KOBAYASHI Keiichiro: The very first piece I would like to introduce is "Deflation and the International Great Depression: A Productivity Puzzle" (NBER Working Paper 11237) by Harold L. Cole, Lee E. Ohanian, and Ron Leung, (2005). It has been 75 years since the international Great Depression and even today many economists are still conducting research to identify its causes. It remains a very attractive research subject and continues to drive researchers to explore the causes, for which no established theory has been developed. Moreover, a series of events in the decades to follow - currency crises that often flared in different parts of the world in the 1980s and '90s and more recently, Japan's prolonged economic downturn - show that this "great depression" phenomenon is not a thing of the past. Cole, Ohanian, and Leung (2005) attempted to measure the relative contributions of deflation shocks (monetary factor) and productivity shocks (real factor) to the Great Depression in order to assess which was quantitatively more important.
Econo-kun: There are many research papers written by many economists. So why did you pick this particular piece?
KOBAYASHI Keiichiro: This type of research, an attempt to analyze the United States' Great Depression by applying a strict neoclassical model, was initiated by Cole and Ohanian in the 1990s and they were followed by many from the real business cycle school. Consequently, a number of papers that analyzed national economies - not only of the U.S. but also of the United Kingdom, Canada, and Germany - during the period of the Great Depression have been published. (Japan's prolonged recession in the 1990s was analyzed in the same manner by Hayashi and Prescott [2002].)
However, each of these works focused on the economy of a single country. Cole, Ohanian, and Leung (2005) is innovative in that it analyzed data on 17 countries during the Great Depression.
Their model assumes that both monetary shock (decrease in money supply) and real shock (decrease in productivity) have an impact on the real economy. Households are also assumed to make their labor supply decisions before the monetary and real shocks become observable, so real economic activity is to be affected by nominal money.
In the 1930s, economic statistics were still underdeveloped; prices and output are about all that is available from that period. Neither the monetary nor real shock can be observed from these data. Therefore, Cole et al. constructed the values of country-specific monetary and real shocks so that the actual output and price level of each country can be reproduced via their model. Then, based on thus-determined values of monetary and real shocks, they estimated how much each type of shock accounted for the actual decrease in output as measured by gross national product (GNP). They found that the real shock (lower productivity) accounted for approximately two-thirds of the decrease in output, with only the remaining one-third attributable to the monetary shock (deflation). This finding differs substantially from the conventional view that worldwide deflation was the major cause of the Great Depression. However, a series of charts presented by Cole et al. shows that the severity of the output fall observed in each country during this period has little correlation with the degree of deflation. This finding is also supported by model calibration results.
Econo-kun: Why did productivity fall?
KOBAYASHI Keiichiro: To find this out, Cole et al. examined how the estimated productivity shocks correlate with four variables: the size of each country's trade share, the value of real exchange rate, size of agricultural sector, and presence or absence of banking panics. All the variables but the size of trade share showed strong correlations with the productivity shock. This indicates that certain anomalies in the foreign exchange rates and banking sector might have materialized in industrialized economies in the form of lower productivity.
Another interesting fact discovered by Cole et al. is that a very strong correlation is observed between the productivity shocks and lagged changes in real stock prices. This correlation was conspicuously strong during the Great Depression but weakened in the postwar period. In standard neoclassical theory, stock prices are considered to be a major indicator of productivity. Thus a correlation between these two factors is not surprising. But what should be noted is that the correlation between productivity and stock prices was abnormally strong during the Great Depression when stock prices took a free fall.
If companies were borrowing funds by pledging equity securities as collateral, the catastrophic plunge in stock prices must have severely constrained their ability to secure finance and this might have caused a significant decline in productivity. If so, it makes perfect sense that the extremely strong correlation between stock prices and productivity is observable only during the Great Depression.
Whatever the case may be, it seems fair to say that the mechanism for the occurrence of a major depression, such as the Great Depression, cannot be sufficiently explained by the recent Dynamic New Keynesian model, which argues that deflationary shocks are transmitted via information asymmetry and sticky prices to cause a negative impact on the real economy.
Econo-kun: I think this shows just how complex the mechanism of deflation is. Thank you very much, Kobayashi-sensei.
