Prof. Bryan Caplan

Econ 311

Fall, 1999

Week 13: The Macroeconomics of Laissez-Faire and Interventionism: The Great Depression and European Unemployment

  1. The AD Puzzle and the AS Puzzle
    1. From 1929 until World War II, most of the world suffered extraordinary economic problems. These were at their most severe in the U.S.
      1. Unemployment reaches about 25%.
      2. Real output falls even more.
      3. The price level falls by about 1/3.
      4. Real wages RISE by about 25%.
    2. In the U.S., the downturn began in 1929, and got much worse from 1931-1933. The economy slowly recovered over the next 8 years. (Interrupted by a further downturn in 1937-8).
    3. What happened during the GD? This question needs to be decomposed into two questions:
      1. The AD Puzzle: What caused the sharp negative shocks to AD?
      2. The AS Puzzle: Why did the AD shocks matter so much, and for so long? After all, isn't AS only supposed to matter in the short-run?
  2. Solving the AD Puzzle: Monetary Contraction
    1. It took economists a long time to figure this out, but the AD is easily answered: there was a huge worldwide contraction in the (broadly measured!) money supply. In the U.S., M2 fell by about 1/3 from 1929 to 1933. It fell again in 1937-8. The same happened all over the world.
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    3. In other countries, the monetary base itself often declined. In the U.S., this was only a brief and minor factor. Rather, the broad money supply declined because there was a huge increase in demand for the monetary base.
    4. As I've pointed out before, if the monetary base changes, you know who is responsible: the government. But if a broader measure of money supply changes, the question is tougher. So what actually happened?
    5. The monetary decline and the depression in the U.S. were not especially severe until 1931. Then, Britain went off the gold standard, sparking fears that the U.S. would do the same.
    6. Under the gold standard, central banks pledged to maintain the value of their currencies in terms of gold weight, and freely bought and sold gold at the official rate. This offered a kind of "no-inflation guarantee" - IF CBs actually kept their pledge! Britain's devaluation threw every CBs integrity into doubt, leading to a "run on the dollar."
    7. As fear that the U.S. would leave the gold standard mounted, people began withdrawing currency from banks to exchange it for gold before the dollar was devalued.
    8. The (broad) monetary contraction in the U.S. was made more severe by the fact that U.S. branch banking and other laws made banks extremely un-diversified, hence very risky.
    9. The U.S. finally devalued in 1933 when Roosevelt took office. If you were smart enough to have cashed in your dollars for gold a year earlier, you almost doubled your money!
    10. Reserve requirements were doubled in 1937, sparking a second monetary contraction.
  3. Solving the AS Puzzle: Labor Market and Other Intervention
    1. Economic theory suggests that AD shocks should only have short-run effects. Why, then, did the monetary contraction have such long-lasting effects? Labor market intervention is the most plausible answer.
    2. Important to note: Hoover had long been viewed as being on the far left ("progressive") wing of the Republican party, not a reactionary proponent of laissez-faire as many historians argue. Roosevelt supported Hoover presidential bid in 1920.
    3. Under Hoover: major CEOs pressured to pledge not to make (nominal) wage cuts. This meant that as prices fell, workers got paid more and more in real terms if you had a job at all! [Hoover quote]
    4. Under Roosevelt, array of more formal government action to keep up wages taken. Pro-union laws probably the most important. Note the insanity of trying to push wages UP when there is already massive unemployment.
    5. Around the world: similar labor market intervention everywhere.
    6. Government policy: instead of trying to address either of the real AD or AS problems, the U.S. government under both Hoover and Roosevelt initiated a mad hodgepodge of government programs, interventions, and policies:
      1. Large spending (and tax!) increases.
      2. Agricultural cartels:
      3. Large increase in public works spending under both H&R.
      4. Under Roosevelt: direct cartelization of industry with NRA.
      5. Under Roosevelt: SEC, Social Security, public utilities, and similar initiatives unrelated to actual problems.
  4. European Unemployment
    1. Since the '70's, high unemployment has plagued most of Europe. Basic facts:
      1. Visual inspection: While U.S. unemployment rate has ups and downs, European unemployment rises, then plateaus, then rises again - with only one brief recovery.
      2. Total employment increase from 1970-1996: 58% for U.S., 12% for Europe (47 M vs. 18 M; note European population is greater).
      3. Labor force participation: in the U.S., rise from 65% to 75%; in Europe, fall from 65% to 60%.
    2. What explanations can be ruled out?
      1. Oil shocks
      2. Productivity growth decline
    3. Unemployment is permanently high, as in the Great Depression. Supply shocks don't seem important, so the labor market seems to be the right place to look.
  5. Exacerbating Labor Market Rigidities: European Unemployment Policies
    1. High legal minimum wages. (E.g. 34% of median in U.S. vs. 60% in France).
    2. High unemployment/welfare benefits with long durations.
    3. Firing/layoff regulations.
    4. Mandatory benefits (vacation, sick leave, maternity leave, etc.) (How does the interaction between mandatory benefits and nominal and real rigidity work?)
    5. High unionization rates with strong legal support for unions. (Note: In some countries like France, non-union workers still have their wages determined by union negotiations.)
    6. Main mistake: over-emphasis on AD, underemphasis on AS. AD may start depressions, but it is AS problems that make them severe and long-lasting.