1920-21 and the Great Depression

Steven Horwitz

I started this as a long comment on the Hayek and deflation thread, but figured I'd make it separate post.

Yes, during 1920-21 we had deflation and yes we didn't have a Great Depression.  But we did have a significant drop in GDP and unemployment of around 12%, and a recession that lasted about two years.  It's possible that better monetary policy could have prevented such a steep recession.  I know free banking could have.  (And it's worth mentioning for all this debate about what the Fed should and shouldn't do that it's all about the world of the second best.)

And I absolutely agree on the importance of Hoover's wage policies for the depth of the Great Depression.  I make that argument in my recent EJW piece.  Part of the point is that the combination of government-generated severe wage rigidity and a falling money supply is a particularly deadly one.  However, either alone is also bad.  Put them together and you, not surprisingly, get 25% unemployment and all the rest.

Put differently:  the 1920-21 episode was, in fact, a severe, though not particularly long, recession.  Allowing the money supply to fall isn't painless.  Allowing the money supply to fall in an environment of severe downward wage rigidity is VERY "not painless."  The 1920-21 episode doesn't demonstrate that deflation is harmless.  It DOES demonstrate that if you have deflation, it will be less bad if you have nominal wages that are flexible downward.  That recession is the best example of why Hoover's wage policies were such a mistake.  Hoover, as Secretary of Commerce, wanted to intervene in that recession but Harding held him off and we had "only" a severe recession.  The 1920-21 episode does not, in my view, show that deflation by itself is painless.

Again:  if the questions are why:

1. The Great Depression got started
2. Why the GD got so bad so fast
3. Why it lasted so long

You need:

1. Austrians
2. Friedman & Schwartz/Monetary disequilibrium theory
3. Higgs, Cole/Ohanian etc.

Consider that there are four possible interactions between monetary policy and wage policy: 

Possible interactions of monetary policy and wage policy post-1929

	Fed allows MS to fall by 30%	Fed maintains MV
Hoover wage rigidities	Great Depression – 25% unemployment, years of collapsing GDP and private investment.	Counter-factual A:  significant unemployment, though not nearly 25% and a longer recession with a slower recovery as misallocated resources linger.  The “Great Recalculation” is slower and less effective.
No Hoover wage rigidities	Counter-factual B: 1920-21 type recession – (e.g., 12% unemployment, 18-24 months of recession, GDP falls 17% in 1920.)	Counter-factual C:  quick relatively mild recession as unemployment climbs but not as high as 20-21 and resources are fairly quickly reallocated away from malinvestments.  The “Great Recalculation” happens quickly.

 

If the Fed had not allowed the 30% fall in the MS in the early 30s (Counter-factual A), but we still had wage rigidity, we would not have nearly the problems we had, but we still would have had some level of unemployment and lingering problems reallocating malinvested resources.  Had we had the deflation but no wage rigidities (Counter-factual B), I think we would have had 1920-21 again, but that included double-digit unemployment and a two year long recession. Had the Fed not allowed the decline AND we had no Hoover wage policies (Counter-factual C), we would have had a short and not particularly sharp recession.  Those are, obviously, counter-factuals, but ones I think that are reasonable inferences from theory and history.

Recessions do and should produce unemployment.  Even the best monetary policy cannot avoid it entirely.  But that unemployment should be due to malinvested resources being reallocated to more appropriate uses, both directly misallocated labor and labor complementary to misallocated capital.  There's no need to enhance that level of unemployment by allowing the total effective amount of circulation (Hayek's term) to fall during what Arnold Kling nicely calls the "recalculation" process.

As is generally the case with monetary policy, getting it right simply allows the microeconomic market process to do the best it can.  During a recession, getting monetary policy right allows the necessary micro-level corrections to take place as smoothly as they can.  Getting monetary policy wrong screws that up, either by inflating and regenerating the malinvestments or by deflating and unnecessarily reducing the flow of money needed to make those corrections happen

So don't misread me (or Bill!).  Neither of us are arguing, at least I'm not, that a central bank can and should act so as to prevent any recession-generated unemployment or prevent the very much needed reallocation of malinvested resources.  Recessions are the correction process and they can and should involve some pain.  But there's no need to magnify the pain needlessly, or avoid relieving pain in ways that don't interfere with the correction process. 

Taking an Advil when you have the flu doesn't stop your body from fighting off the infection but it does relieve needless pain.  Maintaining MV during a recession is analogous.

Comments

[Greg Ransom]

"the combination of government-generated severe wage rigidity and a falling money supply is a particularly deadly one."

These are the same conditions found in union dominated Britain after the 1925 return to Gold at pre-war parity.

[Lee Kelly]

Moreover, even though the Fed "did nothing" in response to the 20-21 recession, that doesn't mean it didn't intervene in the economy, because its very existence is an intervention, whatever it does or doesn't do.

If the government granted itself a monopoly on playing cards (to use White's example), and card games stated increasing in popularity, then holding the supply of playing cards constant *would not* be an example of "letting the market work."

The market would adjust, as best it could, around such obstacles, and it did during the 20-21 recession. But this would not be the response of an unhampered market, no more so than long queues at gas pumps were in the 70s.

[Sheldon Richman]

Nicely put, Steve!

[Nikolaj]

Steve,

in order to justify your revision of Hayek, you are now revisiting conventional economic history of "Forgotten depression" 1921-22. Conventional history, including Friemdan and Schwartz and all others teaches us that recession 1921-22 was unusually short-lived and and milder than one would expect, having in mind Fed' inactivity. Your revisionist interpretation now says that 1921-22 was really terrible and much longer than it should be, BECAUSE Fed was inactive and conventional policy tools had not been used!

In order to see why your counterfactual C is completely wrong and why credit inflation during recession would not lead to "Great Recalculation", but rather to "Further Miscalculation" please read again Pries and Production, chapter IV and De Soto's book, pp. 675-705. You never tried to refute arguments presented there, you simply avoided them, and took refuge in macroeconomic fictions ("stabilizing MV", although Hayek himself explained that stabilizing MV "cannot be a maxim o practical policy").

The most basic question you must at least try to answer before you can plausibly expect from anybody to believe in your counterfactual C is - what is your basis to believe that the same misdirecting forces of money creation that distorted a productive structure during the boom and brought about the credit cycle in the first place, would miraculously cease to operate in the recession, leading to "recalculation" instead?! How the same type of monetary stimulants would lead to mislaculation during the boom, and to "quick recalculation" during the bust? What is microeconomic or, if you don't mind, "praxeological" basis for such a belief?

[Greg Ransom]

Is there a detailed study comparing the Great Depression experience of Canada vs the United States?

Canada wasn't victimized by Hoover & FDR, and Canada's banking system wasn't as pathological as America's.

Still, Canada experienced a period of significant unemployment.

[Greg Ransom]

Arnold Kling identifies a significant contemporary problem -- the financial sector is pathologically overgrown and pathologically structured. Which makes it extremely hard or impossible to know how much is "malinvestment" or how much of the money suck/sink of the financial sector is monetary inflation, monetary deflation, rent seeking, Ponzi fraud, executive equity plundering, too big to fail, etc. -- or simply what is required for the system as a whole.

Steve wrote:

"During a recession, getting monetary policy right allows the necessary micro-level corrections to take place as smoothly as they can. Getting monetary policy wrong screws that up, either by inflating and regenerating the malinvestments or by deflating and unnecessarily reducing the flow of money needed to make those corrections happen."

[Dave Prychitko]

"getting monetary policy right allows the necessary micro-level corrections to take place as smoothly as they can."

Steve, I fully agree and the Great Depression wouldn't have been so dreadful had the Fed increased the Ms appropriately.

But still nobody responded to my question (I was hoping that you would) about precisely what the Fed should do today. In short, how do you come to terms with the knowledge problem and public choice problems? Getting it right is of course the ideal, but should we believe that the Fed can get it right in today's world? What evidence can you muster that offers a clear path for a Fed-generated monetary equilibrium, and what theory do you have that argues that the Fed can and will achieve it without over-or-under shooting?

Advil is a purely physiological metaphor. We are dealing with knowledge, expectations, and incentives.

[Dave Prychitko]

oops -- analogy not metaphor....

[Steve Horwitz]

Nicolaj: I'm really tired of debating the same points with you over and over again. You assert that increases in the money supply that serve to meet increases in money demand will create distortions. I have argued that they avoid many more distortions than they might create. I have offered reasons for that. You find my reasons insufficient. I find your discounting of the effects of monetary deflation lacking. We've been over and over this and I'm not going to spend my time rehashing the debate. We're not going to convince each other and the rest of the folks have heard it all before. And thanks for the advice on reading P&P - I'd never considered that I might learn something from reading that book [insert eyeroll here].

In fact, one of the things I learned from chapter IV of P&P is this:

"Such a change in the 'velocity of circulation' has rightly always been considered as equivalent to a change in the amount of money in circulation, and though, for reasons which it would go too far to explain here, I am not particularly enamoured of the concept of an average velocity of circulation [footnote to Mises] it will serve as sufficient justification of the general statement that *any change in the velocity of circulation would have to be compensated by a reciprocal change in the amount of money in circulation if money is to remain neutral toward prices.*" (123-24)

It's important to remember that Hayek's notion of neutrality emerges from his 1928 article and the idea that money should not "interfere" with the process by which prices, especially intertemporal prices, emerge. It is a policy norm, not a feature of money as an institution.

Finally, I didn't say 1920-21 was "terrible" and "much longer" than it needed to be. I said it was "severe, though not particularly long." I stand by that. I consider 12% unemployment to be "severe" as a matter of "depth." But that's a judgment call. I did last 18-24 months. I agree that this was "longer that it needed to be" as I think better monetary policy would have reduced its depth and thereby, possibly, its length. How "much" shorter it would have been is an open question. I do think your characterization of my argument distorts what I actually wrote. Of course maybe you think 12% unemployment isn't "severe." Then just say so.

[Steve Horwitz]

Dave,

We're back to where we've been among you, me and Pete. I think the question you raise, which I read as "even if you think the Fed should do X, what reason do you believe it can actually accomplish X should it try? And won't trying to do X possibly give us Y, which is worse than doing nothing?" is the best counter-argument one can make against what I've argued. In a prior thread, George offered some reasons to think that targeting NGDP or the like isn't perhaps as hard as one might think. Maybe, maybe not.

For me, there's no apriori answer here (despite Pete almost wanting to claim there is). At the risk of stirring up another hornet's nest, it's something like the question of whether, given state-sanctioned marriage, libertarians should think same-sex marriage should be legalized. We might agree that getting the state out is the best solution (like free banking) but given the state's role, is there a clear libertarian view on the question?

I can see both sides. Some will argue that legalizing it will indirectly give the state more power over more marriages. Others will argue that it will actually protect more people from arbitrary state power. Others will argue that liberal commitments to equality under the law trump these considerations.

My point of THIS analogy is only that in these kind of second best problems, our responses are frequently matters of political and social judgment (thymology, if you will). Yes, we have the issues you've raised to guide us, and I think we have real concerns about the costs of doing nothing in the face of a deflation. In the end, my *judgment* is that, given the Fed, it should have been expansionary last fall, though not nearly as much as it did (nor should it have taken on new powers to make that expansion happen). That's a judgment that the costs of that sort of action, even given what we now know happened, was worth the risk. I might have been wrong, ex post, but if I were in the driver's seat last fall, that's what I would have recommended.

[Niko]

I've been lurching on this site for a while. It is very painful to see how low the Austrians have fallen.

There is another country, very important, where interesting things happened during 1920-1923. It's name is Germany.

This whole deflation-unemployment-inflation-unemployment thing is very very misleading. You are all missing some very important aspects, but since you are all to old to learn new things, I'll live it like that.

[DG Lesvic]

Congratulations for a marvelous presentation, and, entirely in words and sentences, without any math. Glad to see that you're learning.

[David Stinson]

I'm new to the whole Austrian thing but wouldn't a return of the market interest rate to the natural rate post-boom require at least an initial reduction of MV?

[Pablo]

I am truly amazed at what you think Hayek said or didn´t say. For one, we know or don´t know actually what the velocity of money is. We cannot know in an environment where distortions exist. It would be a guessing game. Second, I do agree that in a second best world you must make choices, but in this case, I see no better second best than doing nothing. Mr. Prychitko is right: how can you circunvent the public choice dilemma. It is very obvious to everybody here the bail out or policies inacted did not work as publicized. Either way I do enjoy your blog and many of the comments, it is quite a learning experience.

[Dave Prychitko]

My reading of Stiglitz made me push the point. Recall, he argues that markets fail and therefore government intervention can nudge the economy closer to the optimal outcome. Many problems with this, including (1) he does not know where the "optimum" lies, he only "knows" that failed markets aren't there -- knowledge problem; (2) his equilibrium is assumed constant, whereas it is really a process -- at most, a moving equilibrium if we wish to use that language; and (3) he has no consideration of public choice issues.

For these reasons I slammed Stiglitz in a review of Whither Socialism that I wrote some years ago.

I just can't help but see the similarity between Stiglitz's effort (which is one trapped in GE theory) and your effort, Steve, which is even more difficult considering the dynamic process of the market(yes, you do use the monetary "equilibrium" concept but we know -- or should know, as you do -- that yours is not a general equilibrium construct).

Anyway, no need to further respond. I just thought I'd provide some background which animated my questions.

[Wladimir Kraus]

I think Steve has made a truly excellent point. His point is fundamental to the understanding of the dynamics of the system which is: before you can think about microeconomic adjustments within the system, the overall general characteristics and conditions of the system must be thoroughly grasped first.

Mv=PY is such a general condition. Deflation, i.e. a severe reduction in the volume of spending (Mv), makes it impossible to demand the pre-deflationary quantities of both products of business and labor (Y) at pre-deflationary prices. To restore the equilibrium in goods' and labor markets, prices of both must come down to clear them. That this transition doesn't happen immediately and without frictions, is true even under the most favorable laissez-faire conditions in labor contracting.

Furthermore, Steve is exactly correct arguing that whenever it's possible don't let a disastrous deflation to develop, especially under the present of rock-rigid wage rates.

Pablo's argument that since we don't know at any given point in time precisely how great the velocity is, we can safely forget about it is highly peculiar, to say the least. Has he ever heard of how changes in the demand for money for holding affect the volume of spending in the economy? Has he ever heard of astronomic velocity of circulation (or virtually non-existent demand for money) in a hyperinflation? What about Great Depression? Didn't demand for money rise significantly compared to the boom-years?

Because of the implied reallocations and readjustments, distortions in the real capital-structure are wealth-destructing and represent enormous obstacles on the way to recovery. Still, the deflationary forces pose a problem in addition to distortions; they swamp "undistorted" industries in the orgy of widespread bankruptcies as well, causing severe unemployment above induced by the corrective "reallocation" process. I.e. another great point scored by Steve.

As to the question how to stabilize aggregate spending, once in a recession/depression, without contributing to a further boom-bust cycle, consider the proposal of Prof. George Reisman on how a return to a 100% gold standard would solve the twin problems of inflation/deflation. (audio-file: http://mises.org/multimedia/mp3/MU2007/61-Reisman.mp3)

[Steve Horwitz]

Pablo writes:

"I am truly amazed at what you think Hayek said or didn´t say."

It's not what I THINK he said, it's what he ACTUALLY said. Read the fourth lecture carefully and read both the parts where he criticizes the idea of an elastic currency and then supports it.

"For one, we know or don´t know actually what the velocity of money is. We cannot know in an environment where distortions exist. It would be a guessing game."

Much of the time, yes. Which is why I support free banking as free banks would do a much better job of getting it right (or minimizing error) than central banks. However, in times of major upheaval, as Wladimir notes, knowing that velocity/money demand has changed in a significant way is not that hard.

"Second, I do agree that in a second best world you must make choices, but in this case, I see no better second best than doing nothing. Mr. Prychitko is right: how can you circunvent the public choice dilemma. It is very obvious to everybody here the bail out or policies inacted did not work as publicized. "

Let me be clear to those new to this ongoing discussion: I am NOT making a case for the bailouts or any of that nonsense. Nor am I saying what the Fed *actually* did was the right thing. My point is more narrow: faced with what appeared to be a significant drop in velocity/rise in the demand for money last fall, the appropriate monetary response to have taken was to provide additional liquidity to meet that demand. That's all.

I have argued that's what the Fed should have tried to do. Others have thrown a form of my own "ought implies can" argument back at me by suggesting there's no reason to think the Fed would do that and only that. I think it's possible that they could have (and note that none of my critics have answered my example of the 1987 stock market crash where the demand for money rose, Greenspan and the Fed met that demand, and nothing bad happened).

Bottom line: there's nothing in the Austrian-Public Choice arguments that suggest governments must fail *every single time they try something*. We did, after all, put a man on the moon and the Coast Guard did save thousands of lives in Katrina. The point, as I understand it, is that those few "getting it rights" come at an enormous cost of lots of "getting it wrongs" such that other institutional responses are to be preferred. All of the criticisms raised don't *automatically* imply the Fed couldn't have got it right last fall in the same way they appeared to have gotten it right in 1987 (even as they got it spectacularly wrong for most of the current decade).

[Steve Horwitz]

Greg,

Great question about Canada. One of the students in my GD seminar last spring did his paper on that topic. However, he was not among the more skilled in the class and the paper wasn't very good. He did, however, have trouble finding any good sources that offered a direct comparison. What he did find was that agriculture played a much bigger role in Canada and much of the pain and suffering was in that sector.

You are quite right that one key difference was the far superior Canadian banking system, which saw only 1 failure in the 20s and 30s, while a third of US banks went under. This also raises one other relevant difference with the 1920-21 recession: that one did not spread to the banking system, which created many more complications in the early 30s.

But yes, it would be a terrific economic history dissertation to write "Canada's Great Depression."

[Steve Horwitz]

Niko:

Instead of insulting us, teach us. What can we learn from looking at that episode more closely that would change how we're seeing events in the US?

[David Stinson]

"You are quite right that one key difference was the far superior Canadian banking system, which saw only 1 failure in the 20s and 30s, while a third of US banks went under. This also raises one other relevant difference with the 1920-21 recession: that one did not spread to the banking system, which created many more complications in the early 30s."

Canada didn't have a central bank until 1935.

[Don Lloyd]

Why do wages not fall in a recession, even without the effects of unions, unemployment insurance or direct government mandates?

Even though a book was written with the first phrase as a title, it still didn't get the correct answer.

The primary fact of a recession is that most manufacturers will experience falling unit sales volume even after lowering prices as much as practical. What this means is that even if the wages of direct, marginal labor are reduced, that won't solve the problems of over-capacity that are beyond shortened work weeks, etc.

Layoffs and unemployment are inevitable. But just who is laid off determines whether the wage rates of the remaining workforce end up higher or lower as a group than before the layoffs.

In fact the layoffs will tend to sequentially impact those workers with the highest ratio of marginal cost to marginal productivity. Although it doesn't have to work out this way, those laid off will tend to have lower wages than those retained. This is because experienced workers will have seen their wages rise over the years, but less rapidly than their productivity. This, in turn, is because wages paid must only match the gains in general productivity that would be available to a competing prospective employer. This gain in general productivity would not include gains in specific productivity, realized by the existing employer, but for which additional pay is not required.

Alternately, it is entirely feasible for salary reductions for non-direct, non-marginal labor to occur as the higher specific experience content of their work history is unlikely to attract alternate employers in a recession.

Regards, Don

[Wladimir Kraus]

Don,

the only reason why business, as a whole or on average, would experience "falling unit sales volume even after lowering prices" is when the aggregate demand for products of business falls even further, i.e. if the economy experiences continuous deflation. But why should it? What's the ultimate stopping point? What determines it?

Similarly, whatever differences in productivity between marginal and non-marginal workers, the problem is that the demand for labor (in terms of money) is entirely inadequate to clear the labor market with pre-deflationary wages. In WWII the problem was rather the opposite, i.e. shortage of labor brought about by price and wage controls.

This means that whenever the relation between the aggregate demand for labor and the average wage rate is out of proportion with the supply of labor, there will be either oversupply(unemployment) or shortage of labor.

[Don Lloyd]

Wladimir,

"the only reason why business, as a whole or on average, would experience "falling unit sales volume even after lowering prices" is when the aggregate demand for products of business falls even further, i.e. if the economy experiences continuous deflation. But why should it? What's the ultimate stopping point? What determines it?"

You have no reason to assume that a lowering of price will restore unit sales volume in the face of reduced demand in a recession. The unit price will tend to be set at or near the point of profit maximization both before and after the onset of the recession. This seems highly unlikely to be enough of a price decrease to fully restore the unit sales volume.

Average wages are a statistical outcome, not a determining force. This the same effect as a minimum wage, the resulting employed labor has a higher level of skills and productivity as compared to those who become unemployed.

Regards, Don

[Lee Kelly]

There is an interesting symmetry between Austrian and Keynesian economics.

Austrian economists tend to be very worried about inflation, and Keynesian economists tend to be very worried about deflation, but each also tends to ignore or minimise the worries of the other. These worries reflect the experience of the founders of each school: the original Austrian economists lived through terrible inflation, and the original Keynesian economists lived through a painful deflation.

Both seem to lack a theory of free banking. Both seem to imagine that when the Fed "does nothing," we get a glipse of what life would be like without a central bank. But that is nonsense. When the Fed does something, it intervenes in the economy, and when the Fed does nothing, it intervenes in the economy. But given the assumption that inaction by the Fed is equivalent to "letting the market work," I can quite understand the Keynesian aversion to savings, since they envision no mechanism by which the distortionary effects of deflation can be countered.

[Lee Kelly]

That last sentence should read -

"But given the assumption that inaction by the Fed is equivalent to "letting the market work," I can quite understand the Keynesian aversion to savings, since they envision no mechanism by which the distortionary effects of deflation can be countered other than by a central bank."

[Nikolaj]

Steve,

it's a shame that your learning from P&P is so selective. For example you never learned that;

"The only way permanently to “mobilize” all available resources is, therefore, not to use artificial stimulants—whether during a crisis or thereafter—but to leave it to time to effect a permanent cure by the slow process of adapting the structure of production to the means available for capital purposes",

or maybe,

"in order to eliminate all monetary influences on the formation of prices and the structure of production, it would not be sufficient merely quantitatively to adapt the supply of money to these changes in demand, it would be necessary also to see that it came into the hands of those who actually require it, i.e., to that part of the system where that change in business organization or the habits of payment had taken place. It is conceivable that this could be managed in the case of an increase of demand. It is clear that it would be still more difficult in the case of a reduction. But quite apart from this particular difficulty which, from the point of view of pure theory, may not prove insuperable, it should be clear that only to satisfy the legitimate demand for money in this sense, and otherwise to leave the amount of the circulation unchanged, can never be a practical maxim of currency policy."

As for recession, it is not a problem what I think about level of unemployment back then (unlike you, I don't think the proper role of the economist is to know what is "optimal level" of unemployment and to advocate "control" of it by artificial inflationary measures), but how do you justify your belief that credit creation during recession does not have the same predictable distorting effects as it has during the boom. I would like to know more about that, but obviously I expect too much.

[Mengers&Talents]

Sir,
w.r.t. the table of policy options you have used, I wanted to comment that it has clear analogies with "Truth Table" H. Minsky (1982 xxi).

[Wladimir Kraus]

Nikolaj,

I think Steve's position is very reasonable and can be defended on both theoretical and practical grounds. Please consider the following.

What he says, if I interpret him correctly, is that we should do everything possible to *avoid* the slide into secondary-deflation which would only add unnecessary harm and hardship to economy and employment. This is true even with flexible wages/prices but still more true with rigid wages/prices. To say this is not to deny the distortions caused by the Fed's induced misallocations in the previous boom.

There are some Austrians who positively rejoice at the prospect of a major deflation, apparently believing that it is pure blessing. Unfortunately, they don't recognize the catastrophic secondary effects of a deflationary spiral.

Nobody proposes to cure the disease with the same poison that caused it in the first place. The point is to get our thinking straight and recognize all possible harms -- seen and unseen, recognized or unrecognized by our intellectual fathers -- to the economy.

There are additional reasons to look hard for the least painful ways to prevent the aggregate demand from falling off the clip as it did during the Great Depression. For example, severe deflation causes widespread bankruptcies. Widespread bankruptcies imply legal voids and stoppage of production until assets are transferred to their new owners. Under the present conditions, it takes many months and even years to effectuate a complete repossession.

The simplistic liquidationist standpoint defies common sense and reality under which the economic system operates. And it simply won't work. Before advocating something as monstrous as millionfold bankruptcies, production stoppages and catastrophic unemployment with God-knows which consequence for civil peace and stability, one should better learn to understand how to avoid the disaster with the least pain and disruption, even if it would require to persuade the government to do so. Indeed, how would it ever be possible to bypass working with the government? How genuinely free-market reforms could ever be implemented in practice without active collaboration with the government?

Is there a chance to scrap labor legislation and effectively establish flexible wages in the foreseeable future? I don't see any movement along these lines. Are there efforts to reform bankruptcy laws and procedures? I haven't seen any.

Perhaps we should all be thinking about how to prevent MV from falling. If we don't do that, someone else certainly will.

[Jim Rose]

Greg,

You asked about work on the Canadian great depression.

Monetary historian Michael Bordo has written papers on the Canadian depression in the 1930s and the founding of their central bank in 1935. Canada had 11 banks in 1929 and had one merger in the 1930s.

James MacGee and Pedro Amaral wrote a paper on Canada from a real business cycle perspective. The output loss in the Canadian great depression was similar to the Great Depression in the United States. Total factor productivity (TFP) in Canada did not recover relative to trend; in the United States, TFP had revered to trend by 1937.

MacGee and Amaral’s modelling attributed over half of the decline in output relative to trend in Canada to lower TFP. Bordo concluded that there was a negative aggregate shock common to the USA and Canada.

As with all real business cycle theory, once the total factor productivity is identified, such as in Canada, the long term research agenda is to unpack the total factor productivity and other shocks into the ultimate causes. (Oddly enough, Keynesian macroeconomic explanations of recessions and depressions such as autonomous shifts in consumption and investment demand and wage and price rigidities were given a 60 year pass-out on having to provide any microeconomic foundations for the ultimate sources of shocks. Keynesian critics and opponents face much higher bar - they have to explain the microeconomic foundations of any shocks or frictions in their framework of analysis from its first day out).

The great puzzle MacGee and Amaral found was that the conventional explanations for the Great Depression - monetary shocks, terms of trade shocks and labour market and competition policies - do not work for Canada.

Trade was a much more important part of the Canadian economy, with exports and imports each accounting for roughly a quarter of Canadian GDP in 1928. The trade share of GDP fell by roughly 50 per cent between 1928 and 1933.

Austrian business cycle theory work by John Cochran treats total factor productivity shocks in real business cycle analysis as resource shifts between sectors at lower levels of aggregation.

At a lower level of aggregation, what looks like an economy’s response to a positive technology shock may be in fact an economy’s response to credit creation.

As malinvestments are discovered and corrected, measured productivity will decline and show up in more aggregated data as the negative productivity shock. Changes in the structure of production are not free goods.

[billwoolsey]

Don:

If prices and wages are "too high" the real quantity of money is "too low" relative the demand to hold money. This restults in real expenditure being "too low" relative to the ability to produce goods and services. This problem is overlaid any imbalance between the composition of real demand (the demand for this or that good) and the composition of productive capacity (the abililty to produce this or that both in terms of the current location of labor, the skills of the labor, and the specific capital goods existing now.)

In this scenario, a sufficiently lower price and wage level increases the real quantity of money to the real demand for money (how much people want to hold) and at the same time, the real volume of expenditures to real productive capacity. There may or may not be an imbalance between the composition of this demand and the composition of productive capacity.

Anyway, your discussion of "unit price," which is usually called "price," and profit maximization, appear to be confused. It is like you are doing a micro analysis with the assumption that the demand for a paritcular good has fallen, and the demands for everything else are unchanged. Then, taking that to be the typical market, and calling that recession. But, you made an error because if that is the typical market, then the assumption that the demadn for everything else is unchanged is wrong.

[Lord Buzungulus, Bringer of the Purple Light]

I find it pretty amazing that people can appeal to a tautology like MV = PY to talk about a monetary system being in or out of balance.

[billwoolsey]

Stinson, your wrote:

"I'm new to the whole Austrian thing but wouldn't a return of the market interest rate to the natural rate post-boom require at least an initial reduction of MV?"

No. What is needed is a change in relative prices and the composition of output. (The time structure of the allocation of resources.) This can occur without a decease in nominal expenditure. In fact, it will occur despite growing nominal expenditures. Attempts to use money creation to maintain the allocation of resources including malinvestments require indeterminately large increases in nominal expenditure--hyperinflation and the destruction of the monetary unit. If the monnetary authority backs off from that disaster, then the composition of demand and the allocation of resources shift, showing some specific capital goods to be malinvestments. But nominal expnediture might still be growing. It is just that the demand for consumer goods rises faster than capital goods. Consumer goods prices rise faster than capital good prices. And some of the existing capital goods must be abandoned.

My view is that this sort of recession won't look very much like a traditional recession.

[Wladimir Kraus]

Lord,

would you describe a monetary system with too high a price and wage level as being out of balance? Would you describe a monetary system that first brings about wild swings in the volume of spending but then, after a while, cuts it substantially as being out of balance?

Would you deny that MV = PY is a useful formula that describes fundamental monetary relationships in a simply but still correct way? What's so tautological in the formula which says that the volume of spending in any given period is determined by how much money is in existence times how often it gets spend during that period? Is this so obvious and useless?

Please think about these questions. I don't think these questions are so amazingly obvious and useless, but if you do please share with us your reasons.

[Lord Buzungulus, Bringer of the Purple Light]

Wladimir, the equation of exchange *defines* V, it doesn't express a relaionship between four different economically meaningful entities. It's an empty relationship. Thinking of V as a rate of spending (that could somehow be measured or even identified) doesn't change this fact.

[Wladimir Kraus]

Lord,

I respectfully disagree.

If I'm correct in my interpretation, you probably mean it's empty because it does not "explain" how V is determined. In this case, you're asking too much of a single formula.

You would have a valid reason to attack the formula, I believe, if V did not exist in reality which therefore would be a redundant or confusing concept. But that's clearly not the case. The speed at which an average monetary unit is spent in a period is a real magnitude. There is no doubt that the speed at which money is spent exerts an enormous influence on the economic system. It is an important factor. Moreover, it itself depends on things that are within our control.

[Greg Ransom]

Jim Rose -- thanks. Very helpful.

I'll see what John Cochran has on line.

[Greg Ransom]

Jim -- Is there any particular paper by Cochran you'd point me to in this regard. (I have his book.):

"Austrian business cycle theory work by John Cochran treats total factor productivity shocks in real business cycle analysis as resource shifts between sectors at lower levels of aggregation.

At a lower level of aggregation, what looks like an economy’s response to a positive technology shock may be in fact an economy’s response to credit creation."

[David Stinson]

Lee Kelly wrote:

"When the Fed does something, it intervenes in the economy, and when the Fed does nothing, it intervenes in the economy."

Nicely put, Lee.

Thanks Bill for the explanation. I have found, as I have been learning about the Austrian school, that many of the papers on the Austrian Business Cycle Theory focus well on the mechanism by which malinvestments arise in the boom phase but many (most?) tend to rely too heavily, in my view, on tightening by the monetary authority for their explanation of how the boom turns to bust. I find that usually insufficient attention is paid to explaining how the dynamic set up at the level of the real economy by the boom phase results inevitably in the bust, even absent ham-fisted monetary tightening. I know that some papers and people have addressed this point but I find it a weakness of many explanations of ABCT.

[Lee Kelly]

Whenever someone dismisses something *because* it is a tautology, I immediately wonder if they know what a tautology is.

MV = PY is a tautology, i.e. it is true, on pain of contradiction, that MV is equal to PY.

The question is then whether or not this equation describes a relation which actually exists. Are there things called the money supply, money velocity, price level, and output, and does this equative relation hold between them in every instance? Are there any further assumptions (such as the money supply being on earth rather than the moon) which are necessary for the relation to be true? Does the situation we are trying to describe actually conform to these assumptions so that the equation is a satisfactory approximation or illustration of reality?

The answer to all these questions is certainly not tautological, though our investigations would be a whole lot easier if it were. Besides, every logical deduction is a tautology too, so we're in a real reflexive bind if it is a reason to reject something.

[Lee Kelly]

Regarding my last comment, the equation does not actually assume that the money supply is on earth rather than the moon.

[Mario Rizzo]

Steve Horwitz is great!

[Lee Kelly]

Let me exapnd. When I say that every logical deduction is a tautology, I mean:

P & Q |= Q is a tautology because it is true, on pain of contradiction, that Q is entailed by P & Q.

The MV = PY equation is actually a scientific hypotheses, in my opinion, i.e. I can specify a finite set of observations that would falsify it.

[Lee Kelly]

One more thing, I interpret the MV = PY to describe what the economy has a propensity to move toward, rather than what it is like at any specific moment. Inflation can be loosely defined as MV > PY, and deflation MV < PY, or at least in the monetary equilibrium sense.

[Lord Buzungulus, Bringer of the Purple Light]

I would recommend reading Hazlitts discussion of velocity in The Inflation Crisis, and How to Resolve It, downloadable at the Mises Institute web site.

[Lord Buzungulus, Bringer of the Purple Light]

Also:

http://mises.org/story/918

[Lee Kelly]

You recommend that article!? Where Shostak is right he is arguing against a straw man, and the rest is, ... well, let's just say if I were an Austrian, then I'd I would be annoyed at Shostak for making my team look dumb.

[Lord Buzungulus, Bringer of the Purple Light]

One of these days, Lee, I might take you seriously. That day is a long way off, though.

[Bill Woolsey]

V is defined to be Py/M

And so, MV = Py by definition.

On the other hand, V = 1/k where:

k = M/Py

If we say that k is the ratio of the quantity of money to nominal income, then it is a definition too.

However, if we say that Md = Md(P,y,.), and believe that we can say that Md = P md(y,) that is, that the demand for money is a demand for purchasing power. And further, that Md = Py k(.), that the real demand for purchasing power is proportional to real income, (which makes money services exactly on the cusp between a necessity and luxury,) then:

Md = Pyk(.)

In equilibrium, Ms = Md.

Ms = Py k(.)

Dropping the "s" and understanding that M = quantity of money..

M = Py k(.)

M*(1/k) = Py

1/k = V

MV = Py.

It is an equilibrium condition, not an identity, but V is just an odd way of looking at the demand for money. The reciprocal of the fraction of nominal income that people choose to hold in the form of money.

I don't find the concept of velocity all that useful. Not that I don't talk about it sometimes. But I don't believe that the real demand for money is exactly proportional to real income, or if it is, there is no reason why it should be. And so, I stick with M/P = md(y,.)

The price level adjusts so that the real quantity of money meets the real demand for money. And the real demand for money is positively related to real income--because the services from money are a normal good.

(The ".", like md(y,.) or k(.) represent other things, including interest rates, that impact the amount of money people choose to hold.)

While I am most interested in the market processes that occur when there money supply and money demand aren't equal, and how they lead to the real quantity of money adjusting to the real demand, I actually think these algebraic manipulations are enlightening.

That is, how k and V and money demand are all related and what we are saying about the relationship beween real income and real money demand.

I use a similar treatment to try to make sense of Kling's view about nominal income and recalculation.

http://monetaryfreedom-billwoolsey.blogspot.com/2009/09/klingonomics-4.html

[Bill Woolsey]

Rose:

So the Canadian experience shows that if nominal expenditure would have been maintained during the 1930's, in the U.S. and Canada, output and employment would have been the same, but there would have been something like 30% inflation?

It was just a massive supply shock. And the drop in nominal expenditure was irrelevant. Prices and wages adjusted appropriately the entire time, keeping real expenditure equal to the reduced productive capacity due to the 30% drop in productive capacity.

Is that what you are saying?

[Lee Kelly]

Oh, thank goodness. If I ever argue like Shostak (at least in that article), then I hope that it is indeed a "long way off."

[Lord Buzungulus, Bringer of the Purple Light]

As Bill Woolsey notes, BY DEFINITION, v = py/m. Thus people who talk about mv being greater than or less than py shouldn't be calling others dumb. (They may also want to take more care in distinguishing a contradiction from a tautology.)

[David Stinson]

"It is an equilibrium condition, not an identity, but V is just an odd way of looking at the demand for money. The reciprocal of the fraction of nominal income that people choose to hold in the form of money."

Yup.

[Don Lloyd]

The demand for money to hold is far too fragile a variable to employ in the exercise of monetary policy.

There are a million ways to demonstrate this, but let's start with a grossly over-simplified example that should at least raise doubts.

There are 30 people in an economy with 30 workdays a month. Everyone gets paid $1000 a month in cash on a different day of the month and pays $1000 in monthly rent the day before payday.

Roughly, let's say that everyone holds $1000 in cash 29 days a month and nothing the 30th day.

This means that the average demand for money to hold is a total of $29K.

But let's make a simple change. Instead of holding cash for 29 days, everyone puts their pay in a non-checkable MMMF for 28 days, converts it to cash for one day and then pays his rent. In this case, the average demand for money to hold has been reduced by a factor of 29X to $1K without any of the individuals seeing much of any significant difference in their life.

If individuals can randomly change their cash management plans, it is hard to see how trying to track the demand for money with the supply of money makes even the slightest bit of sense.

Of course this simple problem really has nothing to do with the true demand for money, which is a demand for the medium of exchange, but almost everyone actually holds more money than they need as a medium of exchange because it isn't usually worth the trouble to turn excess money into short term investments in liquid financial assets.

Regards, Don

[Steve Horwitz]

Two quick comments:

Lee is correct and Lord B is wrong: Shostak's article is awful and is pretty much arguing against a straw man, specifically the idea that "velocity" as an independent effect. Certainly Austrians who talk about the equation of exchange don't make that mistake, as we recognize it's (more or less) the inverse of the demand for money, our explanation of which comes right out of Mises. And no decent neoclassical economist I know would talk about velocity without talking about the demand for money. That is indeed the kind of argument that makes Austrians look silly to other economists.

Lord B is quite right about it not being possible for MV to be less than or greater than PY. They are equal by definition, assuming equilibrium. Change one variable and something else has to change to compensate to maintain the equilibrium it describes. When free banking types talk about "stabilizing MV," all we're saying is that if V (money demand) changes, M should be the variable that changes to maintain the equilibrium, not anything on the right side.

[DG Lesvic]

“Inflation was promoted by a desire to speed recovery from the 1920-1921 recession.”

Rothbard, America’s Great Depression, P 126

Prof. Horwitz is confusing an increasing marginal with an increasing total demand for money. A greater demand for each dollar is not a demand for more dollars. It is a demand for more savings, and “additional liquidity” defeats that purpose.

[Dave Prychitko]

"When free banking types talk about "stabilizing MV," all we're saying is that if V (money demand) changes, M should be the variable that changes to maintain the equilibrium, not anything on the right side."

Steve, you've said this a thousand times on this blog, for months and months on end. At some point the varied reiterations on reluctant minds reaches negative returns. I think we've reached that point.

[billwoolsey]

Don:

If people changed their payment habits in that extreme fashion, so that the demand for money fell so much. And the quantity of money remained unchanged. Then the results would be awful. The quantity of money should fall to match the reduced demand.

[Don Lloyd]

Bill,

"If people changed their payment habits in that extreme fashion, so that the demand for money fell so much. And the quantity of money remained unchanged. Then the results would be awful. The quantity of money should fall to match the reduced demand."

This is not an extreme change at all, but a very marginal one, at least in terms of well-being.

Let's consider a ball in near equilibrium in the bottom of a bowl. The restoring force that the ball experiences depends greatly on the depth of the bowl and the slope that the ball feels relative to gravity. In the case of money beyond what an individual requires for a medium of exchange, the slope is extremely shallow and large adjustments in the amount of money held vs some alternate liquid financial asset can be easily accomplished by each individual without significant impact. It's far easier for an individual to satisfy his own equilibrium for the holding of money than have it done by the banking system responding to useless data.

I'm not sure that it would work this way, but all of the individuals together could adjust for a total money supply between $2K and $28K without any great strain, remembering the grossly over-simplified nature of this problem. The difference between holding a lump of $10K in cash and a lump of $10K worth of an alternate liquid financial asset earning 0.3% per annum won't have much effect on how much you would be willing to pay for a given marginal good.

Regards, Don

[DG Lesvic]

I should have put it like this.

The greater demand for money is really for more savings. So, "increasing liquidity" does not "meet the demand," but, by reducing the value of savings, counteracts it.

[DG Lesvic]

Counteracts the demand for it.

[Jim Rose]

Greg,

John Cochran’s paper is the first link at http://mises.org/literature.aspx?action=author&Id=224

A summary is at

http://www.iaes.org/conferences/past/philadelphia_52/prelim_program/e00-1/cochran-call.htm

He applied it to Japan and the USA in

http://www.ijeb.com/Issues/data/June04_1_cbmbabijatus.pdf

[Bill Woolsey]

Don:

You are in error. Assuming I have been able to follow your examples, you have shown something like a 90% decrease the demand for money. You correctly point out that from the individual point of view, this is easy. Then you fail to recognized that the quantity of money is unchanged. What happens to the money that no one wants to hold? In your story, I guess the issuers of the noncheckable money market funds have it immediately. What do they do with it!

This is what macroeconomics is about. Looking at each individual and forgetting that things have to add up is the _worst_ error possible.

For every borrower there is a lender. Somebody is always holding all the money that exists.

The fundamental proposition of monetary theory is that the individual can adjust money demand to money supply by changing expenditures or trading nonmonetary assets. (In my lectures, I always add, it is obvious what to do, and easy, though a shortage of money does require you gie something else up to get more money.) But for the entire economy, equilibrium requires a change in pretty much every nominal price, including nominal incomes.

In your scenario, the price level would need to rise by 900%. (Well, you say 29x, so that is a good bit more.)

What needs to happen is that the quantity of money fall to match the decrease in demand, just as the quantity of noncheckable money market funds needs to expand to meet the increase in demand. I think you are someone assuming that happened. Well, if it did, there would be no reason for a monetary policy response. You are assuming it has somehow already happened.

[Current]

Regarding persuading others...

Steve Horwitz and the rest of you guys did persuade me. I agree it's unlikely you will persuade others.

I'm not sure that more can't be done with this discussion. Salerno's view of markets is quite reasonable. Rothbard's discussion around money is quite reasonable too, even if his conclusions aren't. In a long article it would be possible to zero in on the problems though, doing this might be a useful exercise. Even if it doesn't convince any existing Austrian Economist it may persuade a newer generation.

I might write an article like that some time when I have the time.

[Don Lloyd]

Bill,

I certainly agree that when we effectively define money demand as equal to what is held, the supply of and the demand for money do in fact match.

But my point was that the demand for money is exceptionally erratic. The demand for mens' hats is likely to have at least some relationship to the number of mens' heads, but the demand for money to hold is wildly unpredictable even for a given individual.

Generally speaking, any quantity of money in a wide feasible range can be matched by exchanges between actual money held and liquid financial assets without significant effects on prices. This is consistent with Steve's definition of inflation (and from Mises) as only being an increase in the supply of money not matched by an increase in the demand for money to hold, or something along those lines.

The missing piece is an incentive. Why would individuals care what the total supply of money is? The only incentive for holding more money is to stretch one's holding of the medium of exchange from paycheck to paycheck. Once you have enough money for that, the choice between money and an alternative liquid financial asset has only weak incentives.

Thanks, Don

[DG Lesvic]

Curent wrote,

"I might write an article like that some time when I have the time."

I can hardly wait.

And, Prof. Horwitz, I am not being sacrcastic. I really mean it.

I've lost track of things here, but isn't the basic question to inflate, oops, pardon me, to ease or not to ease in the face of deflation.

The deflation is the market saying, I see an avalanche coming, and I want to get out of the way.

And Prof. Horwitz saying that that will cause needless pain to innocent bystanders is saying that the market should not get out of the way, but take the hit.