Case of the Day: The Great Depression
The Broad Outline
The Great Depression of the 1930s has affected the study of macroeconomics more than any other event in history. Indeed, the founding of macroeconomics as a distinct discipline largely coincided with attempts to explain the Great Depression. It had such a dominant influence on the discipline that it wasn't until the 1970s and 1980s that mainstream macroeconomics emerged from being dominated by theories of recession and depression.
The most common association that the general public has with the Great Depression is the crash of the stock market that occurred in October of 1929. Stock prices did fall dramatically on the day of the crash and continued in a general downward trend for several years. However, the Great Depression was much more than a crash in financial markets. Although the crash had an impact on the Depression, it was less a cause of the Depression than a co-symptom of a collection of underlying problems.
Both because of its magnitude as a social phenomenon and because of its impact on the development of macroeconomics, it is important to understand some basic facts about what happened during the Great Depression. In the words of Milton Friedman and Anna Schwartz, from their Monetary History of the United States, "The contraction from 1929 to 1933 was by far the most severe business-cycle contraction during the near-century of U.S. history we cover [1867-1960] and it may well have been the most severe in the whole of U.S. history. Though sharper and more prolonged in the United States than in most other countries, it was worldwide in scope and ranks as the most severe and widely diffused international contraction of modern times. U.S. net national product in current prices fell by more than one-half from 1929 to 1933; net national product in constant prices, by more than one-third; implicit prices [a broad index of prices across the economy], by more than one-quarter; and monthly wholesale prices, by more than one-third."
The most commonly cited indicator of business cycles, the unemployment rate, rose from 3.2% of the labor force in 1929 to 24.9% in 1933. Unemployment receded back to 14.3% in 1937, but then increased again to 19.0% in 1938 and was still 9.9% in 1941 before the military boom associated with World War II brought it down to 1.9% in 1943. Real gross national product (output of goods and services) per person did not until 1940 recover to the level it had achieved in 1929. As the quote from Friedman and Schwartz indicates, prices were falling steadily through the 1930s as well. Table 1 summarizes some major macroeconomic statistics for the period 1925 to 1940.
(1958 = 100)
Prime 4-6 month commercial paper
30-year corporate bonds
Source: Historical Statistics of the United States, Colonial Times to 1970 (Washington, DC: United States Bureau of the Census, 1975).
Financial markets, banks, and the real economy
The stock-market problems—stock prices lost about three-quarters of their value between October 1929 and 1933—had significant repercussions for the banking system, which, in turn, affected the economy. At that time, it was common for investors to borrow from banks to purchase stocks "on the margin," using the value of the stocks as collateral on the loans. (Such margin loans are now much more carefully restricted.) A sudden collapse in stock prices reduced the value of the collateral, causing banks to make "margin calls," in which investors were asked to either repay their loans or provide additional collateral. In order to try to obtain enough liquidity to do one of these things, many investors attempted to sell their stock, which of course drove stock prices down even more rapidly in a self-reinforcing spiral.
Since many customers were not able to get enough liquidity to make their margin calls, defaults on bank loans soared, leading to a loss in confidence in the banking system. Meanwhile, as the economy soured, other bank loans were beginning to look less safe as well, raising the prospect of significant bank failures. At that time, bank deposits were not insured, so that if a bank was destined to fail, those depositors who were able to get their money out before it actually closed would be paid in full, while those further back in line would get their money back only in part and only after a delay (because the bank's remaining assets would have to be sold to determine how much could be paid). This gave depositors a very strong incentive to race to the withdrawal window to be first to get their money, starting a "run on the bank" any time a bank was thought to be in difficulty.
However, banks—then as now—keep only a small amount of depositors' money in the form of reserves (vault cash and readily available deposits at the Federal Reserve Banks). The rest is lent to customers to earn interest or used to purchase interest-bearing securities. A bank run can use up a bank's reserves very quickly, forcing it to either (1) sell off some of its loans and securities very quickly to get cash, (2) borrow cash from someone, perhaps the Federal Reserve, or (3) close down, at least temporarily. The securities (and even certain loans) of an individual bank may be quite "liquid" (commonly traded, so it is easy to find a willing buyer) during normal times, but when a whiff of crisis is in the air there are far more sellers in the market than buyers. If a bank is forced to sell into a frightened market, they may get very low "fire-sale" prices for the assets they are able to sell. If they have to sell assets at a loss, this worsens the bank's financial situation and may push it over the edge into insolvency, where the bank's liabilities exceed the value of its assets—the bank may fail.
When the Federal Reserve System was founded in 1913, its principal mission was to provide an "elastic currency" by acting as a "lender of last resort" for banks, lending to them through the "discount window" by purchasing their loans and securities for cash when the banks faced possible runs and needed liquidity. However, during the bank crises of the Great Depression the Fed had strict rules about the kinds of assets that it would buy, so that emergency borrowing from the Fed failed to avert bank runs. Between 1929 and 1933, bank failures were so wide-spread that the number of commercial banks operating in the United States fell by over one-third.
The extraordinarily high rate of unemployment of the economy's labor resources was mirrored by underutilization of its capital. Industrial production declined by about half from 1929-33, leaving many factories, mines, and shops shut down and many others operating at far below their capacity. The economy had entered a vicious circle: aggregate demand for goods and services was so low that firms could not sell as much output as they could produce with full utilization of available resources. Because production and employment were so low, households' incomes contracted severely so that they could not afford to buy many goods, which in turn kept aggregate demand depressed.
The apparent failure of the market system to coordinate households' and firms' economic decisions in an efficient way directly contradicted the fundamental efficiency implications of classical economics, which was based on the perfectly competitive model of general equilibrium. Moreover, the source of this coordination failure did not seem to lie in any of the classical causes of market failure such as externalities, public goods, or monopoly. Rather, the price system seemed to be ineffective at providing the appropriate signals to clear the markets for products and resources. Markets did not seem to clear; demand was apparently not equal to supply.
Explaining the nature of this failure was the task attempted by John Maynard Keynes, a brilliant but maverick British economist, in The General Theory of Employment, Interest and Money, published in 1936. Keynes focused on the key role played by "aggregate demand" in determining the overall level of economic activity in an economy. The refinement of models based on Keynes's insights and of alternative models exploring the relationships among economic aggregates led to the development of the discipline of macroeconomics.
Modern macroeconomists fall into two broad categories. Neoclassical macroeconomists think of the world as being primarily well explained by the competitive, market-clearing model. Keynesian (or New Keynesian) macroeconomists emphasize the imperfections of the market and the difficulties that may attend convergence to market clearing. Although these two groups agree on a broad set of issues, they tend often to support different strategies for macroeconomic policy. Neoclassical economists usually favor a laissez-faire approach, relying on the self-correcting mechanism of the market to restore the economy to equilibrium. Keynesians tend to support a more active role for the government in managing aggregate demand either directly through fiscal policy (government spending and taxation levels) or monetary policy (using changes in the quantity of money to affect liquidity, interest rates, and hence aggregate demand).
The differences are highlighted in an amusing way by this video.
Questions for analysis
1. Macroeconomists classify variables as "procyclical" if they tend to be positively related to real output across the business cycle, in other words, if they usually rise in booms and fall in recessions. Variables that move in the opposite direction are called "countercyclical." Based on the evidence in Table 1, would you say that inflation was procyclical or countercyclical during the period shown? What about nominal interest rates? The unemployment rate?
2. Describe the pattern of nominal and real interest rates during the Great Depression. (Recall that the real interest rate is approximately the nominal rate minus the rate of inflation.) Why can't nominal interest rates be negative except in unusual circumstance? What bound does this put on real interest rates when there is substantial deflation? Is it possible that this could prevent the loanable-funds market from clearing?
3. Can you explain why long-term interest rates moved down less in the Great Depression than short-term rates? The rates shown in Table 1 are rates on loans to extremely creditworthy borrowers: the U.S. government and the largest corporations. How do you think the "spread" between these rates and those of less reliable borrowers changed during the Great Depression?
4. If you operated a bank that had not (yet) experienced a run during the Great Depression, how would you change your lending and reserve-holding policies to try to prepare yourself for that possibility? Would these changes in lending, in turn, contribute further to the depression in aggregate demand?