What can we learn from the Depression?

Free Exchange has discussed in a recent post the academic views on the Great Depression. They suggest that recent research (say the last 20 years or so) has produced a different view, and "that many traditional views about the causes of the Depression have been overturned by academics in recent decades." In particular, they suggest that neither protectionism nor the financial crash are seen as central anymore. They correctly note that the dominant view, associated to Barry Eichengreen and Peter Temin,* now puts an emphasis on the effects of the Gold Standard (note that Keynes also emphasized the role of the Gold Standard, to which he referred to as a 'barbarous relic'). 

And by the way that means that the consensus is that a demand shock caused the Depression. Note that a few authors have pushed the Real Business Cycle (RBC) story in recent times. For example, Prescott argues that:

“In the 1930s, there was an important change in the rules of the economic game. This change lowered the steady-state market hours. The Keynesians had it all wrong. In the Great Depression, employment was not low because investment was low. Employment and investment were low because labor market institutions and industrial policies changed in a way that lowered normal employment.”

In other words, the changes in incentives led to less supply of labor and less demand for investment goods by firms. Same ideas have been put forward by Cole and Ohanian, and by popularizers like Amity Shlaes in her The Forgotten Man. However, most of the New Deal regulations that the revisionists abhor, actually came to late to have caused the Depression. They generally try to explain the 'slow' recovery (growth averaged 8% in the first FDR term) as a result of the New Deal, and leave the question of what was the supply side shock that caused the Depression.

Lucas, who converted to RBC at some point in the 1980s, asked (cited here) poignantly: "Where is the productivity shock that cuts output in half in that period? Is it a flood or a hurricane? If it really happened, shouldn't we be able to see it in the data?" For that reason Lucas still believes, like Friedman, that the Fed did it. And if one is going to blame regulation for the duration of the Depression, one must deal with the fact that in the 1950s, if anything, labor and financial regulations were as stringent, if not more, than in the 1930s and unemployment was fairly low.

A more subtle critique of the conventional view, and its emphasis on the Gold Standard comes from Christina Romer. She suggests that the path of American output and unemployment before 1931 can be explained quite well with only domestic factors, and that even after 1931, international factors affected American economic conditions mainly through their impact on American policy decisions. Note that that this is not incompatible with Kindleberger's view that the US, in the process of becoming the hegemon, was central for the global economic collapse.

This should cast some doubts on FE's conclusion that:

"putting all the blame on Wall Street for the Great Depression -- or on bankers in the current crisis -- does not stand up to historical scrutiny. The responsibility may more properly lie in a complex combination of factors, like how global financial systems are structured."

Romer notes that in the US the collapse in consumption was more important than in other economies (harking back to Peter Temin's reply to Friedman that it was the collapse in consumption, not monetary policy, that caused the Depression). And the collapse in the demand for consumer durables, which depended on credit for their purchase, was affected by financial conditions. Romer argues:

“Both the initial recession in the United States in the summer of 1929 and the acceleration of the decline in late 1929 and 1930 are ultimately attributable to the stock market boom and bust of the late 1920s. The stock market boom is the prime explanation for why the Federal Reserve was pursuing tight monetary policy starting in 1928. The stock market crash is the prime source for the collapse in durable goods purchases starting in November 1929.”

So the financial bubble and the crash did matter, and John Kenneth Galbraith (among others) was correct about it. I would add that income distribution, which we know from Piketty and Saez, was as bad in the 1920s as now, did also play a role in the bubble and the expansion of private indebtedness. So Wall Street was to blame indeed, as much as it should be too in the recent Great Recession.

* Kindleberger, in his classic The World in Depression, goes further and suggests that it was the absence of an hegemon that acted as a source of demand in situations of crises (distressed markets), as a stabilizer of exchange rates, and as a source of international finance (an international lender of last resort) that caused  the Depression, since the UK was incapable and the US unwilling to assume that position. The Depression was essentially an hegemonic crisis.

PS: For further reading my forthcoming paper in the Cambridge Journal of Economics here.

Hysteresis and the natural rate

I've been teaching on the price and quantity interactions, and the natural rate or NAIRU (Non Accelerating Inflation Rate of Unemployment), that is the level of activity at which you have price stability. One of the papers assigned is the one by Franklin Serrano (here or here for a Spanish version; another assigned paper is this one by yours truly). By the way, I've dealt with the issue of hysteresis briefly before here, mostly to distinguish it from path dependency, following Setterfield (Serrano also suggests differences between heterodox and more conventional views on hysteresis).

As noted by Serrano, the research by Nelson and Plosser (1982) (here; subscription required) and Real Business Cycle (RBC) authors suggests that GDP follows a random walk, and as a result after a productivity shock (which they measure as changes in TFP, in spite of significant problems with that measure; see here) output does not return to its previous trend. The point is that once the output trend is affected there are persistent effects that change the trend itself, that is hysteresis. Fluctuations are variations of the optimal level itself.

Serrano correctly points out that "this means that the long run trend of output is not only partially determined by whatever drives short run output (presumably aggregate demand) but rather that potential output is actually fully determined by the trend of whatever drives actual output. As it is well known, this result of strong hysteresis in the output (GDP) series has been taken to provide evidence in favor of the 'real business cycles' strand of new classical macroeconomics in which the common element driving trend and cycle are factor supplies and their productivity." The natural rate or NAIRU is supply determined, but is variable (something that, in a different context, Robert Gordon would call the Time Varying NAIRU or TV-NAIRU).

Supply shocks imply that in a boom the potential output moves first, and actual output adjusts as individuals readjust to higher productivity. Hence, the output gap, if defined as the difference between actual and potential output, becomes negative. And if you believe in a Phillips curve and some sort of central bank monetary rule, a negative output gap suggests a deflationary pressure (and yes RBC authors do believe in endogenous money). Yes, that's what the RBC theory implies! In fact, according to Kydland and Prescott (1990): "the price level has displayed a clear countercyclical pattern."*

Serrano points out a simpler (Occam's Razor applies) explanation for the favorable evidence on hysteresis, namely that demand (in fact, the autonomous components of demand) determine potential output (the supermultiplier). Note that this approach does not require, as the RBC or the acceleracionist versions of the Phillips Curve, any definite relationship between prices and quantities. As noted here (and here) before, there is no reason to expect an unambiguous or systematic relation between prices and quantities, unless you think that prices are always driven by excess (or lack of) demand.

As Serrano argues the: "trend and the cycle indeed have a common nature as the empirical literature shows but this common nature reflects that both are explained by demand (not supply) factors" and "with full hysteresis in output levels and partial inertia on inflation, 'demand-pull' inflation is just a temporary phenomenon and therefore does not determine 'core' or persistent inflation." And it is hard not to agree on this with New Keynesians, and their dismissal of supply shocks as the main cause of business cycles. It is harder to agree with their insistence on a natural rate, even if it's variable.

* The obvious historical event they would have in mind is the stagflation of the 1970s. Note, however, that more often than not deflationary periods are contractionary, like the 1930s. Of course the oil shocks and the increase in costs can explain, together with wage resistance and price inertia, the inflationary pressures of the 1970s in a model that is perfectly compatible with demand driven recessions.