Myths of the Great Depression

The Great Depression is often studied in history. There has been a resurgence of interest since fears of our current 'great recession' Some myths have developed around the Great Depression.

1. The Fall in Output Lasted Until WW2.

US GDP 1920 - 1940

If we look at data for the US economy, the fall in output lasted 4 years from 1929 to March 1933. There then followed a period of economic expansion where growth increased until 1937 regaining previous output levels. The US then experienced a double dip recession in 1937-38, but soon recovered.

Many economists say the depression lasted 10 years because even in 1937, unemployment was in double digit figures. It was not until 1941 and the US entries into the war that unemployment fell to pre-1929 levels.

2. Hoover was a follower of neo clasical Economics.

Hoover oversaw an increase in national debt from 20% to 40% between 1929 and 1933. 1930 to 1931. The federal government’s share of GNP soared from 16.4 percent to 21.5 percent. This was partly due to the fall in tax revenues due to the economic downturn and some attempts to increase government spending. But, Hoover was no Keynesian he was appauled at the rise in National Debt and sought to raise taxes to reduce debt in the early 1930s.

Hoover also sought to protect wages and implemented the Smoot-Hawley Tariff Act - a measure to reduce international trade.
He is associated with the laissez faire approach because he shared a belief that the depression was a necessary 'penance' for previous excesses. He felt that if his policies were given longer enough they would enable a recovery. But, after 3 devastating years he was never given chance to see whether his approach would lead to recovery.

3. Roosevelt was A Good Keynesian

Because of Roosevelt's New Deal, many assume he was an adherent and follower of John M.Keynes and his policies for expansionary fiscal policy. Schemes such as Public Works Administration (PWA) and Works Progress Administration (WPA) did provide some fiscal boost and provided relief to a significant number of unemployment. But, Roosevelt was always a reluctant adherent of Keynes. In particular he was nervous over the idea of government borrowing to finance fiscal expansion. The effect was that the fiscal expansion was much less than Keynes would have advocated leading to only a moderate, insufficient fiscal boost to the economy. Roosevelt increased the top rate of income tax to 73% and later increased it to 90%.
In 1937, worried about government borrowing, Roosevelt increased taxes and cut spending. Unsurprising, the economy returned to another recession.

Also many of Roosevelt's New Deal policies were of dubious value. For example, the National Industrial Recovery Act (NIRA) was really a license for firms to form cartels and raise prices. Because of this it was declared unconstitutional by the Supreme Court. It was a set back for Roosevelt but had nothing to do with Keynesian demand management. The National Recovery Act was also renowned for having a large amount of rules and regulations which created administrative headaches for firms and workers. The problem is that lazy critics say that because some government intervention created problems such as these rules and regulations then QED all government intervention must make things worse.

4. The Stock Market Crash of 1929 is Synonymous with Great Depression.

Many assume the Great depression was caused by great stock market crash of October 1929. Many may equate the two events as being the same thing. However, stock market crashes don't always cause recessions. For example, 1987 stock crash had no effect on the real economy.

The Wall Street Crash was certainly a precipitating factor. The crash reflected the fact the economy was already slowing down; it also helped to reduce confidence, reduce bank liquidity and push the economy into recession. But, the great depression occured because of many more factors:

• the credit bubble
• deflation
• being in the gold standard
• bank collapses and fall in money supply.
• Inappropriate government responses.

• Causes of Great Depression

Lessons from the Great Depression

These lessons from the Great Depression are very relevant for the current economic situation.

1. Credit Bubbles can be Very Damaging.

In the 1920s, the US economy expanded rapidly on the basis of cheap credit, rising money supply and an exuberance bordering on overconfidence. It led to consumers buying large quantities on credit and a booming stock market. By 1928, the US economy was heavily unbalanced with over inflated asset and share prices. (At least one lesson we didn't learn from)

2. Deflation can Devastate Economic Growth.

From 1929, to 1933, in the US the money supply fell by 35%. Prices fell by 33%. This deflation was caused by bank collapses, restriction in lending and adherence to the gold standard. The effects of deflation have widely been shown to be very damaging to the economy.

• Debt Inflation. Falling prices and wages increase the real value of debt. This makes it harder for people to pay off their debt repayments reducing consumer spending. This rising debt burden was exacerbated by the number of American consumers who had bought expensive items on credit with short repayment periods.
• Real Interest Rates Very High. With falling prices, real interest rates were very high, reducing investment.
• Real Wages become too high. Hoover actually tried to bolster the power of labour to set higher wages. But, with falling prices, firms couldn't afford the labour.

(Through zero interest rates and quantitative easing, UK and US central banks have shown they are taking this threat of deflation very seriously)

3. Depressions should not be Seen as a form of Penitence.

In the Great Depression there was a widespread feeling that somehow the depression was a necessary penance for the excesses of the 1920s. In the early stages of the great depression, Treasury Secretary Andrew Mellon, who advised President Hoover told him to:

“Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.... It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people” (Hoover, 1952).

To some extent an unsustainable boom is going to cause a painful period of correction. But, this doesn't mean that the depth of the depression was inevitable. This attitude encouraged a hands off approach to the depression. H.Hoover in his memoires claimed that if only Roosevelt had continued his policies the depression would have been resolved. But, Hoover had 3 years of failed policies which had seen industrial output fall by 33%. It is hard to see how he could have done a worse job.

4. Don't Let Banks Fail.

The Wall Street Crash precipitated many problems, but in 1930, there was no certainty the economic downturn had to develop into a full blow depression. One of the most damaging events was the widespread failure of medium sized American banks - with the Federal Reserve unable or unwilling to act as lender of last resort. The widespread bank failure caused a decline in the money supply and loss of confidence in banking sector - investment fell drastically.

5. Avoid Protectionism and 'Beggar My Neighbour'

The infamous Smoot-Hawley Tariff tariffs of 1930 were designed to protect American jobs by raising tariffs on imports. The consequence is that it led to a global rise in tariffs, reducing trade and exacerbating the global recession. Trade slumped apart from areas of trade preference like within the British Empire. (there are powerful protectionist impulses which will take political courage to avoid) See: Beggar my my neighbour

6. Don't Balance the Budget in a Depression.

The neo-classical response to the depression was to attempt to balance the budget. In the 1931 UK budget, the Labour party was split as Ramsey McDonald followed treasury advice to increase taxes and cut unemployment benefits. This contributed to a further fall in aggregate demand, lower growth and ironically required higher borrowing. In 1932, Hoover increased the top rate of income tax from 24% to 63% in an effort to pay for his modest spending commitments. (thankfully the Republicans lost the US elections. Republican leaders have been calling for a balanced budget). More worryingly the 50 US states have been forced to cut spending to meet legal requirements for state budgets.

7. Fiscal Policy does Help.

Between 1929 and 1931, Japanese GDP fell by 8%. The Japanese Finance Minister Takahashi Korekiyo oversaw a genuine period of expansionary fiscal policy financed by government borrowing. This led to a remarkable turnaround in the Japanese economy; it became one of the first economies to experience lasting recovery.

People often point to the Roosevelt's New Deal as evidence of failed Fiscal Policy. But, the problem with Roosevelt is that he was actually reluctant to finance the New Deal by government borrowing. He wanted to raise taxes to finance it. In 1937, the US made an attempt to balance the budget, this harmed the recovery and was one factor in creating a recession within the depression (37-38).

8. Government Borrowing is not the End of the World.

People assume government borrowing is very damaging. But, in a depression, government borrowing helps to offset the rise in private sector spending. The US was reluctant to borrow until the start of the second world war, when national debt rose to 125% of GDP. It was only then unemployment fell to pre 1929 levels.

9. The Gold Standard was Very Damaging

The Gold standards forced countries to peg their exchange rate at a certain level. In the UK this cause deflationary pressure as the UK lost gold reserves and rejoined at a rate too high. Often countries who left the gold standard were able to recover. E.g. UK recovered after leaving in 1931, the US recovery was delayed until 1933 after leaving. The Netherlands experienced one of the longest economic depressions until it finally left the gold standard in 1936. It was a similar situation for France and Poland

10. Government Intervention doesn't mean micro management of industries.

The New deal was heavy on regulations for industry. The power of labour was increased (e.g. National labour Relations Act1935 - also known as Wagner Act) This led to an rise in strikes and poor industrial relations. Governments set prices for many industries. People were even jailed for selling suits at the wrong price. Keynes didn't advocate this kind of government intervention. He argued the government's main job was to boost demand by government borrowing. This doesn't require a command economy with many fiddly regulations.


11. The Human Cost of Great Depression

After finding the photos for the great depression. I was struck at one obvious lesson from the Great Depression - the human cost. Just read Road to Wigan Pier by George Orwell or J.Steinbeck's classics of this period

Tomorrow - Myths of Great Depression

Further Reading

• Causes of Great Depression
• Essays on Great Depression

Photographs from the Franklin D. Roosevelt Library, courtesy of the National Archives and Records Administration.

Quantitative Easing Explained

Looking in my favourite economics textbook, (J.Sloman) there is no mention of quantitative easing. There are lots of policies for reducing inflation. But, in the post war period, when it comes to fighting deflation and depression there is very little experience. Interestingly, the Bank of England has been in close negotiation with the Bank of Japan and the Federal Reserve - perhaps to gain advice on how to implement quantitative easing.

The decision to inject £75bn into the economy (could be upto £150bn or 10% of economy) is a radical step for the Bank of England and the economy. The decision to pursue quantitative easing has been taken because of:

• The extent of the economic downturn
• The fact lower interest rates have not helped the economy recover
• The fact interest rates cannot effectively be cut further (0.5% today)
• The fact inflation is predicted to fall below target of 2% risking prospect of deflation.
  

What is Quantitative Easing?

• The Central bank undertakes to buy various assets - commercial and government bonds from banks. To buy these bonds the Central Bank issues Central Bank reserves. This is effectively creating money through electronic means
  
• Banks gain an increase in liquidity because they sell assets for cash. This increase in banks balance sheets should hopefully encourage them to lend more.
• By buying assets and government bonds. The price of bonds rises causing interest rates on bonds to fall. These lower rates should help boost spending
• Bank of England £75bn Asset purchase scheme at B of E website
  

Possible Problems of Quantitative Easing

• Inflation. When economy recovers it might be difficult to take out the excess money supply causing uncontrollable inflation.
• Investors could lose confidence in economy due to risk of inflation
• Danger of 'bond bubble'. Bonds and gilts will rise in price encouraging investors to buy and interest rates to fall. This could cause a bubble in the price of gilts which could collapse at a later stage causing long term interest rates to rise at an early stage in the business cycle.
• Could cause lower value of Pound - Pound slumps on QE fears
  

• Problem of printing money
• Printing money and inflation
  

Economic Stability

The period 1993-2007 is (was) often referred to as the period of Great Stability. This seems rather paradoxical after the financial turmoil that has gripped the world since everything started to unravel in late 2006, 2007. Yet, on the surface there was a great stability (apart from short lived panic from the dot com bubble in 2001)

Why was this period Known as The Great Stability?

In recent history the UK had experienced 3 painful periods of boom and bust economic growth. Periods of high inflation were followed by painful recessions:

Previous UK Recessions

1974: 1.4% fall in GDP
1975: 0.6% fall
1980: 2.1% fall
1981: 1.5% fall
1991: 1.4% fall

Annual GDP figures by market prices (Source: Official for National Statistics)

The UK developed a reputation for the 'boom and bust cycle'

It seemed that high inflation was the cause of macro economic instability. If we allowed inflation to increase it caused a boom and bust. Therefore the idea was that if we could prevent inflation we could prevent recessions.

After trying Bretton Woods (upto 1970s), Monetarism (1979-1984), ERM (1990-92), we finally moved to inflation targeting and gave independence of setting interest rates to the Bank of England.

Everything seemed to work well. The UK experienced the longest period of economic expansion on record. (1992-2007) and inflation stayed close to the government target.

The government even brought public sector borrowing down from a peak 73% of GDP in the 1970s to 29% in 2003. The government lost no opportunity to pat themselves on the back and share the very impressive economic statistics with anyone who cared to listen (and even those who didn't particularly want to.) It appeared we had broken the 'inflationary boom and bust cycle'

So Why Was this Great Stability so Instable?

Using statistics of inflation, unemployment, growth and government borrowing, the economy was doing well. In the past this had been sufficient to maintain a stable growth. However, the macro economic stability hid a growing financial instability.

• Asset prices rises well above inflation - primarily house prices. This rise in house prices exacerbated a boom in lending.
  
• Bank Lending becoming based on riskier models. e.g. Northern Rock, RBS e.t.c
  
• Growth of financial derivatives which helped hedge risk. But, actually caused a build up of more risk
• Decline in bank reserves as banks borrowed on money markets to lend new mortgages.
• In short there was a credit bubble. Credit was made cheaply available to a new range of customers. This encouraged high levels of debt, low levels of personal saving and an unbalanced economy.
• Inflationary boom and bust cycles had been replaced with a credit boom and bust.
• Also, it should be said, the economic statistics were impressive. 17 years of economic growth is not based on a complete illusion. The causes of this very deep recession are global and we would be in recession even if the UK credit bubble had been less.
  

Problems in Economy

• Policy makers underestimated how much asset bubbles could effect the economy
• Very few realised how the new bank lending practises and balance sheets could be so destabilising for the economy.
• Economic growth was unbalanced - dependent on rising house prices, low saving rates and high personal debts.
  

Faced with these developments in the finance sector. The old measures of economic stability have proved to be insufficient. Policy makers paid too much attention to headline figures like inflation and growth and ignored seemingly less significant statistics.

Future for Macro economic policy

1. Greater weighting to credit and asset prices in macro economic models
2. A greater flexibility in macro policy making. The models which worked in the past and even at present moment (e.g. inflation targeting) can become insufficient in the future.
3. More policy instruments. Interest rates alone are insufficient to deal with growth, inflation and asset bubbles. Increasingly policy makers see the need to force banks to ration credit in a boom building up reserves for a recession.