Did the Great Depression and WWII have the same cause?

I got a very good question from saifedean, and thought my answer might be worth a separate post.  He asked:

I am, however, surprised that you, of all people, think that Harding’s handling of the 1921 depression was good. According to your Monetarist rule-book, shouldn’t Harding have expanded the money supply to fight the depression? Yet he didn’t. And there was a fast recovery.

Doesn’t that make you doubt the veracity of the monetarist view? Doesn’t that support more the Austrian deflationist liquidationist view?

This is a very good question.  And although I can and will answer the question, my answer will raise deeper questions that may undercut part of my Great Depression story.  But that will be for you guys to decide.  Your views may influence how I revise my Depression manuscript.

Start with a few stylized facts.  The price level fluctuated around a fairly stable trend line under the gold standard.  Call that trend line 100.  During WWI gold demand fell sharply as European countries sold off their gold stocks to pay for the war.  Even in the US prices doubled as the purchasing power of gold fell in world markets.  In 1920-21 the price level fell back from roughly 200 to 150, in other words halfway back to the “natural” pre-war level.  A good argument could be made that more declines were inevitable as the European countries continued to rebuild their gold stocks.  This problem was recognized and countries were encouraged to economize on gold holdings to prevent further costly deflation.  The idea was to have central banks hold other forms of international reserves such as dollars and British pounds.

The quick answer to saifedean is that I am OK with Harding’s actions (or the Fed’s) because the gold standard was accepted dogma at that point, and some deflation was necessary unless we were to devalue.  Even though the 1920-21 depression was much milder than the Great Depression, it was still bad, and in a perfect world inflation targeting would have been even better.  But that was not an option.  What were the options going forward?

1.  Currency devaluation right after WWI, to make the new price level permanent.  This was done in some countries, but wasn’t politically acceptable in the US or UK.

2.  Allow gradual deflation during the 1920s.  (The Austrian view.)

3.  Keep fine-tuning the economy to insure roughly stable prices during the 1920s (which was what Fed Governor Strong actually did.)  Thus if Britain needed to rebuild its gold stock in the late 1920s, the US would run an easy money policy to insure that gold flowed from the US to Britain.  The monetarists and Keynesians both argued that it would have been better if this policy had continued into the 1930s.

4.  Adopt fiat money and start targeting inflation at 2%.

Which would have been best?  I’d say number 4, but that wasn’t an option.  What about among the first three?  I think they all have problems, but what I would most like to emphasize is that any one of these options would have been far better than what actually happened.

You might be puzzled here.  Didn’t we adopt number 3?  No.  We adopted number 3 from 1921-29, and then shifted to number 2, but in a very clumsy way.  As a result, the price level (which had been stable at around 150 during the 1920s), fell to about 100 by 1933.  We were back to the pre-war gold standard price level, but it happened in about the worst way possible.  The 1929-33 deflation represented a sudden change from the Strong regime, and thus was largely unexpected.  Unexpected, rapid, and long lasting deflation causes more damage than any other kind.  The deflation of 1929-33 literally could not have been worse.   It would have been much better if it had happened immediately after WWI.  Or if prices had fallen at a slow rate during the 1920s.  Or if we had devalued after WWI.  Or if we had continued to prop up prices with Strong’s policies after 1929.  Even fiat money would have been much better.

What we had in the 1920s was the illusion of control.  Or to borrow the name of Jim Jarmusch’s new film, the limits of control.   We led people to believe that we were in a new era where scientific management of money would lead to unending prosperity.  And for a few years we delivered on that promise.  Then we reverted to the crudest form of gold standard, where each central bank madly scrambled for gold like hysterical depositors lined up outside a failing bank.

Does this remind you of anything in my previous history post?  It’s exactly the same argument I applied to Wilson and WWII.  If we stay out of WWI, Germany doesn’t get humiliated and some sort of rough equilibrium is achieved.  If we go in and make sure the strongest country loses, we’d better make sure we hang around to assure the new balance of power is stable.  (Say through a post WWI NATO-type system.)  The worst possible scenario would be to go in and create an artificial equilibrium through heavy intervention, but then revert to a very passive (isolationist) policy after WWI.

You may have noticed that in this account Wilson essentially plays the role of Gov. Strong in the 1920s.  Someone who reshaped the world equilibrium (price level or balance of power) but wasn’t powerful enough to ensure that that new equilibrium outlasted him.  Why then do I have a much more favorable view of Strong than Wilson?  I don’t know if I have any good reasons, but I’ll try.

1.  Wilson’s policies were very destructive to US lives even when he was in office.  Strong’s produced good times.

2.  Wilson could not even implement his vision while in office.  Strong’s policy was much more plausibly long-lasting.  Indeed as late as the summer of 1929 (one year after his death) stock investors thought his policies would continue.  And the political obstacles to maintaining them were much less than what Wilson faced.  With continued international cooperation we could have finessed the undervaluation of gold problem with a very mild deflation in the 1930s.

Both the Great Depression and World War II were partly a natural reflection of these unstable equilibria, but also a product of a virtual “perfect storm” of bad luck (too complicated to get into here.)

Just to be clear, one of my points is that all of the theories of the Great Depression are partly right:

1.  The Mundell/Johnson gold undervaluation problem.

2.  The Austrian claim that prices were artificially held too high in the 1920s.

3.  The Keynesian/monetarist claim that prices should have been held up in the 1930s as well.

Where they differ is on relevant counterfactuals.  What were the other options?  What else could we have plausibly done?  Could the good times have gone on forever as I (and monetarists and Keynesians) argue, or was tragedy an inevitable product of the 1920s policies, as the Austrians (and to a lesser degree the Mundellians) argue?  In my manuscript I take an “efficient markets” perspective on causality.  Causal factors are events that surprise markets.  If markets thought prosperity could continue, then it was bad luck or bad policy that caused the Depression.  On the other hand the Austrians have the advantage of arguing that the very thing they worried about actually happened.

On or about December 1910, the human character changed. — Virginia Woolf.

I guess when this quotation is discussed people usually think about radical changes in art, culture, science, etc, that occurred around this time.  But the “modern era” also had a profound effect on politics and economics.  Laissez-faire and isolationism were out, and interventionism and statism were in.  The thing that is so fascinating, and tragic, about this sudden change is that our power raced ahead of our good judgment.  We started treating society like a machine that could be controlled, without really knowing how complex the problems were, and how fragile were the new equilibria being created.

[BTW, something vaguely analogous had occurred when the gradual spread of liberal ideas after the Renaissance led to an explosion of technological progress that within a few hundred years made Europe the master of the world.  Unfortunately, although the liberal revolution did gradually improve moral values, it improved power much more rapidly.  Many indigenous people suffered as the West rampaged all over the world spreading disease and slavery and stealing land.]

I used to think that WWI changed everything.  But maybe what really happened is everything changed and that caused WWI.  After all, we have a dizzying series of “progressive” (i.e. statist) initiatives right on the eve of WWI, the income tax (1913), the Fed (1913), the War on Drugs (1914), and so on.  I’m not trying to blame the progressives for WWI; just suggesting that a sudden cultural change occurred, which somehow led to the perception that the state should be made much more powerful.  Any radical change along those lines is likely to have some rather unpleasant side effects.  Today some of these progressive ideas (like an alliance of democracies (NATO) and central banks) actually work pretty well, but we had to learn some very painful lessons to get here.

What does this tell us about our current problems?  I’m actually not as worried about global warming as most people (although I have no reason to doubt the science.)  It’s the things that catch us unaware that worry me the most.  A natural or genetically engineered disease that is fatal and easily spread, or even something as mundane as a solar flare, which Robin Hanson claims could easily plunge us into a dystopian world out of a Cormac McCarthy novel.  (At least the articles he links to suggest that.)  We’ve built this incredibly complex electrical distribution system, without thinking about what would happen if it all failed at once.  I’ve wandered so far from the original topic that perhaps I should stop this late night dorm room monologue before I start scaring small children.  Anyway, is there an answer to your question in there anywhere, saifedean?


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80 Responses to “Did the Great Depression and WWII have the same cause?”

  1. Gravatar of Lord Lord
    27. June 2009 at 08:24

    I wonder if this wasn’t just the product of globalization at the time with countries in competition for sources of raw materials and markets for their manufacturers very much along the lines of Marx. One where competition is never free enough and is displaced by exclusive internal blocks. One where dissatisfaction with outcomes replaces any hope of further expansion.

  2. Gravatar of ssumner ssumner
    27. June 2009 at 10:13

    Lord, You may be right, but if so these countries deluded themselves. The British impoverished themselves with empire and wars, while the Switzerlands, Swedens, and Denmarks of the world simply bought the raw materials they needed. I think you know which approach I think turned out best.

  3. Gravatar of Carl Futia Carl Futia
    28. June 2009 at 17:31

    Barry Eichengreen has a good discussion of the depression of 1920-21 in his book “Golden Fetters”.

    He asserts that the recovery in the U.S. which began during the summer of 1921 was a direct consequence of a U-turn in monetary policy by the Fed. Their move to lower rates and increase the monetary base was motivated by the start of a big inflow of gold to the U.S. which began in early 1921. This inflow dropped the reserve ratio (gold to value of currency held by the public)from near the statutory limit of 40% to lower levels. This encouraged the Fed to loosen its policy.

    And why did gold flow to the U.S. after flowing out during 1919-20? Eichengreen’s answer is that, in contrast to what would happen in 1929, European economies were off gold and were allowing their currrencies to float. The deflationary policy of the Fed therefore was not followed by foreign central banks who were content to allow their currencies to depreciate. So capital flowed to the U.S. in response.

  4. Gravatar of saifedean saifedean
    28. June 2009 at 18:00

    Well, Scott, I presume you won’t be surprised if I told you that I don’t think this answers my question satisfactorily. But please don’t take that personally—it’s not you, it’s the position you’re trying to argue! The 1920 depression saw the fastest recovery from a depression in the 20th century. All the other depressions—with Keynesians and Fischerites controlling prices, digging-and-refilling holes and printing money—lasted longer. You’re trying to argue that the shortest depression would’ve been shortened even further had the policies adopted been the ones adopted for the longer depressions. That’s a very tough sell.

    However, my main point is not so much that depressions should not be fought with monetary expansion; rather, that monetary expansion is the cause of the depressions in the first place! The key problem with the monetarist view is that it continues to ignore the insight of Hayek and the Austrian Business Cycle Theory: when you expand the money supply, you create an unsustainable boom and bust that leads to a recession. Even though monetarists (and even many Keynesians) will admit this when interrogated, they still refuse to bring this fact to bear on their analysis of boom and bust. It’s as if this inconvenient truth simply exists in an alternate universe where it doesn’t affect the real world. After the bust has happened and the recession started everyone (even Keynesian NYTimes columnists!) is happy to admit that the monetary expansion before this crisis led to the crisis. While the monetary expansion is underway, however, everyone thinks Hayek is a crank and monetary expansion is the solution to all of life’s problems.

    The main difference between us continues to be that you always look at any crisis (1920, 1929, 2008, etc…) from the starting point of the crisis, whereas I look at the monetary expansion that led to the crisis in the first place. Without looking at the origin of the crisis, you have no hope of understanding the crisis. You always begin with the collapse in demand, and therefore suggest that printing money can remedy it. I realize that the printing of money was what led to the bubble, boom and bust that led to the collapse of the demand. Therefore, printing more money is only going to lead to a bigger bubble, boom and bust in the future. The best illustration of this is Greenspan fighting the 1992 recession with expansion that led to the 2001 recession, which he fought with expansion that led to the 2008 crisis.

    This is the concept of iatrogenic medicine: what you think is the cure, is actually the cause of the ailment.

  5. Gravatar of saifedean saifedean
    28. June 2009 at 18:00

    I will comment specifically on some of your points here:
    SS: “The quick answer to saifedean is that I am OK with Harding’s actions (or the Fed’s) because the gold standard was accepted dogma at that point, and some deflation was necessary unless we were to devalue.”
    Yes, there inevitably would’ve had to be deflation or devaluation. Both would’ve been terrible. But you continue to ignore that both were caused by the monetary expansion of WWI! That was the problem; the deflation/devaluation conundrum is the sad outcome of that monetary expansion, and is the reason that monetary expansion shouldn’t have happened in the first place. The gold standard (which I don’t support, incidentally) isn’t dogma—it was the abuse of the gold standard in WWI that led to the 1920 depression, just like the abuse of the gold standard in the 1920’s led to the 1929 crash and the great depression.

    And hang on a second? You seem to be suggesting that deflation is better than devaluation? Is that true? If so, you do realize that devaluation is simply another word for inflation, which is another word for expanding the money supply. If the money supply is increased, inflation happens and the currency is devalued. But you also believe that increasing NGDP by 2% is the solution to all of life’s problems. And that is inflation—devaluation. And yet here, in the 1920’s you seem to be endorsing Harding’s choosing of deflation over devaluation.

    SS: “Even though the 1920-21 depression was much milder than the Great Depression, it was still bad, and in a perfect world inflation targeting would have been even better.”
    How? The recovery was very fast and it is frankly hard to believe that printing more money would’ve made it faster—unless it led to another crisis in the future. This is the fastest recovery from a depression in the 20th century; all the depressions that were followed by inflation targeting had slower recoveries—or had their recoveries collapsed into another crisis.

    SS: “3. Keep fine-tuning the economy to insure roughly stable prices during the 1920s (which was what Fed Governor Strong actually did.) Thus if Britain needed to rebuild its gold stock in the late 1920s, the US would run an easy money policy to insure that gold flowed from the US to Britain. The monetarists and Keynesians both argued that it would have been better if this policy had continued into the 1930s. “
    –I don’t understand how you continue to ignore the fact that it was this monetary expansion of the 1920’s that led to the crash of 1929. Surely you’re not suggesting that the collapse of “aggregate demand”, the stock market crash and the depression that followed were completely independent from Strong’s monetary expansion? How could it possibly not have led to the crash? What else could have possibly led to the crash? Saying “drop in aggregate demand” or “flagging animal spirits” is cute and sells books, but it doesn’t answer the question. Whatever you mean by “drop in aggregate demand” and “flagging animal spirits” can’t be an explanation unless you tell me what actually led to these things happening—and your answer must be reality-based.

    “You might be puzzled here. Didn’t we adopt number 3? No. We adopted number 3 from 1921-29, and then shifted to number 2, but in a very clumsy way. “
    –You seem to have omitted from this sentence the small matter of the 1929 crash and the great depression starting. It was number 3 that led to this crash and the start of the depression. Shifting to number 2 was the only way to avoid a run on the government’s gold and a collapse of the currency. A few years before, Germany was unequivocal in adopting number 3, and that ended in hyperinflation. You must realize that printing more currency devalues the currency. Printing a lot more leads to Weimar and Zimbabwe—that is the only logical end to monetary expansion, and that is the fate of every currency in history that was diluted (except for the ones that are yet to meet that fate).

    “The deflation of 1929-33 literally could not have been worse. It would have been much better if it had happened immediately after WWI. Or if prices had fallen at a slow rate during the 1920s. Or if we had devalued after WWI. Or if we had continued to prop up prices with Strong’s policies after 1929. Even fiat money would have been much better.”
    – Continuing Strong’s policies would’ve led to Zimbabwe. But you must now agree that better than all of these policies would have been the Fed not expanding the money supply in the first place. Not for WWI, not in the 1920’s to help Britain, not anytime. Without that expansion, none of this drama would’ve happened.

    Monetary expansion, as soon as it happens, sets in motion the boom and bust of the Austrian Business Cycle. If it was to be stopped quickly, it would only lead to a small bust. If it were to be carried out longer, it would lead to a bigger bust as soon as it is stopped. If it were to be carried out indefinitely… it will only end with Zimbabwe. There is no pleasant ending to monetary expansion—which is precisely why the Austrians are always telling you that you should not do it in the first place!

    SS: “We led people to believe that we were in a new era where scientific management of money would lead to unending prosperity. And for a few years we delivered on that promise. Then we reverted to the crudest form of gold standard”
    –You miss a key point here: after the “scientific management” fracas and before what is wrongly called “switching to the gold standard” there was the stock market crash and the bank runs and the beginning of the depression. These were no accident; these were the RESULT of the “scientific management” fatal conceit. “Scientific management” of prices does not work. It did not work in Soviet Russia, Cambodia, Cuba, 1960’s Britain, or anywhere else. And when tried by Fischer and Strong in 1920’s America, it led to the biggest economic crisis in history. This is a glaring truth that you simply cannot continue to ignore—no matter how little it fits with your worldview. This is the lesson of the socialist calculation debate from the 1920’s—another important question on which the Austrians have been repeatedly and unequivocally vindicated by history.

    As for the gold standard… There is no such a thing as a “crude” gold standard. There is an observed gold standard, and an abused gold standard. If the gold standard is observed, the government never prints an extra dollar more than the gold, the money supply is constant, and economic growth is deflationary. Holland had 150 years of uninterrupted growth with this gold standard. If the gold standard is abused, the government prints more money than there is gold, expanding the money supply, causing a boom and an inevitable bust. America stopped abusing it in 1920, and it got a depression, but then recovered. Britain continued to abuse it, and got America to abuse it as well to help it out in the 1920’s, and the result was the 1929 crash and depression. Germany was the one that abused it the most, and it got hyperinflation. These are the three possible outcomes of monetary expansion: short recession if the expansion is stopped quickly (America 1920); giant depression if the expansion continues for long and is stopped (America and Britain in 1929); and hyperinflation if the expansion is continued quickly (Weimar Germany)

    SS: “You may have noticed that in this account Wilson essentially plays the role of Gov. Strong in the 1920s. Someone who reshaped the world equilibrium (price level or balance of power) but wasn’t powerful enough to ensure that that new equilibrium outlasted him. “
    –Wilson’s new equilibrium could’ve been enforced with troops. Strong’s equilibrium was no equilibrium; it was unending monetary expansion that would’ve either led to a depression or hyperinflation, or both.

    SS: “In my manuscript I take an “efficient markets” perspective on causality. Causal factors are events that surprise markets. If markets thought prosperity could continue, then it was bad luck or bad policy that caused the Depression.”
    –Here’s the problem with Chicago’s “efficient markets hypothesis”: The whole idea of talking about “efficient markets” I find meaningless. Efficient compared to what? Efficiency is useful for looking at a car engine that could function at an optimum—efficiency tells us how close the engine is to its optimum. But markets do not have an optimum; they’re a dynamic ever-changing process of discovery where every individual tries to find opportunities to improve their situation based on prices. They are no more efficient than evolution of species is efficient. Markets only function through prices. Prices are the coordination mechanism of the economy. (Read Hayek’s The Use of Knowledge in Society.) With legal tender laws, all prices are denominated in the currency of the government. So when the government expands the money supply it distorts the price mechanism. This then causes dislocations within the economy—leading to booms in certain sectors (stocks in 1920’s, dot.com’s in 1990’s, housing, oil and finance in 2000’s, etc…) and leading to malinvestment in long-term projects. (Read Hayek’s Monetary Theory and the Trade Cycle). This is NOT a market failure, and this does not mean markets are inefficient or efficient. There are no efficient markets; there are only harmful interventions. Any intervention with the price mechanism causes miscalculations. The crashes of 1929 and 2007 were not caused by “market failures”; they were caused by government meddling with the price mechanism.

    SS: “On the other hand the Austrians have the advantage of arguing that the very thing they worried about actually happened.”
    –This tends to happen when you’re right! The Austrians also argued the same thing about the monetary expansion of the 2000’s and the housing bubble (Read Peter Schiff, Mark Thornton or Roger Garrison.) The Austrians’ problem, however, is that no one wants to listen to warnings during the boom years, so they spend 6-7 years being dismissed as crazy doomsayers—so much so that by the time they are vindicated everyone had dismissed them so much that people aren’t even willing to contemplate that they were indeed vindicated. Have you heard any mainstream professional economist admit that perhaps Peter Schiff’s warnings were right? No, because Schiff is a crazy Austrian doomsayer—nevermind the fact that the doom he predicted is now completely here, we’ve discredited him before he could be vindicated! I knew nothing about Austrians until this crisis. I then read what they had to say and what others had to say, and came to the conclusion that when it comes to monetary expansion and the business cycle, they are simply the only people who have a clue.

  6. Gravatar of ssumner ssumner
    29. June 2009 at 06:52

    Carl, I don’t completely agree with Eichengreen. I see the Fed’s decision to increase it’s gold holdings as a cause of the deflation, not a symptom. Gold flows tell us nothing about the stance of world money policy. If foreign gold demand fell just as fast as US demand rose, then there would have been no deflation. In fact, foreign gold demand did not fall as fast, which is why many countries experienced deflation, not just the US. The purchasing power of gold rose throughout the world in 1921.

    There may have been a slightly expansionary monetary policy in 1921-22, but it was far less expansionary than in 1933, so it cannot explain why the recovery in 1922 was so much faster.

    saifedean#1, You misunderstood my argument. The depression of 1921 was quite deep, but I am not arguing that Fisherite policies would have caused a faster recovery, I am arguing that Fisherite policies would have prevented the depression. A lot of misery results from industrial production falling 32 percent. That misery was needless.

    I am not arguing Greenspan’s policy was ideal, but the US economy from 1987-2006 was certainly more stable than at any other 20 year period in US history. And with NGDP targeting, we could do even better.

    saifedean#2, Sorry but the WWI inflation in American was not caused by American monetary expansion, it was caused by a worldwide drop in demand for gold. Every country on the gold standard suffered inflation, regardless of what they did to their money supply. Prices are determined in world markets.

    No, I think devaluation is better than deflation, I said devaluation was politically impossible in 1921.

    You said:

    “–I don’t understand how you continue to ignore the fact that it was this monetary expansion of the 1920’s that led to the crash of 1929.”

    With all due respect this is just silly. Even other Austrian visitors to my blog eventually admitted that this couldn’t explain the crash, because much more expansionary monetary policies in the 1940s 1950s and 1960s and 1970s didn’t lead to stock market crashes and Great Depressions. And that theory implies investors are like irrational lemmings. Austrians must be pretty rich if they can predict the stock market. Do stock mutual funds run by Austrian managers outperform index funds?

    You also have your history wrong. The stock market crash occurred because we were switching back to the old gold standard, which led to a much higher demand for gold. When the world’s major central banks began hoarding gold in late 1929 it naturally caused the value of gold to soar. Under the gold standard that means deflation and falling AD.

    You said:

    “A few years before, Germany was unequivocal in adopting number 3, and that ended in hyperinflation.”

    Wow! You are saying Germany had a policy of targeting the price level in the early 1920s? That would be news to most historians. The standard view is that they were paying there debts by printing money.

    I also notice that you Austrians keep repeating the myth that under a gold standard the money supply would be constant and you would have deflation. I had an endless argument with another Austrian (current) on this point before he finally admitted that he was wrong. I would simply suggest that you check the data on world gold stocks, which have soared in recent centuries, increasing at least 10 fold. The money supply grows over time, and the price level trend was flat. The US price level in 1932 was similar to the late 1700s. I don’t know where you Austrians get all this misinformation, but unless you go out and check the data yourself, you will continue to repeat false information, and base your model of false data.

    Regarding all your comments about fiat money inevitably ending in hyperinflation, I have a gentlemen’s bet with a well known Austrian blogger (Bob Murphy) who predicts double digit inflation in the second half of 2009. I predict single digit inflation, probably under 5%. Come back in December and we’ll see if all this money that the Fed has flooded the economy with since last fall has the inflationary effects the Austrians predict. I say it won’t. So does the bond market.

  7. Gravatar of Alex Golubev Alex Golubev
    29. June 2009 at 07:17

    saifedean, great points all around. I just saw a great quote earlier today and i dont’ mean to rip solely on economists, because i think this applies to finance and some social “sciences” as well. But it’s still true:

    “Economists suffer from a deep psychological disorder that I call ‘physics envy’. We wish that 99 percent of economic behavior could be captured by three simple laws of nature. In fact, economists have 99 laws that capture 3 percent of behavior. Economics is a uniquely human endeavor …”
    Andrew Lo, a professor of finance at the Massachusetts Institute of Technology

  8. Gravatar of Alex Golubev Alex Golubev
    29. June 2009 at 07:46

    Scott, interesting article (page 4 – 5.5 particualry):
    http://www.scientificamerican.com/article.cfm?id=the-science-of-economic-bubbles&page=4

    i don’t know what Lo’s claimed to have invented, but it’s probably statistical mumbo jumbo using autocorrelation. It’s all great as long as he proposes to reduce the degree of leverage/credit when that starts happening.

  9. Gravatar of Current Current
    29. June 2009 at 09:19

    On ABCT related things….

    Scott: “Sorry but the WWI inflation in American was not caused by American monetary expansion, it was caused by a worldwide drop in demand for gold. Every country on the gold standard suffered inflation, regardless of what they did to their money supply. Prices are determined in world markets.”

    I think Scott is mostly right about that. WWI was towards the end of the old monetary system where currencies were really global and linked to gold. It was not like today.

    However the US banking system was highly regulated in quite a complex way. Bans on branch banking forced individual banks to behave oddly. And, of course, the Fed protected them by being a lender of last resort.

    Scott: “With all due respect this is just silly. Even other Austrian visitors to my blog eventually admitted that this couldn’t explain the crash, because much more expansionary monetary policies in the 1940s 1950s and 1960s and 1970s didn’t lead to stock market crashes and Great Depressions. And that theory implies investors are like irrational lemmings. Austrians must be pretty rich if they can predict the stock market. Do stock mutual funds run by Austrian managers outperform index funds?”

    Scott, you don’t understand our argument. I you would read one of the books on ABCT you might.

    Modern Austrian business cycle theory does not indicate that every episode of money supply inflation must lead to a recession. Rather it describes a mechanism that may cause a recession. It doesn’t give a way that an Austrian fund manager can use to outperform other sorts of fund manager since it cannot really time the crash. (Greg Ransom, I think, believes that it can, I don’t really agree with him). It is more like a form of medicine. It can’t tell you when you’ll have a heart attack but it can tell you what behaviour is unwise.

    The problems caused by inflation on the structure of production are diminished if:
    1) Capital goods tend to be more generally substitutable than specific.
    2) Inflation is expected by the parties involved.
    3) There are few “more roundabout” methods of production which producers can employ.
    4) Expectations of the future are uncertain so businesses decide not to use more roundabout methods of production.

    (The ideas of Austrian Economics may have helped a few folks make money. David and Charles Koch are knowledgeable about the subject and fund a lot of the associated research organizations now.)

    Scott: “I had an endless argument with another Austrian (current) on this point before he finally admitted that he was wrong.”

    What I have admitted is that the view of Austrian monetary historians is different to your view. I don’t know whose view is correct though. What is quite certain though is that you disagree with George Selgin about the facts. When I get some time I’ll read what both of you have wrote and decide which side I think is right.

    Scott: “Regarding all your comments about fiat money inevitably ending in hyperinflation, I have a gentlemen’s bet with a well known Austrian blogger (Bob Murphy) who predicts double digit inflation in the second half of 2009. I predict single digit inflation, probably under 5%.”

    I agree with you about this, for reasons of monetary equilibrium. I disagree with him about the recession side of things. I agree with him though about the boom side of things, which is in my view much more important in the long term.

  10. Gravatar of Current Current
    29. June 2009 at 09:24

    That should have been “If you read one of the books on ABCT you might.”

    Perhaps you have and you disagree. I shouldn’t assume that you haven’t. If you have though what’s wrong with the analytical argument?

  11. Gravatar of a student a student
    29. June 2009 at 16:16

    Meltzer’s book on the Fed is very critical of the policy of the 20-21 recession. They increased interest rates! Wasn’t that a bad thing during a recession?
    On while on Meltzer’s book, he talks a lot about the real bills doctrine. A post on that would be great.

  12. Gravatar of saifedean saifedean
    29. June 2009 at 16:34

    Scott,

    Thanks a lot for your thoughtful reply. I’ll respond as much as I can to your specific points.

    SS: “I am arguing that Fisherite policies would have prevented the depression.”
    The only thing that would have prevented the depression was not expanding the money supply for WWI in the first place (see below). Once the monetary expansion happened, the depression was inevitable. Continuing Fischerite policies would’ve just delayed the depression to a bigger one that would happen when the expansion stops, or monetary expansion would continue until Zimbabwe.

    It was Fischerite policies that caused the Great Depression. Fischer was in charge of the scientific management of prices through the 1920’s. This obviously ended with the massive crash of 1929 and the depression. Fischer’s ideas were so clueless he continued to claim the market was undervalued and would bounce up. These disastrous prognostications are not a tiny flaw in a genius’s otherwise splendid record, these are the complete refutation of everything Fischer believed and did during the 1920’s. The proof is so blatantly in the pudding.

    SS: “I am not arguing Greenspan’s policy was ideal, but the US economy from 1987-2006 was certainly more stable than at any other 20 year period in US history.”
    –And what happened after 2006? A giant crash! Don’t you see how this crash is related to the policies enacted before it? Just like in 1929? You continue to refuse to see the glaring connection between expansionary policies and the crashes the follow them. By your book, Madoff is a great asset manager, because he posted awesome returns until December 2008. If only he’d kept on borrowing from new people to pay old ones, things would be perfect today! The problem with Madoff, by your book, is not that he carried out a ponzi-scheme, it is that he stopped it.

    SS: “Even other Austrian visitors to my blog eventually admitted that this couldn’t explain the crash, because much more expansionary monetary policies in the 1940s 1950s and 1960s and 1970s didn’t lead to stock market crashes and Great Depressions.”
    This is the same goalpost-shifting you did before. When I explain to you the process in the 1920’s, you then make an assumption about what Austrian theory would say about the 1940s-70s, conclude that that must be wrong, and therefore ABCT is always wrong. But what you are assuming is ABCT’s view on the 1940s-70s is nothing but YOUR misunderstanding of ABCT. If you’d like to understand what ABCT would say about the 1940s-70s, then go and read a book about it instead of setting up straw men from your imagination and knocking them down. Or let’s sit and discuss these properly. But don’t keep using them as red herrings to distract from the fact that you have no answer to the 1920’s. We’re discussing the 1920’s, and I gave you the ABCT explanation of what happened, which fits much better with the facts than the monetarist story. You refuse to engage that, and instead set up straw men about other periods.

    I don’t see how you can continue to deny that the monetary expansion of the 1920’s caused the 1929 crash. You accept that this story is true for the 2000’s. You have admitted that monetary expansion did occur. How can you not tie the expansion of the 1920s to the crash? Could the expansion have had nothing to do with the crash?! How?! What other explanation do you have for the stock market crash? You can’t tell me that it was because the monetary expansion stopped; because you’d be exactly like someone telling me Madoff’s fault was not the ponzi-scheme, but that he stopped his ponzi-scheme.

    SS: “Sorry but the WWI inflation in American was not caused by American monetary expansion, it was caused by a worldwide drop in demand for gold. Every country on the gold standard suffered inflation, regardless of what they did to their money supply. Prices are determined in world markets.”
    This is factually wrong, blatantly illogical, and betrays a deep misunderstanding of the basics of money and gold. It is wrong, because if you look at Friedman and Schwartz’s Monetary History of the United States, Table 10 on p.206 (1963 ed) it tells you that there was a 115% increase in the money stock between June 1914 and May 1920. Only 26% of that increase was due to increases in gold holdings. The rest was our good old friend: monetary expansion.

    It is illogical because if America did not expand its money supply, and other countries expanded theirs, then you would expect to see an exit of gold from these other countries to America, since gold’s price would be cheaper in the inflationary country. It would therefore make sense to trade in your gold and ship it to America and sell it there, making more money. This is what was happening in the 1920’s in Britain when they expanded and their gold was leaving to America. This is also what happened when Nixon expanded the money supply and gold was leaving America, forcing the closing of the window of convertibility. This would simply be a transfer of real wealth (gold); there would be nothing inflationary about it—the real money in America would increase, but it would be real money backed by real gold, and there’s nothing inflationary about that. Inflation is when there is more money not backed by gold. But that’s not what happened.

    The reason all these countries that were on the gold standard experienced inflation was simply because they all inflated in order to fund their war efforts. The fact that they could continue inflating was the reason that a small tiff in the Austro-Hungarian Empire’s Balkan backyard snowballed into global carnage. Without central banks capable of inflating money to fund the war effort, those governments would’ve had to fund their wars with tax money. There is absolutely no way taxpayers would’ve put up with paying for all this meaningless carnage that was supposed to initially be an August Bank Holiday war without much justification or reason. But with inflatable money in the hands of the warring governments, the sky was the limit to how much they could fight. Only after millions had died and the currencies were all debauched did the fighting stop.

  13. Gravatar of azmyth azmyth
    29. June 2009 at 17:41

    “We started treating society like a machine that could be controlled, without really knowing how complex the problems were, and how fragile were the new equilibria being created.”
    You’re starting to sound like an Austrian, Scott.

    Prices transmit information. Expansionary monetary policy damages the economy by screwing up price signals. Austrians understand the problem with inflation better than anyone else, but sometimes miss this point for deflation. Monetary policy should strive to preserve the price signal as clearly as possible. Unemployment targeting is horrible by this criterion because it relies on screwing up relative prices (wages) and misleading people. Unexpected deflation could trick firms into thinking that there is a reduced demand for their individual products, just as an inflationary boom produces an illusory increase in demand.

    So what would an optimal monetary policy look like? (Assuming we stick with the government monopolized fiat currency.) People should always know what to expect and price signals should transmit loud and clear. Suppose there’s a earthquake that destroys a major iron mine (fortunately, no one is hypothetically killed). The price of iron skyrockets which causes a reduction in output as entrepreneurs scramble to adjust their production. P goes up, Y goes down. Should monetary policy do anything? No. By contracting the money supply, it would force down prices unrelated to iron, which is costly and stifles the relative price signals. If you have a positive supply shock, prices should be allowed to fall to reflect the increased efficiency of production. However, demand shocks cause output and prices to move together. Monetary policy should react to demand shocks because they don’t transmit any useful information to either producers or consumers. They just add noise and wind up confusing entrepreneurs. Suddenly this is all starting to look familiar…

  14. Gravatar of TGGP TGGP
    29. June 2009 at 18:24

    saifedean, I know Rothbard wrote a monetary history of the interwar period and also nineteenth century economic panics (could be just one or a number) but I don’t know of any Austrian economic histories of the 40s-70s. Do you have any recommendations?

  15. Gravatar of saifedean saifedean
    29. June 2009 at 21:05

    TGGP,

    Check out the four different introductions to the four different editions of Rothbard’s America’s Great Depression [all can be found in this 5th edition: http://mises.org/rothbard/agd.pdf). Whenever monetary central planners would cause a recession, it seems, they would stimulate demand for a new edition of Rothbard’s AGD, and he would oblige them with a new introduction that analyzes the newest round of monetary disasters. Reading these after reading AGD really expresses the true tragicomedy of American monetary policy in the 20th century.

    Azmyth,

    You hit the nail right on the head. It’s the central planning of money that messes up the price mechanism, which then causes recessions and disaster.

    But here’s where you and I differ: Without any central planning, the price mechanism would work, economic growth would be deflationary, and the economic coordination process would occur seamlessly. But, whenever a central planner intervenes in the price mechanism, that necessarily disrupts the economic coordination process, distorts people’s plans and causes disasters.

    For the very same reason you wouldn’t want inflationary expansion of the money supply, you wouldn’t want the central planners to avoid deflation. Deflation is nothing but economic growth. Economic growth happens when we find cheaper ways of doing more stuff better. That makes that stuff cheaper and better. Hence, growth, and hence, deflation. Economic growth happens when your money can buy you more and better stuff. That is economic progress. Once you realize that, all of economics seems to start to make sense! The irrational fear of deflation that people have is just another unfortunate side-effect of decades of Keynesian and Fisherite economics.

    Look at the computer industry, one of the few industries whose productivity growth rate is fast enough to supersede monetary authorities’ inflation. Every year, computers becomes much better and much cheaper. And yet, there are no massive coordination problems in this industry. There is no irrational fear of purchasing computers. Deflation of computer prices has not destroyed the computer industry. HP did not get deceived by deflation of its laptop prices into producing less laptops. And I still bought my crappy HP laptop last year, even though I know full well it will be cheaper this year.

    Monetary policy cannot “strive to preserve the price signal as clearly as possible.” Monetary policy can only ever distort the price signal, because monetary policy is always and forever a form of central planning the price signal.

    Just like central planning of potatoes doesn’t and cannot work, central planning of the price signal doesn’t and cannot work. If left alone, the price mechanism would simply coordinate people’s plans effectively. If centrally planned, it would lead to catastrophe.

  16. Gravatar of Greg Ransom Greg Ransom
    29. June 2009 at 22:41

    Hayek favored #1, I’d suggest.

    And Austrians don’t favor deflation in the case you list.

    Deflation is benign if their is productivity gain.

    Hayek and the Austrians had a much more sophisticated understanding of international monetary economics and the gold standard than you suggest.

  17. Gravatar of Greg Ransom Greg Ransom
    29. June 2009 at 22:56

    Scott, you are throwing around “Austrian” this and “Austrian” that in a very false way.

    Many if not most of these things are NOT “Austrian” that you call Austrian.

    Read some Horwitz, White, Selgin, hayek — it’s very different stuff than you imagine.

  18. Gravatar of Bill Woolsey Bill Woolsey
    30. June 2009 at 05:45

    Ranson:

    Perhaps you should discuss this with those who identify Austrian economics with Misist-Rothbardist thought. If you need examples, just read the other commenters here.

  19. Gravatar of Greg Ransom Greg Ransom
    30. June 2009 at 06:42

    Bill — I think I just did.

  20. Gravatar of Jon Jon
    30. June 2009 at 07:08

    Look at the computer industry, one of the few industries whose productivity growth rate is fast enough to supersede monetary authorities’ inflation. Every year, computers becomes much better and much cheaper. And yet, there are no massive coordination problems in this industry. There is no irrational fear of purchasing computers. Deflation of computer prices has not destroyed the computer industry.

    Yes. There is a decided dishonesty about price deflation. Most of the ills attributed to it are fatuous. The honest answer is that price inflation primarily serves to protect the banking sector. For instance, I was recently reading about rising default rates in Turkey. The banker was quite sanguine about it. He argued that given inflation rates, the typical interest payment was between 15-20% per year–with that level of income the bank could absorb substantial loses. Sure depositors lose in real-terms but the bank’s capital is preserved which means for the owners its ‘heads I win a super-leveraged bet, tails I get to play tomorrow’.

    The confusion here is that monetary deflation (a sudden loss of quantity) causes actual perverse effects that happens to include price deflation. However, because QE can break the liquidity trap, there is no need for a cushion of inflation a priori as is commonly assumed.

  21. Gravatar of ssumner ssumner
    30. June 2009 at 11:14

    Alex, Until physicists answer the following question they will have explained nothing, only predicted things.

    Question: Why is there something rather than nothing?

    Alex#2, SA usually has really, really, bad economics articles, because they cater to scientists who usually (in my experience) have really bad economic intuition. Sorry if I have scientist readers, but the scientists I have met often tell me “the government should just . . . ” and then describe some idea that is beyond crazy.

    [Don't take my insults personally, it's just my physics envy.]

    I just have one question for Lo; how does irrationality cause NGDP to fall rapidly? Isn’t that just bad monetary policy?

    Current, I agree that branching barriers were a big problem, it mostly explains why Canada did so much better.

    You say not all 1920s-type situations lead to a recession. Fine. But my theory is that all falling NGDP periods do lead to a recession. So isn’t my theory more powerful? (And I’d add not just falling, but if NGDP is suddenly rising at a much slower rate.

    I don’t follow your last point. Do you agree with me or Bob about inflation over the next 6 to 12 months?

    a student,

    Good question. From a modern fiat money perspective Meltzer is right, a stable price level would have been better. But the price level was much too high for the gold standard at that time, as it had been artifically inflated by the war. So in the long run Meltzer’s proposal (while wise) would have forced us off the gold standard. My point was that that wasn’t politically feasible at the time. A short sharp deflation was probably better than the grinding 4 year deflation of 1929-33. or a quick devaluation, back on the gold stand, and then try to stablize prices as Meltzer suggested.

    Saifedean, Didn’t Hawtrey accuse the Austrians of “crying fire, fire, in Noah’s flood”

    You keep referring to Zimbabwe, Zimbabwe, for a decade that saw nothing but deflation (1921) or flat prices (1922-29) I just don’t get the worry. I am saying make all the years of the 1920s have flat prices, and the 1930s too.

    The US never, ever followed Fisher’s prefered policies until 1933. Fisher favored adjusting the price of gold to stablize prices. FDR adopted the policy in 1933 to bring prices back up to there pre-depression level, where they would be stabilized. Not only did Fisher’s policies not cause the Depression, they would have cured it in two years if not for the stupid NIRA.

    You said:

    “I don’t see how you can continue to deny that the monetary expansion of the 1920’s caused the 1929 crash. You accept that this story is true for the 2000’s.”

    No I don’t. The recent crash was caused by tight money last fall, by failing to follow the 1987-06 policy of fairly steady NGDP grwoth.

    The Friedman and Schwartz data you cite are meaningless because domestic money supplies are endogenous under a gold standard. A big country like the US has some influence, but only to the extent that it can affect the world demand for gold. Suppose the data you cite had applied to Canada, or Bermuda. If their money supplies had rose 115% and their gold supplies rose 26%, would they be to blame for the doubling of the world price level? I’m not saying the US had no affect, but it wasn’t the main factor.

    Azmyth, And the most important price to get right is wages. As if they are out of line you get employment fluctuations. So you should stabilize the aggregate wage rate. They any wage movement will be a relative wage change. Wage signals will be very revealing. That’s pretty close to the ideas of some Austrians (modestly different from Selgin’s proposal.) And it was my favorite proposal for monetary policy–only replaced by NGDP targeting for reasons of political expediency.

    I don’t know why the Austrians are so irritated by my stuff, much of it is very sympathetic to their ideas. Maybe for the same reason that religious disputes are most virulent between closely aligned sects.

    Greg, That’s good to know about Hayek favoring currency depreciation after WWI. It raises my view of Austrian economics.

    Yes I oversimplify, as does everyone. I do sometimes mean the Rothbard school, which I do consider less enlightened that Selgin and the others you mention. I’ll try to be more specific.

    One problem is that it is hard for me to know what the theory says. Austrians keep telling me the Depression was caused by too much money in the 1920s. Then other Austrians say no it wasn’t. In some cases (like replying to saifedean) when I say “Austrian” I am just refering to his specific views, which are those I am replying to. I do not assume that Selgin would have exactly the same view as Saifedean, in fact I know he wouldn’t.

    I don’t understand why you say Austrians don’t favor deflation in the case I mentioned. The case I mentioned was the 1920s, which saw big productivity gains. Of course they favored deflation. Or were you refering to a different case?

    Jon, I understand the point about computers. I have always said the real problem is wages. And wages aren’t falling in computers. To me what matters is not the trend rate of inflation, but sharp fluctuations in the price level that cause sticky wages to rise in real terms. Then you get unemployment. Like right now. If workers had priced zero inflation into their wage contracts last year, the unemployment rate today would be much lower. But we were used to positive inflation, so even zero inflation is a “shock.”

  22. Gravatar of Bababooey Bababooey
    30. June 2009 at 12:13

    “Many indigenous people suffered as the West rampaged all over the world spreading disease and slavery and stealing land.”

    A minor point, but natives didn’t suffer anything they weren’t already suffering. Disease, war, and slavery preceded white man and are not unique to him. (Disease is not like the others, its has its own agency (the blanket story is hokum) and the natives gave pretty good disease too.)

    Natives murdered each other for gain, fun and slavery before white man got there. Arabs enslaved 3 million Europeans over a couple of centuries and untold Africans. The British are the first country I know of that used its Navy to stop slave trading by other nations.

  23. Gravatar of Greg Ransom Greg Ransom
    30. June 2009 at 15:01

    Scott — the insight here is that there is no shortcut to economic understanding other than studying the economics, you are not going to “get it” by reading random blog comments about a very, very complex historical period.

    Steve Horwitz has put many of the basics of Austrian macro in a very simple and very brief form here:

    http://www.mercatus.org/uploadedFiles/Mercatus/Publications/WP0923_The%20Microeconomic%20Foundations%20of%20Macroeconomic%20Disorder.pdf

    But even that doesn’t get you much on money — it doesn’t get you what you’d find in White or Selgin, or in Hayek’s writing on the gold standard, international monetary economics, or the history of monetary thought.

    And it doesn’t come close to what you’ll find in Roger Garrison’s _Time and Money_ or Horwitz’s own book. But it’s a start.

    My sense is that most economics professors today have a very superficial understanding of how the “gold standard” actually worked, or how economists of the time like Hayek understood it to work. I’d love to be disabused of that impression.

    Scott writes:

    “One problem is that it is hard for me to know what the theory says. Austrians keep telling me the Depression was caused by too much money in the 1920s’

  24. Gravatar of Greg Ransom Greg Ransom
    30. June 2009 at 15:07

    Hayek blamed Churchill and Britain’s return to parity in 1925 for Britain’s unemployment problem — and in turn he blamed that for inspiring Keynes’s various efforts to invent an economics that would excuse his pre-existing solution — massive inflation.

    Hayek never took Keynes economics seriously, one he figured out it was all BS window dressing to excuse the political position — if you read Hayek on Keynes that truly is his well considered assessment of Keynes and his economics.

  25. Gravatar of Greg Ransom Greg Ransom
    30. June 2009 at 15:08

    I should add that Keynes solution was much more than merely inflation — his “solution” also involved various forms of the socialization of investment.

  26. Gravatar of azmyth azmyth
    30. June 2009 at 16:57

    saifedean – “Deflation is nothing but economic growth.”
    90% of the time you are right, but deflation can also be caused by steep drops in the money supply, sudden increases in the demand for currency or Fisher debt deflation.

    Scott – As a thought experiment, suppose policy makers had all perfect knowledge of why every price in the economy changed. Which price changes would be microeconomically efficient to offset with monetary policy? Any changes to the money supply would still affect all prices, imposing menu and transactions costs on firms/households. My conclusion is that changes in monetary policy would only be worthwhile when there are large AD shocks that would otherwise cause prices to fall across the board.

    After considering the wage targeting idea, I think NGDP targeting is better. I don’t see the advantage in excluding capital income from the index. What both methods have in common is that both don’t respond strongly to AS shocks (such as the technology shocks saifedean mentions), but they do respond strongly to AD shocks. Whenever people talk about the good side of deflation, they always give examples of supply side changes.

    Austrian economics is better characterized by methodology than conclusions. Austrian economics is about methodological individualism, spontaneous order, praxeology, and taking seriously the problems of time, ignorance and uncertainty. There are several schools of thought, although the Rothbardian school is the best represented on the internet. I don’t think Austrians are singling you out, pretty much everyone gets pro-Austrian comments; most bloggers just don’t respond.

  27. Gravatar of Current Current
    1. July 2009 at 04:01

    Scott: “I agree that branching barriers were a big problem, it mostly explains why Canada did so much better.”

    Yes. My point was I think that the US was less prepared for variations due to gold flows than other countries were. The Fed exacerbated the problems.

    You point about gold flows is certainly valid. But what effect gold flows had depended on the banking systems in place in various countries.

    When you say…
    Scott: “The Friedman and Schwartz data you cite are meaningless because domestic money supplies are endogenous under a gold standard. A big country like the US has some influence, but only to the extent that it can affect the world demand for gold.”

    I don’t think you’re really correct. During the period we are discussing, the 1920, the base currencies were linked to gold. However other sorts of money such as bank deposits were subject to national variations due to the existence of national central banks. National central banks provided national reserves and national lender-of-last resort facilities.

    Read a bit of Hayek’s “Monetary Nationalism and International Stability”.
    http://mises.org/books/monetarynationalism.pdf
    In it Hayek write:
    “A great part of the argument of the classical writers on money proceeded on this assumption of a ‘purely metallic currency’. I wholly agree with these writers that for certain purposes it is a very useful assumption to make. I shall however not follow them in their practice of assuming that the conclusions arrived from these assumptions can be applied immediately to the monetary systems actually in existence. This belief was due to their conviction that the existing mixed currency systems not only could and should be made to behave in every respect in the same way as a purely metallic currency, but that—at any rate in England since the Bank Act of 1844—the total quantity of money was actually made to behave in this way. I shall argue later that this erroneous belief is responsible for much confusion about the mechanism of the gold standard as it existed”

    As he explains in that book the national central banks changes the way things worked substantially. A demanding to hold banknotes or deposits backed by gold in one currency became something quite different to a demand for the same in another country, despite the fact both were on the gold standard.

    As Saifedean says in the US there was a greater expansion of the money supply than there was of the gold supply. I think this is significant because it is not only the price level that is relevant. As I’ve mentioned earlier where and how money supply increases take places matter, as does their effect on the market rate of interest.

    The mechanisms that bring about problems were already present once central banks became lenders of last resort. That allowed the commercial banks to expand more than is wise. Here’s another good snippet from “Monetary Nationalism”:
    “So long as central banks are regarded, and regard themselves, only as ‘lenders of last resort’ which have to provide the cash which becomes necessary in consequence of a previous credit expansion with which, until this point arrives, they are not concerned, so long as central banks wait until ‘the market is in the Bank’ before they feel bound to check expansion, we cannot hope that wide fluctuations in the volume of credit will be avoided. Certainly Mr. Hawtrey was right with his now celebrated statement that ‘so long as the credit is regulated with reference to reserve proportions, the trade cycle is bound to recur’.”

    All of the blame for what happened in the US can’t be placed on the Fed. Neither though can it all be blamed on gold prices. The other central banks played a large part.

    Scott: “You say not all 1920s-type situations lead to a recession. Fine. But my theory is that all falling NGDP periods do lead to a recession. So isn’t my theory more powerful? (And I’d add not just falling, but if NGDP is suddenly rising at a much slower rate.”

    I agree with monetary equilibrium economists too. If the money supply does not expand to facilitate an increase in demand to hold money then there will be recession. I agree with the Austrians also though. There is nothing really contradictory about this since each deal with different subjects.

    Scott: “I don’t follow your last point. Do you agree with me or Bob about inflation over the next 6 to 12 months?”

    I agree with you, I disagree with Bob in that timeframe.

    Scott: “I don’t know why the Austrians are so irritated by my stuff, much of it is very sympathetic to their ideas. Maybe for the same reason that religious disputes are most virulent between closely aligned sects.”

    Yeah, I’ve noticed we’re getting into that. Judean People front, Splitters!

    We’re not trying to irritate you, and I apologize if we are.

  28. Gravatar of ssumner ssumner
    1. July 2009 at 04:14

    bababooey, Yes that is true, although because the Eurasian population was much larger, the disease mostly flowed to the Americas. But I certainly agree that it was an accident. I should also say that I wasn’t trying to suggest the Europeans were morally inferior to the peoples they conquered. As you point out many indigenous people did the same things. What made the European crimes look worse is that they were so powerful and their victims were relatively weak. Obviously if the Aztecs had been powerful, and the Europeans had been weak, the opposite would probably have happened. For almost all of human history the world was a very brutal place. It still is in many places, but not in Newton, Massachusetts, where I live. That’s why these crimes seem so appalling to people like me. But I can’t really disagree with anything you say.

    I should add that when I said liberalism made Europeans powerful before it made them good, the implication was that it did eventually make them good. As far as I know the British anti-slavery movement of the early 1800s was the first coordinated attempt in human history to stamp out slavery throughout the entire world. Economists were heavily involved in that endeavor. (I also recall reading that some British authors like Carlyle and Dickens were skeptical of the early civil rights movements in England. Can anyone confirm that?)

    greg, I have spent almost my whole working life studying how the gold standard really works, so if by now I don’t know how it “really worked” then it is unlikely that any new information will shake my ignorance. I do understand the gold standard is incredible complex, and that no two economists even agree as to what a gold standard “really is.”

    This blog is not set up to explore Austrian ideas, it is set up to explore my ideas. If Austrians bring comments into my comment section that is fine. I will respond to their comments, flawed or not. I won’t respond to how Selgin would have raised the issue, if he had been commenting n my blog. I don’t have time now to study Austrain econ, I don’t even have time to do this blog, but I am. Again, when I said “Austrians” I meant the comments of Austrians on this blog. I’ll try to leave that term out in the future, and just say “your ideas” when responding to a particular Austrian.

    Instead of defending Austrian in general, it would be more helpful if you could find Austrians who didn’t think it was “easy money” when Greenspan cut rates to 1% in 2002. My impression is that almost all Austrians think it was an easy money policy, which also makes me think they are still stuck in a crude Keynesian mindset. But if I am wrong then please provide some citations of Austrians that don’t equate low interest rates with easy money.

    Greg#2, Keynes did not favor “massive inflation” he favored zero inflation. Zero is not massive, is it? Maybe in the Austrian world it is, as there was zero inflation in the 1920s (actually a bit of deflation) and yet it is viewed by Austrians as a highly inflationary decade, or I should say by the Austrians that comment here.

    greg#3, The whole problem with the GT in one sentence is that Keynes did not favor inflation. If he had, he certainly would not have favored the socialization of investment. I’ll take three percent inflation over socialism any day. With 3% inflation there is no liquidity trap, and no need for fiscal stimulus. (Noticed what happened last fall when we briefly slipped into deflation?) Meltzer pointed out that Keynes missed that obvious solution to the secular stagnation problem that he perceived in capitalism–mild inflation.

    azmyth, You said:

    “saifedean – “Deflation is nothing but economic growth.”
    90% of the time you are right, but deflation can also be caused by steep drops in the money supply, sudden increases in the demand for currency or Fisher debt deflation.”

    Yes, and not just in 1929-33, but also late last year, which is the whole point of my blog. (To be clear, the 2,3,4th lines quoted are azmyth.)

    The reason wage income is different is because wages are sticky. Capital prices are not sticky. Of the optimal level of employment is reached, capital will be used efficiently. The point of targeting wages is to minimize the amount of wages that are away from their Walrasian equilibrium values, and hence minimize suboptimal employment fluctuations, aka business cycles.

    But we end up in the same place, as I favor NGDP targeting for political reasons. Also, wages are very hard to calculate. You need hourly wage rates, but we lack that data for huge chunks of the workforce, like me. So in the end we agree.

  29. Gravatar of azmyth azmyth
    1. July 2009 at 05:21

    Scott – “Carlyle and Dickens were skeptical of the early civil rights movements in England. Can anyone confirm that?”

    In his essay “Occasional Discourse on the N**** Question”, Carlyle argued in favor of slavery against the abolitionist economists of the time. He dubbed economics “the dismal science” in an attempt to discredit his opponents.

  30. Gravatar of TGGP TGGP
    1. July 2009 at 05:26

    Levy & Peart have an article/series “How the Dismal Science Got Its Name” which discusses Carlye, Dickens & Ruskin’s opposition to laissez-faire & civil rights. Mencius Moldbug (who you might remember in your comments section earlier) is a big fan of Carlyle and thinks Governor Eyre was in the right.

    George Selgin also believes Greenspan’s easy money caused the crash. David Henderson & Jeff Hummel have had a running argument with him on that. They claim by Selgin’s theories of monetary equilibrium Greenspan’s fed was not really that easy.

  31. Gravatar of Jon Jon
    1. July 2009 at 06:09

    Scott: I have to quibble with the light in which you cast the transition from #3 to #2. As I recall, and I must really defer to you here as the better expert, the public began to lose faith that gold standard was being seriously implemented.

    You mention elsewhere that under a gold-standard, inflation can cause real-effects because inflation expectations are rooted at a stable price-level. But of course, the public does learn eventually.

    And so it went at the end of the 1920s. Doubts developed, real-rates then rose, and confidence had to be restored. But this meant of course increasing the gold-cover rapidly to get ahead of perception.

  32. Gravatar of d kite d kite
    1. July 2009 at 06:16

    I feel somewhat like Denmark when the major powers are battling it out in the trenches over, what?

    Bad luck is mentioned in passing in this piece. Somehow I wonder if no matter how much liquidity, stimulus, magic incantations the housing structure was going to collapse. The whole enterprise was predicated on yearly double digit price increases. The same credit schemes sustained uncompetitive GM and Chrysler. And more dangerously in my opinion, the ‘prosperity’ of the last decade allowed government to grow if not in size but in scope and as we are seeing now in ideals.

    Throw in a changing of the guard due to demographics (we learn by mistakes). And the normal accumulation of rent seekers, dead beats and stupidity that a run of prosperity generates.

    In 1929-33 the Fed tightened, in 2009 the Fed loosened. Maybe we will see the same results, expressed in different ways. It is out of their hands.

    Derek

  33. Gravatar of Greg Ransom Greg Ransom
    1. July 2009 at 07:59

    Scott,

    Memory can fail and I stand to be corrected, but the way I recall it is that part of Keynes’s solution to the British unemployment problem caused by the 1925 return to parity was monetary expansion.

    Keynes’ policy positions — and his economics — were known to change, of course.

    On the gold standard, as someone who understands it, I’d be interested in your view of economic understanding of how the gold standard worked among contemporary economists. Do you think most economists understand how the gold standard worked?

    Note well that I nowhere challenged your understanding, I expressed by sense about most contemporary economists — all the folks who’ve put very little time studying the actual functioning of the thing.

  34. Gravatar of ssumner ssumner
    2. July 2009 at 06:00

    Current:

    You said:

    “I agree with monetary equilibrium economists too. If the money supply does not expand to facilitate an increase in demand to hold money then there will be recession. I agree with the Austrians also though. There is nothing really contradictory about this since each deal with different subjects.”

    If you agree that money supply should change to reflect changes in money demand, then why criticize Strong in the 1920s? He increased the money supply just enough to match money demand, and kept prices stable.

    azmyth, Thanks, I knew about the “dismal science” quote. Anyone know about Dickens?

    TGGP, Thanks for the info about Dickens and Ruskin. A lot of people in the humanities look down on us heartless economists. It’s good to know who was for civil rights and who was against back in the period of classical liberalism.

    I will debate Selgin in November, or perhaps I should say we will have a panel discussion, at the Southern Economic Conference.

    Jon, I read the history differently. In 1929 the gold standard was very solid in the US. No doubts at all. The Fed did a tight money policy to pop the Wall Street bubble, not because we were losing gold. Indeed we gained lots of gold. Only much later in late 1931 when Britain left gold did doubts set in. That led to both private and central bank hoarding of gold, which was deflationary. But the initial deflation was just tight money.

    d kite, The housing structure WAS going to collapse, and did collapse. But that is not enough to cause a severe recession. Housing just isn’t that big a part of the economy. The decline in housing from mid-2006 to mid-2008 was very orderly, with not much effect on other sectors. Only when the Fed let NGDP collapse after mid-2008, did other sectors like manufacturing go into steep decline.

    Sorry, The Fed hasn’t “loosened” unless you look at meaningless indicators like interest rates and the monetary base. But then your history of 1929-33 would be wrong, because rates fell sharply and the MB rose sharply then as well.

    Greg, No, I don’t think economists then or now understand how the gold standard worked, that’s why I am working on a book on the Depression. BTW, I assume people are sick of hearing about this mythical book–but most of the key ideas are out in numerous papers on the Depression that I have published.

    Keynes opposed the return to gold in 1925 because he (correctly) understood that it would prevent the BOE from being able to stabilize the price level. He certainly didn’t favor inflation, perhaps just enough monetary expansion to keep prices from falling. But I don’t think he even expected that to work at an exchange rate of $4.86, which overvalued the pound.

  35. Gravatar of Current Current
    2. July 2009 at 06:27

    Scott: “If you agree that money supply should change to reflect changes in money demand, then why criticize Strong in the 1920s? He increased the money supply just enough to match money demand, and kept prices stable.”

    Well, I don’t think that he really did that. When you say he kept prices stable I assume you mean prices of consumer and producer goods. However in the 1920s investments rose in price very strongly. I think that this was probably caused by unnecessary monetary expansion. Though I see what you mean about the problems Strong would have had resisting that.

  36. Gravatar of Greg Ransom Greg Ransom
    2. July 2009 at 09:55

    Scott — See Skidelsky, Keynes, Vol. 2, for Keynes switch from a price stability position to a loose money position, p. 284.

    See also p. 297-298.

    Keynes called for credit & money expansion to solve the twin problems of absent “cost deflation” in the face of “price deflation”, and as a cure for “profit deflation”.

    Central bank credit & money expansion was part of Keynes’ program of “the socialization of investment”.

    What Keynes was attempting to justify in the late 20s was obvious to everyone, e.g.:

    “What Keynes is after, of course, is a definite inflation of credit.”

  37. Gravatar of Alex Golubev Alex Golubev
    2. July 2009 at 09:57

    Scott, come on, that’s a horrible argument even for one that falls back on semantics. Physics being able to predict is quite valuable. I think you’re referring to metaphysics by your definition of “explaining” things. ;) Your question of why soemthing exists cannot be based on rationality, only faith and feelings.

    Either way, it wasn’t an outsider attack on economics. The quote is attributed to the same econ professor who’s trying to popularize the Adaptive Market Hypothesis. It’s hard to argue that economists disagree about a much larger proportion of their body of knowledge than physicists. I’d say that economics is a “social science”, but that’s an oxymoron. And in my original post i said that this quote applies to all social sciences.

    This doesn’t make them useless. Just like “evolution” is a useful tautology but has nothing to do with science, because it has no predictive value either – only explanatory value in hindsight on who turned out to be the fittest. yet this framework helps us figure out how thing are NOT. That’s why i like the implications of the AMH. it explains the existance of bubbles much better than EMH.

  38. Gravatar of Greg Ransom Greg Ransom
    2. July 2009 at 10:09

    In a 1928 article Keynes is explicit in calling for a rising price level. See pp. 297-298 of Skidelsky, Vol. 2.

  39. Gravatar of Current Current
    3. July 2009 at 01:03

    Alex Golubev,

    Read Hayek’s stuff on the philosophy of Science.

    I am an electromagnetic physicists by training – an Antenna Designer. I think we should all be wary of overly restrictive definitions of what science is. A problem that beset early physics too. See http://www.peterleeson.com/scientism.pdf on that.

    Evolution is not a “useful tautology”. Certainly there are parts of it that are not fallible, but not by any means the whole thing. I think the situation in economics is similar. For example, Mises aprioristic idea of Human Action may we be rather close to tautology but that doesn’t mean that the book Human Action is.

  40. Gravatar of ssumner ssumner
    3. July 2009 at 12:04

    Current, When goods prices are stable and stock prices soar, that is a very good thing. Real stock prices were high in 1928-29 partly because we had some of the best, most market oriented economic policies in American history. Too bad they didn’t continue the Coolidge policies. Hoover favored bigger farm supports, economic planning, tight money, Smoot-Hawley, higher taxes, and opposed wage cuts during deflation.

    Greg, you may be right, my Skidelsky is in my office so I can’t check now. Keynes was famously inconsistent. But two points:

    1. He usually favored price stability.

    2. I interpret the statement below as opposition to deflation, not support for inflation:

    Greg said:

    Keynes called for credit & money expansion to solve the twin problems of absent “cost deflation” in the face of “price deflation”, and as a cure for “profit deflation”.

    Greg I think he is saying that since costs (i.e. wages) aren’t falling, and prices are, then profits are squeezed. the solution is to stop deflation.

    Alex, I was half joking. There is no point in debating whether economics is a science. Everyone knows what economics is, but there is no generally accepted definition of “science.” I think biologists would disagree with your argument that there are no prediction from evolution, if by evolution you mean Darwin’s theory of natural selection. If an environment changes, I think biologists have at least some ability to predict how creatures will evolve in the new environment. Even dog breeding is evolution.

  41. Gravatar of ssumner ssumner
    3. July 2009 at 12:07

    Current, I forgot to mention that I agree with both of your responses to Alex.

  42. Gravatar of Greg Ransom Greg Ransom
    3. July 2009 at 20:26

    The key thing was that after the return to the gold standard at parity in 1925, British labor was overpriced — and Britain found itself with an unemployment problem. And the unemployment problem was overdetermined by extremely powerful unions and by expansive unemployment benefits.

    The “deflation” had already happened by 1928 — and the key artifact of that deflation identified by Keynes was relatively overly costly labor. How to fix the problem politically. Keynes wagered that there was no way to break union and no way to reduce unemployment benefits — these were not politically feasible. What was politically feasible was inflation via credit expansion.

    Keynes’ political solution works even if you don’t buy is British version of “Foster & Catchings” economics.

    Scott writes:

    “Keynes called for credit & money expansion to solve the twin problems of absent “cost deflation” in the face of “price deflation”, and as a cure for “profit deflation”.

    Greg I think he is saying that since costs (i.e. wages) aren’t falling, and prices are, then profits are squeezed. the solution is to stop deflation.”

  43. Gravatar of Current Current
    4. July 2009 at 04:48

    Scott: “When goods prices are stable and stock prices soar, that is a very good thing. Real stock prices were high in 1928-29 partly because we had some of the best, most market oriented economic policies in Am erican history. Too bad they didn’t continue the Coolidge policies. Hoover favored bigger farm supports, economic planning, tight money, Smoot-Hawley, higher taxes, and opposed wage cuts during deflation.”

    I agree with you that generally high stock prices are a good thing. However, they aren’t in all times and places.

    I think we have to look at why capital prices are high. If it is due to capital _appreciation_, perhaps caused by good government policies, high investment or good business practices then that is good. However, capital _inflation_ isn’t good. I think this is probably what happened in the late 20s and it’s what happened recently.

    Capital inflation and producer price inflation distort capital accounts and produce illusory profits.

  44. Gravatar of ssumner ssumner
    4. July 2009 at 07:41

    Greg, you make a good point about the British unions. In retrospect it seems that Britain’s problem throughout the entire interwar period was not so much AD as AS. Keynes did not recognize that. If the Austrians did, then that is to their credit. In other words the persistently high unemployment in Europe throughout both the 1920s and 1930s reflected the same factors that have kept the average unemployment rate in the Eurozone relatively high for decades; a combination of labor regulations, unions and generous unemployment benefits, which raises the structural rate of unemployment. This problem affected the US to some degree in the 1930s, especially after 1933. So I may have been too kind to Keynes here. Stable prices would have solved the US unemployment problem in 1930, in my view, but we were more flexible than the UK. It wouldn’t have solved Britain’s problems.

    Current, Believe me, I do understand the Austrian argument about price indices being misleading, but I still think people need a sense of proportion. 1927-29 was the only expansion phase of the business cycle in the entire 20th century were the CPI fell. So even if the Austrian argument is right, that particular cycle was not really all that inflationary, even including asset prices. Remember that there is a difference between physical assets, like buildings, which should arguably be counted in a price index, and paper assets, like stocks and bonds, which clearly should not be counted in even an expanded price index, as they capture future income, not current. I am very confident that even a proper price index in 1927-29, including physical assets, would not have showed much inflation. In a relative sense 1927-29 was very good, and thus real stock prices (i.e DJIA/CPI) should have risen strongly. Maybe it overshoot a bit, but markets aren’t perfect. The main point is that the stock crash was caused by the oncoming Depression, which was a policy mistake.

  45. Gravatar of Current Current
    6. July 2009 at 00:51

    Scott,

    I don’t think you really do understand fully. ABCT doesn’t just involve price inflation of present goods. We are not arguing for an “expanded price index” of present goods, though that may help. One of the major points is that the relative prices of future goods are distorted.

    Due to monetary distortion there appears to be a larger pool of real resources for investment than there really is.

    Have you read Garrison’s slides? They are the best summary I know of: http://www.auburn.edu/~garriro/cbm.ppt

  46. Gravatar of Alex Golubev Alex Golubev
    6. July 2009 at 08:39

    Current,
    thanks for the feedback. i’ll check out the papers on science/philosophy. I cannot respond until I find out what they say.

    evolution is not a tautology, because it isn’t even a statement, but “survival of the fittest” is one.

    Scott,
    breeding doesn’t prove or disporve the predictive value of “survival of the fittest”. nothing proves a theory right, right? The point is that one cannot design an experiment to prove it wrong. it is true by definition always.

    But that doesn’t mean it’s not useful. All i’m saying is that it isn’t necessary for something to be a science to be helpful. It’s also not necessary to use the scientific method to discover knowledge. But one can be envious of such an ability and that’s what Mr Lo was stating.

    I would maintain that the scientific method is too LINEAR for the social “sciences”. it doesnt’ allow for behavior change very well, so I believe that linear statements arent’ gonna hold up very well in the economic “body of knowledge”. We will have to live with a lot of uncertainty and that i think is a positive. otherwise we’ll always end up having to ENDURE the consequences of the head economist’s beliefs (be it Greenspan, Bernanke, or Sumner :) ). I think a healthy does of model scepticims is in order. Dont’ think Chruchill was advocating fascism when he expressed healthy scepticism of democracy.

  47. Gravatar of Current Current
    6. July 2009 at 08:56

    I certainly agree there should be healthy criticism of the assumptions used in models.

    The problem with evolution is that you must build an overall framework before you can talk sensibly about it. The same is true about most economic theories. There must be an overall theory. Then bits of it can be criticized.

    But, by criticizing one part a defect is likely to be found in it, that is on close inspection really a defect in how it links to the other parts.

    None of this is really unscientific.

    Also, these sorts of problems arise often in physics. A “full version” of Newton’s laws with every i dotted and t crossed is actually quite complicated. It must be seen as an overall system before it can be critiqued. Electromagnetics is the same.

  48. Gravatar of Alex Golubev Alex Golubev
    6. July 2009 at 11:43

    I don’t think we really disagree on anything. I see the “scientific method” merely as a tool in our arsenal for discovery. On the edge of discovery, even in math, the disagreements between experts resemble the mumblings of charlatans. The scientific method allows for some sort of resolution to be reached after multitudes of experiments that aproach the problems from different angles.

    We can argue on whether scientific method is misapplied in econ and social sciences, but it would be more productive to move on to my specific beef with econ – EMH. Unpredictability is used to argue for rationality. By the same token we can argue that “natural selection” is “rational”, because it is unpredictable, which makes little sense. And so did the merlin who said that weather is unpredictable and he’s the only one that can speak with gods, thus his word is true. I think the question is whether resources are misallocated not whether one can consistently predict when they are and convince the one eyed masses of this. There’s a wonderful story I read back in high school of a man that ended up in a settlement of the blind. he didn’t live very long.

    So all i’m suggesting is that the Adaptive Market Hypothesis is a natural resolution to this conflict in economics. We’re all already used to the discomforts of evolution and it’s been proven to have interdisciplinary value, so it’s only natural (hehe, is that a pun or linquistic survival of the fittest?) for economics to take on an evolutionary spin.
    http://en.wikipedia.org/wiki/Adaptive_market_hypothesis

  49. Gravatar of ssumner ssumner
    6. July 2009 at 15:17

    Current, If stabilizing current prices is so bad, why is it so hard to find economic disasters where the price level was stable? And yes, I have looked at Garrison’s set of slides on ABCT.

    Alex, I would say that anyone who is envious that economics is not like physics really doesn’t know what economics is all about. The average person thinks that the fact that economists cannot predict interest rates is evidence of our incompetence, whereas it is actually a prediction of the EMH. Let them think what they want, we know better.

    Alex#2, I never use unpredictability to argue for rationality, I use it to argue for Ratex. But rational expectations aren’t really about rationality at all, they should be called consistent expectations. In the end, what I like about the EMH is that it suggests that the market forecast is the best forecast, and I’d believe that whether people are “rational” or not. So I really don’t care about all the behavioral economics research showing people aren’t rational. Until they come up with a useful prediction, I’ll stick with ratex.

  50. Gravatar of Current Current
    7. July 2009 at 01:06

    Scott: “If stabilizing current prices is so bad, why is it so hard to find economic disasters where the price level was stable? And yes, I have looked at Garrison’s set of slides on ABCT.”

    In general I don’t think that it is. However, that doesn’t mean that inflating the price of future goods, or goods of high orders is good.

    I think the reason this is rare is that in common circumstances an increase of money supply will lead to a rise in the consumer price level. The circumstances where it leads only to increases in the price of future goods and high-order capital goods are rare.

  51. Gravatar of ssumner ssumner
    7. July 2009 at 05:30

    Current, That doesn’t really answer my question. You said “In general I don’t think it is.” Then provide counterexamples.

  52. Gravatar of Current Current
    7. July 2009 at 05:32

    Well, the recent crisis and the crash of ’29 are the most obvious examples.

  53. Gravatar of Alex Golubev Alex Golubev
    7. July 2009 at 06:58

    I always get in trouble for loose wording, but maybe that’s the nature/benefit of discussion in general.

    My view:
    EMH -> informational efficiency = yes
    Information efficiency -> rational expectations = no

    but then again it will depend on the definition of “rational expectations”. I think it’s a slippery slope from “the market is the best forecast” to “the market says so, so it must be true”. That type of error, increases the element of confidence and thus self-reinforcement in momentum chasers, which increases the likelihood of bubbles and misallocations of capital.

    if “rational expectations” encompasses systemic biases along with rationality, then why in the world do we name it that? That is a bit misleading. Not to a professor of course, but the label sticks and in the real world, people “sell”. Even if it was named “not so rational expectations”, people would figure out how to sell the rational part.

    Don’t believe me, look at the portfolio theory and optimizing efficient frontiers all stemming from a misinterpreted study stating that “asset allocation explains more than 90% of the variability in portfolio returns”. This single study is used to sell all kinds of financial mumbo jumbo. In reality, it simply stated that highly diversified funds’ holdings are… well… diversified. There’s very little argument against market timing there, but that’s how it’s used quite often in the real world.

    Same goes for “survival of the fittest”.

    I’ll try it for a third time, but Adaptive Market Hypothesis DOES claim to integrate behavior economics and EMH:
    http://en.wikipedia.org/wiki/Adaptive_market_hypothesis

    But then again, i’ll have a heck of a time trying to convince someone that evolution can, does, and always will take inefficient routes, too. At the very least the word “adaptive” calls it what it is. But then again, that’s me. To a lot of people “adaptive” can mean “always best”. Ok, I give up.

  54. Gravatar of Current Current
    8. July 2009 at 05:41

    Scott,

    I think I see what you mean now. If we’re talking about exact stability then neither the GD or current events count. Since price fell slightly in the years before the GD and rose in the years before today.

    So it really comes down to economic arguments not history.

    Alex,

    I agree with some of what you say. In my view the phrase “rational expectations” is open to abuse. If you’re interested see Hayek’s various definitions of French and Scots rationality in “The Constitution of Liberty” for example. People don’t really agree about what “rational” means.

    Let’s call what a person thinks about the world “background knowledge”. If a person’s background knowledge is not sufficient to interpret what they know then they are still rational in (what Hayek calls) the Scottish sense, but they are irrational in the French sense.

    I don’t really know much about EMH so I won’t comment on that.

  55. Gravatar of ssumner ssumner
    8. July 2009 at 06:01

    Current, The price level was certainly not constant after 1929. It fell sharply, which is why we had a depression. When the Fed didn’t allow the price level to fall after the equally severe 1987 stock crash, we had a boom in 1988 and 1989 (and unemployment actually fell), not a Great Depression. So your example actually proves my point.

    Alex, I am not interested in new theories to supplant Ratex, unless they work better in the real world. So far I haven’t seen that, but I’ll keep an open mind. I wish people would call Ratex “consistent expectations” but we are stuck with the old label.

    Current, No, I am not talking about exact stability. I am fine with people calling prices stable from 1922-29. But that proves might point. We got into trouble precisely when we abandoned stable prices.

  56. Gravatar of Current Current
    8. July 2009 at 06:30

    Scott: “The price level was certainly not constant after 1929. It fell sharply, which is why we had a depression. When the Fed didn’t allow the price level to fall after the equally severe 1987 stock crash, we had a boom in 1988 and 1989 (and unemployment actually fell), not a Great Depression. So your example actually proves my point.”

    I’m not talking about after I’m talking about before, the late 20s. That was what we were discussing in the thread above.

    Scott: “No, I am not talking about exact stability. I am fine with people calling prices stable from 1922-29. But that proves might point. We got into trouble precisely when we abandoned stable prices.”

    I agree that after the Great Crash the Fed made mistakes. They did not expand when they should have done to satisfy the demand for money.

    However, I don’t think that these mistakes alone caused the depression. The depression would have happened anyway because of the misallocation caused by the preceding boom.

    Do you think that the growth of the 1920s was sustainable and that the only cause of the initial stages of the depression was monetary policy?

  57. Gravatar of Adam P Adam P
    8. July 2009 at 06:50

    Current,

    perhaps rate of growth was not sustainable and thus would have slowed on it’s own. I don’t think anyone is saying monetary policy could make the economy grow faster then technological progress allows.

    The question is, why did we have to give it all back? Scott is saying that monetary policy could have prevented that and he is quite correct.

  58. Gravatar of Alex Golubev Alex Golubev
    8. July 2009 at 07:18

    Scott,
    AMH doesn’t compete with rational expectations. It’s still argues for “informational efficiency”, but has different implications down the line. But whatever. I tried.

    Current, i’m guessing Scott’s reply to misallocations would be that they alone would have cause a “small” crisis, but the fed’s mistakes made it a huge one. I’ve gotten that one for the current crisis quite a few times :)

    In my world, misallocations and unfairness ARE crisis that are big enough for policy concern. And i don’t believe the misallocation is ever curred with broad stimulus. It may prevent a system shutdown, but it doesnt’ do much for the misallocation, but it doesn’t sound like Scott claim’s it would. He’s just sayign it isn’t that important and will work itself out anyways. There’s no way in hell i’d prioritize 5% growth over unfair misallocations. Saving crisis – sure (although i’d argue that that only existed in the fall and now we’re technically now in a system shut down mode). But arguing that the fed should focus on growth instead of trying to figure out why all the incentives are backwards is a reach.

  59. Gravatar of Alex Golubev Alex Golubev
    8. July 2009 at 07:20

    “now in a system shut down” = “not in a system shut down” sorry.

  60. Gravatar of Current Current
    8. July 2009 at 07:31

    Alex,

    Part of the point of Austrian economics is that bad policy responses to recessions would be of much less consequence if there were fewer of them. Having fewer of them is just as important – if not more important – than handling those that occur well.

    Mainstream economists seem to believe that crises emerge from nowhere for no particular reason. That’s one of the main things I with them disagree about.

    Also, I’m not particularly concerned with “unfairness” here. I’m not arguing for redistribution or anything like that.

  61. Gravatar of Current Current
    8. July 2009 at 07:50

    Adam P: “perhaps rate of growth was not sustainable and thus would have slowed on it’s own. I don’t think anyone is saying monetary policy could make the economy grow faster then technological progress allows.”

    I don’t think that anyone thing that monetary policy can do that. I suppose the overall issue is whether an unsustainable rate of growth will slow or whether it will result in something more sudden.

    Adam P: “The question is, why did we have to give it all back? Scott is saying that monetary policy could have prevented that and he is quite correct.”

    Another important question though is “how much of it did we actually have in the first place”? The problem being that capital wealth isn’t an “it” rather it is an overall structure. So neither question can be answered quantitatively.

    There is this idea called “Austrian Capital theory” behind what I’m saying.

    See:
    http://www.auburn.edu/~garriro/b4mismac.htm
    http://www.auburn.edu/~garriro/cbm.ppt

  62. Gravatar of Current Current
    8. July 2009 at 07:53

    Adam P: “perhaps rate of growth was not sustainable and thus would have slowed on it’s own. I don’t think anyone is saying monetary policy could make the economy grow faster then technological progress allows.”

    I don’t think that anyone thing that monetary policy can do that. I suppose the overall issue is whether an unsustainable rate of growth will slow or whether it will result in something more sudden.

    Adam P: “The question is, why did we have to give it all back? Scott is saying that monetary policy could have prevented that and he is quite correct.”

    Another important question though is “how much of it did we actually have in the first place”? The problem being that capital wealth isn’t an “it” rather it is an overall structure. So neither question can be answered quantitatively.

    There is this idea called “Austrian Capital theory” behind what I’m saying.

    See Roger Garrison’s stuff:
    http://www.auburn.edu/~garriro/

  63. Gravatar of Adam P Adam P
    8. July 2009 at 08:17

    Current you’re missing the point. Your question is “how much of it did we actually have in the first place?” is irrelevant.

    Even if we woke up one morning and found our entire capital stock was worthless (perhaps that’s why the stock market crashed) what stopped us from getting on with the job of producing a new capital stock? Why did potentially productive workers have to be left with nothing to do except get food from soup kitchens?

    The reason was the break down in trade, it was a massive coordination failure because the price system stopped performing its coordinating function (as described by Hayek in the “Use of Knowledge…” paper).

    All because of a lack of money.

    PS: the “it” I referred to was prosperity, not capital.

  64. Gravatar of Current Current
    8. July 2009 at 08:38

    Adam P,

    I agree mostly. I agree with what you say about coordination failure.

    However, there are good reasons to think that recessions caused by misallocation will cause unemployment. We live in a world of very extensive division-of-labour. So, the skills of single individuals only have value in the context of the capital available and the knowledge of others. If the demand for the good or service in question dries up then so does that for the relevant skilled workers. That should at the very least increase transient unemployment. Sometimes this may occur to the extent that some workers can only hope to find unskilled work though they may be skilled. In the modern world unskilled workers are often not in high demand.

    All that is a problem before we get to sticky wages and the lack of money.

  65. Gravatar of Adam P Adam P
    8. July 2009 at 09:02

    Current sure, all those real frictions you mention are there and can cause fluctuations in real output. They explain for example why we have a natural rate of unemployment that is not naturally equal to zero.

    Nobody is saying that even an absolutely perfect monetary policy would mean that REAL GDP would grow by exactly the same amount each year.

    But are you really claiming that those sorts of frictions caused the great depression? With 25% unemployment, even in completely labor intensive industries? That just doesn’t pass the smell test.

  66. Gravatar of Current Current
    8. July 2009 at 09:36

    Adam P: “But are you really claiming that those sorts of frictions caused the great depression? With 25% unemployment, even in completely labor intensive industries? That just doesn’t pass the smell test.”

    My point is that I think they triggered it off. It was later exacerbated by sticky prices and many bad government policies.

    Even “labour intensive” industries are not immune from the effects of the collapse of an unsustainable boom. Those industries may rely on the inputs of other industries that may use very roundabout methods of production. Or they may output to other more capital intensive industries. Apart from that there will be the decrease in what mainstream economists call AD. That is the knock on effect of lower income elsewhere.

  67. Gravatar of Adam P Adam P
    8. July 2009 at 09:54

    Well, there where plenty of really bad investments being made in the dotcom bubble (and other instances) and sticky wages have been with us in the time since the depression, as have all the real frictions you mention. There have been other market crashes, why no other depressions?

    Because of better monetary policy.

    Now, it is true that a downturn was happening anyway but how can you say that, in conjunction with stick wages etc., caused the depression when an appropriate monetary policy response has prevented all the same factors from causing any other depressions since? All those factors have statyed with us the whole time.

  68. Gravatar of Current Current
    8. July 2009 at 10:21

    Adam P: “There have been other market crashes, why no other depressions?

    Because of better monetary policy.”

    I think that has played a part, yes.

    Adam P: “Now, it is true that a downturn was happening anyway but how can you say that, in conjunction with stick wages etc., caused the depression when an appropriate monetary policy response has prevented all the same factors from causing any other depressions since? All those factors have statyed with us the whole time.”

    Many of those factors existed for many decades before the Great Depression too.

    The problem here though is that what we need to know to predict the extent of an ABCT crash we can’t directly find out. The essential problems are the degree of roundaboutness and the substitutability of capital goods. The stickiness of prices affects how serious the problems are afterwards.

    It may be that I am wrong and that capital somehow behaves as an aggregate quantity. Though I can’t see how.

    Or it could be that since the GD we have been lucky. Maybe substitutability has saved us. Or maybe technologically determined maximums to degrees of roundaboutness have saved us.

  69. Gravatar of Adam P Adam P
    8. July 2009 at 22:53

    “Many of those factors existed for many decades before the Great Depression too.”

    Yes, and an underappreciated fact is that before WWI we had better monetary policy (in the form of international cooperation to manage the gold standard).

  70. Gravatar of Current Current
    9. July 2009 at 00:50

    Adam P: “Yes, and an underappreciated fact is that before WWI we had better monetary policy (in the form of international cooperation to manage the gold standard).”

    Yes, then afterwards a period of monetary nationalism.

  71. Gravatar of Adam P Adam P
    9. July 2009 at 01:04

    Current, “Yes, then afterwards a period of monetary nationalism.”

    made possible by the stupidity of the gold standard and solved by getting rid of the stupidity of the gold standard.

  72. Gravatar of Current Current
    9. July 2009 at 03:14

    There is nothing at all stupid about the gold standard. Amongst monetary arrangements it is probably the best.

  73. Gravatar of ssumner ssumner
    9. July 2009 at 05:47

    Current, You said:

    “Do you think that the growth of the 1920s was sustainable and that the only cause of the initial stages of the depression was monetary policy?”

    Of course the growth in the 1920s was sustainable! It was nothing like the recent tech or housing bubbles. It was cars, office buildings, refrigerators, radios, etc, etc. Lot’s of stuff we consumers want, and the buildings required to hold offices. If the economy would have kept growing, we would have continued churning out these goods, as we did once we recovered from the GT and WWII. Are you telling me that Austrians claim the stuff produced in the 1920s wasn’t valuable?

    Adam, I agree, and I’d go even further. We didn’t have to give any back. The 1930s was the most technologically progressive decade in the 20th century according to noted historian Alexander Fields. We could have continued 3% real growth all through the 1930s, if only the Fed had provided enough money for 3% NGDP growth.

    Alex, No, I am arguing that in the 1920s that there was no major misallocation. You are right about 2006-08, however. I do agree there was a misallocation into housing, and I think it could have, AND WAS, handled smoothly from 2006 to mid-2008—until NGDP started falling.

    Current, No, I don’t think the Depression came out of nowhere. I think it was caused by tight money.

    Adam and Current, I have to agree with Adam in this dispute. In an earlier discussion the issue of frictions in re-allocation came up, and I think Bill Woolsey argued that “OK, but why are the industries that should be attracting workers also losing jobs?” It not just the overbuilt housing sector that is losing jobs, but also manufacturing. The response, I kid you not, was that manufacturing was also overbuilt. So now were are back in the world of general gluts. We have too much of everything. Then I had one commenter apply this to China. China has too much capacity, has overbuilt housing, even though the average Chinese peasant lives in about 200 sq foot house. It just never ends. I agree with Adam, this misallocation story just isn’t plausible for big American recessions or depression.

  74. Gravatar of Current Current
    9. July 2009 at 07:12

    Scott: “Of course the growth in the 1920s was sustainable! It was nothing like the recent tech or housing bubbles. It was cars, office buildings, refrigerators, radios, etc, etc. Lot’s of stuff we consumers want, and the buildings required to hold offices. If the economy would have kept growing, we would have continued churning out these goods, as we did once we recovered from the GT and WWII. Are you telling me that Austrians claim the stuff produced in the 1920s wasn’t valuable?”

    The problem is not that these things were not valuable. I think the problem was that they didn’t form a sustainable production structure overall.

    Consumer goods are certainly directly useful, though even their degree of usefulness depends on circumstances – as the suburbs of Detroit demonstrate. Other sorts of goods are capital, they are intermediate steps. Their usefulness depends on a set of inter-related circumstances.

    The mainstream approach to this problem is to ignore it. Capital is abbreviated to a single aggregate variable. The market supposedly produces capital in the right forms at the right times. How this happens is hardly ever explained.

    Scott: “it not just the overbuilt housing sector that is losing jobs, but also manufacturing. The response, I kid you not, was that manufacturing was also overbuilt.”

    I don’t understand what is wrong with that. I largely agree, I think that manufacturing was overbuilt.

    Artificially low interest rates made consumers feel they were richer than they really were. So they thought themselves able to buy more consumer goods.

    Scott: “So now were are back in the world of general gluts. We have too much of everything. Then I had one commenter apply this to China. China has too much capacity, has overbuilt housing, even though the average Chinese peasant lives in about 200 sq foot house. It just never ends. I agree with Adam, this misallocation story just isn’t plausible for big American recessions or depression.”

    I don’t understand what is wrong with what this idea. Some of my friends have told me about cities in China that are full of empty apartment blocks. Those blocks were built on the expectation of the continued growth of industry in the cities provoking immigration from the country. That continued migration didn’t happen.

    I suppose this is what I’d say to the critics in this thread: How do you think capital works?

  75. Gravatar of ssumner ssumner
    10. July 2009 at 11:36

    Curent, If there was ever a statement that encapsulated what I don’t like about ABCT, it is this one:

    “I don’t understand what is wrong with what this idea. Some of my friends have told me about cities in China that are full of empty apartment blocks. Those blocks were built on the expectation of the continued growth of industry in the cities provoking immigration from the country. That continued migration didn’t happen.

    I suppose this is what I’d say to the critics in this thread: How do you think capital works?”

    China could double it housing stock tomorrow, or triple its housing stock, and there would still be far less housing per person than in America. It is all about demand. If houses are empty then you need more demand, not fewer houses! By your argument any time there is a recession in the US, it shows we have too much manufacturing stock, because there are always some empty factories. But why isn’t there too little demand? Why not boost demand so that factories are put to use? I thought the Austrians did have one very good argument, that some capital might be misallocated during a bubble. And the meaning was very precise–this was capital that would not have been useful EVEN IF THE ECONOMY WAS AT FULL EMPLOYMENT. Thus internet and telecom infrastructure built in the tech boom, unneed even in full employment. Or houses in some cities that were overbuilt in 2007, even at full employment. But if you are going to point to unused capital as an ipso facto misallocation of capital, then ABCT because a useless tautology. Recessions always have unused capital even if merely due to low demand.

    The capital built during the 1920s would have been very useful if deflationary monetary policies hadn’t pushed us into a depression. There was no tech or housing bubble in the 1920s, at least of a magnitude to produce general distress across the country (obviously there were bubbles in Florida, etc.)

  76. Gravatar of Jon Jon
    10. July 2009 at 17:31

    Scott, I fail to see the relevance of Full Employment.

    A concise rendition of ABCT in marginalist terms is:
    That quantity of capital in use is only so much such that MC=MR. When inflation undershoots expectations, MR drops. marginal units of capital then become disused. Only when inflation expectations reset ‘lower’ will the MC of depreciation be deflated and the capital returned to use.

    When the MC includes fixed obligations, bankruptcy may result anyways because expectations are contractual. So there is a dead-weight loss to needless changing expectations too.

    The connection to employment ought to be second order. That is unemployment lowers the expected natural-rate of return as a result of disavings.

    Scott: I agree with what you say provided you delete the word ‘demand’. Its not a lack of demand that’s the problem. Its a mismatch between expectations and immediate reality. The goal of monetary policy is not to create demand. Its to keep inflation at the expected value.

  77. Gravatar of Scott Sumner Scott Sumner
    11. July 2009 at 12:12

    Jon, I don’t follow your argument. Do you agree with Current that excess capacity in an industry is, ipso facto, evidence that capital was mis-allocated in the preceding boom?

    Surely the fact that there are lot’s of empty buildings in China (which I don’t think is true by the way) is not evidence that too many houses were built? It could be a lack of demand, couldn’t it?

    BTW, I use the term “demand” synonymously with NGDP. I believe some Austrians favor stabilizing NGDP, so I don’t think this yardstick necessarily conflicts with ABCT.

  78. Gravatar of Current Current
    13. July 2009 at 09:00

    Scott,

    I see your point. The problem though we have here is to do with the sequence of events in time.

    If I said that any case of unemployment of resources is “misallocation” then I could be accused of being meaningless.

    That isn’t my point though. My point is that in the cases I mentioned there are good reasons to think that misallocation has been occurring in the past. Now we are in a recession we have the additional secondary problems that this causes, such as the vastly increased demand to hold money. That causes additional problems that some describe as aggregate demand problems.

    The point I’m making here is that the misallocation problems still matter. Scott, you are certainly right that China needs more homes. However, they are only useful if they are in the same places as jobs are so they can be used. Homes are not really a commodity. From what I understand about China many of the homes are not. I may be entirely wrong I don’t know much about China.

    Now, let’s suppose that the correct policies to avert the problems of the secondary recession are put into place.

    If that happens there will be two different sorts of resources that Austrians describe as “misallocated”.

    Firstly, there will be the misallocation in the long term projects. Things like optical fibre, research and development, some houses etc fall into this category. After the recession begins it must fall in price. This is the capital that some may say would not be utilized in a situation of full employment, however this idea is not quite correct.

    The reason it isn’t really correct is that the decisions that allocated capital to long-term project had other effects. Agents believed that these projects would pay and acted on that view. Investors, for example, will spend on the basis that their investments will pay some return. They find that their likely future returns will be much less than they had thought. This means they must spend less and save more. And this harms production of consumer goods. This creates another sort of misallocation. Garrison calls this the derived-demand effect.

    To describe this he draws a broken-triangle with a kink in it. Inside that a normal triangle is inscribed. The economy can sustain the capital configuration given by the normal triangle.

    Now, we can’t really differentiate the derived-demand misallocation from the effect of the secondary recession. That is the problem, and why you may be right in what you are saying about China. This is one of the key problems with Austrian Capital theory and always has been. I think though that it may be possible in the future to measure this, but it isn’t at present.

    These days both sorts of misallocation will cause increased temporary unemployment of labour. Because jobs are in most cases skilled and quite specifically tied to industries and parts of the production process.

    To put it in a bit of a tragicomic way. When I lived in England two years ago some acquaintances of mine bought a new house with a home-loan that charged a low rate for the first few years. They bought the house on the expectation that it would rise in price. On that same expectation they bought a new sports car for a bit of fun. Now there is a crisis housing speculators, house builders and sports car builders must all take a loss.

    Of course there are plenty of businesses and other agents whose plans are consistent with a sustainable production structure. They’ll only take run into problems caused by the secondary recession.

    Jon,

    ABCT is already in “marginalist terms” as stated by Hayek and Mises. You are putting it in terms of aggregates, that’s putting it into Marshallian terms. What you have described is really a sort of post-Keynesian business cycle theory. There are no “units” of capital in ABCT. If capital were homogeneous ABCT would be useless. Read Garrison’s slides:
    http://www.auburn.edu/~garriro/macro.htm

  79. Gravatar of ssumner ssumner
    14. July 2009 at 06:54

    Current, I’m not sure I know exactly where we disagree. I agree that fiber optic lines and sub prime housing markets fit the Austrian story. I just think they tend to apply it to too many cases that don’t. Certainly the cities are exactly where China needs lots more housing. And a generalized fall in manufacturing is, in my view, never a misallocation story. It is always to little AD (unless of course you are going from unusually low unemployment to normal, like 1945-46. But we are obviously not in that situation.

  80. Gravatar of Current Current
    14. July 2009 at 07:23

    Scott: “I just think they tend to apply it to too many cases that don’t. ”

    I think that’s a valid criticism.

    Scott: “and a generalized fall in manufacturing is, in my view, never a misallocation story.”

    When people’s expectations of their future wealth are harmed that must have an effect on their present behaviour. In terms of productivity theory of interest, the expectation of future benefits from improved productivity turns out to be incorrect for some agents. So, they must save more and spend less. In this particular crisis I think it is home-owners who are faced with this problem.

    I’m not so sure about that. “Manufacturing” is a set of stages of production. Some of these deal with goods very far away from their finished form as consumption goods, others with goods much closer to consumption goods.

    Retailing and some services are certainly closer to consumer goods. Research and Development, most mining and commercial building construction are much further away. I think it’s hard to say that manufacturing lies closer to consumption goods on the Hayek triangle or further away. So, I don’t think it’s clear that a decline in manufacturing must always be because of AD, or that it must not be.

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