Wednesday, January 7, 2015

Neoclassical and Quantity Theory Explanations of the 1873–1896 Deflation

Neoclassical economists have various explanations for the 1873–1896 deflationary period, and usually using the quantity theory of money.

Neoclassicals generally think that the 1873–1896 era in Britain, though there was a severe contraction of some agricultural activity, was mainly a fall in nominal, not real values (Capie and Wood 1997: 287).

The traditional view before this was that the period had been one of depression, but this had become discredited by the 1960s (Saul 1969; Crafts, Leybourne and Mills 1989), in view of the data that real output did in fact continue to increase in the long-run.

New work on money supply growth in the 19th century such as that of Capie and Webber (1985) also suggested that the quantity theory of money was sufficient to explain the deflation and earlier problems with a quantity theory explanation could be overcome (Capie and Wood 1997: 287). In particular, modern neoclassicals think that the so-called “Gibson paradox,” relating to the behaviour of interest rates, does not prevent quantity theory explanations of this period (Capie, Mills and Wood 1991)

The UK broad money supply grew at an average annual growth rate of about 1.3% a year from 1873 to 1896 and at about 2% from 1897 to 1913, with money supply in total growing by 33% by 1896 as compared with 1873 and real output by 53% in that same period (Capie and Wood 1997: 287).

If we take the standard form of the Cambridge Cash Balance Equation:
M = kd PY
where M = the quantity of money;
kd = the amount of money held as cash or money balances;
P = the general price level;
Y = real value of the volume of all transactions entering into the value of national income (that is, goods and services).
then, assuming that kd remained more or less stable in the 1873–1896 period, the quantity theorists would argue that Y was growing but M not at a sufficient rate to allow a neutral price level.

Even John Maynard Keynes in A Treatise on Money (volume 2; 1930: 164–170, 198–208) adhered to a quantity theory explanation of most of this period (at a time when he was of course both a Wicksellian and an advocate of the quantity theory). Keynes thought that falling production of gold and rising demand for it in the 1873 to 1886 period was the fundamental cause of the deflation in these years (Keynes 1930 164–165). However, he also thought that gold supply rose sufficiently from about 1886 to 1896 and at the same time that there was an “ease of credit” (Keynes 1930 165), so that the price deflation of these years was caused by saving exceeding investment.

Modern Post Keynesians say that the quantity theory is not true for modern advanced capitalist economies, where money is largely endogenous.

Is this true for the 19th century?

The quantity theory requires certain prior assumptions to be true, as follows:
(1) the money supply is exogenously determined, and there is an independent money supply function;

(2) the assumption of long-run money neutrality, and

(3) the direction of causation as assumed in the quantity theory equation is from left to right (that is, from the money supply to the price level). That is to say, an exogenously-determined money supply that is the fundamental cause, or driver, of price level changes.
Were these true in the pre-1913 era in Britain?

The supply of gold which functioned as a monetary base was exogenously determined, and in the 1873–late 1880s period its growth rate seems to have fallen. Yet at the same time the Bank of England did print its own banknotes as limited by Bank Charter Act of 1844. Although the 1844 Bank Charter Act had imposed a legal constraint on the Bank of England to issue banknotes as against gold, in practice that legal restraint was suspended in times of financial crisis (Glasner 1997: 32).

Although I do not have precise data at hand, it would seem that Bank of England banknotes functioned as close substitute for gold and so augmented the gold supply that acted as a monetary base, and it would also seem that the role of gold actually fell in the late 19th century as demand deposits and banknotes became the largest form of money. Demand deposit money was endogenous to a significant degree, and to the extent that they were not limited by the Bank Charter Act of 1844 Bank of England banknotes were presumably endogenous to some degree was well.

At best, then, the truth of assumption (1) is questionable.

Assumption (2) is not credible, even in the 19th century.

Assumption (3) may have been true to the extent that exogenous gold supply could drive inflation, but one would suspect that direction of causation was reversed with respect to endogenous credit money in the 19th century too.

All in all, the orthodox quantity theory of money explanation of the 1873 to 1896 looks dubious. If an inelastic supply of gold imposed constraints on growth in this period, it would have been by reducing the ability of business people to obtain credit.

I am undecided on what the primary cause of the deflation of this era was. But, if the primary cause of the price deflation of the 1873–1896 era was price reductions caused by positive supply factors and technological advances reducing prices, then it is likely that the lower money supply growth of that same era was partly the result of the falling prices, given that money supply was partly endogenous.

Finally, yet another explanation in mainstream economics is that the 1873 to 1896 period was part of a “Kondratieff cycle” (or “Kondratieff wave), a supposed phenomenon in which long-run cycles of expansions and contraction of about 40 to 60 years affect capitalist economies. If a “Kondratieff cycle” contraction is assumed to be a continuous period of recession, then it is obvious that 1873–1896 was not a Kondratieff cycle, and this view had fallen into disrepute (Capie and Wood 1997: 288).

However, other economists define a “Kondratieff cycle” downturn as a period not of continuous recession, but of overcapacity where supply exceeds demand. If a “Kondratieff cycle” is defined in this looser way, then 1873–1896 might possibly be interpreted in this way (see, for example, Bortis 2013: 346), though it is highly dubious that modern capitalism really is prone to regular “Kondratieff cycles” even in this sense.

Bortis, Heinrich. 2013. “Post-Keynesian Principles and Economic Policies,” in G. C. Harcourt and Peter Kriesler (eds.), The Oxford Handbook of Post-Keynesian Economics. Volume 2: Critiques and Methodology. Oxford University Press, New York. 326–390.

Bordo, M. D. and Schwartz, A. J. 1981. “Money and Prices in the 19th Century: Was Thomas Tooke Right?,” Explorations in Economic History 18: 97–127.

Cagan, Phillip. 1965. Determinants and Effects of Changes in the Stock of Money: 1875–1960. Columbia U.P. New York and London.

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

Capie, Forrest H., Mills, T. C. and G. E. Wood. 1991. “Money, Interest Rates and the Great Depression: Britain from 1870 to 1913,” in James Foreman-Peck (ed.), New Perspectives on the Late Victorian Economy: Essays in Quantitative Economic History, 1860–1914. Cambridge University Press, Cambridge. 251–284.

Capie, Forrest H. and Alan Webber. 1985. A Monetary History of the United Kingdom, 1870–1982. Volume 1. Data, Sources, Methods. George Allen & Unwin, London.

Crafts, N. F. R., Leybourne, S. J. and Mills, T. C. 1989. “The Climacteric in Late Victorian Britain and France: A Reappraisal of the Evidence,” Journal of Applied Econometrics 4: 103–117.

Glasner, David. 1997. “Bank Charter Act of 1844,” in D. Glasner and T. F. Cooley (eds). Business Cycles and Depressions: An Encyclopedia. Garland Publishing, New York. 31–33.

Keynes, John Maynard. 1930. A Treatise on Money. Volume 2. The Applied Theory of Money. Macmillan, London.

Saul, S. B. 1969. The Myth of the Great Depression, 1873–1896 (1st edn.), Macmillan, London.

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


  1. "The UK broad money supply grew about 1.3% a year from 1873 to 1896 and at 2% from 1897 to 1913, with money supply growing by 33% in the 1873–1896 era"

    Not sure what you mean here.

    1. "The UK broad money supply grew at an average annual growth rate of about 1.3% a year from 1873 to 1896 and at 2% from 1897 to 1913, with money supply in total growing by 33% by 1896 as compared with 1873."
      Have fixed this in the post.

  2. population growth was a major factor.

    p.s. do you have any info on interest rates in this period?

    1. 3% consols fell from 3.24% in 1873 to 2.28% in 1896.

  3. LK: Have you ever considered writing about the Real Bills Doctrine?

  4. Primary cause was US pegging to gold at a bad exchange rate.