My Links on the Deflation of 1873 to 1896

I’ve done a lot of research on the deflationary period from 1873 to 1896 in the Western world over the course of the last few months, and how this can be best explained by Post Keynesian economics. I also point to how the period had severe economic problems in contrast to the theories of the pro-deflation libertarian and Austrian schools, such as profit deflation, debt deflation, loss of business confidence, and in the UK an astonishing fall in and stagnation of investment.

My links on this subject are below:

“Libertarian Gold Standard Myths Never Die,” January 13, 2015.

“Neoclassical and Quantity Theory Explanations of the 1873–1896 Deflation,” January 7, 2015.

“More Evidence on the Profit Squeeze of 1873–1896,” January 5, 2015.

“UK Gross Domestic Fixed Capital Formation in the 1873 to 1896 Deflation,” December 18, 2014.

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

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

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

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

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

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

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

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

“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.

Keynes on Deflation and Liquidity Preference in “The Consequences to the Banks of the Collapse of Money Values” (1931)

From Keynes’ essay “The Consequences to the Banks of the Collapse of Money Values” (1931):

“Let us begin at the beginning of the argument. There is a multitude of real assets in the world which constitute our capital wealth—buildings, stocks of commodities, goods in course of manufacture and of transport, and so forth. The nominal owners of these assets, however, have not infrequently borrowed money in order to become possessed of them. To a corresponding extent the actual owners of wealth have claims, not on real assets, but on money. A considerable part of this ‘financing’ takes place through the banking system, which interposes its guarantee between its depositors who lend it money, and its borrowing customers to whom it loans money wherewith to finance the purchase of real assets. The interposition of this veil of money between the real asset and the wealth owner is a specially marked characteristic of the modern world. Partly as a result of the increasing confidence felt in recent years in the leading banking systems, the practice has grown to formidable dimensions. The bank-deposits of all kinds in the United States, for example, stand in round figures at $50,000,000,000; those of Great Britain at £2,000,000,000. In addition to this there is the great mass of bonded and mortgage indebtedness held by individuals.

All this is familiar enough in general terms. We are also familiar with the idea that a change in the value of money can gravely upset the relative positions of those who possess claims to money and those who owe money. For, of course, a fall in prices, which is the same thing as a rise in the value of claims on money, means that real wealth is transferred from the debtor in favour of the creditor, so that a larger proportion of the real asset is represented by the claims of the depositor, and a smaller proportion belongs to the nominal owner of the asset who has borrowed in order to buy it. This, we all know, is one of the reasons why changes in prices are upsetting.” (Keynes 1931: 169–170; reprinted in Keynes 1972: 150–158).
http://gutenberg.ca/ebooks/keynes-essaysinpersuasion/keynes-essaysinpersuasion-00-h.html

So here Keynes is referring to the destabilising effects of price deflation via the process that Irving Fisher would call “debt deflation” a few years later in his classic article “The Debt-Deflation Theory of Great Depressions” (Fisher 1933), though, as Philip Pilkington points out here, it seems that “Keynes is not only aware of the debt deflation theory in 1931 but he also suggests that everyone is aware of it.”

Keynes goes on to point out that the prices of many asset that function as the underlying collateral for bank loans had fallen disastrously during the early years of the depression, and that this induced a further crisis of insolvency in the banking system:

“To sum up, there is scarcely any class of property, except real estate, however useful and important to the welfare of the community, the current money value of which has not suffered an enormous and scarcely precedented decline. This has happened in a community which is so organised that a veil of money is, as I have said, interposed over a wide field between the actual asset and the wealth owner. The ostensible proprietor of the actual asset has financed it by borrowing money from the actual owner of wealth. Furthermore, it is largely through the banking system that all this has been arranged. That is to say, the banks have, for a consideration, interposed their guarantee. They stand between the real borrower and the real lender. They have given their guarantee to the real lender; and this guarantee is only good if the money value of the asset belonging to the real borrower is worth the money which has been advanced on it. It is for this reason that a decline in money values so severe as that which we are now experiencing threatens the solidity of the whole financial structure. ….

In many countries bankers are becoming unpleasantly aware of the fact that, when their customers' margins have run off, they are themselves ‘on margin.’ I believe that, if to-day a really conservative valuation were made of all doubtful assets, quite a significant proportion of the banks of the world would be found to be insolvent; and with the further progress of Deflation this proportion will grow rapidly. Fortunately our own domestic British Banks are probably at present—for various reasons—among the strongest. But there is a degree of Deflation which no bank can stand. And over a great part of the world, and not least in the United States, the position of the banks, though partly concealed from the public eye, may be in fact the weakest element in the whole situation. It is obvious that the present trend of events cannot go much further without something breaking. If nothing is done, it will be amongst the world's banks that the really critical breakages will occur.

Modern capitalism is faced, in my belief, with the choice between finding some way to increase money values towards their former figure, or seeing widespread insolvencies and defaults and the collapse of a large part of the financial structure;—after which we should all start again, not nearly so much poorer as we should expect, and much more cheerful perhaps, but having suffered a period of waste and disturbance and social injustice, and a general re-arrangement of private fortunes and the ownership of wealth.” (Keynes 1931: 175–177).
http://gutenberg.ca/ebooks/keynes-essaysinpersuasion/keynes-essaysinpersuasion-00-h.html

Furthermore, there is another point that Keynes is making, as Philip Pilkington again also argues here: for Keynes, the fall in asset prices and the rush to physical cash or liquid forms of money is a rise in liquidity preference, which can also induce destabilising effects that are worse than debt deflation.

Further Reading
Philip Pilkington, “Keynes’ Liquidity Preference Trumps Debt Deflation in 1931 and 2008,” Fixing the Economists, February 24, 2014.

BIBLIOGRAPHY
Fisher, Irving. 1933. “The Debt-Deflation Theory of Great Depressions,” Econometrica 1.4: 337–357.

Keynes, J. M. 1931. “The Consequences to the Banks of the Collapse of Money Values,” in J. M. Keynes, Essays in Persuasion. Macmillan, London.

Keynes, J. M. 1972 [1931]. “The Consequences to the Banks of the Collapse of Money Values,” in J. M. Keynes, The Collected Writings of John Maynard Keynes. Volume IX. Essays in Persuasion. Macmillan, London. 150–158.

Dennis Robertson on Deflation

From Dennis Robertson’s book Money (1922):

Ҥ 2. The Effects of Falling Prices.
Our next question is this: What are the general consequences of a pronounced fall in the price-level? Let us suppose, first, that the fall is not accompanied by any corresponding increase in the real productivity of industry: and let us further suppose for the moment that it were to be brought about at one fell swoop, without any period of transition. As consumers we should all rejoice; but those of us who were traders would soon begin to wonder how they were going to pay for their stocks of goods ordered at the old prices; and those who were employers would soon begin to think very seriously about their wages bill; and even those who were wage earners would begin to reflect that, whether or not automatically tied to the cost of living, their existing rate of money wages had been based on certain assumptions about the price-level which were no longer in accordance with the facts. Some of us would look forward to bankruptcy or heavy loss, and all of us to a good deal of unsettlement and dislocation while contracts and understandings and standards of calculation were being drastically overhauled.

Nor is this all. There is one contract to which, whether we like it or not, we in Britain are all parties, and of which it is not open to us to propose any revision, namely the payment of interest to our fellow-citizens on some £6000 m. of War Debt, and the gradual repayment of the principal. That contract is fulfilled by means of taxation on incomes derived mainly from the sale of goods and services: and if the prices of all goods and services were to be halved, the rate of taxation necessary to fulfil that contract would be roughly speaking doubled. This is not the place to discuss whether this load of debt should have been, or should even now be, reduced by means of a general levy assessed on existing private wealth. But unless that step is taken, we must regard with suspicion any proposal to increase deliberately the value of money; for the inevitable consequence would be an increase in the rates and the real burden of taxation.

Next let us continue to suppose that the fall in the price-level is unaccompanied by any increase in the real productivity of industry; but let us now suppose, as is indeed probable, that it is brought about gradually, and not at one blow. In one respect the results will be less serious; for there will be a breathing space to revise contracts and adjust expectations, and therefore less panic, fewer catastrophic failures. But in another respect the consequences will be more paralysing. To develop this point we must once more pick up some threads which in earlier chapters have been left hanging in the air. In Ch. VI, § 2, it was pointed out that a rising price-level, by gratifying and stimulating those who hold the reins of business, tends to increase the volume of employment and the productivity of industry; and we may well enquire rather closely whether a falling price-level must not be expected to have an exactly opposite result. In Ch. VII, § 6, indeed, we glided over the process by which under a gold standard a rise in the price-level is reversed as though it were the most natural and painless operation in the world. But in Ch. IV, § 5, we accepted provisionally the opinion of the ‘more money’ enthusiasts that a banking system which allowed a great or prolonged fall in prices would be failing to meet the requirements of a progressive community. Let us try to discover how the truth stands in this matter.

§ 3. Falling Prices and Trade Depression. Now once more we must walk carefully. A trade depression is a complex thing, and it would not be fair to ascribe all its evils to what may be a consequence rather than a cause of more deep-seated maladjustments. Nevertheless there is reason to think that a falling price-level is not only a symptom of depression, but an active agent in increasing its severity and prolonging its duration. For let us consider how it operates. A downward swoop of the price-level reveals like a flare a line of struggling figures, caught in their own commitments as in a barbed-wire entanglement. Not one of them can tell what or how soon the end will be. For a while each strives, with greater or less effectiveness, to maintain the price of his own particular wares; but sooner or later he succumbs to the stream, and tries to unload his holdings while he can, lest worse should befall. And right from the start he has taken the one step open to him; he has cut off the new stream of enmeshing goods, and passed the word to his predecessor not to add to his burden. So the manufacturer finds the outlet for his wares narrowing from a cormorant’s gullet to a needle’s eye; and he too takes what steps occur to him. If he is old and wily and has made his pile he retires from business for a season, and goes for a sea-voyage or into the House of Commons. If he is young and ambitious or idealistic he keeps the ball rolling and the flag flying as best he can. If he is an average sort of manufacturer he explains that while he adheres to his previous opinion that the finance of his business is no concern of the working-classes, yet just so much financial knowledge as to see the absurdity of the existing Trade Union rate is a thing which any workman should possess.

In any case, ... [sc. he soon] restricts in greater or less degree the output of his product. Thus two things happen which (it is believed) cause much merriment among the inhabitants of other planets. The world deliberately adopts a standard of comfort lower than that which its natural resources and its capital equipment place within its reach, cutting of its nose, as it were, to spite its face. And men trained and (within limits) willing to work find no work to do, and tramp the streets with the parrot-cries of journalists about increased output ringing in their ears, and growing rancour in their hearts. ....

It seems to be falling prices per se, irrespective of their cause, which both impose a real handicap on the business man in favour of the debenture holder and the wage earner, and damp his ardour by making that handicap loom larger in shadow than it turns out to be in substance. ....

Our general conclusion then must be that a pronounced fall in prices is not always an exhilarating or painless process, or one to be altogether welcomed with open arms.” (Robertson 1922: 159–164).

Although Dennis Robertson’s specific example concerns the real burden of government debt and taxation under price deflation, nevertheless it is clear that even in 1922 he understood the essence of the process of debt deflation, as Keynes did.

In fact, Keynes described deflation in these terms in a passage in his A Tract on Monetary Reform (1923):

“In the first place, Deflation is not desirable, because it effects, what is always harmful, a change in the existing Standard of Value, and redistributes wealth in a manner injurious, at the same time, to business and to social stability. Deflation, as we have already seen, involves a transference of wealth from the rest of the community to the rentier class and to all holders of titles to money; just as inflation involves the opposite. In particular it involves a transference from all borrowers, that is to say from traders, manufacturers, and farmers, to lenders, from the active to the inactive.

But whilst the oppression of the taxpayer for the enrichment of the rentier is the chief lasting result, there is another, more violent, disturbance during the period of transition. The policy of gradually raising the value of a country’s money to (say) 100 per cent above its present value in terms of goods … amounts to giving notice to every merchant and every manufacturer, that for some time to come his stock and his raw materials will steadily depreciate on his hands, and to every one who finances his business with borrowed money that he will, sooner or later, lose 100 per cent on his liabilities (since he will have to pay back in terms of commodities twice as much as he has borrowed). Modern business, being carried on largely with borrowed money, must necessarily be brought to a standstill by such a process. It will be to the interest of everyone in business to go out of business for the time being; and of everyone who is contemplating expenditure to postpone his orders so long as he can. The wise man will be he who turns his assets into cash, withdraws from the risks and the exertions of activity, and awaits in country retirement the steady appreciation promised him in the value of his cash. A probable expectation of Deflation is bad enough; a certain expectation is disastrous. For the mechanism of the modern business world is even less adapted to fluctuations in the value of money upwards than it is to fluctuations downwards.” (Keynes 1923: 143–144).

It seems clear that the deleterious nature of debt deflation was already well understood in the Cambridge Marshallian tradition of economics in England by the 1920s (see also Keynes 1931).

In this respect, as Philip Pilkington has pointed out here, Irving Fisher did not suddenly “discover” the phenomenon of debt deflation in his famous 1933 paper (Fisher 1933).

However, to be fair to Fisher, he did admit that in chapter 7 of Thorstein Veblen’s book The Theory of Business Enterprise (1904), Veblen had come close to a prior debt deflation theory (Fisher 1933: 350, n.).

Addendum
The “Economicreflections” blog has an excellent and fascinating post that shows that the essence of debt deflation was already understood as early as 1817 by the economist Thomas Attwood:

“Debt-Deflation Theory in Early 19th Century Britain,” Economicreflections, 13 September, 2014.

In this post, there is an extended and remarkable passage from Thomas Attwood’s Prosperity Restored, or, Reflections on the Cause of the Public Distresses: and on the only means of relieving them (Baldwin, Cradock, and Joy, London, 1817), which shows how he understood that the real burden of private and public debt is increased by deflation, and that this also has deleterious economic effects.

It is interesting that Thomas Attwood was part of the “Birmingham School” of economists, who were a proto-Keynesian school, and included the following economists:

Birmingham School
Thomas Attwood
George Frederick Muntz
Matthias Attwood
Arthur Young
Patrick Colquhoun
Sir John Sinclair
Robert Montgomery Martin.

In general, on the Birmingham School see S. G. Checkland, 1948. “The Birmingham Economists, 1815–1850,” The Economic History Review n.s. 1.1: 1–19.

Further Reading
“Fisher on Debt Deflation,” October 26, 2012.

BIBLIOGRAPHY
Fisher, Irving. 1933. “The Debt-Deflation Theory of Great Depressions,” Econometrica 1.4: 337–357.

Keynes, John Maynard. 1923. A Tract on Monetary Reform. Macmillan, London.

Keynes, John Maynard. 1931. “The Consequences to the Banks of the Collapse of Money Values,” in J. M. Keynes, Essays in Persuasion. Macmillan, London. 168–178.

Robertson, Dennis Holme. 1922. Money. Nisbet & Co. London.

Veblen, Thorstein. 1904. The Theory of Business Enterprise. Charles Scribner’s Sons, New York.

Hayek the Evil Inflationist!

… or that is what I would call this post if I were a Misesian or Rothbardian Austrian economist.

I refer to the passage below from a talk that Hayek gave on April 9, 1975 to the American Enterprise Institute in Washington DC, in which he had been asked to speak on 1970s inflation.

Early in this talk Hayek said that he rejected the Keynesian view that employment is “a direct and simple function of what is called aggregate demand” (Hayek 1975: 4), even though he proceeded to concede two important instances where aggregate demand was the “dominating factor in determining the level of employment”:

“Let me say, first, that there are two circumstances in which changes in aggregate demand are indeed the dominating factor in determining the level of unemployment; and these two circumstances have governed the development of the theory.

The first one was an accidental historic situation—but an historic situation that determined the climate of opinion in the country which then dominated economic theory. In 1925, Great Britain had made a laudable attempt to return to gold but mistakenly to do so at the former parity. This policy created a situation where real wages were generally too high because they had been artificially raised by the revaluation of the pound. In consequence, British industry, largely dependent on exports, had become unable to compete in the world market. In this situation, the restoration of employment required a reduction of real wages which could be achieved by a general rise of prices.

This particular situation, however, while it largely explains the growth of Keynes’s own views, would not be sufficient to explain their wide acceptance.

The second situation in which it is true that an increase of employment requires an increase in aggregate demand is found in the later stages of a depression when, in consequence of the appearance of extensive unemployment, the economy frequently is subjected to a cumulative process of contraction. The original substantial unemployment lends to a shrinkage of demand that causes more unemployment, and so on; it releases a deflation due to the ‘inherent instability of credit’ (to use the terminology of a once very influential but now undeservedly almost forgotten economist who died a few days ago, R. G. Hawtrey).

Once you have the kind of situation in which there already exists extensive unemployment, there is thus a tendency to induce a cumulative process of secondary deflation, which may go on for a very long time. I am the last to deny — or rather, I am today the last to deny—that in these circumstances, monetary counteractions, deliberate attempts to maintain the money stream, are appropriate.

I probably ought to add a word of explanation: I have to admit that I took a different attitude forty years ago, at the beginning of the Great Depression. At that time I believed that a process of deflation of some short duration might break the rigidity of wages which I thought was compatible with a functioning economy. Perhaps I should even then have understood that this possibility no longer existed. I think it disappeared in 1931 when the British government abandoned its attempt to bring wages down by deflation, just when it seemed about to succeed. After that attempt had been abandoned, there was no hope that it would ever again be possible to break the rigidity of wages in that way.

I still believe that we shall not get a functioning economy until wages again become flexible, but I think that we shall have to find different techniques for that purpose. I would no longer maintain, as I did in the early ’30s, that for this reason, and for this reason only, a short period of deflation might be desirable. Today I believe that deflation has no recognisable function whatever, and that there is no justification for supporting or permitting a process of deflation.” (Hayek 1975: 4–5).

This is Hayek’s mea culpa and a repudiation of his 1930s liquidationism.

But what policy does Hayek recommend to avoid deflation? He does not here specify how, but elsewhere makes it clear that he supported monetary intervention (like Milton Friedman) and (probably) a guarded and conservative use of fiscal policy involving public works expenditure. In one word: inflation.

Most interesting is Hayek’s implicit admission that inflation was the right course for the British economy in the 1920s after the disastrous return to the gold exchange standard at too high a parity:

“In 1925, Great Britain had made a laudable attempt to return to gold but mistakenly to do so at the former parity. This policy created a situation where real wages were generally too high because they had been artificially raised by the revaluation of the pound. In consequence, British industry, largely dependent on exports, had become unable to compete in the world market. In this situation, the restoration of employment required a reduction of real wages which could be achieved by a general rise of prices.”

So Hayek, after all his attacks on Keynes in the 1930s, essentially admitted Keynes was right, at least on these points at any rate.

BIBLIOGRAPHY
Hayek, Friedrich A. von. 1975. A Discussion with Friedrich A Von Hayek. American Enterprise Institute, Washington.

The Recession of 1920–1921 versus the Depression of 1929–1933

Updated
The recession of 1920–1921 is alleged to have been an instance of wage and price flexibility allowing a rapid and smooth recovery from recession.

The recession lasted from January 1920 to July 1921, a period of 18 months. But an 18-month recession is relatively long by the standards of the post-1945 US business cycle, in which the average duration of US recessions fell to about 11 months.

It is also often alleged that the 1920–1921 recession shows that wage and price flexibility could have cured the depression of 1929–1933.

But one should note the following points on how the recession of 1920–1921 was quite different from the initial downturn in 1929–1930, and indeed was a highly anomalous recession in terms of its place in the economic history of the US:

(1) while the Great Depression, with its severe contraction in world trade, was virtually a worldwide phenomenon and certainly almost universal throughout the developed world, in 1920–1921 a number of nations escaped the recession: e.g., a number of European nations such as Germany, Netherlands, and Belgium and other Western offshoots such as Australia (as found in the real GDP data in Maddison 2003).

Importantly, Germany, the largest economy in Europe, was in the midst of an inflationary boom (Temin 1989: 61; Orde 2002: 146). Therefore in 1920–1921 the US was not subject to the type of shocks from collapse of world trade as in 1929–1933.

And, moreover, in 1920–1921 the US seems to have benefited from external demand from nations recovering from WWI (Gertler 2000: 242, n. 5), and in particular the boom in Germany created a strong demand for US goods in 1921 (Orde 2002: 146).

It appears, then, that the demand side of the US economy as determined by foreign demand for US exports was not badly deficient during the downturn of 1920–1921 (Kuehn 2012: 159).

(2) Although deflation in 1920 to 1921 was severe, one significant cause of the deflation was a positive supply shock in commodities due to the resumption of shipping after the war (Romer 1988: 110). After WWI, there was a recovery in agricultural production in Europe, even though American farmers had continued their production at wartime levels. When primary commodity supplies from other countries were resumed after international shipping recovered, there was a great increase in the supply of commodities and their prices plummeted. As Romer argues,

“Tiffs suggests that a flood of primary commodities may have entered the market following the war and thus driven down the price of these goods. That these supply shocks may have been important in stimulating the economy can be seen in the fact that the response of the manufacturing sector to the decline in aggregate demand in 1921 was very uneven …. The industries that were most devastated by the downturn were those in heavy manufacturing …. On the other hand, nearly all industries… that used agricultural goods or imports as raw materials experienced little or no decline in labour input in 1921 .... That industries related to agricultural goods and imports flourished during 1921 suggests that beneficial supply shocks did stimulate production in a substantial sector of the economy” (Romer 1988: 111).

Vernon (1991) comes to the same conclusion as Romer: the deflation in 1920-1921 was caused not just by a decline in aggregate demand but also by a positive aggregate supply shock.

(3) in 1920–1921 US consumption behaved very differently to what happened in 1929–1930.

As we can see below in the graph index of the consumption component of US real GDP, real consumption spending fell sharply in 1929–1930, but actually rose from 1920–1921 (Gertler 2000: 242; data from Cole and Ohanian 2000: 185, Table 1).

Gertler (2000: 242) argues that the end of WWI released pent-up demand for consumption goods that continued in 1920–1921.

So the forces of debt deflation and high real interest rates were offset by the postwar consumption demand (Gertler 2000: 242).

Even real private investment did not slump as much in 1920–1921 as it did from 1929–1930, as we can see in the graph below.

Since we have already seen that neither (1) export demand nor (2) US consumer demand appears to be a major cause of the recession of 1920 to 1921, it follows that a slump in US domestic investment was the primary problem.

But what exactly did the fall in private investment represent in 1920–1921 and what caused it?

To that, let us turn to (4).

(4) Temin’s analysis of the causes of the recession of 1920–1921 is very interesting:

“The decline that started in 1929 was due to a failure of aggregate demand … . The depression of 1920–21, by contrast, was due largely to a shift of demand. The war had ended, and demobilization resulted in a massive transfer of demand among industries and firms. In the United States, government expenditures contracted sharply in 1920, reducing demand and releasing workers. But the war had suppressed private demand and increased private wealth. The United States had borrowed from its citizens and loaned to allied governments, making a rapid transition from international borrower to international lender. As a result private demand rose to take the place of war expenditures. This wealth effect made for a short depression after the war. The comparable effect was strong enough to obviate any recession after the Second World War.” (Temin 1989: 60).

According to Temin, then, this was essentially a post-war reconstruction recession: this type of recession is qualitatively different from those characterised by severe failures of aggregate demand and shocks to business expectations.

Although I have not yet looked in greater detail at Temin’s explanation and I would not strongly commit to that view without further research, it at least deserves consideration.

And I would also note that the slump in investment demand was presumably also partly induced by the contractionary monetary policy implemented by the Federal Reserve before 1920. I also note in passing that Paul A. Samuelson had some interesting analysis of the recession of 1920–1921 (Samuelson 1943: 47–50) and attributed it to the collapse of a boom in 1919 that was itself fuelled by continued (but falling) large government spending, business inventory accumulation and price inflation.

(5) the levels of US private debt were lower in 1921 than the very high levels in 1929.

Given the lower levels of US private debt in 1920–1921 and the fact that demand and business confidence revived in 1921, the US escaped a cumulative process of factors like that which caused the severity of the depression from 1929–1933.

While there was a debt deflationary effect in 1920–1921, one must remember that the deflation of 1920–1921 came after the high inflation of the First World War and 1919 boom which must have inflated away the real value of the private debts of many people contracted in the years before 1920 (an important point made by Kuehn 2012: 159).

So the deflation of 1920–1921 was not nearly so severe when one considers the preceding inflation (Kuehn 2012: 159), and the likelihood that people expected a post-war deflationary episode (Bordo, Erceg, and Evans 2000: 235–236).

In contrast, the massive rise in US private debt in the 1920s occurred with a relatively stable price level and low inflation (as noted by Kuehn 2012: 159), and people were not expecting a severe protracted deflation in 1929.

And, as we have seen, in 1929 the level of private nominal debt was much higher than in 1920 (Dimand 1997: 140).

One must also look at the composition as well as higher level of private debt in 1929, as Irving Fisher noted:

“From 1921–29, as the boom developed, the new corporate issues took more and more the form of stocks instead of bonds. This policy of reducing the proportion of bonds had one good effect: It left the corporations less encumbered with debt so that, despite the depression, many corporations kept in a strong position throughout the whole of the depression. This advantage, however, was more than offset by shifting the debt burden from the corporations to the stockholders. That is, in order to buy the stock, many persons borrowed, so that, instead of being indebted collectively in the form of a corporation, they became indebted individually. Moreover, their borrowing was of the most dangerous type: largely margin accounts with brokers, whose loans were call loans. Thus, upon the corporate equities represented by common stocks was superimposed a structure of equities represented largely by margin accounts and brokers’ loans.” (Fisher 1933: 72).

So, although there was debt deflation in 1920–1921, the lower levels of private debt and previous inflation meant that its effects were not as bad as in 1929–1933, and fundamentally with the revival in investment and business confidence in 1921, the cumulative effect of debt deflation (along with a host of other factors) was stopped in its tracks as the recovery proceeded in 1922 and later years.

(6) The flexibility of US real and nominal wages in the period from 1914 to 1921 – and especially the downwards flexibility in 1920 to 1921 – stands out as an historically unprecedented event in US economic history (Sundstrom 1992: 433): it is a deviation from a general trend of relative wage rigidity. Even the late 19th century showed an increasing and significant relative wage stickiness, so that, at least as far back as the 1880s/1890s, there was no golden age of wage flexibility before 1929 that was somehow destroyed by government intervention.

The fall in nominal and real wages in 1920–1921 was mostly the consequence of the fact that they had been driven to high levels in the First World War. That this wage adjustment helped the US economy in this atypical instance, especially in the export sectors, is no doubt true, but it does not prove that wage flexibility is an appropriate or reliable solution to involuntary employment in other normal circumstances when recessions occur.

(7) the 1920 to 1921 recession saw no disastrous financial crisis. Although some bank failures occurred, there were no mass bank runs and collapses as in 1929–1933 (Brunner 1981: 44).

All in all, the recession of 1920–1921 was obviously a highly anomalous downturn, and merely because there was a recovery in 1921, this does not prove that the recovery was caused by wage and price flexibility, given

(1) that the recession was not fundamentally caused by deficient aggregate demand in the GDP components of (a) export demand and (b) US consumer demand;

(2) that positive supply-side shocks were important;

(3) that there was a rise in demand for American exports in 1921, and

(4) the possibility that the downturn was a reconstruction recession.

All of these suggest that the recovery in 1921 can be understood as a demand-side phenomenon.

Further Reading
“The US Recession of 1920–1921: Some Austrian Myths,” October 23, 2010.

“There was no US Recovery in 1921 under Austrian Trade Cycle Theory!,” June 25, 2011.

“The Depression of 1920–1921: An Austrian Myth,” December 9, 2011.

“A Video on the US Recession of 1920-1921: Debunking the Libertarian Narrative,” February 5, 2012.

“The Recovery from the US Recession of 1920–1921 and Open Market Operations,” October 4, 2012.

“Rothbard on the Recession of 1920–1921,” October 6, 2012.

External Links
David Glasner, “Daniel Kuehn Explains the Dearly Beloved Depression of 1920–21,” Uneasy Money, February 1, 2012
http://uneasymoney.com/2012/02/01/daniel-kuehn-explains-the-dearly-beloved-depression-of-1920-21/

Murphy, Robert P. “Krugman and Kuehn take me to the Woodshed on the 1920–1921 Depression,” Free Advice, 24 January 2012
http://consultingbyrpm.com/blog/2012/01/krugman-and-kuehn-take-me-to-the-woodshed-on-the-1920-1921-depression.html

Daniel Kuehn, “Glasner on 1920–21,” Facts and Other Stubborn Things, February 2, 2012
http://factsandotherstubbornthings.blogspot.com/2012/02/glasner-on-1920-21.html

Daniel Kuehn, “Krugman on 1920–21,” Facts and Other Stubborn Things, January 23, 2012
http://factsandotherstubbornthings.blogspot.com.au/2012/01/krugman-on-1920-21.html

Daniel Kuehn, “My CJE article has been published,” Facts and Other Stubborn Things, January 17, 2012
http://factsandotherstubbornthings.blogspot.com/2012/01/my-cje-article-has-been-published.html

Daniel Kuehn, “Casey Mulligan would have loved the 1920–1921 Depression,” Facts and Other Stubborn Things, August 20, 2011
http://factsandotherstubbornthings.blogspot.com/2011/08/casey-mulligan-would-have-loved-1920.html

Daniel Kuehn, “Ryan Murphy on my 1920–21 Paper,” Facts and Other Stubborn Things, April 5, 2011
http://factsandotherstubbornthings.blogspot.com/2011/04/ryan-murphy-on-my-1920-21-paper.html

Daniel Kuehn, “Krugman on the 1921 Depression,” Facts and Other Stubborn Things, April 1, 2011
http://factsandotherstubbornthings.blogspot.com/2011/04/krugman-on-1921-depression.html

BIBLIOGRAPHY
Bordo, Michael, Erceg, Christopher and Charles Evans. 2000. “Comment” (on “Re-Examining the Contributions of Money and Banking Shocks to the U.S. Great Depression”), NBER Macroeconomics Annual15: 227–237.

Brunner, K. 1981. The Great Depression Revisited. Nijhoff, Boston and London.

Cole, Harold L. and Lee E. Ohanian. 2000. “Re-Examining the Contributions of Money and Banking Shocks to the U.S. Great Depression,” NBER Macroeconomics Annual 15: 183-227

Dimand, Robert W. 1997. “Debt-Deflation Theory,” in D. Glasner and T. F. Cooley (eds.), Business Cycles and Depressions: An Encyclopedia, Garland Pub., New York. 140–141.

Fisher, Irving. 1933. Booms and Depressions: Some First Principles. George Allen and Unwin, London.

Gertler, Mark. 2000. “Comment,” NBER Macroeconomics Annual 15: 237–258.

Kuehn, Daniel. 2012. “A Note on America’s 1920–21 Depression as an Argument for Austerity,” Cambridge Journal of Economics 36.1: 155–160.

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

Orde, Anne. 2002. British Policy and European Reconstruction after the First World War. Cambridge University Press, Cambridge.

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

Samuelson, Paul A. 1943. “Full Employment after the War,” in Seymour E. Harris (ed.), Postwar Economic Problems, McGraw-Hill, New York and London. 27–53.

Sundstrom, William A. 1992. “Rigid Wages or Small Equilibrium Adjustments? Evidence from the Contraction of 1893,” Explorations in Economic History 29.4: 430–455.

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

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

The Profit Deflation of the 1890s

The phenomenon of “profit deflation” in the 1890s is described in this fascinating analysis by H. Clark Johnson:

“The international deflation of 1891–96 directly compressed profits. The extent of actual price decline was less than for the two income deflations considered above. From 1890 through 1896, Sauerbeck’s British wholesale price index declined by 18 percent and The Economist’s index dropped by 14 percent. British money wages, however, actually rose by several percentage points, so the rise in real wages was striking. The rate of investment dropped sharply; new capital issues averaged £102 million during 1880–89 and £154 million during 1889-90 but fell to an average level of £70 million during 1891–96. (These data depict a trend; investment need not be financed through new issues.) The rate of saving was high and increased from perhaps £150 million annually in 1880 to £200 million annually in 1896. Aggregate savings deposits grew greatly during the 1890s, both at the Post Office and at private banks. As investment declined despite the increase in savings, the second term of the price equation turned negative, while the first term increased slightly but steadily — reflecting the rigidity of input costs.

The pattern in the United States was similar. During 1893–96, the wholesale price index declined by 2.4 percent annually, compared to a decline of 1.1 percent annually during 1879–92. Unlike wages during the deflation of the 1870s, hourly wages were steady in nominal terms and hence rose in real terms. (Evidence on British and American wage levels during the 1890s undermines frequent assertions that wages were flexible during the period of the prewar gold standard.) Whereas the (nominal) volume of New York City bank clearings was steady during the deflation of the 1870s, it decreased abruptly during 1892–94. Tobin’s q declined moderately from 1892 through 1896, which was significant in part because it followed a full decade of stagnation in real stock prices. The annualized stock index level of 1881 was not exceeded until 1899.

The 1890s saw intense agitation for inflationary policies, and a central plank of William Jennings Bryan’s Democratic party platform of 1896 was that the gold standard should be abandoned in favor of bimetallism. When the Republicans won the election, the gold standard was again perceived as being secure. This conclusion was soon reinforced by rising world gold output and the beginning of a mild international inflation, which weakened the political attraction of bimetallism.” (Johnson 1997: 20).

There are two issues here, although the second is more important for my purposes:

(1) the idea that the 19th century was a period of relatively flexible wages, and

(2) the effects of the price deflation from 1873 to 1896, and in particular on profits and the level of investment.

First, it appears wages were not as flexible in the 1890s, during this later era of the gold standard, as some economists think.

Secondly, it appears that profit deflation, from the price deflation, with relative wage rigidity, induced a fall in investment. That was part of the economic crisis in the 1890s.

Now some neoclassical Marshallian economists at Cambridge University had their own pre-Keynesian theory about the causes of the late 19th century economic problems in the 1880s.

John Neville Keynes, John Maynard Keynes’s father, gave his own evidence to the UK “Royal Commission on the Depression of Trade and Industry” (whose final report was published in 1886).

He saw price deflation as having the following undesirable effects, as described by Skidelsky:

“These linkages were brought out by Neville Keynes in his evidence to the Royal Commission on the Depression of Trade and Industry (1886). The depression in trade was ‘partly but not wholly due’ to the rise in the value of gold relative to other commodities. This discouraged enterprise for five reasons:

(a) because a fall in price between the start and the completion of a transaction involved the trader in loss;

(b) because the trader tended to exaggerate his own loss by not taking sufficient account of the general fall in prices,

(c) because the profits of enterprise were temporarily diminished on account of increased depreciation of fixed capital;

(d) because the ratio of profits to wages fell as a result of the fall in money wages lagging behind the fall in prices, and

(e) because the fall in prices increased the burden of debt, transferring wealth from borrowers to lenders.

Such evidence was not intended to challenge the now orthodox quantity theory, merely to point to the difficulties of adjusting from one price level to another. Its implication was that monetary policy should be used to raise prices, and thereafter stabilise the price level. Out of such considerations developed the movement for bimetallism, which was an attempt to increase the amount of legal tender money by obliging the central bank to mint both gold and silver on demand at a fixed ratio.” (Skidelsky 1983: 231).

So John Neville Keynes anticipated modern concerns about debt deflation and also identified profit deflation as one of the causes of decreased private investment during this period of deflation.


BIBLIOGRAPHY
Johnson, H. Clark. 1997. Gold, France, and the Great Depression, 1919–1932. Yale University Press, New Haven and London.

Skidelsky, R. J. A. 1983. John Maynard Keynes: Hopes Betrayed 1883–1920 (vol. 1). Macmillan, London.

Alfred Marshall’s Judgement on the “Depression” of 1873–1896

To expand on a point in the last post, between 1873 and 1896 nations on the gold standard had a protracted period of deflation.

I will repeat here some comments I have made before.

In the 19th century, people tended to use the term “depression” loosely to refer to contractions in real output often accompanied by deflation. In the Oxford English Dictionary, we get a general definition:

“5. a. A lowering in quality, vigour, or amount; the state of being lowered or reduced in force, activity, intensity, etc. In mod. use esp. of trade; spec. the Depression, the financial and industrial ‘slump’ of 1929 and subsequent years.”(Oxford English Dictionary [2nd edn. 1989], s.v. “depression,” 5.a.).

The earliest use of the word in this sense cited in the Oxford English Dictionary is from an 1827 publication, where we read that the

“commencement of the present year was marked by a continuance of that depression in manufactures and commerce, which had prevailed at the close of the preceding [year]” (The Annual Register: Or a View of the History, Politics, and Literature, of the Year 1826, 1827, p. 1).

In the 19th century, when people referred to output contractions (normally with price deflation), they spoke of a “slump in trade,” “depression of commerce” or “depression of trade and industry”, and so on. Sometimes writers spoke of a “depression” in certain particular sectors as well. That is, “depression” was used in the modern sense of a “recession” accompanied by price deflation.

The later 1870s, 1880s and 1890s (down to 1896) were widely spoken of at the time as decades marked by “depression,” partly because of the persistent price deflation, decline in profits, and business pessimism in these years.

But we now know that actually there were several business cycles in these years, and real output was higher in 1896 than in 1873. The whole period was clearly not a “depression” or “recession” in the modern sense.

Nevertheless, there were still economic problems in these years, as follows:

(1) a serious financial crisis and recession around 1873 in many countries and serious economic stagnation in some countries like the US for almost the rest of the decade.

(2) financial crises and a serious recession in the early 1890s and economic problems in the later 1890s in some nations such as the US.

(3) a dissatisfaction with deflation from various classes of people, above all business people and debtors. In the US, this period coincided with the free silver movement and bimetallist political movement that opposed the gold standard.

In the UK and other European countries, there was also a pessimistic outlook in the business press and feelings that something was not right. Farmers were also complaining of depression.

The UK “Royal Commission on the Value of Gold and Silver” was instituted in 1887 after a report on the “depression of trade.” The commission was to investigate the question of changes in the value of gold and silver and the effects on trade and production.

Alfred Marshall was called to give evidence and this exchange with Henry Chaplin is interesting:

“[Henry Chaplin, MP:] Do you share the general opinion that during the last few years we have been passing through a period of severe depression? …

[Marshall]: 9823. Yes, of severe depression of profits.

[Henry Chaplin, MP:] 9824. And that has been during a period of abnormally low prices? …

[Marshall]: A severe depression of profits and of prices. I have read nearly all the evidence that was given before the Depression of Trade and Industry Commission, and I really could not see that there was any very serious attempt to prove anything else than a depression of prices, a depression of interest, and a depression of profits; there is that undoubtedly. I cannot see any reason for believing that there is any considerable depression in any other respect.” (Court 1965: 20).

So according to Marshall there was a “severe depression of profits.”

With price deflation, there was a squeeze on profits, as deflated prices meant lower profits in nominal terms and perhaps even in real terms when wages did not fall enough as well. Labour apparently often had rising real wages in this period, as wages did not fall as rapidly as prices. When business tried to cut wages, that provoked labour disputes (Livingston 1986: 34).

There is, strangely, also evidence of declining productivity growth in the 1880s and early 1890s (Livingston 1986: 34), and in the US price deflation, with rising real wages and insufficient labour productivity growth (Livingston 1986: 38).

The falling profits caused pessimistic businesses expectations and that, most probably, meant a reduced aggregate level of investment, since the level of investment is very much dependent on expectations, as well as aggregate demand.

Can we find any evidence for this in the economic data? I would say, yes.

Let us take the UK as an example. First, the real GDP data from 1873:

Year | GDP* | Growth Rate
Millions of international Geary-Khamis dollars
1873 | 108266 | 2.33%
1874 | 110063 | 1.66%
1875 | 112758 | 2.45%
1876 | 113881 | 0.99%
1877 | 115004 | 0.99%
1878 | 115454 | 0.39%
1879 | 115004 | -0.39%
1880 | 120395 | 4.69%
1881 | 124663 | 3.54%
1882 | 128257 | 2.88%
1883 | 129155 | 0.70%
1884 | 129380 | 0.17%
1885 | 128706 | -0.52
1886 | 130728 | 1.57%
1887 | 135894 | 3.95%
1888 | 141959 | 4.46%
1889 | 149596 | 5.38%
1890 | 150269 | 0.45%
1891 | 150269 | 0%
1892 | 146676 | -2.39%
1893 | 146676 | 0%
1894 | 156559 | 6.74%
1895 | 161500 | 3.15%
1896 | 168239 | 4.17%
1897 | 170485 | 1.33%
1898 | 178796 | 4.87%
1899 | 186208 | 4.14%
(Maddison 2003: 47).

This doesn’t look so bad at first. The worst recession was from 1891 to 1893, and mild recessions in 1879 and 1885.

But when we turn to UK unemployment from 1873 to 1896, we see something interesting:

Year | Unemployment Rate
1873 | 2.8%
1874 | 3.3%
1875 | 4.0%
1876 | 4.8%
1877 | 6.6%
1878 | 7.9%
1879 | 9.1%
1880 | 6.6%
1881 | 5.7%
1882 | 5.0%
1883 | 4.9%
1884 | 6.3%
1885 | 8.0%
1886 | 7.9%
1887 | 7.1%
1888 | 5.8%
1889 | 4.3%
1890 | 4.0%
1891 | 4.9%
1892 | 6.1%
1893 | 7.3%
1894 | 7.0%
1895 | 7.3%
1896 | 6.1%
1897 | 5.9%
1898 | 4.9%
1899 | 4.3%
1900 | 4.3%
(Boyer and Hatton 2002: 667).

Some particularly bad periods of unemployment were 1876–1880, 1884–1888 and 1892–1896. The 1876–1880 unemployment figures are very strange, because the real GDP estimates for this period show real output growth in all years but 1879.

What is fascinating is that the period of high unemployment from 1884–1887 comes at just the right time when the Royal Commission on the Value of Gold and Silver was set up. The fears of a depression in these years were not unjustified, given the high unemployment. Alfred Marshall was wrong to think there was no evidence of depression, apart from “a depression of prices, a depression of interest, and a depression of profits” (but, then, of course there were no proper national unemployment estimates in those days).

But why the high unemployment? That there was insufficient private investment seems a reasonable answer. But why insufficient private investment?

If profits were depressed and this caused business expectations to become pessimistic, then the underlying cause was deflation. Moreover, it is likely that debt deflationary dynamics were at work.

The 1890s look like a good candidate for another serious economic crisis (as was the case in the US), and, as noted above, there was a serious recession in the UK from 1891 to 1893.


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

Court, W. H. B. 1965. British Economic History, 1870–1914: Commentary and Documents. Cambridge University Press, Cambridge.

Johnson, H. Clark. 1997. Gold, France, and the Great Depression, 1919–1932. Yale University Press, New Haven and London.

Livingston, James. 1986. Origins of the Federal Reserve System: Money, Class, and Corporate Capitalism, 1890–1913. Cornell University Press, Ithaca, N.Y. and London.

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

George Selgin on Deflation

An interesting and stimulating talk here by George Selgin at the Adam Smith Institute, called “Could Deflation be Salvation?”





Some comments:

(1) The idea of steep price falls and perhaps general deflation this century owing to strong productivity growth is not unrealistic.

Now Selgin makes the case for “good” and “bad” deflation. But is the so-called “good” deflation really good? Specific price falls in individual goods (but not general deflation) that occur from productivity growth are no doubt a good thing. But even here it does not follow that general price deflation, even when solely from productivity growth, is a good thing.

The idea that, since the price fall of an individual good from productivity growth is positive, then general price deflation from the same cause will be positive as well is a fallacy of composition, despite Selgin’s protestations that it is not (from 13.20). It fails to consider the macroeconomic effects of general price deflation, and, above all, debt deflation. This issue is very briefly touched on at 13.05–13.20 and 38.23–40.20. However, I do not see any strong counterargument against the debt deflation objection. What is being assumed is that deflation from productivity growth will not result in involuntary unemployment and downward pressure on wages (see (4) below).

Strangely, Selgin defends by his position by accusing his opponents of being guilty of a “vast reverse fallacy of composition,” whatever this means.

(2) On the so-called Great Depression of 1873 to 1896, I agree it was not a depression in the conventional sense (see Capie and Wood 1997; Saul 1985). It was a period of several businesses cycles, and certainly real GDP in all nations was higher in 1896 than in 1873. Selgin argues that these 19th century periods of deflation from productivity growth were not “harmful,” and that “nobody back” in that century was aware of a depression from 1873 to 1896. While one can recognise that there is a kind of myth about 1873 to 1896, nevertheless I think that these claims are doubtful. I dispute that nobody then thought there was any kind of economic crisis in these years. There was concern from various groups in the years from 1873 to 1896: business people who saw their profits fall, European farmers who saw a real depression (Capie and Wood 1997: 188), and debtors hit by debt deflation.

On the specific economics problems of the 1870s and 1890s, see here:

“US Unemployment in the 1890s,” January 24, 2012.

“US Unemployment, 1869–1899,” January 26, 2012.

“Per Capita GDP Growth Rates During the Gold Standard Era,” September 11, 2012.

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

(3) But if the price reductions from productivity growth are not of the type that cause significant falls in the need for labour (unlikely, in my view), then that can only put strong downward pressure on wages as profit margins are squeezed. Selgin denies this (from 15.15) and protests that he is not advocating wage deflation.

But, if wages are cut, then that would induce debt deflation pressures, as the real burden of nominally fixed debts soars.

Even if one wants to assume that there are no really no wage falls, then we still have (4) below.

(4) Alternatively, and more likely, if the productivity growth causes sharp falls in the need for labour and serious unemployment, then, despite the prices falls, involuntary unemployment will result in an aggregate demand problem. Moreover, debt deflation is still a problem for the unemployed, even assuming the employed face no wage reductions. A market economy does not automatically adjust to full employment, and there is no reason to think that large-scale structural unemployment would not cause macroeconomic problems.

BIBLIOGRAPHY
Capie F. H. and G. H. Wood, 1997, “Great Depression of 1873-1896,” in D. Glasner et al. (eds), Business Cycles and Depressions: An Encyclopedia. Garland Pub., New York, 287–289.

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

Woods on “Sound Money” and Deflation: A Critique

After looking at the video, if you do not want to read the whole discussion, I suggest merely reading point (3) below. It makes the point that the actual “gold standard” era was mostly a myth owing to the overwhelming amount of non-commodity credit money in that era.




Points to consider:

(1) I’m not concerned with the first comments on the alleged idea that elites are “pushing” the gold standard and Austrian economics. That is obviously false!

(2) The idea that entirely privatised money will control inflation or even money supply growth is nonsense, and the whole notion that “creating money out of thin air” is fraudulent or immoral is not true. Anyone can create money: witness how private sector agents can create negotiable bills of exchange, promissory notes, negotiable cheques and private banknotes, all of which add to the money supply.

(3) Woods is also mistaken that the gold standard saw “the greatest burst of economic progress in the history of the world.” He refers here to the industrial revolution.

First, people forget that the actual real output growth during the industrial revolution was only revolutionary compared to what preceded it. Real output growth in the periods that followed the gold standard has been superior.

We can easily verify this by looking at real per capita GDP growth across the whole OECD in historical terms:

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

First, it is obvious that the 1820–1913 period (roughly the industrial revolution) was superior to the 1700–1820 period and previous periods. But those periods also had a commodity standard: silver and gold were the base money in many ancient, medieval and pre-modern economies. Yet none of those economies experienced an industrial revolution. It is naive in the extreme to think that there was any necessary connection between the gold standard and the industrial revolution. The invention of new technologies such as steam power and the mechanisation of textile production did not necessarily require commodity money, but human ingenuity. (In the UK, the emergence of the mechanised textile production – the basis of the British industrial revolution – required a large degree of protectionism.)

Moreover, the 1946–1973 era won out as the best period in terms of per capita GDP growth: in fact, it was better than all other eras by a very considerable degree.

If any era deserves the mantle of “the greatest burst of economic progress in the history of the world,” it is the Keynesian golden age of capitalism.

Secondly, capitalism before 1914 during the industrial revolution was certainly a dynamic era. But investment and economic growth requires credit and credit money, and since the latter is essentially a part of the broad money supply, that requires an elastic or partly endogenous money stock.

In the face of rising demand for credit money during the 19th century, Western nations created credit money in ever greater amounts in addition to gold:

“[the] reconciliation of high rates of economic growth with exchange-rate and gold-price stability [in the 19th century] was made possible … by the rapid growth and proper management of bank money, and could hardly have been achieved under the purely, or predominantly, metallic systems of money creation characteristic of the previous centuries. Finally, the term ‘gold standard’ could hardly be applied to the period as a whole, in view of the overwhelming dominance of silver during its first decades, and of bank money during the latter ones. All in all, the nineteenth century could be far more accurately described as the century of an emerging and growing credit-money standard, and of the euthanasia of gold and silver moneys, rather than as the century of the gold standard.” (Triffin 1985: 153).

Triffin (1985: 152) estimates that in 1800 bank money or credit money probably constituted less than 33% of the money supply. But by 1913 paper currency and bank deposits accounted for 90% of overall currency circulation in the world, and actual gold itself for not much more than 10%.

So much for the classic gold standard era! It was mostly a myth.

(4) The notion that Canada did not suffer from financial “panics” during the 19th century because it had no formal central bank ignores the fact that the financial system in Canada was stabilised by the large and powerful “Bank of Montreal” that in some ways acted like a de facto central bank (Bordo 2002: 121), by taking over insolvent banks and being committed to the stability of the Canadian financial system.

Woods suggests that if only the US had no restrictions on branch banking (from 18.00) then its financial system might have been more stable. But Australia had the closest thing to a free banking system in the 19th century with free branch banking, and yet the system ended in a disastrous asset bubble, financial crisis and debt deflationary depression.

(5) Financial panics existed in many nations without central banks, and the Rothbardian notion that fractional reserve banking is inherently immoral or fraudulent is wrong. Capitalism is stuck with fractional reserve banking, and whatever destabilising effects unregulated fractional reserve banking might have – and it certainly does have such effects – are an inherent flaw of capitalism.

(6) Woods repeats the idea of Murray Rothbard that the 1873–1879 era was “one of the most prosperous periods in American history.” But that idea is now totally discredited, as I have shown here:

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

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

It appears that the US had a recession from 1873 to 1875 lasting less than 3 years, and unemployment was rising in these years and continued rising until 1878.

(7) The second part of this video (from about 19.00) is taken up with an Austrian defence of price deflation. The gaping whole in the analysis is the absence of any reference to debt deflation.

(8) While it is true that an economy can have real output growth with price deflation, nevertheless economic problems can develop, both in theory and in practice in real world economies where deflationary periods have been observed.

(9) Woods states that “we had falling prices all through US history up through the early 20th century” (my emphasis; 19.15–19.22). That is false, if he means that there was continuous price deflation throughout all that period.

Perhaps Woods means that there was a long-term falling trend in prices throughout US history, but even if you want to take him in that sense there were plenty of inflationary episodes in US history, as can be seen here:

Year | Inflation Rate
1775 | -5.24%
1776 | 14.17%
1777 | 21.87%
1778 | 29.78%
1779 | -11.51%
1780 | 12.25%
1781 | -19.34%
1782 | 9.70%
1783 | -12.33%
1784 | -3.88%
1785 | -4.84%
1786 | -2.55%
1787 | -1.85%
1788 | -4.43%
1789 | -0.93%
1790 | 3.75%
1791 | 2.71%
1792 | 1.87%
1793 | 3.45%
1794 | 10.95%
1795 | 14.38%
1796 | 5.26%
1797 | -3.75%
1798 | -3.33%
1799 | 0.00%
1800 | 2.10%
1801 | 1.31%
1802 | -15.73%
1803 | 5.49%
1804 | 4.38%
1805 | -0.70%
1806 | 4.23%
1807 | -5.41%
1808 | 8.66%
1809 | -2.05%
1810 | 0.00%
1811 | 6.80%
1812 | 1.26%
1813 | 20.02%
1814 | 9.89%
1815 | -12.29%
1816 | -8.65%
1817 | -5.36%
1818 | -4.34%
1819 | 0.00%
1820 | -7.87%
1821 | -3.52%
1822 | 3.65%
1823 | -10.65%
1824 | -7.88%
1825 | 2.57%
1826 | 0.00%
1827 | 0.83%
1828 | -4.96%
1829 | -1.85%
1830 | -0.89%
1831 | -6.26%
1832 | -0.95%
1833 | -1.93%
1834 | 1.97%
1835 | 2.89%
1836 | 5.62%
1837 | 2.77%
1838 | -2.70%
1839 | 0.00%
1840 | -7.10%
1841 | 0.95%
1842 | -6.62%
1843 | -9.24%
1844 | 1.12%
1845 | 1.10%
1846 | 1.09%
1847 | 7.69%
1848 | -4.14%
1849 | -3.14%
1850 | 2.16%
1851 | -2.11%
1852 | 1.08%
1853 | 0.00%
1854 | 8.68%
1855 | 2.95%
1856 | -1.91%
1857 | 2.92%
1858 | -5.67%
1859 | 1.00%
1860 | 0.00%
1861 | 5.96%
1862 | 14.17%
1863 | 24.82%
1864 | 25.14%
1865 | 3.68%
1866 | -2.53%
1867 | -6.82%
1868 | -3.91%
1869 | -4.14%
1870 | -4.24%
1871 | -6.40%
1872 | 0.00%
1873 | -2.03%
1874 | -4.83%
1875 | -3.62%
1876 | -2.35%
1877 | -2.31%
1878 | -4.73%
1879 | 0.00%
1880 | 2.48%
1881 | 0.00%
1882 | 0.00%
1883 | -2.02%
1884 | -2.06%
1885 | -2.00%
1886 | -2.15%
1887 | 1.10%
1888 | 0.00%
1889 | -3.25%
1890 | -1.12%
1891 | 0.00%
1892 | 0.00%
1893 | -1.13%
1894 | -4.36%
1895 | -2.40%
1896 | 0.00%
1897 | -1.23%
1898 | 0.00%
1899 | 0.00%
1900 | 1.24%
1901 | 1.23%
1902 | 1.21%
1903 | 2.28%
1904 | 1.17%
1905 | -1.16%
1906 | 2.23%
1907 | 4.47%
1908 | -2.09%
1909 | -1.12%
1910 | 4.42%
1911 | 0.00%
1912 | 2.06%
1913 | 2.13%
1914 | 0.94%

http://www.measuringworth.com/calculators/inflation/result.php

(10) Woods tells us that:

“Two of the periods of the most robust economic growth in US history were the periods from 1820–1850 and 1865–1900. And in those two cases – in each case prices fell about in half – ... [sc. there was] robust growth.” (from 19.36)

In regard to the 1820–1850 period, we can already see that there were plenty of inflationary periods here:

1820 | -7.87%
1821 | -3.52%
1822 | 3.65%
1823 | -10.65%
1824 | -7.88%
1825 | 2.57%
1826 | 0.00%
1827 | 0.83%
1828 | -4.96%
1829 | -1.85%
1830 | -0.89%
1831 | -6.26%
1832 | -0.95%
1833 | -1.93%
1834 | 1.97%
1835 | 2.89%
1836 | 5.62%
1837 | 2.77%
1838 | -2.70%
1839 | 0.00%
1840 | -7.10%
1841 | 0.95%
1842 | -6.62%
1843 | -9.24%
1844 | 1.12%
1845 | 1.10%
1846 | 1.09%
1847 | 7.69%
1848 | -4.14%
1849 | -3.14%
1850 | 2.16%

http://www.measuringworth.com/calculators/inflation/result.php

The inflationary periods roughly coincided with expansions in the business cycle (booms) and the deflation mostly associated with recessions, as far as I can see. There were probably recessions in this period in the following years:

US Recessions, 1820–1850
Years (Peak–Trough) | Recession Length (years)
1822–1823 |
1828–1829 |
1833–1834 |
1836–1837 | less than 1
1839–1840 | less than 3
(Davis 2006: 106).

These seem to coincide with deflationary periods (the correlation is not perfect, of course, but neither is the real GDP data).

In the end, whatever this GDP data is telling us, it is not showing the effects of continuous price deflation.

At any rate, from 1820 to 1850 real US GDP increased by 239.36% from $12,548 million to $42,583 million (in 1990 international Geary-Khamis dollars; Maddison 2003: 85–96).

But in a comparable 30 year period between 1934 (the beginning of the recovery from the Great Depression and 1964 (in the Keynesian “golden age of capitalism”) real US GDP increased by 277.46%, from $649,316 million to $2,450,915 million (in 1990 international Geary-Khamis dollars; Maddison 2003: 85–96).

So even real GDP growth from 1820 to 1850 was inferior to a later period after the gold standard had been abandoned.

With regard to the 1865–1900 period, it is certainly true that there was mostly deflation from 1873–1896. Although I do not have annual GDP estimates for 1865–1869, the average real GNP growth rate from 1870–1900 was 4.08%, which was historically high.

But matters are very different once we look at real per capita GDP: it was only 1.78% from 1871–1900, one of the lowest of all periods in modern US history:

Historical Real Per Capita GDP Growth Averages
Average Growth Rate 1879 to 1896: 1.36%
Average Growth Rate 1871–1914: 1.63%
Average Growth Rate 1871–1900: 1.78%
Average Growth Rate 1873–1879: 1.64%
Average Growth Rate 1991–2000: 1.94%
Roaring 20s, Average Growth Rate 1920–1929: 2.04%
Average Growth Rate 1971–1980: 2.16%
Average Growth Rate 1981–1990: 2.26%
Average Growth Rate 1948–1973: 2.30%.
Recovery from Depression 1934–1940: 5.75%.

The whole period of 1873–1879, which was the “great deflation of the late 19th century,” had a comparatively low real per capita GDP growth rate average of 1.64%, and a period within this from 1879–1896 had an average of 1.36%, the worst ever seen.

But more specifically, both the 1870s and 1890s were periods of clear economic malaise in US history, and the underlying cause may well have been debt deflation:

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

“Davis on US Recessions in the 19th Century,” August 25, 2012.

“US Unemployment in the 1890s,” January 24, 2012.

(11) Woods cites Atkeson and Kehoe (2004) on the alleged benign nature of deflation. He cites its finding that deflation is not necessarily related to recession. Any look through economic history shows that you can have real output growth with price deflation, so that Atkeson and Kehoe’s finding is not that surprising. Price deflation is a serious problem under certain circumstances: when it induces debt deflation in an economy with a high level of private debt.

But there are other reasons to be cautious about Atkeson and Kehoe’s findings. First, there is the question of the actual reliability of the real GDP data available for the 19th century. Most nations only have annualised (not quarterly) estimates for the 19th century which are provisional at best, so that any correlations or lack thereof between deflation and recession for the period before 1914 are hardly definitive. Secondly, after 1945, modern monetary and fiscal interventions have reduced deflationary periods, and even when they have occurred the same monetary and fiscal interventions have allowed modern economies to stave off the worst effects of debt deflation.

Thirdly, Woods ignores the important qualification at the end of Atkeson and Kehoe’s article:

“The data suggest that deflation is not closely related to depression. A broad historical look finds many more periods of deflation with reasonable growth than with depression, and many
more periods of depression with inflation than with deflation. Overall, the data show virtually
no link between deflation and depression.

This study simply characterizes the relation in the raw data between deflation and output growth, with no attempt to control for anything, like the type of monetary regime or the extent to which the deflation was anticipated. Perhaps a link between deflation and depression could be teased out of the data with a well-motivated set of controls. Our contribution here is to note that, without such controls, the data show no obvious relationship.” (Atkeson and Kehoe 2004: 102).

In other words, this is a crude study, with “no attempt to control for anything.”

Once you control for

(1) periods of unexpected deflation where
(2) the level of private debt was very high and
(3) asset bubbles were in existence, and
(4) modern stabilising monetary and fiscal interventions were not implemented,

then I have little doubt one could show a strong empirical relationship between deflation and economic crisis, via the mechanism of debt deflation.

BIBLIOGRAPHY

Atkeson, Andrew and Patrick J. Kehoe. 2004. “Deflation and Depression: Is There an Empirical Link?,” The American Economic Review 94.2, Papers and Proceedings of the One Hundred Sixteenth Annual Meeting of the American Economic Association San Diego, CA, January 3–5, 2004 (May, 2004): 99–103.

Bordo, M. D. 2002. “The Lender of Last Resort: Alternative Views and Historical Experience,” in Charles Goodhart and Gerhard Illing (eds.). Financial Crises, Contagion, and the Lender of Last Resort: A Reader. Oxford University Press, Oxford. 109–125.

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.

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

Triffin, R. 1985. “Myth and Realities of the Gold Standard,” in B. Eichengreen and M. Flandreau (eds), The Gold Standard in Theory and History. Routledge, London and New York. 140–161.

Keynes on the Nature of Deflation

I have not read Keynes’s A Tract on Monetary Reform (1923) in a while, but I was struck by the following passage on a recent re-reading of the work. This is Keynes arguing against post-war deflation in Europe after the First World War:

“In the first place, Deflation is not desirable, because it effects, what is always harmful, a change in the existing Standard of Value, and redistributes wealth in a manner injurious, at the same time, to business and to social stability. Deflation, as we have already seen, involves a transference of wealth from the rest of the community to the rentier class and to all holders of titles to money; just as inflation involves the opposite. In particular it involves a transference from all borrowers, that is to say from traders, manufacturers, and farmers, to lenders, from the active to the inactive.

But whilst the oppression of the taxpayer for the enrichment of the rentier is the chief lasting result, there is another, more violent, disturbance during the period of transition. The policy of gradually raising the value of a country’s money to (say) 100 per cent above its present value in terms of goods … amounts to giving notice to every merchant and every manufacturer, that for some time to come his stock and his raw materials will steadily depreciate on his hands, and to every one who finances his business with borrowed money that he will, sooner or later, lose 100 per cent on his liabilities (since he will have to pay back in terms of commodities twice as much as he has borrowed). Modern business, being carried on largely with borrowed money, must necessarily be brought to a standstill by such a process. It will be to the interest of everyone in business to go out of business for the time being; and of everyone who is contemplating expenditure to postpone his orders so long as he can. The wise man will be he who turns his assets into cash, withdraws from the risks and the exertions of activity, and awaits in country retirement the steady appreciation promised him in the value of his cash. A probable expectation of Deflation is bad enough; a certain expectation is disastrous. For the mechanism of the modern business world is even less adapted to fluctuations in the value of money upwards than it is to fluctuations downwards.” (Keynes 1923: 143–144).

Keynes, then, was well aware of the debt deflationary effects of price deflation from early in his career, and the way in which price deflation penalises businesses that have borrowed money.

BIBLIOGRAPHY
Keynes, John Maynard. 1923. A Tract on Monetary Reform. Macmillan, London.

Reply to “Unemployment, Deflation and Growth During the Period of 1873–1896”

A commentator on Mises.org called “Rodolphe Topffer” attempts a critique of my views on US GNP growth in the late 19th century:

“Unemployment, Deflation and Growth During the Period of 1873–1896,” 4 September, 2012.

My response:

(1) The whole post suffers from the use of a straw man argument.

Curiously, the author cites Bordo and Filardo for the view that it is “abundantly clear that deflation need not be associated with recessions, depressions, and other unpleasant conditions” – but this very view is, as far as I can see, already accepted by Keynesians. Certainly, I accept it.

The idea that there is “a common belief among Keynesians that a situation of a falling prices will result in a recession” is simply not true, if by that we mean that academic Keynesian economists think that price deflation always results in recession. On the contrary, any Keynesian with a decent knowledge of economic history knows about the long period of deflation in the Western world from 1873–1896, during which there was in fact real output growth. In one of the first posts on my blog, I in fact noted this myself.

Now what Keynesians would say is that deflation can be a consequence of economic crisis when the money supply collapses, or that, in an environment of heavy private debt, steep deflation is likely to induce debt deflationary effects. This is quite different from thinking price deflation is always bad or results in real output collapse.

(2) Rodolphe Topffer states:

“The periods running from 1873 to 1879 and 1879 to 1896 show a huge increase in GNP per capita, see Rothbard (2002) ‘A History of Money and Banking in the United States’ (see pages 360–361, 400–403, 154–155, 159–161, 164).”

Let us look at US per capita GDP in the late 19th century from the figures in Angus Maddison (2006), which appear to be calculated from the estimates in Balke and Gordon (1989):

US per capita GDP 1870–1900
(in 1990 international Geary-Khamis dollars)
Year | GDP | Growth rate
1870 | 2445 |
1871 | 2489 | 1.79%
1872 | 2524 | 1.40%
1873 | 2562 | 1.50%
1874 | 2601 | 1.50%
1875 | 2643 | 1.61%
1876 | 2686 | 1.62%
1877 | 2732 | 1.71%
1878 | 2780 | 1.75%
1879 | 2829 | 1.76%
1880 | 2880 | 1.80%
1881 | 2921 | 1.42%
1882 | 2963 | 1.43%
1883 | 3008 | 1.51%
1884 | 3056 | 1.59%
1885 | 3106 | 1.63%
1886 | 3158 | 1.67%
1887 | 3213 | 1.74%
1888 | 3270 | 1.77%
1889 | 3330 | 1.83%
1890 | 3392 | 1.86%
1891 | 3467 | 2.21%
1892 | 3728 | 7.52%
1893 | 3478 | -6.70%
1894 | 3314 | -4.71%
1895 | 3644 | 9.95
1896 | 3504 | -3.84%
1897 | 3769 | 7.56
1898 | 3780 | 0.29
1899 | 4051 | 7.16
1900 | 4091 | 0.98
Average Growth Rate 1871–1900: 1.78%
Average Growth Rate 1873–1879: 1.64%
Average Growth Rate 1879 to 1896: 1.36%
Average Growth Rate 1871–1880: 1.64%
Average Growth Rate 1881–1890: 1.65%
Average Growth Rate 1891–1900: 2.04%
(Maddison 2006: 465–466).

The average per capita GDP rate from 1873 to 1879 was 1.64%.

The average per capita GDP rate from 1879 to 1896 was 1.36%. This was not especially high historically.

As always, the data is only an estimate and might be challenged. For example, Joseph H. Davis’s (2006) list of recessions in the 19th century, on the basis of his annual dataset of US industrial production from 1796 to 1915, shows that the US had a recession from 1873 to 1875 lasting about 3 years, a recession which is absent from Balke and Gordon (1989).

If Davis is right, the mid-1870s was hardly a prosperous period.

The most telling data is unemployment, which we can see here from the estimates is that of J. R. Vernon (1994):

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).

The 1873–1896 era saw two periods of rising unemployment: (1) 1875–1878 and (2) 1893–1896.

Thus the period from 1873–1896 in the US had two periods of economic crisis: the mid/late 1870s and 1893–1896. During both these periods unemployment rose sharply. A financial crisis also appears to have begun the crisis periods. It is quite likely that the economy in both 1870s and 1890s experienced some degree of debt deflation, so that the deflation was the cause of economic malaise.

(3) The author objects to a comparison of per capita GDP between 1946–1973 and 1873–1896, but the major objection is simply absurd:

“2) Theoretically, we can say that economic growth is much easier when the economy has to recover from the damages caused by the war. The comparison therefore does not hold.”

Why is this absurd? The US was not invaded or damaged during the war in the way the European economics were. Thus there was no “war reconstruction” in the US as there was in Europe. Instead, what occurred was the reconversion of the US economy from its wartime command structure to a peacetime consumer economy. That was certainly accomplished by 1950. So even if we were to subtract the 1946–1949 period, it is obvious that a comparison of 1950–1973 with an equivalent period in the late 19th century (say, 1873–1896) should be perfectly justifiable.



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

Maddison, Angus. 2006. The World Economy: Volume 1: A Millennial Perspective and Volume 2: Historical Statistics. OECD Publishing, Paris.

Hayek on Monetary Stabilisation in a Secondary Deflation

My post on the Selgin versus Skidelsky debate has brought up many issues. Professor Selgin points out errors I have made, which I feel bound to correct.

In particular, I previously claimed that it was only late in life that Hayek changed his mind and admitted he had been wrong in supporting the effects of a “secondary deflation” in the initial years of the Great Depression. For my assertion, I relied on an interview with Hayek published in 1978, where he made this statement:

“Although I do not regard deflation as the original cause of a decline in business activity, such a reaction has unquestionably the tendency to induce a process of deflation – to cause what more than 40 years ago I called a ‘secondary deflation’ – the effect of which may be worse, and in the 1930s certainly was worse, than what the original cause of the reaction made necessary, and which has no steering function to perform. I must confess that forty years ago I argued differently. I have since altered my opinion – not about the theoretical explanation of the events, but about the practical possibility of removing the obstacles to the functioning of the system in a particular way” (Hayek 1978: 206).

There is also this statement of Hayek in an interview conducted in July, 1979 at Hayek’s home in Freiburg, Germany:

“There is no doubt, and in this I agree with Milton Friedman, that once the Crash had occurred, the Federal Reserve System pursued a silly deflationary policy. I am not only against inflation but I am also against deflation! So, once again, a badly programmed monetary policy prolonged the depression” (Pizano 2009: 13).

But Selgin points out:

“[sc. Hayek] … changed in in 1931--that is, 5 years before the appearance of the GT and while the spending collapse was still in progress! You can hear me quoting a passage from his 1933 essay ‘Saving’ to prove this point during the debate; and you may examine the Preface of the 2nd (1935) edition of Prices and Production (which I also referred to, but which was edited out), for more evidence.

Selgin also emphasises that he is “a stable MV person, as was Hayek from ’31 onwards.”

The relevant passage in the second edition of Prices and Production (1935) is here:

“The second effect of this assumption of separate ‘stages’ of production of equal length was that it imposed upon me a somewhat one-sided treatment of the problem of the velocity of circulation of money. It implied more or less that money passed through the successive stages at a constant rate which corresponded to the rate at which the goods advanced through the process of production, and in any case excluded considerations of changes in the velocity of circulation or the cash balances held in the different stages. The impossibility of dealing expressly with changes in the velocity of circulation so long as this assumption was maintained served to strengthen the misleading impression that the phenomena I was discussing would be caused only by actual changes in the quality* [sic] of money and not which neglected in this way the phenomenon of changes in the desire to hold money balances could not possibly say anything worthwhile. While in my opinion this is a somewhat exaggerated view, I should like to emphasise in this connection how small a section of the whole field of monetary theory is actually treated in this book. All that I claim for it is that it deals with an aspect which has been more neglected and misunderstood than perhaps any other and the insufficient understanding of which has led to particularly serious mistakes. To incorporate this argument into the body of monetary theory is a task which has yet to be undertaken and which I could not and did not try to undertake here. But I may perhaps add that so far as the general theory of money (as distinguished from the pure theory of capital) is concerned, it is this work of Professor Mises much more than that of Knut Wicksell which provides the framework inside which I have tried to elaborate a special point.” (Hayek 1975 [1939]: xii–xiii).

* This appears to be a typo for “quantity”.

But this passage does not show Hayek urging monetary stabilisation during times of severely fluctuating velocity of circulation of money or falls in the quantity of money during depressions. He is talking about the implications of the fluctuation in the velocity of circulation of money for capital goods investment in his trade cycle theory.

I have also read Hayek’s essay Savings (1933; reprinted in Hayek 1975 [1939]: 157–170), but cannot see any statements there either on monetary stabilisation in a depression. That essay seems mostly concerned with definitions of saving, and questions like voluntary and forced saving.

Perhaps I have missed something. If Hayek did indeed urge monetary stabilisation as early as 1931 where is the evidence of this? Does anyone have a citation?

Let us say for the sake of argument that Hayek did indeed urge monetary stabilisation as early as 1931. That would show good sense by Hayek, of course. But then the question becomes: what was the best method of doing this?

If he thought the central bank should have done it, we already have an obvious problem, and one that monetarists also face: it is highly unlikely that radical open market operations (what we call quantitative easing) will in fact stabilise the broad money stock. At most, this would have prevented the collapse of large parts of the financial sector (of course, a good thing), but a contraction of the broad money supply would no doubt still have happened as a heavily indebted private sector engaged in distress selling of assets and deleveraging, which would have spilled over into shocks to business confidence, net negative changes in debt, and a slump in consumption, investment and employment. The banks would have hoarded their excess reserves, just as they mostly do now, and a public saturated with private debt would have been unwilling to take on new debts for investment or consumption. I do not see how a free banking system on a gold standard would overcome such a problem either.

If monetary policy were really all that is needed to prevent secondary price deflation, then why did Japan’s zero interest rate policy (ZIRP) in the 1990s and quantitative easing in the 2000s not prevent the descent into price deflation in 1999? And why did price deflation persist in Japan for years after the beginning of quantitative easing in 2001?

If we take the income quantity theory of money equation, as follows:

Equation 2: MV = PY

where
M = quantity of money;
V = velocity of circulation of money;
P = average price of the transactions, and
Y = the volume of all transactions that enter into the value of national income (goods and services),

then the only really effective way to stabilise M (conceived as the broad money stock) and V is fiscal policy, not merely monetary policy. Since the broad money stock is endogenous, its expansion and contraction is largely driven by the dynamics of private debt issued by banks. If it is contracted by deleveraging, and the private sector is overloaded with debt already (as in the 1930s, Japan in the 1990s, or America and other nations in the 2010s), businesses will not take on significantly new levels of debt, and consumers are unlikely to either. If one increases the excess reserves of banks to a great extent, these reserves will not get injected into the economy in significant flows to increase investment or spending. It is government spending that will be the only reliable way of doing it.


BIBLIOGRAPHY

Hayek, F. A. von. 1967 [1935]. Prices and Production (2nd edn.), Augustus M. Kelley Publishers, New York.

Hayek, F. A. von. 1975 [1939]. Profits, Interest and Investment, Augustus M. Kelley Publishers, Clifton, NJ.

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

Pizano, D. 2009. Conversations with Great Economists, Jorge Pinto Books Inc., New York.