Friday, October 31, 2008

Policy mistakes were manifold 

Interesting that the media has latched onto a paper written a few years ago about FDR and the Great Depression.

Using 1929 data, the two researchers calculated what wages and prices would have been had without the New Deal, and then compared them to actual wages and prices at the time. Their findings were startling: In 11 key industries, actual wages averaged 25 percent higher than market conditions warranted, but unemployment was also 25 percent higher as well. Meanwhile, the New Deal pushed up prices 23 percent higher than they should have been, so consumers couldn�t afford to buy, leading to even more unemployment.

Cole and Ohanian blame FDR�s National Industrial Recovery Act for �short-circuiting the market�s self-correcting forces.� Instead of stimulating the economy, they argue, FDR managed to depress it even further. Without government intervention, the Great Depression would have ended in 1936 instead of 1943. If FDR unnecessarily prolonged the Great Depression, thank the Federal Reserve Bank for starting it. Current Federal Reserve chairman Ben Bernanke conceded the central bank�s culpability in a Nov. 8, 2002 speech honoring University of Chicago free market economist Milton Friedman on his 90th birthday.

Here's an ungated version of the Cole and Ohanian [1999] paper and an early version of the 2004 paper (published in one of our top journals, the Journal of Political Economy). The papers use a real business cycle model to estimate how various kinds of shocks would have affected the economy. �I link the earlier paper in part to show how the authors work through a narrowing of the possible causes of the length of the Great Depression.

A valid criticism of the model is that, by using a neoclassical framework, it assumes that the economy should recover from a productivity shock relatively quickly. �And in both papers, it is clear that if you use a series of negative productivity shocks -- like the stock market crash or a drought -- you should see a recovery within a few years of the initial 1929 shock. �There are of course a whole series of policy mistakes one could point to as well, with NIRA being only one. �Two others could be Smoot-Hawley and the Revenue Act of 1932. �The latter raised the top marginal tax rate from 25 to 63 percent and was signed into law by Hoover. �FDR gave us more tax increases on corporations, but it's hard to avoid the point that there were policy mistakes ahead of NIRA. �

The obvious implication of these stories is that an Obama Administration could lead to another depression by making the same mistakes. �I'll borrow from Brad DeLong: �like Paulson and Bernanke, they're more likely to make their own mistakes.