Back to the Great Depression Debates Again

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.)

Comments

[moonbat1775:]

I do not see Murray N. Rothbard's book "The Great Depression" mentioned. Rothbard was an Austrian Economist as was Ludvig von Mises who predicted the Great Depression.

2008 Oct 09 02:02 PM

[venividivici:]

Perhaps you can explain how eight years of rule by George Bush has brought America to the very brink of economic collapse. Whilst he's always admitted to not knowing much about ecomonacks, tax cuts have been one of his big favourites, the result. The Federal Govenment's debt just passed $10 trillion. Well done, George, that's just one of your legacies that should bedevil Americans for many years to come. Another four years of the same, should see America looking even more like Zimbabawe.

2008 Oct 09 02:08 PM

[PainfullyAware:]

Government Is A Puppet - Look at the bailout.

When you can create money out of thin air you can buy governments.

The Sub Prime Mortgage Fiasco Was Only The Fuse.

Off Accounting Sheet Level 3 Assets, "Financial Engineering", was the real bomb.

The Criminality crosses party lines and goes way beyond the past 8 years.

2008 Oct 10 03:48 PM

[Blair:]

Regarding venividivici's posting about Bush's tax policies, there appears that the democrats have clean hands.

Believe that, and you can easily be convinced that the Brooklyn Bridge is an excellent buy.

2008 Oct 10 07:45 PM

[Moneyloser:]

A Mankiw student...go figure. My goodness, the Great Depression was caused by the fact that restaurant prices do not move around day by day.
Oh, and in case you missed it, you sticky price guy, have you noticed how the price of gasoline stays sticky minute by minute? Sheesh. Get an education.

2008 Oct 13 07:13 AM