Ricardo’s Big Idea, and Its Vicissitudes

Ricardo’s Big Idea, and Its Vicissitudes

INET Edinburgh Comparative Advantage Panel


Ricardo believes in labor value prices because capital flows to put people to work wherever those things can be made with the fewest workers. This poses a problem for Ricardo: The LTV tells him that capitalist production should take place according to absolute advantage, with those living in countries with no absolute advantage left in subsistence agriculture.

The doctrine of comparative advantage is Ricardo’s way out. For him, the LTV holds within countries. Countries’ overall price levels relative to each other rise and fall as a result of specie flows until trade balances. And what is left is international commodity price differentials that follow comparative advantage. Merchants profit from these differentials, and their demand induces specialization.
Thus Ricardo reconciles his belief in the LTV with his belief in Hume’s “On the Balance of Trade“ and with the fact that capitalist production is not confined to the industry-places with the absolute advantage. His doctrine reconciles his conflicting theoretical commitments with the reality he sees, as best he can.

By now, note that we are far away from the idea that “comparative advantage” justifies the claim that free trade is for the best in the best of all possible worlds. There are a large number of holes in that argument:

  • Optimal tariffs.
  • The fact of un- and underemployment.
  • Externalities as sources of economic growth, in any of the “extent of the market”, “economies of scale”, “variety”, “learning-by-doing”, “communities of engineering practice”, “focus of inventive activity”, or any of its other flavors.
  • Internal misdistribution means that the greatest profit is at best orthogonal to the “greatest good of the greatest number” that policy should seek.

Given these holes, the true arguments for free trade have always been a level or two deeper than “comparative advantage”: that optimal care of equilibrium is unstable; that other policy tools than trade restrictions resolve unemployment in ways that are not beggar-thy-neighbor; that countries lack the administrative competence to successfully execute manufacturing export-based industrial policies; that trade restrictions are uniquely vulnerable to rent seeking by the rich; and so forth.

The only hole for which nothing can be done is the internal misdistribution hole. Hence the late 19th C. “social Darwinist” redefinition of the social welfare function as not the greatest good of the greatest number but as the evolutionary advance of the “fittest“—that is, richest—humans.

Hence “comparative advantage” takes the form of an exoteric teaching: an ironclad mathematical demonstration that provides a reason for believing political-economic doctrines that are in fact truly justified by more complex and sophisticated arguments. And, I must say, arguments that are more debatable and dubious than a mathematical demonstration that via free trade Portugal sells the labor of 80 men for the products of the labor of 90 while England sells the labor of 100 men for the products of the labor of 110.

But even if you buy all the esoteric arguments that underpin the exoteric use of comparative advantage on the level of national political economy, there still is the question of the global wealth distribution. Stipulate that the Arrow-Debreu-Mackenzie machine generates a Pareto-optimal result. Stipulate that every Pareto-optimal allocation maximizes some social welfare function. What social welfare function does the Arrow-Debreu-Mackenzie machine maximize.

It maximizes the social welfare function with Negishi weights. When individual utilities are weighted before they are added, each individual’s is waited by the inverse of their marginal utility of wealth. If the typical individual utility function has curvature that corresponds to a relative risk aversion of one, then Negishi weights are proportional to each individual’s wealth. For a relative risk aversion of three, Negishi weights are proportional to the cube of each individual’s wealth.

“Comparative advantage” is the market economy on the international scale. And the market economy is a collective human device for satisfying the wants of the well-off. And the well-off are those who control scarce resources useful in producing things for which the rich have a serious Jones.

Thank you.

2017-10-22 :: 673 words

NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage

On Keynesian Economicses and the Economicses of Keynes: Hoisted from June 2, 2007

Hoisted from June 2, 2017: On Keynesian Economicses and the Economicses of Keynes http://www.bradford-delong.com/2007/06/keynesian_econo.html: With respect to http://bookclub.tpmcafe.com/blog/bookclub/2007/jun/01/rebutted_but_not_refuted

I think that there are two ways to understand the divergence of perspectives here…

The first is to note that Jamie Galbraith sees Keynes’s General Theory as part of something bigger: combine it with John Kenneth Galbraith’s New Industrial State, with Hyman Minsky’s approach to financial crises, and perhaps with Piero Sraffa’s Production of Commodities by Means of Commodities, and you do have an alternative theoretical framework for economics that owes very, very little to the Marshallian or even the Smithian tradition—and that owes nothing at all to the Walrasian tradition.

Call this “East Anglian Keynesianism.”

My macroeconomics teachers—Kindleberger, Eichengreen, Dornbusch, Fischer, Abel, Blanchard, Sargent—by contrast, see Keynes’s macroeonomics (not just the single book that is the General Theory, but also How to Pay for the War, The Economic Consequences of Mr. Churchill, the Tract on Monetary Reform, and so forth) as part of a different bigger thing. They see Keynes, Wicksell, and even Milton Friedman (though he would rarely admit it) as all groping toward an understanding of the macroeconomy that ends in the belief that limited, strategic, focused, yet powerful government interventions can create a situation in which the market economy could then work more-or-less along Smithian lines—that these focused government policies can, as I like to say, make Say’s Law true in practice even though it is false in theory.

Call this “MIT Keynesianism.”

MIT Keynesianism tends to downplay the most Galbraithian moments of Keynes—for example, his cracks about how bankers would prefer to fail in a conventional manner than to profit and grow rich in an unconventional manner. They regard the General Theory as just one of Keynes’s works written at a particular time (one of Great Depression) and thus focusing on the issues of greatest importance at that particular historical moment.

East Anglian Keynesianism throws Keynes’s earlier work out the window, and argues that the General Theory marks a genuine epistemological and theoretical break. But it has severe and serious problems with passages in the General Theory like this one, which Keynes puts at the very end of the book, where he argues that his theory is:

moderately conservative…. The State will have to exercise a guiding influence on the propensity to consume partly through its scheme of taxation, partly by fixing the rate of interest…. I conceive… that a somewhat comprehensive socialisation of investment will prove the only means of securing an approximation to full employment; though this need not exclude all manner of… devices by which public authority will co-operate with private initiative…. Our criticism of the accepted classical theory of economics has consisted… in pointing out that its tacit assumptions are seldom or never satisfied, with the result that it cannot solve the economic problems of the actual world. But if our central controls succeed in establishing an aggregate volume of output corresponding to full employment… the classical theory comes into its own… then there is no objection to be raised against the classical analysis of the manner in which private self-interest will determine what in particular is produced, in what proportions the factors of production will be combined to produce it, and how the value of the final product will be distributed between them… no objection…against the modern classical theory as to the degree of consilience between private and public advantage in conditions of perfect and imperfect competition respectively…. [T]he result of filling in the gaps in the classical theory is not to dispose of the ‘Manchester System’, but to indicate the nature of the environment which the free play of economic forces requires…. [T]here will still remain a wide field for the exercise of private initiative and responsibility. Within this field the traditional advantages of individualism will still hold good.

Let us stop for a moment to remind ourselves… [of] the advantages of efficiency—the advantages of decentralisation and of the play of self-interest… and of individual responsibility…. [A]bove all, individualism, if it can be purged of its defects and its abuses, is the best safeguard of personal liberty…. It greatly widens the field for the exercise of personal choice… the best safeguard of the variety of life… the loss of which is the greatest of all the losses of the homogeneous or totalitarian state. For this variety preserves the traditions which embody the most secure and successful choices of former generations; it colours the present with the diversification of its fancy; and, being the handmaid of experiment as well as of tradition and of fancy, it is the most powerful instrument to better the future…

And this one from the start of chapter 2 of the General Theory:

[O]rdinary experience tells us, beyond doubt, that a situation where labour stipulates (within limits) for a money-wage rather than a real wage, so far from being a mere possibility, is the normal case. Whilst workers will usually resist a reduction of money-wages, it is not their practice to withdraw their labour whenever there is a rise in the price of wage-goods. It is sometimes said that it would be illogical for labour to resist a reduction of money-wages but not to resist a reduction of real wages. For reasons given below (section III), this might not be so illogical as it appears at first; and, as we shall see later, fortunately so. But, whether logical or illogical, experience shows that this is how labour in fact behaves…

Thus not just Keynes’s earlier work, but chunks of the General Theory have to be purged and thrown overboard.

MIT Keynesianism does not claim that East Anglian Keynesianism is not “Keynesianism.” (It claims that it is not a fruitful research program, that given the world as it is pursuing its line of research is harmful to graduate students’ careers, and that its model-building practices lead to fuzzy thinking, but it doesn’t excommunicate East Anglian Keynesianism.)

By contrast, East Anglian Keynesianism does excommunicate MIT Keynesianism.

We’ve seen this here, with Thomas Palley’s claim that “[t]oday’s orthodoxy is laissez-faire neo-classical economics” and that “the last time a paper on macroeconomics with a Keynesian structure was published in the American Economic Review was in the early 1980s. Send in such a paper and it will be immediately rejected as “old” economics.”

Whatever you think of the MIT Keynesians, they were never laissez-faire—orthodoxy yes, neoclassical yes, but never laissez-faire.

My view is that, as a matter of the history of economic thought, the MIT Keynesians have the better of it. But my view is that both research programs are useful and both should be pursued (although I think the MIT Keynesian one has been more successful, and I find that I have a much easier time working within it), and that both are very far indeed from any form of laissez-faire.

The second way to understand the difference of perspectives is different.

It is to interpret Jamie Galbraith as noting that there are two right-wing reactions to Keynes’s: “The Economic Consequences of Mr. Churchill.”

The first is Milton Friedman’s reaction: if the problem is that Churchill as Chancellor of the Exchequer pursues a stupid monetary policy, the answer is to get Churchill’s hands off the steering wheel and make monetary policy automatic.

The second is Friedrich Hayek’s reaction: if the problem is that nominal wages cannot be easily forced down to their equilibrium level because the labor unions have too much bargaining power, the answer is to destroy the unions so that workers have no bargaining power to keep nominal wages sticky at all.

Now Keynes rejected both of these reactions. He wrote chapter 12 “The State of Long-Term Expectation” in the General Theory in order to say contra Friedman that “automatic” monetary policy cannot do the job. He wrote chapter 19 “Changes in Money Wages” to argue contra Hayek that sticky nominal wages are more likely to be a stabilizing than a destabilizing factor.

According to this second way of understanding this conversation, Galbraith is saying that modern orthodox establishment MIT Keynesianism gives much too little weight to ideas springing from chapter 12 and chapter 19, and seeks to build analytical bridges to—peacefully coexist with—both Friedmanite and Hayekian perspectives, to the extent that this is possible.Its Keynesianism is domesticated, in a process started by John Hicks with “Mr. Keynes and the ‘Classics’: A Suggested Interpretation”. It sees “Keynesian” ideas as a cloud in a two-dimensional continuum that shade into Friedmanite and even Hayekian ideas at their edges. The idea that this continuum hypothesis was wrong—that there was for all intents and purposes a complete epistemological break between Keynes and the classics—is essentially the criticism of establishment MIT Keynesianism made by Axel Leijonhufvud in hisOn Keynesian Economics and the Economics of Keynes.

If this is what Galbraith is saying, I agree with him–and I think others agree with him too: Mark Gertler, Ben Bernanke, Larry Summers, James Tobin, Stanley Fischer, Rudi Dornbusch, and Robert Shiller are the first names that spring to my mind…

The “Confidence Fairy” and the Ideology of Economic Theory and Policy: Alas! Still Preliminary Little More than Notes…

I promised more on this in August.

Last August.

August 20125.

I am, clearly, very late:

Paul Krugman: Fairy Tales:

Mike Konczal, channeling Kalecki, pointed out…

…arguments rejecting Keynes and declaring that only business confidence can achieve full employment serve [the] very useful political purpose… [of] empower[ing] plutocrats and big business…. And this speaks to the wider point of the politicization of macroeconomics. Why did freshwater macroeconomists refuse to learn from the lessons of the Volcker recession and recovery, which clearly refuted their approach and supported some kind of Keynesian view on monetary policy? Why has the overwhelming recent evidence for a Keynesian view of fiscal policy been ignored? You might think that business, at least, would welcome policies that boost sales; but the ideology of confidence must be defended.

At the level of academic economics it is a huge puzzle–after all, Ed Prescott and Bob Lucas decide that downturns are driven not by monetary but by real factors just at the very moment when Paul Volcker hits the economy with a brick, and demonstrates not just that contractionary policy has contractionary effects on the real economy, but that doing everything he could to make his contractionary policy anticipated and credible did not materially lessen those real effects. A bigger example of “who are you going to believe, me and Ed or your lying eyes?” would be hard to imagine.

The best excuse I have found takes off from Marion Fourcade et al.‘s analysis of the American economics profession, especially their observations on the rise of business schools and business economics in shaping what economists think about and how they think it. That they are predisposed by their social location into believing that bankers (and the businessmen) are key value-adders in the economy creates an elective affinity with the macroeconomic doctrine that the bankers and businessmen have got us by the plums, and so the only durable way to create a strong and healthy economy is to keep them confident and enthusiastic about investing in new capital equipment now–which means keeping them very confident and very secure in their expectations of future profits.

My current (very imperfect) thoughts about this are contained right now in: The Confidence Fairy in Historical Perspective.

I was going to revise it into a proper paper before letting it out of the gate into the public. But that has not yet happened. So let me at least put the slides below the “fold”, if “fold” has any meaning anymore. Or, rather, below the next “fold”:

NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage

“Concrete Economics”, Pragmatism, the Hamilton Tradition, the Evolution of Macroeconomics, and the Post-2008 Nominal Demand Shortfall

Brad DeLong and David Beckworth: Macro Musings Podcast:

And the transcript, very kindly paid for by David, but so far unchecked:

Macro Musings: Episode 17 – Brad DeLong on Hamiltonian Political Economy & Economic History

[00:00] [background music]

David Beckworth: [00:02] Welcome to Macro Musings, the podcast series where each week we pull back the curtain and take a closer look at the important macroeconomic issues of the past, present, and future. I’m your host David Beckworth of the Mercatus Center. We are glad you’ve decided to join us.

[00:18] Our guest today is Brad DeLong. Brad is a professor of economics at the University of California, Berkeley. He is also a research associate at the National Bureau of Economic Research and was formerly in the Clinton Administration as the Deputy Assistant Secretary of the U.S. Treasury.

[00:37] Brad’s work ranges from business cycle dynamics to the political economy to the history of economic thought. Brad is also the author of several books, including his 2010 book The End of Influence: What Happens When Other Countries Have the Money and his more recent 2016 book Concrete Economics: The Hamilton Approach to Economic Growth and Policy. Brad, welcome to the show.

Brad DeLong: [00:58] Thank you very much. I’m extremely pleased to be here. Whatever “here” is in some metaphysical Internet sense.

David: [01:05] That’s the beauty of this day and age, when I can have someone like you on the other side of the country on the show. I want to begin like I do with most of my guests by asking how you got into economics. This show’s about macro. You have broader interests than just macro, but how did you get into economics and into macro in particular?

Brad: [01:23] I suppose first it would be Rick Erickson, Soviet specialist, Soviet economic specialist. Assistant professor at Harvard at the end of the late 1970s, who taught the most mind blowing version of Econ 1 for those of us who had I would say relatively advanced math, that he wound up with an Econ 1 section which was a go faster, do more section, and which had a great many people in it who could handle partial derivatives. He took full advantage of that.

[02:00] That was a mind-blowing experience in terms of getting one interested in economics. Then that was followed by having John Geanokopolos for Intro to Micro. Which was also a mind blowing experience, because he also had a largely applied math major class and was willing to push the envelope.

[02:23] If you know John, you know he is the most dynamic, witty, engaged, enthusiastic person imaginable, as well as being one of the very smartest people on the planet and very much willing to share that.

[02:37] After that point, we were excited about economics. We were interested in pushing it more. We were uninterested in taking undergraduate courses, because they seemed to us to go too slow and not to use the mathematical toolkit that made things a lot easier and a lot clearer and allowed you to go a lot faster and do a lot more.

[03:00] At that point we we being me, my freshman roommate Andrei Shleifer, and our friend Steven Kaplan bullied ourselves into the graduate macro core course at Harvard in the spring semester of our sophomore year taught by Olivier Blanchard and Marty Feldstein. Their view was “If you want to come, come. You’ll probably die.”

[03:29] We came, we didn’t die. We’re all happy now. Steve at Chicago, Andrei at Harvard, me at Berkeley. Andrei with his Clark medal and so forth.

[03:43] Olivier and Martin were as inspiring, as smart, and as impressive as John and before him Rick Erickson had been. Then immediately after that Andrei hooked up with Larry Summers as a research assistant. From there it seemed that the social network was very well greased. The intellectual project was very well greased. The fact that we had the analytical tools made it a no brainer as to what we should do.

[04:22] That’s how I wound up here. That and the fact that when I graduated from college in 1982, the unemployment rate was 10.6 percent, and graduate school, especially one funded by the NSF, seemed a smarter thing to do than to go out into the private sector job market.

David: [04:46] It’s always good to hear that great teachers play a role in shaping one’s life. I think in economics, it’s one of those disciplines where you can either have a great teacher or a disappointing teacher and they make a big difference whether you thrive in it.

[05:01] I read a story about you as an undergrad. You mentioned your roommate Andrei. This story said he and another roommate I believe of yours were overwhelmed by your reading prowess. You would just blow through books incredibly fast. In fact I think at one point he called you a superhuman when it comes to reading. Can you share with us that little story?

Brad: [05:26] I actually don’t remember ever being called a superhuman.

David: [05:29] It’s in the Harvard Crimson, that’s right.

Brad: [05:31] I do remember being told, “How do you read so much?” I felt the shoe was on the other foot. That here is Andrei showing up in Cambridge, Massachusetts as someone who claimed not to have been by any means the strongest mathematic student that Moscow Science Mathematics High School Number Two. I had been well and expensively prepared. How many of us were there?

[06:09] I guess I was one of the four people in Washington, DC in 1978 to have graduated from high school with a second year of calculus expensively provided to me by the Sidwell Friends School to which I am grateful. Not all high schools would assign a teacher to teach a class of four.

[06:32] This way we’re very much willing to, but they were relatively well paid for it, so I’m grateful to them as well. I show up, my first semester at Harvard and wind up in advanced calculus math 55.

[06:46] I’m finding that math 55 has a syllabus, a third of which I had already covered, and so since I had since the first third of math 55 before, I’ll be at a much, much more elementary level in terms of the linear algebra curriculum, and Andrei hadn’t. The first two months impressed him with the false idea that I was a mathematical genius, I’d just seen this before.

[07:18] Ever since then, I have been in awe of how quickly he can grasp theoretical and quantitative arguments, and see where the mathematical argument is going and what will be possible and what won’t. I’ve been feeling like I’ve been running other false pretenses that he thinks I’m smarter than I am, but that’s because I was well prepared by Sidwell Friends.

David: [07:39] Let’s turn to your new book. It’s actually co authored with Stephen Cohen called Concrete Economics. Tell us the key arguments that you are making in that book. I know you have some historical examples, if you could draw in some of those as well.

Brad: [07:56] If you look at the United States since the late 1970s and if you look at where the economy has been going, you see we’ve been making a whole bunch of debts in terms of how the government structures the market place or de-structures the market place. We’ve been pouring a whole lot of economic resources into a large number of areas.

[08:27] We’ve been devoting a lot of resources to elite consumption in the belief that if we pay our elites, our top 1 percent, our top 0.1 percent, and our top 0.01 percent more a greater share of the total national product than we were from the 1940s to the 1970s, they’ll do a better job at corporate control, at corporate management, at allocating investments that’s spurring people to work hard.

[08:57] We’ve been pouring an absolute fortune into health care administration in an attempt to keep a private sector health insurance market place of one sort of another up and running, and we’ve been pouring a massive amount of money into finance that the way very smart Thomas Sclafani puts it.

[09:22] That we used to have financial assets of about two and a half times a year’s GDP, and we would pay all told in management fees, in commissions, in price pressure to market makers. Pay about one percent of asset value each year to finance for managing our stuff which makes two and a half percent of GDP plus a half percent of GDP to run the payment system, a financial sector of three percent of national product.

[09:56] Today, we have four times annual GDP in gross marketed market of all financial assets of one form or another and we seem to be paying two percent of GDP to Wall Street in a metaphorical sense, in commissions, in management fees, and in price pressure when we panic and sell, or get enthusiastic and buy from the professionals. That’s eight percent plus another half percent of GDP for running the payment system. That’s eight and a half percent.

[10:28] That’s a huge social investment in a sector that really does provide intermediate goods, the payment system, the corporate control, allocation of investment, and so forth.

[10:42] I think that the returns from all of these investments, whether it’s in a more unequal distribution of income and wealth and higher elite consumption in order to spur our overclass to actually put their nose to the grindstone and do the job, whether it’s devoting a fortune to healthcare administration.

[11:07] Uwe Reinhardt of Princeton, I think, has the statistic about how American doctors are 30 percent more cost effective than German doctors, but American healthcare administrators are only one sixth as effective as German healthcare administrators at output per cost and in the hypertrophy of finance.

[11:26] These are not really the industries of the future. These are not industries that lead to rising standards of living and economic growth in general. This is very different from the industries that America used to invest in. Whether it was aerospace, whether it was the initial waves of government support for the computer revolution, whether it was the interstate highway system.

[11:55] Before then, whether it was the decision to actually go for infrastructure, and also the Hamiltonian support for manufacturing and for what was then an advanced payment system and Indeed, an initial capital market back at the very early days.

[12:16] These are all political economic decisions. These are all produced by ways the government does or does not structure and restructure marketplaces. These are all the result of pushing and hauling by populist groups on the one hand, by technocrats on the other, by people who’ve managed to get a good thing going and are properly seeking rents on the third. Of course, it’s easier to get rents if what you’re doing is actually productive.

[12:49] Yet, it seemed to work quite well up until 1980 or so. By and large, the industries of the future, whether they were the Republican bet on land grant colleges in the 1870s, or the Jefferson Lincoln — on up to the 1890s — decision that we were going to sell off public lands cheaply to occupiers, rather than, with the exception of the railroads, allow land barons to engross them.

[13:24] The decision to give large and highly corrupt subsidies to build out a transcontinental railroad network that then enabled all kinds of not just extremely high scale mass production, but also high scale distribution. That is, the continental market for the Americas played a big role in producing America’s edge over Europe in the late 19th century.

[13:48] All of these seem to be smart, in the way that our decisions since 1980 really have not been, so we thought we should write a little book about why this was so. The elevator pitch takeaway message is that back before 1980, we were self interested, we were political, we were somewhat corrupt, but we were also pragmatic.

[14:19] We thought we should be in the business of growing the economic pie more than anything else, and we would take a look at what were the options open to us at any one point and say, “What’s going to grow this economic pie?” Given what’s actually happening on the ground without paying too much attention to grand theories.

[14:42] Then around 1980, somehow we lost the narrative and we began pulling ourselves much more toward grand theories, as in, “Ideology tells us that this cannot work. Ideology tells us that that cannot work.” It’s that loss of American pragmatism that we want to blame for the fact that we currently have an economy that’s grossly underperformed, except for our superrich over the past 35 years.

[15:22] We want a call to get back to a non ideological, but rather pragmatic approach to economic policy and political economy. Don’t say that fundamental principles tell us that this is a good thing to do. Tell us how this policy is going to make us richer on the ground, soon and now.

David: [15:45] Let me ask you about one of the original discussions in your book. That goes back to Alexander Hamilton. You referenced him earlier…

Brad: [15:54] Yes, we’re trying to sail as close as possible to the Hamilton boom without having an intellectual property misappropriation test case right now.

David: [16:02] You mentioned there’s this tension, that any student who’s had American History knows, between Alexander Hamilton’s view of where America should go versus Thomas Jefferson. Here’s a question I have that ties it to the point you mentioned about 1980. One of the things that’s happened since 1980, that maybe confounds this issue is globalization begins to take off.

[16:28] The world economy slowly opens up and that’s going to have some effect. I wonder. Today we see the rise of populism with certain candidates in different parts of the world. There seems to be a populist backlash. Does it hearken back to this debate between Alexander Hamilton and Thomas Jefferson? The elite versus the farmer philosopher…

Brad: [16:55] Thomas Jefferson is pretty damned elite.

David: [16:57] That’s true. Fair point.

Brad: [17:00] Thomas Jefferson is not your yeoman farmer, much as he idealized yeoman farmers and thought, very ideologically, that…One of the guys who’d learned a little too much and yet not enough history of the duration and collapse of the Roman republic.

[17:27] He had people who thought that Rome was a great society, as long as it was all yeoman farmers who believed in the republic and solidarity, and farmed their own land, but willingly contributed to public purposes, waging wars, and serving in office.

[17:45] You go to Washington, DC, and you see all of these buildings reminiscent of what the people in the late 18th and the early 19th Centuries thought classical Rome ought to have looked like. Classical Rome being the Rome before the empire. Jefferson heard that and he believed that, so he loathed banks, he loathed cities, he loathed merchants, he loathed manufacturers, he loathed an urban proletariat.

[18:18] He wanted a country of yeoman farmers with all the other corrupt stuff somewhere offshore, with the exception of those people who were his own personal slaves. He did, at least, manage to free those who were his own personal descendants.

[18:44] That was a very strongly ideological road that Jefferson and company wanted America to take after 1776, after 1787, and fortunately, we did not take that road.

David: [18:57] Let’s go to the example of the First Bank of the United States and the Second Bank of the United States. Hamilton clearly was a supporter of the First Bank of the United States which is our first central bank, and Jefferson was opposed to it. Then we see that lasted 20 years, and then a few years later the Congress charters the Second Bank of the United States which is our second central bank.

[19:21] Andrew Jackson comes into the picture, and he effectively shuts it down when he wins an election. What I want to point out about that period, though, is there is this tension again between at least perceived harm being done by the Second Bank of the United States by the elites. The president of the Second Bank was perceived as this elite, and it echoes to the present, I guess.

[19:46] Coming to the present, do you see any similarities between this debate between Hamilton, Jefferson, in terms of banks, in terms of elites, versus the Donald Trump supporters of the world, the people in Brexit, the rise of populism in Europe…Do you see that? Going back to your book, what proposals do you have to bring that tension down, to address it in a meaningful way?

Brad: [20:21] I say there are people who say that tension really isn’t there in any stronger sense than in the past. That the way Tyler Cowen puts it, that it was always the case that 20 percent of America was crazy, but it used to be that 20 percent was divided between the two political parties.

[20:44] That there were western and northern type of people who were fairly crazy, who were ensconced in the Republican Party because they feared immigrants and the immigrant Democratic machines of the cities, and crime, and so forth.

[21:01] There were the people on the southern side, but they were not in the Republican Party. They were in the Democratic Party because Lincoln had freed the slaves, and they weren’t going to forget that. The elements of Trumpism were always there, but they were marginalized because they were split between the two great coalitions of American politics, the right of center and the mostly left of center coalition.
[21:34] If you want to put it another way, as Truman’s Secretary of State Dean Acheson did, the party of enterprise, and the party of those who feared that enterprise is not going to give them their fair share of the stuff.

[21:50] Then we have this great partisan realignment starting in 1964, when Goldwater decides that there’s a political opportunity to throw overboard the Republican Party’s historic commitment to the American, African American population.

[22:06] Now we have everyone sorted, and so the Trumpists are still 20 percent of America, but they’re 40 percent of the Republican Party, and because they’re energized, they’re 60 percent of the Republican primary electorate. That’s Tyler’s view, and I think there’s a very strong case that that’s a correct view. That it’s a serious problem, and it’s a serious problem not just for the Republican Party, but for America as a whole.

[22:41] In some ways it reflects the problems of America and of the Democratic Party back in the 1850s when the southern slave power was a minority in the country as a whole, and a minority even in the south.

[22:57] Because they were energized and activist and concentrated the Democratic Party, effectively the southern slave power elite controlled the Democratic Party and then were able to win more than their fair share of national elections.

[23:15] A grave problem, but it’s not a big change in terms of the underlying economic interests and views of the people, or even of the underlying sociological interests and views of the American people. It’s just a concentrate not a weak point in our political system. I think that’s by and large likely to be correct.

[23:42] In Britain and elsewhere, other things are happening and the other things that are happening are produced largely by the fact that the Great Recession has now been significantly deeper in Europe than in the United States. As we know from the 1930s, European political systems and America, too, are very vulnerable to any form of economic distress.

[24:10] “Throw the bastards out and go for somebody who is not part of the establishment,” seems to be what they do. They can go left, they can go right, they can go into outer space, they can go deep underground. They’re just going to go somewhere.

[24:30] It’s a combination of politicians who are attempting to ride this wave, coupled with true believers, coupled with the fact that ex Prime Minister Cameron is a real idiot, has produced a situation in which Scotland and Wales are regarding non London England with horror and despair right now.

[24:57] In which case, the great cosmopolitan city of London is looking at the people surrounding them and just wondering what’s going to happen to them as their political destinies are settled by a bunch of politicians who are riding a wave composed of people who truly do not understand, who have not been briefed, who have been substantially misled as to what their proper relationship with Europe should be.

David: [25:32] I’m sympathetic to your argument about the deepness of the Eurozone crisis setting the stage for some of the challenges over there. That’s a fair point. The Great Depression, 1930s, we saw that same phenomenon occur across the world, particularly in Germany and Italy.

[25:51] I want to move on now to an article you wrote in “The Journal of Economic Perspectives” in 2000. It was titled, “The Triumph of Monetarism,” and you recently revisited it. I’d like you just to tell us the argument you made back then and what observations are you making now 15, 16 years later about that argument?

Brad: [26:12] I think that the germ of it, although I don’t know if I acknowledge it in the article, came from Matthew Shapiro, now at the University of Michigan, who said that he had an interesting time as he went through undergraduate at MIT and then through graduate school at MIT. As a freshman at Yale, he was taught that monetarists were bad because they believed that changing the money stock changed nominal GDP and changed output.

[26:44] This was why the Chicago school was a bad thing, and yet by the end of his last year of his graduate study at MIT, he was being taught that Chicago style economics was bad because they thought that changes in the money stock did not affect nominal GDP. Or maybe they affected nominal GDP, but they certainly did not affect output. [laughs] This was very weird. That is, to be a Keynesian in 1974 was to deny that monetary variables had an important role to play in the C + I + G = PY equation.

[27:32] By 1984, 1985, the Keynesians were saying, “Well, of course, the money stock is close to a sufficient statistic for nominal GDP. Velocity’s not very volatile, and you combine nominal GDP with some degree of price inertia at the aggregate level, and of course, most movements and business cycle frequencies are driven by changes in demand and spending. Money demand and money supply.”

[27:58] Money supply being partly exogenous and partly endogenous, and then saying this was truly weird. A very weird change in a very short time as to what one was supposed to say in order to a Keynesian in good standing.

[28:16] I decided I should go back and I should take a look at the intellectual history. The conclusion of “The Triumph of Monetarism” was that practically all modern Keynesians, as of 2000, were really monetarists.

[28:32] That is the only dispute they possibly had with Uncle Milton was on whether a key percent fixed nominal money stock growth rate rule was an adequate feedback rule for monetary policy, in order to do the best you could at stabilizing aggregate demand.

[28:55] That practically everyone agreed that fiscal policy planning and legislative implementation lags meant that fiscal policy really should be off the table except for automatic stabilizers, which were useful. With Paul Krugman whimpering off in the corners saying, “What if you happen to hit the zero lower bound and wind up in a liquidity trap like Japan?” Everyone also saying, “Nah, Japan’s weird. We won’t get there.”

[29:23] Fiscal policy should have automatic stabilizers but otherwise should be settled on classical terms. Monetary policy should be the primary economic stabilization tool, and the interesting research questions are all about what should replace the k percent growth rule as an intermediate target which the central bank should try to use in order to try to stabilize the ultimate variables that it cares about.

[29:53] Calvo pricing, price rigidity, the Euler equation, the new Keynesian IS curve, all of these things, all of these tools, all of these doctrines, all of these arguments, were simply an attempt to put an underlying rationale behind instincts that were generally Friedman like.

[30:18] That is that monetary policy was the key link, that the central bank had an awesome responsibility, that you didn’t want anything as fully automatic and rigid as the gold standard, but you did somehow want to effectively constrain the central bank so that it couldn’t misbehave the way that Richard Nixon had persuaded Arthur Burns to misbehave in 1972 and that Richard Nixon had failed to persuade Martin to misbehave back in 1960.

[31:00] This was the problematic within which the discussion was taking place outside of the real business cycle people, who were off on their own building tools and yet failing to build anything that could be estimated or even calibrated to actually match the data as it came through.

[31:21] How it was that a bunch of people who were essentially monetarists had decided they were really Keynesian seemed to be an interesting question.

[31:30] The fact that they were really monetarists, even though many of them didn’t know it and others claimed not to know it, that they were much closer to Friedman than they were to someone like Tobin seemed to me something that people should be taught and that should be underlined.

David: [31:48] What was the insights that you have looking back now at this 15 years later, 16 years later?

Brad: [32:03] Suppose you’re Milton Friedman. It’s just after World War II. You’ve managed to get an academic job at Chicago. You’ve had a relatively difficult time getting it because you’re not enthusiastic about socialist planning or even semi socialist planning. You’re a member in good standing at the Mont Pelerin Society.

[32:28] Simon Kuznets had given you a job at the NBER for a while, even though he’d worked you hard.

[32:34] Before then, your first attempt to have an academic career had flamed out when, as I understand it, the legislature at Wisconsin had told the administrators in Madison there were too many Jews on the faculty. We don’t want you tenuring, promoting any more young Jews. There are too many of them, especially for Wisconsin.

[32:52] This gives Friedman a very sensible and rational fear of an over mighty government, reinforces his predispositions to think that what we want is a competitive markets everywhere. Pigouvian taxes where they’re really necessary, but only where they’re really necessary, because the process of passing them is subject to rent seeking.

[33:20] Even a bias toward actively engaging in Pigouvian taxes is probably harmful, as much as the micro says you ought to have them. The best you can do is try to preserve competitive markets and let the market system rip. If monopolies do emerge, they’ll be eroded over time if they aren’t powerfully backed up by the government. The whole thing.

[33:44] The problem with this, though, is that people point and look at the Great Depression and say, “Isn’t this an absolutely mammoth market failure? Doesn’t the fact that the market failed here and badly needed correction by some public sector entity indicate that there are likely to be equally big and bad market failures elsewhere?”

[34:08] The one hand, macroeconomics is a weak point for the general Chicago/Mont Pelerin view of the world. Also, his allies, ideological and otherwise, in other parts of economics, they want to say, “Gee, we have to have a gold standard, because anything else is government intervention in the marketplace.”

[34:33] We see this today. Someone like John Taylor is confused, highly, highly confused, when he claims that somehow central bank opened market operations to shift the interest rate or like a minimum wage, and a market distortion, and create Harberger triangles. Never been able to figure out what the Harberger triangle is, because he’s simply wrong.

[34:58] Friedman decided he needed to sail a very narrow and very clever intellectual path through the clear ocean between these Scyllas and Charybdises.

[35:10] Which was to say the Great Depression was a government failure because the government has as one of its principle market structuring obligations to maintain a proper monetary standard, just as it has an obligation to maintain proper weights and measures so you know what you’re buying and selling.

[35:30] A proper monetary standard requires the avoidance of both deflation and inflation, requires a monetary policy. A k percent growth rule is an approximation to that. The policy of having the central bank massively intervene in the marketplace buying and selling high powered money in order to keep the money stock stable, that’s actually a neutral monetary policy.

[36:00] That’s government non intervention in the marketplace. The non interventionist government is the one that frantically buys and sells liquid assets in order to keep the supply of liquidity services flowing to the private sector through the banking system constant.

[36:17] At some level, this is insane. The money stock is, after all, a thing that is largely inside money. The money stock is largely a measure of the amount of liquidity services provided to the rest of the economy by the banking sector. Milton Friedman’s k percent rule is a quantity target for the output of the liquidity services industry.

[36:43] Is there any other industry for which the government has an obligation to obtain a quantitative target for the service flow? Do we have a Federal Electricity Board that follows a policy of trying to keep the path of kilowatt hours generated stable? Do we have a Federal Railroad Commission with the job of trying to keep the number of freight cars loaded per month stable?

[37:08] No, we don’t. Why are liquidity services, in some sense, the key link? Friedman never answered this. As long as he could maintain that his k percent rule or even a modified k percent rule, something that approached nominal GDP targeting, at least by the time Friedman was giving advice to Japan in the late 1990s…

[37:36] As long as he could maintain that that was actually the neutral monetary policy that was non interventionist, you could maintain the seamless garment of being a free market, libertarian economist who believes that competitive markets without government interference were ideal.

[37:56] Yet, avoid the vulnerabilities to financial chaos, collapse, and Great Depression that Friedman strongly believed had been generated by the interwar gold standard and, before then, by the fact that the pre Federal Reserve United States monetary system was extremely vulnerable to collapses of the money supply and financial crises.

[38:23] It turns out that that was a successful rhetorical line intellectual position to hold on for pretty much until Milton Friedman died. As soon as 2008 rolled around, all of a sudden the monetarist coalition that had understood, say, the types of policies that Friedman recommended for Japan in the 1990s and also for the US in the Great Depression…

[39:11] The right of center coalition willing to swallow that as a neutral monetary policy was simply not there. Maybe if Friedman, in his time, had still been in there arguing, it might have been able to maintain, but the number of people who confidently expected quantitative easing to produce massive inflation no later than 2011 was very, very large.

[39:42] Paul Ryan still doesn’t understand why all his economic advisers told him that Ben Bernanke was debasing the currency and needed to be stopped immediately.

[39:57] When then Texas governor Rick Perry went to Iowa and said that Bernanke’s monetary policies were almost treasonous and that if he came down to Texas, we would give him the hot reception that people in Texas used to give to Communists and civil rights leaders, he was pursuing, in some sense, what had become the mainstream of right of center opinion on monetary policy.

[40:36] Which is that somehow there’s something very wrong with having the government do the massive, large scale interventions in the money market that it has been doing ever since mid 2008, and this is bound to be a destructive interference with the free market somehow.

[40:57] That’s a very strange position for people who at least still bow to Milton Friedman as great libertarian economist ancestor to put themselves in.

David: [41:10] Let me switch topics, but in a similar vein, in the few minutes that we have left. That is you have mentioned several times in your writings how you thought prior to 2008 it was widely understood that macroeconomic policy, both fiscal and monetary policy, would be used to stabilize the growth path of nominal demand.

[41:33] It didn’t do that. It’s disappointing. I think we can both agree on that point. In the next five minutes we have left in the program, why do you think it’s come to this? What has led policymakers to settle for allowing past mistakes to have occurred and not to correct for them?

Brad: [41:54] Damned if I know.

David: [41:56] You think it’s inflation targeting? Is it commitment to low inflation?

Brad: [42:02] I really do not know. I’m supposed to do a paper for this for the Federal Reserve Bank of Boston in October, and I agreed because it’s still very much a mystery to me. That is, you have a consensus model, at central banks at least, that we have. We very much want to avoid deflation, because we fear Irving Fisher like debt deflation spirals.

[42:40] We believe in substantial amounts of nominal price rigidity in the short and medium run in labor and product markets, so we can’t count on rapid price adjustment, either downwards or upwards, in order to stabilize nominal GDP. As John Maynard Keynes said, inflation and deflation are really unjust, as well.

[43:07] It seemed to me that, given your belief in a world where there’s this macroeconomically significant market failure of short and medium run price rigidity, what you do is you use monetary policy to try to stabilize nominal GDP.

[43:23] If monetary policy won’t do the job, then you turn to your next tool, which is fiscal policy. After all, the purpose of macro policy is to make Say’s law true in practice given the market failures we have out there. This wage and price rigidity is the principle market failure.

[43:43] Yet, ever since late 2009, not just politicians in legislatures and in executives but central bankers, as well, have been reaching for reason after reason not to take the signal that decelerating growth in nominal GDP should lead one to think in the context of a world in which you think that stable inflation expectations and short and medium run price inertia are the key features that need to be handled.

[44:31] I really do not know why, especially with interest rates at their current level and thus with real debt service on the US national debt, not just zero but negative, that you don’t even need hysteresis of any form at current interest rates for fiscal expansion to reduce the debt burden, just the short run stuff. The short run tax offset will do it.

[45:04] Then, the long run, we’re borrowing at less than the nominal GDP growth rate of the economy.

[45:14] Why helicopter drops and infrastructure investment are not obvious no brainers across the political spectrum and also across the spectrum of economics as tools to get nominal GDP back onto its pre 2008 track remains an extraordinary mystery to me.

[45:37] As much as I try to listen to the Ken Rogoffs, and the Marty Feldsteins, and the others who are opposed to one or more of these tools, I simply cannot wrap my mind around what their arguments really are.

David: [45:48] I look forward to reading your paper for this conference, since you’ll be thinking about this issue for some time. Our guest today has been Brad DeLong. Brad, thank you for being on the show.

Brad: [46:00] You’re welcome. Thank you very much.

[46:02] [background music]

David: [46:05] Macro Musings” is produced by the Mercatus Center at George Mason University. If you haven’t already, please subscribe via iTunes or your favorite podcast app. While you’re there, please consider rating us and leave a review. This helps other thoughtful people like you find the podcast. Thanks for listening.

Transcription by CastingWords

J. Bradford DeLong (2012): This Time, It Is Not Different: The Persistent Concerns of Financial Macroeconomics

This Time, It Is Not Different: The Persistent Concerns of Financial Macroeconomics

ABSTRACT: When the Financial Times’s Martin Wolf asked former U.S. Treasury Secretary Lawrence Summers what in economics had proved useful in understanding the financial crisis and the recession, Summers answered: “There is a lot about the recent financial crisis in Bagehot…”. “Bagehot” here is Walter Bagehot’s 1873 book, Lombard Street.

How is it that a book written 150 years ago is still state-of-the-art in economists’ analysis of episodes like the one that we hope is just about to end? There are three reasons:

  1. The first is that modern academic economics has long possessed drives toward analyzing empirical issues that can be successfully treated statistically and theoretical issues that can be successfully modeled on the foundation of individual rationality. But those drives are disabilities in analyzing episodes like major financial crises that come too rarely for statistical tools to have much bite, and for which a major ex post question asked of wealth holders and their portfolios is: “just what were they thinking?”.

  2. The second is that even though the causes of financial collapses like the one we saw in 2007-9 are diverse, the transmission mechanism in the form of the flight to liquidity and/or safety in asset holdings and the consequences for the real economy in the freezing-up of the spending flow and its implications have always been very similar since at least the first proper industrial business cycle in 1825. Thus a nineteenth-century author like Walter Bagehot is in no wise at a disadvantage in analyzing the downward financial spiral.

  3. The third is that the proposed cures for current financial crises still bear a remarkable family resemblance to those proposed by Walter Bagehot. And so he is remarkably close to the best we can do, even today.

I. Introduction

At the spring 2011 INET Conference in Bretton Woods, New Hampshire, Financial Times correspondent and columnist Martin Wolf asked:

[Doesn’t] what has happened in the past few years simply suggest that [academic] economists did not understand what was going on?…

Former U.S. Treasury Secretary Lawrence Summers, in the course of his long answer, said:

There is a lot in [Walter] Bagehot that is about the crisis we just went through. There is more in [Hyman] Minsky, and perhaps more still in [Charles] Kindleberger…1

Walter Bagehot (1826-1877) refers to his Lombard Street, published in 1873.2 Hyman Minsky (1919-1996) is a twentieth-century observer and theorist of financial crises best approached not through his books3 4 5 or his collected essay volume—Can “It” Happen Again?—but rather through the use that economic historian Charles Kindleberger (1910-2003) made of his work in Kindleberger’s 1978 Manias, Panics, and Crashes: A History of Financial Crises.6 Asked to name where to turn in the works of economists to understand what was going on in 2005-2011, Summers cited three dead economists—one of them long dead. Summers did then enlarge his answer to include living economists, starting with the economic historian Barry Eichengreen and then moving on to mention “[George] Akerlof, [Robert] Shiller, many, many others…”. Summers then stressed the success of empirical work in aiding understanding, in contrast to the failure of modern “macroeconomic [theory to] keep up with [the] revolution” in finance “as it was realized that asset prices show large volatility that does not reflect anything about fundamentals”.[7][7]

How is it that Walter Bagehot (1873), Lombard Street: A Study of the Money Market, a book written 150 years ago is still state-of-the-art in economists’ analysis of episodes like the one that we hope will be dated as ending next year, in 2013? And what, exactly did Bagehot say that is still useful?

There are three reasons that Bagehot (1873) still has considerable authority:

  1. The first reason is that modern academic macroeconomics has long possessed two drives. It has possessed a drive toward analyzing empirical issues that can be successfully treated statistically. It has possessed a drive toward analyzing theoretical issues that can be successfully modeled on the foundation of a representative agent possessing individual rationality. These drives are often very useful: most of the successes of modern macroeconomics as a policy science are built on top of them. These drives, however, become positive disabilities in analyzing episodes like major financial crises. Major financial crises come too rarely for statistical tools to have much bite. Given that a major ex post question asked of wealth holders and their portfolios after a crisis is “just what were they thinking?”, a baseline assumption of individual rationality forecloses too many issues—as does any assumption of a representative agent.

  2. The second reason is that, while the causes of financial collapses are diverse, the effects are pretty much constant across time. Since 1825 we have seen a single mechanism transmit financial distress to the real economy of production and employment. transmission mechanism, in the form of the flight to liquidity and/or safety in asset holdings, and the consequences for the real economy, in the freezing-up of the spending flow and its implications for employment and production, looks much the same in episode after episode. The transmission mechanism and the consequences have typically been very similar since at least the first proper industrial business cycle in 1825.

  3. Thus, third, a nineteenth-century author like Walter Bagehot is in no wise at a disadvantage in analyzing the causes and spread of the downward financial spiral, or in analyzing its consequences for the real economy.

The basic story is simple. Through the arrival of new information, through sheer panic, or through the effects of government policies, wealth-holders lose their confidence that a good chunk of the financial assets that they had thought were safe, liquid stores of value and potential means of payment are in fact safe and liquid. Such assets thus lose their attractiveness as safe stores of value and liquid potential means of payment. This causes wealth-holders to attempt to dump their holdings of such now-impaired assets to try to rebalance their portfolios with respect to safety and liquidity. But the dumping of the now-impaired assets makes them even less safe and less liquid. The recognition of reality (or the simple panic) triggers an attempted shift of portfolios in the direction of holding more safe, liquid stores of value just at the moment that the value of assets that count as such declines. This was the story in 2007-9. And this was also the story in 1825-6. Thus it is not surprising that a good analysis of 1825-6 and like financial crisis-driven downturns like Bagehot (1873) is still a (nearly) state-of-the-art analysis of 2007-9.

Bagehot’s (1873) key relevant insight was that expansionary policies affect both the demand for and the supply of safe, liquid stores of value. When households and businesses are convinced that they need to hold more safe, liquid stores of value, they will try to push their spending on currently-produced goods and services below their incomes. But since economy-wide incomes are nothing but spending on currently-produced goods and services, the net effect is only to push incomes, production, and spending down until households and businesses feel so poor that they forget about building up their stocks of safe, liquid stores of value.

This brings us to an additional feature of the situation that Bagehot saw back in 1873. The natural cure for the financial system and for the real economy is for something to lead households and businesses to lower their demand for or something to expand the supply of safe, liquid savings vehicles. If this is accomplished so that desired safe and liquid asset holdings at full employment are once again equal to asset supplies, the economy will recover. Bagehot (1873) saw aggressive expansionary policies as desirable both to increase the supplies of the safe, liquid stores of value that households and businesses wish to hold and to damp down demand for such assets by demonstrating that risks will be managed and reduced. And those are still the policies, in many different flavors it is true, advocated today.

Thus Walter Bagehot (1873) is remarkably close to the best we can do, even today.

II. Aggregate Supply and Aggregate Demand

A. Say’s Law

Back at the beginning of economics, back at the very start of the nineteenth century, Jean-Baptiste Say (1803) wrote that the idea of a “general glut”—of economy-wide “overproduction” and consequent mass unemployment—was incoherent.8 Nobody, Say argued, would ever produce anything beyond what they expected to use themselves unless they planned to sell it, and nobody would sell anything unless they expected to use the money they earned in order to buy something else.

Thus, “by a metaphysical necessity”9, as John Stuart Mill put it back in 1829, there can be no imbalance between the aggregate value of planned production-for-sale, the aggregate value of planned sales, and the aggregate value of planned purchases. This is what would become “Say’s Law”. Say pointed out that producers could certainly guess wrong about what consumers wanted—and thus produce an excess of washing machines when what consumers really wanted were more yoga lessons. But, Say argued, that would produce a clear market signal in the form of an excess demand for and high profits in making commodities short supply and an excess supply of and losses in making commodities in surplus. The market system had the incentive and the power to quickly iron out such imbalances. The fact remained that planned spending had to equal planned production. And, in reply to those who claimed that general depression could be produced if the economy’s money supply was too low, Say said that producers could and would always give credit:

To say that sales are dull, owing to the scarcity of money, is to mistake the means for the cause…. Should the increase of traffic require more money to facilitate it, the want is easily supplied… merchants know well enough how to find substitutes for the product serving as the medium of exchange or money…10

Thomas Robert Malthus thought at the start of the 1820s that there was something wrong with Say’s argument. Malthus believed that he could see the excess supply, but not the corresponding excess demand:

[W]e hear of glutted markets, falling prices, and cotton goods selling at Kamschatka lower than the costs of production. It may be said, perhaps, that the cotton trade happens to be glutted; and it is a tenet of [Say’s and Ricardo’s] new doctrine on profits and demand that if one trade be overstocked with capital it is a certain sign that some other trade is understocked. But where, I would ask, is there any considerable trade that is confessedly under-stocked, and where high profits have been long pleading in vain for additional capital? The [Napoleonic] war has now been at an end above four years; and though the removal of capital generally occasions some partial loss, yet it is seldom long in taking place, if it be tempted to remove by great demand and high profits…11

But Malthus did not have a coherent view of what was wrong with Say’s basic argument. Malthus tended to see what we would call cyclical unemployment as, rather, an aspect of his other Malthusian concerns about the causes of poverty— and thus as something, like the rest of poverty, best addressed through long-run reform measures to strengthen monarchy, patriarchy, and religion.[12][12] 13

The proper answer to Say was given by John Stuart Mill in a piece he wrote in 182914 but did not publish until 1844:

[T]here cannot be an excess of all other commodities, and an excess of money…. But those who have… affirmed that there was an excess of all commodities, never pretended that money was one of these commodities…. [P]ersons in general, at that particular time, from a general expectation of being called upon to meet sudden demands, liked better to possess money than any other commodity. Money, consequently, was in request, and all other commodities were in comparative disrepute…. When this happens to one single commodity, there is said to be a superabundance of that commodity; and if that be a proper expression, there would seem to be in the nature of the case no particular impropriety in saying that there is a superabundance of all or most commodities, when all or most of them are in this same predicament…

What has the potential to break Say’s Law—the equality of expected production and incomes on the one hand and planned spending on the other “by metaphysical necessity” as Mill put it—is, Mill said, that people do not just buy currently-produced goods and services with their incomes, they also buy money—or, more generally, financial assets. The easiest way for a wealth holder to build up his or her holdings of financial assets is for him or her not to spend the financial assets he or she already owns: to attempt to cut planned spending below expected income. But while each individual can cut planned spending below expected income, an economy as a whole cannot cut its actual spending below its actual income, because what is one economic agent’s income can come from nowhere but some other economic agent’s spending.

B. The British Downturn of 1825-1826

It is unfair to expect Jean-Baptiste Say to have seen this back in 1803. He did not live in an industrial economy. He had not seen a deflationary financial panic or elevated cyclical unemployment. John Stuart Mill had the advantage of having seen the first industrial business cycle in Britain in the form of the 1825-6 downturn, a downturn generated by the 1825 financial crisis, which was in its turn produced by the collapse of the early-1820s canal boom.

Figure 1 plots the percentage change in British apparent cotton consumption across the bulk of the nineteenth century. In the forty-five years of peace between the end of the Napoleonic Wars in 1815 and the disruption of the global cotton industry by the U.S. Civil War that started in 1861, apparent cotton consumption by the textile factories of Great Britain declined in only seven episodes. Cotton textile production was the high-tech high-profit rapidly-expanding leading sector of Britain’s first industrial revolution, growing at a pace of more than 8% per year on average. 1826 was the second-worst decline in this leading sector, and in British industrial production in general.

It was this episode that John Stuart Mill was looking back on in 1829 when he evolved his view of the relationship between aggregate supply and aggregate demand as mediated by the potential for an excess demand for money and other financial assets.

Figure 1: Annual Percentage Change in Apparent British Cotton Consumption, 1810-1875

Delong typepad com 20120411 russell sage delong paper pdf
Source: Wladimir Woytinsky and Emma Woytinsky (1952), World Population and Production http://tinyurl.com/dl201108d

And, also in 1829, it was looking back on this episode led Jean-Baptiste Say to revise his doctrine. In his Complete Course of Applied Political Economy, Say begins his analysis of 1825-1826 with the Bank of England’s recognition in late 1825 that many of its potential counterparties had overleveraged and overinvested in speculative canals, and were now of questionable solvency either on their own account or because many of their debtors had overleveraged and overinvested in speculative canals. The Bank of England therefore decided in 1825 to reduce its own risk by applying stricter standards:

[It] cease[d] to discount commercial bills. Provincial banks were in consequence obliged to follow the same course, and commerce found itself deprived at a stroke of the advances on which it had counted, be it to create new businesses, or to give a lease of life to the old.

And the consequence, Say wrote, was financial collapse:

As the bills that businessmen had discounted came to maturity, they were obliged to meet them, and finding no more advances from the bankers, each was forced to use up all the resources at his disposal. They sold goods for half what they had cost. Business assets could not be sold at any price. As every type of merchandise had sunk below its costs of production, a multitude of workers were without work. Many bankruptcies were declared among merchants and among bankers, who having placed more bills in circulation than their personal wealth could cover, could no longer find guarantees to cover their issues beyond the undertakings of individuals, many of whom had themselves become bankrupt…[15][15]

What of Say’s 1803 declaration that when there is a shortage of money in an economy, merchants “know well enough how to find substitutes for the product serving as the medium of exchange”?

What Say had missed in 1803 was that such “inside money” can be quite difficult to create. Only those economic agents whose solvency is common knowledge can create money. Only they can create the safe savings vehicles and stores of value that serve as means of payment and mediums of exchange that everybody will accept, and that everybody will accept because everybody will accept.

But what economic agency is of unquestioned solvency in a time of overleverage, overinvestment, and significant but unrealized losses whose location is unknown?

That was the problem created in 1825-1826 by the collapse of the canal boom, and by the Bank of England’s first reaction to the potential insolvency of its counterparties.

III. Origins of Central Banking

A. The Market Failure

Thus by late 1825 in Britain the revaluation of assets that was the collapse of the canal boom had created a situation in which “money” was “in request”: safe, liquid stores of value were scarce relative to demand both because the financial crisis had led banks and businesses to seek to hold a greater share of their wealth in safe, liquid form and because the financial crisis meant a substantial proportion of safe and liquid “inside” assets—the debts of bankers, merchants, and industrialists presumed to be well-capitalized—were not so.

Note that the assets households and businesses scramble for in and in the aftermath of a financial crisis do not have to be, exclusively, means of payment themselves: assets that are still trusted will do as well, or almost as well. In the fall and winter of 1825-6, all across the British economy, economic agents were attempting to build up their stocks of safe, liquid financial assets out of a fear that they might need them because their creditors, who were also trying to build up their stocks of safe, liquid financial assets, might not roll over their loans. All across the British economy economic agents were trying to cut their flow of spending below their expected flow of income—and finding themselves unable to do so, as one agent’s income comes from another agent’s spending. The consequence was that currently- produced goods and services became “in comparative disrepute”: as spending fell, production and employment fell.

What, then, was it appropriate for the government to do?

Neither Say (1803) nor Say (1829) not Mill (1844) connected the dots and drew out the implications. But they are clear. In normal times, banks exist to undertake and make their profits by undertaking liquidity and safety transformations: turning illiquid and risky claims on the capital stock of the economy and on its income into the safe, liquid claims that businesses and households demand and that are used for transactions purposes. They thus create “inside money”. They do this by bearing risks, by figuring out which risks to bear, and by convincing their creditors that they know their business so that their liabilities are safe assets—and thus become liquid means of payment.

But what if the private financial sector is at the moment unable to perform these safety and liquidity transformations at the scale needed to satisfy demand? What if merchants and bankers are not able to create inside-money substitutes for the product serving as the medium of exchange? What if the private market fails?

B. “Inside Money” and “Outside Money”

The natural way to repair this market failure is for the government to temporarily supplement the “inside money” that the financial system can no longer create with its own “outside money”. It is then the task of the government to create the safe and liquid financial assets that the private market desires. The central bank should then act as the financial system’s lender-of-last-resort.16

It can do so through any of a number of channels:

  1. It can buy relatively risky and illiquid bonds in exchange for its own safe and liquid liabilities: that is called expansionary monetary policy.
  2. It can take risk onto its balance sheet by guaranteeing the liabilities of private banks: that is called expansionary banking policy.
  3. It can make investments in bridges, in the human capital of twelve-year-olds, and in social welfare and pay for them by issuing its own relatively safe and liquid debt: that is called expansionary fiscal policy.

All of these were attempts to resolve the problem noted by John Stuart Mill and Jean-Baptiste Say in 1829: an excess demand for safe and liquid financial assets, an excess demand that by Walras’s Law is matched by an excess supply of currently-produced goods and services.

Economic theory was not to get to this destination in a clear and coherent fashion until Bagehot (1873). But economic practice and policy ran ahead of theory, getting there at the end of 1825. Such an attempt to compensate for the failure of the market to create sufficient “outside money” to cure a financial crisis and the resulting downturn in real activity—to create the safe, liquid financial assets to match market demand—was undertaken by the Bank of England at the end of 1825. And this first such attempt is the origin of what we today would see as modern central banking.

C. “Outside Money”, Financial Crisis Policy, and E.M. Forster’s Great-Aunt Marianne

Our best single window into the origin of central banking in 1825 comes from English novelist E.M. Forster, whose great-aunt Marianne Thornton had helped raise him after his father’s death and left him a legacy of £8,000 pounds, and who as a consequence wrote Marianne Thornton: A Domestic Biography 1797-1887,17 stringing her letters together with scene-setting prose. In the middle of 1825 Marianne Thornton’s younger brother, the 25-year-old Henry Thornton, was invited to join what had in earlier generations been the Thornton family bank as the most junior of its six partners. Marianne writes of profits of £40,000 pounds a year to be split among six partners.[18][18]

In a letter of December 1825 to her friend Hannah More, she wrote that:

There is just now a great pressure in the mercantile world, in the consequence of the breaking of so many of these scheming stock company bubbles…

And she criticized the management of the bank that young Henry had just joined. The bank’s managing partner:

had been inexcusably imprudent in not keeping more cash in the House, but relying on [the bank’s] credit … which would enable them to borrow whenever they pleased….

Today we would say that the bank was overleveraged, and had made the mistake of including in its core capital reserves assets that had been misclassified as “AAA”. Marianne Thornton writes of an “inexcusably imprudent” reliance on the bank’s credit. But the essence of the mistake is the same. The story that Marianne Thornton tells in her letter to Hannah More has a modern ring.

Then there came a “dreadful Saturday [Marianne] shall never forget” and a run—a wave of depositors liquidating their accounts and depleting the bank’s reserves— leaving the bank vault “literally empty.”
According to Marianne, all the other partners of Pole, Thornton, and company panicked:

[The managing partner] insisted on proclaiming themselves bankrupts at once, and raved and self-accused himself…. [Senior partner Scott] cried like a child of 5 years old…

Partner Pole was away at his country estate. Another partner was on a business trip. It fell to 25-year-old Henry to deal with the fact that in the last business hour of Saturday it was expected that Pole, Thornton:

would have to pay 33,000 [pounds], and they should receive only 12,000 [pounds]. This was certain destruction….

Henry Thornton quickly found another banker John Smith. Smith asked if the bank was solvent. Henry lied, and said that it was. Well, then, Smith said, Pole, Thornton would have all he could spare:

Never, [Henry] says, shall he forget watching the clock to see when 5 would strike, and end their immediate terror. … The clock did strike … as Henry heard the door locked, and the shutters put up, he felt [Pole, Thornton] would not open again but would be forcibly liquidated Monday morning…

There were, however, other wheels that had already been set in motion.

The First Lord of the Treasury, Robert Banks Jenkinson, Lord Liverpool, had been having conversations with Bank of England Governor Cornelius Buller about the need of the Bank of England to do something to calm the crisis by acting as a “lender of last resort”.19 John Smith had gotten wind of these conversations between Liverpool and Buller. And that Saturday evening, after the banks had closed, John Smith told Henry Thornton that if Henry truly believed that Pole, Thornton was solvent he, John Smith, would undertake to get it cash from the Bank of England. This was a shock. As Marianne Thornton wrote:

[T]he Bank [of England] had never been known to do such a thing in the annals of banking…

Sunday at 8 AM the members of the Court of the Bank of England who were in London were assembled to meet John Smith and Henry Thornton:

John Smith began by saying that the failure of [Pole, Thornton] would occasion so much ruin that he should really regard it as a national misfortune… then turned to Henry and said, “I think you give your word the House is solvent?” Henry said he could … [and] had brought the books.

“Well then”, said the governor and the deputy governor of the Bank, “you shall have 400,000 pounds by 8 tomorrow morning, which will I think float you”. Henry said he could scarcely believe what he had heard…

Monday morning, in the pre-dawn dark, Henry Thornton was at the Bank of England as Goveror Buller and Deputy Governor Richards personally counted out £400,000 pounds in bank notes. Marianne Thornton claims that one of the two said:

I hope this won’t overset you, my young man, to see the governor and deputy governor of the Bank [of England] acting as your two clerks…


rumors that the Bank of England had taken [Pole, Thornton] under its wing soon spread, and people brought back money [on Monday] as fast as they had taken it out on Saturday…

Henry Thornton had been irrationally exuberant and in error when he had sworn that the bank was solvent. The bank was eventually closed. The partners lost their capital shares. The Bank of England had to wait years before getting its emergency loan back in nominal terms, and it never recovered accrued interest. (But it did not care much.)20

The particular intervention to support Pole, Thornton was only a small part of what the Bank of England did in the Panic of 1825. To quote from Bank of England Director Jeremiah Harman:

We lent [cash] by every possible means and in modes we had never adopted before; we took in stock on security, we purchased Exchequer bills, we made advances on Exchequer bills, we not only discounted outright, but we made advances on the deposit of bills of exchange to an immense amount, in short, by every possible means consistent with the safety of the Bank, and we were not on some occasions over-nice. Seeing the dreadful state in which the public were, we rendered every assistance in our power…21

Did it work? Relative to the 8% per year trend rate of increase in cotton consumption in Britain, it appears that cotton consumption in 1826 was some 24% below trend before rebounding with a 30% growth rate in 1827. Relative to trend it looks like a deep, albeit short downturn. There is good reason to fear that the downturn would have been considerably worse had the Bank of England behaved like the U.S. Treasury and Federal Reserve in the early 1930s, and washed their hands of the situation.

From the standpoint of Mill’s theory of how the flip side of deficient general demand for currently-produced commodities is an excess demand for safe and liquid financial assets, it is straightforward to understand how the Bank of England’s 1825-6 interventions would have boosted the economy. That the Bank of England was willing to guarantee the liabilities of Pole, Thornton turned them from shaky, risky assets back into “inside money”—safe, liquid assets that would satisfy the unusual demand at that moment for near-riskless stores of value and sources of liquidity. That the Bank of England was itself printing up extra banknotes— expanding its balance sheet—raised the supply of “outside money” that the government was providing to the banking system. That the Bank of England was taking action to deal with the crisis may have restored that elusive “confidence” which diminishes desired portfolio demand for an unusually-high amount of safe, liquid assets. And when banks, businesses, and households no longer wish to cut their planned expenditure below their expected income, the economic downturn is over. As A.C. Pigou quotes Mary Paley and Alfred Marshall, the industrial depression

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…22

IV. The Development of Central Banking Practice in the Mid-Nineteenth Century

A. Robert Peel and “Moral Hazard”

In 1844 the British Parliament took a look at the system of central-bank support for the economy in a financial crisis that the Bank of England’s intervention in 1825 had left it. It held a debate on the terms on which the charter of the Bank of England should be renewed. In the end, the conclusion of the 1844 Bank Recharter debate was twofold:23

  1. The Bank of England should not have the power to print unlimited amounts of money to support the banking system in a financial crisis—in fact, it should be illegal for the Bank of England to print extra banknotes in a crisis. The important principle was that bankers should be on notice that they should not expect a bailout—for that would create too great a risk of substantial losses from moral hazard.
  2. In the event of a real emergency coming–which, Prime Minister Robert Peel claimed, should not happen–then the government could and would request that the Bank of England print as many banknotes as needed to fix the financial crisis.

The reason for (1) was very clear to the Parliamentary debaters back in 1844. Any confident expectation on the part of the financial community that the Bank of England did stand behind them and would intervene to prevent large-scale bankruptcy in a financial crisis would greatly amplify the chances of such a crisis by removing fear and caution. Bankers confident that in the last analysis they were gambling with the public’s money would do what bankers tend to do in such situations. Hence, Robert Peel and his majority in the Parliament thought, it was very important to establish the principle that the Bank of England could not be relied upon to bail out the banking system. And, Peel thought, the best way to establish that principle would be to make it illegal for The Bank of England to do so. As of 1844 the worry was that a government backstop for financial markets would enable moral hazard, lead financiers confident of rescue in an emergency to gamble with the government’s and the taxpayers’ money, and in the end the expectation of rescue would bring on the financial crises that lender-of-last-resort activities were supposed to cure.

This chain of logic leads to the conclusion that, as Charles Kindleberger put it, since “if the market is sure that a lender of last resort exists, its self-reliance is weakened”. This led Kindleberger to the conclusion that:

The lender of last resort… should exist… but his presence should be doubted…. This is a neat trick: always come to the rescue in order to prevent needless deflation, but always leave it uncertain whether rescue will arrive in time or at all, so as to instill caution in other speculators, banks, cities, or countries…. some sleight of hand, some trick with mirrors… [because] fundamentalism has such unhappy consequences for the economic system…24

Hence the legal prohibition of unlimited expansions of the note issue: Parliament made it illegal for the Bank of England to expand its balance sheet by buying up other assets and issuing additional Bank of England notes, unless the extra note issues were matched by additional gold reserves. The difficulty is that the supply of “outside money” is thereby rendered inelastic, and as Charles Kindleberger noted:

The difficulty in making the note issue inelastic… is that it became inelastic at all times, when the requirement in an internal financial crisis is that money be freely available…

And, much earlier, Karl Marx (1848) had complained that the Bank Recharter Act of 1844 was by its nature destructive, for it:

put into practice a self-acting principle for the circulation of paper money…. The issuing department is by law empowered to issue notes to the amount of fourteen millions sterling…. Beyond these fourteen millions, no note can be issued which is not represented in the vaults of the issuing department by bullion to the same amount…. Suppose now that a drain of bullion sets in, and successively abstracts various quantities of bullion from the issuing department…. This is not a mere supposition. On October 30, 1847, the reserve of the banking department had sunk to £1,600,000 while the deposits amounted to £13,000,000. With a few more days of the prevailing alarm, which was only allayed by a financial coup d’état on the part of the Government, the Bank reserve would have been exhausted and the banking department would have been compelled to stop payments…. Sir Robert Peel’s much vaunted Bank law does not act at all in common times; adds in difficult times a monetary panic created by law to the monetary panic resulting from the commercial crisis…25

And Peel’s passing the Bank Recharter Act played a large role in generating Marx’s scorn for Peel:

Peel himself has been apotheosized in the most exaggerated fashion… One thing at least distinguished him from the European ‘statesmen’ — he was no mere careerist…. [T]he statesmanship of this son of the bourgeoisie… consisted in the view that there is today only one real aristocracy: the bourgeoisie…. [H]e continually used his leadership of the landed aristocracy to wring concessions from it for the bourgeoisie… Catholic emancipation… the reform of the police… the Bank Acts of 1818 and 1844, which strengthened the financial aristocracy… tariff reform… free trade… with which the aristocracy was nothing short of sacrificed to the industrial bourgeoisie…. His power over the House of Commons was based upon the extraordinary plausibility of his eloquence. If one reads his most famous speeches, one finds that they consist of a massive accumulation of commonplaces, skillfully interspersed with a large amount of statistical data…26

And, indeed, Marx’s complaints about the 1844 Bank Recharter Act would have been well-taken—if the Act had been applied.

B. Robert Peel’s Successors and “Suspension Letters”

But as Robert Peel wrote in 1844, looking back on the Bank Recharter Act, the mere fact that the Act had made lender-of-last-resort operations illegal did not mean that they should not or would not be undertaken:

My confidence is unshaken that we have taken all the Precautions which legislation can prudently take up against the Recurrence of a pecuniary Crisis. It my occur in spite of our Precautions, and if it does, and if it be necessary to assume a grave responsibility for the purpose of meeting it, I dare say men will be found willing to assume such a responsibility. I would rather trust to this than impair the efficiency and probable success of those measures by which one hopes to control evil tendencies in their beginning, and to diminish the risk that extraordinary measures may be necessary…27

Peel saw a choice: either (i) give the Bank of England explicit powers (and so run the risk that financiers, expecting that those powers would be used, would exploit moral hazard and so produce irrational exuberance, extravagant overleverage, and repeated frequent financial crises), or (ii) forbid the Bank of England from acting and rely on financial statesmen in the future to take actions ultra vires under the principle that in the end salus populi suprema lex. Peel chose (ii). To him and his peers, the risks that granting explicit powers would enable moral hazard appeared greater than the risks that when a crisis should come the makers of monetary policy would not understand that their proper role was to create enough “outside money” to satisfy the panic demand for safe, liquid assets and so eliminate the gap between planned economy-wide spending and expected income that would otherwise generate a deep economic downturn.

And, indeed, Peel’s expectations of how his successors would act in a crisis were rational. Men were indeed found willing to assume a grave responsibility and go ultra vires and undertake actions that they had no legal power to perform—indeed, actions that they were expressly forbidden by the terms of the Bank of England’s new charter from undertaking. The Governors of the Bank of England, however, would not expand their balance sheet beyond its legal limit purely on their own initiative, however. They required first a blessing from the government of the day.

The blessing took the form of a “suspension letter” written by the Chancellor of the Exchequer—the British Treasury Secretary. First in 1847 and then in 1857 and then in 1866, the Chancellor would write a letter to the Governor of the Bank of England stating that he was suspending for the duration of the financial crisis those provisions of the 1844 Bank Recharter Act of 1844 that restricted the Bank of England’s ability to expand its balance sheet. Nothing in the black-letter law or in previous custom gave the Chancellor any such power to at his will suspend provisions of a corporation charter and grant the corporation extra privileges and powers above those Parliament had granted it. Successive Chancellors did so anyway. They judged it, as Peel had foretold: “necessary to assume a grave responsibility for the purpose of meeting” the crisis. They did so. And few people complained.
One who did complain was the irate Karl Marx. He asked whether:

it [will] be believed that the Committee has contrived to simultaneously vindicate the perpetuity of the law and the periodical recurrence of its infraction? Laws have usually been designed to circumscribe the discretionary power of Government. Here, on the contrary, the law seems only continued in order to continue to the Executive the discretionary power of overruling it. The Government letter, authorizing the Bank of England to meet the demands for discount and advances upon approved securities beyond the limits of the circulation prescribed by the Act of 1844, was issued on Nov. 12…28

The reason that few people complained was that the system seemed to work less badly than other systems that could be envisioned. The system was inconsistent— and that annoyed Marx. But the Act’s originator’s blessing of ultra vires lender-of-last-resort powers coupled with the Act’s text’s forbidding of them accomplished Charles Kindleberger’s “neat trick… sleight of hand… trick with mirrors…” and made it possible for the “lender of last resort… [to] exist… but [for] his presence [ex ante] tp be doubted”; for the Bank of England to “come to the rescue in order to prevent needless deflation, but always leave it uncertain whether rescue will arrive in time or at all, so as to instill caution…”

And most frequently, in the third quarter of the nineteenth century at least, the taking on of risk onto the Bank of England’s books and the issuing of additional banknotes above the legal limit was not needed: simply the declaration that the Chancellor of the Exchequer had sent a suspension letter to the Governor of the Bank of England, or even was just planning to send a suspension letter, was enough to eliminate the high demand for additional safe, liquid savings vehicles all by itself.

V. From Practice Back to Theory: Walter Bagehot’s Lombard Street

A. Bagehot’s Rules

Thus when Walter Bagehot settled down to write his Lombard Street, he had at his back not only the analytical apparatus of British classical political economy but also half a century’s worth of policymakers’ experience at dealing with financial crises, and policymakers’ memoirs in which they reflected upon their experience. He thus had several rich veins of material to draw upon as he attempted to systematize what was known about how central banking worked in a financial crisis. The mid-nineteenth century practice of central banking he took it upon himself to rationalize and explaican be summed up simply: when, in a financial crisis, private savers want desperately to hold more safe, liquid savings vehicles, give them what they want.

And Bagehot explained how a central bank should go about doing this with four rules:

His first rule is that the central bank exists to keep the fall in the supply of safe, liquid savings vehicles in a financial crisis as small as possible, and to do so by lending freely to all–or at least to all who have collateral to indicate that they would be solvent if times were normal and if the financial crisis had passed:

They must lend to merchants, to minor bankers, to ‘this man and that man’, whenever the security is good. In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them…. On the surface there seems a great inconsistency… like saying–first, that the reserve should be kept, and then that it should not be kept. But there is no puzzle….. The ultimate banking reserve of a country (by whomsoever kept) is not kept out of show, but for… meeting a demand for cash caused by an alarm within the country….. [W]e keep that treasure for the very reason that in particular cases it should be lent…

Bagehot’s second rule is that it is very dangerous to place an ex ante limit on how much the monetary authority will commit to operation as a lender of last resort: the central bank needs to stand ready to expand the supply of safe, liquid assets by as much as turns out to be necessary, which may be more (or less) than anybody thinks possible (or necessary):

[A]n opinion that most people, or very many people, will not pay their creditors; and this too can only be met by enabling all those persons to pay what they owe, which takes a great deal of money…. Just so before 1844, an issue of notes, as in 1825, to quell a panic entirely internal did not diminish the bullion reserve. The notes went out, but they did not return. They were issued as loans to the public, but the public… never presented them for payment….. [W]e must keep a great store of ready money always available, and advance out of it very freely in periods of panic, and in times of incipient alarm…

Bagehot’s third rule is that the central bank must not play favorites:

[A]dvances should be made on all good banking securities, and as largely as the public ask for them…. The object is to stay alarm…. But the way to cause alarm is to refuse some one who has good security to offer…. If it is known that the Bank of England is freely advancing on what in ordinary times is reckoned a good security—on what is then commonly pledged and easily convertible—the alarm of the solvent merchants and bankers will be stayed…

The purpose is to destroy risk. And the risk that a particular firm’s assets will not receive symmetrical treatment with the assets of other, more favored firms is not an extra source of risk that needs to be introduced.

Bagehot is often glossed as if he had declared that a central bank in a financial crisis should lend to illiquid but not insolvent institutions.29 But it is difficult to see how any institution whose solvency is common knowledge could possibly be illiquid. Indeed, it is only because the central bank’s solvency is common knowledge that it can create the safe, liquid “outside money” needed to reflate the financial system in a financial crisis.30 Bagehot did not say “illiquid but not insolvent”. He said something more clever: that the central bank should be seen to be “freely advancing on what in ordinary times is reckoned a good security—on what is then commonly pledged and easily convertible”, then “the alarm of the solvent merchants and bankers will be stayed”.31

And Bagehot’s fourth rule is that central bank lending in a financial crisis should be undertaken at a “penalty rate”: nobody—no organization, no manager, no trader, and no investor—should end the crisis in any sense happy that they were forced to rely on the government. This would appear to mean, particularly, that equity should be extinguished before the central bank begins providing support at interest rates that are at all concessionary. To the extent that equity rights are preserved as less than a proper penalty rate is charged, the criticism that the central bank has unnecessarily provided incentives for moral hazard is unanswerable.32

B. The Great Depression

How effective are these rules? How necessary are these rules? They are a systematization of nineteenth-century British central-banking practice. They do have theoretical banking in John Stuart Mill’s observation that deficient aggregate demand—planned total economy-wide spending less than expected income—is the flip side of excess demand for financial assets or for some subset thereof. They do, at least in Peel’s formulation, attempt the sleight of hand and tricks with mirrors, the “ambiguity, verging on duplicity… promis[ing] not to rescue banks and merchant houses… to force them to take responsibility for their behavior, and then rescu[ing] them… for otherwise trouble might spread…” that Kindleberger calls for in the hope of minimizing ex ante moral hazard. But are there alternative public- policy strategies that would do as well?

We do not really know. We do however, know that the one major time in a deep financial crisis that Bagehot’s rules were not followed turned into the Great Depression.33 34

In part this was because of the sovereign-debt aspect. In Europe there was no actor large enough to be a lender of last resort. The United States did not want to step in and serve as a lender-of-last-resort for Europe. In part this was because there was no visible shortage of “liquidity”. Money remained very cheap, in the sense of very low safe short-term interest rates. So how could there be a role for the central bank? What point in swapping cash for short-term government bonds when both are indistinguishable zero-yielding government assets? We today would presumably distinguish between a shortage of liquidity pure-and-simple—a situation in which investors are dumping interest-earning assets at almost any price in order to build up their stocks of means of payment—and a shortage of safe assets—in which investors are dumping risky assets in order to build up their stocks of safe assets. We would say that there is a strong case for the central bank to rebalance the economy by increasing the money supply in the first case and by increasing the safe asset supply in the second.35 But interwar policymakers did not make that leap.

In part it was because of the rising Austrian tide. The 1920s and 1930s saw the heyday of the doctrine that business-cycle depressions are the necessary breathing of the economic mechanism.[36][36]

In part it was out of a fear that large deficits and rising government debt would shake business confidence and add to uncertainty, and raise fears of destructive inflation.37 Monetary experts like R.G. Hawtrey could denounce those who called for fiscal austerity to fight the danger of inflation as “Crying ‘Fire! Fire! in Noah’s Flood”.38 But they had little effect on policy at the end of the 1920s, and less effect on policy in the post-trough 1930s than they wished.

Kindleberger’s judgment was that Bagehot’s rules are applied because they had, more often than not, worked reasonably well:

Whether there is a theoretical rationale for letting the market find its way out of a panic or not, the historical fact is that panics that have been met most successfully almost invariably found some source of cash to ease the liquidation of assets before prices fell to ruinous levels…39

The fact remains that when policymakers and commentators confronted the financial crisis of 2008-9, they almost invariably reached for the rules of Walter Bagehot. It is in that sense that Lawrence Summers was correct when he said that “there is a lot in Bagehot that is about the crisis we just went through…”

VI. Conclusion: From 1873 to 2009

It is traditional for economic historians and historians of economic thought to lament productive research programs of the past that were then only little further developed, with many threads left dangling for decades if not longer. And it is indeed a fact that the number of economists whose work makes it into the graduate curriculum who build on Bagehot is relatively small: Minsky (1982, 1986) is present to a small degree. Kindleberger (1978, 1984) is present to a somewhat larger one. Eichengreen (1992, 2008) is present in economic history courses. Otherwise, Bagehot (1873) remains remarkably good preparation for reading modern works that attempt to pick up the same or similar threads like Richard Koo (2003, 2009) or Carmen Reinhart and Kenneth Rogoff (2008).

One reason that Bagehot (1873) still has considerable authority is that the tools of modern academic macroeconomics are not of a great deal of help in weaving together the threads trailing off from Bagehot. Rare and complex events like large financial crises that produce deep and lengthy downturns are not frequent enough for statistical methods to have much purchase. Financial crises are generated when leveraged agents make large bets and get them wrong, while modern economics has a hard time sustaining models in which agents make bets at all: it is difficult to construct economic actors who are both believable and who fail to realize that they know less than their potential counterparty, and any deal that their potential counterparty is willing to offer is not one that they should accept. Academic macroeconomics can and has made progress on lots of issues,but working in the tradition of Bagehot goes against the grain.

Alongside the lack of comparative advantage of the analytical tools of modern economics in making progress on Bagehot-type issues is the fact that, qualitatively, our knowledge base is little better than his. As of his writing, Bagehot or his predecessors had seen the industrial-economy financial crises of 1825-6, 1847-8, 1857, and 1866. Since then we have seen global-scale crises in 1873, 1884, 1893, 1907, 1929-33, and 2008-9, alongside a host of local-scale crises. However, the qualitative mechanism has remained the same. Since 1825 we have seen a single mechanism transmit financial distress to the real economy of production and employment. It takes the form of a recognition that previous confidence in the liquidity or safety of assets was built on sand, of an attempted flight to liquidity and/or quality in asset holdings, and the consequent excess demand for financial assets generating, via Walras’s Law, deficient demand for currently-produced goods and services. The freezing-up of the spending flow and its implications for employment and production looks much the same in episode after episode. Thus a nineteenth-century author like Walter Bagehot is at little disadvantage in analyzing the causes and spread of the downward financial spiral, or in analyzing its consequences for the real economy.

While it would certainly have been helpful and productive had the threads left dangling by Lombard Street been woven further over than they have been over the past 140 years, that failure to make more rapid progress was not a great disability for economics. What was a great disability for economics was a failure to pick up the toolkit of Lombard Street and use it to its full effect over the past five years. And here I do not have answers: I have only questions. Specifically:

  1. Why were economists so confident that highly-leveraged money-center banks—banks that had just switched from a partnership to a corporate structure—had effective control over their risks?

  2. Why were economists so confident that the Federal Reserve had both the power and the will to easily stabilize the growth path of nominal GDP?

  3. And what happened to economists’ effective consensus on the technocratic goals of macroeconomic policy? The presumption since at least 1936 was that it was the business of government to intervene strategically in asset markets to stabilize the growth path of nominal GDP, and so to attempt to attain both effective price stability and maximum feasible employment and purchasing power. Yet when the crunch came in late 2008, the technocratic policy consensus on even the goal of maintaining the flow of spending proved to be fragile and ephemeral.

Bagehot, however, was very clear and vocal on the root cause of the problem:

Any sudden event which creates a great demand for actual cash may cause, and will tend to cause, a panic in a country where cash is much economised, and where debts payable on demand are large…. [S]ome writers have endeavoured to classify panics according to the nature of the particular accidents producing them. But little, however, is, I believe, to be gained by such classifications. There is little difference in the effect of one accident and another upon our credit system. We must be prepared for all of them, and we must prepare for all of them in the same way…. [O]wners of savings not finding, in adequate quantities, their usual kind of investments, rush into anything that promises speciously…. The first taste is for high interest, but that taste soon becomes secondary. There is a second appetite for large gains to be made by selling the principal which is to yield the interest. So long as such sales can be effected the mania continues; when it ceases to be possible to effect them, ruin begins…

And on what needed to be done in response:

Ordinarily discredit does not at first settle on any particular bank… [it] amounts to a kind of vague conversation: Is A. B. as good as he used to be? Has not C. D. lost money?… A panic, in a word, is a species of neuralgia, and according to the rules of science you must not starve it. The holders of the cash reserve must be ready not only to keep it for their own liabilities, but to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to ‘this man and that man’…. The problem of managing a panic must not be thought of as mainly a ‘banking’ problem. It is primarily a mercantile one…. At the slightest symptom of panic many merchants want to borrow more than usual; they think they will supply themselves with the means of meeting their bills while those means are still forthcoming. If the bankers gratify the merchants, they must lend largely just when they like it least; if they do not gratify them, there is a panic. On the surface there seems a great inconsistency…. First, you establish in some bank or banks a certain reserve…. And then you go on to say that this final treasury is also to be the last lending-house; that out of it unbounded, or at any rate immense, advances are to be made when no one else lends. This seems like saying—first, that the reserve should be kept, and then that it should not be kept. But… the ultimate banking reserve of a country (by whomsoever kept) is not kept out of show, but for certain essential purposes, and one of those purposes is the meeting a demand for cash caused by an alarm within the country…

Jane Austen (1813), Pride and Prejudice .

Walter Bagehot (1873), Lombard Street: A Study of the Money Market (London: Henry S. King) http://www.econlib.org/library/Bagehot/bagLomCover.html

Bank Charter Act of 1844 http://www.ledr.com/bank_act/1844032.htm. British Parliamentary Papers 1847 [1969], Vol. 2, p. xxix.

Ricardo Caballero (2010), “The ‘Other’ Imbalance and the Financial Crisis” (Cambridge: NBER Working Paper 15636).

Fabio Castiglionesi and Wolf Wagner (2012), “Turning Bagehot on His Head: Lending at Penalty Rates When Banks Can Become Insolvent”, Journal of Money, Credit and Banking 44:1 (February), pp. 201–219.

Barry J. Eichengreen (1992), Golden Fetters: The Gold Standard and the Great Depression (Oxford: Oxford University Press) http://books.google.com/books/reader?id=Qk1flhynCD8C.

Barry J. Eichengreen (2008), Globalizing Capital (Princeton: Princeton University Press) http://books.google.com/books?id=8wrdqjYloSQC.

E.M. Forster (1956), Marianne Thornton: A Domestic Biography (New York: Harcourt Brace) http://tinyurl.com/dl201108f.

R.G. Hawtrey (1938), A Century of Bank Rate.

Friedrich von Hayek (1931), “The Fate of the Gold Standard”, in The Collected
Works of F. A. Hayek: Good Money.

Herbert Hoover (1932), “Budget Message for Fiscal 1933” (Washington: GPO).

J. K. Horsefield (1944), “The Origins of the Bank Charter Act, 1844”, Economica NS 11:43 (November), pp. 180ff.

Thomas M. Humphrey and Robert E. Keleher (1984), “The Lender of Last Resort : a Historical Perspective” (Richmond: Federal Reserve Bank of Richmond Working Paper 84-3) http://www.richmondfed.org/publications/research/economic_review/1989/pdf/er750202.pdf.

John Maynard Keynes (1936), The General Theory of Employment, Interest and Money (London: Macmillan) http://www.marxists.org/reference/subject/economics/keynes/general-theory/.

Charles Kindleberger (1978), Manias, Panics, and Crashes: A History of Financial Crises (New York: John Wiley) http://books.google.com/books?id=nBb-xYi9O-sC.

Charles Kindleberger (1984), A Financial History of Western Europe (London: Routledge) http://books.google.com/books?id=s8hiamcsiFQC.

Richard Koo (2003), Balance-Sheet Recession (New York: John Wiley).

Richard Koo (2009), The Holy Grail of Macroeconomics (New York: John Wiley).
Thomas Robert Malthus (1798), An Essay on the Principle of Population (London: J. Johnson) http://goo.gl/OqHVA.

Thomas Robert Malthus (1820), Principles of Political Economy Considered with a View Toward Their Practical Application (London) http://goo.gl/IYvxI.

Karl Marx and Friedrich Engels (1980), Collected Works (Moscow: Progress Publishers), vol. 15, pp. 379-384 .

Karl Marx and Friedrich Engels (1850), Neue Reinische Zeitung Politische- Oekonomische Revue .

Karl Marx (1868), “The English Bank Act of 1844”, New York Tribune (August 23) http://marxengels.public-archive.net/en/ME1077en.html.

John Stuart Mill (1844), Essays on Some Unsettled Questions in Political Economy http://tinyurl.com/dl201108e.

Hyman Minsky (1986), Stabilizing an Unstable Economy (New York: Twentieth Century Fund) http://books.google.com/books?id=MD3zrAe5iOYC;

Hyman Minsky (1982), Can “It” Happen Again?: Essays on Instability and Finance (New York: M.E. Sharpe) .

A.C. Pigou (1923), Essays in Applied Economics (London: P.S. King and Son) http://books.google.com/books?id=FXU40tmugnIC.

Carmen Reinhart and Kenneth Rogoff (2008), This Time It’s Different (Princeton: Princeton University Press).

Lionel Robbins (1934), The Great Depression (London: Macmillan).

Jean-Baptiste Say (1803), Treatise d’Economie Politique (Paris); Eng. trans. Biddle

Jean-Baptiste Say (1829), Cours Complet d’Economie Politique Pratique .

Aurel Schubert (1991), The Credit-Anstalt Crisis of 1931 (Cambridge, UK: Cambridge University Press) http://books.google.com/books?id=D4gIbPmjzhcC.

Joseph A. Schumpeter (1934) ‘Depressions”, in Douglass Brown, ed., Economics of the Recovery Program (New York: McGraw-Hill) http://books.google.com/books?id=fq7nAAAAMAAJ.

Robert Shiller (1980), “Do Stock Prices Move too Much to Be Justified by Subsequent Movements in Dividends?” (Cambridge: NBER Working Paper 456) http://www.nber.org/papers/w0456.pdf.

“Larry Summers and Martin Wolf on New Economic Thinking” (April 8, 2011 video) http://tinyurl.com/dl201108a

P. Barrett Whale (1944), “A Retrospective View of the Bank Charter Act of 1844”, Economica NS 11:43 (August), pp. 109ff.

Janet Yellen (2009), “A Minsky Meltdown: Lessons for Central Bankers” (San Francisco, CA: Federal Reserve Bank of San Francisco)

[7]: http://www.nber.org/ papers/w0456.pdf (See Robert Shiller (1980), “Do Stock Prices Move too Much to Be Justified by Subsequent Movements in Dividends?” (Cambridge: NBER Working Paper 456). The conclusion of a very long subsequent literature was that Shiller was right: assuming that standard tools for constructing estimates of rational expectations apply, only a small part of aggregate equity price variation comes from revisions of rational expectations of future dividends and earnings flows.)
[12]: http://goo.gl/OqHVA See Thomas Robert Malthus (1798), An Essay on the Principle of Population (London: J. Johnson))
[15]: http://tinyurl.com/ dl201108c (Jean-Baptiste Say (1829), Cours Complet d’Economie Politique Pratique)
[18]: http://www.pemberley.com/janeinfo/ pridprej.html (Jane Austen’s hero in her Pride and Prejudice, Fitzwilliam Darcy, received £10,000 pounds a year from his estate of Pemberly, and is thus richer than any other non-noble character we meet. See Jane Austen (1813), Pride and Prejudice)
[36]: http://books.google.com/ books?id=fq7nAAAAMAAJ (See Friedrich von Hayek (1931), “The Fate of the Gold Standard”, in The Collected Works of F. A. Hayek: Good Money; Joseph A. Schumpeter (1934) ‘Depressions”, in Douglass Brown, ed., Economics of the Recovery Program (New York: McGraw-Hill); Lionel Robbins (1934), The Great Depression (London: Macmillan))

Slides For: The Confidence Fairy in Historical Perspective

History of Economics Society :: June 17, 2016 :: Geneen Auditorium, Fuqua School of Business, Duke University, Durham, NC:

https://www.icloud.com/keynote/00033GAKBnIHC53Sv0UDhbqEw#2016-06-17_HES_Confidence_Fairy_in_Historical_Perspective | http://delong.typepad.com/2016-06-17-hes-confidence-fairy-in-historical-perspective.pdf

NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage NewImage

Today’s Economic History: John Maynard Keynes (1931): Unemployment as a World Problem

Unemployment as a World Problem


I. We are today in the middle of the greatest economic catastrophe—the greatest catastrophe due almost entirely to economic causes—of the modern world. I am told that the view is held in Moscow that this is the last, the culminating crisis of capitalism and that our existing order of society will not survive it. Wishes are fathers to thoughts. But there is, I think, a possibility—I will not put it higher than that—that when this crisis is looked back upon by the economic historian of the future it will be seen to mark one of the major turning-points. For it is a possibility that the duration of the slump may be much more prolonged than most people are expecting and that much will be changed, both in our ideas and in our methods, before we emerge. Not, of course, the duration of the acute phase of the slump, but that of the long, dragging conditions of semislump, or at least sub-normal prosperity which may be expected to succeed the acute phase. Not more than a possibility, however. For I believe that our destiny is in our own hands and that we can emerge from it if only we choose—or rather if those choose who are in authority in the world.

My main theme is to be an attempt to analyze the originating causes of the slump. For unless we understand these—unless our diagnosis is correct—I do not see how we can hope to find the cure. I shall make use of my own theories of monetary causation and therefore I may, perhaps, assume implicitly some measure of familiarity with them; but I shall try not to assume so much as to embarrass those who are not acquainted with them.

I see no reason to be in the slightest degree doubtful about the initiating causes of the slump. Let us consider a brief history of events beginning about 1924 or 1925. By that time or shortly afterward the perturbations which had, perhaps inevitably, ensued on the war and the treaty of peace and the readjustments of economic relations between different countries seemed to have about run their course. Confidence was more or less restored; the mechanism of international lending was functioning freely; and while several European countries still had serious difficulties to overcome, for the world as a whole conditions seemed to be set fair.

It was widely believed that the general restoration of the gold standard would complete the edifice of prosperity and that an indefinitely long period of ever increasing economic well-being was in front of the progressive industrial nations of the world. So, apart from certain local domestic troubles in Great Britain (and I am not dealing except incidentallv with the British problem), was indeed the case for some four or five years. Now what was the leading characteristic of this period? Where and how were the seeds of subsequent trouble being sown?

The leading characteristic was an extraordinary willingness to borrow money for the purposes of new real investment at very high rates of interest—rates of interest which were extravagantly high on pre-war standards, rates of interest which have never in the history of the world been earned, I should say, over a period of years over the average of enterprise as a whole. This was a phenomenon which was apparent not, indeed, over the whole world but over a very large part of it.

Let us consider the United States first, because the United States has held throughout the key position. The investment activity in this country was something prodigious and incredible. In the four years 1925-28 the total value of new construction in the United States amounted to some $38,000,000,000. This was—if you can credit it—at an average rate of $800,000,000 a month for forty-eight months consecutively. It was more than double the amount of construction in the four years 1919-22, and, I may add, much more than double the amount that is going on now.

Nor was this the whole of the American story. The growth of the instalment system, which represents a sort of semi-investment, was going on pari passu. And, more important still, the United States was a free purchaser of all kinds of foreign bonds, good, bad, and indifferent—a free lender for investment purposes,that is to say, to the rest of the world. To an important extent the United States was acting, in this generous foreign-loan policy, as a conduit pipe for the savings of the more cautious Europeans, who had less confidence in their own prosperity than America had; so that the foreign-bond issues were often largely financed out of short- term funds which the rest of the world was, for considerations of safety or liquidity, depositing in New York.

But Great Britain was also lending on a substantial scale. Altogether it is estimated that in 1925 the net foreign lending of capital-exporting countries amounted to about $2,300,000,000. Naturally the result was to facilitate investment schemes over a wide area, especially in South America. All the countries of South America found themselves in a position to finance every kind of scheme, good or bad.

A comparatively small country like the republic of Colombia, to give an example, found itself able to borrow—I forget the exact figure—something approaching $200,000,000 in New York within a brief space of time. Rates of interest were high indeed. But the lender was willing and so was the borrower. Germany, as we all know, was another country that was both able and willing to borrow on a gigantic scale; indeed, in 1925 she alone borrowed sums approaching $1,000,000,000.

This free borrowing was duly accompanied by capital expansion programs. In France there was long-continued building activity; in Germany industry was reconstructed and municipal enterprise was conducted on an extravagant scale; in Spain the dictatorship embarked on enormous public works; indeed, in almost every European country a large force of labor and plant was being employed on construction, thus consuming, but not producing, consumption goods. The same was true over the whole of South America and in Australia. Even in China the prolonged civil war involved great expenditures otherwise than on producing consumption goods—which, so long as it is going on, is analytically identical with investment, even though its future fruits are less than nothing. In Russia, at the same time, immense efforts were being made to direct an unusually large proportion of the national forces to works of capital construction.

There was really only one important partial exception, namely, Great Britain. In that country investment continued throughout on a somewhat moderate scale. Road development and housing programs did something to keep up investment. But the return to the gold standard and the relative decline of the British staple export trades seriously cut down her ability to carry on foreign investment up to anything like the same proportion of her savings as had been the case from 1900 to 1914; and for various reasons home investment was not on a sufficient scale to absorb the whole of the balance. This, I am sure, is the fundamental reason why we in Great Britain were feeling depression before the rest of the world. We were not participating in the enormous investment boom which the rest of the world was enjoying. Our savings were almost certainly in excess of our investment. In short, we were suffering a deflation.

While some part of the investment which was going on in the world at large was doubtless ill-judged and unfruitful, there can, I think, be no doubt that the world was enormously enriched by the constructions of the quinquennium from 1925 to 1929; its wealth increased in these five years by as much as in any other ten or twenty years of its history. The expansion centered round building, the electrification of the world, and the associated enterprises of roads and motor cars. In those five years an appreciable change was effected in the housing, the power plant, and the transport system of a large part of the world.

But it was not unduly specialized. Almost every department of capital development took its share. The capacity of the world to produce most of the staple food-stuffs and raw materials was greatly expanded; machinery and new techniques directed by science greatly increased the output of all the metals, rubber, sugar, the chief cereals, etc. The economic section of the League of Nations has published the figures. In the three years 1925-28 the output of foodstuffs and raw materials in the world as a whole increased by no less than 8 per cent and the output of manufactured goods rose by 9 per cent, that is to say, at least as fast as that of raw materials. Progress was especially rapid in Europe where the increase in output was probably greater than even in North America.

Doubtless, as was inevitable in a period of such rapid change, the rate of growth of some individual commodities could not always be in just the appropriate relation to that of others. But, Onthe whole, I see little sign of any serious want of balance such as is alleged by some authorities. The rates of growth of construction capital such as houses, of capital for manufacturing production, and of capital for raw material production; or again those of foodstuffs, of raw materials, of manufactures, of activities demanding personal services seem to me, looking back, to have been in as good a balance as one could have expected them to be. A very few more quinquennia of equal activity might, indeed, have brought us near to the economic Eldorado where all our reasonable economic needs would be satisfied.

It is not necessary for my present purpose to decide exactly how far this investment boom was inflationary in the special sense which I have given to that term—whether, in other words, it was balanced by saving or whether it was financed by surplus profits obtained by selling output at a price which was inflated above the normal costs of production. I am inclined to the view that the part played by inflation was surprisingly small, and that savings kept pace with investment to a remarkable degree. In fact, there was very little rise in the price of the commodities covered by index numbers.

This does not prove that there was no inflation: first, because we have no proper consumption index numbers, so that these might, if we had them, show a different result; second, because the period was one of rapidly increasing efficiency, and it may be that while the price of many commodities was unchanged, too small a proportion of the increasing product was accruing to the factors of production and too much to the entrepreneurs, which would, according to my definition, be inflationary. Probably in some places and at some dates inflation was definitely present. But I think that the evidence suggests that savings were in fact abundantly available and were adequate to finance a very large part of the investment which was going on. This conclusion, if it is correct, will be important in the sequel.

What was it, then, that brought all this fruitful activity to a sudden termination? This brings me to the second part of my discourse.

II. It seems an extraordinary imbecility that this wonderful outburst of productive energy should be the prelude to impoverishment and depression. Some austere and puritanical souls regard it both as an inevitable and a desirable nemesis on so much overexpansion, as they call it; a nemesis on man’s speculative spirit. It would, they feel, be a victory for the mammon of unrighteousness if so much prosperity was not subsequently balanced by universal bankruptcy. We need, they say, what they politely call a “prolonged liquidation” to put us right. The liquidation, they tell us, is not yet complete. But in time it will be. And when sufficient time has elapsed for the completion of the liquidation, all will be well with us again.

I do not take this view. I find the explanation of the current business losses, of the reduction of output, and of the unemployment which necessarily ensues on this not in the high level of investment which was proceeding up to the spring of 1929, but in the subsequent cessation of this investment. I see no hope of a recovery except in a revival of the high level of investment. And I do not understand how universal bankruptcy can do any good or bring us nearer to prosperity, except in so far as it may, by some lucky chance, clear the boards for the recovery of investment.

I suggest to you, therefore, that the questions to which we have to bend our intelligences are the causes of the collapse of investment and the means of reviving investment. We cannot hope either to prophesy or to limit the duration of the slump except as the result of our understanding of these phenomena.

Looking back, it is now clear that the decline of investment began early in 1929, that it preceded (and, according to my theory, was the cause of) the decline in business profits, and that it had gathered considerable momentum prior to the Wall Street slump in the autumn of 1929.

Why did investment fall away? Probably it was due to a complex of causes:

1.Too high a rate of interest was being paid. Experience was beginning to show that borrowers could not really hope to earn on new investment the rates which they had been paying.

  1. Even if some new investment could earn these high rates, in the course of time all the best propositions had got taken up, and the cream was off the business. In other words, as one would expect, the increased supply of capital goods meant that the rate of interest was due for a fall if further expansion was to be possible.
  2. But just at this moment, so far from falling, the rate of interest was rising. The efforts of the Federal Reserve banks to check the boom on Wall Street was making borrowing exceedingly dear to all kinds of borrowers.
  3. A further consequence of the very dear money in the United States was to exercise a drag on the gold of the rest of the world and hence to cause a credit contraction everywhere.
  4. And a third consequence was the unwillingness of American investors to buy foreign bonds since they found speculation in their own common stocks much more exciting. In 1929 net purchases of this character by the United States fell to about a quarter of what they had been in the previous year, and in 1930 they fell so low as to be negligible.

I need hardly remind you how much fixed investment fell away in the United States. If we take the familiar Dodge figures for 1925 as our index of 100, we find a fall to 88 in 1929 and to 64 in 1930, while at the present time the figures are still lower. But this falling-away of fixed investment, while most marked, perhaps, in the United States, was not confined to that country. The complex of circumstances which I have outlined combined to cause a very marked diminution in the rate of investment all over the world.

Once this decline was started on a significant scale, it is exceedingly easy to see (on my way of looking at the matter) how the mere fact of a decline precipitated a further decline, for the high level of profits began to fall away, the prices of commodities inevitably declined, and these things brought with them a series of further consequences:

  1. The decline in output brought a disinvestment in working capital. In the United States this was on a huge scale.
  2. The decline in profit diminished the attractions of all kinds of investment.
  3. The fall in prices and the cessation of lending destroyed the credit of overseas borrowers, and made borrowing dearer for them just at the moment when they needed cheaper loans if they were to continue.

This decline has continued down to the present time, and so far as fixed investment is concerned, the volume of new investment must be today, taking the world as a whole, at the lowest figure for very many years.

Here I find—and I find without any doubts or reserves whatsoever—the whole of the explanation of the present state of affairs. But there is, I am afraid you may say, one very serious gap in my argument. I have been making all through a tacit assumption. And for those who do not accept this assumption, the conclusions must be unconvincing.

My assumption is this: I have taken it for granted so far that if investment falls off, then of necessity the level of business profits falls away also. Grant me this and the rest, I think, follows. Now I believe this to be true, and I have set forth in detail the reasons for my belief in the first volume of my recently published Treatise on Money. But the argument is not easy, and I cannot claim that it is yet part of the accepted body of economic thought.

It will be my duty, therefore, to endeavor in my next lecture to give you an outline of this reasoning in terms as well adapted as I can find for the medium of oral exposition. I shall then, in the light of this, pass on to what I have to say of a constructive character.


I have said that it is easy on my theory of the causation of these things to see why a severe decline in the volume of investment should have produced the results that we see around us in the world today. This theory, however, will not be familiar to many of you; and I must, if my argument is to be complete and intelligible, endeavor to set forth for you at least an outline of it. You must, therefore, forgive me a somewhat abstract discussion. Those who may wish to pursue the matter further I must refer to my Treatise on Money. But I will try, though it be at the risk of straining your attention, to put the gist of the matter very briefly as follows.

Entrepreneurs pay out in salaries, wages, rents, and interest certain sums to the factors of production which I shall call their “costs of production.” Some of these entrepreneurs are producing capital goods, some of them are producing consumption goods. These sums, these costs of production, represent in the aggregate the incomes of the individuals who own or are the factors of production.

These individuals in their capacity of consumers expend part of these incomes on buying consumption goods from the entrepreneurs; and another part of their incomes, which part we shall call their savings, they put back, as we may express it, into the financial machine—that is to say, they deposit it with their banks or buy stock-exchange securities or real estate or repay instalments in respect of purchases previously made or the like.

At the same time the financial machine will be enabling a different set of people to order and pay for various kinds of currently produced capital goods from the entrepreneurs who produce this class of goods, such as buildings, factories, machines, equipment for transport, and public-utility enterprises and the like; and the aggregate of expenditures of this kind I find it convenient to call the “value of current investment.”

Thus there are two streams of money flowing back to the entrepreneurs, namely, that part of their incomes which the public spend on consumption and those expenditures on the purchases of capital goods which I have called the value of current investment. These two amounts added together make up the receipts or sale proceeds of the entreprqneurs.

Now the profitableness of business as a whole depends, and can depend, on nothing but the difference between the sale proceeds of the entrepreneurs and their costs of production. If more comes back to them as sale proceeds than they have expended in costs of production, it follows that they must be making a profit. And, equally, if less comes back to them than they have paid out, they must be making a loss. I am speaking all the time, remember, of entrepreneurs as a whole. As between individual entrepreneurs, some will at all times be doing better than the average and some worse.

Now for my equation, a very simple one, which gives, to my thinking, the clue to the whole business:

The costs of production of the entrepreneurs are equal to the incomes of the public. Now the incomes of the public are, obviously, equal to the sum of what they spend and of what they save. On the other hand, the sale proceeds of the entrepreneurs are equal to the sum of what the public spend on current consumption and what the financial machine is causing to be spent on current investment.

Thus the costs of the entrepreneurs are equal to what the public spend plus what they save; while the receipts of the entrepreneurs are equal to what the public spend plus the value of current investment. It follows, if you have been able to catch what I am saying, that when the value of current investment is greater than the savings of the public, the receipts of the entrepreneurs are greater than their costs, so that they make a profit; and when, on the other hand, the value of current investment is less than the savings of the public, the receipts of the entrepreneurs will be less than their costs, so that they make a loss.

That is my secret, the clue to the scientific explanation of booms and slumps (and of much else, as I should claim) which I offer you. For you will perceive that when the rate of current investment increases (without a corresponding change in the rate of savings) business profits increase. Moreover,the affair is cumulative. For when business profits are high, the financial machine facilitates increased orders for and purchases of capital goods, that is, it stimulates investment still further; which means that business profits are still greater; and soon. In short, a boom is in full progress. And contrariwise when investment falls off. For unless savings fall equally, which is not likely to be the case, the necessary result is that the profits of the business world fall away. This in turn reacts unfavorably on the volume of new investment; which causes a further decline in business profits. In short, a slump is upon us.

The whole matter may be summed up by saying that a boom is generated when investment exceeds saving and a slump is generated when saving exceeds investment. But behind this simplicity there lie, I am only too well aware, many complexities, many pitfalls, many opportunities for misunderstanding. You must excuse me if I slide over these, for it would take me weeks to expound them fully.

Indeed, let me simplify further, for I should like for a moment to leave the variations in saving out of my argument. I shall assume that saving either varies in the wrong direction (which may, in fact, occur, especially in the early stages of the slump, since the fall in stock-exchange values as compared with the boom may by depreciating the value of people’s past savings increase their desire to add to them) or is substantially unchanged, or if it varies in the right direction, so as partly to compensate changes in investment, varies insufficiently (which is likely to be the case except perhaps when the community is, toward the end of a slump, very greatly impoverished indeed). That is to say, I shall concentrate on the variability of the rate of investment. For that is, in fact, the element in the economic situation which is capable of sudden and violent change. In the actual circumstances of the present hour that is the element which, according to common observation, has indeed suffered a sudden and violent change. And nothing, obviously, can restore employment which does not first restore business profits. Yet nothing, in my judgment, can restore business profits which does not first restore the volume of investment, that is to say (in other words), the volume of orders for new capital goods. (For the only theoretical alternative would be a large increase of expenditures by the public at the expense of their savings, an extravagance campaign, which at a time when everyone is nervous and uncertain and sees the value of his stocks and shares depreciating is most unlikely to occur, whether it is desirable or not.)

In the past it has been usual to believe that there was some preordained harmony by which saving and investment were necessarily equal. If we intrusted our savings to a bank, it used to be said, the bank will of course make use of them, and they will duly find their way into industry and investment. But unfortunately this is not so. I venture to say with certainty that it is not so. And it is out of the disequilibriums of savings and investment, and out of nothing else, that the fluctuations of profits, of output, and of employment are generated.

What sorts of circumstances are capable of occurring which would be of a tendency to bring the slump to an end?

It is important to notice that so long as output is declining, the effect of any decline of fixed investment is aggravated by disinvestment in working capital. Rut this continues only so long as output continues to decline. It ceases as soon as output ceases to decline further even though the level at which output is steady is a very low one. And as soon as output begins to recover, even though it still remains at a very low level, the tide is turned and the decline in fixed investment is partly offset by increased investment in working capital.

Now there is a reason for expecting an equilibrium point of decline to be reached. A given deficiency of investment causes a given decline of profit. A given decline of profit causes a given decline of output. Unless there is a constantly increasing deficiency of investment, there is eventually reached, therefore, a sufficiently low level of output which represents a kind of spurious equilibrium.

There is also another reason for expecting the decline to reach a stopping-point. For I must now qualify my simplifying assumption that only the rate of investment changes and that the rate of saving remains constant. At first, as I have said, the nervousness engendered by the slump may actually tend to increase saving. For saving is often effected as a guide against insecurity. Thus savings may decrease when stock markets are soaring and increase when they are slumping. Moreover, for the salaried and fixed-income class of the community the fall of prices will increase their margin available for saving. But as soon as output has declined heavily, strong forces will be brought into play in the direction of reducing the net volume of saving.

For one thing the unemployed will, in their effort not to allow too great a decline in their established standard of life, not only cease to save but will probably be responsible for much negative saving by living on their own previous savings and those of their friends and relations. Much more important, however, than this is likely to be the emergence of negative saving on the part of the government, whether by diminished payments to sinking funds or by actual borrowing, as is now the case in the United States. In Great Britain, for example, the dole to the unemployed, largely financed by borrowing, is now at the rate of $500,000,000 a year—equal to about a quarter of the country’s estimated rate of saving in good times.

In the United States the Treasury deficit to be financed by borrowing is put at $1,000,000,000. These expenditures are just as good in their immediate effects on the situation as would be an equal expenditure on capital works; the only difference—and an important one enough—is that in the former cases we have nothing to show for it afterwards.

Let me illustrate this by figures for the United States which are intended to be purely illustrative, though I have chosen them so as to be, perhaps, not too remote from the facts. Let us suppose that at the end of 1928 American investment was at the rate of $10,000,000,000 a year, while the national savings were $9,000,000,000. This meant, as my fundamental analysis shows, abnormal profits to American business at the rate of $1,000,000,000. Now let us suppose a decline in investment to $9,000,000,000. The exceptional profits are now obliterated. Next a further fall to$5,000,000,000. This means that the exceptional profits are not only obliterated, but that their place is taken by very large abnormal losses, namely, $4,000,000,000, so long as savings continue at $9,000,000,000. These developments naturally cause a steady decline in output, which aggravates the loss by bringing with it a disinvestment in working capital.

Let us suppose that the disinvestment in working capital is at the rate of $1,500,000,000 a year. As long as this is going on, the rate of net investment may fall as low as $3,500,000,000. This means (or would mean if other factors remained unchanged) business receipts (including agriculture, of course) of $5,500,000,000 below normal, and output will settle down to the level which just shows a margin over prime cost even when aggregate receipts are this much short of normal profits. But by this time the situation itself will have bred up some remedial factors. Let us suppose that a government deficit of $1,000,000,000 has developed and that saving by the public has fallen off by $1,000,000,000.

Moreover, as soon as output ceases to fall further, disinvestment in working capital will cease. Thus the falling-off in business receipts below normal will no longer be $5,500,000,000 but only $2,000,000,000 ($1,000,000,000 relief from government deficit, $1,000,000,000 from diminished saving, and $1,500,000,000 from the cessation of disinvestment in working capital). This means that output is below what is justified by the new level of business receipts. Consequently it rises again. This rise means reinvestment in working capital, and business receipts may, for a time and so long as this reinvestment is going on, recover almost to normal.

Nevertheless, if the nation’s savings stand at $9,000,000,000, granted a normal level of output and employment, then, so long as the rate of long-term interest in conjunction with other factors is too high to allow of more than $5,000,000,000 expenditure on fixed investment, a recovery staged along the foregoing lines is bound to be an illusion and a disappointment. For after it has proceeded a certain length, there is bound to be reaction and a renewed slump. Indeed, the figures accurately appropriate to the illustration may be such that the extent of the recovery will be comparatively slight.

There can, therefore, I argue, be no secure basis for a return to an equilibrium of prosperity except a recovery of fixed investment to a level commensurate with that of the national savings in prosperous times.


I. Whether or not my confidence is justified, I feel, then, no serious doubt or hesitation whatever as to the causes of the world-slump. I trace it wholly to the breakdown of investment throughout the world. After being held by a variety of factors at a fairly high level during most of the post-war period, the volume of this investment has during the past two and a half years suffered an enormous decline—a decline not fully compensated as yet by diminished savings or by government deficits.

The problem of recovery is, therefore, a problem of re-establishing the volume of investment. The solution of this problem has two sides to it: on the one hand, a fall in the l long-term rate of interest so as to bring a new range of propositions within the practical sphere; and, on the other hand, a return of confidence to the business world so as to incline them to borrow on the basis of normal expectations of the future. But the two aspects are by no means disconnected. For business confidence will not revive except with the experience of improving business profits. And, if I am right, business profits will not recovery except with an increase of investment. Nevertheless the mere reaction from the bottom and the feeling that it may be no longer prudent to wait for a further fall will be likely, perhaps in the near future, to bring about some modest recovery of confidence. We need, therefore, to work meanwhile for a drastic fall in the long-term rate of interest so that full advantage may be taken of any recovery of confidence.

The problem of recovery is also, in my judgment, indissolubly bound up with the restoration of prices to a higher level, although if my theory is correct this is merely another aspect of the same phenomenon. The same events which lead to a recovery in the volume of investment will inevitably tend at the same time toward a revival of the price level. But inasmuch as the raising of prices is an essential ingredient in my policy I had better pause perhaps to offer some justification of this before I proceed
to consider the ways and means by which the volume of investment and at the same time the level of prices can be raised.

Unfortunately there is not complete unanimity among the economic doctors as to the desirability of raising the general price level at this phase of the cycle. Dr. Sprague, for example, in an address made recently in London which attracted much attention, declared it to be preferable that:

manufactured costs and prices should come down to equilibrium level with agricultural prices rather than that we should try to get agricultural prices up to an equilibrium level with the higher prices of manufactured goods.

For my own part, however, I dissent very strongly from this view and I should like, if I could, to provoke vehement controversy—a real discussion of the problem—in the hope’ that out of the clash of minds something useful might emerge. Until we have definitely decided whether or not we should wish prices to rise we are drifting without clear intentions in a rudderless vessel.

Do we, then, want prices to rise back to a parity with what, a few months ago, we considered to be the established levels of our salaries, wages, andincome generally? Or do we want to reduce our incomes to a parity with the existing level of the wholesale prices of raw commodities? Please notice that I emphasize the word “want,” for we shall confuse the argument unless we keep distinct what we want from what we think we can get. My own conclusion is that there are certain fundamental reasons of overwhelming force, quite distinct from the technical considerations tending in the same direction, which I have already indicated and to which I shall return later, for wishing prices to rise.

The first reason is on grounds of social stability and concord. Will not the social resistance to a drastic downward readjustment of salaries and wages be an ugly and a dangerous thing? I am told sometimes that these changes present comparatively little difficulty in a country such as the United States where economic rigidity has not yet set in. I find it difficult to believe this. But it is for you, not me, to say. I know that in my own country a really large cut of many wages, a cut at all of the same order of magnitude as the fall in wholesale prices, is simply an impossibility. To attempt it would be to shake the social order to its foundation. There is scarcely one responsible person in Great Britain prepared to recommend it openly. And if, for the world as a whole, such a thing could be accomplished, we should be no farther forward than if we had sought a return to equilibrium by the path of raising prices. If, under the pressure of compelling reason, we are to launch all our efforts on a crusade of unpopular public duty, let it be for larger results than this.

I have said that we should be no farther forward. But in fact even when we had accomplished the reduction of salaries and wages, we should be far worse off, for the second reason for wishing prices to rise is on grounds of social justice and expediency which have regard to the burden of indebtedness fixed in terms of money. If we reach a new equilibrium by lowering the level of salaries and wages, we increase proportionately the burden of monetary indebtedness. In doing this we should be striking at the sanctity of contract. For the burden of monetary indebtedness in the world is already so heavy that any material addition would render it intolerable. This burden takes different forms in different countries. In my own country it is the national debt raised for the purposes of the war which bulks largest. In Germany it is the weight of reparation payments fixed in terms of money. For creditor and debtor countries there is the risk of rendering the charges on the debtor countries so insupportable that they abandon a hopeless task and walk the pathway of general default. In the United States the main problem would be, I suppose, the mortgages of the farmer and loans on real estate generally. There is, in fact what, in an instructive essay, Professor Alvin Johnson has called the “farmers’ indemnity.” The notion that you solve the farmers’ problem by bringing down manufacturing costs so that their own produce will exchange for the same quantity of manufactured goods as formerly is to mistake the situation altogether, for you would at the same time have increased the farmers’ burden of mortgages which was already too high. Or take another case—loans against buildings. If the cost of new building were to fall to a parity with the price of raw materials, what would become of the security for existing loans?

Thus national debts, war debts, obligations between the creditor and debtor nations, farm mortgages, real estate mortgages—all this financial structure would be deranged by the adoption of Dr. Sprague’s proposal. A widespread bankruptcy, default, and repudiation of bonds would necessarily ensue. Banks would be in jeopardy. I need not continue the catalogue. And what would be the advantage of having caused so much ruin? I do not know. Dr. Sprague did not tell us that.

Moreover, over and above these compelling reasons there is also the technical reason, the validity of which is not so generally recognized, which I have endeavored to elucidate in my previous lecture. If our object is to remedy unemployment it is obvious that we must first of all make business more profitable. In other words, the problem is to cause business receipts to rise relatively to business costs. But I have already endeavored to show that the same train of events which will lead to this desired result is also part and parcel of the causation of higher prices, and that any Policy which at this stage of the credit cycle is not directed to raising prices also fails in the object of improving business profits.

The cumulative argument for wishing prices to rise appears to me, therefore, to be overwhelming, as I hope it does to you. Fortunately many if not most people agree with this view. You may feel that I have been wasting time in emphasizing it. But I do not think that I have been wasting time, for while most people probably accept this view, I doubt if they feel it with sufficient intensity. I wish to take precautions beforehand against anyone asking—when I come to the second and constructive part of my argument—whether, after all, it is so essential that prices should rise. Is it not better that liquidation should take its course? Should we not be, then, all the healthier for liquidation, which is their polite phrase for general bankruptcy, when it is complete?

II. Let us now return to our main theme. The cure of unemployment involves improving business profits. The improvement of business profits can come about only by an improvement in new investment relative to saving. An increase of investment relative to saving must also, as an inevitable by-product, bring about a rise of prices, thus ameliorating the burdens arising out of monetary indebtedness. The problem resolves itself, therefore, into the question as to what means we can adopt to increase the volume of investment, which you will remember means in my terminology the expenditure of money on the output of new capital goods of whatever kind.

When I have said this, I have, strictly speaking, said all that an economist as such is entitled to say. What remains is essentially a technical banking problem. The practical means by which investment can be increased is, or ought to be, the bankers’ business, and pre-eminently the business of the central banker. But you will not consider that I have completed my task unless I give some indication of the methods which are open to the banker.

There are, in short, three lines of approach:

The first line of approach is the restoration of confidence both to the lender and to the borrower. The lender must have sufficient confidence in the credit and solvency of the borrower so as not to wish to charge him a crushing addition to the pure interest charge in order to cover risk. The borrower, on the other hand, must have sufficient confidence in the business prospects to believe that he has a reasonable prospect of earning sufficient return from a new investment proposition to recover with a margin the interest which he has to bind himself to pay to the lender. Failing the restoration of confidence, we may easily have a vicious circle set up in which the rate of interest which the lender requires to cover what he considers the risks of the situation represents a higher rate than the borrower believes he can earn.

Nevertheless, there is perhaps not a great deal that can be done deliberately to restore confidence. The turning-point may come in part from some chance and unpredictable event. But it is capable, of course, of being greatly affected by favorable international developments, as for example, an alleviation of the war debts such as Mr. Hoover has lately proposed; though if he goes no farther than he has promised to go at present, the shock to confidence, long before his year of grace is out, may come perhaps just at the moment when it will interfere most with an incipient revival. In the main, however, restoration of confidence must be based, not on the vague expectations or hopes of the business world, but on a real improvement in fundamentals; in other words, on a breaking of the vicious circle. Thus if results can be achieved along the two remaining lines of approach which I have yet to mention, these favorable effects may be magnified bv their reaction on the state of confidence.

The second line of approach consists in new construction programs under the direct auspices of the government or other public authorities. Theoretically, it seems to me, there is everything to be said for action along these lines. For the government can borrow cheaply and need not be deterred by overnice calculations as to the prospective return. I have been a strong advocate of such measures in Great Britain, and I believe that they can play an extremely valuable part in breaking the vicious circle everywhere. For a government program is calculated to improve the level of business profits and hence to increase the likelihood of private enterprise again lifting up its head. The difficulty about government programs seems to me to be essentially a practical one. It is not easy to devise at short notice schemes which are wisely and efficiently conceived and which can be put rapidly into operation on a really large scale. Thus I applaud the idea and only hesitate to depend too much in practice on this method alone unaided by others. I am not sure that as time goes by we may not have to attempt to organize methods of direct government action along these lines more deliberately than hitherto, and that such action may play an increasingly important part in the economic life of the community.

The third line of approach consists in a reduction in the long-term rate of interest. It may be that when confidence is at its lowest ebb the rate of interest plays a comparatively small part. It may also be true that, in so far as manufacturing plants are concerned, the rate of interest is never the dominating factor. But, after all, the main volume of investment always takes the forms of housing, of public utilities and of transportation. Within these spheres the rate of interest plays, I am convinced, a predominant part. 1 am ready to believe that a small change in the rate of interest may not be sufficient. That, indeed, is why I am pessimistic as to an early return to normal prosperity. I am ready enough to admit that it may be extremely difficult both to restore confidence adequately and to reduce interest rates adequately. There will be no need to be surprised, therefore, if a long time elapses before we have a recovery all the way back to normal.

Nevertheless, a sufficient change in the rate of interest must surely bring within the horizon all kinds of projects which are out of the question at the present rate of interest. Let me quote an example from my own country. No one believes that it will pay to electrify the railway system of Great Britain on the basis of borrowing at 5 per cent. At 4 1/2 per cent the enthusiasts believe that it will be worth while; at 4 per cent everyone agrees it is an open question; at 3 per cent it is impossible to dispute that it will be worth while. So it must be with endless other technical projects. Every fall in the rate of interest will bring a new range of projects within a practical sphere. Moreover, if it be true—as it probably is—that the demand for house room is elastic, every significant fall in the rate of interest, by reducing the rent which has to be charged, brings with it an additional demand for house room.

As I look at it, indeed, the task of adjusting the long-term rate of interest to the technical possibilities of our age so that the demand for new capital is as nearly as possible equal to the community’s current volume of savings must be the prime object of financial statesmanship. It may not be easy and a large change may be needed, but there is no other way out.

Finally, how is the banking system to affect the long-term rate of interest? For prima facie the banking system is concerned with the short-term rate of interest rather than with the long.

In course of time I see no insuperable difficultv. There is a normal relation between the short-term rate of interest and the long-term, and in the long run the banking system can affect the long-term rate by obstinately adhering to the correct policy in regard to the short-term rate. But there may also be devices for hastening the effect of the short-term rate on the long-term rate. A reduction of the long-term rate of interest amounts to the same thing as raising the price of bonds. The price of bonds amounts to the same thing as the price of non-liquid assets in terms of liquid assets. I suggest to you that there are three ways in which it is reasonable to hope to exercise an influence in this direction.

The first method is to increase the quantity of liquid assets—in other words, to increase the basis of credit by means of open-market operations, as they are usually called, on the part of the central bank. I know that this involves technical questions of some difficulty with which I must not burden this lecture. I should, however, rely confidently in due course on influencing the price of bonds by steadily supplying the market with a greater quantity of liquid assets than the market felt itself to require so that there would be a constant pressure to transform liquid assets into the more profitable non-liquid assets.

The second course is to diminish the attractions of liquid assets by lowering the rate of deposit interest. In such circumstances as the present it seems to me that the rate of interest allowed on liquid assets should be reduced as nearly as possible to the vanishing-point.

The third method is to increase the attractions of non-liquid assets, which, however, brings us back again in effect to our first remedy, namely, methods of increasing confidence.

For my own part, I should have thought it desirable to advance along all three fronts simultaneously. But the central idea that I wish to leave with you is the vital necessity for a society living in the phase in which we are living today, to bring down the long-term rate of interest at a pace appropriate to the underlying facts. As houses and equipment of every kind increase in quantity we ought to be growing richer on the principle of compound interest. As technological changes make possible a given output of goods of every description with a diminishing quantity of human effort, again we ought to be forever increasing our level of economic well-being. But the worst of these developments is that they bring us to what may be called the dilemma of a rich country, namely, that they make it more and more difficult to find an outlet for our savings. Thus we need to pay constant conscious attention to the long-term rate of interest for fear that our vast resources may be running to waste through a failure to direct our savings into constructive uses and that this running to waste may interfere with that beneficent operation of compound interest which should, if everything was proceeding smoothly in a well-governed society, lead us within a few generations to the complete abolition of oppressive economic want.

Must-read: John Maynard Keynes (1923): “A Tract on Monetary Reform”

Must-Read: John Maynard Keynes (1923): A Tract on Monetary Reform: “One is often warned that a scientific treatment of currency questions…

…is possible because the banking world is intellectually incapable of understanding its own problems…. I do not believe it…. If the new ideas… are sound and right, I do not doubt that sooner or later they will prevail. I dedicate this book, humbly and without permission, to the Governors and Court of the Bank of England, who now and for there future has a much more difficult and anxious task entrusted to them than in former days…


It is not safe or fair to combine the social organization developed during the nineteenth century (and still retained) with a laisser-faire policy towards the value of money…. we must make it a prime object of deliberate State policy that the standard of value… be kept stale… adjusting in other ways the redistribution of the national wealth if… inheritance and… accumulation have drained too great a proportion… into the spending control of the inactive….

We see… rising prices and falling prices each have their characteristic disadvantage…. Inflation… means Injustice to individuals… particularly to investors: and is therefore unfavorable to saving [and investment in capital]…. Deflation… is… disastrous to employment…. Inflation is unjust and Deflation is inexpedient. Of the two perhaps Deflation is, if we rule out exaggerated inflations such as that of Germany, the worse; because it is worse, in an impoverished world, to provoke unemployment than to disappoint the rentier.

But it is not necessary that we should weigh one evil against the other. It is easier to agree that both are evils to be shunned. The Individualistic Capitalism of to-day, precisely because it entrusts saving to the individual investor and production to the individual employer, presumes a stable measuring-rod of value, and cannot be efficient–perhaps cannot survive–without one.

?For these grave causes we must free ourselves from the deep distrust which exists against allowing the regulation of the standard of value to be the subject of deliberate decision

The economist as…?: The public square and economists

My paper for the Notre Dame conference on “public intellectualism” is finally making its way through the publication process…

I. The Salience Today of the Economic

Sit down some evening and watch the news on the TV, or scan the magazine covers in the supermarket, or simply immerse yourself in modern America…


A. Elements of Public-Square Gossip

If you are like me, you will be struck by the extent to which our collective public conversation focuses on seven topic areas:

  1. The personal doings of the beautiful, the powerful, and the rich – and how to become more like them.
  2. The weather.
  3. Local threats and dangers, especially to children.
  4. Amusements – usually gossip about the past or about our imaginary friends, frenemies, etc. (it is amazing how many people I know who have strong opinions about Daenerys Stormborn of House Targaryen1 – many more than have any opinions at all about her creator George R.R. Martin, author of the Song of Ice and Fire novels on which “Game of Thrones”2 is based).
  5. How to best procure necessities and conveniences.
  6. Large scale dangers (and, rarely, opportunities): plagues, wars and rumors of wars, the fall and rise of dynasties, etc.
  7. “The economy”: unemployment, spending, inflation, construction, stock market values, and bond market interest rates.

Now out of these seven topic areas, the first six are found not just in our but in other societies as far back as we have records. They are common in human history as far back as we have been writing things down, or singing long story-songs to one another around the campfire.

What, after all, is the story of Akhilleus, Hektor, and Agamemnon in Homer’s Iliad but a combination of (1), (4), and (6)?3

In April 2014, by a strange chance, the internet led me to a passage from the lost Biographies of third-century B.C.E. philosopher Hermippos of Smyrna. The passage was about a fourth-century B.C.E. Athenian, Phryne, who may or may not have been a model for the sculptor Praxiteles of Athens’s lost Aphrodite Knidia and the painter Apelles of Kos’s lost Aphrodite Anadyomene. Hermippos of Smyrna wrote of “the dazzling Phryne, who:

at the great festival of the Eleusina and that of the Posidonia in full sight of a crowd that had gathered from all over Greece, she removed her cloak and let loose her hair before stepping into the sea.

This provided the Athenians and the tourists with a rare opportunity to see her nude. Otherwise you had to be satisfied with art: “it was from her that Apelles painted his likeness of Aphrodite coming out of the sea.”4

That made me think: was the occupation “philosopher” in the third-century B.C.E. some weird mixture of what we would call a “philosopher” and what we would call a “writer for People magazine”? It appears so. Surely Hermippos of Smyrna’s agent would have welcomed a booking on “Oprah”.5

Six of these seven topics of public-square conversation are recognizably common across societies and across history. But we have a seventh. It is somewhat different. And it is what I want to focus on: that our collective public-sphere concern about the economy is unusual in historical perspective. Past society’s public squares have dealt with issues we would call economic: the local price of food is always of general interest as is the supply and demand of traded goods of interest to merchants. The wealth or lack thereof of individuals and cities of interest is always of interest to money-lenders.


B. The Rise of the Economy

But the economy?

There really wasn’t such a thing before 1700. We only begin to even see the word in the eighteenth century, as the phrase “home economics” – teaching how to cook, how to sew, how to clean, and how to budget – finds its first word replaced by “political”.6 Then “political economy” becomes a study of how the government managers should do for the state the things that a household manager does for a household. And then, in the late nineteenth and early twentieth century, the “political” gets dropped, and the “-y” gets replaced by an “-ics”. Why? As part of a movement to make the subject less, well, political – less partisan. It was a semi-deliberate move by those who were political economists and seek to become economists to claim a mantle for their discipline as more than an objective branch of knowledge that can at least aspire to the prestige of a true natural science and the respect given to its advice possessed by a technocratic what-works discipline like engineering.

So why does “the economy” and its study – “economics” – become a concept that needs a label in the eighteenth century? Why do we today watch it on the TV and read about it in the newspaper instead of learning more normal things – like Phryne’s fashion secrets, or Odysseus’s most-tricky battle strategems, or Akhilleus’s favorite strength-building recipes?

I believe that there is a simple answer. When we look into the deep past, the evidence – especially the skeletal evidence that finds adult humans around the year 1 little more than five feet tall7 – strongly suggests that, save for a small upper class, and save for lucky generations born into times of temporary land abundance (from technological changes like the invention of the wet-rice paddy or the horse collar, or from previous plague) the bulk of human populations saw very little economic change. Most people lived for the most part close to subsistence in the years between the invention of agriculture and 1500 or so. We can guess at what their material standard of living was like, and we can guess that their income level would strike us in today’s dollars as something less than $1000 per person per year.8 We do see substantial population growth: we guess that there were about 5 million humans in 8000 B.C.E., and 500 million in 1500, for we had much better agricultural and herding “technology” in 1500 than we did in 8000 B.C.E. But all or nearly all of better technologies between 8000 B.C.E. and 1500 showed up in Malthusian fashion as increasing population rather than increasing living standards.9 Crunch these guesstimates, and find a worldwide economic growth rate of 0.05%/year. That is not five percent per year – that is five percent every hundred years.

Thus what might have been called “the economy” was pretty much an unchanging backdrop back before 1500 from the standpoint of any individual year, or, indeed, from the standpoint of any individual’s lifetime – plagues, war and rumors of war, and their economic consequences aside. Substantial transformations of what might have been called the economic would have been visible only if one stepped back and looked across multiple centuries at what Fernand Braudel called the Longue Durée10 – the analytical perspective from which the long and gradual four-century long spread of the Merino-breed sheep across Mediterranean and then northwest Europe truly was a really big deal. Thus in any previous era the idea that one should pay attention to somebody called “an economist” – that there would even be a subject called economics that could be thought of as significant – would have been a strange one indeed.


C. The Centrality Today of the Economic

Compare that to the years since 1900 in which worldwide average real GDP growth was 3.5% per year. Compare that to the years from 1990-2007: worldwide average real GDP growth of 4.5%/year.11 And compare that to what happened in 2008-9: an eight-percent fall in total economic production in the United States and a six percent fall in employment driven purely by the monetary-financial derangement of our economy as a system, and not by any change in our knowledge or our technological capabilities or in the rest of the natural world.12

The fact is that we today see roughly 100 times as much economic growth and change in any given period – for good and for ill – than our pre-1500 ancestors did. Today economic change is a very big deal that determines what kind of job you will have, and if you will have a job, and how you will live ten or twenty years from now – if not tomorrow. Is it any wonder, given this ramping up of the pace of change, that the economy is salient today? Ours is an era in which, in our consciousness, issues like the filioque clause and the vicissitudes of the Bush or Habsburg dynasties appear to us to be in relative terms less salient, and the economy much more so. In such an age it is natural that the public square has a desire to listen to economists – for they claim to have knowledge about what is an important, newsworthy, and changing aspect of our civilization. And it is natural that economists will seek to speak today in the public square as public intellectuals.

II. Analyzing Emergent Properties of Systems of Decentralized Exchange

So what do economists have to say when they speak as public intellectuals in the public square? As I see it, economists have six things to teach:

  1. the deep roots of markets in human psychology and society,
  2. the extraordinary power of markets as decentralized mechanisms for getting large groups of humans to work broadly together rather than at cross-purposes,
  3. the ways in which markets can powerfully reinforce and amplify the harm done by domination and oppression,
  4. the manifold other ways in which the market can go wrong because it is somewhat paradoxically so effective, and
  5. how the market needs the state to underpin and manage it on the “micro” level.


A. The Five “Micro” Things Economists Have to Say

At the level of the “micro” – of how individuals act, and of their well-being as they try to make their way in the world – economists really have five things to say when they enter the public square as public intellectuals:

First, the Deep Roots of Markets: Probably most importantly, at some deep level human sociability is built on gift-exchange – I give you this, you give me that, and rough balance is achieved, but in some sense we both still owe each other and still are under some kind of mutual obligation to do things to further repay each other. Wherever we look in human societies across space or across time we find such overlapping networks of gift-exchange and resulting reciprocal obligation to be an important share of the social glue that holds us humans together.13 On top of this deep gift-exchange sociability, we economists say, we humans have built an economic system of decentralized market exchange. Today a great many of our gift-exchange relationships are not long-term relationships over time with people we come to know well, but rather one-shot exchanges with people we do not necessarily expect to ever see again. These exchanges are mediated by tokens called “money” that are acceptable to each of us as payment or repayment because they are acceptable to all of us. And this great enhancement of our potential network of those with whom we can exchange is what allows us to have a wide and productive rather than a cramped and penurious social distribution of labor.

This part of what economists have to say has been very clear since Adam Smith in 1776 published the first edition of his Inquiry into the Nature and Causes of the Wealth of Nations.14 Because humans have a “natural propensity to truck, barter, and exchange,” we can build markets of wide extent. Because “the division of labor depends on the extent of the market,” our extensive markets allow a detailed and sophisticated division of labor. And Adam Smith saw the detailed and sophisticated division of labor of eighteenth-century Britain as the principal cause of its relative productivity and prosperity. It is, perhaps, the most important thing that economists have to say as public intellectuals in the public square.

Second, the Extraordinary Power of Markets: Perhaps next in importance, organizing a great deal of our societal distribution of labor around market exchange mediated by tokens called “money” is more than something that works with the grain of the crooked timber of humanity. It is also something that turns out to be extraordinarily powerful and effective. The market system works amazingly, remarkably well as a decentralized societal calculating mechanism for determining what is to be collectively produced, how it is to be produced, and for whom it is to be produced. Take market exchange, add private property in things, and the proviso that people can get together and form smaller hierarchical or cooperative forms of economic organization within the matrix of the market economy when they think best, add the proviso that there is a government to enforce its conventions about property rights and contract obligations, and you find that you have a system that as a whole has marvelous advantages.

First of all, it happens that the great bulk of commodities in this world are what economists call rival in use – if I am making use of it, you cannot be. Thus one person’s enjoyment and use of a particular item reduces the available options of others. It thus makes sense for a rational and efficient social system to make a person who decides to feel the effect of their actions on the opportunities and choices of others. It turns out that if you (a) assign exclusive property rights to use to someone, and (b) require a person to pay a market price for the privilege of transferring those rights, then you have (c) a marvelously effective way of making each feel the effect of their decisions on the well-being of all. This is quite a coincidence. Nineteenth-century economist Richard Whately – the only person ever to have been in rapid succession Professor of Political Economy at Oxford and Archbishop of Dublin – detected the hand of Providence in this truly divine coincidence.15

Second of all, it just turns out to be the great bulk of decisions about what is the best economic use of resources in the world are best made at the local level, by individuals who actually know what is going on. It is not good to make them in some centralized Kremlin or GOSPLAN office.16 And, again by coincidence, it turns out that exclusive and transferable private property is a good way of making decisions take place where the information is at the periphery, rather than at the center where the information is not. And, as Ronald Coase pointed out, one of the geniuses of our market system is that it allows for islands of centralized hierarchy wherever and whenever people decide that there is stuff to be gained by centralized hierarchical planning and coordination, or by some other mode of coordination and collective decision-making other than decentralized market exchange.

That extraordinary power of markets that just happens to fit our world of largely rival commodities in which decision-making is largely better decentralized is, perhaps, the second most important thing that economists have to say as public intellectuals in the public square – along with noting that what has been true in the agrarian age in which Adam Smith lived that ended with the eighteenth century and in the industrial age of the nineteenth and twentieth centuries may not be true in whatever kind of age the twenty-first century turns out to be.

Third, Market Systems Reinforce and Amplify the Harms of Domination: Next, however, comes the serpent in the garden: that market systems can and do amplify the harm done by power imbalances: slavery in the context of the American South’s cotton plantations was a much worse thing than slavery in the context of West African households precisely because the first were embedded in a market economy and so there was a great deal of money to be made by whipping slaves to work until they dropped. Market systems are at the bottom very good ways of getting people to respond to incentives. Power imbalances create situations in which we would rather that people not have more reason to use their power.

Such power imbalances can cause enormous misery in the context of a market economy even in the absence of incentives to behave with affirmative cruelty, for power imbalances turn into wealth imbalances, and a market economy’s underlying calculus is a calculus of doing what wealth wants rather than what people need. Wealth imbalances alone produce a situation in which we do not like the pattern of incentives that the market system provides to individuals, and in which market systems go horribly, dreadfully, diabolically wrong.

Consider the Bengal famine of of the middle of the last century.17 In Bengal, in 1942, because of the interruption of world trade, those whose sole wealth was their labor in the jute plantations found their wealth valued at zero – nobody wanted to hire rural workers then because nobody thought it worthwhile to grow jute that would then have to be shipped out through the Indian Ocean as long as there was a chance that the aircraft carriers of Japanese Admiral Nagumo’s Kido Butai might be prowling the ocean. Moreover, the large logistical demands of supporting the armies of the United Nations in Burma pushed up urban food prices, and rural food prices as well. Without wages to earn, the ex-jute workers of Bengal had no wealth and no money to pay. With no money to pay, the market provided those in other parts of India who had food with no incentive to move the food to Bengal and sell it to the ex-jute workers. Two million people died, even though there was ample food in India for the population as a whole.

And the British state that ruled India, and was responsible for checking to see whether the incentives the market system was providing really were the incentives that people were responding to. Prime Minister Winston Churchill sent a telegram, asking: if it were really true that there was famine in India, why was Mohandas Gandhi still alive?18

Such behavior by the British Empire was not exceptional. My Gallagher ancestors knew well the earlier failure of the British state to take appropriate action to rebalance the distribution of wealth and prevent mass starvation in 1846-8, similarly in the midst of ample food nearby and plenty of resources to transport it.

Fourth, Other Ways in Which the Market Can Go Wrong: Moreover, even when the distribution of wealth is right, modes of “market failure” are many. The market system can and does wrong and provide the wrong incentives for behavior in myriad ways. The brilliant Ronald Coase of the University of Chicago – who remained productively at work as an economist a decade into the twenty-first century, even though his age had reached three figures – was interpreted to have argued that pretty much any arrangement of property rights will do about as well as any other and the government should simply step back.19 The canonical case adduced was the locomotive that occasionally throws off sparks that burn the nearby farmer’s crops. If the railroad has a duty of care not to burn the crops, Coase said, the railroad will attach spark-catchers if it is cheap and makes sense to do so – and the railroad will pay damages and settle in order to avoid being hauled into court on a tort claim if it is expensive and doesn’t make sense to do so. If the railroad has no duty of care, Coase said, then the farmer will offer to pay the railroad to install spark-catchers – and spark-catchers will be installed if the potential damage to the crops is greater than the cost of the spark-catcher and it makes sense to do so, and spark-catchers will not be installed if the damage to the crops is less than the cost.

Thus the same decisions will be made whatever the property rights – as long as there are settled property rights. If there are not settled property rights, then the crops burn and lawyers grow fat. But as long as there are property rights, the market will work fine. Maybe the widows and orphans who own railroad shares will be wealthier under one setup and maybe the farmers will be wealthier under the other, but that is rarely a matter of great public concern.

Now this argument has always seemed to me to be wrong. If there is no duty of care on the part of the railroad, it has an incentive not just to threaten not to install a spark-catcher, but to design and build the most spark-throwing engine imaginable – to make sure that the firebox is also a veritable flamethrower – and then to demand that the farmer bribe it not to set the fields on fire. What economists call “externalities” are rife, and call for the government to levy taxes and pay bounties over wide shares of the economy in order to make the incentives offered by the tax-and-bounty-augmented market the incentives that it is good for society that decision-making individuals have. Cutting property rights “at the joints” to reduce externalities is important. But it will never be efficient: what economists call Pigovian taxes and bounties make up a major and essential part of the business of government.

Fifth, the Market Needs the State: Last, the market needs the state. For the market system to work well and produce a good outcome, outcomes need to be dictated not by inequalities of wealth or power but by genuine win-win exchanges. This means that the government has to set out and maintain its laws of property and contract, so that what is yours stays yours and what is promised is delivered at good weight. In the absence of a properly-regulating government, what is yours is not yours, what is promised will not be delivered, and weight will not be good: instead, either roving bandits, local notables with bully boys functioning as barely-better stationary bandits, or the government’s own functionaries abusing its powers will decide that what was yours is now theirs. And having a government powerful enough to set out and enforce laws of property and contract that does not then turn around and become the largest and most destructive stationary bandit of all is perhaps the most difficult of all problems of political economy, for a government is, as the philosopher Ibn Khaldun wrote,20 at its foundation an organization that prevents all injustices save for those it commits itself.

Those five points and their application to the issues of today are what economists have to say about “micro” topics when they don the mantles of public intellectuals and speak in the public square. Moreover, it is economists’ task to speak about how much the technical details matter, and the technical details do matter – would you have thought ex ante that it would be important whether the property rights of the farmer were boosted by a requirement that anybody running machinery nearby have a duty of care? Economists are worth listening to – and hopefully paying – to the extent that they can combine their knowledge of the basic principles with sufficient institutional knowledge to understand just what small differences in regulatory institutions and organizations will mean for the distribution of wealth, and for the on-the-ground incentives provided to humans.

Economics in the public sphere is thus a difficult, important, and subtle discipline. It is concerned with what are the emergent properties of basing a great deal of the construction of our collective social division of labor on a decentralized system of money-mediated market exchange. Many of these emergent properties are not obvious and not well understood. And the devil is often in the details. That is why I looked forward in my twenties to making a comfortable living as an economist – as a speaker in the public square, as someone pushing forward we economists’ collective understanding of these emergent properties, and as someone teaching non-economists how to listen when we do speak in the public square. So far I have not been disappointed.


B. Macroeconomics in the Public Square

But: I lied back when I said that economists really have five things to say when they enter the public square. They actually have six:

(6) How the market needs the state to underpin and manage it on the “macro” level.

Sometimes the entire market system appears to go awry in some puzzling way. Sometimes when you go to the market, you find the money prices that you have to pay higher than you expected – perhaps 10% higher than you expected last year when you made your plans. It seems that, somehow, there is too much spending money chasing too few goods. How is it that this happens? And what should the government do to make sure that it does not happen?

Conversely, we can have the opposite problem – not a glut of money relative to goods, but what early-nineteenth century economists used to call a “general glut” of unsold commodities, idle factories and workshops, and idle workers all across the economy. Economists have important things to say about how to try to prevent these episodes and what to do when they happen to cure them.

And this sixth role of economists as public intellectuals in the public square is worth going into in more depth.

Back in the 1820s, the question of whether the circular flow of economic activity as mediated by the market system could break down and the economy become afflicted by a “general glut” of commodities was a live theoretical question. Everybody agreed that there could be particular gluts. Consider what happens should households decide that they want to spend less on electricity to power large-screen video- and audio- entertainment systems, and more on yoga lessons to seek inner peace. The immediate consequence – within the “market day,” as late-nineteenth century British economist Alfred Marshall would have put it21 – of this shift in preferences is excess demand for yoga instructors and excess supply of electric power. Prices of electricity (and of large-screen TVs, and of audio systems) fall as unsold inventories pile up in stores and as generators spin down and stand idle. Yoga instructors, by contrast, find themselves overscheduled, working ten-hour days, and stressed out – and find the prices they can charge for their lessons going through the roof. Workers in electric power distribution and in video and audio production and sales find that they must either accept lower wages or find themselves out on the street without jobs.

Over time the market system provides individuals with changing incentives that resolve the excess-supply excess-demand disequilibrium. Seeing the fortunes to be earned by teaching yoga, more young people learn to properly regulate their svadisthana chakra and teach others to do so. Seeing unemployment and stagnant wages in electrical engineering, fewer people major in Electrical Engineering/computer Sciences (EECS). The supply of yoga instructors grows. The supply of electrical engineers shrinks. Wages of yoga instructors fall back towards normal. Wages of electrical engineers rise. And balanced equilibrium is restored. Thus we understand how there can be a glut of a particular commodity – in this case, electric power. And we understand that it is matched by an excess demand for another commodity – in this case, yoga instructor services to properly align your svadisthana chakra.

But can there be a general glut, a glut of everything?

Some economists early in the nineteenth century said yes. Others said that the idea of a “general glut” was logically incoherent. Jean Baptiste Say, for example:

Letters to Mr. Malthus: I shall not attempt, Sir, to add… in pointing out the just and ingenious observations in your book; the undertaking would be too laborious…. [And] I should be sorry to annoy either you or the public with dull and unprofitable disputes. But, I regret to say, that I find in your doctrines some fundamental principles which… would occasion a retrograde movement in a science of which your extensive information and great talents are so well calculated to assist the progress….

What is the cause of the general glut of all the markets in the world, to which merchandize is incessantly carried to be sold at a loss?… Since the time of Adam Smith, political economists have agreed that we do not in reality buy the objects we consume, with the money or circulating coin which we pay for them. We must in the first place have bought this money itself by the sale of productions of our own. To the proprietor of the mines whence this money is obtained, it is a production with which he purchases such commodities as he may have occasion for…. From these premises I had drawn a conclusion… “that if certain goods remain unsold, it is because other goods are not produced; and that it is production alone which opens markets to produce.”…

[W]henever there is a glut, a superabundance, [an excess supply] of several sorts of merchandize, it is because other articles [in excess demand] are not produced in sufficient quantities… if those who produce the latter could provide more… the former would then find the vent which they required…22

Yet Say changed his mind. By 1829, in his analysis of the British financial panic and recession of 1825-6, Jean-Baptiste Say was writing that there could indeed be such a thing as a general glut of commodities after all: “every type of merchandise had sunk below its costs of production, a multitude of workers were without work. Many bankruptcies were declared…” The general glut, Say wrote in 1829, had been triggered by a panicked financial flight to quality in financial markets. What was going on? The answer was nailed by John Stuart Mill:

Those who have… affirmed that there was an excess of all commodities, never pretended that money was one of these commodities…. What it amounted to was, that persons in general, at that particular time, from a general expectation of being called upon to meet sudden demands, liked better to possess money than any other commodity. Money, consequently, was in request, and all other commodities were in comparative disrepute….

The result is, that all commodities fall in price, or become unsaleable…. [A]s there may be a temporary excess of any one article considered separately, so may there of commodities generally, not in consequence of over-production, but of a want of commercial confidence…23

Note that these financial-market excess demands can have any of a wide variety of causes: episodes of irrational panic, the restoration of realistic expectations after a period of irrational exuberance, bad news about future profits and technology, bad news about the solvency of government or of private corporations, bad government policy that inappropriately shrinks asset stocks, et cetera.

When the government does not create “enough” money and safe savings vehicles you have an excess demand for them, an excess supply of everything else, and high unemployment and idle factories.

It seems as if there is always or almost always something that the government can do to affect asset supplies and demands that promises a welfare improvement over, say, waiting for prolonged nominal deflation to raise the real stock of liquid money, of bonds, or of high-quality AAA assets. Monetary policy open market operations swap AAA bonds for money. Quantitative easing that raises expected inflation diminishes demand for money and for AAA assets by taxing them. Non-standard monetary policy interventions swap risky bonds for AAA bonds or money. Fiscal policy affects both demand for goods and labor and the supply of AAA assets – as long as fiscal policy does not crack the status of government debt as AAA and diminish rather than increasing the supply of AAA assets. Government guarantees transform risky bonds into AAA assets. Et cetera.

And the government’s proper task is made much more difficult by the fact that what is “enough” jumps around as the set of savers and investors do their behavioral-economics thing: the Kindlebergian cycles of displacement, profit, transformation, boom, speculation, enthusiasm, mania, crisis, panic, revulsion, and discredit.24

When the government creates “too much” money and safe savings vehicles, you have an excess supply of them and an excess demand for everything else–which means inflation. And what if there is a glut not of commodities but inflation? Simply apply the same policy tools in reverse.

Right now our economy is going badly wrong in this “macro” dimension, with a prime-age 25-54 adult employment-to-population ratio of barely 78% even as late as the spring of 2016, when in a healthy and well-functioning macroeconomy that number should north of 80%.25 The only excuse my friends in the Obama administration offer is that Europe is doing much worse.26

That is the last of the six things economists have to say in the public square: that the economy does not consistently balance itself at high employment with stable prices. The principle that it does economists have called Say’s Law – even though Say himself had abandoned it by 1829.27 And it is important for economists to say, loudly, that Say’s Law is not true in theory, and it takes delicate and proper technocratic management to make it work in practice.

So economists’ τεχνε (“art, skill, qualities of craftsmanship”) does have many powerful lessons for the public square. They are: (i) a bias toward freedom, choice, decentralization, and individual responsibility; (ii) knowledge that systems of decentralized market exchange have important emergent properties that depend on close knowledge of and careful reasoning from institutional details; (iii) a recognition that markets can amplify oppression as well as opportunity; (iv) a fear that getting those institutional details wrong produces horrible outcomes; (v) a recognition of the importance of government to get details right; and (vi) to act as a balance wheel when the set of savers and investors do their behavioral-economics thing.

III. Economics as a Vocation

That is how we economists try to sell ourselves, and also how we see ourselves. We as a species have made a choice to organize our very large – now seven-billion human wide – social division of labor largely through decentralized arms-length market exchange. Such a system has powerful advantages. Such a system also has lots of emergent properties, good and bad, that are non-obvious consequences of institutional and regulatory details. Economists are here to tell you what’s what, and how to do it.


A. John Maynard Keynes

The aim is, as John Maynard Keynes said at the start of the 1930s at the end of his talk about “Economic Possibilities for Our Grandchildren,” to be a profession that performs a very useful but not overwhelmingly important role in understanding the economy and how to treat it in a way analogous to the way that dentists perform a useful but not overwhelmingly important role in understanding teeth and how to treat them. People should not:

overestimate the importance of the economic problem, or sacrifice to its supposed necessities other matters of greater and more permanent significance. It should be a matter for specialists – like dentistry. If economists could manage to get themselves thought of as humble, competent people, on a level with dentists, that would be splendid28

Yet was there ever a dentist who attempted to reshape, in the interest of dental hygiene, not just a single human mouth but rather the shape of human destiny in the way that Keynes in the interest of economic hygiene tried to do pretty much every day? Here is Keynes reviewing Leon Trotsky’s Where Is Britain Going:

A CONTEMPORARY reviewing this book says: “He stammers out platitudes in the voice of a phonograph with a scratched record.”… In its English dress it emerges in a turbid stream with a hectoring gurgle which is characteristic of modern revolutionary literature translated from the Russian. Its dogmatic tone about our affairs, where even the author’s flashes of insight are clouded by his inevitable ignorance of what he is talking about, cannot commend it to an English reader…. The book is, first of all, an attack on the official leaders of the British Labour Party because of their “religiosity”, and because they believe that it is useful to prepare for Socialism without preparing for Revolution…. “Together with theological literature, Fabianism is perhaps the most useless, and in any case the most boring form of verbal creation…. “ [T]hat is how the gentlemen who so much alarm Mr. Winston Churchill strike the real article….If only it was so easy! If only one could accomplish by roaring, whether roaring like a lion or like any sucking dove!…

[Trotsky] assumes that the moral and intellectual problems of the transformation of Society have been already solved – that a plan exists, and that nothing remains except to put it into operation…. [But] force would settle nothing…. We lack more than usual a coherent scheme of progress, a tangible ideal. All the political parties alike have their origins in past ideas and not in new ideas – and none more conspicuously so than the Marxists. It is not necessary to debate the subtleties of what justifies a man in promoting his gospel by force; for no one has a gospel. The next move is with the head, and fists must wait.29

Did ever, would ever any humble dentist ever write so?

On the one hand, Keynes claims to be asserting only a very minor kind of authority – that based on his expert knowledge of the emergent properties of systems of decentralized market exchange – and to be giving merely technical advice about adjustments needed to achieve self-evidence and obvious goals like full employment, price stability, and healthy increases in productivity. He claims to be performing the economic equivalent of the dentist saying: “you should brush your molars much longer in the morning” and “that tooth has to come out now or you will be in real trouble”.

On the other hand, Keynes then leverages his professedly limited technical and technocratic expertise to attempt to banish from participation in high politics entire schools of political and moral thought, entire mass movements with their utopian aspirations, and to silence via their exclusion from valid technocratic debate the prophets of those schools of thought and mass movements. Trotsky is indeed a prophet – as Edmund Wilson wrote in his To the Finland Station:

Here are some references [from Trotsky]…. “If the prince was not succeeding in peacefully regenerating the country, he was accomplishing with remarkable effectiveness the task of a more general order for which history had placed him at the head of the government: the destruction of the political illusions and the prejudices of the middle class.” “History used the fantastic plan of Gapon for the purpose of arriving at its ends.”… History, then, with its dialectical Trinity, had chosen Prince Svyatopolk-Mirsky to disillusion the middle class, had propounded revolutionary conclusions which it had compelled Father Gapon to bless…. These statements make no sense whatever, unless one substitutes for the words “history” and “dialectic of history” the words “Providence” and “God”…30

And it is not just Trotsky and his followers whom Keynes wishes to banish. He would apply the same to the stewards of Europe today, and to that part of President Barack Obama who speaks of how because the current Lesser Depression has compelled households to tighten their belts that the government needs to tighten its. As Keynes said back in 1931:

It seems an extraordinary imbecility that this wonderful outburst of productive energy [in the boom] should be the prelude to impoverishment and depression. Some austere and puritanical souls regard it both as an inevitable and a desirable nemesis on so much overexpansion, as they call it; a nemesis on man’s speculative spirit. It would, they feel, be a victory for the mammon of unrighteousness if so much prosperity was not subsequently balanced by universal bankruptcy. We need, they say, what they politely call a ‘prolonged liquidation’ to put us right. The liquidation, they tell us, is not yet complete. But in time it will be. And when sufficient time has elapsed for the completion of the liquidation, all will be well with us again. I do not take this view. I find the explanation of the current business losses, of the reduction in output, and of the unemployment which necessarily ensues on this not in the high level of investment which was proceeding [during the boom]… but in the subsequent cessation of this investment. I see no hope of a recovery except in a revival of the high level of investment. And I do not understand how universal bankruptcy can do any good or bring us nearer to prosperity…31

There is more than a little inconsistency and tension here…


B. Alasdair Macintyre

You can resolve this inconsistency and tension in one of several ways.

It is impossible to think about issues of history and moral philosophy, especially here at Notre Dame, without thinking of Alasdair Macintyre and his brilliant After Virtue32, surely one of the best and most important books in history and moral philosophy of the second half of the twentieth century. We economists seek to leverage a narrow claim to limited technical and technocratic expertise to banish and dispel the Trotskys and all his peers and all their works – for, in our view, they contain many false works and empty promises. Alasdair Macintyre, by contrast, seeks to banish and dispel all of us economists – for we are the archetypes of what he regards as one of the most unhealthy and poisonous diseases of modernity, the disease of “managerialism.” What MacIntyre sees as the vice of the manager – that he or she doesn’t tell you that you ought to do X or not to do X, only how to do X if you decide you should – we see as respect for autonomy, as granting people equal significance to us, and as the virtue of the economist: we are just supposed to tell you what is likely to happen if you do X.

Of course to provide someone with knowledge of the consequences may be simply to give them the kind of freedom that is necessity: the freedom to do what is the right thing. The old Cold War joke was of the strategist who would offer the president three possible options: immediate surrender to the Russians, total thermonuclear war, and his preferred policy.33 To the extent that there is no grave disagreement about what the good is and what the ends are, control is exercised not by the one who chooses the ends but rather the one who chooses how the means are evaluated.

It is still not completely clear to me what Macintyre’s root objection to economics in particular and “managerialism” more generally is. The possibilities are:

  • We economists say “our technical expertise tells you that if you do X the effects will be Y” when we should say “you need to do X”.

  • We economists say “our technical expertise tells you that if you do X the effects will be Y”, but we do so because we hold to moral values Z that we do not express, and are in fact harmful.

  • When we say “our technical expertise tells you that if you do X the effects will be Y” we refuse to stake an explicit claim as to what the moral order inscribed in the firmament is, and so we encourage nihilism by teaching not how to reach the good but how to reach whatever you take to be your good.

It is clear to me that John Maynard Keynes believed in second of these objections: that economics was good for the body but taught moral values that were bad for the soul, yet in a world as poor as the world Keynes saw the needs of the body took precedence. When the world becomes rich, Keynes wrote:

We shall be able to rid ourselves of many of the pseudo-moral principles which have hag-ridden us for two hundred years, by which we have exalted some of the most distasteful of human qualities into the position of the highest virtues. We shall be able to afford to dare to assess the money-motive at its true value. The love of money as a possession – as distinguished from the love of money as a means to the enjoyments and realities of life – will be recognised for what it is, a somewhat disgusting morbidity, one of those semi-criminal, semi-pathological propensities which one hands over with a shudder to the specialists in mental disease. All kinds of social customs and economic practices, affecting the distribution of wealth and of economic rewards and penalties, which we now maintain at all costs, however distasteful and unjust they may be in themselves, because they are tremendously useful in promoting the accumulation of capital, we shall then be free, at last, to discard…34

Briefly detouring into anti-semitism:

Perhaps it is not an accident that the race which did most to bring the promise of immortality into the heart and essence of our religions has also done most for the principle of compound interest and particularly loves this most purposive of human institutions.

And then calling for, someday, Kingdom Come: a rejection of “managerialism” and of economics as thorough as Macintyre could wish for:

I see us free, therefore, to return to some of the most sure and certain principles of religion and traditional virtue – that avarice is a vice, that the exaction of usury is a misdemeanour, and the love of money is detestable, that those walk most truly in the paths of virtue and sane wisdom who take least thought for the morrow. We shall once more value ends above means and prefer the good to the useful. We shall honour those who can teach us how to pluck the hour and the day virtuously and well, the delightful people who are capable of taking direct enjoyment in things, the lilies of the field who toil not, neither do they spin. But beware! The time for all this is not yet. For at least another hundred years we must pretend to ourselves and to every one that fair is foul and foul is fair; for foul is useful and fair is not. Avarice and usury and precaution must be our gods for a little longer still. For only they can lead us out of the tunnel of economic necessity into daylight.35

From this viewpoint, the fundamental difference between Keynes, at least in his “Economic Possibilities for Our Grandchildren”, and Macintyre is that Keynes believes that the Kingdom is still a century off, while Macintyre believes that the Kingdom is at hand.

But Keynes’s century is now almost over. And there is no Kingdom at hand, or even within sight, here in this world.


C. Leon Trotsky and St. Benedict

But I believe that we can go further. Macintyre, at least in his After Virtue mode, believes that good civilizations are ones with moral consensus led by prophets, rather than ones with moral confusion managed by managers. It is Macintyre’s belief that we should hope for a civilization led by Trotskys (less preferred) or St. Benedicts (more preferred), but in either event it is to be preferred to managerial Keyneses.

If you step back, however, and inquire into the content of the this-world secular ideologies of the Trotskys, it then becomes very difficult to prefer the prophetic Trotskys to the managerial Keyneses. Trotsky’s gospel, it turns out, is in reality little more than a managerialist gospel. Trotsky says that History speaking through Marx and him knows how to build a Communist utopia. What is a Communist utopia? It is a society in which humans pull together and coordinate their activities. It is a society in which people are free to do what they want, within reason of what is not destructive for the community. It is a society in which people are prosperous: well-fed, well-clothed, well-housed, and well-entertained. Trotsky’s gospel is that Keynes’s market economy is incapable of even approaching such a utopia, while Marx and History have together told him how to accomplish it.

And here we have to bring in history: the regimes that accepted versions of Trotsky’s gospel in the twentieth century and tried to implement it range from Pol Pot’s to Fidel Castro’s, with Stalin’s and Mao’s regimes at the worst, and something like Erich Honeker’s Stasi-spies-on-everyone East Germany close to the best.

The whole point of saying that you would prefer Trotsky to Keynes is that Trotsky has a gospel which, if not true, is true enough to hold society together in moral consensus and produce a modicum of prosperity. But what if Keynes’s managerialism does better at fulfilling what Trotsky claims will be the accomplishments of Trotsky’s gospel more effectively than Trotsky does? It does. We can see that Keynes was totally correct in wanting to reduce the influence of a Trotsky in the public square, because a Trotsky’s ideas about good organization of the economy were seen immediately by Keynes as, and turned out to be a horrible disaster, even from the perspective of Trotsky’s values–especially from the perspective of Trotsky’s values.

In a similar fashion, many of the same conclusions follow if you step back and inquire into the content of the other-worldly gospels of the St. Benedicts. Their lodestones swing from following the ethical teachings of Rabbi Yeshua of Nazareth to worshipping the Anointed Λόγος that is of a higher order of reality than we, with a certain tension between them. But when Rabbi Yeshua spoke of what the Anointed Λόγος commanded his followers to do in this world, his followers were commanded to successfully attain managerial ends:

Then shall the king say to them that shall be on his right hand: “Come, ye blessed of my Father, possess you the kingdom prepared for you from the foundation of the world. For I was hungry, and you gave me to eat; I was thirsty, and you gave me to drink; I was a stranger, and you took me in: Naked, and you covered me: sick, and you visited me: I was in prison, and you came to me.”

Then shall the just answer him, saying: “Lord, when did we see thee hungry, and fed thee; thirsty, and gave thee drink? And when did we see thee a stranger, and took thee in? or naked, and covered thee? Or when did we see thee sick or in prison, and came to thee?” And the king answering, shall say to them: “Amen I say to you, as long as you did it to one of these my least brethren, you did it to me.”36

That is a very powerful statement that what is sought after is successful managerialism – a successful managerialism with a preferential option for the poor: one that feeds the hungry, clothes the naked, heals the sick, welcomes the immigrant, and visits the imprisoned. Right ritual, right moral orientation, right faith seem to be nowhere – at least in this part of Matthew.37

IV. We Dwell Not in the Republic of Plato But in the Sewer of Romulus

In the last days before the coming of the Roman Empire, Marcus Tullius Cicero in Rome wrote to his best correspondent Titus Pomponius Atticus in Athens:

You cannot love our dear [Marcus Porcius] Cato any more than I do; but the man – although employing the finest mind and possessing the greatest trustworthiness – sometimes harms the Republic. He speaks as if we were in the Republic of Plato, and not in the sewer of Romulus…38

Whatever you may think about economists’ desires to use their technical and technocratic expertise to reduce the influence of both the Trotskys and the St. Benedicts in the public square, there is the prior question of whether here and now – in this fallen sublunary sphere, among the filth of Romulus – they have and deploy any proper technical and technocratic expertise at all. And we seem to gain a new example of this every week.

The most salient relatively-recent example was provided by Carmen Reinhart and Kenneth Rogoff39 – brilliant, hard-working economists both, from whom I have learned immense amounts. Rogoff’s depth of thought and breadth of knowledge about how countries act and how economies respond in the arena of the international monetary system is a global treasure. Reinhart’s breadth and depth of knowledge about how governments have issued, financed, amortized, paid off, or not paid off their debts over the past two centuries is the greatest in the world.

Debt to GDP Ratio and Future Economic Growth pdf page 5 of 6

However, they believed that the best path forward for the developed economies – the U.S., Germany, Britain, and Japan – was for them to shrink their government deficits quickly and quickly halt the accumulation of and begin to pay down government debt. My faction, by contrast, believed that the best path forward for these economies was for them to expand their government deficits now and let the debt grow until either economies recover to normal levels of employment or until interest rates begin to rise significantly.

Why does my faction disagree with them? Let me, first, rely on the graph above that is the product of work by Berkeley graduate student Owen Zidar,40 plotting how economic growth in different industrialized countries in different eras has varied along with the amount of government debt that they had previously accumulated. And let me give the explanation of why I disagree with Reinhart and Rogoff that I was giving at seminars around the country in the early 2010s:

The argument [for fiscal contraction and against fiscal expansion in the short run] is now: never mind why, the costs of debt accumulation are very high. This is the argument made by Reinhart and Rogoff: when your debt to annual GDP ratio rises above 90%, your growth tends to be slow.
This is the most live argument today. So let me nibble away at it. And let me start by presenting the RRR case in the form of Owen Zidar’s graph.

First: note well: no cliff at 90%.

Second, RRR present a correlation – not a causal mechanism, and not a properly-instrumented regression. Their argument is a claim that high debt-to-GDP and slow subsequent growth go together, without answering the question of which way causation runs. Let us answer that question.

The third thing to note is how small the correlation is. Suppose that we consider two cases: a multiplier of 1.5 and a multiplier of 2.5, both with a marginal tax share of 1/3. Suppose the growth-depressing effect lasts for 10 years. Suppose that all of the correlation is causation running from high debt to slower future growth. And suppose that we boost government spending by 2% of GDP this year in the first case. Output this year then goes up by 3% of GDP. Debt goes up by 1% of GDP taking account of higher tax collections. This higher debt then reduces growth by… wait for it… 0.006% points per year. After 10 years GDP is lower than it would otherwise have been by 0.06%. 3% higher GDP this year and slower growth that leads to GDP lower by 0.06% in a decade. And this is supposed to be an argument against expansionary fiscal policy right now?

The 2.5 multiplier case is more so. Spend 2% of GDP over each of the next three years. Collect 15% of a year’s extra output in the short run. Taking account of higher tax revenues, debt goes up by 1% of GDP and we have the same ten-year depressing effect of 0.06% of GDP. 15% now. -0.06% in a decade. The first would be temporary, the second is permanent, but even so the costs are much less than the benefits as long as the economy is still at the zero lower bound.

And this isn’t the graph that you were looking for. You want the causal graph. That, worldwide, growth is slow for other reasons when debt is high for other reasons or where debt is high for other reasons is in this graph, and should not be. Control for country and era effects and Owen reports that the -0.06% becomes -0.03%. As Larry Summers never tires of pointing out, (a) debt-to-annual-GDP ratio has a numerator and a denominator, and (b) sometimes high-debt comes with high interest rates and we expect that to slow growth but that is not relevant to the North Atlantic right now. If the ratio is high because of the denominator, causation is already running the other way. We want to focus on cases of high debt and low interest rates. Do those two things and we are down to a -0.01% coefficient.

We are supposed to be scared of a government-spending program of between 2% and 6% of a year’s GDP because we see a causal mechanism at work that would also lower GDP in a decade by 0.01% of GDP? That does not seem to me to compute.

Now I have been nibbling the RRR result down. Presumably they are trying to see if it can legitimately be pushed up. This will be interesting to watch over the next several years, because RRR is the heart of the pro-austerity case right now.41

That ends what I would typically try to say.

And that is as concise and simple an explanation of why I disagree with Reinhart and Rogoff as I can give.

If you are not a professional economist and have managed to understand that, I salute you.

They disagree with me, first, they started with different prior beliefs – different assumptions about the relative weight to be given to different scenarios and the relative risks of different courses of action that lead them to read the evidence differently. Second, they made some data processing errors – although those are a relatively minor component of our differences – and are now dug in, anchored to the positions they originally took, and rationalizing that the data processing errors do not change the qualitative shape of the picture. Third, they have made different weighting decisions as to how to handle the data. Is Owen Zidar putting his thumb on the scales, and weighting the data because he knows that the effects of high debt in reducing growth are small? I don’t think so: his weighting scheme is simple, and he is too young to be dug in and have a dog in this fight. But I am, perhaps, not the best judge.

But when we venture out of data collection and statistics and the academy into policy advocacy in the public square the differences become very large indeed. Matthew O’Brien quotes Senator Tom Coburn’s report on Reinhart and Rogoff’s briefing of the Republican Congressional Caucus in April 2011:

Johnny Isakson, a Republican from Georgia and always a gentleman, stood up to ask his question: “Do we need to act this year? Is it better to act quickly?”

“Absolutely,” Rogoff said. “Not acting moves the risk closer,” he explained, because every year of not acting adds another year of debt accumulation. “You have very few levers at this point,” he warned us.

Reinhart echoed Conrad’s point and explained that countries rarely pass the 90 percent debt-to-GDP tipping point precisely because it is dangerous to let that much debt accumulate. She said, “If it is not risky to hit the 90 percent threshold, we would expect a higher incidence.”42

I think we have by far the better of the argument. Yet it is very clear that even today Reinhart and Rogoff – and allied points by economists like Alberto Alesina, Francesco Giavazzi, et al.,43 where I also think we have the better of the argument by far – have had a much greater impact on the public debate than my side has.

Thus, the key problem of knowledge: Since technical details matter, conclusions must be taken by non-economists on faith in economists’ expertise, by watching the development of a near-consensus of economists, and by consonance with observers’ overall world-view. But because political and moral commitments shape how we economists view the evidence, we economists will never reach conclusions with a near-consensus – even putting to one side those economists who trim their sails out of an unwarranted and excessive lust for high federal office. And note that neither Carmen Reinhart nor Kenneth Rogoff have such a lust.

We do not live in the Republic of Plato. We live in the Sewer of Romulus. In this fallen sublunary sphere, the gap between what economists should do and be and what they actually are and do is distressingly large, and uncloseable.

And this leaves you – those of you who must listen to we economists when we speak as public intellectuals in the public square – with a substantial problem.

V. Should You Pay Attention to Economists as Public Intellectuals in the Public Square?

You have to.

You have no choice.

You all have to listen.

But you have nearly no ability to evaluate what you hear. When we don’t reach a near-consensus, then Heaven help you. Unless you are willing make me intellectual dictator and philosopher-king, I cannot.44

Must-read: Adam Smith (1776): “As if by an Invisible Hand…”

Must-Read: Adam Smith’s “Invisible Hand” argument. It’s not “markets are good”. It is, instead, two moves:

  1. Complicated processes involving the interactions of large numbers of humans have emergent properties and produce outcomes that often are not and cannot be understand as intended by any one of the humans whose actions led to the outcome.

  2. Sometimes (often?) the emergent properties are those that we want to nurture and develop: as Bernard Mandeville first noted, one of the tasks of the clever statesman is to structure things so that the satisfaction of private vices does in fact yield public benefits.

Note that in this particular example, it is the (a) psychological home bias of merchants combined with (b) increasing returns in the agglomeration of economic activity that leads to the good outcome–and it is a good outcome for Amsterdam, not for Lisbon or Königsberg…

Adam Smith (1776): Wealth of Nations, Book IV, Chapter 2: “The capital which an Amsterdam merchant employs in carrying corn from Konigsberg to Lisbon…

…and fruit and wine from Lisbon to Königsberg, must generally be the one half of it at Königsberg and the other half at Lisbon. No part of it need ever come to Amsterdam. The natural residence of such a merchant should either be at Konigsberg or Lisbon, and it can only be some very particular circumstances which can make him prefer the residence of Amsterdam. The uneasiness… which he feels at being separated so far from his capital generally determines him to bring part… of the… goods… to Amsterdam… though this necessarily subjects him to a double charge of loading and unloading, as well as to the payment of some duties and customs, yet for the sake of having some part of his capital always under his own view and command, he willingly submits…. In this manner that every country which has any considerable share of the carrying trade becomes always the emporium, or general market, for the goods of all the different countries whose trade it carries on….

A capital employed in the home-trade… necessarily puts into motion a greater quantity of domestic industry, and gives revenue and employment to a greater number of the inhabitants of the country…. Upon equal, or only nearly equal profits, therefore, every individual naturally inclines to employ his capital in the manner in which it is likely to afford the greatest support to domestic industry, and to give revenue and employment to the greatest number of people of his own country….

By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it…