Lecture Seventeen
Rules vs. Discretion; the Great Depression
(Economics 100b; Spring 1996)
Professor of Economics J. Bradford DeLong
601 Evans, University of California at Berkeley
Berkeley, CA 94720
(510) 643-4027 phone (510) 642-6615 fax
delong@econ.berkeley.edu
http://www.j-bradford-delong.net
February 26, 1996
Administration
Rules vs. Discretion
Great Depression of 1929-1933
Spending Hypothesis
Money Hypothesis
Destabilizing Deflation
Next Time: Using the IS-LM Model for Reading the Wall Street
Journal
Administration
My conversations with David Romer...
Rules vs. Discretion
"Discretion" (or "authorities"): do what the Federal Reserve
feels like.
"Rules": money growth = 3% + (Unemployment rate - 6%)
More realistic today: rule is: interest rate = 2% + inflation -
(unemployment - 6%)
Reasons for rules:
- Minimize uncertainty
- Avoid political business cycle
- Avoid the time inconsistency of discretionary policy
Reasons for authorities:
We don't know enough to write a complete rule--there are always
surprises
Better to choose authorities and give them the proper
incentives...
Argument still goes on, with no sign of ending. But some facts (or
semi-consensuses):
- "Independent" central banks appear to have pluses but no
minuses
- Rules based on narrow monetary aggregates are less attractive
than they used to be
- "Successful" manipulations of the political business cycle are
relatively rare (even though economic prosperity has a lot to do
with reelection).
Great Depression
By far the most extraordinary economic disaster to have befallen
America was the Great Depression of 1929-1939. From the unemployment
rate rose from 3.2 to 25.2 percent. Real GDP fell by 30 percent;
gross investment fell by more than 85 percent--and the nominal
interest rate i (on prime private commercial paper) fell from 5.9
percent in 1929 to an average of 1.7 percent in 1933. On pages
275-281 Greg Mankiw runs through the Great Depression, dividing
accounts of how the Great Depression happened into two groups--the
"Spending Hypothesis" and the "Money Hypothesis".
Spending Hypothesis
The most important fact about the Great Depression as seen by
proponents of the "Spending Hypothesis" is that throughout the 1930s,
as production fell and unemployment rose, nominal interest rates
continued to fall. A recession that is produced by monetary
stringency--by a sudden tightening of monetary policy, as was the
case in 1979-1983--sees very high nominal interest rates.
Since the Great Depression was not caused by monetary
stringency--since, at least as measured by interest rates, there was
no monetary stringency (and, in fact, the "real" liquidity of the
economy did not fall between 1929 and 1933 because the price level
fell as fast as the money stock. 1933's real money stock was less
than 4% below 1929's)--it must have been caused by a spending
shock.
Possible candidates for a spending shock:
- Collapse of investment (from $40 down to $5 billion dollars at
1958 prices between 1929 and 1933)
- Possibly because of "overbuilding" in the 1920s; possibly a
delayed effect of the cut-off in immigration.
- Possibly a result of other forces: bank failures and
investment.
- Multiplier-induced fall in consumption (from $140 down to $113
billion).
- Contractionary fiscal policy; Herbert Hoover and budget
balance; bipartisan.
- Fall in consumption in late 1929 as people wait and see after
the stock market crash (Christina Romer)
But this is not fully satisfactory. Why should investment
suddenly collapse by more than 85%?
Hence, Money Hypothesis
Best known advocates are Friedman and Schwartz, who say that monetary
forces "caused" the Great Depression.
Using the IS-LM model, we might interpret the money hypothesis as
explaining the Depression by a contractionary shift in the LM curve.
Seen in this way, however, the money hypothesis runs into two
problems.
- First, the behavior of real money balances. Monetary policy
should lead, in the IS-LM model, to a contractionary shift
in the LM curve only if real money balances fall. Yet real money
balances did not fall significantly in the Depression.
- Second, the behavior of nominal interest rates. Not at
all like 1979-1983.
So general conclusion: when Friedman and Schwartz write that
monetary forces "caused" the Great Depression, they are using a
peculiar definition of "cause": they think that monetary policy
could have averted the Great Depression, but did not.
Destabilizing Deflation
But easy to see attractiveness of money hypothesis. Spending
hypothesis is, what? That investment demand simply collapsed one day,
for no reason, by more than 80%? Not fully satisfactory.
The line of explanation that I think is most likely to be true--that
I wrote my first and third articles ever on, in fact--hinges on the
fact that the interest rate in the "LM" curve is a nominal and
the interest rate in the IS curve is a "real" interest rate. And here
let me proudly announce my complete and enthusiastic agreement with
Greg Mankiw's treatment of the issue, which I think is superb on
pages 278-281.
From 1929 to 1933 the U.S. price level fell by a quarter--and it was
this deflation that turned what in 1930 or early 1931 was a
typical economic downturn into an unprecedented Great Depression.
- Debt-deflation: effects of bankruptcy...
- Destabilizing deflation: effects of expected deflation
on real interest rates; think: if you just stuff your money under
the mattress, you will be able to buy 10% more in terms of real
commodities next year.
So consider:
(1) Y = C(Y - T) + I(i - E(p)) + G
(2) M/P = L(i, Y)
and let's take an equilibrium, and suddenly shift E(p)--for which
Greg Mankiw's textbook writes a little Greek letter "pi" with an "e"
superscript. What do we find? Well, if we have plotted the nominal
interest rate "i" on the vertical axis, we find we have suddenly
shifted the IS curve down by a lot. If we have plotted the real
interest rate "r" on the vertical axis, we find we have suddenly
shifted the LM curve up by a lot.
What sudden shifts in expected inflation (or deflation) do is they
break the link between shifts in i and shifts in r.
Thus between 1929 and 1933, money can be "loose" in the sense of
nominal interest rates being low, yet credit can be "tight" in the
sense of very high real interest rates--because of expected
deflation.
- Would monetary policy have stopped the Great Depression?
Maybe. Potential problem: liquidity trap. Potential solution: act
on the price level directly.
In a sense the economy has become a snake that eats its own tail:
there is deflation because people fear a Great Depression, yet the
only reason to fear an Great Depression is the existence of general
deflation.
Next Time: Using the IS-LM Model for Reading the Wall Street
Journal
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