How Crises End:

Some Lessons from the 1930s

Barry Eichengreen
September 1, 2009

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• A couple of months ago Kevin O’Rouke
and I put out some charts comparing “then
and now” as a column at Vox EU.
• We were motivated by the feeling that US-
centric comparisons were misleading
• We certainly didn’t intend to crash the
servers at Vox…
• Why all this attention not hard to see: the
comparisons are striking and alarming
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 Industrial production: we may
have gotten off to a slow start…
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5 10 15 20 25 30 35 40 45 50

Ju ne 1929=100 April 2008=100

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Trade volumes: this one
deserves further analysis
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90

80

70

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5 10 15 20 25 30 35 40 45 50

Ju ne 1929=100 April 2008=100

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Stock markets: we are certainly
outdoing our predecessors
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90

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5 10 15 20 25 30 35 40 45 50

Ju ne 1929=100 April 2008=100

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• Now, of course, a forceful policy response
appears to have succeeded in ending this
free fall, and maybe even initiating a global
recovery (time will tell…).

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Global stock markets are doing
better

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Industrial production may be
bottoming out

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 We haven’t seen the
stabilization of trade yet, but it
may be next
(US exports were up by 2/2% in June, Japanese exports by 1.1%)

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• The slides that follow illustrate that the
policy response has been very different
this time around.

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Compared to the 1930s, central banks have
cut rates to much lower levels

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Unlike the 1930s, money supplies have
continued to rise
(M1; note earlier startings point than previous graphs)

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 Compared to the 1930s, the fiscal policy
response has been much more aggressive
(surplus ratio – again, note earlier starting points)

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 How much can we hope from
the policy response?
• This is something that on which an
analysis of the 1930s, when we similarly
were in an environment of near-zero
interest rates, deflationary fears, and
disfunctional banking systems, can
presumably shed light.

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 Presumptions in the literature
• Monetary policy is likely to be ineffective or at
best weakly effective when interest rates
approach zero (liquidity trap conditions) and
banks are reluctant to lend.
• Fiscal policy is likely to be especially effective in
crisis countries (where agents otherwise face
tighter liquidity constraints).
– Both these points are argued by the IMF in its WEO of April 2009
– specifically in the context of effectiveness of ending an ongoing
recession – on the basis of post-1970s experience.
– Our evidence, it turns out, is consistent with the second of these
conclusions but not with the first.
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• We have analyzed this 3 ways:
– Using policy multipliers and model
simulations.
– Using panel VARs
– Using cross-section instrumental variables
regressions

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 Exercises using policy
•
multipliers
Christina Romer has estimated monetary and fiscal policy multipliers
for the 1930s on the basis of US experience. (“What Ended the
Great Depression?” Journal of Economic History 1992.)
– She assumes that the 1920-1 and 1936-7 recessions were caused
exclusively by monetary and fiscal policies (for which there is historical
justification).
– She specifies two equations, one in which the 1920-1 change in output
is a function of the deviation of M and deviation of F from normal levels
(which are linked to the change in output by M and F multipliers to be
estimated) and a second in which the 1936-7 change in output is a
function of the deviation of M and deviation of F from normal levels
(which are again linked to the change in output by the same two
multipliers).
– This gives her two equations in two unknowns (two unknown multipliers)
which can then be solved simultaneously.
• Alternatively, one can take policy multipliers from a mainstream
macroeconomic model.
– These turn out to be somewhat larger than Romer’s multipliers but not17
by enough to change the conclusions.
 We can replicate Romer’s results for
the US
(Normal fiscal balance is zero, normal monetary policy is 1923-7. We
then compare actual with normal. We use a different start date.)
Little impact of fiscal Monetary policy makes a
policy difference

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 We can extend the analysis to other
countries
(now defining normal period for M1 as 1924-7, still keeping normal F
balance as zero)
Fiscal impact is hardly But monetary impact is evident
detectable anywhere where it was applied

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 Of course, applying US
multipliers everywhere is
“heroic”
• So we also estimate panel VARs. Again following Romer, we
allow dM and dF to affect GDP growth with a lag.

• gGDPt= b31 dSURt-1 + b32 gM1t-1 + b33 gGDPt-1 + uGDPt

• dSURt= b11 dSURt-1 + b12 gM1t-1 + b13 gGDPt-1 + uSt-1
• gM1t= b21 dSURt-1 + b22 gM1t-1 + b23 gGDPt-1 + uMt-1

• Model is estimated on annual data for 1925-39 for 29 countries.

• We include country and year dummies.
• Shocks are identified with a Choleski ordering but are
insensitive to whether we put M or F first.
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First interesting result:
Monetary policy in the
full sample
• Monetary policy has a significant
impact on the full 29 country
sample (despite being in an
environment of near-zero interest
rates, deflationary expectations,
and financial distress).
• A 10 percentage point increase
in M1 growth raises growth by 1.2
percent in the next year.
• This is contrary to presumption in
WEO and much of the literature.
• Effectiveness here, I would
suggest, derives from dispatching
deflationary expectations, which
contemporaneous literature
suggests was an important effect.
• A study of post-1970s crises,
which occurred against an
inflationary backdrop, would not
pick this up.
• But the environment of deflation
is the one relevant to us.
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Second interesting
result: monetary policy
in the crisis subsample

• Even bigger impacts here when

we estimate the same relationships
separately for the 14 countries
classified by Bernanke and James
as experiencing banking/financial
crises.

•Here a 10 percentage point

increase in M1 growth raises
growth the following year by 1.7 per
cent, not 1.2 per cent.

• I conjecture that the importance

of vanquishing deflationary
expectations was even more
important in crisis countries (where
the problem of deflation was
generally worst).

• The historical literature is

consistent with this point. Consider
the United States: 22
Look how price expectations jumped
up (solid line is the price of cotton, dotted line the
exchange rate)
 Look how investment spending
jumped immediately upon dollar
devaluation
Third interesting
result: fiscal policy in
the full sample

•Effect is in the textbook direction:

larger surplus means lower GDP.

• But the effect is statistically

indistinguishable from zero (very
much so).

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Fourth interesting
result: fiscal policy in
crisis subsample

• Effect is in the textbook direction

but now also statistically significant
in the crisis subsample.

• This is indeed consistent with the

presumption that fiscal policy will
matter more in crisis countries
(where other agents are more likely
to be liquidity constrained and not
spending).

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Final interesting result:
fiscal policy in
noncrisis subsample

• Cannot rule out that the effect is

zero in this subsample.

• Is this because liquidity

constraints were not prevalent and
fiscal policy was otherwise
ineffective?

• Or was it that the small size of the

fiscal impulse simply makes it
difficult to estimate an effect?

• This is a topic for future research,

as they say…

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 Finally, we can estimate IV
regressions
• Using a gold standard dummy as an instrument
for monetary policy.
– Alternatively, inflation in the 1920s.
• Using defense spending as an instrument for
fiscal policy.
– Imperatives like Ethiopia. Justification: GDP doesn’t
affect defense spending. Certainly works for Italy, the
UK…
• The first stage fits well
– No problem of weak instruments for fiscal policy,
although monetary policy is a bit more problematic.
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Note that here “def_gdp” is defense spending/GDP

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Second stage again picks up an
effect of M but not F

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• So for monetary policy we continue to get
significant results, and even larger effects
a year out than before.
• For fiscal policy we continue to get
insignificant coefficients.
– Next: distinguishing crisis and noncrisis
countries.

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• So again we find a strong impact of
monetary policy using a different
identification strategy.
• But no discernible impact of fiscal policy.
• First stage regressions don’t seem to be
the problem. Maybe lack of variation in
fiscal variable is.

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 Conclusion
• Looking at the crisis globally, starting in the
spring of 2008 we were tracking a Great
Depression.
• A concerted policy response appears to have
pulled us out of that nose dive.
• Future scholars will investigate the relative
importance of the monetary and fiscal response.
• Evidence from the 1930s that both probably
mattered, given the prevalence of deflationary
fears and the disfunctionality of financial
systems in the first year of the Great Recession.33
• Thank you.

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