Arnold Kling  

Stories of the 1930s

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I am reading The Dark Valley: A Panorama of the 1930s, by Piers Brendon. Much of it annoys me. For example, he writes,


Nor did he [President Hoover] attempt to reduce financial inequalities, perhaps the most fundamental cause of the Crash.

The story that the Depression was caused by unbalanced income distribution took root very early among historians. I think that a lot of this came from Marx, who predicted a cycle in which the rate of capitalist profit would rise and crash in ever-increasing extremes. I am not saying that historians were Marxists, but his theories were in the air, and other theories did not displace them.

Along these lines, Brendon writes,


Edmund Wilson was one of a number of middle-class intellectuals who concluded that "Karl Marx's predictions are in the process of coming true." Capitalism was in crisis because of its inherent contradictions: economic competition resulted in greater industrial efficiency at the expense of workers, so "the more cheaply and easily goods can be produced, the fewer people are able to consume them." By contrast, Wilson was impressed by the apparent success of Stalin's Five Year Plan

Once the first generation of Depression historians had emphasized unbalanced income distribution, then future historians kept the story alive. The line of least resistance when writing history is to quote other historians, so there is a sort of path-dependency in the process. But among economists, I think that the focus is on monetary factors (including mishandling of the gold standard), financial factors (problems with banks), and supply-side factors (regime uncertainty, trade barriers).

Incidentally, in other ways, I think that Marx had a huge influence on economists who do not consider themselves Marxists. For too long, under the shadow of Marx, economists have had an intense focus on the process of capital accumulation, as illustrated by the popularity of the Solow Model of economic growth. Only when the Solow Residual started to be taken seriously, by Paul Romer among others, did we start to realize the importance of factors other than physical capital. Now we have Mokyr's analysis of knowledge and science, McCloskey's analysis of culture, North's analysis of institutions, and so forth. See From Poverty to Prosperity.


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COMMENTS (6 to date)
mojakus writes:

Arnold - you clearly disagree with the 'inequality' explanation of the Great Depression and Great Recession, but you don't go into detail. It would be great to hear where you think it goes wrong. The work of Emmanuel Saez and Thomas Piketty suggests there may be something to it.

fundamentalist writes:

It's important to realize that Solow, McCloskey and North are not alternative theories of growth, but links in the chain. Capital formation is absolutely necessary, but what are the conditions for capital formation? You need North's institutions that protect property from theft by the powerful elite. But how do you get those institutions? You need the values of McCloskey.

Where does Mokyr fit? I don't think he does. Science didn't begin to contribute to development until well into the 20th century. Education and research are products of development and the icing on the cake, not the cause.

fundamentalist writes:

mojakus, I don't see how rising inequality can cause business cycles. For that to be the case inequality would have to cycle as well and at the frequency of business cycles, which is a cycle of 6-8 years. And if inequality did cause business cycles, then how does the middle class get back the money necessary to spend and end the business cycle?

Of course, someone could argue that inequality doesn't cause regular business cycles but the big ones like the Great D and the Great R. But again, you would have the problem explaining how we got out of the depressions. You would have to show a major increase in taxes on the wealthy with massive spending increases by the state. Borrowing from the wealthy won't reduce inequality; it will make it worse. But we didn't have massive tax increases on the wealthy after either depression.

Research I have seen on inequality shows that the Gini coefficient today is about what it was 200 years ago in the US and UK. It does change, but mostly due to immigration and population age. Immigration increases the number of poor people while older people earn far more than younger.

In fact, as the baby boomers age we should see inequality jump sharply until after all have retired. When all of the boomers are dead you'll see inequality fall dramatically.

mojakus writes:

Fundamentalist writes:

Of course, someone could argue that inequality doesn't cause regular business cycles but the big ones like the Great D and the Great R. But again, you would have the problem explaining how we got out of the depressions. You would have to show a major increase in taxes on the wealthy with massive spending increases by the state. Borrowing from the wealthy won't reduce inequality; it will make it worse. But we didn't have massive tax increases on the wealthy after either depression.

good points.

I think the argument is as follows: the 'Big' cycles of recession and depression in the US have been preceded by increases in inequality (empirically expressed by Saez et al. as the share of income accruing to the top decile of income-earners). The narrative is that increasing inequality is eventually unsustainable, since at some point all the real income eventually ends up accruing to a small portion of the population who cannot consume it all. This is the main 'internal contradiction of capitalism'. Overcapacity ensues, jobs are cut and aggregate demand falls well below potential.

For a while, especially in the long lead-up to the current big cycle starting in the early-1980s, debt can be used to engender a rising standard of living despite stagnant real wages. Thus we observe consumption-to-income ratios that rise at roughly the same rate as debt-to-income ratios and inequality. The middle-class (broadly defined here) is able to keep accumulating debt because interest rates and inflation are kept low (through Fed policy and Asian labor integration/currency management), so its debt service costs stay roughly flat, despite higher overall debt burdens. Every time debt burdens cause the non-capital owners to slow down consumption, the Fed comes in and stimulates the economy with lower rates, allowing new debt to bail out old debt and creating the softer, more regular and familiar business cycle. Eventually, a Minsky-ite debt-sustainability crisis arises and we end up with one of the 'Big' cycles.

The 'Big' Cycles are resolved by wealth-transfer (between savers and spenders, between rich and poor, between the living and the yet unborn) as well as old-fashioned Schumpeterian/Hayekian liquidation.

According to http://www.truthandpolitics.org/top-rates.php, the (admittedly simplified) tax rates for the top cohort of income earners in the US went from 25% in 1931 to 63% in 1932. The cost of current fiscal deficits and (potentially) monetary stimulus today will have to be borne by either future workers (in the form of higher savings rates/productivity), by savers/entitlement beneficiaries (in the form of inflation/default), or by tax-payers.

fundamentalist writes:

mojakus, Good points! And it is a believable scenario: the wealth accumulates to the rich until a crisis occurs and then the state redistributes wealth to get the economy going again. And clearly there is data to support it.

However, I think it takes a short-term view of how the economy works and follows bad theory. It's short term in that it ignores prices. If companies produce more than they can sell, prices will fall (in a free market) until they are low enough that people can buy them. So there is no need for a depression. Businesses who have borrowed too much won't be able to pay back the loans with lower prices and will go out of business, but businesses managed better will pick up the slack.

And we have to look at the reason for the overproduction in the first place. In a free market without fractional reserve banking, savings act as a break on investment so that overproduction is very unlikely. Only the introduction of fractional banking makes possible massive credit expansion that causes over production. Otherwise, why would companies continue to produce things for which there is no demand?

As for theory, the inequality theory violates Say's law (production creates the money to demand goods) and Mill's law (demand for goods does not equal demand for labor). If capitalists are producing goods, then they have to be paying labor wages and labor uses those wages to demand goods. Mill's law means that if consumption decreases (savings increase) then interest rates will fall and capitalists will invest in more capitalistic methods of production and demand more labor.

But an important thing to keep in mind is that all measures of inequality are relative, not absolute. They measure the proportions of income going to each segment, not the absolute incomes. In a wealthy country like the US, inequality can be very high and the poor still be very well off and consuming a lot of stuff. For an extreme example, would you rather be in the bottom 10% in the US or the bottom 10% in Bangladesh? The bottom 10% in the US live like the wealthy in Bangladesh.

Douglass Holmes writes:

I think what describes the situation is that the wealth accumulates to the rich, a crisis occurs, and the state attempts to redistribute the wealth. This causes the rich to withdraw the capital thus causing extended high unemployment. That certainly fits what happened in the 1930s.

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