Comparative Economic Studies (2011) 53, 383–406. doi:10.1057/ces.2011.5; published online 24 March 2011
Crisis and Growth in the Advanced Economies: What We Know, What We Do not, and What We Can Learn from the 1930s
Barry Eichengreen1
1University of California, Evans Hall 508, CA 94708 Berkeley, USA. E-mail: eichengr@econ.berkeley.edu
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Abstract
This
paper addresses the question of whether the medium- and long-term
growth potential of the advanced economies has been impaired by the
global financial crisis. It evidence from the Great Despression of the
1930s to illuminate the prospects, concluding the following. First, the
impact of weak bank balance sheets and heightened risk aversion made it
harder for small firms. in particular, to fund investment projects.
Second, there is little evidence that increased public debt or policy
uncertainity had major effects in depressing investment. Third,
structural unemployment dissolved quickly in the face of increased
demand. Fourth and finally, the crisis was also an opportunity as firms
used the downtime created by the Depression to reorganize and modernize
their operations.
Keywords:
economic growth; crisis; output losses; bank leading; productivity
JEL Classifications:
N10
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INTRODUCTION
As
this paper is drafted, it has become commonplace to observe that there
is a high degree of uncertainty about the course of the economy. Those
making this observation are typically concerned with the high level of
uncertainty surrounding the short-term growth prospects of the advanced
economies: whether the expansion now underway will continue or be
interrupted by a double dip. I would like to suggest that a comparably
high degree of uncertainty surrounds the question of whether the medium-
and long-term growth potential of the advanced economies has been
impaired. This uncertainty arises for three reasons.
First,
experience in other recent recessions is of dubious relevance to the
current episode. Typically, studies of this question have looked at the
trend rate of growth and its determinants before and after a set of
banking crisis dates. The crises considered are heterogeneous: while
some are as serious as the recent episode, others are considerably less
so.1
Financial crises also differ in how effectively they are resolved;
growth experience following the Swedish crisis of the early 1990s, in
the wake of which damage to the banking system was repaired relatively
quickly, is unlikely to tell us much about the medium-term effects of
the current crisis. Whereas the crises considered are, with few
exceptions, idiosyncratic national events, the recent crisis infected
the entire OECD; thus, the opportunity for individual countries to
export their way out of domestic difficulties did not arise to anywhere
near the same extent in the recent episode. Where previous studies look
at growth performance in the wake of banking crises, the recent episode
is more than just a crisis for the banking system. It affected the
shadow banking system and securitization markets at the same time it
affected the banks, and in some cases it affected them even more
powerfully.
Second, empirical work focusing on
aggregate effects is inconclusive and unconvincing. Estimating what has
happened to the trend rate of growth as a result of a crisis presupposes
an ability to estimate the trend. This is something on which economists
do not agree. Growth potential is not constant in the absence of a
crisis. A pre-crisis trend estimated over a relatively long period may
under-state pre-crisis growth potential and therefore overlook
post-crisis damage if productivity growth was accelerating prior to the
crisis. Recall the ‘new economy’ argument that US productivity growth
accelerated around the middle of the 1990s due to the adaptation to new
information and communications technologies. If there really was and is a
new economy, then attempting to measure the trend rate of growth over a
longer period will underestimate it. Alternatively, measuring
pre-crisis growth over a shorter period, say as growth between the two
immediate pre-crisis business-cycle peaks, creates the danger that
estimates of the trend will be distorted by peculiar features of the
cyclical expansion and the unsustainable growth that sowed the seeds for
the crisis itself. This approach will tend to over-estimate pre-crisis
growth and exaggerate the damage. It is no surprise, then, that studies
seeking to identify changes in trend growth before and after crises
reach a variety of conclusions.
Third, there is
little agreement on the relative importance of the mechanisms through
which major recession and financial distress may impact long-term growth
potential. Some analysts emphasize the danger that investment will fail
to recover because the return to capital will have fallen permanently
as a result of the crisis and the misallocation of pre-crisis
investment. Financing constraints will be tighter because bank balance
sheets have been impaired, because borrowers have less collateral, and
because of tighter regulation. Finance being harder to come by, there
may be less investment in research and development and related
activities that throw off positive externalities for growth. Other
observers emphasize the pernicious effects of the policy uncertainty
that inevitably arises in a crisis and its aftermath. The list goes on.
Public debt loads will be higher in the wake of a crisis: this implies
higher taxes and interest rates. Structural and hard core unemployment
will rise, causing skill acquisition on the job to suffer. Labor force
participation will be discouraged. The long-term unemployed will become
demoralized and apathetic. Finally, there is the danger that, the
problems that brought on the crisis not having been dispatched,
instability may be back.2
In
the remainder of this paper, I will argue that progress on determining
whether growth potential been impaired will occur through research on
specific mechanisms through which recession and financial distress
affect growth capacity. I will suggest that historical evidence from
earlier episodes like the 1930s, when the recession was deep, the crisis
was global, and financial distress was pervasive, is a promising source
of information on the issues at hand.
On the basis
of this evidence, I will argue that there is little reason to think that
the long-term growth potential of the advanced economies has been
significantly impaired, at least insofar as such damage operates through
the standard economic channels. Neither financing constraints, nor
public debt burdens and structural unemployment was a binding constraint
on long-term economic growth in the wake of the Great Depression.
Insofar as the conclusions carry over, it is unlikely that they will be
binding constraints today.
Rather, the operative
constraint in the 1930s was fractionated, polarized politics that
resulted in reactive policies. Where such policies predominated, they
hindered the economy's adjustment to its new circumstances and depressed
productivity growth. If one is concerned to avoid permanent damage from
the crisis, this is the channel of which to beware.
The
next section first elaborates my argument about the inconclusiveness of
studies using aggregate data on GDP growth in an effort to determine
whether growth potential is impaired by crises. The two subsequent
sections then consider specific mechanisms through which crises may lead
to secular growth slowdowns – damage to the financial system, increased
public debt, heightened policy uncertainty, structural unemployment,
and less spending on research and development – and tests them against
data from the Great Depression. The penultimate section highlights the
danger that the political polarization may prevent a constructive policy
response. The final section concludes.
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LIMITS OF AGGREGATE EVIDENCE
To
be clear, there is no disagreement about the existence of losses from
financial crises in the form of output losses that are not made up
subsequently. Recessions associated with crises are unusually severe.3
This fact comes through not just in recent data but in historical
experience, and it is even more clearly true of global financial crises
than of isolated national events.4
Even true believers in Zarnowitz's Law – that unusually deep recessions
are followed by unusually strong recoveries – do not argue that these
output losses are fully made up subsequently. At best, growth resumes,
following the crisis and recovery, at the same trend rate as before, but
the level of GDP is now lower at each point in time than in the
counterfactual with no crisis. In a graph with time on the horizontal
axis and log GDP on the vertical axis, the new trend line is parallel to
the old trend line but below and to its right. Worse still is if growth
potential has been permanently impaired, in which case the new trend
line is flatter and the gap between actual and counterfactual log GDP
widens progressively over time.
But if there is a presumption in the literature, it is that permanent growth effects are minimal. Furceri and Mourougane (2009) find that a financial crisis lowers output by 1.5%–2.4% and that a severe crisis reduces output by 4%, but they find no evidence of it reducing the economy's subsequent capacity to grow. IMF (2009)
similarly finds that there is no rebound to the pre-crisis trend but
again concludes that in most cases the trend rate itself is not
depressed in the medium term: growth resumes at the pre-crisis rate but
from a lower level. OECD (2010) puts the OECD-wide decline in potential output due to the recent crisis at 3% but sees no evidence of the decline in potential rising over time. Haugh et al. (2009)
look at the trend of labor productivity and total factor productivity
(TFP) growth in the 10 years before and after crises and again conclude
that there is little evidence of a downward shift.
These
same studies, however, emphasize the heterogeneity of country
experiences, reflecting the heterogeneity of crises and of how
effectively they are managed. Haugh et al. (2009)
find a sharp downshift in labor and TFP growth rates between the 10
years before and after the onset of the Japanese crisis. They find
negative effects around the time of the Nordic crises of the early 1990s
when they limit the comparison to the 5 years before and after the
event. IMF (2009) points to cases in which there is evidence of lower employment and a lower capital/labor
ratio following crises. In these episodes, TFP growth typically
recovers from the low levels plumbed during the crisis, but not
entirely.
As noted, the limitation of these analyses –
and the difficulty of knowing what to generalize from them – is the
difficulty of measuring the pre-crisis trend rate of growth. Crises
often follow booms that bias upward estimates of the pre-crisis trend.
Some authors, Krugman (2010)
for example, dispute the implication: they argue that there is nothing
wrong with using data from the pre-crisis boom and estimating the trend
on the basis of peak-to-peak interpolation. The boom, in this view, may
affect what is being produced (in the most recent case, more housing and
financial services, fewer other goods and services) but not the
economy's capacity to produce.
Others who see the
boom as pushing investment and capacity utilization beyond sustainable
limits will not be convinced. Their approach is therefore to estimate
the pre-crisis trend excluding the years preceding the crisis. In IMF (2009,
p. 125), the Korean economy around the time of the 1997 financial
crisis is used to illustrate this approach. First, a trend line is fit
to output growth between 1987 and 1994. The 3 years immediately
preceding the crisis are omitted from this trend calculation on the
grounds that the economy may have been expanding unsustainably during
the pre-crisis boom. This pre-crisis trend is then compared to
post-crisis growth in the period 1998–2004. The two lines – the
extrapolation of pre-crisis output and actual post-crisis output – first
evolve in parallel but subsequently show signs of diverging, as if the
capacity of the economy to grow was permanently impaired.
This
Korean example inadvertently illustrates the problem with the
methodology. After more than two decades of rapid growth, the Korean
economy's capacity to grow was already declining in the late 1980s.5
The labor force began expanding more slowly. The pool of underemployed
labor in agriculture had been drained. Slower growth was a natural
corollary of economic maturity. But this fact was disguised by the
unsustainable investment binge of 1990–1997, which the country's large
conglomerates financed by issuing debt and raising their leverage to
ultimately dangerous heights. The investment/GDP ratio rose from the 30% typical of the 1970s and 1980s to nearly 40% before returning to its customary 30%
following the crisis. Much of the additional investment in the
intervening period was of dubious utility and productivity – this was
when the chaebol branched into unrelated businesses far removed from
their core competencies.6
The implication is that the trend rate of growth prior to the crisis is
over-estimated even when the 3 immediate pre-crisis years are excluded;
hence the extent of any post-crisis decline in the trend is also
exaggerated.
Note that this is the opposite of the
illustration in the introduction, where a relatively recent acceleration
in the potential rate of growth causes the pre-crisis trend to be
underestimated and post-crisis damage to be understated. Either way,
mechanical calculations yield misleading results. It seems unlikely,
therefore, that analyses of aggregate data can succeed in resolving the
issue. Rather, determining whether long-term growth potential has been
impaired will require studying the specific mechanisms through which
financial crises affect the economy over time.
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US Bank Loans Outstanding.
Sources: Board of Governors of the Federal Reserve System, All Bank Statistics 1896–1955; Global Financial Data; and Angus Maddison, ‘Statistics on World Population, GDP and Per Capita GDP, 1–2006 AD’ (March update)
Full figure and legend (21K)
US Bank Loans Outstanding and Real GDP.
Sources: Board of Governors of the Federal Reserve System, All Bank Statistics 1896–1955; Global Financial Data; and Angus Maddison, ‘Statistics on World Population, GDP and Per Capita GDP, 1–2006 AD’ (March update)
Full figure and legend (20K)
US capital spending as a percentage of GDP.
Source: Historical Statistics of the United States: Millennium Edition online, Table Ca74-90
Full figure and legend (18K)
FINANCIAL DISTRESS
When
one considers specific mechanisms through which a financial crisis may
affect the growth potential of the economy, the obvious place to start
is impairment of the financial system. Weakly capitalized banks will be
reluctant to lend. Having been burned in the crisis, they will adopt
tighter lending standards. Aspiring borrowers, having suffered balance
sheet damage, will have less collateral and be less credit worthy. More
stringent regulation adopted in response to the crisis requires
financial institutions to hold more capital and liquid assets and to
otherwise restrain their lending. The more limited supply of bank credit
will mean a higher cost of capital. The lesser availability of finance
will mean less investment. This effect is most likely to be felt by
smaller, younger firms (start-ups) that are disproportionately the
source of innovation and employment growth in normal times, that cannot
expand on the basis of internal funds, and that find it difficult to tap
securities markets.7
In the Great Depression, the evidence of a persistent slump in bank lending is overwhelming (Figures 1 and 2),
but evidence of a persistent impact on investment and growth is weak.
First, to the slow recovery of lending: in part this reflected
balance-sheet problems. Using state-level data, Calomiris and Mason (2003)
show that banks with less capital and more real-estate assets in their
portfolios (and therefore more losses due to foreclosures) grew their
loans more slowly in the 1930s. In part, it reflected the flight from
risk and scramble for liquidity by all banks. Calomiris and Wilson (2004),
analyzing individual bank data, find that banks curtailed their lending
and shifted into holding more liquid, less risky assets (primarily cash
and treasury securities) following depositor runs in 1931–1933.8
Banks cut the share of loans in their portfolios not just by limiting
new lending but by allowing existing loans to run off as they matured.
In 1934–1940, FDIC-insured commercial banks held as much as 30% of their assets in cash, 37% in treasury bills and other liquid securities, and only 28% in loans (FDIC, 2008).
Figure 1.
US Bank Loans Outstanding. Sources: Board of Governors of the Federal Reserve System, All Bank Statistics 1896–1955; Global Financial Data; and Angus Maddison, ‘Statistics on World Population, GDP and Per Capita GDP, 1–2006 AD’ (March update)
Full figure and legend (21K)
Figure 2.
US Bank Loans Outstanding and Real GDP. Sources: Board of Governors of the Federal Reserve System, All Bank Statistics 1896–1955; Global Financial Data; and Angus Maddison, ‘Statistics on World Population, GDP and Per Capita GDP, 1–2006 AD’ (March update)
Full figure and legend (20K)
But, did the limited availability of bank credit slow the recovery? Between 1933 and 1937 the US economy grew by more than 8% a year. There was also a reasonable recovery of investment in the 1930s. (See Figure 3) A pair of survey by the National Industrial Conference Board found only limited evidence of borrowing difficulties.9 In 1932 (when the problem was presumably at its peak), 86%
of the responding industrial firms indicated either no borrowing
experience or no difficulty in obtaining bank credit. It could be, of
course, that the large number of respondents reporting no recourse to
bank credit reflected the depressed circumstances of the time (no demand
meaning no investment plans).10
Alternatively, many firms may have been intent on deleveraging as a way
of reducing their vulnerability to financial disturbances (analogous to
the argument sometimes made nowadays that the slow growth of bank
lending reflects not the weakness of the banks but the reluctance of
firms and households to borrow).11
Figure 3.
US capital spending as a percentage of GDP. Source: Historical Statistics of the United States: Millennium Edition online, Table Ca74-90
Full figure and legend (18K)
In the 1932 survey, the firms reporting difficulty in borrowing were disproportionately small.12
Since, in normal circumstances, these small firms and start-ups are
disproportionately the source of innovation, this observation does not
bode well for productivity growth. But the 1930s were not normal
circumstances; I return to this below.
In the aftermath of the recent crisis, OECD (2010) estimates that two-thirds of the fall in potential output will reflect a higher cost of capital, which will reduce the capital/labor
ratio. However, it assumes that the increase in the cost of capital
will be 150 basis points, which seems like a large number. The Institute of International Finance (2010),
in analyzing the impact of more stringent capital and liquidity
requirements, assumes very large increases in bank lending rates and
concludes that these could reduce global GDP by as much as 3% between 2010 and 2015.13
Other analysts, such as the Bank for International Settlements, dispute
not just the magnitude but the existence of these effects, putting the
upper bound in terms of cumulative growth impact at less than 1%.14
One suspects that if there are long-term effects from more limited
credit availability, these will come from the stricter application of
existing regulations at the national level more than from new capital
standards promulgated in Basel. And one suspects that the major impact
will be on more credit-intensive activities and sectors rather than the
growth of the economy as a whole.
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US Public Debt and Real Interest Rates.
Source: Board of Governors of the Federal Reserve System, ‘Banking and Monetary Statistics 1914–1941’; Global Financial Data; Maddison, A. (2009) ‘Statistics on World Population, GDP and Per Capita GDP, 1–2006 AD’ (March update); public debt kindly provided by Carmen Reinhart and Kenneth Rogoff
Full figure and legend (21K)
PUBLIC DEBT
Another plausible channel through which crises can lead to slower growth is by leaving an overhang of public debt. Reinhart and Rogoff's (2009)
stylized fact, based on experience in 13 post-World War II financial
crises, is that the real value of public debt roughly doubles in the 3
years following onset.15
The increase is due to a combination of lower tax revenues, reflecting
output losses, and increases in public spending taken in response to the
crisis. Higher debt burdens imply higher future taxes and higher
interest rates, other things equal, pointing to lower levels of
investment and slower rates of growth.16
The
‘other things equal’ caveat is a big one. The argument that government
deficits leading to higher levels of debt crowd out private investment
and depress growth operates mainly through higher interest rates, and
there is less than abundant evidence of upward pressure on interest
rates in the United States and other advanced economies at the moment.17
Deficit spending directed at recapitalizing a weak banking system and
stabilizing economic activity, by restoring confidence, may do more to
encourage investment than depress it. The debt ratio may also rise
insofar as the economic conditions are depressed and deflationary (that
is to say, for other reasons). Slow growth may cause heavy indebtedness
rather than the other way around.
The 1930s is again an obvious battleground for the competing schools. The US public debt/GDP ratio more than doubled from 17% in 1929 to 40%
in 1933–1937. This was certainly a period of depressed capital
formation: stocks of both equipment and structures were lower in 1941
than they had been in 1929. But it was not a period of high interest
rates; as in recent years precisely the opposite was true. (See Figure 4) Arithmetically, the main factor behind the rise in the debt ratio was the fall in nominal GDP by nearly 50%
between 1929 and 1933. The swing in the federal government deficit as a
percentage of Gross National Product between 1929 and 1933 was a
relatively modest 4%; this is telling us that the rise in indebtedness was mainly driven by the fall in GDP, not the other way around.
Figure 4.
US Public Debt and Real Interest Rates. Source: Board of Governors of the Federal Reserve System, ‘Banking and Monetary Statistics 1914–1941’; Global Financial Data; Maddison, A. (2009) ‘Statistics on World Population, GDP and Per Capita GDP, 1–2006 AD’ (March update); public debt kindly provided by Carmen Reinhart and Kenneth Rogoff
Full figure and legend (21K)
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POLICY UNCERTAINTY
Thus,
those seeking to argue that government policy discouraged investment
and otherwise impaired the environment for growth must look elsewhere.
In the literature on the 1930s, as in the recent period, they look to
the possibility that policy uncertainty increased the option value of
waiting. Friedman and Schwartz (1963)
argue that business confidence was weakened by uncertainty about the
implications of new regulatory measures for the business environment:
they cite, among other regulatory interventions, the Securities Act of
1933, the Securities Exchange Act of 1934, and the Glass-Steagall Act of
1933. Higgs (1999)
is the definitive modern exponent of this point of view, arguing that
‘pervasive uncertainty among investors about the security of their
property rights in their capital and its prospective returns’ depressed
private investment from the mid-1930s all the way up to World War II.
His list of problematic policies is long. He points to tax policy (the
Wealth Tax of 1935, a tax on incorporate dividends, increases in estate
and gift taxes, increases in surtaxes on high incomes, and a graduated
surtax on corporate earnings), and the tax increases imposed under the
guise of ‘closing loopholes’ in the 1937 Tax Act. He points to the
abrupt reversal of some of these measures by the Congress in 1938–1939.
He points to the uncertain consequences of the National Labor Relations
Act, creation of the Temporary National Economic Committee in 1938,
uncertainty about the enforcement of antitrust laws by the Department of
Justice, and new regulation of securities markets by the Securities and
Exchange Act. In arguments that anticipate recent criticism of
President Obama for his allegedly anti-business rhetoric, he points to
Roosevelt's criticism of business as creating a more uncertain business
climate.
Arguments hinging on the existence of
perceived uncertainty and an unobservable hostile-to-business climate
are intrinsically difficult to test, notwithstanding the depressed level
of investment that is their alleged consequence. Higgs looks at time
variation in investment and in the composition and policies of the
Roosevelt Administration. He argues that 1938 saw a significant change
in the makeup of the Roosevelt Administration, with the replacement of
dedicated New Dealers by pro-business men, together with a stronger
Conservative Coalition opposing the New Deal after the 1938
congressional election; this was followed by a substantial rise in gross
private investment in 1939 and again in 1940. But the rise in
investment is equally attributable to other factors, such as recovery
from a 1937–1938 recession that was widely attributed to the Fed's
decision to raise reserve requirements.
Fortunately for us, an earlier paper by Mayer and Chatterji (1985)
looks directly at the impact of policy shocks and other variables on
industrial equipment orders and investment in non-residential
structures. The authors construct dummy variables for the major policy
innovations and shocks of the period and find no evidence that it was
these as opposed to other plain-vanilla determinants of investment like
the cycle that drove investment spending.
An
alternative hypothesis is that investment will recover fully only once
capacity utilization returns to normal levels. This was the explanation
for the less-than-complete recovery of investment of the original
historian of US capacity utilization in the 1930s (Streever, 1960). Capacity utilization in US industry fell from 83% in 1929 to 42% in 1932; at its peak in 1937 it just matched the 1929 level of 83% before falling back again in 1938 and 1939. A level of 83%
does not suggest inadequate capacity; this is more-or-less normal
levels of utilization by second-half-of-20th-century standards.
Moreover, the 1929 level was also down considerably from the earlier
part of the decade. (See Figure 5)18
The
bulk of the evidence, then, suggests that the failure in the 1930s of
investment to recover more fully reflected not crowding out or policy
uncertainty but the continuing low level of capacity utilization. The
latter was a legacy of the singular depth of the slump. It was something
that solved itself eventually – in the event, with the intervention of
World War II. This suggests that, with growth and with time, there is no
reason why investment cannot again recover to pre-crisis levels.
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Measure of mismatch or turbulence for the United Kingdom.
Source: British Labour Statistics, Historical Abstract 1886–1968, Table 114
Full figure and legend (19K)
Measure of mismatch or turbulence for the United States.
Note: The mismatch (M) is calculated as the sum of the (absolute) changes in the percentage share of total employment for all industries.
M = ∑i‖Δei‖, where ei is the percentage share of total employment in industry i
Source: Historical Statistics of the United States: Millennium Edition online, Table Ba814-830.
Full figure and legend (19K)
STRUCTURAL UNEMPLOYMENT
Another
worry is that a rise in structural unemployment will reduce labor input
and efficiency. It is harder to grow when you have to retrain
construction workers and hedge fund managers to work as welders and
nurses, as will be the case when the economy is undergoing structural
change – including when it is rebalancing away from unsustainable
activities that boomed before the crisis. The mismatch between skills
supplied and demanded will then constrain the growth of employment.
Firms may not be able to find workers with the requisite training and
experience. One currently hears complaints from manufacturing firms of a
shortage of, inter alia, machinists – see Bowers (2010).
Similarly, workers lacking the skills and experience demanded may find
it more difficult to find their way out of a crisis. The outward shift
in the Beveridge Curve starting in 2009 Q2 (Federal Reserve Bank of Atlanta, 2010) is at least superficially consistent with this view.19
More generally, there is evidence that unemployment is concentrated to
an unusual extent in the current recession among individuals previously
with long-term jobs who are now faced with the challenge of finding new
jobs in different sectors.
Similar complaints about
shortages of qualified machine-shop and tool-room workers were voiced in
the midst of high unemployment in the 1930s (Allen and Thomas, 1939).
Motor vehicle manufacturers in Oxfordshire complained that Welsh
coalminers lacked both the skills and attitudes required of productive
factory workers (Heim, 1983).
Regional labor market problems and geographical disparities are
similarly evident in the recent recession, accentuated by housing market
declines which leave homeowners with negative equity hesitant to sell
and by exceptional distress in traditionally vibrant areas like
California and Florida which have traditionally absorbed workers from
declining regions.20 More generally, mismatch is a theme in studies of the British labor markets in the 1930s (see for example, Booth and Glynn, 1975). Dimsdale et al. (1989)
develop an empirical measure of the extent of mismatch in interwar
Britain, summing the absolute value of the change in the shares of total
employment across 27 industries.21
They show that a high level of mismatch moderates the downward pressure
on real wages normally exerted by a rise in the number of unemployed
workers, in turn limiting employment and output growth in their model.22
Figure 6
displays their mismatch index (the sum of absolute changes in the
shares of total employment across 27 industries as described in the
previous paragraph). Not surprisingly, it is procyclical, rising with
the onset of the slump in the early 1930s, falling when recovery
commences in 1932, and then rising again sharply with the 1937–1938
slowdown. With capital goods industries hit especially hard in the
slump, it is not surprising that the dispersion of employment growth
rates moved so strongly with the cycle.23
Figure 6.
Measure of mismatch or turbulence for the United Kingdom. Source: British Labour Statistics, Historical Abstract 1886–1968, Table 114
Full figure and legend (19K)
But
the other striking feature of the figure is that the mismatch index
falls quickly and sharply with recovery after 1931. Evidence of
structural unemployment dissolves, it would appear, with the recovery of
aggregate demand. This suggests that present-day evidence of structural
unemployment will similarly dissolve in the face of economic growth.
Figure 7 shows the analogous mismatch index for the United States, constructed from data from Table Ba814-840 of Historical Statistics of the United States.
Again, the pattern is strongly procyclical. Compared to the United
Kingdom, the peak in the 1930s is later, reflecting the fact that the
first full year of recovery is 1934. Once again, however, evidence of
persistent structural unemployment dissolves in the face of economic
recovery.
Figure 7.
Measure of mismatch or turbulence for the United States.Note: The mismatch (M) is calculated as the sum of the (absolute) changes in the percentage share of total employment for all industries.
M = ∑i‖Δei‖, where ei is the percentage share of total employment in industry i
Source: Historical Statistics of the United States: Millennium Edition online, Table Ba814-830.
Full figure and legend (19K)
Then
there are worries about hysteresis due to the concentration of
joblessness among a hard core of long-term unemployed. There is some
evidence that unemployment in the current cycle is concentrated among a
hard core of long-term unemployed to a greater extent than in the
preceding recessions.24 The same was true of the 1930s. Woytinksy (1942)
describes the US unemployed as subject to two very different patterns,
pointing to ‘the existence of two contrasting groups among the
unemployed: persons who have a fair chance of reemployment in the near
future, and those who remain out of jobs for considerable periods of
time’.25 Jensen (1989)
estimates that structural and hard core unemployment accounted for
fully half of US unemployment in 1935 and an even higher fraction of the
total in subsequent years.26 Crafts (1987) similarly documents the exceptionally high incidence of long-term unemployment in 1930s Britain.
The
pernicious effects of long-term unemployment are well known. Skills
acquired on the job atrophy when off it. Individuals experiencing
long-term unemployment tend to become demoralized and apathetic.27
An influential 1933 study by Paul Lazarsfeld and associates of the
Austrian town of Marienthal painted this picture in detail, as did a
1938 study of England by the Pilgrim Trust.28 Crafts (1987) cites commentary from the 1930s to this effect for the United Kingdom from both private commentators and policy authorities.29
The long-term unemployed may also become stigmatized in the eyes of employers. Jensen (1989,
p. 556) writes of the long-term unemployed in the United States and
United Kingdom in the 1930s that ‘(e)mployers distrusted their job
qualifications; they would not hire them for any reason at any wage’.
This problem particularly afflicted older workers: ‘Some entry into the
hard core resulted … when middle-aged workers became, at age 45 or 50,
“too old” ’.
Together,
these mechanisms imply a decline in the efficiency of labor utilization
and in growth capacity, underscoring the damage to growth potential
from long-term unemployment.
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TECHNOLOGICAL PROGRESS
Another
worry is that technological progress may slow as a result of the
crisis. Research and development, especially by small firms and
startups, is sensitive to the availability of bank funding, as noted
above. R&D has a long lead time, which means that the effects of
financial disruptions can be persistent.
Nabar and Nicholas (2009)
observe that there was a drop in R&D activity in the early 1930s
due to the depth of the economic collapse and tighter financial
constraints.30
But this history also points to the possibility of a more positive
outcome. Rather than being depressed as the previous perspective would
suggest, TFP growth in the 1930s in the United States was unusually
fast. Between 1929 and 1941, TFP growth ran at an annual average
compound rate of growth of 2.3%, faster than in
the first two decades of the century, faster than in the 1920s, faster
than during World War II, and faster than in the second half of the 20th
century.31
The
external effects of capital deepening cannot explain this, as noted:
net stocks of both equipment and structures did not rise over the
period. The phenomenon was not simply mis-measurement of labor input:
while there was probably some tendency for firms to retain their most
skilled and productive workers in the downturn, the fact that both 1929
and 1941 were business cycle peaks suggests that the contribution of
this factor was limited. Rather, there was a fundamental reorganization
of operations in a variety of industries. The example given in Field (2009b) is the railroads, which suffered from severe financial shocks (Schiffman, 2003),
a depressed economy, and competition from road (and nascent air)
transport. Managers fought back by figuring out how to use their labor
and capital more efficiently, through inter alia more efficient
scheduling and continuous utilization of freight cars, changes in
staffing practices, and so forth.
Field refers to
this as the ‘adversity effect’: to survive in the face of adverse demand
conditions, firms have to figure out how to cut costs and raise
efficiency. Koenders and Rogerson (2005)
present a model that predicts (or rationalizes) this behavior. In their
framework, firms invest in internal reorganization at the cost of
diverting resources from more immediate uses. In periods of high
economic activity, organizations postpone structural changes to take
advantage of more immediate opportunities. In periods of low activity,
they do the opposite.
While Koenders and Rogerson do
not apply it to the 1920s and 1930s, their framework has two
implications consistent with that historical experience. One is a
continued high unemployment rate following the shock: once immediate
opportunities dissipate and the firm turns to reorganization, it is less
likely to hire because reorganization is less labor intensive than
current production. The second is that the effects in question will be
stronger following a long expansion like that of the 1920s. The longer
the expansion, during which the firm will have focused on production
rather than reorganization, the larger will be the backlog of potential
structural changes. Looking at post-1964 experience, Koenders and
Rogerson show that the longer the preceding expansion, the more jobless
but also efficiency enhancing is the subsequent recovery. 1921–1929 was
the longest unbroken expansion in US history up until the expansion of
the 1991–2001 (the case that motivates their study); hence the same
logic plausibly applies.
There are hints that what
was true of railroads in the 1930s was also true, broadly speaking, of
the manufacturing sector. As factories were idled, firms had more
opportunity to adapt factory layout and raw-material flow to the
availability of the small electric motors that became available in the
1920s. More firms adopted the modern personnel management practices
pioneered by a handful of large enterprises in preceding years.32
More firms set up in-house research laboratories to develop new methods
and products; in a period when overall employment was stagnant, total
R&D employment in US manufacturing rose from 6,274 in 1927 to 10,918
in 1933 and 27,777 in 1940, despite double digit unemployment (Mowrey, 1982).
With less pressure to push product out the door, more time and effort
could be devoted to commercializing new technologies like neoprene and
nylon. Firms could experiment with new materials like plastics and alloy
steels. They could experiment with instrumentation capable of saving
both capital and labor. They could invest in new chemical processes for
extracting minerals and processing agricultural materials.33
These
examples of technologically progressive firms in the 1930s are
disproportionately large ‘Chandlerian’ firms in a position to pioneer
the commercialization of complex technologies, able to build in-house
research labs and personnel departments, and in a position to reorganize
large existing factories to take advantage of electric motors. These
were not the kind of small firms and start-ups most heavily impacted by
the limited availability of bank credit (see above). The question for
our time, of course, is whether small or large firms will be the locus
of innovation and productivity growth going forward.
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POLICY AND POLITICS
Crises
can also catalyze efficiency enhancing public-policy initiatives. It
can be argued that the economic and financial crisis of the early 1930s
catalyzed a whole host of economic policy changes that limited
instability and set the stage for faster and more successful growth.
Those of us who live in the San Francisco Bay Area and rely on the San
Francisco-Oakland and Golden Gate Bridges cannot help but recall that
the federal government contributed to the build-out of the road network
and otherwise financed growth-friendly infrastructure investments in the
depressed conditions of the 1930s. Government dealt with threats of
financial instability through the adoption of deposit insurance and
other bank regulatory measures. The Federal Reserve Act of 1935
centralized monetary policy decision making at the Board, preventing
disagreements between regional reserve banks from again immobilizing
central bank policy. Social welfare policies from unemployment insurance
to social security were put in place, ensuring a fair sharing of the
burden of adjustment and providing the social foundations for the
post-World War II golden age of economic growth.34
The
recent literature suggests that certain kinds of economies are most
likely to respond in efficiency enhancing ways to economic and financial
crises.35
These are economies with cohesive, stable, centrist political systems
that are able to equitably share out the costs of adjustment, compensate
the losers, and facilitate rather than resist adjustment. The United
States, which adopted not just unemployment insurance and Social
Security but also the Reciprocal Trade Adjustment Act, was evidently
able to do just that.
But other countries, such as
the United Kingdom, were less successful. The response of British TFP
growth to the crisis of the 1930s, in both the short and longer terms,
was decidedly less positive.36 Broadberry and Crafts (1990, 2003)
show that many of the policies put in place in the 1930s – import
restraints, the absence of an effective anti-trust policy, and the heavy
regulation of public utilities, for example – created enduring
obstacles for productivity growth. As they put it, ‘The response of
British industry to the Depression of the 1930s was a further retreat
from competition, a process already well under way from the depressed
conditions of the 1920s. There was a substantial increase in
concentration, brought about primarily by a merger boom during the 1920s
… Furthermore … the 1930s saw the introduction of a General Tariff’.37
In the absence of competition, rent seeking by cloistered management
became pervasive. Rather than systematically restructuring, industries
like cotton textiles and iron and steel were cartelized and protected
from foreign competition to avoid further short-term falls in
employment. For a quarter of a century, political control then swung
back and forth between a hard-line Labor Government and equally
hard-line Conservatives. Politics were fractionalized and fragmented.
There was little serious talk of burden sharing. Policy was stop-go. Not
until the 1980s was the legacy of the interwar Depression finally
cleared away.
These observations about political
structure are not reassuring about the growth prospects of the United
States today. Is its political system, with strong inter-party
competition and checks on the executive, conducive to a positive
response to the crisis? Or have there been changes in American politics
that have rendered the political system more polarized and less capable
of mounting a coherent response to the crisis?
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CONCLUSION
This
analysis of impacts of the Great Depression on the long-term growth
potential of the advanced economies highlights the following points.
First, the impact of weak bank balance sheets and increased risk
aversion on the part of lenders in the wake of the Depression was mainly
felt by smaller, younger firms. But with large firms enjoying access to
other sources of funding and retained earnings growing reasonably
strongly after 1933, it is hard to conclude that this had a first-order
impact on capital spending or output growth. Second, there is little
evidence that increased public debt or policy uncertainty had major
effects in depressing investment. Third, while there was extensive
structural and long-term unemployment in the 1930s, this also declined
relatively quickly once sustained recovery set in. Fourth, the crisis
was also an opportunity, as firms used the downtime created by the
Depression to reorganize and modernize their operations in ways that
boosted productivity growth. But creating a policy environment where
they had an incentive to do so required political compromise of a sort
that can be difficult given the polarizing effects of financial crises.
Mark Twain is alleged to have once said ‘History does not repeat itself, but it does rhyme’.38
There is no certainty, in other words, that the impact on long-term
growth potential of the 2007–2009 financial crisis will be the same as
the impact of the Great Depression. Indeed, the more carefully policy
makers study Depression experience and the more successfully they avoid
the errors of their predecessors, the more likely it is that the
aftermaths of the two crises will differ.
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Notes
1 Consider
Canada in 1983–1985, France in 1994–1995, Germany in 1976–1979, and the
Savings and Loan crisis in the United States in the early 1980s, for
example.
2 This
observation highlights another issue. In the wake of the crisis, the US
will have to rebalance away from the production of housing in favor of
merchandize and away from consumption in favor of net exports. A decline
in the US real exchange rate that makes the country's merchandize
exports more attractive to foreign consumers is a necessary part of this
adjustment. That decline can occur either through a fall in US dollar
prices (deflation) or depreciation of the dollar exchange rate; this way
of putting it makes clear why American policy makers prefer a
controlled depreciation of the dollar. The problem is that other
countries are reluctant to see their currencies rise. At the time of
writing, recovery in the other advanced economies is weak, making
stronger currencies the last thing that they need. Emerging markets, for
their part, are reluctant to abandon a model of export-led growth that
has served them well. They see export-oriented manufacturing as a locus
of learning by doing and productivity spillovers and worry that their
competitiveness would be damaged by excessive real appreciation. But,
absent nominal exchange rate changes, we will either see the same
adjustment occur through other less desirable mechanisms (deflation in
the US and/or a further acceleration of
inflation in emerging markets), or else the US current account deficit
will widen again. Since US indebtedness to the rest of the world cannot
rise indefinitely (especially if the denominator of the foreign debt/GDP
ratio is growing more slowly), sooner or later something will have to
give, presumably in the form of a sudden sharp fall in the value of the
dollar like that warned of by some observers before the crisis. This,
however, is the subject of another paper.
3 See for example IMF (2009).
5 If
one mechanically uses statistical methods to pinpoint the break in the
trend, the computer places it in 1989 – midway through the period when
the authors of the IMF fit a single linear trend. See Eichengreen et al. (2011).
6 Businesses
that they often liquidated subsequent to the crisis. On explanations
for the over-investment phenomenon in Korea in this period, see Lee and Wong (2003).
7 Thus, Robb and Robinson (2009)
show that start-ups rely on bank credit for their financing needs to an
unusual extent, all the high-profile attention attracted by the venture
capital industry notwithstanding.
8 Their sample of banks is for New York City.
10 The
two occasions that saw upticks in loans outstanding were 1939 and
1940–1941, which were the only times in the 1930s when late 1920s levels
of capacity utilization were reached and a substantial number of firms
felt compelled to borrow for capacity expansion (Weiland, 2009).
11 See Koo (2009).
12 A
substantial fraction of the firms in question reported that they would
not have experienced comparable difficulties in more normal
financial-market conditions. The 1939 study concluded that the majority
of loan refusals reflected changes in the instructions given loan
officers (‘bank policy’) and not the condition of the borrowing firm or
its industry.
13 In other words, it could reduce growth by as much as a fifth.
14 See Bank for International Settlements (2010).
In any case, there has been agreement since the earlier Institute of
International Finance analysis (for better or worse) on scaling back
proposed increases in capital and liquidity requirements and delaying
their implementation for as long as 7 years.
15 The precise increase averages 86%.
16 With the deficit currently running at 10% of national income, the US debt/GDP ratio is now reaching the 90% threshold where the authors argue that these growth-reducing effects kick in with a vengeance.
17 Greece is a different story, but the contrast is, presumably, instructive.
18 Another
possibility is that investment is depressed in the post-crisis period
not so much by the crisis itself as the nature of the pre-crisis
investment boom. Residential construction will remain depressed in the
wake of a housing boom that leaves the residential sector overbuilt.
Investment will be less productive and slower to recover insofar as
complementary investments made before the crisis embody an economic
structure and expectations that no longer prevail. To continue with the
case of housing, new investment is more costly insofar as prior
encumbrances (how the land was subdivided, for what uses it was zoned)
are difficult to change, and when existing structures have to be
demolished in order for new ones can be built. Field (2009a)
suggests that such encumbrances (excessive sub-development, poorly
planned infrastructure investment) depressed the construction sector all
through the 1930s. Developers wishing to build multiple units within a
subdivision had to incur heavy costs to reassemble subdivided acreage
(something complicated by the sheer difficulty of tracking down the
individual plot owners), demolish inappropriate improvements, and adapt
preexisting site hookups and street layouts. One is reminded,
inevitably, of recent arguments about the difficulty of replacing
McMansions with green housing.
19 More detailed analyses by Dowling et al. (2010) and Weidner and Williams (2010) suggest that the natural rate of unemployment has risen by 1.5% to 2.8% points since the onset of the crisis purely as a result of the mismatch problem.
20 On this, see Katz (2010).
21 Data taken from British Labour Statistics.
22 The alternative interpretation, now largely discredited (on this, see Hatton, 1985 and Eichengreen, 1987),
is that generous unemployment benefits discouraged search activity. One
hears today the same argument that the extension of unemployment
benefits has shifted up the level of unemployment for any level of
vacancies. But Federal Reserve Bank of Atlanta (2010)
shows that even making a generous adjustment for this factor is not
enough to eliminate the shift in the Beveridge curve. There is an
analogous set of arguments for the US, centering on New Deal policies (Cole and Ohanian, 2004) for which this author does not hold much brief.
23 A
further notable feature of the series is the relatively high level of
mismatch in the mid-1920s, this being a period when commentators
referred to the international competitive difficulties of Britain's old
industries (the so-called staple trades): textiles, coal, and iron and
steel, and shipbuilding. The literature on the interwar period
emphasized spatial as well as industrial mismatch, pointing to the much
higher unemployment rate in ‘Outer’ than ‘Inner’ Britain as an
additional dimension of mismatch that slowed labor-market adjustment
(Inner Britain being London, the Southeast, the Southwest, and the
Midlands). Even adjusting for differences in industrial composition,
some regions displayed persistently higher unemployment rates (Hatton, 1986). This suggests that the problem was more than just the fact that some industries are more cyclically sensitive than others.
24 See Leonhardt (2010).
At the time of writing, the share of the unemployed out of work for
more than 27 weeks was nearly double that of any other post-World War II
recession.
25 Woytinksy (1942), p.67.
26 He reports for cities like Buffalo that the share of the unemployed who had been out of work 1 year or more rose from 9% in 1929 to 21% in 1930 to 43% in 1931 to 60% in 1932 and 68% in 1932; the share of the male labor force in this condition rose from 0.5% in 1929 to 20% in 1932.
27 Machin and Manning (1998) provide survey evidence from 1990s Europe that individuals’ self-worth deteriorates as a result of unemployment.
28 Marienthal was banned by the Nazis soon after publication, and all extant copies were burned. The republication is Jahoda et al. (1972). In the psychological effects in particular, see Eisenberg and Lazarsfeld (1938). A companion study for the modern period is Fryer and Fagan (2003).
29 George Orwell described the effect in The Road to Wigan Pier:
‘It is only when you lodge in streets where nobody has a job, where
getting a job seems about as probable as owning an aeroplane and much
less probable than winning 50 pounds in the Football Pool, that you
begin to grasp the changes that are being worked out in our
civilization’.
30 And
also because of the perceived rise in uncertainty associated with the
structural transformation of the economy. At the same time, they provide
evidence that firms were able to learn about the nature of these shifts
and redirect their R&D investments by the late 1930s.
31 By Field's (2006) calculations, TFP growth averaged 1.08% in 1900–1919, 2.02% in 1919–1929, 2.31% in 1929–1951, 1.29% in 1941–1948, 1.90% in 1948–1973, 0.34% in 1973–1989, and 0.78% in 1989–2000.
32 See Jacoby (1985).
33 Field (2006), p.216.
34 See Bordo et al. (1998).
The reader will have noted that that this is the opposite of how the
policy response of the 1930s is characterized by the regime-uncertainty
school. The two views can probably be reconciled in practice. Policy
reforms that are supportive of growth in the longer run can still
heighten uncertainty in the short run, making immediate post-crisis
recovery more difficult. It is not inconceivable that both effects
resulted from the Great Depression.
35 See inter alia Tomassi (2004) and Cavallo and Cavallo (2008).
36 See Matthews et al. (1982).
37 Broadberry and Crafts (1990), p. 603.
38 Twain scholars have disputed the accuracy of the attribution.
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