Some Observations on the Great Depression
Prescott, Edward C., Federal Reserve Bank of Minneapolis Quarterly Review
The prosperity of the 1920s in the United States was followed by the Great Depression in the 1930s. Will the prosperity of the 1980s and 1990s be followed by another great depression in the coming decade? This question is not that far-fetched. Depressions are not a thing of the past. The Japanese economy, for example, has been depressed for nearly a decade and is currently operating at a level far below trend. Argentina experienced a depression in the 1980s every bit as severe as the one experienced by the United States in the 1930s. The Brazilian economy is currently operating at a level well below trend and could fall even farther. Empirically, depressions are not a thing of the past, and only by understanding why depressions occurred in the past is there any hope of avoiding them in the future.
Given the importance of understanding depressions, I'm surprised that Harold Cole and Lee Ohanian (in an article in this issue of the Quarterly Review) are the first to study the Great Depression systematically from the perspective of neoclassical growth theory. I'm surprised because economists use growth theory to study economic growth and business cycle fluctuations quantitatively and to evaluate tax policies. Why hasn't growth theory been used to study the Great Depression? Perhaps because economists are reluctant to use standard theory to study an event that historically was treated as an aberration defying an equilibrium explanation.
Cole and Ohanian examine the Great Depression from the perspective of growth theory and show that growth theory cannot account for the Great Depression as a 10-year economic event. In the process of documenting deviations from existing theory, they define what a successful theory of the Great Depression must explain. Their analysis led me to conclude that the key to defining and explaining the Great Depression is the behavior of market hours worked per adult. (Cole and Ohanian report this measure of labor input as total hours. Adult is defined as 16 years and older.) Briefly, market hours worked per adult (from here on, simply market hours) dipped to 72 percent of their 1929 level in 1934 and remained low throughout the 1930s. Even in 1939, market hours were still only about 79 percent of their 1929 level.
By focusing on the entire decade of the 1930s, Cole and Ohanian shift the nature of the question from
Why was there such a big decline in output and employment between 1929 and 1933?
Why did the economy remain so depressed for the entire decade?
In particular, in the 1934-39 period, why didn't the economy recover from its depressed level? Cole and Ohanian show that the standard conjectures put forth to explain the Great Depression are not consistent with observations. In the last half of the 1930s, there were no banking crises. There was no deflation. There was a large increase in the money supply and a corresponding drop in the interest rate, just as the demand-for-money relation predicts. There was growth in total factor productivity. So why were market hours still 21 percent below their 1929 level in 1939? Given the considerable evidence against technology, monetary, or banking explanations, I am led, as Cole and Ohanian are, to the view that there must have been a fundamental change in labor market institutions and industrial policies that lowered steady-state, or normal, market hours.(1)
Before I explain why I think the behavior of market hours is the key to explaining the Great Depression, a brief review of growth theory is in order. The now-textbook theory includes two basic decisions. One is the consumption-investment decision, in which investment is roundabout consumption. That is, investment in more machines, office buildings, and factories today enhances future production possibilities, permitting greater consumption in the future. This feature of the production technology provides a way to transform consumption today into consumption in the future. …