Economic_Lessons_from_the_Great_Depression

“What lessons from the great depression are relevant to restoring the global economy following the recent financial crisis'” 1. Introduction: An understanding of the Great Depression is considered by some economists as the holy grail of macroeconomics (Bernanke, 1994). Aside from giving birth to macroeconomics as a distinctive field of study, the experience of the Great Depression (1929-1939) continues to guide macroeconomists' beliefs and policy recommendations (Romer, 2009). It is useful to reflect on that episode and what lessons it holds for policymakers today in the midst of the current global recession. In particular, what can we learn from the 1930s that will help us to end the worst recession since the Great Depression and restore the global economy' While Romer (2009) acknowledges that we are experiencing a less severe crisis than the Great Depression, she emphasizes that there are parallels that make it a useful point of comparison and a source for learning about policy responses today. Drawing on both theory and empirical evidence from the period of the Great Depression, this essay provides an overview of the most relevant lessons in restoring the global economy. The organization of the paper has the next section presenting the traditional aggregate demand mechanism (macroeconomic stabilization) while section three focuses on the less advocated notion termed endogenous propagation, which has its roots in the aggregate supply mechanism. The final section concludes. 2. Macroeconomic Stabilization: The Great Depression provided economists with a new way of thinking- a shift from Classical economics which had proven to be ineffective, to the Keynesian school of thought (firstly introduced in1936) which endorsed Governments’ role through economic intervention as a remedy to recessions (Abel, Bernanke, & Croushore, 2008).[1] Keynesians subsequently proposed two approaches: i. An Increase in money supply/Monetary Stabilization. The quantity theory of money is a useful framework that can be used to understand movements of prices and output. The theory asserts that increases in the supply of money relative to the demand result in increased spending on goods, services, and assets (Steindl, 2008). The theory can be expressed in the following equation, where M is the nominal stock or supply of money, V is velocity or turnover rate of money, which is the opposite of the demand for money, that is the desire to hold it. P is the price level and y is real output. MV=Py An increase in M relative to V hence increases P and y. Using the AD-AS framework, Abel et al (2008) show that in a recession, an increase in money supply (through its effects of lowering interest rates in the asset market) will increase aggregate demand for goods and consequently setting-off higher levels of output (at least in the short run).[2] Post war research into the 1930s recovery strongly points out to growth of nominal money stock as the main driver of economic recovery. Steindl (2008) identifies various comprehensive studies that dealt with the recovery following the Great Depression. In 1963, Milton Friedman and Anna Schwartz showed that the broad movements in the stock of money were proportional to those in income and concluded that the rapid rate at which the money stock increased certainly promoted and facilitated the concurrent economic expansion (Friedman & Schwartz, 1963 in Steindl, 2008). Christina Romer reaches a similar conclusion and concedes to the crucial role growth of money stock played in the recovery. Furthermore she reveals that the United States economy, for instance, would have been 50 percent below its pre-depression trend path by 1942 if the money stock was maintained at its pre-depression levels (Romer, 1992). Ben Bernanke in 1994 similarly stressed on the importance of the growth of the money stock and how it was a basis of the recovery. He focused on the gold standard monetary system and showed that nations that pulled out of the system recovered at a faster pace as they had greater freedom to instigate expansionary monetary policies following the depression (Bernanke, 1994).[3] ii. An Increase in Government Purchases/Fiscal Stabilization. Macroeconomics theory posits that an increase in Government purchases shifts the IS curve (which represents equilibrium in Goods market) up and rightwards and therefore raising the aggregate demand and eventually output at any price level. For an economy that is in a recession, an increase in Government purchases will take the economy back to the full employment level of output (Abel et al, 2008). In the United States for example, the most widely accepted view explicitly emphasizes that the nation’s entry into World War II coupled with its resultant financing expenditure for armament is what ended the Great Depression (Steindl, 2007). Steindl (2007) proceeds to claim that unlike the monetary approach which was a view shared merely by economists, the notion that the war ended the Great Depression is a view held by the public in general. The following three decades after the Great Depression, Governments and policy- makers around the world opted for this approach and attempted to increase Government expenditure whenever faced by recessionary conditions (Black, Calitz, & Steenekamp, 2007). The United States experience also serves as an important cautionary tale for present policymakers. After only four years of recovery, the nation’s economy plummeted into a recession in 1937 owing much of this to the sudden preemptive withdrawal of fiscal stimulus (Steindl, 2008). Eventually, recovery will take on a life of its own as aggregate demand rises and consumer confidence and optimism are restored. But, before this happens, the economy has to be monitored closely to be sure that the private sector is back on its feet before Government withdraws its critical support (Romer, 2009). 3. Endogenous Propagation: Conventional wisdom dictates that macroeconomic stabilization was the driving force to recovery following the Great depression (Romer, 1992; Bernanke, 1994; Steindl, 2008). If the rising stock of money was fundamental to the recovery, and if we utilize the quantity theory of money (refer to Section 2 part i), prices and output would have been rising, as the aggregate demand for output, induced also by fiscal expansion, would have been increasing relative to aggregate supply. What baffled economists was the unexpected experience of over two years of deflation (May 1938 to August 1940) in the face of dramatically rising aggregate demand in the United States. Something else appeared to be driving the economy during the recovery, forces that were obscured by the seemingly dominant aggregate demand pressures (Steindl, 2008). This conundrum brought about the notion of endogenous propagation which has its roots in the aggregate supply mechanism. Steindl (2007) goes on to explain that when the economy is receding, it is not solely aggregate demand impulses that influence the movement toward trend but also impulses originating in the aggregate supply sector. One plausible cause of such impulses to aggregate supply would be declining real wages that would spur the hiring of additional workers (Abel et al, 2008). But with prices declining, it is unlikely that real wages would have fallen in the revival from the late 1930s depression.[4] The economic phenomenon behind the recovery was likely increasing productivity. Alexander Field presents evidence showing that the period 1929-1941 was, in the aggregate, the most technologically progressive of any comparable period in U.S. economic history (Field, 2003). Steindl (2008) attests to the large and abrupt productivity increases being an important factor explaining the puzzling behaviour of rapid recovery and the stubbornness of the unemployment rate.[5] 4. Conclusion: The emphasis on aggregate demand effect (macroeconomic stabilization) appears to be dominant in professional discourse as supported by vast literature (refer to section two). This particular view of the depression decade as a problem of insufficient aggregate demand ascribes the subsequent recovery to aggregate demand management, principally monetary expansion. One of the difficulties of macroeconomic interpretation, as of any scientific inquiry in general, is perhaps isolating a dominant mechanism from the combination of concurrent mechanisms that are operating (Steindl, 2007). The much-vaunted success of economic policy in the post-depression years thus should not be ascribed solely to aggregate demand actions. Forces intrinsic to and inherent in the economy were operating to move it toward its trend path and our understanding needs to be modified to allow for the influence of induced aggregate supply responses, the forces of endogenous propagation. If policy-makers continue to heed the lessons of the Great Depression, there is every reason to believe that the global economy will be restored sooner rather than later. Bibliography: Abel, A., Bernanke, B., & Croushore, D. (2008). Macroeconomics. Boston: Addison Wesley. Bernanke, B. (1994). The Macroeconomics of the Great Depression: A Comparative Approach. National Bureau of Economic Research , Working paper No 4814, 1-30. Retrieved January 25, 2010, from http://www.nber.org/papers/w4814.pdf Black, P., Calitz, E., & Steenekamp, T. (2007). Public Economics (3rd edition ed.). Capetown: Oxford University Press Southern Africa (pty) Ltd. Field, A. (2003) The Most Technologically Progressive Decade of the Century. American Economic Review , 93,1399-1413. Retrieved January 25, 2010, from http://econpapers.repec.org/article/aeaaecrev/v_3a93_3ay_3a2003_3ai_3a4_3ap_3a1399-1413.htm Romer, C. (2009). Lessons from the Great Depression for Economic recovery in 2009. The brookings Institution, (pp. 1-11). Washington DC. Retrieved January 25, 2010, from http://www.brookings.edu/~/media/Files/events/2009/0309_lessons/0309_lessons_romer.pdf Romer, C. (1992). What ended the Great Depression' Journal of Economic History , 52, 757-84. Retrieved January 25, 2010,from http://www.shsu.edu/~eco_www/resources/documents/WhatEndedtheGreatDepression.pdf . Steindl, F. (2008, March 16). Economic Recovery in the Great Depression. (R. Whaples, Ed.). Retrieved January 25, 2010, from http://eh.net/encyclopedia/article/Steindl.GD.Recovery Steindl, F. (2007). What ended the Great Depression' It was not World War II. Oklahoma State University. Retrieved January 25, 2010, from http://www.shsu.edu/~eco_www/resources/documents/WhatEndedtheGreatDepression.pdf ----------------------- [1] See The General Theory of Employment, Interest, and Money by John Maynard Keynes. [2] Classical and Keynesian economists have a consensus on money being “neutral” in the long run. See (Abel et al, 2008, p 335-336,341-343) [3] Gold standard monetary system dates back to early 18th century were the standard economic unit of account was a fixed weight of gold. [4] With a few exceptions, real wages increased throughout the deflationary period therefore being a detriment to increased supply and discarding the notion that they induced greater aggregate supply. See Steindl (2008). [5] This is a phenomenon termed “Jobless Recovery” where higher output is attained through increased productivity as opposed to higher labour input.