EC104 Topic 7

amarjotsidhu's version from 2015-06-09 23:35

Causes of Great Depression

Question Answer
What is the Great Depression?Largest macreoconomic crisis ever - international financial, banking and currency crisis followed by enormous GDP drop, massive and persistent unemployment lasting from 1930 to WWII
What shocks caused the Great Depression?(no single cause) Tight monetary policy, investment boom and bust, trade collapse, banking crisis, currency crisis
How were the shocks that caused the depression caused?Fixed exchange (gold standard), trade dependencies, capital flows (*international contagion)
Causes: investment boom and bustFlorida real estate boom: 1920-25 and then Wall street stock bubble 1925-29; bubble of the 1920s greatly increased volatility during the years preceding the crisis (investment increasingly speculative)
Severity of Wall Street Crash1929 stock market crash - dramatic shock (Dow Jones nearly halved in 3 months)
Was the Wall Street Crash the cause of the depression?was a symptom of the crisis rather than cause; firm profits and dividends were falling = fundamental issues present; commercial failures rising before and during GD; main effect of crash = destroyed consumer confidence = depression of demand = hindered recovery
What happened after the stock market bubble burst in 1929?banks began to fail (at an accelerating pace), poor US banking institutions left banks small and fragile
Response of Fed to GDDid not forcefully intervene to save the banking system and tightened monetary policy instead (Fed sees its role as enforcing the gold standard). This creates problems as banks can no longer borrow (more expensive)
Consequences of banking crisis in 1929mortgages and other debts call in, not given out which led to even more banking failures = vicious cycle
US banking crisis consequences internationallyEurope dependent on US capital exports = once money stops flowing, Europeans who relied on credit started defaulting = banking crisis in Europe
Problems in Europe in 1931US banking crisis = collapse of major Austrian bank; biggest problem - Germany - "dual crisis" - German mark collapses in value (current account deficits financed by US loans = pressure on exchange rate) and banking system collapses.
German "dual crisis"government imposes capital controls (problems caused by massive indebtedness and unbalanced budgets and reparation burdens). Germany increased interest rates to attract savings but this made problems such as unemployment worse. Problem with this: Germany owed money to European countries which it financed by borrowing from the US = many countries depended on Germany paying back its debts = liquidity crisis created by capital controls in Britain whose merchant banks were exposed to Germany = Bank of England faced massive withdrawals and dwindling reserves = abandoned the Gold Standard in 1931
US attempt to stay on gold standardTried to stay on till 1931 = raised interest rates to attract reserves, causing deflation and depressing demand. Election of FDR in 1933 = US reverses course (capital controls imposed, leaves gold standard, lowers interest rates)
"Gold Fetters" (Eichengreen)Staying on old slowed recovery from the Great Depression ; freeing up domestic monetary policy key to expansionaey policy
Trade collapse (1933)total world trade was 33% of the 1929 level due to reduced demand, increased trade barriers and frozen credit markets = deglobalisation
Eichengreeen and Irwin (1995) on trade collapseas late as 1938, trade volume was still barely 90% of 1929
Export decline - US (1933)US exports in 1933 31% of those in 1929
What explains collapse in world tradeoverproduction during WWI, tariffs and barriers to trade imposed
Causes of trade collapse: overproduction during WWICountries like US and Canada focused production on war exports e.g. foodstuffs,; European countries became dependent on foreign trade; post WWI period led to inevitable collapse in trade
Causes of trade collapse: tariffs and barriers to tradeUS Smoot-Hawley tariff; Canada (1930) retaliated with tariffs on 16 products; France and UK responded with tariffs and Imperial preference
US Smoot-Hawley Tariff (1930)goal = protect American industrial workers and farmers from competition associated with post WWI surplus (protect from low prices); designed to make US self sufficient and protect domestic firms e.g. milk, butter, cotton, wool; consequences = retaliation (Canada, UK, France)
UK General Tariff = Import Duties Act (1932)introduced a general 10% on all imports (excluding raw materials and foodstuffs); marked an end to free trade dating back to 1846; dominions exempt from tariffs (imperial preference); not very aggressive act but more symbolic
Relative importance of factorsfactors = interlinked and reinforce one another

Effects of Great Depression

Question Answer
2 factors that made Great Depression so depressingincomes fell and unemplloyment increased = political pressure
Country that fared the worst in GD in terms of incomeUS - lost 30% of GDP between 1929-33
Income decline in EuropeGermany and France suffer most severe (around 15%) while UK mild; dramatic fall in industrial output = mass unemployment caused;
Why did the US fall so much (asset bubble) vs. Europe?The US had boomed much more than Europe in 1920 = much further to fall and bigger bubble to burst
High unemployment and consequencesover 35% in US and over 40% in Germany = perpetually lost output = political pressure to fix domestic economic problems (increased state involvement - New Deal in US, Nazis in Germany)
Consequences of deflationprices fall = real wages rise but nominal wages sticky = firms stop hiring and start firing workers = lower demand and bigger deflationary shock
Why was there deflation in the US?central bank policy ; fragile banking system; worldwide price collapse for primary products (wheat)
Deflation causes in US: Federal reservedeflationary policy from 1929-1933 (did not cut interest rates, worried about gold standard; fall in velocity of money caused by bank collapses and cash hoarding; deflation = real interest rates high = Fed's measure to lower nominal interest rates ineffective
Deflation causes in US: fragile banking systemProne to crisis, small, poorly capitalised banks couldn't make it use of economies of scale' many "unit banks' - no branches across state borders; banking system cannot maintain credit flows once banks to fail (credit destroyed, investment and consumption crashes = deflation); banks = too small to succeed (vs. Canadian banks = large national banks which were fine during Depression)
Increases in tariffs (1928-1938)Germany (8% - over 33%) ; UK (10% - 24.1%)
Formation of trade blocs£ sterling area (most commonwealth, Denmark, Norway, et.c) ; Germany and Schacht agreements (Poland, Greece, Austria, Hungary, etc.); $ Dollar Area (US, Canada, Latin America); Gold Bloc (France, Switzerland) -> trade increasingly within the blocs
Latin American exports1929-30 = volume of exports fell from Latin America by 19%; export revenues in 41 primary producing developing countries fell by 50%
Consequences of fall in export revenues (Latin Aemrica)inability to pay back debts; "Original Sin" and "Sudden Stop"; exit from gold standard but countries that defaulted and exited recovered quite quickly e.g. Brazil, Argentina (low agricultural prices = incentives to industrialise + import substitution industrialisation) = periphery, cut off from credit and trade, begins Import Substitution Industrialisation