I’m referring to 1929, 1937, 2008, which all saw severe stock market crashes, accompanied by falling commodity prices. We can better understand our current crisis if we first step back and look at the two earlier October crashes, which bear some interesting resemblances to recent events.
Although in each case the problem was “monetary” broadly defined, in none of these three episodes can modern monetary economics easily identity the problem. In contrast, the monetary model sketched out in the previous post will allow us to see the subtle forces that pushed the economy into severe recession. For instance, in 1929 the problem was central bank hoarding of gold, in 1937 it was private hoarding of gold, and in 2008 it was banks hoarding reserves.
There were also some important differences between these three crashes. The first was a pure demand shock, not entangled with significant financial or supply-side problems. In 1937 the banking system was stable, but the economy experienced a severe wage shock. And 2008 saw a significant oil shock and a severe financial crisis.
What strikes me most about these three episodes, however, is the strong sense one gets from the financial press that expectations changed dramatically around October of each year. There is a sense that investors suddenly and dramatically downgraded their forecasts of nominal GDP growth going forward for at least 2 or 3 years. Of course even today newspapers almost never mention “nominal GDP,” but in all three Octobers there was a palpable sense that inflation expectations and real growth expectations were falling sharply. For instance, in mid-1929 the economy was in the midst of a powerful boom, and yet already by December there were many ominous reports that, unlike recent recessions, the slump would be extremely severe. Industrial production fell at an extraordinary rate in the 4th quarter. In both 1937 and 2008 the dramatic fall in the stock market was accompanied by very bearish news from commodity markets (where prices fell precipitously), the the Treasury bond market, where short term rates fell to near-zero levels. And once again, output fell at extremely rapid rates, even compared to other downturns
One might ask whether the three stock market crashes triggered the subsequent recessions. I doubt it, as the equally big October 1987 crash (what is it about October!) was not followed by a recession, or even a mild slowdown in the economy. Yes, each case is different, but if stock crashes exerted a powerful independent effect on growth, wouldn’t one expect to see at least a tiny blip down after the 1987 crash?
In my manuscript on the Depression I am skeptical that we will ever be able to fully explain the 1929 crash, but I do think we can offer a partial explanation. The key problem was monetary policy. Under a gold standard the gold reserve ratio (gold/monetary base) is the only truly exogenous policy instrument. Between December 1926 (when France returned to gold), and October 1929, this ratio rose at about a 2.5% annual rate worldwide–a mildly deflationary policy. The world price level had a slight downward trend during this period.
Then, in the next 12 months, the ratio soared by 9.6%, pushing most of the developed world into severe deflation and depression. For those who missed my course on money in the previous post, central bank hoarding of gold increases its real value. Under a gold standard, gold is the medium of account. So a rise in its real value (or purchasing power) means deflation.
The causes of this are too complex to cover here. Nor is it clear whether the markets knew what was going on. My hunch is that they understood at an intuitive level that central banks had stumbled unknowingly into a highly deflationary policy stance, albeit probably without visualizing the problem in terms of the gold ratio. Unlike in the 1930-38 period, when it is often easy to connect up major stock market movements with policy shocks, I had trouble finding the “smoking gun,” evidence that tight money caused the crash. Still it is at least interesting that the highly contractionary monetary policy that triggered the Depression seems to have begun around the time of the October crash. Indeed I believe that I am the only researcher to find this link.
In the end, I found 4 factors that probably contributed to the crash. In order of importance they are:
1. A monetary policy stance was adopted that led to a large increase in the world’s gold ratio, especially in the US, France, and Britain.
2. The fierce Congressional fight over Smoot-Hawley, which was the headline news story in the NYT around the time of the crash. Jude Wanniski made this argument, and I think he is partly right, albeit for somewhat different reasons.
3. The death of German statesman Stresemann in early October, and the deteriorating political situation in Germany in late October. (Right wing nationalist parties gained ground, threatening a recently crafted international war debt agreement.)
4. An October 26th administration decision to crack down on mergers (for anti-trust reasons.) George Bittlingmayer says the news may have reached the markets a few days earlier.
I have my doubts about how important these factors were to the stock market in October 1929, but in retrospect the first three factors should have been very important. Tight money depressed the economy until March 1933. A renewed fight over Smoot-Hawley in the spring of 1930 clearly caused a major stock market crash in May and June. And between mid-1931 and the end of 1932 the German crisis was probably the major factor depressing the U.S. stock market.
The 1937 October crash (which like the 1929 and 2008 crashes actually lasted from September to November) was just as interesting as 1929, and even more complex. First we need to consider a few basic facts:
1. In 1937 the U.S. was back in the international gold standard. It wasn’t much of a standard (with only a few countries), and Americans could no longer own gold (officially—but they hoarded it in London banks.) Nevertheless, our monetary policy was now at the mercy of shocks to the international gold market. Put simply, an orgy of gold dishoarding caused the US WPI to soar about 10% between mid-1936 and mid-1937, despite the depressed economy. Then between mid-1937 and mid-1938 it fell back my an equal amount. By itself, this would have caused a very strong period of growth in late 1936 and early 1937, and a mild recession thereafter. But that is not exactly what happened. The very strong growth in industrial production in 1936 leveled off in the spring of 1937, despite the expansionary monetary policy.
2. The second factor was the third of FDR’s five wage shocks, and the one least directly connected to government policy. Toward the end of 1936 and throughout much of 1937 union membership soared. The 1935 Wagner Act had made it much easier to organize unions, and FDR’s overwhelming victory in 1936 assured union organizers that Washington would support them in their battles. The resulting wage shock looks a lot like the WPI price bubble, except shifted a half year into the future. Wages started rising later, peaked later, and fell later than the WPI. In addition they fell by much less that prices. This is why output didn’t grow even faster in early 1937, and it’s also the factor that turned what would have been just a mild recession from the pullback if commodity prices, into a deep depression–comparable to 1920-21.
The real wage rate (nominal wages divided by the WPI) tracks monthly industrial production very closely throughout the 1930s, and 1936-38 is no exception. (Actually you have to invert the real wage series—as wages were countercyclical.) The economy boomed when real wages fell (due to the WPI rising faster than nominal wages, and fell when nominal wages rose much faster than prices. Some growth occurred when real wages were flat. So 1936-38 fits my overall model of the Depression. Then it all comes down to explaining wages and the WPI. The main exogenous factors influencing wages were the five New Deal wage shocks discussed in an earlier post. The WPI can be explained with a model of the international gold market when the price of gold is fixed (1929-33, 1934-40) or by changes in the price of gold itself in 1933-34—as in my Warren post.
Working with this model, I found that there were three factors pushing up prices in 1936-37. Central bank dishoarding of gold increased in late 1936, as countries such as France abandoned the gold standard. Another factor was increasing Russian gold sales, along with the (incorrect) expectation that much more was coming from Russia. And this also led to private dishoarding, motivated by both the collapse of the gold standard in Europe (no longer a need to hoard gold in expectation of future devaluation), and fears that the huge gold flows to the US would prove so inflationary that FDR would be forced to revalue the dollar upward. This is what the Paul Einzig quotation in my “worse than economists expected. . . ” post was referring to.
For very complex reasons this process started to reverse in mid-1937. As rising wages slowed the US economy, revaluation fears disappeared. The Russian gold sales that were expected never fully materialized. Gradually, gold dishoarding gave way to gold hoarding, as people saw that the U.S. was again sliding back into depression and investors worried that FDR might seek another monetary “shot in the arm,” just as in 1933. By the fall, devaluation fears grew rapidly and gold hoarding increased sharply. Gold inflows to the U.S. virtually ceased. Under the burden of high wages and sharply falling prices the U.S. slid into a deep depression, and stock and commodity prices fell sharply.
I find several interesting parallels between 1937 and 2008. Both years started with rapidly rising commodity prices all over the world, and ended with prices falling just as rapidly. One difference was that the 1936-37 boom was purely monetary, as the economy was still somewhat depressed. In contrast, the 2007-08 boom was driven by strong growth in developing countries.
An even more interesting parallel is the sharp reversal of expectations of medium term growth and inflation. In the first half of 1937 it was very obvious that both the financial markets and the press expected inflation to continue due to the expected swelling of the US gold stock. By the end of 1937 expectations had changed radically, and there was a perception (which turned out correct) that we were headed for a prolonged period of deflation. The WPI did decline almost continuously from mid-1937 to mid-1940.
When a similar sharp reversal of expectations occurred in October 2008, I immediately recalled the events of 1937 and began to fear that the trajectory of nominal growth could fall far below the 5% norm unless the Fed acted quickly and effectively. They did act quickly, but focused on the wrong problem—banking instability.
But the comparisons don’t stop there. In 1936-37 the Fed doubled reserve requirements in three steps. Given my recent criticism of the Fed’s interest on reserves policy (which raises the demand for reserves), you might expect me to blame the 1937-38 depression on this mistake. But that is too easy. Investors initially paid little attention to the moves, as they lacked credibility. The financial press indicated that the huge gold flows would overwhelm any Fed attempts at sterilization, and speculators drove commodity prices sharply higher in expectation that the Fed would be unable to restrain growth in the money supply.
The Fed’s big mistake didn’t come until late 1937, when they did not act aggressively enough after expectations turned around in the gold market. But (unlike 1929) monetary policy was not the only culprit in 1937, the wage shock also played a major role in the depression.
Someone will probably ask me about fiscal policy. The payroll tax instituted in 1937 was fairly small, but it did play a modest role in the wage shock, as it increased the cost of labor to employers. Beyond that, the role of fiscal policy was minor. To the extent that the 1937-38 depression was due to lack of demand (let’s say the depression was 50% wages and 50% deflation for the sake of argument), fiscal policy played at best a very minor role. The sharp deflation of 1937-38 was clearly linked to a turnaround in the world gold market, just as the previous inflation of 1936-37 had been. The timing is all wrong for fiscal policy. Like the monetarists, Keynesian economic historians overlook the need to link up their account of policy mistakes with contemporaneous movements in the commodity, stock, and bond markets. I believe that I am the only one to provide that sort of comprehensive analysis of the Great Depression.
There are many factors that played a role in the monetary policy errors that led to a sharp fall in stock markets, commodities markets, industrial production, and bond yields in the fall of 2008. The two most important were the commodity price boom and the financial crisis.
Notice I don’t say the commodity boom and financial crisis caused the fall in AD, I said they led to the monetary policy errors that caused this collapse. In the first half of 2008 growth was modest, but positive. Stocks held up pretty well, still within about 10% of their record highs in early June. The world economy was even stronger, which explains the extraordinary commodity price boom that peaked in July. It was the second half of the year when the key mistakes were made. It is useful to distinguish between the 3rd and 4th quarters, and also two types of policy mistakes.
In the 3rd quarter policy continued to be optimal in the Lars Svensson sense; the internal Fed forecast for growth in nominal spending was close to the Fed’s target. This is shown by the fact that the Fed still viewed the risks of inflation and recession as being roughly equally balanced in their September 16th meeting, when they decided to stand pat. But the private sector was probably already ahead of the Fed in understanding what was going on. We now know that nominal growth slowed sharply in the 3rd quarter. Industrial production (which had held up for two years of housing recession), began falling sharply in August. Basically the Fed made two mistakes in the third quarter. First they put too much weight on internal forecasts and not enough weight on market forecasts. And second, they focused too much on inflation, and not enough on nominal GDP growth. (Notice how NGDP consistently provides better signals to policymakers than inflation—recall the 2004-06 housing bubble as well.)
In the 4th quarter of 2008 things immediately got much worse. By mid-October it was obvious to me (and I think to almost everyone) that monetary policy had lost credibility even by the looser Svenssonian standards—that is, even the Fed’s internal forecast was now far below the policy target. Even worse, the markets understood that rates were approaching zero and that the US could easily slide into a Japanese-style situation, which could persist for years. The only way to prevent that from occurring would be through aggressive steps to enact unconventional monetary policies—it was probably too late to simply swap base money for T-bills.
Unfortunately, the Fed made two key mistakes. First, after going 5 months without a rate cute, the Fed adopted the highly deflationary policy of paying interest on reserves, which negated any expansionary effects their base expansion might have had. But even worse, they got distracted from monetary policy under the erroneous assumption that the financial crisis was the “real problem,” and had to be cured before AD could be boosted. This is certainly an understandable mistake. I recall in October 2008 being one of the very few economists who worried that the real problem was monetary, not financial. And the financial crisis certainly played a big role in the recession in two ways.
1. It distracted policymakers.
2. It reduced the Wicksellian equilibrium rate required for macro stability.
The crisis depressed the effective demand for credit so sharply that fears of a liquidity trap developed. It didn’t cause the sharp fall in AD, but it made the Fed’s job much harder. But it is important to remember that the Fed itself claims their job is to stabilize prices and output, they themselves say their duty is too offset shocks to money demand and velocity, they themselves acknowledge that their responsibility to be proactive, especially when there is a threat of deflation, they are the ones who have said that market indicators also provide useful signals. Bernanke has written that monetary policy can still be effective at zero interest rates. They failed, even according to their own criteria.
This quick summary glossed over many important details. My chapter on 1929-30 is roughly 40 pages. The two chapters on 1937-38 are even longer. The manuscript is 14 chapters. You still need to buy my book (if it ever finds a publisher.) 🙂
I will continue to touch on other aspects of the Depression in this blog.