The Midas Paradox: Financial Markets, Government Policy Shocks, and the Great Depression by Scott B Sumner

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Last annotated on March 16, 2017

1 IntroductionRead more at location 128

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Many economists now see the initial contraction as being caused, or at least exacerbated, by monetary policy errors and/or defects in the international gold standard.Read more at location 130

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Some argue that New Deal policies delayed recoveryRead more at location 131

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But we still lack a convincing narrative of the many twists and turns in the economy between 1929 and 1940.Read more at location 132

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disturbances in the world gold market.Read more at location 134

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the seventeen high-frequency changes in the growth rate of U.S. industrial productionRead more at location 137

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I will show that if we take the gold market seriously we can explain much more about the Great Depression than anyone had thought possible.Read more at location 138

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changes in central bank demand for gold, private sector gold hoarding, and changes in the price of gold.Read more at location 140

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remaining output shocks are linked to five wage shocks that resulted from the New Deal.Read more at location 141

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financial market responses to the policy shocks of the 1930s were consistent with a gold market approach,Read more at location 149

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In 1963, Friedman and Schwartz’s Monetary History of the United States seemed to provide the definitive account of the role of monetary policy in the Great Depression.Read more at location 153

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Friedman and Schwartz paid too little attention to the worldwide nature of the Depression, especially the role of the international gold standard.Read more at location 154

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the complex interrelationship between gold, wages, and financial markets during the 1930s.Read more at location 177

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I was shocked to see so many misconceptions from the Great Depression repeated in the current crisis:Read more at location 188

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Assuming causality runs from financial panic to falling aggregate demand (rather than vice versa).Read more at location 189

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Assuming that sharply falling short-term interest rates and a sharply rising monetary base meant “easy money.”Read more at location 191

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Assuming that monetary policy became ineffective once rates hit zero.Read more at location 192

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the view that Fed policy was “easy” during late 2008 was almost universal.Read more at location 194

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we congratulate the Fed for avoiding the mistakes of the 1930s, even as it repeats many of those mistakes.Read more at location 198

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Chapter 1Read more at location 202

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financial markets respond immediatelyRead more at location 203

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there was an especially close correlation between news stories related to gold and/or wage legislation and financial market prices.Read more at location 204

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The demand shocks were triggered by gold hoarding (or changes in the price of gold), and the supply shocks were caused by policy-driven changes in hourly wage rates.Read more at location 206

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Chapter 2Read more at location 208

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World monetary policy (as measured by changes in the gold reserve ratio) was stable between June 1928 and October 1929, and then tightened sharply over the following twelve months. It was this policy switch, perhaps combined with bearish sentiment from the reduced prospects for international monetary coordination, which triggered a sharp decline in aggregate demand.Read more at location 210

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Chapter 3Read more at location 213

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The German economic crisis of 1931 was a key turning point in the Depression. It led to substantial private gold hoarding, and between mid-1931 and late 1932 strongly impacted U.S. equity markets.Read more at location 214

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Chapter 4Read more at location 218

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Keynes suggested that the Fed’s spring 1932 open market purchases might have been ineffective due to the existence of a “liquidity trap.”Read more at location 218

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The open market purchases were associated with extensive gold hoarding, and this prevented any significant increase in the money supply.Read more at location 221

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Chapter 5Read more at location 223

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President Roosevelt instituted a dollar depreciation program in April 1933 with the avowed goal of raising the price level back to its 1926 level. This program was unique in U.S. history and was the primary factor behind both the 57 percent surge in industrial production between March and July 1933 and the 22 percent rise in the wholesale price level in the twelve months after March 1933. The initial recovery was triggered not by a preceding monetary expansion, but rather by expectations of future monetary expansion.Read more at location 224

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Chapter 6Read more at location 228

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The National Recovery Administration (NRA) adopted a high wage policy in July 1933, which sharply increased hourly wage rates. This policy aborted the recovery, led to a major stock market crash, and helped lengthen the Depression by six to seven years.Read more at location 229

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a second “Great Depression” began in late July 1933,Read more at location 231

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Chapter 7Read more at location 233

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The gold-buying program of late 1933Read more at location 233

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was essentially a monetary feedback rule aimed at returning prices to pre-Depression levels.Read more at location 235

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Although the program helped promote economic recovery, it eventually became a major political issue and led key economic advisors to resign from the Roosevelt Administration.Read more at location 235

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Chapter 8Read more at location 238

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Although the conventional view is that Franklin D. Roosevelt took America off the gold standard, U.S. monetary policy became even more strongly linked to gold after 1934 than it had been before 1933. A recovery in the United States finally got underway when the Supreme Court declared the NIRA to be unconstitutional in mid-1935.Read more at location 239

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Chapter 9Read more at location 243

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During 1937, the expansionary impact of gold dishoarding began to be offset by wage increases, which reflected the resurgence of unions after the Wagner Act and Roosevelt’s landslide reelection.Read more at location 246

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Chapter 10Read more at location 249

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Chapter 11Read more at location 255

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A misinterpretation of two key policy initiatives, the open market purchases of 1932 and the NIRA, had a profound impact on macroeconomic theory during the twentieth century. Because early Keynesian theory was based on a misreading of these policies, it could not survive the radically altered policy environment of the postwar period.Read more at location 256

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Chapter 12Read more at location 260

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At the deepest level, the causes of the Great Depression and World War II are very similar—both events were generated by policymakers moving unpredictably between passivity and interventionism.Read more at location 263

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Chapter 13Read more at location 265

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high frequency fluctuations in real wages during the 1930s were tightly correlated with movements in industrial production. Understanding real wage cyclicality is the key to understanding the Great Depression.Read more at location 267

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New Deal legislation led to five separate nominal wage shocks, which repeatedly aborted promising economic recoveries.Read more at location 269

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is even more useful during the first five years after the United States departed from the gold standard. Under an international gold standard, the domestic money supply, the interest rate, and gold flows are not reliable indicators of domestic monetary policy.Read more at location 271

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Methodological IssuesRead more at location 274

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The problem of causalityRead more at location 274

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Economists often look for leads and lagsRead more at location 276

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we still don’t know how to identify monetary “shocks.”Read more at location 277

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gold marketRead more at location 279

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labor market)Read more at location 279

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“efficient market hypothesis”Read more at location 280

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we probably cannot go beyond financial market reactions to economic shocks.Read more at location 281

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(A modern example of this conundrum occurred when many pundits blamed the Fed for missing a housing bubble that was also missed by the financial markets.)Read more at location 283

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advocates the more eclectic approachRead more at location 285

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the most relevant example would be Friedman and Schwartz’s Monetary History. Their work combined an extremely detailed narrative, insightful theoretical analysis, and a wealth of descriptive statistics.Read more at location 286

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the narrative gives a sense of whether policy changes were exogenous,Read more at location 293

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I develop a narrative of the Great Depression that relies heavily on the relationship between policy news and the financial markets.Read more at location 312

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It is easy to imagine finding a spurious correlation for a single observation; it is less obvious that it would be easy to do so for many dozens of observations that all exhibit a common causal relationship.Read more at location 313

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It has been my good fortune that stock prices during the Depression were unusually volatile, and unusually closely related to policy-oriented news events linked to the world gold market and also to federal labor market policies.Read more at location 319

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stock prices were highly correlated with industrial productionRead more at location 329

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One purpose of this study is to show that monetary policy lags are much shorter than many researchers have assumed,Read more at location 330

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A recent study of the U.S. Treasury bond market showed that if one divides the trading day into five-minute intervals, virtually all of the largest price changes occur during those five-minute intervals that immediately follow government data announcements.Read more at location 342

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Although we need to look at qualitative news stories, this does not mean that we should dogmatically reject the tools of modern statistical analysis.Read more at location 353

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This supports new Keynesian models in which changes in the current setting of the policy instrument are much less important than changes in the future expected path of monetary policy.Read more at location 366

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The Plan of the BookRead more at location 378

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On the supply side, there were five autonomous wage shocks during the New Deal, each of which led to higher nominal wage rates.Read more at location 383

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On the demand side, a series of gold market shocks produced a highly unstable price level, which then impacted real wage rates.Read more at location 384

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The mixture of gold market and labor market shocks can explain the high frequency changes in industrial production, and indeed can explain the Great Depression itself.Read more at location 385

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In Part II (Chapters 2–4), I focus on the Great Contraction of 1929–1932.Read more at location 388

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I concentrate most of the analysis on how a lack of policy cooperation led to central bank gold hoarding and how devaluation fears triggered private gold hoarding.Read more at location 390

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If I were to choose a metaphor for the approach taken in Part II, it might be something like “the Midas curse”—that is, a world impoverished by an excessive demand for gold.Read more at location 392

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Because the expansionary impact of dollar depreciation was largely offset by the contractionary impact of the NIRA wage codes, economic historians have greatly underestimated the importance of each shock considered in isolation.Read more at location 396

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it is a model based on two assumptions, the ineffectiveness of monetary policy and the lack of a self-correcting mechanism in the economy. The first assumption confuses the two (unrelated) concepts of gold standard policy constraints and absolute liquidity preference. And Keynes’s stagnation hypothesis falsely attributes problems caused by government labor market regulations to inherent defects in free-market capitalism.Read more at location 409

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If the monetary model in this book is correct, then we have fundamentally misdiagnosed the stock and commodities market crashes of late 2008,Read more at location 414

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Unfortunately, just as contemporaneous observers misdiagnosed those earlier crashes, our modern policymakers attributed the current recession to financial market instability, rather than to the deeper problem of falling nominal expenditures caused by excessively tight monetary policy.Read more at location 415

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A Simple AS/AD FrameworkRead more at location 420

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It would be an understatement to suggest that the AS/AD model works well for the contraction of 1929–1933; it is the event the model was built to explain.Read more at location 421

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