December 26, 2009

A DECLINE IN CONFIDENCE THAT WAS EVEN BETTER ILLUSTRATED...:

Be careful of accounting identities (the Money Illusion, 12/11/09)

n the period around March and April 193o, there were a few “green shoots” in the economy. The stock market recovered a significant chunk of the huge losses in 1929. (I recall the Dow fell well below 200 during the famous crash, and got back up over 260 in April. The 1929 peak had been 381.) Then in May and June everything seemed to fall apart, and stocks crashed again. So what happened in May and June?

The headline news stories during those months were the progress of Smoot-Hawley through Congress. Each time it cleared a major legislative hurdle, the Dow fell sharply. This pattern was obvious to those following the markets, and was frequently commented upon. After it cleared Congress it went to Hoover. The President received a petition from over 1000 economists pleading with him to veto the bill. (A veto would not have been overridden.) Over the weekend Hoover decided to sign the bill, and on Monday the Dow suffered its biggest single day drop of the entire year.

Yes, the stock market isn’t the economy, and this incident certainly doesn’t prove anything about the impact of Smoot-Hawley on aggregate demand. But it will give us clues to the transmission mechanism. Before explaining why stocks fell, let’s look at one additional piece of evidence. Recall that standard theory says trade barriers are a supply shock. And we all know that supply shocks reduce output and raise prices. There is just one problem with the standard view; it doesn’t appear to be true. The various commodity and wholesale price indices fell sharply at the same time that the stock market was plunging in May and June. And commodities were a far larger part of the economy in the 1930s than they are today. So Smoot-Hawley was almost certainly deflationary.

When I saw the real world impact of Smoot-Hawley, I realized that there was something wrong with the standard Keynesian view of protectionism. Keynes wasn’t a protectionist, but he did argue that during a depression a country might benefit from tariffs that kept out cheap foreign goods. According to this view, Smoot-Hawley should have been inflationary. So what happened?

My answer relates to my earlier discussion of China’s weak yuan policy. Trade is not a zero sum game. Smoot-Hawley, along with likely foreign retaliation, had a negative impact on the world economy. It is very likely that the (unobservable) Wicksellian equilibrium interest rate fell all over the world as the result of these trade barriers. And I believe the fall in the stock market was a symptom of this decline. Keynes would have called it a decline in “confidence.”


...by the first immigration quotas ever enacted in the United States, a sure sign of hysteria.

Posted by Orrin Judd at December 26, 2009 6:21 PM
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