Given how much energy I’ve put into this blog, I’m hoping my readers can help me out a bit. I have been getting suggestions that I really need to finish revising my manuscript. So I decided that to better focus on it, I’d devote my blog to the Great Depression for the next two months. Hopefully this will allow for synergy, as I will work on the manuscript and also post bits of it on the blog to get feedback. I will also set a deadline of April 15 to finish revisions, in the hope that this will overcome the commitment problem (since I have little self-control.) The fear of a public embarrassment for not finishing by this arbitrary deadline should force me to get it done.
Of course you readers will have to sacrifice a bit, as the Great Depression may be much less interesting than our Great Recession. But after mid-April I plan to go back to current events. I will also have to sacrifice a bit, because I much prefer blogging, and my inflated ego may not be able to go long without excessively flattering commentaries like this and this.
Today I will sketch out a very brief summary of my explanation of the Great Depression, and the models I use to evaluate it. This will summarize the first three chapters of the book. I’d like to put the entire manuscript on my blog, but I don’t think the publisher would allow that. But here is what I think I can do, I can probably post the three chapters that cover the early 1930s, as they are merely slightly modified versions of papers already in the public realm, published in the early 1990s. So I will do that over the next few weeks.
So the plan is that you can give me feedback on my basic approach, and then later when I post chapters 4, 5, and 6 of the manuscript, a few comments on those as well. You will notice that the writing style of those chapters (much of which were written in the early 1990s), is far inferior to this blog. I still think the content is pretty good, but unfortunately my later chapters are more convincing in terms of economic analysis. But what can I do, we are stuck with the fact that the earliest parts of the Great Depression are the most difficult to explain. And I can’t very well do my narrative in reverse order, like a Hollywood movie with flashbacks. (Or can I . . . )
Part 1. What caused the Great Depression?
I believe the Great Depression had two primary causes. One cause was deflationary monetary policies during 1929-33, and 1937-38. The other cause was five nominal wage shocks during 1933, 1934, 1936-37, 1938 and 1939. These 5 shocks were caused by New Deal programs, and slowed the recovery. This is why the Great Depression lasted 12 years, ending about the time of Pearl Harbor. I don’t know what ended the Great Depression, and don’t really discuss it in my manuscript, but I suspect it had something to do with the German invasion of France, which led to a military mobilization in the US and elsewhere. This may have directly raised AD, and indirectly increased expected NGDP growth by raising the expected inflation rate. Wars are usually inflationary.
I also think there were many secondary factors that depressed output. During 1929-33 there were at least three important adverse supply shocks; Hoover’s high wage policy, Smoot-Hawley, and the big jump in MTRs during 1932. But without the deflationary monetary policy, the tax hike wouldn’t have happened, the wage policy would have had little effect, and even Smoot-Hawley would have had only a modest effect. And of course after 1933 there were many other New Deal polices that inhibited recovery, but I focus on the 5 wage shocks, as I am convinced that they are far more important than the other policies.
You may have noticed that the two variables I focus on are prices and nominal wages. If you look at a real wage series (manufacturing wages over the WPI) it captures both of these effects. I’d rather use NGDP as an indicator of deflationary policies, but lack monthly NGDP data. But I think the WPI does almost as well, at least during periods where monthly industrial production is moving in the same direction. Thus during 1929-33, and 1937-38, we observe both monthly wholesale prices and monthly industrial production falling sharply. It is a pretty good bet that if we had monthly NGDP, it would also have been falling almost continuously during those periods.
If you invert monthly real wages, and graph it against monthly de-trended industrial production, the correlation is amazing. Indeed I regard it as the single most astounding graph I have ever seen in business cycle theory. Especially since modern theory predicts no correlation at all. But this does not mean that changes in real wages drove changes in IP, nor do I make that claim. Rather I claim that the two components drivers of real wages, deflationary monetary policies and autonomous nominal wage shocks caused by New Deal policies, caused the changes in industrial production. My model is completely ad hoc, and I am proud of that fact. I have a model that fits the Great Depression. I don’t believe there are “timeless Platonic models” that fit all business cycles.
Understanding the GD is like peeling an onion, after you remove one layer of causality there is always another inside. So now we know the proximate cause of the Great Depression; deflation, and wage shocks. But what are the deeper causes of each shock? The wage shocks were simply policy initiatives by FDR, all the complexity is in the deflationary shocks.
Recall that the Great Depression was a global phenomenon. Prices fell almost everywhere. The theory of PPP provides one explanation of the linkage. Thus prices fell even in countries like Canada, which did not see a single bank fail. And of course exchange rates were fixed by the international gold standard.
Part 2. How do we evaluate monetary policy under an international gold standard?
Except in 1933, gold was the medium of account in the US during the interwar years. Thus changes in the price level were identical to the inverse of changes in the value of gold. This isn’t a theory, it is an identity. If the price level fell 20%, then ipso facto the purchasing power of gold rose 25%. Thus to explain why prices fell sharply in the US after 1929, we need to explain why the value of gold rose sharply after 1929. That can’t be so hard! And surprisingly, is really isn’t all that hard. The value of any commodity is determined by supply and demand. The fact that gold equaled money doesn’t change that at all.
The supply of newly mined gold is pretty stable, roughly 2% of the stock of existing gold. So to explain any big change in the price level, we will need to focus on shocks to gold demand. Unfortunately, I didn’t have good data on total gold stocks. Instead, I relied on monetary gold stocks. Actually I could have constructed reasonably accurate estimates for total gold stocks, but I found monetary gold stocks served my purposes just as well. All I had to do was consider changes in the non-monetary demand for gold (hoarding or jewelry) to be factors that affected the supply of monetary gold.
So there are two things that could have caused the great deflationary shock of 1929-33; more private demand for gold, and more central bank demand for gold. Both happened, although central banks seemed by far the biggest culprits. Central banks held gold reserves to back their liabilities, basically the monetary base. I had to take a few short cuts for foreign countries, where I used currency as a proxy for the base. This ratio is called the “gold reserve ratio” and is the ratio of monetary gold stocks to currency or the monetary base. The model starts with this identity:
Price level = (monetary gold supply)/(real monetary gold demand)
P = (monetary gold supply)/[gold reserve ratio*real currency demand]
All three variables on the right side played a role in the Great Deflation. But the supply of monetary gold actually increased over those four years, so in net terms it pushed prices higher. Nevertheless, private gold hoarding reduced world monetary gold stocks at certain key moments in 1931-33, and this played a role in the intensification of the Great Depression. During a depression gold supplies will normally increase even faster than usual, as gold is brought to central banks in response to the increase in the real value of gold. Private gold hoarding in 1931-33 (and 1937-38) due to devaluation fears slowed this process, and worsened the Depression.
Even so, the big problem was central bank gold demand, which soared for two reasons. First, people hoarded lots of cash, especially in the US and France. This was due to low interest rates and fears of bank failures. More gold was required to back up this increase in real cash demand. Even worse, central banks dramatically increased their gold reserve ratios. They essentially hoarded gold. Under the “rules of the game” this wasn’t supposed to occur. As gold flowed into your country you were supposed to increase the currency stock in proportion to the rise in gold stocks. Had this occurred, had central banks played by the rules of the game, it is very likely (though not certain) that the Great Depression would not have occurred. There might have been some deflation in the 1930s, but much milder than what actually occurred.
There was almost no currency hoarding during the first 15 months of the GD. Instead, the initial sharp contraction was triggered by a huge increase in the world gold reserve ratio, which drove prices and output much lower in most countries. The only major exception was France. It had recently devalued its currency and prices had not yet fully risen to reflect PPP. As a result, the onset of the Depression occurred about a year later in France.
Part 3. Beyond ideology
I’m not interested in producing a narrative that fits anyone’s ideological bias. Right-wingers may not like the first half of the book. As I indicated, I think Hoover’s supply-side screw-ups were secondary factors. If NGDP falls in half, you’ve got a major depression on your hands, regardless of trade, tax and wage policies. Look how much trouble we’re having adapting to a 3% fall in NGDP in the 12 months after July 2008.
Left-wingers won’t like the last half of the book, as I attribute the slow recovery to FDR’s high wage policies. But although I have a right wing reputation, FDR comes off far better in the narrative than Hoover. Much of it is devoted to FDR’s dollar devaluation policy, which Keynes correctly called “magnificently right.” In contrast, Hoover did absolutely nothing right. He didn’t intervene where he should have (monetary policy) and the areas he did intervene just made things worse. No single ideology was capable of creating a disaster this big (Just as WWII in Europe was jointly produced by Hitler and Stalin.) The first half of the Depression was a failure of right wing economics, as it was conceived at the time. The second half was a failure of left wing economics, circa 1935. If a single screw-up was capable of creating a Great Depression, we would have had many of them. Instead, this 12 year Depression was three times as long as any other Depression in American history.
The current recession (which was also caused by a failure of both right and left wing ideas) may end up being the second longest, at least if we measure it from the onset to the point where unemployment falls below some reasonable figure like 8%. But at least right-wingers no longer believe in the gold standard, and left wingers no longer support the NIRA. So we won’t have another Great Depression. We are making all the same mistakes, but in much milder forms.
Part 4. Proposed Table on Contents
THE MIDAS CURSE: GOLD, WAGES, AND THE GREAT DEPRESSION
Table of Contents
Part 1: Gold, Wages, and the Great Depression
Chapter 1: Introduction
Chapter 2: A Model of the Great Depression
Chapter 3: Monetary Policy under a Gold Standard
Part 2: The Great Contraction
Chapter 4: From the Wall Street Crash to the First Banking Panic
Chapter 5: The German Crisis of 1931
Chapter 6: The “Liquidity Trap” of 1932
Part 3: Bold and Persistent Experimentation: Macroeconomic Policy During 1933
Chapter 7: A Foolproof Plan for Reflation
Chapter 8: The NIRA and the Hidden Depression
Chapter 9: The Rubber Dollar
Part 4: Back on the Gold Standard
Chapter 10: The Demise of the Gold Bloc
Chapter 11: The Gold Panic
Chapter 12: The Midas Curse and the Roosevelt Depression
Part 5: Conclusion
Chapter 13: The Influence of the Depression on Macroeconomic Thought
Chapter 14: Concluding Remarks