For this lecture, I am going to speak in my own voice, not Claude’s.
There are many plausible causes of the Great Depression. I will examine many narratives. The one that appeals to me most is a narrative that emphasizes the collapse of banks and other financial intermediaries.
A severe attack of … What?
In other words, what happened to the United States in the 1930s was a severe attack of contagious laziness!
In the 1970s, some economists at the University of Minnesota wanted to explain unemployment as “intertemporal substitution.” Workers were saying “I’m better off working tomorrow than today.” Franco Modigliani, one of my professors at MIT, pointed out the absurdity of trying to apply this to the Great Depression.
The alternative approach, favored especially by Keynesians, is to treat an economic slump as caused by a drop in “aggregate demand.” I think that this could be called a severe attack of contagious satiety. All of a sudden, people no longer want the goods and services that they wanted yesterday.
In the 1930s, people were not feeling unusually lazy. Neither were they feeling satiated. They wanted to work, but they could not find jobs. They wanted to obtain more goods and services, but they could not afford to do so.
Folk Narratives
One variation on the “aggregate demand” story is “circular flow” theory, or what I call folk Keynesianism. The idea is that jobs create spending and spending creates jobs. There is a circular flow in which spending on goods and services leads firms to hire workers, and wages paid to workers lead them to spend.
Although this “circular flow” appears in freshman economics texts and in the high school AP economics curriculum, it is bogus economics, in that prices play no role. In proper economics, demand and supply are affected by prices. Prices are supposed to tend toward equilibrium values, at which there is neither excess demand nor excess supply.
Another folk narrative is “false prosperity.” According to this narrative, the good times of the 1920s were artificial. The Depression was a return to reality or a punishment for excess.
Again, standard economics does not allow for false prosperity. If an economy can produce a lot of output this year, there is no reason why it cannot produce a lot of output next year. As long as markets are working properly, the price and profit system serves to guide resources to their most productive uses.
From the standpoint of conventional economics, the Depression appears to be a massive failure to allocate resources. In particular, mass unemployment looks like an excess supply of workers that the markets could not correct. The usual adjustment mechanisms apparently failed to operate.
Monetary narratives
Monetary narratives are stories in which the money supply contracts, causing prices of outputs to fall. Wages do not fall, so that for producers the cost of labor is too high. They reduce output and labor demand, and unemployment results.
For the period 1929-1933, the money supply contraction is blamed on the gold standard. The United States had set the value of the dollar as $20.67 per ounce of gold. At that price, speculators and foreign banks were sellers of dollars and buyers of gold, reducing our gold reserves. To defend our gold holdings, the Fed had to raise interest rates and lower the money supply.
This was difficult to understand at the time, and even now it is somewhat puzzling. The whole idea of a gold standard is to provide an anchor for prices. Suppose that a pound of copper is worth one ounce of gold. Then if 20.67 dollars buys one ounce of gold, it should buy one pound of copper. Yet the monetarist narrative says that as the demand for gold rose and the money supply fell, the price of copper (and other commodities) plummeted. Stabilizing the dollar price of gold, which is supposed to anchor prices, instead resulted in extreme deflation.
The gold standard story is probably the most popular narrative among economists today. But as you will see, I prefer the financial contraction narrative.
Productivity
Another narrative is that labor became too productive. Unemployment rose because the same output could be produced using less labor. But this narrative implicitly assumes that there is a fixed “lump of demand” for output. Instead, it would make more sense for the demand for output to rise as productivity goes up.
The opposite narrative is that labor became too unproductive. That is, because of new regulations, the cost of production rose and firms reduced output and labor demand. This causal mechanism works like the mechanism of an increase in real wages. It makes labor too expensive, resulting in cutbacks.
The Financial Sector Contraction
According to this narrative, the collapse of the banking system served to reduce output. Ben Bernanke suggested that bank lending requires an ongoing relationship between banks and borrowers. As banks failed, these relationships were severed, and lending declined.
My own view is similar, but it does not depend on specific relationships. I see households and firms as wishing to hold riskless short-term assets (like checking accounts) while issuing risky long-term liabilities (like borrowing to buy a house or start a business). The financial sector accommodates this by having a balance sheet with the opposite characteristics: riskless short-term liabilities backed by risky long-term assets.
Banks are able to combine long-term lending with short-term checking accounts by using diversification across customers, careful choices of risks, and maintaining confidence of depositors. If depositors lose confidence, too many depositors try to withdraw funds at once, and the risky long-term assets of the banks cannot be sold to cover the bank runs.
In this narrative, confidence in the banking system is self-fulfilling. When people trust banks, banks can do more lending. This supports more economic activity. By the same token, loss of confidence in banks can be self-fulfilling. Bank runs force banks to reduce lending and even to close altogether, forcing economic activity to contract.
My preferred narrative of the Great Depression is that a self-fulfilling contraction of financial intermediation took place. This included the stock market, where people put their faith in the 1920s and lost faith in the 1930s. It included the markets for corporate bonds, where nominal interest rates for low-risk firms in the 1930s were 5 percent, and with deflation taking place real rates were even higher. Moreover, the risk premium of Baa corporate bonds over Aaa corporate bonds was an additional 5 percent. These high interest rates reflected a severe shortage of financial intermediation. Incidentally, they refute the relevance of a “liquidity trap,” which would occur if interest rates approached the lower bound of zero.
Financial intermediaries support economic activity by allowing households and firms to undertake risky, long-term projects. But this requires people to have confidence in banks and other intermediaries. When confidence fell, financial intermediation collapsed, and economic activity fell in response.
While the collapse was sudden, the recovery was more gradual. And it was interrupted by the 1937-38 recession. People did not yet have much confidence in financial intermediaries. This confidence took decades to recover. It fell again in the 1970s, when high inflation once again undermined it (and also refuted the idea that high inflation would help boost employment). In subsequent decades, confidence recovered again, until the Financial Crisis of 2008. But this is taking us outside of the period covered by these lectures.
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