From Wikipedia, the free encyclopedia https://en.wikipedia.org/wiki/Monetarism Monetarism is a school of thought in monetary economics that emphasizes the role of policy-makers in controlling the amount of money in circulation. It gained prominence in the 1970s, but was mostly abandoned as a direct guidance to monetary policy during the following decade because of the rise of inflation targeting through movements of the official interest rate.
Though Friedman opposed the existence of the Federal Reserve, he advocated, given its existence, a central bank policy aimed at keeping the growth of the money supply at a rate commensurate with the growth in productivity and demand for goods.
Money growth targeting was mostly abandoned by the central banks who
tried it, however. Contrary to monetarist thinking, the relation between
money growth and inflation proved to be far from tight. Instead,
starting in the early 1990s, most major central banks turned to direct inflation targeting, relying on steering short-run interest rates as their main policy instrument. Afterwards, monetarism was subsumed into the new neoclassical synthesis which appeared in macroeconomics around 2000.
Monetarist theory draws its roots from the quantity theory of money, a centuries-old economic theory which had been put forward by various economists, among them Irving Fisher and Alfred Marshall, before Friedman restated it in 1956.
Monetarists argued that central banks sometimes caused major
unexpected fluctuations in the money supply. Friedman asserted that
actively trying to stabilize demand through monetary policy changes can
have negative unintended consequences. In part he based this view on the historical analysis of monetary policy, A Monetary History of the United States, 1867–1960, which he coauthored with Anna Schwartz
in 1963. The book attributed inflation to excess money supply generated
by a central bank. It attributed deflationary spirals to the reverse
effect of a failure of a central bank to support the money supply during a liquidity crunch. In particular, the authors argued that the Great Depression of the 1930s was caused by a massive contraction of the money supply (they deemed it "the Great Contraction"),
and not by the lack of investment that Keynes had argued. They also
maintained that post-war inflation was caused by an over-expansion of
the money supply. They made famous the assertion of monetarism that
"inflation is always and everywhere a monetary phenomenon."
Fixed monetary rule
Friedman proposed a fixed monetary rule, called Friedman's k-percent rule,
where the money supply would be automatically increased by a fixed
percentage per year. The rate should equal the growth rate of real GDP,
leaving the price level unchanged. For instance, if the economy is
expected to grow at 2 percent in a given year, the Fed should allow the
money supply to increase by 2 percent. Because discretionary monetary policy
would be as likely to destabilise as to stabilise the economy, Friedman
advocated that the Fed be bound to fixed rules in conducting its
policy.
Opposition to the gold standard
Most monetarists oppose the gold standard.
Friedman viewed a pure gold standard as impractical. For example,
whereas one of the benefits of the gold standard is that the intrinsic
limitations to the growth of the money supply by the use of gold would
prevent inflation, if the growth of population or increase in trade
outpaces the money supply, there would be no way to counteract deflation
and reduced liquidity (and any attendant recession) except for the
mining of more gold. But he also admitted that if a government was
willing to surrender control over its monetary policy and not to
interfere with economic activities, a gold-based economy would be
possible.
Thus, according to Friedman, when the money supply
expanded, people would not simply wish to hold the extra money in idle
money balances; i.e., if they were in equilibrium before the increase,
they were already holding money balances to suit their requirements, and
thus after the increase they would have money balances surplus to their
requirements. These excess money balances would therefore be spent and
hence aggregate demand
would rise. Similarly, if the money supply were reduced people would
want to replenish their holdings of money by reducing their spending. In
this, Friedman challenged a simplification attributed to Keynes
suggesting that "money does not matter." Thus the word 'monetarist' was coined.
In 1979, United States President Jimmy Carter appointed as Federal Reserve Chief Paul Volcker, who made fighting inflation his primary objective, and who restricted the money supply (in accordance with the Friedman rule)
to tame inflation in the economy. The result was a major rise in
interest rates, not only in the United States; but worldwide. The
"Volcker shock" continued from 1979 to the summer of 1982, decreasing
inflation and increasing unemployment.
By the time Margaret Thatcher, Leader of the Conservative Party in the United Kingdom, won the 1979 general election defeating the sitting Labour Government led by James Callaghan, the UK had endured several years of severe inflation, which was rarely below the 10% mark and by the time of the May 1979 general election, stood at 10.3%.
Thatcher implemented monetarism as the weapon in her battle against
inflation, and succeeded at reducing it to 4.6% by 1983. However, unemployment in the United Kingdom
increased from 5.7% in 1979 to 12.2% in 1983, reaching 13.0% in 1982;
starting with the first quarter of 1980, the UK economy contracted in
terms of real gross domestic product for six straight quarters.
Decline
Monetarist ascendancy was brief, however.
The period when major central banks focused on targeting the growth of
money supply, reflecting monetarist theory, lasted only for a few years,
in the US from 1979 to 1982.
The money supply is useful as a policy target only if the
relationship between money and nominal GDP, and therefore inflation, is
stable and predictable. This implies that the velocity of money must be
predictable. In the 1970s velocity had seemed to increase at a fairly
constant rate, but in the 1980s and 1990s velocity became highly
unstable, experiencing unpredictable periods of increases and declines.
Consequently, the stable correlation between the money supply and
nominal GDP broke down, and the usefulness of the monetarist approach
came into question. Many economists who had been convinced by monetarism
in the 1970s abandoned the approach after this experience.
The changing velocity originated in shifts in the demand for money
and created serious problems for the central banks. This provoked a
thorough rethinking of monetary policy. In the early 1990s central banks
started focusing on targeting inflation directly using the short-run interest rate
as their central policy variable, abandoning earlier emphasis on money
growth. The new strategy proved successful, and today most major central
banks follow a flexible inflation targeting.
Legacy
Even though
monetarism failed in practical policy, and the close attention to money
growth which was at the heart of monetarist analysis is rejected by most
economists today, some aspects of monetarism have found their way into
modern mainstream economic thinking. Among them are the belief that controlling inflation should be a primary responsibility of the central bank. It is also widely recognized that monetary policy, as well as fiscal policy, can affect output in the short run. In this way, important monetarist thoughts have been subsumed into the new neoclassical synthesis or consensus view of macroeconomics that emerged in the 2000s.
The causes of the Great Depression in the early 20th century
in the United States have been extensively discussed by economists and
remain a matter of active debate. They are part of the larger debate about economic crises and recessions. The specific economic events that took place during the Great Depression are well established.
There was an initial stock market crash that triggered a "panic sell-off" of assets. This was followed by a deflation in asset and commodity
prices, dramatic drops in demand and the total quantity of money in the
economy, and disruption of trade, ultimately resulting in widespread
unemployment (over 13 million people were unemployed by 1932) and
impoverishment. However, economists and historians have not reached a
consensus on the causal relationships between various events and government economic policies in causing or ameliorating the Depression.
Current mainstream theories may be broadly classified into two main points of view. The first are the demand-driven theories, from Keynesian and institutional economists
who argue that the depression was caused by a widespread loss of
confidence that led to drastically lower investment and persistent underconsumption. The demand-driven theories argue that the financial crisis
following the 1929 crash led to a sudden and persistent reduction in
consumption and investment spending, causing the depression that
followed.
Once panic and deflation set in, many people believed they could avoid
further losses by keeping clear of the markets. Holding money therefore
became profitable as prices dropped lower and a given amount of money
bought ever more goods, exacerbating the drop in demand.
Second, there are the monetarists,
who believe that the Great Depression started as an ordinary recession,
but that significant policy mistakes by monetary authorities
(especially the Federal Reserve) caused a shrinking of the money supply which greatly exacerbated the economic situation, causing a recession to descend into the Great Depression. Related to this explanation are those who point to debt deflation causing those who borrow to owe ever more in real terms.
There are also several various heterodox theories that reject the explanations of the Keynesians and monetarists. Some new classical macroeconomists have argued that various labor market policies imposed at the start caused the length and severity of the Great Depression.
General theoretical reasoning
The
two classical competing theories of the Great Depression are the
Keynesian (demand-driven) and the monetarist explanation. There are also
various heterodox theories that downplay or reject the explanations of
the Keynesians and monetarists.
Economists and economic historians are almost evenly split as to
whether the traditional monetary explanation that monetary forces were
the primary cause of the Great Depression is right, or the traditional
Keynesian explanation that a fall in autonomous spending, particularly
investment, is the primary explanation for the onset of the Great
Depression.
Today the controversy is of lesser importance since there is mainstream
support for the debt deflation theory and the expectations hypothesis
that building on the monetary explanation of Milton Friedman and Anna Schwartz add non-monetary explanations.
There is consensus that the Federal Reserve System
should have cut short the process of monetary deflation and banking
collapse. If the Federal Reserve System had done that, the economic
downturn would have been far less severe and much shorter.
In his book The General Theory of Employment, Interest and Money (1936), British economist John Maynard Keynes
introduced concepts that were intended to help explain the Great
Depression. He argued that there are reasons that the self-correcting
mechanisms that many economists claimed should work during a downturn
might not work.
One argument for a non-interventionist policy during a recession was that if consumption fell due to savings, the savings would cause the rate of interest to fall. According to the classical economists,
lower interest rates would lead to increased investment spending and
demand would remain constant. However, Keynes argues that there are good
reasons that investment does not necessarily increase in response to a
fall in the interest rate. Businesses make investments based on
expectations of profit. Therefore, if a fall in consumption appears to
be long-term, businesses analyzing trends will lower expectations of
future sales. Therefore, the last thing they are interested in doing is
investing in increasing future production, even if lower interest rates
make capital inexpensive. In that case, the economy can be thrown into a
general slump due to a decline in consumption. According to Keynes, this self-reinforcing dynamic is what occurred to an extreme degree during the Depression, where bankruptcies
were common and investment, which requires a degree of optimism, was
very unlikely to occur. This view is often characterized by economists
as being in opposition to Say's Law.
Keynes argued that if the national government spent more money to
help the economy to recover the money normally spent by consumers and
business firms, then unemployment rates would fall. The solution was for
the Federal Reserve System
to "create new money for the national government to borrow and spend"
and to cut taxes rather than raising them, in order for consumers to
spend more, and other beneficial factors.
Hoover chose to do the opposite of what Keynes thought to be the
solution and allowed the federal government to raise taxes exceedingly
to reduce the budget shortage brought upon by the depression. Keynes
proclaimed that more workers could be employed by decreasing interest
rates, encouraging firms to borrow more money and make more products.
Employment would prevent the government from having to spend any more
money by increasing the amount at which consumers would spend. Keynes'
theory was then confirmed by the length of the Great Depression within
the United States and the constant unemployment rate. Employment rates
began to rise in preparation for World War II
by increasing government spending. "In light of these developments, the
Keynesian explanation of the Great Depression was increasingly accepted
by economists, historians, and politicians".
In their 1963 book A Monetary History of the United States, 1867–1960, Milton Friedman and Anna Schwartz
laid out their case for a different explanation of the Great
Depression. Essentially, the Great Depression, in their view, was caused
by the fall of the money supply. Friedman and Schwartz write: "From the
cyclical peak in August 1929 to a cyclical trough in March 1933, the
stock of money fell by over a third." The result was what Friedman and
Schwartz called "The Great Contraction"
— a period of falling income, prices, and employment caused by the
choking effects of a restricted money supply. Friedman and Schwartz
argue that people wanted to hold more money than the Federal Reserve was
supplying. As a result, people hoarded money by consuming less. This
caused a contraction in employment and production since prices were not
flexible enough to immediately fall. The Fed's failure was in not
realizing what was happening and not taking corrective action. In a speech honoring Friedman and Schwartz, Ben Bernanke stated:
"Let me end my talk by abusing slightly my status as an
official representative of the Federal Reserve. I would like to say to
Milton and Anna: Regarding the Great Depression, you're right. We did
it. We're very sorry. But thanks to you, we won't do it again."
— Ben S. Bernanke
After the Depression, the primary explanations of it tended to ignore
the importance of the money supply. However, in the monetarist view,
the Depression was "in fact a tragic testimonial to the importance of
monetary forces". In their view, the failure of the Federal Reserve
to deal with the Depression was not a sign that monetary policy was
impotent, but that the Federal Reserve implemented the wrong policies.
They did not claim the Fed caused the depression, only that it failed to use policies that might have stopped a recession from turning into a depression.
Before
the Great Depression, the U.S. economy
had already experienced a number of depressions. These depressions were
often set off by banking crisis, the most significant occurring in 1873, 1893, 1901, and 1907. Before the 1913 establishment of the Federal Reserve, the banking system had dealt with these crises in the U.S. (such as in the Panic of 1907)
by suspending the convertibility of deposits into currency. Starting in
1893, there were growing efforts by financial institutions and business
men to intervene during these crises, providing liquidity to banks that
were suffering runs. During the banking panic of 1907, an ad hoc
coalition assembled by J. P. Morgan
successfully intervened in this way, thereby cutting off the panic,
which was likely the reason why the depression that would normally have
followed a banking panic did not happen this time. A call by some for a
government version of this solution resulted in the establishment of
the Federal Reserve.
But in 1929–32, the Federal Reserve did not act to provide liquidity to banks suffering bank runs. In fact, its policy contributed to the banking crisis by permitting a sudden contraction of the money supply. During the Roaring Twenties, the central bank had set as its primary goal "price stability", in part because the governor of the New York Federal Reserve, Benjamin Strong, was a disciple of Irving Fisher,
a tremendously popular economist who popularized stable prices as a
monetary goal. It had kept the number of dollars at such an amount that
prices of goods in society appeared stable. In 1928, Strong died, and
with his death this policy ended, to be replaced with a real bills doctrine requiring that all currency or securities have material goods backing them. This policy permitted the U.S. money supply to fall by over a third from 1929 to 1933.
When this money shortage caused runs on banks, the Fed maintained
its true bills policy, refusing to lend money to the banks in the way
that had cut short the 1907 panic, instead allowing each to suffer a
catastrophic run and fail entirely. This policy resulted in a series of
bank failures in which one-third of all banks vanished. According to Ben Bernanke, the subsequent credit crunches led to waves of bankruptcies.
Friedman said that if a policy similar to 1907 had been followed during
the banking panic at the end of 1930, perhaps this would have stopped
the vicious circle of the forced liquidation of assets at depressed
prices. Consequently, the banking panics of 1931, 1932, and 1933 might
not have happened, just as suspension of convertibility in 1893 and 1907
had quickly ended the liquidity crises at the time."
Monetarist explanations had been rejected in Samuelson's work Economics,
writing: "Today few economists regard Federal Reserve monetary policy
as a panacea for controlling the business cycle. Purely monetary factors
are considered to be as much symptoms as causes, albeit symptoms with
aggravating effects that should not be completely neglected." According to Keynesian economist Paul Krugman, the work of Friedman and Schwartz became dominant among mainstream economists by the 1980s but should be reconsidered in light of Japan's Lost Decade of the 1990s. The role of monetary policy in financial crises is in active debate regarding the financial crisis of 2007–2008; see Causes of the Great Recession.
Additional modern nonmonetary explanations
The
monetary explanation has two weaknesses. First, it is not able to
explain why the demand for money was falling more rapidly than the
supply during the initial downturn in 1930–31.
Second, it is not able to explain why in March 1933 a recovery took
place although short term interest rates remained close to zero and the
money supply was still falling. These questions are addressed by modern
explanations that build on the monetary explanation of Milton Friedman
and Anna Schwartz but add non-monetary explanations.
Debt deflation
Crowd at New York's American Union Bank during a bank run early in the Great Depression.Crowd gathering on Wall Street after the 1929 crash.
Total debt to GDP levels in the U.S. reached a high of just under 300
per cent by the time of the Depression. This level of debt was not
exceeded again until near the end of the 20th century.
Jerome (1934) gives an unattributed quote about finance
conditions that allowed the great industrial expansion of the post-W.W.I
period:
Probably never before in this country had such a volume of funds been available at such low rates for such a long period.
Furthermore, Jerome says that the volume of new capital issues
increased at a 7.7% compounded annual rate from 1922 to 1929 at a time
when the Standard Statistics Co.'s index of 60 high grade bonds yielded
from 4.98% in 1923 to 4.47% in 1927.
There was also a real estate and housing bubble in the 1920s, especially in Florida, which burst in 1925. Alvin Hansen stated that housing construction during the 1920s decade exceeded population growth by 25 per cent. See also: Florida land boom of the 1920s:
Statistics kept by Cook County, Illinois show over 1 million vacant
plots for homes in the Chicago area, despite only 950,000 plots being
occupied, the result of Chicago's explosive population growth in
combination with a real estate bubble.
Irving Fisher
argued the predominant factor leading to the Great Depression was
over-indebtedness and deflation. Fisher tied loose credit to
over-indebtedness, which fueled speculation and asset bubbles.
He then outlined nine factors interacting with one another under
conditions of debt and deflation to create the mechanics of boom to
bust. The chain of events proceeded as follows:
Debt liquidation and distress selling
Contraction of the money supply as bank loans are paid off
A fall in the level of asset prices
A still greater fall in the net worths of business, precipitating bankruptcies
A fall in profits
A reduction in output, in trade and in employment.
Pessimism and loss of confidence
Hoarding of money
A fall in nominal interest rates and a rise in deflation adjusted interest rates.
During the Wall Street Crash of 1929 preceding the Great Depression, margin requirements were only 10%.
Brokerage firms, in other words, would lend $90 for every $10 an
investor had deposited. When the market fell, brokers called in these
loans, which could not be paid back. Banks began to fail as debtors
defaulted on debt and depositors attempted to withdraw their deposits en
masse, triggering multiple bank runs.
Government guarantees and Federal Reserve banking regulations to
prevent such panics were ineffective or not used. Bank failures led to
the loss of billions of dollars in assets.
Outstanding debts became heavier, because prices and incomes fell
by 20–50% but the debts remained at the same dollar amount. After the
panic of 1929, and during the first 10 months of 1930, 744 U.S. banks
failed. (In all, 9,000 banks failed during the 1930s.) By April 1933,
around $7 billion in deposits had been frozen in failed banks or those
left unlicensed after the March Bank Holiday.
Bank failures snowballed as desperate bankers called in loans,
which the borrowers did not have time or money to repay. With future
profits looking poor, capital investment
and construction slowed or completely ceased. In the face of bad loans
and worsening future prospects, the surviving banks became even more
conservative in their lending. Banks built up their capital reserves and made fewer loans, which intensified deflationary pressures. A vicious cycle developed and the downward spiral accelerated.
The liquidation of debt could not keep up with the fall of prices
it caused. The mass effect of the stampede to liquidate increased the
value of each dollar owed, relative to the value of declining asset
holdings. The very effort of individuals to lessen their burden of debt
effectively increased it. Paradoxically, the more the debtors paid, the
more they owed. This self-aggravating process turned a 1930 recession into a 1933 depression.
Fisher's debt-deflation theory initially lacked mainstream
influence because of the counter-argument that debt-deflation
represented no more than a redistribution from one group (debtors) to
another (creditors). Pure re-distributions should have no significant
macroeconomic effects.
Building on both the monetary hypothesis of Milton Friedman and Anna Schwartz as well as the debt deflation hypothesis of Irving Fisher, Ben Bernanke
developed an alternative way in which the financial crisis affected
output. He builds on Fisher's argument that dramatic declines in the
price level and nominal incomes lead to increasing real debt burdens
which in turn leads to debtor insolvency and consequently leads to
lowered aggregate demand,
a further decline in the price level then results in a debt
deflationary spiral. According to Bernanke, a small decline in the price
level simply reallocates wealth from debtors to creditors without doing
damage to the economy. But when the deflation is severe falling asset
prices along with debtor bankruptcies lead to a decline in the nominal
value of assets on bank balance sheets. Banks will react by tightening
their credit conditions, that in turn leads to a credit crunch
which does serious harm to the economy. A credit crunch lowers
investment and consumption and results in declining aggregate demand
which additionally contributes to the deflationary spiral.
Economist Steve Keen revived the debt-reset theory after he accurately predicted the 2008 recession based on his analysis of the Great Depression, and recently advised Congress to engage in debt-forgiveness or direct payments to citizens in order to avoid future financial events. Some people support the debt-reset theory.
Expectations hypothesis
Expectations have been a central element of macroeconomic models since the economic mainstream accepted the new neoclassical synthesis. While not rejecting that it was inadequate demand that sustained the depression, according to Peter Temin, Barry Wigmore, Gauti B. Eggertsson and Christina Romer
the key to recovery and the end of the Great Depression was the
successful management of public expectations. This thesis is based on
the observation that after years of deflation and a very severe
recession, important economic indicators turned positive in March 1933,
just as Franklin D. Roosevelt
took office. Consumer prices turned from deflation to a mild inflation,
industrial production bottomed out in March 1933, investment doubled in
1933 with a turnaround in March 1933. There were no monetary forces to
explain that turnaround. Money supply was still falling and short term
interest rates remained close to zero. Before March 1933, people
expected a further deflation and recession so that even interest rates
at zero did not stimulate investment. But when Roosevelt announced major
regime changes people began to expect inflation and an economic
expansion. With those expectations, interest rates at zero began to
stimulate investment as planned. Roosevelt's fiscal and monetary policy
regime change helped to make his policy objectives credible. The
expectation of higher future income and higher future inflation
stimulated demand and investments. The analysis suggests that the
elimination of the policy dogmas of the gold standard, a balanced budget
in times of crises and small government led to a large shift in
expectation that accounts for about 70–80 percent of the recovery of
output and prices from 1933 to 1937. If the regime change had not
happened and the Hoover policy had continued, the economy would have
continued its free fall in 1933, and output would have been 30 percent
lower in 1937 than in 1933.
The recession of 1937–38,
which slowed down economic recovery from the Great Depression, is
explained by fears of the population that the moderate tightening of the
monetary and fiscal policy in 1937 would be first steps to a
restoration of the pre March 1933 policy regime.
Austrian economists argue that the Great Depression was the
inevitable outcome of the monetary policies of the Federal Reserve
during the 1920s. The central bank's policy was an "easy credit policy"
which led to an unsustainable credit-driven boom. The inflation of the
money supply during this period led to an unsustainable boom in both
asset prices (stocks and bonds) and capital goods.
By the time the Federal Reserve belatedly tightened monetary policy in
1928, it was too late to avoid a significant economic contraction.
Austrians argue that government intervention after the crash of 1929
delayed the market's adjustment and made the road to complete recovery
more difficult.
Acceptance of the Austrian explanation of what primarily caused
the Great Depression is compatible with either acceptance or denial of
the monetarist explanation. Austrian economist Murray Rothbard, who wrote America's Great Depression
(1963), rejected the monetarist explanation. He criticized Milton
Friedman's assertion that the central bank failed to sufficiently
increase the supply of money, claiming instead that the Federal Reserve
did pursue an inflationary policy when, in 1932, it purchased $1.1
billion of government securities, which raised its total holding to $1.8
billion. Rothbard says that despite the central bank's policies, "total
bank reserves only rose by $212 million, while the total money supply
fell by $3 billion". The reason for this, he argues, is that the
American populace lost faith in the banking system and began hoarding
more cash, a factor very much beyond the control of the Central Bank.
The potential for a run on the banks caused local bankers to be more
conservative in lending out their reserves, which, according to
Rothbard's argument, was the cause of the Federal Reserve's inability to
inflate.
Friedrich Hayek had criticised the Federal Reserve and the Bank of England in the 1930s for not taking a more contractionary stance.
However, in 1975, Hayek admitted that he made a mistake in the 1930s in
not opposing the Central Bank's deflationary policy and stated the
reason why he had been ambivalent: "At that time I believed that a
process of deflation of some short duration might break the rigidity of
wages which I thought was incompatible with a functioning economy.
In 1978, he made it clear that he agreed with the point of view of the
monetarists, saying, "I agree with Milton Friedman that once the Crash
had occurred, the Federal Reserve System pursued a silly deflationary
policy", and that he was as opposed to deflation as he was to inflation. Concordantly, economist Lawrence White argues that the business cycle theory of Hayek is inconsistent with a monetary policy which permits a severe contraction of the money supply.
Marxists generally argue that the Great Depression was the result of the inherent instability of the capitalist mode of production. According to Forbes,
"The idea that capitalism caused the Great Depression was widely held
among intellectuals and the general public for many decades."
Specific theories of cause
Non-debt deflation
In addition to the debt deflation there was a component of productivity deflation that had been occurring since The Great Deflation of the last quarter of the 19th century. There may have also been a continuation of the correction to the sharp inflation caused by World War I.
Oil prices reached their all-time low in the early 1930s as production began from the East Texas Oil Field, the largest field ever found in the lower 48 states. With the oil market oversupplied prices locally fell to below ten cents per barrel.
Productivity or technology shock
In the first three decades of the 20th century productivity and economic output surged due in part to electrification, mass production and the increasing motorization of transportation and farm machinery. Electrification and mass production techniques such as Fordism permanently lowered the demand for labor relative to economic output.
By the late 1920s the resultant rapid growth in productivity and
investment in manufacturing meant there was a considerable excess
production capacity.
Sometime after the peak of the business cycle in 1923, more
workers were displaced by productivity improvements than growth in the
employment market could meet, causing unemployment to slowly rise after
1925. Also, the work week fell slightly in the decade prior to the depression.Wages did not keep up with productivity growth, which led to the problem of underconsumption.
Henry Ford and Edward A. Filene were among prominent businessmen who were concerned with overproduction and underconsumption. Ford doubled wages of his workers in 1914. The over-production problem was also discussed in Congress, with Senator Reed Smoot proposing an import tariff, which became the Smoot–Hawley Tariff Act.
The Smoot–Hawley Tariff was enacted in June 1930. The tariff was
misguided because the U.S. had been running a trade account surplus
during the 1920s.
Another effect of rapid technological change was that after 1910
the rate of capital investment slowed, primarily due to reduced
investment in business structures.
The depression led to additional large numbers of plant closings.
It cannot be emphasized too strongly that the
[productivity, output and employment] trends we are describing are
long-time trends and were thoroughly evident prior to 1929. These trends
are in nowise the result of the present depression, nor are they the
result of the World War. On the contrary, the present depression is a
collapse resulting from these long-term trends. — M. King Hubbert
In the book Mechanization in Industry, whose publication was sponsored by the National Bureau of Economic Research,
Jerome (1934) noted that whether mechanization tends to increase output
or displace labor depends on the elasticity of demand for the product.
In addition, reduced costs of production were not always passed on to
consumers. It was further noted that agriculture was adversely affected
by the reduced need for animal feed as horses and mules were displaced by inanimate sources of power following World War I. As a related point, Jerome also notes that the term "technological unemployment" was being used to describe the labor situation during the depression.
Some portion of the increased unemployment which characterized the post-War years in the United States may be attributed to the mechanization of industries producing commodities of inelastic demand. — Fredrick C. Wells, 1934
The dramatic rise in productivity of major industries in the U. S.
and the effects of productivity on output, wages and the work week are
discussed by a Brookings Institution sponsored book.
Corporations decided to lay off workers and reduced the amount of
raw materials they purchased to manufacture their products. This
decision was made to cut the production of goods because of the amount
of products that were not being sold.
Joseph Stiglitz and Bruce Greenwald
suggested that it was a productivity-shock in agriculture, through
fertilizers, mechanization and improved seed, that caused the drop in
agricultural product prices. Farmers were forced off the land, further
adding to the excess labor supply.
The prices of agricultural products began to decline after W.W.I
and eventually many farmers were forced out of business, causing the
failure of hundreds of small rural banks. Agricultural productivity resulting from tractors, fertilizers, and hybrid corn
was only part of the problem; the other problem was the change over
from horses and mules to internal combustion transportation. The horse
and mule population began declining after W.W.I, freeing up enormous
quantities of land previously used for animal feed.
The rise of the internal combustion engine and increasing numbers
of motorcars and buses also halted the growth of electric street
railways.
The years 1929 to 1941 had the highest total factor productivity growth in the history of the U. S., largely due to the productivity increases in public utilities, transportation and trade.
Disparities in wealth and income
Economists such as Waddill Catchings, William Trufant Foster, Rexford Tugwell, Adolph Berle (and later John Kenneth Galbraith), popularized a theory that had some influence on Franklin D. Roosevelt.
This theory held that the economy produced more goods than consumers
could purchase, because the consumers did not have enough income.
According to this view, in the 1920s wages had increased at a lower
rate than productivity growth, which had been high. Most of the benefit
of the increased productivity went into profits, which went into the stock market bubble
rather than into consumer purchases. Thus workers did not have enough
income to absorb the large amount of capacity that had been added.
According to this view, the root cause of the Great Depression
was a global overinvestment while the level of wages and earnings from
independent businesses fell short of creating enough purchasing power.
It was argued that government should intervene by an increased taxation
of the rich to help make income more equal. With the increased revenue
the government could create public works to increase employment and
'kick start' the economy. In the U.S.A. the economic policies had been
quite the opposite until 1932. The Revenue Act of 1932
and public works programmes introduced in Hoover's last year as
president and taken up by Roosevelt, created some redistribution of
purchasing power.
The stock market crash made it evident that banking systems
Americans were relying on were not dependable. Americans looked towards
insubstantial banking units for their own liquidity supply. As the
economy began to fail, these banks were no longer able to support those
who depended on their assets – they did not hold as much power as the
larger banks. During the depression, "three waves of bank failures shook
the economy."
The first wave came just when the economy was heading in the direction
of recovery at the end of 1930 and the beginning of 1931. The second
wave of bank failures occurred "after the Federal Reserve System raised
the rediscount rate to stanch an outflow of gold"
around the end of 1931. The last wave, which began in the middle of
1932, was the worst and most devastating, continuing "almost to the
point of a total breakdown of the banking system in the winter of
1932–1933".
The reserve banks led the United States into an even deeper depression
between 1931 and 1933, due to their failure to appreciate and put to use
the powers they withheld – capable of creating money – as well as the
"inappropriate monetary policies pursued by them during these years".
According to the gold standard theory of the Depression, the
Depression was largely caused by the decision of most western nations
after World War I
to return to the gold standard at the pre-war gold price. Monetary
policy, according to this view, was thereby put into a deflationary
setting that would over the next decade slowly grind away at the health
of many European economies.
This post-war policy was preceded by an inflationary policy
during World War I, when many European nations abandoned the gold
standard, forced
by the enormous costs of the war. This resulted in inflation because
the supply of new money that was created was spent on war, not on
investments in productivity to increase aggregate supply that would have
neutralized inflation. The view is that the quantity of new money
introduced largely determines the inflation rate, and therefore, the
cure to inflation is to reduce the amount of new currency created for
purposes that are destructive or wasteful, and do not lead to economic
growth.
After the war, when America and the nations of Europe went back
on the gold standard, most nations decided to return to the gold
standard at the pre-war price. When the United Kingdom,
for example, passed the Gold Standard Act of 1925, thereby returning
Britain to the gold standard, the critical decision was made to set the
new price of the Pound Sterling at parity with the pre-war price even though the pound was then trading on the foreign exchange market at a much lower price. At the time, this action was criticized by John Maynard Keynes
and others, who argued that in so doing, they were forcing a
revaluation of wages without any tendency to equilibrium. Keynes'
criticism of Chancellor of the Exchequer Winston Churchill's form of the return to the gold standard implicitly compared it to the consequences of the Treaty of Versailles.
One of the reasons for setting the currencies at parity with the
pre-war price was the prevailing opinion at that time that deflation was
not a danger, while inflation, particularly the inflation in the Weimar Republic,
was an unbearable danger. Another reason was that those who had loaned
in nominal amounts hoped to recover the same value in gold that they had
lent. Because of the World War I reparations that Germany had to pay France,
Germany began a credit-fueled period of growth in order to export and
sell enough goods abroad to gain gold to pay the reparations. The U.S.,
as the world's gold sink, loaned money to Germany to stabilize its
currency, which allowed it to access additional credit
to spur the growth needed to pay back France, and France to pay back
loans to the U.K. and the U.S. The loan and a reparations schedule were
codified in the Dawes Plan.
In some cases, deflation can be hard on sectors of the economy
such as agriculture, if they are deeply in debt at high interest rates
and are unable to refinance, or that are dependent upon loans to finance
capital goods when low interest rates are not available. Deflation
erodes the price of commodities while increasing the real liability of
debt. Deflation is beneficial to those with assets in cash, and to those
who wish to invest or purchase assets or loan money.
More recent research, by economists such as Temin, Ben Bernanke, and Barry Eichengreen,
has focused on the constraints policy makers were under at the time of
the Depression. In this view, the constraints of the inter-war gold standard
magnified the initial economic shock and were a significant obstacle to
any actions that would ameliorate the growing Depression. According to
them, the initial destabilizing shock may have originated with the Wall Street Crash of 1929 in the U.S., but it was the gold standard system that transmitted the problem to the rest of the world.
According to their conclusions, during a time of crisis, policy makers may have wanted to loosen monetary and fiscal policy,
but such action would threaten the countries' ability to maintain their
obligation to exchange gold at its contractual rate. The gold standard
required countries to maintain high interest rates to attract
international investors who bought foreign assets with gold. Therefore,
governments had their hands tied as the economies collapsed, unless they
abandoned their currency's link to gold. Fixing the exchange rate of
all countries on the gold standard ensured that the market for foreign
exchange can only equilibrate through interest rates. As the Depression
worsened, many countries started to abandon the gold standard, and those
that abandoned it earlier suffered less from deflation and tended to
recover more quickly.
Richard Timberlake, economist of the free banking school and protégé of Milton Friedman, specifically addressed this stance in his paper Gold Standards and the Real Bills Doctrine in U.S. Monetary Policy,
wherein he argued that the Federal Reserve actually had plenty of
lee-way under the gold standard, as had been demonstrated by the price stability policy of New York Fed governor Benjamin Strong, between 1923 and 1928. But when Strong died in late 1928, the faction that took over dominance of the Fed advocated a real bills
doctrine, where all money had to be represented by physical goods. This
policy, forcing a 30% deflation of the dollar that inevitably damaged
the U.S. economy, is stated by Timberlake as being arbitrary and
avoidable, the existing gold standard having been capable of continuing
without it:
This shift in control was decisive. In accordance with the
precedent Strong had set in promoting a stable price level policy
without heed to any golden fetters, real bills proponents could proceed
equally unconstrained in implementing their policy ideal. System policy
in 1928–29 consequently shifted from price level stabilization to
passive real bills. "The" gold standard remained where it had
been—nothing but formal window dressing waiting for an opportune time to
reappear.
Financial institution structures
New York stock market index
Economic historians (especially Friedman and Schwartz) emphasize the
importance of numerous bank failures. The failures were mostly in rural
America. Structural weaknesses in the rural economy made local banks
highly vulnerable. Farmers, already deeply in debt, saw farm prices
plummet in the late 1920s and their implicit real interest rates on
loans skyrocket.
Their land was already over-mortgaged (as a result of the 1919
bubble in land prices), and crop prices were too low to allow them to
pay off what they owed. Small banks, especially those tied to the
agricultural economy, were in constant crisis in the 1920s with their
customers defaulting on loans because of the sudden rise in real
interest rates; there was a steady stream of failures among these
smaller banks throughout the decade.
The city banks also suffered from structural weaknesses that made
them vulnerable to a shock. Some of the nation's largest banks were
failing to maintain adequate reserves and were investing heavily in the
stock market or making risky loans. Loans to Germany and Latin America
by New York City banks were especially risky. In other words, the
banking system was not well prepared to absorb the shock of a major
recession.
Economists have argued that a liquidity trap might have contributed to bank failures.
Economists and historians debate how much responsibility to
assign the Wall Street Crash of 1929. The timing was right; the
magnitude of the shock to expectations of future prosperity was high.
Most analysts believe the market in 1928–29 was a "bubble" with prices
far higher than justified by fundamentals. Economists agree that somehow
it shared some blame, but how much no one has estimated. Milton
Friedman concluded, "I don't doubt for a moment that the collapse of the
stock market in 1929 played a role in the initial recession".
But the idea of owning government bonds initially became ideal to investors when Liberty Loan
drives encouraged this possession in America during World War I. This
strive for dominion persisted into the 1920s. After World War I, the
United States became the world's creditor and was depended upon by many
foreign nations. "Governments from around the globe looked to Wall
Street for loans". Investors then started to depend on these loans for further investments. Chief counsel of the Senate Bank Committee, Ferdinand Pecora, disclosed that National City
executives were also dependent on loans from a special bank fund as a
safety net for their stock losses while American banker, Albert Wiggin,
"made millions selling short his own bank shares".
Economist David Hume stated that the economy became imbalanced as
the recession spread on an international scale. The cost of goods
remained too high for too long during a time where there was less
international trade. Policies set in selected countries to "maintain the
value of their currency" resulted in an outcome of bank failures.
Governments that continued to follow the gold standard were led into
bank failure, meaning that it was the governments and central bankers
that contributed as a stepping stool into the depression.
The debate has three sides: one group says the crash caused the
depression by drastically lowering expectations about the future and by
removing large sums of investment capital; a second group says the
economy was slipping since summer 1929 and the crash ratified it; the
third group says that in either scenario the crash could not have caused
more than a recession. There was a brief recovery in the market into
April 1930, but prices then started falling steadily again from there,
not reaching a final bottom until July 1932. This was the largest
long-term U.S. market decline by any measure. To move from a recession
in 1930 to a deep depression in 1931–32, entirely different factors had
to be in play.
Protectionism, such as the American Smoot–Hawley Tariff Act, is often indicated as a cause of the Great Depression, with countries enacting protectionist policies yielding a beggar thy neighbor result.
The Smoot–Hawley Tariff Act was especially harmful to agriculture
because it caused farmers to default on their loans. This event may have
worsened or even caused the ensuing bank runs in the Midwest and West
that caused the collapse of the banking system. A petition signed by
over 1,000 economists was presented to the U.S. government warning that
the Smoot–Hawley Tariff Act would bring disastrous economic
repercussions; however, this did not stop the act from being signed into
law.
Governments around the world took various steps into spending
less money on foreign goods such as: "imposing tariffs, import quotas,
and exchange controls". These restrictions formed a lot of tension
between trade nations, causing a major deduction during the depression.
Not all countries enforced the same measures of protectionism. Some
countries raised tariffs drastically and enforced severe restrictions on
foreign exchange transactions, while other countries condensed "trade
and exchange restrictions only marginally":
"Countries that remained on the gold standard, keeping
currencies fixed, were more likely to restrict foreign trade." These
countries "resorted to protectionist policies to strengthen the balance
of payments and limit gold losses". They hoped that these restrictions
and depletions would hold the economic decline.
Countries that abandoned the gold standard, allowed their currencies to depreciate which caused their Balance of payments
to strengthen. It also freed up monetary policy so that central banks
could lower interest rates and act as lenders of last resort. They
possessed the best policy instruments to fight the Depression and did
not need protectionism.
"The length and depth of a country's economic downturn and the
timing and vigor of its recovery is related to how long it remained on
the gold standard.
Countries abandoning the gold standard relatively early experienced
relatively mild recessions and early recoveries. In contrast, countries
remaining on the gold standard experienced prolonged slumps."
In a 1995 survey of American economic historians, two-thirds agreed
that the Smoot-Hawley tariff act at least worsened the Great Depression.
However, many economists believe that the Smoot-Hawley tariff act was
not a major contributor to the great depression. Economist Paul Krugman
holds that, "Where protectionism really mattered was in preventing a
recovery in trade when production recovered". He cites a report by Barry
Eichengreen and Douglas Irwin: Figure 1 in that report shows trade and
production dropping together from 1929 to 1932, but production
increasing faster than trade from 1932 to 1937. The authors argue that
adherence to the gold standard forced many countries to resort to
tariffs, when instead they should have devalued their currencies. Peter Temin
argues that contrary the popular argument, the contractionary effect of
the tariff was small. He notes that exports were 7 percent of GNP in
1929, they fell by 1.5 percent of 1929 GNP in the next two years and the
fall was offset by the increase in domestic demand from tariff.
International debt structure
When the war came to an end in 1918, all European nations that had been allied with the U.S. owed large sums of money to American banks, sums much too large to be repaid out of their shattered treasuries. This is one reason why the Allies had insisted (to the consternation of Woodrow Wilson) on reparation payments from Germany and Austria-Hungary. Reparations, they believed, would provide them with a way to pay off their own debts. However, the German Empire and Austria-Hungary
were themselves in deep economic trouble after the war; they were no
more able to pay the reparations than the Allies to pay their debts.
The debtor nations put strong pressure on the U.S. in the 1920s
to forgive the debts, or at least reduce them. The American government
refused. Instead, U.S. banks began making large loans to the nations of
Europe. Thus, debts (and reparations) were being paid only by augmenting
old debts and piling up new ones. In the late 1920s, and particularly
after the American economy began to weaken after 1929, the European
nations found it much more difficult to borrow money from the U.S. At
the same time, high U.S. tariffs were making it much more difficult for
them to sell their goods in U.S. markets. Without any source of revenue
from foreign exchange to repay their loans, they began to default.
Beginning late in the 1920s, European demand for U.S. goods began
to decline. That was partly because European industry and agriculture
were becoming more productive, and partly because some European nations
(most notably Weimar Germany)
were suffering serious financial crises and could not afford to buy
goods overseas. However, the central issue causing the destabilization
of the European economy in the late 1920s was the international debt structure that had emerged in the aftermath of World War I.
The high tariff walls such as the Smoot–Hawley Tariff Act
critically impeded the payment of war debts. As a result of high U.S.
tariffs, only a sort of cycle kept the reparations and war-debt payments
going. During the 1920s, the former allies paid the war-debt
installments to the U.S. chiefly with funds obtained from German
reparations payments, and Germany was able to make those payments only
because of large private loans from the U.S. and Britain. Similarly,
U.S. investments abroad provided the dollars, which alone made it
possible for foreign nations to buy U.S. exports.
The Smoot–Hawley Tariff Act was instituted by Senator Reed Smoot and Representative Willis C. Hawley,
and signed into law by President Hoover, to raise taxes on American
imports by about 20 percent during June 1930. This tax, which added to
already shrinking income and overproduction in the U.S., only benefitted
Americans in having to spend less on foreign goods. In contrast,
European trading nations frowned upon this tax increase, particularly
since the "United States was an international creditor and exports to
the U.S. market were already declining". In response to the Smoot–Hawley Tariff Act, some of America's primary producers and largest trading partner, Canada, chose to seek retribution by increasing the financial value of imported goods favoured by the Americans.
In the scramble for liquidity that followed the 1929 stock market
crash, funds flowed back from Europe to America, and Europe's fragile
economies crumbled.
By 1931, the world was reeling from the worst depression of
recent memory, and the entire structure of reparations and war debts
collapsed.
Population dynamics
In 1939, prominent economist Alvin Hansen discussed the decline in population growth in relation to the Depression.
The same idea was discussed in a 1978 journal article by Clarence Barber, an economist at the University of Manitoba. Using "a form of the Harrod model" to analyze the Depression, Barber states:
In such a model, one would look for
the origins of a serious depression in conditions which produced a
decline in Harrod's natural rate of growth, more specifically, in a
decline in the rate of population and labour force growth and in the
rate of growth of productivity or technical progress, to a level below
the warranted rate of growth.
Barber says, while there is "no clear evidence" of a decline in "the
rate of growth of productivity" during the 1920s, there is "clear
evidence" the population growth rate began to decline during that same
period. He argues the decline in population growth rate may have caused a
decline in "the natural rate of growth" which was significant enough to
cause a serious depression.
Barber says a decline in the population growth rate is likely to
affect the demand for housing, and claims this is apparently what
happened during the 1920s. He concludes:
the rapid and very large decline in
the rate of growth of non-farm households was clearly the major reason
for the decline that occurred in residential construction in the United
States from 1926 on. And this decline, as Bolch and Pilgrim have
claimed, may well have been the most important single factor in turning
the 1929 downturn into a major depression.
The decline in housing construction that can be attributed to
demographics has been estimated to range from 28% in 1933 to 38% in
1940.
Among the causes of the decline in the population growth rate during the 1920s were a declining birth rate after 1910
and reduced immigration. The decline in immigration was largely the
result of legislation in the 1920s placing greater restrictions on
immigration. In 1921, Congress passed the Emergency Quota Act, followed by the Immigration Act of 1924.
Factors that majorly contributed to the failing of the economy
since 1925, was a decrease in both residential and non-residential
buildings being constructed. It was the debt as a result of the war,
fewer families being formed, and an imbalance of mortgage payments and
loans in 1928–29, that mainly contributed to the decline in the number
of houses being built. This caused the population growth rate to
decelerate.
Though non-residential units continued to be built "at a high rate
throughout the decade", the demand for such units was actually very low.
There is an ongoing debate between historians as to what extent President Calvin Coolidge's laissez-faire
hands-off attitude contributed to the Great Depression. Despite a
growing rate of bank failures, he did not heed voices that predicted the
lack of banking regulation as potentially dangerous. He did not listen
to members of Congress warning that stock speculation had gone too far
and he ignored criticisms that workers did not participate sufficiently
in the prosperity of the Roaring Twenties.
From the point of view of today's mainstream schools of economic
thought, government should strive to keep some broad nominal aggregate
on a stable growth path (for proponents of new classical macroeconomics and monetarism, the measure is the nominal money supply; for Keynesian economists it is the nominal aggregate demand itself). During a depression the central bank
should pour liquidity into the banking system and the government should
cut taxes and accelerate spending in order to keep the nominal money
stock and total nominal demand from collapsing.
The United States government and the Federal Reserve did not do that during the 1929‑32 slide into the Great Depression The existence of "liquidationism"
played a key part in motivating public policy decisions not to fight
the gathering Great Depression. An increasingly common view among
economic historians is that the adherence of some Federal Reserve
policymakers to the liquidationist thesis led to disastrous
consequences. Regarding the policies of President Hoover, economists Barry Eichengreen and J. Bradford DeLong
point out that the Hoover administration's fiscal policy was guided by
liquidationist economists and policy makers, as Hoover tried to keep the
federal budget balanced until 1932, when Hoover lost confidence in his
Secretary of the Treasury Andrew Mellon and replaced him.
Hoover wrote in his memoirs he did not side with the liquidationists,
but took the side of those in his cabinet with "economic
responsibility", his Secretary of Commerce Robert P. Lamont and Secretary of Agriculture Arthur M. Hyde, who advised the President to "use the powers of government to cushion the situation".
But at the same time he kept Andrew Mellon as Secretary of the Treasury
until February 1932. It was during 1932 that Hoover began to support
more aggressive measures to combat the Depression.
In his memoirs, President Hoover wrote bitterly about members of his
Cabinet who had advised inaction during the downslide into the Great
Depression:
The leave-it-alone liquidationists
headed by Secretary of the Treasury Mellon ... felt that government must
keep its hands off and let the slump liquidate itself. Mr. Mellon had
only one formula: "Liquidate labor, liquidate stocks, liquidate the
farmers, liquidate real estate ... It will purge the rottenness out of
the system. High costs of living and high living will come down. People
will work harder, live a more moral life. Values will be adjusted, and
enterprising people will pick up the wrecks from less competent people."
Before the Keynesian Revolution, such a liquidationist theory was a common position for economists to take and was held and advanced by economists like Friedrich Hayek, Lionel Robbins, Joseph Schumpeter, Seymour Harris [it] and others.
According to the liquidationists a depression is good medicine. The
function of a depression is to liquidate failed investments and
businesses that have been made obsolete by technological development in
order to release factors of production (capital and labor) from
unproductive uses. These can then be redeployed in other sectors of the
technologically dynamic economy. They asserted that deflationary policy
minimized the duration of the Depression of 1920–21
by tolerating liquidation which subsequently created economic growth
later in the decade. They pushed for deflationary policies (which were
already executed in 1921) which – in their opinion – would assist the
release of capital and labor from unproductive activities to lay the
groundwork for a new economic boom. The liquidationists argued that even
if self-adjustment of the economy took mass bankruptcies, then so be
it. Postponing the liquidation process would only magnify the social costs. Schumpeter wrote that it
... leads us to believe that
recovery is sound only if it does come of itself. For any revival which
is merely due to artificial stimulus leaves part of the work of
depressions undone and adds, to an undigested remnant of maladjustment,
new maladjustment of its own which has to be liquidated in turn, thus
threatening business with another (worse) crisis ahead.
Despite liquidationist expectations, a large proportion of the
capital stock was not redeployed and vanished during the first years of
the Great Depression. According to a study by Olivier Blanchard and Lawrence Summers, the recession caused a drop of net capital accumulation to pre-1924 levels by 1933.
Criticism
Economists such as John Maynard Keynes and Milton Friedman
suggested that the do-nothing policy prescription which resulted from
the liquidationist theory contributed to deepening the Great Depression. With the rhetoric of ridicule, Keynes tried to discredit the liquidationist view in presenting Hayek, Robbins and Schumpeter as
...austere and puritanical souls
[who] regard [the Great Depression] ... as an inevitable and a desirable
nemesis on so much "overexpansion" as they call it ... It would, they
feel, be a victory for the mammon of unrighteousness if so much
prosperity was not subsequently balanced by universal bankruptcy. We
need, they say, what they politely call a 'prolonged liquidation' to put
us right. The liquidation, they tell us, is not yet complete. But in
time it will be. And when sufficient time has elapsed for the completion
of the liquidation, all will be well with us again...
Milton Friedman stated that at the University of Chicago such "dangerous nonsense" was never taught and that he understood why at Harvard University —where such nonsense was taught— bright young economists rejected their teachers' macroeconomics, and become Keynesians. He wrote:
I think the Austrian business-cycle
theory has done the world a great deal of harm. If you go back to the
1930s, which is a key point, here you had the Austrians sitting in
London, Hayek and Lionel Robbins, and saying you just have to let the
bottom drop out of the world. You've just got to let it cure itself. You
can't do anything about it. You will only make it worse [...] I think
by encouraging that kind of do-nothing policy both in Britain and in the
United States, they did harm.
Economist Lawrence White,
while acknowledging that Hayek and Robbins did not actively oppose the
deflationary policy of the early 1930s, nevertheless challenges the
argument of Milton Friedman, J. Bradford DeLong
et al. that Hayek was a proponent of liquidationism. White argues that
the business cycle theory of Hayek and Robbins (which later developed
into Austrian business cycle theory
in its present-day form) was actually not consistent with a monetary
policy which permitted a severe contraction of the money supply.
Nevertheless, White says that at the time of the Great Depression Hayek
"expressed ambivalence about the shrinking nominal income and sharp
deflation in 1929–32".
In a talk in 1975, Hayek admitted the mistake he made over forty years
earlier in not opposing the Central Bank's deflationary policy and
stated the reason why he had been "ambivalent": "At that time I believed
that a process of deflation of some short duration might break the
rigidity of wages which I thought was incompatible with a functioning
economy."
1979 Hayek strongly criticized the Fed's contractionary monetary policy
early in the Depression and its failure to offer banks liquidity:
I agree with Milton Friedman that
once the Crash had occurred, the Federal Reserve System pursued a silly
deflationary policy. I am not only against inflation but I am also
against deflation. So, once again, a badly programmed monetary policy
prolonged the depression.
Unemployment
rate in the US 1910–60, with the years of the Great Depression
(1929–39) highlighted; accurate data begins in 1939, represented by a
blue line.
Economic policy
Historians
gave Hoover credit for working tirelessly to combat the depression and
noted that he left government prematurely aged. But his policies are
rated as simply not far-reaching enough to address the Great Depression.
He was prepared to do something, but nowhere near enough. Hoover was no exponent of laissez-faire. But his principal philosophies were voluntarism,
self-help, and rugged individualism. He refused direct federal
intervention. He believed that government should do more than his
immediate predecessors (Warren G. Harding, Calvin Coolidge) believed. But he was not willing to go as far as Franklin D. Roosevelt later did. Therefore, he is described as the "first of the new presidents" and "the last of the old".
Hoover's first measures were based on voluntarism by businesses
not to reduce their workforce or cut wages. But businesses had little
choice and wages were reduced, workers were laid off, and investments
postponed. The Hoover administration extended over $100 million in
emergency farm loans and some $915 million in public works projects
between 1930 and 1932. Hoover urged bankers to set up the National Credit Corporation
so that big banks could help failing banks survive. But bankers were
reluctant to invest in failing banks, and the National Credit
Corporation did almost nothing to address the problem. In 1932 Hoover reluctantly established the Reconstruction Finance Corporation,
a Federal agency with the authority to lend up to $2 billion to rescue
banks and restore confidence in financial institutions. But $2 billion
was not enough to save all the banks, and bank runs and bank failures continued.
Federal spending
Federal
spending in millions of dollars (1910–60). The time period of the
Hoover administration, the New Deal and World War II are highlighted.
J. Bradford DeLong
explained that Hoover would have been a budget cutter in normal times
and continuously wanted to balance the budget. Hoover held the line
against powerful political forces that sought to increase government
spending after the Depression began for fully two and a half years.
During the first two years of the Depression (1929 and 1930) Hoover
actually achieved budget surpluses of about 0.8% of gross domestic product
(GDP). In 1931, when the recession significantly worsened and GDP
declined by 15%, the federal budget had only a small deficit of 0.6% of
GDP. It was not until 1932 (when GDP declined by 27% compared to
1929-level) that Hoover pushed for measures (Reconstruction Finance Corporation, Federal Home Loan Bank Act, direct loans to fund state Depression relief programs) that increased spending. But at the same time he pushed for the Revenue Act of 1932 that massively increased taxes in order to balance the budget again.
Uncertainty was a major factor, argued by several economists,
that contributed to the worsening and length of the depression. It was
also said to be responsible "for the initial decline in consumption that
marks the" beginning of the Great Depression by economists Paul R.
Flacco and Randall E. Parker. Economist Ludwig Lachmann argues that it
was pessimism that prevented the recovery and worsening of the
depression President Hoover is said to have been blinded from what was right in front of him.
Economist James Duesenberry
argues economic imbalance was not only a result of World War I, but
also of the structural changes made during the first quarter of the
Twentieth Century. He also states the branches of the nation's economy
became smaller, there was not much demand for housing, and the stock
market crash "had a more direct impact on consumption than any previous
financial panic".
Economist William A. Lewis describes the conflict between America and its primary producers:
Misfortunes [of the 1930s] were due
principally to the fact that the production of primary commodities
after the war was somewhat in excess of demand. It was this which, by
keeping the terms of trade unfavourable to primary producers, kept the
trade in manufactures so low, to the detriment of some countries as the
United Kingdom, even in the twenties, and it was this which pulled the
world economy down in the early thirties....If primary commodity markets
had not been so insecure the crisis of 1929 would not have become a
great depression....It was the violent fall of prices that was
deflationary.
The stock market crash was not the first sign of the Great
Depression. "Long before the crash, community banks were failing at the
rate of one per day".
It was the development of the Federal Reserve System that misled
investors in the 1920s into relying on federal banks as a safety net.
They were encouraged to continue buying stocks and to overlook any of
the fluctuations. Economist Roger Babson tried to warn the investors of
the deficiency to come, but was ridiculed even as the economy began to
deteriorate during the summer of 1929. While England and Germany
struggled under the strain on gold currencies after the war, economists
were blinded by an unsustainable 'new economy' they sought to be
considerably stable and successful.
Since the United States decided to no longer comply with the gold
standard, "the value of the dollar could change freely from day to
day". Although this imbalance on an international scale led to crisis, the economy within the nation remained stable.
The depression then affected all nations on an international scale. "The German mark collapsed when the chancellor
put domestic politics ahead of sensible finance; the bank of England
abandoned the gold standard after a subsequent speculative attack; and
the U.S. Federal Reserve raised its discount rate dramatically in
October 1931 to preserve the value of the dollar". The Federal Reserve drove the American economy into an even deeper depression.
Tax policy
In 1929 the Hoover administration responded to the economic crises by temporarily lowering income tax rates and the corporate tax rate. At the beginning of 1931, tax returns
showed a tremendous decline in income due to the economic downturn.
Income tax receipts were 40% less than in 1930. At the same time government spending proved to be a lot greater than estimated.
As a result, the budget deficit increased tremendously. While Secretary
of the Treasury Andrew Mellon urged to increase taxes, Hoover had no
desire to do so since 1932 was an election year.
In December 1931, hopes that the economic downturn would come to an end
vanished since all economic indicators pointed to a continuing downward
trend.
On January 7, 1932, Andrew Mellon announced that the Hoover
administration would end a further increase in public debt by raising
taxes. On June 6, 1932, the Revenue Act of 1932 was signed into law.
The majority of historians and economists argue the New Deal was
beneficial to recovery. In a survey of economic historians conducted by
Robert Whaples, professor of economics at Wake Forest University, anonymous questionnaires were sent to members of the Economic History Association. Members were asked to either disagree, agree, or agree with provisos
with the statement that read: "Taken as a whole, government policies of
the New Deal served to lengthen and deepen the Great Depression." While
only 6% of economic historians who worked in the history department of
their universities agreed with the statement, 27% of those that work in
the economics department agreed. Almost an identical percent of the two
groups (21% and 22%) agreed with the statement "with provisos", while
74% of those who worked in the history department, and 51% in the
economics department, disagreed with the statement outright.
Arguments for key to recovery
According to Peter Temin, Barry Wigmore, Gauti B. Eggertsson and Christina Romer the biggest primary impact of the New Deal
on the economy and the key to recovery and to end the Great Depression
was brought about by a successful management of public expectations.
Before the first New Deal measures people expected a contractionary
economic situation (recession, deflation) to persist. Roosevelt's fiscal
and monetary policy regime change helped to make his policy objectives
credible. Expectations changed towards an expansionary development
(economic growth, inflation). The expectation of higher future income
and higher future inflation stimulated demand and investments. The
analysis suggests that the elimination of the policy dogmas of the gold
standard, balanced budget and small government led to a large shift in
expectation that accounts for about 70–80 percent of the recovery of
output and prices from 1933 to 1937. If the regime change would not have
happened and the Hoover policy would have continued, the economy would
have continued its free fall in 1933, and output would have been 30
percent lower in 1937 than in 1933.
Arguments for prolongation of the Great Depression
In the new classical macroeconomics
view of the Great Depression large negative shocks caused the 1929–33
downturn – including monetary shocks, productivity shocks, and banking
shocks – but those developments become positive after 1933 due to
monetary and banking reform policies. According to the model
Cole-Ohanian impose, the main culprits for the prolonged depression were
labor frictions and productivity/efficiency frictions (perhaps, to a
lesser extent). Financial frictions are unlikely to have caused the
prolonged slump.
In the Cole-Ohanian model there is a slower than normal recovery
which they explain by New Deal policies which they evaluated as tending
towards monopoly and distribution of wealth. The key economic paper
looking at these diagnostic sources in relation to the Great Depression
is Cole and Ohanian's work. Cole-Ohanian point at two policies of New
Deal: the National Industrial Recovery Act and National Labor Relations Act
(NLRA), the latter strengthening NIRA's labor provision. According to
Cole-Ohanian New Deal policies created cartelization, high wages, and
high prices in at least manufacturing and some energy and mining
industries. Roosevelts
policies against the severity of the Depression like the NIRA, a "code
of fair competition" for each industry were aimed to reduce cutthroat
competition in a period of severe deflation,
which was seen as the cause for lowered demand and employment. The NIRA
suspended antitrust laws and permitted collusion in some sectors
provided that industry raised wages above clearing level and accepted
collective bargaining with labor unions. The effects of cartelization can be seen as the basic effect of monopoly.
The given corporation produces too little, charges too high of a price,
and under-employs labor. Likewise, an increase in the power of unions
creates a situation similar to monopoly. Wages are too high for the
union members, so the corporation employs fewer people and, produces
less output. Cole-Ohanian show that 60% of the difference between the
trend and realized output is due to cartelization and unions. Chari, Kehoe, McGrattan also present a nice exposition that's in line with Cole-Ohanian.
This type of analysis has numerous counterarguments including the
applicability of the equilibrium business cycle to the Great
Depression.
