I’ve been meaning to discuss how increased income disparity is bad for economic growth, because in the end you wind up with insufficient labor income to fund consumption (note that America’s high consumption rate has been achieved by lowering its already low savings rate to zero) and too much capital chasing too few investment opportunities (even a sound bet will produce a bad return if you pay too much for it).
It turns out I was beaten to the punch by nearly 50 years, as Robert Reich tells us in his latest post, invoking former Fed chairman Marriner Eccles . Insufficient consumption is one theory of the roots of the Depression (the monetarist version has gained ascendance), but Eccles links the consumption shortfall directly to a shift in wealth towards the top. And some of the other patterns of the Twenties, such as debt-fueled growth, are worryingly familiar.
While I wouldn’t go as far as seeing this shift as the cause of the Depression or our current woes, it plausible that it was a culprit then and now.
From Reich’s “Are We Headed for Another Great Depression?”:
Probably not. But go back 75 years and you’ll find eerie similarities. Marriner S. Eccles who served as Franklin D. Roosevelt’s Chairman of the Federal Reserve from November, 1934 to February, 1948 gave his view of what caused the Depression in his memoirs, “Beckoning Frontiers” (New York, Alfred A. Knopf, 1951):
As mass production has to be accompanied by mass consumption, mass consumption, in turn, implies a distribution of wealth — not of existing wealth, but of wealth as it is currently produced — to provide men with buying power equal to the amount of goods and services offered by the nation s economic machinery. Instead of achieving that kind of distribution, a giant suction pump had by 1929-30 drawn into a few hands an increasing portion of currently produced wealth. This served them as capital accumulations. But by taking purchasing power out of the hands of mass consumers, the savers denied to themselves the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants. In consequence, as in a poker game where the chips were concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped.
That is what happened to us in the twenties. We sustained high levels of employment in that period with the aid of an exceptional expansion of debt outside of the banking system. This debt was provided by the large growth of business savings as well as savings by individuals, particularly in the upper-income groups where taxes were relatively low. Private debt outside of the banking system increased about fifty per cent. This debt, which was at high interest rates, largely took the form of mortgage debt on housing, office, and hotel structures, consumer installment debt, brokers’ loans, and foreign debt. The stimulation to spending by debt-creation of this sort was short-lived and could not be counted on to sustain high levels of employment for long periods of time. Had there been a better distribution of the current income from the national product — in other words, had there been less savings by business and the higher-income groups and more income in the lower groups — we should have had far greater stability in our economy. Had the six billion dollars, for instance, that were loaned by corporations and wealthy individuals for stock-market speculation been distributed to the public as lower prices or higher wages and with less profits to the corporations and the well-to-do, it would have prevented or greatly moderated the economic collapse that began at the end of 1929.
The time came when there were no more poker chips to be loaned on credit. Debtors thereupon were forced to curtail their consumption in an effort to create a margin that could be applied to the reduction of outstanding debts. This naturally reduced the demand for goods of all kinds and brought on what seemed to be overproduction, but was in reality underconsumption when judged in terms of the real world instead of the money world. This, in turn, brought about a fall in prices and employment.
Unemployment further decreased the consumption of goods, which further increased unemployment, thus closing the circle in a continuing decline of prices. Earnings began to disappear, requiring economies of all kinds in the wages, salaries, and time of those employed. And thus again the vicious circle of deflation was closed until one third of the entire working population was unemployed, with our national income reduced by fifty per cent, and with the aggregate debt burden greater than ever before, not in dollars, but measured by current values and income that represented the ability to pay. Fixed charges, such as taxes, railroad and other utility rates, insurance and interest charges, clung close to the 1929 level and required such a portion of the national income to meet them that the amount left for consumption of goods was not sufficient to support the population.
This then, was my reading of what brought on the depression.
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yves,
Your gonna kill me, but this kinda gets my goose and I gotta toss in here:
Kevin M. Warsh, 35 The newest Fed Gov (35 …hmmm) Read on:
Jane Lauder is joining the migration of the well-heeled from their traditional breeding ground east of Central Park to the treeless precincts of Lower Manhattan. She plans to occupy a newly purchased $12.63 million penthouse triplex with a terrace in a recently converted building in NoLIta. Ms. Lauder, 31, the daughter of Ronald Lauder and the granddaughter of the cosmetics pioneer Estée Lauder, is vice president for marketing for the Estée Lauder brands American Beauty and Flirt! She is married to Kevin M. Warsh, 35, who works in the White House as a special assistant to the president for economic policy. Mr. Warsh has his primary residence in Washington, according to the White House press office. The couple were married in April 2002 at Mr. Lauder’s estate in Palm Beach, Fla. Two years earlier, Ms. Lauder gave an interview to Harper’s Bazaar, in which she showed off her apartment on Park Avenue on the Upper East Side. That article highlighted Ms. Lauder’s collections of snow globes and modern art and described an apartment full of works by Ellsworth Kelly, Jasper Johns, Warhol, Matisse, Lichtenstein and de Kooning and furniture designed by Frank Lloyd Wright and Alvar Aalto.
Doc here…..Puking in a bucket, sick with fear that as hyperinflation is ramping, we have a retarded no-nothing zombie that might know how to spend money with his mega rich wife………oh great, just when you thought bread was gonna be $5.00 a loaf by summer, I see this……I cant take this anymore…!!!
Its traditional in giving explanations of the Depression to ignore the main issue: what the Government did. Read Murray Rothbard’s book (available online). So we find Galbraith invoking greed, and others invoking income disparities, Snoot Hawley (never plausible), income disparities and so on.
As Rothbard makes clear, the origins were in a dramatic increase of banks ability to lend which was caused by changes in reserve requirements in the teens. This set the stage for a credit bubble. The credit bubble finally got underway in the late twenties.
Credit bubbles always lead to enormous income disparities and to flat or declining working class wages. The reason is, everyone who handles the distribution and management of credit is in demand. But the debt goes into malinvestment, profitless investment, so the industrial and commercial profits out of which the wages could be paid shrink. Often this is not apparent because financial accounting standards are lowered to the point of fraudulence. It is not that the workers are not being paid enough. It is that the goods they are producing are not saleable. Galbraith refers to this as the phenomenon of profitless prosperity, without understanding what he is describing. As too often, he stands in front of the statue gesturing at it, without asking where the bronze that made it came from.
When the crash occurred, we had a sharp contraction. But crashes had occurred before and recoveries were usual. The thing that produced a depression was government behaviour. It is now accepted that the early phase of the New Deal, up to about 1936, was totally counterproductive. It encouraged cartels (both labor unions and price cartels), it froze prices at unrealistic levels, it tried to keep enterprises which had failed from indulging in malinvestments going, thus preventing redeployment of assets and renewed investment and employment. It was only when the government abandonned all this, moved to anti trust measures and relaxed counterproductive policies that the recovery started.
This is not from Rothbard. This is now mainstream economics.
As for the idea that the debt should have been extended to the working classes to decrease wage disparity, that is totally idiotic. Debt, the debt bubble, but behind that the government creation of debt, that was the problem. Putting individuals more into debt would solve nothing, as you can see from today. What we have done this time around is hand as much of that debt as we could to the working classes, and the result is not a lowering of income disparities, which debt cannot do, but an increase in personal bankruptcies and repossessions.
There is no level of wage increases which will make sense of the idiotic investments in excess and mislocated capacity which managers have been lured into by the credit bubble.
The lesson of the Depression is that only governments can create credit bubbles, only governments can prevent recovery from the subsequent bust, and that there can come a day, which may have arrived now, when the government produces so huge a credit bubble that it cannot materially influence the course of the subsequent bust because it does not have enough money.
More nearly forgotten wisdom…
Anon of 1:18 AM,
There is nothing in the post that suggests that debt should be extended to the working classes to combat wage disparity, I don’t know where you got that idea from.
Nor did I say that Eccles should be applied literally to today. But his observations view that an increasing accumulation of wealth at the top helped feed a credit bubble, and his comments about the rise in debt formation outside the banking system are surprisingly similar to our current situation given the vast gulf in time and intervening changes in our economy and financial system.
I do submit, however (and have said elsewhere, repeatedly) that overly cheap credit, such as the negative real interest rates, as we had in the 2002-2003 period, will inevitably lead to bad investments. With so much cheap money on offer, promoters of all sorts will come up with schemes to put it to work. And it’s even worse now than in the past, since it’s acceptable for agents to take fees off the top, which further encourages financial “entrepreneurship”.
I’m not disagreeing with your (Rothbard’s) analysis, just making the point that an economy that produced income disparity helped grease the wheels. Thomas Palley has been saying similar things (regarding how government policies post 1980 helped create our credit bubble).
Also, (too long to go into here) but most analyses of the depression treat the US as a closed system. In fact, the US was lending to Germany to pay reparations which enabled England and the other Western Powers to pay its WWI war debts to us.
The reparations were effectively cancelled in the wake of the 1929 crash, which in turn led the British to default on their payments to us (it may have been called a deferral, but the result was the same). That played a bigger role in the US banking crisis than is generally acknowledged.
Yves? So i take this as you agreeing with Rothbards (the Austrians) analysis of the business cycle?
If not, please explain because this posting, and other like it, that bring up supposed causes of booms and busts without mention of the Austrian view seems to put readers down the wrong path as to the cause of those booms and busts.
Frankly, I have read various theories of the Great Depression and find none of them fully convincing. I’m not on board with the monetarist conventional wisdom that the Depression resulted from the Fed’s failure to increase money supply, because the Fed in fact (in terms of its monetary efforts, anyhow) did the right thing. The Fed does not control money supply; it only controls the monetary base. It DID increase the monetary base in 1930-1931, but money supply contracted nevertheless. Why? Banks were failing. People who didn’t lose everything in bank failures (my grandfather got 3 cents on the dollar) yanked their cash out of bank, creating a huge fall in the money supply.
I find just about no theories of the Great Depression that give sufficient attention to bank failures, which to me (as a financial person) seems to be one of the biggest causes (or more accurately, accelerants that turned a panic into a huge crisis). If you don’t have a functioning banking system, it’s kind of hard to have a functioning economy. And once it’s broken, it’s bloody hard to resuscitate.
I’m an empiricist, so I don’t hold truck with any one school. I do think the Austrians have some valid ideas, like the value of recessions in thinning the weak members of the herd (and in our current situation, the long-term costs of recession avoidance will prove worse than the disease). I’m also taken with Hyman Minsky. But I am not a fan of their die-hard libertarian streak. I think the MIT school (you need regulation to make most markets work properly) has a lot to be said for it.
I also think monetarism has been incorrectly left by the wayside. Volcker used it very effectively in 1980-1982. Yet it’s been abandoned by the Fed because its traditional measures (M1, M2, and the no-longer published M3) quit working the way they did historically, due to the proliferation of near money (increased use of credit and debit cards, for instance) and newfangled debt instruments.
But to me, that said it should have been imperative for the Fed to try to get a new understanding of these new instruments and what they meant to money, banking, and credit. They might have had to add new data series, or do new analyses. But I guarantee if they had stayed on the path of trying to stay on top of financial flows, they’d have a hell of a lot better grasp of what was going on now, even if they didn’t decide to use monetary targets as Volcker did.
Two points: It is not an idea of the Austrian economics that recessions are valuable in culling the weaker members of the herd. Rather recessions put an economy back on track after the period of wasteful investment (the boom) prompted by credit expansion. The Austrians hold that the severity of the boom is magnified by government support, mainly central banking. But independently of central banking a credit boom could take place and it would be followed by a recession. It is just that the boom is like to be much less severe if it is not sustained by the government. The subsequent bust is therefore likely to much shorter and milder.
The second point relates to the specific thesis advanced. First, it seems a bit strange and impertinent to distinguish between debt created by the banking system and debt created outside the banking system. To the extent that debt created (credit extended) outside the banking system is lower quality (a dubious theoretical point) then, of course, this is more likely to contribute to an eventual contraction. To the extent that the “excessive” savings (whatever that might mean) of the wealthy are devoted to predatory lending to foster consumption by poor well then that too would undoubtedly contribute to the severity of the boom. And to the extent that tax policies favor savings, or perhaps especially investment income, then that too will contribute to the severity of the boom.
Bush’s policies supplied the rich with cash and (unscrupulous) lenders with cheap credit.
His policies were of no long-term value to the middle class.
Greenspan always made much of American labor’s flexibility; shackling them to overpriced houses will significantly reduce their flexibility/mobility, and make it almost impossible for people to move to promising job markets.
Think silicon valley is gonna convince a decent engineer to move from Cleveland to Mountain View? Not unless the signing bonus drops a $1.5m 3-BR house in his lap.
I find it very interesting and refreshing that Eccles, a Chairman of the Federal Reserve, can write so clearly, sensibly and succinctly to an educated lay audience. Would that it were so now. Compare Eccles with Greenspan, for instance.
Hard to believe we are making progress in the dismal science when confronted with such evidence.
It would be interesting to see a chart of the salaries of the bottom 90% as a pct of GDP over the last 70 years.
There have been so many changes to the economy in the last 50 years, that it is almost impossible to say when we stopped being the “Leave it to Beaver” family of stay at home mom with working dad, to credit card working mom and HELOC working dad. People in general want to maintain their standard of living, and the Wall Street-Credit Machine allowed them to do it. As we have de-industrialized, and became a (financial)service economy, we have become addicted to credit. Recessions are politically unacceptable, and who can deflate bubbles when “bubbles can’t be seen”. There is only one solution. Tighten our belts, re-industrialize, go through any necessary recession and RE-REGULATE WALL STREET! We still may not succeed, but trying to reflate or inflate or any other phony temporary “solution” will only make it worse!
Yves,
I agree fully that no explanation of the great depression is fully convincing. it is howver ironic that the free trade idealogues march out smooty almost reflexivily. It seems what is occuring rhymes with the 30s. Everyone keeps saying that bank capital ratios are much better and can;t happen again etc. I keep wondering if indeed there could be a major bank to fail, outside of C? The implications would be catastrophic. That said, clearly there would be a fiscal pickup from existing the Iraq war, but the knock on effects of what could happen to the 70% of GDP that is consumer and the 15% represented by private investment. Seems people are overly focused on the size of the GDP not the composition. By contining to understate inflation, the TReasury/Fed will try to preserve the real number via inflation.
The last post seems apt, but at the core of the issue is the policy that has resulted in this situation. Don;t count on the governement which suggests we are heading for some serious pain. what will it be that causes the coming plunge?
What I find entertaining about the Austrian viewpoint on the Depression is that the proposed cure for government-created credit bubbles is … wait for it … privately-created credit bubbles.
Privatizing the issuance of money somehow is alleged to solve the problem. After all, the private sector is inerrant. As we have witnessed in recent years, allowing unregulated banking (and not-quite-banking) companies to originate vast quantities of mortgages, create enormous amounts of money (in the form of Asset Backed Commercial Paper) and shuffle this credit around has produced a marvelous improvement on the 1920’s. End snark.
As usual, the real difficulty is establishing causation. Certainly Keynes’ “Paradox of thrift” — too little spending — is a plausible explanation for a lack of growth, but which came first? Weak growth or weak spending?
Ever since the ‘Laffer curve’ there has been an endless stream of ideology and blather, mostly of the “free market” variety, from Wall Street, the govt and regulatory agencies, and the MSM.
I think the influence has been dire. We’ve “decoupled” from prudence and reality based policy making, and worse, the American people have been hoodwinked into confusing wishful thinking with prudent planning.
I fear that we are finding ourselves in a situation where these bad tendencies and decisions are coming home to roost all at once. We don’t even have a political class capable of leveling with the American people.
Dear American people: No, you do not deserve a break today.
Yves,
Actually, the bank failures are central to virtually all monetary explanations of the Depression. (No, I’m not a monetarist myself.) Your point that the Fed increased the monetary base but couldn’t (or wouldn’t) prevent the thousands of bank failures, is actually made at length in Friedman & Schwartz’s bulky _Monetary History of the United States_.
More recently (1983), a fellow by the name of Bernanke published a seminal paper in _American Economic Review_ on the collapse of credit intermediation during the Great Depression – the title is “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression.” The bank failures’ effect of shutting down the normal and productive flow of funds from savers to borrowers, as opposed to the reduction in the money supply, is Bernanke’s emphasis. (Bernanke has written a lot of seminal papers, but I’d say that’s the one that made him.)
Otherwise, keep up the great work. Your site is awesome.
Ranjit
Yves,
Actually, the bank failures are central to virtually all monetary explanations of the Depression. (No, I’m not a monetarist myself.) Your point that the Fed increased the monetary base but couldn’t (or wouldn’t) prevent the thousands of bank failures, is actually made at length in Friedman & Schwartz’s bulky _Monetary History of the United States_.
More recently (1983), a fellow by the name of Bernanke published a seminal paper in _American Economic Review_ on the collapse of credit intermediation during the Great Depression – the title is “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression.” The bank failures’ effect of shutting down the normal and productive flow of funds from savers to borrowers, as opposed to the reduction in the money supply, is Bernanke’s emphasis. (Bernanke has written a lot of seminal papers, but I’d say that’s the one that made him.)
Otherwise, keep up the great work. Your site is awesome.
Ranjit
Yves,
Actually, the bank failures are central to virtually all monetary explanations of the Depression. (No, I’m not a monetarist myself.) Your point that the Fed increased the monetary base but couldn’t (or wouldn’t) prevent the thousands of bank failures, is actually made at length in Friedman & Schwartz’s bulky _Monetary History of the United States_.
More recently (1983), a fellow by the name of Bernanke published a seminal paper in _American Economic Review_ on the collapse of credit intermediation during the Great Depression – the title is “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression.” The bank failures’ effect of shutting down the normal and productive flow of funds from savers to borrowers, as opposed to the reduction in the money supply, is Bernanke’s emphasis. (Bernanke has written a lot of seminal papers, but I’d say that’s the one that made him.)
Otherwise, keep up the great work. Your site is awesome.
Ranjit
Ranjit,
I will confess to not having read Friedman & Schwartz, but at least as their work has been widely presented, the conclusion is always “the Fed caused the Depression by not expanding the money supply quickly enough.” The implication is that monetary measures alone could have stopped the train wreck. That’s the assumption that most policymakers seem to be operating on.
When I say “most stories about the Depression don’t talk enough about bank failures,” it’s that the one line story above, which appears to be widely accepted, does not acknowledge the role of institutional failure and how long it takes to remedy that. It isn’t clear to me that a depression of some sort could have been avoided, but it may have been possible to rebound much faster. Solvency issues are much more difficult to resolve than liquidity problems.
I have rarely seen the monetary base vs. money supply issue discussed in an MSM or fairly serious economic articles (I don’t generally read those geeky papers with math). And again, not having read the tome myself, just about every reference to it I’ve ever seen says it blames the Fed precisely for not expanding the money supply, which as you know they can influence only indirectly.
The fact that they couldn’t (in an eerie parallel to now) get liquidity into the “stuck” parts of the system suggests the need for new institutional measures, regulatory reform, or government backstops to patch up the broken parts of the credit machinery. The FDIC was a key element in restoring confidence in bank; England similarly had to guarantee bank deposits in the wake of the Northern Rock bank run. Yet those sort of measures are the exact opposite of what I understand the Friedman playbook to be.
Austrian business cycle theory is incorrect.