Lecture 6 - The U.S. Great Depression.pdf

Economic History The U.S. Great Depression Felix Ward Erasmus University Rotterdam 1/54 1 From Great Crash to Great Depression 2 The spending hypothesis 3 The monetary hypothesis 4 The credit crunch hypothesis 5 Transmission mechanisms 2/54 Great Crash 3/54 Black days on Wall Stre...

Economic History The U.S. Great Depression Felix Ward Erasmus University Rotterdam 1/54 1 From Great Crash to Great Depression 2 The spending hypothesis 3 The monetary hypothesis 4 The credit crunch hypothesis 5 Transmission mechanisms 2/54 Great Crash 3/54 Black days on Wall Street Peak in September: Dow Jones Index at 381 First Panic: Black Thursday on October 24th Banks try to stem stock price fall Second Panic: Black Tuesday on October 29th Dow Jones Index troughs at 198 in November Small recovery to 250 by the end of the year 4/54 20 40 60 80 100 Great Crash 1926m1 1928m1 1930m1 Year 1932m1 1934m1 Figure: Industrial stock price index, Dow-Jones (Index: Sep 1929=100) Data source: NBER Macrohistory Database 5/54 Consequences of the Great Crash Recession in the real economy speeds up after the Wall Street Crash Investment behavior Tobin’s Q Household consumption behavior Wealth effect probably small: only 2% of Americans held equity shares1 Uncertainty effect: consumers delay purchase of big-ticket items2 1 2 Temin, Peter. 1976. Did monetary forces cause the Great Depression?. New York: Norton. Romer, Christina D. 1993. The Nation in Depression. Journal of Economic Perspectives, 7(2). 6/54 New machine orders plummet during Great Crash in 1929 Ritschl, Albrecht. 1999. Peter Temin and the onset of the Great Depression in Germany: a reappraisal. Working Paper, University of Zurich. 7/54 Remarkably strong consumption drop Romer, Christina D. 1993. The Nation in Depression. Journal of Economic Perspectives, 7(2). 8/54 Uncertainty after the Great Crash Press reports on rising uncertainty1 Business Week, November 1929: “Hysteria accompanied the market upheaval” Thereafter: “Suspicious and nervous public” Moody’s, December 1929: “The stock market break undermined general confidence” The option value of waiting: Will I lose my job and income? Rather than make irreversible decision to buy expensive durable now, wait and see allows you to keep the option to buy or not to buy until a later period when uncertainty has resolved 1 Romer, Christina D. 1993. The Nation in Depression. Journal of Economic Perspectives, 7(2). 9/54 Uncertainty: consumers cut back on puchase of durables Romer, Christina D. 1990. The Great Crash and the onset of the Great Depression. The Quarterly Journal of Economics, 105(3). 10/54 1 From Great Crash to Great Depression 2 The spending hypothesis 3 The monetary hypothesis 4 The credit crunch hypothesis 5 Transmission mechanisms 11/54 The spending hypothesis The Great Crash consumption drop is consistent with the spending hypothesis Temin1 : Great Depression was caused by a drop in autonomous consumption demand Great Crash consumption drop Construction slowdown since late 1920s Keynes’/Hansen’s secular stagnation thesis2,3 : demand decline due to slowdown in population growth 1 Temin, Peter. 1976. Did Monetary Forces Cause the Great Depression?. W.W. Norton Keynes, John M. 1937 [1978]. Some economic consequences of a declining population, Population and Development Review, 4(3) 3 Hansen, Alvin H. 1939. Economic progress and declining population growth?. The American Economic Review, 29(1). 2 12/54 The spending hypothesis through the lens of IS-LM i i $%# %"# !"# %'# ((# ) %'& ((& ) Y M !"& Autonomous demand drop: ''# to ''& DD ''# ''& IS shifts left Less money demand: %'# to %'& ⇒ Y and i fall Y 13/54 0 2 4 6 8 10 12 Interest rates during the Great Depression 1928m1 1929m7 Commercial paper rate 1931m1 1932m7 Baa Rated Bond Yield Nominal rates fell during the Great Depression’s first phase ✓ But in October 1930 risky interest rates began to rise E Data source: NBER Macrohistory Database 14/54 50 60 70 80 90 100 Spending hypothesis can explain first Depression phase 1928m1 1929m7 1931m1 1932m7 Figure: Index of production of manufactures (October 1929=100) Data source: NBER Macrohistory Database 15/54 1 From Great Crash to Great Depression 2 The spending hypothesis 3 The monetary hypothesis 4 The credit crunch hypothesis 5 Transmission mechanisms 16/54 Influential among policymakers Milton Friedman’s and Anna Schwartz’ seminal work on the Great Depression became the single most important piece of economic research that provided guidance to Federal Reserve Board members during the crisis. Randall Kroszner, Board of Governors of the Federal Reserve (2006–2009) 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 Bernanke, Chairman of the United States Federal Reserve (2006–2014) 17/54 The monetary hypothesis Friedman & Schwartz1 : a monetary contraction caused the Great Depression in the U.S. Money supply collapsed over the course of three banking crises Banks fail ⇒ deposit money is lost M1 ↓ = money in circulation + bank deposits ↓ Friedman & Schwartz’ allegation: Fed failed to stabilize the money supply Should have acted as lender of last resort to prevent bank runs 1 Friedman, Milton and Anna J. Schwartz. 1963. A monetary history of the United States, 1867–1960. Princeton University Press. 18/54 Fractional reserve banking: cash < deposits ⇒ bank run risk Assets Cash & deposits at central bank Liabilities Deposits of customers Lender of last resort: prevents failure of illiquid banks Assets Cash & deposits at central bank Liabilities Deposits of customers + Cash Loans Liabilities to central bank Liabilities to central bank Net worth Loans + Liabilities to central bank Net worth 19/54 The first banking crisis (October 1930) Until October 1930 the recession was severe, but still normal Then the first banking crisis starts Friedman & Schwartz: “In October 1930, the monetary character of the recession changed dramatically.” December 11th, 1930: The Bank of United States goes bankrupt Friedman & Schwartz: “That failure was of special importance” Largest bank failure in U.S. history (until then) 20/54 Bank run on The Bank of United States New York, 1930 21/54 Banking crises begin in late 1930 500 400 300 200 100 0 1929m1 1930m1 1931m1 1932m1 1933m1 Figure: Deposits of failing banks (million USD) Data source: NBER Macrohistory Database 22/54 New phase of the Great Depression Deposits decrease Total money stock decreases Currency in circulation increases Friedman, Milton and Anna J. Schwartz. 1963. A monetary history of the United States, 1867–1960. Princeton University Press. 23/54 New phase of the Great Depression Investors increasingly search for liquidity and safety Interest rate spread between safe assets (e.g. U.S. government bonds) and risky assets (e.g. Baa corporate bonds) increases 24/54 The second banking crisis (March 1931) Smaller U.S. banking crisis in March 1931 Central European banking crisis starts May 1931: Kreditanstalt (Austria) goes bankrupt July 1931: German banks close Capital controls in Germany, 1-year moratorium on foreign debts (Hoover moratorium) ⇒ Post-WW1 international financial structure begins to fall apart 25/54 Bank run on the Danatbank Berlin, July 1931 26/54 The central European banking crisis spreads Figure: US and British banks’ exposure to central Europe (% of total assets) Accominotti, O. (2019). International banking and transmission of the 1931 financial crisis. The Economic History Review, 72(1). Dark gray: commercial banks; Light gray: acceptance houses 27/54 The U.K. leaves the Gold Standard (September 1931) Hoover moratorium had frozen U.K. loans in Germany ⇒ U.K. suffers banking problems and capital flight / gold outflows ⇒ Bank of England fears to run out of gold and FX-reserves ⇒ U.K. leaves the Gold Standard and devalues in September 1931 U.K.’s gold exit is a major shock (cf. France leaving euro tomorrow) ⇒ Global investors now doubt Gold Standard stability ⇒ Violent international capital flows ensue as investors try to avoid future devaluation losses (Who’s next to leave gold?) Doubts about U.S. commitment to gold (bank runs & silver lobby) ⇒ U.S. capital flight / gold outflows: 700 million USD leave the U.S. 28/54 The reaction of the Fed Fed sharply raises interest rates by 2 percentage points to stop capital outflows and gold reserve depletion / attract capital inflows Success: higher interest rates stop the capital outflow; Gold Standard and fixed exchange rate successfully defended Problem: higher interest rates also intensify U.S. banks’ problems In October 1931, 522 banks with 471 million USD of deposits close down (peak of second banking crisis in U.S.) ⇒ From Aug 1931 to Jan 1932 money supply falls by an annualized 31% Recap Trilemma: capital mobility & fixed exchange rate ⇒ monetary policy is not free to address domestic problems 29/54 The third banking crisis (late 1932) Election of Roosevelt (Nov 1932): new doubts about the U.S.’s commitment to the Gold Standard Renewed gold outflow in late 1932, which intensifies in early 1933 From Feb to Mar the NY Fed loses 60% of its gold reserves Fed again raises interest rate to counter outflow and initially does not react to the worsening of banks’ liquidity situation ⇒ Final wave of bank failures that peaks in early 1933 30/54 A final round of bank runs Depositors lining up in 1933 31/54 Bank holiday Bank holiday: On March 6th, 1933 president Roosevelt announces a 4 day closure of banks U.S. leaves Gold Standard and devalues the USD by around 70% Monetary policy becomes strongly expansionary Recovery from the Great Depression begins in the U.S. 32/54 Why didn’t the Fed act as a lender of last resort Bagehot’s rule: central banks should act as lenders of last resort that lend freely at penalty rates against good collateral1 Why? A fractional reserve banking system has multiple sunspot equilibria: 1 Optimism ⇒ no bank run ⇒ bank survival validates optimism 2 Pessimism ⇒ bank run ⇒ bank failure validates pessimism ⇒ Bagehot’s rule eliminates the self-fulfilling crisis equilibrium2 Why didn’t the Fed act accordingly? Friedman & Schwartz: death of Benjamin Strong (1928) ⇒ Fed power shifted to less experienced individuals at district level 1 Bagehot, Walter. 1873. Lombard street: a description of the money market. Henry S. King & Co. Diamond, D. W., & Dybvig, P. H. (1983). Bank runs, deposit insurance, and liquidity. Journal of Political Economy, 91(3), 401-419. 2 33/54 Regional differences across Fed districts The State of Mississipi is divided into two Fed districts 1 Atlanta Fed followed Bagehot’s rule 2 St. Louis Fed did not act as lender of last resort ⇒ Fewer bank failures in Atlanta Fed district Richardson, Gary and William Troost. 2009. Monetary intervention mitigated banking panics during the Great Depression: quasi-experimental evidence from a Federal Reserve district border, 1929–1933. Journal of Political Economy. 117(6). 34/54 The monetary hypothesis through the lens of IS-LM i $%( $%# !"# i %"( %"# %&# ('# ) %&( ('( ) Y M ⇒ Money supply and output decline ✓ But risk-free interest rates should have increased E 35/54 Criticisms of the monetary hypothesis 1 Spending hypothesis proponents: something must have depressed demand, because risk-free interest rates decreased 2 Malinvestment thesis: as a consequence of bad loans, banks were insolvent rather than illiquid Lender of last resort policy ineffective at preventing bank failures 3 Fed policy actually was mildly expansionary Discount rate: decreased after October 1929 (except for September 1931 hike) Monetary base: slowly expanded from late 1930 onwards 36/54 Illiquid bank: net worth > 0, but cash < deposits Assets Cash & deposits at central bank Loans Liabilities Deposits of customers Liabilities to central bank Net worth Insolvent bank: assets < liabilities ⇒ net worth < 0 Assets Cash & deposits at central bank Loans Bad Loans Liabilities Deposits of customers Liabilities to central bank Net worth 37/54 Illiquidity and insolvency both played a role Figure: Solvency and insolvency among terminated banks (Jan 1929 – Mar 1933) Source: Richardson, G. 2007. Categories and causes of bank distress during the great depression, 1929–1933: The illiquidity versus insolvency debate revisited. Explorations in Economic History, 44(4), 588-607. 38/54 1 6 2 Fed discount rate 3 4 5 8 10 12 14 Monetary base (billion USD) 6 Fed policy was (mildly) expansionary 1925m1 1930m1 Year Fed discount rate 1935m1 1940m1 Monetary base Data source: NBER Macrohistory Database 39/54 2 4 Reserve multiplier 6 8 10 But base expansion was too little to offset the loss of traction 1925m1 1930m1 Year 1935m1 1940m1 Figure: Reserve multiplier in the U.S., 1925-1939 Banks lent out less than they could: credit crunch Recap: Reserve multiplier = 1/reserve ratio ≈ 10; D = 1/rr · R and M1 = C + D Data source: NBER Macrohistory Database 40/54 1 From Great Crash to Great Depression 2 The spending hypothesis 3 The monetary hypothesis 4 The credit crunch hypothesis 5 Transmission mechanisms 41/54 Credit crunch Extensive information asymmetries between borrowers and lenders How to distinguish good from bad borrowers? ⇒ Banks screen and monitor ⇒ Banks accumulate relationship-specific knowledge When banks fail relationship-specific knowledge is lost ⇒ The failing bank’s clients cannot easily find a new bank that provides them with credit at the same interest rate ⇒ Costs of credit intermediation (CCI) increase ⇒ Less credit and higher credit spreads Bernanke, Ben S. 1983. Nonmonetary effects of the financial crisis in the propagation of the Great Depression. The American Economic Review. 73(3). 42/54 Financial accelerator Balance sheet channel: any shock that negatively affects the net worth of borrowers makes it more difficult for them to borrow During the Great Depression asset prices plummet and thus negatively affect potential borrowers’ net worth ⇒ Less credit and higher credit spreads Bernanke, Ben S. and Mark Gertler. 1995. Inside the black box: the credit channel of monetary policy transmission. Journal of Economic Perspectives. 9(4). 43/54 Bank failures and credit contraction Credit spreads (DIF) rise after each banking crisis Credit falls by more than deposits do (L/DEP) Legend: IP = industrial production Banks = deposits of failing banks Fails = liabilities of failing firms ∆L/IP = new bank loans / personal income L/D = outstanding loans / deposits DIF = Baa bond–safe rate spread Bernanke, Ben S. 1983. Nonmonetary effects of the financial crisis in the propagation of the Great Depression. The American Economic Review. 73(3). 44/54 The credit crunch hypothesis through the lens of IS-LM As credit spreads (ρ) widen, the average firm has to pay a higher premium above the risk-free rate (i) ⇒ spread-augmented IS shifts from IS0 to IS1 '(+ '(# i i ("+ ("# B C B A !"# (%# ) !"+ (%+ ) Y A C ()# (*# ) ()+ (*+ ) (), (*, ) M Banking crises cause the money supply to decrease and spreads to rise ✓ while output decreases and risk-free rates fall ✓ Bernanke, Ben S. and Alan S. Blinder. 1988. Credit, money, and aggregate demand. The American Economic Review, 78(2), Papers and Proceedings. 45/54 1 From Great Crash to Great Depression 2 The spending hypothesis 3 The monetary hypothesis 4 The credit crunch hypothesis 5 Transmission mechanisms 46/54 How were monetary shocks transmitted to the real economy? Rigid prices: price level had become less flexible over time as economies have shifted from agriculture to industry Sticky wages: wages had become more rigid as unionization rates increased after WW1 Nominally fixed debt contracts: high debt levels after Roaring Twenties (also: WW1 farming expansion) 47/54 Flex-price primary sector vs. administered prices in industry Figure: Price versus production drop for 10 industries, 1929–1933 ⇒ Production declines were most severe for goods with rigid prices Means, Gardiner C. 1935. Industrial prices and their relative inflexibility. U.S. Senate Document, 13, 74th Congress, 1st Session. 48/54 60 Price indices (Aug 1929=100) 70 80 90 100 110 Protracted deflation: prices fall for three years 1926m1 1928m1 1930m1 Year Consumer price index 1932m1 1934m1 Wholesale price index Data source: NBER Macrohistory Database 49/54 Three contractionary effects of protracted deflation 1 Ex ante expected real interest rate increase (r = i − π e ) ⇒ Firms invest less, households save more (note: this only happens when deflation is anticipated) 2 W Wage deflation ( P↓ ↑): real wages increase ⇒ Firms hire fewer workers 3 D Debt deflation1,2 ( P↓ ↑): more difficult to repay debt, and redistributes wealth from borrowers to creditors ⇒ Implies lower aggregate demand when creditors have lower propensity to consume 1 Fisher, Irving. 1933. The debt-deflation theory of great depressions. Econometrica. 1(4). Eggertsson, G. B., and Krugman, P. 2012. Debt, deleveraging, and the liquidity trap: a Fisher-Minsky-Koo approach. The Quarterly Journal of Economics, 127(3), 1469-1513. 2 50/54 Deflation was not anticipated ⇒ Probably little effect on ex ante expected real interest rate Hamilton, James D. 1987. Monetary factors in the Great Depression. Journal of Monetary Economics, 19. 51/54 Prices outrun wages ⇒ Wage deflation increases real wages by more than 10% Bordo, Micheal D. Christopher J. Erceg, and Charles L. Evans. 2000. Money, sticky wages, and the Great Depression. The American Economic Review, 90(5). 52/54 Debt deflation Nominal debt reduction (payback and default): Between 1929 and 1933 internal debt decreased by 20%, from 200 billion USD to 160 billion USD But real debt increased: Because of deflation, 160 billion USD in 1933 correspond to 280 billion USD in 1929 (dashed extension) Fisher, Irving. 1933. The debt-deflation theory of great depressions. Econometrica. 1(4). 53/54 Summary The U.S. Great Depression can be decomposed into two phases 1 Until October 1930: aggregate demand drop dominates Great Crash: lower investment spending, high uncertainty, lower consumption spending 2 After October 1930: repeated waves of banking crisis Monetary contraction and credit crunch Fed fails to intervene 54/54