sector was vulnerable to the arrival of bad news regarding utility regulation. In October 1929, the bad news arrived and utility stocks fell dramatically. After the utilities decreased in price, margin buyers had to sell and there was then panic selling of all stocks.” Harold Bierman, Jr., Cornell University http://eh.net/encyclopedia/article/Bierman.crash

12. Bierman..P/E of 10 was ok Utility regulation reduced expected profits of utilities. “Investment Trusts” also crashed. While they were interesting precursors to today’s mutual funds, they did not publish or calculate Net Asset Values. This lack of transparency became a problem in the downturn. Harold Bierman, Jr., Cornell University http://eh.net/encyclopedia/article/Bierman.crash

13. Dow Jones in GD http://www.creating-wealth.co.nz/history_dow_jones_index.htm

14. FRB policy Friedman and Schwartz blame the GD on bad monetary policy. The Fed allowed 3 waves of bank failures.

15. Bernanke on Money M1 = (M1/BASE) x (BASE/RES) x (RES/GOLD) x PGOLD x QGOLD (1) where M1 = M1 money supply (money and notes in circulation plus commercial bank deposits), BASE = monetary base (money and notes in circulation plus reserves of commercial banks), RES = international reserves of the central bank (foreign assets plus gold reserves), valued in domestic currency, GOLD = gold reserves of the central bank, valued in domestic currency = PGOLD x QGOLD, PGOLD = the official domestic-currency price of gold, and QGOLD = the physical quantity (for example, in metric tons) of gold reserves. (Introduction to Essays on the Great Depression http://press.princeton.edu/chapters/s6817.html)

16. Bernanke on Money M1 = (M1/BASE) x (BASE/RES) x (RES/GOLD) x PGOLD x QGOLD (1) FRB did not realize that money supply was falling! The ratio of (cash and checking accounts)/(bank reserves) rose as people “hoarded” cash. Before US left gold the FRB had to guard the ratio between bank reserves and the value of its gold reserve. Once Roosevelt devalued relative to gold the Price of Gold increased, automatically increasing the value of the FRB’s gold reserves. Later in 1936-37 the FRB raises reserve requirements because it becomes afraid of excess reserves and inflation. Commercial banks stop lending to reestablish excess reserves. This helps cause the ‘recession with in the recession’.

17. FRB also mislead by Interest Rates • Low nominal interest rates and excess reserves give FRB reason to think it is “loose”. • Yet real interest rates were high—especially in 1931-32—and FRB lending was not high.

18. Source: Checchetti 1997

19. Source: Checchetti 1997

20. +20 0 -20 1929 1931 1933 1935 1937 1939 1941 Source: Checchetti 1997

21. +25 +15 0 -15 1929 1931 1933 1935 1937 1939 1941 Source: Checchetti 1997

22. Source: John Lovett http://faculty.tcu.edu/jlovett/

23. MVPY and Wages • In depression V falls due to “hoarding” • M falls due to bank failures • P deflating • Y falling • W/P rises due to deflation and partly due to NRA

24. Source: DeLong 1997

25. Source DeLong 1997

26. Why didn’t output quickly return to trend in 1933-1934? Harold Cole and Lee Ohanian, Federal Reserve Bank of Minneapolis Quarterly Review The Great Depression in the United States from A Neoclassical Perspective 1999 http://www.minneapolisfed.org/research/QR/QR2311.pdf Manufacturing real wages wages were well above trend. “Government policies toward monopoly changed in the 1930’s…Firms that attempted to cut prices were pressured by other industry members and publicly berated by the head of NIRA as “cut-throat chiselers.” In return for government-sanctioned collusion, firms gave incumbent workers large pay increases.”

27. Real Wage S D Labor

28. Investment and FP • Real Investment is very low • Fiscal Policy was not tried until the war-time build up. • Deflation increases the real burden of debts

29. Source: John Lovett http://faculty.tcu.edu/jlovett/

30. Source: John Lovett http://faculty.tcu.edu/jlovett/

31. Source: John Lovett http://faculty.tcu.edu/jlovett/

32. Source: John Lovett http://faculty.tcu.edu/jlovett/

33. Source: John Lovett http://faculty.tcu.edu/jlovett/

34. Housing and Credit Channels • House prices slide and only recover with the war. • Recession within a recession stops household net worth from recovering.

35. Housing and Consumer Balance Sheet in GD

36. F. Mishkin J Ec Hist, 1978 http://links.jstor.org/sici?sici=0022-0507%28197812%2938%3A4%3C918%3ATHBSAT%3E2.0.CO%3B2-0

37. From the New Deal, a Way Out of a Mess ALAN S. BLINDER NYT Feb. 24, 2008 “During the Depression, President Franklin D. Roosevelt and Congress dealt with huge impending foreclosures by creating the Home Owners’ Loan Corporation.”

38. The HOLC was established in June 1933 to help distressed families avert foreclosures by replacing mortgages that were in or near default with new ones that homeowners could afford. It did so by buying old mortgages from banks — most of which were delighted to trade them in for safe government bonds — and then issuing new loans to homeowners. The HOLC financed itself by borrowing from capital markets and the Treasury.

39. HOLC • The scale of the operation was impressive. Within two years, the HOLC received about 1.9 million applications from distressed homeowners and granted just over a million new mortgages. (Adjusting only for population growth, the corresponding mortgage figure today would be almost 2.5 million.) Nearly one of every five mortgages in America became owned by the HOLC. Its total lending over its lifetime amounted to $3.5 billion — a colossal sum equal to 5 percent of a year’s gross domestic product at the time. (The corresponding figure today would be about $750 billion.)

40. Ben Bernanke on ‘credit channel’ • The debt-deflation idea is that corporate balance sheets matter for economic contraction and monetary policy. • When credit markets tighten small firms are hit hardest because the banks that lend to them only lend against collateral. But the value of business collateral falls in recessions. This limits company borrowing and constricts the economy, even if the interest rate set by the FRB is falling!

41. Interest rate gaps • The ‘credit channel’ view of the money-credit system and monetary policy notes that the gap between what it costs firms to raise funds internally vs externally crisis in times of tight money. • This is tricky to document but simpler interest rate gaps are evident as of March 2008. • The federal funds rate fell from mid 2007 5.25% to 3% by early March 2008. • Over the same period the yield that some municipalities pay for borrowing rose to 20% due to a failure of the “auction bond market”. (Boomberg.com 5 Mar 08, “Auction Bond Failures Near 70%)

42. 9. Conclusions Fear of deficits must not be allowed to eliminate fiscal policy. The exchange rate regime (fixed vs flexible exchange rates) has dramatic implications for monetary policy. The credit system is subject to collapses that require us to look at the balance sheets of firms and banks, not just interest rates. Many of the international crises of the 1980’s and 1990’s have this characteristic.

43. Sources: Checcetti, Steven, 1997, ‘Understanding the Great Depression: Lessons for Current Policy’ NBER Working Paper Series #6015 DeLong, Bradford J., 1997 Slouching Towards Utopia?: The Economic History of the Twentieth Century -XIV. The Great Crash and the Great Slump- (February 1997) http://econ161.berkeley.edu/Brad_De_Long's_Website.htmlTemin, Peter, 1994 ‘The Great Depression’ NBER Working Paper Series on Historical Factors, Historical Paper No. 62 For NBER Working Papers go to DePaul Library website, select databases, then N and NBER. Once there you can search by author.