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.

Magliulo on “Hayek and the Great Depression of 1929”

Antonio Magliulo has an interesting paper here on Hayek’s opinion of the Great Depression, and whether he changed his mind on the policy solutions to depressions:

Magliulo, Antonio. 2013. “Hayek and the Great Depression of 1929: Did he really Change his Mind?,” The European Journal of the History of Economic Thought, Published online, 27 September, 2013.
http://www.tandfonline.com/doi/abs/10.1080/09672567.2013.792373?journalCode=rejh20#preview

Magliulo’s (2013: 22) conclusion is that Hayek did not change his views on the origin of depressions (as derived from his Austrian trade cycle theory), but did come to change his views on (1) the economic role of deflation in inducing wage flexibility, and (2) policy responses to depressions when “secondary deflation” had set in.

Magliulo points to Hayek’s reconsidered theory of the Great Depression that he developed in the 1970s, in which Hayek tried to maintain his business cycle theory but emphasised the role of “secondary deflation” and the possibility that government intervention could arrest his deleterious secondary phenomenon (Magliulo 2013: 15–21).

In particular, there was a change in Hayek’s view of deflation. While in the 1930s, Hayek seems to have still believed that deflation had a positive role to play in breaking general wage stickiness, by the 1970s Hayek admitted that this was “politically unachievable” and that deflation was “harmful, with the sole effect of increasing real wages” (Magliulo 2013: 16).

Magliulo draws attention to this paper by Gottfried von Haberler in which Haberler described Hayek’s new views on the role of aggregate demand in an economy, and the two instances where Hayek now admitted that aggregate demand was able to affect the level of employment:

“In later writings Hayek (1974, 1975) has clarified and somewhat modified his views, coming to grips with the problem of secondary deflation. He still rejects what he believes is the basic mistake of Keynesian economics, namely, ‘that employment is a direct and simple function of what is called aggregate demand, and that by keeping aggregate demand at a sufficiently high level we can lastingly secure full employment’ (1975, p. 4). In a later publication he goes so far as to say that ‘the whole notion that he [Keynes] has made popular, macroeconomics,’ must be ‘set aside.’

Hayek now says there are two exceptions to the rule that changes in aggregate demand do not affect the level of employment. The first one was ‘an accidental historic situation.’ In 1925 Britain made the mistake of returning to the gold standard at the prewar parity, which meant that real wages were too high. ‘In this situation,’ he wrote, ‘the restoration of employment required a reduction of real wages which could he achieved by a general rise of prices’ (1974, p. 4).

‘The second situation in which it is true that an increase of employment requires an increase in aggregate demand,’ Hayek (1974, p. 5) now maintains, ‘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. … of secondary deflation, which may go on for a very long time.’” (Haberler 1986: 426; reprinted in Haberler 1991).

Further evidence for this can be found in the published text of a talk on April 9, 1975 that Hayek gave to the American Enterprise Institute in Washington, DC:

“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, delib¬erate 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: 5; see also 13).

Magliulo (2013: 17, n. 20) notes that Hayek, in a 1978 work, seems to have accepted the need for public works spending to arrest bad deflation (Hayek 1978: 210–212).

But there is evidence that already in 1937 Hayek had accepted that fiscal policy via public works was an acceptable way to end “secondary deflation.”

There is this passage in Hayek’s essay “The Gold Problem” (originally published in 1937 as “Das Goldproblem,” but available in an English translation in Hayek 1999: 169–185), where he essentially approves of the policy recommendations of Lionel Robbins’s 1937 paper “How to Mitigate the Next Slump”:

“Even though there are many concerns about organizing public works ad hoc during a depression, everything speaks in favour of having public agencies perform during a depression whatever investment activities need to be carried out in any case and can possibly be postponed until then. It is the timing of these expenses that presents a problem, since funds are often extremely hard to raise in the midst of a severe depression and the accumulation of reserves in good times generally faces the objections mentioned above. There is little question that in times of general unemployment the state must intervene to mitigate genuine hardship either by disbursing unemployment compensation or, as in earlier times, by legislation to help the poor.” (Hayek 1999 [1937]: 184).

Moreover, in The Road to Serfdom (1944), Hayek appears to accept the possibility of public works spending even if “in experimenting in this direction we shall have carefully to watch our step if we are to avoid making all economic activity progressively more dependent on the direction and volume of government expenditure” (Hayek 2001 [1944]: 126).

I would say that already in the 1930s at some point after 1933 and before 1937, there was already a significant change in
Hayek’s thinking, in which he repudiated hard “liquidationism.”

Further Reading
“Hayek on Secondary Deflation,” January 24, 2011

“Hayek on Monetary Stabilisation in a Secondary Deflation,” August 6, 2011.

“Did Hayek Advocate Public Works in a Depression?,” September 25, 2011.

“When Did Hayek Renounce Liquidationism?,” January 1, 2012.

“Steven Horwitz on Stimulus Spending and Hayek,” August 24, 2012.

“Hayek the Evil Socialist,” January 1, 2012.

“Hayek on Aggregate Demand in a Depression,” March 21, 2013.

“Hayek was originally a Liquidationist: Free Bankers are Wrong!,” August 13, 2013.

“Hayek the Stable MV Theorist?,” August 13, 2013.

“The Evidence for Hayek the Stable MV Theorist is still Feeble,” August 21, 2013.

“Hayek on ‘The Flow of Goods and Services,’” March 20, 2013.

BIBLIOGRAPHY
Haberler, G. 1986. “Reflections on Hayek’s Business Cycle Theory,” Cato Journal 6: 421–435.

Haberler, G. 1991. “Reflections on Hayek’s Business Cycle Theory,” in John Cunningham Wood and Ronald N. Woods (eds.), Friedrich A. Hayek: Critical Assessments (vol. 4). Routledge, London. 249–262.

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

Hayek, Friedrich A. von. 1978. “Further Considerations on the Same Topic,” in F. A. Hayek, New Studies in Philosophy, Politics, Economics and the History of Ideas. University of Chicago Press, Chicago. 209–218.

Hayek, Friedrich A. von. 1999. “The Gold Problem” (trans. G. Heinz), in S. Kresge (ed.), The Collected Works of F. A. Hayek. Volume 5. Good Money, Part 1. The New World. Routledge, London. 169–185.

Hayek, Friedrich A. von. 2001 [1944]. The Road to Serfdom. Routledge, London.

Magliulo, Antonio. 2013. “Hayek and the Great Depression of 1929: Did he really Change his Mind?,” The European Journal of the History of Economic Thought, Published online, 27 September, 2013.

Robbins, Lionel. 1937. “How to Mitigate the Next Slump,” Lloyd Bank Monthly Review n.s. 8 (May): 238–240.

Canada’s Banking Stability in the Early 20th Century and the 1930s

Austrian, libertarian and free banking myths about Canada’s banking system persist.

Two myths are (1) that Canada’s alleged free banking system with its extensive branch banking was the only or the major reason why the Canadian financial system did not experience mass bank failures from 1929–1933, and (2) that there was no significant government intervention in the financial sector in the 1920s and 1930s before 1935.

Some typical statements of these ideas can be found here:

“Canada’s experience during the Great Depression also gives us reason to doubt the wisdom of monetary intervention. Canada has historically had low levels of government intervention and an unregulated banking system. Professor White noted that people did not run on Canadian banks in the same way that they ran on American banks during the Great Depression. In part, this was due to the absence of branch banking restrictions that prevented American banks from diversifying their risks. The Canadian banking system adjusted to new market conditions and did not undergo the protracted crisis that occurred in the United States.”
Art Carden and Christina Magrans, “A Free Market in Money?” Mises Daily, July 21, 2009
http://mises.org/daily/3548/

“Thousands of U.S. banks failed during the panics of the 1930s, most in states with unit banking laws.

In contrast, Canada allowed branch banking and experienced zero bank failures during the Great Depression. According to Milton Friedman and Anna Schwartz, in Canada ‘10 banks with 3,000-odd branches throughout the country did not even experience any runs,’ even though Canada experienced the same decline in its quantity of money as the United States did.” (Murphy 2009: 126).

“No episode illustrates more dramatically the weakening effect of anti-branching laws than the Great Depression. Between 1931 and 1933 several thousand US banks—mostly small unit banks—failed. In contrast Canada’s branch-banking network did not suffer a single bank failure even though in other respects Canada was just as hard hit by the depression—it could hardly have escaped all of the adverse effects on Canadian business of a 33 per cent fall in the US money supply. (The Canadian money supply fell by about 13 per cent.) Ironically the United States at the time did have a lender of last resort, whereas Canada did not.” (Selgin 1996: 209).

Now, while it is entirely reasonable to accept that a branch banking system in Canada spread risk in a better way than in the United States, and that this branch banking system was one reason why Canada had a more stable banking system, it is simply wrong that Canada had no “lender of last resort” in these years. The fact is that, despite having no formal central bank until 1935, Canada did have a lender of last resort via the discount window that was created by the Finance Act of 1914. Nor was it true that Canada’s banking system was unregulated.

This and other government interventions – and not just the branch banking system in Canada per se (although it did no doubt have some role) – are much more plausible reasons why Canada’s banking system from 1914 to 1935 had reasonable stability.

The crucial points which discredit the libertarian position on Canada are as follows:

(1) Canada did not have a classical gold standard after 1914: legal tender in the Canadian system was either gold coin or Dominion notes, which were issued by the Canadian government (Shearer and Clark 1984: 278).

(2) Haubrich (1990: 226) reports that chartered banks in Canada even in the 1920s and 1930s were “heavily regulated” by the Bank Act of 1871 and subsequent revisions of that act, which “specified (among other things) audits, capital requirements, directors’ qualifications, and loan restrictions, including a prohibition against holding mortgages.”

In particular, the Bank Act of 1871 had prohibited banks from lending on real estate (see Darroch 1994: 277–278, with a list of revisions; see also Anonymous 1900), which would presumably have checked debt-financed asset bubbles in property and real estate speculation – all major sources of instability in capitalist systems.

(3) in 1907 the Canadian government lent $5 million in Dominion notes to the private sector banks during a banking panic, which averted a serious financial crisis.

And the “Canadian Bankers Association” (formed in 1891) – which in 1900 became a public corporation – also provided stability by organising bank mergers to deal with insolvent banks.

(4) in August 1914 the Canadian government suspended the gold standard and Canada only returned to the gold exchange standard for a brief period from 1 July, 1926 to January 1929, when in the latter year it was unofficially suspended (Shearer and Clark 1984: 277) and permanently and officially suspended in 1931 (Dowd 1992: 90).

But even more important was the Finance Act of 1914. This allowed Dominion banks to borrow notes directly from the Canadian Department of Finance: such notes were issued at the request of the banks with no gold-reserve requirement (Shearer and Clark 1984: 279).

This meant that from 1914 onwards Canada had a lender of last resort in the form of government issued money:

“The Finance Act, passed in 1914 to facilitate wartime finance, provided the chartered banks with a liberal rediscounting facility. By pledging appropriate collateral (this was broadly defined) banks could borrow Dominion notes from the Treasury Board. The Finance Act clause, which was extended after the wartime emergency by the Amendment of 1923, provided a discount window/lender of last resort for the Canadian banking system.” (Bordo 2005: 292).

Thus the Finance Act (1914) allowed the Canadian government the power to expand the money supply by creating dominion notes unbacked by gold (Bothwell, Drummond, English 1987: 183–184). This Finance Act of 1914 was amended and made permanent by the legislation of 1923.

Moreover, the use of this system continued long after the war:

“… the Finance Act provided a ‘discount window’ for the chartered banks as early as 1914, and … this mechanism had extensive use during the 1920’s. In a sense it was Canada’s answer to the Federal Reserve System of the United States.” (Bond and Shearer 1972: 402).

The private banks in fact had lines of credit with the discount window at the Department of Finance which they could access on demand through advances at a posted interest rate.

These lines of credit were definitely used and used in a significant way:

“Between 1920 and 1935, on average, advances amounted to only 16 percent of aggregate lines of credit, and in 100 of the 180 months, to less than 15 percent. Borrowing reached 25 percent of aggregate lines of credit in only 30 months, and the maximum usage was 39 percent (November 1929). At no time did the banking system have less than 60 percent of authorized lines of credit available for immediate use.” (Shearer and Clark 1984: 279).

“To a bank, an unused line of credit was a costless liquid asset that guaranteed almost instant access to legal tender. In principle, control over lines of credit was like control over cash reserves.” (Shearer and Clark 1984: 283).

The Finance Act of 1914, then, effectively made the government a “lender of last resort” and became a permanent part of the financial system (Naylor 2006: 526–527).

For example, in 1924, the Dominion and Imperial Banks experienced runs and turned not just to other banks, but to the Department of Finance for liquidity to avert a crisis (Carr, Mathewson, Quigley 1995: 1147).

And one can posit that the heaviest use of this lender of last resort facility was in the crisis years from 1929–1933 during the depression, which must have contributed to the stability of the Canadian banking system.

(5) A related point is that, while it is generally reported that no bank failures occurred in Canada during the Depression, we should note that the banking system did, however, contract:

“Although Canada’s branch banking system proved immune to runs and panics, the number of branches dropped from 4049 to 3640 between 1929 and 1933, loans and deposits fell, and bank-stock prices dropped. The interwar period showed a trend towards fewer and larger banks.” (Haubrich 1990: 224).

Even if no bank failed, nevertheless, it must have been the case that many bank branches were closed in the course of the depression.

(6) After WWI, a third of Canadian banks failed outright or were unloaded on other institutions, and it was government issued money and a continued infusion of these government legal tender notes that keep the banking system solvent (Naylor 2006: 527).

(7) another major factor was that Canada’s branch banking system had become highly concentrated by 1920. The number of banks declined from 30 in 1900 to 11 in 1920 as mergers and the acquisition of smaller banks by larger ones occurred (Bordo 1995: 10–11; Bothwell, Drummond, English 1987: 184; cf. Haubrich 1990: 225, who reports that in 1920 there were 18 banks and by 1929 this had fallen to 10).

(8) There is some evidence that successive Canadian governments from the 1920s made public statements and implicit promises to protect depositors in failed private banks, at least to some extent (Kryzanowski and Roberts 1993; with Carr, Mathewson and Quigley 1995 and Kryzanowski and Roberts 1999), as described here.

While Carr, Mathewson, Quigley (1995) dispute this and argue that there was no explicit or implicit promise of 100% deposit protection, nevertheless the evidence shows that governments did pay to reimburse or protect depositors: when in August 1923 the Home Bank of Canada failed, the Canadian government in June 1925 passed legislation which eventually resulted in the government paying 22.3% of average depositors’ claims (Carr, Mathewson, Quigley 1995: 1143). Even provincial governments provided stability: for example, in 1923 the government of Quebec provided $15 million via bond issues for the merger of the Bank Nationale with the Banque d’Hochelaga to avoid a bank failure (Kryzanowski and Roberts 1993: 365; Carr, Mathewson, Quigley 1995: 1149).

These interventions and possible implicit promises were further policies that contributed to the stability of the system.

(9) Canada finally had a formal central bank in 1935 (Dowd 1992: 91), which simply took over the discount window facility from the previous Department of Finance.

It is perfectly clear, then, that Canada after 1914 and during the Depressions years – but before its formal central bank of 1935 – had significant government interventions that provided banking stability.

What is especially ridiculous here is that these basic facts are freely admitted by free banking scholars like Dowd (1992: 89–92). Yet the libertarian myths continue.

Further Reading on Critiques of Free Banking
“Selgin, Lastrapes and White on ‘Has the Fed been a Failure?,’” February 29, 2012.

“Free Banking in Australia,” May 16, 2012.

“A Tale of Two Depressions: 1930s and 1890s Australia,” May 18, 2012.

“Why Did Canada Have no Mass Banking Failures in the Great Depression?,” September 12, 2012.

“Free Banking in Scotland,” April 12, 2013.

BIBLIOGRAPHY
Anonymous. 1900. “The Canadian Bank Amendment Act of 1900,” The Quarterly Journal of Economics 14.4: 543–551.

Bond, David E. and Ronald A. Shearer. 1972. The Economics of the Canadian Financial System: Theory, Policy and Institutions. Prentice-Hall, Scarborough, Ont.

Bordo, Michael D. 1995. “Regulation and Bank Stability: Canada and the United States, 1870–1980,” Policy Research Working Papers 1532, World Bank, Policy Research Dept., Finance and Private Sector Development Division, and Financial Sector Development Dept.

Bordo, Michael D. 2005. “The Lender of Last Resort: Alternative Views and Historical Experience,” in Forrest Capie and Geoffrey E. Wood (eds.), The Lender of Last Resort. Routledge, London. 279–296.

Bothwell, Robert, Drummond, Ian and John English. 1987. Canada, 1900–1945. University of Toronto Press, Toronto and Buffalo.

Carr, Jack, Mathewson, Frank, and Neil Quigley. 1995. “Stability in the Absence of Deposit Insurance: The Canadian Banking System, 1890-1966,” Journal of Money, Credit, and Banking 27.4 (Part 1): 1137–1158.

Darroch, James L. 1994. Canadian Banks and Global Competitiveness. McGill-Queen's University Press, Montreal.

Dowd, Kevin. 1992. The Experience of Free Banking. Routledge, London.

Haubrich, Joseph G. 1990. “Nonmonetary Effects of Financial Crises: Lessons from the Great Depression in Canada,” Journal of Monetary Economics 25: 223–252.

Kryzanowski, Lawrence and Gordon S. Roberts. 1993. “Canadian Banking Solvency, 1922–1940,” Journal of Money, Credit, and Banking 25: 361–376.

Kryzanowski, Lawrence and Gordon S. Roberts. 1999. “Perspectives on Canadian Bank Insolvency during the 1930s,” Journal of Money, Credit and Banking 31.1: 130–136.

Murphy, Robert. 2009. The Politically Incorrect Guide to the Great Depression and the New Deal. Regnery Publishing, Inc. Washington, DC.

Naylor, R. T. 2006. Canada in the European Age, 1453–1919 (2nd edn.). McGill-Queen’s University Press, Montreal.

Selgin, George. 1996. Bank Deregulation & Monetary Order. Routledge, London.

Shearer, Ronald A. and Carolyn Clark. 1984. “Canada and the Interwar Gold Standard, 1920–35: Monetary Policy without a Central Bank,” in Michael D. Bordo and Anna J. Schwartz (eds.), A Retrospective on the Classical Gold Standard, 1821–1931. University of Chicago Press, Chicago, Ill. and London. 277–310.

Herbert Hoover Rejected Keynesianism

And he tells us explicitly that he did so in a speech in October 1936, when describing his time as president, recently cited by Daniel Kuehn in a really excellent post here.

I cite the full quotation below:

“During my four years powerful groups thundered at the White House with these same ideas [i.e., the ideas of Roosevelt’s New Deal – LK]. Some were honest, some promising votes, most of them threatening reprisals, and all of them yelling ‘reactionary’ at us.

I rejected the notion of great trade monopolies and price-fixing through codes. That could only stifle the little businessman by regimenting him under the big brother. That idea was born of certain American Big Business and grew up to be the NRA [National Recovery Act].

I rejected the scheme of ‘economic planning’ to regiment and coerce the farmer. That was born of a Roman despot fourteen hundred years ago and grew up into the AAA [Agricultural Adjustment Act].

I refused national plans to put the government into business in competition with its citizens. That was born of Karl Marx. I vetoed the idea of recovery through stupendous spending to prime the pump. That was born of a British professor. I threw out attempts to centralize relief in Washington for politics and social experimentation.

I defeated other plans to invade State rights, to centralize power in Washington. Those ideas were born of American radicals.

I stopped attempts at currency inflation and repudiation of government obligation. That was robbery of insurance-policy holders, savings-banks depositors and wage earners. That was born of the early Brain Trusters.” (Hofstadter 1968: 259–260).
http://newdeal.feri.org/court/hoover02.htm

So there you have it.

Even though Hoover in his autobiography said that he had rejected the “hard liquidationism” of Andrew Mellon, he was also adamant that he “vetoed the idea of recovery through stupendous spending to prime the pump.”

And he was not lying as I have demonstrated again and again:

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

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

“Steven Horwitz on Herbert Hoover: Mostly Misleading,” February 20, 2012.

BIBLIOGRAPHY
Hofstadter, Richard. 1968. Ten Major Issues in American Politics. Oxford University Press, New York.

Hayek on Aggregate Demand in a Depression

Gottfried von Haberler describes Hayek’s views on the role of aggregate demand in an economy, and the two instances where Hayek admitted that aggregate demand was able to affect the level of employment:

“In later writings Hayek (1974, 1975) has clarified and somewhat modified his views, coming to grips with the problem of secondary deflation. He still rejects what he believes is the basic mistake of Keynesian economics, namely, ‘that employment is a direct and simple function of what is called aggregate demand, and that by keeping aggregate demand at a sufficiently high level we can lastingly secure full employment’ (1975, p. 4). In a later publication he goes so far as to say that ‘the whole notion that he [Keynes] has made popular, macroeconomics,’ must be ‘set aside.’

Hayek now says there are two exceptions to the rule that changes in aggregate demand do not affect the level of employment. The first one was ‘an accidental historic situation.’ In 1925 Britain made the mistake of returning to the gold standard at the prewar parity, which meant that real wages were too high. ‘In this situation,’ he wrote, ‘the restoration of employment required a reduction of real wages which could he achieved by a general rise of prices’ (1974, p. 4).

‘The second situation in which it is true that an increase of employment requires an increase in aggregate demand,’ Hayek (1974, p. 5) now maintains, ‘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. … of secondary deflation, which may go on for a very long time.’” (Haberler 1986: 426; reprinted in Haberler 1991).

Yet it seems difficult to see why an increase in aggregate demand would increase employment in a depression, but not in a recession, or indeed in any situation where extensive unemployment and idle resources exist.

One can only marvel at the inconsistency in Hayek’s thought. And what was Hayek’s explanation for the repeated instances we see in the real world in which government fiscal stimulus is followed by increased private investment and falling unemployment?

BIBLIOGRAPHY

Haberler, G. 1986. “Reflections on Hayek’s Business Cycle Theory,” Cato Journal 6: 421–435.

Haberler, G. 1991. “Reflections on Hayek’s Business Cycle Theory,” in John Cunningham Wood and Ronald N. Woods (eds.), Friedrich A. Hayek: Critical Assessments (vol. 4). Routledge, London. 249–262.

A Tale of Two Depressions: 1930s and 1890s Australia

This is a quick follow up to my post on free banking in Australia.

According to the GDP estimates of Noel G. Butlin, Australia in the early 1890s suffered a depression in the aftermath of the collapse of its huge property and financial asset bubble:

Angus Maddison’s Estimates of Australian Real GDP from Butlin (millions of 1990 international Geary-Khamis dollars)
Year | GDP | Growth Rate
1888 | $14,685
1889 | $15,953 | 8.64%
1890 | $15,402 | -3.45%
1891 | $16,586 | 7.69%
1892 | $14,547 | -12.29%
1893 | $13,748 | -5.49%
1894 | $14,217 | 3.41%
1895 | $13,418 | -5.62%
1896 | $14,437 | 7.59%
1897 | $13,638 | -5.53%
1898 | $15,760 | 15.56%
1899 | $15,760 | 0%
1900 | $16,697 | 5.95%
(Maddison 2006: 452).

The moderate recession began in 1890, there was a brief recovery in 1891, but a full-blown depression from 1892 (that is, a period of real GNP/GDP contraction of 10% or more), which continued into 1893. From 1891 to 1893, GDP fell by a shocking 17.11%. From its height in 1889, it plunged by 13.82% by 1893.

How does this compare with Australia’s experience of the Great Depression in the 1930s?

Let’s see:

Angus Maddison’s Estimates of Australian Real GDP from Butlin (millions of 1990 international Geary-Khamis dollars)
Year | GDP | Growth Rate
1927 | $34,716
1928 | $34,164 | -1.59%
1929 | $33,834 | -0.96%
1930 | $32,181 | -4.88%
1931 | $32,720 | 1.67%
1932 | $31,878 | -2.57%
1933 | $33,696 | 5.70%
1934 | $34,991 | 3.84%
1935 | $36,424 | 4.09%
1936 | $38,160 | 4.76%
1937 | $40,336 | 5.70%
1938 | $40,639 | 0.75%
(Maddison 2006: 452).

It appears that a recession already began in Australia in 1928 (this was bad timing), and then the Australian economy was hit by the effects of global Great Depression in 1929. From 1928 to 1930, the Australian economy contracted by 7.30%. There was a brief recovery in 1931, but a further recession in 1932.

These data can be compared:

(1) from 1891 to 1893, under a free banking system, Australian GDP fell by 17.11%. From 1889, it plunged by 13.82% by 1893 (despite the recovery in 1891).

(2) from 1928 to 1930 the Australian economy contracted by 7.30%. Even if one looks at the overall fall from 1927 GDP to 1932 GDP, that fall was 8.17%. Therefore the title of my post is a bit misleading: for the real output contraction of the 1930s did not technically qualify as a depression, just a very severe recession (see here for formal definitions of the terms “recession” and “depression”).

The conclusion is clear as can be: the Australian debt deflationary depression in the early 1890s under a free banking system was worse than its Great Depression of the 1930s!

So much for the superiority of free banking.


APPENDIX: WHY SHOULD BUTLIN’S ESTIMATES BE PREFERRED?

Let me repeat Angus Maddison’s assessment of Bryan Haig’s (2001) revised figures of Australian GDP for 1860–1911, and why Butlin’s are very probably better. Angus Maddison points out the following:

(1) for 1860–1911 Haig has no quantitative measure of 70% of GDP (Maddison 2006: 453);

(2) Haig described the estimating procedure he used in but five pages, but Butlin provided his in 200 pages (Maddison 2006: 453);

(3) Butlin provided data for more states than Haig did: Haig used data from Victoria and New South Wales to fill in gaps for overall Australian estimates (Maddison 2006: 453).

(4) one of Haig’s fundamental objections to Butlin’s estimates was that they conflicted with traditional interpretations of Australian economic history: but this is just an unreasonable a priori objection. As Maddison says in reply to this, “it is up to those who disagree with Butlin to prove him wrong” (Maddison 2006: 451).

All in all, I do not see any reason to think Haig’s estimates are to be preferred.

BIBLIOGRAPHY

Butlin, Noel G. 1962. Australian Domestic Product, Investment and Foreign Borrowing 1861–1938/39, Cambridge University Press, Cambridge.

Haig, Bryan. 2001. “New Estimates of Australian GDP: 1861-1948/49,” Australian Economic History Review 41.1 (March): 1-34.

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

Lachmann Endorsed Keynesian Stimulus in a Depression

Following on from my last post, I want to emphasise the gulf that exists between Ludwig Lachmann and many other Austrians today.

Ludwig Lachmann explicitly accepted certain government interventions in a depression. You can read his statement on this question below, or just click on the quote and hear Lachmann in his own words:

“The question is to be welcomed, because we historically have [?] certain points. In the British situation of 1932, Hayek and his friends rejected the proposals of Keynes and some non-Keynesian British economists – that at the bottom of the depression the government should take certain steps, and so on. Hayek has now realised that that was wrong. That is to say, I think Austrians today would not reject all measures to relieve unemployment and increase employment, in a situation in which nothing really is scarce. And in this respect I think Austrians … would have … have ... learned.”

This statement was made in the question session of a lecture on the history of Austrian economics, but Lachmann also said much the same thing in print.

What is extraordinary is Lachmann’s belief that “Austrians today would not reject all measures to relieve unemployment and increase employment, in a situation in which nothing really is scarce.”

The type of Austrian economists Lachmann has in mind here are far from the hordes of anarcho-capitalists and denizens of the Mises Institute, whose irrationality and hostility to government put them in a completely different category from Lachmann. The latter type of Austrians haven’t learned anything from history.

The Definition of a Depression

What is a depression? What is the proper definition?

In the 19th century, people tended to use the term 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.

The 1870s and 1890s were widely spoken of as decades marked by depression in the 19th century, and the whole 1873–1896 period was also sometimes misleadingly referred to as a depression by contemporaries, because of the persistent price deflation in these years (even though real output growth went through several cycles).

But the sheer scale and length of the early 1930s contraction in many countries led to the expression the “Great Depression” to refer to this historically unprecedented slump.

However, today we would tend to refer to most contractions of output or downturns in the business cycle as “recessions.” A recession is often defined as two or more consecutive quarters of negative real GNP/GDP growth, accompanied by rising unemployment (Oxford English Dictionary [2nd edn. 1989], s.v. “recession,” 5.b: the earliest use in the quotations is from 1905).

The word “depression” has come mostly to refer to severe recessions. While there is no universal, formal and strictly-used definition, there is in fact a definition widely employed by economists:

“There is no formal definition of a depression, though an old joke says that a recession is when your neighbor loses his or her job, a depression is when you lose your job. An informal definition is an economic contraction in which output falls by more than 10 percent.” (Knoop 2010: 14).

“Another proposed definition of depression includes two general rules: (1) a decline in real GDP exceeding 10%, or (2) a recession lasting 2 or more years.”
http://en.wikipedia.org/wiki/Depression_%28economics%29

“Some economists say that if gross domestic product were to decline at a 10 percent or greater annualized rate for some unspecified period of time, that would be a depression.” (Posner 2010: 218).

This definition is also used by some astute popular writers, commentators and journalists in the popular press.

I contend that the definition of a depression as an real output contraction of 10% or more is a very useful one and ought to be employed in formal economic analysis.

Recessions are those periods where output contacts by less than 10%. I think this is a useful way of categorising recessions:

(1) A mild recession would be a real GDP contraction of up to 3.33%;

(2) a moderate recession from 3.33–6.66%, and

(3) a very severe recession from 6.66–9.99%.

By these definitions, there was no “depression” in 1920–1921 by recent, revised GNP estimates: there was a moderate recession (either a 3.47% or 5.58% fall in real output).

Whatever definition of “depression” economists, bloggers or commentators on economics use, above all they ought to be consistent in their use and see where consistent use of the definition leads.

Let us take a very loose and, I charge, unsound definition of depression: simply using it to refer to the aftermath of a real output contraction where there is positive GNP/GDP growth but high unemployment.

While the “Great Depression” normally includes (1) the years after 1933 when the US economy suffered high unemployment along with (2) the actual period of contraction from 1929–1933, this is a special and often popular historical usage, and it is potential misleading: for the US had positive GNP growth after 1933 and falling unemployment until 1938 (when fiscal contraction again plunged the economy into recession).

Some Austrians claim that the US in 2010 and 2011 was, or is now (January 2012), in depression. Yet the US has positive GDP growth now and did so last year (and has had positive GDP growth since 2009). There has not been a period of actual GDP contraction since 2009. By adopting such a loose definition of depression and applying it consistently, what does this lead to? By using the same definition, I could now claim that the US was in depression for virtually the whole 1890s after 1893 because of high unemployment. I could also claim it was in depression for most of the late 1870s. Only it wasn’t really by the other important metric we have: real GNP growth. There appears to have been positive GNP growth in 1895 and 1897–1900, and after 1874 in the US. What happened was a severe shock to the economy and real GNP fell well below its potential in these years. The economy was not generating enough growth to create high employment. Thus high unemployment persisted for years. This is in fact a regular condition in capitalist economies, even though they are in periods of output expansion: full or high employment is not reached.

But this state is a different situation from an actual depression (a period of severe fall in output by 10% or more). The former is what Keynes’s (misleadingly) called an “unemployment equilibrium” (which is better called an “unemployment disequilibrium”). Keynes’s view was that real-world capitalist systems have a tendency to fluctuate around a state well below full employment:

“our actual experience … [sc. is] that we oscillate, avoiding the gravest extremes of fluctuation in employment and in prices in both directions, round an intermediate position appreciably below full employment and appreciably above the minimum employment a decline below which would endanger life.” (Keynes 2008 [1936]: 229).

But such a state (with positive GNP growth) is not a “depression”: it is better called an “unemployment disequilibrium.”

Moreover, by continuing to use the same loose definition of “depression,” I could also demonstrate that many capitalist economies outside of the 1945–1973 period were very frequently in depression, because they had high involuntary unemployment. But, by that point, I have robbed the word “depression” of useful meaning, and the same also applies to the original loose use anyway: something is wrong with this self-serving definition of “depression.” It is a rhetorical trick, unsound and ought to be discarded.

A depression can be defined with respect to severity of a real output contraction or its duration. In short, a depression is

(1) a period of actual real GNP/GDP contraction where real output falls by 10% or more, or

(2) a period of actual real GNP/GDP contraction that lasts for 2 years or more (but where real output may not fall by 10% or more).

BIBLIOGRAPHY

Keynes, J. M. 2008 [1936]. The General Theory of Employment, Interest, and Money, Atlantic Publishers, New Delhi.

Knoop, Todd A. 2010. Recessions and Depressions: Understanding Business Cycles (2nd edn.), Praeger, Santa Barbara, Calif.

Posner, Richard A. The Crisis of Capitalist Democracy, Harvard University Press, Cambridge, Mass. 2010.

The Annual Register: Or a View of the History, Politics, and Literature, of the Year 1826, J. Cuthell, et al., London.

A Startling Admission from Ludwig Lachmann

To follow up on my post “Ludwig Lachmann on Government Intervention” (July 9, 2011), I have (thanks to Gene Callahan) located a work where Lachmann gives his views on cases where government intervention might be effective.

One can find the relevant passage in Lachmann’s short essay Macro-economic Thinking and the Market Economy: An Essay on the Neglect of the Micro-Foundations and its Consequences (1973), which is worth reading in its own right.

Lachmann comments on the nature of aggregates towards the end of his essay, and states:

“Aggregates, such as gross domestic product or gross investment in manufacturing industries, are therefore not to be regarded as magnitudes which would or could remain constant but for growth. Their composition is undergoing continuous change affecting their total magnitude. Growth of the aggregates is always the cumulative result of other changes in quantities of resources and factor productivity, in relative prices and demand, and so on. Only in a one-commodity world could it be otherwise. It is therefore impossible to discuss meaningfully policy measures designed to affect the magnitude of such aggregates without also discussing those changes in their composition which must accompany them.

Perhaps an historical example will elucidate what we mean. Policies based on Keynesian macro-economic recipes might have succeeded (had they then been tried) in 1932 and did succeed in 1940 because it so happened that at the bottom of the Great Depression as well as during the Second World War all sectors of the economy were equally affected. In 1932 any kind of additional spending on whatever kind of goods would have had a favourable effect on incomes because there was unemployment everywhere, as well as idle capital equipment and surplus stocks of raw materials. During the war the situation was exactly the opposite, but precisely for this reason the same recipes, but with opposite sign, applied. With millions of men and women in the armed forces everything, not merely labour, was scarce and any reduction in demand anywhere welcome.

These are, of course, abnormal situations. Normally in an industrial economy we find some declining industries (coal mining, cinemas) side by side with rapidly expanding ones. Problems arising here require detailed study and are resistant to macro-economic panaceas.” (Lachmann 1973: 50).

In conditions of severe unemployment, idle capital equipment (what we would now call low capacity utilization), and surplus stocks of raw materials, according to Lachmann, we have reason to believe that Keynesian policies will work.

It seems to me that, although capacity utilization has risen from less than 70% in the depth of the US recession in 2009 to 76% in 2011, these factors still apply to the US economy: mass unemployment and space for increased production. The US can also import raw materials and other commodities needed for expansion, and this would help growth in the rest of the world. The US is in much the same state now as it was in 1935: a recovery owing to fiscal stimulus, but not enough stimulus for full employment.


BIBLIOGRAPHY

Lachmann, L. M. 1973. Macro-economic Thinking and the Market Economy: An Essay on the Neglect of the Micro-Foundations and its Consequences, Institute of Economic Affairs.