Remembering the Old New Republic: Hoisted from the Archives from Five Years Ago

More Musings on "Monetary Economics"

Over at Equitable Growth: There is, I think, a profound reason why those who have been able to understand the business cycle over the past two centuries have been those who have defined themselves as doing "monetary economics", and those who have not been able to understand the business cycle have not...

Three things strike me while rereading Schumpeter's 1934 "Depressions" (and also his 1927 Explanation of the Business Cycle): READ MOAR

  1. How much smarter Schumpeter is than our modern liquidationists and austerians--he manages to say a great many true things. He manages to say them even though his fundamental belief--that structural adjustment requires a downturn and a wave of bankruptcies that releases resources into unemployment--is mistaken. That false belief turns his overall argument into chaff. But there are a lot of insights nevertheless. How much more fun and useful it would be right now to be debating a Schumpeter right now than the ideologues calling for, say, more austerity for and more unemployment in Greece!

  2. How very strange it is for Schumpeter to be laying out his depressions-cause-structural-change-and-growth theory of business cycles at the very same moment that he is also laying out his entrepreneurs-disrupt-the-circular-flow-and-cause-structural-change-and-growth-theory of enterprise. It is, of course, the second that is correct: Growth comes from entrepreneurs pulling resources into the sectors, enterprises, products, and production methods of the future. It does not come from depressions pushing resources into unemployment. Indeed, as Keynes noted, times of depression and fear of future depression are powerful brakes halting Schumpeterian entrepreneurship: "If effective demand is deficient... the individual enterpriser... is operating with the odds loaded against him. The game of hazard which he plays is furnished with many zeros.... Hitherto the increment of the world’s wealth has fallen short of the aggregate of positive individual savings; and the difference has been made up by the losses of those whose courage and initiative have not been supplemented by exceptional skill or unusual good fortune. But if effective demand is adequate, average skill and average good fortune will be enough..."

  3. How Schumpeter genuinely seems to have no clue at all that the business cycle is a feature of a monetary economy--how very badly indeed he needed to learn, and how he never did learn, what Nick Rowe and company teach today about the effects of monetary stringency on economic coordination.

The key, I think, is that Schumpeter--and Hayek, and all the other Austrians past and present--never grappled with the Mill-Bagehot-Wicksell-Fisher traditions in monetary economics. Overinvestment is one thing that can produce an excess demand for safe and liquid assets. It is not the only thing that can. It is not the case that excess demand for safe and liquid assets necessarily implies a previous bout of overinvestment. And it is not the case that curing the excess demand for safe and liquid assets always requires painful "liquidation" and austerity.

There was an alternative road of understanding open to Schumpeter, Hayek, and company--one that the line of argument from Mill through Wicksell and Fisher to Keynes and Friedman took. It goes roughly like this:

  1. Demand for safe and liquid financial assets sometimes spikes. It can spike because previously investors were over-sanguine, and their beliefs have now come back to normal. It can spike because investors were previously realistic, and are now overly pessimistic. It can spike because of news about increasing fundamental risk. It can spike because of news about decreasing expected returns.

  2. No matter what the cause, there emerges an excess demand for safe and liquid financial assets.

  3. That excess demand is, by Walras's Law, the counterpart of an excess supply at full employment of currently-produced goods and services.

  4. That excess supply causes inventories to pile up, and production, employment, and incomes to fall.

  5. Because of sticky prices and sticky nominal contracts, declines in the price level--declines in the prices of currently-produced goods and services relative to money--cannot quickly rebalance the economy at full employment. Sticky prices do not fall fast enough to do so. And non-sticky prices that do fall produce chains of bankruptcies that further boost demand for money--for safe and liquid assets.

  6. Hence the economy gets stuck, for a while at least, with lots of involuntary unemployment.

This is a clear, coherent story about downturns. It says that downturns can be triggered by a recognition of overinvestment. But it also says that downturns can be triggered by other things. And there is no reason why the recognition of overinvestment has to be followed by a period of high involuntary unemployment. Structural adjustment and sectoral rebalancing may be desirable, but periods of structural adjustment and sectoral rebalancing do not always require high structural unemployment. And curing high demand slack-driven involuntary unemployment does not require slowing structural adjustment: you do not have to refill a tire through the puncture.

Yet neither Schumpeter nor Hayek nor any of their latter-day epigones could ever go to that Mill-Bagehot-Wicksell-Fisher-Keynes-Friedman argument. Instead, we have an alternative axis--a Ricardo-Marx-Schumpeter-Hayek-Hoover axis--that denies that anything other than budget surpluses and "sound money" can ever be appropriate economic policies. Why not? The root of the rejection of Mill-Friedman really does seem to me a belief that the market and its "general gluts" cannot be improved by macroeconomic management, either because (Ricardo-Schumpeter-Hayek-Hoover) the market is and must be good, or because (Marx) the market is and must be bad.


Joseph Schumpeter (1934): [Depressions: What Can We Learn from Past Experience?](https://books.google.com/books?id=WVMUGqMU5bAC&pg=PA115&dq=schumpeter+depressions+are+not+simply+evils,+which+we+might+attempt+to+suppress&hl=en&sa=X&ei=rQ2QVZTfHsnvoASqpYaAAw&ved=0CCwQuwUwAg#v=onepage&q=schumpeter depressions are not simply evils, which we might attempt to suppress&f=false)

The problems presented by periods of depression may be grouped as follows: First, removal of extra economic injuries to the economic mechanism: Mostly impossible on political grounds. Second, relief: Not only imperative on moral and social grounds, but also an important means to keep up the current of economic life and to steady demand, although no cure for fundamental cases.

Third, remedies: The chief difficulty of which lies in the fact that depressions are not simply evils, which we might attempt to suppress, but--perhaps undesirable--forms of something which has to be done, namely, adjustment to previous economic change.

Most of what would be effective in remedying a depression would be equally effective in preventing this adjustment. This is especially true of inflation, which would, if pushed far enough, undoubtedly turn depression in to the sham prosperity so familiar from European postwar [i.e., World War I] experience, but which, if it be carried to that point, would, in the end, lead to a collapse worse than the one it was called in to remedy.

Fourth, reforms of institutions intended to remedy the situation but suggested by the moral and economic evils of both booms and depressions: The crucial point of these reforms lies in the coincidence of a political atmosphere exceptionally favorable, and an economic situation exceptionally unfavorable to their success. No doubt they will always be carried amidst enthusiastic clapping of hands. But they will also be stigmatized in the future by their tendency to prevent or retard recovery. This should not blind to us to any merits they may have, but it is a plain and undeniable fact.

The Atmosphere of Periods of Depression: We have seen that the course of events in all periods of depression presents a significant family likeness. So do the attitudes of the people. Defeat on the battlefield destroys the prestige of military rulers and their confidence in themselves; crises destroy whatever of both these things business leaders may enjoy. Their cry for help is the more damaging for them the more they disapproved of government interference before. For the time being, the majority of people grows out of humor with the economic system under which they live, and becomes inclined to favor what in some cases we call reaction and in others radicalism. In fact, it makes astonishingly little difference which way they more politically. The consequences are much the same in both cases....

The Upshot: There is on reason to despair--this is the first lesson to be derived from our story. Fundamentally the same thing has happened in the past, and it has--in the only two cases which are comparable to the present one--lasted just as long. We are more keenly alive now to human suffering, and we are dealing with the situation under political pressure by political methods, but substantially we are confronted only with problems which the world was confronted with before.

In all cases, not only the two which we have analyzed, recovery came of itself. There is certainly this much of truth in the talk about the recuperative powers of our industrial system. But this is not all: our analysis leads us to believe that recovery is sound only if it does com of itself. For any revival which is merely due to artificial stimulus leaves part of the work of depressions undone and adds, to an undigested remnant of maladjustment, new maladjustment of its own which has to be liquidated in turn, thus threatending business with another crisis ahead. Particularly, our story provides a presumption against remedial measures which work through money and credit. For the trouble is fundamentally not with money and credit, and policie of this class are particularly apt to keep up, and add to, maladjustment, and to produce additional trouble in the future...


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