Archive | July, 2012

More Sex Is Safer Sex (for some) and how to clean up the dating pool with Pigouvian pseudo-taxation

24 Jul

First, consider these statistics.  32% of males reported contracting a non-HIV sexually transmitted infection (STI) in 2005.  Compare that number to a startling 67.7% of females  who reported contracted a non-HIV STI in the same year- that’s over a 100% more cases!  So, Dudes, I think it is fair to say that we are the ones being a little less scrupulous with our partners.

Steven Landsburg hit it big with his 1996 article in Slate Magazine entitled “More Sex is Safer Sex.”  For readers unaware of the argument, it’s fairly straightforward.    We can think of the dating market consisting of two types of men; promiscuous Petes, and (sexually) conservative Carls.  Now, every time Carl decides to spend the night in, he is effectively increasing the riskiness of each sexual encounter made out there on the market (the NC-17 one, to be specific).  That’s because now there are more Pete’s for every Jane, and more chances that an infection will result from any given sexual liaison.  That’s exactly not what we want if we would like a shot at defeating the STD/HIV problem.  What we want is to minimize the chance of infection resulting from any given sexual liaison.

Like everything on the market, there are costs and there are benefits, there are prices and there are profits.   The problem is that saying “Hey, I don’t have HIV or an STD, so you should hook up with me” does not exactly make for a good pick up line or conversation starter.  So, Carl’s services are underpriced.  But that’s not the only problem- promiscuous Pete is generating a negative externality on society every time he makes a date or enters the bar looking to score.  By this I mean the externality is the infection passed on to his unsuspecting (or careless) lover, we’ll call her Jane, and every other girl he hooks up with after that, and every other guy she hooks up with as well.  If only there were a way to clean up the dating pool by incentivizing the Carl’s to go out and the Pete’s stay in (alone).  Well, economics is a wonderful thing, and it has given me an idea.

Now, condoms are already free on college campuses so we’ve already brought the cost of safe sex down to zero dollars.  But that doesn’t mean much when condoms are pretty cheap to begin with, so presumably Pete’s not wearing them for some other reason than the expense.  We want to minimize the likelihood that Jane becomes infected  (who may then go on to infect another).  Thus, I propose we deal with this problem in the same manner in which other negative externalities in the marketplace are dealt with- Pigouvian Taxation.

For those uninitiated, Pigouvian taxation is simple; it’s a policy prescription laid out in A.C. Pigou’s 1920 text The Economics of Welfare, which calls for taxing an amount equal to the marginal environmental damage (MED) of an activity in which the private producer does not account for the external diseconomy in his cost calculations (i.e., the total social costs exceed the total social benefits). [1] This differential between private and social costs is referred to as a market failure, and is sufficient reason for government intervention.  Theoretically, by taxing the amount of the environmental damage will internalize the externality by reducing production to the optimal quantity (i.e. to the point where total social costs are equated with total social benefits, or where private costs equal social costs), thereby remedying the alleged market failure.[2]  Such a policy prescription is particularly attractive in the case of negative externalities resulting from all the promiscuous Petes out there spreading the virus.   To clarify, the private producer is Pete, and the marginal environmental damage is each new woman he infects with an STD or HIV.   The private cost to Pete is nothing, as he already has the virus.  Yet, the social cost is a dirty dating pool (and however many dollars it takes treat those viruses).

Now the questions remain, (a) how do we calculate the marginal environmental damage, and (b) how do we go about implementing the tax?  I would assume that the most accurate MED calculation would include the amount of dollars spent on treatment.  But the problem still remains on how to preemptively tax all the Petes?  One simple way would be to require bi-annual checkups.   At each check up, the doctor will either give you a stamped gold slip if you’re clean, or a stamped red slip if you’re dirty.  Now, all your partner has to do is ask to see the slip, and you’re GOLDEN (assuming you’ve got a winning personality to go with it ;))!  Now, I’m against the government mandating people to do anything, even to go in for a check-up, but I’m all for creating a well-incentivized marketplace.  Now the “tax” is not monetary at all but simply a red slip if you went or a lack of any slip if you didn’t go.  That,  my friends, would be Pigouvian “taxation” at it’s finest.  Now, all the prices of the Petes and Carls are accurately reflecting their services, and everyone has the freedom of choice to go to the check-up or not.   However there is one caveat; when your prospective partner asks for to see your slip (price) and it’s either bad news or no news, I guess you’ll have to come up with a better excuse than “My dog ate it.”

[1] Harvard economist Gregory Mankiw is one of the leading advocates of Pigouvian taxation as a solution to externalities and as a tax reform which would reduce several of the negative incentives associated with the current tax code, for example, the disincentive to the labor force resulting from the income tax, and the disincentive to invest resulting from the capital gains tax.  On his blog he has advocated for a $1.00/gal tax on gasoline, and he has also started an unofficial club, The Pigou Club, advocating an increased use of gas and carbon taxes.  Several noted economists aside from Mankiw are members of the club, such as Alan Greenspan, Christopher Dodd, Paul Krugman, Richard Posner, and Paul Volker, among others.

Although Pigouvian taxation has received most of the attention, it is also Pigou’s original work, in general, that is gaining popularity.   The New Yorker columnist John Cassidy wrote an article appearing in the Wall Street Journal on November 28, 2009, in which he extols Pigou as the economist whose work “best explains financial crises, global warming, and other pressing issues of today.”  The article is entitled “An Economist’s Invisible Hand: Arthur Cecil Pigou, overlooked for decades provides a guide to the financial crisis.”

[2] See Part II of The Economics of Welfare for the original analysis, or for an exceptionally clear and more modern take, see pages 133-135 in Jonathan Gruber’s 2007 textbook entitled Public Finance and Public Policy.

Copyright Nelson R Hoffman

A New, Eclectic View of the Great Depression: Concluding Thoughts

24 Jul


While the gold standard played a critical role in the propagation of the Great Depression, it was not the only factor at play.  Of course, Fed policy played a role in the contraction, but Bernanke and Fischer both offer convincing evidence that debt-deflation was another contributing factor to the declines in output and prices.  Additionally, recovery was not merely the result of depreciation or abandonment of the gold standard, as this must have been met with a subsequent expansionary monetary policy to halt the deflationary pressure.  Indeed, this has been the point of focus by Bordo, Choudhri, and Schwartz (2002), who offer convincing evidence against Eichengreen’s argument that the US could not provide liquidity because of a commitment to gold.  The authors suggest that because the US had such vast quantities of gold and was a large, closed economy, expansionary monetary policy was not constrained by maintenance of the gold standard.  In their model, they show that had the US expanded the monetary base by $1 billion, as opposed to $37 million, at two decisive periods, even in the most compromising scenario of perfect capital mobility, expansionary monetary policy would have “successfully averted” the US banking panics, thereby halting the deflation and subsequent worldwide crisis—“without endangering convertibility.”


If it was not already apparent to the reader coming in, it should be rather obvious now that the Depression of the 1930s was not a monolith—it did not solely affect the US, but it affected every major industrialized economy at the time.  Additionally, it was likely not the result of any single cause, but rather of a multitude.  I hope the reader has also found that although there is debate among the particulars, there is also much agreement.  The vast majority of economists generally agree that the major proximate causes of the US deflation were the banking crises and the failure of the Federal Reserve to offset the subsequent decline in the money multiplier.  It is also agreed upon that the US deflation was transmitted abroad via the gold standard, and that leaving gold is highly correlated with rapidity of recovery.  The point of contention seems to be whether or not the US would have been able to accommodate monetary policy while maintaining a commitment to gold.

Further research which does not rely on a model of counterfactuals would help allay this point of contention.  It would be necessary to gather empirical evidence of other instances during the Depression in which a large economy engaged in open market operations sufficient to quell the deflation.  Unfortunately, the US seems to be the only economy during the Depression of the 1930s to fit this bill.  However, today’s crisis may offer room for comparative research. Perhaps it would be informative to look at the US monetary response and its affect on exchange rates and the value of the dollar, using this as a proxy for credibility of maintain adherence to gold?  Or, maybe there is some better proxy to look at?  Thus, although Bordo, Choudhri, and Schwartz offer a competing argument against “golden fetters,” all counterfactual models are better when there is corroborating empirical evidence, and until then, the “golden fetters” does not deserve to be put to rest just yet.

On a side note, while attending Milton Friedman’s 90th birthday party, Bernanke spoke and commented that You’re (Friedman) right.  We (the Fed) did it. We’re very sorry…We won’t do it again.”  In the wake of QE3, I ask, what was it he would not let happen again?  Surely it was not to exemplify Federal Reserve incompetence?  Well, whatever the case may be, I am working doggedly to put together a comprehensive analysis of the major policies affecting the Great Recession of 2008 and beyond.  It’s a bit scattered at the moment, but I’ll be putting up bits and pieces as they come together.

A New, Eclectic View of the Depression: Part III- Examining the data on recovery influences

23 Jul

Leaving Gold and Recovery

            If it is indeed the case that the gold standard contributed to the global decline in output and prices during the 1930s, then one would expect that those countries not on gold at the time and those countries first to leave gold would experience the most rapid recoveries.  The evidence to support such a hypothesis is remarkable.  Kochin and Choudhri (1980), Eichengreen and Sachs (1985), and Bernanke and James (1991) each contribute to the evidence.

IN a landmark study of the Great Depression and exchange rate regimes, Kochin and Choudhri (1980) examine the efficacy of floating exchange rates in insulating economies from exogenous shocks.  To do this, look at output and prices of three different sets countries during the Great Depression, with each set then being compared to the United States and each other in regression analysis.  The authors examined (1) Spain, which had a fully floating exchange rate regime at the time, (2) the Netherlands, Belgium, Italy, and Poland; which were on gold throughout the Depression until 1935, and (3) the Scandinavian countries of Denmark, Finland, and Norway, which left gold in 1931.  The US left gold in 1933.

The authors find that US output and prices had no statistically significant impact on Spanish output and prices.  Indeed, the Spanish economy was astonishingly resilient to exogenous shocks from the US, with prices and output hardly falling during the Depression.  When looking at the data on the Scandinavian countries, the US did influence their output and prices, but to a much lesser extant than the countries of the Netherlands, Belgium, and Italy, and Poland.  For the eight sampled countries, the authors conclude that the severity of the Depression experienced by the individual country was “strongly related to the contraction…in the United states.”  The Scandinavian countries enjoyed greater insulation after leaving gold, and Spain was the only country which appeared essentially unaffected by the Depression.

Eichengreen and Sachs (1985) add to Choudhri and Kohin’s (1980) analysis of exchange rates by examining the way different exchange rate devaluations affected both the domestic and foreign economy.  The authors identify four different types of exchange rate devaluations, and find that while every from of devaluation certainly had a positive effect on domestic output, but that the “devaluation cycle” that occurred in the late 1920s and throughout the duration of the Depression indeed had a beggar-thy-neighbor effect.  However, this was merely because various countries devalued unilaterally, but had they each engaged in bilateral, cooperative devaluations, the authors predict that the beggar-thy-neighbor effect would have been subdued, and world interest rates would have been reduced to the point where investment was stimulated on a global scale.

The authors identify several mechanisms by which devaluation would increase domestic output.  On the supply side  there are two primary effects.  First, devaluation would make domestic goods more attractive on the foreign market and would also have the effect making foreign goods less attractive to domestic consumers.  The combination of these two would bid up the price of domestic goods, stimulating production.  Secondly , by bidding up domestic goods prices, real wages decline, which also stimulates output.  The authors show that those countries which devalued the most, relative to France, experience the largest reductions in real wages and the largest increases in real output.  Both Denmark and Sweden depreciated the most, and they also achieved the largest changes in real wages and the largest change in industrial production.  Another mechanism the authors identify is that by depreciation, the country could, and often did, expand its domestic money supply, thus lowered domestic rates and stimulating investment.  The regression, which looks at the discount rate and the extent of depreciation verifies such a relationship.  Additionally, the authors find that the direction of gold flows following devaluation is indicative of whether or not it was beggar-thy-neighbor, under the particular circumstance where a country devalues and accommodates their money supply enough to induce gold outflows and stimulate demand via declining foreign interest rates.  However their regression analysis indicates that depreciating countries largely experienced gold inflows, thus making their devaluations beggar-thy-neighbor.  In their view, the, the uncoordinated devaluation cycle contributed to the declines in global output, but had devaluations been strategically employed, they could have lowered world interest rates, accelerating the recovery process.

Bernanke and James (1991) look at prices, money supplies, and industrial production form a sample of 24 different countries.  The countries in the data set are subdivided into one of four categories, depending on adherence to and date at which the gold standard was abandoned.  When looking at the log-differences of the wholesale price index between countries from 1920-1936, the trend is apparent that gold standard countries experienced deflation of prices to a far greater extend than those which abandoned the standard.  Indeed, Spain, Australia, and New Zealand all experienced only minor deflations up to 1933, and then slight inflation from 1934 to 1936.  Those countries which abandoned the standard in 1931 encountered deflation of about 13% from 1930 until abandonment, after which time inflation is characteristic of these countries.  In contrast, those countries latest to abandon still experienced average deflation of 4 and 5% in 1935 and 1936., respectively.  The US experienced deflation of 10, 17, and 12% from 1930-1933, and upon abandoning the gold standard in 1933, experienced rates of inflation of 2, 13, 7, and 1% from 1933-1936.  In stark contrast, those countries still on gold as of 1936 experienced deflation of prices on average of 5% to as late as 1935, with France experiencing deflation as high as 11% in 1935.  In 1936, after these countries abandoned gold, each of them turned inflationary.  Thus, the authors conclude, “the link between deflation and adherence to the gold standard…seems quite clear.”

To compliment the data on the price index, the authors also examine data on money supplies, with the same breakdown of countries as before.  It would be assumed that leaving gold would be correlated with more aggressive growth in the aggregates, although, as Bernanke notes, the correlation is “less than anticipated.”  For instance, in 1932, countries on gold experienced an average of 13% deflation, yet comparisons of average monetary growth rates between gold and non-gold countries during that year reveal a difference of less than 1%.  Despite this, after 1933 the expected correlation is obvious, with the average differences between rates of growth in the monetary aggregates between gold and non-gold standard countries being about 5% in 1933, 3% in 194, and 8.6% in 1935.  I suspect this is merely due to lag, as money makes its way through the economy and people adjust to new expectations.  Thus, from 1933 on, it appears that remaining on the gold standard restricted a central bank’s ability to engage in quantitative easing.

The authors also look at industrial production with the same sample, and the finding support the view that the global deflation precipitated by the inter-war gold standard had substantial real effects on the economy.  When looking at the period from 1932-1935, it is evident that countries not on gold experienced, on average, nearly 7% greater industrial output than the gold-bound countries.  Bernanke notes this as “a very substantial effect.”

Bernanke and James interpret their findings as evidence to suggest that adherence to the gold standard lengthened both the deflation and declines in output that countries experienced during the Depression, as well as suggesting, though with less certainty, that monetary policy effectiveness was restricted by a country’s decision to remain on gold.

A New, Eclectic View of the Great Depression: Part II- Non-monetary Influences and the “Golden Fetters” Model

23 Jul

concerned shareholders outside Berlin bank during wake of the 1931 banking crisis.

Non-monetary Roles

While Friedman and Schwartz, Bernanke, and Eichengreen all agree that the impulse to the depression was the US monetary tightening in 1928, both Eichengreen  (1992) and Bernanke (1983) stress that, while this was the impetus, the duration cannot be accounted for by a mono-causal theory, and that the financial crises and bank runs during the first half of the 1920s also played contributing roles.

In his 1983 work, Bernanke notes the high correlation between the banking crisis and declines in output,  and argues that the combination bank of bank runs and insolvency of debtors increased the costs of credit intermediation, which affected aggregate demand and had real effects on the economy.  This hypothesis was not meant to supplant that then-reigning monetarist interpretation, but merely to compliment it.  The attractiveness of this particular analysis is that it simultaneously accounts for both the magnitude and duration of the Depression, and that it does not assume irrationality or “animal spirits” on the behalf of economic agents, but instead assumes rationality.

First, Bernanke illustrates the two main causes of the financial collapse- the bank runs and the level of inside debt.  The bank runs of 1930-1932 were initiated by “bad financial news” and grim forecasts.  As banks began liquidating their assets, prices were driven down, causing some banks to fail.  Thus, merely the expectation of bank runs may result in a self-fulfilling prophecy.  The second mechanism is what Bernanke refers to as the “debt crisis,” whereby any deflation exacerbated the burden on banks, because debts were nominal and indexed to changes in the prices level.  Hence the term debt-deflation.  Bernanke notes that the level of inside debt was particularly high for both households and farmers, as the level of mortgage default rose to over 60% in some cities and nearly half of all farmers’ mortgages were delinquent by 1933.  Bernanke notes that although debt crises were not by any means unprecedented in the history of recessions, the magnitude of this one was.

The series of bank runs and the extraordinarily high level of inside debt inevitably led to an increase in the costs of credit intermediation (the flow of funds from lenders to borrowers).  Now, as loans tuned sour, debtors became increasingly insolvent, and as bank capital was squeezed, banks found it harder and harder to value the quality of their loans.  Consequently, to avoid further losses, they vastly curtailed the total amount of outstanding credit.  Indeed, the magnitude of this credit contraction in the US was twice that of any other major economy during the Depression, with farmers, households, and small businessmen being hit the hardest.   Thus, despite there being low yields on treasury or blue-chip corporate liabilities—typical indicators of easy money—it was just an illusion.  Even those who would be deemed creditworthy in good times could not get loans, as capital markets had effectively dried up.  The spread between Baa corporate bonds and T-bills is indicative of taste for safe, liquid assets.  Bernanke notes that from 1929 to 1932, the spread increased 5.5% percentage points, from 2.5% to 8%.  Even two years after the Depression’s nadir—marked as the March 1933 bank holiday—there was till a “genuine unsatisfied demand for credit by solvent borrowers.”  This reflects a change in attitude among bankers, who had, as a result of the crisis, grown “chastened” and “conservative.”

Of additional importance is the correlation between the banking crises and the reduction of outstanding credit.  Bernanke notes that the credit contraction “shared the rhythm of the banking crises.”  Such a reduction in aggregate demand naturally had a deleterious effect on GDP.  The argument is as follows; as the cost of credit intermediation increased, it became more expensive for borrowers to take out loans, which lead to a decline in aggregate consumption of goods.  To quantitatively determine the magnitude of this nonmonetary hypothesis, Bernanke fits two output equations using monetary variables and then adds in nonmonetary proxies, such as deposits of failing banks and liabilities of failing businesses.  What Bernanke finds is that “adding proxies for the financial crisis substantially improves the performance of these equations.”  This indicates that the Friedman and Schwartz monetary interpretation on its own insufficiently accounts for the Depression, failing to explain the magnitude of the output trends from 1930-1933.  Thus, it can be concluded that nonmonetary aspects of the financial crisis played a significant contributing role in the depth and duration of the Depression, and that any complete analysis must account for these variables.

The “Golden Fetters” Model

The question still remains as to why the central banking authorities did not act to stem the financial collapse?  Eichengreen’s answer is that the gold standard as it had come to be tied the hands of the authorities (hence, the title of his book).  Under the gold standard, if one bank were to inflate, lower interest rates would cause outflows of gold, and quickly negate any efforts to relate if parity was to be maintained.  Additionally, the inflating country would face a credibility problem, so foreign nations would ask to have their gold redeemed, and there would be a “flight from foreign exchange,” further counteracting the inflating country’s efforts if the standards was to be maintained.  There was thus a dilemma countries faced; they could either maintain the gold standard, or reflate.  They could only do both if they did so cooperatively, but, as stated in Part I, such cooperation had deteriorated since the war.  Eichengreen notes that in 1993, the London Economic Conference was one such attempt to engage in coordinated efforts to reflate.  However, the conference was “an utter failure,” as war reparation questions were still on the table, and policymakers continued to butt heads.

To illustrate the interplay between maintaining gold, trying to reflate unilaterally, and the non-monetary influences at hand, Eichengreen points to the German Reichsbank experience, which at the onset of the Depression was dangerously close to the mandated cover ratio of 40% due to extensive debt.  During the Austrian banking crisis of 1931, Central European capital markets froze, and the Reichsbank could not redeem their deposits in Vienna.  When the news spread of the deteriorating balance sheets of Central European banks, foreign nations quickly demanded gold redemption, further exacerbating the liquidity problem.  When the Reichsbank decided to act and provide liquidity, its efforts were quickly stymied by further capital outflows induced by the lower interest rates.  Thus, the Reichsbank was forced into passivity by its golden fetters.

A New, Eclectic View of the Great Depression- Part I: breaking the rules and debt-deflation

17 Jul

Bank run sketch of customers demanding deposits “en masse.”

The Pre-War Gold Standard

In order to understand that interwar gold standard, it is first to contrast it to the better, more efficient pre-war gold standard.  Eichengreen (1992) argues that the pre-war gold standard operated so efficiently for over 25 years preceding World War I because it functioned under two critical tenants of credibility and cooperation.  The three countries at the heart of the system were Britain, France, and Germany, and each one had a strong commitment to operating under the “rules of the game” as dictated by the price-specie-flow mechanism, where debtor countries drawing down reserves were supported by increased interest rates domestically and decreased interest rates abroad, channeling reserves to the debtor country at sufficient speed.  Eichengreen that the reason this commitment was so rigidly maintained was because, prior to the turn of the century, central bankers were given little authority and thought to influencing unemployment.  That is, central bankers focused on external, rather than internal balance.  Thus, “the commitment was international;” other central banks followed the discount rate policy of the Bank of England during “tranquil” times, and in times of crisis, each central bank explicitly cooperated with one another.

With the outbreak of WWI, the system was alerted significantly, and ultimately broke down.  With the rearrangement of war debt and fiscal burdens, each country had alternative views on how to cope, and instead of relying on import duties as taxes as they had in the past, countries adopted no unified system.  Additionally, the influence of unions and special interest groups strengthened during the war years, which increased pressure on central banking authorities to consider employment targets.  Each country had its own ideology and view on the proper role of central banks in dealing with theses issues, which depended upon the particular political atmosphere at the time and the countrys’ past experiences with inflation.  Thus, there was a conflict of visions, as the external focus of the pre-war era shifted inward, the old system broke down.

The Inter-War gold Standard

Bernanke and James (1991) identify three technical problems associated with the interwar gold standard; an asymmetry of monetary response by deficit and surplus countries, the pyramiding of reserves, and a lack of central bank authority.  Each of these factors assisted in creating global deflation.

The “rules of the game” dictated that in order for the price-specie-flow mechanism to operate smoothly, countries receiving an inflow of gold must expand their money supplies, while those experiencing an outflow were to contract.  Theoretically, this would serve to maintain the world ratio of m1/base.  With the inter-war gold standard, there existed a statutory minimum on the coverage ratio of 40%, thus making it mandatory that deficit countries contract as gold drained from their central banks.  However, no such minimum existed for the base/reserves ratio, so surplus countries could sterilize inflows if the central bank authorities deemed it necessary or prudent.  Consequently, this asymmetry made the interwar system biased towards deflationary pressure.

However, this was not the tendency toward deflation the interwar gold standard possessed.  Bernanke notes that factionary reserve requirements amplified the deflationary bias in the system via two mechanisms.  First, because central banks held a 40% minimum amount of gold as reserves, they were effectively tied up and could not be used to pay liabilities.  Thus, a portion of all the gold reserves was immobilized.  Bernanke sites League of Nations data, which shows that of the total amount of gold reserves held by 41 countries, only about 23% was available as surplus to be used for the payment of debts.  The second mechanism by which fractional reserve requirements created a deflationary bias is because the ratio of monetary contraction to gold outflows was not one-to-one.  Under the fractional reserve system, whenever the domestic money supply was contracted, gold flowed out of the country at some multiple of the contraction.  For instance, under the 40% reserve requirement for the interwar gold standard, the multiple loss of gold was 2.5.

The second technical flaw, addressed by Bernanke, has to do with the fact that under the system, foreign exchange reserves were a near equal substitute for gold.  IN the 1930s, when the threat of exchange rate crises and devaluation loomed, central banks fled from foreign exchange “en masse,” leading to declines in the reserves/gold ratio.   Then, in order to insulate their economies from currency attacks, countries increased their coverage ratio in a “scramble for gold,” causing the base/reserves ratio to fall.  Thus, this  “pyramiding of reserves” was yet another technical impediment, resulting in further deflationary bias in the system.

Bernanke points out a third flaw, and it is a conspicuous lack of policy tools available to central banks during the interwar period.  Most notabley, he points to the Bank of France, who between the United States and itself possessed approximately 60% of the world’s gold supply.  During the 1920s, in order to prevent the monetization of deficits, the Bank of France was restricted of its authority to engage in open market operations, thus leaving only the discount rate as a tool to effect policy.  However, European commercial banks seldom borrowed from the bank of France, thus enervating the Bank of France’s ability to affect the domestic money supply.  Form the period 1928-1932, France’s holdings of gold increased over 100%, peaking at an amount equal to 32% of the world’s gold supply.  This entailed a substantial drain on reserves from deficit nations.  Yet, with France unable to expand, the price-specie-flow mechanism was disrupted, resulting in deflationary pressure transmitted internally.  The US, fearing inflation and potential asset bubbles, began sterilizing and become concretionary in 1928.  This combined contraction by the US and out of France led to a drastic decline in the world money multiplier, and set the stage for the global deflation that characterized the 1930s.


The specific transmission mechanism by which deflationary pressure leads to depression is an important consideration.  IN the spirit of Irving Fisher’s 1933 work, Bernanke and Gertler (1990) stress debt-deflation as a principal cause for the declines in output, whereby the borrower’s real debt burden is increased with deflation (i.e. every penny they owe is now costs more than before).  Borrower reactions to this “financial distress” impose a negative externality, which results in a deadweight loss to others.  For instance, in order to repay his new, higher real debt, he may make cutbacks and lay off workers, who in turn make cutbacks in spending on their own.  These create significant nominal shocks, particularly to consumer and investment spending, and precipitous decline in prices and aggregate demand ensue.

Bernanke and James (1991) emphasize that the banking panics—which peaked in 1931 not just in the US, but in several another countries as well, ranging from Hungary, to Japan, to Sweden—were a direct result of the deflation by the disrupted interwar gold standard, and served as a primary conduit linking nominal shocks of declining prices to the real side of the economy, namely aggregate output.  According to this view, the banking sector, whose assets (deposits) are set in strictly nominal terms but whose liabilities (debt and equity) are real, were squeezed by any fall in prices, as this caused their assets to decline in value.  This is similar to Fisherian debt-deflation.  As already noted, under the gold standard central banks could not engage in quantitative easing at will due to cover ratio statutes in already in place.

The authors (Bernanke and James) run regression analysis on several variables to determine the effect of banking panics on output and find that banking panics reduced output by 16%, which is statistically significant.    IN addition to the regression, Bernanke offers an alternative analysis using the standard AD-AS/IS-LM framework, and again finds that banking panics have statistically significant effects on output.

Also addressed is the scenario in which banking panics initiated by the gold standard deflation could set of a further deflationary contagion transmitted again via the gold standard.  Theoretically, banking panics in small, debtor countries on gold could not affect world prices, because their money supplies must ultimately respond to those of their creditors.  This theory is supported by regression analysis again by Bernanke and James (1991), where they find no significant link between banking panics in small countries and deflation.  However, such is not the case for large creditor countries, where domestic shocks to the price level will be transmitted via the gold standard to the smaller countries, whose prices must adjust.  Indeed, Bernanke offers empirical evidence on wholesale prices and money growth in the United States and France to support this view.  He finds that there is, in fact, “cointegration,” which means that shocks to the prices level in large countries under the interwar gold standard will be transmitted to smaller countries on gold.  Thus, the banking panics in the US and France exacerbated the global deflation and declines in output during 1931 and 1932 (Bernanke and James, 1991).

 Part II will be up soon, in which I’ll discuss some non-monetary contributing factors, and the workings of Eichengreen’s “golden fetters” model.

Copyright Nelson R Hoffman

A New, Eclectic View of the Great Depression- Introduction

16 Jul

Black Tuesday 1929

A coherent understand of the nature and causes of the Great Depression of the 1930s remains the “Holy Grail” of macroeconomics, and the subject has been hotly debated ever since John Maynard Keynes’s General Theory of Employment, Interest and Money débuted in 1936 (Bernanke, 1993).  Indeed, Robert Skidelsky  (1996) has argued that without the Great Depression, the General Theory may never have found a publisher, and the economics profession, and macroeconomics in particular, would be dramatically altered from its present state.  Relative stagnation in the advancement of hypotheses occurred in the decade lasting from the mid 1970s to the mid ‘80s, and it wasn’t until Barry Eichengreen’s groundbreaking work in the mid ’80s that the research took on a new vigor

Milton Friedman and Anna Schwarz’ 1963 publication of  A Monetary History of the United States, 1867-1960, and Peter Temin’s subsequent rejoinder in his 1976 publication Did Monetary Forces Cause the Great Depression? characterized the debate that lasted up until the mid 1980s, with one side giving a definitive “yes” in response and the other giving a definitive “no (Bernanke, 1993).  The monetary hypothesis focuses on the “unprecedented decline in the nominal money supply,” with M1 falling a staggering 26.5% between 1929 and 1933 (Bernanke, 1993).  Friedman and Schwartz assert that the proximate causes of this decline in M1 were the result of both severe banking crises, in the form of bank runs, and the Federal Reserve’s failure to respond with sufficient quantitative easing to accommodate the decline in the nominal money supply (Snowdon and Vane, 2005).  The Fed’s failure to accommodate is blamed on its incompetence and poor management.  IN terms of the equation of exchange—where the money supply (M) times velocity (v) equals the price level (P) times output (Y)—an exogenous decline in M caused the decline in P and Y, with V playing only a passive role.  Temin opposed this view, and concentrated on endogenous, real factors as the cause of the decline in aggregate demand.[1]  As Temin argued, it was the public’s demand for liquidity and the accompanying decline in consumption spending that precipitated the downturn.  Thus, the decline in prices and output is seen as the result of a drop in V.  This Friedman-Temin debate persisted until the mid 1980s, and during this period little progress was made in new theories of the proximate cause of the Great Depression, as both sides merely argued past one another.

Barry Eichengreen’s series of publications in 1984, ’85, and ’86 broke this decade of research of stagnation.  As Ben Bernanke points out in his 1993 publication in “The Journal of Monetary Economics,” the focus had previously been strictly on the US or Great Britain, with little to no mention of the other industrialized or peripheral economies, and Eichengreen’s identification of the interwar gold standard was the first hypothesis that recognized a unified transmission mechanism that could account for the global nature of the downturn (Bernanke, 1993).  According to this view, the Depression was the “inevitable” consequence of “perverse,” “contradictory” policies pursed by the central banks of nations adhering to the “flawed interwar gold-standard (Bernanke, 1993) (Snowdon and Vane, 2005).  This rapidly ignited further research advancement influences by Eichengreen’s internationalist perspective and focus on the inter-war gold standard.

The intention of this 3 part series is to lay out a single, coherent interpretation of the Great Depression.  What the reader will find is that there is not one single answer.  While I draw heavily on the monetarist, internationalist, and gold fetters view of the Depression, these are not the only interpretations that come into play; non-monetary factors and debt-deflation played critical roles as well.  While this is not a small task, it is my hope that the reader will find this eclectic interpretation an informative overview and addition to the existing literature on subject.

Part II is on its way , in which I’ll briefly explain the differences between the pre and inter-war gold standards and the effect on the international economy .  After that you can expect to see a series discussing some significant macro-repercussions as a consequence of government micro-regulation of the housing and financial markets, and some startling similarities between the Great Depression and the Great Recession of 2008 and beyond.  Thus, in order to gather context for today, one must examine the past.

Copyright Nelson R Hoffman