Deflation, Real Wages, and the International Great Depression: A Productivity Puzzle

The high real wage story is one of the leading hypotheses for how deflation caused the International Great Depression. The story is that world-wide deflation, combined with incomplete nominal wage adjustment, raised real wages in a number of countries, and these higher real wages reduced employment as firms moved up their labor demand curves. This paper studies the high real wage hypothesis in an international cross section of 17 countries between 1930-33 using dynamic, general equilibrium monetary models. We find that the high real wage story by itself does not account for output changes in the international cross section. The models make large errors predicting output in the international cross section, largely because the correlation between real wages and output in the models is -1, while this correlation is positive in the data. This means that the world-wide Depression was not just firms moving up their labor demand curves in response to high real wages. Instead, accounting for the Depression requires a shock that shifts labor demand curves differentially across countries. We add productivity shocks to the model as a candidate labor demand shifter. We find that the productivity shocks in the model are very similar to productivity changes in the data. We also find that productivity shocks account for about 2/3 of output changes, while monetary shocks account for about 1/3 of output changes