Tuesday, April 7, 2009

More theories about the Great Depression

There is renewed interest in the Great Depression. Greg Mankiw quotes from a paper by UCLA economist Lee Ohanian:
I conclude that the Depression is the consequence of government programs and policies, including those of Hoover, that increased labor’s ability to raise wages above their competitive levels. The Depression would have been much less severe in the absence of Hoover’s program. Similarly, given Hoover’s program, the Depression would have been much less severe if monetary policy had responded to keep the price level from falling, which raised real wages.

The 1930s would have been a better economic decade had government policy promoted competition in product and labor markets, rather than adopting policies that extended monopoly in product markets, and that set wages above competitive levels which prevented labor markets from clearing.
Over in The Wall Street Journal, Steven Gjerstad and Vernon L. Smith are examining bubbles. They state that experimental economics shows that bubbles are natural in markets, but some bubbles pop with few effects while others have cause substantial damage to the real economy. They note that the popping of the dot.com bubble led to a loss of $10 trillion in assets but caused no damage to the financial system, while the decline in housing prices caused $3 trillion in losses and devastated the financial system.

Part of the answer, they say, was leverage. When the borrowing is by the rich, the losses are absorbed by the rich. But when the borrowing is by the poor, it is absorbed by financial institutions.
According to First American CoreLogic, 10.5 million households had negative or near negative equity in December 2008. When housing prices turned down, many borrowers with low income and few assets other than their slender home equity faced foreclosure. The remaining losses had to be absorbed by the financial system. Consequently, the financial system has suffered a blow unlike anything since the Great Depression, and the source is the weak financial position of the people holding declining assets.

The causes of the Great Depression need more study, but the claims that losses on stock-market speculation and a monetary contraction caused the decline of the banking system both seem inadequate. It appears that both the Great Depression and the current crisis had their origins in excessive consumer debt -- especially mortgage debt -- that was transmitted into the financial sector during a sharp downturn.

A week ago James Hamilton looked at the impact of oil prices on the current economy.
Although the approaches are quite different, they all support a common conclusion: had there been no increase in oil prices between 2007:Q3 and 2008:Q2, the U.S. economy would not have been in a recession over the period 2007:Q4 through 2008:Q3.

Something in addition to housing began to drag the economy down over the later period, and all the calculations in the paper support the conclusion that oil prices were an important factor in turning that slowdown into a recession.
He is not arguing that the housing market has not been the factor that makes the current financial mess special among downturns over the last 50 ears, but that the crisis in the housing market was triggered by the oil-price shock.

On a more positive note, the Federal Reserve Bank of New York is suggesting that, based on the pattern of economic recovery and the yield curve, we may have hit the bottom of this recession.

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