The Yale University economist Irving Fisher invented a clever system for easily displaying index cards, later known as the Rolodex. He sold his Index Visible Company for a tidy sum in 1925, amidst the economic boom years known as the Roaring Twenties. In the next few years he turned that sum into a reported $10 million fortune (the equivalent of $132 million in 2011 dollars) by speculating in stocks. Stock prices were rising rapidly, and Fisher’s positions soared. He became known as a stock market prog-nosticator. On October 15, 1929, he told a dinner meeting audience in New York City, as reported by the New York Times, that stock prices had reached “what looks like a permanently high plateau.” He said he agreed with another observer that “the market may be at its peak now and for sev-eral months to come,” but added, “I do not feel there will soon, if ever, be a 50 or 60 point break from present levels, such as [he] has predicted.” Fisher was even more optimistic in the question-and-answer period, saying that he expected “to see the stock market a good deal higher than it is today within a few months.”1
Two weeks later the market crashed. Fisher was wiped out, having bor-rowed heavily to buy stocks on margin. To pay his debts he was forced to sell his New Haven home. He then turned to his sister-in-law for a place to live.
The stock market crash followed a downturn in manufacturing out-put that had begun a few months earlier. Economies in other industrial
1 “Fisher Sees Stocks Permanently High,” New York Times, 16 Oct 1929, accessed online via ProQuest Historical Newspapers The New York Times (1851–2007). The other observer was Roger W. Babson, who was predicting a crash. There was a connection between Fisher’s faith in the economy’s higher plateau and the fact that the alcohol prohibition he advocated (see Chapter 1) was then in force. He believed that greater sobriety was boost-ing worker productivity. Fisher’s 1930 book The Stock Market Crash – and After (New York: Macmillan) included the chapter “The Dividends of Prohibition.”
countries similarly slumped. Economists around the world, as puzzled as Fisher (though seldom as impoverished) by the events, sought to figure out what had happened. Could the downturn have been avoided, or was there something about the boom years that destined them to come to an end?
THE ROARINg TWENTIES
Real gross domestic product in the United States grew more than 45 per-cent in the eight years between 1921 and 1929, rising to $865.2 billion (in year-2000 dollars) from $595.1 billion in the recession year 1921. The com-pound annual growth rate of per capita real gDP was a mighty 3.29 percent, compared to a century-long rate of 1.97 percent.2 The boom was not evenly distributed across industries but was especially pronounced in the output of producers’ goods. The 1929 volumes of pig iron and steel production nearly tripled the volumes of 1921. Construction activity and machine tools out-put both more than tripled. From September 1921 to its peak in September 1929, the total index of industrial production rose by 96.7 percent, more than double the rise of consumers’ goods output. Between 1925 and 1929, the output of producers’ goods rose 22 percent while the output of con-sumers’ goods rose only 7 percent.3 Price levels meanwhile moved little: the wholesale price index in 1929 was only 1.5 percent below its 1922 level.
A cyclical downturn began to develop in 1927. The young Federal Reserve System, having begun operations in 1914, experimented with its powers. It pursued an expansionary policy to stabilize wholesale prices, keep interest rates low, and thereby extend the boom. Over the five years from June 1922 to June 1927, the M2 measure of the money stock (total deposits plus currency outside the banks) had expanded by 34 percent, or about 6.0 percent per annum. Now, over the eighteen months between June 1927 and December 1928, it grew by 10 percent, or about 6.7 percent per annum.4 Between July and September of 1927 the Federal Reserve Banks reduced their dis-count rate to 3.5 percent from 4 percent. The Fed expanded its holdings of
2 Real gDP grew 4.79% per year, higher than the 3.32% rate over the entire twentieth cen-tury. Lawrence H. Officer and Samuel H. Williamson, “Annualized growth Rate and graphs of Various Historical Economic Series,” MeasuringWorth.Com.
3 Index of Industrial Production from Federal Reserve Board Statistical Release g.17, Industrial Production and Capacity Utilization (not seasonally adjusted), http://www.
federalreserve.gov/Releases/g17/table1_2.htm. All other figures from C. A. Phillips, T. F. McManus, and R. W. Nelson, Banking and the Business Cycle: A Study of the Great Depression in the United States (New York: Macmillan, 1937), pp. 123–7, 194.
4 Board of governors of the Federal Reserve System, Banking and Monetary Statistics 1914–
1941, p. 34. Available online at http://fraser.stlouisfed.org/publications/bms/.
commercial bills and made open-market purchases of Treasuries.5 A few years later, Cornell University economist Harold L. Reed observed that “the greatly increased open market purchases of the Reserve banks in the first half of 1927, and the ensuing reductions in discount schedules [interest rates] from July of that year on,” had brought about an “extremely large”
growth in bank loans and “record volume” of corporate security issues, thereby financing “a remarkable expansion of our capital equipment.”6
The stock market also responded to the expansion of credit, stock prices rising 50 percent during 1928 and another 27 percent from January to October 1929. The Fed became alarmed at the extraordinary run-up in stock prices and tightened monetary policy, hiking the discount rate (the interest rate at which it lent to banks) from 3.5 percent in early 1928 to 5 percent by early 1929.
The boom finally came to an end. The Fed’s production index peaked in June 1929 and declined thereafter.7 The National Bureau of Economic Research dates the end of the expansion to August 1929. The Bureau of Labor Statistics’ Index of Industrial Production began to decline after September. The stock market crashed in late October. Unlike the short sharp shock of the eighteen-month recession of 1920–1, and of crises in earlier decades, the sharp decline in real activity continued for four years, later to be known as the opening phase of the great Depression. By 1933, real gDP had fallen to $635.5 billion (again in year-2000 dollars), a decline of 26.5 percent from its 1929 peak.8 Industrial production had fallen 47 percent. gross Private Domestic Investment plummeted from $16.5 billion in 1929 to only $1.3 billion in 1932.9 To Harold L. Reed, surveying the econ-omy from the perspective of late 1932, the “remarkable expansion” of plant and equipment from 1927–8 still crowded the market, discouraging new investment: “Productive power was so geared up that, ever since the 1929 recession in the security markets, it has been difficult to find a satisfactory outlet for bank credit in plant improvement projects.”10
5 Milton Friedman and Anna J. Schwartz, A Monetary History of the United States, 1867–
1960 (Princeton, NJ: Princeton University Press, 1963), p. 288.
6 Harold L. Reed, “Reserve Bank Policy and Economic Planning,” American Economic Review 23 (Supplement) (March 1933), p. 112.
7 Allan H. Meltzer, “Money and Monetary Policy: An Essay in Honor of Darryl Francis,”
Federal Reserve Bank of St. Louis Review (July/August 2001), p. 28.
8 In the worst slump since the great Depression, real gDP fell only 3.7% peak to trough from October 2007 to May 2009.
9 gross Private Domestic Investment (gPDIA), U.S. Department of Commerce, Bureau of Economic Analysis. http://research.stlouisfed.org/fred2/data/gPDIA.txt.
10 Reed, “Reserve Bank Policy,” p. 112.
PRE-KEYNESIAN MACROECONOMICS
What explanations did contemporary economists have to offer for this boom and bust? Paul Krugman has suggested that they had nothing to say before John Maynard Keynes came to the rescue:
But classical economics offered neither explanations nor solutions for the great Depression. By the middle of the 1930s, the challenges to orthodoxy could no longer be contained.11
Krugman here uses “classical economics” in the idiosyncratic way that Keynes used it in his General Theory, to mean the main current of economic theory before Keynes’s 1936 work, rather than in the standard way to mean the main current of economics (exemplified by Adam Smith, David Ricardo, and John Stuart Mill) before the 1871 marginalist-subjectivist revolution.
Keynes at least acknowledged that he was using nonstandard labels: “I have become accustomed, perhaps perpetrating a solecism, to include in ‘the clas-sical school’ the followers of Ricardo, those, that is to say, who adopted and perfected the theory of the Ricardian economics, including (for example) J. S. Mill, Marshall, Edgeworth, and Prof. Pigou.”12 Using standard labels, Mill was the only Ricardian or classical economist on Keynes’s list. The later three were all non-Ricardian and neoclassical because they accepted the marginalist subjective-value theory of price, with its twin focus on individ-ual optimization and market equilibrium, over Ricardo’s labor-cost theory of price and focus on distributive shares. Keynes idiosyncratically used “the classical school” and “Ricardian economics” to designate any economics using the hypothesis that prices and wages will adjust, where free to do so, to clear markets and allow full employment of resources.
Contrary to Krugman, many leading pre-1936 economists did offer explanations for the boom and bust. Each explanation implied solutions in the sense of lessons for policy. Ludwig von Mises, building on the analysis of Knut Wicksell and the nineteenth century’s British Currency School, had sketched a monetary business cycle theory as early as 1912 in The Theory of Money and Credit, refining and extending it in the book’s 1924 second edition and in a 1928 monograph.13 F. A. Hayek began to
11 Paul Krugman, “Who Was Milton Friedman?”
12 John Maynard Keynes, The General Theory of Employment Interest and Money, ed.
Elizabeth Johnson and Donald Moggridge, vol. VII in The Collected Writings of John Maynard Keynes (London: Macmillan, 1973), p. 3 n. 1.
13 Ludwig von Mises, The Theory of Money and Credit [1912; 2nd german ed. 1924; with additional essay added to 1953 American ed.], trans. H. E. Batson (Indianapolis: Liberty
develop a more elaborate version of Mises’s theory a few years before the 1929 crash, emphasizing the behavior of the economy’s structure of pro-duction over the course of the cycle. With the onset of the Depression, Mises, Hayek, and other “Austrian School” economists (most notably Fritz Machlup, gottfried Haberler, and Lionel Robbins) applied their theory to the task of explaining the crisis.14 The Austrian theory was widely debated, as we will see later in this chapter. With the publication of his Prices and Production in 1931, Hayek’s account of what had gone wrong (in a nut-shell: loose monetary policy had kept interest rates too low and thereby distorted production into an unsustainably top-heavy structure) became the chief rival to Keynes’s account (in a nutshell: loss of nerve by investors meant that investment spending failed to make up for too little consump-tion spending).15
Other pre-Keynesian monetary and business cycle theorists offered their own explanations, some of them overlapping the Mises-Hayek account in various degrees. Some of the leading names in the United Kingdom were Dennis H. Robertson, Ralph Hawtrey, and Arthur C. Pigou; in the United States there were Irving Fisher, Wesley Clair Mitchell, Jacob Viner, and John Maurice Clark.16 Keynes and his followers would find these explana-tions lacking in various respects, but it can’t accurately be said that before Keynes’s General Theory the leading economists offered nothing. Outside the Austrian camp, leading economists offered anti-Depression policy recommendations that anticipated those later associated with Keynes, in particular easier monetary policy and an increase in government spending financed by borrowing.17
Fund, 1981); Mises, “Monetary Stabilization and Cyclical Policy” [1928], trans. Bettina Bien greaves, reprinted in Mises, On the Manipulation of Money and Credit, ed. Percy L.
greaves, Jr. (Dobbs Ferry, NY: Free Market Books, 1978).
14 Fritz Machlup, The Stock Market, Credit and Capital Formation [1931], trans. Vera C. Smith (London: William Hodge, 1940); gottfreid Haberler, “Money and the Business Cycle,” in Quincy Wright, ed., Gold and Monetary Stabilization (Chicago: University of Chicago Press, 1932), pp. 43–74; Lionel Robbins, The Great Depression (London: Macmillan, 1934).
Appearing slightly later (1937) but offering further empirical evidence for the applicability of the Austrian theory to the boom and bust was Phillips, McManus, and Nelson, Banking and the Business Cycle.
15 John Maynard Keynes, “The great Slump of 1930” and “Economy: (i) Saving and Spending,” in Essays in Persuasion, pp. 135–56.
16 On Fisher’s theory see Scott Sumner, “Price-level Stability, Price Flexibility, and Fisher’s Business Cycle Model,” Cato Journal 9 (Winter 1990), pp. 719–27.
17 For a thorough account of the antidepression policy recommendations of mainstream economists between 1929 and 1936 see J. Ronnie Davis, The New Economics and the Old Economists (Ames: Iowa State University Press, 1971).
THE MISES-HAYEK THEORY OF THE BOOM-BUST CYCLE In the Theory of Money and Credit, and in his 1928 monograph, Mises modernized a credit-cycle theory of boom and bust previously sketched by British economists in a mid-nineteenth-century debate over the Bank of England’s role in business fluctuations. He added monetary dynamics drawn from the Swedish economist Knut Wicksell, and a capital-and-interest the-ory based on the earlier Austrian economist Eugen von Böhm-Bawerk. The result was a “monetary malinvestment theory” of the business cycle.
In Mises’s theory, the boom period begins when the banking system arbi-trarily expands the supply of loanable funds beyond the supply of voluntary savings, reducing the interest rate below its equilibrium value (Wicksell’s
“natural rate of interest”). Here “the banking system” that expands is either a central bank that is not tightly constrained by the gold standard, or a sys-tem of commercial banks acting in concert like (or following the lead of) such a central bank. Mises wrote that “the banks . . . intervene on the mar-ket in this case as ‘suppliers’ of additional credit, created by themselves, and they thus produce a lowering of the rate of interest, which falls below the level at which it would have been without their intervention.”18
The low interest rate induces, and the expansion of credit finances, the undertaking of new investment projects:
The lowering of the rate of interest stimulates economic activity. Projects which would not have been thought “profitable” if the rate of interest had not been influenced by the manipulations of the banks, and which, therefore, would not have been undertaken, are nevertheless found “profitable” and can be initiated.19
The newly perceived profitability, however, vanishes when the inter-est rate returns to equilibrium. To the extent that workers and machines have been drawn into unsustainable activities, they will have to find new employments:
If . . . the banks decided to halt the expansion of credit in time to prevent the collapse of the currency and if a brake is thus put on the boom, it will quickly be seen that the false impression of “profitability” created by the credit expan-sion has led to unjustified investments.20
18 Ludwig von Mises, “The Austrian Theory of the Trade Cycle” [1936], in The Austrian Theory of the Trade Cycle and Other Essays, compiled by Richard M. Ebeling (Auburn, AL:
Mises Institute, 1996), p. 2.
19 Ibid.
20 Ibid., p. 3.
Alternatively, if nothing stops the expansion, the currency will collapse.
The public will eventually react to rising inflation by abandoning the cur-rency, resulting in a “crack-up” such as the german hyperinflation of the 1920s. Mises implied, though postwar experience does not bear this out, that an ongoing inflation at a steady percentage rate was an unsustainable knife-edge path.
Mises’s policy lesson was: to avoid economic downturns, avoid creating the credit booms that precede them. According to one story, perhaps apocry-phal, an audience member asked Mises after a lecture: “Do you really advise that once a depression begins the central bankers should do nothing?” To which Mises replied: “Madam, my advice is that they should start doing nothing much sooner than that!” If a credit expansion has already been started, Mises’s advice was to stop it as soon as possible. The longer the boom, the bigger the bust:
The longer the period of credit expansion and the longer the banks delay in changing their policy, the worse will be the consequences of the malinvest-ments and of the inordinate speculation characterizing the boom; and as a result the longer will be the period of depression and the more uncertain the date of recovery and return to normal economic activity.21
Mises blamed unwarranted credit expansion on political pressures for cheap money that the central bank failed to resist. As an institutional reform to avoid the problem he favored free banking, a monetary system without a central bank, although he acknowledged that the spread of central banking throughout Europe in previous decades had made the choice between free banking and central banking one of those “questions that have long been regarded as closed.” Exemplified by Scotland, Sweden, Canada, Switzerland, and other countries in the periods before their central banks were created, free banking meant a system in which decentralized and competitive com-mercial banks issue the paper currency, tied down by a contractual obliga-tion to redeem their notes for gold or silver coin.
Advocates of free banking argued that competition would prevent all the banks from colluding to expand in concert, and interbank redemption of excess notes or deposits would restrain any smaller set of banks from over-expanding. International redemption would restrain the system as a whole.
In his later treatise Human Action Mises wrote along these lines:
Free banking is the only method for the prevention of the dangers inherent in credit expansion. It would, it is true, not hinder a slow credit expansion, kept
21 Ibid., pp. 5–6.
within very narrow limits, on the part of cautious banks which provide the public with all the information required about their financial status. But under free banking it would have been impossible for credit expansion with all its inevitable consequences to have developed into a regular – one is tempted to say normal – feature of the economic system. Only free banking would have rendered the market economy secure against crises and depressions.22
Hayek, in a series of works from the mid-1920s through The Pure Theory of Capital (1941), added to Mises’s theory a more detailed account of how an easy-money lowering of the interest rate prompts malinvestment during the boom, and how that malinvestment skews the economy’s structure of production away from its sustainable equilibrium structure.23 Hayek com-mented in 1932 that “what I tried to do in Prices and Production, and in certain earlier publications, was to show that monetary factors may bring about a kind of disequilibrium in the economic system.”24
The problem caused by the distortion of the interest rate is a mismatch-ing of the plans of savers and investors. As Hayek sometimes put it, the distorted interest rate fails to equalize the supply with the demand for real capital. The artificially lowered interest rate no longer meshes the time-pro-file of output for which businesses are making their investment plans – to produce so much for the present and so much for various future periods – with the public’s planned time-profile of saving and consumption across the same periods. Instead it skews investment too much toward the “higher stages” of production, meaning projects such as mineral extraction, heavy industry, and building construction that will yield consumable output pre-dominantly in the distant future, leaving too little consumable output in the
The problem caused by the distortion of the interest rate is a mismatch-ing of the plans of savers and investors. As Hayek sometimes put it, the distorted interest rate fails to equalize the supply with the demand for real capital. The artificially lowered interest rate no longer meshes the time-pro-file of output for which businesses are making their investment plans – to produce so much for the present and so much for various future periods – with the public’s planned time-profile of saving and consumption across the same periods. Instead it skews investment too much toward the “higher stages” of production, meaning projects such as mineral extraction, heavy industry, and building construction that will yield consumable output pre-dominantly in the distant future, leaving too little consumable output in the