Bryan Caplan writes:
What was the reason for the pre-war depression anyway? A large consensus of economic historians argues, persuasively in my view, that the essential cause of the Great Depression was the international monetary contraction of the late 20's and early 30's. Milton Friedman and Anna Schwartz's A Monetary History of the United States [105] was the seminal academic work which established the magnitude and importance of the monetary contraction in the United States. Barry Eichengreen's Golden Fetters [106] largely extends Friedman and Schwartz's argument to the international economy, showing how the gold standard re-established after World War I was very shaky and wound up yielding an international monetary contraction."
Thoughts, ideas and opinions about this common explanation?
I'm of the opinion that it was the levels of private debt raked up in the years preceding it that led to a long period of delevereging that stifled demand.
The cause of the Great Depression was the interventionist policies of the administrations of presidents Hoover and FDR. The cause of the market crash of 1929 is quite a different issue.
I've read that Friedman and Schwartz just showed a correlation, but gave no logical explanation of causation.
Why does a monetary contraction cause a depression? It should be just the opposite. Monetary contraction means there is less money pursuing the same amount of goods. Which means whoever wants those goods will pay less for them. Great. Isn't the whole point of economic progress that things get cheaper?
Imagine if someone worked ten hours a day and then went home and, instead of spending his paycheck, burned it. That essentially means he worked for free. If you had someone working for you for free, would you be richer or poorer?
Now in the case of the worker who burns his paycheck, or let us say burns his dollars up, somebody loses. He had money and lost it. But in a monetary contraction, that money that contracted did not come out of some ones pocket. All that happened is that banks lost the ability to create new money out of thin air. Nobody lost a dime.
Only if you subscribe to the Austrian theory can one understand why a monetary contractions harmful. And it's not the contraction that is harmful per se, but the expansion of the money supply that preceded it and caused malinvestments, aka burning up precious resources [as opposed to imaginary money]. The contraction merely reveals and lays bare the already existing disaster.
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It's easy to refute an argument if you first misrepresent it. William Keizer
Consumeriat,
Why didn't prices drop enough to revive demand?
Also, when one deleverages, that means one repays ones debts. So the money X has just is handed over to Y. Y can now spend it. Why does demand drop?
"Imagine if someone worked ten hours a day and then went home and, instead of spending his paycheck, burned it. That essentially means he worked for free. If you had someone working for you for free, would you be richer or poorer?"
If I was relying on that same employee to use the money to purchase what was produced, then I would certainly be poorer because I would not be able to sell my product. Also, whilst the worker may have 'worked for nothing' in a colloquial sense, from the employers perspective it only matters that the wages were paid in the first place. So no, the employer is not better off.
"But in a monetary contraction, that money that contracted did not come out of some ones pocket. All that happened is that banks lost the ability to create new money out of thin air. Nobody lost a dime."
I'm not a hundred percent sure what you mean by this, sorry.
"Why didn't prices drop enough to revive demand?"
Well if there is deflation at a time of high indebtedness, the debts rise in relation to people's income. This means that people are even less likely to spend, and eventually will have to default. Debt-deflation occurred like this in the first few years of the GD; you can see an initial spike of private debt between '29 and around '33 on the graph I posted. That was the result of this process.
"Also, when one deleverages, that means one repays ones debts. So the money X has just is handed over to Y. Y can now spend it. Why does demand drop?"
As I say, not all debts will be repaid because of an increased chance of default. Also, even if the debt does get repaid it is most likely repaid to a financial institution who, in a time of depression, are keen to shore up their reserves rather than lend out the money.
1. Why are you relying on that same employee? Plenty of fish in the sea. Let's look at it from another angle. If someone came to your place of business and said he will work for free, will you send him away, saying "Oh no, if you work for free, that will just make me poorer, because I cannot sell you my product. I'll only be richer if I pay you. Decreasing my costs of production will totally ruin me."
2. Are you familiar with fractional reserve banking?
3. There is a law of supply and demand. If people cannot afford stuff, the price will drop until they can. Why are they less likely to spend? Are they less hungry than before?
As for the increase of debt to GDP, that happened because GDP dropped [due to previous wasting of resources, explain Austrians], not because debt increased. How could broke people suddenly get a loan?
As for default, people defaulted on their loans because they foolishly borrowed money to buy stocks they could not afford, gambling the price of the stock would rise. They made their bed. Someone will have to lose money, of course. But someone else had already gained money by selling them that worthless stock. Purchasing power does not just disappear because of defaults.
As Say explained so brilliantly, purchasing power comes from production, not from money supply. The obvious conclusion is that it doesn't go away due to changes in the money supply. Of course, it can be redistributed by giving one fellow a lot of new money, thus taking it away from someone else, but that is another story.
4. When a debt is not repaid, that doesn't decrease purchasing power in the economy as a whole. The money is there. nobody sent it into the phantom zone.
A. A depression is caused by defaults, because otherwise everyone would just spend.
B. But defaults are caused by a depression, for otherwise everyone would just pay their bills.
Are you claiming both A and B? If yes, how do you resolve the contradiction inherent there?
Consumariat:I'm of the opinion that it was the levels of private debt raked up in the years preceding it that led to a long period of delevereging that stifled demand.
Okay, but . . .
Expanding the data even further back, it doesn't look like anything significant happened with debt levels in the 1920-1929 period, especially not when contrasted to the 1981-2009 period. If it's just the debt levls, is there some sort of "tipping point"? And why wasn't there a depression in the 90's? Also, why should debt levels be measured against GDP? And what do you think the contributory factors to increasing private debt levels were?
Why are you relying on that same employee? Plenty of fish in the sea.
I assumed you were making an analogy where the employee represented the workforce of a country, I represented the firms in a country. I may have misinterpreted you.
Let's look at it from another angle. If someone came to your place of business and said he will work for free, will you send him away, saying "Oh no, if you work for free, that will just make me poorer, because I cannot sell you my product. I'll only be richer if I pay you. Decreasing my costs of production will totally ruin me."
Well of course if someone came and offered to work for me without pay, I would be better off. But your first example had me paying out wages first, and him then going and burning his money. Him burning his money has no bearing on the fact I already paid him; I am out of pocket until I manage to sell the goods we produced. Anyway, I'm not sure where this hypothetical scenario is meant to be going.
Are you familiar with fractional reserve banking?
Yes
There is a law of supply and demand. If people cannot afford stuff, the price will drop until they can. Why are they less likely to spend? Are they less hungry than before?
Well people don't spend simply because they are hungry. People will have many places where they can cut back on spending before they are down to living a subsistence life. They might stop buying DVD's, or beer, or potted plants. Demand can drop by a fair amount without the floor of hunger imposing a limit. Unless of course you mean “are they less hungry for potted plants and DVD's?”, in which case the answer is yes.
I think maybe I did not explain myself clearly. I am not saying that broke people were able to take out more loans, I am saying that in a deflationary situation a fixed amount of debt will become a higher burden to an individual because of a declining income.
You are of course correct in saying that some of that increase in debt was due to a decline in GDP, and that is kind of linked to what I am saying – incomes fall but debt levels stay the same, and as a result become more of a burden. Debt rises as a proportion of income.
As for default, people defaulted on their loans because they foolishly borrowed money to buy stocks they could not afford, gambling the price of the stock would rise. They made their bed. Someone will have to lose money, of course. But someone else had already gained money by selling them that worthless stock. Purchasing power does not just disappear because of defaults. 4. When a debt is not repaid, that doesn't decrease purchasing power in the economy as a whole. The money is there. nobody sent it into the phantom zone. A. A depression is caused by defaults, because otherwise everyone would just spend. B. But defaults are caused by a depression, for otherwise everyone would just pay their bills. Are you claiming both A and B? If yes, how do you resolve the contradiction inherent there?
I'm not claiming that a depression is caused by defaults. You are correct in saying that a default does not diminish demand in the overall economy. In fact, one way in which the economy would correct itself is for the debt to be wiped out in this process of widespread default. The debt can never be paid down in a debt-deflation scenario, and so won't be. Once people stop trying to pay off a debt that can never be paid off, and instead go back to consuming, then goods start to circulate again.
As Say explained so brilliantly, purchasing power comes from production, not from money supply. The obvious conclusion is that it doesn't go away due to changes in the money supply.
But money is required to lubricate that process, and so if it is not flowing sufficiently in the right places, a blockage can occur in the system.
As Say explained so brilliantly, purchasing power comes from production, not from money supply. The obvious conclusion is that it doesn't go away due to changes in the money supply. But money is required to lubricate that process, and so if it is not flowing sufficiently in the right places, a blockage can occur in the system.
There we go. The we agree on all the important stuff. What is left over is one tiny detail to discuss. Mainly, is money some kind of lubricant that has to flow sufficiently, or else there will be a blockage in the system?
Let me give you my take. I have the impression that you are sincere, truly think that your teachers taught you the right stuff, and [and I'm going out on a limb here] you are open to changing your mind if presented with the evidence.
Tell you what. I don't have anything original to contribute. All I do is popularize those few tidbits of AE [=Austrian Economics] that I manage to understand. And I've written about this already.
So you can visit my blog and look around, or go to the sources themselves and look around mises.org for discussion of the above point. Also, of course, there is the howling error most people are taught, that spending is what grows an economy, an error that needs to be addressed.
A link would be nice, SD.
http://smilingdavesblog.blogspot.com/2011/08/classic-keynes-and-why-credit-card.html [=Keynes is wrong empirically].
http://smilingdavesblog.blogspot.com/2012/04/marxs-refutation-of-says-law.html [=if Say is right in barter economy, he must be right in money economy].
http://smilingdavesblog.blogspot.com/2011/09/problem-according-to-keynesians.html [=list of links to refute this Keynes stuff from all angles].
Deleveraging was not the major cause of the Great Depression, as it seems that a great amount of deleveraging (i.e. the recovery) had already taken place by mid-1930 - the true problem was the interventionist policies of Hoover and FDR:
"Unemployment peaked at 9 percent, two months after the stock market crashed, and began drifting generally downward until it reached 6.3 percent in June 1930. That was when the federal government made its first major intervention into the economy, with the Smoot-Hawley tariff."
- Thomas Sowell, Economic Facts and Fallacies
Notice that unemployment was far worse throughout the entire decade of the 1930s than it was at the worst point of the 1929 market crash.
Expanding the data even further back, it doesn't look like anything significant happened with debt levels in the 1920-1929 period, especially not when contrasted to the 1981-2009 period.
I'm not sure what you mean. It was high and rising over the course of the 1920's (one decade), and high and rising over the course of 1981-2009 (three decades). Is it surprising that three decades of rising debt would see more of a rise than one decade?
If it's just the debt levls, is there some sort of "tipping point"? And why wasn't there a depression in the 90's? [...] And what do you think the contributory factors to increasing private debt levels were?
I believe that the first two questions can be answered by first answering the last. I am presently of the opinion that Hyman Minsky's theory of Financial Instability best explains what we see with regards to private debt levels. Quoting at length from here:
Hyman Minsky has proposed a post-Keynesian explanation that is most applicable to a closed economy. He theorized that financial fragility is a typical feature of any capitalist economy. High fragility leads to a higher risk of a financial crisis. To facilitate his analysis, Minsky defines three approaches to financing firms may choose, according to their tolerance of risk. They are hedge finance, speculative finance, and Ponzi finance. Ponzi finance leads to the most fragility. · for hedge finance, income flows are expected to meet financial obligations in every period, including both the principal and the interest on loans. · for speculative finance, a firm must roll over debt because income flows are expected to only cover interest costs. None of the principal is paid off. · for Ponzi finance, expected income flows will not even cover interest cost, so the firm must borrow more or sell off assets simply to service its debt. The hope is that either the market value of assets or income will rise enough to pay off interest and principal. Financial fragility levels move together with the business cycle. After a recession, firms have lost much financing and choose only hedge, the safest. As the economy grows and expected profits rise, firms tend to believe that they can allow themselves to take on speculative financing. In this case, they know that profits will not cover all the interest all the time. Firms, however, believe that profits will rise and the loans will eventually be repaid without much trouble. More loans lead to more investment, and the economy grows further. Then lenders also start believing that they will get back all the money they lend. Therefore, they are ready to lend to firms without full guarantees of success. Lenders know that such firms will have problems repaying. Still, they believe these firms will refinance from elsewhere as their expected profits rise. This is Ponzi financing. In this way, the economy has taken on much risky credit. Now it is only a question of time before some big firm actually defaults. Lenders understand the actual risks in the economy and stop giving credit so easily. Refinancing becomes impossible for many, and more firms default. If no new money comes into the economy to allow the refinancing process, a real economic crisis begins. During the recession, firms start to hedge again, and the cycle is closed.
Also, why should debt levels be measured against GDP?
First of all, thank you for being so polite in your response. More than anything I hope that I am able to keep an open yet critical mind as I progress over the years in my understanding of economic systems. I'm sure I don't always live up tp that ambition but I do like to try. I have no formal economics education, btw.
[...] is money some kind of lubricant that has to flow sufficiently, or else there will be a blockage in the system?
I think this is once of the roles that it fulfils, yes. Other roles are as a store of value and a measure of 'value' (whatever that might be).
I haven't yet visited your blog, but will certainly do so when I get the time. As for the issue of spending growing an economy, of course it is not sufficient to do so, and production is the source of wealth at all times. However, prodution cannot take place sustainably without the equal and opposite force of consumption, and it is money that enables these two sides of the process to coordinate.