Monday, June 11, 2012

Balance sheet Great Depression?

Okay, let's recount three versions of the Great Depression story: the Federal Reserve contracted the money supply, causing the Great Depression (Friedman-Schwarz); the Federal Reserve and the insane Bank of France increased the demand for gold, causing the need for massive deflation and the Great Depression was the result (Hawtrey-Cassel-Thompson-Glasner), which I mentioned in my post A different perspective on the Great Depression; then the balance-sheet Great Depression where debt-deflation is the main cause (Fisher, Krugman), which I hinted at in Why intervention is necessary.  I'm still not sure which story I am most inclined to believe, but I'm not particularly sure that they are mutually exclusive.

For one thing, the money supply contracting would be pretty similar to the process involved in sticking to the gold standard as gold appreciated enormously.  And this might very well precipitate a sell-off in the financial markets, which could feed a cycle where declining asset values require the liquidation of other assets in a self-reinforcing cycle.

Consider the above graph, which shows the Dow Jones Industrial Average from 1918 until 1942, along with the rental component of CPI throughout that same (with a base of 100 in 1933). As one can see, the Dow Jones plunged from 1929 to a low sometime during 1932. Sometime in 1933 or so the Dow Jones Industrial Average started a recovery. I've seen representations of household debt levels that show them at roughly the level just prior to the recent crisis in 1929, so what we could be seeing is that, in accordance with the story that John Kenneth Galbraith represented in The Great Crash 1929. What occurs is a feedback loop from declines in asset prices, in this case, stocks, leading to margin calls, which require sales of assets, leading to further declines in asset prices and so on. Frankly, this is fairly compelling. As for what set it off, maybe the fact that stock prices were totally out of line with the underlying growth of the economy, but that's just a first stab. There also appears to have been a bit of a housing bubble, though not one that catastrophically "popped", but, instead, "deflated", which looks pretty clear from the trend before and after the 1920s to early 1930s bulge. This in contrast with our more recent housing troubles, which I discussed in Consumer spending battered by housing market.

Such an implosion of asset values left debtors holding a very large bag, which became heavier due to deflation.  The answer could be seen as (a) easing the debt burden of debtors (through inflation and debt relief), (b) propping up aggregate demand while there was gap between what society could supply and what consumers and businesses were willing to spend and (c) enacting a national balanced budget framework (just kidding!). It could certainly be argued that Franklin Roosevelt's occasional attempts to balance the federal budget were misguided and perhaps increasing taxes so precipitously as he and the  Democratic congress did might have been a mistake, although one could also see it as a transfer from low-spending persons with higher incomes to a government which needed to provide relief to lower income individuals (through workfare or the dole).

Another note, which detracts from this narrative somewhat, is that early in the Roosevelt administration, two things were done which may have helped bring recovery faster. The policy of "reflation" was announced, which basically is a price level target (not an inflation target), which said that the policy of the government was to attain a certain price level. Also, the United States government "suspended" the gold standard. I have a feeling Professor Glasner would identify these as major reasons why there was a rather sharp turnaround early in the Roosevelt administration, despite his "wrong-headed" experiment, National Recovery Act.

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