I plan to discuss a very impressive (unpublished) paper from 1991 written by Ronald W. Batchelder and David Glasner. Then I hope to use this paper as a springboard to re-think the evolution of 20th century macro. With apologies to Mr. Batchelder, I will refer to “David’s ideas” for simplicity. (I know David, and he provides some excellent comments to this blog.) David and I also share similar views on monetary policy, and in many cases he published his views first. Unfortunately, the paper I refer to is not available on the internet.
The paper focuses on the views of Ralph Hawtrey and Gustav Cassel, two unjustly neglected interwar economists. Both economists favored an international gold standard, but both were also concerned that the post-WWI system was potentially unstable. During WWI many countries sold off their gold stocks to help pay for the war. This big drop in the demand for gold caused the value of gold to plummet, which meant that the price level more than doubled. Some of that was reversed in the 1920-21 deflation, but Cassel and Hawtrey feared that as countries rebuilt their gold stocks the price level might fall, causing higher unemployment. They favored policies that would economize on the use of gold, such as replacing gold coins with gold-backed paper money. Another idea was to supplement gold reserves with some sort of international accepted currency, such as the dollar and/or the pound. And some of these reforms were implemented.
At first it looked like their fears were overblown. Throughout most of the 1920s, prices in terms of gold were fairly stable. After 1929, however, their worst fears came to pass. Both central bank and private hoarding of gold caused severe deflation throughout most of the world, leading to mass unemployment. So why didn’t they get credit for their predictions? Why aren’t they famous today? It turns out that the answer is surprisingly complicated, and tells us a lot about how macroeconomics evolves over time.
Hawtrey and Cassel were actually part of a broader tradition, which I’ll call “progressive.” These economists favored using monetary policy to stabilize the economy, generally through a price level target. Fisher and Keynes also held these sorts of progressive views, although they did not support the international gold standard. Fisher wanted to adjust the price of gold each month to prevent changes in the price level. Keynes’ views are a bit harder to pin down, but he generally favored a stable price level as a domestic policy objective, and what might be called a Bretton Woods-type international monetary system. Gold would still be in the background, but countries could revalue or devalue when the exchange rate constraint conflicted with domestic stabilization objectives.
I believe that the views of these four progressive economists, who were also arguably the 4 best monetary theorists of the interwar period, are roughly analogous to the position occupied by the top new Keynesian economists of the 1990s and early 2000s. Think of Fisher as a modern American new Keynesian, with a closed economy focus. Cassel and Hawtrey would be closer to Mundell, someone with a more international perspective. And Keynes would be somewhere in between.
However, they point out that by 1930 all four of them had been eclipsed by another economist—-Hayek. Here is how they describe his impact:
Moreover, the Austrian theory achieved an enormous breakthrough in 1930, when Hayek, at the invitation of Lionel Robbins, gave four lectures on monetary and business-cycle theory at the London School of Economics. Greatly impressive both for their command of the history of monetary theory and for their analytical brilliance, the lectures caused an instant sensation in the British economics profession, leading to Hayek’s being awarded a chair at LSE in 1931 and to their publication as Prices and Production in the same year.
A warning to my Austrian readers; I am going to describe Austrian economics not as someone like George Selgin would describe it today, but more as it was perceived by those who listened to the 1930 lectures, and also in line with much of the pop-Austrian stuff floating around on the internet today. According to this view, the Fed made a mistake by adopting a low interest rate policy in 1927. The Fed wanted to help the UK, and keep US prices from falling, but they merely succeeded in blowing up a big stock market bubble. In the long run these speculative excesses led to malinvestment and a crash. The crash was necessary to purge the excess from the system and allow resources to be reallocated. David likes Hawtrey and Cassel’s views much better, and notes that it may seem “surprising” that these views were eclipsed by the Austrians:
Though the timing may be only coincidental, the influence of Hawtrey and Cassel on monetary policy seems to have declined after 1927 as the Austrian analysis became increasingly well known. Surprising as it may now seem, the deflationary policy implications of the Austrian business-cycle theory attracted a following among many policy makers, among groups in the population who were morally offended by the greed, speculation, and financial excesses of the 1920s, and by powerful creditor interests concentrated in the major banks that had an enormous financial stake in a reduced price level (Temin 1990, Batchelder and Glasner 1991).
I’m going to argue that it wasn’t surprising at all. I think the Austrian story is very appealing (although ultimately I will argue it isn’t quite right.) People who followed the events of the late 1920s and 1930, especially people with conservative temperaments, probably found the Austrian story to be extremely persuasive. All the speculative excesses of the 1920s built on cheap money, and then the hangover when you have to pay the piper. There must be a million literary analogies to this sort of story. But here’s something that is very surprising, only two years later the entire Austrian analysis was rapidly sliding into disrepute. And here’s something that is still more surprising, the profession did not suddenly wake up and return to the progressive tradition of Cassel and Hawtrey (and Fisher, Robertson, Keynes, Wicksell, etc.) Instead, Austrian economics was eclipsed by a third school of thought, and one that hadn’t even existed in 1930.
David has a pretty convincing explanation for the decline of Austrian economics. In 1930 Hayek had indicated that recession and deflation was an unfortunate price that had to be paid for the previous excesses. Later Hayek acknowledged that the deflation went much too far, but at the time the Austrian school was increasingly associated with reactionary policies, just as the severity of the Great Depression was pushing people toward government activism as a solution. In their paper they suggest that 1932 was a turning point, the year when Keynes moved away from his 1920s-style views, to a very different perspective.
Here I’d like to break away from David’s paper, and discuss what I think happened in 1932. Before doing so, let’s think about three ways of visualizing monetary policy during a deflationary recession like 1930:
1. Progressive/new Keynesian: Use monetary policy to boost prices and/or AD, in order to stabilize the economy
2. Austrian: Run a passive monetary policy as any attempt to prop up the economy would merely cause an ever greater crash later on.
3. Keynesian: An expansionary monetary policy would be nice, but monetary policy is ineffective in a depression with falling prices. You can lead a horse to water . . .
Of course these are crude charicatures, especially for the Austrian view. But I do think they capture three basic ways of thinking about the problem. It is clear that in 1932 Keynes moved from 1 to 3, and within a few years much of the profession followed him. The question is why.
I’d point to three reasons. First the UK devalued in September 1931, and by 1932 it was clear that this action would not be enough to quickly restore prosperity to Britain. David argues that this weakened the Cassel/Hawtrey explanation for the Depression, which focused on problems with the international gold standard. I would also point to the large US open market purchases conducted in the spring of 1932, which failed to revive the US economy. And finally, interest rates fell to very low levels in 1932, another indication that monetary policy was accommodative but impotent.
I think Keynes was wrong about almost everything. Britain was helped by the devaluation, but also faced enormous structural problems, rigid labor markets, and a world economy that continued to be very weak. The failed Fed open market purchases, which were cited by Keynes in the GT as an example of a liquidity trap (called absolute liquidity preference in the GT) were actually an example of the constraints of the international gold standard. And of course low interest rates aren’t easy money; they are an indicator of deflationary monetary policies. Nevertheless, Keynes views were much more appealing than mine, I know this because I have had a million arguments over the last year, and people keep throwing Keynes’ perspective back at me in conversation.
So here is my argument. It’s all about the zeitgeist. Maybe I overuse this concept, but I really think it explains an awful lot. No matter how good the progressive arguments were in the 1920s, they simply could not overcome the powerful story provided by the Austrians in 1930. Everyone accepted the Austrian story, because they already believed it in some sort of deep (Jungian?) sense. It confirmed their prejudices. Trying to hold it back with academic arguments was like trying to stem the tide.
But again, it didn’t last long. Perhaps if the Depression had ended in 1930 then by 1932 Keynes might have said; “We’re all Austrians now.” But it didn’t, it was much longer than normal business cycles, and thus you had the amazing spectacle of not one but two new zeitgeists appearing almost back to back. By 1932 almost everyone was pessimistic about monetary policy. I read a lot of conservative newspapers from that era, and was struck by how often conservative pundits would mock the idea that monetary policy could stop the Depression. The failed 1932 OMOs were always thrown in the face of the progressives. There was a sort of “we tried printing lots of money and it didn’t work” perspective that had become conventional wisdom by mid-1932. And note that these articles were written 4 years before the GT introduced liquidity traps and by people that hated Keynes even more than they disliked the progressives.
So when Keynes introduced his new ideas about monetary policy in 1936, he didn’t have to try very hard to convince people. He found a very receptive audience that already believed much of what he was preaching. All he had to do was point out that if you are in a liquidity trap, all kinds of crazy things are possible. (Check out this very funny Wilkinson post.)
Take a look at the paragraph I quoted where they explained the mindset of people who adopted the Austrian view in 1930. How would you test my theory that the zeitgeist explains Hayek’s initial success? In 1991 I would have held out little hope that a test was possible. Think about what would be required. You’d need an “easy money” policy (i.e. low nominal rates) that was highly controversial. Then you’d need that policy to be followed by a big asset bubble. Then you’d need the bubble to burst and lead to falling NGDP. And all this would somehow have to produce a surge in popularity for Austrian economics.
But in 1991 we hadn’t had that set of events in over 60 years. And even when we did have a massive stock bubble in 2000, it was not preceded by ultra low interest rates, nor was it followed by falling NGDP. But then it all came together. The highly controversial low interest rate policy of 2003-04, aimed at preventing deflation. The massive housing bubble and collapse. And then in 2009 the biggest fall in NGDP since 1938.
And what happened? How did my zeitgeist story hold up? Well just in the past few weeks I have run across three conservative economists who expressed a new and sudden interest in Austrian economics. Where is that interest coming from? The zeitgeist. It is in the air. And if this time we don’t have a Great Depression, if the recovery continues, it is possible that the Austrian view may take hold. Will we soon ”all be Austrians now?”
But that’s not all. Remember my story about how merely two years after Austrian economics went into severe decline, the formerly dominant progressive tradition also faded away, and both were replaced by Keynesian economics? Now think about the following. Inflation became the big problem in the post-war period, and economists stopped worrying about liquidity traps. New Keynesian economists ruled the roost. By the late 1990s most of the best monetary economists were basically new Keynesians, especially the Krugman/ Svensson/Woodford/Bernanke quartet at Princeton. So you might assume that when the Austrians roared back in the wake of the subprime fiasco, with their highly persuasive stories that played on our deepest instincts, they would have been battling it out with the new Keynesians. Not so, as Arnold Kling points out the new Keynesians just sort of quietly folded up shop. They simply disappeared, they went into hiding. The minute interest rates hit zero all the well-thought out solutions to liquidity traps, developed by people such as the Princeton 4 mentioned above, seemed to be either forgotten or ignored. Instead the old Keynesian tradition roared back to re-fight the battles of the early 1930s. Who will win? Let’s hope the Austrians, as if the Keynesians win that means we would have had an extremely long and deep recession.
Let’s talk about two interesting figures from the early 1930s, and see if you can spot the modern equivalents:
1. Keynes started as a mainstream progressive, favoring the use of monetary policy to stabilize the business cycle. He favored using interest rates as a policy instrument. He went through a sort of midlife crisis in 1932, and he later indicated that while he used to believe monetary policy was always the best way to stabilize the economy, he no longer believed that. Does this sound familiar yet? His views could be maddeningly hard to pin down, and were somewhat more complex and subtle than those of his followers. Sometimes he would appear to favor an expansionary monetary policy, but a week later you could find him saying that monetary policy was ineffective at low interest rates. Before I had this blog I used to sometime criticize Keynes in emails to a friend of mine who likes Keynes. He kept insisting that I was wrong about Keynes, and would point to passages in the Treatise showing Keynes wasn’t as clueless about monetary policy as I kept alleging (based on my reading of the GT.) If you follow my comment sections you may know where I am going.
Keynes was also a great writer, with a very persuasive style. His supporters loved him, but beware if you were on the receiving end of his pointed barbs. He was the leading liberal intellectual among economists. Still don’t have it? OK, one last clue, his name starts with “K.”
2. Now let’s talk about George Harrison. I am afraid I know much less about him and perhaps my memory may less than perfect. So please correct me if I am in error. I recall that when Strong headed the Federal Reserve Bank of NY, Harrison was second in command. Harrison was supportive of Strong’s activist stance. Strong favored a policy of stabilizing the economy, and tried to use monetary policy to offset cyclical changes in prices and output. He was a “flexible inflation targeter.” After Strong died in 1928, (one year before the bubble burst!!) Harrison took over, and became the most important policymaker in the Fed (which was more decentralized at the time.) He acted very aggressively during the stock market crash. In early 1930 he was unsuccessful in pressing the inflation hawks at other Fed branches to ease policy more aggressively. Then for some reason as the economy went downhill in late 1930 and 1931, Harrison himself became strangely passive, despite his earlier reputation for activism. Who does that remind you of?
So what does all this say about current events? Krugman says we are going through a “dark ages” of macro, forgetting much of what we have learned. He is mostly referring to those who deny that inadequate aggregate demand is the main problem that we face today. Or that think Say’s Law holds in a recession. He is not referring to those who advocate unconventional monetary stimulus, as Krugman himself does this on occasion.
In my view we are going through two dark ages, which is probably a horrible metaphor. I see the problem as both Austrian and Keynesian economics, or (so that I don’t offend any Austrians or Keynesians reading this) at least the cruder versions of each school of thought. For an analogy, recall the politics of the interwar period. The fascists and socialists were battling each other, each full of “passionate intensity.” In contrast, classical liberals had “lost all conviction.” Since I have picked on Hayek in this post, let me emphasize that the Hayek of The Road to Serfdom is a hero in that political story, fighting the lonely battle for classical liberal ideas.
Commenters keep taunting me, pointing out that I criticize Hayek without having read his work. But David’s paper makes me even less inclined to read it. Not because I think it wouldn’t be persuasive, but because I fear it would be. The Austrian story was already so persuasive that today “we are all Austrians now.” Then add Hayek’s rhetorical skills. If I could read Prices and Production in the same way that Odysseus listened to the Sirens, then I would be tempted. But what is to stop me from becoming bewitched by his message? Like crack cocaine, it is best not to tempt fate by sampling the most powerful types of Austrian economics. I’ll stick to Garrison’s Powerpoint slides.
So are we fated to keep endlessly circling between the Austrian pessimism, the Keynesian fiscal follies and the new Keynesian inflation targeting? I’m not that pessimistic. As bad as things are, the Great Depression was much worse. Surely we gain a little each time events teach us these painful lessons. So even when I read this sort of depressing quotation from George Harriso . . . I mean Ben Bernanke, I still refuse to give up hope. Someday we will say “we are all NGDP futures targeters now.”
Update. Just after I posted this I noticed that Krugman said Bernanke was Montegu Norman, not George Harrison. Well at least we picked from the same “Lords of Finance” book.
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