The Great Depression in the United States From A Neoclassical Perspective

Can neoclassical theory account for the Great Depression in the United States— both the downturn in output between 1929 and 1933 and the recovery between 1934 and 1939? Yes and no. Given the large real and monetary shocks to the U.S. economy during 1929–33, neoclassical theory does predict a long, deep downturn. However, theory predicts a much different recovery from this downturn than actually occurred. Given the period’s sharp increases in total factor productivity and the money supply and the elimination of deflation and bank failures, theory predicts an extremely rapid recovery that returns output to trend around 1936. In sharp contrast, real output remained between 25 and 30 percent below trend through the late 1930s. We conclude that a new shock is needed to account for the Depression’s weak recovery. A likely culprit is New Deal policies toward monopoly and the distribution of income. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. Between 1929 and 1933, employment fell about 25 percent and output fell about 30 percent in the United States. By 1939, employment and output remained well below their 1929 levels. Why did employment and output fall so much in the early 1930s? Why did they remain so low a decade later? In this article, we address these two questions by evaluating macroeconomic performance in the United States from 1929 to 1939. This period consists of a decline in economic activity (1929–33) followed by a recovery (1934– 39). Our definition of the Great Depression as a 10-year event differs from the standard definition of the Great Depression, which is the 1929–33 decline. We define the Depression this way because employment and output remained well below their 1929 levels in 1939. We examine the Depression from the perspective of neoclassical growth theory. By neoclassical growth theory, we mean the optimal growth model in Cass 1965 and Koopmans 1965 augmented with various shocks that cause employment and output to deviate from their deterministic steady-state paths as in Kydland and Prescott 1982. We use neoclassical growth theory to study macroeconomic performance during the 1930s the way other economists have used the theory to study postwar business cycles. We first identify a set of shocks considered important in postwar economic declines: technology shocks, fiscal policy shocks, trade shocks, and monetary shocks. We then ask whether those shocks, within the neoclassical framework, can account for the decline and the recovery in the 1930s. This method allows us to understand which data from the 1930s are consistent with neoclassical theory and, especially, which observations are puzzling from the neoclassical perspective. In our analysis, we treat the 1929–33 decline as a long and severe recession. But the neoclassical approach to analyzing business cycles is not just to assess declines in economic activity, but to assess recoveries as well. When we compare the decline and recovery during the Depression to a typical postwar business cycle, we see striking differences in duration and scale. The decline, as well as the recovery, during the Depression lasted about four times as long as the postwar business cycle average. Moreover, the size of the decline in output in the 1930s was about 10 times the size of the average decline. (See Table 1.) What factors were responsible for these large differences in the duration and scale of the Depression? One possibility is that the shocks—the unexpected changes in technology, preferences, endowments, or government policies that lead output to deviate from its existing steadystate growth path—were different in the 1930s. One view is that the shocks responsible for the 1929–33 decline were much larger and more persistent versions of the same shocks that are important in shorter and milder declines. Another view is that the types of shocks responsible for the 1929–33 decline were fundamentally different from those considered to be the driving factors behind typical cyclical declines. To evaluate these two distinct views, we analyze data from the 1930s using the neoclassical growth model. Our main finding differs from the standard view that the most puzzling aspect of the Depression is the large decline between 1929 and 1933. We find that while it may be possible to account for the 1929–33 decline on the basis of the shocks we consider, none of those shocks can account for the 1934–39 recovery. Theory predicts large increases in employment and output beginning in 1934 that return real economic activity rapidly to trend. This prediction stands in sharp contrast to the data, suggesting to us that we need a new shock to account for the weak recovery. We begin our study by examining deviations in output and inputs from the trend growth that theory predicts in the absence of any shocks to the economy. This examination not only highlights the severity of the economic decline between 1929 and 1933, but also raises questions about the recovery that began in 1934. In 1939, real per capita output remained 11 percent below its 1929 level: output increases an average of 21 percent during a typical 10-year period. This contrast identifies two challenges for theory: accounting for the large decline in economic activity that occurred between 1929 and 1933 and accounting for the weak recovery between 1934 and 1939. We first evaluate the importance of real shocks—technology shocks, fiscal policy shocks, and trade shocks—for this decade-long period. We find that technology shocks may have contributed to the 1929–33 decline. However, we find that the real shocks predict a very robust recovery beginning in 1934. Theory suggests that real shocks should have led employment and output to return to trend by 1939. We next analyze whether monetary shocks can account for the decline and recovery. Some economists, such as FriedmanandSchwartz (1963),argue thatmonetaryshocks were a key factor in the 1929–33 decline. To analyze the monetary shock view, we use the well-known model of Lucas and Rapping (1969), which connects changes in the money supply to changes in output through intertemporal substitution of leisure and unexpected changes in wages. The Lucas-Rapping model predicts that monetary shocks reduced output in the early 1930s, but the model also predicts that employment and output should have been back near trend by the mid-1930s. Both real shocks and monetary shocks predict that employment and output should have quickly returned to trend levels. These predictions are difficult to reconcile with the weak 1934–39 recovery. If the factors considered important in postwar fluctuations can’t fully account for macroeconomic performance in the 1930s, are there other factors that can? We go on to analyze two other factors that some economists consider important in understanding the Depression: financial intermediation shocks and inflexible nominal wages. One type of financial intermediation shock is the bank failures that occurred during the early 1930s. Some researchers argue that these failures reduced output by disrupting financial intermediation. While bank failures perhaps deepened the decline, we argue that their impact would have been short-lived and, consequently, that bank failures were not responsible for the weak recovery. Another type of financial intermediation shock is the increases in reserve requirements that occurred in late 1936 and early 1937. While this change may have led to a small decline in output in 1937, it cannot account for the weak recovery prior to 1937 and cannot account for the significant drop in activity in 1939 relative to 1929. The other alternative factor is inflexible nominal wages. The view of this factor holds that nominal wages were not as flexible as prices and that the fall in the price level raised real wages and reduced employment. We present data showing that manufacturing real wages rose consistently during the 1930s, but that nonmanufacturing wages fell. The 10-year increase in manufacturing wages is difficult to reconcile with nominal wage inflexibility, which typically assumes that inflexibility is due to either money illusion or explicit nominal contracts. The long duration of the Depression casts doubt on both of these determinants of inflexible nominal wages. The weak recovery is a puzzle from the perspective of neoclassical growth theory. Our inability to account for the recovery with these shocks suggests to us that an alternative shock is important for understanding macroeconomic performance after 1933. We conclude our study by conjecturing that government policies toward monopoly and the distribution of income are a good candidate for this shock. The National Industrial Recovery Act (NIRA) of 1933 allowed much of the economy to cartelize. This policy change would have depressed employment and output in those sectors covered by the act and, consequently, have led to a weak recovery. Whether the NIRA can quantitatively account for the weak recovery is an open question for future research. The Data Through the Lens of the Theory Neoclassical growth theory has two cornerstones: the aggregate production technology, which describes how labor and capital services are combined to create output, and the willingness and ability of households to substitute commodities over time, which govern how households allocate their time between market and nonmarket activities and how households allocate their income between consumption and savings. Viewed through the lens of this theory, the following variables are keys to understanding macroeconomic performance: the allocation of output between consumption and investment, the allocation of time (labor input) between market and nonmarket activities, and productivity.