Italy and the Great Depression: An Analysis of the Italian Economy, 1929–1936

EXPLORATIONS IN ECONOMIC HISTORY ARTICLE NO.

34, 265–294 (1997)

EH970672

Italy and the Great Depression: An Analysis of the Italian Economy, 1929–1936* Fabrizio Mattesini University of Molise, Campobasso and LUISS, Rome

and Beniamino Quintieri University of Rome, ‘‘Tor Vergata’’ We study the performance of the Italian economy during the period 1929–1936 using monthly data. The main contention of the paper is that the Italian depression, comparable to that of other major industrialized countries, was the combined result of a contraction in world demand and of the restrictive monetary policies imposed by the rules of the Gold Standard. The results obtained through the estimation of a series of structural VAR models are consistent with this view and indicate also that deflation affected output mainly by increasing real wages. We do not find evidence, however, of the role of financial factors as a major independent determinant of the depression. r 1997 Academic Press

INTRODUCTION Over the years, the Great Depression has been the subject of heated debate; the intensity and the pervasiveness of the phenomenon make it unique in economic history and understanding its origins and effects represents a continuing challenge to macroeconomists. While in the earlier literature, following the seminal work of Friedman and Schwartz (1963), the debate focused mainly on the unique American experience, the most recent studies have emphasized the worldwide dimension of this important event.1 Eichengreen (1992a, 1992b), Eichengreen and Sachs (1985a, 1985b), Temin (1989, 1993), Hamilton (1987), and Bernanke and James (1991), for example, have explored the role of the Gold Standard. * The paper has greately benefited from the advice of G. De Arcangelis. We also thank B. Bernanke, M. Bordo, F. Cotula, G. Gallo, N. Rossi, G. Toniolo, the participants in the 1995 ‘‘Brescia Seminar on Monetary History,’’ and three anonymous referees for their useful comments. 1 For earlier accounts of the role of international factors during the Depression see Kindleberger (1973), Metzler (1976), and Choudri and Kochin (1980). 265 0014-4983/97 $25.00 Copyright r 1997 by Academic Press All rights of reproduction in any form reserved.

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According to these authors, the need for countries to adopt a strict monetary discipline in order to maintain the gold parity of their currencies turned a normal cyclical slowdown in aggregate economic activity into a crisis of unprecedented dimensions. Other studies have concentrated on the real effects of the deflation due to nominal rigidities in labor and financial markets (Bernanke and James, 1991; Eichengreen and Sachs, 1985b; and Bernanke and Carey, 1996), and a third important area of research has focused on the nonmonetary effects of the financial crisis that took place in the period 1930–1933. In contrast with the view of Friedman and Schwartz (1963), which emphasized the contractionary effect on the money supply of the decrease in the volume of bank deposits, Bernanke (1983) suggests that the intensity of the Depression should be attributed to the disruption of the financial system and to the precipitous decline in borrowers’ net worth.2 In light of these recent developments the Italian economy during the period of the Great Depression is a very interesting case study. First, Italy was one of the countries most committed to the rules of the Gold Standard, even in the presence of a chronic balance of payments deficit. Second, industrial relations were governed by a corporatist system imposed by the Fascist regime. Third, thanks to the capable management of the financial crisis by the Italian authorities, Italy did not experience the panics and bank runs that characterized the American intermediation system and that of other countries in Central Europe. Even though there are a number of studies that analyze the Italian economy during the interwar period,3 we cannot find any systematic, quantitative assessment of the Great Depression in Italy. This is partly due to the difficulty of collecting reliable data on the period at the monthly or quarterly level. The purpose of this paper is twofold. First, we investigate the depth and the intensity of the Great Slump in Italy. To this purpose we present a set of data, at the monthly level, that, surprisingly, has been virtually ignored in the literature. These series imply that the contraction in economic activity in Italy during the thirties is comparable with that experienced by the major industrialized countries. Our second aim is to focus on the possible explanations of the Depression and to investigate, at a quantitative level, what the major determinants were of the impressive cyclical downturn that occurred in Italy at the beginning of the thirties. This analysis is performed through a series of structural VAR models of the Italian economy for the period 1929–1936. In Section 1 we present evidence on the intensity of the output contraction that took place at the beginning of the thirties. In Section 2 we analyze the policies followed by the Italian authorities and the evolution of the monetary aggregates. The results obtained from the VAR analysis are reported in Sections 3–5: in 2 This view of the role financial factors, which is shared also by Hamilton (1987) and has been recently reemphasized by Calomiris (1993), also stresses the importance of the debt-deflation mechanism proposed by Fisher (1933). 3 See for example Toniolo (1980) and the essays in Ciocca and Toniolo (1976) and in Toniolo (1978).

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FIG. 1.

Industrial production index (1929: 1 5 100; deseasonalized data).

Section 3 we discuss the basic model; in Section 4 we extend the model in order to account for the role of real wages and real interest rates; finally, in Section 5 we briefly describe the problems faced by the financial intermediation system, and we evaluate the role of several proxies of the financial crisis in our VAR model. 1. HOW DEEP WAS THE GREAT DEPRESSION IN ITALY? The first problem we face in the analysis of the Great Depression in Italy is establishing the extent and the intensity of the depression itself.4 A reliable indicator of the crisis is provided by the monthly index of industrial production computed by the Ministry of Corporations, shown in Fig. 1.5 Looking at this index, we get a quite dramatic picture of the depression. The fall of industrial production between 1929 and 1932 was approximately 33%, with the index dropping from a value of 109 in 1929 to a value of 73 in 1932. In the following 4 Existing studies on the subject seem to suggest that the slowdown in economic activity experienced in Italy was less dramatic than in other countries. This emerges from the observation of the GNP series provided by ISTAT and from recent revisions of such series proposed by Maddison (1989), Rey (1991), and Rossi, Sorgato and Toniolo (1992). For example, according to the data presented by Rossi, Sorgato and Toniolo, GNP, valued at constant prices, shows a significant reduction (24.8%) only in 1930 and a more limited decrease in 1933, while in all the other years of the period 1929–36 the growth rate of GNP is positive. The GNP series, which have been reconstructed on the basis of long run tendencies, might underestimate the cyclical variability of output and therefore might not be appropriate in the analysis of an episode like the Great Depression. 5 Surprisingly, this index, which is available only for the period 1929–1939, has been virtually ignored in the Italian literature on the interwar years. As it is calculated on the basis of the international standards of the time, this index, not only describes the short run dynamics of output, but also permits an accurate comparison with the indexes of industrial production of the other countries. For a description of the criteria used to compute the series see Sindacato e Corporazione, August, 1934.

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FIG. 2.

Index of industrial activity (1929:1 5 100; deseasonalized data).

years a rapid recovery occurred, with the exception of 1936, the year in which industrial production decreased by 7%.6 Other series also confirm the intensity of the Italian depression. Looking at the industrial activity index, computed on the basis of the total labor hours in the industrial sector (Fig. 2), we observe a remarkable fall in labor hours between mid 1929 and the beginning of 1932, in line with that of industrial production. The intensity of the depression is also reflected by the index of employment of blue collar workers (Fig. 3).7 The slowdown in industrial production in Italy was similar to the one observed in the other major economies, like the United States, Germany, Great Britain, and France.8 In Fig. 1, the Italian industrial production index is shown together with another index computed as a weighted average of the indexes of industrial 6 The index of industrial production is commonly used, especially in empirical analysis, as an indicator of the level of economic activity. One might argue, however, that in an economy relatively underveloped, such as Italy during the thirties, ignoring agricultural production could lead to wrong conclusions on the situation of the entire economic system. Unfortunately aggregate indexes of agricultural production are not available. However the evidence we have on the period seems to indicate that also the agricultural sector underwent a deep crisis. The estimates of value added at current prices we mentioned in note 4 (Rey 1991) for example, show that agricultural output between 1928 and 1933, fell by about 47 per cent, while industrial output, during the same period, fell by about 29 per cent. 7 The dynamics of employment reflect that of production, but with a lower variability. This, together with the large variability of hours worked, seems to indicate that the unemployment crisis associated with the sudden fall of industrial production was softened by the reduction of hours worked individually. 8 In Italy, as in other countries, industrial production reached its lowest point in the first half of 1932. At that time the Italian industrial production index was below that of Great Britain and France, but higher than that of Germany and the United States. From 1933 onward a common recovery process took place in different ways in all countries. Again, the Italian economy performed at an intermediate level with respect to the other four countries.

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FIG. 3.

Index of blue collar employment (1929:1 5 100; deseasonalized data).

production of the four major industrialized countries.9 The series obtained may be regarded as a synthetic index of the trend of ‘‘worldwide’’ production and as such will be utilized in the empirical analysis in Section 3. As we can see, the graphs of the two series show the same behavior throughout the entire period, with the Italian index being slightly above the ‘‘world’’ index. These data seem to indicate that, at least in Italy, the fall in world demand might have represented the initial shock leading to the precipitous decrease in output. Trade figures also support this view, showing that Italy was heavily affected by the decline in international trading of goods and services. Exports slumped between 1929 and 1932; real exports halved in those two and a half years, passing from 1,300 million lire at mid 1929 to about 650 million lire at the beginning of 1932 (Fig. 4).10 Nonetheless, even though almost all countries underwent a recovery after 1932, Italian exports continued to decrease, probably because of the protectionist measures adopted by all countries and the increase in the real exchange rate. The value of real exports reached a minimum of about 400 million lire at the end of 1935 and only in the last months of the period under consideration do we notice an inversion of the trend. The description of the Great Depression cannot be complete without considering the impressive deflation that took place in Italy as in all major countries. Italy experienced an unprecedented fall in both wholesale and consumer prices (Fig. 6). The wholesale price index decreased from 106 in March 1929 to a minimum value of 63 in April 1934, a reduction of 40%, while the fall in consumer prices for the same period amounts to about 25%. 9

The individual indexes were weighted according to GNP. The sudden fall in exports seems to result mainly from the fall in world demand, since the real exchange rate (Figure 5), increased only slightly between 1929 and 1931. 10

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FIG. 4.

Real exports (in millions of liras).

2. ITALY IN THE GOLD STANDARD: MONETARY POLICY DURING THE GREAT DEPRESSION As we have seen in the previous section, Italy experienced a slump comparable to those of the major industrialized countries and the fall in world demand seems to have been an important factor behind the intense contraction in economic activity. There is however another element that must be considered in the analysis of this important cyclical episode. Italy, like all the major industrialized countries, had adhered to the Gold Standard in 1927 and this had implied a shift in monetary policy aimed at maintaining the established gold parity. An interesting problem therefore is whether the monetary discipline imposed by the rules of the Gold Standard was a major factor behind the depression. Recent cross-country evi-

FIG. 5.

Real exchange rate (1929 5 100).

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FIG. 6.

Wholesale and consumer price indexes (1929: 1 5 100; deseasonalized data).

dence (Eichengreen and Sachs, 1985b) seems to indicate that countries that never adhered to the Gold Standard or left it early experienced a recession less intense than that experienced by countries remaining in the gold system. The existing studies (Toniolo, 1980; Ciocca and Toniolo, 1983) on the Italian experience do not consider monetary policy as a major factor behind the fall in output. This is still, however, an open issue and therefore in this and the following section we investigate the role played by monetary factors during the Great Depression. The Great Depression hit Italy at a time when the economy was recovering from the effects of an important stabilization maneuver, which had been implemented between 1925 and 1927. The climax of this policy was reached when Mussolini, in his speech in Pesaro in August 1926, announced the objective of revaluing the lira with respect to the English pound to the pre-war parity (‘‘quota 90’’). The stabilizing maneuver was quite comprehensive, consisting of a series of measures that included an increase in the discount rate, achievement of budget surpluses, the restriction of the right of emission of legal tender to the Bank of Italy, the reduction of money circulation, and settlement of war debts that reopened access for Italian businessmen to the international financial markets. Moreover, at the end of 1927, the important decision to consolidate the public debt was made. The return to full convertibility took place on December 21, 1927, when the gold content of 100 Italian lire was fixed at 7.919 grams, with an exchange rate of the lira to the sterling of 92.46 and of the lira to the dollar of 19.11 11 Other measures were also adopted in order to facilitate the decrease in prices in coherence with the objective of appreciating the exchange rate. These measures included the modification of the tax legislation, the regulation of rents, and in particular a significant reduction in nominal wages. This policy could be pursued thanks to the ‘‘corporatist’’ regime of industrial relations imposed by the

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The stabilization measures undertaken by the government resulted in a slowing down of production during the years 1926 and 1927.12 With the return to the Gold Standard the Italian Government oriented all its efforts to the defense of the exchange rate, which was regarded as a source of international prestige and an instrument to regain credibility in the international financial markets. During the period we are taking into account Italy experienced a continuous loss of international reserves, which fell from 10.8 billion liras in January 1929 to 2.0 billion liras in September 1936. This loss of reserves reflects the fact that the Italian balance of payments was in deficit during the period.13 In addition, as is well documented by Cotula and Spaventa (1993), the Fascist Government until 1932 maintained a regime of free capital movements, which exposed the economy to capital outflows with the consequent loss of reserves. The adherence of Italy to the rules of the Gold Standard, coupled with the chronic disequilibrium in the balance of payments, induced monetary authorities to pursue restrictive monetary policies. As a result, the monetary base14 decreased continuously from the beginning of 1929 until the middle of 1935. As we can see from Fig. 7, the monetary base contraction between January 1929 and February 1935 amounted to about 25%, going from a value of 21,025 to 15,700 million liras.15 The contraction in the monetary base, however, is less dramatic than the fall in total reserves. At the beginning of the period the ratio of total reserves to fiduciary issue was well above the 40% requirement adopted by Italy upon joining the Gold Standard (Fig. 8). This allowed the monetary authorities to buffer the impact of the reserve loss on the monetary base by progressively reducing this ratio. The 40% limit was reached at the beginning of 1935; this triggered the decision to abandon this fundamental rule of the Gold Standard. As a consequence of this decision, monetary authorities were free to expand (126%) the monetary base during 1935 in order to finance the public deficit generated by the expenses of the

Fascist dictatorship, which created a centralized system of wage bargaining between the official Fascist unions and the representatives of industrialists. 12 According to the Mitchell (1975) data, the index of industrial production remains stable in 1926 and shows a slight decrease (from 83 to 80) in 1927. In 1928 there was a recovery in economic activity (the Mitchell index increases from 80 to 88) which lasted until the first half of 1929. 13 The current account showed a deficit in 1929 (3.1 billion liras) and improvement in the following years reaching a small surplus in 1931. Thereafter it returned to a deficit until 1936. 14 Following the traditional methodology and the institutional characteristics of the time the monetary base is defined as the sum of Notes and coins and Deposits at the Bank of Italy. A different definition of monetary base has been used by Spinelli and Fratianni (1991) which includes deposits with the postal system. 15 The relationship between industrial production and the monetary base will be explored in the following section. A comparison between the graphs (Fig. 1 and Fig. 7) shows a dramatic fall of both these variables during the period 1929–1932. In the two following years we observe a recovery in the level of output while the monetary base continues to decrease although slightly. This is consistent with the view that monetary shocks produce real effects mainly in the short and medium run.

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FIG. 7.

Monetary base (in billions of liras).

Ethiopian war. This decision represents the preliminary step toward the definitive exit from the Gold Standard which occurred in September 1936. It is important to notice that the Italian monetary authorities were able to pursue the policy of continuous contraction of the monetary base during the period 1929–1934 even though they decided, differently from what happened in other countries, to react to the financial crisis of the years 1930–1931, by injecting liquidity into the system. As we will see in Section 6, the Fascist government averted the bankruptcy of the

FIG. 8.

Cover ratio (total reserves/notes in circulation).

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major banks through the direct and secretive intervention of the Bank of Italy. As shown by Cotula and Spaventa (1993, Table 19, p. 178), the increase in the monetary base, following the bank ‘‘rescues,’’ was largely offset by reducing the lending activity to the rest of the banking system. This policy, if on one side was successful in preventing the explosion of a major financial crisis, on the other side increased the burden of the monetary contraction on the industrial system. The monetary base, which is the only monetary aggregate available at the monthly level, is a good indicator of the central bank policy. However, a more complete picture can be obtained by considering the whole money stock, which is available only at the annual level, and interest rates. In Table 1 we report the values and the percentage changes of the monetary base, the money stock, and the money multiplier for the years 1929–1936. The monetary crunch shown by the contraction of the monetary base seems slightly less evident if we look at the behavior of the money supply. The money multiplier shows a limited increase during the period of monetary stringency, only partly offsetting, however, the contraction of the monetary base. It is also interesting to notice that the increase in the value of the money multiplier is associated with a contraction of bank deposits and an almost offsetting increase in the deposits held by the postal system. This is also reflected by the currency–deposit ratio which decreases by 25% from 1929 to 1934, while the ratio between currency and bank deposit does not change much in the same period. In order to clarify this point it is useful to notice that in Italy the postal system had, and still has, an important role in the collection of funds with the public, due to its widespread presence also in areas scarcely serviced by the banking system. Given the low risk assigned by the public to a postal system run by the government, it is hardly surprisingly that, in a period of financial crisis (see Section 5), agents reallocated their savings from bank toward postal deposits. The behavior of the currency–deposit ratio was used by Friedman and Schwartz (1963), in their classic account of the Great Depression, to show that the cause of the monetary contraction in the United States was not a direct consequence of the action of the monetary authorities, but rather the result of a series of severe banking panics. Our data seem to suggest that in Italy the monetary stringency was mainly the result of the deliberate policies of the monetary authorities. As far as interest rates are concerned, they also were pegged consistently with the objective of defending the exchange rate.16 However, in a period of intense price fluctuations, nominal interest rates are not informative; one should examine the dynamics of real interest rates. This issue will be addressed in Section 5.

16 The official discount rate was kept by the Italian monetary authorities constantly above that of the other major countries for the whole period. The official discount rate was kept at a relatively high level during the period 1929–1933 (between 5 and 7%), while the financial crisis induced the monetary authorities to reduce substantially the official discount rate to a level of 3% at the end of 1933. The other interest rates follow a similar pattern.

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Monetary base

20530.9 19937.0 18203.3 17134.0 16654.0 16094.5 20048.0 20762.0

Years

1929 1930 1931 1932 1933 1934 1935 1936 22.9 25.0 25.9 22.8 23.4 24.6 3.6

D Monetary base 65759 63382 61323 56930 58111 57055 52649 57410

Bank deposits

23.6 23.2 27.2 2.1 21.8 27.7 9.0

D Bank deposits 10045 13378 15076 17493 19999 21055 20643 23010

Postal deposits

33.2 12.7 16.0 14.3 5.3 22.0 11.5

D Postal deposits 96552.5 96812.0 94932.0 92328.5 94935.3 93474.1 93885.2 102778.5

Money supply

TABLE 1 Monetary Aggregates: 1929–1936

3.0 21.9 22.7 2.8 21.5 0.4 9.5

D Money supply 4.70 4.86 5.22 5.34 5.70 5.81 4.68 4.95

Money multiplier

0.25 0.23 0.22 0.21 0.20 0.20 0.25 0.24

Currency/total deposits

0.29 0.28 0.27 0.28 0.26 0.27 0.36 0.33

Currency/bank deposits

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3. AN ECONOMETRIC ANALYSIS OF THE ITALIAN ECONOMY: 1929–1936 In order to analyze the determinants of the impressive cyclical downswing during the period from January 1929 to the exit of Italy from the Gold Standard, i.e., September 1936, we estimate a small structural VAR model of the Italian economy. We study the dynamic relationships among output (proxied by the industrial production index), money (proxied by the monetary base), and prices (represented by the consumer price index). Given the important role that external factors seem to have played in the transmission of the Great Depression among industrialized countries, and given also the relative openness of Italy, we include in the model variables linking the Italian economy to the rest of the world. The influence of international factors on the level of output could be captured by including real exports. However, as exports depend in turn both on the fluctuations in world demand and on the terms of trade, we have chosen to include directly in the model these last two variables. This will allow us to distinguish between the effects of changes in ‘‘world demand’’ and the effects of changes in the degree of competitiveness. Therefore, we use the index of ‘‘world’’ production, previously discussed, and the effective real exchange rate. We denote by y the log of output, by m the log of money, by p the log of prices, by yw the log of ‘‘world’’ output, and by e the log of the real exchange rate. Before estimating the VAR model we have analyzed the statistical properties of the series. Standard stationarity tests showed that each series should be treated as a univariate unit root process which requires first differencing to achieve stationarity.17 We also performed cointegration tests which we report in Appendix 1, aimed at detecting the existence of common stochastic trends in the data. The tests based on the Engle and Granger procedure rejected in all cases the hypothesis of the existence of a common stochastic trend among the variables and the Johansen and Joselius Full Maximum Likelihood test partially18 confirmed these results. The overall evidence, therefore, does not seem in favor of the existence of a cointegrating relationship among the variables of the model. These preliminary tests lead us to specify the system in terms of first differences [Dy, Dm, Dp, Dyw, De]. We use the ‘‘structural VAR’’ approach developed by Bernanke (1986) and Blanchard and Watson (1986) for the ortogonalization of residuals. This approach allows us to solve a simultaneous-equations model in innovations avoiding the limits of the Choleski decomposition, which assumes that the contemporaneous structural model underlining the data is recursive. The model is estimated in two steps. First we estimate a traditional reduced form VAR in which lagged values of 17 We also performed stationarity tests for the log of the real interest rate r, and for the log of real wages, w, that we will consider in Section 5. 18 As shown in Appendix 1 the tests based on the maximum eigenvalue of the stochastic matrix reject the null hypothesis of the existence of a cointegrating vector among the variables. The tests based on the trace of the stochastic matrix seem to suggest instead the existence of two cointegrating relationships.

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ITALY AND THE GREAT DEPRESSION TABLE 2a VAR Estimation Results (1929:1–1936:9): F Tests, Significance Levels Variable

Dy

Dm

Dp

Dyw

De

Dy Dm Dp Dyw De

0.266 0.719 0.964 0.103 0.668

0.047 0.154 0.006 0.883 0.432

0.015 0.032 0.948 0.773 0.533

0.043 0.097 0.660 0.004 0.690

0.491 0.177 0.417 0.822 0.990

Note. The rows give the value of the significance level of F tests for each equation in the VAR system. This statistic evaluates the null hypothesis that the block of lags pertaining to the variable in each column is zero.

all variables are included to compute predictions, to generate causality tests and to derive residuals. Second, we specify and estimate a contemporaneous structural model using the residuals of the first step as data. The reduced form estimation of the VAR model includes four lags of each variable. The lag length was chosen according to the Akaike criterion. In Table 2a we show the significance levels of F tests of the hypothesis that blocks of lags of each variable in an equation are zero. These results seem consistent with the main contention of the paper; i.e., that the behavior of output during the Great Depression was determined both by the fall of world demand and by the monetary stringency induced by the monetary authorities to defend the gold parity. In particular, output is marginally predicted, below the 5% level, by the monetary base and by the index of ‘‘world production.’’Also, lagged values of the price level enter significantly in the output equation. This indicates the existence of an important link between deflation (falling prices) and depression (falling output). As we will discuss below, it is in fact possible to identify some important channels through which prices affect economic activity. The only variable which does not help in forecasting output is the real exchange rate. This seems to suggest that the fall in exports which occurred over the period19 was mainly due to the fall in world demand rather than to the fall in competitiveness. As far as the price equation is concerned, only lagged values of the monetary base are significant in explaining the behavior of prices. Interestingly, lagged changes in output do not help predict prices. The relationship between money and prices appears to be particularly strong: the significance level of the F test is below 1%. However, the causality nexus between these two variables is not unidirectional. From the money equation we can see that the price level is an important explanatory variable of the monetary base together with yw. This is hardly surprising considering that the Gold Standard required a ‘‘reaction’’ of the monetary authorities to changes in prices and in the 19 Results similar to those reported in Table 2a have been obtained in a VAR model where real exports were included in place of yw and e. These results, which are not reported here, confirm the robustness of the estimates of our model.

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MATTESINI AND QUINTIERI TABLE 2b VAR Estimation Results (1929:1–1936:9): Correlation Matrix of Residuals Variable

Dy

Dm

Dp

Dyw

De

Dy Dm Dp Dyw De

1 0.243 0.020 20.009 20.316

1 0.066 0.257 0.049

1 0.117 0.155

1 0.177

1

balance of trade position. As expected, the last two equations of Table 2a show that both world output and the terms of trade are substantially exogenous relative to the other variables of the model. This confirms the fact that the Italian economy can be regarded as a small open economy. The correlation matrix of the residuals is given in Table 2b. The signs of these simple correlations provide prima facie evidence of the relationships among the relevant variables. All the correlation coefficients, except for the one linking the residuals of y and yw (which is however very close to zero), show signs in accordance with economic theory. The results from specifying and estimating the structural model are reported in Table 2c. We denote by yˆw, eˆ, m ˆ , pˆ, and yˆ the first stage VAR residuals of the estimated variables. Equation (1) postulates that the innovation to the index of ‘‘world demand’’ within a month is not correlated with any other u’s, i.e., is a structural disturbance. In Eq. (2) innovations in the real exchange rate are primarily a function of innovations in world demand and in the price level. Equation (3) is the monetary authority reaction function; coherently with the rule of the gold standard the monetary base is allowed to respond, within the current month, to innovations in yˆw and eˆ, which affect the balance of payments, and in pˆ. Equation (4) is an aggregate supply curve which relates innovations in prices to innovations in output. Equation (5) is a reduced form aggregate demand equation, TABLE 2c Results from the Structural VAR Model: Coefficient Estimates Dyˆw 5 u1 Deˆ 5 0.109 Dyˆw 1 0.186 Dpˆ 1 u2 (14.74) (9.45) Dm ˆ 5 0.169 Dyˆw 1 0.001 Deˆ 1 0.040 Dpˆ 1 u3 (22.84) (0.01) (2.08) Dpˆ 5 0.015 Dyˆ 1 u4 (4.03) Dyˆ 5 20.024 Dyˆw 2 0.683 Deˆ 1 0.541 Dm ˆ 1 u5 (1.66) (31.06) (24.50)

(1) (2) (3) (4) (5)

Note. t statistics in parentheses. LM test for over-identification: Chi-squared (1) 5 1.22; significance level 5 0.27.

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ITALY AND THE GREAT DEPRESSION TABLE 2d Forecast Error Variance Decomposition Forecast horizon

Dyw

De

Dm

Dp

Dy

0.00 6 0.00 9.06 6 9.35 10.50 6 10.41 10.39 6 10.35 10.40 6 10.30

83.02 6 1.54 70.87 6 8.70 61.55 6 10.85 59.67 6 11.45 59.40 6 11.52

99.74 6 0.00 90.66 6 7.87 75.80 6 12.37 73.89 6 13.06 73.59 6 13.26

0.02 6 0.00 0.05 6 0.00 2.18 6 4.37 2.65 6 5.00 2.69 6 5.13

Output 1 3 6 9 12

0.00 6 0.00 4.04 6 2.93 4.69 6 4.40 4.82 6 4.62 4.90 6 4.64

10.44 6 1.29 10.85 6 3.93 12.37 6 6.68 14.32 6 7.51 14.28 6 7.47

1 3 6 9 12

0.00 6 0.00 1.97 6 3.78 2.52 6 4.39 2.56 6 4.34 2.91 6 4.59

0.00 6 0.00 0.06 6 2.17 2.47 6 5.17 3.78 6 5.64 3.78 6 5.59

6.44 6 1.00 5.18 6 1.41 10.89 6 7.31 10.80 6 7.02 11.02 6 7.06 Prices 0.00 6 0.00 6.21 6 6.97 17.03 6 11.07 17.11 6 10.63 17.04 6 10.56

Note. Entries show percentage of forecast variance of y or p at different horizons attributable to innovations in column. Ranges indicated represent approximate 95% confidence intervals.

which relates output to shocks in world demand, the real exchange rate and the monetary base. With the exception of the coefficient of the price level in the central bank reaction function and of the coefficient of yˆw in the aggregate demand equation, all the estimated parameters for the contemporaneous shocks have the predicted sign and all of them, except for one, are significant. The probability value corresponding to the test for over-identification shows that the model is not rejected at the 0.05 level. In Table 2d we report the results of the forecast error variance decomposition of output and prices at different horizons. These results show that shocks in the monetary base account for a significant proportion of the variance in output and prices. In particular, as the horizon increases, the fraction of the variance attributable to monetary shocks rises and reaches a level of about 11% in the case of output and of 17% in the case of prices. Price shocks and terms of trade shocks also play an important role in explaining the variance of output. The response of output and prices to a one standard deviation innovation in output, monetary base, prices, world output, and the real exchange rate are shown in Table 2d. Summing up, the results obtained so far seem consistent with the interpretation of the Great Depression which emphasizes the role of the Gold Standard in transmitting deflationary impulses across countries. The fall in world demand seems to have had an important role in determining the fall in Italian industrial production. At the same time, the monetary contraction, induced by the commitment of the monetary authorities to defend the gold parity appears to have been a major factor behind the huge contraction in the level of economic activity and the most important factor behind the deflation of the period. The fact that changes in

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the monetary base seem to be influenced by changes in world demand and in the price level is consistent with the existence of a reaction function of the monetary authorities imposed by the rules of the Gold Standard. Our results also show a significant effect of deflation on changes in the level of output, suggesting the possibility of relevant rigidities in nominal variables. The channel through which prices affected output during the Great Depression will be explored in the next section. 4. PRICE DEFLATION AND THE ROLE OF NOMINAL RIGIDITIES The relevance of price changes in determining the strong output contraction which occurred during the Great Depression raises the difficult question of what were the channels linking deflation and depression. The recent literature identifies three main channels: the real wage channel, the real interest rate channel, and the financial crisis. In this section we focus on the first two factors, the role of the financial crisis will be discussed in the following section. Price deflation can affect output if some degree of nominal rigidity can be found in wages. At the cross-country level, a relationship between real wages and the output fall has been found by Eichengreen and Sachs (1985a), Bernanke and James (1991), and Bernanke and Carey (1994). As far as Italy is concerned, one must first consider that industrial relations were governed by a corporatist system in which wages were the result of the bargaining between centralized fascist unions and representatives of entrepreneurs. As a consequence, the Government had a strong influence on wages, and wage controls were in fact an important policy instrument. As is documented by Vera Zamagni (1976), nominal wages were cut in several instances with the aim of compensating for the rapid fall in prices which took place during the period 1929–1934.20 Even though the income policy enacted by the Fascist regime seems impressive, the data show that it was not able to prevent an increase in real wages. As we see from Fig. 9, real wages, computed by using the consumer price index as a deflator, increased by about 20% between 1929 and the beginning of 1934.21 In a period of deflation real interest rates may also be an important variable to consider. Real interest rates affect output in two important ways. First, in a traditional IS-LM model, an increase in the real interest rate, induced by a monetary contraction, reduces investment and aggregate demand. Second, since nominal interest rates cannot go below the nominal return on cash balances, which is zero, an expected deflation of a given amount will impose a real rate 20 The policy of wage cut began in 1927 when wages were reduced twice, by 10% and again by 20%. In the years of the depression wages were cut in November 1930 by about 8% and in the spring of 1934 by an amount ranging from 7% to 12%. 21 Even though this increase does not seem particularly relevant, one must consider that it occurred in a period of rapid fall in aggregate demand. Moreover, if we deflate nominal wages with the wholesale price index, the observed increase in real wages is even more impressive. These observations suggest the existence of some degree of nominal wage rigidity which might have played a role in the transmission of the Depression.

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FIG. 9.

Average industrial wage (in liras per hour).

equal to at least the same amount. In the period we are taking into account the real interest rate underwent wide fluctuations.22 In order to analyze the relevance of these two transmission channels for the Italian case, we have estimated a new structural VAR model including, instead of the price level, the real wage and the real interest rates.23 The results, reported in Tables 3a and 3b, are coherent with the ones obtained from the previous model. Again the monetary base and the index of the world demand play an important role in determining the behavior of industrial production. Interestingly, only lagged values of the real wage are significant in explaining changes in real output, while no role is played by movements in the real interest rate. The specification and the estimation of the new structural VAR model is reported in Table 3b. In this model contemporaneous innovations in the real interest rate are assumed to depend on shocks on the monetary base while innovations in the real wage are linked to shocks in real output and in the monetary base. The forecast error variance decomposition is reported in Table 3c. From this table we can see that changes in the real wage explain a large fraction of the variance of output, while changes in the real interest rate account only for a 22 The real interest rate we used in the estimation has been computed as the ratio between the nominal private discount rate and the rate of change of consumer prices. The real interest rate increases sharply during the period 1929–1931 (from about 3% to about 20% at the end of 1931). During the following three years (1932–1935) the real interest rate drops by about 10 points as a result of the fall in nominal rates and the slowdown of the rate of price deflation. Between the end of 1934 and September 1936 the price increase causes a significant fall in the real interest rate down to negative levels. 23 In order not to increase excessively the dimension of the VAR we decided to drop the real exchange rate, i.e. the variable that in the previous model shows the lowest explanatory power.

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MATTESINI AND QUINTIERI TABLE 3a VAR Estimation Results (1929:1–1936:9): F Tests, Significance Levels Variable

Dy

Dm

Dw

Dr

Dyw

Dy Dm Dw Dr Dyw

0.217 0.732 0.103 0.838 0.048

0.053 0.192 0.310 0.351 0.395

0.054 0.033 0.110 0.528 0.704

0.930 0.184 0.399 0.011 0.732

0.035 0.184 0.429 0.788 0.003

Note. The rows give the value of the significance level of F tests for each equation in the VAR system. This statistic evaluates the null hypothesis that the block of lags pertaining to the variable in each column is zero.

negligible fraction of the variance of y. Overall, the results indicate that deflation affected output mainly through real wages: even if nominal wages were decreased in several instances during the period, this did not compensate for the fall in prices. In a period of falling demand and monetary stringency the increase in the real cost of labor seems to have played an important role in determining the fall in economic activity. 5. THE ROLE OF FINANCIAL FACTORS IN THE ITALIAN DEPRESSION The results obtained in the previous sections emphasize how the Italian Depression can be linked to the fall in world output and to the restrictive monetary policy adopted by the Italian authorities in accordance with the rules of the Gold Standard. There is, however, another potentially important aspect that we have not yet analyzed: the role of financial factors in explaining the Great Depression. Recently, following the seminal paper by Bernanke (1983), a series of studies has explored the possibility that the extensive financial crisis that occurred in almost all countries during the Great Depression, had autonomous effects on economic activity. This approach emphasizes the decline in the efficiency of the economy’s TABLE 3b Results from the Structural VAR Model: Coefficient Estimates Dyˆw 5 u1 Drˆ 5 20.041 Dm ˆ 1 u2 (5.1) Dm ˆ 5 0.171 Dyˆw 1 u3 (23.3) Dwˆ 5 20.094 Dm ˆ 2 0.043 Dyˆ 1 u4 (14.0) (13.7) Dyˆ 5 20.089 Dyˆw 1 0.552 Dm ˆ 1 u5 (5.6) (23.4)

(1) (2) (3) (4) (5)

Note. t-statistics in parentheses. LM test for over-identification: Chi-squared (4) 5 8.63; significance level 5 0.071.

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ITALY AND THE GREAT DEPRESSION TABLE 3c Forecast Error Decomposition for Output Forecast horizon

Dyw

Dr

Dm

Dw

Dy

1 3 6 9 12

0.00 6 0.00 3.08 6 1.97 4.71 6 4.15 4.69 6 4.45 5.25 6 4.49

0.00 6 0.00 0.00 6 2.95 1.72 6 4.25 2.79 6 4.90 2.85 6 4.84

6.59 6 0.00 6.21 6 1.31 9.65 6 5.19 9.72 6 4.98 9.85 6 5.00

0.00 6 0.00 7.40 6 7.97 13.83 6 10.22 15.06 6 10.71 14.97 6 10.60

93.40 6 0.00 82.43 6 7.18 70.10 6 9.86 67.31 6 10.94 67.09 6 10.97

Note. Entries show percentage of forecast variance of y at different horizons attributable to innovations in column. Ranges indicated represent approximate 95% confidence intervals.

financial allocation mechanism induced by the extensive difficulties encountered by the banking system, which led, in countries like the United States, to bank crises and bank failures. This, together with the collapse of producers and consumers net worth, may be responsible for the rise in what Bernanke defines as ‘‘the cost of credit intermediation.’’ The empirical evidence (Bernanke, 1983; Hamilton, 1987) seems to indicate that in the United States the deep financial crisis, which occurred between 1930 and 1933, had significant real effects beyond those generated by the monetary contraction. Bernanke and James (1991), analyzing a cross section of countries, find that countries experiencing panics or other severe banking problems had significantly worse depressions than countries in which banking was more stable. Haubrich (1990), in his analysis of Canada, finds instead that measures of financial distress had no economic or statistical significance in predicting economic activity. Haubrich’s interpretation is that without bank failures (which did not occur in Canada’s nationwide branch-banking system), financial distress has no major macroeconomic effects. All this evidence indicates that the effects of the financial crisis crucially depend on the structure of the banking system and on the measures undertaken by the authorities to insure stability. As far as Italy is concerned, two main questions arise: one regards the depth of the financial crisis; the other relates to the evaluation of the extent to which financial factors affected economic activity. The Italian banking system was characterized by the existence of a small group of large, nationwide institutions and a large number of small, mostly unit, banks. Among the large banks we find the three major universal banks whose portfolios were composed mainly of loans to and shares of the leading industrial firms. The financial distress that occurred during the Great Depression is indicated by the reduction of the number of banks and by the crisis of the major universal banks (Banca Commerciale Italiana, Credito Italiano, and Banco di Roma). In the period 1928–1936 the number of active banks fell from 3860 to 2099, which implies a reduction of about 46%. This reduction does not reflect only extensive bankruptcies. In fact, the disappearance of small banks is a phenomenon which had already begun at the beginning of the 1920s, and continued in the following decade. Indeed, it could have been the result of a natural process of reorganization of the

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intermediation system.24 Moreover, when failures occurred, the following crises were managed mainly through mergers and acquisitions and this prevented relevant episodes of panics and bank runs. Indirect evidence of the difficulties encountered by the banking system is given by a 20% decrease in bank deposits between 1929 and 1935 and by the doubling of postal deposits in the same period. As we already argued in Section 2, in a period of financial turmoil the postal system represented in Italy a safe haven for the savings of households who reallocated their portfolios away from assets, such as bank deposits, which had become riskier. The difficulties encountered by the major mixed banks are instead well documented.25 During the 1920s, and in particular during the second half of the decade, the large German-type universal banks had become (often the major) shareholders of large manufacturing and service companies, granting at the same time a large volume of long term loans to the same firms. These banks were therefore very vulnerable when the Great Depression hit the Italian economy with its fall in demand, stock market crisis, debt deflation and withdrawal of deposits. By the end of 1930 the second largest Italian bank, Credito Italiano, found itself in a situation of insolvency; by May 1931 also the largest and most prestigious bank (Banca Commerciale) was no longer able to honor its obligations, followed by Banca di Roma, and other banks. Differently from what happened in other countries, the Italian Government intervened very rapidly in each case, first providing insolvent banks with necessary liquidity, and afterward promoting a general restructuring of the Italian intermediation system. The intervention of the Government, thanks to the existence of an established dictatorship, was conducted with great secrecy, avoiding in this way the suspension of payments, bank holidays, panics, and other phenomena that characterized the financial crises in Central Europe and in the United States. The Government, through the Bank of Italy, supplied an enormous amount of credit to the insolvent banks: at the end of 1932 this volume of credit reached 54% of the notes in circulation. Following the emergency measures, a final solution of the crisis was reached through the creation in 1933 of a new state holding company (IRI), which acquired all the equities held by the major universal banks and through a deep restructuring of the Italian intermediation system. This was based on two basic principles: the prohibition for banks to hold firms’ equity and the separation between short and long term credit. Whether or not the financial crisis in Italy had significant real effects is still an open question. In a recent paper Ferri and Garofalo (1994) present some descriptive evidence suggesting the existence of a credit crunch during the Great Depression. This evidence however is not conclusive on whether the contraction in the amount of credit granted to the private sector was the result of a disruption

24 25

See Biscaini, Cotula and Ciocca (1979). For a detailed analysis see Ciocca and Toniolo (1983), and Toniolo (1978).

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FIG. 10.

Stock market index (1929: 1 5 100).

in the financial intermediation system, or was simply the consequence of the fall in economic activity. Finding reliable indicators of the cost of credit intermediation is obviously a difficult task. In a case in which extensive bank failures have been observed, an obvious candidate is the number of failing banks or the amount of their deposits. As far as Italy is concerned, there is no evidence of panics or extensive bankrupticies among intermediaries and we must therefore choose other indicators. We employ, as a proxy of the financial crisis, four variables: the bank stock index deflated by the general stock index (BS), the difference between the yield on bonds of industrial companies and the yield on Italian government consols (DIF), the number of business failures (FAIL), and finally the number of dishonored notes (DN). By choosing these variables we also try to avoid the risk of misdefining the financial transmission mechanism as depending only on bank failure and bank lending supply contraction. These variables in fact allow nominal debt rigidity and ‘‘balance sheets’’ effects unrelated to the banking system to enter the analysis. The ratio between the bank stock index and the general stock market index indicates the perceived value of the major banks listed in the stock market relative to the value of the rest of the economy and therefore should measure the health and the profitability of the Italian banking sector. As we can see from Fig. 10 the fall in the value of bank shares was smaller than that of the stock index. This seems to indicate that the government intervention in favor of the major banks contributed to generate a climate of relative confidence in the stability of the banking system. The other three variables, DIF, FAIL, and DN, are all proxies of the level of risk in the economy and therefore represent a measure of the cost of credit intermediation. All of these variables indicate a generalized increase in the level of risk faced by intermediaries up to the beginning of 1932, i.e., the period in which production fell to its lowest level.

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TABLE 4 VAR Estimation Results: F Tests, Significance Levels. Output Equation in a Five Variable System: Dy, Dp, Dm, Dyw , Financial Crisis Indicator Dy

Dm

Dp

Dyw

DIF

0.080 0.447 0.234 0.134

0.016 0.044 0.046 0.011

0.092 0.043 0.013 0.145

0.044 0.029 0.072 0.033

0.442

DFAIL

DDN

DBS

0.574 0.739 0.315

Note. Each row gives the value of the significance level for the output equation in the VAR system. This statistic evaluates the null hypothesis that the block of lags pertaining to the variable in each column is zero. FAIL: Number of business failures. DN: Number of dishonored notes. DIF: Difference between yields on bonds of industrial companies and Italian government consols (observed on the Milan financial market). BS: Bank stock index deflated by the general stock index.

In order to detect whether the increase in riskiness had a significant impact on economic activity, we reestimate our VAR model including the variables described above. The results of these estimations are reported in Table 4, where the significance levels of the F tests are shown only for the output equations. The inclusion of the various proxies of the financial crisis does not alter substantially the results we have previously obtained and does not suggest a significant role of these variables in affecting real output. Lagged values of DBS, DDIF, DFAIL, and DDN do not enter significantly in the output equation. The financial crisis therefore does not seem to have affected significantly the level of economic activity. This is hardly surprising in light of the previous discussion which suggested that major financial distress in the economy was prevented by the intervention of the government. As in all other countries, the Italian intermediation system suffered from an increase in the level of risk and this, presumably, was reflected in a credit crunch. However, the assistance provided by the government to the banking system prevented the transformation of a situation of financial distress into a complete disruption of the intermediation system, with the consequent adverse effects on the resource allocation process. 6. CONCLUSIONS In this paper we have studied the Italian economy in the period 1929–1936. The contraction in economic activity, which is evidenced by the fall in industrial production, the fall in the number of hours worked, the fall in employment and the decrease in real exports, was very strong and certainly comparable to that of the other major industrialized countries. The main contention of the paper is that the Great Depression in Italy was the combined result of the contraction in world demand and of restrictive monetary policies followed by the Italian Government in adherence to the rules of the Gold

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Standard. Italy, running a continuous balance of payments deficit, experienced a dramatic fall in gold and foreign reserves which determined a remarkable monetary stringency. Prices fell significantly but, because of the asymmetries embedded in the Gold Standard, which implied a generalized deflation in all countries, this did not lead to relevant gains in competitiveness. Our analysis is consistent with an interpretation that assigns to a restrictive monetary policy, induced by a strenuous defense of the exchange rate, a major role in determining the level of economic activity. The intense deflationary process, which was probably not fully anticipated, was not followed by a complete adjustment of nominal variables. This was true especially for wages that, despite the wage cuts imposed by the Fascist regime through its corporatist system of industrial relations, increased in real terms during the period 1929–1932. Our analysis suggests that this nominal rigidity was partially responsible for the output contraction. A third important point is that there is no evidence of the role of financial factors as a major, independent determinant of the fall of economic activity. Indeed the Italian financial system ran into deep difficulties. The large universal banks that had supported the industrialization of the country in the previous decades became by 1932 practically insolvent, and at the same time many small banks disappeared because of bankrupticies and reorganization processes. Because of the higher risk of the banking system, households moved part of their bank deposits toward the safer postal system. Our econometric analysis seems to indicate that the credit crunch that ensued did not have the intensively disruptive effects on real output as it did in other countries. This was probably the result of the massive and secretive intervention of the government, which, by supplying funds to the banking system, prevented the panics, bank runs and bankrupticies which occurred in the United States and in Central Europe.

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APPENDIX 1 TABLE A1a Cointegration Tests Results: Engle and Granger Procedure Dependent variable

Independent variable

y

m

y

p

y

yw

y

x

y

e

p

m

p

e

y

m, p, yw , e

DF

ADF(1)

ADF(4)

ADF(8)

21.85 (23.40) 21.77 (23.40) 23.35 (23.40) 21.70 (23.40) 21.64 (23.40) 21.55 (23.40) 21.83 (23.40) 23.66 (24.57)

21.91 (23.40) 21.76 (23.40) 23.36 (23.40) 21.57 (23.40) 21.57 (23.40) 21.63 (23.40) 22.07 (23.40) 23.62 (24.57)

21.99 (23.41) 21.56 (23.41) 22.58 (23.41) 21.32 (23.41) 21.43 (23.40) 21.47 (23.41) 21.94 (23.41) 22.63 (24.58)

21.85 (23.41) 21.56 (23.41) 22.49 (23.41) 21.58 (23.41) 21.67 (23.40) 20.57 (23.41) 21.43 (23.41) 22.51 (24.58)

TABLE A1b Cointegration Tests Results: Johansen and Joselius FML Procedure. Variables y, m, p, yw , e: Maximum Lag in VAR 5 4 Nontrended

Trended (no trend in DGP)

Trended (trend in DGP)

Null

Alternative

Stat 1 a

Stat 2 b

Stat 1 a

Stat 2 b

Stat 1 a

Stat 2 b

r50

r$1

r#1

r52

r#2

r53

r#3

r54

r#4

r55

30.84 (34.40) 23.57 (28.14) 13.73 (22.00) 11.91 (15.67) 6.39 (9.24)

86.43 (76.07) 55.59 (53.11) 32.02 (34.91) 18.30 (19.96) 6.39 (9.24)

29.44 (33.32) 23.33 (27.14) 11.92 (21.07) 7.12 (14.90) 6.19 (8.18)

77.99 (70.59) 48.55 (48.28) 25.23 (31.52) 13.31 (17.95) 6.19 (8.18)

29.44 (33.46) 23.33 (27.07) 11.92 (20.97) 7.12 (14.07) 6.19 (3.76)

77.99 (68.52) 48.55 (47.21) 25.22 (29.68) 13.31 (15.41) 6.18 (3.77)

Note. Values in parentheses are 95% critical values. Test based on the maximum eigenvalue of the stochastic matrix. b Test based on the trace of the stochastic matrix. a

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APPENDIX 2: THE DATA SET Data Sources The industrial production index comes from ‘‘Sindacato e Corporazione,’’ various issues; for the other countries (United States, France, Germany, Great Britain) see ‘‘League of Nations,’’ Statistical Yearbook, various issues. The industrial activity index, exports and the average industrial wage come from Bollettino di Notizie Economiche, various issues. The index of employment of blue collar workers, the number of unemployed, consumer and wholesale price indexes, monetary base (notes and coins 1 deposits at the Bank of Italy), private discount rate, the yield on industrial bond, the yield on government consols, the stock market indexes, the number of business failures, and the number of dishonored notes from the ISTAT, Bollettino Statistico, various issues. For the real exchange rate see Cotula and Spaventa (1993). For the level of reserves see Bankof Italy, Annual Report, various issues.

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TABLE A2a

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TABLE A2a—Continued

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ITALY AND THE GREAT DEPRESSION TABLE A2b—Continued

REFERENCES Bernanke, B. S. (1983), ‘‘Non-monetary Effects of the Financial Crisis in the Propagation of the Great Depression’’, American Economic Review 73, 257–276. Bernanke, B. S. (1986), ‘‘Alternative Expanations of the Money–income Correlation.’’ In K. Brunner and A. H. Meltzer (Eds.), Real Business Cycles, Real Exchange Rates and Actual Policies, Carnegie– Rochester Conference Series on Public Policy, 25, Amsterdam: North Holland. Pp. 49–99.

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