Cause of the Great Depression

Chris M. Sciabarra sciabrrc at is2.NYU.EDU
Wed Sep 20 20:46:14 MDT 1995

On Thu, 21 Sep 1995 P8475423 at wrote:

> Now here's a point where I *do* part company with Chris S:
> |        Welfare was created to keep the poor in their place because the
> |social economy of the early 20th century was careening from one statist
> |crisis to another, smashing up in the Great Depression which was caused
> |by Federal Reserve monetary manipulation...
> This interpretation of the Great Depression is one that both Austrian
> and neoclassical economists (with Friedman the arch example) have
> promulgated. It is one rejected by Post Keynesian economists (and
> Marxian, though for different reasons). PKs tend to see it as the
> product of a debt deflation following a debt-financed boom (though I
> know Austrians have some sympathy with the final part of this statement),
> and the crash would have happened no matter what the Federal Reserve
> did--though what the FR did do may well have made the crash worse.

	I know that Steve and I part company on this issue, but I don't
know if he is aware of the distinction between the Austrian and
monetarist arguments in this regard.  The Austrian argument is best
summarized in Murray Rothbard's AMERICA'S GREAT DEPRESSION, but it has
more recently been promoted in a form that directly answers Post
Keynesians in a wonderful article by Gene Smiley in CRITICAL REVIEW (vol.
5, no. 1, Winter 1991):  "Can Keynesianism explain the 1930s? - Reply to
Cowen."  Smiley summarizes the difference between the Austrian and
Friedmanite-monetarist view thusly:

	"Austrian economists have offered monetary explanations since the
early 1930s.  To the Austrians the Depression was the inevitable result
of the inflation of the stock of money engineered by the Federal Reserve
System during the 1920s.  This expansion pushed interest rates lower than
consumers' rates of time-preference, resulting not only in more
investment than there would otherwise have been, but in a different
pattern of investment.  The new level and pattern of investment was only
sustainable as long as the Fed continued to expand the stock of money at
an increasing rate.  When the Fed changed course in late 1928, the
Depression began -- the inevitable process by which resources were
reallocated to those uses consistent with consumer time-preferences.
Monetarists, by contrast, imply that if the Fed had maintained the money
stock's growth rate, the contraction (if any) would not have been so severe."

	I would add that monetarists have no problem with central banking
per se; Austrians do and would abolish such banking.  Some Austrians
favor the historical model of free banking -- which one could find in the
earlier days of capitalism; others are advocates of a strict specie
standard of value for money.  Historically, dollars and other
denominations were interchangeable according to their weight in gold.
Taking the economy off the gold standard was a political decision that
gave banks the power to inflate at fractional
reserve levels most conducive to a
reallocation of wealth and power toward the banking sector and toward its
chief beneficiaries -- debtor, capital-intensive industries.  The
Austrians are probably closer to Marxists than to monetarists in this
regard; they do believe that "ultimate decision-making" under state or
finance capitalism lies in the hands of the financial institutions in
league with political authorities.
	Let's not forget too, that the pattern of contraction spurred on
by monetary expansion and manipulation was further aggravated by more
wrong-headed state policies.  Countries were engulfed in economic
nationalism; the U.S. adopted the Smoot-Hawley tariff, raising the
average tariff on imports from 19.8 to 36.4 percent.  Few commodities
escaped tariff increases, and other countries retaliated.  These actions
further distorted prices and created a push of resources toward firms
producing import-competitive products and services.  A greater bulge in
unemployment resulted, especially amongst exporting firms -- usually
among the most productive and innovative of firms.  There was also a
delay in the onset of wage deflation caused by political factors,
creating ultimately, a greater push toward unemployment.  The further
intervention of the Reconstruction Finance Corporation, and continued
monetary juggling only exacerbated the problem.  The newly created
NRA raised wage rates and prices, and flirted with legalized monopoly
and cartelization, choking off a mild recovery. Further Fed actions led
to a lesser contraction in 1937-38.  Unemployment didn't disappear until
the war; by 1945, 18 percent of the labor force was in military service
and 63 percent of that military was conscripted.  This was no "recovery"
-- it was a state-guided "solution" to a state-generated problem.

> In my opinion, Minsky's "financial instability hypothesis" gives the
> best explanation of the mechanism behind such a collapse, and for those
> that are interested, I have posted an excerpt from my JPKE paper where
> I summarize that theory at the end of this post. For Jerry's interest,
> the paper itself models that process using a nonlinear system.
> I don't disagree hugely with what Chris then led on to:
> |Corporations and unions JOINED
> |FDR in creating the original New Deal corporate state modelled on
> |Mussolini's Italy.  Welfare was part of this corporativist structure, as
> |it was for Bismark.  If it helps the poor from starving, it also helps
> |the rich keep the poor from fully grasping the system that created
> |poverty.  The social democrats who provided the rich with an ideology of
> |altruism to help the poor may not have known that that ideology would be
> |used in such an insidious way, but thems the facts.
> But I would argue that such mechanisms are a vital, non-market
> "homeostatic" input, without which capitalism would lurch into many more
> Great Depressions, no matter who was running the federal reserve.

> Finally, a bit of decent statistics I've recently found. In a paper
> entitled "Business Cycles, Real facts and a monetary myth", the authors
> argue:
> "There is no evidence that either the monetary base or M1 leads the
> cycle, although some economists still believe this monetary myth.
> Both the monetary base and M1 series are generally procyclical, and,
> if anything, the monetary base lags the cycle slightly."
> "An exception to this rule occurred during the expansion of the
> 1980s... During the expansion, M1 was uncommonly volatile, and M2,
> the more comprehensive measure of the money stock, showed some
> evidence that it leads the cycle by a couple of quarters."
> "The difference in the behaviour of M1 and M2 suggests that the
> difference of these aggregates (m2 minus M1) should be considered.
> .. The difference ... leads the cycle by even more than M2 ..."
> "... it is also apparent that money velocities are procyclical
> and quite volatile."
> To summarize the implications of the above, it implies that
> the money supply is endogenous--and that therefore,
> manipulation of the money supply as a means to control the
> economy (whether for good or ill, such as causing the GD)
> is difficult, if not impossible. It also implies that
> endogenous credit cycles may well drive the trade cycle,
> a view that is consonant with Minsky's hypothesis.

> Cheers,
> Steve Keen
> Kydland FE & Prescott EC, "Business Cycles, Real facts
> and a monetary myth", Federal Reserve Bank of Minneapolis
> Quarterly Review, 1990, pp. 3-18
> Minsky excerpt:
> Minskys analysis of a financial cycle begins at a time when the economy
> is doing well (the rate of economic growth equals or exceeds that needed
> to reduce unemployment), but firms are conservative in their portfolio
> management (debt to equity ratios are low and profit to interest cover is
> high), and this conservatism is shared by banks, who are only willing to
> fund cash-flow shortfalls or low-risk investments. The cause of this high
> and universally practised risk aversion is the memory of a not too distant
> system-wide financial failure, when many investment projects foundered,
> many firms could not finance their borrowings, and many banks had to write
> off bad debts. Because of this recent experience, both sides of the
> borrowing relationship prefer extremely conservative estimates of
> prospective cash flows: their risk premiums are very high.
> However, the combination of a growing economy and conservatively financed
> investment means that most projects succeed. Two things gradually become
> evident to managers and bankers: "Existing debts are easily validated and
> units that were heavily in debt prospered: it pays to lever." (Minsky
> 1982, p. 65). As a result, both managers and bankers come to regard the
> previously accepted risk premium as excessive. Investment projects are
> evaluated using less conservative estimates of prospective cash flows, so
> that with these rising expectations go rising investment and asset prices.
> The general decline in risk aversion thus sets off both growth in
> investment and exponential growth in the price level of assets, which is
> the foundation both of the boom and its eventual collapse.
> More external finance is needed to fund the increased level of investment
> and the speculative purchase of assets, and these external funds are
> forthcoming because the banking sector shares the increased optimism of
> investors (Minsky 1980, p. 121). The accepted debt to equity ratio rises,
> liquidity decreases, and the growth of credit accelerates.
> This marks the beginning of what Minsky calls "the euphoric economy"
> (Minsky 1980, pp. 120-124.), where both lenders and borrowers believe that
> the future is assured, and therefore that most investments will succeed.
> Asset prices are revalued upward as previous valuations are perceived to
> be based on mistakenly conservative grounds. Highly liquid, low-yielding
> financial instruments are devalued, leading to a rise in the interest
> rates offered by them as their purveyors fight to retain market share.
> Financial institutions now accept liability structures both for themselves
> and their customers "that, in a more sober expectational climate, they
> would have rejected" (Minsky 1980, p. 123.). The liquidity of firms is
> simultaneously reduced by the rise in debt to equity ratios, making firms
> more susceptible to increased interest rates. The general decrease in
> liquidity and the rise in interest paid on highly liquid instruments
> triggers a market-based increase in the interest rate, even without any
> attempt by monetary authorities to control the boom. However the increased
> cost of credit does little to temper the boom, since anticipated yields
> from speculative investments normally far exceed prevailing interest
> rates, leading to a decline in the elasticity of demand for credit with
> respect to interest rates.
> The condition of euphoria also permits the development of an important
> actor in Minskys drama, the Ponzi financier (Minsky 1982, pp. 70, 115;
> Galbraith 1954, pp. 4-5). These capitalists profit by trading assets on a
> rising market, and incur significant debt in the process. The servicing
> costs for Ponzi debtors exceed the cash flows of the businesses they own,
> but the capital appreciation they anticipate far exceeds the interest
> bill. They therefore play an important role in pushing up the market
> interest rate, and an equally important role in increasing the fragility
> of the system to a reversal in the growth of asset values.
> Rising interest rates and increasing debt to equity ratios eventually
> affect the viability of many business activities, reducing the interest
> rate cover, turning projects which were originally conservatively funded
> into speculative ones, and making ones which were speculative "Ponzi".
> Such businesses will find themselves having to sell assets to finance
> their debt servicingand this entry of new sellers into the market for
> assets pricks the exponential growth of asset prices. With the price boom
> checked, Ponzi financiers now find themselves with assets which can no
> longer be traded at a profit, and levels of debt which cannot be serviced
> from the cash flows of the businesses they now control. Banks which
> financed these assets purchases now find that their leading customers can
> no longer pay their debtsand this realisation leads initially to a
> further bank-driven increase in interest rates. Liquidity is suddenly much
> more highly prized, holders of illiquid assets attempt to sell them in
> return for liquidity. The asset market becomes flooded and the euphoria
> becomes a panic, the boom becomes a slump.
> As the boom collapses, the fundamental problem facing the economy is one
> of excessive divergence between the debts incurred to purchase assets, and
> the cash flows generated by themwith those cash flows depending both upon
> the level of investment and the rate of inflation. The level of investment
> has collapsed in the aftermath of the boom, leaving only two forces which
> can bring asset prices and cash flows back into harmony: asset price
> deflation, or current price inflation. This dilemma is the foundation of
> Minskys iconoclastic perception of the role of inflation, and his
> explanation for the stagflation of the 70s and early 80s.
> Minsky argues that if the rate of inflation is high at the time of the
> crisis, then though the collapse of the boom causes investment to slump
> and economic growth to falter, rising cash flows rapidly enable the
> repayment of debt incurred during the boom. The economy can thus emerge
> from the crisis with diminished growth and high inflation, but few
> bankruptcies and a sustained decrease in liquidity. Thus though this
> course involves the twin "bads" of inflation and initially low growth, it
> is a self-correcting mechanism in that a prolonged slump is avoided.
> However the conditions are soon re-established for the cycle to repeat
> itself, and the avoidance of a true calamity is likely to lead to a
> secular decrease in liquidity preference.
> If the rate of inflation is low at the time of the crisis, then cash flows
> will remain inadequate relative to the debt structures in place. Firms
> whose interest bills exceed their cash flows will be forced to undertake
> extreme measures: they will have to sell assets, attempt to increase their
> cash flows (at the expense of their competitors) by cutting their margins,
> or go bankrupt. In contrast to the inflationary course, all three classes
> of action tend to further depress the current price level, thus at least
> partially exacerbating the original imbalance. The asset price deflation
> route is, therefore, not self-correcting but rather self-reinforcing, and
> is Minskys explanation of a depression.
> The above sketch basically describes Minskys perception of an economy in
> the absence of a government sector. With big government, the picture
> changes in two ways, because of fiscal deficits and Reserve Bank
> interventions. With a developed social security system, the collapse in
> cash flows which occurs when a boom becomes a panic will be at least
> partly ameliorated by a rise in government spending--the classic
> automatic stabilisers", though this time seen in a more monetary light.
> The collapse in credit can also be tempered or even reversed by rapid
> action by the Reserve Bank to increase liquidity. With both these forces
> operating in all Western economies since WWII, Minsky expected the
> conventional cycle to be marked by "chronic and ... accelerating
> inflation" (Minsky 1982, p. 85). However, by the end of the 1980s, the
> cost pressures which coincided with the slump of the early 70s had long
> since been eliminated, by 15 years of high unemployment and the diminution
> of OPECs cartel power. The crisis of the late 80s thus occurred in a
> milieu of low inflation, raising the spectre of a debt deflation.
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