Steve Keen Talk at Cambridge on Monetary Macroeconomics

This is a talk by Steve Keen to the Heterodox Economics Students at Cambridge University, given on November 28th, 2012.

In the talk, Keen stresses the need for a monetary approach to macroeconomics. That is opposed to the “real” analysis so popular amongst neoclassicals, which essentially analyses modern economies as if there were barter systems.

Robert Murphy’s Politically Incorrect Guide to the Great Depression, Chapter 2: A Critique

This is my critique of Chapter 2 (“Big-Government Herbert Hoover makes the Depression Great”) of Robert Murphy’s The Politically Incorrect Guide to the Great Depression and the New Deal (Washington, DC, 2009).

Again, let us review the problems with this chapter, as follows:

(1) Murphy has serious problems with his definition of “depression.” He cannot define the word “depression” and then stick to that definition.

At p. 162 (note 4), Murphy states that he sides “with the man on the street” in viewing the Great Depression as lasting “throughout the entire 1930s,” because unemployment never fell below 14% in that period.” Yet Murphy is wrong about unemployment, as I mentioned in the last post. When employment provided by government relief work is included in the employment figures, unemployment under Roosevelt came down from 25% to just over 9% by 1937 (Darby 1976). This is a much better record on unemployment than the official statistics reveal. The unemployment rate soared again when Roosevelt cut government spending in 1937, but the adjusted figures show it rising from under 10% to about 12.5% in 1938, and not to around 19% in the old figures.

But, to return to my main point, Murphy seeks to define a “depression” not only as (1) a period of serious real output collapse but also as (2) the aftermath of that real output collapse when unemployment is still high.

If we wish to define “depression” in this way, then we can prove that America had a seven year depression in the 1870s, and another seven year depression in the 1890s.

Let us take the 1870s as an example: the industrial index data of Joseph H. Davis (2004, 2006) shows serious industrial contraction from 1873–1875 and essentially stagnation until 1877 (Davis 2004: 1189), and then unemployment soared right down until 1878 and remained high in 1879:

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%
(Vernon 1994)

Murphy claims that a liquidationist solution “worked” in the 1870s (Murphy 2009: 30): “the ‘liquidationist’ medicine eventually worked, and recovery kicked in apparently much faster than many observers had expected”! The figures we have do not support such a rosy interpretation of the 1870s.

(2) Murphy (2009 30–39) points out that Hoover was not an advocate of liquidationism.

At this point, Murphy is right and does a valuable service in correcting this myth.

Hoover often gets unfairly blamed as an advocate of the extreme liquidationist solution to the Great Depression, a solution which was actually recommended by Andrew Mellon (US Treasury Secretary from 1921–1931). In truth, Hoover rejected extreme liquidationism, and attempted to fight the onset of Great Depression with a number of limited interventions, including increased government spending. But we must not exaggerate the nature of Hoover’s interventionism. Hoover did not preside over a fiscal policy that could have counteracted the depression: his spending was much too small. Hoover was no modern Keynesian.

(3) After his remarks on Hoover, Murphy comes to an incredibly unconvincing conclusion:

“had Hoover followed the practice of his predecessors, we would not remember him today as presiding over the worst economic calamity in U.S. history” (Murphy 2009: 30).

I am assuming that Murphy here thinks that, if only a liquidationist solution to the depression had been adopted from 1929 onwards, then the depression would not have been as deep and would have ended much more quickly.

There is not a shred of convincing evidence for such an idea. Let us take a real world example that happened at exactly the same time as the US collapse of 1929–1933: Weimar Germany.

In Germany, the government responded with deflationary policies and fiscal contraction, and employers were able to implement very significant wage cuts (Welskopp 2009: 164). Yet Germany still suffered a devastating depression, with severe GDP loss and very high unemployment. In fact, it seems unemployment in Germany soared to over 30% by 1932 – higher even than in the US! (Balderston 2002: 79). How does Murphy explain this?

Another example is Australia in the 1890s: Australia had a gold standard, no Keynesian fiscal policy, no central bank, no capital controls, and light banking regulation (what little that existed was mostly ignored anyway). The 1880s saw a huge asset bubble in certain financial assets and land. When it collapsed, the economy was hit by a debt deflationary depression, and from 1891 to 1893 Australian GDP fell by 17.11%. High unemployment and economic stagnation persisted until the end of the decade. Why did Australia suffer such a depression with no quick recovery?

You can read more about Australia here:

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

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

(4) Murphy is also mistaken in thinking that, without Hoover’s limited interventions, the 1930s US depression would have been a “boom-slump, comparable to all earlier ones” (Murphy 2009: 30). In this strange world, apparently all slumps are essentially the same! There are no unprecedented factors like the scale and extent of private debt, the structure and leverage of financial institutions, the size of asset bubbles distorting an economy, and so on. The Great Depression was so severe precisely because it was a debt deflationary collapse caused by underlying economic factors not seen to that degree before in earlier periods. To this extent, 1929–1933 was a disaster different in degree, though not in kind.

And again Murphy never considers counterexamples: why did Germany and numerous other counties suffer even with contractionary fiscal polices?

Why did America plunge back into depression in 1938 when Roosevelt engaged in fiscal contraction and budget balancing?

(5) Murphy ridiculously exaggerates the extent and nature of Hoover’s interventions from 1929 to 1933. At one point, we read (hopefully a joke?) that Hoover tried to fight the depression with policies so destructive that, in retrospect, one almost wonders if he were a Soviet agent”! (Murphy 2009: 31).

(6) Murphy points to Hoover’s attempts to maintain wage levels during the early years of the depression as a major cause of the depth of the Great Depression. Yet, by his own admission (Murphy 2009: 39), many industrialists did not need to be forced into this move: many agreed with Hoover, so, even if one could demonstrate that wage inflexibility was a serious cause of the depression, the fault lay just as much with America’s private capitalists than with the government.

Murphy points to the recession of 1920–1921 as evidence for flexible wages and prices leading to rapid adjustment to full employment, yet for many reasons the recession of 1920 was unlike that of 1929–1933. In 1920, there was no massive asset bubble, nor was there very high private debt levels, and no financial sector collapse.

But one can question how significant Hoover’s high-wage policy really was. According to Murphy, “because … Hoover forbade businesses from cutting wages after the 1929 crash, unemployment went up and up, hitting the unimaginable monthly peak of 28.3 percent in March 1933” (Murphy 2009: 42). But wages were not maintained at high levels after 1931. First, even Rothbard admits that, despite Hoover’s high wage policy, wages began falling in 1931 (Rothbard 2008: 270). In fact, wages began falling significantly from 1931 and continued to fall in 1932 and 1933 (Wigmore 1985: 229), along with severe price falls. So why didn’t this arrest the depression?

Also, why didn’t wage and price falls in Germany prevent a very severe depression there?

It is here that Murphy reveals his true colours: the underlying assumptions behind his analysis are not really different from the way a mainstream neoclassical economist analyses economics. Neoclassicals think that, if only nasty government and unions would get out of the way, then we would have a set flexible wages and prices that would allow an economy to converge towards full employment equilibrium. This Walrasian idea sees markets as adjusting smoothly to shocks by automatic processes that adjust prices and wages to new levels that clear all markets, including the labour market. That vision of economics is utterly false and flawed. Markets do not tend to Walrasian general equilibrium, and there is no reason to think flexible wages and prices would clear markets.

For all the Austrian attempts to paint themselves as different from neoclassicals, at heart they share a common fantasy: the naïve belief in price and wage flexibility clearing markets.

There is yet another reason why wage cuts did not work when they happened in the 1930s: debt deflation. If a business or individual has debts fixed in nominal terms, cutting wages will simply made the real burden of debt soar, possibly causing bankruptcy to debtors and then creditors. For a business, its earnings/profits are analogous to workers’ “wages,” and if it cuts it prices and lowers profit, it will also make the real value of its debt soar.

But Murphy has no clue on the dynamics of debt deflation.

(7) In discussing Smoot-Hawley, Murphy exaggerates its effects on the US economy. The Tariff Act of 1930 (or Smoot–Hawley Tariff) became law on June 17, 1930. While Smoot Hawley undoubtedly hurt foreign export-led growth nations dependent on the US market, it was not a major factor in the US contraction from 1929–1933.

Peter Temin explains:

“A tariff, like a devaluation, is an expansionary policy. It diverts demand from foreign to home producers. It may thereby create inefficiencies, but this is a second-order effect. The Smoot-Hawley tariff also may have hurt countries that exported to the United States. The popular argument, however, is that the tariff caused the American Depression. The argument has to be that the tariff reduced the demand for American exports by inducing retaliatory foreign tariffs … Exports were 7 percent of GNP in 1929. They fell by 1.5 percent of 1929 GNP in the next two years. Given the fall in world demand in these years from the causes described here, not all of this fall can be ascribed to retaliation from the Smoot-Hawley tariff. Even if it is, real GNP fell over 15 percent in these same years. With any reasonable multiplier, the fall in export demand can only be a small part of the story. And it needs to be offset by the rise in domestic demand from the tariff. Any net contractionary effect of the tariff was small.” (Temin 1989: 46).

That does not mean that Smoot Hawley was good policy, of course. It clearly harmed world trade and many other countries. But this does not change the fact that the fall in the value of US exports from 1929 onwards – owing to Smoot Hawley, retaliatory tariffs, non tariff barriers, and trade war – does not explain the depth of the contraction of US GNP from 1929 to 1933.

(8) On pp. 45–55, Murphy attempts to paint Hoover as a big spending Keynesian and blames Hoover’s alleged “profligacy” for the seriousness of the depression.

The problem is that (to put it mildly) this is a cartload of garbage, as I have shown here:

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

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

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

Let us start with a simple observation.

What happened to total US government spending from 1929–1933? We can see the figures as follows:

Total (federal, state and local) US Government Spending
Year | Total Spending ($ bns) | Increase in Spending
1928 | $11.44 | $0.22
1929 | $11.68 | $0.24
1930 | $11.92 | $0.24
1931 | $12.18 | $0.26
1932 | $12.44 | $0.26
1933 | $12.62 | $0.18

In reality, total spending hardly deviated from its 1920s trend line and growth path. Also, in 1929 total federal expenditures were about 2.5 per cent of the GNP. Government spending as a percentage of GDP rose from 1929–1933 mainly because GNP collapsed not because of huge spending.

So where is Hoover’s huge profligate Keynesian spending? It doesn’t show up because there was no huge profligate Keynesian spending under Hoover.

Yet this is the myth that Murphy peddles and would have his readers believe:

“As with the evaluation of Hoover’s high-wages policy, his high-federal-budget policy can be usefully contrasted with the depression occurring at the end of Woodrow Wilson’s watch. With the conclusion of World War I, the U.S. government slashed its budget from $18.5 billion in FY 1919 down to $6.4 billion one year later. As the U.S. economy entered a depression at the turn of the decade, receipts fell. The Wilson Administration responded by cutting spending even more, down to $5.0 billion in FY 1921 and then following with a single-year slash of 34 percent, down to $3.3 billion in FY 1922. (Because of the fiscal/calendar year mismatch, it is debatable whether Wilson or Harding should be associated with the FY 1922 budget.)

So how do the two strategies stack up? We already know that Hoover faced 20+ percent unemployment after the second full year of his Keynesian stimulus policies. Wilson/Harding, on the other hand, was Krugman’s worst nightmare, taking the axe to federal spending in a way that would have given even Ron Paul the willies, and during a depression to boot! Yet as we already know, unemployment peaked at 11.7 percent in 1921, then began falling sharply. The depression was over for Harding, at the corresponding point when a desperate Hoover had decided to (try to) rein in his massive budget deficits” (Murphy 2009: 49–50).

Some basic facts should be stated first:

(1) In fiscal year 1930, Hoover actually ran a federal budget surplus, not a deficit. Federal policy was contractionary in this fiscal year.

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

(3) In fiscal year 1933, total federal spending was cut in relation to fiscal year 1932. Hoover introduced the Revenue Act of 1932 (June 6) which increased taxes across the board and applied to fiscal year 1932 and subsequent years. These were contractionary measures, and these two policies are the very antithesis of Keynesianism stimulus.

Murphy declares that Hoover engaged in “Keynesian stimulus policies.” If by this he means that the effect of federal government fiscal policy was weakly expansionary in 1931 and 1932 relative to the collapse of GNP, this is true enough. In 1931, for example, it is well known that fiscal policy was expansionary: one of the stimulative measures (passed over Hoover’s objections, however) included the Veterans’ Bonus Bill. The budget may have expanded demand by 2% of GNP in 1931 more than the 1929 budget, but this was not large relative to the collapse of GNP, which is the key (Temin 1989: 27–28). In 1931, GNP collapsed by 16.11% relative to its level in 1930, from $91.2 billion to $76.5 billion.

If by these words above, Murphy means that Hoover engaged in the type of Keynesian fiscal expansion designed to halt the depression to restore growth, he is wrong, and contemptibly wrong.

In fiscal years 1931 and 1932, Hoover did indeed raise federal spending (especially in 1932), but it was woefully inadequate. In no sense do these miserable increases compared to the scale of the GDP collapse contradict Keynesian economics. Once you factor in state and local austerity and surpluses, these total federal spending increases was significantly reduced.

In order to stimulate an economy back to its growth path and potential GDP, one has to do the following:

(1) calculate potential GDP and estimate how severely GDP is likely to collapse by,
(2) estimate the Keynesian multiplier and
(3) then design fiscal policy to expand demand by tax cuts and/or appropriate level of discretionary spending increases to hit potential GDP via the multiplier.

In 1931, US GDP collapsed by $14.7 billion dollars, in a debt deflationary spiral with bank failures and a collapse in consumption, employment and investment. If we assume a multiplier of 4 (which is very high), then Hoover’s federal spending increase of $257 million dollars in fiscal year 1931 might have generated at most $1.028 billion of GDP in fiscal year 1931 (the effect of state and local fiscal policy reduced this, however).

But GDP fell by $14.7 billion dollars, and it is the height of idiocy to seriously argue that Hoover’s increase in spending in fiscal year 1931 could have prevented the depression, to offset such a catastrophic fall in GDP. It could never have done any such thing.

To stop the downturn, Hoover needed to do the following:

(1) spend an additional $3.675 billion in fiscal year 1931 in stimulus;

(2) Hoover needed to at least stop fiscal contraction by states and local government, so some bailout of them was necessary to make (1) work.

He did no such thing. Not even close. $257 million dollars is not $3.675 billion. Hoover’s federal fiscal expansion was 6.9% of the sum required.

Of course, if Hoover had quickly stabilised the banking system in 1931, the GNP collapse would have been significantly reduced as well, and the scale of the needed stimulus would have been reduced too.

But Keynesianism did not fail, because Hoover never tried a proper Keynesian stimulus. Hoover’s fiscal policy in 1931 and 1932 was weak and feeble fiscal expansion, woefully inadequate.

(9) On p. 36, Murphy lazily assumes that extra income to producers will simply be spent on either consumption or capital goods investment, even though there is no reason to think this will happen when business expectations are shocked. It also ignores the fact that the richer you are the more likely you are to spend extra income on financial assets on secondary markets, rather than consumption or capital goods investment.

(10) On p. 37, Murphy badly misunderstands the cause of the Great Depression, invoking the unsound and false Austrian business cycle theory.

The main problem in the 1920s was massive debt-fuelled asset inflation in stocks and shares, not allegedly “unsustainable” real capital goods projects induced by Federal Reserve expansion of the money supply.

Unrelated Note

I was astonished to see this recent post where Jonathan Catalán agrees with me!:

Jonathan Finegold Catalán, “When Hell Froze Over,” 22 November, 2012 by
http://www.economicthought.net/blog/?p=3238

BIBLIOGRAPHY

Balderston, Theo. 2002. Economics and Politics in the Weimar Republic. Cambridge University Press, Cambridge.

Darby, M. R. 1976. “Three-and-a-Half Million U.S. Employees Have Been Mislaid: Or, an Explanation of Unemployment, 1934–1941,” Journal of Political Economy 84.1: 1–16.

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

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

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

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

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

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

Welskopp, T. 2009. “Birds of a Feather: A Comparative History of German and US Labor in the Nineteenth and Twentieth Centuries,” in H.-G. Haupt and J. Kocka (eds.), Comparative and Transnational History: Central European Approaches and New Perspectives. Berghahn Books, New York and Oxford. 149–177.

Wigmore, Barrie. 1985. The Crash and its Aftermath: A History of Securities Markets in the United States, 1929–1933. Greenwood Press, Westport, Conn.