Stockman (3) Great Depression

In his book The Great Deformation, David Stockman gives some interesting background on the 1930s Depression. He argues that Ben Bernanke does not understand its cause.

The Great Depression was not caused by the banking crisis. The US depression was rooted in the collapse of global trade, not in some flaw of capitalism or any of the other uniquely domestic afflictions on which the New Deal programs were predicated.

The American economy had been thoroughly internationalised after 1914, and had grown in leaps and bounds as a great export machine and prodigious banker to the world. While it lasted, the export boom of 1914-29 generated strong gains in domestic incomes, which in turned fuelled the post-war rise of the new durables industries like autos and home appliances. The tremendous expansion of export and durables output also triggered the greatest capital spending boom in history. Auto production capacity rose from under 2 million units in 1920 to nearly 6 million in 1929, while completely new industries like radios and washing machines were born almost overnight.

The American economy had been supersized for continuous expansion of exports, but that was its Achilles heel. When international trade collapsed after 1929, the manufacturing and capital goods industries collapsed rapidly.

A crucial element in the expansion of American exports was the $10 million of foreign bonds underwritten by Wall Street. This was the equivalent of $1.5 trillion in today’s values. It was these extensive borrowings which allowed many American export customers to finance their purchases, not unlike the Chinese have been funding the purchase of their exports during the last decade.

The problem was that this growth was not sustainable. When the stock market crashed, this financial fuelled chain of economic expansion snapped and violently unwound. Sales of author dropped like a stone from 5.3 million units in 1929 to 1.4 million vehicles in 1932. This 75% drop in auto sales cascaded through the auto supply chain with devastating impact. The collapse of these growth industries caused a huge cut back in business investment.

The Depression was not caused by a mysterious disappearance of domestic demand as the Keynesian model claims. It was caused by this massive contraction of international trade. After 1929, politicians and bankers all over the world made the problem worse, by raising barriers to trade and financial transfers.

The New Deal pushed pulled and reshuffled the supply of the domestic economy, but it could not regenerate the external markets upon which post -1914 American prosperity had vitally depended.

Sticky Wages

A common view among economists is that wage stickiness is one of the reasons for the high levels of unemployment during the great depression. In most markets, excess supply pushes prices down which increase demand until the market is cleared. They argue that this cannot happen in the labour market, because unions prevent wages from falling. Unemployment, which is excess supply of labour, becomes a problem because high wages prevent the labour market from clearing. These economists argue that unemployment would not have been a problem during the great depression, if wages had been allowed to fall.

There are two problems with this view. Firstly, all wages do not need to fall to clear the market. If all wages were forced down, the capacity of employees to consume is severely restrained, which harms the economy. Fortunately, prices only have to fall at the margin to clear a market.. The price only has to fall for those goods currently on offer for sale, not for all those that have been sold previously.

Wages only have to fall at the margin for unemployment to be cleared and this happens anyway. People who lose their jobs usually have to take lower-paying work to get another position. When a business replaces people, it can usually take on less experienced people who are not paid so much. These two effects mean that wages do tend to fall at the margin during times of unemployment.

The second problem is that business declined so rapidly during the Great Depression that the marginal wage would have had to fall to zero to clear the market. The collapse of the banking sector and the collapse of commodity prices killed off many businesses. These were the problems that had to be resolved, before the labour market could return to normal. An overall decline in wages was not the solution.

The crisis in the 1930s was caused by problems in the capital markets and not in the labour market. The depression was the consequence of a distortion of the capital markets. Wages could not adjust enough to resolve a problem in the capital market.

Actions have Consequences

Some actions have consequences that are unavoidable. Attempts to avoid the consequences only make them worse.

A person who goes out on the town and gets sloshed will have a headache the next day. Aspirin might ease the pain slightly, but cannot cure it. The only way to avoid the pain of a hangover is to avoid the drinking binge. Once the binge is binged the clock cannot be rolled back.

That is where we are in the world economy. We had years of binging on consumption laced with debt. The party was a good one, but now it is over and the hangover is here. Wishing we had not gone so hard, is futile.

The hungout person may be tempted to go another binge to drown their sorrows, but that it just putting off the evil day. In the same way, governments should be careful that their policies for dealing with recession do not make the crisis last longer. That happened during the 1930s.

Ending the Depression

The Second World War did not end the Great Depression. The coming of war just replaced one form of misery with another. Unemployed men were moved off the streets into the infantry (where you lived like a dog and were used as target practice by the German and Japanese soldiers).

The Great Depression really ended in 1946 when factories that had been producing tanks and trucks for the military switched to producing cars and those that produced radios and radar for the military started making radios and television for American families. The war had produced a disciplined, hard-working work force so industry became very efficient..

People had saved during wartime, because they were earning, but could not spend due to rationing. After the war they started spending to sustain their growing families.

Production and Consumption grew rapidly together.

The Great Depression

Many experts believe that the great depression was caused by a lack of consumption. If this was true, the consumption goods industry would have been worst hit. This is not the case. The capital goods industries were hit the worst. This shows that the depression was really caused by malinvestment.