Great Depressions: A Real Business Cycle View
As noted above, REBCT has been criticized for its lack of plausibility with
respect to explaining the Great Depression. However, during recent years
several economists have begun to investigate economic depressions using
neoclassical growth theory.
Cole and Ohanian (1999) were the first economists to study the Great
Depression from this perspective and they attempt to account not only for the
downturn in GDP in the period 1929–33, but also seek to explain the recov
ery of output between 1934 and 1939. In their analysis they do not deny the
contribution of real and monetary aggregate demand shocks in initiating the
Great Depression. However, conventional models predict a rapid recovery
from such shocks after 1933 given the expansionary monetary policies adopted
after abandoning the Gold Standard constraint, the elimination of bank failures
and deflation, and the significant rise in total factor productivity. Given
these changes, output should have returned to trend by 1936, but US output
remained up to 30 per cent below trend throughout the 1930s. Cole and
Ohanian argue that the weak recovery process was mainly due to the adverse
consequences of New Deal policies, particularly policies related to the National
Industrial Recovery Act (NIRA) of 1933. The NIRA, by suspending
anti-trust laws in over 500 sectors of the US economy, encouraged cartelization
and reductions in price competition. Firms were also encouraged to grant
large pay increases for incumbent workers. Cole and Ohanian claim that it
was the impact of NIRA that depressed employment and output during the
recovery, thereby lengthening the Great Depression. Prescott (1999) provides
a similar perspective for the US economy, arguing that the Great Depression
was ‘largely the result of changes in economic institutions that lowered the
normal steady-state market hours per person over 16’. Thus, for Prescott, the
Keynesian explanation of the slump is upside down. A collapse of investment
did not cause the decline in employment. Rather employment declined as a
result of changes in industrial and labour market policies that lowered employment!
(see also Chari et al., 2002). While arguing that a liquidity preference
shock rather than technology shocks played an important role in the contraction
phase of the Great Depression in the USA (providing support for the
Friedman and Schwartz argument that a more accommodative monetary policy
by the US Federal Reserve could have greatly reduced the severity of the
Great Depression), Christiano et al. (2004) also agree with the Cole and
Ohanian view that the recovery of employment in the USA during the 1930s
was adversely affected by President Roosvelt’s ‘New Deal’ policies.
In a subsequent paper, Cole and Ohanian (2002b) focus on why both the US
and UK Great Depressions lasted so long, with output and consumption in both
economies some 25 per cent below trend for over ten years. Such a duration in
both countries cannot be ‘plausibly explained by deflation or other financial
shocks’. Instead, Cole and Ohanian focus on the negative impact of the NIRA
(1933) and the NLRA (National Labour Relations Act, 1935) in the USA, both
of which distorted the efficient working of markets by increasing monopoly
power. In the case of the UK, their analysis follows the lead given in earlier
research by Benjamin and Kochin (1979) that a generous increase in unemployment
benefits lengthened the Great Depression.
This new approach to explaining depressions has not convinced the majority
of economists, who mainly continue to highlight the importance of
aggregate demand shocks and monetary and financial factors in their explanations
of the Great Depression (see Chapter 2). Nevertheless, Prescott’s
(2002) Ely Lecture focused on using supply-side explanations of ‘Prosperity
and Depression’ for the interwar experience of the USA, UK and Germany,
the recent depression in France and the post-war record of Japan. In each
case the most important factor causing output to be below trend is supplyside,
rather than demand-side in origin (see also Kehoe and Prescott, 2002).
Crucial to the maintenance of prosperity are policies that focus on enhancing
total factor productivity. Given this perspective, Prescott recommends supply-
side policies that will:
1. promote the establishment of an efficient financial sector to allocate
scarce investment funds;
2. enhance competition, both domestic and international; and
3. promote international integration, including the establishment of trading
clubs such as the EU.
As noted above, REBCT has been criticized for its lack of plausibility with
respect to explaining the Great Depression. However, during recent years
several economists have begun to investigate economic depressions using
neoclassical growth theory.
Cole and Ohanian (1999) were the first economists to study the Great
Depression from this perspective and they attempt to account not only for the
downturn in GDP in the period 1929–33, but also seek to explain the recov
ery of output between 1934 and 1939. In their analysis they do not deny the
contribution of real and monetary aggregate demand shocks in initiating the
Great Depression. However, conventional models predict a rapid recovery
from such shocks after 1933 given the expansionary monetary policies adopted
after abandoning the Gold Standard constraint, the elimination of bank failures
and deflation, and the significant rise in total factor productivity. Given
these changes, output should have returned to trend by 1936, but US output
remained up to 30 per cent below trend throughout the 1930s. Cole and
Ohanian argue that the weak recovery process was mainly due to the adverse
consequences of New Deal policies, particularly policies related to the National
Industrial Recovery Act (NIRA) of 1933. The NIRA, by suspending
anti-trust laws in over 500 sectors of the US economy, encouraged cartelization
and reductions in price competition. Firms were also encouraged to grant
large pay increases for incumbent workers. Cole and Ohanian claim that it
was the impact of NIRA that depressed employment and output during the
recovery, thereby lengthening the Great Depression. Prescott (1999) provides
a similar perspective for the US economy, arguing that the Great Depression
was ‘largely the result of changes in economic institutions that lowered the
normal steady-state market hours per person over 16’. Thus, for Prescott, the
Keynesian explanation of the slump is upside down. A collapse of investment
did not cause the decline in employment. Rather employment declined as a
result of changes in industrial and labour market policies that lowered employment!
(see also Chari et al., 2002). While arguing that a liquidity preference
shock rather than technology shocks played an important role in the contraction
phase of the Great Depression in the USA (providing support for the
Friedman and Schwartz argument that a more accommodative monetary policy
by the US Federal Reserve could have greatly reduced the severity of the
Great Depression), Christiano et al. (2004) also agree with the Cole and
Ohanian view that the recovery of employment in the USA during the 1930s
was adversely affected by President Roosvelt’s ‘New Deal’ policies.
In a subsequent paper, Cole and Ohanian (2002b) focus on why both the US
and UK Great Depressions lasted so long, with output and consumption in both
economies some 25 per cent below trend for over ten years. Such a duration in
both countries cannot be ‘plausibly explained by deflation or other financial
shocks’. Instead, Cole and Ohanian focus on the negative impact of the NIRA
(1933) and the NLRA (National Labour Relations Act, 1935) in the USA, both
of which distorted the efficient working of markets by increasing monopoly
power. In the case of the UK, their analysis follows the lead given in earlier
research by Benjamin and Kochin (1979) that a generous increase in unemployment
benefits lengthened the Great Depression.
This new approach to explaining depressions has not convinced the majority
of economists, who mainly continue to highlight the importance of
aggregate demand shocks and monetary and financial factors in their explanations
of the Great Depression (see Chapter 2). Nevertheless, Prescott’s
(2002) Ely Lecture focused on using supply-side explanations of ‘Prosperity
and Depression’ for the interwar experience of the USA, UK and Germany,
the recent depression in France and the post-war record of Japan. In each
case the most important factor causing output to be below trend is supplyside,
rather than demand-side in origin (see also Kehoe and Prescott, 2002).
Crucial to the maintenance of prosperity are policies that focus on enhancing
total factor productivity. Given this perspective, Prescott recommends supply-
side policies that will:
1. promote the establishment of an efficient financial sector to allocate
scarce investment funds;
2. enhance competition, both domestic and international; and
3. promote international integration, including the establishment of trading
clubs such as the EU.
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