In an earlier post, I argued that the newclassical framework may be the right one for macroeconomic analysis. This was because recent microeconomic evidence suggests that prices are actually quite flexible. It means that market responds to clear the shelves! Were markets responsive even during the Great Depression? Obviously not- otherwise we would not have had a severe and prolonged depression in the first place. In fact Lord Keynes famously argued that prices and wages were rigid downwards and hence markets could not clear causing the great depression. An important question is was this rigidity a result of optimizing decisions or was caused because of something else?
If we decide to believe Prof. Ohanian of UCLA, then this rigidity was not because markets did not respond but it was more of a case where they were not allowed respond. To support this claim, he develops a theory of labor market failure for the Depression based on Herbert Hoover’s industrial labor program that provided industry with protection from unions in return for keeping nominal wages fixed. He finds that the theory accounts for much of the depth of the Depression and for the asymmetry of the depression across sectors. The theory also can reconcile why deflation/low nominal spending apparently had such large real effects during the 1930s, but not during other periods of significant deflation.