Money and Finance in the Great Depression

As the global economy struggles with the worst recession since the interwar period, research into the Great Depression has rarely been so important. Especially important is research into the link between monetary factors and the financial sector, given the financial nature of our current troubles. CEP member Albrecht Ritschl is working in this area, offering new insights into the role of financial transmission and monetary policy in the Great Depression.

Monetary policy in the Great Depression

Pooyan Amir Ahmadi and Albrecht Ritschl reexamine the Friedman-Schwarz monetary interpretation of the Great Depression using econometric evidence from the FAVAR approach. VAR work on the great depression is sparse due to data issues - GDP data from this period is not particularly reliable. The FAVAR methodology is advantageous here because it does not require aggregate GDP data, but instead works with many smaller time series, creating reliable data for this period. The second advantage of the FAVAR approach in this framework is that it reduces the need to impose structure on the estimation. This is important in the Great Depression since many channels of monetary policy are thought to have been at work: Friedman & Schwarz emphasize contractions in the monetary base, whereas Bernanke’s research has focused on the financial transmission through feedbacks to the banking sector.

Some form of VAR research is essential in assessing the relative importance of monetary policy as a contributor to the Great Depression. VAR evidence on the Great Depression is sparse. In one such paper, Ritschl and Woitek (2000) employ time-varying techniques on four different specifications of the monetary transmission mechanism and find that monetary policy explains less than 5 per cent of output forecast error variance. Thus the VAR evidence does not support the central role of monetary policy in the Great Depression advocated by Friedman & Schwarz. However, the forecasting performance of these VARs is be poor. This suggests that a traditional monetary policy VAR, run with the imperfect aggregate data available for the interwar period, might not be able to capture the business cycle dynamics of the Great Depression very well.

This is what motivates the FAVAR approach. Compared to existing research on the Great Depression, the authors impose less structure and at the same time analyze a richer dataset. FAVAR techniques were introduced into monetary policy by, among others, Bernanke, Boivin, and Eliasz (2005), and can be interpreted as augmenting the information content in a VAR by a two-step procedure. In a first step,the common dynamics in a large panel of time series are identified using dynamicfactor model (DFM) techniques. In a second step, the causality between a properly chosen policy instrument and some representative measure of economic activity is examined in a traditional VAR, including the factors as the relevant description of the underlying economic dynamics.

Their dataset includes a total of 164 time series, ranging from industrial production to order flows and housing startups, agricultural, raw material, and finished goods prices, measures of deposits, savings, and liquidity in the banking system, as well as interest rates on call money, commercial paper, and various medium and long term bonds. Thus the data benefits of FAVAR are clear.

Despite the flexible functional form, the authors still find that while monetary policy was clearly not neutral, its effects on the real economy were mixed and changed signs. Also, they find the overall contribution of monetary policy to the variance explanation of real variables to be as low as in the postwar period, if not lower. The authors thus conclude that while monetary policy certainly played some role in the interwar depression, there is only scant support for the traditional hypothesis that the Great Depression was mostly a monetary phenomenon.

Money and Finance: The 1931 German Financial Crisis

Ben Bernanke (1983) conjectured that an independent, non-monetary, financial channel of crisis propagation operated during the Great Depression. In further work with Samad Sarferaz, Albrecht Ritschl has investigated this conjecture. They examine the role of monetary and financial factors in causing the German financial crisis of 1931 and propagating it to the US. They use the same FAVAR methodology described above and thus provide the first application of modern time series methods to propagation during the interwar period.

They find that not only was a financial propagation mechanism active in propagating the German financial crisis to the US, but that it was the dominant channel of propagation. This contrasts with traditional views of propagation, which place much higher importance on monetary transmission through the Gold Standard. Sarfarez and Ritschl find that while this channel was operative, it was dwarfed in importance by the financial channel. Hence their results mirror those of Ahmadi & Ritschl, except on an international scale.

Therefore the authors' story of the propagation of the financial crisis from Germany to the US is due to the interlinkages between the US and German financial systems. This is consistent with the fact that both Germany's financial system and foreign public debt were mainly underwritten by the US (Schuker, 1988).

Having specified a dynamic econometric model, the authors also investigate several other relationships between monetary and financial factors. They find that, contrary to expectations, crisis transmission from the US to Germany was relatively minor, and that the role of monetary factors in causing the financial crisis was small.

To read more about Pooyan Amir Ahmadi, Samad Sarferaz and Albrecht Ritschl's work on money and finance, see

• "Crisis? What Crisis? Currency vs. Banking in the Financial Crisis of 1931" [Full document in Adobe PDF] (Albrecht Ritschl and Samad Salferaz), CEP Discussion Paper 0977, May 2010
  
  
• "Depression Econometrics: A FAVAR Model of Monetary Policy During the Great Depression" [Full document in Adobe PDF] (Pooyan Amir Ahmadi and Albrecht Ritschl), CEP Discussion Paper 0967, January 2010