Last night I criticized a new Robert Hall article in the JEP, which argued that the financial crises of 1929 and late 2008 caused the Great Depression and the Great Recession. I pointed out that there was no financial crisis in 1929, and that it was the Depression that caused the later banking panics. I pointed out that the 2008 recession was well advanced before the banking crisis of late 2008 occurred. Undoubtedly those crises worsened each slump by further depressing AD, but they weren’t the cause—tight money was.
Soon after I read a new article by Lee Ohanian from the same journal that supported my argument regarding the Great Depression, and provided lots of new evidence for the current recession. Here he points out that the Great Depression could not have been caused by the financial crisis:
For example, many cite the fact that the number of U.S. banks declined by about 40 percent between 1929 and 1933 as a central reason why the Great Depression was “Great,” and draw inferences from this fact for the potential effect of financial crises more generically (for example, Reinhart and Rogoff, 2009). But most of the Depression-era banks that closed were either very small or merged, which indicates that the decline in banking capacity resulting from bank closings during the Depression was small. In fact, the share of deposits in banks that either closed or temporarily suspended operations for the four years from years 1930–1933 was 1.7 percent, 4.3 percent, 2 percent, and 11 percent, respectively (Cole and Ohanian, 2001).
Moreover, the Depression was indeed “Great” before any of the monetary contraction or banking crises identified by Friedman and Schwartz (1963) occurred. Figure 2 shows that industrial hours worked had declined by 29 percent between January 1929 and October 1930, which is not only before the first Friedman and Schwartz–identified banking crisis (November 1930 to January 1931), but is also before the money stock fell.
I agree with Friedman and Schwartz that the 1930s banking crises were important, but only because they led to the hoarding of base money, not for Bernankean disintermediation reasons. Indeed Ohanian misses his strongest argument here—the 1933 crisis was worse than all the others put together, yet 1933 was the first year of recovery, seeing brisk growth in industrial production and prices. You might argue; “But that’s because dollar devaluation pushed up AD in 1933.” Bingo—it’s all about AD, not disintermediation. Then Ohanian turns his attention to the current crisis:
The corporate sector typically has nearly as much cash as they invest in plant and equipment, and cash is relatively high during the last few years.
One possible issue with Figure 3, however, is that perhaps the cash reserves displayed in the figure are only being held in certain sectors while other sectors have little or no cash. To address this issue, Chari and Kehoe (2009, in progress) examine firm-level data from Compustat to compare firms that use external finance to those that do not. These data indicate that on average about 84 percent of investment is financed internally. Indeed, about two-thirds of investment is undertaken by firms not using external funds, and slightly more than half of the investment undertaken by those using external funds is still financed internally. . . .
Another assertion often made in the financial explanation is that small firms have much less access to capital markets, and thus small firms decline much more than large firms during crises. However, Cravino and Llosa (2010, in progress) show that there is virtually no change at all in the relative sales performance of small versus large firms during the 2007–2009 recession. They compare the share of sales accounted for by small, medium, and large firms during the fourth quarters of 2007, 2008, and 2009. The shares are virtually identical in these periods, indicating that firm sales growth was unrelated to firm size. This fact is thus inconsistent with a central assumption in the financial explanation.
The financial explanation also argues that the 2007–2009 recession became much worse because of a significant contraction of intermediation services. But some measures of intermediation have not declined substantially. . . . bank credit relative to nominal GDP rose at the end of 2008 to an all-time high. And while this declined by the first quarter of 2010, bank credit was still at a higher level at this point than any time before 2008.6 Similarly, flow of funds data show that borrowing levels of households and of the nonfinancial businesses that households own, are virtually unchanged since 2007, and that the composition of those liabilities across mortgages and other liabilities are also unchanged. These data suggest that aggregate quantities of intermediation volumes have not declined markedly. But perhaps the most challenging issue regarding the financial explanation is why economic weakness continued for so long after the worst of the financial crisis passed, which was around November 2008
I’ve consistently argued that if the AD was there then firms would have supplied the output, and I think most business people would tell you the same thing. Many have pointed to a Rogoff-Reinhart study that shows financial crises are usually followed by severe recessions. I have responded by asking “how many of those financial crises were associated with a sharp currency appreciation?” I believe the answer is “damn few,” and I often cite the US in the early 1930s, Argentina in 1998-2002, and the US in the last half of 2008. Note that in all three cases the financial crisis was caused by tight money, and in the first two cases rapid growth resumed almost immediately after the currency was devalued. Here’s how Ohanian addresses the evidence:
From the perspective of the financial explanation, the continuation of recession long after the worst of the crisis passed raises an important puzzle about why employment did not recover sooner. This question is not resolved simply by noting that economies often remain below trend for years following a significant financial crisis (Cerra and Saxena, 2008; Blanchard, 2009). In many of these cases, output remains below trend because productivity is far below trend (Ho, McGrattan, and Ohanian, 2010, in progress). But as documented above, the productivity deviation during the 2007–2009 U.S. recession was very small, which means that low productivity is not the reason why U.S. macroeconomic weakness continued.
Ohanian explores whether the Great Recession can be explained in a “neoclassical” (i.e. real business cycle) framework. He argues that the data on hours worked, productivity, etc, indicate that the marginal rate of substitution between labor and leisure had fallen far below the marginal productivity of labor. He speculates that various government policies might have created an implicit tax wedge in the labor market that discouraged employment. In my view this explanation suffers from some of the same problems as the financial disintermediation story—it doesn’t explain the sharp fall in NGDP and RGDP after June 2008. But in making his argument he keeps scoring points that indirectly support my alternative wage/price stickiness story. It’s like some alternative universe version of TheMoneyIllusion. We both agree that the standard story is wrong. We both agree on why it is wrong. But we disagree on which alternative story is better. I believe Ohanian has a very persuasive critique of the disintermediation story, and I very much want Ohanian to win in his attempt to discredit the mainstream story. Then the dispute will be between my sticky wage/price transmission mechanism for falling AD, and his tax wedge argument that relies on the sort of explanation put forth by people like Casey Mulligan:
A policy explanation for the 2007–2009 recession is that economic policies, including the 2008 tax rebate, the Troubled Asset Relief Program (TARP), the American Recovery and Reinvestment Act (ARRA), Cash for Clunkers, Treasury mortgage modififi cation programs, and other policies signififi cantly contributed to the recession. The common argument here is that these policies distorted incentives through their deficient design and also increased uncertainty about the underlying economic environment. . . .
For example, Mulligan (2010a) studies the possible effect of U.S. Treasury mortgage modification programs on the low employment rate by evaluating how the eligibility requirements for these programs implicitly raised income tax rates on some households to levels of more than 100 percent.
I think I know which alternative explanation will win out among mainstream economists.
PS. I did find one flaw in the Ohanian article. He seems to assume that US productivity did much better than German productivity during the recession. But this may be because he was only able to find employment data for Germany (which did not decline) whereas hours worked data in Germany (which did decline) might have told a different story