The Great Depression 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 appreciatedthe 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. Some basic numbers Peak August 1929, Trough May 1933 Real GDP falls 39% Real Consumption falls 29% Prices (GDP deflator) falls 23% Unemployment rises from 3.2% in 1929 to 21 or 25% (Lebergott/Darby) in 1933 and in 1939 it is 11 or 17%. July 1929, there were 24,504 commercial banks with $49 billion deposits. By December 1932 there were 17,802 banks with $36 billion. After Bank Holiday March 1933 there are 11,878 banks with $23 billion. World War I and the World Economy U.S. enters the war late. ( ) effects on U.S. economy relatively small compared to European economies. Huge damage and disruption to European economies. Real GDP = 100 in In 1919, UK=101 France=75 Germany=72 US = 116 Inflation! Price level = 100 in In 1918 UK=210 France=213 Germany304 US=164 Huge climb in Debt/GDP ratios. Consequences 1.World War I 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 commoditiesboom 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) United States United Kingdom France Other Countries To pay principal and interest, war devastated economies would have to run balance of payments surpluses. German Reparations 83% of one years GDP 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. tienne Mantoux (1946) Reparations not excessive, destructive or uncollectible. The French paid in 1815 and Le Boche Paiera 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 financenot London Return to Gold Standard 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 British pound is 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. Germanys hyperinflation---returns to gold at near purchasing power Major imbalances---brittle equilibrium. U.S. Economic Prosperity in 1920s No trend inflation High productivity growth , GNP grew at 4.7%, Unemployment averaged 3.7%. Fed accommodated seasonal demands for credit and attempted to smooth economic fluctuations. (2 brief recessions) 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 How Did the Depression Begin in the United States? U.K. problem of internal and external balance with overvalued currency U.S. expansionary monetary policy begun in the spring of 1927 to ease pressure on the British balance of payments following secret central bank meeting. Critics assert policy too easy, and allows stock market boom to ignite. Fed tightens policy in 1928 (discount rate 3 to 5%, and there is little increase in total money or credit for The Stock Market Boom U.S. stock market boom begins March Everyone wants to be rich. 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. The Recession Starts Economy starts to cool in Summer of 1929 Federal Reserve had started to tighten policy in Open market sales and increased demand for money led to rise in interest rates Stock Market Crash Effects After the crash of October 1929, the Federal Reserve (NY Fed) provides open market purchasesflushes system with high-powered money. Nominal and expected interest rates fall. Romer (1990) crash generates considerable uncertainty about future income. Thus consumer perishable purchases remain stable, semi-durables change a little and durable purchase plunge. Temin (1976) argued crash decreased wealth and hence consumption Mishkin (1978) argued that crash shifted households balance sheets towards illiquidity If the stock market had a bubble---this is exogenous. Collapse is an exogenous shock from Wall Street to the U.S. economy and the rest of the world. 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 Britain abandons the Gold Standard First Quarter Banks suspend operations. Depositors and stockholders lose $2.5 billion = 2.4% of GDP. 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. 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? Why didnt the Fed act? Friedman and Schwartz (1963): Up to end of 1930, no expansion as see the fall out as a result of stock market collapse. Banks just being winnowed. Beginning in 1931, Friedman and Schwartz argue that Fed could have expanded but chose not to. Benjamin Strong? 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 Congress---open market operations of $1 billion. Until Congress adjourns. Eichengreen (1992) argues that Fed was constrained by the gold standard. Reserves falling after UK goes off gold in 1931, must retain high interest rates. Fed should have acted differently at least up to late 1931. How is the economy driven into a severe depression? Romer (1993) canonical argument is simple. Basically.. Depression is the result of a series of aggregate demand 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 Wage Conundrum---markets dont seem to clear How did deflation affect the economy? Conventional 19 th century view: fall in wages and prices raises real balances and thus stimulates investment, countering shock. High real interest rate hypothesis: Deflation affects expectations. Deflation generates expectations of higher real rate of interest, raising real rates. Debt-Deflation hypothesis: Unanticipated inflation increased real debt, increasing defaults and thus depressing supply of credit Rising Interest Rates Nominal commercial paper rate to 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. Railroad Shippers Forecast Errors Sources of the onset /1931 contrasts previous experience The decline in consumer spending and fixed investment that are the key elements that need to be explained. Effects of Banking Panics In addition to monetary collapse, there was a disruption of intermediation. One shortcoming of F&S monetary explanation is that there is no theory of monetary effects on the real economy that can explain protracted non-neutrality. 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. Major contribution to economic decline 1931 and 1932. Bernankes argument Information asymmetries are solved by financial intermediaries. For a competitive banking system, the cost of credit intermediation is the cost of channeling funds from savers into hands of good borrowers. It includes screening, monitoring, and accounting costs as well as expected losses from bad borrowers. Banking crises an important determinant of loans as much as industrial production. Liquidation of loans after stock market crash But then credit declines little even though IP falls 25% until banking crises. Recovery.why? Real GDP grows at 10% p.a But real GDP on reaches 1929 peak in 1937 and trend path in What drove the recovery. Friedman and Schwartz (1963) and Romer (1992): huge increases in 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 depreciatesets 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 Devaluation also improved the competitiveness of U.S. goodsrise in the trade balance. Devaluation attracted capital flows from Europe, especially with Hitlers rise to power. High powered money rises 40% from April 1934 to April Result: real interest rates fall and recovery of investment and consumer durable spending. Recession of 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. Romer (1992) New Deal Legislation National Industry Recovery Act (NIRA) of 1933 created the National Recovery Administration (NRA). (Declared unconstitutional May 1935, but not 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. 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. Some Effects of the Great Depression: The Defining Moment (1998) 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