A negative real interest rate has guaranteed macroeconomic equilibrium during every national emergency in the United States since the early 19th century, except the Great Depression in the 1930s when deflation interfered with the interest rate mechanism. During the Great Depression, the interest rate mechanism failed because the zero bound on the nominal interest rate implies that the real interest rate cannot be negative if there is deflation. This points to a monetary explanation of the Great Depression, and it suggests that central banks should suspend monetary policy rules that target inflation if there is an adverse political or economic shock that creates consumer pessimism.
JEL classification: D91, E21, E52, G12, N21
One would expect that the severity of the Great Depression in the 1930s made it easy to discern its cause, but far from it! No consensus has emerged on the cause of the Great Depression from the writings of three generations of economists, starting with those who, like John Maynard Keynes, lived through it. Certainly, most economists agree that aggregate demand must have declined, but there is no agreement on the source of the decline in demand and why lower demand set into motion a disastrous downward spiral in economic activity from which there was seemingly no escape. Keynes’s view that a fall in investment spending reduced demand is still standing side by side with the hypothesis of Temin (1976) that autonomous consumption spending declined, and the hypothesis of Friedman and Schwartz (1956) who argued that a fall in the money stock lowered aggregate demand. Recently, even the consensus on the deficiency of aggregate demand has been challenged by Prescott (1999), Cole and Ohanian (1999, 2004), and Chari et al. (2002) who maintain that New Deal changes in labor market institutions accounted for the persistence of the Great Depression.
This paper applies the tools of dynamic macroeconomic analysis to the Great Depression in the 1930s. The focus is on the first order optimum condition of consumers, which relates consumption growth to the real interest rate. Using American data, the Great Depression is compared with other severe economic downturns since the early 19th century. The main puzzle is that there was no obvious economic shock to the US economy in the 1930s, whereas there were strong shocks that could plausibly have given rise to economic depressions before and after the 1930s. Why has the Great Depression remained unique? Why did an elusive shock trigger an economic crisis in the 1930s, while easily identifiable shocks during national emergencies affected the US economy much less earlier and later? In this paper it is argued that a negative real interest rate guaranteed macroeconomic equilibrium during every emergency, except the Great Depression when deflation accounted for a positive real interest rate. During the Great Depression, the interest rate mechanism failed to produce a macroeconomic equilibrium because the zero bound on the nominal interest rate implies that the real interest rate can be negative only if there is inflation. The finding that inflation is needed to prevent a depression if the equilibrium real interest rate is negative has important implications for the conduct of contemporary monetary policy. Central banks should abandon inflation targets if an economic shock induces an expected decline in consumption that requires a negative real interest rate.
Section 1 reviews the theory of consumer behavior in dynamic macroeconomic models.
Section 2 provides a historical narrative of the behavior of the real interest rate in the United States since the early 19th century. The historical analysis makes two assumptions: (1) the consumption Euler equation represents a macroeconomic equilibrium relationship between the real interest rate and consumption growth, and (2) expected consumption fell and the volatility of consumption rose during national emergencies. Section 3 shows how the monetary standard conditioned the inflation process. The econometric analysis, which is provided in the next two sections, supports the hypothesis that there exists an equilibrium relationship between the real interest rate and consumption growth. In Section 4 the nonlinear consumption Euler equation is estimated, and in Section 5 the log-linear functional form is considered. The second moments, which enter the log-linear Euler equation, are estimated using the EWMA/ARCH methodology. Section 6 concludes with a word of caution against the use of monetary policy rules in the presence of adverse political and economic shocks that give rise to pessimistic consumer expectations that necessitate a negative real interest rate.