In The Midas Paradox Scott Sumner provides a fresh, new narrative in regards to the Great Depression and its economic backstory. He points to various ways in which the modern day understanding of the Great Depression is flawed and how the causality of it has been largely misunderstood. The understanding held by many about the financial crisis of 2008 is mistaken as well due to the attributed similarities between this instance and the happenings of the early-mid 19th century. The book includes a broader discussion about how the understanding of economic factors and imperative to understanding these significant historical events and thus understanding of economic dynamics moving forward.
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The Midas Paradox
Financial Markets, Government Policy Shocks, and the Great Depression
By Scott Sumner
Independent InstituteCopyright © 2015 Independent Institute
All rights reserved.
OVER THE PAST fifty years economic historians have made great progress in explaining the causes of the Great Depression. Many economists now see the initial contraction as being caused, or at least exacerbated, by monetary policy errors and/or defects in the international gold standard. Some argue that New Deal policies delayed recovery from the Depression. But we still lack a convincing narrative of the many twists and turns in the economy between 1929 and 1940. This book attempts to provide such a narrative.
In this book I use an unorthodox approach to monetary economics: one that focuses not on changes in the money supply or interest rates, but rather on disturbances in the world gold market. Others have looked at how the gold standard constrained policy during the Great Depression, and/or how the undervaluation of gold after World War I put deflationary pressure on the world economy. These studies gave insights into the structural inadequacies of the interwar monetary system, but they didn't tell us why a major depression began in America in late 1929, and they certainly didn't explain the seventeen high-frequency changes in the growth rate of U.S. industrial production shown in Table 1.1.
I will show that if we take the gold market seriously we can explain much more about the Great Depression than anyone had thought possible. Three types of gold market shocks generated much of the variation shown in Table 1.1: changes in central bank demand for gold, private sector gold hoarding, and changes in the price of gold. The remaining output shocks are linked to five wage shocks that resulted from the New Deal. This is the first study to provide a comprehensive and detailed look at all high frequency macro shocks during the Great Depression.
In order to be useful, economic history must be more than mere storytelling. Because asset prices in auction-style markets respond immediately to policy news, they can be much more informative about policy than econometric studies relying on estimated "long and variable lags." Throughout the narrative we will see that financial market responses to the policy shocks of the 1930s were consistent with a gold market approach, but inconsistent with many preceding narratives of the Depression.
This model of the Great Depression has radical implications for monetary theory and policy, and particularly for the current economic crisis. Just as in the early 1930s, policymakers in 2008 missed important warning signs that monetary policy was disastrously off course. Later, we'll see important similarities between the slumps that began in 1929, 1937 and, 2008.
In 1963, Friedman and Schwartz's Monetary History of the United States seemed to provide the definitive account of the role of monetary policy in the Great Depression. Over the past few decades, however, a number of economic historians have suggested that Friedman and Schwartz paid too little attention to the worldwide nature of the Depression, especially the role of the international gold standard. Here are just a few of the revisionist studies that influenced my own research:
1. Deirdre [Donald] N. McCloskey and J. Richard Zecher (1984) on monetary policy endogeniety.
2. David Glasner (1989) on the impact of changes in the demand for gold.
3. Peter Temin (1989) on how devaluation impacts policy expectations.
4. Barry Eichengreen (1992) on the importance of policy coordination.
5. Ben Bernanke (1995) on multiple monetary equilibria.
6. Clark Johnson (1997) on the undervaluation of gold and French hoarding.
Why, then, is there a need for an additional narrative of the Depression, which also focuses on the role of monetary policy and the gold standard?
The analytical framework used in this book differs in important ways from preceding gold standard oriented monetary analyses of the Depression. For instance, although others have pointed to the deflationary consequences of an increased demand for gold, it has generally been viewed more as a secular problem — that is, as a factor tending to depress prices throughout the late 1920s and the 1930s. This is the first study to examine the impact of high frequency gold demand shocks on short-term fluctuations in U.S. output.
In addition, most previous studies have focused on central bank gold hoarding, paying relatively little attention to private gold hoarding. Where central bank hoarding has been examined, it has often been in an ad hoc context, without a framework capable of providing a quantitative estimate of the impact of each central bank on the world price level. And those who did look at the role of gold often focused on the period before the United States and France left the gold standard, and thus missed the severe instability in the world gold market during 1936–1938.
The book concludes with a chapter that describes a gold and labor market model of the Depression, and specialists may wish to examine this chapter first. However, the most important contributions of this study show up not in the formal models, but rather in the narrative provided in Chapters 2 through 10. These chapters offer the first comprehensive examination of the complex interrelationship between gold, wages, and financial markets during the 1930s. We'll see repeated examples of how policy shocks that influenced gold demand and/or wages also impacted financial markets, which will give us a better understanding of how macroeconomic policy impacts the broader economy. This narrative is followed by a brief essay where I show how a misreading of the events of 1932–1933 profoundly influenced the development of twentiethcentury macroeconomics.
As with much of economic history, the goal of this exercise is not simply to fill in blank spots in our understanding of the Depression, but also to develop a better understanding of macroeconomics as a whole. To take just one example, I believe this account provides the first convincing explanation for why the Depression began (in the United States) during the fall of 1929. If other researchers have not been able to provide a convincing explanation for the onset of the Depression, then how can they claim to have explained the cause of the Depression? Indeed, this timing issue calls into question all sorts of standard assumptions about policy exogeniety, the identification of shocks, transmission mechanisms, and policy lags. Thus, I see this study as offering both a narrative of the Depression and a critique of modern monetary analysis.
The manuscript was basically completed in 2006, but revisions were made after the severe crisis of late 2008. During this period I was shocked to see so many misconceptions from the Great Depression repeated in the current crisis:
1. Assuming causality runs from financial panic to falling aggregate demand (rather than vice versa).
2. Assuming that sharply falling short-term interest rates and a sharply rising monetary base meant "easy money."
3. Assuming that monetary policy became ineffective once rates hit zero.
I had thought that Friedman and Schwartz had disposed of these misconceptions, and was surprised to see so many economists making these assumptions during the current crisis. Indeed, the view that Fed policy was "easy" during late 2008 was almost universal. How could we have so quickly forgotten the lessons of the Great Depression? The reaction of economists to the current crisis suggests that much of macroeconomic theory is built on a foundation of sand. We think we have advanced far beyond the prejudices of the 1930s, but when a crisis hits we reflexively exhibit the same atavistic impulses as our ancestors. Even worse, we congratulate the Fed for avoiding the mistakes of the 1930s, even as it repeats many of those mistakes.
The next section lists a few key findings from each chapter, many of which are new, and some of which directly challenge previous accounts of the Depression. In other cases, I develop explanations for events that most economic historians have overlooked.
Because financial markets respond immediately to new information, they can be especially useful in resolving questions of causality — arguably the most difficult problem faced by economic historians. Between 1929 and 1938, U.S. stock prices were unusually volatile. And between 1931 and 1938, there was an especially close correlation between news stories related to gold and/or wage legislation and financial market prices. A simple aggregate supply and demand (AS/AD) framework can explain most of the output volatility of the 1930s. The demand shocks were triggered by gold hoarding (or changes in the price of gold), and the supply shocks were caused by policy-driven changes in hourly wage rates.
U.S. monetary policy tightened in mid-1928, but there is little evidence to support the view that the events of October 1929 were a lagged response to this action. World monetary policy (as measured by changes in the gold reserve ratio) was stable between June 1928 and October 1929, and then tightened sharply over the following twelve months. It was this policy switch, perhaps combined with bearish sentiment from the reduced prospects for international monetary coordination, which triggered a sharp decline in aggregate demand.
The German economic crisis of 1931 was a key turning point in the Depression. It led to substantial private gold hoarding, and between mid-1931 and late 1932 strongly impacted U.S. equity markets. The two October 1931 discount rate increases by the Federal Reserve (Fed) had little or no impact. Instead, gold hoarding triggered by the British devaluation was the most important factor depressing aggregate demand during the fall of 1931.
Keynes suggested that the Fed's spring 1932 open market purchases might have been ineffective due to the existence of a "liquidity trap." Friedman and Schwartz suggested that the modest upswing in late 1932 was a lagged response to the Fed's efforts. Neither view is supported by the evidence. The open market purchases were associated with extensive gold hoarding, and this prevented any significant increase in the money supply. Stock prices, commodity prices, and economic output only began rising when renewed investor confidence in the dollar curtailed the hoarding of gold.
President Roosevelt instituted a dollar depreciation program in April 1933 with the avowed goal of raising the price level back to its 1926 level. This program was unique in U.S. history and was the primary factor behind both the 57 percent surge in industrial production between March and July 1933 and the 22 percent rise in the wholesale price level in the twelve months after March 1933. The initial recovery was triggered not by a preceding monetary expansion, but rather by expectations of future monetary expansion.
The National Recovery Administration (NRA) adopted a high wage policy in July 1933, which sharply increased hourly wage rates. This policy aborted the recovery, led to a major stock market crash, and helped lengthen the Depression by six to seven years. In a sense, one depression ended and a second "Great Depression" began in late July 1933, unrelated to the contraction of 1929–1933.
The gold-buying program of late 1933 is a little known and widely misunderstood part of the New Deal. The program was a variant of Irving Fisher's "Compensated Dollar Plan," and was essentially a monetary feedback rule aimed at returning prices to pre-Depression levels. Although the program helped promote economic recovery, it eventually became a major political issue and led key economic advisors to resign from the Roosevelt Administration. This program exposed the deep structure of the monetary transmission mechanism, a structure hypothesized by modern new Keynesians, but normally almost entirely hidden from view.
Although the conventional view is that Franklin D. Roosevelt took America off the gold standard, U.S. monetary policy became even more strongly linked to gold after 1934 than it had been before 1933. A recovery in the United States finally got underway when the Supreme Court declared the NIRA to be unconstitutional in mid-1935. Because the demise of the gold bloc in 1936 reduced devaluation fears, its impact on gold demand and the broader macroeconomy was exactly the opposite of the British devaluation of 1931.
Actual and prospective gold dishoarding led to high inflation during late 1936 and early 1937. Expectations of future gold supplies were so high that tight monetary policies lacked credibility. Rapid inflation led to a "gold panic" in the spring of 1937 as investors became concerned that the buying price of gold would be reduced. During 1937, the expansionary impact of gold dishoarding began to be offset by wage increases, which reflected the resurgence of unions after the Wagner Act and Roosevelt's landslide reelection.
Many economic historians have argued that the 1937–1938 depression was caused by restrictive fiscal policy and/or increases in reserve requirements. Neither view is persuasive. Instead, the rapid wage inflation (combined with the end of gold panic–induced price inflation) modestly slowed the economy during the spring and summer of 1937. This slowdown led to renewed expectations of dollar devaluation during the fall, and as gold was again hoarded on a massive scale, expectations of future U.S. monetary growth declined sharply. It was this shift in expectations that triggered the precipitous declines in stock prices, commodity prices, and industrial production during late 1937.
A misinterpretation of two key policy initiatives, the open market purchases of 1932 and the NIRA, had a profound impact on macroeconomic theory during the twentieth century. Because early Keynesian theory was based on a misreading of these policies, it could not survive the radically altered policy environment of the postwar period. By the 1980s, the original Keynesian model had been largely replaced by a (quasi-monetarist) "new Keynesianism," featuring highly effective monetary policy and a self-correcting economy. This era may have ended in 2008.
Economic historians continue to debate whether the international gold standard was an important constraint for interwar central banks. It seems unlikely that this issue can ever be resolved, and the debate may have diverted attention from the much more important issue of how the world gold market impacted contemporaneous policy expectations. At the deepest level, the causes of the Great Depression and World War II are very similar — both events were generated by policymakers moving unpredictably between passivity and interventionism.
If one defines real wages as the ratio of nominal wages to wholesale prices, then high frequency fluctuations in real wages during the 1930s were tightly correlated with movements in industrial production. Understanding real wage cyclicality is the key to understanding the Great Depression. This requires separate analysis of nominal wage and price level shocks.
New Deal legislation led to five separate nominal wage shocks, which repeatedly aborted promising economic recoveries. The gold market approach can help us understand price-level volatility between October 1929 and March 1933, and, surprisingly, is even more useful during the first five years after the United States departed from the gold standard. Under an international gold standard, the domestic money supply, the interest rate, and gold flows are not reliable indicators of domestic monetary policy. Rather, changes in the gold reserve ratio, and the dollar price of gold, are the key monetary policy instruments.
The problem of causality is a central issue in both macroeconomics and history. Yet, despite impressive improvements in econometric techniques, no consensus has been reached on how to model the monetary transmission mechanism. Economists often look for leads and lags as a way of establishing causality, but as we will see, these attempts have foundered on the problem of identification. Put simply, 250 years after David Hume elegantly described the quantity theory of money, we still don't know how to identify monetary "shocks."
From a methodological perspective, the most notable aspect of this study is its use of financial and commodity market responses to disturbances in the gold market (and to a lesser extent, the labor market) as a way of establishing causality. Indeed, the "efficient market hypothesis" suggests that if we wish to think of causality pragmatically, say as a guide to policy, then we probably cannot go beyond financial market reactions to economic shocks. Any factors that were invisible to financial markets, even root causes that seem blindingly obvious to historians, do not provide a realistic guide to policymakers. (A modern example of this conundrum occurred when many pundits blamed the Fed for missing a housing bubble that was also missed by the financial markets.)
Excerpted from The Midas Paradox by Scott Sumner. Copyright © 2015 Independent Institute. Excerpted by permission of Independent Institute.
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Table of Contents
PART I Gold, Wages, and the Great Depression,
PART II The Great Contraction,
2 From the Wall Street Crash to the First Banking Panic,
3 The German Crisis of 1931,
4 The Liquidity Trap of 1932,
PART III Bold and Persistent Experimentation: Macroeconomic Policy during 1933,
5 A Foolproof Plan for Reflation,
6 The NIRA and the Hidden Depression,
7 The Rubber Dollar,
PART IV Back on the Gold Standard,
8 The Demise of the Gold Bloc,
9 The Gold Panic of 1937,
10 The Midas Curse and the Roosevelt Depression,
PART V Conclusion,
11 The Impact of the Depression on Twentieth-Century Macroeconomics,
12 What Caused the Great Depression?,
13 Theoretical Issues in Modeling the Great Depression,
About the Author,