Before discussing the chart, let me point to an old debate that seems to have been re-ignited between those who judge business cycle phenomena such as a possible Depression to be the result of shifts in productive potential or whether such phenomena are always the result of demand deficiency. Peter Temin (MIT, JEL, September 2008) recently reviewed work by Tim Kehoe and Ed Prescott (Minnesota School, Response FRB Minneapolis, December 2008) on the causes of Great Depressions and severely questioned the basic hypothesis that it was possible to think of the Great Depression as resulting from the former rather than the latter. In recent work, Kehoe and Prescott point to a sharp fall in US productivity in 1929-33, which was associated with a sharp fall in labour hours which did not recover even when productivity recovered later in the 1930s. Temin argues that: “(a)ny description of sort run macro events needs to pay attention to the effects of monetary and fiscal policy”. I am very sympathetic to the Minnesota School but when I start to think about the current debate and possible causes of this downturn, in a world of immense and prolonged analysis, I have seen little or no reference to a productivity slowdown as a cause of the financial crisis. Maybe it will come.
Turning to the data. The data gives us 1990 US$ price GDP in a variety of countries and I simply normalise the GDP at 100 for 1929 and see when output returned back to its previous level for a few countries. The results surprised me. The UK seemed to have a relatively mild output recession following its exit from the Gold Standard in 1931. Following my previous blog, it is remarkable how often the exchange rate helps adjustment in the UK. The US did not return to its previous output level until 1936/7 but that masks positive growth from as early as 1933.
In some senses the US path is probably the worst we might expect given an absence of effective countercyclical monetary (Friedman and Schwartz, 1963) and fiscal policy and the adoption of protectionism, which exacerbated negative trade multipliers. The stylised fact for the Great Depression is that world trade (exports plus imports) in 1913 US$ constant prices was around US$36bn in 1929 and fell to $25bn in 1938 i.e. around 33% and world output over the same period moved from US$241bn to US$270bn, which meant that the fraction of trade to GDP fell from around 15% in 1929 to 9% by 1938 (Estevadeordal, et al, QJE, 2003).
For obvious reason, we may not want to dwell on the militaristic solutions in Japan and Germany but, at a stretch, these might be analogous to making some kind of point that with the right kind of demand management, economic growth might return quickly and rapidly. So the question then is whether extreme monetary and fiscal policy stimuli currently being developed are sufficient to drive demand in the absence of much global demand (recent market inflation expectations data suggests this might be the case)? And under what circumstances will the saving nations (e.g. China) shift their investment functions outwards – as this will probably require some reform of their financial institutions it will probably not happen anytime soon? A financial crisis is difficult as it impacts on demand, as agents’ wealth and ability to smooth consumption evaporates, and it impacts on supply, with capital and labour shedding resulting. So we know that output will fall and demand management can have, at best, a temporary impact. So in the end the authorities simply do what they can, given tremendous uncertainties, and hope that confidence returns.