Lessons from New Deal

Lee Ohanian summarises the broad lessons from Great Depression and his huge research in this speech. He says the depression was mainly because of the New Deal.

The failure to recover is puzzling, because economic fundamentals improved considerably after 1933. Productivity growth was rapid, liquidity was plentiful, deflation was eliminated, and the banking system was stabilized. With these fundamentals in place, the normal forces of supply, demand, and competition should have produced a robust recovery from the Depression. Figure 3 shows the recovery in productivity, real bank deposits, and the level of the GNP deflator, which stops falling after 1933, and rises modestly afterwards. Why wasn’t the recovery stronger?

My research shows that one policy that delayed recovery was the National Industrial Recovery Act (NIRA), which was the centerpiece of New Deal recovery policy. The NIRA prevented market forces from working by permitting industry to collude, including allowing firms within an industry to set minimum prices, restrict expansion of capacity, and adopt other collusive arrangements, provided that firms raised wages considerably. These policies worked. Following government approval of an industry’s “code of fair competition”, industry prices and wages rose significantly.

Promoting collusion reduces employment and output, while setting the wage above its market-clearing level depresses employment by making labor expensive. Employers respond to high wages by reducing employment relative to the market-clearing level that is jointly determined by supply and demand. Figure 2 shows hours worked and the real manufacturing wage. The most striking feature of the graph is that the continuation of the Depression coincides with rising real wages. This fact stands in sharp contrast to standard economic reasoning, which indicates that normal competitive forces should have reduced industry wage levels and increased employment and output. This coincidence of high industry wages and low hours worked is one of the most telling signs that the market process was considerably distorted.

The broad lessons are that policies that are supposed to ease recession should not distort market incentives. This was a lesson from works of Prescott et al as well.


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