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6.17 Great Depressions: A Real Business Cycle View

As noted above, REBCT has been criticized for its lack of plausibility with

respect to explaining the Great Depression. However, during recent years

several economists have begun to investigate economic depressions using

neoclassical growth theory.

Cole and Ohanian (1999) were the first economists to study the Great

Depression from this perspective and they attempt to account not only for the

downturn in GDP in the period 1929–33, but also seek to explain the recovThe

ery of output between 1934 and 1939. In their analysis they do not deny the

contribution of real and monetary aggregate demand shocks in initiating the

Great Depression. However, conventional models predict a rapid recovery

from such shocks after 1933 given the expansionary monetary policies adopted

after abandoning the Gold Standard constraint, the elimination of bank failures

and deflation, and the significant rise in total factor productivity. Given

these changes, output should have returned to trend by 1936, but US output

remained up to 30 per cent below trend throughout the 1930s. Cole and

Ohanian argue that the weak recovery process was mainly due to the adverse

consequences of New Deal policies, particularly policies related to the National

Industrial Recovery Act (NIRA) of 1933. The NIRA, by suspending

anti-trust laws in over 500 sectors of the US economy, encouraged cartelization

and reductions in price competition. Firms were also encouraged to grant

large pay increases for incumbent workers. Cole and Ohanian claim that it

was the impact of NIRA that depressed employment and output during the

recovery, thereby lengthening the Great Depression. Prescott (1999) provides

a similar perspective for the US economy, arguing that the Great Depression

was ‘largely the result of changes in economic institutions that lowered the

normal steady-state market hours per person over 16’. Thus, for Prescott, the

Keynesian explanation of the slump is upside down. A collapse of investment

did not cause the decline in employment. Rather employment declined as a

result of changes in industrial and labour market policies that lowered employment!

(see also Chari et al., 2002). While arguing that a liquidity preference

shock rather than technology shocks played an important role in the contraction

phase of the Great Depression in the USA (providing support for the

Friedman and Schwartz argument that a more accommodative monetary policy

by the US Federal Reserve could have greatly reduced the severity of the

Great Depression), Christiano et al. (2004) also agree with the Cole and

Ohanian view that the recovery of employment in the USA during the 1930s

was adversely affected by President Roosvelt’s ‘New Deal’ policies.

In a subsequent paper, Cole and Ohanian (2002b) focus on why both the US

and UK Great Depressions lasted so long, with output and consumption in both

economies some 25 per cent below trend for over ten years. Such a duration in

both countries cannot be ‘plausibly explained by deflation or other financial

shocks’. Instead, Cole and Ohanian focus on the negative impact of the NIRA

(1933) and the NLRA (National Labour Relations Act, 1935) in the USA, both

of which distorted the efficient working of markets by increasing monopoly

power. In the case of the UK, their analysis follows the lead given in earlier

research by Benjamin and Kochin (1979) that a generous increase in unemployment

benefits lengthened the Great Depression.

This new approach to explaining depressions has not convinced the majority

of economists, who mainly continue to highlight the importance of

aggregate demand shocks and monetary and financial factors in their explanations

of the Great Depression (see Chapter 2). Nevertheless, Prescott’s

(2002) Ely Lecture focused on using supply-side explanations of ‘Prosperity

and Depression’ for the interwar experience of the USA, UK and Germany,

the recent depression in France and the post-war record of Japan. In each

case the most important factor causing output to be below trend is supplyside,

rather than demand-side in origin (see also Kehoe and Prescott, 2002).

Crucial to the maintenance of prosperity are policies that focus on enhancing

total factor productivity. Given this perspective, Prescott recommends supply-

side policies that will:

1. promote the establishment of an efficient financial sector to allocate

scarce investment funds;

2. enhance competition, both domestic and international; and

3. promote international integration, including the establishment of trading

clubs such as the EU.