From Correction to Crisis

I have often told the young athletes I work with that there are two pains they must choose between -- the pain of hard work, or the pain of regret.  I argue that the pain of regret will sting for much longer.

In the context of the Great Depression, one has to remember that after the stock market crash in 1929 market corrections were set in motion.  Resources were reallocated, prices adjusted to the new realities.  By June of 1930, the economy was recovering, when it was hit with the shock of a massive policy shift on tariffs.   The Smoot-Hawley Tariff Act effectively raised the price on 20,000 imported goods by up to 50%.  The consequence of this was the destruction of trade.  Market correction (which works through the vehicle of trade) became a full blown economic crisis.  Restrictions on the market economy were evident from the simplest of trades to the most complicated contractual relationships.

In other words, policy shocks transformed the pain of correction, into the pain of a crisis.

I am deeply concerned that we are repeating this lesson from the Great Depression all over again in the hope of avoiding a particular understanding of the monetary policy failure of the 1929-1933 period.  Yes, removing all the oil out of car will make an engine grind to a halt.  But the Great Contraction, as Robert Higgs has pointed out in Crisis and Leviathan and in Depression, War and Cold War, cannot alone explain the depth and length of the Great Depression.  To understand that, one must examine the policy shocks that prevented market correction through price adjustments and resource reallocation.  The microeconomic environment was distorted and plagued by uncertainty.  In other words, the exchange network was destroyed by government as attempts were made to minimize the pain of market correction resulted in the pain of economic crisis.

What if this is what we are doing again --- stopping necessary market corrections to imprudent decisions in the past and in the process transforming a correction into a crisis.

Comments

[Richard Ebeling]

The emphasis that has been given to the monetary contraction in the early 1930s has overshadowed the degree to which governments at that time resticted market flexibility.

Not only the tariff increases, as Peter brings out, but the resistence in general to price and wage adjustments.

Vedder and Galloway highlight in their book, "Out of Work," the degree to which, on average, real wages rose from the employers' perspective due to prices moving downwards more than money wages between 1929-1933. Thus, the cost of hiring labor was increasing helping to cause a prolonging and increase in unemployment.

These rigidities were understood and emphasized by the free market economists of that time, and not only by Mises, Hayek, and Robbins, for instance.

In 1931, Moritz J. Bonn delivered the annual Richard Cobden lecture in London on "The Manchester School and the Economic Crisis." (Bonn may not be well-known to many classical liberal and Austrian Economists nowadays, but he was a prominent and respected free market thinker who left Germany in 1933 and taught for most the remainder of the 1930s at the LSE before moving to the U.S.)

He details the imbalances and distortions dragging economies down due to tariffs, rigid prices and wages, government-sponsored cartel schemes to limit output and price adaptation, etc.

He asked, how can balance be stored when some prices are being adjusted downwards but an entire network of complementary prices are being kept above post-boom market clearing levels? No wonder, he points out, the crisis keeps getting worse.

There were many such free market writers at the time.

Unfortunately, many of the most prominent economists at the present time are all advocating more government and more spending.

"Der Speigel" recently asked five Nobel Prize-winning economists to share their views on the current crisis, including Robert Lucus.

He called for more spending and more monetary expansion to just "pump" our way out of the crisis.

Richard Ebeling

[Rafael Guthmann]

""Der Speigel" recently asked five Nobel Prize-winning economists to share their views on the current crisis, including Robert Lucus.

He called for more spending and more monetary expansion to just "pump" our way out of the crisis."

It appears that Lucas only believes in his theory of business cycles if it is in the blackboard...

[Bogdan Enache]

For more commentary from top top economists related to current economic affaires, read also this timely e-book, "What G 20 leaders must do to stabilise the economy and solve our financial problems" by Barry Eichengreen and Richard Baldwin http://www.voxeu.org/reports/G20_Summit.pdf

[Rafe Champion]

Pete, what is the rejoinder to people who downplay the role of Smoot Hawley on the grounds that there was not very much economic activity across the national border at the time?

http://clubtroppo.com.au/2008/11/18/some-economic-commentary/

[Peter Boettke]

Rafe,

I spoke too loosely --- the tariff act along with several other policy steps destroyed trade, not just the tariff act itself. Only 6% of GNP in some higher bound estimates consisted of imports. But we need to also look at retaliatory policies which cut down US ability to export.

But no doubt it was a series of policies, including the doubling of the income tax, etc. that "destroyed" the trading enviroment.

Anyway, my fault should be more careful with sweeping statements.

Pete

[Steve Horwitz]

Richard wrote:

"Vedder and Galloway highlight in their book, "Out of Work," the degree to which, on average, real wages rose from the employers' perspective due to prices moving downwards more than money wages between 1929-1933. Thus, the cost of hiring labor was increasing helping to cause a prolonging and increase in unemployment."

V&G's book is excellent and any Austrians who haven't read it, should.

Their point is even stronger than Richard's summary lets on. They rightly note the increasing real wage due to the price level falling more quickly than nominal wages, but they ALSO point out that when you factor in declines in productivity (which should cause real wages to FALL), the "productivity-adjusted real wage" rose even further during the 30s (thanks to bad policy), causing the unprecedented levels of unemployment.

It was gov't policies that caused both the fall in the price level (the deflation) and the downward stickiness of nominal wages (Hoover then FDR jawboning businesses and the indirect effects of the tariff). It arguably also caused the productivity declines as well. The sum of those three effects was massively over-priced labor and the subsequent devastating unemployment levels.

[matthew mueller]

My "nasty" response to all this can be found here:

http://post-austrianeconomics.blogspot.com/

[Richard Ebeling]

Steve is right about the degree to which real wages were kept artifically high due to sticky money wages and falling productivity, as Vedder and Galloway explain in great detail.

If I may summarized their argument:

In November 1929, President Herbert Hoover met with leading American business and labor leaders; he told them that in this period of crisis purchasing power had to be maintained to keep the demand for goods and services high.

He argued that wage rates should not be cut, that the work week should be shortened to “spread the work” among the labor force, and that governments at all levels should expand public works projects to increase employment.

Under the persuasion of the president and then through the power of trade unions, the money wage rates for many workers were kept artificially high. But this merely created the conditions for more, rather than less, unemployment.

In 1930, consumer prices fell by 2.5 percent, while money wages declined on average by 2 percent. In 1931, consumer prices fell by 8.8 percent, while money wages decreased by only 3 percent.

In 1932, consumer prices declined by 10.3 percent, while money wages decreased by only 7 percent. In 1933, consumer prices fell by 5.1 percent, and money wages decreased by 7.9 percent. While consumer prices fell almost 25 percent between 1929 and 1933, money wages on average only decreased 15 percent.

Besides money wages lagging behind the fall in the selling prices of consumer goods through most of these years, labor productivity was also falling—by 8.5 percent. As a result, the real cost of hiring labor actually increased by 22.8 percent.

The “high-wage” policy of the Hoover administration and the trade unions, therefore, only succeeded in pricing workers out the labor market, generating an increasing circle of unemployment.

This certainly helped the Great Depression become "great."

Since there is much talk today about the current crisis being as severe as the early 1930s, it is worthwhile recalling some of the facts of that period.

Between 1929 and 1933, the gross national product in the United States decreased by 54 percent, with industrial production declining 36 percent. Between 1929 and 1933, investment spending decreased by 80 percent, while consumer spending declined by 40 percent; expenditures on residential housing declined by 80 percent.

In 1929, unemployment had been 3.2 percent of the civilian work force; by 1932 unemployment had gone up to 24.1 percent, and it rose even further, to 25.2 percent, in 1933.

The wholesale price index decreased by 32 percent from 1929 to 1933, and the consumer price index decreased by 23 percent. American agriculture saw the prices paid by farmers for raw materials, wages, and interest decrease by 32 percent, while the amounts farmers received for their output decreased by 52 percent.

Between 1930 and 1933, 9,000 banks failed in the United States, and tens of thousands of people lost their savings. The money supply (measured as currency in circulation and demand and time deposits, or “M-2”) decreased by more than 30 percent between 1929 and 1933. Even if a larger measurement of the money supply is calculated (“M-2” plus deposits at mutual savings banks, the postal savings system, and the shares at savings and loans, a measurement known as “M-4”), the supply of money still decreased by about 25 percent between 1929 and 1933.

Internationally, the Great Depression was also devastating. The value of global imports and exports decreased by almost 60 percent, while the real volume of goods and services traded across borders declined by almost 30 percent.

The gross domestic product fell by 5 and 7 percent, respectively, in Great Britain and France between 1929 and 1933. From 1929 to 1932, industrial production fell 12, 22, and 40 percent, respectively, in Great Britain, France, and Germany. Wholesale prices fell, on average, 25, 38, and 32 percent, respectively, in Great Britain, France, and Germany. Declines in consumer prices were 15 percent on average in both Great Britain and France, and 23 percent in Germany during this period.

We have not, yet, approached anything like numbers of this magnitude.

Richard Ebeling

[PCLE]

Some of the commentators (Horwitz, Ebeling) appear to be in error in regards to productivity.
As I understand it from Kendrick's figures, labor productivity increased by 25% between 1929-1939.

[Steve Horwitz]

PCLE,

You give us a ten-year period. The Vedder and Gallaway figures focus on 1929-33 and the question of what made the Great Depression "great". It's possible, and I don't know the numbers, that productivity increased between 33 and 39 such that the ten-year series is positive even though the first 4 years were negative.

In any case, take it up with Vedder and Gallaway.

[Peter Boettke]

Matthew,

What is the point of your "criticism"? BTW, I have never argued with your tone, I have pointed out that you are confused. That is different. Your confusion comes from the fact that you make statments about positions that you really don't understand. A case in point is the discussion of Henry's paper. His paper is a classic example of the sort of bad scholarship that gets published sometimes in heterodox circles and guarantees that it will remain heterodox. First, he assumes an ascendency of laissez faire that actually isn't there in the policy arena (prove that point --- is the Washington Consensus really laissez faire, or it is actually just conservative Keynesianism?). Second, he equates a variety of arguments from Milton Friedman with F. A. Hayek and Robert Lucas which demand a more subtle analysis (is new classical economics the same as Austrianism? Perhaps a reading of Kevin Hoover can fix that). Third, he examines the funding trail of different organizations as if the Cowles Commission, Ford Foundation, NSF, etc. didn't swamp the amount. Heck, the New School received a giant grant not many years ago from Ford. (A nice discussion might be found in Phil Mirowski's work on the economics of science across the board --- though Phil, as brilliant as he is, has a hard time keeping his enthusiasm on track in discussions of the founding of the Chicago School).

In the movie the Right Stuff, there is a great line: "No bucks, no Buck Rodgers." Well this is true of science in general. Science advances due to 3 factors --- ideas, funding and positions. A scientific movement that has ideas, but no funding and positions dies out. A scientific movement without ideas, but with funding and positions will also die out because ultimately the ideas are the currency in this realm of human endeavors. UMKC has centers, it has faculty, and it engages in a series of activites to promote their heterodox agenda. Aren't there conferences that heterodox economists put on to promote their ideas? Oh, I don't really have to wait for your answer becasue I know they do because I have actually used some grant money that I raised to help support their cause. Perhaps you should help me get it back if you think it taints the purity of the cause!?

Tone isn't the issue, being naive and too convinced of your own mastery of the material is. Study hard, read widely, and think seriously ... back that up by learning to write clearly for the journals --- and then again tone will not matter because the force of your argument may very well be enough to win the day.

Pete