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)
o Possibly because of "overbuilding" in the 1920s; possibly a delayed effect
of the cut-off in immigration.
o 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