The Great Depression, 1929 – 1939 What explains its scale and duration?

1. The Great Depression in the United StatesFrom A Neoclassical PerspectiveHarold L. Cole and Lee E. Ohanian

2. The Great Depression, 1929 – 1939 • What explains its scale and duration? • The 1933 – 39 recovery period witnessed significant increases in money supply, total factor productivity, the elimination of deflation, no more bank failures • According to neoclassical theory, output should have returned to trend around1936. • But output remained 25%-30% below trend throughout the 1930’s.

3. Neoclassical Growth Model (drop time subscripts) Maximize Σβtu(c,l) Maximize discounted utility from consumption and leisure Subject to y = zf(k,xn) >= c + iOutput exceeds c + investment n + l = 1 Hours of work + leisure = 1 k = (1-δ) k-1 + ikapital stock and δeprec. x = (1+γ)x-1 Labor productivity γrowth z = random technology shocks Introducing fiscal shocks, y = zf(k,xn) >= c + i + g Introducing money shocks complicates things Cash in advance assumption: m >= pc

4. Cole and Ohanian consider the following shocks • Technology shock  Real Business Cycle? • Fiscal shock  Tax disincentive to work • Trade shock  World in depression • Monetary shock  Lucas-Rapping intertemporal substitution of leisure for work • Financial intermediation shock  Bank failures • Reserve requirements • Inflexible nominal wages and increased real wages • Real wages rose in manufacturing • But real wages declined in other sectors

5. Technology Shocks? Perhaps initially Shocks that reduce the productivity of capital and labor. • Prescott (1986) finds technology shock accounts for 70% of post-WWII business cycle fluctuations Real business cycle paradigm Cobb-Douglas production function y = zf(k,xn) = zkθ(xn)(1-θ) θ= 1/3γ = 1.9 %n growth rate = 1% z = Actual total factor productivity in each year • Model predicts a smaller decline in 1929-1933 output than actually occurred. • Output should have returned to trend by 1936 per model. • It actually remained below trend by 25% during the recovery.

6. Correction for decline in capital stock during depression • Use the actual capital stock in 1934—20% below trend. • Output still should have returned to trend by 1937. • It did not. Problem: “Actual” capital stock ignores idle capacity • There was lots of idle capacity both in descent and recovery phases of the depression. • This complicates estimates of total factor productivity

7. Fiscal Shocks? A little Decreased government spending increases consumption, decreasing the marginal rate of substitution of consumption for leisure Leisure increases  Hours of work decreases • To explain the depression, government spending should have decreased • 1929 – 33: government spending decreased modestly • After 1933: government spending increased by 12% above trend.But hours of work remained below trend. • Taxes rates essentially stayed the same during 1929-33 but increased for the rest of decade. • From 3.5% to 8.3% on labor and from 29.5% to 42.5% on capital. • Feeding this into the model • Labor input falls by 4% • Only 20% of the weak recovery is explained.

8. Trade Shocks? No • Tariffs caused world trade to fall 65% b/w 1929-1932. • Lucas(1994) argues that trade was such a small share of US output that it could not possibly have any explanatory relevance. • Even if import elasticity of substitution was very low, it would have only taken a short time for domestic producers to adjust. • Trade shocks do not account for output deviation from trend during the recovery.

9. Monetary Shocks? Maybe for the decline • Friedman and Schwartz: declines in the supply of the money stock have preceded declines in output for a century • A large decline in M1 preceded the 1929-33 output decline. • The real money stock fell less than the nominal money stock. • 1933 – 1939: The real money stock increased during recovery • The variation in real money stock is consonant with the variation in real output.  money non-neutrality something keeps prices from changing in sync with money supply.

10. Is non-neutrality an equilibrium outcome? • Lucas and Rapping (1969) and Lucas (1972): cyclical fluctuations explained by leisure/labor substitution and unexpected changes in real wages. • If real wages are high, workers opt for more labor and less leisure. • Rapid decline in money supply led to real wage falling below expected level in 1930. • Workers chose more leisure...Gone fish’n’ • Could account for the decline in output, 1929-1933. • For rest of the decade the real wage was at or above expected level • This should have resulted in less leisure and more work, returning output to 1929 level. • This did not happen.

11. Money, deflation and debt deflation (per Fisher)? • Deflation transfers nominal wealth from debtors to creditors • Debtors’ decrease in net worth leads to reduced borrowing, reduced business expansion and reduced consumption. • This could partly explain the 1929-1933 decline (qualitatively) • The quantitative aspect for the recovery period remains unchartered.

12. Intermediation Shocks? Only briefly • Bernanke (1983): bank failures  negative changes in output. • Cole and Ohanian report low loss of output due to this source • Output reduction (1929-1933) attributable to finance, insurance and real estate = 4.7%. Reserve Requirements? Not much • 1936-37: Reserve reqm’t raised from 10% to 15% to 17.5% to 20%  Weak recovery to these increases via reduced lending? • But output rose by 12% during this period. • The downturn started in 10/1937 or 14 months after first increase in reserve requirements. • Interest rate increases were very small and transitory during this period and for the rest of the decade. • It is therefore questionable that increased reserve requirements can explain the weak recovery.

13. Inflexible Nominal Wages?Real wage too high? • Manufacturing real wages rose above trend between 1929-1933 and were 16% above trend by 1939. • Nonmanufacturing wages fell 15% between 1929 - 1933 and remained 10% below trend in 1939.  Mixed signals • Money illusion and nominal contracts can’t explain the weak recovery

14. Cole and Ohanian’s Postulate: Blame the New Deal • National Industrial Recovery Act (NIRA) • Cartelization of the US manufacturing sector. • Monopolists earn more by producing less • Manufacturing wages were set in the same political/ administrative manner. Qualitatively this shock seems promising in explaining why output was so much and so consistently below trend from 1934-1939.