Sunday, 26 October 2008

Mankiw on what caused the depression of the 1930s

In his latest article in the New York Times, But Have We Learned Enough?, Gregory Mankiw gives us an outline of his view of what caused the depression of the 1930s. He writes,
The Depression began, to a large extent, as a garden-variety downturn. The 1920s were a boom decade, and as it came to a close the Federal Reserve tried to rein in what might have been called the irrational exuberance of the era.

In 1928, the Fed maneuvered to drive up interest rates. So interest-sensitive sectors like construction slowed.

But things took a bad turn after the crash of October 1929. Lower stock prices made households poorer and discouraged consumer spending, which then made up three-quarters of the economy. (Today it’s about two-thirds.)

According to the economic historian Christina D. Romer, a professor at the University of California, Berkeley, the great volatility of stock prices at the time also increased consumers’ feelings of uncertainty, inducing them to put off purchases until the uncertainty was resolved. Spending on consumer durable goods like autos dropped precipitously in 1930.

Next came a series of bank panics. From 1930 to 1933, more than 9,000 banks were shuttered, imposing losses on depositors and shareholders of about $2.5 billion. As a share of the economy, that would be the equivalent of $340 billion today.

The banking panics put downward pressure on economic activity in two ways. First, they put fear into the hearts of depositors. Many people concluded that cash in their mattresses was wiser than accounts at local banks.

As they withdrew their funds, the banking system’s normal lending and money creation went into reverse. The money supply collapsed, resulting in a 24 percent drop in the consumer price index from 1929 to 1933. This deflation pushed up the real burden of households’ debts.

Second, the disappearance of so many banks made credit hard to come by. Small businesses often rely on established relationships with local bankers when they need loans, either to tide them over in tough times or for business expansion. With so many of those relationships interrupted at the same time, the economy’s ability to channel financial resources toward their best use was seriously impaired.
But the big question is What does this have to do with the situation we face today? Mankiw sees parallels. But Anna Schwartz, co-author with Milton Friedman of "A Monetary History of the United States" thinks not much. In a recent interview she said
Today's crisis isn't a replay of the problem in the 1930s, but our central bankers have responded by using the tools they should have used then. They are fighting the last war. The result, she argues, has been failure. "I don't see that they've achieved what they should have been trying to achieve. So my verdict on this present Fed leadership is that they have not really done their job."
Schwartz and Friedman argued in "A Monetary History," that in the 1930s the US was faced with a liquidity crisis in the banking sector. As banks failed, depositors became alarmed that they'd lose their money if their bank, too, failed. So bank runs began, and these became self-reinforcing. If borrowers had left their money in the banks, the banks would have been fine. But they didn't and importantly the Fed just sat by and did nothing, so bank after bank failed. And that only motivated depositors to withdraw funds from banks that were not in distress. This just deepened the crisis and causing still more failures. But
"that's not what's going on in the market now," Ms. Schwartz says. Today, the banks have a problem on the asset side of their ledgers -- "all these exotic securities that the market does not know how to value."
So the history of the Great Depression may not be a good guide to what needs to be done today. The problems of the two time periods are different and thus the solutions need to be different. The government's justification for the current activism in terms of monetary policy just doesn't meet the historical test.


Peter Cresswell said...

Considering Mankiw posted that scary chart of today's money supply on his blog recently, it's more than surprising that his analysis of the cause of the crash only gores back to one year before it, and like most mainstream economists he makes no effort to explore the root cause of the "irrational exuberance."

If I may quote myself:

"But what caused the collapse of 1929? Like every monumental hangover, the collapse was inherent in the orgy. And like that one, those responsible for the monumental blunder are shucking off the blame, and seeking even more power to do it all over again.

"Financially speaking, the twenties in the US were characterised by three things: the rise of the central bank to prominence and the idea that there was a "new era of prosperity" in the air; an era of easy credit, which helped to foster the idea that a "new era of prosperity" was in the air; and the single-minded pursuit of "price stability," which led to the pumping of the money supply and all that easy credit.

"Sound familiar?

"For almost the entire decade of the twenties, the Federal Reserve vigorously pursued a policy of "price stability." The grandaddy of all Fed Governors, Benjamin Strong -- the predecessor to Greenspan and Bernanke -- wrote in 1925,

"that it was my belief, and I thought it was shared by all others in the Federal Reserve System, that our whole policy in the future, as in the past, would be directed toward the stability of prices so far as it was possible for us to influence prices."

And again in 1927, when asked in that years "Stabilization Hearings," whether the Fed could "stabilize the price level" through open-market operations and other control devices:

"I personally think that the administration of the Federal Reserve System since the reaction of 1921 has been just as nearly directed as reasonable human wisdom could direct it toward that very object."

"Sound familiar?

"They aimed for "price stability," and they succeeded: Consumer prices and wholesale prices were stable for most of the decade. But they shouldn't have been. They should have fallen. Increased mechanisation, increases in scale and increasing productivity should have made prices fall. To keep prices up -- to keep them 'stable' -- The Fed had to inflate, and inflate and inflate again. In 1921, before their inflation of the currency began, the total American money supply was $45.3 billion. By July 1929, when the stock market first started to crack after a year-on-year expansion of the money supply (which in 1924 was as high as 11.6% !), it had exploded to $73.29 billion.

"As economists CA Philips, TF McManus and RW Nelson said in 1937, "the end-result of what was probably the greatest price-level stabilization experiment in history proved to be, simply, the greatest depression."

"That $28 billion, created out of thin air, had to go somewhere. Where it went, for the most destructive part, was into capital goods. Consumer prices and wholesale prices were stable, but the General Price Level (which included housing, commercial property, foods and farm products) rose considerably.

"Sound familiar?

"Just as in the twenties, so too over the last decade, where in order to keep consumer prices "stable," the money supply had to be inflated year-on-year to conceal by inflation the productivity effects of the internet age and and of the flood of cheaper consumer goods from Asia -- and the monetary inflation blew out first in the housing market. Just as in the twenties, so too in the 'Noughties,' the expansion of the money supply squandered real wealth and led to economic destruction. And so it has been every time the expansion of the money supply has been substituted for genuine prosperity, in the US and NZ just as surely as in Zimbabwe -- as this graph so clearly demonstrates..."

Can any mainstream economist spell malinvestment? Or smell it?

Paul Walker said...

I'm not sure why " "price stability," which led to the pumping of the money supply and all that easy credit. " After all pumping up the money supply would not give you stability. In fact it would give you inflation.

Strong was not Governor of the Federal Reserve, he Governor of the Federal Reserve Bank of New York, one part of the Fed. Daniel R. Crissinger was Chairman of the Fed. May 1923-Sept.1927 and Roy A. Young Oct. 1927-Aug. 1930.

An issue here is the difference between changes in the price level and changes in relative prices. Changes in relative prices are the signals in the system, they act as incentives, provide information and act as guides as to what is needed, when and where. Changes in the price level are just noise in the system. Problems arise when you can't tell the difference between the two. When the price level is constantly changing you can't be sure as to whether the changes you notice are noise or signal. Changes in the price level should be ignored, changes in relative prices should not, it is these that provide the information and incentives to allocate resources efficiently. Thus the efforts to control the price level, so that any remaining price changes can be safely interpreted as relative price changes.

I had a discussion of Pure inflation v. relative price changes earlier in the year.