Supply-Side Policies in the Depression: Evidence from France

Abstract

The effects of supply-side policies in depressed economies are controversial. We shed light on this debate using evidence from France in the 1930s. In 1936, France departed from the gold standard and implemented mandatory wage increases and hours restrictions. Deflation ended but output stagnated. We present time-series and cross-sectional evidence that these supply-side policies, in particular the 40-hour law, contributed to French stagflation. These results are inconsistent both with the standard one-sector new Keynesian model and with a medium scale, multi-sector model calibrated to match our cross-sectional estimates. We conclude that the new Keynesian model is a poor guide to the effects of supply-side shocks in depressed economies. 2 librium effects. General equilibrium effects are the basis for the new Keynesian model's prediction that an hours restriction is expansionary with fixed nominal interest rates. To assess whether such general-equilibrium effects are plausible, we follow Nakamura and Steinsson (2014) and calibrate a medium-scale, multi-sector new Keynesian model to match the cross-sectional evidence. The model draws on existing medium-scale models such as Smets and Wouters (2007) with two new features to match the French data: first, firms optimally employ workers for 48 hours a week, but are restricted to a 40-hour work-week when the 40-hour law is implemented. As in the data, the implementation of the 40-hour law is staggered across industries. Second, the central bank follows a fixed nominal interest rate policy. We show that to replicate our cross-sectional regression results in the model requires fairly flexible prices (an average duration of four months) and fully-flexible wages. Thus as in Nakamura and Steinsson (2014), our empirical work is informative about general-equilibrium effects because it narrows the plausible parameter-space.With this parameterization of price and wage stickiness in the model, the 40-hour law more than doubles the level of output. The increase in the marginal cost of production from the hours restriction causes firms to gradually raise their prices, ultimately more than doubling the price level. Consumers and firms thus anticipate substantial inflation, which given fixed nominal interest rates means low ex ante real interest rates. The resulting stimulus to consumption and investment leads to the large predicted increase in output.Put differently, because the 40-hour law is so successful at generating expected inflation and lowering ex ante real interest rates, the model predicts it should have lifted the French economy out of depression and generated an unprecedented boom.The model's prediction of output doubling is implausibly large given the French data. Therefore, in section 5 we consider possible sources of the disconnect between the new Keynesian prediction and the data, such as political uncertainty, capital flight, and ongoing strikes. While an evaluation of these factors is necessarily uncertain, we argue that none can resolve the disconnect between the ...