1. EH447, 08/09, Week 3-1 Great Depressions in Economic History Did Monetary Forces Cause the Great Depression?

2. Albrecht Ritschl Univ. of Pennsylvania and Humboldt Univ. of Berlin Ulrich Woitek Univ. of Zurich

3. Did Monetary Forces Cause the Great Depression? 3 of 49 Conventional wisdom  Monetary hypothesis Hayek (1931): money too loose Friedman/Schwartz (1963): money too tight  Investment/spending hypothesis Keynes (1937), Hansen (1938): declines in fertility, immigration Temin (1976): Residential investment

4. Did Monetary Forces Cause the Great Depression? 4 of 49 Later additions to monetary paradigm on Great Depression  Financial accelerator/banking transmission: Bernanke (1983, 1995), Bernanke/Gertler (1990)  Nominal wage stickiness: Bernanke/Carey (1996)  Money in DSGE models of Great Depr.: Bordo/Erceg/Evans (2000) (nominal wage stickiness) Christiano/Motto/Rostagno (2003) (no exogenous monetary policy shock, but yes liquidity preference shock, which the Fed should have accommodated)

5. Did Monetary Forces Cause the Great Depression? 5 of 49 Critics of monetary paradigm  Productivity shocks, little role for money : Cole/Ohanian (2000), Cole/Ohanian/Leung (2005)  Slow recovery, related to wages: Cole/Ohanian (2005)  Rise in preference for leisure: Chari/Kehoe/McGrattan (2002)  Investors’ animal spirits/sunspots: Harrison/Weder (2004)

6. Did Monetary Forces Cause the Great Depression? 6 of 49 Evaluating monetary paradigm  Little consensus in existing literature  Overfitting properties of DSGE: what you want is what you get  But: Sims (1999) –VAR approach, closest to what we do here –Monetary policy shocks throughout 20 th century explain < 20% of output variance –holds also for Great Depression

7. Did Monetary Forces Cause the Great Depression? 7 of 49 What this paper does  Submit Friedman/Schwartz et al. hypothesis to rigorous test  the only other work doing this (in passing) seems to be Sims (1999)  Use off-the-shelf specifications of monetary policy channels  Account for Lucas critique  Account for time-varying volatility

8. Did Monetary Forces Cause the Great Depression? 8 of 49 What this paper does (continued)  We employ VARs –Bayesian (non-random, non-sample dataset) –Time-varying coefficients (structural breaks) –Time-varying VCV matrix (TVAR volatility)  Two exercises on policy effectiveness –Granger causality: policy effectiveness as forecast improvement (Lucas-proof) –Identifying assumptions: time-varying impulse-response functions (partly prone to Lucas critique)

9. Did Monetary Forces Cause the Great Depression? 9 of 49 MCMC: How we currently extend this research  Cogley/Sargent’s (2005) VAR/GARCH methodology (first results confirm ours)  With different sets of coauthors: –Replace VAR with factor-augmented VAR a la Bernanke/Boivin/Eliasz (2005) (same result) –Replace VAR with Bayesian Dynamic Factor Analysis of International Business Cycle a la Otrok/Whiteman (2003, 2004) (same result)

10. Did Monetary Forces Cause the Great Depression? 10 of 49 Preview of Results: Did Monetary Forces Cause the Great Depression? No. Even less so than in Sims (1999). And we tried really hard..

11. Did Monetary Forces Cause the Great Depression? 11 of 49 Estimation strategy Assume a VAR of order p : with time-dependent coefficient matrices A t-1 where Var(u t )=Q t obtained from OLS estimate

12. Did Monetary Forces Cause the Great Depression? 12 of 49 Coefficient matrices are time-varying according to: or, for every equation i :

13. Did Monetary Forces Cause the Great Depression? 13 of 49 Priors We assume a Litterman prior with: where –for every equation i,, all others zero –the initial VCV matrix is diagonal with a number of restrictions on diag. elements

14. Did Monetary Forces Cause the Great Depression? 14 of 49 Motivation for Bayesian Approach  Bayesian unit roots: we have given dataset of (very short) length, do not want to fuzz about asymptotic properties, any classical unit root test would have very little power  Hence, won’t exploit asymptotic characteristics / cointegration properties for identification

15. Did Monetary Forces Cause the Great Depression? 15 of 49 Implementation  In this version: –Kalman filter updating to time t, t = 1928:1,…,1935:6 –Obtain and Cholesky-decompose for every t –Back out IRFs and VarDecs for every t  Next version: MCMC –Run Monte Carlo simulations on posterior marginal distributions of coefficients –Obtain convergence through Markov Chain properties (ca. 50-500 000 iterations) –Discard realizations with explosive roots

16. Did Monetary Forces Cause the Great Depression? 16 of 49 Two exercises  First exercise: Granger causality of policy instrument for output –VAR w/ policy instrument should improve output forecast –If output forecast from VAR including policy instrument is “bad”, conclude that policy is ineffective (provided transmission mechanism is correctly specified) –No counterfactual exercises: have Lucas critique on board

17. Did Monetary Forces Cause the Great Depression? 17 of 49 Two exercises  Second exercise: impulse response functions –Traditional Cholesky decomposition –Two runs: order policy instrument both first and last (the latter implicitly assumes policy reaction functions)  But: TVAR coefficients and VCV –IRF takes on different values every period –So does variance decomposition –Plot IRFs and VarDecs at given intervals as time series graphs –Great way of visualizing structural breaks –Hello, Lucas …

18. Did Monetary Forces Cause the Great Depression? 18 of 49 VCV decomposition: a quick refresher  General VCV matrix: Response of x i,t+s cannot easily be attributed to shock u j,t in any variable x j,t.

19. Did Monetary Forces Cause the Great Depression? 19 of 49 Recursive VCV matrix

20. Did Monetary Forces Cause the Great Depression? 20 of 49 Finding There always exists matrix decomposition: such that where D is a diagonal matrix and where has the desired orthogonality properties:

21. Did Monetary Forces Cause the Great Depression? 21 of 49 Orthogonality of

22. Did Monetary Forces Cause the Great Depression? 22 of 49 Four specifications  Money / income causality: –M1 (alternatively: High Powered Money) –Non-borrowed reserves –Total reserves –Wholesale prices –CPI –Output

23. Did Monetary Forces Cause the Great Depression? 23 of 49 Four specifications  Interest rate targeting: –Federal Discount Rate –Non-borrowed reserves –Total reserves –Wholesale prices –CPI –Output

24. Did Monetary Forces Cause the Great Depression? 24 of 49 Four specifications  Nominal wage rigidity: –Wages –Federal Funds Rate –Wholesale prices –CPI –Hours –Output

25. Did Monetary Forces Cause the Great Depression? 25 of 49 Four specifications  Credit crunch / financial accelerator: –Federal Funds Rate –Total reserves –Deposits in failed banks –Wholesale prices –CPI –Output

26. Did Monetary Forces Cause the Great Depression? 26 of 49 Exercise 1: Forecasts  Take forecasts from each of four specifications at 3 critical junctures:  Late 1928 (when FED contracts)  After Oct 1929 (NYSE crash)  After Dec 1930 (banking panics)

27. Did Monetary Forces Cause the Great Depression? 27 of 49 Forecasting the Great Depression (Out of Sample) Interest rate model

28. Did Monetary Forces Cause the Great Depression? 28 of 49 Interest rate model  Late 1928: predicts cyclical downturn of output  Late 1929: much less pessimistic outlook!  1930/31: predicts imminent recovery, as did many contemporaries (but wide error bands)

29. Did Monetary Forces Cause the Great Depression? 29 of 49 Forecasting the Great Depression (Out of Sample) Monetarist model

30. Did Monetary Forces Cause the Great Depression? 30 of 49 Monetarist model: Same conclusions  Late 1928: predicts cyclical downturn of output  Late 1929: much less pessimistic outlook!  1930/31: predicts imminent recovery, as did many contemporaries (but wide error bands)

31. Did Monetary Forces Cause the Great Depression? 31 of 49 Forecasting the Great Depression (Out of Sample) Bernanke banking model

32. Did Monetary Forces Cause the Great Depression? 32 of 49 Bernanke banking model: Slightly more mileage  Late 1928: predicts slide into mild recession  Late 1929: again,fails to predict anything  1930/31: some further decline predicted; banking has some but limited forecasting power for 1932

33. Did Monetary Forces Cause the Great Depression? 33 of 49 Forecasting the Great Depression (Out of Sample) Wage rigidity model

34. Did Monetary Forces Cause the Great Depression? 34 of 49 Wage rigidity model  No predictive power for anything in 1928, 1929  1930/31: better than money or interest rates, not as good as banking model

35. Did Monetary Forces Cause the Great Depression? 35 of 49 Conclusions from First Exercise  Tried to evaluate policy effectiveness through forecasting power in VAR –which avoids counterfactual exercises and hence Lucas flogging  Very little predictive power –Models almost indistinguishable –Banking, wages do slightly better job at deepening of depression –No evidence for monetary causation of beginning of recession

36. Did Monetary Forces Cause the Great Depression? 36 of 49 But …  … maybe we asked the model too much?  Very few observation periods  No history of prior business cycles  Maybe VAR simply doesn’t pick up time series dynamics fast enough? [rubbish..]  Repeat exercise in-sample with Kalman filter smoothed parameters

37. Did Monetary Forces Cause the Great Depression? 37 of 49 Forecasting the Great Depression (In-Sample)

38. Did Monetary Forces Cause the Great Depression? 38 of 49 In-sample forecasts  1928 results unchanged  1929 results capture turning point better, all “predict” mild recession  1930 results show continuing recession, still fail to capture further slump  Even after-the-fact predictions not satisfactory

39. Did Monetary Forces Cause the Great Depression? 39 of 49 Second Exercise  Impulse Response Functions  TVAR coefficients  TVAR IRFs –Graph them for given lags as time series  TVAR coeff’s vs. TVAR volatility –Obtain IRFs from Q t at every t.

40. Did Monetary Forces Cause the Great Depression? 40 of 49 Monetarist model Response of output to M1 shock -+ Structural breaks in 1929:10, 1933:1 Explained forecast error var. of output below 6%

41. Did Monetary Forces Cause the Great Depression? 41 of 49 Interest targeting model Response of output to Fed Rate shock - + Explained forecast error var. of output below 6% Structural breaks in 1929:10, 1933:1

42. Did Monetary Forces Cause the Great Depression? 42 of 49 Response of output to Fed Rate shock Wage rigidity model Banking model -+ + Structural breaks in 1928:10, 1932:1 Would explain a lot, but sign mistake!

43. Did Monetary Forces Cause the Great Depression? 43 of 49 Conclusions from Second Exercise  Lots of sign problems in IRFs  Very little explanatory power –Typically 2%, max 6%  IRFs and VarDecs susceptible to structural breaks as monetary regime changes –particularly 1929:10 and 1933:1  Lucas was right  No evidence for Friedman/Schwartz

44. Did Monetary Forces Cause the Great Depression? 44 of 49 So … which Forces Caused the GD?  Still have to prove that VARs not entirely useless for the purpose  Are the alternative sets of indicators?  Bad news: no predictability of GD from leading indicators Shapiro/Fair/Dominguez (1988) Klug/White (1997)

45. Did Monetary Forces Cause the Great Depression? 45 of 49 Predicting the GD from leading indicators  Temin (1976): declining real investment –Residential construction –Equipment investment  Hence look for leading investment indicators –Output, residential building permits, production of steel sheets, of steel ingots, shipments of new machinery

46. Did Monetary Forces Cause the Great Depression? 46 of 49 Forecasts mostly in line with realized output data, already by late 1928!

47. Did Monetary Forces Cause the Great Depression? 47 of 49 Conclusion: Towards A Nonmonetary View of GD  Early, catastrophic slump in real investment  Itself not predictable by stock market (we tried, it leads the stock market)  Monetary policy largely passive  No monetary panacea to avoid or dampen the slump

48. Did Monetary Forces Cause the Great Depression? 48 of 49 Conclusions: bonus material from new version  New version: –Allow for TVAR VCV matrix –This implements TVAR simultaneous restrictions –And TVAR CB policy feedback rule –Then, model cannot be estimated with restricted OLS anymore. –Parameters follow nonstandard joint distribution –Have to iterate over marginal distributions, using simulation methods

49. Did Monetary Forces Cause the Great Depression? 49 of 49