Back to the Great Depression Debates

Or…Salt Water/Fresh Water Redux!


Figure 1: Log GDP (1996$), 1900-1967 (blue line), and linear trend (red line). Source: S.B. Carter, S.S. Gartner, M.R. Haines, A.L. Olmstead, R. Sutch, G. Wright, Historical Statistics of the United States, Millenial Edition (CUP, 2006).

From Greg Mankiw’s blog, an argument against the New Deal policies.

Lessons from the Past

UCLA econ prof Lee Ohanian:

There are many historical precedents of bad policies following crises. The worst case was after the stock-market crash in October 1929, which produced a truly perfect storm of bad policies. Tax rates rose, tariffs rose (reflecting special interest groups attempting to insulate domestic producers from foreign competition), and both Presidents Herbert Hoover and Franklin Roosevelt strongly promoted industry-labor cartels that were designed to stifle domestic competition.

In the absence of these policies, the Great Depression would almost certainly have been like every other U.S. recession — short-lived and relatively mild. Normal recovery didn’t begin until the most onerous of these policies were reversed, a process that didn’t begin until the end of the 1930s when antitrust activity was resumed, and during World War II when the National War Labor Board reduced union bargaining power by limiting negotiated wage increases to cost-of-living adjustments only….

I am particularly concerned about bad policies because significantly higher taxes have been proposed by Barack Obama. His plan would raise the marginal tax rate on the most productive workers more than 10 percentage points — an increase that would bring us near Western European levels. His plan would also raise capital income taxes, taxing capital gains and dividends at 20%, compared to a 15% rate under Sen. John McCain’s plan. A five percentage-point difference might strike you as small, but it is not. I have calculated that a five percentage-point difference in overall capital income taxation over the long haul is equal to a difference in the nation’s capital stock of about 18%. This means a 6% difference in GDP and a 6% difference in the average wage rate. This means that real GDP and the average wage would fall, gradually but persistently declining about 6% after 25 years. That’s not quite a Great Depression, but a significant step towards one.

Here’s a link to the Cole-Ohanian paper (ungated working paper version) which is the basis for the view that the New Deal policies exacerbated the decline in output during the Great Depression.

While the types of macro models that Ohanian uses to analyze the New Deal policies are not the ones I work with, I have always wondered how robust the results are. Here’s one paper which suggests the results are not robust. From the abstract to Gauti Eggertson, “Was the New Deal Contractionary?”

Can government policies that increase the monopoly power of firms and the militancy of unions increase output? This paper studies this question in a dynamic general equilibrium model with nominal frictions and shows that these policies are expansionary when certain “emergency” conditions apply. These emergency conditions — zero interest rates and deflation — were satisfied during the Great Depression in the United States. Therefore, the New Deal, which facilitated monopolies and union militancy, was expansionary, according to the model. This conclusion is contrary to the one reached by a large previous literature, e.g. Cole and Ohanian (2004), that argues that the New Deal was contractionary. The main reason for this divergence is that the current model incorporates nominal frictions so that inflation expectations play a central role in the analysis. The New Deal has a strong effect on inflation expectations in the model, changing excessive deflation to modest inflation, thereby lowering real interest rates and stimulating spending.

So, a lot hinges upon one’s feelings regarding the stickiness of prices. As a person who taught graduate students the Mankiw menu cost model from Mankiw and Romer’s, New Keynesian Economics (MIT Press, 1991), I’m on the side of nominal rigidities, and hence the model that re-establishes the conventional wisdom regarding the New Deal policies. But, if you feel that prices are fully flexible (i.e., somehow you’ve missed the fact that the prices at your local restaurant are moving around day by day), then you should side with Cole and Ohanian’s perspective.

Regarding Ohanian’s calculation of the tax impact, it’s not clear from the text exactly what assumptions are made to obtain these effects. We do know that assumptions regarding whether deficits are run are not when taxes are cut yield drastically different results for output — see this point illustrated in sharp relief in the context of the 2006 Treasury study [1].

By the way, the deterministic trend line (red) in Figure 1 has no meaning aside from highlighting the movement down in GDP during the Great Depression. For a statistical analysis of the time series properties of real GNP over a long span, see Cheung and Chinn, “Further investigation of the uncertain unit root in GNP,” Journal of Business and Economic Statistics, 1997 (NBER Technical WP version) (We find that over a long time span, GDP does appear to be trend stationary.) .

Originally published on Oct 8, 2008 at Econbrowser and reproduced here with the author’s permission.

3 Responses to “Back to the Great Depression Debates”

MikeOctober 9th, 2008 at 1:43 pm

While government policies walling off trade, are important causes of the events of 1928-38, what is more important in the inner-war period, is the time between the hot wars was an economic war. Also the Federal Reserve and the Bank of France were drawing gold from the global monetary system, creating deflation

AnonymousOctober 9th, 2008 at 2:32 pm

Prices at restaurants do not change day to day but that is because restaurants have menus and because restaurants have regulars who quickly react to even small price changes and also represent a large percentage of their business.However this is not the case at other businesses. Go to Walmart, Home Depot, Futureshop and you will see that prices change every single week. Repricing is a constant activity in these stores. Menzie chose his example carefully…I could change it to : somehow you’ve missed the fact that the prices at your local gas station are moving around day by day.

GuestNovember 26th, 2008 at 2:07 am

Presumably this logic also means that as soon as it becomes clear that the hoped-for pattern of inflation expectations are not being produced, then the policy should promptly be discarded. The display of magic tricks tried in the 1930′s didn’t in fact induce the desired set of inflation expectations. There is surely less reason to believe it would work, if at all, for very long today. It’s too obvious to too many people what the result of impeding a necessary set of structural adjustments is likely to be.

Most Read | Featured | Popular

Blogger Spotlight

Håvard Halland Håvard Halland

PHåvard Halland is a natural resource economist at the World Bank, where he leads research and policy agendas in the fields of resource-backed infrastructure finance, sovereign wealth fund policy, extractive industries revenue management, and public financial management for the extractive industries sector. Prior to joining the World Bank, he was a delegate and program manager for the International Committee of the Red Cross (ICRC) in the Democratic Republic of the Congo and Colombia. He earned a PhD in economics from the University of Cambridge.