Scott Sumner  

Bob Murphy reviews The Midas Paradox

PRINT
Big Day for Britain... A few thoughts in the immediat...

Bob Murphy was kind enough to review my recent book on the Great Depression, in the Quarterly Journal of Austrian Economics. Here are the concluding two paragraphs:

Putting aside the detailed statistics, I will end this review with a simple question: How can it be that the classical gold standard is largely responsible for the Great Depression, when the classical gold standard was operating during several previous financial panics and depressions (small "d")? To blame the Great Depression on the gold standard is akin to blaming a particular plane crash on gravity.

In contrast, the Rothbardian analysis at least has a shot at being satisfactory. After all, Herbert Hoover in his memoirs tried to defend his legacy by assuring his readers (truthfully) that his administration had taken unprecedented measures in battling the Depression, meddling in the economy in ways that no president during peacetime had done before. That's the place to start, when we ponder why Herbert Hoover suffered from a worse downturn than any president before.


I don't recall ever saying precisely that the classical gold standard was largely responsible for the Great Depression. If I did, it was an error. My actual belief (which explains the original title of my book---The Midas Curse) is slightly different---that the initial phase of the Great Depression was caused by massive gold hoarding during 1929-33 (under the interwar gold standard), especially by central banks. This gold hoarding sharply reduced prices and NGDP, and since nominal wages were sticky it also led to mass unemployment. The unusual duration of the Great Depression (including an 8 year recovery after a 3 1/2 year contraction) is partly explained by FDR's high wage policies.

I believe that the gravity metaphor better applies to Bob's explanation for high unemployment---sticky wages. In my view, sticky wages and prices are just one aspect of reality, something that policymakers must account for, just as airplane designers must account for gravity. Thus monetary policy should aim for stable growth in NGDP, so that sticky wages don't become a problem.

In fairness to Bob, there is a grain of truth in his attempt to blame wage stickiness. He points to the fact that Hoover pressured firms not to cut wages after 1929, whereas during the severe 1920-21 price deflation, wages were allowed to adjust downwards. But I don't think this proves as much as Bob assumes. Even without any government interference, wages would be sticky in the short run, and the 1921 depression was also quite steep. The difference in 1929-33 was that the deflation continued for 3 and 1/2 years, whereas after 1921 prices started rising again. So the monetary shock was far worse in 1929-33, which largely explains why the latter contraction was longer and deeper.

Having said that, I do agree with Bob that Hoover's high wage policy was also a significant factor, and explains part of the greater severity of the 1929-33 slump. I also agree with the Murphy/Rothbard view that other Hoover policies were also destructive, such as the Smoot-Hawley tariff and the sharp increase in marginal income tax rates.

However, Adam Smith was right when he said there's a great deal of ruin in a nation. During 1964-73, Johnson and Nixon did lots of things that led to greater government spending and regulation, as well as higher taxes. The net effect of these on measured economic efficiency was negative (aside from civil rights laws). And yet the economy boomed. It didn't boom because supply-side factors don't matter, it boomed because in the short run demand shocks are the primary determinant of output and employment. Hoover's policies were quite counterproductive, but nowhere near important enough to explain the Great Contraction. It was tight money that did it.

When I wrote the book, I consciously tried to avoid monocausal explanations that pinned "blame" on a single policy or political figure. The Great Depression was very complex, and my book makes it quite clear that if during the 1930s the gold standard had been operated according to the "rules of the game", there might well have been no Great Depression (we can't be sure either way). That's why I say it's an oversimplification to say I "blamed" the gold standard for the Great Depression, especially the claim that I blamed the "classical gold standard", which usually refers to the pre-WWI system (where central bank intervention was milder and hence the rules of the game were more closely followed).

On the other hand I'm quite comfortable saying that I think we would have been better off if the gold standard had been replaced by fiat money after WWI. Even that new system would have probably performed poorly by the standards of the 1990s, but it would have done less poorly than the actual result that we got under the interwar gold standard.

One other point. I think Bob makes too much of the fact that I was unable to explain the stock market crash of 1929. I explained as much of it as I could (which is far more than what anyone has been able to do for the similar 1987 crash) but freely acknowledged that I fell well short. It remains something of a mystery. At the beginning of the book I indicated that I believe I was able to do a much better job of explaining stock market movements in 1930-38, as compared to 1929. A reviewer certainly should point out that I fell somewhat short of explaining 1929 (although I still think I did better than others) but the greatest weakness in the book (in my view) is that I had almost nothing interesting to say about the rapid recovery of 1940-41.

But then that's where I'd guess a Keynesian reviewer would take me to task, not Bob Murphy. :)

Despite these quibbles, I appreciate Murphy's review, which did have some positive things to say as well.

HT: CA

Screen Shot 2016-06-23 at 2.34.31 PM.png


Comments and Sharing






COMMENTS (12 to date)
Ilya writes:

Scott,

Could WWII explain the rapid recovery during 1940-41? What else could it be?

I'm thinking of either rapid gold inflows from European countries or increase Export demand from the Allies.

John Hall writes:

I like that line about avoiding a monocasual explanation of the Great Depression.

I read the book while visiting my parents last year, and my father asked me whose fault the book said it was. I had a visceral, negative reaction to that, responding that it wasn't a partisan book and that it's more complicated than just saying it was all FDR's fault or something.

Anonymous writes:
I believe that the gravity metaphor better applies to Bob's explanation for high unemployment---sticky wages. In my view, sticky wages and prices are just one aspect of reality, something that policymakers must account for, just as airplane designers must account for gravity. Thus monetary policy should aim for stable growth in NGDP, so that sticky wages don't become a problem.

My understanding of wage stickiness is that, while it is a very persistent effect, it is a problem of individuals behaving irrationally, not a collective action problem of rational individuals imposing externalities onto one another. Is that correct?

If so, I was wondering if there are any conceivable circumstances in which this irrationality might be prevented - which if my depiction of the problem in the previous paragraph is accurate, could surely be done on a case-by-case basis without requiring any large-scale overarching legal changes.

For example - why wouldn't it work to include on your job acceptance letter, "If an economic downturn ever occurs and you are tempted to lay me off to cut costs, please just cut my pay instead, as I recognize that this option can be better for both of us. I will suppress the part of my brain that sees this as fundamentally unfair and immoral and oppressive and everything else. Yes, I'm serious. Yes, really."

Why wouldn't this work - is it just too odd? Is it not even conceivable that a startup might manage to standardize this process, and make participating in it cool rather than weird? Or am I just misunderstanding the problem entirely?

Philip George writes:

You miss the obvious point. The stock market crash of 1929 was hugely more severe than the stock market crash of 1921. See graph on Dow Jones Historical Chart to see how big the difference was. (Uncheck the inflation adjusted box). The only other crash that bears comparison is the one during the Great Recession (and of course that was accompanied by another asset market crash, in housing).

Is it an accident that the three greatest recessions of the past century -- the Great Depression, Japan's Lost Decade and the Great Recession -- all followed huge asset market crashes?

The huge loss in net worth of individuals in the Great Depression led them to sharply cut their consumption. This in turn led to a drying up of investment, a cut in output by firms and overall drop in income.

For a more detailed explanation see my book Macroeconomics Redefined

Scott Sumner writes:

Ilya, Yes, I think it was WWII, specifically the spring 1940 invasion of Western Europe. (The earlier Polish invasion did not help the US economy.

Thanks John.

Anonymous, I'm not sure whether it represents irrational behavior. In terms of our models it looks that way, but with a deeper view of rationality there may be good reasons for it.

Philip, You said:

"The only other crash that bears comparison is the one during the Great Recession"

That's just totally inaccurate. The 1987 and 1929 crashes were almost identical. And the 1987 crash did not lead to even a tiny slowdown in growth. No effect at all.

Philip George writes:

Prof Sumner,

The 1987 crash was extremely short-lived.

The Dow Jones fell 22.6% on October 19, 1987. By the end of 1987 it had recovered 11% from that low. By the end of 1988 it had almost completely recovered the entire loss.

So to say that the 1987 and 1929 crashes were identical is totally inaccurate.

After the housing and stock market crashes that caused the 2008-09 recession the median US household lost 18 years of inflation-adjusted net worth. Given that interest rates are close to zero, they would have had to double their saving rate for 18 years to recover their lost net worth. That is why the recession is so long-drawn-out.

By focusing on NGDP and ignoring financial assets you have merely helped bring on the next crash and recession.

Lorenzo from Oz writes:

Bob Murphy's review seems to be part of the "but it was not a REAL gold standard" fetish about the interwar gold standard.

I have very little sympathy for this view. Once the Fed was created and such a large proportion of gold reserves was in the hands of a single institution, any gold standard was going to operationally be whatever the key central banks decided. From 1928 onwards, the Bank of France decided to drive up the value of gold and the Fed decided not to stop them. (In much the same way as the 2008 Fed decided to tighten monetary conditions.) Great Depression follows.

A commodity standard creates great potential vulnerability -- as China on the silver standard found out when FDR played fun and games with silver prices.

Bob Murphy writes:

Scott,

No lie, I was getting ready to apologize to you for the "classical gold standard" line, since you of course were quite nuanced in your book. (For what it's worth, I was trying to distinguish between the pre- and post-War War II gold standards, although you're right, we could identify at least three separate regimes.)

But then Lorenzo from Oz wrote this:

"Bob Murphy's review seems to be part of the "but it was not a REAL gold standard" fetish about the interwar gold standard.

I have very little sympathy for this view."

So I either (incorrectly) accused you of attacking the classical gold standard, Scott, when you instead realized what was in play in the 1930s wasn't the old-school standard...OR I fetishized it with a weak defense, as Lorenzo claims... but I couldn't have made both mistakes in the same review.

Jim Glass writes:

My understanding of wage stickiness is that, while it is a very persistent effect, it is a problem of individuals behaving irrationally, not a collective action problem of rational individuals imposing externalities onto one another. Is that correct?

It's not so irrational at all.

First look at it from labor's point of view. The clearest example is with a labor union - if the union votes on a proposal, "either all members take a 10% pay cut, or the 10% of most junior members are laid off with everyone else keeping full pay", the vote result is going to tend strongly towards 9-1 to preserve the wages of the 90% by the layoff, and that vote will be entirely rational. This happens in the real world all the time. The same dynamic exists in a workforce when there is no union, the union action only makes it clearly visible.

Now look at it from management's point of view. Even in recessions businesses always have competition, with some competitors being stronger than others. And competition for labor can be not only within an industry but across industries -- workers can jump.

Now consider an employer imposing a 10% pay cut across the board. This is going to hurt employees' morale -- some will be angered, some will take it as a sign that the business going down the tubes, etc. The first result is the damaged morale hurts productivity and operations. The second is that the workers who can will bolt to other, better, more secure opportunities. Who are the workers who can? The firm's best workers.

So in order to avoid long-term ongoing damage to morale that will hurt operations, and the loss of its best and most valuable employees to competitors, the firm instead picks the 10% of its least capable employees and fires 'em. The survivors remain happy and productive. There's not much that's irrational about making that decision.

Combine the points of view of labor and management, and one can see a very rational grounds from which wage stickiness springs.

Jim Glass writes:

The 1987 crash was extremely short-lived... By the end of 1988 it had almost completely recovered

Why? And the real economy barely noticed it. Why?

If financial asset collapses are definitionally so devastating to the economy, why wasn't this monster of a collapse harmful to the economy?

It doesn't seem persuasive to say that financial assets collapses crush the economy, except in cases when they don't, in which case because the economy remains strong the financial assets recover their value in a year, so that even a monstrously huge financial asset collapse doesn't count as a "real" financial asset collapse because it didn't crush the economy.

Lorenzo from Oz writes:

Jim Glass:

Why? And the real economy barely noticed it. Why?
Because the key monetary authority acted differently.

Asset crashes drive up demand for money. If the monetary authority responds to that demand, and is expected to keep doing so, the demand is satisfied/abates and total spending is not seriously affected.

If the monetary authority fails to respond and does not manage expectations, spending falls, income falls and the asset crash flattens the real economy.


DZ writes:

Scott/Ilya -

Regarding an alternative view on the recovery in the early '40s, David Stockman has some interesting things to say in this article:
http://davidstockmanscontracorner.com/krugmans-dopey-diatribe-deifying-public-debt/

To sum up, he basically points out that war-time private saving levels increased dramatically due to a dearth of consumer goods production.

Comments for this entry have been closed
Return to top