Armitage-Smith on the Profit Deflation of the 1873–1896 Era

From George Armitage-Smith’s book The Free-Trade Movement and its Results (1898), in which he discusses profit deflation in the context of the new calls for protectionism in Britain in the late 19th century:

“The Protectionist reaction has received some countenance from a very different quarter. If agricultural profits have fallen, so also have business profits (both industrial and commercial) declined during the last quarter of a century, and among the classes dependent upon this source of income much discontent has arisen. This finds ready publicity with the capitalist class. Without very profound investigation of the causes of the decline in profits, some of the sufferers fall in with the suggestion offered on behalf of agriculture, that Protection may provide a remedy by stimulating home industry.

Various circumstances have contributed to the decline in profits. If, as has been maintained, the chief cause be an alteration in the standard of value. Protection can provide no remedy. Two other factors, however, enter unmistakably into the explanation of low profits: (i) the great increase in the supply of capital which has kept pace with the prosperity of the country, and which, being more rapid in its growth than the demand, has forced down the rate of interest; and (2) the sharper competition of foreign countries in the markets formerly held by British produce, which has sprung up of late years.

Formerly capital was saved only by the rich landed classes from rents, and by the merchant traders. The industrial revolution brought in new wealthy classes, the manufacturer and dealer, to whom the term capitalist came to be applied. These made fortunes rapidly, and accumulated wealth. Time has wrought great changes in this field also. The joint-stock system, banking, and all the machinery of modern investment stimulated saving among the professional and middle classes, and opened up new sources of income. As education and prosperity extended, capital was augmented from the thrifty shopkeeper and artisan class; the openings for fresh investments were made easily available to all classes by new developments of the loaning and company system, so that the term ‘capitalist’ is no longer capable of restriction to any particular class. The joint-stock system is tending in some industries to drive out the private employer, and capital is brought into the reservoirs of trade from tiny rivulets of saving over the whole field of industry. Two events have followed, which are specially relevant to the present matter. Although the field of loaning has been enlarged so as to cover the whole industrial world, capital has increased so much more rapidly than fresh openings for its investment that the rate of interest has declined; and owing to the facility with which it can be borrowed the competition of employers of capital has been greatly intensified by an accession to the class of controllers of industry, of men who live, not on their own capital, but by the skilful employment of borrowed capital. Both facts have tended to depress profits.

Another not less potent influence in the fall of profits is the increased knowledge and power of the working classes, who now, with better capacity for bargaining and strength gained through their trade-unions, succeed in obtaining a larger share of the product than formerly, while legislation on behalf of labour tends to throw greater expense upon the employer. Meanwhile keener competition among employers hands over, in reduced prices, an increasing portion of the commodity to the consumers of their products, and tends to keep down profits by ‘cutting rates’. On all sides circumstances seem to have been combining to reduce ordinary profits; fortunes are rarely made now with the rapidity of bygone times; men have to remain longer in business, and be content to earn a living instead of making a fortune. While the general standard of comfort has advanced and prosperity has been more widely diffused, capital has suffered a reduction in value. The so-called depression of trade in recent years would seem to be more correctly described as a fall in the value of investments and capital employed in industry; it is a genuine depression as regards capital and profits, but wages on the whole have advanced, and goods have been cheapened. From business men complaints of dulness in trade have been frequent. The real fact is, that trade has been quieter but steadier than formerly; while there have been no periods of violent excitement and huge profits, commercial crises, once frequent and very acute, have been fewer and less disastrous in their effects during the past twenty-five years, and the interference with industry from these causes has been diminished. Profits, however, have steadily declined, and among the numerous causes to which this has been attributed, our free-trading system has, without any reason, been included. If profits were determined by Free-trade, the fall should have commenced from its adoption, but the contrary was the case; profits rose and were maintained for thirty years after 1846. The decline has taken place during the last twenty years, and must therefore be accounted for by causes which have made themselves felt in that period.

The other factor contributing to the fall of profits is the competition of other countries, which has lately become so keen and intense. On this account some persons favour protective proposals as a species of retaliation or defence. Our rivals have gained a firmer footing in neutral markets, and their rivalry has reduced prices. Time was when Great Britain had sole command of many markets, she was in the van of mechanical invention, and early succeeded in spreading the products of her industries over the globe; but she could not hope to retain this monopoly. There is no ‘corner’ in scientific knowledge or industrial skill; other nations are rapidly developing their powers and extending their industries, and their commercial activity is increasing; their competition is inevitable, and has hereafter to be recognized and reckoned with. Its tendency is, however, to lower profits. This fact has naturally excited some concern; it is not the sole, nor yet the chief, cause of the fall; profits, as we have seen, have fallen from causes at home which are independent of foreign competition. But it is the commonest of errors to mistake a part of the cause for the whole; and since in this case self-interest seems opposed to foreign interests, undue emphasis is placed upon this factor. Many persons dependent upon interest on capital have suffered from reduced incomes without understanding the economic grounds for the reduction; such persons are naturally attracted by any proposal which promises a remedy; they cannot demonstrate the effects of that exclusion of foreign goods from which they are told to anticipate a revival of vigorous trade and large profits, but join in the demand for Protection, in the vague hope that it may resuscitate their business profits and restore the prosperity of a past period. There is, however, no basis for any such expectation by the method of trade regulation.” (Armitage-Smith 1898: 196–199).

This was written in 1898, a few years after the deflation ended in 1896, but still gives a fascinating insight into how contemporaries saw the “profit deflation” of 1880s and 1890s.

BIBLIOGRAPHY
Armitage-Smith, G. 1898. The Free-Trade Movement and its Results. Blackie & Son, London.

S. B. Saul on the Profit Deflation of the 1873–1896 Period

S. B. Saul’s book The Myth of the Great Depression, 1873–1896 (London 1985) is frequently cited by defenders of price deflation. Though it is indeed an important book, the deflation advocates ought to read it more carefully, for I contend that it does not really support their case.

Saul comments on the UK economy during the long period of price deflation from 1873 to 1896:

“one major source of finance for industry was industrial profits and variations in their level were of high importance in determining the trends in industrial investment. Evidence for the years after 1870 suggests that such investment varied more than proportionately with changes in profits. When profits fell, for instance, industrial investment declined to a greater extent. Probably at those times entrepreneurs used such profits as they made to buy foreign securities or to maintain dividends. Now, as we have already seen, a major feature of the British economy after 1876 was the low level of such profits.” (Saul 1985: 41).

Even more interesting is Saul’s conclusion about the
UK:

“Lower prices squeezed profits to the benefit of wages and probably this led to lower industrial investment.” (Saul 1985: 53).

So here price deflation’s effects may have been good for real wages of labour at certain times, but bad for business, which in the end only decreased aggregate investment and employment.

So much for the great claims made for this period of late 19th century deflation! Business seems to have hated it and the deflation depressed their expectations and investment levels.

BIBLIOGRAPHY

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

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.