What happened to interest rates in the early 1930s?
Relevant data from the USA in the first half of the 1930s are consistent with Keynes's theory, but starkly inconsistent with classical theory. This is hardly a surprise because Keynes had US financial markets in this period in mind when he wrote the "insane casino" chapters of The General Theory.
For example, in 1930, just as the crisis hit, AAA-rated corporate bonds (the safest class of corporate bonds) had an interest rate of 4.6 percent, while riskier Baa bonds paid 5.9 percent. In May 1932, in the midst of the collapse, the AAA rate rose to 5.4 percent. However, many bonds initially in the AAA category in the boom of the late 1920s had been downgraded to Baa by 1932. The Baa interest rate rose to 11.6 percent (Board of Governors of the Federal Reserve System 1943, p. 468). Long-term bond prices were in a state of collapse.Keep in mind that there was a severe deflation in this period starting in early 1930 that saw a 25 percent price decline in the USA between 1929 and 1932, so real long-term rates increased by much more than nominal rates. The real Baa interest rate was more than 20 percent in 1932 - with a nominal interest rate of 11.6 percent added to a 10.3 percent rate of deflation that blew up the real value of nominal interest payments.18 The real AAA interest rate was 15.7 percent. This huge leap in real longterm rates, along with the severe stock price collapse that accompanied it, obviously made the real-sector crisis qualitatively worse. Rather than reducing instability in the real sector as asserted by classical theory, the bond market greatly magnified it. This was an immensely destructive disequilibrium process.
Keynes pointed out that there was little the Fed could do to stop this onslaught.
Where, however, (as in the United States, 1933-34) open-market operations have been limited to the purchase of very short-dated securities, the effect may...
be mainly confined to the very shortterm rate of interest and have but little reaction on the much more important long-term rate of interest.(CW 7, p. 197)19
In the context of a panic in the long-term bond market, open market operations merely widened the long-short interest rate spread.
Of course, at the same time and through the same process, the shortterm interest rate on "money" fell as investors fled the risk of capital loss in stocks and bonds and used the cash generated by these sales to buy the capital safety provided by short, safe financial assets. This caused the Treasury bill rate, which was 4.4 percent in 1929, to decline to 2.2 percent in 1930 and 1.2 percent in 1933 and led to an explosion of the long-short interest differential. But the fall in the short rate could do nothing to stop the collapse of capital investment spending.
By 1936, in the midst of the depression, the nominal Baa rate had declined to 5 percent, but by this time the actual and the expected gross profit rates on capital investment were so low and excess capacity so high that even a sharp drop in the long-term interest rate could not possibly get capital investment out of the doldrums. Net investment (gross investment minus depreciation) in the USA was actually negative in 1933. And the banks were more concerned with their solvency than with providing ample credit to businesses and households.