Please take a close look at the data from the Great Depression, before doing more posts claiming I don’t know the facts.

Mike Kimel continues to insist that I don’t know what was going on in 1933, a period I’ve spend 20 years studying.  He insists that FDR’s dollar depreciation program began in October 1933, even though all economic historians agree in began in mid-April 1933, when the exchange rate for the dollar began declining (against gold and against other currencies.)  He insists prices began rising before FDR took office off, which is not true.  He presents a graph that he claims shows prices rising before FDR took office, but his graph shows inflation rates, not the price level.  In fact, the graph actually supports my argument that inflation didn’t turn positive until after FDR took office.  There’s a difference between the rate of inflation and the price level.

When I complained that Keynesian theory wasn’t able to explain the rapid inflation of 1933-34, a period of massive economic “slack,” he responded:

The problem for Sumner is that Keynesian theory is merely an extension of good old fashioned Adam Smith. Prices depend on supply and demand. You can have a good or service go up in price locally even as it goes down everywhere else.

Keynesian theory is just supply and demand?  Then why not call it ‘Smithian Theory.’  In any case, I was discussing the overall price level, not individual prices.  I could go on, but perhaps that’s enough.

PS.  Ironically, his post is entitled “Scott Sumner digs deeper.”

Every few months I get attacked by the Angry Bear blog.  Here Mike Kimel questions my interpretation of the 1933-34 inflation, which I attribute to dollar depreciation:

I see a much simpler story.

1.Aggregate demand was very slack when FDR took office.

2.FDR showed up in Washington with a plan to start spending a lot of money and thus boost aggregate demand.

3.The immediate effect was to convince factories they’d be running down their inventories. That boosted producer prices. It had a much smaller effect on consumer prices because everyone knew the gubmint was going to buy a heck of a lot more producer goods than consumer goods. (The government did buy some consumer goods for the various programs, plus there was a spillover effect, but as the graph clearly shows, the action was on the producer side.)

4.After a bit of time, the public realized FDR wasn’t planning just a one-off, but rather a sustained program of purchases of industrial items. That led them to start using some of their idle capacity, which meant not just selling the fixed amount that was in inventory. The rate of price increases thus dropped.

5.GDP increased at the fastest rate in the United States peacetime history since data has been kept. There was a big hiccup, of course, in 1937 when the government cut back on spending for a while.

There are all sorts of the problems with the argument that the inflation of 1933-34 was caused by expectations of fiscal stimulus.  First of all, it’s completely at variance with Keynesian theory, which Kimel seems to be trying to defend.  Keynesian theory says demand stimulus doesn’t raise prices when there is “slack,” and there has never been more slack in all of American history than in 1933.

But put that problem aside; assume the Keynesian theory did predict inflation.  Prices didn’t start rising when FDR came to Washington with spending plans; they started rising when he began depreciating the dollar.  Furthermore, the weekly rise in the WPI index was highly correlated with weekly increases in the dollar price of gold (i.e. currency depreciation.)  And those changes (in gold prices) were caused by explicit statements and actions by FDR.  Not by fiscal stimulus, which would be expected to appreciate the dollar.

In addition, the fiscal stimulus was far too small to produce the more than 20% WPI inflation observed in the 12 months after March 1933.  So the fiscal stimulus theory of 1933-34 inflation fails on all counts.  Indeed I’m almost certainly that Keynes himself would acknowledge that it was dollar depreciation that boosted prices in 1933 (he favored the policy), despite the fact that it conflicted with his “bottleneck” theory of inflation.

I don’t have time to fully address all his comments, but a few brief points.  Kimel says:

So…. his story requires the devaluation of the currency to worsen the trade balance, and rational expectations to cause a one time explosion in industrial prices and a rather smaller recovery in consumer prices. Rational expectations, however, that came an abrupt halt, at roughly the same amount of time one would predict companies might decide that demand will be sustained enough to start producing more rather than just selling off inventory sitting in warehouses. And his story doesn’t explain why growth was so much faster during the New Deal era than any other period of peacetime since the US began keeping data, nor why there was the big hiccup in 1937.

No, my story doesn’t require devaluation to worsen the deficit, but economic theory suggests it can do so via the income effect.  Lars Svensson has written on this subject.  And my story does explain 1937, but I don’t have time to write a 400 page blog post on the Depression every time I comment on it.  I’ve published numerous articles on the topic over the years.  The 1937 downturn was caused by a combination of falling prices (due to gold hoarding) and rising nominal wages (due to the post-Wagner Act unionization drives.)  I have no idea what the phrase “rational expectations . . . that came to an abrupt halt” means.

The growth in the New Deal period was very uneven.  During March to July 1933 industrial production rose 57%.  That ended with the NIRA wage shock, and IP was no higher in mid-1935 (when the NIRA was repealed) than in July 1933.   If IP had continued rising after July 1933 at the rate of the fast 1921-22 recovery, the Depression would have been essentially over by the end of 1934.

When output falls sharply due to a demand shock, it’s possible to have very fast “catch-up” growth.  Since the hole in 1933 was much deeper than at any time in US history, it’s not surprising that the growth rates during the recovery were quite rapid.  But as late as mid-1940 the US economy was still deeply depressed.  So it’s a glass half full/half empty situation.  There were both good and bad aspects of FDR’s policies.  Monthly data shows those effects quite clearly.

In my research on the Great Depression, I noticed that an interesting correlation developed in the middle of 1931.  But first a bit of background.  Germany had major debt problems after WWI, partly due to the unfortunate Allied decision to impose large war reparations.  After a series of negotiations, Germany issued “Young Plan Bonds” in 1929 to help finance these debts.  There was initially a high level of confidence in these bonds.  However as the Depression worsened, Germany’s manufacturing sector was hit quite hard.  Banking trouble developed.  And the Nazi party began to make political gains, partly due to its opposition to war debts.

In the middle of 1931 the price of Young Plan bonds suddenly became highly correlated with the US DJIA.  Indeed the actual correlation was even stronger than estimated in the table below, as the markets closed at different times.

Table 5.1  The Relationship Between Variations in the Dow Jones Industrial Average (DLDOW), and the Price of Young Plan Bonds (DLYPB), Sept. 1930 – Dec. 1931, Selected Periods, Daily.

Dependent Variable – DLDJIA

Sample                       Number of     Coefficient                       Adjusted     Durban-

Period                      Observations    on DLYPB   T-Statistic   R-squared   Watson

1.   9/14/30 – 9/30/30        14             .5492            2.18           .225          2.69

2.   12/31/30 – 3/20/31      65             .1202            0.71          .000          2.19

3.   3/20/31 – 5/1/31          35             .5714             2.12          .094           2.59

4.   5/1/31 – 6/19/31          41            -.1084           -0.54          .000          1.94

5.   6/19/31 – 7/30/31        34             .4559             5.05          .426           1.96

6.   7/30/31 – 9/17/31        40             .3554            3.78           .254           2.39

7.   9/17/31 – 11/6/31        41              .2888            3.85          .257           2.40

8.   11/6/31 – 12/30/31      43             .2801            3.72          .234           2.33

9.   12/30/31 – 3/31/32      75              .2617            4.03          .171          1.80

10.  3/31/32 – 6/30/32       77             .3152             3.75          .147           2.30

11.  6/30/32 – 9/30/32       76             .0799             0.66          .000           1.92

__________________________________________________________________

Those R2 figures for late 1931 and early 1932 may not look that impressive, but they are actually extraordinarily high, especially for daily first differences of asset prices.  If you read the NYT year end report on stocks, by month, there is no discussion of Germany in the first 6 months.  In the final six months Germany is mentioned in every single monthly summary.  People saw what was happening.  Furthermore, the correlation tended to jump up at times with heavy German news, further evidence of the direction of causation.  So that’s not really at issue, the dispute is over why German debt problems impacted US stock prices.

Those who don’t believe monetary shocks are important would point to German debt held by US banks, or the fact that Germany is an important export market of the US.  But then why did the correlation suddenly jump up when the debt crisis began to coincide with stresses on the international monetary system?

My view is that the German crisis led to a loss of confidence in their currency and perhaps other currencies as well.  This led to gold hoarding, as gold was the ultimate source of liquidity, the medium of account in most major economies.  More demand for gold means a higher value of gold, and that means deflation for any country on the gold standard.  And according to the supposedly “discredited” Phillips Curve, deflation means job losses and lower stock values, even in real terms.

How could we test this theory?  Ideally you’d want a country that’s way too small to have any direct real effects on the world economy.  But big enough where it might cause a chain reaction, which would lead to an increase in demand for the ultimate source of liquidity in the 21st century world economy.  Which is, of course, the US dollar.  Ideally it would be a tiny country of no more than 10 million people, containing little villages with donkeys walking down the street.  Not a big industrial powerhouse like Germany, which might have important real effects.

Then you’d want to see if financial turmoil in that small country could dramatically impact stock values in the US, even though US banks held relatively little of that country’s debt.  And dramatically impact stock prices in East Asia, which is part of the dollar bloc but has even less of that country’s debt.  In other words, a country like Greece.

As far as I’m concerned, my conjecture as to what happened in 1931 is now pretty much confirmed.  When I see daily reports of the effects of Greece on the world economy, it seems just like Germany in July 1931.  When I see it spread to Italy, it seems just like Britain, in September 1931.  When I see daily reports of Italian bond yields in the US media, it seems just like news of the Young Plan bonds, which was reported almost daily in the US financial press during 1931.  Yes, it’s 1931 all over again.

So what is the solution?  I hate to tell you this, but the problem is even harder to solve today than in 1931.  Yes, most countries were tied down by gold in 1931 (what Barry Eichengreen called “golden fetters.”)  But at least they had their own currencies, which could be easily devalued.  Now even that option is gone.  And despite all the pain, 70% of Greeks oppose giving up the euro.  This crisis isn’t ending anytime soon.

And I really don’t even know what the optimal solution is.  In isolation, you could argue that Greece should leave the euro, just as one could recommend that the UK devalue in 1931.  But the British devaluation made things much worse for those countries still on the gold standard.

So maybe Greece should just tough it out.  But then in retrospect the attempt of the major countries to “tough it out” in the 1930s was what made the Great Depression so great.  Most economic historians think the optimal solution was for them all to have devalued right away.  But if even Greece is highly reluctant to devalue, just imagine those countries that are still nowhere near in as bad shape.

The real lesson of 1931 is like that old joke about the guy who asks directions to Dodge City, and is told “first of all, if you want to go to Dodge City you shouldn’t be starting from here.”  The best solution to the euro crisis is to not set up a single currency in the first place.

Tyler Cowen has recently done some very depressing posts discussing the way the euro crisis is likely to play out.  I don’t have a strong opinion on this issue, because every alternative seems unacceptable.  But I will say that his scenario is not all that unlike the way things actually did play out in Europe during 1931-36, as the first to leave were the weakest countries, but by 1936 even France devalued.  In monetary terms, France was the Germany of the 1930s.  French hoarding of gold made the gold standard crisis worse, just as German demands for tight money at the ECB are making the euro crisis worse today.  By 1936 the deflationary effects of French policy rebounded against France herself, in a weird sort of cosmic justice.  Something to think about in Berlin.

PS.  I don’t want to push the comparison too far.  The Greek government really did behave recklessly in the years leading up to the 2008 crisis, hiding the scale of their debt problems.  And Italian voters kept electing Berlusconi, with predictable results.

PPS.  I apologize if I haven’t answered your email.  Still very busy, but feel a need to keep posting.

During the Great Depression prices fell by about 25%.  You might think that a deflation that bad would convince even the most hard-hearted conservative that monetary stimulus was needed.  Not so, conservatives were horrified by FDR’s attempt to reflate, even though the price level remained far below 1929 levels for the rest of the 1930s.

But the conservatives were pragmatists.  They understood the Depression was a big problem.  So instead of monetary stimulus, they supported all sort of other grotesque policies.  Statist policies.  Protectionism.  Much higher marginal tax rates.  Forced cartelization of product and labor markets under the NIRA.

If we’ve got a demand problem, why not simply have a bit more demand, and leave the free market system in place?  I just don’t get it.  What is it about demand deficiencies that makes people become unglued?  What makes people see every other problem in the world except a demand shortfall.  (BTW, I have no problem with people saying there is a demand shortfall, and other problems too.)

I thought of the Great Depression when I read this essay by Martin Feldstein:

HOMES are the primary form of wealth for most Americans. Since the housing bubble burst in 2006, the wealth of American homeowners has fallen by some $9 trillion, or nearly 40 percent. In the 12 months ending in June, house values fell by more than $1 trillion, or 8 percent. That sharp fall in wealth means less consumer spending, leading to less business production and fewer jobs.

But for political reasons, both the Obama administration and Republican leaders in Congress have resisted the only real solution: permanently reducing the mortgage debt hanging over America. The resistance is understandable. Voters don’t want their tax dollars used to help some homeowners who could afford to pay their mortgages but choose not to because they can default instead, and simply walk away.

Gee, I can’t imagine why someone who lives frugally would be resentful of seeing an affluent neighbor with a good job use his house like an ATM machine, with one re-fi after another to buy boats and fancy vacations, and then dump his mortgage on the taxpayer, even though he could afford to pay it, just because his house was underwater.  Why would anyone have a problem with that?

OK, I’m a utilitarian, and am therefore supposed be above emotions like envy.  I’m not supposed to divide people into the deserving and undeserving.  But I don’t see how this could even be justified on bloodless utilitarian grounds:

To halt the fall in house prices, the government should reduce mortgage principal when it exceeds 110 percent of the home value. About 11 million of the nearly 15 million homes that are “underwater” are in this category. If everyone eligible participated, the one-time cost would be under $350 billion. Here’s how such a policy might work:

If the bank or other mortgage holder agrees, the value of the mortgage would be reduced to 110 percent of the home value, with the government absorbing half of the cost of the reduction and the bank absorbing the other half.

And why would a respected conservative advocate this sort of grotesque interference in the free market—leading to all sorts of future moral hazard, future politicization of the credit markets, etc?

But failure to act means that further declines in home prices will continue, preventing the rise in consumer spending needed for recovery. As costly as it will be to permanently write down mortgages, it will be even costlier to do nothing and run the risk of another recession.

Oh, so we have an AD problem.  In that case, WWMS (what would Milton say?)  Doesn’t an AD problem call for easier money?  But not only is Martin Feldstein not advocating monetary stimulus, he opposes it.  So just as in the Great Depression we have conservatives who would apparently abandon the traditional system of private contracts rather than provide some monetary stimulus.  Even though they concede we have a demand shortfall that threatens to push us back into recession. I just don’t get it.

What does all this have to do with Goya?  Nothing much, except for some reason his proposal reminded me of this etching:

Alternative post title:  Sleeping central bankers produce statist monstrosities.

Here’s Narayana Kocherlakota:

Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said the central bank has put its credibility at risk by easing during a year in which inflation rose and unemployment fell.

.   .   .

“As the economy recovers, the FOMC should respond by reducing the level of monetary accommodation,” Kocherlakota said.

“The FOMC should only increase accommodation if the economy’s performance, relative to the dual mandate, actually worsens over time,” he said, referring to the central bank’s goals of maintaining price stability and ensuring full employment.

Between March and December 1933 the unemployment rate probably fell a bit, say from 25% to 23%.  And inflation rose.  So are we to assume that Kocherlakota would have voted to tighten monetary policy at that time?

We can take some comfort from the fact that the Fed is currently headed by a Great Depression scholar.  Surely he wouldn’t recommend tightening monetary policy just because inflation rose at bit and the unemployment rate dipped a bit.  After all, the economy is still severely depressed and most indicators point to low inflation ahead.  See what you make of this statement by Ben Bernanke:

The Fed’s chairman, Ben S. Bernanke, has said since the decision was announced that the central bank is willing to act again if necessary, but also that there would be a high bar. In particular, he has said that the Fed was most likely to act if the pace of inflation abated to the point where there was a risk that prices and wages might begin to decline. Such a trend, known as deflation, can cause buyers to delay purchases, derailing the economy.

Didn’t the decision to end QE2 effectively tighten policy?

I’m sure many of you are thinking that I just don’t get it.  The Fed knows what it is doing; they simply have a different objective function from us market monetarists.  OK, let’s see if they know what they are doing.  Do they rely on voodoo VAR models, or market forecasts of inflation?

The minutes, which are normally released three weeks after a policy decision, made clear that the Fed had not changed its view that the pace of inflation was likely to remain at roughly 2 percent a year, the rate that the Fed considers most healthy.

Yet the TIPS spreads show less than 2% inflation over the next 5 years, and the Cleveland Fed says the correctly measured expected inflation rate is lower still.

“But what makes you think markets can forecast better than the Fed?”  How about this:

The internal divisions were partly the product of a lack of clarity about the health of the economy. In its predictions since the end of the recession, the Fed has repeatedly overestimated the pace of economic growth, and the minutes report that the board does not understand why it has been wrong.

“It was again noted that the cyclical impetus to economic expansion appeared to be weaker than in past recoveries, but that the reasons for the weakness were unclear,” the minutes said.

The Fed noted that labor market conditions in particular had been disappointing, with companies adding fewer workers than expected. It also noted that both consumers and businesses remained surprisingly pessimistic.

When the markets expect your policy to fail, it might succeed.  But I wouldn’t count on it.

Actually, the Fed has no reason to believe it has provided any “accommodation” at all.  None.  Let’s review what they have done:

1.  Cut rates to near zero, just like the Herbert Hoover Fed and the Bank of Japan did.  A situation Milton Friedman correctly called a sign that money has been too tight.

2.  Injected lots of reserves, but then neutralized their effect by paying IOR at a rate exceeding T-bill yields.  High-powered money is high powered if and only if it earns an interest rate below that of bonds.

3.  Promised to keep interest rates at Herbert Hoover/BOJ levels for years to come.

4.  Operation Twist; a policy that was widely viewed by monetary economists to be a pathetic failure when it was tried in the early 1960s.

Have I missed anything?