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Wednesday, Aug 21, 2002

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The Great Depression revisited

S. Gurumurthi

THE Great Depression of 1929-33 can easily be called the greatest peacetime cataclysm in economic history. Since the US was then the largest economy, it experienced the deepest contraction; its nominal gross national product (GNP) fell from $104.6 billion to $56.1 billion in the four-year period. Most countries experienced recession in 1929-30 and their recoveries started in 1932-33. In France, however, the contraction occurred only during 1932-35. Output losses in the US, Germany, France, Italy, Japan, Canada, Sweden, and Australia exceeded 10 per cent of GNP, and were also sizable in many other countries.

The recent World Economic Outlook carries an interesting analysis of the causes for the Great Depression, summarising different theories put forth by various economists.

Several economic historians, such as Michael Bordo, agree that the Great Depression — at least the first stage — was caused primarily by US' monetary policy, propagated mostly by a series of banking panics, and then spread to the rest of the world via the international gold exchange standard.

The US Federal Reserve tightened monetary policy in early 1928, in response to the stock market boom that began in 1926 and the belief that banks should confine their lending strictly to commercial bills and not finance stock market speculation, commonly referred to as the `real bills doctrine'. The contractions in central bank credit and the monetary base, along with a rise in the discount rate, brought about a downturn in the US economy starting in August 1929, before the stock market crash of October 1929.

A series of banking panics beginning in October 1930 turned an otherwise serious recession into a depression. According to Friedman and Schwartz (1963), these panics, resulting in the suspension of 9,000 banks (more than a third of the total), exacerbated the economic contraction because they reduced broad money. The US Fed was insufficiently aggressive in trying to counter the collapse in broad money, for example, via open market purchases. Friedman and Schwartz attributed it to a breakdown in governance at the Fed, following the death in 1928 of Benjamin Strong, Governor of the Federal Reserve Bank of New York, whom they believed would have acted correctly to offset the banking panics.

Alternatively, Wheelock and Meltzer argued that the policy failure stemmed from the adherence to two beliefs: i) the `real bills doctrine', which held that the low interest rates observed in the early 1930s were a sign of expansionary monetary policy and that even looser monetary policy would rekindle speculation; and ii) the liquidationist view, which held that recessions were a necessary purge to the excesses of the previous booms.

The collapse of broad money reduced output through several channels: i) lower aggregate demand, which, in the face of nominal wage rigidity, decreased real output (according to Bernanke and Carey, 1966, and Bordo, Erceg, and Evans, 2000); ii) disruption of financial intermediation from the bank failures (Bernanke, 1983); iii) asset price deflation, whereby declining asset prices reduced the value of collateral for bank loans, inducing weakened banks to engage in a fire sale of their securities, leading to further asset price deflation (Bernanke and Gertler, 1989): and iv) debt deflation, in which falling goods prices led to rising debt burdens in an environment where contracts were not fully indexed (Fisher 1933) and rising ex ante real interest rates (Cecchetti, 1992).

The fall in broad money in the US raised interest rates, leading to a capital inflow from the rest of the world, and reduced output, lowering US demand for the rest of the world's output. The US ran persistent balance of payments surpluses with its main trading partners during 1929-31. In the rest of the world, the combination of the gold outflow and the fall in exports to the US caused aggregate demand to decline. This was exacerbated by a loss of confidence in the currencies of the reserve countries, leading central banks to convert their holdings of foreign exchange into gold, which caused a contraction in the world money supply.

The gold exchange standard also exacerbated the contractions in other countries by preventing central banks from responding aggressively to the banking panics prompted by weakened bank balance-sheets. Central banks were reluctant to extend liquidity support to banks, fearing a speculative attack that would force them off the gold standard — they, according to Bernanke and James (1991) and Eichengreen (1992), were confined by "golden fetters". At the same time, foreign depositors' fears of either devaluation or the imposition of exchange controls or both fuelled the spread of banking crises from Austria in May 1931 to Germany and other central European countries, and then to France and Belgium. Finally, the banking crises in the continent led to a speculative attack on the Bank of England's gold reserves, leading the UK to suspend gold convertibility in September 1931. The contagion even reached the US, leading the central bank to raise its discount rate in order to protect its gold reserves, thereby, aggravating the banking crisis already under way.

The Great Depression generally ended once countries left the gold exchange standard and adopted policies that restored confidence in the financial system and stimulated aggregate demand, including expansionary fiscal and monetary policies. The UK and other countries in the sterling bloc, including Australia, Denmark, Finland, Norway, and Sweden, left gold in 1931 and started to recover. The US ended its link to gold in 1933 and effectively devalued by raising the price of gold, which in turn revalued the monetary gold stock and expanded the monetary base.

The principal remaining gold standard adherents were France, Belgium, the Netherlands, and Switzerland (the "gold bloc" countries), which had returned to gold in the late 1920s. After the UK, the US, and much of the rest of the world devalued, France and the gold bloc countries were placed at an ever deteriorating competitive disadvantage. To preserve their gold reserves, they followed increasingly contractionary macroeconomic policies, which served to exacerbate the Depression. In the end, Belgium left gold in 1935 and France in 1936, followed by the Netherlands and Switzerland.

The pace of recovery from the Great Depression varied widely across countries. In the UK, which left gold early, it took only a year for output to exceed its peak level before the recession began. In the US, recovery began in 1933 but was sluggish.

Recent research suggests that the weak recovery and the following second stage of the Depression partly reflected New Deal policies that enhanced the monopoly power of firms and labour unions, which strongly reduced aggregate supply, especially in manufacturing.

It was not until the 1930s that economic and political forces brought fundamental changes in the legal attitude towards unions in the US.

During the 1920s, the most rapid employment gains came in the automobile, steel and rubber industries, which employed primarily unskilled and semi-skilled labour. Recognising the potential political power of the working class, Franklin Roosevelt ran for the presidency in 1932 on a platform which addressed the needs of the blue-collar worker.

Against the backdrop of the Great Depression, Roosevelt's platform had broad public appeal. Soon court rulings started reflecting the change in social attitudes. In 1932, the US Congress passed the Norris-LaGuardia Act, which established the right of the unions to bargain collectively. This Act was the forerunner of the National Labour Relations Act, commonly known as the Wagner Act, which was passed in 1935. Often called labour's Magna Carta, the Wagner Act broadened the collective bargaining rights first set forth in the Norris-LaGuardia Act, It gave workers the right to form and join unions without interference from employers and required employers to bargain "in good faith" with any union certified by the newly established National Labour Relations Board.

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