And Apropos of Keynes, ch. 19...

Paul Krugman writes:

The New Deal and the Depression: Interesting stuff. I agree that the NIRA might have raised the structural rate of unemployment - but the economy got nowhere near the structural level of unemployment during the NIRA period, so what difference could that have made?

What really puzzles me, though, is the assertion that wage and price rigidity created by the New Deal aborted the natural recovery process. Through what channel could price flexibility have helped? The US spent most of the 30s pretty much up against the zero bound, with interest rates well below 1 percent. A fall in the price level would have had the same effect as an increase in the monetary base - that is, no effect at all - except for the slight wealth effect of rising real balances. And even this slight effect could easily have been outweighed by debt deflation.

You just have to bear in mind that this was, um, the Great Depression - normal rules about monetary policy did not apply. And the same goes for any possible role of price flexibility.

Comments

[anne]

http://www.calvorn.com/gallery/photo.php?photo=7054&exhibition=7&ee_lang=eng&u=91407,10

Purple Sandpiper
Barnegat Light, New Jersey.

Thank you, Paul and Brad.

[pgl]

I seem to recall James Tobin talk about a debt deflation hypothesis, which basically suggested that households who saw the real value of their debt rise with price-level decreases would consume less. So if the LM curve is flat and the IS curve moves in, then price deflation could reduce aggregate demand.

[rea]

"households who saw the real value of their debt rise with price-level decreases would consume less."

Certainly that corresponds to my mother's recollection of those times, when her family had problems affording food.

[anne]

"households who saw the real value of their debt rise with price-level decreases would consume less."

This was a constant problem in Japan through the deflation, while the contraction effect was only countered with fiscal policy.

[andres]

Wow. Paul Krugman and Brad DeLong have a post-Keynesian moment. Let's hope it's not the last.

[pgl]

I hope rea's mom appreciates my Angrybear post re the Debt Deflation hypothesis. I had to add to it a really nice (or was that snarky) comment from Daniel Gross (via an email) re Bryan Caplan's comment about FDR scaring investors. Yes, investment demand rose in spite of this as other leaders in the 1930's were scaring people a lot more.

[Cranky Observer]

Brad,
Interesting stuff, and quite interesting to read. But I get the impression that you (and Krugman) are using the USS Iowa to sink a rowboat here.

Cranky

[Robert Waldmann]

I am impressed by Krugman's brilliance (as always) but not convinced by his argument (is this the first time for me ?). I don't know exactly what to do.

My problem is this. Krugman discusses the price level and notes it didn't matter given the liquidity trap with nominal interest rates as low as they can go. However, this was due to deflation. The price level may not have mattered in the usual way, but the deflation rate mattered a lot.

I can present a story in which the key issue was to get the deflation rate up to 0 and price flexibility was needed to do this. That is a more rapid deflation would be a briefer deflation.

The story follows
banks fail and the money supply falls partly because their reserves become cash in circulation and the money multiplier thus falls and partly because fearing more failures consumers take cash out of banks (more vault cash to cash in circulation) and banks feel they need higher reserves. Finally some of the cash in circulation is really cash stored under matresses so it is not working as money at all.

The reduction of the money supply causes an increase in the relative price of money (a deflation) so 1% nominal is huge real and investment collapses. Only when the deflation ends can firms afford to invest again.

The deflation ends when the real value of money is so high that there is enough so that money actually circulating fits
M*V = P*Y with a normal V. For this to happen, it is necessary that people have built up the desired amount of cash under matresses.

The story is there is a new lower equiilibrium price level and deflation continues until it is reached.

Now, if Krugman bothers to respond to my argument, he will say "what about the Phillips curve. The price level affects nominal interest rates (unless there is a liquidity trap) and they affect aggregate demand, but the change in the inflation rate depends on the unemployment rate via the Phillips curve. The only way to end deflation was to get the unemployment rate down using fiscal policy and/or/including the WPA and public works projects.

To which I say hmmm the old Phillips curve applies in normal times and not when the key issue is how much money people have stuffed under their matresses. There is no empirical evidence, because we have no information on the shape of the Phillips curve at unemployment over 15% do we ?

So finally bottom line. Maybe with more price flexibility there would have been a quicker briefer deflation. Real interest rates would have been even huger during this deflation but investment can be less than zero. I we assume that the bankruptcy of most industrial corporations due to debt deflation would have been no big deal, we can conclude that the NIRA may have prolonged the depression by a few months (by slowing and extending deflation until it was a dead letter).

[mds]

"But I get the impression that you (and Krugman) are using the USS Iowa to sink a rowboat here."

And yet, decades after the New Deal was implemented, Kling can still vomit up the same old pool of bile and be taken seriously. Social Security can still be attacked by "serious" economists and pundits as a horrific error that must be annihilated. Years after Galbraith was at his height, we still get to read WSJ pontificators making the argument that the poor have too much money, while the rich have too little. So I think Doctors DeLong and Krugman can be forgiven for using 16-inch guns to blast away at this impressively durable rowboat. Zombie Louis XIV and Jay Gould have proven very hard to kill.

[Robert Waldmann]

Ah I see that it was all there in the General Theory (of course). My argument is the one Keynes deals with immediately before making the argument also made by Krugman

"The contingency, which is favourable to an increase in the marginal efficiency of capital, is that in which money-wages are believed to have touched bottom, so that further changes are expected to be in the upward direction. The most unfavourable contingency is that in which money-wages are slowly sagging downwards and each reduction in wages serves to diminish confidence in the prospective maintenance of wages.
("my" argument)

[snip]

It is, therefore, on the effect of a falling wage- and price-level on the demand for money that those who believe in the self-adjusting quality of the economic system must rest the weight of their argument; though I am not aware that they have done so."

("Krugman's" argument follows)

[Cranky Observer]

> And yet, decades after the New Deal was
> implemented, Kling can still vomit up the
> same old pool of bile and be taken
> seriously. Social Security can still be
> attacked by "serious" economists and pundits
> as a horrific error that must be
> annihilated.

mds,
You are correct. I should have said "using the USS Iowa to sink a garbage scow".

Cranky

[anne]

http://www.calvorn.com/gallery/photo.php?photo=7050&u=91407,18

Red-tailed Hawk Taking Flight
New York City--Riverside Park.

Robert, nice argument and resolution. I was going along similarly.

[kevin quinn]

I would also cite on this topic one of my favorite papers, Delong and Summers on the potentially destabilizing effects of price deflation

[josh]

in any case, you've been working pretty hard to establish something the no "normal" person could disagree with, eh?

[elliottg]

There is a reason to do this. Kling can be safely ignored on all topics henceforward as well as Alex Tabarrok (who admits to being not normal over at marginal revolution). I just wish that Brad would use the howitzer on Mankiw instead of the kid gloves.

[ionides]

I have read that the recession of 1920 was short-lived precisely because of price and wage flexibility. Both declined severely and suddenly and recovery was rapid.

[Barry]

Piling on, 'cause it's deserved:

A look at GNP growth/shrinkage rates belies the idea that the New Deal prolonged the Great Depression. The pre-Keynesian policies had failed abysmally, to an unprecedented level. Immediately upon FDR's adoption of more Keynesian policies, the GNP started to grow - at rates not achieved by any GOP president before or after, and probably not achieved by any country operating under approved classical or neoclassical economic policies.

The only fly in the oinment is the late 1930's recession, which (a) is a mote in the eye compared with the beam that was the Great Depression and (b) happened after Republicans in Congress forced anti-Keynes/anti-New Deal policy changes on FDR.

Anybody who maintains that FDR's policies prolonged the Great Depression is using the data to infer causality in a way contradictory to how any honest person would use it.

Many people never forgave FDR for saving their *sses, then and now. In all cases, probably due to the belief that a failure to save capitalism from itself then would have lead to, shall we say, a Fascist Deal, rather than a New Deal.

[Gauti Eggertsson]

Paul Krugman’s observations are to some extent formalized in a recent paper “Was the New Deal Contractionary?” at

http://www.newyorkfed.org/research/staff_reports/sr264.html

The paper goes in fact much further than Paul’s comment. It shows that more price rigidity can increase output under the condition of zero interest rates and deflation, the “emergency” conditions observed in 1933.

Moreover, and somewhat surprisingly, the paper shows that increasing monopoly power of firms and workers temporarily (i.e. the NIRA and AAA policies that were a central part of the New Deal aim of fighting deflation) also increase output-- in other words policies that temporarily increase what Paul calls the “structural rate of unemployment” increase output under the type of emergency conditions observed in 1933.

These policies were expansionary according to the paper because they changed deflationary expectations to being inflationary, thus reducing real interest rate and stimulating demand. This is shown in a relatively standard New Keynesian general equilibrium model.

Interstingly the paper cites an article by Keynes from 1933 arguing strongly against these policies using IS-LM arguments.

[anne]

http://www.calvorn.com/gallery/photo.php?photo=7048&u=91407,16

Red-headed Woodpecker Feeding
New York City--Riverside Park.

Thank you, Gauti.

[Keith]

Robert Waldman has some great posts. The liquidity trap argument has always been one of the weaker arguments for the cause of the Great Depression.

It's plenty clear that there's still a good deal of debate about the net effect of the New Deal, that the debate is good and helpful, and that the left-wing hate-filled commenters here who try to use invective against fine economists like Kling and Tabarrok have an almost totalitairian inability to handle any sort of disagreement.

And nobody here will admit the painfully obvious: Even if the New Deal was positive on net, destroying crops while people starved was still wrong. What's the big deal about saying that one of FDR's policies was morally wrong? Are you all so brittle that you can't even handle that? I really pity Anne and others like her.

[Ari]

Again we have our troll, mean-spirited and lying as always:

"Even if the New Deal was positive on net, destroying crops while people starved was still wrong. What's the big deal about saying that one of FDR's policies was morally wrong?"

This is garbage from a troll who Brad Delong has continually deleted. The point is to attack Franklin Roosevelt and the commenters on the board.

[Ari]

Troll, the hate-filled lying comments are always yours.

[anne]

http://www.mhric.org/fdr/chat8.html

September 6, 1936

Labor Day Eve
By Franklin Roosevelt

I have been on a journey of husbandry. I went primarily to see at first hand conditions in the drought states; to see how effectively Federal and local authorities are taking care of pressing problems of relief and also how they are to work together to defend the people of this country against the effects of future droughts.

I saw drought devastation in nine states.

I talked with families who had lost their wheat crop, lost their corn crop, lost their livestock, lost the water in their well, lost their garden and come through to the end of the summer without one dollar of cash resources, facing a winter without feed or food -- facing a planting season without seed to put in the ground.

That was the extreme case, but there are thousands and thousands of families on western farms who share the same difficulties.

I saw cattlemen who because of lack of grass or lack of winter feed have been compelled to sell all but their breeding stock and will need help to carry even these through the coming winter. I saw livestock kept alive only because water had been brought to them long distances in tank cars. I saw other farm families who have not lost everything but who, because they have made only partial crops, must have some form of help if they are to continue farming next spring.

I shall never forget the fields of wheat so blasted by heat that they cannot be harvested. I shall never forget field after field of corn stunted, earless and stripped of leaves, for what the sun left the grasshoppers took. I saw brown pastures which would not keep a cow on fifty acres.

Yet I would not have you think for a single minute that there is permanent disaster in these drought regions, or that the picture I saw meant depopulating these areas. No cracked earth, no blistering sun, no burning wind, no grasshoppers, are a permanent match for the indomitable American farmers and stockmen and their wives and children who have carried on through desperate days, and inspire us with their self-reliance, their tenacity and their courage. It was their fathers' task to make homes; it is their task to keep those homes; it is our task to help them with their fight.

First let me talk for a minute about this autumn and the coming winter. We have the option, in the case of families who need actual subsistence, of putting them on the dole or putting them to work. They do not want to go on the dole and they are one thousand percent right. We agree, therefore, that we must put them to work for a decent wage, and when we reach that decision we kill two birds with one stone, because these families will earn enough by working, not only to subsist themselves, but to buy food for their stock, and seed for next year's planting. Into this scheme of things there fit of course the government lending agencies which next year, as in the past, will help with production loans.

Every Governor with whom I have talked is in full accord with this program of doing work for these farm families, just as every Governor agrees that the individual states will take care of their unemployables but that the cost of employing those who are entirely able and willing to work must be borne by the Federal Government.

If then we know, as we do today, the approximate number of farm families who will require some form of work relief from now on through the winter, we face the question of what kind of work they should do. Let me make it clear that this is not a new question because it has already been answered to a greater or less extent in every one of the drought communities. Beginning in 1934, when we also had serious drought conditions, the state and Federal governments cooperated in planning a large number of projects -- many of them directly aimed at the alleviation of future drought conditions. In accordance with that program literally thousands of ponds or small reservoirs have been built in order to supply water for stock and to lift the level of the underground water to protect wells from going dry. Thousands of wells have been drilled or deepened; community lakes have been created and irrigation projects are being pushed.

Water conservation by means such as these is being expanded as a result of this new drought all through the Great Plains area, the western corn belt and in the states that lie further south. In the Middle West water conservation is not so pressing a problem. Here the work projects run more to soil erosion control and the building of farm-to-market roads.

Spending like this is not waste. It would spell future waste if we did not spend for such things now. These emergency work projects provide money to buy food and clothing for the winter; they keep the livestock on the farm; they provide seed for a new crop, and, best of all, they will conserve soil and water in the future in those areas most frequently hit by drought.

If, for example, in some local area the water table continues to drop and the topsoil to blow away, the land values will disappear with the water and the soil. People on the farms will drift into the nearby cities; the cities will have no farm trade and the workers in the city factories and stores will have no jobs. Property values in the cities will decline. If, on the other hand, the farms within that area remain as farms with better water supply and no erosion, the farm population will stay on the land and prosper and the nearby cities will prosper too. Property values will increase instead of disappearing. That is why it is worth our while as a nation to spend money in order to save money.

I have, however, used the argument in relation only to a small area -- it holds good in its effect on the nation as a whole....

[dale]

I for one will boldly step up to the plate and tell Keith that, yes, starvation is a terrible thing, and that if FDR's government policy contributed to people starving or caused it, then that too is a terrible thing.

In fact, I will speak for the entire world in acknowledging that causing people to needlessly suffer is wrong.

I think we have made a real breakthrough here today.

[wkwillis]

When the Democrats were paying farmers to spill milk into creeks, it was not to take food away from hungry people, it was because they were already spilling milk into creeks, and oil, too. It was not profitable to pay someone to move the food and oil to someplace else because the cost of food had collapsed, just like the cost of oil had collapsed. Oil collapsed because of the discovery of the huge East Texas supergiant field, and the price of food had collapsed because of the substitution of tractors that burned oil for horses that burned hay, and of oil based nitrogen fertilisers and oil sulfur manufactured phosphate fertilisers that ramped up farm productivity and crashed prices.
To repeat, the Democrats paid the farmers to destroy food that was going to be destroyed anyway.
My people were farmers in the depression.