http://www.forbes.com/2009/10/29/depression-recession-gdp-imf-milton-friedman-opinions-columnists-bruce-bartlett.html
Notations
The Great Depression and the Great Recession
More alike than everyone thinks.
Bruce Bartlett, 10.30.09
Eighty years ago this week, the stock market crashed. Although it was more a symptom of the economy's underlying problems than a cause of the Great Depression, it is still considered the day the worst economic crisis in American history began.
I've always been curious about the Great Depression. In fact, I think I decided to study economics because of it. As a child, I remember asking my father about its causes, and he told me that there wasn't enough money for people to spend. I asked where the money went, thinking that vast amounts of currency and coin couldn't have just disappeared. My father explained that most money is in the form of checking accounts, so when the banks failed, a lot of money did just vanish.
My father was not an economist, but somehow he had figured out an essential truth about the cause of the Great Depression that most economists didn't know at the time. I remember my high school history teacher saying that it happened because people suddenly stopped buying cars because the market was saturated; everybody who wanted one owned one.
My college professors weren't much more sophisticated. They talked about a lot of different things--the Smoot-Hawley tariff, the gold standard, international debts et al.--but beneath these specifics was an undercurrent of blame for capitalism itself. It was in its nature, they said, that it generated bubbles that created great hardship when they burst, as the stock market bubble of the 1920s had done in late October 1929.
The idea that capitalism caused the Great Depression was widely held among intellectuals and the general public for many decades. Indeed, there was widespread belief that capitalism bred secular stagnation; consequently, there was enormous fear that the Great Depression would simply start up again where it left off after the temporary prosperity of World War II ended with the war.
Policymakers were united in their desire to make sure this didn't happen if humanly possible. Many postwar institutions such as the World Bank, General Agreement on Tariffs and Trade and International Monetary Fund were created to fix various problems thought to be responsible for the Great Depression. Congress even passed a law, the Employment Act of 1946, that requires the president to do everything in his power to prevent another depression.
To everyone's great relief, the doomsayers were wrong and secular stagnation did not resume after the war. But as long as there was no satisfactory explanation for the Great Depression, the default position was to blame the private sector, which greatly handicapped conservatives in economic debates about the role of government. Those favoring a free market were at a severe disadvantage against those who said government spending and regulation were the only things standing between prosperity and another Great Depression.
Fortunately for conservatives, the greatest free market economist of all time, Milton Friedman, found an explanation for the Great Depression that let capitalism off the hook. The fundamental problem, he said, was that the Federal Reserve foolishly allowed the money supply to shrink by a third between 1929 and 1933. Since my father had already told me that the problem in the 1930s was a lack of money, Friedman's explanation made perfect sense to me.
A sharp decline in the money supply sets in motion forces that inevitably cause an economic crisis. Because the gross domestic product (GDP)--goods and services sold times their prices--equals the money supply times its rate of turnover, which economists call velocity, then a fall in the money supply of a third is going to necessarily cause nominal GDP to fall by about a third. This will lead to both deflation--falling prices--and falling output.
The faster prices adjust, the faster the economy will turn around and resume growth. The problem is that prices are sticky--they don't adjust quickly to changes in monetary conditions--and wages are even stickier. Getting workers to accept large pay cuts is extremely difficult, especially in heavily unionized industries.
An even bigger problem is that the Fed can't expand the money supply by cutting interest rates because a large deflation would require a negative nominal interest rate. But no bank is ever going to lend at a negative nominal rate, so the zero-bound problem, as economists call it, is a serious barrier to reversing a deflation through monetary policy alone. Also, a deflation magnifies the real burden of debts.
By fingering the Fed's mistakes as the root cause of the Great Depression, Friedman rescued capitalism from blame. Today, I think most economists accept this explanation, although they differ on the appropriate response to the decline in the money supply. Many conservatives still believe the government should have done nothing, or at least different things than it did, because it just made things worse. In particular, conservatives are highly critical of deficit spending during the Roosevelt administration.
Most economists do not accept the do-nothing theory. They believe that government must play an active role in stimulating growth when the economy is suffering from a large, sustained deflation. Government spending must compensate for the fall in private spending that results from a deflation--people and businesses will put off buying when they think prices will be lower in the future. Only when spending is again rising will monetary policy become effective; until then it is like pushing on a string to get money circulating and prices rising again.
In the 1930s, there were a number of economists who argued strenuously for a do-nothing policy. But as the Great Depression dragged on and collapsed in 1937--when conservatives were successful in having the federal government slash the budget deficit (it fell from 5.5% of GDP in 1936 to 0% in 1938)--they lost credibility. Economists today generally believe that it was the unprecedented deficits resulting from World War II that actually ended the Great Depression.
Fortunately for policymakers, every postwar recession until this one occurred under inflationary conditions. This made the readjustment vastly easier because real wages could be cut just by reducing their growth rate to less than the inflation rate; real interest rates could easily be pushed to a negative level if necessary; and Fed policy was always effective.
Unfortunately, the current crisis is caused by the same deflationary forces that caused the Great Depression. Monetarists dismiss this argument on the grounds that the money supply has not only not fallen, but in fact has risen sharply. At the end of September, the money supply (M2) was up by $523 billion over a year earlier--a substantial increase. For this reason, they dismiss the idea that government stimulus was necessary to get the economy moving again.
What my monetarist friends forget is that that the money supply impacts GDP through the velocity multiplier. Normally, it is around 1.9. But it fell to 1.86 in the third quarter of 2008, 1.76 in the fourth quarter, 1.7 in the first quarter of 2009 and 1.69 in the second quarter before rising a bit to 1.72 in the third quarter.
This may not sound like much, but a decline of 10% in the velocity ratio has exactly the same macroeconomic effect as a 10% decline in the money supply. If velocity were still at 1.9, third-quarter GDP would have been $15.8 trillion instead of $14.3 trillion. In other words, there would be no recession.
Getting velocity to rise presents policymakers with the same problem they had in the 1930s and requires the same solution: Government spending has to compensate for the falloff in private spending, which should be $1.5 trillion higher based on M2 of $8.3 trillion at the end of September.
The main differences between today's crisis and the Great Depression is that the deflationary pressure is less than a third of what it was in the 1930s and policymakers today reacted much more swiftly and more appropriately than they did after 1929. Those who think the government should have done nothing risked turning the current downturn into another Great Depression. Thankfully, their advice was ignored.
Economics
If GDP equals money supply times the velocity multiplier, saying that the GDP shrinks because the velocity multiplier shrinks isn't actually saying enything. We need to know why the velocity multiplier itself shrinks.
It is amazing that economists have no real idea why things happen in the economic world. After years of study, the conservative will blame everything on the government and the liberal will blame everything on the free market, which is exactly what they believed before undertaking all the study. Perhaps this is why economics is not well respected as a science. Only sociology is worse.
Hoover's highwage & cartelisation policy
UCLA economists have shown that Hoover's high wage and cartelisation policies cause a crash in industrial employment and output before any significant deflation or any bank failures had occured in 1929-1930.
So your facts are out of order here -- the causal time line doesn't fi your Friedman story. Deflation made the depression worse and made it longer, but it wasn't the initial or central cause.
And note well, Horwitz, Hayek, Rizzo, Selin, White and other free market economists all identify deflation as a pathology that needed to be counteracted by sound monetary policy -- and they all say that the Fed botched it in the 1930s with deflationary policies that made things worse. They all believe that monetary policy needed to be different in the 1930s in a way to counter the deflation.
So your account of what "conservatives" believe is wrong.
Gold Standard
You are derisive of the gold standard issue as it relates to the Great Depression but wasn't adherence to the gold standard one of the main reasons why the Fed allowed the money supply to contract? It wasn't just foolishness as you imply, the theory behind it was the gold standard.
Nicely Done
Bruce - as nicely done a summary of the basic factors as I've read. Clear, simple and accurate. BtW, just to chime in, when Churchill "restored" the gold standard at pre-WW1 rates he effectively tightened the British money supply and took them into a Depression in the 20s.
What would be really interesting is a part two talking about inherent instabilities in complex economies, especially ones with financial markets (channeling Minsky here). But also thinking that the economy is a complex ecology of many inter-connected parts that are mutually dependent. When one part mal-adjusts the impacts ripple across the economy. So when labor markets do not clear, as even Barro admits, then no other market can clear.
Which gets us to Keynes' "Fallacy of Composition". Local detail behavior is not the behavior of the whole system, private frugalities can lead to systemic collapse.
How 'bout shooting for a clear exposition of that little detail in a second article? Don't think I've ever seen it well explained.
Credit crunch
"We need to know why the velocity multiplier itself shrinks."
It shrinks because banks aren't lending. The system froze up, and banks are still hoarding money because many are still in trouble.
"FDIC Fridays" tell you all you need to know. During the Great Depression thousands of banks failed. It was also a credit crunch (a huge one). When money isn't moving through the system (lending) it impacts velocity. Add to this the fact that Americans are cutting up their credit cards and frantically trying to pay down debt (activities that don't create velocity), and we've got an issue.
To solve the problem the government has to leverage up to counter the deleveraging of banks and, consequently, consumer spending. That's what the bank bailout (hundreds of billions infused into the system) and stimulus were designed to do. It was the right response, and it appears we are beginning the slow slog out at this point.
Read Galbraith's "The Great Crash" (about the causes of the Great Depression). He describes the credit crunch, and the parallels with today's banking environment are uncanny.
Crapitalism?
Looks like a money supply problem, compounded with the fact banks are insolvent,unable to lend, consumers are reigning in spending and paying off the very debts that make this system go...
Actually the driving cause of
Actually the driving cause of the Great Depression and our current depression was labor productivity rising faster than wages. Between 1900 and the 1930s manufacturing productivity of labor increased by two or three orders of magnitude, but wages were stagnant. Eventually, there were more goods than people had money to buy. Read some back issues of Fortune from the 30s for a good study of this. Sure, the GDP might be growing, but no one was hiring, nor did they need to. Our information revolution has led to a similar problem. We can crank out goods and services, but people can't afford to buy enough of them.
Also, money supply as a cause is overrated. The real issue was the investment pool, the money looking for a return on capital. In the 20s, the big boom and bust was built on a pool of about $15 billion, but in the 30s, there was close to $30 billion of money sitting around in 0.8% treasury notes. There weren't enough people making enough money to make investment worthwhile, so investors put up with zilch returns. One of the big fears of the mid-30s was that all that scared money would stop being scared and lead to an even bigger boom followed by a bust from which recovery was inconceivable.
I'm willing to believe that better control of the money supply might have made some difference, but it would not have had any effect on the real problem. Wages were too low.
For shame
"there was enormous fear that the Great Depression would simply start up again where it left off after the temporary prosperity of World War II ended with the war."
"Economists today generally believe that it was the unprecedented deficits resulting from World War II that actually ended the Great Depression."
I simply cannot fathom the way that this myth has continued exist among economists, perhaps its a desire to elevate WW2 to loftier standards or the desire to have a definitive answer to solving the great depression, but it is a repulsive lie.
You used the word "prosperity"- but there was no prosperity for people during WW2- did people have more and better food, clothing and durable goods? No, shortages were persistent throughout the war- so much so that the lack of consumption during the war is used as an excuse by Keynesians for the lack of a deep depression that they predicted after the end of government spending. They call it "pent up demand".
Over 400,000 US soldiers died during the war, nearly 700,000 more were wounded- and you use the word "prosperity"? This is a shameful facet of economics where researchers tag meaning to numbers like GDP and forget why the concept of GDP was useful in the first place. Rising GDP is supposed to mean more goods, more services- a bigger pie for all, not simply an accounting identity where by we can spew out tanks and trucks and corpses of men and slap a number to them and proclaim "growth" and "prosperity".
Consumption during WWII was due to government leveraging
"You used the word "prosperity"- but there was no prosperity for people during WW2- did people have more and better food, clothing and durable goods? "
No but they had jobs, and that was prosperity coming on the heels of the depression. Those who weren't being paid by Uncle Sam to staff the military machine were working in factories to put out the goods here at home (women worked outside the home in unprecedented numbers). Many saved their earnings (savings bonds were a big deal, as there weren't a lot of goods to purchase -- auto factories were making tanks, for example). Those savings served as another economic stimulus after the war, as people rushed to buy homes, home appliances, autos, etc.
My parents fit this profile (mother worked during the war and saved her money, father was a Marine, fighting in the Pacific, but his money went back home to his widowed mother), as did my in-laws (mother was working in a job she wouldn't have obtained if men were around, and father was a code-breaker/linguist for the army).
WWII was one massive stimulus program. People had jobs and saved money. Many women planned and saved for the day when their men would come home, and when they did they married, bought homes, and had children (the baby boom). Many women also saved (if they were married or had kids) because they wanted a cushion, in case their man did not make it back. As you mention, many did not. My father lost many friends in the war. The waste of lives does not change the economic reality and stimulus of deficit spending that occurred at that time . . .
half the equation at best
"No but they had jobs, and that was prosperity coming on the heels of the depression. Those who weren't being paid by Uncle Sam to staff the military machine were working in factories to put out the goods here at home (women worked outside the home in unprecedented numbers"
Women went to work in unprecedented numbers because millions of men were conscripted. You can't say "look we created 1 job" and ignore the fact to create that job you had to forcibly remove the previous worker and send them off to fight and possible be seriously wounded or killed. It is trivial to reduce UE to zero, oppressive regimes do it all the time, but that doesn't make it prosperity.
"as there weren't a lot of goods to purchase"
"WWII was one massive stimulus program"
Your statements are contradictory. If WW2 was a true stimulus program then there would have been more goods for people to consume, not fewer. You can't have an effective stimulus and declining real output- and real output can only be measured by voluntary purchases. Otherwise one could argue that the Soviet Union had a fine economy for many years- pumping out boots that were never worn and bread that was never eaten. Simply increasing the tally of goods produced does not mean an increase in the standard of living.
Goods consumed were tanks, guns, bullets
"there would have been more goods for people to consume"
The goods were going to the war fronts. They were being "consumed", just not on the home front. Voluntary purchases were replaced by government purchases -- either way, goods were being purchased and consumed. The home front was deleveraging, but the government more than took up the slack by leveraging up. That's an important form of stimulus.
After the war the factories were retooled to produce consumer goods again (cars, washing machines, etc.) and they were bought up in mass quantities through voluntary purchasing.
Keyenesian stimulus
Keynesian stimulus is (theoretically) supposed to work like this (basically)
1. Output gap
2. Government spending fills output gap
3. Individuals get wages from government spending
4. Individuals consume with said wages
5. Private enterprise picks up to satisfy consumers
6. economic growth ensues
What happened in WW2 was
1. Output gap
2. Government spending fills output gap
3. Individuals get wages from government spending
4. Didn't happen
5. Didn't happen
6. Didn't really happen (see Robert Higgs' "Wartime Prosperity? A Reassessment of the US economy in the 1940s"
Government spending during WW2 doesn't fit the bill as Keynesian stimulus because steps 4 and 5 never happened- private output of non war materials was the same in 1944 as it was during the depression. When WW2 ended there was a sharp recession and then booming growth (which totally took all Keynsians by surprise and they had to scramble for an explanation).
The "stimulus" of WWII -- the mega Broken Window Fallacy
The goods were going to the war fronts. They were being "consumed", just not on the home front. Voluntary purchases were replaced by government purchases -- either way, goods were being purchased and consumed.
"Consumed" in mass destruction. An odd definition of "consumption". Make vehicles, craft, bombs, all sorts of such things en masse on unprecedented scale -- and blow them up. (Those that survive the years of war become worthless scrap or deep-discount war surplus.)
Meanwhile, economic welfare on the home front declined by all measures even from Depression levels -- because of the forced cutbacks on consuming by consumers.
Rationing, etc., prevented people from consuming even their controlled wages. Of course, many consumer goods were no longer produced at all. (Mass forced, not voluntary, saving resulting.) Conscription of millions, involuntary by definition, added to the effect. (No reason to dwell on all the dead and wounded.)
Yes, Higgs is very good on economic welfare measures during the war years.
The home front was deleveraging, but the government more than took up the slack by leveraging up. That's an important form of stimulus.
Was there really a lot of "leverage" to deleverage in the economy of 1939, after a full decade of Depression? I kind of doubt it.
You may instead mean that the massive war expenditures (financed by huge tax increases, plus debt equal to 70% of GDP) going to big corporations producing war materials boosted their profits and the equity on their balance sheets. As they put it in the parlance of the time, Daddy Warbucks made a fortune.
The thing is, voluntary economic purchases create economic wealth for society -- the material and labor used in producing a civilian truck produces a truck to be constructively used in commerce that is worth more in use than its cost.
But governmental command purchases from Daddy Warbucks Production Line Inc produce economic deadweight loss -- all the stuff gets blown up, sent to the bottom of the sea, or junked ... the value of the material and labor put in it is lost forever ... while the cost of all those lost resources goes 100% onto the taxpayers' bill. Though yes, Daddy's profits and balance sheet improve a lot.
The illusion that all this wartime mass destruction of production is good for the economy and the economic welfare of the citizenry because it profits DWPL Inc is the Broken Windows Fallacy writ out on its hugest scale.
In 1944 there were 12 million people in the military, the great bulk conscripted -- equivalent to 27 million today. Removing 27 million workers from today's workforce by compulsion surely would make it easier for the rest to find a job, eh?
And a full 40 percent of employment in 1944 was within the "destruction goods" military industries, working for DWPL Inc (up from 2% in 1940) -- slashing production for civilians by that much, while ladling the profits to Daddy and his shareholders.
OK, as much as we all like low employment and high corporate profits, do either of these really appear attractive as "stimulus" measures that make life better for people, so that we'd recommend them again?
After the war the factories were retooled to produce consumer goods again (cars, washing machines, etc.) and they were bought up in mass quantities through voluntary purchasing.
Well, sure. Prohibit consumers from buying, say, any new cars for five years, while imposing massive forced savings, then afterward the demand for new cars will be huge!! We could try that with Detroit again today.
In fact, we could try the whole scheme again today to end this recession. Why not? The laws of economics are the still same. Have the govt conscript 15 million workers, buy several million cars from Detroit to fix its balance sheet, "consume" all the cars by blowing them up before they get to consumers...
The one and ONLY obstacle to using this solution today is the morale problem to be expected among the public during the five years of mass conscription, wage controls, rationing, debt and taxes used to run up the profits of big industries with no consumer products to show for it, etc. Without an enemy like the Nazis to fight after an event like the attack on Pearl Harbor to justify it all, the average voter might not think the economic benefits really do.
Of course Orwell had an answer for that -- the endless war between Oceania, Eurasia and Eastasia was the "stimulus" of WWII writ even larger and taken to its ultimate conclusion, pretty explicitly. That's where he got the idea.
Anyhow, in our real lives we have received the same benefits -- lowered unemployment, profits boosting the balance sheets of military contractors, stimulating additions to the national debt -- from the wars in Viet Nam, Iraq, Afghanistan, etc. Although these wars have been so comparably tiny, their economic benefits seem to have gone largely overlooked. Bad luck.