Tuesday, November 25, 2008

Steve Hanke & Daniel Gross On The Great Depression

With many now fearing that we're heading towards a second Great Depression, there is increased interest in the history of the first Great Depression, the one in the 1930s. Those of you interested in the correct interpretation I recommend Murray Rothbard's "America's Great Depression" (available online here, can be bought in traditional paper form here (as well as a few other online book stores)). Although it is not perfect, it is certainly far superior to all other historical accounts of that period, and the inflationary boom that preceded it, while also describing the Austrian business cycle theory in a very good way.

The main point of this point is however not to again recommend that book, but rather to discuss to recent articles about the (first) Great Depression. The first is from Cato Institute fellow Steve Hanke, who unlike many others at Cato is fairly Fed critical and hard money oriented.

His article is mostly informative and interesting, although he starts of with a really grave error, namely measuring the depth of the Depression in terms of national income in nominal terms instead of real terms. Given the massive price deflation of the time, that greatly exaggerates just how bad the downturn was. Also, his statistics in general is completely inconsistent with the numbers you find at the statistical authority that publishes these statistics, the Bureau of Economic Analysis (BEA). He claims that nominal national income fell from $84.7 billion in 1929 to $39.4 billion in 1933, whereas the BEA says that it fell from $94.2 billion to $48.9 billion (Note that I don't think that Hanke deliberately tried to mislead. Most likely he simply relied on older data series that have now been revised)..

While his specific numbers are wrong, the general trends he describe is still more or less right. He describes how the Depression shifted national income from corporate profits to net interest, which is confirmed in the BEA numbers, although the shift was somewhat less dramatic than Hanke claimed. Another relative beneficiary by the way was labor income, which in the BEA numbers rose from 54.3% of national income to 60.5%.

Hanke explains the disappearance of profits with price deflation, and a theory of profits that they are created by buying something now and selling it later, which is more difficult during price deflation. There is a limited degree of truth in that, but it also misses the distinction between price deflation caused by higher productivity and price deflation caused by monetary deflation. If productivity is rising then it can in fact be profitable to buy now input and sell finished goods later, as is illustrated by the profits made in the technology sector despite falling prices there. What caused the decline in profits during the Depression was the shift from significant monetary inflation during the 1920s to significant monetary deflation in 1930-32.

Moreover, the main cause of the collapse in profits wasn't price deflation. Instead, it was the fact that too many industries only had the capacity to produce things which weren't in demand anymore, meaning capital goods including houses and durable consumer goods. In other words, the primary cause was the malinvestments predicted by Austrian theory in more capital intensive industries, which given the loss of purchasing power for workers and owners there spread even to non-durable consumer goods and services.

Hanke finishes by noting how the unpredictable behavior of policy makers during the New Deal slowed the recovery and the similarities with that and the erratic and unpredictable behavior of Hank Paulson with regard to how the bailout money should be used. A good point, although it must be emphasized that predictable bad policies wouldn't be good either....

The other column is from Daniel Gross in Newsweek, which argued that we need not fear another Depression (Gross BTW repeats Hanke's error of looking at national income in nominal and not real terms). Again, I agree with that in the sense that I don't think it is likely that the slump will be fully as deep as the one in 1929-33. But let's just say that Gross' arguments aren't exactly strengthening my conviction of that. They are in fact weakening them.

The reason why Gross argues that this slump won't be as bad as that in the 1930s is because in the 1930s the government allegedly believed in laissez faire, while now they believe in the welfare state and bailouts of banks. As anyone who has read the Rothbard book knows, the assertion that the Hoover administration believed in laissez faire is simply false. The quote from Treasury secretary Andrew Mellon completely overlooks the fact that Herbert Hoover (the man in charge) ignored his advice and despite the disastrous results was always eager to emphasize just how good it was that he contrary to Mellon's advice pursued massive government intervention in the economy.

Now, to be sure, the bank bailouts will likely limit the degree of monetary deflation, which in the short-term can limit how deep the slump will be. But this will instead likely mean that the crisis will be even more prolonged, just like for Japan during the 1990s. While the short-term slump for that reason will likely be less severe than in 1929-33, it means that the recovery will be much weaker and short-lived, similarly to what happened in the Japanese case.


Blogger marc.van.den.bosch said...


I was wondering. Somehow I get the impression from your blog that you are not a big fan of government intervention in the economy. (Correct me if I'm wrong). The signs at the moment are that many countries are about to embark in massive government funded investment programs to boost employment en the economy as a whole and to soften the impact of the current recession on people's lives. Could you devote a blog on the main counterarguments against such keynesian government intervention?

10:38 PM  
Blogger stefankarlsson said...

"Somehow I get the impression from your blog that you are not a big fan of government intervention in the economy"

Whatever gave you that idea.....:-)?

Seriously speaking, though, I will probably in a not too distant future write the kind of post you suggest, though it remains to be seen when I will find time for it.

11:16 PM  
Anonymous Arend said...

He claims that nominal national income fell from $84.7 billion in 1929 to $39.4 billion in 1933, whereas the BEA says that it fell from $94.2 billion to $48.9 billion

There is 9.5 between 94.2-84.7 and 48.9-39.4, maybe that's a pointer.

@marc.van.den.bosch (if you don't object Stefan): the short answer to your question is the heroin addict whose addiction is progressive and very near to make him take a lethal overdose. A bad example actually because the patient with the illness in reality is the economy (all of us) and the addict is the government which actually thrives on crises.

12:45 AM  
Anonymous Ke said...

Stefan, What are your thoughts on China's 586 billion dollar stimulus plan?

1:24 AM  
Anonymous newson said...

i am a big fan of rothbard's agd, the book that first introduced me to austrian economics.
from memory though, only the deflationary episode was treated, and not the inflationary period 1934 onwards. pity.

4:26 AM  
Anonymous TTD said...

Andrew Mellon, not Paul Mellon, was Secretary of the Trasury.

4:30 AM  
Anonymous Farley99 said...


What sort of investment asset classes and sectors would do well (or at least relatively well) during a depression according to the Austrian economics model? I am only starting to learn about Austrian economic theory so forgive me if this is a naive question.

4:48 AM  
Blogger stefankarlsson said...

Interesting observation, Arend, though in the years in between the difference was slightly smaller. It should be noted that since a $45.3 billion is less than 50% if the base is $94.2 billion and more than 50% if the base is $84.7 billion, this distinction is not trivial.

Ke, China's so-called stimulus plan is not very different from other Keynesian plans. And while I therefore do not really approve of it per se, it should be noted that compared to the alternative of pushing down the yuan further it is a lesser evil both for China and the rest of the world.

Newson, you're right,in addition to Austrian business cycle theory AGD only dealt with the inflationary boom of the 1920s as well as the Hoover era. It would have been great to see him analyze the Roosevelt era as well.

TTD, you're right, it was Andrew and not Paul that was Treasury secretary. It was Daniel Gross that first said it was Paul, which I should have corrected it directly but didn't, but I have now.

Farley: In a deflationary depression, government securities and other safe interest bearing investments is the place to be.

8:45 AM  
Blogger earth that was said...

I agree that Murray Rothbard has an excellent history of the Great Depression. But what would you vote for as the 'second best book on the Great Depression'.

10:20 AM  
Blogger Hans Bystr√∂m said...

nice that you dwell a bit on this THE MOST IMPORTANT QUESTION RIGHT NOW, will there be a depression or not?

And thanks for the references, I hope to find some arguments in them to support my negative feelings regarding govt support. I can't put the finger on it but I am sceptical about the whole idea.


12:17 PM  
Blogger Wille said...

Considering the deficits the UK and US are running, the fact that Japan are turning a trade surplus to a deficit, and the Swiss and others are racing to debase their currencies..
Are there any currencies or government securities that are actually "safe" these days?

To my untrained eye it seems we are about to see an inflationary bomb go of in a year or two, and government bonds paying low yields are no good if inflation is running at around or near double digit numbers.. Unless the aim of the game is to "not loose as much as others", as opposed to "wealth preservation".

12:42 PM  
Blogger marc.van.den.bosch said...

@ Arend

I don't quite follow your reasoning. Sure, looking at the US reaction to the crisis thus far, especially their efforts to ensure the securitisation of loans keeps humming, you could call this giving additional heroin (i.e. credit) to an addict (i.e. an excessive consumer). That however has nothing to do with the keynes doctrine (Please correct me if I'm wrong, because my economic knowledge surely is not as good as yours). I understand the Keynes doctrine as government investment projects (especially in infrastructure) during slumps AND restraint (even budget surplusses) during boom times.

10:59 PM  
Blogger stefankarlsson said...

Earth that was, the only two books I've read that specifically dealt with the Depression is Rothbard's book, the Friedman-Schwartz book as well as some book by someone called Ravi Batra that falsely predicted a depression in 1990 (based on the alleged similarities he noted between the 1920s and 1980s) and blamed the depression on income inequality. Of the two others, the Friedman-Schwartz book is somewhat better I guess, but that only reflects on just how bad that other book was.

I think that Lionel Robbins wrote a book about the Great Depression in 1934 when he was still an Austrian (he later converted to Keynesianism). I haven't read that book, but presumably it is better than both the Friedman-Schwartz book and the Batra book.

Wille, I said in a deflationary depression. In an inflationary depression, this would of course not hold, and gold would be better.

11:43 PM  
Anonymous newson said...

earth that was: stefan's right about ravi batra's book. i remember reading it shortly after the 1987 sharemarket collapse.
a crock of shit.

to stefan: i'd like your thoughts on this bit by hayek on sweden:

"During World War I the great paper money inflation in all the belligerent countries brought down not only the value of paper money but also the value of gold, because paper money was in the large measure substituted for gold, and the demand for gold fell. In consequence, the value of gold fell and prices in gold rose all over the world. That affected even the neutral countries. Particularly Sweden was greatly worried: because it had stuck to the gold standard, it was flooded by gold from all the rest of the world that moved to Sweden which had retained its gold standard; and Swedish prices rose quite as much as prices in the rest of the world. Now, Sweden also happened to have one or two very good economists at the time, and they repeated the advice which the Austrian economists had given concerning the silver in the 1870s, "Stop the free coinage of gold and the value of your existing gold coins will rise above the value of the gold which it contains." The Swedish government did so in 1916 and what happened was again exactly what the economists had predicted: the value of the gold coins began to float above the value of its gold content and Sweden, for the rest of the war, escaped the effects of the gold inflation."

there are some strange things in this analysis. if there is a fixed ratio between coins and banknotes, under a gold standard, how could the coins trade significantly above spot gold without arbitrage? surely the only price differential would be the minting cost.
how could fiddling with the coinage affect the money supply?
anyway, why bother? after the war, the gold would have flowed out, and sweden would have suffer a monetary contraction (inevitable given the increased demand for gold.)

4:00 AM  
Blogger stefankarlsson said...

Newson, the end of free coinage of gold meant that people *couldn't* practice arbitrage. It meant they were not permitted to turn gold into the higher valued gold coins and so couldn't legally practice arbitrage. It is similar to how for example the value of paper money is significantly above the value of the paper it is made of.

As for the motive for avoiding the initial inflation and following contraction, well that was simply a wish to avoid a boom-bust cycle.

Flavian, monetarism is better than keynesianism as they at least recognice the importance of money supply.

8:35 PM  
Anonymous newson said...

stefan: i understand that as far as it goes for swedish nationals, but couldn't foreign gold holders arbitrage? that is, swap gold for coins?

11:31 PM  
Blogger stefankarlsson said...

No, how could they do that? Foreigners weren't allowed to make Swedish gold coins either.

5:51 PM  
Anonymous newson said...

to stefan: yep, you're right. but what i cannot figure out is why this didn't result in gold coins disappearing from circulation via gresham's law. surely people would have hoarded coin and spent notes, or am i wrongheaded here?

12:16 AM  

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