Alfred Marshall on Wage Stickiness and Debt Deflation

In a fascinating passage from Alfred Marshall’s The Economics of Industry (1879) (which he wrote with his wife Mary Marshall):

“The connexion between a fall of prices and a suspension of industry requires to be further worked out.

There is no reason why a depression of trade and a fall of prices should stop the work of those who can produce without having to pay money on account of any Expenses of production. For instance a man who pays no wages, who works with his own hands, and produces what raw material he requires, cannot lose anything by continuing to work. It does not matter to him how low prices have fallen, provided that the prices of his goods have not fallen more in proportion than those of others. When prices are low, he will get few coins for his goods; but if he can buy as many things with them as he could with the greater number of coins he got when prices were high, he will not be injured by the fall of prices. He would be a little discouraged if he thought that the price of his goods would fall more than the prices of others; but even then he would not be very likely to stop work.

And in the same way a manufacturer, though he has to pay for raw material and wages would not check his production on account of a fall in prices, if the fall affected all things equally, and were not likely to go further. If the price which he got for his goods had fallen by a quarter, and the prices which he had to pay for labour and raw material had also fallen by a quarter, the trade would be as profitable to him as before the fall. Three sovereigns would now do the work of four, he would use fewer counters in measuring off his receipts against his outgoings; but his receipts would stand in the same relation to his outgoings as before. His net profits would be the same percentage of his total business. The counters by which they are reckoned would be less by one quarter, but they would purchase as much of the necessaries, comforts, and luxuries of life as they did before.

It however very seldom happens in fact that the expenses which a manufacturer has to pay out fall as much in proportion as the price which he gets for his goods. For when prices are rising, the rise in the price of the finished commodity is generally more rapid than that in the price of the raw material, always more rapid than that in the price of labour; and when prices are falling, the fall in the price of the finished commodity is generally more rapid than that in the price of the raw material, always more rapid than that in the price of labour. And therefore when prices are falling the manufacturer's receipts are sometimes scarcely sufficient even to repay him for his outlay on raw material, wages, and other forms of Circulating capital; they seldom give him in addition enough to pay interest on his Fixed capital and Earnings of Management for himself.

Even if the prices of labour and raw material fall as rapidly as those of finished goods, the manufacturer may lose by continuing production if the fall has not come to an end. He may pay for raw material and labour at a time when prices generally have fallen by one-sixth; but if, by the time he comes to sell, prices have fallen by another sixth, his receipts may be less than is sufficient to cover his outlay.

We conclude then that manufacturing cannot be carried on except at a low rate of profit, or at a loss, when the prices of finished goods are low relatively to those of labour and raw material; or when prices are falling, even if the prices of all things are falling equally.

§6. Thus a fall in prices lowers profìts and impoverishes the manufacturer: while it increases the purchasing power of those who have fixed incomes. So again it enriches creditors at the expense of debtors. For if the money that is owing to them is repaid, this money gives them a great purchasing power; and if they have lent it at a fixed rate of interest, each payment is worth more to them than it would be if prices were high. But for the same reasons that it enriches creditors and those who receive fixed incomes, it impoverishes those men of business who have borrowed capital; and it impoverishes those who have to make, as most business men have, considerable fixed money payments for rents, salaries, and other matters. When prices are ascending, the improvement is thought to be greater than it really is; because general opinion with regard to the prosperity of the country is much influenced by the authority of manufacturers and merchants. These judge by their own experience, and in time of ascending prices their fortunes are rapidly increased; in a time of descending prices their fortunes are stationary or dwindle. But statistics prove that the real income of the country is not very much less in the present time of low prices, than it was in the period of high prices that went before it. The total amount of the necessaries, comforts and luxuries which are enjoyed by Englishmen is but little less in 1879 than it was in 1872.” (Marshall and Marshall 1879: 155–157).

So already in the 1870s Marshall says that wages are liable to be inflexible downwards, or at least there is a lag between price deflation and nominal wage cuts that reduces profits and causes business pessimism.

Also very striking is that Marshall is well aware of the essence of debt deflation, but not, I think, how damaging debt deflation can be, and how business pessimism arising from deflation, debt deflation and profit deflation can reduce the aggregate level of investment and hence the aggregate wealth and employment of a nation, for the reasons outlined by Keynes in Chapter 19 of the General Theory. An equally serious flaw is that Marshall also continued to defend Say’s law in the form expressed by John Stuart Mill (Marshall and Marshall 1879: 154).

However, Marshall thinks that mild to modest inflation actually increases the confidence of business people because their profits are rising, a not unreasonable idea at all, and he was right to stress the role of business confidence as a driving force of capitalism and investment (Marshall and Marshall 1879: 154–155).

These issues are very interesting because during the great deflation of 1873 to 1896 it seems clear that business expectations became pessimistic and people at the time spoke of a “profit deflation” that sapped business confidence.

Marshall himself spoke of this in his evidence before the UK “Royal Commission on the Value of Gold and Silver” instituted in 1887.

Alfred Marshall stated:

“[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.”

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.

The evidence would then suggest that downwards nominal wage stickiness was the cause of a “severe depression of profits” and along with debt deflation the cause of business pessimism in these years.

And even if wages did adjust after considerable lags, the nominal fall in money profits may well have been sufficient to cause business pessimism, since business people were probably more focussed on nominal values than the real, inflation-adjusted value of profits (or what neoclassicals call the “money illusion”). And even with wage adjustments in the long-run, businesses were still probably hit by debt deflation.

A final and very interesting question to my mind is this: did the aggregate level of investment in Europe and America fall as the great deflation of 1873 to 1896 unfolded?

S. B. Saul in his book The Myth of the Great Depression, 1873–1896 thought so, and argued that lower industrial investment was a characteristic of this period (Saul 1985: 41, 53).

Further Reading
“The Profit Deflation of the 1890s,” June 13, 2013.

“Alfred Marshall’s Judgement on the “Depression” of 1873–1896,” June 13, 2013.

“S. B. Saul on the Profit Deflation of the 1873–1896 Period,” June 14, 2013.

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

“Alfred Marshall’s Interest Rate Theory,” November 3, 2014.

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

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

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

Thomas Attwood on Debt Deflation in 1817

Following on from my last post, I noted that the author of the “Economicreflections” blog has done some sterling work, and written a fascinating post here showing how the essence of debt deflation was already understood as early as 1817 by the economist Thomas Attwood.

The passage from Thomas Attwood’s Prosperity Restored, or, Reflections on the Cause of the Public Distresses: and on the only means of relieving them (London, 1817) is worth quoting at length:

“If the whole mass of the property of England was valued at Four Thousand Millions sterling four years ago, which is perhaps a moderate calculation at the prices then established there has been a loss of full One Thousand Millions sterling, sustained by some persons or other, by the redaction of prices in these four years; a loss, which was a mere nominal or monied loss at the first, but which has become a real loss in the end. But whilst this loss has been sustained upon property, there has been no elimination of the engagements or debts to which all property is more or less subjected. Those debts have, in fact, nearly doubled in their value in the meanwhile, and have given the creditor generally the command of nearly double the property which he ever advanced to the debtor. The debtor has found his debts doubled whilst he has been thinking that he was paying them off, and all his efforts to accomplish that object have been in vain, for they have grown under his exertions, and have encreased faster than his exertions could reduce them. If they bore any considerable proportion to his property at first, say one half or two thirds, it would have been much better for him to have relinquished the whole of his property to his creditors three years ago; for all his efforts to discharge debts of that amount must generally have proved in vain, and must now have left him no better consolation than the conviction of having done the most in his power for his creditors, without the prospect of saving himself from bankruptcy and ruin.

The situation of the nation, considered as a debtor, has been the same, and this is the true cause of the pressure of taxes. The national debt, three months ago, would have commanded double the quantity of the good things of life that it would have commanded four years ago, and yet while the taxes thus became virtually doubled, the means of the payers became diminished in the same proportion. The payers of taxes had to contribute double the quantity of good things of life in the shape of taxes, whilst the amount of the good things of life in their possession was diminished every day, by the stagnation of industry, and the diminution of production, which was occasioned by the same depression of prices, which bad occasioned the same doubling of the real amount of their taxes.

Here is the true cause of the pressure of taxes, which does not lie in their nominal amount, but in the action upon money, which has given a quadruple weight to their operation. The real value of the taxes has been doubled, whilst the real property of the nation has been diminished in nearly the same degree. For three years the labourers generally have not had more than one half or two thirds of full work, and thus the productive powers of the country have been stagnant, whilst its necessary consumption has been going on, and whilst all the debts and engagements, both public and private, have become virtually doubled. Thus a nominal loss of One Thousand Millions sterling has become a real loss of that enormous sum to the nation. I do not hesitate to say, that whilst the relations between property and money were fixed on the same scale as they were four years ago, there was no difficulty at all in the payment of seventy millions per annum in taxes. Nor do I hesitate to assert, that the country could have born to have had those taxes raised to one hundred and forty millions per annum in the last four years, with far less injury than it has born the action upon currency, or what is called the depression of prices.

But it may be said, how can the depression of prices produce such an immense loss, when I, myself, allow that it is of no consequence upon what terms the relations between property and money are fixed, provided they are fixed and understood.

I have endeavoured to shew in the ‘Remedy’ that it is the action of this depression whilst in progress that creates the evil, and not the depression itself when once fixed and understood. Whilst the action is taking place the principles of production are arrested; for since almost all the transactions of life take place through the medium of debts or obligations, and more of them through that of currency or money invested with legal powers and privileges, those transactions can no longer be carried on when the legal responsibilities which the production or purchase of property incurs, are greater than that property will redeem when produced.

When prices have only risen for a short time, they may be reduced without injury, because they have not operated upon the debts and obligations tinder which property is held, nor upon the labour and system under which it is obtained. Such a rise of prices as this, is a mere monied profit into the hands of the property holders whilst it continues, and when it falls, it occasions no loss to the property holders, because the state of prices only returns to what it was when their property was obtained. Of course, there is nothing here to arrest production and consumption, or to interfere in any serious way with the prosperity of the country : but when prices fall after having been long fixed and understood, and after having operated upon all debts and obligations, and upon the production and consumption of property, they cannot be reduced without breaking up the channels and the systems through which society is supported, and without discharging the great body of the labourers, and reducing the whole population to a state of penury and distress.

If prices were to fall suddenly, and generally, and equally, in all things, and if it was well understood, that the amount of debts and obligations were to fall in the same proportion, at the same time, it is possible that such a fall might take place without arresting consumption and production, and in that case it would neither be injurious or beneficial in any great degree, but when a fall of this kind takes place in an obscure and unknown way, first upon one article and then upon another, without any correspondent fall taking place upon debts and obligations, it has the effect of destroying all confidence in property, and all inducements to its production, or to the employment of labourers in any way.” (Attwood 1817: 75–79).

The crucial passage at the end:

“If prices were to fall suddenly, and generally, and equally, in all things, and if it was well understood, that the amount of debts and obligations were to fall in the same proportion, at the same time, it is possible that such a fall might take place without arresting consumption and production, and in that case it would neither be injurious or beneficial in any great degree, but when a fall of this kind takes place in an obscure and unknown way, first upon one article and then upon another, without any correspondent fall taking place upon debts and obligations, it has the effect of destroying all confidence in property, and all inducements to its production, or to the employment of labourers in any way.” (Attwood 1817: 75–79).

As I said, it is interesting that Thomas Attwood was part of the “Birmingham School” of economists, who were a proto-Keynesian school.

BIBLIOGRAPHY
Attwood, Thomas. 1817. Prosperity Restored, or, Reflections on the Cause of the Public Distresses: and on the only means of relieving them. Baldwin, Cradock, and Joy, London.

Debt Deflation: 1920–1921 versus 1929–1933

The issue of why the price deflation of 1920 to 1921 did not prove a more serious problem for the US economy, as compared with 1929 to 1933, is explained by two factors:

(1) the level of private debt in 1929 was much higher than in 1920–1921.

In particular, the 1920s (after 1921) saw an explosion in credit-financed consumption spending such as “instalment credit” and margin borrowing for asset speculation.

(2) the price deflation of 1920–1921 was preceded by a massive wartime inflation (1915–1918) and the inflation of the boom of 1919.

Factor (2) can be seen in the graph below (with data from Measuringworth.com).

From 1915 there was a huge price (and wage) inflation that reduced the real value and burden of private debt (Kuehn 2012: 159). Even the deflation of 1920 to 1921 is not great relative to the preceding inflation.

Furthermore, the relative stability of the price level in the 1920s can also be seen above.

The rising private debt in the 1920s occurred in the context of a stable price level, and when the deflation came in 1929–1933 it was much more serious in its cumulative effects – along with all the other factors in this period such as the banking crises, mass loss of deposits, wage cuts, collapsing asset prices, the shocks to aggregate demand and so on.

Moreover, the 1920s had seen a fundamental change in the composition of private debt involving an explosion in private household debt to finance purchases of consumer durables through credit from “consumer lending institutions” (Brown 1997: 619).

Rather than commercial banks, it was consumer finance companies that accounted for this growth in credit: in 1919 there were very few consumer finance companies, but by 1925 there were around 1,500 such institutions (Brown 1997: 619).

Brown (1997: 624–633) points to a severe type of “household-debt deflation” that affected the US economy in 1929–1930, as households lost confidence and cut consumer spending to liquidate accumulated debt. This was but part of a broader debt deflationary trend, but was an important factor in the severity of the US depression in its initial years.

BIBLIOGRAPHY
Brown, Christopher. 1997. “Consumer Credit and the Propensity to Consume: Evidence from 1930,” Journal of Post Keynesian Economics 19.4: 617–638.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

To that, let us turn to (4).

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The General Theory, Chapter 19: Changes in Money-Wages

Chapter 19 of The General Theory is a crucial one: it discusses the consequences of nominal wages cuts in modern market economies.

Keynes begins by pointing out that neoclassical economics (which he called the “Classical” theory) assumes that a major reason why market economies are supposed to self-adjust is via flexible wages (and, by implication, prices). When wages are rigid, this is (allegedly) the cause of serious maladjustment in neoclassical theory (Keynes 1964 [1936]: 257).

Keynes accepted that a “reduction in money-wages is quite capable in certain circumstances of affording a stimulus to output, as the classical theory supposes” (Keynes 1964 [1936]: 257), but there were many reasons why it would not generally do so.

Keynes also emphasised the need to distinguish the real wage from the nominal wage (or “money-wage”) (Keynes 1964 [1936]: 259).

Keynes analysed the effects of reductions in nominal wages in the following way:

(1) a reduction in nominal wages may reduce prices, but if the price falls are uneven, it will redistribute real income from wage-earners to other classes of society, such as producers and rentiers (the latter of whom often have fixed incomes) (Keynes 1964 [1936]: 262). But this is likely to reduce the aggregate level of consumption (or propensity to consume), so that the macroeconomic effects will actually be harmful (Keynes 1964 [1936]: 262).

(2) if the reduction in nominal wages affects industries that export products, then a reduction in money wages might stimulate demand for a nation’s exports and hence its domestic investment (Keynes 1964 [1936]: 262–263). Keynes noted that the UK of his day was an export-led economy (as compared with the United States), and that this accounted for the popularity of the belief that cutting money-wages would increase employment in Great Britain (Keynes 1964 [1936]: 263).

(3) but in an open economy, a reduction in money wages may increase the favourable balance of trade but worsen the terms of trade (Keynes 1964 [1936]: 263).

(4) If a reduction in money wages occurs but with expectations of further wage rises in the future, then this might be favourable to consumption and investment (Keynes 1964 [1936]: 263).

But, if a reduction in money wages leads to expectations of further wage cuts in the future, then it may well be counterproductive as it may lead to deferment of both investment and consumption (Keynes 1964 [1936]: 263).

(5) If both a reduction in wages and some fall in prices occur, and lead to a lower liquidity preference, then this will reduce the rate of interest, and prove favourable to investment.

But if, at the same time, there is an expectation of further wage and price increases in the future, then demand for long-term loans may not be as great as demand for short term loans (Keynes 1964 [1936]: 263), and if wage cuts cause loss of confidence and discontent, the increase in liquidity preference might more than offset the original reduction in the latter (Keynes 1964 [1936]: 264).

(6) A reduction of wages simply within one particular industry will be advantageous to the capitalist owners and/or managers of that industry, and a general reduction in wages throughout an economy might produce an optimistic mood amongst entrepreneurs in general, but labour troubles are likely to complicate matters badly:

“On the other hand, if the workers make the same mistake as their employers about the effects of a general reduction, labour troubles may offset this favourable factor; apart from which, since there is, as a rule, no means of securing a simultaneous and equal reduction of money-wages in all industries, it is in the interest of all workers to resist a reduction in their own particular case. In fact, a movement by employers to revise money-wage bargains downward will be much more strongly resisted than a gradual and automatic lowering of real wages as a result of rising prices.” (Keynes 1964 [1936]: 264).

(7) And, crucially, Keynes pointed to the disastrous effects of debt deflation:

“On the other hand, the depressing influence on entrepreneurs of their greater burden of debt may partly offset any cheerful reactions from the reduction of wages. Indeed if the fall of wages and prices goes far, the embarrassment of those entrepreneurs who are heavily indebted may soon reach the point of insolvency, — with severely adverse effects on investment. Moreover the effect of the lower price-level on the real burden of the National Debt and hence on taxation is likely to prove very adverse to business confidence.” (Keynes 1964 [1936]: 264).

To this Keynes could have added that private household debt will have much the same disastrous effects if wage and price deflation proceeds far enough.

Keynes, then, pointed to the negative distributional and other effects of wage reductions, and contended that only (4) or (5) gave much hope of inducing favourable results from nominal wage cuts.

But, with respect to (4), in order to prevent the expectation of further nominal wage cuts, a wage reduction would have to be deep and wide enough throughout an economy and limited to a single occurrence:

“The contingency, which is favourable to an increase in the marginal efficiency of capital, is that in which money-wages are believed to have touched bottom, so that further changes are expected to be in the upward direction. The most unfavourable contingency is that in which money-wages are slowly sagging downwards and each reduction in wages serves to diminish confidence in the prospective maintenance of wages. When we enter on a period of weakening effective demand, a sudden large reduction of money-wages to a level so low that no one believes in its indefinite continuance would be the event most favourable to a strengthening of effective demand. But this could only be accomplished by administrative decree and is scarcely practical politics under a system of free wage-bargaining.” (Keynes 1964 [1936]: 265).

Next Keynes notes that market equilibration in neoclassical theory depends on effective wage and price adjustment maintaining consumption and smoothing out changes in the demand to hold money:

“It is, therefore, on the effect of a falling wage- and price-level on the demand for money that those who believe in the self-adjusting quality of the economic system must rest the weight of their argument; though I am not aware that they have done so. If the quantity of money is itself a function of the wage- and price-level, there is indeed, nothing to hope in this direction. But if the quantity of money is virtually fixed, it is evident that its quantity in terms of wage-units can be indefinitely increased by a sufficient reduction in money-wages; and that its quantity in proportion to incomes generally can be largely increased, the limit to this increase depending on the proportion of wage-cost to marginal prime cost and on the response of other elements of marginal prime cost to the falling wage-unit.” (Keynes 1964 [1936]: 266).

In effect, Keynes is saying that the neoclassical belief in market equilibration via wage reductions depends on the “real balances” effect (Hayes 2006: 177) (and note how Keynes assumes an exogenous money supply here too).

Keynes continues by noting that, in some respects, a cut in nominal wages is effectively equivalent to expansionary monetary policy (Keynes 1964 [1936]: 266; Hayes 2006: 178). But Keynes argues that the clear advantages of increasing the money supply over reductions in nominal wages make the latter an absurd policy.

Keynes sketches his argument for this view in the following way:

(1) It is paradoxically only in a fully socialist economy that wage policy can be done uniformly and effectively by administrative decree. In a market economy, it is unrealistic to think that there could be “uniform wage reductions for every class of labour” (Keynes 1964 [1936]: 267):

“The result [sc. uniform wage reductions] can only be brought about by a series of gradual, irregular changes, justifiable on no criterion of social justice or economic expediency, and probably completed only after wasteful and disastrous struggles, where those in the weakest bargaining position will suffer relatively to the rest. A change in the quantity of money, on the other hand, is already within the power of most governments by open-market policy or analogous measures. Having regard to human nature and our institutions, it can only be a foolish person who would prefer a flexible wage policy to a flexible money policy, unless he can point to advantages from the former which are not obtainable from the latter. Moreover, other things being equal, a method which it is comparatively easy to apply should be deemed preferable to a method which is probably so difficult as to be impracticable.” (Keynes 1964 [1936]: 267–268).

(2) Since certain classes of people such as rentiers have fixed incomes, a relatively rigid wage system is fairer:

“Thus the greatest practicable fairness will be maintained between labour and the factors whose remuneration is contractually fixed in terms of money, in particular the rentier class and persons with fixed salaries on the permanent establishment of a firm, an institution or the State. If important classes are to have their remuneration fixed in terms of money in any case, social justice and social expediency are best served if the remunerations of all factors are somewhat inflexible in terms of money. Having regard to the large groups of incomes which are comparatively inflexible in terms of money, it can only be an unjust person who would prefer a flexible wage policy to a flexible money policy, unless he can point to advantages from the former which are not obtainable from the latter.” (Keynes 1964 [1936]: 268).

(3) Above all, money supply growth rather than wage cuts will overcome the dangers of debt deflation:

“The method of increasing the quantity of money in terms of wage-units by decreasing the wage-unit increases proportionately the burden of debt; whereas the method of producing the same result by increasing the quantity of money whilst leaving the wage unit unchanged has the opposite effect. Having regard to the excessive burden of many types of debt, it can only be an inexperienced person who would prefer the former.” (Keynes 1964 [1936]: 268).

(4) Finally, if a fall in interest rates is brought about by falling nominal wages, this can, as Keynes already noted, cause deferment of investment (Keynes 1964 [1936]: 269).

Furthermore, Keynes argued, gradual reductions in nominal money wages might have the perverse effect of actually increasing real wages (Keynes 1964 [1936]: 269).

Keynes’s conclusion, then, was as follows:

“In the light of these considerations I am now of the opinion that the maintenance of a stable general level of money-wages is, on a balance of considerations, the most advisable policy for a closed system; whilst the same conclusion will hold good for an open system, provided that equilibrium with the rest of the world can be secured by means of fluctuating exchanges. There are advantages in some degree of flexibility in the wages of particular industries so as to expedite transfers from those which are relatively declining to those which are relatively expanding. But the money-wage level as a whole should be maintained as stable as possible, at any rate in the short period.

This policy will result in a fair degree of stability in the price-level; — greater stability, at least, than with a flexible wage policy. Apart from ‘administered’ or monopoly prices, the price-level will only change in the short period in response to the extent that changes in the volume of employment affect marginal prime costs; whilst in the long period they will only change in response to changes in the cost of production due to new technique and new or increased equipment.” (Keynes 1964 [1936]: 270–271).

As an aside, I note here how Keynes seems to have assumed that “administered or monopoly prices” were not very significant. And that leads me into my last point.

What is especially interesting about Keynes’s analysis is this: it concedes points to neoclassical economics – such as the idea of exogenous money, prices determined by marginal cost, and relatively flexible but uneven price movements – that Keynes did not need to concede, but still Keynes shows that the neoclassical theory is deficient.

BIBLIOGRAPHY
Hayes, Mark. 2006. The Economics of Keynes: A New Guide to The General Theory. Edward Elgar, Cheltenham.

Keynes, J. M. 1964 [1936]. The General Theory of Employment, Interest, and Money. Harvest/HBJ Book, New York and London.

Murphy on Sticky Wages

Robert P. Murphy in his recent response to Krugman on Mises and the Great Depression refers us to the following post to refute the idea that “sticky wages” really are a problem for free market economics:

Murphy, Robert P. 2010. “Do Sticky Wages Weaken the Case for Markets?,” Mises Daily, June 7
http://mises.org/daily/4353/Do-Sticky-Wages-Weaken-the-Case-for-Markets

This post deserves to be read by everyone who wants to see how far Austrian economists (and, incidentally, even mainstream New Keynesians like Mankiw) are from understanding real-world capitalism.

Keynes was clear that even if wages and prices were perfectly flexible this would still be no reliable and automatic cure for involuntary unemployment, and that there could still be failures of aggregate demand (Davidson 1992). Keynes, then, would not have been a New Keynesian like Mankiw.

But the issue here is wage stickiness.

First, Murphy does not even dispute that wage stickiness is a real phenomenon in modern market economies (what is now called a “stylised fact”), but instead wishes to put the blame for it mostly on modern governments.

I will return below to why this is wrong, but Murphy makes an astonishing claim that is utterly untrue:

“Now we have to ask, why do workers hold out for so long without jobs, insisting on wages that no one is willing to pay? After all, the other goods and services in the economy see their prices fall in a speedy fashion even though the sellers of these items depend on them for their livelihood. So if a street vendor knows enough to slash his hot dog prices when demand collapses, why don’t hairdressers accept pay cuts when the same happens to their industry?

What was that? Murphy is saying that real world “prices fall in a speedy fashion”?

Has Murphy ever noticed that in virtually all recessions since the late 1930s throughout the developed world, even recessions tend to be inflationary? Deflation has virtually disappeared.

Relative price rigidity is a fact of life. Even in the terrible disaster that was the Great Depression it was a clear phenomenon.

The reason has been known since the work of Gardiner Means: most prices in modern capitalist economies are relatively inflexible mark-up/administered prices (for the empirical evidence, see Appendix 2 below).

Flexible price setting as required in standard economics textbooks – where prices are set by supply and demand dynamics – is largely shunned by the private sector itself.

A great part of the economy of each modern capitalist nation consists of mark-up pricing sectors, but even though (of course) flexprice markets do exist they are a considerably smaller part of the economy than most people think (perhaps less than 30% in many nations).

And, even though many nations saw price deflation in the Great Depression, even in the 1930s mark-up prices were significant and relatively inflexible as compared with other markets: Gardiner Means, for example, discovered that the administered pricing sector of the US economy had seen price declines of only about 10% during the depression, whereas the more competitive or flexprice sectors had seen price falls of about 40 to 60% (Means 1975).

So even Robert Murphy’s initial assumption that we live in a world of highly flexible prices cannot be taken seriously, and utterly collapses.

But to return to the issue of sticky wages. The main cause of sticky wages is not government intervention.

The empirical evidence that has accumulated over the years shows that people in general object to having their nominal wages cut. But even managers and capitalists often dislike pay cuts. Recent studies suggest that employers avoid pay cuts because they diminish workers’ morale, and then falling morale reduces productivity, amongst many other reasons (Bewley 1999). The evidence of Bewley shows that even employers are often averse to wage cuts during recessions. A nice summary of Bewley’s work on wages is available here.

But moving on, even Murphy’s explanation of wage rigidity during the depression in the US is flawed:

“…why don’t hairdressers accept pay cuts when the same happens to their industry? In the case of the Great Depression, the answer is simple enough: the federal government didn’t allow wages to fall. After the 1929 crash, Herbert Hoover gathered the nation's leading businessmen for a conference in Washington and urged them to allow profits and dividends to take the hit, but to spare workers’ paychecks. Rather than cut wages, businesses were supposed to implement spread-the-work schemes where workers would cut back their hours.”

First, Hoover’s “high wage” policy was not an alien, evil government intervention imposed on unwilling and hostile business people: it was a policy that many largely agreed with, as I note here. Already in the 1920s and 1930s many employers had grown averse to wage cuts.

Secondly, Rose (2010) presents some (admittedly ambiguous) evidence that Hoover’s “high wage” policy actually did not have much effect on the timing of US wage cuts during the depression.

Of course, that rigid wages in the face of falling prices squeezed profits and induced business pessimism and bankruptcy is undoubtedly true, but the solution was not wage cuts.

Why? Keynes showed why in Chapter 19 of the General Theory (Keynes 1964 [1936]: 257–271), and one important reason is that, even when nominal wages fall, this induces debt deflationary effects (especially when levels of private debt are very high), just as Irving Fisher had argued (Fisher 1933; see also Dimand 1997 and Dimand 2011).

Above all, if price deflation is quite uneven across sectors and product markets (as in many countries during the depression), the burden of fixed nominal debt will soar, inducing difficulty in servicing debt to many debtors and actual bankruptcy to others.

A further means by which demand for final goods and services is contracted is that a greater transfer of wealth from debtors to creditors occurs and creditors often have a lower marginal propensity to consume.

And eventually severe debt deflation will cause distress and bankruptcy to creditors and the financial system. So the smooth and rapid market clearing as postulated by Austrians and other mainstream neoclassicals as the cure for high involuntary unemployment simply could not and did not happen.

Murphy cites the recession of 1920–1921 as an example of how (alleged) wage and price flexibility cleared markets and led to a (supposedly) quick recovery. But the recession of 1920–1921 is highly anomalous, as I have shown elsewhere (see Appendix 1 below), and a demand-side explanation is more convincing as an explanation of recovery in 1921. There was no financial crisis, no banking failures, the deflation was probably expected, some actual positive supply shocks, and private debt levels were considerably lower than in 1929.

Murphy is also wrong that the Federal Reserve “jacked rates up to record high levels,” if he is talking about the recovery in 1921:

Discount Rate of the Federal Reserve Bank of New York
Date | Rate
1920
May | 6%
June | 7%
Dec. | 7%
1921
Jan. | 7%
Apr. | 7%
May. | 6.5%
Jun. | 6%
Jul. | 5.5%
Sep. | 5%
Nov. | 4.5%

1922
Jan. | 4.5%
Jun. | 4%.
http://fraser.stlouisfed.org/download-page/page.pdf?pid=38&id=1477

As we can see, the Fed lowered interest rates from May 1921, and a recovery began in August 1921, after looser monetary policy had been adopted.

Then from November 1921 to June 1922, the Fed engaged in unprecedented open market operations to aid the recovery process.

The Austrian obsession with the recession of 1920–1921 is strange, given its anomalous nature. Why don’t they look at the US recessions of the 1870s and 1890s, for example?

The US had no central bank in these years, small government, a gold standard, either no or very limited unemployment relief at best, and (presumably) a greater degree of price and wage flexibility (although even in this period wage stickiness existed: see Sundstrom 1990; Sundstrom 1992; Hanes 1992; Hanes 1993). Yet serious economic problems occurred in both the 1870s and 1890s.

Take the 1890s. The graph below shows US unemployment in the 1890s according to three estimates. For various reasons, Lebergott’s estimates may be the better ones for unemployment rates in this period.

High unemployment continued for years after the shock of 1892–1893.

So what is the Austrian explanation for this? If wages and prices were not sticky, then there was still no rapid recovery and quickly self-adjusting labour market.

If wages were sticky, then not even late Gold Standard capitalism escaped the “stylised fact” of relatively rigid wages.

Either way the Austrian view is damned.

Appendix 1: The Recession of 1920–1921
“The US Recession of 1920–1921: Some Austrian Myths,” October 23, 2010.

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

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

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

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

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

Appendix 2: Empirical Evidence on Administered Prices
“Downward’s Pricing Theory in Post-Keynesian Economics: Chapter 8,” January 23, 2014.

“Mark-up Pricing in South Africa,” January 20, 2014.

“Mark-up Pricing in Sweden,” January 9, 2014.

“Mark-up Pricing in Canada,” January 7, 2014.

“Some More Empirical Evidence on Full Cost Pricing,” December 10, 2013.

“Mark-up Pricing in New Zealand,” November 30, 2013.

“Mark-up Pricing in Australia,” November 30, 2013.

“Mark-up Pricing in Japan,” November 29, 2013.

“Mark-up Prices in Iceland,” November 25, 2013.

“Mark-up Pricing in Norway,” November 23, 2013.

“Mark-up Pricing in Ireland,” November 22, 2013.

“Two Marketing Studies on US Administered Prices,” November 16, 2013.

“Hall and Hitch on Marginal Cost and Price,” November 4, 2013.

“Administered Pricing in the United Kingdom,” October 19, 2013.

“Administered Prices in the Eurozone: Some Empirical Data,” October 16, 2013.

“Gardiner Means on Administered Prices,” June 20, 2013.

“Early Literature on Administered Pricing,” May 8, 2013.

BIBLIOGRAPHY
Bewley, T. F. 1999. Why Wages Don’t Fall During a Recession. Harvard University Press, Cambridge, MA.

Davidson, P. 1992. “Would Keynes be a New Keynesian?,” Eastern Economic Journal 18.4: 449–463.

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

Dimand, Robert W. 2011. “Lessons from the 1929 Crash and the 1930s Debt Deflation: What Bernanke and King Learned, and what they could have learned,” in Claude Gnos and Louis-Philippe Rochon (eds.), Credit, Money and Macroeconomic Policy: A Post-Keynesian Approach. Edward Elgar, Cheltenham. 33–44.

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

Keynes, J. M. 1964 [1936]. The General Theory of Employment, Interest, and Money. Harvest/HBJ Book, New York and London.

Means, Gardiner C. 1975. “Simultaneous Inflation and Unemployment: A Challenge to Theory and Policy,” in Gardiner C. Means et al., The Roots of Inflation: The International Crisis. Wilton House Publications, London.

Sundstrom, William A. 1990. “Was There a Golden Age of Flexible Wages? Evidence from Ohio Manufacturing, 1892–1910,” The Journal of Economic History 50.2: 309–320.

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

Monetary Disequilibrium Austrians are Clueless about Debt Deflation

And this can be seen here in these videos.






Underlying all these videos is the idea is that, if only prices and wages were perfectly or near perfectly flexible, then economic problems would be resolved.

The glaring hole in this argument is the inability to consider the macroeconomic effects of debt deflation: if debts are nominally fixed, cutting wages and prices will simply exacerbate the real burden of debt, putting pressures on debtors, and eventually driving up the level of bankruptcies which in turn is liable to cause losses and even bankruptcies to creditors.

Another problem is that the only significant period that Austrians can point to as a time of “good” deflation, the 1873 to 1896 era, turns out to have had serious economic problems related to the price deflation and (most likely) debt deflationary dynamics of that era:

“Alfred Marshall’s Judgement on the “Depression” of 1873–1896,” June 13, 2013.

“The Profit Deflation of the 1890s,” June 13, 2013.

“S. B. Saul on the Profit Deflation of the 1873–1896 Period,” June 14, 2013.

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

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

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

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

The Profit Deflation of the 1890s

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

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

Fisher on Debt Deflation

This paper of Irving Fisher (1867–1947) is now a classic:

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

This is where Fisher expounded his theory of debt deflation, or at least the paper people generally cite.

Yet it was not in fact Fisher’s first statement of the idea. Fisher’s theory was first stated in his Yale lectures in 1931, and then in a talk before the American Association for the Advancement of Science on 1 January 1932 (Fisher 1933: 350, n.). It was then published in his book Booms and Depressions: Some First Principles (London, 1933).

Even Fisher admitted that Thorstein Veblen’s book The Theory of Business Enterprise (in chapter 7) came close to a prior debt deflation theory (Fisher 1933: 350, n.).

Fisher also mentions Ralph Hawtrey and Frederic L. Paxson (University of Wisconsin) as other forerunners of the debt deflation idea, though their theories were far from complete, and Fisher still claimed a degree of originality and sophistication not seen in earlier theories (Fisher 1933: 350, n.).

Fisher described his 1933 paper as “embodying … my present ‘creed’ on the whole subject” (Fisher 1933: 337).

Fisher viewed business cycles as caused by many factors or forces, both exogenous and endogenous (Fisher 1933: 338). It is noticeable that Fisher had still not completely freed himself from general equilibrium theory, even in his 1933 paper, for he could write the following:

“We may tentatively assume that, ordinarily and within wide limits, all, or almost all, economic variables tend, in a general way, toward a stable equilibrium.” (Fisher 1933: 339).

Nevertheless, it “is as absurd to assume that, for any long period of time, the variables in the economic organization, or any part of them, will ‘stay put,’ in perfect equilibrium, as to assume that the Atlantic Ocean can ever be without a wave” (Fisher 1933: 339).

Fisher rejects Say’s law and accepts that general overproduction at certain times is a reality (Fisher 1933: 340).

Fisher saw two factors as playing a major role in the business cycle: (1) over-indebtedness and (2) deflation “following soon afterwards,” and regarded the economic crises of 1837, 1873 and 1929–1933 as important examples of debt deflationary episodes (Fisher 1933: 341). The excessive debt may cause over-investment and over-speculation in the boom (Fisher 1933: 341).

According to Fisher we have the following steps in a debt deflationary crisis:

“(1) Debt liquidation leads to distress selling and to
(2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes
(3) A fall in the level of prices, in other words, a swelling of the dollar [that is, price deflation – LK]. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be
(4) A still greater fall in the net worths of business, precipitating bankruptcies and
(5) A like fall in profits, which in a ‘capitalistic,’ that is, a private-profit society, leads the concerns which are running at a loss to make
(6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies, and unemployment, lead to
(7) Pessimism and loss of confidence, which in turn lead to
(8) Hoarding and slowing down still more the velocity of circulation.

The above eight changes cause (9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.” (Fisher 1933: 342).

This description is of course a model, and in real life the order, intensity, effects and interrelations of the factors above may be different in any actual recession or depression (Fisher 1933: 342 and 344).

Fisher was also quite clear that deflation alone in an environment without great private debt does not necessarily cause economic disaster:

“Likewise, when a deflation occurs from other than debt causes and without any great volume of debt, the resulting evils are much less. It is the combination of both-the debt disease coming first, then precipitating the dollar disease-which works the greatest havoc.” (Fisher 1933: 344).

By the end of the paper, Fisher turns to solutions to debt deflation, and his cure is “reflation” or price stabilisation (Fisher 1933: 346–348), a cure he appears to think can be achieved mainly by monetary policy. We see here how Fisher wrote before the Keynesian revolution and the turn to the importance of fiscal policy.


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

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

Raines, J. Patrick and Charles G. Leathers. 2008. Debt, Innovations, and Deflation: The Theories of Veblen, Fisher, Schumpeter and Minsky. Edward Elgar, Cheltenham and Northampton, MA.

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

Bibliography on Debt Deflation

I provide a bibliography below on debt deflation, which includes some of the neoclassical literature, as well as the Post Keynesian work.

See Steve Keen’s criticisms of an earlier version of Eggertsson and Krugman (2012) for the problems in the neoclassical approach to debt deflation.

Arestis, P. and E. Karakitsos. 2003. “How Far Can U.S. Equity Prices Fall Under Asset and Debt Deflation,” Levy Economics Institute, Economics Working Paper Archive

Capie, Forrest and Geoffrey E. Wood (eds.), Asset Prices and the Real Economy. Macmillan, Basingstoke.

Challe, Edouard. 2000. “La ‘debt-deflation’ selon Irving Fisher, Histoire et actualite d’une theorie de la crise financiere” [Irving Fisher’s Debt-Deflation Theory of Great Depressions: History and Current Relevance of a Theory of Financial Crises], Cahiers d’Economie Politique 36: 7–38.

Chiarella, Carl, Flaschel, Peter and Willi Semmler. 2001. “The Macrodynamics of Debt Deflation,” in Riccardo Bellofiore and Piero Ferri (eds.), Financial Fragility and Investment in the Capitalist Economy: The Economic Legacy of Hyman Minsky, Volume II. Edward Elgar, Cheltenham. 133–184.

De Antoni, Elisabetta. 2010. “Minsky, Keynes, and Financial Instability: The Recent Subprime Crisis,” International Journal of Political Economy 39.2: 10–25.

Di Martino, Paolo. 1999. “A Re-discovered Approach: Irving Fisher’s Debt-Deflation Theory,” History of Economic Ideas 7.3: 193–207.

Dimand, Robert W. 1994. “Irving Fisher’s Debt-Deflation Theory of Great Depressions,” Review of Social Economy 52.1: 92–107.

Eggertsson, G. B. and P. Krugman. 2012. “Debt, Deleveraging, and the Liquidity Trap: A Fisher-Minsky-Koo Approach,” Quarterly Journal of Economics 127.3: 1469–1513.

Eichengreen, Barry and Richard S. Grossman. 1997. “Debt-Deflation and Financial Instability: Two Historical Explorations,” in Forrest Capie and Geoffrey E. Wood (eds.), Asset Prices and the Real Economy. Macmillan, Basingstoke. 65–96.

Fackler, James S. and Randall E. Parker. 2005, “Was Debt Deflation Operative during the Great Depression?,” Economic Inquiry 43.1: 67–78.

Fisher, I. 1933. The Debt-Deflation Theory of Great Depressions,” Econometrica 1: 337-357.

Goodhart, C. and B. Hofmann. 2004. “Deflation, Credit and Asset Prices,” in R. Burdekin and P. Siklos (eds.), Deflation: Current and Historical Perspectives. Cambridge University Press, Cambridge. 166–188.

Guttmann, Robert. 2009. “Asset Bubbles, Debt Deflation, and Global Imbalances,” International Journal of Political Economy 38.2: 46–69.

Hudson, Michael. 2012. “The Road to Debt Deflation, Debt Peonage, and Neofeudalism,” Levy Economics Institute, Economics Working Paper Archive.

Hughes Hallett, Andrew and Y. Ma. 1996–1997. “The Dynamics of Debt Deflation in a Monetary Union,” Journal of International and Comparative Economics 5.1: 1–29.

Kaku, Kagehide. 1997. “Debt-Deflation in Japan,” in Forrest Capie and Geoffrey E. Wood (eds.), Asset Prices and the Real Economy. Macmillan, Basingstoke. 242–270.

Keen, Steve. 2000. “The Nonlinear Economics of Debt Deflation,” in Commerce, Complexity, and Evolution: Topics in Economics, Finance, Marketing, and Management. Cambridge University Press, New York. 83–110.

King, Mervyn. 1994. “Debt Deflation: Theory and Evidence,” European Economic Review 38: 419–445.

King, Mervyn. 2005. “Debt Deflation: Theory and Evidence,” in Pierre L. Siklos (ed.), The Economics of Deflation (vol. 1). Edward Elgar, Cheltenham. 220–246.

Lando, Henrik. 1992. “The Economic Consequences of Debt-Deflation,” in Bruno Amoroso and Jesper Jespersen (eds.), Macroeconomic Theories and Policies for the 1990s: A Scandinavian Perspective. St. Martin’s Press, New York. 53–71.

Lucarelli, Bill. 2008. “The United States Empire of Debt: The Roots of the Current Financial Crisis,” Journal of Australian Political Economy 62: 16–38.

Meltzer, Allan H. 1997. “Debt-Deflation: Theory and Evidence: Comment,” in Forrest Capie and Geoffrey E. Wood (eds.), Asset Prices and the Real Economy. Macmillan, Basingstoke. 228–235.

Minsky, H. P. 1982. Can “It” Happen Again?: Essays on Instability and Finance. M.E. Sharpe, Armonk, N.Y.

Minsky, Hyman P. 1980. “Capitalist Financial Processes and the Instability of Capitalism,” Journal of Economic Issues 14.2: 505–523.

Minsky, H. P. 1992. The Financial Instability Hypothesis. Working papers (Jerome Levy Economics Institute no. 74).

Minsky, H. P. 2008 [1975]. John Maynard Keynes. McGraw-Hill, New York and London.

Nidhiprabha, Bhanupong. 1998. “Economic Crises and the Debt-Deflation Episode in Thailand,” ASEAN Economic Bulletin 15.3: 309–318.

Pollin, Robert. 1997. “The Relevance of Hyman Minsky,” Challenge 40.2: 75–94.

Raines, J. Patrick and Charles G. Leathers. 2008. Debt, Innovations, and Deflation: The Theories of Veblen, Fisher, Schumpeter and Minsky. Edward Elgar, Cheltenham.

Shiller, R. J. 2011. “Irving Fisher, Debt Deflation and Crises,” Cowles Foundation Discussion Papers 1817.

Wolfson, Martin H. 1996. “Irving Fisher’s Debt-Deflation Theory: Its Relevance to Current Conditions,” Cambridge Journal of Economics 20.3: 315–333.

Wray, L. Randall. 2009. “The Rise and Fall of Money Manager Capitalism: A Minskian Approach,” Cambridge Journal of Economics 33.4: 807–828.

Wray, L. Randall. 2011. “Financial Keynesianism and Market Instability,” Levy Economics Institute, Economics Working Paper Archive.

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

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

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

My response:

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

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

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

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

(2) Rodolphe Topffer states:

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

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

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

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

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

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

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

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

Year | Unemployment Rate
1869 | 3.97%
1870 | 3.52%
1871 | 3.66%
1872 | 4.00%
1873 | 3.99%
1874 | 5.53%
1875 | 5.83%
1876 | 7.00%
1877 | 7.77%
1878 | 8.25%
1879 | 6.59%
1880 | 4.48%
1881 | 4.12%
1882 | 3.29%
1883 | 3.48%
1884 | 4.01%
1885 | 4.62%
1886 | 4.72%
1887 | 4.30%
1888 | 5.08%
1889 | 4.27%
1890 | 3.97%
1891 | 4.34%
1892 | 4.33%
1893 | 5.51%
1894 | 7.73%
1895 | 6.46%
1896 | 8.19%
1897 | 7.54%
1898 | 8.01%
1899 | 6.20%
(Vernon 1994: 710).

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

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

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

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

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



BIBLIOGRAPHY

Balke, N. S., and R. J. Gordon, 1989. “The Estimation of Prewar Gross National Product: Methodology and New Evidence,” Journal of Political Economy 97.1: 38–92.

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

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

Steve Keen on the Keiser Report

A nice interview with Steve Keen by Max Keiser, dealing with current affairs, asset bubbles and debt deflation.

ABCT and the Flow of Credit

In the 1970s, Hayek attempted to analyse stagflation. In doing so, he acknowledged the limitations of his earlier Austrian business cycle theory (ABCT) in explaining the 1970s crisis, because the flows of credit and monetary expansion were of a different type from those he had dealt with in his earlier work:

“There is one special difficulty about accounting for the present situation. In the misdirection of labour and the distortion of the structure of production during past business cycles, it was fairly easy to point to the places where the excessive expansion had occurred because it was, on the whole, confined to the capital goods industries. The whole thing was due to an over-expansion of credit for investment purposes, and it was therefore possible to regard the industries producing capital equipment as those which had been over-expanded.

In contrast, the present expansion of money [sc. in the 1970s], which has been brought about partly by means of bank credit expansion and partly through budget deficits, has been the result of a deliberate policy, and has gone through somewhat different channels. The additional expenditure has been much more widely dispersed. In the earlier cases I had no difficulty in pointing to particular instances of overexpansion; now I am somewhat embarrassed when I am asked the question, because I would have to know the particular situation in a particular country, where the additional money flows went in the first place, etc. I would also have to trace the successive movements of prices which indicate these flows. In consequence, I have no general answer to the question.” (Hayek 1978: 212).

And this remains a severe flaw in the Austrian trade cycle theory: the original theory assumes credit expansion goes to businesses investing in capital goods, and has no role for loans for consumer durables or debt-fuelled asset bubbles. Karen Vaughn has already drawn attention to the latter failing of ABCT (Vaughn 1994: 87–88).

Even Hayek himself made a remarkable qualification of his theory with respect to conditions after the Second World War:

“HIGH: The Austrian theory of the cycle depends very heavily on business expectations being wrong. Now, what basis do you feel an economist has for asserting that expectations regarding the future will generally be wrong?

HAYEK: Well, I think the general fact that booms have always appeared with a great increase of investment, a large part of which proved to be erroneous, mistaken. That, of course, fits in with the idea that a supply of capital was made apparent which wasn’t actually existing. The whole combination of a stimulus to invest on a large scale followed by a period of acute scarcity of capital fits into this idea that there has been a misdirection due to monetary influences, and that general schema, I still believe, is correct.

But this is capable of a great many modifications, particularly in connection with where the additional money goes. You see, that’s another point where I thought too much in what was true under prewar conditions, when all credit expansion, or nearly all, went into private investment, into a combination of industrial capital. Since then, so much of the credit expansion has gone to where government directed it that the misdirection may no longer be overinvestment in industrial capital, but may take any number of forms. You must really study it separately for each particular phase and situation. The typical trade cycle no longer exists, I believe. But you get very similar phenomena with all kinds of modifications.” (Nobel Prize-Winning Economist: Friedrich A. von Hayek, pp. 184–186).

Hayek’s belief that a proper application of his trade cycle theory to the modern world requires looking at the direct of credit expansion “separately for each particular phase and situation” is one lost on most modern Austrians. Instead, they flog the dead horse of Hayek’s 1930s theory, which he himself admitted had lost its relevance in modern economies.

The modern Austrians present a fossilised Hayekian relic of a theory derived from Prices and Production (1931; 2nd edn. 1935) and Profits, Interest and Investment (1939), as can be seen in Roger W. Garrison’s Time and Money: The Macroeconomics of Capital Structure (Routledge, London, 2002). Hayek himself by the 1970s had moved on from believing his 1930s work on trade cycles could be simply applied to the modern world, at least not without serious modification.

And one further observation should be made: a monetary theory that examines business cycles by looking at the flows of credit to debt-financed asset bubbles already exists: it is called Irving Fisher’s debt deflation theory (Fisher 1933), which has been developed in Hyman Minsky’s financial instability hypothesis (FIH) (Minsky 1982; 2008). This has been further developed in Post Keynesian economics, most notably by Steve Keen.

This is the true monetary theory of the trade cycle when credit flows to speculation that creates asset bubbles and their collapse spills over into severe effects on the real economy. This theory explains many 19th century trade cycles, the Great Depression, Japan’s lost decade, and now the mess that many Western nations are in.


BIBLIOGRAPHY

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

Garrison, R. W. 2000. Time and Money: The Macroeconomics of Capital Structure, Routledge, London and New York.

Hayek, F. A. von, 1931. Prices and Production, G. Routledge & Sons, Ltd, London.

Hayek, F. A. von, 1935. Prices and Production (2nd edn), Routledge and Kegan Paul.

Hayek, F. A. von, 1939. Profits, Interest and Investment, Routledge and Kegan Paul, London

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

Minsky, H. P. 1982. Can “It” Happen Again?: Essays on Instability and Finance, M.E. Sharpe, Armonk, N.Y.

Minsky, H. P. 2008 [1975]. John Maynard Keynes, McGraw-Hill, New York and London.

Nobel Prize-Winning Economist: Friedrich A. von Hayek. Interviewed by Earlene Graver, Axel Leijonhufvud, Leo Rosten, Jack High, James Buchanan, Robert Bork, Thomas Hazlett, Armen A. Alchian, Robert Chitester, Regents of the University of California, 1983.

Vaughn, K. I. 1994. Austrian Economics in America: The Migration of a Tradition, Cambridge University Press, Cambridge and New York.