Garett Jones  

Alfred and Mary Paley Marshall: Depressions as Self-Fulfilling Prophecies

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There are some ideas I love to believe in despite a lack of evidence.  

Among my favorites: That the business cycle is partly a self-fulfilling prophecy: You go to the party you think everyone else is going to, you stay away from the swap meet because you think nobody else is going.  Even in a world without banks, without money, without collateralized debt obligations, without sticky prices and wages, firms want to take on big projects when they think other firms in their supply chain are doing the same.  And that happens in waves.  

Adam Smith taught us that the division of labor was valuable, Alchian and Demsetz taught us the division of labor was quite hard enough to pull off inside a firm, and Rousseau, with his tale of the Stag Hunt, taught us it was even harder to pull off between firms.  In the Stag Hunt, the division of labor leads to multiple equilibria, to self-fulfilling prophecies of boom and bust.  

By way of my colleague David Levy and an old paper by Columbia's Michael Woodford, I learned that Alfred Marshall and his wife Mary Paley Marshall also believed in the business cycle as a self-fulfilling prophecy.  At least they did in 1879; Alfred Marshall let the book go out of print and went to at least some effort to have existing copies destroyed. 

In the excerpt below I've italicized three words: disorganization, confidence, think.  The idea that recessions are times of disorganization deserves greater attention, greater testing.  

Excerpted from Alfred and Mary Paley Marshall, 
The Economics of Industry, 1879, Book 3 c.1, s.4, italics added. 

After every crisis, in every period of commercial depression, it is said that supply is in excess of demand...And it is thought that this state of things is one of general over-production. We shall however find that it really is nothing but a state of commercial disorganization; and that the remedy for it is a revival of confidence. 

...For when confidence has been shaken by failures, capital cannot be got to start new companies or extend old ones. ...Other trades, finding a poor market for their goods, produce less; they earn less, and therefore they buy less; the diminution of the demand for their wares makes them demand less of other trades. Thus commercial disorganization spreads, the disorganization of one trade throws others out of gear, and they react on it and increase its disorganization

The chief cause of the evil is a want of confidence. The greater part of it could be removed almost in an instant if confidence could return, touch all industries with her magic wand, and make them continue their production and their demand for the wares of others....Confidence by growing would cause itself to grow .... 

There is of course no formal agreement between the different trades to begin again to work full times and so make a market for each other's wares. But the revival of industry comes about through the gradual and often simultaneous growth of confidence among many various trades; it begins as soon as traders think that prices will not continue to fall: and with a revival of industry prices rise.

I especially like the phrase "out of gear." 

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CATEGORIES: Macroeconomics

COMMENTS (3 to date)
roystgnr writes:

The growth of overconfidence in booms may generally be coordinated and gradual; the loss of confidence in busts surely isn't. The last two recessions began with price bubbles suddenly "popping", the few before that started with sudden energy price spikes.

callummcp writes:

This is what Krugman likes to call the 'confidence fairy'. The sad thing is that believing in it doesn't make it real. No matter what supply-side reforms we try during a depression, the problem is one of low demand. The way you can tell a really strongly analytical economist is that they write things like "There are some ideas I love to believe in despite a lack of evidence." Might as well call some economic doctrines what they are: blind faith. No amount of evidence can change some peoples' minds; and these people should be ignored.

MingoV writes:

There is a big difference between "self-fulfilling prophecy" and "following the herd." I believe the latter is the bigger factor in economic depressions, booms, and bubbles.

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