Econbrowser: The gold standard and the Great Depression

Econbrowser: The gold standard and the Great Depression:

"Under a pure gold standard, the government would stand ready to trade dollars for gold at a fixed rate. Under such a monetary rule, it seems the dollar is 'as good as gold.'

Except that it really isn't-- the dollar is only as good as the government's credibility to stick with the standard. If a government can go on a gold standard, it can go off, and historically countries have done exactly that all the time. The fact that speculators know this means that any currency adhering to a gold standard (or, in more modern times, a fixed exchange rate) may be subject to a speculative attack. ...A gold standard only works when everybody believes in the overall fiscal and monetary responsibility of the major world governments and the relative price of gold is fairly stable. And yet a lack of such faith was the precise reason the world returned to gold in the late 1920's and the reason many argue for a return to gold today. Saying you're on a gold standard does not suddenly make you credible."

Ben Bernanke and Harold James found that there was a strong correlation between going off the gold standard and economic recovery during the great depression (NBER working paper version here). The gold standard causes deflation during recessions and limits monetary policy. That is also its main advantage the rest of the time. It prevents inflation by limiting monetary policy as long as governments stick with it, but they don't.

In the following graph, what would be inflation and what would be deflation if the US were on a gold standard?

 Click on graph to see full size.

Usually countries try to lower interest rates during a severe recession, but several countries dramatically raised a basic interest rate (the discount rate) in 1931 during the Great Depression in a failed attempt to preserve the gold standard.  Krugman:

[The graph] shows discount rates in the US, Britain, and Germany in the late 20s and early 30s, and highlights the way attempts to defend the gold standard led to perverse monetary policies at what was arguably a crucial moment.

The good news is that we don’t have a gold standard now, and thus aren’t as perverse. In truth, though, Asian crisis countries did raise rates in the 1990s

 Brad Delong points out that a major lesson of the Great Depression is that the sooner each of the biggest economies left the gold standard, the sooner they began recovery.  The arrows indicate ending the gold standard:

History Repeats? | The Big Picture

History Repeats? | The Big Picture: "comparison between the 1929 Dow and the 2000 Nasdaq"

Matthew Yglesias » The Trouble With Prescience

Matthew Yglesias » The Trouble With Prescience: "And in the reputational economy of analysts the consequences are even worse. If you go along with the herd and then predict a problem a month before it arises, then you strike everyone as prescient. But if you start warning about something and then it doesn’t happen, and then you keep nagging people, and then you keep complaining about how nobody’s listening to you, you start getting dismissed as a crank. And when you’re proven right, you’re still that crank nobody wants to listen to. You don’t get hailed as a hero. But Ben Bernanke who made very mainstream mistakes and then pivoted adroitly once the bill came due does."

Calculated Risk: Bankruptcy Filings and Mortgage Delinquencies by State

Calculated Risk: Bankruptcy Filings and Mortgage Delinquencies by State: "Here is a graph of bankruptcy filings vs. mortgage delinquencies (including homes in foreclosure process) by state for Q2 2009."

One look at this tells me that this recession may be tamed, but it is not going away any time soon.

Austrian Business Cycle Theory

Ron Paul has been evangelizing among congressional Republicans for the economic thought of Thomas Woods, a figure who was unpopular in this crowd when he was arguing against Bush’s wartime policies. Now, however, Woods is popular for his “Austrian business cycle theory", memorably criticized by Tyler Cowen, Bryan Caplan and Gordon Tullock at the libertarian/Chicago end of the spectrum to Keynesians like Paul Krugman and Brad DeLong.
See John Quiggan's history of the contributions of the Austrian theory.

Japan's Lost Decade and Financial Crises

Why we need a new macroeconomic paradigm | vox - Research-based policy analysis and commentary from leading economists: "Do the US and Europe risk repeating Japan’s lost decade? This column warns that if the US or European financial clean-ups falter, they will be vulnerable to recurring financial crises. It argues that macroeconomic models should not treat finance as an innocuous veil and calls for a new approach that places financial intermediaries at the centre of its models."

Part of the problem of macroeconomics is that macroeconomists mostly ignore finance and a big problem with finance economics is that they ignore macroeconomics.  More cross-specialty work please.

The Great Moderation

The Great Moderation was a phrase sometimes used to describe the perceived end to economic volatility created by the new 21st century banking systems. ...
In the mid 1980s major economic variables such as GDP, industrial production, monthly payroll employment and the unemployment rate began a decline in volatility. ... The greater predictability in economic and financial performance was caused firms to hold less capital and to be less concerned about liquidity positions. This, in turn, is thought to have been a factor in encouraging increased debt levels and a reduction in risk premia required by investors.

That kind of hubris sounds exactly like what Minsky said would cause a credit bubble. 


FRB: Speech, Bernanke--The Great Moderation--February 20, 2004: This is a speech from Fed chairman Bernanke that he would never think of giving today.

One of the most striking features of the economic landscape over the past twenty years or so has been a substantial decline in macroeconomic volatility. In a recent article, Olivier Blanchard and John Simon (2001) documented that the variability of quarterly growth in real output (as measured by its standard deviation) has declined by half since the mid-1980s, while the variability of quarterly inflation has declined by about two thirds.1 Several writers on the topic have dubbed this remarkable decline in the variability of both output and inflation 'the Great Moderation.' Similar declines in the volatility of output and inflation occurred at about the same time in other major industrial countries, with the recent exception of Japan, a country that has faced a distinctive set of economic problems in the past decade.

Reduced macroeconomic volatility has numerous benefits. Lower volatility of inflation improves market functioning, makes economic planning easier, and reduces the resources devoted to hedging inflation risks. Lower volatility of output tends to imply more stable employment and a reduction in the extent of economic uncertainty confronting households and firms. The reduction in the volatility of output is also closely associated with the fact that recessions have become less frequent and less severe.²
Why has macroeconomic volatility declined? Three types of explanations have been suggested for this dramatic change; for brevity, I will refer to these classes of explanations as structural change, improved macroeconomic policies, and good luck. Explanations focusing on structural change suggest that changes in economic institutions, technology, business practices, or other structural features of the economy have improved the ability of the economy to absorb shocks. Some economists have argued, for example, that improved management of business inventories, made possible by advances in computation and communication, has reduced the amplitude of fluctuations in inventory stocks, which in earlier decades played an important role in cyclical fluctuations.³ The increased depth and sophistication of financial markets, deregulation in many industries, the shift away from manufacturing toward services, and increased openness to trade and international capital flows are other examples of structural changes that may have increased macroeconomic flexibility and stability.
The second class of explanations focuses on the arguably improved performance of macroeconomic policies, particularly monetary policy. The historical pattern of changes in the volatilities of output growth and inflation gives some credence to the idea that better monetary policy may have been a major contributor to increased economic stability. As Blanchard and Simon (2001) show, output volatility and inflation volatility have had a strong tendency to move together, both in the United States and other industrial countries. In particular, output volatility in the United States, at a high level in the immediate postwar era, declined significantly between 1955 and 1970, a period in which inflation volatility was low. Both output volatility and inflation volatility rose significantly in the 1970s and early 1980s and, as I have noted, both fell sharply after about 1984. Economists generally agree that the 1970s, the period of highest volatility in both output and inflation, was also a period in which monetary policy performed quite poorly, relative to both earlier and later periods (Romer and Romer, 2002).⁴ Few disagree that monetary policy has played a large part in stabilizing inflation, and so the fact that output volatility has declined in parallel with inflation volatility, both in the United States and abroad, suggests that monetary policy may have helped moderate the variability of output as well.
The third class of explanations suggests that the Great Moderation did not result primarily from changes in the structure of the economy or improvements in policymaking but occurred because the shocks hitting the economy became smaller and more infrequent. In other words, the reduction in macroeconomic volatility we have lately enjoyed is largely the result of good luck, not an intrinsically more stable economy or better policies. Several prominent studies using distinct empirical approaches have provided support for the good-luck hypothesis (Ahmed, Levin, and Wilson, 2002; Stock and Watson, 2003).
Explanations of complicated phenomena are rarely clear cut and simple, and each of the three classes of explanations I have described probably contains elements of truth. Nevertheless, sorting out the relative importance of these explanations is of more than purely historical interest. Notably, if the Great Moderation was largely the result of good luck rather than a more stable economy or better policies, then we have no particular reason to expect the relatively benign economic environment of the past twenty years to continue. Indeed, if the good-luck hypothesis is true, it is entirely possible that the variability of output growth and inflation in the United States may, at some point, return to the levels of the 1970s. If instead the Great Moderation was the result of structural change or improved policymaking, then the increase in stability should be more likely to persist, assuming of course that policymakers do not forget the lessons of history.
My view is that improvements in monetary policy, though certainly not the only factor, have probably been an important source of the Great Moderation. In particular, I am not convinced that the decline in macroeconomic volatility of the past two decades was primarily the result of good luck, as some have argued, though I am sure good luck had its part to play as well. In the remainder of my remarks, I will provide some support for the "improved-monetary-policy" explanation for the Great Moderation. I will not spend much time on the other two classes of explanations, not because they are uninteresting or unimportant, but because my time is limited and the structural change and good-luck hypotheses have been extensively discussed elsewhere.⁵ Before proceeding, I should note that my views are not necessarily those of my colleagues on the Board of Governors or the Federal Open Market Committee.
...

Conclusion
The Great Moderation, the substantial decline in macroeconomic volatility over the past twenty years, is a striking economic development. Whether the dominant cause of the Great Moderation is structural change, improved monetary policy, or simply good luck is an important question about which no consensus has yet formed. I have argued today that improved monetary policy has likely made an important contribution not only to the reduced volatility of inflation (which is not particularly controversial) but to the reduced volatility of output as well. Moreover, because a change in the monetary policy regime has pervasive effects, I have suggested that some of the effects of improved monetary policies may have been misidentified as exogenous changes in economic structure or in the distribution of economic shocks. This conclusion on my part makes me optimistic for the future, because I am confident that monetary policymakers will not forget the lessons of the 1970s.
I have put my case for better monetary policy rather forcefully today, because I think it likely that the policy explanation for the Great Moderation deserves more credit than it has received in the literature. However, let me close by emphasizing that the debate remains very much open. Although I have focused on its strengths, the monetary policy hypothesis has potential deficiencies as well. For example, although I pointed out the difficulty that the structural change and good-luck explanations have in accounting for the rather sharp decline in volatility after 1984, one might also question whether the change in monetary policy regime was sufficiently sharp to have had the effects I have attributed to it.¹⁵ The consistency of the monetary policy explanation with the experience of the 1950s, a period of stable inflation during which output volatility declined but was high in absolute terms, deserves further investigation. Moreover, several of the channels by which monetary policy may have affected volatility that I have mentioned today remain largely theoretical possibilities and have not received much in the way of rigorous empirical testing. One of my goals today was to stimulate further research on this question. Clearly, the sources of the Great Moderation will continue to be an area for fruitful analysis and debate.

Fed Independence

A Fed chair like Alan Greenspan is arguably one of the ten most powerful people in the world. Why does congress want the Fed to be politically independent? 

Grasping Reality with Both Hands: "WILLIAM McChesney Martin, a Democrat, was twice reappointed chairman of the United States Federal Reserve by Republican President Dwight D. Eisenhower.

Paul Volcker, a Democrat, was reappointed once by the Reagan administration (but not twice: there are persistent rumors that Reagan's treasury secretary, James Baker, thought Volcker too invested in monetary stability and not in producing strong economies to elect Republicans).

Alan Greenspan, a Republican, was reappointed twice by Bill Clinton. And now Barack Obama has announced his intention to renominate Republican appointee Ben Bernanke to the post.

The Fed chairmanship is the only position in the US government for which this is so: it is a mark of its unique status as a non or not-very-partisan technocratic position of immense power and freedom of action - nearly a fourth branch of government, as David Wessel's recent book 'In Fed We Trust' puts it."

Calculated Risk: House Prices: Real Prices, Price-to-Rent, and Price-to-Income

Calculated Risk: House Prices: Real Prices, Price-to-Rent, and Price-to-Income: "Here are three key measures of house prices: Price-to-Rent, Price-to-Income and real prices based on the Case-Shiller quarterly national home price index."

Argues that housing prices are still too high!

Science: Prediction or Explanation?

Economist's View: "There has been no shortage of effort devoted to predicting earthquakes, yet we still can't see them coming far enough in advance to move people to safety. When a big earthquake hits, it is a surprise. We may be able to look at the data after the fact and see that certain stresses were building, so it looks like we should have known an earthquake was going to occur at any moment, but these sorts of retrospective analyses have not allowed us to predict the next one. The exact timing and location is always a surprise."

Felix Salmon » Blog Archive » Chart of the Day: The stock market’s P/E Ratio | Blogs |

Felix Salmon - The stock market’s P/E Ratio:

"Stocks are now trading at p/e ratios not seen since 2004. This is more than pricing in a recovery — this looks very much like pricing in a return to the status quo ante. Does anybody really still think that corporate profits are going to be able to rise faster than US GDP indefinitely? It seems from the level of the stock market that, yes, they do."

See the chart at the link. However, the main reason that P/E is high is not that prices are high, it is that earnings are unusually low. In the absence of bubble psychology, prices should stay fairly stable since they are the forecasts of future earnings streams, but earnings are certainly very volatile. Thus, the P/E should fluctuate during recessions and really ought to be higher during downturns than it is during booms.

More on deficits and interest rates (wonkish) - Paul Krugman Blog - NYTimes.com

More on deficits and interest rates (wonkish) - Paul Krugman Blog - NYTimes.com: "I noted that over the past decade there has been a close negative correlation between deficits and interest rates:"

This is the exact opposite of what macroeconomics textbooks teach.  If there is deficit spending, the net national savings rate tends to go down and the interest rate goes up (as in the standard savings and investment graph).  That is true during economic growth.  However, during a recession, there is excess savings because consumers try to save more and firms tend to invest a lot less and that makes the interest rate drop (again as the standard savings and investment graph would predict). The reason is that short-run deficit fluctuations are caused by the automatic stabilizers (tax revenues automatically decline and government spending automatically increases)
Read the whole thing.  

Global Development: Views from the Center » Blog Archive » Crisis? Not If We Take a Long View (Development Impacts of Financial Crisis)

Global Development: Views from the Center » Blog Archive » Crisis? Not If We Take a Long View (Development Impacts of Financial Crisis): "When you’re done reading today’s news stories about the crisis, take a deep breath. Media coverage is focused on the very short term, as usual. Speculation abounds that we live in a different world now. I’m reminded of portentous claims after the Asian Financial Crisis that “the miracle was over”, claims which look very overwrought in hindsight. In historical perspective, many of the most worrisome recent crises are small bumps on a very long road."

Grasping Reality with Both Hands

Grasping Reality with Both Hands: "Why Aren't We Undergoing Another Great Depression?

Paul Krugman: "The answer, basically, is Big Government...."

The loose end in Krugman's article is why there weren't more Great Depressions back in the old days, before big government. The answers, I think, are two:

1. Business cycles are a disease of the post-agricultural economy--of the nonfarm economy. If you look back at the nonfarm unemployment rate before 1930, things look not as bad as the Great Depression but still pretty bad.

2. Most countries had a form of "big government"--a military large in size relative to its nonfarm economy and an activist, interventionist central bank--reaching far back into the past.

Chart: The Collapse In Global Trade - Planet Money Blog : NPR

Chart: The Collapse In Global Trade - Planet Money Blog : NPR: "The chart above shows that we're living through the only major, sustained fall in global trade since 1970. ..."Behind each story lies a catastrophic decline in gross exports," Weinberg writes. The IMF data on exports track a 36 percent fall from the peak of $1.5 trillion in July 2008. "We have never experienced anything like this in our lifetimes. Neither, quite frankly, did we ever think we would."

Marginal Revolution: Identifying and Popping Bubbles: Evidence from Experiments

Marginal Revolution: Identifying and Popping Bubbles: Evidence from Experiments: "On the way up, bubbles encourage excessive investment in the bubble sector. On the way down a bursting bubble can create wealth shocks, liquidity shortages, and balance-sheet death-spirals. For both of these reasons, it would be good to be able to identify and pop bubbles. Identifying bubbles isn't easy, however, because, especially when interest rates are low, prices can increase rapidly with small, rational changes in investor expectations. But the difficulty of identifying bubbles is reasonably well known. What I think may be less appreciated is that bubbles are hard to pop even when you know that they exist."

If we can't identify them and we can't pop them, then we better create institutions that make them less dangerous.