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Slouching Towards Utopia?
10:
9253
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DRAFT
6.08 August 27, 2019
Slouching Towards Utopia?
:
An
Economic History of the
Long
Twentieth
Century
X. The Great Depression
J. Bradford DeLong
U.C. Berkeley
Economics and Blum Center,
NBER
, WCEG
<
https://www.icloud.com/pages/0mzIvbURq0n3I0Ct0e3aCZbEw
>
10.1: Understanding the Industrial Business Cycle
10.1.1: Jean-Baptiste Say’s Law
Back when market economies emerged, there was great worry that things would
not necessarily fi t together: Might not the farmers be unable to sell the crops they
grew to the artisans because the artisans could not sell the products they made to
the merchants who would be unable to make money carrying artisans products to
the farmers because the farmers would not purchase anything? B
ack at the
beginning of economics it was
Jean-Baptiste Say
who
wrote that
such an
idea of a
“general glut”—of economy-wide “overproduction” and consequent mass
unemployment—was incoherent. Nobody, Say argued, would ever produce
anything
for sale
unless they expected to use the money they earned in order to buy
something else.
Thus, “by a metaphysical necessity”, as
subsequent-generation economist
John
Stuart Mill
outlined Say’s argument
in 1829, there can be no imbalance between
the aggregate value of planned production-for-sale, the aggregate value of planned
sales, and the aggregate value of planned purchases. This is “Say’s Law”.
P
roducers could certainly guess wrong about what consumers wanted—
an
economy could easily have
an excess of washing machines
and a shortage of
yoga
classes, if producers had mistaken what consumers wanted and so assembled white
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goods rather than learning how to do the Downward-Facing Dog
.
E
xcess demand
for and high profi ts in making commodities
in
short supply and excess supply of
and losses in making commodities in surplus
was not a bug but a feature: the
market gave incentives to quickly shift resources to erase such imbalances. But an
excess supply of well-nigh everything? That, Say said, was impossible
.
But what if
you wanted to buy before you had sold—if the artisan wanted to buy food before
the merchant had come around to buy the textiles? That, said Say, was what banks
and trade credit were for: “
merchants know well enough how to fi nd substitutes for
the product serving as the medium of exchange
”.
10.1.2: The Panic of 1825
Karl Marx dismissed this as the “childish babbling of a Say”. One did not just sell
in order to buy: one might be forced to sell in order to pay off an old debt if credit
that had been extended by some bank was withdrawn. In that case, the demand for
goods was in the past, and could not in the present balance out your supply. If
everyone was trying to sell in order to pay off old debts, there would indeed be a
“general glut”. And if those who were calling in loans saw businesses collapsing
into bankruptcy around them, they would be unlikely to be wiling to provide
“
substitutes for the product serving as the medium of exchange”
.
As
John Stuart Mill
put it
:
T
hose who have... affi rmed
… [the possibility of]
an excess of all commodities,
never pretended that money was one
…. P
ersons in general, at that particular
time
…
liked better to possess money than any other commodity. Money,
consequently, was in request, and all other commodities were in comparative
disrepute....
T
here would seem
…
no particular impropriety in saying that there is
a superabundance of all or most commodities, when all or most of them are in this
same predicament
…
And if all or nearly all goods and services save money are at one moment in excess
supply, factories will be shut and workers will be jobless—and the fact that
shareholders then have no dividends, lenders have no interest payments, and
workers have no wages will further widen the gap between the aggregate-supply
productive potential of the economy and the current level of aggregate demand.
Say came to recognize that Marx and Mill were correct.
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After the British Canal Panic of 1825, Say changed his mind. Led by the Bank of
England, the banks and merchants of England decided in late 1825 that they had
made too many loans to too many counterparties whose investments were not
turning out well. Therefore they ceased to be willing to discount as many bills—to
advance cash in return for being given title to promises to pay that merchants had
received from customers. Thus, Say wrote: “commerce found itself deprived at a
stroke of the advances on which it had counted, be it to create new businesses, or
to give a lease of life to the old.” And the consequence, Say wrote, was fi nancial
and economic collapse: a true “general glut”: “Businessmen… fi nding no more
advances from the bankers… use[d] up all the resources at his disposal. They sold
goods for half what they had cost… a multitude of workers were without work…
bankruptcies… among merchants and among bankers… individuals… bankrupt…”
What of Say’s 1803 declaration that when there is a shortage of money in an
economy, merchants “know well enough how to fi nd substitutes for the product
serving as the medium of exchange”? Money and credit are, in the last analysis,
liquid trust. And if there is not trust that your counterparty is solvent, the money
and credit will not be there.
10.1.3: Central Banking and Other Expedients
There is one organization that always—or almost always—is trusted to be good for
the money. The government accepts the money that it itself issues as payment for
taxes, and so everybody who owes taxes will be willing to sell what they have in
return for the money the government has printed up. Whenever the economy
freezes up due to a shortage of demand and of income, the government can fi x it—
as long as its own fi nances are trusted over the long term—by boosting the amount
of government-issued cash in the hands of the public. People who then needed to
buy but could not afford to buy because they would not sell will be able to buy.
Their purchases then become extra income for others. Those others will then be
able to scale up their purchases. And so the economy will unwedge itself.
What if the government’s fi nances are not trusted over the long term? Then the
government itself may need a fi nancial rescue: that is what we have an
International Monetary Fund to do. As long as there is one entity somewhere in the
world that is trusted to be good for the money, that entity can issue the cash and
provide the credit needed for the economy to bootstrap itself out of a “general glut”
and back to a normal circular flow of economic activity: production, sales, and
then purchases.
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There are a number of ways the government can get extra purchasing power into
the hands of the public to cure a depression:
1.
It can have its functionaries throw bundles of cash out of helicopters—an
arresting image coined originally by Milton Friedman, a reference to which
earned former U.S. Federal Reserve Chair Ben Bernanke his nickname of
“Helicopter Ben”.
2.
The government can hire people, set them to work, and pay them.
3.
The government can simply buy useful stuff.
4.
The government can have an arm—a central bank—that trades fi nancial assets
for cash.
This last is the dominant expedient. A central bank buys fi nancial assets for cash
when it believes that the flow of purchasing power through the economy is too
slow for a proper level of employment and economic activity and is risking
depression, and that sells fi nancial assets and so pulls cash out of the economy
when it believes
that the flow of purchasing power through the economy is too
rapid
for a proper level of employment and economic activity
and is risking
unwantedly-high inflation.
In making its judgments, central banks are always guided by what the levels of
interest rates are in the economy: Are interest rates above the current guess of the
“neutral” rate—the rate that would prevail if issues of trust and potential
bankruptcy other were not disturbing incentives and willingness to lead and invest?
Then the economy needs more cash or there will be pointless high unemployment,
and the central bank should provide the cash.
Are interest rates
below
the
current
guess of the “neutral” rate
? Then some people and institutions in the economy have
purchasing power that is not backed by realistic expectations of the value of their
undertakings, and unless the cash is pulled out there will be either inflation—as the
unexpectedly-low quantity of goods that are produced are sold for the higher
money values that had been anticipated—or bankruptcies, or both.
In response to the Canal Crisis of 1825, the Bank of England took major steps to
boost the cash holdings—and thus the spending—of the banks, businesses, and
individuals of England, trying to relieve the “general glut”. As Jeremiah Harman,
then one of the Directors of the Bank of England, wrote: “
We lent [cash] by every
possible means and in modes we had never adopted before; we took in stock on
security, we purchased Exchequer bills, we made advances on Exchequer bills, we
not only discounted outright, but we made advances on the deposit of bills of
exchange to an immense amount, in short, by every possible means consistent with
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the safety of the Bank, and we were not on some occasions over-nice. Seeing the
dreadful state in which the public were, we rendered every assistance in our
power
…”
There was a depression: 16
%
less cotton was spun into yarn in England in 1826
than had been in 1825. But the depression was short: 1827 saw 30
%
more cotton
spun into yarn than 1826 had.
There is good reason to fear that the downturn would
have been considerably worse had the Bank of England behaved like the U.S.
Treasury and Federal Reserve
were going to behave
in the early 1930s, and washed
their hands of the situation.
10.2: Managing the Business Cycle Before 1929
10.2.1
:
The Bank of England
10.2.1.1:
Robert Peel and the 1844 Recharter
The actions that the Bank of England had undertaken in its own in 1825 had been
at the behest of the British government. In the runup to the crisis, the Chancellor of
the Exchequer—the Finance Minister—had warned banks that in his opinion they
were extending loans to shaky and overspeculative enterprises, and they should not
expect to be bailed out by the Treasury: they should not think that they could play
the game of “heads we profi t, tails the government bails us out”. But, of course,
when the commercial crisis came and the prospect of many bankruptcies, large
scale unemployment, and riots against the government on the streets of London
threatened, the Chancellor gave his blessing to the Bank of England’s stepping in
to do what the Chancellor had promised and threatened that the Exchequer had not.
In 1844
the time came around to reexamine and recharter the Bank of England.
The British Parliament took a look at the system of central-bank support for the
economy in a fi nancial crisis that the Bank of England’s intervention in 1825 had
created a precedent for
. In the end, the conclusion of the
debate led by Prime
Minister Robert Peel and the subsequent
1844 Bank
of England
Recharter
was
twofold
:
1.
The Bank of England should
defi nitely
not
be authorized by Parliament
to print
unlimited amounts of money to support the banking system in a fi nancial crisis
—in fact, it should be illegal for the Bank of England to print extra banknotes
in a crisis.
B
ankers should be on notice that they should not expect a bailout—
for that would create too great a risk of substantial losses from
“
moral hazard
”,
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as the game of heads-we-profi t-tails-the-government-bails-us-out was just too
tempting to expect bankers to resist.
2.
In the event of a real
fi nancial
emergency
,
the government could and would
request that the Bank of England print as many banknotes as needed to fi x the
fi nancial crisis.
The reason for (1) was very clear to the Parliamentary debaters back in 1844. Any
confi dent expectation on the part of the fi nancial community that the Bank of
England did stand behind them and would intervene to prevent large-scale
bankruptcy in a fi nancial crisis would greatly amplify the chances of such a crisis
by removing fear and caution. Bankers confi dent that in the last analysis they were
gambling with the public’s money would do what bankers tend to do in such
situations
: the only question, as fi nancier Bill Janeway of Warburg Pincus likes to
say, is against which wall bankers will do it.
Hence, Robert Peel and his majority
in the Parliament thought, it was very important to establish the principle that the
Bank of England could
not
be relied upon to bail out the banking system. And, Peel
thought, the best way to establish that principle would be to make it
illegal
for The
Bank of England to do so.
10.2.1.2
:
“Moral Hazard” and the “Lender of Last Resort”
But the mere fact that the Act had made what Charlie Kindleberger calls lender-of-
last-resort operations in a fi nancial crisis illegal did not mean that they should not
or would not be undertaken. As Peel wrote: “We have taken all the Precautions
which legislation can prudently take up against the Recurrence of a pecuniary
Crisis. It may occur… and if it be necessary to assume a grave responsibility for
the purpose of meeting it, I dare say men will be found willing to assume such a
responsibility. I would rather trust to this than impair… those measures by which
one hopes to control evil tendencies in their beginning.”
As
Kindleberger put
s
it
:
“if the market is sure that a lender of last resort exists, its
self-reliance is weakened”
, and hence it is needed more often, and the real
resources thrown down the toilet in the course of what are speculations on a future
bailout
are increased. This
led Kindleberger to the conclusion that:
“
The lender of
last resort... should exist... but his presence should be doubted.... This is a neat
trick: always come to the rescue in order to prevent needless deflation, but always
leave it uncertain whether rescue will arrive in time or at all, so as to instill caution
in other speculators, banks, cities, or countries.... some sleight of hand, some trick
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with mirrors... [because
market
] fundamentalism has such unhappy consequences
for the economic system.
”
10.2.1.3
: Suspension Letters
Peel’s expectations of how the British government would act in what was his future
if what he called a “grave responsibility” came to rest on the Governor and Court
of
the Bank of England
were correct. Men at the Bank of England were found
willing to act
ultra vires
—beyond their [legitimate] strength—
under the principle
that in the end
—
salus populi suprema lex
—the well-being of the people is the
highest law. But they would
not
print cash and so
expand their balance sheet
beyond its legal limit purely on their own initiative. They required a blessing from
the government of the day.
The blessing took the form of a “suspension letter”
written by the Chancellor of the Exchequer. First in 1847 and then in 1857 and
then in 1866, the Chancellor would write a letter to the Governor of the Bank of
England stating that he was suspending for the duration of the fi nancial crisis those
provisions of the 1844 Bank Recharter Act of 1844 that restricted the Bank of
England’s ability to expand its balance sheet. Nothing in the black-letter law or in
previous custom gave the Chancellor any such power to at his will suspend
provisions of a corporation charter and grant the corporation extra privileges and
powers above those Parliament had granted it. Successive Chancellors did so
anyway.
10.2.2
:
Karl Marx’s View
Karl Marx loathed Robert Peel: “
Peel himself has been apotheosized in the most
exaggerated fashion...
his
speeches
…
consist of a massive accumulation of
commonplaces, skillfully interspersed with a large amount of statistical data
”. He
loathed him not least for the Bank Recharter: “
Sir Robert Peel's much vaunted
Bank law
…
adds in diffi cult times a monetary panic created by law to the
monetary panic resulting from the commercial crisis; and
…
must be suspended by
Government interference
.” And how he did rage! He asked, how it could dare be
that:
the Committee has contrived to simultaneously vindicate the perpetuity of the law
and the periodical recurrence of its infraction? Laws have usually been designed
to circumscribe the discretionary power of Government. Here, on the contrary, the
law seems only continued in order to continue to the Executive the discretionary
power of overruling it. The Government letter, authorizing the Bank of England to
meet the demands for discount and advances upon approved securities beyond the
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limits of the circulation prescribed by the Act of 1844, was issued on Nov. 12
.
Marx did not understand that the suspension was the point
—that what was needed
for the avoidance of deep depressions was Kindleberger’s
“neat trick... sleight of
hand... trick with mirrors”
that
made it possible for the “lender of last resort... [to]
exist... but [for] his presence [ex ante] t
o
be doubted”
:
“come to the rescue
[always]
in order to prevent needless deflation, but always leave it uncertain
whether rescue will arrive in time or at all, so as to instill caution.”
10.2.3
:
The Magnitude of the Cycle Pre-Great Depression
10.2.3.1: A Chronic Malady Never Completely Cured
Monetary management was not the only way that governments managed the
business cycle. Many governments undertook, and many economists including
libertarian stalwart Frederic Bastiat approved direct employment of the
unemployed on public-works programs, which “a
s a temporary measure in a time
of crisis
… [has]
good effects... as insurance
…
. [It] takes labor and wages from
ordinary times and doles them ou
t…
in diffi cult times.
” That governments could
always print money and purchase stuff to put lots more people to work was
suffi ciently demonstrated by observing that unemployment was never high in a
serious war.
The business cycle in industrial economies was never cured. Ever since 1825, at
least, industrial market economies have been subject to the recurrence of this
particular kind of macroeconomic epileptic seizure. Central banks could and did
dampen, but not eliminate the cycles.
It may be that you can see this difference looking across the Atlantic Ocean from
Britain to the United States. Britain had a central bank: the Bank of England. Until
1913, when the Federal Reserve was established, the United States did not. Indeed,
the sharp depression of 1907 was the trigger for the creation of the Federal
Reserve.
Before World War II, the typical economic recession in Britain would last for a
year or two, and see a perhaps three to six percent decline in national income and a
perhaps fi ve to ten percent decline in industrial production—until the severe
downturn of 1918-1921 which carried national income per capita down by 21
%
.
British national income per capita did not recovery to its 1914 level until 1929, and
then it immediately dropped again, recovering for good only in 1934.
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The United States had no central bank to lean against the wind and try to smooth
out monetary conditions. At best, it has a few emergency expedients by a U.S.
Treasury shipping gold out of its vaults to provide an emergency boost to the
money stock, and occasional pick-up committees of the wealthiest and soundest
major New York bankers taking coordinated collective action to try to do for New
York fi nance what the Bank of England had done for London fi nance in 1825. That
is quite possibly why, while a typical economic recession in the United States
would also last for a year or two, it would see a larger of perhaps fi ve to ten percent
decline in national income and a perhaps eight to fi fteen percent decline in
industrial production—until the catastrophic Great Depression of 1929-1933,
which carried American national income per capita down by 29
%
.
10.2.3.2
:
Why Wasn’t the Cycle Better Managed?: Ideology
Why was monetary and other tools of macroeconomic management not able to
flatten out but only to damp business cycles? A fi rst reason was the dominance in
the public sphere of the economic doctrine of
laissez faire
: that the government
should establish private property rights, markets, courts to enforce contracts, and
otherwise let the market economy run itself—that that would be the best: “to the
philosophical doctrine that the government has no right to interfere, and the divine
that it has no need to interfere, there is added a scientifi c proof that its interference
is inexpedient
”. This was always much more what journalists and politicians said
professional economists taught than what professional economists actually taught.
Ideology was reinforced by experience. As Keynes noted:
T
he corruption and incompetence of eighteenth-century government
….
Almost
everything which the State did in the eighteenth century in excess of its minimum
functions was, or seemed, injurious or unsuccessful.
[And] on
the other hand,
material progress between 1750 and 1850 came from individual initiative
.
Why should the business cycle be any different?
The market giveth, the market taketh away: blessed be the name of the market.
That central banks and relief agencies had the role they did was due to much uphill
rolling of the boulder against a strong intellectual and ideological gradient.
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10.2.3.3
:
Why Wasn’t the Cycle Better Managed?: Instability
A second reason is that demand for cash was and is very unstable. People talk to
each other, and communicate their hopes and fears. Investors’, managers’,
entrepreneurs’, and fi nanciers’ tolerance for bearing risk, expectations of future
profi ts, and knowledge of opportunities shifted substantially and randomly in
waves. With these shifts came rises and falls in how much of their wealth they
wish to hold in cash. The central bank’s task was to match the economy-wide
supply of money to this fluctuating economy-wide demand. When it succeeded,
aggregate demand is matched to the potential to produce aggregate supply: Say’s
Law—that the potential to supply creates its own demand—was then true in
practice, even though it remained false in theory.
When they failed on one side, and there was an excess demand for money, the flip
side of that excess demand for money was an excess supply of pretty much all
goods and services: a “general glut”, a depression. When they failed on the other
side, there was unexpected inflation. And so the capitalist market economy lurched
forward, subject to this chronic and horrible but not catastrophically debilitating
malady—until 1929, and the coming of the Great Depression.
10.3: The Slide into the Great Depression
10.3.1: 1929-1933
10.3.1.1: The Initial Trigger
It is straightforward to narrate the slide of the world into the Great Depression. The
1920s saw a stock market boom in the U.S. as the result of general optimism:
businessmen and economists believed that the newly-born Federal Reserve would
stabilize the economy, and that the pace of technological progress guaranteed
rapidly rising living standards and expanding markets. The U.S. Federal Reserve
feared continued stock speculation would produce a huge number of overleveraged
fi nancial institutions that would go bankrupt at the slightest touch of an asset price
drop. Such a wave of bankruptcies would then produce an enormous increase in
fear, a huge flight to cash, and the excess demand for cash that is the flip side of a
“general glut”.
The U.S. Federal Reserve decided that it needed to curb the stock market bubble to
prevent the growth of such speculative overleverage that would provide a trigger
for a depression. And it overdid it. The Federal Reserve’s attempts in 1928 and
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