The Great Depression: 1929-1939

1. The Great Depression: 1929-1939 Functional MRI showing fear

2. Fear and panic on Wall Street, 1929 and 2008 2007 2008

3. But on Main Street …

4. US Business Cycle, 1870-2003

5. Growth in Key Indicators • Periods are: • Pre-crash boom • From crash to Britain’s leaving gold • From gold crisis to trough • Note: rates of change at annual rates.

6. Unemployment lines

7. Bread lines

8. Bank runs

9. Total loss in GDP in historical cycles

10. Four views of the source of the GD Major approaches: • Expenditure view”: IS or spending shocks • “Money view”: financial market shocks Others only touch on: 3. “Golden fetters”: Gold standard and fixed exchange rates imposed constraint on domestic monetary policies 4. Real business cycles (AS shocks) caused by monopoly power

11. What caused the Great Depression? AS or AD shocks? • Was the depression caused by AD shocks or AS shocks? • Looks like standard AD shock.

12. IS interpretation of the depression interest rate (i) IS1929 IS1933 LM Y1929 Y1933 0 Real output (Y)

13. The Expenditure Approach: IS Shocks Were shocks in the IS curve responsible? • Foreign trade, government spending and taxes were too small • No exogenous consumption shock • Investment did decline very sharply. • However, it is likely that investment was an endogenous reaction to credit, risk, and economic decline. Most macroeconomists conclude that IS shocks could not have been sufficient to cause that large a decline.

14. The Money View: 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. • You can see this particularly after Britain left gold in 1931. • 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).

15. Interest Rates 1920-39

17. Friedman and Schwartz and the Monetarist Approach • Friedman and Schwartz take the “monetarist view.” • Decline in M responsible for depth and duration of GD • Inept management by Fed responsible in large part for decline in M • Start with standard money identity: Ms= cd + 1 B cd + rr • Bank crises and hording let to increases in cdand rr. With globally stable gold stock, and rr < 1, this led to decline in M. • Friedman Schwartz take monetarist view that demand for money unaffected by interest rates, so Y =Ms/k, which is a horizontal LM curve.

18. Monetarist view of the Great Depression interest rate (i) LM‘ LM i** i* IS Y** Y* Real output (Y)

19. Friedman and Schwartz: The Money View of the GD • F&S clearly right that M declined sharply. • However, Temin and others argue that this was caused by bank failures and hording rather than by Fed policy. • Also, was not pure monetary policy because safe interest rates fell. • Most likely was that cumulative events overwhelmed the Fed.

20. 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. Problem that it does not say HOW economy got into liquidity trap in the first place. • Needed some shock to get into depressed state. • Then liquidity trap would prevent monetary policy from expanding economy

21. Liquidity trap in US in Great Depression

22. Debt-deflation-credit theory of the Depression • Theory that deflation led to bankruptcies and downward spiral of bank failures, panics, and spending decrease. • Some argue that deflation is unstable because raises real interest rate • But main mechanism is that cost of capital to businesses rose sharply as stock prices fell and spreads on risky assets rose sharply. • Reminder on mechanism: re = rff + spread (re= r on business investments and equity; rff = discount rate; spread = risk premium) When things go bad, spread goes up and IS(rff) shifts down

23. rff = federal funds rate or discount rate in 1930s IS(rff - risk premium) MP IS(rff – spread) IS(rff – larger spread) Y = real output (GDP)

24. Note on IS-MP with risk shift In class we discussed the “debt-deflation-credit” model with a shift in risk. (IS) Y = IS(re; G) (MP) rff = rff* + bπ-1 + (bd+c)Y + be = MP(Y; π-1, e) Here re = the cost of capital to businesses; rff = real risk-free rate such as the federal funds rate; spread = risk premium. So (risk equation) re = rff + spread We need to have IS and MP with the same variables, so let’s substitute for rff by putting in (re-spread) instead of rff in the IS equation. Then when spread increases, IS shifts down. Alternatively, you can put re on vertical axis, in which case MP curve would shift up.

25. 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 is a standard IS shift … no puzzle here!

26. The end of the depression …

27. Implication of the Recovery • Recovery from GD required an increase in government spending (G) of 20-25 percent of GDP • Would be equivalent of $3 trillion today! • The magnitude of the fiscal shock required for recovery suggests that no minor M or F expansion would cure GD quickly.

28. Summary • The depth and severity of the Great Depression remains one of the continuing debates of macroeconomics. • 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 (clinging to gold standard, no fiscal response) • bad dynamics (deflation and liquidity trap)

29. What is different in 2008 from 1929? • Macroeconomics as a field did not exist until 1936 • The economy is less susceptible to shocks (Great Moderation): • The government sector is not cyclical and is much larger • There are substantial automatic stabilizers • The government insures most bank deposits, so runs are less likely • Government takes counter-cyclical fiscal policies • Flexible exchange rates instead of gold standard • Countries hated each other (Germany and France) On the other hand: • The overall leverage in 2008 is substantially larger • Information technologies allow much more rapid reaction to shocks (“time compression”) What is the net effect of these? Keep tuned in!