Rothbard on the Recovery from the US Recession of 1920–1921

Rothbard’s comments are interesting because what he said seems to have been forgotten by modern Austrians:

“As early as 1915 and 1916, various Board Governors had urged banks to discount from the Federal Reserve and extend credit, and Comptroller John Skelton Williams urged farmers to borrow and hold their crops for a higher price. This policy was continued in full force after the war. The inflation of the 1920s began, in fact, with an announcement by the Federal Reserve Board (FRB) in July, 1921, that it would extend further credits for harvesting and marketing in whatever amounts were legitimately required. And, beginning in 1921, Secretary of Treasury Andrew Mellon was privately urging the Fed that business be stimulated, and discount rates reduced; the records indicate that his advice was heeded to the full.” (Rothbard 2008: 121).

Rothbard refers here to Federal Reserve discount rate policy. At the beginning of 1921 the discount rates of the Federal Reserve banks were either 6% or 7% (data in Discount Rates of the Federal Reserve Banks 1914–1921, 1922). In May, a number of regional Federal Reserve banks began lowering discount rates from 7% to 6.5%. Then in July a number of rates were cut from 6% to 5.5%, and to 4.5% to 5% by the end of the year. The recovery from the recession is usually dated to July 1921, so that first discount rate cuts did indeed precede the recovery.

The libertarians claim that these rate cuts did not necessarily create loose monetary policy or easy money, but most probably the rate cuts beginning in May 1921 had a great influence on the economy by way of expectations and business confidence: first, by signalling that the punishingly high discount rate policy had come to an end, and secondly by helping to create confidence and expectations of continuing rate cuts and looser monetary policy in the future, as indeed did happen.

Then Rothbard refers to the open market operations of late 1921 to 1922:

“Member bank reserves increased during the 1920s largely in three great surges—one in 1922, one in 1924, and the third in the latter half of 1927. In each of these surges, Federal Reserve purchases of government securities played a leading role. ‘Open-market’ purchases and sales of government securities only emerged as a crucial factor in Federal Reserve monetary control during the 1920s. The process began when the Federal Reserve tripled its stock of government securities from November, 1921, to June, 1922 (its holdings totaling $193 million at the end of October, and $603 million at the end of the following May). It did so not to make money easier and inflate the money supply, these relationships being little understood at the time, but simply in order to add to Federal Reserve earnings. The inflationary result of these purchases came as an unexpected consequence. It was a lesson that was appreciatively learned and used from then on.

If the Reserve authorities had been innocent of the consequences of their inflationary polity in 1922, they were not innocent of intent. For there is every evidence that the inflationary result was most welcome to the Federal Reserve. Inflation seemed justified as a means of promoting recovery from the 1920–1921 slump, to increase production and relieve unemployment. Governor Adolph Miller, of the Federal Reserve Board, who staunchly opposed the later inflationary policies, defended the 1922 inflation in Congressional hearings. Typical of Federal Reserve opinion at this time was the subsequent apologia of Professor Reed, who complacently wrote that bank credit ‘was being productively employed and that goods were being prepared for the consumer at least as rapidly as his money income was expanding.’” (Rothbard 2008: 133–134).

Yet the modern libertarian spin on the recovery of 1921 is now that the monetary policy had no significant role in inducing a recovery. How times change.

BIBLIOGRAPHY
Discount Rates of the Federal Reserve Banks 1914–1921, Government Printing Office, 1922.

Rothbard, Murray Newton. 2008. America’s Great Depression (5th edn.). Ludwig von Mises Institute, Auburn, Ala.

Who Knew!? Banks Create Money out of Nothing

This recent paper by Richard A. Werner should be of interest to Post Keynesians:

Richard A. Werner, “Can Banks individually create Money out of Nothing? — The Theories and the Empirical Evidence,” International Review of Financial Analysis 36 (2014): 1–19.

From the abstract:

“This paper presents the first empirical evidence in the history of banking on the question of whether banks can create money out of nothing. The banking crisis has revived interest in this issue, but it had remained unsettled. Three hypotheses are recognised in the literature. According to the financial intermediation theory of banking, banks are merely intermediaries like other non-bank financial institutions, collecting deposits that are then lent out. According to the fractional reserve theory of banking, individual banks are mere financial intermediaries that cannot create money, but collectively they end up creating money through systemic interaction. A third theory maintains that each individual bank has the power to create money ‘out of nothing’ and does so when it extends credit (the credit creation theory of banking). … This study establishes for the first time empirically that banks individually create money out of nothing. The money supply is created as ‘fairy dust’ produced by the banks individually, ‘out of thin air.’”

I do not mean to be snide or devalue this paper, which I suppose must be seen as a sign of progress in mainstream economics, but surely many economists and historians who have paid attention to the nature and history of modern banking already know that the empirical evidence demonstrates that banks create money out of nothing.

I also feel that plenty of economists with a “fractional reserve theory of banking” also recognise that banks create money from nothing too and are therefore also advocates of the “credit creation theory” of banking.

Despite that, this is an excellent paper, especially its comments on the need for better financial regulation and the inadequacy of the Basel regulations (Werner 2014: 2, 17–18). Werner provides a really useful literature review of the supporters of the “credit creation theory” of banking and their writings (Werner 2014: 2–6).

He lists Knut Wicksell, Henry Dunning Macleod, Hartley Withers, Schumpeter, Robert H. Howe, Ralph Hawtrey, Albert L. Hahn, and Keynes (at least in the Tract on Monetary Reform [1923]) as leading advocates of the “credit creation”/endogenous money theory of banking, and how this view even seemed to be widespread by the 1920s (Werner 2014: 6).

Werner also notes how the correct “credit creation theory” was displaced from the 1930s–1960s by advocates of a “fractional reserve theory of banking” that denied that individual banks can create money, even if the banking system in the aggregate does (Werner 2014: 7).

Paradoxically, Keynes by the time of the Treatise on Money seems to have endorsed the “fractional reserve theory” and, worse still, in the General Theory the financial intermediation theory (Werner 2014: 7, 9), a point which was noted with dismay by Schumpeter (Werner 2014: 9). One of the most interesting aspects of Werner’ paper is how Keynes’ regression to the “financial intermediation” theory of banking in the General Theory had a terribly bad influence on neoclassical synthesis Keynesianism and modern mainstream neoclassical economics, which owing in part to Keynes and the work of James Tobin and others has reverted to the “financial intermediation” theory (Werner 2014: 9–10).

This has been a stark and embarrassing regression in knowledge by mainstream economics, and Werner is absolutely right to complain that “since the 1930s, economists have moved further and further away from the truth, instead of coming closer to it” (Werner 2014: 16).

But, strangely, on p. 11 of the article Werner seems to be saying that “Post-Keynesians” also endorse the “financial intermediation” theory of banking (Werner 2014: 11), which is a most bizarre error.

The important empirical evidence that Werner provides was his personal borrowing of €200,000 from the Raiffeisenbank Wildenberg e.G. bank (in a town of Lower Bavaria) in August 2013, and the bank’s disclosure of how this occurred in accordance with its standard internal credit procedure, accounting practices, balance sheet and IT procedure (Werner 2014: 13–14). The bank did not borrow extra reserves or obtain new “deposits” before it made the loan, and its reserves remained fixed at €350,000 both immediately before and after the loan transaction (Werner 2014: 14). The daily account statements of the bank, obtained by Werner, demonstrate that its accounting activities and balance sheet contradict both the “fractional reserve theory of banking” and “financial intermediation” theory (Werner 2014: 14–15).

This is Werner’s (somewhat rhetorical?) conclusion:

“Thus it can now be said with confidence for the first time – possibly in the 5000 years’ history of banking – that it has been empirically demonstrated that each individual bank creates credit and money out of nothing, when it extends what is called a ‘bank loan’. The bank does not loan any existing money, but instead creates new money. The money supply is created as ‘fairy dust’ produced by the banks out of thin air.” (Werner 2014: 16).

I suppose Post Keynesians should be very pleased indeed with this conclusion, but will be dismayed by the (as far as I can see) total lack in Werner’s article of any reference to their work on banking and endogenous money which already reached this conclusion decades ago.

One final point can be made about Keynes: most probably Werner is right that Keynes’ exogenous money approach in the General Theory of Employment, Interest, and Money (1936) has had a pernicious effect on the modern theory of banking, but, as far as I know, Keynes reverted to the endogenous money theory in his article “Alternative Theories of the Rate of Interest” (1937: 247, 248), where he stressed the finance motive as a basis of endogenous money. Perhaps the trouble is also that many economists have not bothered to read what Keynes wrote after the General Theory.

BIBLIOGRAPHY
Keynes, J. M. 1937. “Alternative Theories of the Rate of Interest,” The Economic Journal 47.186: 241–252

Werner, Richard A. 2014. “Can Banks individually create Money out of Nothing? — The Theories and the Empirical Evidence,” International Review of Financial Analysis 36: 1–19.

Are all Facts Theory-Laden?

If we define “fact” as a synthetic a posteriori proposition, then it would appear that nearly all facts are to some extent “theory-laden,”* but that does not vindicate apriorism or Kant’s synthetic a priori knowledge, nor does it discredit the moderate form of empiricism that is rightly at the heart of modern methodology and epistemology in the natural and social sciences.

When we interpret some data or fact in the natural and social sciences ordinarily we will clearly pre-suppose a number of theories when we make interpretations of the facts.

But the standard theories we presuppose in either the natural sciences and social sciences have already been justified empirically, by experience, inductive argument and inference to the best explanation (which is just another non-deductive, or inductive form of reasoning) by long debates and arguments in philosophy or in the natural and social sciences too.

At the most basic level, there are all sorts of theories we do have about the world in which we exist and we make when we do natural and social sciences (including economics), such as the following:

(1) the real existence of other human minds;

(2) the real existence of an external world of matter and energy that is the causal origin of our sensory data (= an indirect realist ontology);

(3) that the past had real existence (and is not some figment of our imagination);

(4) the existence of a set of physical and chemical laws that have been discovered by the natural sciences that account for the order and nature of the universe;

(5) the view that our earth is about 4.54 billion years old;

(6) the view that all livings things on our earth are the product of a Darwinian process of evolution by natural selection (and, if one wants to be technical, also by (i) sexual selection and (ii) artificial selection by humans);

(7) the human mind is the product of the physical activity of the brain, and so on.

And of course we can keep listing such theories too as we move from natural science to the social sciences. (And note I use the word “theory” in the sense of a hypothesis that has been confirmed or justified by evidence.)

Theories (1) to (3) belong to the philosophical sub-disciplines we call ontology and epistemology. The theory that other human minds really exist and that an external world exists can only be justified empirically by inductive argument by analogy and inference to the best explanation. There are no a priori or deductive arguments that can establish the necessary truth of these ideas. In fact, you cannot prove they are necessarily true at all: they are synthetic a posteriori propositions whose truth is extremely probable at best, and we know this only by experience, induction or inference to the best explanation.

Exactly the same thing can be said of propositions (4) to (7): these are empirical propositions of the natural sciences that are synthetic a posteriori: their truth is extremely probable at best and is confirmed by experience, induction or inference to the best explanation.

We could continue listing “prior” theories that a social scientist like an economist assumes when interpreting some data or facts, but we would also find that these too are nothing but empirical propositions whose truth can be believed because we have good empirical evidence to do so. We will also encounter useful concepts that are formulated to categorise and classify objects and phenomena in the world which are analytic a priori (or true by definition because we define them in such-and-such a way). While this does presuppose a further type of “theory” when looking at data or facts, the ultimate test of whether a system of analytic classifications and definitions is useful and appropriate is how well it can classify and describe the world, so the actual justification for its use is not divorced from empiricism.

At some point of course we will start to encounter bad and false empirical theories or assumptions in some disciplines, such as in neoclassical economics. But even here the only way to know if a theory about the real world is true or false is by experience, induction or inference to the best explanation. You are not going to do it by armchair apriorism.

So what is the substantive point here?

Mises claimed that the German Historical School and the logical positivist empiricists of his time thought that they could take facts without recourse to any theory. Perhaps they did. They were wrong, and modern empiricism has since moved on.

And clearly heterodox economists of the non-neoclassical Institutionalist and Post Keynesian schools seem to accept that facts are theory-laden too (e.g., see Hodgson 1999: 146; Lawson 1997: 295).

But the lazy comment that all facts are “theory-laden” is still used by apriorists like Austrian economists to attack modern empiricism in their attempts to vindicate the intellectually bankrupt method called Mises’ praxeology.

It is an absurd exercise in vain, for the admission that “all facts are theory-laden” does not vindicate epistemological apriorism in either the natural or social sciences and not in economics either, and does not refute a more moderate version of empiricism that accepts that we do indeed have many prior theories but that they are also justified empirically.

The “all facts are theory-laden” mantra does not discredit the modern empirical method. Nor does it refute the observation that we have no good reason to think that all of our knowledge of the real world is anything but empirical and justified empirically: we have no good reason to think epistemological apriorism is a viable or necessary method in our study of the world in all of its complexity, from the natural world to the complex world of human societies.

Any given datum or fact may indeed presuppose a long list of prior theories or propositions. But we will find that these theories or propositions are themselves also empirical and have been justified too by some other social or natural scientist or philosopher who asked the question “how do we know such-and-such is true” and justified its truth convincingly a posteriori by experience, induction or inference to the best explanation.

Note
* The only possible exception I can think of is Descartes’s cogito ergo sum (or cogito) argument, but on closer inspection probably many would argue that it is not free from a prior theory/assumption that there is an “I” that must be understood as a discrete conscious entity and perceiving subject that perceives objects of perception.

On a related point if the cogito argument is reformulated to conclude that some perceptions, sensations or thinking exist or are occurring, then it might possibly be considered an ontologically and epistemologically necessary a posteriori truth (but there are also arguments against this), and even if it were it takes you nowhere epistemologically: it is a dead end and cannot be used as a secure foundation for apriorism, nor to deduce any necessary truth in the natural and social sciences.

BIBLIOGRAPHY
Hodgson, Geoffrey M. 1999. Economics and Utopia: Why the Learning Economy is not the End of History. Routledge, London and New York.

Lawson, Tony. 1997. Economics and Reality. Routledge, London and New York.

Huerta de Soto gets it Wrong on the Gold Standard

One can read this interview with the Austrian school economist Jesús Huerta de Soto in which he praises the “benefits” of deflation:

Jesús Huerta de Soto, 2014. “Deflating the Inflation Myth,” Cobden Centre, 7 December.

He makes an eyebrow raising comment here:

“[Interviewer:] Does that mean we should be happy about deflation?

[Huerta de Soto]: Certainly. It is particularly beneficial when it results from an interplay of a stable money supply and increasing productivity. A fine example is the gold standard in the 19th century. Back then, the money supply only grew by one to two percent per year. At the same time, industrial societies generated the greatest increase in prosperity in history.”
Jesús Huerta de Soto, 2014. “Deflating the Inflation Myth,” Cobden Centre, 7 December.

Really? The deflationary period of the 19th century generated “the greatest increase in prosperity in history”? What is the evidence for that?

Now it is true that there was in virtually all nations a long-run deflationary trend for most of the 19th century, even if punctuated by inflationary booms outside the 1873 to 1896 period (which was marked by almost persistent deflation).

Huerta de Soto’s statement can only mean that the gold standard era had an historically unprecedented real per capita GDP growth rate compared to all other eras both before and since.

Let us look at the average OECD real per capita GDP growth rate estimates and data for various periods over the past three centuries:

1700–1820 – 0.2%
1820–1913 – 1.2%
1919–1940 – 1.9%
1950–1973 – 4.9%
1973–1990 – 2.5%
(Davidson 1999: 22).

Uh oh.

This is what happens when an Austrian economist puts his foot in his mouth and makes statements in accordance with Austrian ideology but not backed by the empirical evidence.

As we can see, the industrial revolution of the 19th century under the gold standard most probably generated the greatest increase in real per capita wealth in history up to that time, but its record has since been surpassed. The best period of real per capita GDP growth was the 1950–1973 era: the time of Keynesian economics and modern macroeconomic management and also a much higher level of government intervention in the economy, both before and since.

But, the critic might counter-argue, didn’t Huerta de Soto really mean it was that specific deflationary period of the 19th century – which is normally taken to be the 1873 to 1896 era – that generated “the greatest increase in prosperity in history”? Possibly that is what he meant.

We can look at the data for the UK, the US and Germany below from 1873–1896 (with data from Maddison 2003):

UK Average per capita GDP Growth Rate 1873–1896: 1.057%
US Average per capita GDP Growth Rate 1873–1896: 1.422%
German Average per capita GDP Growth Rate 1873–1896: 1.495%.

Since these were the most advanced, fastest growing economies of the late 19th century, it is unlikely any other nations achieved an average per capita GDP growth rate higher than them, and certainly not in numbers large enough to affect the average for that era.

So even within the 1873 to 1896 era the figures do not seem to deviate too far from the 1820–1913 OECD average. They were also inferior to the Keynesian golden age of capitalism from 1950–1973, which remains the best period in human history for real per capita output growth.

One can also note that the deflationary era of 1873 to 1896 produced deep business pessimism at the least in the UK (and possibly other nations too) resulting from the “profit deflation” or profit squeeze of that era, and there were also protracted economic problems in the 1870s and 1890s. In the US, this period coincided with the free silver movement and bimetallist political movement that opposed the gold standard, arising in part from the debt deflationary distress to debtors in that era.

In short, the idea that under the gold standard the industrial nations “generated the greatest increase in prosperity in history” at any time before or since is untrue, and is nothing but a libertarian myth.

BIBLIOGRAPHY
Davidson, P. 1999. “Global Employment and Open Economy Macroeconomics,” in J. Deprez and J. T. Harvey (eds), Foundations of International Economics: Post Keynesian Perspectives, Routledge, London and New York. 9–34.

Maddison, Angus. 2003. The World Economy: Historical Statistics. OECD Publishing, Paris.

The Inconvenient Truth about Interest Rates and Investment

Actually Post Keynesians are already well aware that the influence of interest rates on determining the level of investment is grossly overrated, but striking confirmation of the Post Keynesian view can be found in fascinating survey evidence in this Federal Reserve Finance and Economics Discussion Series paper:

Sharpe, Steve A. and Gustavo A. Suarez. 2013. “The Insensitivity of Investment to Interest Rates: Evidence from a Survey of CFOs,” Finance and Economics Discussion Series, Federal Reserve Board, Washington, D.C. December 3
http://www.federalreserve.gov/pubs/feds/2014/201402/201402pap.pdf

In essence, Sharpe and Suarez conducted a survey of 550 corporate executives in nonfinancial industries directly asking them how their investment decisions are affected by a change in interest rates with other factors held constant in September 2012, and 541 responded (Sharpe and Suarez 2013: 3, 7–8).

The executives were asked these questions:

(1) “By how much would your borrowing costs have to decrease to cause you to initiate, accelerate, or increase investment projects in the next year?” and

(2) “By how much would your borrowing costs have to increase to cause you to delay or stop investment projects?” (Sharpe and Suarez 2013: 3).

They could choose from these responses:

(1) not applicable;

(2) 0.5 percentage point;

(3) 1 percentage point;

(4) 2 percentage points;

(5) 3 percentage points and

(6) more than 3 percentage points (Sharpe and Suarez 2013: 3–4).

The findings were as follows:

“The vast majority of CFOs indicate that their investment plans are quite insensitive to potential decreases in their borrowing costs. Only 8% of firms would increase investment if borrowing costs declined 100 basis points, and an additional 8% would respond to a decrease of 100 to 200 basis points. Strikingly, 68% did not expect any decline in interest rates would induce more investment. In addition, we find that firms expect to be somewhat more sensitive to an increase in interest rates. Still, only 16% of firms would reduce investment in response to a 100 basis point increase, and another 15% would respond to an increase of 100 to 200 basis points.” (Sharpe and Suarez 2013: 4).

We can put this in graph form below.

The findings are pretty stark: 68% of CFOs said that they would not expect “any decline in interest rates would induce more investment.” Of the firms in this category many were insensitive to interest rates changes because they finance investment out of retained or current earnings (Sharpe and Suarez 2013: 20).

Curiously, some 139 respondents answered “not applicable” (Sharpe and Suarez 2013: 7–8). Presumably this was because such firms also finance investment through retained or current earnings or do not have easy access to credit anyway (Sharpe and Suarez 2013: 20).

It would appear that many firms that invest via retained or current earnings or just do not have borrowing plans in a coming investment period are relatively unaffected by interest rate hikes – or at least the interest rate hike has to be pretty large to make them cut investment plans (Sharpe and Suarez 2013: 4).

Overall, however, businesses are more sensitive to rate rises than rate reductions.

Furthermore,

“… firms that expected their investment plans to be unresponsive to any conceivable decrease (or increase) in borrowing cost were given the space to provide a reason, and most offered one. The most commonly cited reason for insensitivity was the firm’s ample cash reserves or cash flow. Two other popular reasons were: (i) interest rates are already low (absolutely, or compared to firm’s rate of return); and (ii) the firm’s investment was based largely on product demand or long-term plans rather than on current interest rates. Only about 10% of firms providing a reason for not responding to a decrease cited a lack of profitable opportunities, and only a handful offered high uncertainty as a reason” (Sharpe and Suarez 2013: 5).

The fact that many firms make investment decisions “largely on product demand or long-term plans rather than on current interest rates” should cause no surprise.

Crucially, one year after this survey the respondents were questioned again when longer-term interest rates happened to be 100 basis points higher, and the new answers confirmed that their behaviour had been in line with what they said earlier (Sharpe and Suarez 2013: 5, 23–24).

There is of course one caveat about this survey: interest rates were very low in 2012 and low interest rates may have increased business insensitivity to interest rate changes (Sharpe and Suarez 2013: 20–21). While that is true, it is still quite likely that even this factor has not skewed the survey results so badly that the findings are not generalisable.

In fact, the discovery that most businesses do not regard interest rate changes as a major factor determining investment was already a fundamental finding of the Oxford Economists’ Research Group (OERG) in the 1930s in their survey work: they found that uncertainty was an overriding factor in the investment decision, not interest rates (Lee 1998: 88). Other empirical evidence seems to corroborate this (see Caballero 1999).

A final point can be made about interest rate rises. If interest rates are raised very sharply and severely (as in, say, the “Volcker Shock”), I do not think that anybody disputes that this is most likely to cause recession in a market economy.

But mild to modest rate rises do not necessarily have to depress economic activity. Why? The reason is that many mark-up firms actually include interest payments as part of overhead costs, and many firms will raise their profit mark-up if interest rates are increased (Godley and Lavoie 2007: 265). If demand for a firm’s product is still strong, and a firm then faces an interest rate rise, it can simply raise its prices to recover the cost of higher interest payments.

Further Reading
“Louis-Philippe Rochon on What Should Central Banks Do?,” January 31, 2012.

“Post Keynesian Policy on Interest Rates,” March 12, 2013.

BIBLIOGRAPHY
Caballero, Ricardo J. 1999. “Aggregate Investment,” in John B. Taylor and Michael Woodford (eds.), Handbook of Macroeconomics (vol. 1B). Elsevier, Amsterdam.

Godley, Wynne and Marc Lavoie. 2007. Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth. Palgrave Macmillan, New York, N.Y.

Lee, Frederic S. 1998. Post Keynesian Price Theory. Cambridge University Press, Cambridge and New York.

Sharpe, Steve A. and Gustavo A. Suarez. 2013. “The Insensitivity of Investment to Interest Rates: Evidence from a Survey of CFOs,” Finance and Economics Discussion Series, Federal Reserve Board, Washington, D.C. December 3
http://www.federalreserve.gov/pubs/feds/2014/201402/201402pap.pdf

UK Gross Domestic Fixed Capital Formation in the 1873 to 1896 Deflation

The evidence is very strong that British business people were complaining bitterly of a “profit deflation” by the 1880s during the deflation of 1873 to 1896. This was a major cause of depressed and pessimistic business expectations.

But the crucial question arises: did this affect aggregate investment in this period?

We can look at some data on UK gross domestic fixed capital formation in this era.

The following graph shows UK gross domestic fixed capital formation in millions of pounds at current prices from 1850 to 1913, so we can see the long-run trend (with data from Mitchell 1988: 831–833, National Accounts 5, which is based on Feinstein 1972).

The trend of falling and stagnant investment after 1873 to the later 1880s is stark and leaps out of the data. Of course, this data is in current prices, and, given that factor costs must have fallen, is the data here misleading? Do constant, inflation-adjusted prices show a different trend?

Not really.

The next graph shows real UK gross domestic fixed capital formation in millions of pounds at constant 1900 prices from 1850 to 1913, so that, again, we can see the long-run trend (with data from Mitchell 1988: 837–839, National Accounts 6).

Once again we see much the same trend, even if not so pronounced.

UK real gross domestic fixed capital formation began a sharp drop after the post-1873 deflation commenced, and even during the recoveries around 1880–1884 and 1886–1890 it grew only at a markedly low rate or even essentially stagnated.

The mid-Victorian boom ended in the early 1870s, and (because of price deflation) real gross domestic fixed capital formation reached an inflation-adjusted value of £132 million in 1876, and then began a downward trend until the late 1880s. It did not attain the 1876 peak again until 1894.

It is interesting to note that an inflationary spurt occurred between about 1888 and 1891 in UK wholesale and consumer prices (see the price data in Mitchell 1988: 728 and 738). This can be seen in the graph below of UK wholesale prices from 1871-1913 from the Board of Trade index (with data from Mitchell 1988: 728).

The brief return to inflation might have contributed to the beginnings of a long-run recovery in business confidence in the late 1880s. However, what recovery in investment that occurred looks weak and it was derailed by the deflationary recession of the 1890s.

At any rate, the really strong recovery in investment happened after 1896 when the deflation ended and an inflationary boom developed until the outbreak of World War I.

All in all, I would say that the evidence supports the view that the great deflation was not a period of a healthy, robust economy in Britain. As we have seen, contemporaries noted the phenomenon of “profit deflation” and loss of business confidence.

Post Keynesians argue that the aggregate level of investment is strongly affected by business expectations and that such expectations are subjective, given the fundamental uncertainty that economic agents face.

These insights can clearly be applied to the 1873–1896 era: price deflation with increasing downwards nominal wage rigidity caused a fall in profits by the 1880s.

Though probably not the only reason, it was nevertheless one major cause of loss of business confidence that in turn caused business people to reduce the aggregate level of investment.

Such a Post Keynesian view of the trend of falling investment in this era is the best explanation in my view. And it does not suggest that deflation is a benign and healthy phenomenon, despite what its advocates think.

Further Reading
“UK Real Per Capita GDP 1830–1913,” December 13, 2014.

“UK Average Money Earnings 1880–1913,” December 14, 2014.

“Armitage-Smith on the Profit Deflation of the 1873–1896 Era,” December 15, 2014.

“Nominal Wage Rigidity in the US and the UK 1865/1880–1913,” December 16, 2014.

“UK Real GDP 1830–1918,” October 8, 2012.

“British Money Wages in the 1873–1896 Deflation,” December 10, 2014.

“Saul’s The Myth of the Great Depression, 1873–1896,” December 8, 2014

“Robert Giffen on the Deflation of 1873–1896,” December 7, 2014.

“Alfred Marshall on Business Confidence,” December 3, 2014.

“Alfred Marshall on Wage Stickiness and Debt Deflation,” November 30, 2014.

“The Profit Deflation of the 1890s,” June 13, 2013.

“Alfred Marshall’s Judgement on the “Depression” of 1873–1896,” June 13, 2013.

“S. B. Saul on the Profit Deflation of the 1873–1896 Period,” June 14, 2013.

“Alfred Marshall on the Deflation of 1873–1896,” October 14, 2014.

“Alfred Marshall’s Interest Rate Theory,” November 3, 2014.

BIBLIOGRAPHY
Feinstein, C. H. 1972. National Income, Expenditure and Output of the United Kingdom, 1855-1965. University Press, Cambridge.

Mitchell, Brian R. 1988. British Historical Statistics. Cambridge University Press, Cambridge and New York.

Nominal Wage Rigidity in the US and the UK 1865/1880–1913

A review of the empirical evidence in Hanes (1992 and 1993), Wood (1909), and Feinstein (1990) shows both the UK and US in the late 19th and early 20th centuries had already developed a significant degree of downwards nominal wage rigidity.

The data for the UK can be seen in the graph below, which shows both an index of average UK weekly money earnings and of changes in money earnings within sectors (from Feinstein 1990: 612, Table 6). UK recessions are shaded in blue.

The data in Wood (1909), which can be seen here, indicates that UK money wages did fall significantly in the 1875 to 1879 period. But in the mid-1880s recession nominal wages fell only mildly, and in the 1890s recession hardly moved at all. In the recessions of 1900–1901 and 1908–1909 money wages were again essentially level and inflexible downwards.

Now for the US data.

Davis (2006: 106) provides a useful US recession list on the basis of real manufacturing output:

US Recessions in the 19th Century
Years (Peak–Trough) | Recession Length (years)
1864–1865 | less than 2
1873–1875 | less than 3
1883–1885 | 1
1892–1894 |
1895–1896 |
1903–1904 |
1907–1908 |
(Davis 2006: 106).

The graph below shows fixed weight average US manufacturing wages (dollars per hour) from Hanes (1992: 276–277, Table 3 and Hanes 1993: 753, Table A1). The recessions in Davis are shaded in blue.

US money wages did fall considerably in the economic troubles of the 1870s, but, despite that, there were still protracted economic problems and rising unemployment in the US for years on end in this decade (see the evidence here and here). Nominal wages only fell mildly in the recessions of 1883–1885 and 1892–1894. In the 1895–1896 recession, money wages rose, and in the recession of 1903–1904 they were level and inflexible downwards.

Downwards nominal wage rigidity was a reality both in the UK and America, the two most advanced capitalist economies, well before 1914. In fact, it seems to have become highly significant even by the late 19th century. In America, the degree of money wage falls in the recession of 1920–1921, coming as it did after the unusual wartime wage and price inflation of 1914–1918, was actually anomalous even at that time.

Addendum
While not related directly to this post, I have been looking at UK gross domestic fixed capital formation from 1850 to 1913, in the context of the 1873 to 1896 deflation, so I can see the long-run trend.

This graph shows UK gross domestic fixed capital formation in millions of pounds at current prices from 1850 to 1913.

The fall in investment around 1874 to 1896 sticks out like a sore thumb. What happened here and why? That is a question I will ask in a subsequent post.

Further Reading
“Were Nominal Wages Flexible in 1890s and Early 1900s America?,” January 31, 2014.

“Weir on Historical Estimates of US Unemployment,” February 9, 2014.

“Rothbard on the US Economy in the 1870s: A Critique,” September 24, 2012.

“US Unemployment Graph, 1869–1899,” February 27, 2013.

BIBLIOGRAPHY
Davis, Joseph H. 2006. “An Improved Annual Chronology of U.S. Business Cycles since the 1790s,” Journal of Economic History 66.1: 103–121.

Feinstein, Charles H. 1990. “New Estimates of Average Earnings in the United Kingdom, 1880–1913,” The Economic History Review n.s. 43.4: 595–632.

Hanes, Christopher. 1992. “Comparable Indices of Wholesale Prices and Manufacturing Wage Rates in the United States, 1865–1914,” in Roger L. Ransom, Richard Sutch, and Susan B. Carter (eds.), Research in Economic History 14: 269–292.

Hanes, Christopher. 1993. “The Development of Nominal Wage Rigidity in the Late 19th Century,” The American Economic Review 83.4: 732–756.

Wood, George H. 1909. “Real Wages and the Standard of Comfort since 1850,” Journal of the Royal Statistical Society 72: 91–103.

Peter Temin on Lessons from the Great Depression

Marshall Auerback interviews Peter Temin here about the Great Depression, and about some other issues too, including the US recession/depression of 1837 and the gold standard.

Peter Temin is of course a neoclassical Keynesian, and famous for his book Lessons from the Great Depression (MIT Press, Cambridge, Mass., 1989).



Some of Peter Temin’s other recent books include the following:

Temin, Peter. 2013. The Roman Market Economy. Princeton University Press, Princeton, N.J.

Temin, Peter and Hans-Joachim Voth. 2013. Prometheus Shackled: Goldsmith Banks and England’s Financial Revolution after 1700. Oxford University Press, New York.

Armitage-Smith on the Profit Deflation of the 1873–1896 Era

From George Armitage-Smith’s book The Free-Trade Movement and its Results (1898), in which he discusses profit deflation in the context of the new calls for protectionism in Britain in the late 19th century:

“The Protectionist reaction has received some countenance from a very different quarter. If agricultural profits have fallen, so also have business profits (both industrial and commercial) declined during the last quarter of a century, and among the classes dependent upon this source of income much discontent has arisen. This finds ready publicity with the capitalist class. Without very profound investigation of the causes of the decline in profits, some of the sufferers fall in with the suggestion offered on behalf of agriculture, that Protection may provide a remedy by stimulating home industry.

Various circumstances have contributed to the decline in profits. If, as has been maintained, the chief cause be an alteration in the standard of value. Protection can provide no remedy. Two other factors, however, enter unmistakably into the explanation of low profits: (i) the great increase in the supply of capital which has kept pace with the prosperity of the country, and which, being more rapid in its growth than the demand, has forced down the rate of interest; and (2) the sharper competition of foreign countries in the markets formerly held by British produce, which has sprung up of late years.

Formerly capital was saved only by the rich landed classes from rents, and by the merchant traders. The industrial revolution brought in new wealthy classes, the manufacturer and dealer, to whom the term capitalist came to be applied. These made fortunes rapidly, and accumulated wealth. Time has wrought great changes in this field also. The joint-stock system, banking, and all the machinery of modern investment stimulated saving among the professional and middle classes, and opened up new sources of income. As education and prosperity extended, capital was augmented from the thrifty shopkeeper and artisan class; the openings for fresh investments were made easily available to all classes by new developments of the loaning and company system, so that the term ‘capitalist’ is no longer capable of restriction to any particular class. The joint-stock system is tending in some industries to drive out the private employer, and capital is brought into the reservoirs of trade from tiny rivulets of saving over the whole field of industry. Two events have followed, which are specially relevant to the present matter. Although the field of loaning has been enlarged so as to cover the whole industrial world, capital has increased so much more rapidly than fresh openings for its investment that the rate of interest has declined; and owing to the facility with which it can be borrowed the competition of employers of capital has been greatly intensified by an accession to the class of controllers of industry, of men who live, not on their own capital, but by the skilful employment of borrowed capital. Both facts have tended to depress profits.

Another not less potent influence in the fall of profits is the increased knowledge and power of the working classes, who now, with better capacity for bargaining and strength gained through their trade-unions, succeed in obtaining a larger share of the product than formerly, while legislation on behalf of labour tends to throw greater expense upon the employer. Meanwhile keener competition among employers hands over, in reduced prices, an increasing portion of the commodity to the consumers of their products, and tends to keep down profits by ‘cutting rates’. On all sides circumstances seem to have been combining to reduce ordinary profits; fortunes are rarely made now with the rapidity of bygone times; men have to remain longer in business, and be content to earn a living instead of making a fortune. While the general standard of comfort has advanced and prosperity has been more widely diffused, capital has suffered a reduction in value. The so-called depression of trade in recent years would seem to be more correctly described as a fall in the value of investments and capital employed in industry; it is a genuine depression as regards capital and profits, but wages on the whole have advanced, and goods have been cheapened. From business men complaints of dulness in trade have been frequent. The real fact is, that trade has been quieter but steadier than formerly; while there have been no periods of violent excitement and huge profits, commercial crises, once frequent and very acute, have been fewer and less disastrous in their effects during the past twenty-five years, and the interference with industry from these causes has been diminished. Profits, however, have steadily declined, and among the numerous causes to which this has been attributed, our free-trading system has, without any reason, been included. If profits were determined by Free-trade, the fall should have commenced from its adoption, but the contrary was the case; profits rose and were maintained for thirty years after 1846. The decline has taken place during the last twenty years, and must therefore be accounted for by causes which have made themselves felt in that period.

The other factor contributing to the fall of profits is the competition of other countries, which has lately become so keen and intense. On this account some persons favour protective proposals as a species of retaliation or defence. Our rivals have gained a firmer footing in neutral markets, and their rivalry has reduced prices. Time was when Great Britain had sole command of many markets, she was in the van of mechanical invention, and early succeeded in spreading the products of her industries over the globe; but she could not hope to retain this monopoly. There is no ‘corner’ in scientific knowledge or industrial skill; other nations are rapidly developing their powers and extending their industries, and their commercial activity is increasing; their competition is inevitable, and has hereafter to be recognized and reckoned with. Its tendency is, however, to lower profits. This fact has naturally excited some concern; it is not the sole, nor yet the chief, cause of the fall; profits, as we have seen, have fallen from causes at home which are independent of foreign competition. But it is the commonest of errors to mistake a part of the cause for the whole; and since in this case self-interest seems opposed to foreign interests, undue emphasis is placed upon this factor. Many persons dependent upon interest on capital have suffered from reduced incomes without understanding the economic grounds for the reduction; such persons are naturally attracted by any proposal which promises a remedy; they cannot demonstrate the effects of that exclusion of foreign goods from which they are told to anticipate a revival of vigorous trade and large profits, but join in the demand for Protection, in the vague hope that it may resuscitate their business profits and restore the prosperity of a past period. There is, however, no basis for any such expectation by the method of trade regulation.” (Armitage-Smith 1898: 196–199).

This was written in 1898, a few years after the deflation ended in 1896, but still gives a fascinating insight into how contemporaries saw the “profit deflation” of 1880s and 1890s.

BIBLIOGRAPHY
Armitage-Smith, G. 1898. The Free-Trade Movement and its Results. Blackie & Son, London.

UK Average Money Earnings 1880–1913

Feinstein (1990) provided a new index of UK average full-time weekly money earnings, and his data can be seen in graph below (Feinstein 1990: 612, Table 6).

The graph shows both an index of average weekly money earnings and of changes in money earnings within sectors.

It can be compared with that of Wood (1909), though the differences are not that great.

Although Feinstein’s data are average weekly wages, the average number of hours worked a week stood at about 56 in 1873 and was relatively steady at this figure until 1913 (Boyer 2004: 285), so that this fact does not necessarily mean that the data is an unreliable indicator of average hourly wage rates.

What stands out is that, as the late 19th century drew to its end, British money wages seem to have already developed a strong degree of downwards rigidity. While nominal wages did fall in the period of recession and rising unemployment from the 1875 to 1879 era (which can be seen here in Wood’s data), by the recession of 1891–1893, money wages were essentially stable. In subsequent recessions in the 1897 to 1913 period (namely, in 1900–1901, 1903, and 1908), money wages remained stable and were clearly affected by wage stickiness.

It is consequently difficult to argue that the recovery in 1894 and those in subsequent years after recessions were driven by downwards wage flexibility.

Even in the recession of 1884–1885, nominal wages only fell mildly.

All in all, this would seem to confirm that downwards nominal wage rigidity, in the era of price deflation of 1873–1896, was a significant cause of the “profit deflation” that contemporaries started to complain of by the 1880s.

Further Reading
“UK Real GDP 1830–1918,” October 8, 2012.

“British Money Wages in the 1873–1896 Deflation,” December 10, 2014.

“Saul’s The Myth of the Great Depression, 1873–1896,” December 8, 2014

“Robert Giffen on the Deflation of 1873–1896,” December 7, 2014.

“Alfred Marshall on Business Confidence,” December 3, 2014.

“Alfred Marshall on Wage Stickiness and Debt Deflation,” November 30, 2014.

“The Profit Deflation of the 1890s,” June 13, 2013.

“Alfred Marshall’s Judgement on the “Depression” of 1873–1896,” June 13, 2013.

“S. B. Saul on the Profit Deflation of the 1873–1896 Period,” June 14, 2013.

“Alfred Marshall on the Deflation of 1873–1896,” October 14, 2014.

“Alfred Marshall’s Interest Rate Theory,” November 3, 2014.

BIBLIOGRAPHY
Boyer, George R. 2004. “Living Standards, 1860–1939,” in Roderick Floud and Paul Johnson (eds.), The Cambridge Economic History of Modern Britain. Volume II. Economic Maturity, 1860–1939. Cambridge University Press, Cambridge. 280–313.

Feinstein, Charles H. 1990. “New Estimates of Average Earnings in the United Kingdom, 1880–1913,” The Economic History Review n.s. 43.4: 595–632.

Wood, George H. 1909. “Real Wages and the Standard of Comfort since 1850,” Journal of the Royal Statistical Society 72: 91–103.

UK Real Per Capita GDP 1830–1913

This data is from Maddison (2003: 59, 61) and is very interesting because it has suggested to many economists that something went “wrong” with the late Victorian economy:

Real UK Per Capita GDP 1830–1913
(in 1990 international Geary-Khamis dollars)
Year | GDP | Growth rate
1830 | 1,749 |
1831 | 1,811 | 3.5449%
1832 | 1,774 | -2.0431%
1833 | 1,774 | 0%
1834 | 1,828 | 3.0441%
1835 | 1,906 | 4.2669%
1836 | 1,957 | 2.6758%
1837 | 1,912 | -2.2994%
1838 | 1,996 | 4.3933%
1839 | 2,069 | 3.6573%
1840 | 1,990 | -3.8183%
1841 | 1,930 | -3.0151%
1842 | 1,869 | -3.1606%
1843 | 1,886 | 0.9096%
1844 | 1,981 | 5.0371%
1845 | 2,067 | 4.3412%
1846 | 2,185 | 5.7087%
1847 | 2,213 | 1.2815%
1848 | 2,272 | 2.6661%
1849 | 2,334 | 2.7289%
1850 | 2,330 | -0.1714%
1851 | 2,451 | 5.1931%
1852 | 2,480 | 1.1832%
1853 | 2,555 | 3.0242%
1854 | 2,602 | 1.8395%
1855 | 2,571 | -1.1914%
1856 | 2,730 | 6.1844%
1857 | 2,757 | 0.9890%
1858 | 2,742 | -0.5441%
1859 | 2,790 | 1.7505%
1860 | 2,830 | 1.4337%
1861 | 2,884 | 1.9081%
1862 | 2,880 | -0.1387%
1863 | 2,881 | 0.0347%
1864 | 2,935 | 1.8743%
1865 | 3,001 | 2.2487%
1866 | 3,023 | 0.7331%
1867 | 2,968 | -1.8194%
1868 | 3,037 | 2.3248%
1869 | 3,031 | -0.1976%
1870 | 3,190 | 5.2458%
1871 | 3,332 | 4.4514%
1872 | 3,319 | -0.3901%
1873 | 3,365 | 1.3859%
1874 | 3,386 | 0.6241%
1875 | 3,434 | 1.4176%
1876 | 3,430 | -0.1165%
1877 | 3,425 | -0.1458%
1878 | 3,403 | -0.6423%
1879 | 3,353 | -1.4693%
1880 | 3,477 | 3.6982%
1881 | 3,568 | 2.6172%
1882 | 3,643 | 2.1020%
1883 | 3,643 | 0%
1884 | 3,622 | -0.5764%
1885 | 3,574 | -1.3252%
1886 | 3,600 | 0.7275%
1887 | 3,713 | 3.1389%
1888 | 3,849 | 3.6628%
1889 | 4,024 | 4.5466%
1890 | 4,009 | -0.3728%
1891 | 3,975 | -0.8481%
1892 | 3,846 | -3.2453%
1893 | 3,811 | -0.9100%
1894 | 4,029 | 5.7203%
1895 | 4,118 | 2.2091%
1896 | 4,249 | 3.1811%
1897 | 4,264 | 0.3530%
1898 | 4,428 | 3.8461%
1899 | 4,567 | 3.1391%
1900 | 4,492 | -1.6422%
1901 | 4,450 | -0.9351%
1902 | 4,525 | 1.6854%
1903 | 4,440 | -1.8784%
1904 | 4,428 | -0.2703%
1905 | 4,520 | 2.0777%
1906 | 4,631 | 2.4557%
1907 | 4,679 | 1.0365%
1908 | 4,449 | -4.9156%
1909 | 4,511 | 1.3936%
1910 | 4,611 | 2.2168%
1911 | 4,709 | 2.1253%
1912 | 4,762 | 1.1255%
1913 | 4,921 | 3.3389%
(Maddison 2003: 59, 61).

There were three periods into which mid- and late Victorian history is divided by historians and economic historians:

(1) the mid-Victorian inflationary boom from 1848/1850 to 1873;

(2) the period of deflation from 1873 to 1896;

(3) the inflationary boom leading up to the First World War from 1897 to 1913.

It is notable that the average real capita GDP growth rate seems to have fallen in these three periods that characterised the mid- and late-Victorian age:

Average per capita GDP Growth Rate 1848–1873: 1.6441%
Average per capita GDP Growth Rate 1850–1873: 1.5563%
Average per capita GDP Growth Rate 1874–1896: 1.0432%
Average per capita GDP Growth Rate 1873–1896: 1.057%
Average per capita GDP Growth Rate 1897–1913: 0.8912%

The research literature on whether and why the late Victorian economy failed is enormous (for a sample of some studies, see Ashworth 1966; McCloskey 1970; Crafts 1979; Crouzet 1982; Saul 1985; Foreman-Peck 1991; Lloyd-Jones and Lewis 1998), and those who think it did fail in some sense have suggested these reasons for the decline:

(1) decreased domestic investment from profit deflation and depressed expectations in the 1873 to 1896 period;

(2) decreasing export markets owing to the rise of the US and Germany and foreign competition;

(3) increasing British foreign investment at the expense of domestic investment, and

(4) an actual productivity decline from 1899–1913.

Of course, one would think that factor (1) come to an end in the inflation from 1897 onwards (and I believe there is evidence that domestic investment recovered at least to some extent), but there were other reasons that conspired to cause a continuing trend of lower real per capita GDP rates in the 1897–1913 era.

BIBLIOGRAPHY
Ashworth, W. 1966. “The Late Victorian Economy,” Economica n.s. 33.129: 17–33.

Crafts, N. F. R. 1979. “Victorian Britain Did Fail,” The Economic History Review n.s. 32.4: 533–537.

Crouzet, François. 1982. The Victorian Economy (trans. Anthony Forster). Routledge, London.

Foreman-Peck, James. 1991. New Perspectives on the Late Victorian Economy: Essays in Quantitative Economic History, 1860–1914. Cambridge University Press, Cambridge, UK and New York.

Lloyd-Jones, Roger and M. J. Lewis. 1998. British Industrial Capitalism since the Industrial Revolution. UCL Press, London and Bristol, Pa.

McCloskey, Donald N. 1970. “Did Victorian Britain Fail?,” The Economic History Review n.s. 23.3: 446–459.

Maddison, Angus. 2003. The World Economy: Historical Statistics. OECD Publishing, Paris.

Saul, Samuel Berrick. 1985. The Myth of the Great Depression, 1873–1896 (2nd edn.), Macmillan, London.

British Money Wages in the 1873–1896 Deflation

The graph below shows an index of average British money wages from 1850 to 1902, but in which the trend for the 1873 to 1896 era of price deflation can also be seen (with data from Wood 1909: 102–103).

As we can see, despite the era of strong price deflation, nominal wages either stayed fairly stable or even rose, apart from the notable initial fall in the 1875 to 1879 period. Even in the recessions of 1884–1885 and 1891–1893, money wages almost stayed level.

With price deflation it is no wonder contemporary business people were complaining of a “profit deflation” by the late 1880s.

Further Reading
“Saul’s The Myth of the Great Depression, 1873–1896,” December 8, 2014

“Robert Giffen on the Deflation of 1873–1896,” December 7, 2014.

“Alfred Marshall on Business Confidence,” December 3, 2014.

“Alfred Marshall on Wage Stickiness and Debt Deflation,” November 30, 2014.

“The Profit Deflation of the 1890s,” June 13, 2013.

“Alfred Marshall’s Judgement on the “Depression” of 1873–1896,” June 13, 2013.

“S. B. Saul on the Profit Deflation of the 1873–1896 Period,” June 14, 2013.

“Alfred Marshall on the Deflation of 1873–1896,” October 14, 2014.

“Alfred Marshall’s Interest Rate Theory,” November 3, 2014.

BIBLIOGRAPHY
Wood, George H. 1909. “Real Wages and the Standard of Comfort since 1850,” Journal of the Royal Statistical Society 72: 91–103.

Saul’s The Myth of the Great Depression, 1873–1896

Samuel B. Saul’s The Myth of the Great Depression, 1873–1896 (2nd edn. 1985) analyses the 1873 to 1896 deflationary period from the perspective of Great Britain. Saul raises many questions in this book, such as the question whether we are justified in considering 1873–1896 as a unified period of economic importance, and what causes produced the general deflationary trend.

Of course his major conclusion was that there was no actual continuous depression throughout the period, that real output at the end of the period was higher than at the beginning (Saul 1985: 54), and that the term “Great Depression” should not be used of the period (Saul 1985: 55). Furthermore, some of the trends visible in the 1873–1896 period continued afterwards and perhaps the downwards trend in prices was already underway in the 1860s and may, in some respects, have ended in the late 1880s (Saul 1985: 54). Overall the 1873–1896 period may not be a unified and historically significant era in the way previous economic historians thought (Saul 1985: 54–55).

Nevertheless, Saul also found that there were economic problems within the period (Saul 1985: 54), and a careful reading of the book shows that it presents problems for the advocates of price deflation.

I have summarised the main points and findings of Saul’s book below.

First, are we justified in seeing 1873 to 1896 as a unitary period?

Landes (1965), for example, argued that the whole period from 1815 to 1897 was essentially a unified period displaying a long-run downward trend in prices, with a plateau in prices in the middle, driven by technological advances and positive supply-side factors (Saul 1985: 13).

Nevertheless, to many historians and economists there is also something anomalous about the 1873 to 1896 deflation.

Saul (1985: 15) raises the possibility that there was an overall major factor driving the deflation until the late 1880s, but thereafter perhaps no general overall factor driving it. In fact, this was the view of Keynes in the Treatise on Money (1931), and Keynes saw monetary factors as the general cause of the deflation until the late 1880s, and then a different explanation for the 1890 to 1896 deflation (Saul 1985: 17).

Both at the time and continuing to this day, there have been two main explanations offered for the late 19th century deflation:

(1) falling prices owing to positive supply shocks and revolutionary technologies driving down prices, and

(2) a quantity theory of money explanation, either through (i) the modern neoclassical quantity theory or (ii) one stemming from the quantity tradition in Classical Economics, where the cost of production of gold was assumed to also influence changes in its “price”.

The second neoclassical quantity theory explanation has numerous supporters and certainly amongst monetarists, and it became popular by the 1980s (Saul 1985: 60). This explains the phenomenon as having been caused by the failure of the money supply to grow at a rate consistent with the growth in economic activity.

The second explanation sees the deflation as caused mainly by price falls in many goods from technological factors, innovative production techniques driving down costs and positive supply side factors. For example, freight rates on shipping from America to Britain and to the Continent fell sharply in the 1880s (Saul 1985: 22), as did overland freight rates too (Saul 1985: 23). Many agricultural goods saw price falls as production in the Americas, Australia, New Zealand, and South-East Asia increased markedly and transport costs fell.

In the end, Saul himself preferred an eclectic, not mono-causal, explanation of what caused the deflation that draws on many factors (Saul 1985: 26–28, 55).

But what about the economic problems that resulted from the deflation?

UK wages tell a very interesting story. Money wages fell from 1874 to 1879, but thereafter, despite long-run price deflation, were either stable or actually rose (apart from a brief and small fall from 1884 to 1886) (Saul 1985: 31). Real wages also rose virtually continuously from 1873 to 1896, apart from small falls from 1876–1878, 1879–1880, 1883–1884, and 1890–1892. It is clear that workers were able to maintain money wages even in the deflationary years and even during the recession of the early 1890s: in fact, in this period the share of income going to labour increased at the expense of profits (Saul 1985: 32–33, 63). This strongly confirms what contemporaries were saying: that the 1873–1896 period was marked by “proft deflation” or a profit squeeze that left business people highly pessimistic. While one cause of this for exporting industries is usually taken to be the slower growth of exports in the late 1880s (Saul 1985: 63), a fundamental cause must also have been price deflation and a significant degree of downwards nominal wage rigidity.

There emerges a further crucial point from the “profit deflation” phenomenon of these years. In Britain, it appears that a major source of business and industrial finance in the late 19th century was retained earnings out of profits (Saul 1985: 41). Saul adduces evidence that the share of profits out of industrial income fell as the deflation of 1873–1896 proceeded (Saul 1985: 42, citing Feinstein 1959), as can be seen in the following graph.

As we can see, the inflationary boom of the mid-Victorian age (1850–1873) saw rising levels of profits, but when the long-run deflation occurred, the percentage of profits of total industrial income fell significantly. It is possible too that what we would now call UK capacity utilisation rates fell in the late 19th century in this period (Saul 1985: 43, citing Ashworth 1966).

Saul blames institutional factors, the negative legacy of Britain’s “early start” in industrialisation, and the decline in Britain’s overseas export markets in the late 19th century for its failure to innovate and its lower levels of investment (Saul 1985: 51).

But he also points to another important explanation: it can be argued that, given that UK investment was financed out of retained earnings to an important degree, the price deflation led to a falling profit rate given relatively inflexible wages so that this probably adversely affected aggregate investment and expectations (Saul 1985: 53–54). This actually stands out as one of Saul’s most important conclusions (Saul 1985: 53–54).

So the effects of the “profit deflation” on business expectations were significantly negative, which probably caused increasing pessimism and unwillingness to invest. Saul, however, does not address the issue of debt deflation as a cause of business pessimism, but it may have been an important factor, and there seem to be hints from contemporaries like Alfred Marshall that it was a factor.

Finally, recent estimates of UK unemployment in the late 1800s show that significant unemployment did exist for much of this period, as can be seen in the graph below (with data from Boyer and Hatton 2002).

Further Reading
“Robert Giffen on the Deflation of 1873–1896,” December 7, 2014.

“Alfred Marshall on Business Confidence,” December 3, 2014.

“Alfred Marshall on Wage Stickiness and Debt Deflation,” November 30, 2014.

“The Profit Deflation of the 1890s,” June 13, 2013.

“Alfred Marshall’s Judgement on the “Depression” of 1873–1896,” June 13, 2013.

“S. B. Saul on the Profit Deflation of the 1873–1896 Period,” June 14, 2013.

“Alfred Marshall on the Deflation of 1873–1896,” October 14, 2014.

“Alfred Marshall’s Interest Rate Theory,” November 3, 2014.

BIBLIOGRAPHY
Ashworth, W. 1966. “The Late Victorian Economy,” Economica n.s. 33.129: 17–33.

Beckworth, David. 2007. “The Postbellum Deflation and its Lessons for Today,” The North American Journal of Economics and Finance 18.2: 195–214.

Boyer, George R. and Timothy J. Hatton. 2002. “New Estimates of British Unemployment, 1870–1913,” The Journal of Economic History 62.3: 643–667.

Capie, F. H. and G. E. Wood, 1997. “Great Depression of 1873–1896,” in D. Glasner and T. F. Cooley (eds). Business Cycles and Depressions: An Encyclopedia. Garland Pub., New York. 287–288.

Feinstein, Charles H. 1959. “Home and Foreign Investment: Some Aspects of Capital Formation, Finance and Income in the United Kingdom, 1870–1913,” Ph.D. dissert., University of Cambridge.

Hanes, C. 1998. “Consistent Wholesale Price Series for the United States, 1860–1990,” in Trevor J. O. Dick (ed.), Business Cycles since 1820: New International Perspectives from Historical Evidence. E. Elgar, Cheltenham, UK and Northampton, MA.

Landes, D. S. 1965. “Technological Change and Development in Western Europe, 1750–1914,” in H. J. Habakkuk and M. Postan (eds.) The Cambridge Economic History of Europe (vol. 6). Cambridge University Press, Cambridge. 274–601.

Saul, Samuel Berrick. 1985. The Myth of the Great Depression, 1873–1896 (2nd edn.), Macmillan, London.

Robert Giffen on the Deflation of 1873–1896

In 1885, Robert Giffen (1837–1910), the Scottish statistician and economist who from 1876 held a number of positions in the British Board of Trade, published an article on the ongoing price deflation that had begun in 1873 and its effects on UK business (Giffen 1885).

In this fascinating passage from a later reprint of the article in Giffen’s book Essays in Finance (3rd edn. 1890), he seems to be grasping at what we would now call the issues of expectations, profit deflation, and debt deflation as the causes of the business pessimism at that time:

“A third remark I have to make at the outset is that as trade depression may arise from very small changes in the total amount of production, while industrial organization is of such a nature that such changes need cause no surprise, it becomes equally no matter for surprise that changes in prices have so intimate a connection with the subject. The feeling of depression, judged by the realities of things, frequently appears to be either wholly unaccountable or to go far beyond what the facts warrant. And the explanation would seem to be that as there is a general rise of prices in prosperous times, and prices remain then at a high level, so in times of ‘depression,’ when production and consumption and saving are diminished by a small percentage as compared with what they are at other times, there is often a general fall of prices, and it is this fall of prices which produces much of the gloom. Merchants and capitalists are hit by it. At their stock-takings, with the same quantities of goods, or even with greater quantities, their nominal capital appears reduced. In falling markets their operations result steadily in loss for a considerable period. Many who have conducted operations with borrowed money are cleaned out, and fail. The community need be none the poorer. The goods themselves are not destroyed. Somebody gets the benefit of the lower prices. But the leaders of industrial enterprise, those who run the machine, are all poorer, and feel even poorer than they really are, as they are accustomed to look mainly at nominal values, and not at the quantities of the things themselves which they possess. The moral is that economists and public men should beware to some extent of the outcry from the market-place. Merchants and capitalists are not the whole community. Their interest in the long run is the same as that of all. No community can prosper steadily with its mercantile classes depressed. But the immediate interest of particular classes is often different from that of the community generally, and in this way it is not surprising that the gloom of the market-place in times of depression should appear altogether excessive in relation to the real circumstances of the community as a whole. Apart from exaggeration, which is also a factor to be reckoned with, the particular classes who cry out most from time to time about depression may suffer specially from evils which injuriously affect the community as a whole very little, or may even affect it momentarily for good.” (Giffen 1890: 5–6).

Giffen understood that price deflation can tend to produce depressed expectations and pessimism amongst business people, as Alfred Marshall did, but on the whole thought this pessimism was unwarranted. He could not take the further step of seeing how business pessimism itself can reduce aggregate investment and employment. Also, quite fascinating is Giffen’s observation that business people are more interested in nominal values, rather than real values. Giffen also notes how the deflation was “diminishing the profits of capitalists” (Giffen 1890: 22), a trend also noted by Alfred Marshall in 1887 as one of “profit deflation.”

Giffen was also well aware that prices had begun a long-run downward trend from 1873 and connected this directly with depressed business expectations:

“The most disastrous characteristic of the recent fall of prices has been the descent all round to a lower range than that of which there had been any previous experience. It is this peculiarity which more than anything else has aggravated the gloom of merchants and capitalists during the last few years. Fluctuations of prices they are used to. Merchants know that there is one range of prices in a time of buoyancy and inflation, and quite another range in times of discredit. By the customary oscillations the shrewder business people are enabled to make large profits. But during the last few years the shrewder as well as the less shrewd have been tried. Operations they ventured on when prices were falling to the customary low level have failed disastrously because of a further fall which is altogether without precedent. Similarly, landowners and other capitalists who are usually beyond the reach of fluctuations have had their margins invaded; rents, which rose so steadily for twenty years before 1873, have consequently fallen heavily; the change is more like a revolution in prices than anything which usually happens in an ordinary cycle of prosperity and depression in trade.” (Giffen 1890: 14–15).

“This is another way of putting the fact that merchants and capitalists have lately encountered a descent of prices below the customary level, which has greatly put them out and involved them in fresh and most unexpected difficulties. The minimum of the former period has almost become the maximum of the new, and operations based on the former customary levels have failed.” (Giffen 1890: 17–18).

Giffen, like other commentators at that time, was aware that there was something atypical and remarkable about the long-run deflationary trend from 1873, and that something like a price revolution was occurring.

Next, Giffen concludes that that there was some major underlying cause driving the deflation from 1873, and reviews the two proposed explanations at that time:

“The question then arises on these figures whether the depression at a time like the present may not be largely due to some permanent cause which has lately begun to operate; to which trade was not subject for many years after 1850, and which is now in full operation; and which has for its effect to prevent a rise of prices in good years to what was long considered the customary maximum, and to precipitate a fall in bad years to a point much below the customary minimum. That the answer must be in the affirmative appears to be very clear. There is no mystery at all about the actual course of prices, while the effect of the recent changes in diminishing the profits of capitalists, because the upward movement of prices is less than they expect, and the downward movement greater, is equally palpable. Merchants and capitalists all round have suffered. They have held stocks longer, or bought stocks sooner, than they would have done if they had not to some extent lost their bearings. Their gloom is great, because prices are obstinately low. Whatever may be the cause of so great a change, it is surely worth investigation.

Two causes only have been suggested. One is a great multiplication of commodities and diminution of the cost of production due to the progress of invention, improved facilities of communication, lower freights, international telegraphy, and the like circumstances. The other is, that the precious metal used for standard money—viz., gold—has become relatively scarcer than it was, its production being diminished on the one hand, and the demands for it on the other hand increased. The former of these causes was discussed quite lately by Mr. Fowler, in the Contemporary Review, and a greater weight assigned to it than to the latter cause. I am disposed to give the greater weight to the latter. To a large extent, however, the two causes are not in conflict. The question is of money prices—the relation of money to commodities. Whether it is commodities that multiply, or gold that diminishes or does not multiply in proportion, the relation between gold and the mass of commodities is equally changed. It is quite conceivable that if gold were to increase in quantity, and its cost of production to diminish, as other commodities increase in quantity and have their cost of production diminished, there would be no change of any kind in gold prices. Commodities would be more abundant, but the abundance would make itself felt in a rise of money wages, salaries, rents, and profits, and not in lower prices. That it is felt in lower prices now appears to be absolute proof that the relation between gold and commodities has changed, that they have not increased in quantity and had their cost of production diminished pari passu. In addition, however, while not denying that there has been a change on the commodities side of the balance, I would go farther and maintain that what has happened to gold in the way of diminished production and increased demands upon it, arising from other causes than the multiplication of commodities, must have had great effect.” (Giffen 1890: 22–23).

The two explanations Giffen mentions are:

(1) falling prices owing to positive supply shocks and revolutionary technologies driving down prices, and

(2) a quantity theory of money explanation, though not quite a modern neoclassical one, but one stemming more from the quantity tradition in Classical Economics, where the cost of production of gold was assumed to also influence changes in its “price”.

Giffen (1890: 24–25) noted that as gold production fell off after 1875, actual demand for gold rose as nations like Germany, the US and Italy went on the gold standard (or in the case of the US returned to it).

Giffen sees the influence of gold supply in relation to demand as the crucial factor:

“Looking at all the facts, therefore, it appears impossible to avoid the conclusion that the recent course of prices, so different from what it was just after the Australian and Californian gold discoveries, is the result in part of the diminished production and the increased extraordinary demands upon the supply of gold. It is suggested, indeed, that the increase of banking facilities and other economies in the use of gold may have compensated the scarcity. But the answer clearly is that in the period between 1850 and 1865, and down to 1873, the increase of banking facilities and similar economies was as great relatively to the arrangements existing just before as anything that has taken place since. The same reply may also be made to the suggestion that the multiplication of commodities accounts for the entire change that has occurred. There is no reason to suppose that the multiplication of commodities relatively to the previous production has proceeded at a greater rate since 1873 than in the twenty years before that. Yet before 1873 prices were rising, notwithstanding the multiplication of commodities; and since that date the tendency has been to decline. The one thing which has changed, therefore, appears to be the supply of gold and the demands upon it; and to that cause largely we must accordingly ascribe the change in the course of prices which has occurred.” (Giffen 1890: 27)

The question of what the causes of the great deflation of 1873 to 1896 were remains a very interesting one, and we can see here how some economists at the time like Giffen explained it.

To sum up, we can also see how, despite modern libertarian myths to the contrary, the great deflation of 1873 to 1896 caused a great deal of consternation and business pessimism at the time. This was described in the both the business press and academic writings of the late 19th century (e.g., see Marshall 1887; Wells 1887a, 1887b, 1887c, 1887d).

Further Reading
“Alfred Marshall on Business Confidence,” December 3, 2014.

“Alfred Marshall on Wage Stickiness and Debt Deflation,” November 30, 2014.

“The Profit Deflation of the 1890s,” June 13, 2013.

“Alfred Marshall’s Judgement on the “Depression” of 1873–1896,” June 13, 2013.

“S. B. Saul on the Profit Deflation of the 1873–1896 Period,” June 14, 2013.

“Alfred Marshall on the Deflation of 1873–1896,” October 14, 2014.

“Alfred Marshall’s Interest Rate Theory,” November 3, 2014.

BIBLIOGRAPHY
Giffen, Robert. 1885. “Trade Depression and Low Prices,” The Contemporary Review 47 (June): 800–822.

Giffen, Robert. 1890. Essays in Finance (3rd edn.). George Bell and Sons, London.

Marshall, Alfred. 1887. “Remedies for Fluctuations of General Prices,” The Contemporary Review 51 (March): 355–375.

Wells, David A. 1887a. “The Fall of Prices,” The Contemporary Review 52 (1 July): 523–548.

Wells, David A. 1887b. “The Fall of Prices II,” The Contemporary Review 52 (1 July): 628–643.

Wells, David A. 1887c. “The Great Depression of Trade I,” The Contemporary Review 52 (1 July): 295.

Wells, David A. 1887d. “The Great Depression of Trade II,” The Contemporary Review 52 (1 July): 381.

US Monetary Policy and the Recession of 1920–1921

There are all sorts of discussion of this at the moment such as here, here, here, here, here and here.

The libertarian commentary is attempting to deny that monetary policy had a significant role in the recovery of 1921.

In response to this, it can be said, firstly, that the American banking and financial system did not collapse in 1920–1921, as in 1929–1933. Confidence in banks was, more or less, maintained. An important reason for this was undoubtedly the Federal Reserve banking system acting as a lender of last resort with its discounting policy in 1920 to an extent sufficient to avert a mass panic and bank runs, as argued by Wicker (1966: 223). Indeed, the evidence shows that the number of bills discounted by Federal Reserve banks soared until nearly the end of 1920. This fact alone is enough to damn the idea that the recovery from recession in 1921 was unaided by significant government intervention. Without a basic lender of last resort in 1920, admittedly following the classic guidelines of Bagehot to lend at a penalty rate to businesses in distress, it is unlikely recovery would have been so easy or rapid in 1921.

To some extent too, the US economy was just lucky in 1920–1921: discount rate policy proved sufficient to avert banking collapse (instead of bailouts and much more radical intervention that was required in 1929–1933 but not done), the economy was not hit by the type of debt deflation (except perhaps to some extent amongst farmers) as it was in 1929–1933, nor were financial markets affected by the collapse of a massive debt-fuelled asset bubble as in 1929, nor were aggregate demand shocks as bad either. Even the price deflation was partly, and perhaps even significantly, the result of positive supply shocks after the end of WWI and the resumption of shipping, trade and production (Romer 1988: 110; Vernon 1991), not simply from severe aggregate demand shocks.

To return to monetary policy, while the broad US monetary aggregates M1 and M2 did fall in late 1920 and 1921, they clearly did not suffer a disastrous collapse to the same extent as money supply from 1929 to 1933. For example, the broad money supply as measured by M2 fell by about 6.37% from Q3 1920 to Q2 1921, but began growing again in Q3 1921, as can be seen in the graph below (with data from Balke and Gordon 1986: 803).

In contrast, M2 contracted by an incredible 35.31% between 1929 and 1933, as credit contraction, bank runs and over 9,000 US bank failures (Wells 2004: 51) destroyed demand-deposit money and savings held by the public, while the 1920–1921 recession did not have such mass bank runs or liquidity crises in banks (Friedman and Schwartz 1963: 235), and even if some bank failures did occur one wonders whether the M2 monetary contraction was caused more by negative credit growth than by loss of deposits.

The second element of US monetary policy in 1920–1921 was the discount rate as set by regional Federal Reserve banks. At the beginning of 1921 the discount rates of the Federal Reserve banks were either 6% or 7% (data in Discount Rates of the Federal Reserve Banks 1914–1921, 1922). In May a number of regional Federal Reserve banks began lowering discount rates from 7% to 6.5%. Then in July a number of rates were cut from 6% to 5.5%, and to 4.5% to 5% by the end of the year. The recovery from the recession is usually dated to July 1921, so that discount rate cuts did indeed precede the recovery.

The libertarians claim that these rate cuts did not necessarily create loose monetary policy or easy money, but most probably the rate cuts beginning in May 1921 had a great influence on the economy by way of expectations and business confidence – especially by helping to create confidence and expectations of continuing rate cuts and looser monetary policy in the future, as indeed did happen.

Another point that seems to be ignored is that the Federal Reserve system embarked on a proto-form of quantitative easing from late 1921 in which the Federal Reserve banks bought government bonds from November 1921 to June 1922 and tripled such holdings from $193 million in October 1921 to $603 million by May 1922 – a fact even noted by Rothbard (2000: 133), who complained that, to the Federal Reserve officials, “[i]nflation seemed justified as a means of promoting recovery from the 1920–1921 slump, to increase production and relieve unemployment” (Rothbard 2000: 133). Strange how modern libertarians seem to have forgotten this.

BIBLIOGRAPHY
Balke, Nathan and Robert J. Gordon. 1986. “Appendix B Historical Data,” in Robert J. Gordon (ed.), The American Business Cycle: Continuity and Change. University of Chicago Press, Chicago. 781–850.

Discount Rates of the Federal Reserve Banks 1914–1921, Government Printing Office, 1922.

Friedman, Milton and Anna Jacobson Schwartz. 1963. A Monetary History of the United States, 1867–1960. Princeton University Press, Princeton.

Romer, C. D. 1988. “World War I and the Postwar Depression: A Reinterpretation based on Alternative Estimates of GNP,” Journal of Monetary Economics 22.1: 91–115.

Rothbard, Murray N. 2000. America’s Great Depression (5th edn.). Ludwig von Mises Institute, Auburn, Alabama.

Vernon, J. R. 1991. “The 1920–21 Deflation: The Role of Aggregate Supply,” Economic Inquiry 29: 572–580.

Wicker, Elmus R. 1966. “A Reconsideration of Federal Reserve Policy during the 1920–1921 Depression,” The Journal of Economic History 26.2: 223–238.