We next consider monetary policy, though in doing so we find it expedient to simultaneously discuss some market dynamics. Monetary policy in the period 1933 – 37 has been described as incoherent, and certainly the Federal Reserve (Fed) appeared to make no concerted effort to aid recovery. As noted by Friedman and Schwartz, the discount rate went unaltered from early 1934 to mid 1937, and Fed credit outstanding was almost constant post 1933. The tools developed for monetary policy in the preceding decades went unused during recovery. Whilst changes in holdings of Treasury deposits did cause some fluctuations, this was never a coherent policy and produced no consistent expansionary or contractionary effects.
Romer, however, finds GNP under actual and normal monetary policy to be very different. Without the expansion in the money supply, real GNP in 1937 would have been 25% lower, and in 1942, 50% below trend. Yet we have just said that the Fed took no action to expand the money supply – we need to reconcile the two. The increase in money supply is in fact accounted for by a massive inflow of gold from 1934 onwards, in response to the devaluation of the dollar by FDR (to around 59% of its original value). Given the level of gold reserves in the US, it is difficult to argue that this devaluation was forced, as Britain’s had been, and so it can be seen as a monetary policy decision, aimed at economic recovery. A further policy decision was taken when the gold flows were left unsterilized (until 1937) and so the money supply allowed to increase.
A potential issue here is that the increase in money supply might have been endogenous, responding to an increase in money demand. However, if that had been the case we would expect to see an increase in the deposit:reserve and deposit:currency ratios, but we do not; there is no evidence that the Fed increased the money supply in response to demand.
This increase in the money supply lowered the interest rate and so stimulated investment, leading to economic growth and recovery. Evidence of a causal link is provided by Romer, who notes that consumer spending increased sooner on consumer durables than on services, indicating a fall in interest rates rather than a rise in optimism.
Temin and Eichengreen also attach importance to devaluation, though for different reasons. Eichengreen argues that devaluation proved beneficial to the US economy because it improved US competitiveness and generated capital inflows (the path analysed by Romer), whilst Temin focuses on the effect upon expectations. Devaluation, he argues, being unforced, sent a signal that FDR was serious about implementing an expansionary, aggressive policy and was prepared to put an end to the deflationary policies of the Hoover years, including the international commitments like the Gold Standard. Consequently, expectations of deflation fell (or expected inflation rose), lowering the real interest rate and so stimulating investment.
It is worth noting however that Roosevelt implemented devaluation as a means to raise prices and wages, rather than lower the real interest rate. So the transmission mechanism was not of the policy maker’s intent, but a function of market dynamics.
The main policy force during this period was the “New Deal” of FDR, which promised greater government intervention to restore the economy. A number of policies were introduced under the New Deal, with perhaps the most important, given our discussion, being the creation of Federal Deposit Insurance (FDIC) which guaranteed savings, the National Industry Recovery Act (NIRA), which aimed at attaining high wages and prices, the Agricultural Adjustment Act (AAA), which functioned as NIRA for agriculture, and the National Labour Relations Act of 1935, which served as a replacement for NIRA.
Real business cycle (RBC) theorists attribute the persistence of the Depression to the New Deal, in particular NIRA, which serves as the shock pushing the economy away from full employment and preventing adjustment. Cole and Ohanian claim that the New Deal cartelization policies account for up to 60% of the difference between actual output and trend output, noting that despite positive shocks to the economy, the recovery was weak, with GDP 27% below trend in 1939 and hours worked 21% below trend. Key to their argument is that GNP, consumption and investment are below trend, and real wages are significantly above trend, despite productivity returning quickly to trend. Under classical assumptions, the real wage should equal the marginal product of labour, that it is greater than MPL suggests a failure in the labour market. In this case, we need not look too far for a possible cause – NIRA allowed collusion by industry provided they met certain conditions; higher wages and bargaining with independent unions. The consequence of this was to artificially increase both prices and wages, preventing the labour and goods markets from clearing, restricting employment; unemployment remained at 10% or higher throughout the 30s. As an example of the effect of NIRA on wages, consider manufacturing, bituminous coal and petroleum, sectors covered by NIRA (and subsequently NLRA) and in which wages were 24-33% above trend in 1939.
The sanctioning of unions also created an insider outsider problem, whereby the unions are concerned only with the employment and wages of their members, not the labour force as a whole, and so increase wages to the detriment of the unemployed (the outsiders), who consequently find it harder to get work, as they are unable to bid wages down.
However, RBC theorists fail to explain the transition path to full recovery, there is little evidence of a change in the operation of the New Deal in 1938/39, and it should be noted that 60% is the maximum that can be explained (and even then is based on economic simulations), so this does not give a full explanation of the recovery.
Temin’s argument, touched on briefly earlier, is that one of the forces driving recovery was the effect of FDR’s policies on expectations. Expectations of deflation discourage investment and consumption (it will be cheaper to consume tomorrow if prices are falling) and so reduce aggregate demand, further feeding deflation. These expectations arose in part from the policy of Hoover’s government and the commitment to the Gold Standard, adherence to which caused the Fed to contract the money supply during recession, worsening the problem. FDR came to power on a promise to rebuild and reflate, and the New Deal policies were the means by which he meant to accomplish this. NIRA, which artificially increased wages and prices, was a clear attempt to reflate the economy and so helped increase inflationary expectations, driving down the real interest rate. Temin does agree with RBC theorists, however, that NIRA probably helped preserve the high unemployment witnessed. Furthermore, he argues that the New Deal policies were often contradictory, with the money inflows encouraged by devaluation being countered to some extent by the increasing prices and wages. (From the quantity theory of money, an increase in M can increase prices and/or output, for a given velocity. If prices increase, there is less scope for an increase in output). So although the effect of NIRA on expectations was positive, the actual inflation it caused hindered economic recovery.
As Bernanke argues, the persistence of the Depression can also be attributed to market dynamics resulting from the disruption of financial intermediation. Credit markets rarely function perfectly, there are issues of asymmetric information and moral hazard. Informal institutions arise by which banks amass information on clients. A financial crisis, as occurred in the Depression when a large number of banks failed, wipes out a great amount of information which is costly to regain. Consequently, interest rates rise to reflect these costs to banks when issuing loans to borrowers of uncertain credit worthiness. However, there is also a selection issue – increasing interest rates tends to exclude less risky borrowers who typically have lower returns (but lower variance), and so interest rates can not be increased to the desired level by banks because to do so would restrict the client list exclusively to risky borrowers (high risk of default), so banks also undertake quantitative credit rationing. The end result is a shortage of credit and a fall in investment, leading to a downturn in economic activity.
One final issue of market dynamics to consider is the concept of a ‘long swing’ explanation. The proposed model is that increasing aggregate demand tightens conditions in the labour market, leading to immigration or internal migration from lower wage areas. This then leads to demand for housing, consumer durables, urban services and so on which stimulates investment, further increasing AD and so perpetuating the cycle. As such a cycle is founded upon long term decisions (having a family, settling down), they generate a long wave of resource development and output growth. Adversely, a negative shock can reverse the cycle, leading to emigration and a cycle of falling AD. Taking the Depression as a negative shock to the system, we see that net migration fell until the mid 30s, perhaps explaining in part the persistence of the depression. (It should be remembered also that there were immigration restrictions at this time). When recovery began in 1933/34, let us assume a positive shock to AD, the cycle became virtuous once again; we certainly see an increase in net migration and household growth. This could in part, then, have generated economic recovery.
In conclusion then, we must give our assessment of the relative importance of policy and market dynamics. It seems fair to say that fiscal policy played no role in the recovery until at least 1940, and that the major cause of economic growth during the 1930s was the expansion of the money supply. This was in part driven by policy (devaluation and the decision not to sterilise) and in part by market dynamics; increasing risk in Europe drove gold to the United States. It seems likely that the New Deal policies hindered as well as helped recovery, with the wage and price stickiness introduced preventing market clearing and so preserving unemployment, though the effect upon expectations would have been beneficial. There is also a possible role for a market driven upswing as argued for by Easterlin. However, the main share of the credit for the recovery should go to the expansion of the money supply, whilst the persistence of the Depression can be attributed to both the rigidities introduced by NIRA and NLRA, and also to the higher costs of financial intermediation following the crash.
