Mark Sadowski on Koo and the Great Depression

One of my favorite commenters has done an excellent post discussing Richard Koo’s views on the Great Depression.  Here’s a small portion of the post (by Mark Sadowski, but published on Marcus Nunes’s blog):

The key point is there was no shortage of debt to be placed on the asset side of Federal Reserve member bank balance sheets. Member banks’ share of credit market debt declined from 18.3% in 1929 to 14.8% in 1933 before increasing to 17.4% in 1937, so it would seem, in line with our previous reasoning,  the decline in member bank balance sheets was more due to the shortage of deposits than the shortage of credit market debt.

Extending Koo’s diagram to the final year of the expansion reveals that member banks increased their holding of private debt from 1933 to 1937 almost as much as their holdings of public debt. Furthermore, the rate of increase in general government debt during the contraction from 1929 to 1933 (34.8%) was almost as great as its rate of increase during the expansion from 1933 to 1937 (36.2%). And finally, the rate of increase in nominal GDP was so great during 1933-37 that credit market debt as a percent of GDP declined in every single sector (i.e. household, business and financial), including the government sector, which fell from 72.0% to 60.2% of GDP.

We don’t have detailed sector balance sheets for these years, but according to “Studies in the National Balance Sheet” by Raymond W. Goldsmith and Robert E. Lipsey, private sector assets fell from $923.4 billion to $665.0 billion between 1929 and 1933, or by $258.4 billion. Private sector financial assets fell from $540.9 billion to $389.9 billion or by $151.0 billion, accounting for 58.4% of the decrease in private sector asset value. Private sector holdings of stocks fell from $186.7 billion to $101.5 billion, or by $85.2 billion, accounting for 56.4% of the decline in private financial asset value, and nearly a third of the total decline in private sector assets.

We hear a lot in the media today about the effect of QE on the stock market. Well, in an act that was essentially the QE of its day, FDR took the country off the gold standard in April 1933 and allowed the price of gold to rise from $20.67 an ounce to $35.00 an ounce by January 1934. This price was high enough to attract a large gold inflow from abroad which the Treasury monetized by issuing gold certificates to the Federal Reserve. The monetary base, which had been rising at roughly a 6% annual rate since around mid-1930, skyrocketed upward, reaching a maximum year-on-year rate of increase of 23.0% in February 1935. In turn, the stock market, which reflected an economy starved for aggregate demand (AD), soared as well. The Dow Jones Industrial Average (DJIA) more than tripled from March 1933 to November 1936, before the decision to start sterilizing gold inflows in December 1936 meant prematurely removing the punch bowl, leading to the 1937 Recession:

A few comments:

1.  The 1933 devaluation was actually more powerful than QE, because of its big impact on expectations.  However the recovery was aborted in July 1933 when FDR raised wages by 20%.  After growing 57% between March and July 1933, industrial production showed no increase over the following two years.

2.  In my view there is no such thing as “balance sheet recessions.”  Changes in balance sheets reflect sunk costs and benefits, and hence don’t impact the incentive to produce new output.  Recessions are caused by a fall in NGDP relative to sticky wages–which means bad monetary policy.



15 Responses to “Mark Sadowski on Koo and the Great Depression”

  1. Gravatar of Paul Paul
    2. June 2013 at 09:10

    It’s possible that if the us government cut one trillion dollars in one year and at the same time the FED target 5% NGDP growth the economy doesn’t contracts? and in that case we will have god deflation like Selgin pointed out?

  2. Gravatar of Paul Paul
    2. June 2013 at 09:31

    Sorry i mean “would” have god deflation like Selgin pointed out?

  3. Gravatar of Becky Hargrove Becky Hargrove
    2. June 2013 at 10:36

    I neglected to thank you for your contribution (at Nunes post)so want to do that here. Thanks!!

    I so agree that there is no such thing as a balance sheet recession, which as you say is about sunk costs (or passive elements). NGDP reflects ongoing movement and not what already “happened”.

  4. Gravatar of ssumner ssumner
    2. June 2013 at 10:36

    Paul, There wouldn’t be any deflation.

  5. Gravatar of W. Peden W. Peden
    2. June 2013 at 11:03

    Mark Sadowski is indeed a very good commenter!

    Incidentally, this is from a while ago now, but I never realised that Deepak Lal was a Market Monetarist-

    3:55 – argues for a bigger role for monetary policy in solving the European economic crisis and endorses monetary stimulus as an offset for fiscal austerity. He does raise worries about the most recent monetary stimulus from the US Fed and wrongly raises the threat of hyperinflation, but even then I would agree with him that targeting unemployment is a bad idea; one advantage of a NGDP target is that it means addressing the kind of unemployment that central banks can prevent (or rather, not cause) without the dangers of trying and failing to inflate our way below the natural rate of unemployment. The first principle of monetarism, after all, is the long-term neutrality of money.

  6. Gravatar of Mark A. Sadowski Mark A. Sadowski
    2. June 2013 at 11:44

    “The 1933 devaluation was actually more powerful than QE, because of its big impact on expectations.”

    Naturally I agree. (NGDPLT anyone?)

    In preparing this post I also produced some materials related to the Japanese QE and the contrast between that and FDR’s “QE” is rather striking. Although I believe the Koizumi Boom is greatly underappreciated, clearly the Japanese QE failed to accomplish more precisely because they failed to change their target.

    P.S. Much thanks to all who have expressed their thanks and/or appreciation.

  7. Gravatar of Saturos Saturos
    2. June 2013 at 12:23

    I think Koo would try and tell Scott that “debt overhangs” impact the ability of an economy to produce NGDP. Scott would then reply that this is nonsense as shown by Japanese yen depreciation. Koo would then argue about the halt in Japanese currency fall and stockmarket rise, and Scott would reply that if all BoJ members honestly believed they could boost NGDP then they always would. It would then devolve into an argument about expectations fairies.

    Yes, excellent post Mark.

    W. Peden, glad to know, he is a really intelligent economist, and I like to see that being right in some areas of deep economic understanding correlates with being right in others.

  8. Gravatar of kebko kebko
    2. June 2013 at 18:25


    To what extent do the extremely low layoff numbers in the JOLTS data undermine the theory that sticky wages are still a significant issue?

  9. Gravatar of John John
    3. June 2013 at 04:51

    I think that this econtalk podcast is the best take on the Great Depression that I’ve heard so far.

    Rustici traces the 1929 collapse of the stock market to the Senate passing the Smoot-Hawley tariff and then explains how the tariffs, eventually passed in mid-1930 destroyed the export markets that farmers in particular relied upon leading to a string of bank failures beginning in rural midwestern and southern states. These banks failures then spread as bank failures do and created the collapse of the money supply that made the depression great.

    I particularly like the lesson that looking at things in an aggregative C+I+G+X-M framework misses large impact that microeconomic dislocations can cause.

    Yes the Fed could have done more, but it was terrible supply-side policies that caused the great depression. Without Hoover passing the bill or trying to stop companies from lowering wages, 1930 would probably have been an ordinary recession like 1920.

  10. Gravatar of ssumner ssumner
    3. June 2013 at 05:12

    W. Peden, Thanks but it might be a stretch to call him a MM.

    Mark, I agree.

    Saturos, Surely there can no longer be a serious debate about “expectations fairies?” Does anyone still believe the Japanese are incapable of depreciating the yen? Or that the Swiss are incapable of depreciating the franc? Even today?

    kebko, The major problem today is that sticky wages among the already employed is slowing new job formation, not causing layoffs.

    John, A couple points.

    1. Smoot-Hawley did not cause the 1929 crash, but did contribute heavily to the mid-1930 crash. So he’s partly right. In 1929 the odds of S-H passing was actually decreasing as the stock market crashed.

    2. Hoover’s sticky wage policy was a problem, but the 1921 recession was roughly as deep as the 1930 recession. (Both were very deep.) The 1921 recession was not an “ordinary” recession.

  11. Gravatar of OhMy OhMy
    3. June 2013 at 06:38

    I think you are completely wrong on the balance sheet recessions.

    “Changes in balance sheets reflect sunk costs and benefits, and hence don’t impact the incentive to produce new output.”

    Yes, but they have huge impact on whether you can obtain financing to purchase said output. That is the crucial insight of Keynes and Marx: productive economy may run out of means of finance the necessary spending.

    Recessions are caused by a fall in NGDP relative to sticky wages-which means bad monetary policy.

    “Recessions are caused by a fall in NGDP relative to sticky wages-which means bad monetary policy.”

    Fall in spending is caused by lack of demand for credit by people who deleverage and lack of supply by banks to those who have weak balance sheets. None of these can be cured by monetary policy.

  12. Gravatar of John John
    3. June 2013 at 09:18


    The timing of Smoot-Hawley going through the Senate and the market crash is too good to be a coincidence. According to Rustici, there were 16 senators refusing to pass the bill who caved and agreed to sign it in returns for tariffs for their constituents on October 21st, 1929. This is right at the start of the market crash. In addition, the economy did enter a recession in the third quarter so it seems like the market reacted to the news of recession and Smoot-Hawley with a dramatic sell-off.

    It looked like Smoot-Hawley wouldn’t pass in late 29-early 30 but when it was signed in 1930 the market fell again.

    The interesting point is that real supply side issues can have monetary effects. Under the gold standard constraint, it would have been very difficult for the Fed to ease policy enough to offset a banking panic. I wonder even if they had the liquidity to truly act as an effective lender of last resort given their inability to create currency the way they can now.

    Another thing that I think is important is that for the first time, the Fed didn’t follow Bagehot’s dictum in a financial panic and actually did act to cut rates. While that kind of thing may be appropriate today, it was not appropriate under a gold standard. A hands-off approach works better to recessions under a gold standard because it allows you to protect your gold reserves. Since the Fed did not protect their gold reserves, they had to sharply raise rates at the height of the depression in 1932.

  13. Gravatar of OhMy OhMy
    3. June 2013 at 12:10

    Btw, the devaluation wasn’t a “1933 devaluation” but a “1934 devaluation”. Interestingly prices started rising before the devaluation, at least 6 months before. To most people it means the devaluation hasn’t caused the rise.

  14. Gravatar of ssumner ssumner
    3. June 2013 at 17:12

    OhMy, A fall in NGDP due to a shortage of credit can be addressed with a more expansionary monetary policy, as FDR showed in 1933.

    John, The problem with that theory is that passage of Smoot-Hawley actually became LESS likely in the month after October 21. So while you may be right about that specific day, it doesn’t explain the much bigger crash that occurred in the later part of October.

    I discuss this issue in more depth in my book, which will be out later this year.

    As for protecting their gold reserves, they were actually overprotecting during the key October 1929 to October 1930 period, when the US gold reserve ratio actually rose sharply (an insane policy during a depression.) They should have cut rates even more sharply in 1930. In 1931 and 1932 your argument is more defensible, but it’s all so complicated that counterfactuals are almost impossible.

    The main reason they had to raise rates in October 1931 was that foreign speculators (correctly) reasoned that if Britain left gold, the US might also. It wasn’t primarily due to a lack of US gold reserves—they had a lot. I’m not saying even greater reserves might not have helped, but the fear of devaluation for macro reasons was also a factor. The actual devaluation of 1933 occurred while the US had the world’s largest gold stock.

    OhMy, Technically it was “depreciation,” which occurred from April 1933 to February 1934. The legal devaluation occurred in 1934, as you said, but the currency depreciation occurred in 1933, and that’s what drove up prices.

  15. Gravatar of gregunyk gregunyk
    4. June 2013 at 21:29

    2. In my view there is no such thing as “balance sheet recessions.” Changes in balance sheets reflect sunk costs and benefits, and hence don’t impact the incentive to produce new output.

    Professor Sumner is clearly right that debt itself shouldn’t have a direct effect on incentives to invest, but if you apply a kiotaki-moore style external finance premium, changes in net worth would have real effects. That was bernanke’s big thing, wasn’t it?

Leave a Reply