Transcript Economic 157b - Yale University

The Great Depression:
1929-1939
Functional MRI showing fear
Economics during the Thirty Years War, 1914-1945
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Period of rapid but volatile growth up to World War I
Financial turmoil and hyperinflations of the early 1920s
Stability briefly restored in late 1920s
Problems began to surface in the US:
– Real estate and stock market booms in U.S.
– Resembled Internet bubble of 1990s in (a) hype, (b) new financial
instruments
Problems began with stock market crash of 1929
Followed by bank panics through 1933
Collapse of investment and international trade after 1929
Government and Fed took hesitant steps to stimulate the economy
Trough in 1933
Remember that Keynes’s General Theory not published until 1935 –
the birth of macroeconomics.
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Tales of the labor market in recession/depression:
“I’d get up at five in the morning and head for the
waterfront. Outside the Spreckles Sugar Refinery,
outside the gates, there would be a thousand men.
You know dang well there’s only three or four jobs.
The guy would come out with two little Pinkerton
cops: “I need two guys for the bull gang. Two guys to
go into the hole.” A thousand men would fight like a
pack of Alaskan dogs to get through. Only four of us
would get through.”
Studs Terkel, Hard Times.
3
Comparison with the Great Recession of 2007-09
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Fear and panic on Wall Street, then and now
Stock prices (beginning of period =1)
1.4
2007 - on
1929 - 1933
1.2
1.0
0.8
0.6
0.4
0.2
0.0
1929
1930
1931
2007
2008
2009
1932
1933
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On Main Street with real GDP …
Real output (beginning of period =1)
1.08
1.04
1.00
0.96
0.92
0.88
0.84
0.80
0.76
Real GDP 2007 Real GDP 1929 - 1933
0.72
0.68
1929
1930
1931
2007
2008
2009
1932
1933
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On Main Street with unemployment rate…
Unemployment rate
28
24
20
16
12
8
Unemployment rate (1929 - 1940)
Unemployment rate (2007 - )
4
0
29
30
31
32
33
34
35
36
37
38
39
2007 2008 2009
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Billions of 2005 $
The long cycle by components
1000
1929
800
1939
1933
600
400
200
0
Q
C
I
NX
G
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Growth in Key Indicators
Period
1927:10-1929:8
1929:8-1931:12
1931:12-1933:4
H
M1
Real M1
Ind.
Prod.
42.7%
2.0%
6.5%
1.1%
-8.1%
-10.5%
1.4%
-0.9%
0.6%
11.6%
-22.4%
-10.2%
Real
GDP
Inflation
3.8%
-6.7%
-11.9%
-0.3%
-7.3%
-11.0%
Periods are:
1. Pre-crash boom
2. From crash to Britain’s leaving gold
3. From gold crisis to trough
Note: rates of change at annual rates.
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What caused the Great Depression? AS or AD shocks?
-2.05
1929
-2.10
Detrended prices
• Was the
depression
caused by AD
shocks or AS
shocks?
• Looks like
standard AD
shock.
-2.15
-2.20
-2.25
1940
-2.30
-2.35
-2.40
6.3
1933
6.4
6.5
6.6
6.7
6.8
Actual GDP/Potential GDP
6.9
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Alternative views of the sources of the GD
I. “Expenditure view”: IS or spending shocks
II. Financial market distress:
A. “Money view”: Incompetent Fed reduced money supply
B. [“Golden fetters”: The gold-standard regime required central
banks to act in deflationary manner (an “international LM
curve”). We will not discuss.]
C. Risk, Panic, and deflation theories – most resembles 200709.
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IS interpretation of the depression
interest
rate
(i)
IS1929
IS1933
LM
Y1929
Y1933
0
Real output (Y)
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The Expenditure Approach: IS Shocks
Were shocks in the IS curve responsible? From NX, C, G?
– Foreign trade, government spending and taxes were too small
– No exogenous consumption shock
From I?
– Investment decline was the major shock.
– However, the mechanism is unclear:
• Probably endogenous from financial turmoil and
overhang from 1920s, from accelerator, and from
decline in Tobin’s Q from stock-price shock?
Not a persuasive case for shock to standard IS sources.
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II. Financial Market Background
• Central banks generally have to serve three masters in different
mixes over time. This was the Fed’s trilemma in 1928-33.
1. exchange rates (gold standard and convertibility)
2. macroeconomy (inflation, output, and employment)
3. financial market stability (asset prices, panics, liquidity)
• Fed was primarily concerned about (#3) speculation in 1928-29 and
tightened money at that point.
• When depression was underway, Fed was primarily concerned with
defending the gold standard (#1) until 1933 and didn’t expand M
sufficiently.
• From 1933 on, after US depreciated and others left gold, Fed was
divided about how strongly to stimulate the economy because of
poor macro understanding (#2).
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Monetarism, the Depression, and IS-LM
interest
rate
(i)
LM‘
LM
i**
i*
IS
Y**
Y*
Real output (Y)
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II.A. Friedman and Schwartz and the Monetarist Argument
• The monetarist regime: "Only money matters for output
determination.“
• Friedman’s monetarism. For example, in the “Summing Up” in
Friedman and Schwartz, Monetary History of the United States:
“Throughout the near-century examined, we have found that: Changes in
the behavior of the money stock have been closely associated with changes
in economic activity, money income, and prices. The interaction between
monetary and economic change has been highly stable. Monetary changes
have often had an independent origin; they have not been simply a
reflection of economic activity.” (p. 676)
• We can interpret this as a constant velocity of money, yielding:
PY =VMS , where V is constant velocity of money.
• With fixed prices, this then yields a vertical LM curve because there is
only one level of output consistent with a given money supply.
Friedman and Schwartz: The Money View of the GD
• F&S view the depression as
primarily driven by “incompetent”
monetary policy caused by decline
in money supply
• F/S argued that Fed:
– Could have raised M1 (probably
correct)
– Rise in M1 could have prevented Y
fall and nipped GD in bud (very
contentious)
• F&S largely ignored the role of
maintenance of the gold standard
(clearly wrong)
• In IS-LM model, LM curve shifted
in (see next slide)
1.2
1.1
1.0
0.9
0.8
0.7
0.6
0.5
0.4
28
29
30 31
32
33 34
35
M1 (1929 = 1)
Industrial production (1929 = 1)
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Interest Rates 1920-39
Problem with
LM/monetarist
interpretation:
Safe interest rates
fell in GD!!!
Interest rate (% per year)
10
8
6
4
2
0
20
22
24
26
28
30
3-month T-bill
Fed discount rate (low)
32
34
36
38
40
Corporate bond rate
Commercial paper rate
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IIC1. Liquidity trap in the Depression
An alternative approach is that the world economy was in a
“liquidity trap” in the depression.
Important insight and nightmare of central bankers: M policy
completely ineffective when i gets to 0.
19
6
US short-term interest rates, 1929-45 (% per year)
Liquidity
trap in US in
Great
Depression
5
4
3
2
1
0
1930
1932
1934
1936
1938
1940
1942
1944
interest
rate
(i)
Problem with LT
approach:
Cannot by itself
cause depression.
IS
LM
Y*=Y*’
LM’
II.C2. What about risk?
22
Risk premium on investment grade bonds
8
7
6
5
4
3
2
1
29
30
31
32
33
34
35
36
08
09
Baa rate minus 10-year T bond rate
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Risk premium on investment grade bonds
8
7
6
5
4
3
2
1
0
1930
1940
1950
1960
1970
1980
Baa rate minus 10-year T bond rate
1990
2000
2010
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Risk Premium Theory of the Depression
• Theory that bankruptcies, bank failures, panics increased the
risk premiums on bonds and stocks.
• We can modify our cost of capital as follows:
rr = risky real cost of capital to business (risky interest rate)
= i – π + risk premium = i – π + ρ
• If risk premium rises in recession/depression, this leads to
further falls in asset prices and cuts in investments.
• Easiest to incorporate in IS curve as function of i: **
Y = IS(rr, A0) = IS(i – π + ρ, A0)
• Particularly deadly in case of liquidity trap (also, clearly
relevant today).
** NOTE ADDED AFTER LECTURE: SEE NEXT SLIDE.
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Note added after lecture
Shifting the IS curve is due to substitution.
1. The original IS curve we derived is:
(a)
Y = IS(r, A0)
2. But we need to consider risk, so we rewrite it as the following
(b)
Y = IS(rr, A0)
where rr = risky real cost of capital to business (risky interest rate)
= i – (rate of inflation) + (risk premium) = i – π + ρ
3. We substitute the formula for rr into (b):
(b) Y = IS(i – π + ρ, A0)
This gives the IS as a function of the riskfree nominal rate, i.
4. Note that if π = ρ = 0, then it is the normal IS curve. However, if ρ =
.05, then this means that i must be .05 lower to get the same real rate
relevant to investment, etc. So we lower the IS curve by – π + ρ.
5. Finally, note that with deflation (– π) is a positive number, so it is
also a downward shift.
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Nominal
safe interest
rate
(i)
Impact of Increase in Risk
Premium with Liquidity Trap
IS(i + ρ, A0)
Risk is particularly
deadly in liquidity
trap because Fed
cannot offset.
IS(i + ρ’, A0)
LM: liquidity trap
Y2
Y1
Real output (Y)
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II.C3. Add deflation to risk ….
Alternative interest rates (percent per year)
Risk and deflation a deadly disease
Real risky rate
Nominal risky rate
Nominal riskfree rate
24
20
16
12
8
4
0
29
30
31
32
33
34
35
36
37
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Nominal
safe interest
rate
(i)
Add deflation to risk …
IS(i – π + ρ, A0)
Deflation further
shifts down the IS
curve
IS(i – π’ + ρ’, A0)
LM: liquidity trap
Y3
Y2
Y1
Real output (Y)
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Recovery from the Great Depression
• The end of the Great Depression:
– Military mobilization for World War II led to ENORMOUS
increase in G starting in 1940.
– Recovery took off in 1940.
• This Standard IS shift … no puzzle here!
30
The end of the depression …
30
.6
15
10
Pearl Harbor
Germ invastion Austria, Czech
20
.5
Germ invasion France
25
Germ. invastion Poland
WW II
.4
.3
.2
5
.1
0
.0
30
32
34
36
38
40
42
44
Unemployment rate
Defense spending/GDP
Federal expenditures/GDP
46
48
31
Implication of the Recovery
• Recovery from GD required an increase in high-employment
deficit of 20-25 percent of GDP
– FE Deficit was around 3-4 % in 1938 with unemployment rate of
16-18 %
– U rate declined to 5 percent in 1942, with FE Deficit of 25 % of
GDP.
– Would be equivalent of $3 trillion deficit today!
• The magnitude of the fiscal shock required for recovery
suggests that no minor M or F expansion would cure GD
quickly.
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Summary
• The depth and severity of the Great Depression remains one of the
continuing debates of macroeconomics.
• Probably no simple approach can explain the entire story
– Warning: avoid the seduction simplicity of monocausal approaches.
• Perhaps a complex situation where combination of factors piled up
to produce a “perfect storm” of macroeconomics:
– bad luck (boom of 1920s and bust of 1929)
– poor institutions (gold standard and fragile banking system)
– poor international coordination (legacy of WW I)
– inadequate understanding of macroeconomics (before Keynes’s theory)
– inept policy response (cling to gold standard, no fiscal response)
– bad dynamics (deflation and liquidity trap)
• Will it happen again? How does 2007-2009 differ from the 1930s?
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