Wednesday, March 14, 2012

(How) Was the Problem of Depression-Prevention Solved?

Krugman says that Friedman-style monetarism is really just a special case of postwar Keynesian analysis. I agree. (New Keynesianism in turn is just another name for monetarism.) To get monetarist conclusions out of an ISLM-type model, all you need is an income-elasticity of money demand that is both (a) stable and (b) large relative to the interest-elasticity of money demand.

Of course, for this to work the "money" that's demanded has to be the same as the "money" that the central bank supplies, which requires a particular, and now largely vanished, kind of financial structure, as we've been discussing below. But that's not what I want to talk about here. Rather, it's this other bit:
This time the Fed did all that Friedman denounced it for not doing in the 1930s. The fact that this wasn’t enough amounts to a refutation of Friedman’s claim that adequate Fed action could have prevented the Depression.
Do we think this is right? It doesn't seem right to me. If unemployment in the 1930s had peaked at below 10%, instead of 25%; if industrial production had fallen by one eighth, instead of by over half; if fixed investment had fallen by 20%, instead of by 80% (yes, business investment halted almost entirely in the early 30s); if we'd had one or two quarters of deflation, instead of four years; -- then I think we would say that the Depression had indeed been prevented. Krugman is implicitly assuming here today's economy couldn't collapse the way it did in the 1930s, but how do we know that's true?

We always ask, why was the Great Recession so deep? But you could just as well turn the question around and ask why, despite initial appearances, did it turn out to be not nearly as deep as the Depression?

I can think of four families of answers. One is the one that Krugman is implicitly rejecting -- that policy was better this time. I think most people who tell this story -- including some on the left -- would emphasize the rescue of the banking system. Disgusting as it is to see the same smug assholes who caused the crisis handed truckloads of money, if nature had taken its course and the big banks had been allowed to fail, we might really have had a Depression. That's one story. You might also mention fiscal policy, which, while inadequate, has clearly helped, but it's hard to see that explaining more than a few points of the difference.

The second answer would be that the sheer size of government makes a Depression-scale collapse of demand impossible, regardless of policy. In 1929, with government final demand only a couple percent of GDP, autonomous spending basically was investment spending, especially if we think at the global level so exports wash out. Today, by contrast, G is significantly larger than I (about 20 vs 15 percent of GDP), so even if private investment had collapsed at the same scale as in 1929-1933, the percentage fall in autonomous demand would have been much less. (And of course that fact alone helped keep private investment from collapsing.) Interestingly, despite Hyman Minsky's association with stories about finance, this, and not anything to do with the financial system, was why his answer to the question Can "It" Happen Again was, No. Policy is secondary; big government itself is the ballast that stabilizes the economy.

Third would be that the shock in 1929 was greater than the shock in 2007. Of course that would require that you specify the shock, and assumes that you think the causes of the crises were basically exogenous. We could compare a story of the 1920s about radically changed trade patterns as a result of WWI, or about the transition agriculture to industry, to a story for the more recent crisis about the housing bubble, or global imbalances, or the transition from industry to services. If you believe a story like that, there's no reason you couldn't argue that their exogenous shock was bigger than our exogenous shock, and that's the real difference.

Last, you could argue that private demand is inherently more stable today than it was before WWII. Price stickiness, say, usually cast as a villain in macroeconomic stories, could have prevented outright deflation; and greater debt-financing of consumption, again usually seen as part of the problem, could have helped stabilize consumption demand in the face of falling incomes. Or financial markets are less subject to short-term fluctuations in sentiment. (Haha. I crack myself up.)

Personally, I would lean toward door number two. But the important thing is just to reframe the question -- not why was the recession so bad, but why wasn't it worse? If someone ever did an IGM-style survey of economists, but of the good guys, it would be a good thing to ask.


  1. The Great Depression wasn't one bad event. It was one bad event which caused another which caused another...

    Holding policy constant, it's just luck how far it goes.

  2. Friedman's brilliance in "Monetary History" was to replace actual history with a tendentious counterfactual fantasy constructed out of his not-all-that-sophisticated pet theory. He blamed the huge deflationary spiral, which caused the Great Depression in the United States, on what the Federal Reserve counterfactually failed to do, sidestepping the historically correct answer that the deflation was a consequence of the gold-exchange standard, which limited the Fed's creative discretion, and, of course, Goldman Sachs and corrupt financial practices (deja vu!). Friedman's counterfactual has been hugely influential, and goldbugs will be forever grateful for his role in obscuring the hazards of a gold standard; just as corrupt plutocrats will be forever grateful for his letting them off the hook. (See Amity Schlaes)

    One might note that where the Euro holds sway, enforcing a kind of New Gold Standard, the Great Recession looks a lot like the Great Depression Redux: the numbers for Greece, not to mention the increasingly horrific conditions on the ground (people unable to obtain enough nutrition, etc) are pretty bad.

    And, the opera ain't over, till the fat lady sings, and the fat lady in our case may be China, and not, as circa 1930, the U.S.

    Putting China aside, though, maybe the frame should not be business cycle, but institutional developments. If wages are falling (wages in manufacturing industry rose over the course of the Great Depression), student debt ballooning into universal debt peonage, and there are ads on television touting 7-year, $5000 loans at 111% as superior to payday loans, maybe we should indeed rethink the frame with which we evaluate the Great Recession.

    1. Bruce,

      You are certainly right that the Euro looks a lot like the gold standard, and Europe today looks a lot like, well, Europe in 1929.

      But the US-China dynamic is different. A situation in which the financial center is running trade deficits is much more sustainable than one where it's the financial periphery, especially when the offsetting financial flows are official rather than private. I think it's very important to remember that, to date, the US has seen no upward pressure on interest rates from the balance of payments. This is very different from the situation in Europe.

  3. This is just a different spin on Door #4, but I think levels matter: we are collectively just much richer than we were in the 1930s. That means that aside from government provided income insurance, we were able to fallback on informal private insurance much more easily than we could 70 years ago. Unemployed young-to-middle-aged workers could move back in with Mom and Dad, and (wage-stickily-still-employed or asset-rich) Mom and Dad could afford to feed and house without putting great stress on their own nutrition or finances. I think it's likely that a greater fraction of the unemployed had significant financial savings to fall back on than during the 1930s. (I don't know where one would find data on this.) In general, the median human is less risk-averse, because a downturn would have to be more extreme than in the 1930s to literally threaten ones ability to literally feed herself and her family, thanks to private savings + government and informal insurance. We trade risk-bearing for consumption, the setbacks we experienced during the Great Recession didn't increase the "disutility" of risk-bearing nearly as much as during the Great Depression, when more people were brought close to the "kink" in consumption levels where one becomes a hobo or beggar or just plain starves.

  4. Steve-

    Very interesting thoughts, as always. You're right, that is a version of door four, and probably a more realistic one than the two I suggest. That consumption spending is less closely linked to current income is certainly a testable empirical claim, that if true would tend to reduce the impact of shocks to exogenous demand. I'm sure someone has tried to see if this is true -- altho I'm not quite as sure as one would like to me, given the tendency in contemporary economics to treat behavioral relationships like the consumption function as being like physical laws rather than as evolving historically.

    Financial savings -- according to the Survey of Consumer Finances, households headed by a non-working, non-retired person have media financial assets of $3,700, which I don't think is enough to stabilize consumption much. More significant potentially is access to credit, but that's a double-edged sword since while it can smooth consumption in the face of changes in income, it can be an independent source of instability if credit conditions change.

    I think your second argument is more interesting, that spending is less responsive to current income when people are farther from subsistence. It's provocative because it's reminiscent of Keynes' idea that consumption needs are strictly limited and that there is an absolute decline in the marginal propensity to consume. Whereas the main tendency in economics, from Mill to DeLong has been that consumption demand is insatiable, in which case there is no reason for people to become less risk-averse as their incomes rise. I like your story better.

    1. I should clarify $3,700 is median financial assets for non-retired, non-working households *that report holding financial assets*. An additional 19 percent of non-retired, non-working households report having no financial assets at all.

  5. I think that there is also another possible explanation:
    In the 30's, the USA was an export-based economy, and the depression was caused in part by it's inability to export to the UK (which, I think, was a big deficit spender at the time).
    Today, the USA is the big deficit spender, while other areas (the EU, China and others) are export-dependent economies.
    In this situation a big "slice" of the crisis will fall on export-addicted countries.
    In fact the crisis in the EU is already quite big and I think will get worse, while China is said to have a very "bubble based" economy which is likely to implode soon.
    In this sense, it is not obvious to me that this recession will be less bad than the one in the 30's.

  6. RL-

    I'm afraid that's not right. Export demand was not directly important factor in the Depression, at least in the US. Nominal net exports fell from $400 million to $100 million in 1929-1933, while private investment fell from $15 billion to $3 billion. So the fall in demand due to the collapse in investment was about 40 times larger than the fall in demand due to trade -- there's really no comparison. Far from being export-based, the US economy in 1929 was almost entirely closed -- exports and imports were less than 5 percent of GDP each.

    What is true is that private capital flows out of the United States were necessary for Europe, both to finance both its quantitatively modest, but inelastically demanded, imports from the US, and the large financial payments resulting from the war debts and reparations coming out of World War I. When the willingness of US investors to buy European assets declined in the late 1920s, first because of higher perceived returns in the stock market, and then because of high US interest rates engineered by the Fed to restrain the stock market bubble, European countries on the gold standard were forced to raise their own interest rates and deflate their economies to maintain their balance of payments. There is a close parallel here with the current situation in Europe, where the peripheral countries were dependent on private capital flows from the core, especially Germany. But there is *not* a parallel with the US-Asia dynamic, because the crisis was not associated with any diminished supply of credit to the US -- quite the opposite -- and so did not produce the same kind of deflationary pressure. To the extent that the US has failed to adopt a sufficiently expansionary policy, that is the result of a failure of the political system here, not -- as in Europe in the 1930s, peripheral Europe today, or the various currency crises in the developing world -- the result of constraints imposed by the external account. (I have a working paper on this which I may share on the blog.)

    I think the myth of trade as a cause of the Depression comes pretty straightforwardly from an attempt to enlist it as propaganda for free trade, based on the transparently absurd notion that Smoot-Hawley tariff was a significant factor. (Blanchard says this in his textbook. He should be ashamed.)

    As for China, I'm the farthest thing from an expert. But I have to admit, I'm a little skeptical of claims of a bubble there. From the point of view of our masters, rising wages -- which China's boom certainly is producing -- look a lot like unsustainable price inflation. I

    1. @JW - thanks for the answer.

      I admit that I assumed that the level of american exports was much bigger in the 20s.

      I think, however, that you misunderstood a bit my point:

      First, when I said that China "is likely to implode", I didn't mean that wages are rising too fast, I meant that wages are rising too slowly.

      Second, on the low level of import/export during the great depression, AFAIK, an important part of the economy in the 20s was a very speculative stock market; the fall in the stock market caused the depression. However, from my point of view, the speculative stock market is a consequence of an umbalanced economy, where a relatively big share of wealth goes in profit and capital investiment, and consumption would be weak if not substained, directly or indirectly, by financial investiment (this dependence of demand on various financial fors of speculation is important in Minsky I think, although most people refer to Minsky only with regard of bubbles and not with regard of his Keynesian/Kaleckian ideas about aggregate demand). In this situation, being a net exporter is an important valve to avoid a vicious "deflation" spiral, so that, IMHO, even a small fall in exports (say, 1% of GDP) could have very bad consequences.
      Note that, according to my interpretation, "Smoot-Hawley" can't be the culprit, since it happened after the crash; in facts, the "culprit" IMHO is the trade umbalance that developed in the 20s between the USA and european countries.