Academic journal article Economic Inquiry

Income Uncertainty and the Onset of the Great Depression

Academic journal article Economic Inquiry

Income Uncertainty and the Onset of the Great Depression

Article excerpt


Income uncertainty contributes substantially to explaining the fall in consumption

that marks the onset of the Great Depression. Consistent estimates of the variance of

income measure income uncertainty from 1921-30 and are produced using a linear

moment model. This series provides a statistical link between the large erratic swings

in income uncertainty after September 1929 and the Great Crash in the stock market.

Comparison of the behavior of income uncertainty in the 1920s to the pre-World War

I and post-World War II eras suggests that the experience after the Great Crash was

historically unique.


The Great Depression of 1929-41 can be broken down into several phases: (i) the initial recessionary phase from October 1929 to October 1930, (ii) the first two waves of bank failures between November 1930 and December 1931, (iii) the incipient recovery of late 1932 and the impending collapse in March 1933, (iv) the recovery of the financial system and the economy from the cyclical trough, and (v) the recession of 1937-38, among others. Many researchers have presented well-articulated theories and extensive empirical analyses for each phase of the Depression. Friedman and Schwartz [1963], Hamilton [1987], Gordon and Wilcox [1981], and Burbidge and Harrison [1985] have examined the role of money and monetary policy during the Depression. Brown [1956] examined the stance of fiscal policy during this period. Bernanke [1983b] provided an explanation of the role of the financial crisis in the propagation of the Great Depression. Most of this research has focused on the events that turned a recession in 1929-30 that was not historically unprecedented (that is, it is comparable to the recession of 1920-22) into the deepest slide in the history of the American business cycle.

Explanations of the Depression's initial phase, from late 1929 to October 1930, however, are much less satisfactory. Meltzer [1976] and Mishkin [1978] examined this period and concluded that the fall in output can be attributed largely to the stance of monetary policy and the stock market's impact on the household balance sheet, respectively. The remainder of the existing literature centers around a debate between Temin [1976; 1981] and Schwartz [1981] that has produced no consensus about the role of monetary and nonmonetary factors in providing the impetus for the Great Depression. Hence, the period sometimes called "the mysterious first year"(1) is the least understood of all the phases of the Depression.

We think that recent advances in our understanding of the influence of income uncertainty on consumption expenditures may help explain the onset of the Great Depression. The theoretical work of Leland [1968], Sandmo [1970], Dreze and Modigliani [1972], and others has shown that an increase in uncertainty about future income (measured as the variance of income) results in a reduction in current consumption expenditures under standard assumptions regarding risk preferences. Recently, Flacco and Parker [1990] included an estimate of the standard deviation of income in a conventional specification of the consumption function from Blinder and Deaton [1985] and found that this measure of income uncertainty is indeed negatively related to consumption. This result, estimated using post-World War II data, holds up to a number of statistical significance and specification tests.

Romer [1990] examined the relationship between consumer expenditure (proxied by various disaggregate spending series) and stock market volatility during the first year and a half of the Great Depression. Expanding on Bernanke's [1983a] analysis of investment under uncertainty, Romer estimates a model of consumer spending on durable goods in the face of temporary uncertainty. Empirical evidence reveals that inclusion of the volatility of the stock market as a proxy for income uncertainty dramatically reduces forecast errors for consumption of durable goods in 1929 and 1930. …

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