Graph of the Day

David Beckworth revives his excellent summary of the Depression debate — in graphical form.

The Great Depression Debate

Our friend David Beckworth explains the Great Depression debate with one picture.

Krugman refutes Friedman and Schwartz…

…or so he thinks. Our friend David Beckworth points Krugman to Christina Romer’s excellent work on the Great Depression (which I have mentioned here and here).

My thoughts on Krugman’s take are in the comments on Beckworth’s site.

Keynesian Policies and the Depression

Paul Krugman writes:

Now, you might say that the incomplete recovery shows that “pump-priming”, Keynesian fiscal policy doesn’t work. Except that the New Deal didn’t pursue Keynesian policies. Properly measured, that is, by using the cyclically adjusted deficit, fiscal policy was only modestly expansionary, at least compared with the depth of the slump. Here’s the Cary Brown estimates, from Brad DeLong…Net stimulus of around 3 percent of GDP — not much, when you’ve got a 42 percent output gap.

Alex Tabarrok responds:

Now there is actually a lot of truth to this but the way in which Krugman, Rauchway, DeLong and others present this point is esoteric and likely to mislead even many economists. What Krugman seems to be saying is that the government didn’t spend enough during the thirties (Rauchway, who also cites Cary Brown, says directly “there was never enough spending to achieve the desired effect.”) Yet federal spending during this time increased tremendously. So what is really going on? The answer is actually quite simple.

During the Great Depression federal expenditures increased tremendously but so did taxes. Thus, the reason spending was not stimulative was not that spending wasn’t tried it’s that taxes were also raised to prohibitive levels.

This may seem a bit strange, but both Krugman and Tabarrok are correct here. Much of the increased spending was offset by tax increases as Tabarrok notes. However, I would also point out that one of the main problems with New Deal policies was that they were decidedly NOT Keynesian in that they did not attempt to stimulate demand, but rather attempted to stimulate prices. Many of the New Deal policies were aimed at restricting supply (namely in the agricultural sector) in order to raise prices. Keynes himself in an open letter to Franklin Roosevelt argued against such policies:

Now there are indications that two technical fallacies may have affected the policy of your administration. The first relates to the part played in recovery by rising prices. Rising prices are to be welcomed because they are usually a symptom of rising output and employment. When more purchasing power is spent, one expects rising output at rising prices. Since there cannot be rising output without rising prices, it is essential to ensure that the recovery shall not be held back by the insufficiency of the supply of money to support the increased monetary turn-over. But there is much less to be said in favour of rising prices, if they are brought about at the expense of rising output. Some debtors may be helped, but the national recovery as a whole will be retarded. Thus rising prices caused by deliberately increasing prime costs or by restricting output have a vastly inferior value to rising prices which are the natural result of an increase in the nation’s purchasing power.

[...]

But too much emphasis on the remedial value of a higher price-level as an object in itself may lead to serious misapprehension as to the part which prices can play in the technique of recovery. The stimulation of output by increasing aggregate purchasing power is the right way to get prices up; and not the other way round. [Emphasis added.]

Preventing Deflation

In response to a question regarding the current credit crisis with the Great Depression, Ben Bernanke offered this:

“I believe the difference today is that, you know, that we will address financial issues and try to maintain the integrity and stability of our financial system. We will not let prices fall at 10% a year. We will act as needed to keep the economy growing and stable.”

Of course, the Fed actually caused the decline in prices during the depression.

What Ended the Depression?

Paul Krugman writes:

The fact is that war is, in general, expansionary for the economy, at least in the short run. World War II, remember, ended the Great Depression.

Of course, the evidence is quite to the contrary.

The Gold Standard and the Great Depression

Pete Boettke discusses the gold standard and the depression. My thoughts are in the comments.

UPDATE: Steve Horwitz chimes in with a follow-up post.

Bold Thinking?

Robert Shiller says that it is time for bold thinking in regards to housing:

The public response to the housing downturn of 1925-33 provides an important lesson in what government and private institutions can accomplish. Back then, people weren’t content with temporary palliatives. They were thinking big, and revolutionary changes were made in real estate institutions. Without those fundamental changes, the Great Depression would have been much worse than it was, and we would be in a more vulnerable situation today…

…our reaction to the current crisis is anemic in comparison. The “Super S.I.V.” rescue plan, instigated in October by Henry M. Paulson Jr., the Treasury secretary, in an effort to prevent a meltdown of the market for so-called structured investment vehicles, will be less than a tenth the size of the Federal Home Loan Bank System that is still with us from the 1925-33 debacle.

I am not sure that adding more bureaucrats in Washington classifies as “bold thinking.” Similarly, this quote is a bit troubling:

The radical financial innovations of the 1930s were possible because the real estate crisis and other economic problems of the Depression created a sense of urgency. Innovation, after all, tends to come in troubled times.

My thinking is more in line with Robert Higgs, who presents somewhat of a different thesis.

The Gold Standard

The gold standard has been gaining a great deal of attention recently, largely from Rep. Ron Paul who has main a return to gold-backed currency a major theme of his campaign. While I am hardly an advocate of the gold standard, it is unfortunate that much of the discussion of the gold standard has been riddled with inaccuracies and false causation.

Most recently, David Frum decided to tackle the issue:

Since permanently abandoning gold convertibility in 1933, the US economy has experienced far less economic volatility. Recessions are fewer and shallower (if sometimes longer).

Frum mentions the Great Depression as a byproduct of the gold standard. While this is somewhat correct, it is entirely misleading. It is not the gold standard in and of itself that led to the depression, but rather a mismanagement of the gold standard that created a deflationary bias (for a much more detailed analysis, see Bernanke and James).

This deflationary bias was created by two major factors:

1.) Asymmetrical monetary responsiveness to changes in gold flows. Under the rules of the gold standard, when one experiences an inflow of gold they are to increase the money supply accordingly and when one experiences outflows, they are to decrease the money supply accordingly. During the interwar period, those countries experiencing gold outflows were following suit by reducing the money supply. However, the United States and France, the two countries with the greatest inflow of gold, had little incentive to avoid gold accumulation (relative to currency). Prior to this period, everything had centered around the Bank of England, which had no incentive to accumulate gold and thus ensured convertibility. This lack of incentive for the United States and Franc during the interwar period, however, led to a deflationary bias.

2.) Weak central banks. During this time period, central banks had limited power over the money supply. This was largely as a result large restrictions on open market operations (the simplest way to increase the money supply). This was done following the first World War to prevent monetization of deficits by central banks. However, this limitation led to a deflationary bias.

With the major gold inflow into France, one would have expected the French to inflate their currency. However, due in large part to the strong restrictions on open market operations, France did not follow suit and actually experienced double digit deflation.

Meanwhile, in the United States, the Federal Reserve was keen on limiting stock market speculation and thus tightened monetary policy (Hamilton), despite the inflow of gold. This led to deflationary pressure and the eventual decline of the overall price level in 1929.

While this post is in no way an attempt to justify or defend the gold standard, it is especially important to note is that the gold standard is not directly the cause of the Great Depression. As Bernanke and James note, the was a “self-inflicted wound.” The central banks had little or no reason to avoid gold accumulation relative to the domestic currency and their weak powers coupled with policies that ran counter to the rules of the gold standard created the deflationary pressure that created the depression. In other words, the two countries that experienced the most pronounced inflows of gold had central banks who either chose not to adhere to the rules of the gold standard because of other policy objectives or were ill-equipped to handle such inflows due to heavy restrictions on their powers.