Alfred Marshall’s Interest Rate Theory

We can start with Alfred Marshall’s statement on 19 December 1887 to the British “Royal Commission on the Value of Gold and Silver” (edited for clarity):

[sc. Question:]“9651. The evidence that has been put by some witnesses before us has been intended to show that so far from any connexion being traceable between plentiful money and a low rate of discount and a plentiful supply of the precious metals, the evidence was just the other way?

[sc. Marshall’s answer:] Oh yes, that is certainly true as regards permanent results; the supply of gold exercises no permanent influence over the rate of discount. The average rate of discount permanently is determined by the profitableness of business. All that the influx of gold does is to make a sort of ripple on the surface of the water. The average rate of discount is determined by the average level of interest in my opinion, and that is determined exclusively by the profitableness of business, gold and silver merely acting as counters with regard to it.”
(Final Report of the Royal Commission Appointed to Inquire into the Recent Changes in the Relative Values of the Precious Metals; With Minutes of Evidence and Appendixes. Eyre and Spottiswoode, London, 1888. p. 4).

The “rate of discount” is Marshall’s expression for the money rate of interest. But, for Marshall, in the long-run the money rate of interest is determined by the “real” rate of interest, which is in turn determined by the demand and supply of real capital goods (Bridel 1987: 38): the “real” rate concept is analogous to Wicksell’s natural rate of interest.

But of course, for Marshall, variations in supply of gold can cause short-run changes in the money rate of interest.

In fact, Marshall saw four factors that could influence the money rate of interest, as follows:

(1) changes in the supply and demand for real capital;

(2) changes in the supply of commodity money;

(3) changes in the supply of money available for lending in the banking system, and

(4) the influence of speculators on financial asset markets (Bridel 1987: 38).

If the supply of gold increases, for example, then this will induce excessive demand for real capital goods and price inflation, according to Marshall (Bridel 1987: 41), and if there is an expectation of further prices rises there might be a cumulative process of inflation as further investment occurs (Bridel 1987: 41–42). This process is a short-run phenomenon. Eventually banks will raise money rates of interest and a new equilibrium will be reached as money rates rise to equal the long-run “real” rate (the functional equivalent of the natural rate) (Bridel 1987: 42).

Bridel (1987: 43) argues that Marshall missed the idea of “forced saving” and the latter insights of Keynes in the Treatise on Money (1930), that a contraction of consumption induced by forced saving lowers the marginal productivity of capital and hence lowers the natural rate of interest.

Nevertheless, Marshall’s interest theory is clearly a precursor to the loanable funds theory (Bridel 1987: 44).

BIBLIOGRAPHY
Bridel, Pascal. 1987. Cambridge Monetary Thought: The Development of Saving-Investment Analysis from Marshall to Keynes. Macmillan, Basingstoke.

Final Report of the Royal Commission Appointed to Inquire into the Recent Changes in the Relative Values of the Precious Metals; With Minutes of Evidence and Appendixes. Eyre and Spottiswoode, London, 1888.

A Bibliography on Alfred Marshall

I have recently become more interested in Alfred Marshall (1842–1924), and the Marshallian tradition in economics, which included Keynes in his early career.

That being so, I list a quick, but far from complete, bibliography on Alfred Marshall below:

Biographies and Studies on Marshall’s Economics
Arena, Richard and Michel Quéré. 2003. The Economics of Alfred Marshall: Revisiting Marshall’s Legacy. Palgrave Macmillan, New York and Basingstoke, UK.

Cook, Simon J. 2009. The Intellectual Foundations of Alfred Marshall’s Economic Science: A Rounded Globe of Knowledge. Cambridge University Press, Cambridge and New York.

Groenewegen, Peter. 1995. A Soaring Eagle: Alfred Marshall, 1842–1924. Edward Elgar, Aldershot and Brookfield, VT.
The best and most detailed biography of Marshall.

Groenewegen, Peter. 2007. Alfred Marshall: Economist 1842–1924. Palgrave Macmillan Ltd., New York.
A shorter, introductory biography.

Groenewegen, Peter. 2012. The Minor Marshallians and Alfred Marshall: An Evaluation. Routledge, New York.
A good study of the minor Marshallian economists and students of Marshall and their contributions to economics.

Raffaelli, Tiziano, Becattini, Giacomo, and Marco Dardi (eds). 2006. The Elgar Companion to Alfred Marshall. Elgar, Cheltenham, UK and Northampton, Mass.

Wood, John Cunningham (ed.). 1982. Alfred Marshall: Critical Assessments. Croom Helm, London.

Marshall’s Writings and Collections of his Writings
Marshall, A. 1887. “Remedies for Fluctuations in General Prices,” Contemporary Review 51 (March): 357–375. (reprinted in Marshall 1925.)

Marshall, A. and Marshall, M. P. 1879. The Economics of Industry. Macmillan, London.

Marshall, Alfred. 1890. Principles of Economics (1st edn.). Macmillan, London.

Marshall, Alfred. 1891. Principles of Economics (2nd edn.). Macmillan, London.

Marshall, Alfred. 1895. Principles of Economics (3rd edn.). Macmillan, London.

Marshall, Alfred. 1898. Principles of Economics (4th edn.). Macmillan, London.

Marshall, Alfred. 1907. Principles of Economics (5th edn.). Macmillan, London.

Marshall, Alfred. 1916. Principles of Economics (7th edn.). Macmillan, London.

Marshall, Alfred. 1920. Principles of Economics: An Introductory Volume (8th edn.). Macmillan, London.

Marshall, A. 1923. Money, Credit and Commerce. Macmillan, London.

Marshall, Alfred. 1925. Memorials of Alfred Marshall (ed. by A. C. Pigou). Macmillan, London.

Marshall, Alfred. 1925 [1887]. “Remedies for Fluctuations in General Prices,” in A. C. Pigou (ed.), Memorials of Alfred Marshall. Macmillan, London. 188–212.

Marshall, A. 1926. Official Papers of Alfred Marshall (ed. by J. M. Keynes). Macmillan, London.

Marshall, Alfred. 1975. The Early Economic Writings of Alfred Marshall, 1867–1890 (ed. by J. K. Whitaker). Macmillan for the Royal Economic Society, London.

Whitaker, John K. (ed.). 1996. The Correspondence of Alfred Marshall, Economist. Volume One: Climbing, 1868–1890. Cambridge University Press, Cambridge.

Whitaker, John K. (ed.). 1996. The Correspondence of Alfred Marshall, Economist. Volume Two: At the Summit, 1891–1902. Cambridge University Press, Cambridge.

Whitaker, John K. (ed.). 1996 . The Correspondence of Alfred Marshall, Economist. Volume Three: Towards the Close, 1903-1924. Cambridge University Press, Cambridge.

Alfred Marshall on the Deflation of 1873–1896

On 16th January, 1888, Alfred Marshall appeared before the British “Royal Commission on the Value of Gold and Silver” (instituted in 1887), and was questioned about the economic conditions of the 1870s and 1880s in Britain during the first part of the great deflation of 1873 to 1896.

For clarity, I have edited the original text to make the questions and Marshall’s answers clearer:

“[Question:] 9823. Do you share the general opinion that during the last few years we have been passing through a period of severe depression?

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

[Question:] 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. There is of course great misery among the poor; but I do not believe it is greater than it used to be. I do not mean that we should idly acquiesce in the existence of this misery, and regard it as inevitable. I hold rather extreme opinions in the opposite direction.

[Question:] 9825. (Chairman.) Then I understand you to think that the depression in those three respects is consistent with a condition of prosperity?

[Marshall:] Certainly.

[Question:] 9826. (Mr. Chaplin.) The depression of profits, does not that more or less affect all classes?

[Marshall:] No, I believe that a chief cause of the depression of profits is that the employer gets less and the employé more.

[Question:] 9827. You think that during a period of depression the employed working classes have been getting more than they did before?

[Marshall:] More than they did before, on the average. I do not deny that during the years of spasmodic inflation everybody was working very hard; everybody got exceptionally high returns, employers and employed together. But, as I have already said, I think that history shows that those times have always sown the seeds of coming disasters.

[Question:] 9828. Can you speak as to the fact whether there has been a larger number of the working classes than usual unemployed altogether during this period of depression?

[Marshall:] My belief is that there have not been a larger number of people unemployed during the last 10 years than during any other consecutive 10 years. Of course there are many more unemployed now than there were in 1872–73.

[Question:] 9829. Do you speak with knowledge of the thing and of the working classes?

[Marshall:] I speak from personal observation ranging over many years, and a study of almost everything of importance that has been written on the subject.

[Question:] 9830. Are you aware that we have had evidence given by gentlemen speaking with definite knowledge of a directly opposite nature to what you are stating now?

[Marshall:] I am aware that some persons actively engaged in business have given evidence that they believe there is an increasing unsteadiness of employment. But the facts which they bring forward are, in my opinion, outweighed by the statistical and other evidence in the opposite direction. I have given reasons for believing that the statistics showing unsteadiness of employment require to be carefully interpreted; because the more people are employed in factories the more every interruption of employment shows itself in statistics. I have, however, omitted one thing of very great importance. I think that whatever had been the condition of prices there would have been a special reason causing irregularity of employment now; that is the transitional stage in which a great number of industries are. When an improvement is brought into an industry it benefits the public at once, and in the long run it is pretty sure to benefit even the trade into which it is introduced; but in many cases an improvement in the methods of the industry injures that industry, and throws people temporarily out of employment. Now, I do not think there has been any period in which there have been so many great changes. That has been put before you by Mr. Fowler, and it has been argued at great length in Mr. Wells’ articles that this has been a period of great changes in the methods of industry, changes of such a kind as to tend to throw people out of employment. But in spite of that, I do not believe that the want of employment is, on the average, greater than it has been.

[Question:] 9831. But you mean to say that these changes, as you have described them on the methods of industry, have not been continuing now for a great number of years?

[Marshall:] I think there have been exceptionally great changes within the last few years. Many of them are to be traced to America, and before about 1868 or so, the Americans had other things to do; they had not settled down after the great war sufficiently to exert their full influence in changing the methods of industry. The changes are, I think, chiefly due to the great fall, the unparalleled fall, in the cost of transport, which renders it worth while to do a great many things that it was not worth while to do before; but besides this there are an immense number of changes in all industries, chemical and mechanical. I think Mr. Wells’ evidence points very strongly in that direction.”
Final Report of the Royal Commission Appointed to Inquire into the Recent Changes in the Relative Values of the Precious Metals; With Minutes of Evidence and Appendixes. Eyre and Spottiswoode, London, 1888. Appendix, Minutes of Evidence taken before the Royal Commission on Gold and Silver, pp. 21–22.

According to Marshall, then, there had been a “severe depression of profits and of prices,” but this condition was still compatible with “prosperity.”

An interesting research question is: if real wages were rising in this period, was this because of sticky nominal wages in the face of price deflation, which in turn would have squeezed profits? Or was there some other reason?

On unemployment, Marshall did not think that during the 10 year period from 1878–1888 high unemployment was higher as compared with other periods.

For what they are worth, we have the following recent estimates of UK unemployment from 1873 to 1896 in Boyer and Hatton (2002):

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 (in Maddison 2003) show real output growth in all years but 1879:

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).

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.

But caused 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, though hardly as severe as that which hit the Western world from 1929 to 1933. This seems to be the reasonable explanation for the unusual data for this period.

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.

Final Report of the Royal Commission Appointed to Inquire into the Recent Changes in the Relative Values of the Precious Metals; With Minutes of Evidence and Appendixes. Eyre and Spottiswoode, London, 1888.

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

Alfred Marshall on the Natural Rate of Interest

Joan Robinson (1969: 397) noted that Alfred Marshall had developed something analogous to the concept of a “natural rate of interest,” though this appears to have been independently of Wicksell.

On 19 December 1887, Alfred Marshall gave evidence before a British “Royal Commission on the Value of Gold and Silver,” which was instituted in 1887 to investigate the question of changes in the value of gold and silver and the effects of this on trade and production.

The relevant quotation is as follows:

“9651. The evidence that has been put by some witnesses before us has been intended to show that so far from any connexion being traceable between plentiful money and a low rate of discount and a plentiful supply of the precious metals, the evidence was just the other way?—[sc. Marshall’s answer:] Oh yes, that is certainly true as regards permanent results; the supply of gold exercises no permanent influence over the rate of discount. The average rate of discount permanently is determined by the profitableness of business. All that the influx of gold does is to make a sort of ripple on the surface of the water. The average rate of discount is determined by the average level of interest in my opinion, and that is determined exclusively by the profitableness of business, gold and silver merely acting as counters with regard to it.”
(Final Report of the Royal Commission Appointed to Inquire into the Recent Changes in the Relative Values of the Precious Metals; With Minutes of Evidence and Appendixes. Eyre and Spottiswoode, London, 1888. p. 4).

The notion that the level of interest is determined “exclusively by the profitableness of business” appears quite similar to the way in which Wicksell defined the natural rate in “The Influence of the Rate of Interest on Prices” (1907):

“According to the general opinion among economists, the interest on money is regulated in the long run by the profit on capital, which in its turn is determined by the productivity and relative abundance of real capital, or, in the terms of modern political economy, by its marginal productivity. This remaining the same, as, indeed, by our supposition it is meant to do, would it be at all possible for the banks to keep the rate of interest either higher or lower than its normal level, prescribed by the simultaneous state of the average profit on capital?” (Wicksell 1907: 214).

BIBLIOGRAPHY
Final Report of the Royal Commission Appointed to Inquire into the Recent Changes in the Relative Values of the Precious Metals; With Minutes of Evidence and Appendixes. Eyre and Spottiswoode, London, 1888.

Robinson, Joan. 1969. The Accumulation of Capital (3rd edn.). Macmillan, London.

Wicksell, K. 1907. “The Influence of the Rate of Interest on Prices,” The Economic Journal 17.66: 213–220.

The Various Versions of the Quantity Theory

This issue is vexing me at the moment, as I am writing an article in the course of which I am reviewing the different versions of the quantity theory as an explanation of inflation.

The following post is a work in progress, to help me summarise the history of the quantity theory.

In essence, the quantity theory comes in various versions, as follows:

I. Equation of Exchange Versions(1) Irving Fisher’s equation of exchange in his book The Purchasing Power of Money: Its Determination and Relation to Credit, Interest and Crises (1911) (Fisher 1911: 24–28, and particularly 27):

MV = PT,
where M = the money supply;
V = the velocity of circulation (or the number of times money changes hands);
P = the average price level;
T = the volume of transactions of goods and services.

Fisher also gave this form of the equation:

MV = ΣpQ.
where ΣpQ is the sum of the price multiplied by quantity bought of every good in the economy (Fisher 1911: 26).

But Fisher also thought that ΣpQ could be written as PT:

“We may, if we wish, further simplify the right side by writing it in the form PT where P is a weighted average of all the p’s [prices], and T is the sum of all the Q’s. P then represents in one magnitude the level of prices, and T represents in one magnitude the volume of trade.” (Fisher 1911: 25).

(2) Milton Friedman’s version of the equation of exchange in his paper “The Quantity Theory of Money: A Restatement” (1956):

MV = PY
where M = the quantity of money;
P = the price level;
Y = aggregate income or value of aggregate output;
V = velocity.

Under equilibrium conditions where Q = Y, it can be written as:

MV = PQ.

II. Cambridge Cash Balance Equation Versions(3) Alfred Marshall’s reformulation of the quantity theory as the cash balance approach in the 1870s. It is unclear to me whether Marshall already had an equation form of the quantity theory in the 1870s.

I have read that this was Marshall’s version of the Cambridge Cash Balance Equation:

M = KY
where M = aggregate money supply;
Y = aggregate real income;
K = the proportion or fraction of real income which people hold in the form of money/cash balances.

The value of money is then explained by the following equation:

where P is the purchasing power of money.

But where this was given in Marshall’s works is not yet clear to me.

It seems that the final form of Marshall’s version of the Cambridge Cash Balance Equation was given in his book Money, Credit, and Commerce (1923).

(4) Arthur C. Pigou’s version of the Cambridge Cash Balance Equation in his paper “The Value of Money” (1917: 52):

where P = the purchasing power or value of money;
k = proportion of R (real income) held in the form of money/cash balances;
R = aggregate real income;
M = aggregate money stock or money supply.

(5) J. M. Keynes’ version of the Cambridge Cash Balance Equation in A Tract on Monetary Reform (1923: 77).

The basic form that Keynes gives is this:

n = pk
where n = currency notes or other forms of cash in circulation with the public;
k = consumption units of cash on hand;
p = the index number of the cost of living.

There is also another version that Keynes gives in which he included bank deposits in the total quantity of money, as follows:

n = p(k + rk′),
where n = quantity of money, or currency notes or other forms of cash in public circulation;
p = the index number of the cost of living;
k = consumption units of cash on hand;
k′ = money people want to be available in banks in the form of their demand deposits or checking accounts;
r = cash reserves of the banks.

In this version, Keynes thinks that as long as k, k′ and r remain unchanged, if n rises, then p will rise too (Keynes 1923: 77).

At the time he wrote A Tract on Monetary Reform Keynes had no doubts about the truth of the quantity theory (Keynes 1923: 74).

(6) Marshall’s final formulation of the Cambridge Cash Balance Equation in Money, Credit, and Commerce (1923).

(7) Dennis H. Robertson’s version of the Cambridge Cash Balance Equation in Appendix A of the 1928 edition of his book Money (rev. edn. 1928: 150; later edition 1964: 150):

where M = the quantity of money;
k = proportion of T against which people hold cash or money balances;
P = the price level;
T = the total amount of goods and services purchased.

From this, it is easy to derive the standard form:

M = PkT

¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯
Now the “original” version of the Cambridge Cash Balance Equation (or so I have been told) is usually written as:

M = kPT

and this seems to be Dennis H. Robertson’s version.

However, the standard form of the Cambridge Cash Balance Equation as used today is usually given as follows:

M = kPY or
M = k_d PY
where M = the quantity of money;
k or k_d = 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).

The variable k was held to be equivalent, but superior, to Irving Fisher’s “velocity of circulation” concept V (which is why it is held that 1/k = V), because, unlike V, k is supposed to be empirically measurable.

M and P are causally related, if k_d and Y are constant (Thirlwall 1999).

It is interesting that, while Keynes had formulated his own version of the Cambridge Cash Balance Equation – no. (5) above – he had by 1933, as stated in a letter to Dennis Robertson, come to the view that no version of the Cambridge Cash Balance Equation had any serious use in economic analysis:

“In my present state of mind, however, I doubt that either version of the Cambridge equation is of any serious utility, and I can’t remember that I have ever come across a case of anyone ever using either of them for practical purposes of interpretation. Thus, whether my version is slightly better than yours, or whether I ought to yield to your criticisms, I am not prepared to put up a serious case in defence of either. All this section is really a survival of the time when I was trying to make some practical use of the Cambridge equation, an attempt I have long since given up.” (Keynes, Letter to Dennis Robertson, 3 May, 1933 in Keynes 1971: 18).

Finally, one should note that mathematical statements of the quantity theory were apparently already being given in the 19th century, as Irving Fisher noted:

“An algebraic statement of the equation of exchange was made by Simon Newcomb in his able but little appreciated Principles of Political Economy, New York (Harper), 1885, p. 346. It is also expressed by Edgeworth, ‘Report on Monetary Standard.’ Report of the British Association for the Advancement of Science, 1887, p. 293, and by President Hadley, Economics, New York (Putnam), 1896, p. 197. See also Irving Fisher, ‘The Role of Capital in Economic Theory,’ Economic Journal, December, 1899, pp. 515-521, and E. W. Kemmerer, Money and Credit Instruments in their Relation to General Prices, New York (Holt), 1907, p. 13. While thus only recently given mathematical expression, the quantity theory has long been understood as a relationship among the several factors: amount of money, rapidity of circulation, and amount of trade.” (Fisher 1911: 25, n. 2).

BIBLIOGRAPHY
Dimand, Robert W. 2002. “Patinkin on Irving Fisher’s Monetary Economics,” The European Journal of the History of Economic Thought 9:2: 308–326.

Fisher, Irving. 1911. The Purchasing Power of Money: Its Determination and Relation to Credit, Interest and Crises. The Macmillan Company, New York.

Fisher, Irving. 1920. The Purchasing Power of Money: Its Determination and Relation to Credit, Interest and Crises (rev. edn.). The Macmillan Company, New York

Friedman, Milton. 1956. “The Quantity Theory of Money: A Restatement,” in Milton Friedman (ed.), Studies in the Quantity Theory of Money. The University of Chicago Press, Chicago. 3–21.

Friedman, Milton. 1968. “Money: the Quantity Theory,” in D. Sills (ed.), International Encyclopedia of the Social Sciences (vol. 10). Macmillan Free Press, New York. 432–447.

Humphrey, Thomas M. 2004. “Alfred Marshall and the Quantity Theory of Money,” FRB Richmond Working Paper No. 04–10,
December 1, 2004
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2184929

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

Keynes, John Maynard. 1971. The Collected Writings of John Maynard Keynes. Volume XXIX. The General Theory and After. A Supplement (ed. by D. Moggridge). Macmillan, London.

Laidler, David E. W. 1999. Fabricating the Keynesian Revolution: Studies of the Inter-War Literature on Money, the Cycle, and Unemployment. Cambridge University Press, Cambridge.

Marshall, Alfred. 1923. Money, Credit, and Commerce. Macmillan, London.

Marshall, Alfred. 1926. Official Papers (ed. by J. M. Keynes). Macmillan, London.

Newcomb, Simon. 1885. Principles of Political Economy. Harper, New York.

Pigou, A. C. 1917. “The Value of Money,” The Quarterly Journal of Economics 32.1: 38–65.

Robertson, Dennis Holme. 1928. Money (rev. edn.). Nisbet, London.

Robertson, Dennis Holme. 1964. Money (rev. edn.). University of Chicago Press, Chicago, Ill.

Thirlwall, A. P. 1999. “Monetarism,” in P. Anthony O’Hara (ed.), Encyclopedia of Political Economy: L–Z. Routledge, London and New York. 750–753.

Robinson on Marshall on Diminishing Marginal Utility

John Robinson quotes Alfred Marshall on the law of diminishing marginal utility:

“The marginal utility of a thing to anyone diminishes with every increase in the amount of it he already has.

There is however an implicit condition in this law which should be made clear. It is that we do not suppose time to be allowed for any alteration in the character or tastes of the man himself. It is therefore no exception to the law that the more good music a man hears, the stronger is his taste for it likely to become; that avarice and ambition are often insatiable; or that the virtue of cleanliness and the vice of drunkenness alike grow on what they feed upon. For in such cases our observations range over some period of time; and the man is not the same at the beginning as at the end of it. If we take a man as he is, without allowing time for any change in his character, the marginal utility of a thing to him diminishes steadily with every increase in his supply of it.”
Marshall, Principles of Economics (8th edn.), 1920.
http://www.econlib.org/library/Marshall/marP11.html

Robinson notes that this restriction makes testing of the law of diminishing marginal utility rather difficult (Robinson 1964: 50): for how do we know preferences did not change from one time to the next when a person consumes the same good?

Marshall’s requirement of no “alteration in the character or tastes” of the person supposedly subject to the law of diminishing marginal utility is akin to the ceteris paribus assumption of the law of demand: what we have here is a restriction that, as noted by Hans Albert, comes to immunise the law against empirical testing, and effectively renders it an analytic a priori proposition, which is true merely by definition.

For example, if a person becomes serially addicted to an arcade game after the first game, and appears to derive greater utility from each successive computer game (as he does better at it), then this appears to be an exception to the law of diminishing marginal utility.

But presumably if Marshall lived today he would say that the new addiction altered the man’s “character or tastes” so that he is a different person from the one who played the first game: therefore the law of diminishing marginal utility is not violated.

But now the law has become effectively immune to any testing and a tautologous statement.

And, furthermore, since time must always intervene between one purchase of a good and an additional purchase of the same good, one must wonder how anyone at all can be known to have the same character, tastes or preferences over time given that, technically speaking, even a small or minute change in the latter qualities would render them unstable, under Marshall’s view.

BIBLIOGRAPHY
Marshall, Alfred. 1920. Principles of Economics (8th edn.). Macmillan and Co., Ltd. London.

Robinson, Joan. 1964. Economic Philosophy. Penguin, Harmondsworth.

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.