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Did Monetary Policy End the Great Depression

“Monetary rather than fiscal policy ended the great depression in the USA” – Is this statement true? Was going off the Gold Stan

The Great Depression initiated in 1929 with the “Black Tuesday” in October initiated a decade of under full employment production that only saw full recovery with the emergence of the Second World War. Particularly in the US, since many European countries saw an earlier recovery, whilst the US only saw the beginning of this process with the election of Roosevelt in 1933 and a change in policy that included the implementation of the New Deal.

Unemployment and GDP were way of trend and the policies to correct were late and probably not the appropriate ones, as monetary tightness by the FED has been widely accepted to have been an incorrect policy that further pushed backwards an already struggling economy. This essay analyses what motivated the end of the Great Depression, and asks whether fiscal and monetary policies were effective. But in the end it seems that the black decade for US economy was only fully recovered with the burst of the World War II (WWII), and the impact this had on public spending, production, employment and exports, despite the high levels of economic growth even before the war.
Even before the crisis the FED used a tight monetary policy option that carried through all the length of the Depression. There was a monetary response to the economic problems but this policy came late and it was mostly about going off the Gold Standard in 1933 and the devaluation of the dollar. This could have encouraged a beggar-thy-neighbour behaviour and could have started a race to the bottom, in chasing higher competitiveness for a currency that would motivate successive devaluations improving a country position by leaving the other worse off. On the other hand Roosevelt’s fiscal policy was not exactly Keynesian in the sense that he wanted a balanced budget and never ran big deficits. In fact, under Hoover, the deficits run between 1929 and 1932 were higher than those registered by the New Deal administration. This is one of the main reasons why monetary policy was more effective than fiscal policy, because the fiscal response was insufficient, whilst, even though late, the monetary policy injected a lot more money in the economy.

“Between 1933 and 1937 real GNP in the United States grew at an average rate of over 8 percent per year; between 1938 and, 1941 it grew over 10 percent per year. These rates of growth are spectacular” (Romer). Still “After six years of recovery, real output remained 25 percent below trend, and private hours worked were only slightly higher than their 1933 trough level” (Cole, H. L. and Ohanian, L. E.). So, despite the rapid and spectacular growth, it was not enough to go back to full employment and to potential GDP level. In spite this fact, something was indeed done to boost the economy after the big slump of 1929 to 1933 and it seems to indicate that going off the Gold standard was a defining moment as 1933 was the beginning of the recovery process.
Monetary rather than fiscal policy ended the depression?
This statement seems to be true especially if one looks at Romer’s paper that also highlights that there was not enough strength in the economy to put itself back on track. On the other hand, Cole and Ohanian argued that some of the fiscal policies carried by Roosevelt were counterproductive, mainly the pursuit of high wages, emphasizing that the fiscal policy did not have the expected effect on resolving the crisis, but rather slowed down the economy.
Actual trend and Real Gross National Product, 1919-1942

The deviation of potential GNP shown in the graph is evident as is also evident the growth of the economy in the 1930s, apart from the crisis in 1938, that was motivated by a cutting in spending as budget deficit decreased from -4.4 to -2.2, as well as other cuttings made by the government in some key areas. What motivated this boom was, as Romer sees it and as she illustrates it in the graphs bellow, a direct consequence of monetary policy and nothing to do with the fiscal policy.

In this model created by Romer all the accountability for the recovery goes to the monetary policy(on the right) as her econometric model does not see a great effect in the pursue of the fiscal policy. One might wonder whether this fact is because New Deal fell way below what one may consider as a Keynesian stimulus pack, as no big deficits were ever carried, in order to provide a demand shock that could put the economy back on track. Compared to the recovery in Germany much stimulated by government spending, where it was seen that a fiscal policy did pull up the economy, the fiscal stimulus in the US was insufficient.
GDP vs. Budget %

On the graph above we can see that first the fiscal policy carried could not have been enough for what was the biggest economic downfall ever felt in economic history, and especially it cannot be compared to a Keynesian stimulus of increasing government spending in order to make up for the fall of “animal spirits”. It seems that what really boosted government spending was WWII and this motivated bigger growth rates than the ones in the period from 1933 to 1937, where fiscal policy did not have much impact as it was scarce.
The extraordinary growth rates during the period between 1933 and 1937 have a causation that might also not be just purely economic and rather psychological and though this is little approached the change of government from Hoover to Roosevelt could have lifted “animal spirits” as Temin and Wigmore say it in their paper “…a change in expectations worked with changes in macroeconomic policies to produce changes in prices and real variables that cannot be understood as the result of the new macroeconomic policies taken in isolation.”
Undoubtedly Roosevelt’s policy were a shift in the government from a rather “Laissez Faire” strategy to a more interventionist one. This had not only a macroeconomic effect but also changed people’s perception of the state and of the course of the current administration as being able to shift with Hoover’s incapability to deal with the crisis.
The policies pursued were not absolutely perfect and moreover were late as stimulus packs. Going off the Gold Standard and the devaluation of the currency were pursued by the UK and other European states in 1931 leading to a faster recovery than what happened in the US. But for a late response it did have “spectacular”(Romer) growth rates, though this has to be analysed as not only a consequence of the policies pursued but also as the impact it had on “animal spirits” and on the confidence of the economic agents.
Monetary Policy and going off the Gold Standard
Monetary expansion in 1933 was indeed the boost that provided the pillars to economic recovery, despite the inaction played by the FED as was argued by Friedman and Schwartz and was confirmed by the current chairman Ben Bernanke “I would like to say to Milton and Anna…regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”, illustrating the ineffective response to the 1929 crisis. This inaction resulted in a longer and more serious crisis than what would have happened if there was not a tight monetary policy.
Going off the Gold Standard was not something new and brought only about in this inter war period. Countries used to do it either if they wanted to carry deficits or whether they wanted to devaluate the currency since the Gold Standard did not allow these practices. These sort of practices happened especially during the period of the First World War (WWI). Countries during this period needed to print money and to run budget deficits to support the war effort.

So the same type of response came to no surprise when in September 1931 UK, Sweden and Norway went off the Gold and devaluated their currency. This practice was followed also by Denmark and Finland that before the end of the year had also taken this measure.
The US however only went off Gold in 1933 and devaluated their currency by 41%. This motivated a Gold inflow that resulted in a lowering of interest rates that was crucial to revive the economy, and the money supply grew at a rate of 10% between 1933 and 1937 that caused GDP to also experience an unseen growth during this time.

“The devaluation of the dollar was the single biggest signal that the deflationary policies implied by adherence to the Gold standard had been abandoned, that the iron grip of the Gold standard had been broken. Devaluation had effects on prices and production throughout the economy, especially on farm and commodities prices, not simply on exports and imports. It sent a general message to all industries because it marked a change in direction for government policies and for prices in general.” (Temin& Wigmore)
The devaluation of the dollar, combined with the instability in Europe that lead to many Gold inflows to the US, and a more competitive position in the market, makes it clear that this decision was indeed vital to the recovery. But despite these economic shifts in position and despite knowing that without a doubt the monetary policy was more effective than the fiscal one carried by Roosevelt. The recession did not come about till the burst of WWII. This is confirmed by the graph of Actual trend and Real Gross National Product, 1919-1942 shown previously, where the GNP only meets its trend in 1942.

“…fiscal policy … seems to have been an unsuccessful recovery device in the ‘thirties-not because it did not work, but because it was not tried.”
Milton Friedman and Anna Scwhartz

The US pursued a monetary policy that had its results due partially to the instability in Europe that motivated a Gold inflow. On the other hand New Deal and the fiscal policy were not sufficient in recovering the US economy as Romer said it. For Ohanian and Cole it was even counterproductive as it raised wages, which did not allow for a normal recover to take place “contrast sharply with neoclassical theory, which predicts a strong recovery from the Great Depression with low real wages, not a weak recovery with high wages” (Ohanian & Cole)
What ended the depression was the burst of WWII but the instability felt before made that the inefficient and late monetary policy had bigger results than it would normally, as the US only went of the Gold Standard in 1933, two years after the first European countries to have done it. There seems to be a correlation between going off the Gold Standard and recovery as the earlier countries to do it enjoyed earlier recoveries, and despite enjoyed great economic growth rates, the US had to deal with a lag of two years compared with the European powers.
The extraordinary growth in monetary basis (M1) allowed for a recovery as it allowed for greater spending, for a rapid growth of output and for a boost in confidence, and it contrasted with a weak fiscal response that fell way behind expectations as Roosevelt still felt that a balanced budget was a crucial point and could not be abandoned, therefore colliding with Keynesian theory.

Romer, C. D., 1992, “What Ended the Great Depression?” Journal of Economic History, December
Eichengreen B. And J. Sachs, 1985, “Exchange Rates and Economic Recovery in the 1930s,” Journal of Economic History December
Temin, P & B. A.Wigmore, 1990, “The end of One Big Deflation,” Explorations in Economic History
Cole, H.L and L.E. Ohanian, 2004, “New Deal policies and the persistence of the Great Depression: A general equilibrium analysis”, Journal of Political Economy, No4
Bernanke, B and M. Parkinson, (1989) “Unemployment, Inflation and wages in the American Depression: Are there lessons for Europe?” American economic Review, May
Christina D. Romer Forthcoming in the Encyclopædia Britannica December 20, 2003
Eichengreen, B., 1992, Golden Fetters,
Remarks by Governor Ben S. Bernanke At the H. Parker Willis Lecture in Economic Policy, Washington and Lee University, Lexington, Virginia March 2, 2004
Clif Droke “Bernanke on the Great Depression” June 29, 2009