The New Deal, the Current Crisis and the Road Ahead Alexander J. Field Department of Economics Santa Clara University Santa Clara, CA 95053 email: [email protected].

The New Deal, the Current Crisis The New Deal, the Current Crisis and the Road Aheadand the Road Ahead

Alexander J. FieldAlexander J. FieldDepartment of EconomicsDepartment of Economics

Santa Clara UniversitySanta Clara UniversitySanta Clara, CA 95053Santa Clara, CA 95053email: email: [email protected]@scu.edu

The New SchoolThe New SchoolNew York CityNew York CityMay 19, 2009May 19, 2009

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Similarities with Great DepressionSimilarities with Great Depression

Although both crises were worldwide in Although both crises were worldwide in scope, the epicenter in both instances was scope, the epicenter in both instances was the United Statesthe United States


Both economic downturns were preceded by a Both economic downturns were preceded by a speculative real estate boom characterized by speculative real estate boom characterized by rising land and house prices and a rising share of rising land and house prices and a rising share of GDP devoted to construction. GDP devoted to construction.

1924-27: residential construction exceeded 8 1924-27: residential construction exceeded 8 percent of GDPpercent of GDP

2000: 4.6 percent2000: 4.6 percent 2005: 6.2 percent2005: 6.2 percent 2008: 3.4 percent2008: 3.4 percent


Both residential booms followed by a boom Both residential booms followed by a boom in nonresidential structuresin nonresidential structures

Share of nonresidential construction in GDP:Share of nonresidential construction in GDP: 2000: 3.2 percent2000: 3.2 percent 2004: 2.6 percent2004: 2.6 percent 2008: 3.8 percent2008: 3.8 percent


In both instances the periods preceding the crises featured In both instances the periods preceding the crises featured absent or diminished governmental regulation of the absent or diminished governmental regulation of the financial sector financial sector

Financial innovationFinancial innovation– 1920s: mutual funds, consumer installment buying1920s: mutual funds, consumer installment buying– Current crisis: collateralized debt obligations, credit default swapsCurrent crisis: collateralized debt obligations, credit default swaps

More relaxed attitude toward risky investments and higher More relaxed attitude toward risky investments and higher leverage on the part of financial institutionsleverage on the part of financial institutions

Rise in the relative size of the financial sector and the Rise in the relative size of the financial sector and the remuneration and skill intensity of its employees (Philippon remuneration and skill intensity of its employees (Philippon and Resheff, 2008)and Resheff, 2008)


The bust part of the financial cycle in both cases The bust part of the financial cycle in both cases saw disruptions in credit markets, with many saw disruptions in credit markets, with many bankruptcies or near bankruptcies of financial bankruptcies or near bankruptcies of financial institutions, and big declines in the price of institutions, and big declines in the price of equities,equities,

High stock market volatilityHigh stock market volatility Most of the largest one day stock price Most of the largest one day stock price increasesincreases

in the twentieth century took place between 1929 in the twentieth century took place between 1929 and 1932, as the Dow Jones Industrial Average and 1932, as the Dow Jones Industrial Average lost a total of 89 percent of its value. lost a total of 89 percent of its value.


In both cases during the upswing, In both cases during the upswing, households and firms borrowed, lent, and households and firms borrowed, lent, and spent with abandon. spent with abandon.

And in both instances, the challenge facing And in both instances, the challenge facing policy makers, at least in the short run, was policy makers, at least in the short run, was to cajole, incentivize, and otherwise to cajole, incentivize, and otherwise encourage households and firms to borrow, encourage households and firms to borrow, lend, and spend – just what had gotten them lend, and spend – just what had gotten them into difficulty in the first place. into difficulty in the first place.


Most importantly, within the United States as Most importantly, within the United States as well as other countries, the downturns well as other countries, the downturns resulted in falling output and employment, resulted in falling output and employment, and reductions in world trade, although the and reductions in world trade, although the declines in 2009 do not as yet approach, in declines in 2009 do not as yet approach, in percentage terms, those experienced eight percentage terms, those experienced eight decades ago. decades ago.

Short Run Effects on ProductivityShort Run Effects on Productivity

In each instance, while the upswing of the financial In each instance, while the upswing of the financial cycle supercharged the accumulation of physical cycle supercharged the accumulation of physical capital, particularly structures, its aftermath capital, particularly structures, its aftermath retarded it. retarded it.

The upswing of the financial cycle laid the The upswing of the financial cycle laid the groundwork for a subsequent contraction in groundwork for a subsequent contraction in physical accumulation, which, amplified by physical accumulation, which, amplified by multiplier effects and only partially counteracted by multiplier effects and only partially counteracted by fiscal and monetary policy, contributed in both fiscal and monetary policy, contributed in both cases to the decline in aggregate demand that cases to the decline in aggregate demand that induced recession.induced recession.

Consequence: short run adverse effects on both Consequence: short run adverse effects on both labor productivity and TFP. labor productivity and TFP.

Short Run Effects on ProductivityShort Run Effects on Productivity Between 1890 and 2004, a one percentage Between 1890 and 2004, a one percentage

point increase in the unemployment rate point increase in the unemployment rate reduced TFP growth by about .9 percent reduced TFP growth by about .9 percent (Field, 2008)(Field, 2008)

This is stable across periods in which trend This is stable across periods in which trend growth rates of TFP are quite differentgrowth rates of TFP are quite different

1929-33: about 12 percentage points of the 1929-33: about 12 percentage points of the roughly 30 percent decline in output roughly 30 percent decline in output attributable to plummeting TFPattributable to plummeting TFP

Short Run Effects on ProductivityShort Run Effects on Productivity

1995-2005: IT productivity boom: 1.46 percent per 1995-2005: IT productivity boom: 1.46 percent per year TFP growth in private nonfarm economyyear TFP growth in private nonfarm economy

2005-2007: Anemic TFP growth: .36 percent per 2005-2007: Anemic TFP growth: .36 percent per yearyear

This is before predictable effects of recession are This is before predictable effects of recession are feltfelt

The IT boom productivity boom has now run out of The IT boom productivity boom has now run out of steamsteam

Over the next few years productivity advance will Over the next few years productivity advance will almost certainly be weak or even negative, as it almost certainly be weak or even negative, as it was between 1929 and 1933. was between 1929 and 1933.

Longer Run Effects on ProductivityLonger Run Effects on Productivity

The years of the Great Depression (1929-41) were the The years of the Great Depression (1929-41) were the most prolonged period in US economic history in which most prolonged period in US economic history in which output remained substantially below potential. output remained substantially below potential.

That period was also, the most technologically progressive That period was also, the most technologically progressive of any comparable period in U.S. economic history.of any comparable period in U.S. economic history.

TFP Growth in PNE, 1929-41 = 2.31 percent per year TFP Growth in PNE, 1929-41 = 2.31 percent per year (Kendrick)(Kendrick)

With cyclical adjustment = 2.78 percent (Field)With cyclical adjustment = 2.78 percent (Field) Compare with Golden Age (1948-73) = 1.90 percent per Compare with Golden Age (1948-73) = 1.90 percent per

yearyear Or IT boom (1995-2005)= 1.46 percent per year.Or IT boom (1995-2005)= 1.46 percent per year.

Longer Run Effects on ProductivityLonger Run Effects on Productivity

Since the Depression experienced such Since the Depression experienced such pronounced productivity advance could we pronounced productivity advance could we expect boost to longer run growth as a direct expect boost to longer run growth as a direct consequence of our current recession?consequence of our current recession?

The issue is best approached by thinking of The issue is best approached by thinking of TFP growth across the 1930s as resulting TFP growth across the 1930s as resulting from the confluence of three tributaries. from the confluence of three tributaries.

Contributors to TFP Growth: 1929-41Contributors to TFP Growth: 1929-41

The continuing high rate of TFP growth within The continuing high rate of TFP growth within manufacturing, the result of the maturing of a manufacturing, the result of the maturing of a privately funded research and development privately funded research and development system. system.

Spillovers from the build out of the surface road Spillovers from the build out of the surface road network, which boosted private sector productivity, network, which boosted private sector productivity, particularly in transportation and wholesale and particularly in transportation and wholesale and retail distribution. retail distribution.

An adversity/hysteresis effect: crisis can lead to An adversity/hysteresis effect: crisis can lead to new and innovative solutions with persistent new and innovative solutions with persistent effects (silver lining effect; necessity is the mother effects (silver lining effect; necessity is the mother of invention). of invention).

Contributors to TFP Growth: 1929-41Contributors to TFP Growth: 1929-41

Certain scientific and technological opportunities, perhaps Certain scientific and technological opportunities, perhaps an unusually high number, were ripe for development in the an unusually high number, were ripe for development in the 1930s. They would have been pursued at about the same 1930s. They would have been pursued at about the same rate even in circumstances of full employment. Wallace rate even in circumstances of full employment. Wallace Carothers would still have invented nylon. Carothers would still have invented nylon.

Similarly, by the end of the 1920s, automobile and truck Similarly, by the end of the 1920s, automobile and truck production and registrations had outrun the capabilities of production and registrations had outrun the capabilities of the surface road infrastructure. Strong political alliances in the surface road infrastructure. Strong political alliances in favor of building more and improved roads had been favor of building more and improved roads had been formed, and issues regarding the layout of a national route formed, and issues regarding the layout of a national route system had been hashed out by 1927. Build out of the system had been hashed out by 1927. Build out of the surface road network would have continued in the absence surface road network would have continued in the absence of the Depression. of the Depression.

So it is the third effect, the kick in the rear of So it is the third effect, the kick in the rear of unemployment and financial meltdown, that is most unemployment and financial meltdown, that is most relevant in terms of a possible causal association between relevant in terms of a possible causal association between depression and productivity advance.depression and productivity advance.

Can we be optimistic?Can we be optimistic?

What doesn’t kill you makes you stronger …What doesn’t kill you makes you stronger … But sometimes it kills you …But sometimes it kills you … Adversity makes some work harder, take more Adversity makes some work harder, take more

risks …risks … It causes others to withdraw from the labor force It causes others to withdraw from the labor force

into depression, alcoholism, etc.into depression, alcoholism, etc. Both income and substitution effects operate.Both income and substitution effects operate. No reason to be optimistic simply on a priori No reason to be optimistic simply on a priori

groundsgrounds

Railroads: Poster Child for Silver Railroads: Poster Child for Silver Lining EffectLining Effect

By end of Depression, railroads responsible By end of Depression, railroads responsible for a third of all trackage in receivershipfor a third of all trackage in receivership

Between 1929 and 1941: railroads retired Between 1929 and 1941: railroads retired track, cut rolling stock and employees by a track, cut rolling stock and employees by a thirdthird

In 1941 railroads produced more revenue In 1941 railroads produced more revenue freight ton miles and almost as many freight ton miles and almost as many passenger miles as in 1929passenger miles as in 1929

Remarkable productivity achievementRemarkable productivity achievement Hope for GM and Chrysler?Hope for GM and Chrysler?

The Road AheadThe Road Ahead

Fiscal and monetary response during the Fiscal and monetary response during the Depression was too small to bring us out of the Depression was too small to bring us out of the Depression.Depression.

Although retardation of equipment accumulation Although retardation of equipment accumulation was transitory, not so for structures.was transitory, not so for structures.

Abandonment of gold brought some modest Abandonment of gold brought some modest reflationreflation

Some increase of government spendingSome increase of government spending Recovery from 1933 to 1937 was extraordinarily Recovery from 1933 to 1937 was extraordinarily

rapid, even though it only partially closed the rapid, even though it only partially closed the output gap.output gap.

Figure 10.1Gross Investment, Major Categories, 1919-41

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Equipment and Software

Nonresidential Struct

Residential Structures

Capital Income during the DepresionCapital Income during the Depresion Many wealthy Americans disliked Roosevelt, even hated him. Many wealthy Americans disliked Roosevelt, even hated him.

But that didn’t stop them from making money during his But that didn’t stop them from making money during his presidency. presidency.

The data show that, with one exception, recipients of capital The data show that, with one exception, recipients of capital income did terribly under Hoover. The one exception was income did terribly under Hoover. The one exception was bondholders: the real value of net interest payments went up bondholders: the real value of net interest payments went up almost 22 percent between 1929 and 1932. almost 22 percent between 1929 and 1932.

For all other types of capital income, particularly proprietors’ For all other types of capital income, particularly proprietors’ income and corporate profits, Hoover’s administration was a income and corporate profits, Hoover’s administration was a disaster. Proprietors’ income fell 56 percent in real terms, and disaster. Proprietors’ income fell 56 percent in real terms, and corporate profits fell more than 100 percent – they were negative corporate profits fell more than 100 percent – they were negative in 1932 and 1933. in 1932 and 1933.

Hoover’s presidency was not great for employee compensation, Hoover’s presidency was not great for employee compensation, which declined 24 percent in real terms between 1929 and 1932. which declined 24 percent in real terms between 1929 and 1932.

But it was worse, in the aggregate, for those receiving capital But it was worse, in the aggregate, for those receiving capital income. income.

Capital Income During the Capital Income During the DepressionDepression

Proprietors’ income and corporate profits recovered sharply after Proprietors’ income and corporate profits recovered sharply after 1933, and surpassed their 1929 levels by 1940. 1933, and surpassed their 1929 levels by 1940.

By 1937, the Dow Index was almost five times the level of its By 1937, the Dow Index was almost five times the level of its 1932 trough, reflecting the sharp upswing in corporate profits 1932 trough, reflecting the sharp upswing in corporate profits and more optimistic expectations for the future (the stock and more optimistic expectations for the future (the stock market’s performance was weaker between 1937 and the end of market’s performance was weaker between 1937 and the end of the war). the war).

Bondholders did not do as well under Roosevelt as under Bondholders did not do as well under Roosevelt as under Hoover, but their losses were trivial compared to the huge Hoover, but their losses were trivial compared to the huge increases in other types of capital income. increases in other types of capital income.

The one bleak spot for capital income recipients across both The one bleak spot for capital income recipients across both administrations was rental income of persons, which declined administrations was rental income of persons, which declined through 1935 and recovered only modestly thereafter. through 1935 and recovered only modestly thereafter.

These statistics are consistent with the generally slower These statistics are consistent with the generally slower recovery of construction during the Depression.recovery of construction during the Depression.

Figure 10.9 Income to Capital, 1929-41

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Corporate Profits

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The Response so FarThe Response so Far

Fiscal Stimulus package is well motivated, Fiscal Stimulus package is well motivated, probably too smallprobably too small

Monetary interventions appropriateMonetary interventions appropriate Major problem in response to banking Major problem in response to banking

systemsystem Larry Summers and Tim Geithner too Larry Summers and Tim Geithner too

deferential to Wall Street?deferential to Wall Street? Cognitive capture hypothesisCognitive capture hypothesis

The road aheadThe road ahead

Financial Crises in capitalist systems are Financial Crises in capitalist systems are endogenous (Minsky)endogenous (Minsky)

Combination of greater risk taking on asset Combination of greater risk taking on asset side of balance sheet and greater leverage side of balance sheet and greater leverage on liabilities makes a system increasingly on liabilities makes a system increasingly fragilefragile

A shock that otherwise would not have A shock that otherwise would not have severe adverse effects on the real economy severe adverse effects on the real economy now has the potential to have a devastating now has the potential to have a devastating effect effect


Leverage must be controlled. Involves more Leverage must be controlled. Involves more than just interest rate policythan just interest rate policy

John Taylor (2008) – keeping interest rates John Taylor (2008) – keeping interest rates too low between 2001 and 2004 caused the too low between 2001 and 2004 caused the housing bubble. Implication: higher rates housing bubble. Implication: higher rates would have avoided the financial crisiswould have avoided the financial crisis

But: Other countries with tighter short term But: Other countries with tighter short term rates also had a housing bubblerates also had a housing bubble


Acts of regulatory commission as well as omission Acts of regulatory commission as well as omission got us into the current crisisgot us into the current crisis– Brooksley Born – 1998 – proposal to regulate CDSsBrooksley Born – 1998 – proposal to regulate CDSs– Essentially shouted down by Alan Greenspan, Larry Essentially shouted down by Alan Greenspan, Larry

Summers, Arthur Leavitt, and Robert RubinSummers, Arthur Leavitt, and Robert Rubin– December 2000 legislation – Commodity Future December 2000 legislation – Commodity Future

Modernization Act – prohibits regulationModernization Act – prohibits regulation– Geithner and Bernanke are now advocating a somewhat Geithner and Bernanke are now advocating a somewhat

weaker version of what Born proposedweaker version of what Born proposed

Acts of CommissionActs of Commission

– 2004 decisions by Securities and Exchange 2004 decisions by Securities and Exchange Commission under Christopher Cox to remove controls Commission under Christopher Cox to remove controls that limited leverage of investment banks to the 10 to 11 that limited leverage of investment banks to the 10 to 11 range. range.

– Allowed what were then the five large investment banks Allowed what were then the five large investment banks (Bear Stearns, Goldman Sachs, JP Morgan Chase, (Bear Stearns, Goldman Sachs, JP Morgan Chase, Merrill Lynch, and Lehman Brothers) to enter a Merrill Lynch, and Lehman Brothers) to enter a “Consolidated Supervised Entity” program permitting “Consolidated Supervised Entity” program permitting them to escape the traditional debt to equity limitations, them to escape the traditional debt to equity limitations, and substituting for it an “alternative net capital rule.”and substituting for it an “alternative net capital rule.”

– The consequence was that leverage in these firms The consequence was that leverage in these firms soared to 33 to 35 to 1, with generally disastrous soared to 33 to 35 to 1, with generally disastrous results, once house prices stopped appreciatingresults, once house prices stopped appreciating

Global Savings Glut HypothesisGlobal Savings Glut Hypothesis

Bernanke – Greenspan viewBernanke – Greenspan view Fed not responsible because global savings glut Fed not responsible because global savings glut

drove down long rates, which the Fed doesn’t drove down long rates, which the Fed doesn’t control.control.

This view absolves Fed from responsibilityThis view absolves Fed from responsibility 1920s housing bubble occurred while we were 1920s housing bubble occurred while we were

running current account surplusesrunning current account surpluses Unlikely that large current account deficits/capital Unlikely that large current account deficits/capital

account surpluses are the entire explanationaccount surpluses are the entire explanation


Revisit Basel II? Financial Institutions have too much Revisit Basel II? Financial Institutions have too much discretion regarding how much capital to hold. Sheila discretion regarding how much capital to hold. Sheila Bair’s warningBair’s warning

FDICIA 1991 – responsibilities to take prompt correction FDICIA 1991 – responsibilities to take prompt correction action. Some have argued it doesn’t apply to bank holding action. Some have argued it doesn’t apply to bank holding companies. It doesn’t, but it does apply to the banks they companies. It doesn’t, but it does apply to the banks they hold.hold.

A step in the right direction: FASB will now prohibit financial A step in the right direction: FASB will now prohibit financial institutions from using off balance sheet Special Purpose institutions from using off balance sheet Special Purpose Entities, which permitted reductions in mandated capital Entities, which permitted reductions in mandated capital requirements. requirements.

A step in the wrong direction: relaxation of mark to market A step in the wrong direction: relaxation of mark to market accounting rules. Existing rules already contained accounting rules. Existing rules already contained restrictions and exceptions for assets that traded restrictions and exceptions for assets that traded infrequentlyinfrequently


Control of leverage not just a matter of open market Control of leverage not just a matter of open market operations/ interest rate policyoperations/ interest rate policy

Multiple failure: not just Fed, but OTS, OCC, SEC, CFTC, Multiple failure: not just Fed, but OTS, OCC, SEC, CFTC, as well as state insurance regulators, and private sector as well as state insurance regulators, and private sector groups like FASB, bolstered by an ideology that said the groups like FASB, bolstered by an ideology that said the market knows bestmarket knows best

Need combination of macro prudential regulator Need combination of macro prudential regulator responsible for monitoring and controlling systemic risk and responsible for monitoring and controlling systemic risk and micro prudential regulation and supervision responsible for micro prudential regulation and supervision responsible for health of individual financial entities.health of individual financial entities.

We do know why this happened. Whether or not we We do know why this happened. Whether or not we establish an effective regulatory regime in the aftermath of establish an effective regulatory regime in the aftermath of the downturn will influence the frequency and severity of the downturn will influence the frequency and severity of future financial crises/business cycles. future financial crises/business cycles.

The New Deal, the Current Crisis and the Road Ahead Alexander J. Field Department of Economics Santa Clara University Santa Clara, CA 95053 email: [email protected].

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great depression

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