Category Archives: Economic History

Rhetoric of Capitalism

In November 1957, just a month after Russia’s Sputnik satellite blasted into space, causing Americans to fear that they were losing in the space rate, Lawrence gave an optimistic address about America’s strengths to students and faculty at Seton Hall University in South Orange, New Jersey. Lawrence told the assembly, “Spread of shareownership in America brings about a silent revolution, and this people’s capitalism is given impetus by the Stock Exchange.” He continued, “The most dramatic feature of this free-enterprise system has not erupted in newspaper headlines. Nor has it been squeezed into the small talk of ordinary parlor conversation. The phenomenon I’m talking about is the gradual emergence of what we have come to call a People’s Capitalism — the ownership by millions of people everywhere, through their stock investments, of our means of production.”

— Janice M. Traflet, A Nation of Smaller Shareholders: Marketing Wall Street after World War II (Baltimore: Johns Hopkins University Press, 2013), pp. 139–140.

The Capitalist Mentality

How have views towards the free market changed over time? How society views markets matter, because it may help explain important questions. If, for example, views determined the significant growth rates of the 18th and 19th centuries — after centuries of stagnation —, a change in views could have quite an impact on our future wealth. Indeed, the Great Depression was capitalism’s nadir and communism, socialism, and fascism were at their height between 1920–50. If 1991 shattered the false allure to communism, in 1930 it seemed as if capitalism had failed. Several economists warned of the dangers of anti-liberal and anti-market ideas, arguing that those ideas promote not only low growth, but authoritarianism as well. Some believe that this anti-capitalist mentality has continued into the 21st century. Since the late 1940s, however, the public’s opinion on capitalism has matured and strengthened, and good evidence of this is how the public responded to the 2007–09 crisis.

In certain ways, it seems as if the public’s attitude towards markets has deteriorated over time. The initial reaction to the stock market crash of October 1929 was to blame small investors for making non-expert investment decisions based on emotion. Big finance was not immediately blamed, although its image soon blackened as the world economy continued to plunge, banks began to fail in large numbers, and unemployment rates began climbing to new heights. The 1930s were an “absolute minimum” for free markets, and the experience of the Great Depression continues to inform the public’s opinion. Compare, for example, the initial reaction to the crash of 1929 to that of 2008. Bankers and traders took the brunt of the criticism in 2008; in 1929, they were, at first, given the benefit of the doubt. But, this interpretation leaves part of the story out.

It is true that capitalism’s image was in serious trouble between 1930–50. In A Nation of Small Shareholders, Janice Traflet tells the story of the New York Stock Exchange’s (NYSE) struggle to revive it brand in the face of hostility and mistrust. The initial crash did not immediately wound society’s amicable relationship with markets, but the banking crises, repeated scandals of fraud and theft by part of bankers and wealthy investors, and high unemployment had struck an almost fatal blow. Traflet explains how resistance to regulation and state involvement collapsed by the late 1930s, because, after several crises and scandals, the NYSE and others simply chose to cut their losses and work with regulators, rather than against them. But, by the mid-1950s the situation, for capitalists at least, began to improve. Traflet looks at the NYSE’s advertising program, but external factors were probably even more important for repairing capitalism’s perforated image.

One such external factor was the public’s view of socialism and communism. During the first two decades of the 20th century, many intellectuals held an endearing opinion on socialism. The success of war controls and planning during the First World War served as an important impetus for those looking for a better alternative to capitalism. The initial experience with the Soviet Union was somewhat of a disillusionment — war, famine, and oppression usually are —, but socialist sympathy was at a high point and the Soviet’s rapid industrialization between 1930–50 was inspiring. 1920–40 were the decades of the ongoing socialist calculation debate, where top economics journals became ideological battlegrounds — the possibility for central planning was taken very seriously. “Luckily,” the Cold War would soon change things. Communism, and by extension socialism, became the West’s rival, and between 1950–70 the Keynesian consensus — not quite socialist, but not capitalist enough, either — gave way to a free market revival.

One interesting facet of the revival is the language used to sell capitalism to the people. Financial organizations selling their products, such as mutual funds and monthly investment plans (MIPs), talked about marketplace democracy, shareholding (vs. stocks), and freedom. Capitalism, not communism or socialism, is what empowers the non-wealthy. This is almost a complete reversal from the Great Depression, during which it was the worst off who suffered the most. Capitalism had lost much of its image as a mode of production for owners of capital, at the expense of owners of labor, and gained one of harmony between all classes. This view was not only promoted by industry, but by conservative intellectuals, as well. And, in 1991–92, communism and socialism lost all of its allure as a result of the Soviet Union’s collapse.

While capitalism continued strong during the 1990s, an era of “neoliberalism,” the 2000s is a more ambiguous decade in the context of how the public views markets. The mid- and late 90s are known for a series of crises throughout the world, and the boom of the mid-2000s gave way to the most severe crisis since the Great Depression. Conservatives have interpreted this turn of events as working against free markets. Tom Woods, for instance, declared that we are “back on the road to serfdom.” Oftentimes, rather than looking at the resurgence of popular pro-market sentiment, people look at the growth of the state, concluding that the anti-capitalist mentality has strengthened, or at least gained currency. This interpretation of recent history is problematic, however.

Compare the response to the Great Depression to that of the Great Recession. The 1920s were a period of growing wealth, where all classes seemed to benefit from growth. If Traflet is right, and the initial stock market crash was blamed on the common person (the small investor) instead of on the titans of industry and bankers, pro-market sentiment was very strong prior to 1930. The Great Depression was almost a 180° turn, when markets seemed to benefit only the rich, and at the expense of the poor. That is, the period 1929–33 oversees a dramatic change in public opinion towards capitalism. The 1990s, and even the 2000s, were similar to the 1920s, in that a healthy economy promoted existing market institutions. But, the Great Recession has not had the same effect as the Great Depression, not only in the United States, but also in Western Europe. To be sure, capitalism has received much criticism, but the impetus to choose alternative institutions is weaker — there is much more focus on improving markets. One strong piece of evidence is the pressure to structurally reform markets, and skepticism toward demand-side interventionism.

Why did the Great Recession not cause mass disillusionment with capitalism? First, the extent of the damage has something to do with it. The anti-capitalist mentality is probably stronger in Spain and Greece than in the U.S. or U.K. The two former countries have been hit harder, and a combination of bad demand- and supply-side policy has caused high (20+ percent) unemployment. Still, the extreme right-wing has been benefited almost as much as the extreme left-wing by the depression in those countries. Second, the end of the Cold War. The fall of the Soviet Union, and the gradual “liberalization” of China, shattered whatever credibility non-capitalist institutions, or “modes of production” if you prefer, had. Third, between 1950–06, we had a strong, relatively stable period of growth, where the living standards of all members of society markedly improved. This relates to the role of the end of communism, because elsewhere living standards stagnated or fell as a result of command economies. Capitalism’s great success is more widely appreciated.

The average opinion goes something like this: there are no radical alternatives to capitalism; capitalism is the best we have, it’s just a question of how to achieve robust institutions that minimize the impact of the business cycle. This view stands in stark contrast to average opinion during the 1930s, which did not think very favorably of free markets at all. And that conservatives, and some libertarians, have interpreted the concept of “robust institutions” as evidence of an anti-capitalist mentality actually works in favor of my argument. The standards of the “radical” pro-market advocates have risen. The type of interventions considered “socialistic” or “anti-market” are incredibly tame compared to those of the 1930s — where parts of industry were nationalized, private enterprise was heavily regulated, and public investment stepped to the forefront. We are, on average, a much more market-oriented society today, and the range of allowable changes to these institutions has become much stricter, more narrow. To free market advocates, this is good, not bad, news.

For this reason, the message in books such as The Road to Serfdom no longer resonates with most people. The modern interpretation of this line of reasoning is that any interventionism will eventually lead to full blown socialism. This is not Hayek’s actual argument, who was writing during a period of time in which opinion, intellectual and average, was very hostile towards markets. (In fact, Hayek’s message was, at the time, most popular amongst those looking to synthesize capitalism with a modern liberal democracy.) But, the erroneous interpretation of Hayek is popular because that is the only way one could apply Hayek’s message to the modern context. Many conservatives and libertarians think we are on a road to serfdom, and that there is a strong anti-capitalist mentality that needs to be fought against, but this simply is not so. That The Road to Serfdom is seen, amongst progressive intellectuals, as being mostly wrong is strong evidence that they no longer hold the views Hayek was warning against.

The strengthening of positive opinion towards capitalism is the product of the institutionalization of free market views. Few people believe there is a superior alternative. Communism is seen as a failure. Socialism is taboo. The success of markets in raising the standard of living of all members of society is too obvious to miss. If people advocate intervention, it’s to strengthen markets, not replace them. We are in an era of the pro-capitalist mentality.

Nominal and Real Wages During the Great Depression

Paul Krugman, following Keynes, argues that downward wage adjustments are not conducive to recovery, because real wage rates don’t tend to adjust even when nominal wages are cut. The theory is that output prices will move in line with nominal wages. To justify this theory, Keynes assumes that the most significant determinant of marginal cost are wage costs (wages multiplied by labor, or wL). I want to look into this, but I just wanted to quickly put up some evidence that contradicts the Krugman–Keynes story.

Unfortunately, the data that is most accessible to me comes from Krugman’s “favorite” book on the Great Depression, Rothbard’s America’s Great Depression. Rothbard, in turn, gets his data from Sol Shaviro, specifically from his unpublished manuscript, “Wages and Payroll During the Depression.” Here is that data,

Nominal and Real Wages 1929-33

Keynes’ theory about the relationship between real wages and nominal wage cuts assume that nominal wage cuts will have no effect on real wages. The data from December 1931 to March 1933 shows that this simply isn’t true. Nominal wage cuts correlate with falls in real wages, even if these rates of change are not symmetrical.

I know there is a more complete set of data out there (I can find real wages for the same years in Robert A. Margo’s “Employment and Unemployment in the 1930s,” but he doesn’t list nominal wages [or the wholesale price index he uses those deflate nominal wages] — and I have been having some trouble finding that data online); maybe I’m not looking hard enough.

To me, in any case, the premise that nominal wage cuts will not lead to real wage decreases, because the price of output will adjust to their new marginal costs (which must be almost entirely determined by labor costs), seems to fly against both reality and what we predict in the opposite case. If nominal wages were to rise, say because of labor union involvement, what we predict is unemployment, because the real wage will rise above the market clearing wage. The assumption is that the price level will stay the same. But, what we would predict based on Keynes’ assumption is that nominal wage increases will raise the price level, because the price of output will rise to reflect increases in marginal cost. Admittedly, this is consistent with, say, a wage-push theory of inflation, but it’s not what (I thought) most economists would expect to happen (and I thought most economists, except some of those on the margins, believe that inflation is “always and everywhere a monetary phenomenon” — an increase in M or a fall in the demand for money).

Unemployment Insurance in Interwar Britain

Apropos of the recent discussion of unemployment insurance in the context of demand shortages, it’s worth mentioning Daniel K. Benjamin’s and Levis A. Kochin’s “Searching for an Explanation of Unemployment in Interwar Britain.” During the 1920s, despite strong real growth in national income and wages, Britain was plagued by persistently high unemployment. Between 1921–1938, British unemployment never fell below 9.7 percent, and only in one year (1927) did it fall below 10 percent. At the time, there were several economists who looked at the incentive effects of unemployment insurance, but this explanation was soon drowned out by Keynes’ theory of an underemployment equilibrium. Benjamin’s and Kochin’s research, although not without controversy (as is usually the case in economics), shows that unemployment insurance (UI) did play a large role in increasing the British unemployment rate.

My intention is not to mislead, and it should be said that the situation between 1922–1938 is not necessarily comparable to that of 2007–present, although the longer high unemployment persists against the backdrop of positive income growth, the more similar the two situations become. Also, Benjamin and Kochin include Great Depression years in their research, and they find that unemployment insurance does explain a good chunk of the unemployment rate, although it cannot explain all of it (or even most of it) — this is where monetary disequilibrium explanations come in. Further, I coincidentally became aware of this paper recently (while reading David Glasner’s book on free banking), and I thought that it’s interesting enough to share.

Between 1920–21, like in the United States, Britain underwent a sharp period of deflation, as the monetary authorities attempted to arrest the wartime inflation. Unemployment rose from 3.9 to 17 percent, but this was to be expected — actually, the surprise was how much the recession was represented by the overall decline in prices, rather than a decline in output. However, despite a recovery and strong growth after 1923–24, unemployment remained inexplicably high. Between 1930–31, growing unemployment is explained, in large part, by the Great Depression and its demand-side causes. However, again, as the British economy began to recover after 1932, unemployment rates failed to fall below 15 percent until 1935, and they remained above 10 percent by 1938. By the way, between roughly 1924–28 and 1932–38, this high unemployment is in the context of demand management by central banks.

This situation was an empirical influence on J.M. Keynes. Originally, Keynes advocates the standard interpretation of unemployment, which was that unless nominal wages were adjusted, unemployment would persist until real wages fell to their market clearing level. But, this theory couldn’t make much sense of the persistently high unemployment of the 1920s and 1930s. Indeed, during much of the ’20s, real incomes and wages were growing, and the situation was similar after 1932. Thus Keynes developed his theory of an underemployment equilibrium, which would form part of his General Theory.

But, there is an alternative explanation — one that several economists, including Jacques Rueff and Edwin Cannan, proposed, but was drowned out by the Keynesian revolution. In 1911, the Unemployment Insurance Act was passed in Britain, offering UI to about 15 percent of the workforce. In 1920, these benefits were expanded by about 40 percent (I’m assuming of their 1919 level). Despite the deflation of 1920–21, the nominal value of these benefits was not decreased, and was actually increased a number of times. Benjamin and Kochin write that, by 1931, weekly UI was 50 percent of weekly average wages. In other words, the real value of British UI rose significantly during the 1920s.

After running a regression, Benjamin and Kochin make the following estimations (taken from p. 467),

Interwar Britain Unemployment and UI (Benjamin and Kochin)

Apart from their original regression results, Benjamin and Kochin run two additional tests. First, they look at juvenile (years 16–17) unemployment rates during the same period. Juvenile workers were typically eligible for less benefits than older workers, so the incentive theory predicts that their unemployment rate should be lower than that of older workers. They find that the data supports this conjecture, and that alternative explanations are not strong enough to account for all of the evidence. Second, look at the unemployment rates between married women and men after 1931–32. During the 1920s, married women were eligible for benefits if they were let go or if they voluntarily left their jobs; thus, married women would complement their husband’s incomes by receiving UI. In 1931, the Anomalies Regulations were implemented, blocking many married woman from receiving these benefits. Following this piece of legislation, the female unemployment rate fell from 18 to 13.6 percent, while the male unemployment rate increases from 21 to 25.4 percent.

What does this evidence say in the context of Paul Krugman’s recent defense of UI during demand shortages? (I question his theory, here.) For those of us who are skeptical of demand-explanations and like to point out supply-side distortions, the evidence probably says less than what one might think. For those of us on the opposite side of the spectrum, I think the evidence says quite a bit. Before anything else is said, there are important differences in the details of what exactly UI entails. During interwar Britain, an unemployed person could draw on UI indefinitely. That is not the case in contemporary America. Further, one should question whether the level of real benefits between interwar Britain and the current U.S. are comparable. What this means is that the estimates Benjamin and Kochin come up for interwar Britain are not applicable to our current situation.

Also, I wonder if their estimates for the Great Depression are biased upwards. Multiple regressions are supposed to reduce bias by increasing the number of explanatory variables, where the coefficient for each variable is taken net of shared variation. This idea might be better explained by means of a diagram,

MLR diagram

UI is short for unemployment insurance; DS is short for demand shortage. The unnamed circle is the Y variable, or unemployment. What a multiple linear regression does is reduce the amount of bias in a model by considering, and eliminating (from the coefficient estimate), shared variation — on the right hand side, that is the space jointly shared by UI and DS that overlaps with the dependent (Y) variable. When the real economy is growing and there likely isn’t a demand shortage, the amount of shared variation should fall. This is represented by the diagram on the left, where UI and DS have no shared variation at all. However, during the Great Depression, and whatever other period of demand shortages, the amount of shared variation will be relatively high. The estimates provided by the regression are an average over the period of years covered by the time series data. There were many more years of growth than there were of contraction, so the average will better capture these periods than they will depression years. In other words, there might be a case for a downward revision of the estimates of changes in the unemployment rate for depression years.

Nevertheless, Benjamin and Kochin provide good evidence that could be used to argue against extending UI, even during depressions (and recessions). First, even assuming that we should revise their estimates down (during specific years), Krugman’s theory predicts a net positive employment effect; the evidence provided here argues against that. Second, there is the consideration that governments will not necessarily change UI benefit schemes during periods of growth, meaning that we should also consider future labor market inefficiencies when judging the appeal of increasing UI during recessions. Admittedly, however, we live in a period characterized by steady inflation, rather than price level stability or slight deflation — this means, sans nominal increases in the value of UI benefits, the real value of these benefits will fall over time. Third, Benjamin’s and Kochin’s study should warn us against UI increases in the context of “secular stagnation.” Unemployment may remain high in periods of growth not because of “secular stagnation,” but because of high real unemployment benefits. Fourth, it has been ~6 years since the beginning of the “Great Recession,” and demand-side theories of unemployment are losing some of their attractiveness. This gives credence to supply-side theories of current unemployment.

My opinion is that there are both supply- and demand-side factors that explain current unemployment levels, and that both are important. I don’t think increasing or extending UI is good economic policy, although it is reasonable to justify it under moral or ethical considerations. There are better alternative solutions to demand-shortages. But, the point I really want to make is, just like supply-siders shouldn’t underestimate demand-side factors, demand-siders shouldn’t underestimate supply-side factors. Potentially, supply-side explanations for unemployment can explain a larger chunk than demand-side economists may initially suspect.

The Entrepreneur’s Role in the Emergence of Money

Think of what a pre-monetary economy must have been like. With no commodity generally used as money, trading was costly and time-consuming. In those circumstances, some alert people realized that they could benefit by holding greater stocks of the most marketable commodities than they had immediate use for. Thus they would accept highly marketable commodities in exchange even when they really wanted something else, because marketable commodities could be exchanged quickly on reasonable terms for what they did want. Extra stocks of highly marketable goods increased the chances of acquiring desired goods on favorable terms. (ed. Emphasis mine.)

— David Glasner, Free Banking and Monetary Reform (New York: Cambridge University Press, 1989), p. 6.

One guess of mine is that there arose a type of merchant who coordinated suppliers and consumers by accepting a broader range of assets (goods) and assuming the risk of a lack of double coincidence of wants. They would hedge this risk by accumulating stocks of multiple types of relatively liquid assets, which began to narrow over time, as some goods became more liquid than others. Finally, intermediate exchange would converge on a single asset: money.

The Fed’s Great Depression

In their celebrated Monetary History of the United States, 1867-1960, Milton Friedman and Anna J. Schwartz pointed out that the Fed, having nationalized the roles previously played by clearinghouse associations, particularly the lender-of-last-resort role, did less to mitigate the multiple banking panics of the early 1930s, with their sharply deflationary and depressive effects, than the clearinghouses had done in earlier panics like 1907 and 1893.  They concluded with good reason that the economy would have suffered less if the Fed had not been created.

— Lawrence H. White, “The Fed’s Track Record.”

This is the second piece of this month’s Cato Unbound discussion, which started off with Gerald O’Driscoll’s “The Fed at 100.”

Contra Galbraith on Inflationary Finance

James K. Galbraith has written a strange piece for the New York Times, where he muses on the debt ceiling. He argues that the necessity for government to borrow money is an “anachronism,” product of the gold standard. In answering why the government doesn’t just create new money, he claims that “to do so would expose the “public debt” as a fiction, and the debt ceiling as a sham” — as if the constraint on debt monetization is nonsensical or ideological. Galbraith, however, gets his history wrong, and as a result gets the answer to his question wrong. Governments have tried to get around borrowing constraints throughout history, and the reason we toughen these constraints is exactly because unconstrained governments have misused the power to debase their currency.

Prior to the 20th century, it was often that governments attempted to avoid their financial constraints. The Roman Empire, for example, frequently underwent currency debasement to pay for growing bureaucratic and military expenses (Bartlett [1994]). The Spanish Empire also relied on seigniorage for financing (Motomura [1994]), on top of the new silver and gold it imported from its colonies — this lead to the “European price revolution,” as the value of money fell sharply. Governments don’t need paper money to spend without borrowing. In the era of metallic currencies, all government had to do was lower the content of the precious metal in the coin — replacing it with a less valuable substitute (e.g. copper) —, and encourage acceptance at par.

Contra Galbraith, there were (and remain — after all, economic laws are immutable) economic constraints on seigniorage. By lowering the value of money, and redistributing resources away from non-government market participants, significant and sustained currency debasement leads to the deterioration of exchange. It is no accident that, ultimately, the most successful imperial government that emerged from the pre-modern milieu was England, which made use of a growing finance industry to borrow larger sums of money than rival governments could. English society had learned from a multitude of previous experiences that currency debasement is not a permanent solution to financial constraints, and that over the long run inflationary expenditure is more harmful than anything else.

It could be argued that modern, democratic governments have constraints of other types that would limit the extent of seigniorage. Perhaps, but it wasn’t too long ago that modern governments resorted to the printing press to get around financial constraints. This led to the great inflations and hyperinflations that followed the First World War. Similar to pre-modern experiences, this public finance technique led to the deterioration of European markets, and ultimately the only viable solution was to place a ceiling on public budgets. Now, I do think that we learned “too much” from this experience, making monetary policy more rigid than it really needs to be: case-in-point, the Great Depression. But, there is a big difference between constrained, but flexible-enough monetary policy, and unconstrained inflationary fiscal expenditure.

Increasing the quantity supplied of money is not always a bad thing. When there is a demand shortage increasing the quantity supplied of money is oftentimes a superior alternative to waiting for the price level to fall, because many individual prices do not always fall to their market-clearing level. Maybe what we need today is more money (although, given that the price level has been rising I’m skeptical of the idea that a demand shortage is currently the most important deterrent to economic recovery). But, lifting the constraints on public finance is not a solution. Maybe the current administration, and even many administrations to follow, can be trusted, but political institutions can deteriorate, especially when government is under financial pressure. The reason we don’t voluntarily dismantle them voluntarily is because the risk of gratuitous inflationary public finance is very real, and it has been something governments have resorted to since the beginning of governed civilization.