Prof. Bryan Caplan

Econ 918

Spring, 1998

Week 13: The Great Depression

  1. The Monetary Explanation Proposed: The Classic Case of Friedman and Schwartz
    1. Friedman and Schwartz (1963) pioneered the monetary explanation of the Great Depression, unseating the dinosaur Keynesian fiscalist orthodoxy.
    2. The monetary facts for the U.S.:
    3. Year


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    4. Facts to notice:
        1. Almost all of the fall in the money supply resulted from a fall in the money multiplier, not the monetary base.
        2. Nevertheless, the monetary base fell first, and initially it fell by more in percent terms than M2. (I.e., the money multiplier initially increased a little!)
        3. Most of the monetary contraction did not happen for over two years.
        4. As Selgin and White note in the article on privatization of money, one major factor in the later bank runs was the fear that the U.S. would abandon the gold standard.
        5. The money supply growth rate (both base and M2) was high during the first 4 years of Roosevelt's administration, but M2 growth turned negative for a second stretch when reserve requirements were increased in 1937.
    5. The simplified monetarist story:
        1. The Fed contracted the monetary base during the first year of the Great Depression, getting the downturn going. (Dinosaur Keynesian alternative: "autonomous decline in consumption.")
        2. Once the downturn began, the Fed neglected the function that clearinghouses performed in the pre-Fed days of bailing out temporarily illiquid banks.
        3. Bank failures multiplied as the downturn continued: partly due to the Fed's malign neglect, partly due to suspicion that the U.S. would abandon the gold standard.
        4. After the abandonment of the gold standard, monetary policy was expansionary for four years - and output and employment began to rapidly recover from an extremely deep trough.
        5. The Fed created a second downturn by raising reserve requirements in 1937. (Dinosaur Keynesian alternative: Roosevelt tried to balance the budget by raising taxes).
    6. Since the broad money supply results from both government and market factors, either the Fed or the market could potentially be at fault for the Great Contraction. Friedman and Schwartz lay most of the blame on the Fed, and they are largely justified:
        1. Fed caused initially monetary base contraction.
        2. Fed had supplanted private banking crisis remedies that worked all right before 1913. First two Fed-era downturns after Panic of 1907 were both far more severe than earlier downturns.
          1. In Panic of 1907, M2 fell by only 3.9% (May-to-May).
        3. Branch banking laws and other regulations made banking system more vulnerable to runs.
        4. Second contraction resulted from large increase in reserve requirements (approximate doubling from 12.5% to 25%).
    7. A critic, however, might point out that:
        1. Monetary base growth was quite high during the years of the largest banking crises. (Annualized continuous growth rate of base money from 7/29 to 7/33 was 2.6%; annualized continuous growth rate from 7/22 to 7/29 was 1.9%!)
        2. Market had previous had much milder responses to small contractions in base money - i.e. base money fell 14% during 1921.
    8. Bordo, Choudri, and Schwartz ("Could Stable Money Have Averted the Great Contraction") provides extremely interesting - if speculative - evidence that monetary factors were decisive. After estimating models of the U.S. economy using interwar U.S. data, they simulate alternative policy rules and predictably find that stable money would have either greatly moderated the depression or eliminated it entirely.
        1. Bordo et al also strongly argue that contra Eichengreen, the gold standard could easily have been maintained under much more expansionary policy.
  2. The Monetary Interpretation Confirmed: The International Evidence of Eichengreen and Bernanke
    1. Note Bernanke's identity: M1=(M1/Base)*(Base/Res)*(Res/Gold)*Pgold*Qgold, where:
      1. M1/Base is the money multiplier.
      2. Base/Res is the inverse of the gold backing ratio.
      3. Res/Gold is the ratio of international reserves to gold.
    2. The CGS vs. the inter-war "gold-exchange" standard: as noted in Bordo's piece, the gold standard was only very briefly restored during the inter-war period. Moreover, this restoration was actually a large modification - and weakening - of the CGS:
      1. Switch from gold coin to gold bullion to curtail domestic demand (e.g. 400 oz. minimum in UK).
      2. Peripheral and some core countries switch substantially from gold to foreign exchange reserves. Under CGS Res/Gold=1; under gold-exchange standard Res/Gold>1.
      3. This left the international monetary system vulnerable to an international run that previously could not have happened.
    3. The main reason for the regime change: wartime money creation was enormous, and thus required massive deflation to return at par in an orthodox way. The switch to the "mixed" gold-exchange system and eliminated non-bullion redemption was an attempt to return to the gold standard without devaluation OR severe deflation.
    4. Eichengreen's findings:
      1. On the international scene, the main source of the decline typically came from the monetary base, not the money multiplier as in the U.S. (p.305)
      2. M1 typically declined less than the base, not more - with some notable exceptions. (p.306)
      3. By 1934 almost all countries - except for the "Gold Bloc" led by France - had abandoned the gold-exchange standard and substantially devalued. (p.351)
      4. There is a strong connection between monetary regime and economic performance. Ordering systems from strongest economic growth (1929-1936) to weakest:
        1. Sterling area countries.
        2. Other depreciated currencies.
        3. Exchange control countries.
        4. Gold bloc countries
    5. Main problem with Eichengreen:
      1. The link Eichengreen finds between monetary regimes and economic performance is definitely there, but Eichengreen underemphasizes the fact that it was the gold-exchange standard, NOT the CGS, that failed badly.
      2. The gold-exchange standard existed for barely 5 years, and was deliberately designed to weaken the inflationary constrains of the CGS. This opened up a new possibility for an international run on each countries' currency as its commitment to parity fell into doubt.
      3. It would make more sense to blame the failures of the gold-exchange standard on the initial wartime suspension, and the failure to return to the orthodox gold standard as soon as possible thereafter.
      4. Eichengreen also strangely targets "financial orthodoxy," which includes not only the gold standard, but restrained monetary and fiscal policies. But as will be seen, most of the AS troubles stem from deviation from orthodox economic policies: the problem is combining orthodox monetary policy with unorthodox labor and industrial policies.
    6. Bernanke's AD findings:
      1. Bernanke tries to address two puzzles: the AD puzzle and the AS puzzle. His discussion of the AD puzzle heavily relies on Eichengreen, but his presentation is clearer.
      2. Further evidence of large regime differences (between on-gold and off-gold countries) from panel data:
        1. Manufacturing production higher for non-gold countries.
        2. Price growth higher for non-gold.
        3. M1 growth higher for non-gold.
        4. Nominal wages fall less in non-gold.
        5. Real wages fall more in non-gold.
        6. Employment rises more in non-gold.
        7. Nominal interest rates a little higher in non-gold.
        8. Ex post real rates lower in non-gold (except last year).
      3. Note Bernanke's tabulations of the factors contributing to decline in the money supply. (Note further that U.S. basically lost no gold at any time!)
    7. In general: as Bernanke points out, international comparisons are extremely helpful, and the ideological factors behind monetary regimes strongly indicate that the connection between money and the depressions are causal.
  3. The AS Puzzle: Whatever Happened to Long-Run Neutrality?
    1. Monetary forces explain the severity of the nominal decline, but it seems necessary to look at labor market policies and other interventions to explain why the real reaction to the nominal decline was so sharp. Earlier depressions exhibited short-run nominal-real connections, but swift recoveries. The Great Depression often seemed to have stable high unemployment in the absence of expansionary monetary policy.
    2. Rothbard's main contribution: debunking "the myth of laissez-faire." Herbert Hoover was the most extreme interventionist to occupy the White House prior to FDR. A few interesting pieces of evidence.
      1. FDR supported Hoover's presidential bid in 1920.
      2. Hoover unsuccessfully pushed for federal anti- depression policy in 1920-21.
      3. Hoover repeatedly indicated that he believed that low wages cause unemployment, apparently on the basis of nonsensical "buy-back-the-product"-type arguments.
      4. Hoover quote, 1932 presidential campaign (p.127)
    3. What were Hoover's actual anti-depression policies like?
      1. Major conferences held, in which Hoover elicited pledges from major industrial leaders not to cut nominal wages. (Why no pledge to avoid lay-offs?)
      2. Federal spending increases from $3.3 billion in 1929 to $4.6 billion in 1932 in nominal terms. (3.1% S/GDP to 7.9% S/GDP). Large increase in public works spending.
      3. Rothbard actually attacks the "inflationist" policies of Hoover. In terms of the monetary base, this is not wrong.
      4. Reconstruction Finance Corporation created, partly in order to encourage sound banks to help shaky ones. $2.3 billion in loans in 1932.
      5. Federal Farm Board to cartelize agriculture actually pushed through by Hoover in early 1929 before the depression even began: $500 million revolving fund for price support. Government purchases try to hold up agricultural prices once depression hits, but these fail due to lack of compulsory quantity limits.
      6. Why does anyone believe that Hoover followed laissez-faire policies then? Based almost entirely on Hoover's opposition to the dole (note that evidence of negative consequences on British economy were already evident), and the fact that FDR took the policies considerably further.
    4. Discarding the myth of Hoover's policies permits a more general study of labor market and other interventions during the Great Depression. Internationally, these were ubiquitous, and provide a good explanation for the actual rise in real wages during the Great Depression (with the rise continuing through 1935 in on-gold countries).
    5. Bernanke's evidence:
      1. Regressing output on nominal wage and price shows that higher wages reduce output, and higher prices increase output (although note hard to reject hypothesis of real rigidity when tested against hypothesis of nominal rigidity).
      2. Nominal wages vs. output in gold bloc countries.
    6. Bernanke on why the depression lasted so long: Could this be an instance of dire macro consequences of credit market imperfections (modernization of Fisher's debt-deflation story).
    7. Interesting case studies:
      1. U.S. labor market and industrial policy under Roosevelt. (Schlesinger v.1, p.249; v.2, p.385)
      2. France (Bernanke p.24-25; Eichengreen pp.384-5)
      3. Germany (Barkai, pp.250-1, 256-7)
  4. Questions
    1. Is there an RBC explanation?
      1. Disintermediation
      2. Supply shocks
      3. Intertemporal labor supply [?!]
    2. Is there an institutional/regulatory explanation? Strong case; main puzzle is that small policies must sometimes carry the blame for big effects.
    3. Does the Austrian theory complement the monetarist explanation?
      1. In terms of AS, definitely; although this is not uniquely Austrian.
      2. In terms of the initial downturn, this is far from clear. How would the Austrian origin be established?