Wednesday, April 13, 2016

More on the Great Depression

David Glasner has a new post up on the monetary theory of the Great Depression which reminded me that I could do a bit more in the vein of this post. I'm sure the data is probably consistent with several different causal mechanisms. My only (interesting) opinion about the gold standard was that leaving the gold standard wasn't relevant to the recovery, but rather interest rate pegging driving (effective) hyperinflation.

Anyway, I grabbed the FRED series A08170USA175NNBR (non-agricultural employment 1900-1943) and tested the model that nominal shocks were proportional to labor supply shocks (that I talked about in this post)

In fact, the GNP data go back far enough to look at 1921-1942. So here's the extended inflation graph:

Here's the extended nominal shock graph (with the employment shock model, which works really well):

And here is the interest rate model (from the paper) using the 3-month secondary market rate (solid) as well as data form (dotted):

Unfortunately due to the low resolution of the data, I can't quite see if this mechanism is at play -- that the Fed raised interest rates (see here also) and caused an "avalanche". Raising interest rates (effective monetary tightening) in the run-up to the market crash of 1929 caused the subsequent crash (similar to the effective rise in interest rates in the run-up to the Great Recession), like an airplane stalling to lose altitude.

Here's a graph of that more recent effective rise in interest rates:

And the tightening by the Fed started happening as early as the 1920s, much like the Fed tightening starting in the mid-2000s.


Update 14 April 2016

I finally found a source for this this older data and was able to make some better graphs (instead of a cheesy overlay) in both log and linear scales:


PS [old charts from 13 April 2016]

I did find some data from here that I've overlaid on the interest rate model graph above:

And here's a zoom in on the relevant piece:

What is interesting to me is the piece where the interest rate exactly follows the rising segment of the model output from about 1925 to 1929. That's very similar to the result for the years before the Great Recession, albeit at a much steeper rate:

I'm still looking into this, but the avalanche model where the Fed piles snow on the mountain by tightening policy, creating a bubble and raising GDP above its "natural" rate is looking pretty good.


  1. "the model that nominal shocks were proportional to labor supply shocks"

    This idea of yours is really concerning. Employment is something that economics tries to explain, but you basically seem to have made it exogenous. The problem is that employment should never be an exogenous variable (either constant or determined by random shocks) as it is something that we are trying to explain. Yes, the labor force or working age population can reasonably be made exogenous, but it's extremely strange to do this to one of the most important variables that you want to explain variation in. This model appears to simply say that employment growth is random.

    1. Hi John,

      I'd completely agree that exogenous labor would be a pretty odd model! That's why I think the model at this link is kind of a reductio ad absurdum.

      The thing is that while I'm somewhat agnostic about causality, in general I think the causality goes the other way. The "nominal shocks" are the "source" and non-ideal information transfer (e.g. here) is the "source" of the nominal shocks. Is it non-ideal information transfer in the "money markets" N → M (inflation, interest rates) or the labor market N → L? Both? Some other as yet undiscovered market/information equilibrium relationship?

      I can't really answer that at this point, and I wouldn't say I understand it in any sense of the word.

    2. I think the idea of avalanches in financial markets indicated by the above trend interest rates (the whole PS above) is also part of the explanation. But how it fits together is still unknown.

      For example, there's this from two years ago.

  2. Seems possible that rates reflected what was going on policy wise? This one might be worth a read (if memory serves, Glasner has cited it too):

    1. I'm sure they do. If we look at the monetary base during this period:

      We can see it was flat before the big crash, which is the same as happened in 2008:

      (It's a bit harder to see because QE was so large immediately after compared to the 1930s.)

      Since NGDP was increasing, this effectively raises interest rates leading up to the crash, and the subsequent expansion of the base lowers interest rates.


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