I love financial history. here's a good take (but not wholly logical) on a rough timer in American history.
The "Mysterious" Great Depression
Wednesday, May 30, 2007
Economists like to pose and solve puzzles. In fact, they like it so much that they manage to detect puzzles where no one else ever suspected their presence.
The depression that began, by most accounts, with the stock-market crash of 1929, is regarded by many economists as the biggest puzzle of all, or at least as a giant treasure-trove of smaller puzzles awaiting economists' brilliant (or at least clever) solutions.
Of course any economic event of such tremendous scope and magnitude-the Great Depression lasted over a decade (by some accounts, closer to two decades), and eventually embraced all of the world's industrialized nations-is bound to keep researchers busy sifting for evidence and discovering new insights, for many decades if not forever. Still, many economists seem determined to exaggerate the extent to which this particular episode-and its American manifestation in particular-challenges economic orthodoxy. To read what some economists, and especially those writing for professional journals, have to say about the 1930s cataclysm, you would think that they are just beginning to locate loose strands in a previously impenetrable, giant knot.
Which is rubbish-and self-serving rubbish at that. The rubbish is self-serving because it exaggerates the novelty of the economists' discoveries, thus helping to clear a path toward publication, and also because, in many instances, it supplies an excuse for what might otherwise look like economic obtuseness. Of course, the excuse only works if one overlooks those economists who got things right long ago, whose works are systematically overlooked by their modern counterparts, who instead of referring to them have the brass to claim credit for their recent "discovery" that the National Recovery Administration (to give just one example) may not have been all that it's been cracked up to be. Well, give them credit for progress, if not for scholarship: it hasn't been all that long, after all, since their likes unhesitatingly held up the Great Depression as proof of the inherent instability of capitalism, while entirely ignoring the many ways in which interventionist policies both created and prolonged it.
In truth, while old-fashioned economic theory may not explain every facet of the depression, it explains the major features: the oft-repeated claim that "classical" economics could offer no explanation for what happened (see, for example, Paul Krugman, http://www.nybooks.com/articles/19857) is not even fully valid for the genuinely "classical" economics of the years prior to the marginalist revolution of the 1870s. As a statement meant to refer as well to the neo-classical economics of Knut Wicksell, Ludwig von Mises, Ralph Hawtrey, Dennis Robertson, and a host of other post-1870 but pre-Keynesian thinkers, the claim is a bald-faced lie.
Thanks in part to the contributions of those neo-classical thinkers we know, for example, that a restoration of the international gold standard, following the massive monetary expansions that took place during and after World War I, could only be lastingly secured by means of aggressive devaluation or deflation or a combination of both. We know this from the rudimentary theory of international exchange.
We also know that the post-WWI attempt to limit the need for deflation or devaluation, by erecting a "cheap" gold exchange standard, was fraught with danger, because a crisis in any of the participant countries could cause the entire house-of-cards to come tumbling down, spreading the crisis worldwide. We know this from the elementary theory of cartels, which tells how they are bound to collapse if any participant decides to cheat.
We know that a fragmented, unit banking system increases the risk of bank failures owing to sector-specific or regional shocks. We know this from the first principles of finance.
We know that widespread bank failures can cause a run into currency, which must lead, ceteris paribus, to monetary contraction. We know this from old-fashioned banking theory. We know that state-declared bank "holidays" will only cause more people to withdraw their deposits. We know this by a simple appeal to common sense.
We know that a central bank, faced with a monetary crisis, can avert it only by means of generous issues of base money, and not by stubbornly refusing to sanction a reduction in its own ratio of gold reserves. We know this from reading Walter Bagehot's famous Victorian-era manifesto, Lombard Street.
We know that a massive reduction in a nation's money stock must result either in a deflation of like magnitude or in a "general glut" of goods and general unemployment. We know this from the elementary workings of supply and demand.
We know that recovery from a general glut is impossible to the extent that policies stand in the way of downward price adjustment. We know this also from the elementary theories of supply and demand. (Of course we also know that attempts to raise prices of goods that are in excess supply, or to raise the price of labor when there's already massive unemployment, are bound to make things worse.)
We know that price controls, besides preventing the price level from adjusting in such a manner as to eliminate general gluts or general shortages of goods, also distort the structure of relative prices, thereby undermining efficiency and productivity. We know this from observations of the effects of price controls going back to ancient times.
We know that high tariffs also undermine productivity and economic prosperity. We know this from the most orthodox theories of international trade.
We know, in short, many things that together allow us to go a long way in "unraveling" the knottiest of all economic crises-and we can learn most of these things without having to look beyond the most basic economics textbooks, including textbooks dating from before the 1930s.
Paradoxically, perhaps, the fact that orthodox economics has a good deal to say about how the Great Depression happened itself suggests that there is after all something puzzling about the Great Depression. What's puzzling is not that the depression happened, given policies that were resorted to, but that such destructive policies secured wide support despite their often readily-predictable, adverse consequences. But to call even such perversity a "mystery" is to be guilty of hyperbole. After all, politicians are rewarded for appearing to "do something," and not for their command of "abstract" theories.
And here, perhaps, is the key to modern economists' tendency to exaggerate the mysteriousness of the Great Depression. Look closely at their theories, and chances are you will find that they hold the Great Depression to be mysterious only in a very special sense, to wit: the sense that the events that unfolded cannot be replicated using models populated solely by well-informed and well-meaning, utility-maximizing agents. The problem, in short, isn't a lack of theories capable of explaining how particular government policies went wrong. It is the lack of a sound theory of government itself-a theory of the actions of politicians, whose behavior is often far removed from that of the "representative agents" that populate most macro-economic models. To understand political behavior one must turn, not to self-styled experts on macroeconomists and business cycles, who apparently entertain extremely naïve opinions concerning how governments work, but to specialists of the public-choice school, if not to political scientists and philosophers working outside of the economics profession.
Economists like to pose and solve puzzles. In fact, they like it so much that they manage to detect puzzles where no one else ever suspected their presence.
The depression that began, by most accounts, with the stock-market crash of 1929, is regarded by many economists as the biggest puzzle of all, or at least as a giant treasure-trove of smaller puzzles awaiting economists' brilliant (or at least clever) solutions.
Of course any economic event of such tremendous scope and magnitude-the Great Depression lasted over a decade (by some accounts, closer to two decades), and eventually embraced all of the world's industrialized nations-is bound to keep researchers busy sifting for evidence and discovering new insights, for many decades if not forever. Still, many economists seem determined to exaggerate the extent to which this particular episode-and its American manifestation in particular-challenges economic orthodoxy. To read what some economists, and especially those writing for professional journals, have to say about the 1930s cataclysm, you would think that they are just beginning to locate loose strands in a previously impenetrable, giant knot.
Which is rubbish-and self-serving rubbish at that. The rubbish is self-serving because it exaggerates the novelty of the economists' discoveries, thus helping to clear a path toward publication, and also because, in many instances, it supplies an excuse for what might otherwise look like economic obtuseness. Of course, the excuse only works if one overlooks those economists who got things right long ago, whose works are systematically overlooked by their modern counterparts, who instead of referring to them have the brass to claim credit for their recent "discovery" that the National Recovery Administration (to give just one example) may not have been all that it's been cracked up to be. Well, give them credit for progress, if not for scholarship: it hasn't been all that long, after all, since their likes unhesitatingly held up the Great Depression as proof of the inherent instability of capitalism, while entirely ignoring the many ways in which interventionist policies both created and prolonged it.
In truth, while old-fashioned economic theory may not explain every facet of the depression, it explains the major features: the oft-repeated claim that "classical" economics could offer no explanation for what happened (see, for example, Paul Krugman, http://www.nybooks.com/articles/19857) is not even fully valid for the genuinely "classical" economics of the years prior to the marginalist revolution of the 1870s. As a statement meant to refer as well to the neo-classical economics of Knut Wicksell, Ludwig von Mises, Ralph Hawtrey, Dennis Robertson, and a host of other post-1870 but pre-Keynesian thinkers, the claim is a bald-faced lie.
Thanks in part to the contributions of those neo-classical thinkers we know, for example, that a restoration of the international gold standard, following the massive monetary expansions that took place during and after World War I, could only be lastingly secured by means of aggressive devaluation or deflation or a combination of both. We know this from the rudimentary theory of international exchange.
We also know that the post-WWI attempt to limit the need for deflation or devaluation, by erecting a "cheap" gold exchange standard, was fraught with danger, because a crisis in any of the participant countries could cause the entire house-of-cards to come tumbling down, spreading the crisis worldwide. We know this from the elementary theory of cartels, which tells how they are bound to collapse if any participant decides to cheat.
We know that a fragmented, unit banking system increases the risk of bank failures owing to sector-specific or regional shocks. We know this from the first principles of finance.
We know that widespread bank failures can cause a run into currency, which must lead, ceteris paribus, to monetary contraction. We know this from old-fashioned banking theory. We know that state-declared bank "holidays" will only cause more people to withdraw their deposits. We know this by a simple appeal to common sense.
We know that a central bank, faced with a monetary crisis, can avert it only by means of generous issues of base money, and not by stubbornly refusing to sanction a reduction in its own ratio of gold reserves. We know this from reading Walter Bagehot's famous Victorian-era manifesto, Lombard Street.
We know that a massive reduction in a nation's money stock must result either in a deflation of like magnitude or in a "general glut" of goods and general unemployment. We know this from the elementary workings of supply and demand.
We know that recovery from a general glut is impossible to the extent that policies stand in the way of downward price adjustment. We know this also from the elementary theories of supply and demand. (Of course we also know that attempts to raise prices of goods that are in excess supply, or to raise the price of labor when there's already massive unemployment, are bound to make things worse.)
We know that price controls, besides preventing the price level from adjusting in such a manner as to eliminate general gluts or general shortages of goods, also distort the structure of relative prices, thereby undermining efficiency and productivity. We know this from observations of the effects of price controls going back to ancient times.
We know that high tariffs also undermine productivity and economic prosperity. We know this from the most orthodox theories of international trade.
We know, in short, many things that together allow us to go a long way in "unraveling" the knottiest of all economic crises-and we can learn most of these things without having to look beyond the most basic economics textbooks, including textbooks dating from before the 1930s.
Paradoxically, perhaps, the fact that orthodox economics has a good deal to say about how the Great Depression happened itself suggests that there is after all something puzzling about the Great Depression. What's puzzling is not that the depression happened, given policies that were resorted to, but that such destructive policies secured wide support despite their often readily-predictable, adverse consequences. But to call even such perversity a "mystery" is to be guilty of hyperbole. After all, politicians are rewarded for appearing to "do something," and not for their command of "abstract" theories.
And here, perhaps, is the key to modern economists' tendency to exaggerate the mysteriousness of the Great Depression. Look closely at their theories, and chances are you will find that they hold the Great Depression to be mysterious only in a very special sense, to wit: the sense that the events that unfolded cannot be replicated using models populated solely by well-informed and well-meaning, utility-maximizing agents. The problem, in short, isn't a lack of theories capable of explaining how particular government policies went wrong. It is the lack of a sound theory of government itself-a theory of the actions of politicians, whose behavior is often far removed from that of the "representative agents" that populate most macro-economic models. To understand political behavior one must turn, not to self-styled experts on macroeconomists and business cycles, who apparently entertain extremely naïve opinions concerning how governments work, but to specialists of the public-choice school, if not to political scientists and philosophers working outside of the economics profession.
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