Steven Horwitz on Stimulus Spending and Hayek

Steve Horwitz has the following post here on the London School of Economics (LSE) blog:

Steven Horwitz, “The Work of Friedrich Hayek shows Why EU Governments cannot spend their Way out of the Eurozone Crisis,” LSE blog, 21 August, 2012.

In response, we can say the following:

(1) His analysis is based on the false Austrian business cycle theory (ABCT). Despite Horwitz, the crisis of 2008 did not occur because the US “economy’s productive structure was not sustainable.” It was about the collapse of an asset bubble, excessive private debt, and a financial crisis caused by the collapse in value of the collateralized debt obligations (CDOs) and mortgage backed securities (MBSs) that banks had loaded up on.

(2) Horwitz charges that “advocates of stimulus are arguing is that we need spending, just any old spending, to jump start struggling economies” – a manifestly false claim. Post Keynesians and, I suspect, even New Keynesians understand that spending on asset bubbles would be just another disaster, and that what is needed is thoughtful public investment and social spending, not “just any old spending.”

(3) The issue of using resources that are not idle is raised by Horwitz, but he ignores the obvious point that, even if a stimulus project takes resources already employed, eventually, as a consequence, idle resources will be drawn on by both private and public sector investment projects in need of further factor inputs. Also, Horwitz conveniently ignores that fact that expansionary fiscal policy itself involves not just public investment, but expanding the capacity of the private sector to engage in consumption spending: with more private sector demand, businesses will also hire more workers and increase output.

(4) Horwitz contends that “Politicians and bureaucrats lack the knowledge to know which pieces fit with which pieces as they cannot know the nature of the idled resources and what consumers want.” And yet Keynesian stimulus worked again and again throughout American history when tried: real output soared and unemployment fell when expansionary fiscal policy was done by the US government in 1948–1949, 1954, 1958, 1961, 1964, and 1982. The Austrians might reply that such expansionary fiscal and monetary policies caused Austrian business cycles in all these cases, but that reply is worthless, simply because the Austrian cycle theory is worthless.

(5) Horwitz writes:

“So what can we do? The answer lies in the criticism: free up competition, prices, profits, and losses so that entrepreneurs and others can finish the process of tearing down the mistakes of the boom and figure out how to reallocate those resources to their new best uses. That process takes time, but if politicians cease meddling in it and start allowing market processes to do their job, particularly by allowing failed firms to go bankrupt and sell off their assets for more valuable uses, recovery will take place more quickly.”

This all sounds like liquidationism to me. Horwitz invokes Hayek in his blog title, but fails to tell us that even Hayek eventually repudiated liquidationism, and gave qualified support to Keynesian stimulus in a depression, as we can see here:

“To return, however, to the specific problem of preventing what I have called the secondary depression caused by the deflation which a crisis is likely to induce. Although it is clear that such a deflation, which does no good and only harm, ought to be prevented, it is not easy to see how this can be done without producing further misdirections of labour. In general it is probably true to say that an equilibrium position will be most effectively approached if consumers’ demand is prevented from falling substantially by providing employment through public works at relatively low wages so that workers will wish to move as soon as they can to other and better paid occupations, and not by directly stimulating particular kinds of investment or similar kinds of public expenditure which will draw labour into jobs they will expect to be permanent but which must cease as the source of the expenditure dries up.” (Hayek 1978: 210–212).

(6) The most astonishing statement by Horwitz in the whole post comes at the end:

“Before the advent of Keynesianism, most recessions were very short lived as producers were left free to shuffle the jigsaw pieces into better combinations.”

This distorts history on so many levels it beggars belief.

Take the recession that Austrians claim proves their prescription of liquidationism: the recession of 1920–1921. This lasted 18 months, and was far longer than every post-1945 US recession on record, with the exception of the great recession of 2008–2009 (which also lasted 18 months). This can easily be verified by looking at the NBER data here.

The official estimates from the National Bureau of Economic Research (NBER) show clearly that the length of recessions fell very significantly when modern Keynesian and monetary interventions were used to ameliorate recessions after 1945:

Period | Average Length of Recessions in Months
1854–1919 (16 cycles) | 21.6
1919–1945 (6 cycles) | 18.2
1945–2009 (11 cycles) | 11.1
US Business Cycle Expansions and Contractions, http://www.nber.org/cycles/cyclesmain.html

Now you could complain that the traditional data for the 19th century has been challenged by Romer and Balke and Gordon, but that does not apply to the 1919–1945 period, which shows us quite clearly that the average length of recessions fell after 1945.

The issue of the length and severity of pre-1914 recessions is highly controversial, of course. We will only ever have estimates, whose validity and accuracy is open to question. The old Kuznets-Kendrick GNP series showed beyond any doubt that the pre-1914 era saw far more severe and longer recessions than those after 1945. While that data was challenged by Romer (1989), whose findings could be used to support Horwitz, it is now clear that there are problems with Romer’s estimates and method.

At best, one might appeal to the work of J. Davis (2006; 2004), but he only found no difference between the frequency and average length of recessions in the period 1880-1914 (the National Banking era) and the post-1945 era. If you really think Davis is correct, then that would still refute Horwitz.

In contrast, the work of Balke and Gordon essentially vindicate the Kuznets-Kendrick GNP series in terms of the improvement in output volatility after 1945 as compared with the pre-1914 era (see Appendix below).

Now the measure of how serious a recession is consists of (1) length of output contract, and (2) how long unemployment persists after the recession.

To look more seriously at the 19th century data, let us take the real GDP estimates of Balke and Gordon and the unemployment estimates by J. R. Vernon for the US from 1870–1900.

First, real GDP:

Year | GNP* | Growth Rate
1869 | 78.2 |
1870 | $84.2 | 7.67%
1871 | $88.1 | 4.63%
1872 | $91.7 | 4.08%
1873 | $96.3 | 5.01%
1874 | $95.7 | -0.62%
1875 | $100.7 | 5.22%
1876 | $101.9 | 1.19%
1877 | $105.2 | 3.23%
1878 | $109.6 | 4.18%
1879 | $123.1 | 12.31%
1880 | $137.6 | 11.77%
1881 | $142.5 | 3.56%
1882 | $151.6 | 6.38%
1883 | $155.3 | 2.44%
1884 | $158.1 | 1.80%
1885 | $159.3 | 0.75%
1886 | $164.1 | 3.01%
1887 | $171.5 | 4.50%
1888 | $170.7 | -0.46%
1889 | $181.3 | 6.20%
1890 | $183.9 | 1.43%
1891 | $189.9 | 3.26%
1892 | $198.8 | 4.68%
1893 | $198.7 | -0.05%
1894 | $192.9 | -2.91%
1895 | $215.5 | 11.7%
1896 | $210.6 | -2.27
1897 | $227.8 | 8.16%
1898 | $233.2 | 2.37%
1899 | $260.3 | 11.6%
1900 | $265.4 | 1.95%
* Billions of 1982 dollars
(Balke and Gordon 1989: 84).

It should be noted that these estimates are annualised, and no doubt conceal a number of recessions which lasted for 2 or 3 quarters in one year, where overall annual GDP growth was higher in the year of recession on the previous year. Likewise, where recessions lasted 2 or 3 quarters and spanned two years, but where overall annual GDP growth was higher in the second year on the previous year.

What is notable here is the double dip recession of 1893–1896: not a short recession by any means.

Next let us look at US unemployment in the late 19th century:

Year | Unemployment Rate
1869 | 3.97%
1870 | 3.52%
1871 | 3.66%
1872 | 4.00%
1873 | 3.99%
1874 | 5.53%
1875 | 5.83%
1876 | 7.00%
1877 | 7.77%
1878 | 8.25%
1879 | 6.59%
1880 | 4.48%
1881 | 4.12%
1882 | 3.29%
1883 | 3.48%
1884 | 4.01%
1885 | 4.62%
1886 | 4.72%
1887 | 4.30%
1888 | 5.08%
1889 | 4.27%
1890 | 3.97%
1891 | 4.34%
1892 | 4.33%
1893 | 5.51%
1894 | 7.73%
1895 | 6.46%
1896 | 8.19%
1897 | 7.54%
1898 | 8.01%
1899 | 6.20%
(Vernon 1994: 710).

I have highlighted in yellow those years where unemployment was over 5% and the years where unemployment showed a tendency to rise when it was above 5%.

By these figures, there was a marked rise in unemployment in the 1875–1878 and 1894–1898 periods. The double dip recession of the 1890s explains the rising unemployment from 1893–1896, and there was stubbornly high unemployment until 1898.

The high unemployment in the late 1870s also suggests serious problems in these years. The GDP growth after the recession of 1874 was a “jobless recovery.”

Although Balke and Gordon show positive GNP growth rates from 1875–1878, earlier estimates of GNP showed that the US economy experienced a recession in these years, with the NBER data showing the longest recession in US history from October 1873 to March 1879 (a 65 month recession). In view of the unemployment estimates for these years, at the very least there appears to have been contraction in certain important sectors. It is notable that, most recently, Davis (2006: 106) has found a recession from 1873 to 1875 lasting about two years, a contraction of around 24 months, or about 6 months longer than the longest post-1945 contraction on record (that of 2008-2009, which lasted 18 months).

By these figures alone, it is obvious that the late 19th-century US economy was sick in both the 1870s and 1890s. Recovery from recession was not rapid or smooth in either decade. Above all, the double dip recession of the early 1890s was quite long in terms of actual real output contraction.

For the 19th century, when we consider the impact of high unemployment following a recession, this makes nonsense of Horwitz’s statement that before “the advent of Keynesianism, most recessions were very short lived as producers were left free to shuffle the jigsaw pieces into better combinations.”


Appendix: Output Volatility pre-1914 and post-1945

What about output volatility before 1914 as compared with the post-1945 period?

I will quote Selgin et al. (2010) on this, since Selgin and his co-authors are libertarians:

“According to Romer‘s own pre-1929 GNP series, which relies on statistical estimates of the relationship between total and commodity output movements (instead of Kuznets‘ naïve one-to-one assumption), the cyclical volatility of output prior to the Fed‘s establishment was actually lower than it has been throughout the full (1915-2009) Fed era ... More surprisingly, pre-Fed (1869-1914) volatility (as measured by the standard deviations of output from its H-P trend) was also lower than post-World War II volatility, though the difference is slight.” (Selgin et al. 2010: 10)

“Romer‘s revisions have themselves been challenged by others, however, including Zarnowitz (1992, pp. 77-79) and Balke and Gordon (1989). The last-named authors used direct measures of construction, transportation, and communication sector output during the pre-Fed era, along with improved consumer price estimates, to construct their own historic GNP series. According to this series, the standard deviation of real GNP from its H-P trend for 1869 to 1914 is 4.27%, which differs little from the standard–series value of 5.10%. Balke and Gordon‘s findings thus appear to vindicate the traditional (pre-Romer) view.” (Selgin et al. 2010: 11).

While Selgin et al. cite other evidence that they believe vindicates Romer (see their paper), my point here is to make clear that Balke and Gordon confirm that modern macroeconomic management of the US economy has improved output volatility.

BIBLIOGRAPHY

Balke, N. S., and R. J. Gordon, 1989. “The Estimation of Prewar Gross National Product: Methodology and New Evidence,” Journal of Political Economy 97.1: 38–92.

Davis, J. H. 2004. “An Annual Index of U.S. Industrial Production, 1790-1915,” Quarterly Journal of Economics 119.4: 1177-1215.

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

Hayek, F. A. von. 1978. New Studies in Philosophy, Politics, Economics, and the History of Ideas. Routledge & Kegan Paul, London.

Romer, C. D. 1989. “The Prewar Business Cycle Reconsidered: New Estimates of Gross National Product, 1869–1908,” Journal of Political Economy 97.1: 1–37.

Selgin, G. A., Lastrapes, W. D. and L. H. White, 2010. “Has the Fed Been a Failure?” Cato Working Paper no. 2 (November 9).
http://www.cato.org/pubs/researchnotes/WorkingPaper-2.pdf

Vernon, J. R. 1994. “Unemployment Rates in Post-Bellum America: 1869–1899,” Journal of Macroeconomics 16: 701–714.

Zarnowitz, V. 1992. Business Cycles: Theory, History, Indicators, and Forecasting, University of Chicago Press, Chicago.

Steven Horwitz on Herbert Hoover: Mostly Misleading

Steve Horwitz presents an Austrian view of the economic history of Herbert Hoover’s administration here:

Steve Horwitz, “Ol’ Kruggie is at It Again,” Coordination Problem, February 20, 2012.

However, I think it is ultimately more misleading than illuminating.

First, credit where credit is due: Horwitz is perfectly correct that Hoover was not a liquidationist. Hoover is unfairly caricatured as an advocate of the extreme liquidationist solution to the Great Depression, a solution which was actually recommended by Andrew Mellon (US Treasury Secretary from 1921–1931). In truth, Hoover rejected extreme liquidationism, and attempted to fight the onset of the Great Depression with a number of limited interventions, including increased government spending. On this, Krugman is wrong to suggest that Hoover was a true liquidationist or that he advocated “savage spending cuts.” Horwitz gets this right, but the rest of his post is poor history without proper context.

Let us review the points Horwitz makes:

(1) First, some background. In the US, the fiscal year before 1976 ran from July 1 to June 30 in the next year. So in the relevant years the actual fiscal years were as follows:

Fiscal 1929: July 1, 1928 – June 30, 1929
Hoover inaugurated March 4, 1929
Fiscal 1930: July 1, 1929 – June 30, 1930
Fiscal 1931: July 1, 1930 – June 30, 1931
Fiscal 1932: July 1, 1931 – June 30, 1932
Fiscal 1933: July 1, 1932 – June 30, 1933
Roosevelt inaugurated March 4, 1933.

The figures for federal government spending and the surplus/deficit:

Fiscal Year | Federal Budget
Fiscal 1929 | $3.127 billion (5.60% increase on 1928)
Hoover (March 4, 1929–March 4, 1933)
Fiscal 1930 | $3.320 billion (6.17% increase on 1929)
Fiscal 1931 | $3.577 billion (7.74% rise on 1930)
Fiscal 1932 | $4.659 billion (30.25% rise on 1931)
Fiscal 1933 | $4.598 billion (1.31% fall on 1932).

Fiscal Year | Surplus or Deficit
Fiscal 1930 | $0.7 billion surplus
Fiscal 1931 | $0.5 billion deficit
Fiscal 1932 | $2.7 billion deficit
Fiscal 1933 | $2.6 billion deficit.

I quote Horwitz’s comments below and then reply to them:

“The 1929 budget was $3.1 billion, and Hoover’s first budget in 1930 had $3.3 billion in spending, followed by $3.6 billion, $4.7 billion, and $4.6 billion over the following three years.”

Yet Horwitz leaves out the following crucial points:

(i) In fiscal year 1930 (July 1, 1929 – June 30, 1930), as the depression became a very serious contraction indeed, Herbert Hoover actually ran a federal budget surplus, not a deficit. The net effect of federal fiscal policy on its own was contractionary, not expanionary. Hoover’s first deficit was in fiscal year 1931, when the US economy had already begun contracting severely.

(ii) The Federal Reserve raised the discount rate in 1931.

(iii) Hoover also cut spending in fiscal year 1933, and the net effect of federal fiscal policy in fiscal 1933 was contractionary against 1932. This was made worse by the Revenue Act of 1932 (June 6) which increased taxes across the board and applied to fiscal year 1932 and subsequent years (a measure which, curiously, Horwitz later mentions, but fails to understand properly). These were highly contractionary measures, and these two policies are the very antithesis of Keynesianism!

(iv) This leaves us with fiscal years 1931 and 1932. In both years it has long been known that federal fiscal policy was mildly expanionary, but not large relative to the GNP collapse. In 1931, for example, fiscal expansion included the Veterans’ Bonus Bill, but this was passed over Hoover’s objections. Hoover does not look like a big spending Keynesian on this score.

Now the budget may have expanded demand by 2% of GNP in 1931 more than the 1929 budget, but this was not large relative to the collapse of GNP, which is the key (Temin 1989: 27–28). In 1931, GNP collapsed by 16.11% relative to its level in 1930, from $91.2 billion to $76.5 billion. That is to say, in 1931, US GDP collapsed by $14.7 billion dollars, in a debt deflationary spiral with bank failures and a collapse in consumption, employment and investment. If we assume a multiplier of 4 (which is very high), then Hoover’s federal spending increase of $257 million dollars in fiscal year 1931 might have generated at most $1.028 billion of GDP in fiscal year 1931 (the effect of state and local fiscal policy reduced this, however). But GDP fell by $14.7 billion dollars, and it is the height of idiocy to seriously argue that Hoover’s increase in spending in fiscal year 1931 could have prevented the depression, to offset such a catastrophic fall in GDP. It could never have done any such thing.

Much the same applies to fiscal year 1932. In 1932, US GDP collapsed by $17.8 billion dollars. If we assume a multiplier of 4 again, in theory Hoover’s federal spending increase of $1.082 billion dollars might have generated $4.32 billion of GDP in fiscal year 1932 (in practice, state and local austerity, however, counteracted the effect of federal fiscal policy). But that was not even remotely enough to stop a collapse in GDP of $17.8 billion dollars.

(2) Horwitz continues:

“In nominal terms, [sc. Hoover] … increased spending 48 percent over the last budget of the previous administration. However, this period was one of significant deflation, so if we adjust for the approximately 10 percent per year fall in prices over that period, the real size of government spending in 1933 was almost double that of 1929.”

There is a crucial point Horwitz leaves out: in 1929, total federal spending was only about 2.5% of GNP (Stein 1966: 189–223). Government spending as a percentage of GNP rose in 1929–1933 mostly because GNP collapsed, not because Hoover radically increased government spending. Look at the actual annual increases in federal spending here:

Year | Federal Budget
Fiscal 1929 | $3.127 billion (5.60% increase on 1928)
Hoover (March 4, 1929–March 4, 1933)
Fiscal 1930 | $3.320 billion (6.17% increase on 1929)
Fiscal 1931 | $3.577 billion (7.74% rise on 1930)
Fiscal 1932 | $4.659 billion (30.25% rise on 1931)
Fiscal 1933 | $4.598 billion (1.31% fall on 1932).

Total spending was cut in 1933. If we look at the federal spending increases in the 1920s, 6–7% increases in fiscal 1930 and 1931 were not really much larger than the annual increases that had happened in the 1920s. There was nothing spectacular about Hoover’s spending increases in fiscal 1930 and 1931. In fiscal 1930, Hoover actually ran a budget surplus and drained money and contracted demand in America’s economy.

The only year that does stand out is fiscal 1932, where there was a 30.25% rise over fiscal 1931. But even here we are talking about an increase of only $1.08 billion in a year when GNP fell by $17.8 billion dollars. Hoover’s increase in fiscal 1932 was feeble and ridiculously small compared to the scale of the GNP decline.

(3) Horwitz:

“The budget deficits of 1931 and 1932 represented 52.5 percent and 43.3 percent of total federal expenditures. No year between 1933 and 1941 under Roosevelt had a deficit that large.”

I am not sure how the first figure was calculated. In fiscal 1931 the federal budget was $3.577 billion and the deficit was $0.5 billion. I calculate that the deficit was merely 13.97% of total federal expenditures in fiscal 1931. In fiscal 1932, the deficit was 57.9% of total federal expenditures. But this figure is grossly misleading without further context. The deficit was not large relative to the size of the GNP collapse.

(4) Horwitz lists a number of interventions Hoover introduced in 1931, such as the Reconstruction Finance Corporation, Home Loan Bank, Hoover’s executive order on immigration, enforcement of anti­trust laws, and so on. A number of them have nothing to do with Keynesian fiscal stimulus, and even those that do (e.g., Public Works Administration, direct loans to state governments) were done on a scale far too small to stop the Great Depression.

(5) Horwitz:

“On top of those spending proposals, … Hoover proposed, and Congress approved, the largest peacetime tax increase in American history. The Revenue Act of 1932 increased personal income taxes dramatically, but also brought back a variety of ex­cise taxes that had been used during World War I. The higher income taxes involved an increase of the standard rate from a range of 1.5–5 percent to the 4–8 percent range. On top of that increase, the act placed a large surtax on higher-income earners, leading to a total tax rate of anywhere from 25 to 63 percent. The act also raised the corporate income tax along with several taxes on other forms of income and wealth.”

It is most extraordinary that this is presented as if it is evidence that Hoover was a Keynesian. Raising taxes like this in a depression is contractionary fiscal policy. If anything, a true Keynesian would have passed large tax cuts in 1932, not raised taxes. Hoover on this policy action was no Keynesian.

(6) Finally, Horwitz notes that some of the measures of the New Deal were already introduced by Hoover. Yet a number of the elements of the New Deal had nothing to do with Keynesian economics, and indeed Keynes himself denounced the National Industrial Recovery Act (NIRA). The New Deal was created by a hodgepodge of conflicting groups of ideologues and its programs were not all constructive from the modern Keynesian perspective at all.

(7) Finally, it is fascinating that Austrians like Horwitz never seem to look outside the United States at depression history. Those nations that recovered from the Great Depression or its aftermath rapidly and successfully – New Zealand, Japan and Germany – used large-scale fiscal stimulus:

“Keynesian Stimulus in New Zealand: 1936–1938,” September 23, 2011.

“Takahashi Korekiyo and Fiscal Stimulus in Japan in the 1930s,” August 27, 2011.

“Fiscal Stimulus in Germany 1933–1936,” September 3, 2011.

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For more on Hoover and the New Deal and Austrian nonsense about these subjects, see my posts here:

“Keynes on the New Deal in 1933,” September 2, 2011.

“Herbert Hoover’s Budget Deficits: A Drop in the Ocean,” May 24, 2011

“What Hoover Should have Done in 1931,” January 26, 2012.

BIBLIOGRAPHY

Stein, H. 1966. “Pre-Revolutionary Fiscal Policy: The Regime of Herbert Hoover,” Journal of Law and Economics 9: 189–223.

Temin, P. 1989. Lessons from the Great Depression, MIT Press, Cambridge, Mass.