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"you can start to see how the frictions of the world play a positive role in the explanation of how the market process marshals economic forces to work"

Is there a formal exposition of this idea that "friction makes the market work"? It sounds like Alchian and Kirzner only present a rough sketch of such an analysis.

Actually some of the worst behavior of the Fed occurred early in its existence, as documented by Friedman and Schwartz, with one such episode involving something that has been much represented here and on some similar blogs. I am talking about the 1920-21 recession. A major trigger of it was the Fed pushing up the discount rate, starting in late 1919, to a 7% high in June 1920, the year in which we had a double digit decline in the price level, probably the biggest such decline ever in all of US history. And according to the Conference Board and in contrast with stuff handed out here and elsewhere, nominal wages did not decline that year or in 1921 either.

What turned the recession around, given that real wages were soaring throughout the period? Well, in July 1921 when the unemployment rate peaked, the Fed finally got smart and started systematically lowering the discount rate.

Barkley - which Conference Board statistics are you refering to? I've looked at the NBER weekly manufacturing earnings index (monthly), which showed a very large decline in nominal earnings, the New York Federal Reserve's composite wage index, and Wilford King's quarterly wage numbers which are across multiple sectors and they all show declines. I'd be very curious to see these Conference Board numbers.

I think your analysis about the central role of the Fed is right - I wouldn't dispute that. I'm just curious about your wage numbers.

I wouldn't just write off the Fed's decision either - they probably slammed the breaks too hard, but they were intending to fight some pretty substantial war-time inflation. Reading Benjamin Strong's account of the situation, you get the sense they were really just getting a handle on their capabilities. It was not caused by the sort of naive neglect that you saw at the onset of the Depression.

Thanks for this. Do you have any more economic history suggestions? We're just finishing reading the Invisible Hook in my Economic Research Seminar and I have students that are jonesing for more.

Jenny from... you know.

Daniel,

My source was Table 1 of Dighe and Schmitt, 2008, Did wages become stickier between the world wars? http://www.nzae.org.nz/conferences/2008/110785nr/215477487.pdf, which is according to them based on Ada M. Beney, 1936, Wages, Hours, and Employment, 1914-1936, National Industrial Conference Board.

I looked at NBER site and did not see aggregate index for the years in question, only ones for lots of separate sectors. Something that struck me was wide variation across sectors, with some having wages falling and others having them rise. Given the variability in numbers across data sources for price changes in those years, would not surprise me if such variation exists also for wage data. One thing that seems clear, however, is that prices fell far more than wages, so the story of rising real wages, at least through 1921, looks pretty accurate.

Thanks - I appreciate it

I applaud Barkley for bringing up 1920-21. If you examine how sharp was the downturn, it should have been the Great Depression. Why Not?

That cycle was the last one in which the economy was allowed to recover on its own, as it always had, and did so quickly. Friedman and Schwartz were perplexed by it, because the Fed stayed on the sidelines. The economy recovered on its own.

The Fed had to raise interest rates because of the wartime inflation. It did its job. And prices did their job -- they fell. As Scott Sumner and John Wood have noted, prices did not fall enough compared to pre-war parity. That is why there was continued downward pressure on prices in the 1920s.

Harding ran in 1920 promising austerity, liquidation and deflation. Whether he had a hand in it, the market delivered the all. And it was over so fast annual data don't capture how severe it was. In other words, it was a typical 19th century cycle.

You can't capture Alchian in a blog posting. You need to read him. If you have never read him, you need to read him carefully the first time.

Alchian represents an alternative way of thinking about how markets work. As Pete noted, for Alchian frictions are not an impediment to achieveing plan coordination, but part of the process.

Alchian incorporates Austrian insights, but he is more radical in his development of them than any single Austrian I know. Serious Austrians need ot read him.

I was not an Alchian student, but his "model" dominated UCLA while I was there. (Bill Allen, his colleague, has written a short history of the UCLA department.) Leijonhufvud's book on Keynes is chock full of Alchian insights on uncertainty and equilibrium.

Jerry,

Regarding the claim that "the Fed stayed on the sidelines," that does not look quite right. They began aggressively cutting the discount rate in mid-1921 at the peak of the unemployment rate. What is true is that Harding ran an austere fiscal policy.

Jerry,

"Information Costs, Pricing, and Resource Unemployment" from Economic Inquiry (1969) is an excellent start of Alchian’s views on this area.

Alchian then builds on search by tying wage and price rigidity and unemployment to mutual dependencies arising from relationship specific assets and composite quasi-rents they generate in three papers in the 1980s in the Journal of Institutional and Theoretical Economics about the theory of the firm:
1. Specificity, Specialization, and Coalitions
2. Reflections on the Theory of the Firm (Armen A. Alchian and Susan Woodward)
3. The Firm Is Dead; Long Live the Firm: A Review of Oliver Williamson’s The Economic Institutions of Capitalism (Armen A. Alchian and Susan Woodward), which is in JEL, not JTIE

They show advanced insights into how the market process exactly works.


Barkley,

You have no lags in your story.

All from Friedman and Schwartz.

"Its brevity makes annual data misleading guides to its severity" (232). No time for monetary policy, much delayed, to work.

NBER dates the peak of the expansion in Jan. 1920. It peaked as the Fed began raising rates at the same time, so it couldn't have caused the downturn (231).

Three-quarters of the decline occurred from August 1920 to February 1921 (232). So the worst was over while the Fed was still bickering about whether to cut the discount rate from 7 to 6 percent.

The trough was reached in in January 1922. High-powered money continued to fall after the trough (236). No monetary ease there.

The Fed was behind throughout the downturn. If monetary policy explains the Great Depression, it does not explain 1920-21.

My larger point is that here are self-orderineconomies out of forces that bring ot of contractions. There was no activist monetary policies until the 20th century, which has seen the worst macroeconomic performance. There was no Fed until 1913 to "rescue" the economy. In 1920-21, the Fed didn't act until it was too late to attribute recovery to it.

Monetary policy in terms of the interest rate still looks to have played a role in the downturn. After all, that 7% rate went in as of June 1920 when sharp deflation was occurring, and as you note, the sharpest GDP decline started about two months after that. Not unreasonable. I agree that the turnaround story gets messier, but then this was a different recession than most, with demobilization and postwar inventory things going on.

"The Fed was behind throughout the downturn. If monetary policy explains the Great Depression, it does not explain 1920-21."

Yes, the Fed did almost nothing, but the issue is - was this a problem or a good thing? Did this helped or aggravated the situation? If the passive Fed allowing the money supply to shrink and nominal wages to decline helped in 1921, how then the same thing in 1929-32 could had been said to be a curse?

If, on the contrary, the Fed actually made things worse in 1921 by its inaction (as Steve Horwitz beleives) that's kind of strange, because we've been taught that the Fed's "inaction" made the Great Depression to last so long. The Forgotten depression, on the contrary, was very short. How come?

Barkley and Jerry -
Industrial production indices are also available at higher frequency than output statistics - industrial production picked up about five months after the discount rate was cut... sounds like a perfectly plausible lag to me.

I think the conclusion that tight policy might not have been what put us into the recession in the first place is more reasonable. Sharp contraction of federal spending, the inventory features Barkley mentions, and the adjustment of production after the war provide more than enough to put is into a downturn - wait a couple more months for a 4% to 7% discount rate to kick in and it's even deeper.

But on the other end of things - getting out - the monetary policy story seems much clearer.

Nikolaj -
RE: "If, on the contrary, the Fed actually made things worse in 1921 by its inaction (as Steve Horwitz beleives) that's kind of strange, because we've been taught that the Fed's "inaction" made the Great Depression to last so long. The Forgotten depression, on the contrary, was very short. How come?"

Look at work by Romer, Vernon, Temin, etc. (for that matter, look at my new article in the Review of Austrian Economics on it). All the Austrians who think this is a slam dunk against fiscal policy (Murphy, Woods) conspicuously neglect to cite Romer or any of these others. They conclude that the recession was primarily due to a supply shock (and of course the Fed policy - which was reversed - has already been mentioned). No demand deficiency, no reason to expect a depression that feeds on itself.

That's the story at least. I don't think 1920-21 is a slam-dunk for anyone, but it's consistent with a lot of these stories.

Just to point out that in 1921 it was not the board of governors that set the rates, but according to the Lords of Finance Benjamin strong the head of the NY Fed. Governance at the fed was severly reformed in 1933 with the board of governors becoming the leading body, and the creation of the FOMC, where the board of governors has a majority. So its really two different feds, the first run by the banks in NY for the banks in NY, the second having at least a simdgen of public input.

A couple of points I think are important that have been missed...

Firstly, I think that Daniel Kuehn is right about a real shock after WWI ended. Then end of a war is like a huge preference shift and it causes many real frictional loses. That said, if we measured "war output" differently as some have proposed we wouldn't necessarily see that as a fall in meaningful output.

Secondly, I think what many of you are forgetting about is the nominal anchor provided by gold. The era we're discussing had a central banks and a fractional-reserve gold standard. The gold standard provided a nominal anchor, in the short term the central bank set the discount rate and also thereby influenced the quantity of money. But, as far as I understand it, in the medium term the central banking tools were used to ensure stability of the price level against other gold-convertible currencies, to prevent outflow.

So, any particular short term monetary policy that the central bank enacted wasn't as important as it is now.

Current: "Then [sic] end of a war is like a huge preference shift and it causes many real frictional loses."

Well, yes. But not a severe recession, usually. Look at WWII, which involved vastly greater mobilization and general reorientation of economic activity than WWII.

One big difference between the 1920-1 and 1930-3 crises is that, in the first, people had every reason to anticipate deflation, having seen prices go way up from 1917 to 1920. That expectation made actual downward P and w adjustments a lot easier. In contrast, since p didn't rise during the 30s, no one could quite accept the need for it to fall, and fall a lot, afterwards if recovery was going to proceed despite the collapse of spending.

None of this is meant to deny that Hoover's interventions, and still more so many of Roosevelts, also interfered with recovery and further deepened the Great Depression.

> Well, yes. But not a severe recession, usually.
> Look at WWII, which involved vastly greater
> mobilization and general reorientation of
> economic activity than WWII.

That's a good point.

> One big difference between the 1920-1 and
> 1930-3 crises is that, in the first, people
> had every reason to anticipate deflation,
> having seen prices go way up from 1917 to
> 1920. That expectation made actual downward P
> and w adjustments a lot easier. In contrast,
> since p didn't rise during the 30s, no one
> could quite accept the need for it to fall,
> and fall a lot, afterwards if recovery was
> going to proceed despite the collapse of
> spending.
>
> None of this is meant to deny that Hoover's
> interventions, and still more so many of
> Roosevelts, also interfered with recovery and
> further deepened the Great Depression.

I'm interested in your view on this and I expect the other folks here are too. Do you think that those are the main differences? Do you think that Jerry is essentially correct above?

The happiest is the person who suffers the least pain; the most miserable who enjoys the least pleasure!

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