Tuesday, January 8, 2008

Impressions about depressions

The Federal Reserve Bank of Minneapolis just published a fascinating book about depressions. It covers not just the US Great Depressions but also severe and prolonged downturns elsewhere during the same period or other periods. Depressions are defined generously, as episodes of below average growth over an extended time are also included.

The classical explanation of the US Great Depression, according to Milton Friedman and Anna Schwartz, was that the Federal Reserve severely messed up in response to the 1929 crash, withdrawing liquidity instead of flooding the market with money. Central banks have learned since, seeing their reactions to modern stock market crashes. But while we now understand that reducing drastically the money supply can have adverse consequences on the economy, how could this last for so long? After all, don't we all agree that money is neutral in the long run? And in fact, monetary aggregates and productivity were back to normal by 1933 anyway. So something else was amiss.

Harold Cole and Lee Ohanian challenged convention wisdom by stating the answer has nothing to do with monetary policy. Using theory and historical data, they came to the conclusion that
the real culprit was to a large extend the New Deal. By granting more monopoly power on the labor market, it essentially shut down employment. Generations of school children have been fed the story that the New Deal was the policy that brought the country out of the Great Depression. The New Deal made it worse. The war effort overturned it.

The Minneapolis Fed book is a compendium of the research that has followed the Cole and Ohanian strategy to study other depressions. Not all contributions uncover what makes a depression start and stay so deep for so long. But it is a fascinating read.


Gabriel M said...

I want to be a fan of RBC but I'm not sure what's the proper method for interpreting the inefficient wedges one finds with these kind of models, i.e. how can I know that the highly stylized wedge on labor in the model has anything to do with labor in the micro markets, that sort of thing.

Also, instead of competitive labor markets I'd rather have something that accommodates our undergraduate/Keynesian biases to the effect that there can be frictional and Keynesian unemployment (just a little, I guess).

Anonymous said...

I do not think RBC models limit themselves to frictionless, perfectly competititve labor markets. I think this is the whole point of Lee and Ohanian, market power prolonged the depression.

The inefficiency wedges are certainly important. This is exactly what "business cycle accounting" is after, using RBC models.