The Great Depression:

Why did it begin in late 1929?And why did it last 12 years?

Has the Great Depression been explained?

• Most previous accounts of the Great Depression fail to explain why a severe worldwide slump began in late 1929.

• There are explanations for the slow recovery after 1933, but these are not well integrated into explanations of the Great Contraction.

Output wasn’t just low in the 1930s, it was extraordinarally unstable

• Table 1 Seasonally Adjusted Changes in Industrial Production.___________ •  • Period Change in IPPeriod Change in IP• • 9/29 to 12/30 -29.3% 12/30 to 4/31 +2.5%• 4/31 to 7/32 -34.8% 7/32 to 10/32 +13.3%• 10/32 to 3/33 -9.2% 3/33 to 7/33 +57.4%• 7/33 to 11/33 -18.8% 11/33 to 5/34 +15.9%• 5/34 to 5/35 +3.1% 5/35 to 1/37 +38.8%• 1/37 to 9/37 -0.9%• 9/37 to 5/38 -29.1% 5/38 to 11/38 +23.0%• 11/38 to 5/39 +1.5% 5/39 to 11/39 +22.4%• 11/39 to 5/40 -2.0% 5/40 to 12/41 +39.8%• __________________________________________________________________• Note: These are actual changes, not annualized rates of change.

The Relationship Between Detrended Industrial Production and Detrended (inverted) Real Wages, 1929-39, monthly.

Causal factors in the Great Depression

What needs to be explained?

• AS shocks: 5 new deal wage shocks (other supply shocks such as tariffs and high MTRs may have also played a role.

• AD shocks: Changes in the price of gold, or the purchasing power of gold. a) P = Gs/g

b) P = Gs*(1/r)*(1/md)

c) P = (Pg)*(gs)*(1/r)*(1/md)

Accounting for the Great Deflation• TABLE 2.2 The impact of changes in the world gold-reserve ratio, real demand for currency, real

demand for gold, and monetary gold stock, on the world price level, 1926-1932.•  • Time period•  • Dec 1926 Jun 1928 Oct 1929 Oct 1930 Aug 1931 Dec

1926

to to to to to to• Jun 1928 Oct 1929 Oct 1930 Aug 1931 Dec 1932 Dec

1932•  • (ln 1/r) -3.98 -3.18 -9.62 +1.55 -5.80 -21.86

• (ln 1/md) -4.05 -2.94 -4.97 -16.18 -13.56 -40.80

•  • (ln 1/g) -8.03 -6.12 -14.59 -14.63 -19.36 -62.66• (ln G) +5.82 +5.42 +5.25 +3.93 +5.18 +25.61• • (ln P) -2.21 -0.70 -9.34 -10.70 -14.18 -37.06• • (ln 1/r) = change in the log of (the inverse of) the gold reserve ratio

• (ln 1/md) = change in the log of (the inverse of) real money demand

• (ln g) = change in the log of (the inverse of) the real demand for monetary gold• (ln G) = change in the log of the world monetary gold stock• (ln P) = change in the log of the world price level

A Brief Narrative of the Great Depression

• 1. Mid-1928 to October 1929: The U.S. adopts a tight monetary policy (As U.S. GRR increases.) World monetary policy remains unchanged.

• • 2. October 1929 to October 1930: World monetary policy tightens

sharply. World GRR rises by 9.6%. Expectations change dramatically.• (Late 1929 was very similar to late 1920, late 1937, late 1981, and late

2008. In each case, forecasts for NGDP going several years forward were scaled back sharply.)

• • 3. Mid-1931 to Mid-1932: Private and central bank gold hoarding

increase as German and British exchange rate crises trigger dollar devaluation fears. – a. Gold outflows from the U.S. associated with sharp stock and commodity

price declines. •

– b. Stock and commodity markets seemed to focus primarily on the world gold market, rather than Fed policy changes.

Annualized Changes in World (Physical) Monetary Gold Stock and Related Crises, 1929 - 1939.

• • Time Period DLG Event • • Dec. 1929 - June 1931 6.0 percent • June 1931 - Oct. 1931 -3.4 percent German/U.K. crises• Oct. 1931 - Apr. 1932 6.7 percent• Apr. 1932 - June 1932 -8.7 percent Deficit Fears, Fed OMPs• June 1932 - Jan. 1933 8.4 percent• Jan. 1933 - Feb. 1933 -18.8 percent Third run on the dollar• Feb. 1933 - Apr. 1933 11.8 percent • Apr. 1933 - Jan. 1934 -0.1 percent Dollar depreciation• Jan. 1934 - Mar. 1935 7.6 percent• Mar. 1935 - May 1935 -15.8 percent Belgian crisis• May 1935 - Mar. 1936 5.3 percent • Mar. 1936 - Sep. 1936 0.4 percent French crisis• Sep. 1936 - June 1937 11.3 percent Gold Panic (revaluation fears)• June 1937 - Mar. 1938 0.0 percent Dollar Panic (devaluation fears)• Mar. 1938 - Dec. 1939 9.8 percent • __________________________________________________________________• DLG is the (annualized) first difference of the log of the world monetary gold stock.

1933: A year of “bold and persistent experimentation.”

• 4. Early March 1933: Huge gold outflow fails to depress U.S stock

prices, as investors look forward to FDR taking office on March 4th.

• 5. March to July 1933: Dollar devaluation triggers an extraordinary increase in stock prices, wholesale prices. Industrial production rises 57%, the fastest increase in US history.

• 6. Late July to September 1933: Twenty percent nominal and real wage increase (due to the NIRA) aborts recovery. Recovery resumes in mid-1935 after the NIRA is declared unconstitutional.

Dollar devaluation raises prices despite 25% unemployment

A promising recovery is aborted after FDR raises wages by 22%

• Table 8.1 Selected Indicators, 1933, Monthly.• Industrial Exchange Nominal Real• Month Production WPI COL Rate Wages Wages Dow • • 1/33 106 101 103 100 100 99 99• 2/33 106 99 101 100 100 100 91 • 3/33 100 100 100 100 100 100 100• 4/33 107 100 100 100 99 99 101• 5/33 125 104 101 115 98 94 128• 6/33 144 108 102 118 97 90 143• 7/33 157 114 105 140 99 86 171• 8/33 151 115 108 131 113 98 156• 9/33 143 118 109 144 120 102 165• 10/33 135 118 109 140 122 103 146• 11/33 128 118 108 164 122 104 152• 12/33 129 118 108 154 124 106 161• _____________________________________________________________• Note: The exchange rate is the dollar price of French francs. Both the exchange rate and Dow are mid-

month figures. The real wage is deflated by the WPI.

The Relationship Between Industrial Production and Its Lagged Value, Nominal Wages, Wholesale Prices, 1920-39, monthly.

• • Period• Independent• Variable 1920-39 1920-29 1930-39 • • DLY-1 .509 .345 .543• (9.09) (3.73) (7.43)• • DLW -.459 .124 -.697• (-3.31) (0.60) (-3.84)• • DLP .624 .476 .898• (5.59) (3.91) (4.56)• • Adj. R2 .453 .374 .518• • n 227 107 119• __________________________________________________________________• Note: The variables are defined as follows: DLY and DLY-1 are the first differences of the natural log of industrial production, and its

first lag. DLRW and DLW are the first differences of the natural logs of real and nominal wages of production-workers, respectively, and DLP is the first difference of the natural log of the wholesale price index. All equations included a constant term. T-statistics are in parentheses. A regression of the residuals on the lagged residuals, and other independent variables, showed no evidence of serial correlation.

An uneven recovery• 7. June-1936 to April-1937: Wholesale prices rise 11%. End of international

gold standard triggers rapid reductions in private gold hoards and fears of runaway inflation.

• – a. Process culminates in “gold panic” during spring of 1937. In final stages of panic

U.S. wholesale prices fall slightly on fears of imminent dollar revaluation. •

– b. Wagner Act triggers large wage increases that slow recovery in mid-1937. Revaluation fears end. Gold dishoarding ends.

• • 8. Mid-1937 to Mid-1938: As economy slows, expectations shift toward the

possibility of dollar devaluation. When devaluation fears become significant during the fall of 1937, gold hoarding resumes. Stock and commodity prices fell sharply as future gold stock estimates are scaled back significantly. Industrial production plummets as wages rise and prices fall.

Four month growth rates for industrial production

• Before After• 1933 wage shock +57.4% -18.8%• 1934 wage shock +11.9% -15.0%• 1938 wage shock +15.8% +2.5%• 1939 wage shock +16.0% -6.5% • Note: The dates of the wages shocks are assumed to be 7/33, 5/34, 11/38 and 11/39.

The growth rates are not annualized.

• • The 1936-37 wage shock that accompanied the post-Wagner Act

unionization drives is hard to date because it occurred over a relatively long period of time. During the early stages of that wage shock output continued to rise, as gold dishoarding pushed up prices even faster than wages. Only when inflation slowed after March 1937 did real wages rise sharply. It was at that point that output growth came to a sudden halt, just as in the other four cases.

Understanding the Great Depression

• The stock crash of 1929 did not cause the depression. It was almost identical to the 1987 stock crash, which had zero impact on the economy. More likely, the Depression caused the stock crash.

• The Great Contraction was a worldwide phenomenon, and can only be understood by looking at the world supply and demand for monetary gold.

• The most important influence on current AD, is future expected AD, and hence future expected monetary policy. Gold market shocks affected future expected monetary policy.

• In the absence of the NIRA, FDR’s dollar devaluation program would have resulted in rapid recovery during 1933-34 (as in 1922.) The NIRA and later high wage policies delayed recovery for 6 or 7 years.

• Previous researchers have greatly underestimated the impact of both dollar devaluation and the NIRA, as the programs largely canceled each other out.

• Private gold hoarding did not cause the Great Depression, but it played an important role in 1931-32, and again in 1937-38.

Lessons for today• The crash of 2008 occurred when the Fed (and ECB and BOJ) allowed a sharp fall in

1, 2, and 3 year forward NGDP expectations, causing an immediate and precipitous drop in current AD and current asset prices.

• In the 1930s the banking and currency crises were not independent shocks, but instead were caused by sharply falling NGDP. At the time, most people thought financial turmoil, not tight money, caused the Great Depression. Most pundits made the same error in 2008.

• Things were somewhat different in the recent crisis. The 2007 sub-prime crash was an exogenous shock. However the much more severe financial crisis of late 2008 and early 2009 was caused by sharply falling asset prices (stocks, commodities, and real estate) which mostly resulted from falling NGDP expectations, not foolish sub-prime loans.

• Although Bernanke had written articles discussing the need for an aggressive price level target once rates hit zero, and even recommended such a policy for Japan, he refused to follow FDR’s successful policy of reflation through a price level targeting policy. As a result, the current recovery is anemic.