economics

1. The Great Depression
1929-1933
The Defining Moment

2. 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 appreciated—the
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)

3. 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.”

4. The Prelude 1919-1929
• U.S. enters the war late. (1917-1918)
effects on U.S. economy relatively small
compared to European economies.
• Huge damage and disruption to European
economies.
• Real GDP = 100 in 1913. In 1919,
UK=101 France=75 Germany=72 US = 116
• Inflation! Price level = 100 in 1914. In 1918
UK=210 France=213 Germany304 US=164
• Huge climb in Debt/GDP ratios.

5. Consequences
1. World War I---9.5 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
commodities—boom 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.

6. Inter-Allied War Debts ($ billions)
(Kindleberger,The World in Depression
France
4.0 3.0
4.7 3.5
United States United Kingdom
8.1
3.2
Other Countries
To pay principal and interest, war devastated economies would
have to run balance of payments surpluses.

7. German Reparations
• 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.”
• Étienne Mantoux (1946) Reparations not
excessive, destructive or uncollectible.
• The French paid in 1815 and 1871---”Le
Boche Paiera”

8. The magnitude of reparations
Indemnity Percent Share of
(billions) of One Debt
Year's Service
GDP to GDP
France 1815-1819 FF 1.65 to 18 to 21 1.2 to 1.4
1.95
France 1871 FF 5.0 25 0.7
Germany1923-1931 DM 50 83 2.5
Vichy 1940-44 FF 479 111 2.6
Germany1953-1965 527 US$ 7.7 0.4
Japan 1955-1965 1486 US$ 3.0 0.8

9. 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 finance—not
London

10. Return to Gold Standard
“Status Quo Antebellum”
• 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 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.
• Germany’s hyperinflation---returns to gold at
near purchasing power 1925.
• Major imbalances---brittle equilibrium.

11. Adjustment under restored gold
standard more difficult
• International capital markets are revived---
generally free.
• International labor flows almost eliminated
—immigration restrictions
• Increased protectionism
• Less wage flexibility. Wage now seem
sticky even with high unemployment

12. U.S. Economic Prosperity in 1920s
• No trend inflation
• High productivity growth
• 1922-1929, GNP grew at 4.7%,
• Unemployment averaged 3.7%.
• Fed accommodated seasonal demands
for credit and attempted to smooth
economic fluctuations. (2 brief
recessions)

13. Some basic numbers
• Peak August 1929, Trough May 1933
• Real GDP falls 39%
• Real Consumption falls 29%
• Prices (GDP deflator) falls 23%
• Unemployment Jumps:
– 3.2% in 1929
– 25% in 1933 (21%Darby)
– 17% in 1939 (17% Darby)
• Banking Collapse
– July 1929, 24,504 banks, $49 billion deposits.
– December 1932, 17,802 banks, with $36 billion.
– After Bank Holiday March 1933, 11,878 banks with
$23 billion deposits.

14. 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)

15. 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

16. Understanding the Great Depression:
Its Evolution by Phases
Real GDP, 1920-1941
1. Booming Strong Economy in 1920s
140
2. Beginning Shocks, 1928-1929
3. Aggravating Shocks, 1930-1933
130
4. Rock Bottom and Recovery, 1933-1936
120
5. The 1937-1938 Recession
110
6. The Recovery, 1939-1941
1929=100
100
90
80
70
60
1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 1941

17. Understanding the
Great Depression:
Four Basic Questions Real GDP, 1920-1941
140
1. Why it Began?
2. Why so Deep? 130
3. Duration? 120
4. Recovery? 110
1929=100
100
90
80
70
60
1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 1941

18. Understanding the Great Depression:
Its Evolution by Phases
1. Booming Strong Economy in 1920s…but
a) It’s the Roaring Twenties!
b) No trend inflation
c) High productivity growth
d) 1922-1929, GNP grew at 4.7%,
e) Unemployment averaged 3.7%.
f) Fed accommodated seasonal demands for credit and
attempted to smooth economic fluctuations. (2 brief
recessions)
g) BUT: Weak American Agriculture: low prices, high debt,
weak banks
h) BUT: Weak Europe: reparations, debts to U.S., slow
growth, gold standard fragile (overvalued £, UK slumps)
and (undervalued FF, France booms)
i) BUT: U.S. Stock market boom halts foreign loans to
Germany, Eastern Europe and Latin America

19. Understanding the Great Depression:
Its Evolution by Phases
1. Beginning Shocks, 1928-1929
• Spring 1927 U.S. expansionary monetary policy to ease pressure
on the British balance of payments. Critics assert policy too easy,
and allows stock market boom to ignite
• Fed tightens policy in 1928 (discount rate 3 ½ to 5%, and there is
little increase in total money or credit for 1928-1929.
• U.S. stock market boom begins March 1928.
• 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. Recession begins
Summer 1929
• October 1929 U.S. Stock market crash: wealth effect—lowers
consumption and investment, credit effect—reduces value of
collateral and hence lending
• Smoot-Hawley tariff 1929 by U.S. induces retaliatory tariffs by
other countries, international trade declines

20. Understanding the Great Depression:
Its Evolution by Phases
1. Aggravating Shocks, 1930-1933
a) Banking Panics, 1930, 1931, 1933
– Failure of the Fed to Pursue Expansionary Policy
– Collapse of Gold Standard: Austria, Germany leave the gold
standard, Britain departs after a run on the pound in September 1931
– U.S. begins losing gold, trade deficits and capital flight.
2. From Rock Bottom to Recovery, 1933-1936
– Bank Holiday March 1933
– U.S. abandons the Gold Standard March 1933
– New Deal Banking and Securities Legislation
– Monetary Expansion
– Minimal Fiscal Policy
– National Industrial Recovery Act (NIRA)
3. The 1937-1938 Recession
a) The Fed Raises Reserve Requirements
4. The Recovery, 1939-1941
a) Monetary Expansion
b) Fiscal Expansion in preparation for war.

21. Four Basic Questions:
1. Why It Began?
2. Why So Deep and 3. So Long?
• Friedman and Schwartz (and others), the
economy is entering a recession in late
1929
• The economy is beginning to recover in
1931 like a normal business cycle
• BUT what makes the recession worse?
• What turns the recession into a
depression?

22. 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 1931---Britain abandons the Gold Standard
– First Quarter 1933
• 9000 Banks suspend operations. Depositors
and stockholders lose $2.5 billion = 2.4% of
GDP…...not the whole story

23. Why are there
banking panics?

24. 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panics.

25. 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.

26. How do Friedman and Schwartz
explain why the Fed did not act?
• Up to end of 1930
– What is the Fed concerned
about?
– How does it react to banking
failures?
• Who was Benjamin Strong?
• New York Fed v. Board of
Governors?
• What could the Fed have
done 1930-1931?
• What does Congress do?

27. Why didn’t the Fed act?
• Beginning in 1931, Friedman and Schwartz argue that Fed
could have expanded but chose not to.
• 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 from Congress---open market operations of $1
billion. Until Congress adjourns.
• After Britain leaves gold in September 1931, gold drain
starts. Dollars exchanged for gold---Fed’s reserves fall, it
is afraid that further expansion will lead to greater loss of
gold----constrained by the gold standard. Reserves falling
after UK goes off gold in 1931, must retain high interest
rates.

28. Understanding the Great Depression:
Four Basic Questions
1. Why it Began?
2. Why so Deep?
3. Duration?
4. Recovery?

29. Understanding the Great Depression:
Four Basic Questions
1. Why it Began?
Business Cycle Peak 7/8-1929, Federal
Reserve’s tight policy
2. Why so Deep?
Banking Panics. Inaction of the Federal
Reserve
• Duration?
• Recovery?

30. How is the economy driven into a
severe depression by the declining
money supply?
What is the mechanism of
transmission?
Several Explanations……

31. Romer (1993) basic argument is simple
• Depression is the result of a series of aggregate demand
(monetary) shocks that moved economy down an
upward sloping aggregate supply curve.
Price Price
Level Level
Output Output

32. Romer (1993) basic argument is simple
• Depression is the result of a series of aggregate
demand (monetary) 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.

33. The Sticky Wage Conundrum---markets don’t seem to clear

34. How did deflationary shocks affect the
economy?
• Conventional 19th century view: fall in wages and
prices raises stimulate investment, countering
shock….but not in sticky price world.
• How did the monetary shocks hurt the
economy?
– Explanation 1: High real interest rate hypothesis:
Deflation affects expectations. Deflation generates
expectations of higher real rate of interest, raising real
rates and driving down investment
– Explanation 2: Debt-Deflation hypothesis:
Unanticipated inflation increased real debt, increasing
defaults and thus depressing supply of credit

35. Rising Real Interest r = i – p(expected)
Rates—Did the Fed
understand?
• Nominal commercial paper
rate 1927.4 to 1928.4 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.

36. • Sources of the onset—1929-1930/1931 contrasts
previous experience
• The decline in consumer spending and fixed investment
that are the key elements that need to be explained.

37. Romer (1992)

38. The Risk
Premium
during the
Depression
Rate Romer uses

39. Debt Deflation
Hypothesis:
Hamilton looks at
the futures
markets for
predictions of
future prices----
errors random until
1930s when
underestimate
deflation
seriously----don’t
believe that crisis
will continue

40. Klug, Landon-Lane and White looked at the forecasts of
Railroad Shippers and found huge cumulating errors in
forecasts of carloadings---businessmen keep thinking that
recovery is around the bend.
20
10
0
p rc n g e r
e e ta e rro
-10
-20
-30
-40
-50
12
98 13
90 13
92 13
94 13
96 13
98 14
90
Y a a dQ a r
e r n u rte

41. Bernanke’s Contribution—a Third Factor
• In addition to monetary collapse, there was a
disruption of intermediation.
• 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.
Costs include screening, monitoring, and
accounting costs as well as expected losses
from bad borrowers.
• Major contribution to economic decline 1931 and
1932.

42. Banking crises an
important
determinant of
loans as much as
industrial Panic
production. begins
Liquidation of loans
after stock market
crash
But then credit
declines little even
though IP falls 25%
until banking
crises.

44. Understanding the Great Depression:
Four Basic Questions
1. Why it Began?
Business Cycle Peak 7/8-1929, Federal
Reserve’s tight policy
2. Why so Deep?
Banking Panics. Inaction of the Federal
Reserve—prolonged monetary contraction
• Duration?----Clearly inaction plays a role
—what else?
• Recovery?

45. What about Fiscal Policy—Deficit
Spending?
Price Price
Level Level
Output Output

46. Fiscal Policy?—Deficit Spending?
Federal Deficit as Percentage of GDP
In 2005---it was -2.6%
10
8
6
4
2
Percent
0
1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939
-2
-4
-6
-8
-10
Actual GDP Full Employment GDP

47. Industrial Policy?
• Specific Intervention in industry?
• National Industry Recovery Act (NIRA) of 1933
created the National Recovery Administration
(NRA). (Declared unconstitutional May 1935)
• 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.

48. Industrial Policy
• 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 because of higher
costs to producers---
counterproductive
• Shift in the Aggregate Supply
Curve

49. Did the
Duration have
something to
do with bad
monetary
policy?
After
1929-1933,
had the Fed
learned its
lesson?

50. Recession of 1937-1938
• 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.

51. Understanding the Great Depression:
Four Basic Questions
1. Why it Began?
Business Cycle Peak 7/8-1929, Federal Reserve’s
tight policy
2. Why so Deep?
Banking Panics. Inaction of the Federal Reserve.
Prolonged Monetary Contraction
3. Duration?
Continued Monetary Policy Mistakes, Fiscal Policy
not tried. Industrial Policy makes things worse.
• Recovery? Why?

52. Recovery, 1934-1937….why?
• Real GDP grows at
10% p.a.
1934-1937.
• But real GDP on
reaches 1929 peak
in 1937 and trend
path in 1942.
• What drove the
recovery.
• Friedman and
Schwartz (1963)
and Romer (1992):
huge increases in
the money supply.

53. Real GDP, 1920-1941
140
130
120
110
1929=100
100
90
80
70
60
1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 1941

54. What
Increase
d the
Money
Supply?

55. How was the money supply increased?
• F.D. Roosevelt takes emergency powers granted by
Congress in the 100 days.
• FDR allows the dollar to depreciate—sets 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
1934.
• Devaluation also improved the competitiveness of U.S.
goods—rise in the trade balance.
• Devaluation attracted capital flows from Europe,
especially with Hitler’s rise to power. High powered
money rises 40% from April 1934 to April 1937.
• Result: real interest rates fall and recovery of investment
and consumer durable spending.

56. What drove
the money
supply?

58. Understanding the Great Depression:
Four Basic Questions
1. Why it Began?
Business Cycle Peak 7/8-1929, Federal Reserve’s
tight policy
2. Why so Deep?
Banking Panics. Inaction of the Federal Reserve
Prolonged Monetary Contraction.
3. Duration?
Continued Monetary Policy Mistakes, Fiscal Policy
not tried. Industrial Policy makes things worse.
4. Recovery?
Monetary Expansion

59. Some Effects of the Great Depression
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