Modeling Great Depressions: The Depression in Finland in the 1990s *

Article excerpt

The general equilibrium growth model is the workhorse of modern economics. It is the accepted paradigm for studying most macroeconomic phenomena, including business cycles, tax policy, monetary policy, and growth. The collection of papers edited by Kehoe and Prescott (2002, 2007) and earlier work by Cole and Ohanian (1999) break the taboo against using the general equilibrium growth model to study great depressions like that in the United States in the 1930s. This article is intended as a primer on the great depressions methodology.

If output is significantly above trend, the economy is in a boom. If it is significantly below trend, the economy is in a depression. Trend is defined relative to the average growth rate of the industrial leader. We use a trend growth rate of 2 percent per year because this rate is the secular growth rate of the U.S. economy in the 20th century. In the 21st century, it is possible that the European Union or China will become the industrial leader, and it will be appropriate to define the trend growth rate relative to that economy rather than to the U.S. economy.

A great depression, according to Kehoe and Prescott (2002, 2007), is a particular episode of a negative deviation from trend satisfying the following three conditions:

1. It must be a sufficiently large deviation. Kehoe and Prescott require that the deviation must be at least 20 percent below trend.

2. The deviation must occur rapidly. Kehoe and Prescott require that detrended output per working-age person must fall at least 15 percent within the first decade of the depression.

3. The deviation must be sustained. Kehoe and Prescott require that output per working-age person should not grow at the trend growth rate of 2 percent during any decade during the depression.

Figure 1 displays the evolution of output per working-age person in the United States for more than 100 years, relative to a 2 percent trend. The U.S. Great Depression of the 1930s can easily be identified from this figure. Great depressions are not a relic of the past, however, and, unless we understand their causes, we cannot rule out their happening again. Argentina, Brazil, Chile, and Mexico had depressions during the 1980s that were comparable in magnitude to those in Canada, France, Germany, and the United States in the interwar period. In recent times, New Zealand and Switzerland--rich, democratic countries with market economies--have experienced great depressions. In the 1990s, two countries, Finland and Japan, experienced not-quite-great depressions. The case of Japan has been analyzed in Hayashi and Prescott (2002, 2007). In this article, we analyze the experience of Finland.

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We rely on growth accounting to decompose changes in output into three portions: the first due to changes in inputs of labor, the second due to changes in inputs of capital, and the third due to the changes in efficiency with which these factors are used, measured as total factor productivity (TFP). We then use simple applied dynamic general equilibrium models to identify and quantify the sources of these movements. We analyze the standard neoclassical growth model and then provide three extensions: a model with distortionary taxes and government consumption, a two-sector model with investment specific technological change, and an open economy model with terms-of-trade changes.

An important feature of our analysis is that, given that we provide a battery of models for analysis, we have to provide explicit ways of making the data and the model outcomes comparable. The theory used will guide the measurement in the data, and the discussion of how to do that in a consistent way is a useful contribution on its own.

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The Finnish Experience in the 1990s

Finland has experienced spectacular growth during the past century. Figure 2 displays data on real GDP per working-age person (15-64 years) over the period 1900-2005. …