Possibly the most interesting and insightful book that I have read in recent years, at least from a macroeconomics perspective, was Ben Bernanke’s Essays on the Great Depression. It is a fantastic exercise in economic theory and logic, with the Great Depression proving a complex, yet highly important, economic case study. Consequently, my interest is always piqued when a new academic paper comes out to further our knowledge of this time.
Christina and David Romer have released an NBER Working paper titled ‘The Missing transmission mechanism of the Monetary explanation of the Great Depression.’ Romer and Romer’s findings are interesting on their own, but it was also quite insightful to see how they got there.
The context of the missing transmission mechanism in the monetary explanation
Romer & Romer address some concerns with the monetary explanation of the Great Depression as discussed in the seminal book by Friedman and Swartz titledMonetary History of the United States. The key challenge to the monetary story as a causal factor in the Great Depression is the fact that interest rates fell sharply during this time and remained low throughout. This is the opposite of what one would expect in the presence of a monetary shock to the economy.
The use (& usefulness) of the IS LM model
The diagram below uses the IS LM model to display the more traditional response of a monetary shock. In this scenario, the Central Bank decreases the money supply, which shifts the LM to the right and raises the interest rate.
In the period of 1928-33, interest rates did rise on two occasions as the Federal Reserve attempted to tighten policy in 1928 due to the stock market, as well as another rise in October 1931. Other than these two periods, interest rates were on a downward trend during this time.
Explaining this anomalous interest rate behaviour
Diagrammatically, the following picture displays the scenario that needs further explanation. Compared to the basic picture shown above, we now have a movement of the IS curve as well, which actually negates the shift of the LM curve to result in a lower interest rate. Given that nominal rates were falling for the majority of this period, any explanation needs account for this large shift in the IS curve.
Romer & Romer cite a few possible candidates for this shift that are non-monetary in nature. Firstly, Temin (1976) argued that there was a large drop in consumer spending. Secondly, Romer (1990) suggested that income uncertainty from the stock market crash could have caused this drop in consumer spending. Finally, they discuss Bernanke’s (1983) analysis of banking panics during this time. Bernanke proposed that the banking panics not only caused a fall in money supply, but also a reduction in the credit supply. Romer & Romer believe that there is some truth to these non-monetary effects, but they are not significantly large enough to explain to catastrophic output decline in the early 1930s.
What was needed, what was found, & how they did it
What was needed, therefore, for the monetary explanation of the Great Depression, was evidence of the link from monetary policy to expectations of deflation. In other words, it was necessary to articulate a transmission mechanism from monetary policy to the real economy. In the ISLM framework, the IS has been augmented to include inflation expectations, which means that expectations of deflation would increase the real interest rate and move the IS curve to the left. In this case, nominal rates would be falling, but real rates would be increasing.
So the link from monetary policy to deflation expectations was the missing transmission mechanism in the analysis of Friedman & Swartz. This is, indeed, exactly what Romer & Romer found in their analysis of this period, but the way they did this was quite clever. With a fine-tooth comb, Romer & Romer went through the business press in the first two years of the Depression to find evidence that well-informed observers were expecting deflation as a result of monetary developments. They also found evidence that Business Week changed their expectations of deflation quite frequently, implying that real interest rates would have been volatile during this time, further hampering consumer spending.
Ever since I read Bernanke’s Essays on the Great Depression, I’ve been fascinated with the macro-economics of this period. It holds important lessons for our understanding of economic behaviour, for at the very least, we should avoid such a vast human cost again. What I really appreciated about this work from Romer & Romer was not only the theoretical insight into where the missing transmission mechanism would need to fit in the analysis, but also the technique that was used to measure inflation expectations in the 1930s.