Government policy errors as a cause of the Great Depression
Any discussion of economics quickly reveals the widespread ignorance of college-educated Americans about its basics tenets and dynamics in our history. This is odd, as Economics has long been one of the most popular undergraduate majors.
For a quick and relevant lesson, here is an excerpt from the IMF’s World Economic Outlook of April 2002. It is the best discussion I have seen of recessions, both national and global, esp chapters I and III.
This excerpt from chapter III, box 3.2: “The Great Depression”, by Michael Bordo. It focuses on the role of monetary policy and finance. It does not discuss the role of fiscal policy, a major factor driving fast recovery in those nations who used it properly (such as Germany, driven by their evil genius ruler).
Policy errors can convert a normal cyclical downturn into a depression or Great Depression. Let’s hope the new Administration shows greater wisdom than did the Hoover Administration.
Most economic historians concur that the Great Depression — at least the first stage — was caused primarily by monetary policy in the United States, propagated mostly by a series of banking panics, and then spread to the rest of the world via the international gold exchange standard. [Many other causes of the Great Depression have been proposed, from more restrictive trade policy (Meltzer, 1976) to the stock market crash of 1929 (Galbraith, 1961).]
The U.S. Federal Reserve tightened monetary policy in early 1928, in response to the stock market boom that began in 1926 and the belief that banks should confine their lending strictly to commercial bills and not finance stock market speculation (the “real bills doctrine”). The contractions in central bank credit and the monetary base, along with a rise in the discount rate, precipitated a downturn in the U.S. economy starting in August 1929 (before the stock market crash of October 1929).
A series of banking panics beginning in October 1930 turned an otherwise serious recession into a depression. These panics, which resulted in the suspension of 9,000 banks (more than one-third of the total), exacerbated the economic contraction because they reduced broad money (Friedman and Schwartz, 1963). The U.S. Federal Reserve was insufficiently aggressive in trying to counter the collapse in broad money, for example via open market purchases. (The reason for this policy failure is still being debated.)
The collapse of broad money reduced output through several channels:
- lower aggregate demand, which—in the face of nominal wage rigidity—decreased real output (Bernanke and Carey, 1996; Bordo, Erceg, and Evans, 2000);
- disruption of financial intermediation from the bank failures (Bernanke, 1983);
- asset price deflation, whereby declining asset prices reduced the value of collateral for bank loans, inducing weakened banks to engage in a fire sale of their loans and securities, leading to further asset price deflation (Bernanke and Gertler, 1989); and
- debt deflation, in which falling goods prices led to rising debt burdens in an environment where contracts were not fully indexed (Fisher, 1933) and rising ex ante real interest rates (Cecchetti, 1992).
The fall in broad money in the United States raised interest rates, leading to a capital inflow from the rest of the world, and reduced output, lowering U.S. demand for the rest of the world’s output. The United States ran persistent balance of payments surpluses with its main trading partners during 1929–31.
In the rest of the world, the combination of the gold outflow and the fall in exports to the United States caused aggregate demand to decline. This was exacerbated by a loss of confidence in the currencies of the reserve countries, leading central banks to convert their holdings of foreign exchange into gold, which caused a contraction in the world money supply. Countries that did not adhere to the gold exchange standard, such as Spain, experienced milder contractions (Choudhri and Kochin, 1980).
The gold exchange standard also exacerbated the contractions in other countries by preventing central banks from responding aggressively to the banking panics prompted by weakened bank balance sheets. Central banks were reluctant to extend liquidity support to banks, fearing a speculative attack that would force them off the gold standard—they were confined by “golden fetters” (Bernanke and James, 1991; Eichengreen, 1992).
At the same time, foreign depositors’ fears of either devaluation or the imposition of exchange controls (or both) fueled the spread of banking crises from Austria in May 1931 to Germany and other central European countries, and then to France and Belgium. Finally, the banking crises on the continent led to a speculative attack on the Bank of England’s gold reserves, leading the United Kingdom to suspend gold convertibility in September 1931.
The contagion even reached the United States, leading the central bank to raise its discount rate in order to protect its gold reserves— thereby aggravating the banking crisis already under way.
The Great Depression generally ended once countries left the gold exchange standard and adopted policies that restored confidence in the financial system and stimulated aggregate demand, including expansionary fiscal and monetary policies.
- The United Kingdom and other countries in the sterling bloc, including Australia, Denmark, Finland, Norway, and Sweden, left gold in 1931 and started to recover.
- The United States ended its link to gold in 1933 and effectively devalued by raising the price of gold, which in turn revalued the monetary gold stock and expanded the monetary base.
The principal remaining gold standard adherents were France, Belgium, the Netherlands, and Switzerland (the “gold bloc” countries), which had returned to gold in the late 1920s. After the United Kingdom, the United States, and much of the rest of the world devalued, France and the gold bloc countries were placed at an ever deteriorating competitive disadvantage. To preserve their gold reserves, they followed increasingly contractionary macroeconomic policies, which served to exacerbate the Depression. In the end, Belgium left gold in 1935 and France in 1936, followed by the Netherlands and Switzerland.
The pace of recovery from the Great Depression varied widely across countries, depending in part on macroeconomic and structural policies. In the United Kingdom, which left gold early, it took only a year for output to exceed its peak level before the recession began.
In the United States, recovery began in 1933 but was sluggish compared with the strength of the monetary expansion under way, and it took about three years for output to return to its previous peak level. Recent research suggests that the weak recovery and the following second stage of the Depression partly reflected New Deal policies that enhanced the monopoly power of firms and labor unions, which strongly reduced aggregate supply, especially in manufacturing (Bordo, Erceg, and Evans, 2000; Cole and Ohanian, 1999).
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