Coming (rather wonkishly) Up To Date On The Great Depression

"Has anyone else noticed that the current crisis sheds light on one of the great controversies of economic history?" Paul Krugman asked his readers recently. In fact I could have answered, him with a "yes me", since - to plagiarise Robert Lucas here - scarcely a day has passed since the 9 August 2007 (the day PNB Paribas found themselves short of $2 billion dollars to "close" their books) when I have not been thinking about this. In fact, depsite the many bad things that can obviously be said about the present crisis, it does have the one saving virtue - it enables many of us economists to really see up at first hand how things may actually have worked back then. In this sense I would like to extend my profound thanks to 45 million Spanish men and women and 140 million odd Russians for running round and round the treadmill for the last year and a half helping me triangulate, and sort out a few nagging problems I ahve had since late adolesence.

Monetary Policy On The Zero Bound

The controversy Krugman is refering to concerns the role of monetary policy in what we could call "extreme situations". For present purposes we could describe an extreme situation as one in which either (or both) a severe credit crunch and a liquidity trap are present. The liquidity trap would normally be associated with the presence of general consumer price deflation, while former may, or may not, be, but if it is it certainly complicates things a lot. But before I go any farther, what do we really mean by a credit crunch, and what is a liquidity trap?


Crunch, Crunch Crunch

One of the principal factors which may produce a severe loss effectiveness in conventional monetary policy (or its inability to stimulate an economy) is the presence of what we nowadays call a "credit crunch". Such a credit crunch normally consists of a sharp contraction in the supply of bank credit as a result of a massive loss of inter-bank trust which is produced by the accumulation of a large quantity of nonperforming loans and semi-worthless assets inside the financial system.

There will be close to no growth in lending by Spanish banks in 2009 as the economy contracts, the head of Spanish bank Sabadell said on Tuesday. "Credit this year is going to grow by zero or nearly zero due to the steep adjustment in the economy as it undergoes deleveraging," Sabadell's Chief Executive Officer Jaime Guardiola told a press breakfast.

Such a crunch would normally have two components; a) a decline in bank capital due to the accumulation of bad loans held by the banking sector with a resulting fall in the capital asset ratio large financial institutions. The banks normally respond to such a situation by reducing the amount of loans they are prepared to supply and; b) the emergence of a cautious lending attitude on the part of banks following their experience with a combination of bankruptcies, nonperforming loans, and recession. Such circumstances make firms and households less desirable potential borrowers than they used to be, and they also have the self-reinforcing effect of tightening credit conditions and worsening the developing recession, which is, of course, itself partly a by-product of the initial credit crunch. Thus when the thing locks tight, you need more than some 3 in 1 rapid-ease to unlock it.

Credit crunches would normally characterised by the fact that - despite the presence of a low interest rate environment - a sharp tightening of credit conditions occurs. The "lending attitudes" of financial institutions, at least from the borrower's perspective, suddenly become much more stringent.

A credit crunch implies that injections of liquidity (base and narrow money expansion) do not increase private credit and aggregate lending. This is exactly what we have seen happening in Japan from the mid 1990s onwards. Base and narrow money increased at a robust pace, but the broader money aggregates most directly related to corporate investment and consumer spending only grew modestly, as can be seen in the chart below, which comes from Gauti Eggertsson and Jonathan D. Ostry, Does Excess Liquidity Pose a Threat in Japan? (IMF Working Paper, April 2005 - please click on image for better viewing).




At the same time aggregate bank lending to the private sector decreased sharply, directly producing a tightening of credit conditions as faced by Japanese enterprises, while government borrowing increased substantially, in a pattern we are now getting used to seeing in the United States and Western Europe.



Krugman is now presenting us with evidence that this pattern may well be repeating itself in the United States. As he says, the Federal Reserve has been spectacularly aggressive about expanding the monetary base see chart below), yet bank lending has remained pretty much stationary.

Running On Empty Aka The Liquidity Trap

The other type of extreme situation which needs to be kept in mind is danger of a liquidity trap. Discussion of liquidity traps (or the danger they represent) came back into vogue in the late 1990s following a renewed focus on the problem by Krugman himself in the Japanese context.

In fact most of recent discussion of the liquidity trap problem has been focused on Japan, for the simple reason that Japan was the first major industrial economy to face serious and ongoing price deflation since the 1930s episodes. It was, of course, during the 1930s that Keynes first drew serious attention to the liquidity trap explanation for why monetary policy might be ineffective when interest rates come up against what we now call the "zero bound".

Basically the risk of entering a liquidity trap is heightened when interest rates are at or near zero, and domestic demand contracts with sufficient force to produce a substantial and ongoing fall in prices, since the implicit rate of return on simply holding cash is not that different from holding short term government bonds, and especially when transaction costs are taken into account. (If prices drop at a 2% annual rate, for example, this gives you an implicit rate of return of 2% on bank notes).

Now we need to be careful here, since while monetary policy in one economy after another gradually coming to rest around the zero bound, by and large price inflation has not (yet) fallen below zero (or not for a sufficient length of time), and while it is evident that a number of countries face the imminent risk of this happening (Germany, Spain, Ireland, the UK, Japan and the United States most notably) we are not there yet, and the central banks are working furiously (well I'm not too sure about the ECB) to unblock the credit crunch before the associated contraction in economic activity produces the sort of price deflation which increases the risl of one country after another getting stuck in some kind of liquidity trap.


The simplest explanation for why it is that an increase in the monetary base may have only limited effects on inflationary expectations and real macroeconomic variables goes back to Keynes. Keynes argued that monetary policy ran the risk of becoming impotent in stimulating demand and raising spending since interest rates were already at there lowest possible level. Essentially he argued that increasing the monetary base by buying short-term government bonds is irrelevant at zero interest rates since money and short-term government bonds become perfect substitutes. Therefore, it matters little for economic activity if commercial banks (or private individuals) hold money or government bond as the two assets effectively perfect substitutes.

This argument has been challenged of late, most notably by Ben Bernanke, since while the central bank may remain impotent in the face of short term interest rates, by buying longer term instruments (10 or 30 year bonds) the bank may influence rates all the way up the yield curve.

But there was another dimension to Keynes thinking here, and this was associated with the causal chain between the monetary base (which the central bank evidently controls) and the level of output and prices (which it apparently doesn't). Keynes suggested that the relation between monetary base and the level of output was not a linear one, and indeed in a credit driven economic the chain might run from sentiment to credit availability to the output level to broad money, leaving the central bank free to move the level of base money around at will, but effectively impotent to influence the level of lending and output. This sounds horribly like the sitaution we are seeing around us at the present time.

This is why Keynesian has become so closely associated with the idea of government spending, since given that the central bank has only limited ability to regulate the output level by using monetary policy, he considered direct demand management by via fiscal injections to be much more effective. Indeed in one of his last interviews Milton Freidman himself conceded the point, declaring that "The use of the quantity of money as a target has not been a success".

The core of Krugman's analysis is the idea that the equilibrium real interest rate - that is, the real rate that would match saving and investment - and thus bring output back up towards its capacity level - turns negative in a liquidity trap. Thus we can have an economy which is struggling to find its equilibrium point but which is unable to do so since it effectively cannot generate the rate of interest which would make this possible.

But how can the equilibrium real interest rate be and remain negative? Because, argues Krugman, poor long-run growth prospects (a debt deflationary environment) make investment demand so low that a negative short-term real interest rate would be needed to match saving and investment. Given a nominal interest rate floor of zero a positive expected rate of inflation becomes necessary to generate negative real interest rates, which will stimulate aggregate demand and restore full employment.

Equally importantly, injections of liquidity by the central bank which raise base money (or bank reserves) turn out to be pretty ineffective in raising the growth rate of broader money aggregates. Krugman shows that Japan's monetary base grew 25% from 1994 to 1997, but that the broader monetary aggregate (M2 + Certificates of Deposit) grew only 11%, and bank credit didn't grow at all. And more recent statistics indicated that "money hoarding" continued to be evident in 1998-1999, as an expansion of the monetary base in the range of 8% to 10% resulted in only about a 3% growth in M2 + CDs. Posterior Bank of Japan data show that between March 2001 and May 2004 while Japanese bank reserves grew by 800% the monetary base (which is bank reserves plus cash in circulation) only increased by 67%.

Now, as I say, there little evidence at the present time that we are already in a liquidity trap, but the danger that some countries (including Japan, yet one more time) may fall into one, is certainly real, and non-negligible.

Economics Is Giving Me A Depression

So what has all this got to do with the great depression? Well quite a lot actually.

As Krugman argues, a central theme of Keynes’s General Theory was the impotence of monetary policy in depression-type conditions. But Milton Friedman and Anna Schwartz, in their magisterial monetary history of the United States, claimed that the Federal Reserve could have prevented the Great Depression — a claim that in later, popular writings, including those of Friedman himself, was transmuted into the claim that the Federal Reserve "caused" the Depression.

(As we have seen, what the Fed really controlled was the monetary base — currency plus bank reserves. As the chart displayed below - which comes from Krugman - shows, the base actually rose during the great slump, which is why it’s hard to make the case that the Fed caused the Depression. Although arguably had the Fed acted more aggressively earlier - eg if it had expanded the monetary base faster and done more to rescue banks in trouble - the blow might have been softened, even though as we are seeing at the present time, there are no guarantees, this will always and forever have to remain a huge "what if").

Underlying everything the whole Friedman & Schwartz view of The Depression is the assumption that (in both the short amd long term) the "velocity" of money reflects the "money holding propensities of the community" (p679). Under the normal ceteris paribus convention, tastes are taken to remain unchanged. Thus, the authors feel authorised to write as though a movement in the monetary aggregate in and of itself implied a simple and direct influence on real output. This idea that velocity remains constant has been repeatedly question by critics of the Monetary History, most notably by Irving Fisher who in argued in a now famous Econometrica paper that debt liquidation leads to distress selling and which leads to a contraction in current deposits plus currency as bank loans are paid off, and thus to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes a general fall in the level of prices. Sound familiar?



Friedman & Schwartz for the most part take a pretty simple of the cause of the monetary contraction in The Great Depression:

the monetary authorities could have prevented the decline in the stock of money
- indeed could have produced almost any desired increase in the stock of money.
(P.301: note the almost]. The monetary decline from 1929 to 1933 was not an
inevitable consequence of what had gone before. It was the result of policies
followed during those years (p.699).

On the question of how the authorities could have controlled the money stock, they answer, in words quite evocative of things we have been hearing of late by conducting "extensive open market purchases" to increase bank reserves: What they say of the first year of the depression expresses their view reasonably clearly:

It has been contended with respect to later years (particularly during the years
after 1934....) that increases in high-powered money, through expansion of
Federal Reserve credit or other means, would simply have added to bank reserves
and would not have been used to increase the money stock.... we shall argue
later that the contention is invalid, even for the later period. It is clearly
not relevant to the period from August 1929 to October 1930. During that period,
additional reserves would almost certainly have been put to use promptly. Hence
the decline in the stock of money is not only arithmetically to the decline in
federal Reserve credit outstanding: it is economically a direct result of that
decline. (pp341-2)

Basically Friedman & Schwartz never really seriously consider the possibility that bank lending was held back by factors other than their reserve position. This is becuase they seem to pay practically no attention to the asset side of banks' balance sheets. This view of the world would seem to allow precious little place for the banks' role as financial intermediaries who live by striking a balance between the needs of two types of client: depositors (the public as asset owners) and borrowers (the public as investors and debtors). Nor does it allow for the fact that banks as intermediaries operate in a world of uncertainty, that banks' assessment of their client's creditworthiness varies, and that in the short term their lending determines the size of the money stock.

If these effects are accepted as important, the stock of money has to be seen as determined at least in large part by the business situation, and this is exactly what we are seeing now. It thus becomes more and more plausible that the scale of bank lending during the Great Depression was significantly restrained by the state of the bank loan book, and by their increased caution in lending to customers whose profit expectations had deteriorated drastically, as well as by the capital adequacy position and it was these considerations, and not the size of their reserves, that imposed a limit on the size of the money stock.

The government is losing its patience with the banks,” Spanish Industry Ministry
Miguel Sebastian said just hours after the labour ministry said the number of
people out of work in Spain rose to over 3.3 million as of the end of January, a
12-year high, “I will tell them, with all my power and conviction, that this is
not the time for large profits. It’s the time to support credit and financing
for families and companies in this country,”

Spain's largest union, the CCOO, went a step further and said banks had to start
dolling out credit, or face state efforts to control lending. The demands, and
word the Bank of Spain Governor and other bank sector leaders would address
Congress in coming weeks, raised talk the government could create a state bank
or take stakes in private banks to influence their credit policy. "We shouldn't
rule out the government taking a stake (in a private bank) and, in an extreme
case, creating a public bank," said Paloma Lopez, CCOO employment secretary
general. "If they don't free up financing, if the banks keep putting up
objections, the government has to go a step further."

The point is that one must believe that the fall in income had a major effect on personal consumption, and the great fall in output a major influence on business investment, and the interaction of the two (once the process started) a dominating influence. At most, then, monetary influences could have initiated the depression, or worsened it when it started, but they could not have been the sole dominating influence through its course. The parallel fall in the money stock cannot then be taken as evidence of the latter's causal significance.

“Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. 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.”
Ben Bernanke,

Banco Popular followed the lead of other Spanish banks on Friday, opting to sacrifice 2008 profits to increase provisions against bad loans amid the deepening economic slowdown. Popular posted a 16.8 percent drop in net profit for 2008 on to 1.05 billion euros ($1.4 billion), below analysts' forecasts, as loan loss provisions increased. Popular has one of the highest exposures to Spain's property sector, currently in a steep downturn after a decade-long boom. Many property developers are defaulting.

Popular is expected to post an around 8 percent rise in net interest revenue in 2009. Loans grew 6.1 percent, with 44 percent to small and medium-sized businesses, and client deposits grew 21.1 percent. Higueras said he sees, at best, low digit loan growth in 2009, but stressed that Popular would continue to lend money to businesses and private individuals. "We are not giving up on lending .... We will come through this crisis however long it lasts," he said.

Conclusions


Finally, (below) some more charts on Japan, prepared by the Japanese economist Richard Koo. In the first chart the thick blue line (please click over chart if you can't see adequately) shows the perception of large businesses of the willingness of banks to lend to them, as surveyed by the Bank of Japan for the Tankan index. You will note the line plunges twice, and it is the second plunge, or "credit crunch", which interests me at the moment. This was the crunch that finally drove Japan decisively off into deflation, and produced that now famed "liquidity trap". Basically the first credit crunch was resolved via large scale government contruction spending, the guaranteeing of bank deposits, and the swallowing by the banks of a large number of non-performing loans. Does all this sound familiar? It should. But then Japan reached a point were the financial system could struggle forward no further. So the crunch broke out again, and this time the only way to resolve the problem was with two massive injections of capital into the banking system.

The problem is that these injections - as can be seen below - served to push the Japan government debt to GDP ratio sharply upwards, nd it is this part of the story that I feel we will see repeating itself now in countries like the United States and Spain.




The problem is that the US economy became, as I am sure everyone is now only too aware, very highly leveraged with total (private and public) debt to GDP ratios of around 350% of GDP. This is now unsustainable. The government is basically - via the various bailout processes trying to reduce the part of this ratio which is held by the private sector and hence reduce the degree of leveraging to within a range that will allow bank lending to function again.



The problem is that as these bailouts take effect US GDP is itself contracting, and at the same time prices are pushing the frontier between price increases and price decreases. It is really very important to not allow systematic price falls to set in, and doubly important not to allow expectations for inflation to turn negative.

To Print Or Not To Print, That Is The Question

Well in a week which has seen Kazuo Momma, head of the Bank of Japan’s research and statistics department warning that Japan’s economy now faces faces an “unimaginable” contraction, and Prime Minister Taro Aso's approval rating dropping to a mere 14 percent according to the latest Asahi newspaper survey, it should not surprise us to hear reports that yet another set of "exotic" proposals have been put forward in the search for ways of dragging the Japanese economy out of the mess into which it seems to have fallen.

The proposal I am referring to is the latest "initiative" being quietly cooked up by some members of the ruling Liberal Democratic party. According to reports in the Japanese press the politicians in question, who include Yoshihide Suga, deputy chairman of the LDP’s election strategy council and a close aide to prime minister Aso, have set up a working group and are quietly dusting down plans (first advocated by Nobel economist Joseph Stiglitz on a flying visit to Tokyo) for the government to introduce its own private currency - yes that's right its own currency - to run in tandem as a rival the country's already existing official one (aka the Yen) which is essentially exclusively issued by the Bank of Japan.

The plan would seem to involve the printing of some Y50,000bn ($546bn) worth of a new currency to fund government pump-priming projects and arrives at a time of rising frustration among politicians about the posture being taken by the Bank of Japan who have been notably reluctant to bow to pressure and let the yen printing presses run ever faster in a desperate attempt to stimulate the economy.

Among proposals they have on the table are Y30,000bn of the new money to fund programmes supporting new industries and infrastructure projects, including doubling the size of Tokyo’s Haneda airport. The remaining Y20,000bn would be earmarked for government purchases of stocks and real estate.

“We are facing hyper-deflation, so we need a policy to create hyper-inflation.
We have to do something to undermine the central bank and government’s
credibility or else we won’t be able to halt the yen’s rise. So, while we know
this is drastic medicine, we will do it,” said Koutaro Tamura, an upper house
Diet member who will chair the new group.

The proposals are causing all sorts of controversy in Japan. Prime Minister Taro Aso said on Monday evening that "We are not at all at the stage of considering such an idea", while Chief Cabinet Secretary Takeo Kawamura warned that if the government prints money, it could lead to inflation and weaken the yen against other major currencies. BOJ Gov. Masaaki Shirakawa was also pretty critical of the proposal, saying it could "cause great damage" to the central bank's balance sheet and monetary policy as well as market confidence in the yen.

"The plan would require very careful consideration because it could result in jumps in Japan's long-term interest rates, with market participants losing trust in the government's commitment to repaying its debts," Shirakawa said.

Of course, what may lie behind such thinking is an extremely literal reading of a very influential academic paper by IMF economist (and former Paul Krugman PhD student) Gauti Eggertsson How to Fight Deflation in a Liquidity Trap: Committing to Being Irresponsible - right down to the small print. The basic idea is that as expectations of intensifying deflation set in deeper and the economic contraction intensifies a short sharp shock of irresponsibility is needed to convince people that inflation is inevitable.

Weakening the yen, and raising market participants inflation expectations (or their fear that government will irresponsibly monetise its debt), is just what the Eggerston proposal is all about, so fears of such an outcome - as expressed above - would hardly seem to constitute objections, and while it is unlikely that the plan will get very far in the short term (rather than prodding the BoJ into more aggresive action), Japan's crisis is very severe, and getting worse by the day, so clearly they are something out of the ordinary needs to be considered.

Industrial output plunged by a record 9.6 per cent month on month in December,and the consensus opinion among economists suggests GDP may have fallen more than 3 per cent compared with the previous quarter at the end of 2008 – an annualised decline of over 12 per cent.

“From October to December the scale of negative growth [in GDP] may have been unimaginable – and we have to consider the possibility that there could be even greater decline between January and March,” Mr Momma said in a speech.

So perhaps the unimaginable in negative growth may also call for what would previously have been unimaginable policy as a response.

A Critique Of Freidman and Schwartz's A Monetary History of The United States

by Christopher Dow
(pages 211-214)

Since Friedmann and Schwartz's Monetary History (1963) has had such a major impact on the debate about the causes of the Great Depression, it seems desireable to explain at greater length than possible in the body of my text my reasons for finding their explanations unsatisfactory and implausible.

Interpretations of the theoretical aspects of the book is rendered difficult by its being primarily a historical and not a theoretical work. It provides a dense and scholarly account of monetary development and the evolution of policy in the ninety three years after 1867. The four depression years take 120 pages of the 700 pages of the book (a fifth of the space being footnotes). Within that are around 40 passages varying in length from a paragraph to a sentence which state or imply a view about the causality of the depression. In addition there are about 20 more such passages in the final chapter. These passages are scattered and embedded in not difficult, but dense and demanding, discussions of statistical developments and conflicting views and personalities, themselves requiring attentive reading: they are therefore difficult to do justice to on a first reading, or to extract and collate afterwards.

The massive nature of F&S's history is dictated by the structure of each of its main chapters. Chapter 7 on the Great Depression starts with a general review, covering almost everything discussed later. Section 2 appears to be constructed on the plan of discussing chronologically different monetary aggregates and sub aggregates and the relations between them (ratios and identities); but much else is included within that framework. Section 3 is about bank failures, already discussed once; and section 4 about financial events abroad. Then come two sections discussing, first, monetary policy and contemporary discussions of it, and, second, Friedman's comments thereon. Repetition in analytic narrative is impossible to avoid, but F&S have allowed many layers of it to remain.

The steady thoroughness of their prose acts to induce acceptance of preannounced propositions long before evidence in support of them comes into sight. Chapter 8, for example, is entitled "The Great Contraction", and since that phrase is used in a dual sense, it functions as a suggestion of causal connection. The Great Contraction can apply, on the one hand, to the great decline in real output, but it can apply also (and more aptly) to the contraction of the money stock. The impression given is thus that the two were inextricably intertwined, and that the monetary contraction was the essence of it. That is indeed what F&S believe, and say on the third page; but to which they never later give precision, or, even by the end, much evidential support.

The title of the final section of Chapter 7 is equally indicative. On emight have expected here a connected discussion of whether monetary contraction might have been not cause but the effect of the real contraction, a question of which the authors are aware: had that been the case, it could have been difficult for the authorities to stop money contracting. Instead, the question is begged. The title of the final section is "Why Was Monetary Policy So Inept", - as if by this time the authors had earned their licence to drop the appearance of scholarly caution and objectivity - and we are given an explanation (of something that has never been shown to require explanation) in terms of a "shift in power" within the Federal Reserve System (p 411).

In the following paragraphs I try to analyse F&S's argument by collating statements made at different points. I will discuss it under four headings:

1) why the real depression occured;
2) why the monetary contraction occured;
3) the effects of bank failures, capital adequacy and the flight to cash;
4) the authors identification of three occassions on which in their view the Federal Reserve acted in a sharply restricted fashion

Underlying everything that F&S say on the occassion of The Depression is the assumption that (in the short term as well as the long) the "velocity" of money reflects the "money holding propensities of the community" (p679). Under the normal ceteris paribus procedure, tastes can be taken to be unchanged. By this logic, the authors are enabled to write as though a movement of the monetary aggregate itself implied a simple and direct sympathetic influence on real output.

To one of another way of thinking, this line of argument appears tendentious. In my view, clarity of thought requires recognition of the fact that money supplied by the banking system is not necessarily in equilibrium with the stock the public want to hold, and that in the short term therefore velocity is no more than a ratio between two magnitudes determined in partial independence.F&S's view is connected with the fact, discussed further below, that they give little or no weight to the role of banks as lending institutions.

1/. Though the general tone of what F&S say about the great depression clearly implies that it was caused by the monetary contraction, their statements are often hedged and unclear, and appear at times contradictory. (for instance in the opening to the Chapter on "The Great Contraction" after discussing the changes in attitude to the question whether "money matters" they remark that the "contraction is in fact a tragic testimonial to the importance of money forces" (p. 300). It is tragic presumeably becuase of the poverty and unemployment it caused, and the implication clearly is that that was due or largely due to "monetary forces".

One statement is:

prevention or moderation of the decline in the stock of money, let alone the substitution of monetary expansion, would have reduced the contraction's severity, and almost as certainly its duration. The contraction might still have been relatively severe. But it is hardly conceivable that money income could have declined [as much as it did]. (p301).

This statement however comes just after another one that seems to run in the other sense:

True, as events unfolded, the decline in the stock of money, and the near collapse of the banking system can be regarded as a consequence of non-monetary forces in the United States, and monetary and non-monetary forces in the rest of the world.(p300)

But by the end of the book they appear quite clear.

there is..... only one sense in which a case can be made for the proposition that the monetary decline was a consequence of the economic decline. (p691, also p694).

This is a view which they say is possible only if the Federal Reserve System is held to have been a prisoner of contemporary opinion. That, as they say, is not a matter of economic inter-relations, and is not what we are concerned with.

A Monetary History does not provide a connected view of why, in the authors opinion, the depression happened.

2/. F&S for the most part take a simple and extreme view of the cause of monetary contraction:

the monetary authorities could have prevented the decline in the stock of money - indeed could have produced almost any desired increase in the stock of money. (P.301: note the almost]. The monetary decline from 1929 to 1933 was not an inevitable consequence of what had gone before. It was the result of policies followed during those years (p.699).

On the question of how the authorities could have controlled the money stock, they answer, by "extensive open market purchases" as a means to increase bank reserves: What they say of the first year of the depression seems to express their view:

It has been contended with respect to later years (particularly during the years after 1934....) that increases in high-powered money, through expansion of Federal Reserve credit or other means, would simply have added to bank reserves and would not have been used to increase the money stock.... we shall argue later that the contention is invalid, even for the later period. It is clearly not relevant to the period from August 1929 to October 1930. During that period, additional reserves would almost certainly have been put to use promptly. Hence the decline in the stock of money is not only arithmetically to the decline in federal Reserve credit outstanding: it is economically a direct result of that decline. (pp341-2)

F&S, however, never seriously consider the possibility that they were held back by factors other than their reserve position. That is becuase they take practically no note of the asset side of banks' balance sheets. It is striking that, though the book contains many charts and table of bank liabilities it has only one table of bank assets (and then for selected years only). Their conceptual picture allows little place for the role of banks as financial intermediaries who live by striking a balance between the needs of two types of client: depositors (the public as asset owners) and borrowers (the public as investors and debtors). Nor does it allow for the fact that banks as intermediaries operate in a world of uncertainty, that banks' assessment of their client's creditworthiness varies, and that in the short term their lending determines the size of the money stock.

If these effects are accepted as important, the stock of money has to be seen as determined at least in large part by the business situation. On my view, the scale of bank lending during the Great Depression must have been greatly restrained by banks' bad debts, by banks' increased caution in lending to customers whose profit expectations had deteriorated drastically, and by capital inadequacy. It must have been these considerations, not the size of bank reserves, that imposed a limit on the size of the money stock.

(F&S admit that capital adequacy was a serious problem (p330) but argue that the authorities could and should have remedied this by buying securities to raise their price (hence increasing bank capital) and lending to banks after 1932 through the Reconstruction Finance Corporation. But the former would have been only partial indirect help, and the latter would have augmented banks' capital only if the authorities had taken bad assets in exchange for good.

On this view, the fact that the banks' reserves even by the end of the depression had fallen little, though banks' total assets/liabilities fell by about a third is presumptive evidence that reserves remained on the whole ample. (I admit that there may have been particular episodes when banks were constrained by reserve shortage: see further below).

F&S comment exclusively from their own point of view, and can see no force in the opinions of the authorities at the time based on considerations which they dismiss. They quote, for instance, the exchange of views inside the Federal Reserve System in May and June 1930, when most governors felt that there was already "an abundance of funds in the market" (p. 371): as one observed "we have been putting out credit in a period of depression where it was not wanted and could not be used" (p.373). F&S remark "these views seem to us...confused and misguided". To me they seem common sense. Again in it's report for 1930 the Reserve Board described its policy as one of "monetary ease". This draws from F&S the comment that "this is a striking illustration of the ambiguity of the terms "monetary ease" and tightness..... it seems paradoxical to describe as "monetary ease" a policy which permitted the stock of money to decline in fourteen months [as much as it did], (p. 375). But if one admits that the powers of the authorities are limited, it is not paradoxical at all.

3/. Though F&S rightly devote a good deal of space to the three successive waves of bank failures, these do not take a central place in their argument. At times they speak of their having had a contractional effect on the stock of money. But it becomes clear that what is meant is that the crises drained banks of reserves which depressed the money stock only because (in their view) the monetary authorities did not offset this effect so as to maintain bank reserves.

(The second banking crisis had far more severe effects on the stock of money than the first. P.314, see also P.648).


Hence they can say:

the bank failures were important not primarily in their own right but because of their indirect effect. If they had occured to precisely the same extent without producing a drastic effect on the stock of money, they would have been notable but not crucial. If they had not occurred, but a correspondingly sharp decline had been produced in the stock of money by some other means, the contraction would have been at least equally severe and probably more so. (p. 352, see also p. 357).

I have argued in the main text that the bank failures did indeed have a major effect in accuating the depression, but quite largely by reducing the amount of bank credit available to business - a question that F&S do not consider.

F&S have a curious argument which runs like this. The bank failures provoked a flight from deposits to currency: the former deposits-currency ratio had originally been preferred; hence the flight to cash must have made money less attractive and thus must have reduced the demand for money (that is, deposits and currency). Paradoxically, therefore, the bank failures, by their effect on the demand for money, offset some of the harm they did by their effect on the supply of money. That is why we say that if the same reduction in the stock of money had been produced in some other way, it would probably have involved an even larger fall in income than the catastrophic fall that did occur (p. 353). To be consistent they should also argue that if bank failures had been prevented from causing the money stock to fall (which, as they have already argued, could, and should have been done), then the effect would have been to raise income. The paradox in this argument springs I think from Freidman's practice of treating velocity as if it represented tastes and propensities, and was an independent force. In my view, velocity changes because the banks adjust lending, and thus the stock of money, to changes in income with a lag of several years: only in the very long term does velocity inter alia depend on the demand to hold money.

4/. At the very end of their book there is a passage in which they identify three crucial episodes in US history when the authorities took what is held to be incontrovertibly contractive action. The passage is worth discussing in detail because it is difficult to reconcile with others of their statements, and hence reveals more of their lines of thought: and also becuase it leads me to qualify what I have said already.

After first commenting that "it is often impossible and always difficult to identify accurately the effects of the actions of the monetary authorities, they then proceed:

on three occasions the system deliberately took steps of major magnitude which cannot be regarded as necessary or inevitable economic consequences of necessary changes in money income and prices. The dates are January to June 1920, October 1931, and July 1936 to January 1937. These are the three occasions - and the only three - when the Reserve system engaged in acts of commission that were sharply restrictive: in January 1920 by raising the discount rate from 4.75 per cent to six per cent, and then in June 1920 to 7%, at a time when member banks were borrowing from Reserve banks more than the total of their reserve balances: in October 1931 by raising the rediscount rate from 1.5 per cent to 3.5 per cent within a two week period, at a time when a wave of failures was engulfing commercial banks.... and indebtedness was growing: in July 1936 and January 1937, by announcing the doubling of reserve requirements in three stages, the last effective on May 1 1937, at a time when the Treasury was engaged in gold sterilisation, which was the equivalent of a large-scale restrictive open market operation. There is no other occasion in Federal Reserve history when it has taken explicit restrictive measures of comparable magnitude - we cannot even suggest possible parallels (p 688-9).

It seems that the restrictive action by the authorities in 1931 which F&S have in mind is not high interest rates as such (for the discount rate was low in 1931), but the authorities acting in a way that put further pressure on the banks at a time when, being already short of reserves, they were particularly vulnerable to pressure. This is perhaps the same point as that made in several passages that discuss bank failures in 1929-33, which blame the authorities for allowing bank reserves to fall (see pp 318 and 356).

In looking at any particular critical juncture it must be impossible for a commentator or historian to tell whether a) reserves where adequate because bank lending had fallen first and reduced the need for reserves; or, (b) reserves were at some stage indeed inadequate, and that had forced banks to curtail their lending, and thus to exert a restrictive effect on output. In looking at the whole span of the depression, I have already expressed doubt about whether the banks could have been short of reserves (since, over the whole period, the ratio of reserves to deposits rose). F&S are, however, here speaking of a critical period, in which banks were being drained of reserves by the flight to cash. Banks were therefore particularly dependent on action by the authorities to replenish reserves, and it is quite conceivable that the authorities were insensitive to their needs at this juncture. If that is the criticism, I could see some force in it - though it hardly seems to qualify as what F&S describe as "explicit restrictive measures" of a major sort. But (as I argue in the text) it was in any case perhaps chiefly the nature of existing financial institutional arrangements that was to blame.

Having dealt with vaious particular steps in F&S's particular argument, I will in conclusion give two broad general reasons for discounting a monetarist explanation of the Great Depression.

First, F&S at times admit that there were non-monetary influences at work; but they never explain how these can be integrated into a monetarist explanation. The point is that one must believe that the fall in income had a major effect on personal consumption, and the great fall in output a major influence on business investment, and the interaction of the two (once the process started) a dominating influence. At most, then, monetary influences could have initiated the depression, or worsened it when it started, but they could not have been the sole dominating influence through its course. The parallel fall in the money stock cannot then be taken as evidence of the latter's causal significance.

Second, there is an international dimension which F&S do not face up to which creates a similar difficulty for their argument. Depression in the United States was so deep that it must, be held to have largely determined the coincident depressions in other countries; and in the transmission process non-monetary channels (international trade) must have been important. Now in other countries also there was coincidentally monetary contraction. Does this mean that in other countries the causation ran from non-money to money (the opposite of what is said to have happened in the USA)? Or is it argued that monetary authorities in all countries coincidentally made identical mistakes?

This comes from this link.

More Greek Woes

Athens cautions banks on transfers to Balkans
By Kerin Hope in Athens and Stefan Wagstyl in London

Published: January 27 2009 17:20 | Last updated: January 27 2009 17:20

Greece has warned its banks against transferring funds from a €28bn government support package to their Balkan subsidiaries, because of growing fears of financial turmoil in these countries.

George Provopoulos, governor of the Bank of Greece, told the Financial Times he was concerned about the impact of the global crisis in countries – including Romania, Bulgaria and Serbia – that had experienced recent foreign currency lending booms.


I have advised the banks to be more prudent and to lend on the basis of availability of local funding, taking into careful consideration local economic conditions,” he said.

The warning comes after about 10 international banks, including Greece’s EFG Eurobank, urged European Union governments not to discriminate in their anti-crisis policies against states outside the eurozone and EU.

They were supported by the European Bank for Reconstruction and Development, the multilateral lender, which on Tuesday cut its 2009 growth forecast for the region from 2.5 per cent to 0.1 per cent. Erik Berglof, EBRD chief economist, said the danger of west European countries preparing bank support packages that discriminated against foreign countries was “a very big worry”.

The European Commission has welcomed the international banks’ initiative. The European Central Bank has already given liquidity support to EU members, notably Hungary, but has responded cautiously to proposals for assisting countries outside the union.

Bankers are particularly concerned about steep local currency declines, which have squeezed borrowers with foreign currency loans. Foreign exchange lending accounts for more than 70 per cent of loans in Serbia, 60 per cent in Hungary and in excess of 50 per cent in Romania and Bulgaria.

Mr Provopoulos said: “If economic conditions in these countries were to significantly weaken, Greek banks might find themselves exposed not just to credit risk but also to exchange rate risk.”

Banks with big market shares in south-east Europe include Italy’s Unicredit, Austria’s Raiffeisen International and Erste Bank, and Greece’s EFG, Alpha Bank and National Bank of Greece.

Meanwhile, some south-east European officials are concerned about the danger of foreign banks taking funds from the region.

Radovan Jelasic, Serbia’s central bank governor, told the FT this happened in Belgrade in December when he relaxed banks’ reserve requirements to release €600m ($780m, £564m) in local foreign exchange liquidity. Officials were dismayed to see €600m transferred out of the country by international banks in the following two weeks, he said. Foreign banks contacted by the FT in Belgrade declined to comment.

Elsewhere, Romania’s central bank said inflows from foreign owners were expected to slow, but not reverse. Some 39 per cent of the financing made available to Romanian subsidiaries of international banks was due for repayment this year but there was a “high probability” that about 80 per cent of this would be renewed, the bank said.

In Hungary, foreign banks poured in funds in October when the country faced a crisis and the International Monetary Fund launched an emergency package. Banks injected €2.8bn compared with a previous monthly average of €500m-€600m. Inflows have since dropped below the monthly average but the the central bank says “not a single bank is seeing an outflow”.

Farmers tighten stranglehold on Greece
By Kerin Hope in Athens

Published: January 27 2009 14:38 | Last updated: January 27 2009 18:13

Greek farmers on Tuesday extended a blockade of the country’s main roads that is starving the capital of food and medicine, stalling exports and straining relations with neighbouring countries.

More than 9,000 tractors have blocked the main route for trucks carrying goods to and from western Europe. Farmers are demanding that the government increases a €500m ($660m, £465m) support package.

The eight-day blockade is gradually moving closer to Athens. It highlights widening social unrest in Greece as the centre-right government of Costas Karamanlis, prime minister, struggles to restore credibility following last month’s student riots in Athens.

Mr Karamanlis said the government was “open to dialogue” but only when the roads were open again.

“You cannot hold prisoner a whole society that works to provide the resources to subsidise farming, and burden the economy even further,” he said.

Wholesalers in Athens warned on Tuesday that supermarkets and pharmacies were starting to run short of supplies.

Kostas Michalos, chairman of the Athens chamber of commerce, said: “Exports and trade generally are taking a disastrous hit. Other sectors of the economy should be allowed to meet contracts in these difficult economic times.”

The Bulgarian government appealed to the European Commission to intervene to lift the blockade after tractors surrounded customs posts at all three border crossings with Greece, leaving more than 500 trucks on the Bulgarian side.

Transit traffic at crossings with Macedonia and Turkey were also affected. Customs officials at the Kipi crossing with Turkey said on Tuesday that scuffles had broken out between lorry drivers and farmers.

Bulgaria’s truckers’ association said that it would take legal action against Greek authorities if the protests continued.

The government’s offer to farmers consists of €300m in compensation for crop damage caused by fires and floods last year, and another €200m of extra subsidies for olive oil, wheat and cotton growers who are facing increased input costs.

The farmers want the package to be increased. They also want it to exclude people who cultivate small landholdings in time off from other jobs. About 12 per cent of the Greek workforce are registered as farmers but this number includes many “urban farmers” who have second jobs in the public sector or in tourism.

Greece’s system of fragmented holdings makes farming uncompetitive compared with other Mediterranean producers such as Spain and Italy.

Large tracts of land that were once used mainly for olive growing in southern Greece have been abandoned or offered for building second homes as young people have left for service sector jobs in the cities.

Banks ask for crisis funds for E Europe

Banks ask for crisis funds for E Europe
By Stefan Wagstyl in Vienna

Published: January 21 2009 23:36 | Last updated: January 22 2009 09:52

Leading international banks operating in central and eastern Europe have clubbed together to lobby the European Union and the European Central Bank to extend their anti-crisis policies to ease the credit crunch in the region.

The group of ten, which wants action to ease liquidity shortages and help revive lending, is urging Brussels and the ECB to extend support beyond the EU’s new member states, such as Poland, to prospective members, such as Serbia, and to Ukraine, which has few prospects of joining the bloc soon.

Herbert Stepic, chief executive of Raiffeisen International, the Austrian bank, who brought the group together, said it was important that any action to support banks was not limited to western Europe.

“We fought for 50 years, many of us, to get these countries away from communism and now we have a free market economy in the region, we can’t leave them alone when there is an extremely harsh wind blowing,” he said.

The group has kept a low profile until now, but Mr Stepic told the Financial Times he was speaking out “because of the deteriorating economic circumstances”.

He said the costs of possible support would be “relatively” modest in comparison with the huge sums pledged to assist western European banks. The total gross domestic product of formerly communist central Europe was €740bn and for south-east Europe €270bn. This compared with €290bn for Austria alone.

His remarks come amid a week of fresh turmoil in the financial markets and a darkening economic outlook. The European Commission released a forecast of a 1.8 per cent decline in EU economic output for 2009, its gloomiest prediction in years, while Moody’s, the credit ratings agency, on Wednesday said the outlook for the Ukrainian banking system was negative.

EU institutions have already played a role in the emergency financial packages assembled by the International Monetary Fund in the region. The ECB has extended liquidity support to Hungary and the EU is contributing to Latvia’s bail-out. The ECB has also extended liquidity support to Poland, where the IMF has not been involved.

But the international banks want Brussels and the ECB to make clear that they stand ready to assist vulnerable non-EU members. Mr Stepic declined to specify which countries might need such support but bankers said they could include those with high external financing needs, including Serbia and Bosnia, as well as Ukraine.

As well as Raiffeisen, the banks involved are Italy’s Unicredit and Intesa Sanpaolo, Austria’s Erste Bank, Société Générale from France, Belgium’s KBC, German Bayern Landesbank, Sweden’s Swedbank and SEB and EFG Eurobank from Greece.

Japan's Grim And Bear It 2009 Outlook

Things in Japan are looking grim. They keep getting grimmer, and it doesn't seem they will be getting less grim anytime soon. To give you some idea of what this means, only this week we learnt that Japan’s steel production fell 28 percent in December. This was the steepest decline in no less than six decades. Meanwhile Hiroshi Yoshikawa, Tokyo University professor and head of the Japanese government business cycle measurement committee said that Japan’s present recession may become the longest in the postwar era. “We’d better get ready for a three-year recession,” he said in an interview with the press this week. The decline “will be very severe, not only in terms of duration but also depth”.

And those famous exports, which dropped by an astonishing annual 35% in December, accounted for 61 percent of the growth in the last expansion, an expansion which was the longest in over 60 years. What this means, bluntly put, is that until exports recover there isn't much likelihood of any more general economic recovery, and exports won't recover till global trade starts to expand again, and the bank and credit crisis is over, which means you can pretty much forget about 2009 as far as I can see.

Thus we are over to "do the best you can under the circumstances" mode, and to applying some sort of fiscal stimulus. And of course, Prime Minister Taro Aso has not been backward in coming forward in this regard (especially with elections looming at some point), and his second stimulus package has now been passed by the Lower House. But here comes the shocker - the package provides for an actual increase in deficit spending of a mere 1% of GDP - a drop in the bucket when you are talking about your worst recession since WWII. Even worse, the proposed fiscal 2009 budget - which begins on April 1 - provides no new stimulus. Newspaper reports which mention an increase in spending of 6.5% are misleading since they compare the proposed budget for fiscal 2009 with the initial budget for fiscal 2008. But the final budget for fiscal 2008, actually included two supplementary budgets, and the final readout ended up being a tad higher than what is currently proposed for 2009.

However even with spending staying flat (on the rather dubious assumption of no further packages) the Japanese government will still need to sell 33.3 trillion yen of new debt, the most in four years, since the economic contraction means there will be a revenue shortfall. The so-called primary budget deficit, the excess of spending over revenue excluding bond sales and interest payments, will balloon to 13.1 trillion yen from this year’s 5.2 trillion yen. And here we have Japan's dilemma, since something needs to be done to soften the blow of this recession, but with debt having been allowed to expand so rapidly over the last decade (see chart below), there really are limits on how much can responsibly be done.





The most obvious problem is that increasing spending at a time when tax revenue is falling threatens the government’s goal of balancing the budget by 2011. But Aso has already indicated that the government shouldn’t prioritize fiscal discipline when the economy is ailing, and so far as it goes the argument is reasonable. This is a "once in a lifetime" crisis (we hope) and so once in a lifetime measures are in order. It's just that Japan has now been busily taking "once in a lifetime measures" for over a decade, and we still don't seem to be getting anywhere. But we are ballooning government debt. Many quibble with the widely quoted 2008 OECD debt to GDP number of 182%, since it is a figure for gross debt (which the OECD can easily justify for reasons that we don't need to get into here). But look at the green line above which shows net debt, this has also been rising and rising, and is now near to 100% of GDP on IMF data. The point is we have just been through the longest expansion in over 60 years, and yet at no point did net debt to GDP start to fall. This is the real core of the problem that Japan faces in 2009, that previous fiscal policy did not attack the growing fiscal deficit in the good times, so there is little room to manoeuvre in the bad ones. Which is why the Japan economic outlook in 2009 is grim, grim and nothing but grim.

"Carry" Me Away Captivity - To The Land Of The Rising Sun

"Carried us away in captivity
Requireing of us a song
Now how shall we sing the lord's song in a strange land?"
Boney M

One question which many people in Japan are asking themselves right now is why it is the level of JPY/USD is so high. Not so long ago many of those very same people were busy asking themselves why it was that the yen was so cheap, and why all those imported products (like French mayonaise) were so expensive. Only a year or so ago the currency was trading somewhere in the 105 to 110 yen to 1 US$ range, yet last month it hit a 13 year high against the dollar and is currently hovering around 90 yen to 1 US$ mark - up 15% in just 12 months. In the meantime, as I pointed out in my last post, Japanese exports plummet (down 16.2% y-o-y in November), and with them the rest of the economy.

Indeed so seriously is the problem being taken that Bank of Japan governor Masaaki Shirakawa has made it plain that currency-market intervention is a distinct possibility at some point, and indeed Japan seems to have received a "fire at will" green-light-mandate at the last G8 meeting to do just this as and when it feels such action would be appropriate. "The strong yen at a time of rapid decline in the global economy has a big negative impact on our economy in the short term," Shirakawa said recently. Of particular concern here is the financial health of major Japanese exporters such as Toyota, Honda and Sony. Many of Japan's most important companies are really feeling the pain caused by collapsing external demand and the soaring yen, since a strong yen makes Japanese products more expensive, and hence less competitive, in overseas markets.

Just why the yen is so strong at the present time (as opposed to the Japanese economy which is so weak) can be seen in the above chart. The recent rapid rise in the dollar value of the yen has been the by-product of two distinct but inter-related processes: a decline in global risk appetite on the part of investors and the unwinding of what is known as the yen carry trade. For those not in the know the term "carry trade" is a euphemism for the widespread practice among investors of taking advantage of the yield differential offered by Japan's ultra-low interest rates and borrowing in yen in order to invest in currencies paying substantially higher ones. Some of the higher profile recipients of such funds have been the Icelandic krona, the New Zealand "kiwi" dollar and the Turkish lira, but in fact the practice was fairly extensive, with large inflows of funds being seen in emerging economies from India to Brazil.

The abrupt drop in carry trade activity, and hence the rapid drop in demand for yen denominated loans, can be seen in the chart (the JPMorgan EMBI+ index) which shows the price of emerging market bonds. As we can see, starting in early September, and coinciding with the bankruptcy of Lehman Brothers, the demand for emerging market bonds fell off a cliff (as the yield demanded by investors shot up, the relationship between bond prices and yields is an invese one), all of which lead to a very rapid "liquidation" in yen positions, as a result a lot of yen had to be bought to pay down the loans. Hence the rise in the yen. The situation has now recovered somewhat since the end of November, and hence the yen has eased back slightly, especially in relation to the euro.

Of course people didn't only borrow to invest in emerging markets, US treasuries were also an attractive proposition for some time for those borrowing in or having Japanese yen. The difference between one-year US and Japanese government bond yields was around 4.6% in mid-2006 (5.2% vs. 0.6%), and it thus paid to invest in US government bonds, driving up the demand for dollars and pushing down demand for yen. This particular carry ride has since disappeared though - as the current differential has fallen to very close to zero (0.43% for the US and 0.28% for Japan earlier this week). There is thus no great advantage at the present time in borrowing in yen to invest in US securities, and indeed one of the really interesting questions as Ben Bernanke moves steadily towards his own version of quantitative easing is whether the US dollar may not take over the poll carry position from the yen.

The carry trade is effectively an enormous by-product of financial globalisation and the impact of the kind of massive unwind we have recently seen is very hard to counteract, which is why Japanese officials haven't intervened in currency markets so far. Of course, with Japanese interest rates coming down to even lower levels, and a return to quantitative easing seeming a distinct possibility in coming months, it is quite likely that as the recovery takes hold in a number of key emerging markets we will once more see a revival in risk appetite and an increase in demand for emerging market bonds, and with all this a rise in yen carry and a fall in the value of the yen. It is this expectation, perhaps more than any other factor which has lead the Japanese authorities to hold back so far on intervention, since they are obviously anticipating the problem will solve itself as the global economy rebounds. Let's just hope they are right.