The Macroeconomic Effects of New Deal Policies

University Of California-Los Angeles, Los Angeles CA

Investigators

Abstract

This project continues research on the macroeconomic effects of New Deal labor and industrial policies using quantitative, dynamic, general equilibrium models. The U.S. economy remained substantially depressed long after the trough of the Great Depression in 1933. Hours worked per adult in 1939 were about 22 percent below its 1929 level, and real GNP in 1939 was about 26 percent below its trend-adjusted 1929 level. This slow recovery has long puzzled economists; the economy experienced several positive shocks after 1933 that should have fostered a healthy recovery. Productivity and the money supply both grew rapidly after 1933, and banking panics and deflation, which are considered to be major depressing shocks between before1933, ended in 1933. Some economists, including Robert Lucas, Milton Friedman, and Armen Alchian, have suggested that New Deal policies, such as the National Industrial Recovery Act (NIRA) and the National Labor Relations Act (NLRA), which raised prices and wages, may have been an important contributing factor to the persistence of the Depression. The goal of the research, which is joint with Harold Cole of the Minneapolis Fed, is to quantitatively evaluate for the first time the macroeconomic impact of these policies on the U.S. in the 1930s and 1940s using a plausibly parameterized dynamic, general equilibrium model. The research combines detailed empirical documentation of the effects of policies on wages and prices, and the development of new quantitative theory that captures the main features of these policies. These data suggest that New Deal policies created a significant insider-outsider friction in the economy. The key innovation in the dynamic general equilibrium macroeconomic model is incorporating a dynamic bargaining game between workers and firms in the model. The equilibrium path of the model economy is computed between 1934 and 1939, and is compared to the actual time path of the U.S. economy. A plausibly parameterized version of the benchmark model indicates that New Deal policies were an important contributing factor to the persistence of the Depression. In particular, the predicted equilibrium path of the model economy between 1934 and 1939 is quite similar to that in the data; the model predicts a partial recovery beginning in 1934, and also predicts that the recovery stalls shortly afterwards, leaving output about 14 percent below its normal level. The project also makes theoretical and empirical extensions of the basic analysis. One extension allows for "industry-specific" capital that creates a "hold-up" problem in that labor can appropriate some of the returns to physical investment. This allows the model to capture more aspects of 1930s labor/firm bargaining, and also enriches the model so it can be applied more broadly to general equilibrium studies of unions, hold-up problems, and European insider/outsider frictions. Another extension allows for time variation in the effects of policy. The baseline model treats policy as coming from a single regime. Labor bargaining power increased in 1937, which was followed by a general reversal of New Deal policies during World War II. Modeling these shifts in policy allows the investigators to examine how policy variation contributed to two key fluctuations during this period: the Recession of 1938, and the economic boom of World War II.