Gerard Jackson's  Instablog

I'm inclined to the view that the Great Depression was a seminal turning point in the history of economic thought. Thanks to that politically-induced tragedy something like 150 years of sound economic reasoning was overturned by two mercantilist fallacies that we now call Keynesianism, the first of which was the demand deficiency fallacy. This clearly leads to the second fallacy that increased government spending can promote growth, especially by encouraging consumer spending^1,2. Both fallacies are responsible for the present economic crisis.

I have been publishing data for years that refutes both fallacies. Unfortunately Keynesianism seems to have taken on the characteristics of a cult that brooks no opposition — including contradictory evidence. Nevertheless, facts are facts and the idea that a high level of consumption as a proportion of GDP is needed to prevent unemployment from rising has been thoroughly refuted by statistical evidence as the following table amply demonstrates.

What's amusing about this table is that it reveals the so-called laissez-faire Hoover as doubling government spending as a proportion of GDP. (Hoover was well known at the time to being strongly opposed to laissez-faire policies. Thanks to the dishonest efforts of leftwing historians this fact has been turned on its head). This increased spending in dollar terms was far from trivial. Robert P. Murphy points out that for the financial year 2007 the Bush administration would have had to run a deficit of $3.3 trillion to equal Hoover's "overspending". (Robert P. Murphy, The Politically Incorrect Guide to the Great Depression and the New Deal, Regnery Publishing Inc., 2009, p. 47).

The data also demolishes the idea that debt is counter-cyclical. From 1930 to 1939 total debt rose by 150 per cent and yet America continued to be cursed by widespread unemployment. (Debt is expected to be 101 per cent of GDP in 2010). So how do we account for the very high level of unemployment? What matters to employers is the cost of labour relative to the value of its marginal product. (Every introductory economics textbook explains this process). It obviously follows that if the cost of labour (the gross wage) exceeds the value of its product persistent unemployment will emerge.

The fourth column in our table contains the productivity adjusted wage. This is arrived at by dividing productivity by the real wage. We can now see that real wages did indeed exceed productivity — and to a considerable degree — with the tragic results that economic theory predicts. No matter which indexes are used the result is always the same: excess wage rates. What makes the third column particularly interesting is that though Canada had no New Deal her employment record during the 1930s was vastly better than the US's to the extent that on average the US unemployment rate was 3.9 per centage points higher. (Murphy, ibid., p. 104). An important fact that is usually overlooked is that the great bulk of the unemployed were in manufacturing. In 1934 it was calculated

that of a total of almost 14 million persons were without jobs at the peak of unemployment in March, 1933, 6½ million were from the durable goods industries, nearly 6 million were from the "service" industries, and only 1½ million were from the consumption goods industries. Investment activity, in a word, is the tail that wags the industrial dog. (C. A. Phillips, T. F. McManus and R. W. Nelson, Banking and the Business Cycle, Macmillan and Company 1937, p. 235).

It was noted at the time and is borne out by the figures in the table that consumption was in fact being maintained and that it was the producer goods industries that were suffering the most, a fact that Joseph Stagg Lawrence, an eminent economist, tried to point out to the public. (The same thing happened during 2000 and 2001 recession). It was patently clear to the more astute economists that consumer spending was not the key to recovery.

Unfortunately for Australia Prime Minister Rudd is as profoundly ignorant of economics and economic history as is President obama. Rudd is arguing that the Premiers’ Plan of 1931 that resulted in public spending cuts deepened the depression and raised the level of unemployment. However, Sinclair Davidson, a Professor in the School of Economics, Finance and Marketing at RMIT, produced a chart showing that unemployment not only peaked in 1931 it then began to fall despite government spending cuts.

Why? He doesn't say but the following chart provides a clue. Unemployment peaked when productivity reached its lowest point, after which it began to rise as did the demand for labour. But for this to happen the productivity adjusted wage would have to fall. The real wage in manufacturing for full-time labour in 1927-28 equalled 100. In 1930-31 it was still 100. For 1936-37 it was 99. During this period it never fell below 98. (C. B. Schedvin, Australia and the Great Depression, Sydney University Press, 1988, p. 350).

Now we have our answer. When productivity fell the productivity adjusted real wage rose which then raised the level of unemployment. Once productivity began to increase again this reduced the productivity adjusted real wage and so increased the demand for labour. Therefore government increased borrowing and government spending had absolutely nothing to do with it. This the lesson of the 1930s and one the classical economists understood. Mill spoke for them when he wrote:

The utility of a large government expenditure, for the purpose of encouraging industry, is no longer maintained. Taxes are not now esteemed to be 'like the dews of heaven, which return in prolific showers'. It is no longer supposed that you benefit the producer by taking his money, provided that you give it to him again in exchange for his goods. There is nothing which impresses a person of reflection with a stronger sense of the shallowness of the political reasoning of the last two centuries, than the general reception so long given to a doctrine which, if it proves anything, proves that the more you take from the pockets of the people to spend on your own pleasures, the richer they grow; that the man who steals money out of a shop, provided that he expends it all again at the same shop, is a public benefactor to the tradesman whom he robs, and that the same operation, repeated sufficiently often, would make the tradesman a fortune. (John Stuart Mill, Essays on Economics and Society, Collected Works of John Stuart Mill, Vol. I, University of Toronto Press 1967, pp. 262-63).

Unfortunately President Obama and his advisors are hell bent on imposing on America unsustainable deficits and spending for which there is no economic justification and whose only result will be a great weakening of the economy. Only an unreasoning and fanatical belief in the power of state can account for such behaviour.

1. The immediate post-war economic situation is highly instructive in that it completely explodes the Keynesian idea that government spending is vital if unemployment is to be prevented from rising. Between 1945 and 1947 the Truman government slashed Federal annual spending from $95 billion to $36 billion — a $59 billion cut in two years, a 62 per cent reduction that amounted to 26 per cent of GDP as it stood in 1945. Instead of the mass unemployment that Paul Samuelson confidently predicted would emerge when the war ended and government spending was slashed America entered an unprecedented period of prosperity.

2. In fact, recovery was already underway before Roosevelt could implement his destructive New Deal policies. Roosevelt was inaugurated on 4 March 1933. I don't want to be a party pooper but the depression bottomed out "in the late winter of 1932-33" and recovery was clearly underway in the February-March period with the Federal Reserve Index of Production rising from 60 to 100 in July. (Frederick C. Mills Prices in Recession and Recovery, National Bureau of Economic Research, Inc., 1936, p. 307).

The Dow has passed the 9000 barrier. This has gotta be a recovery, right? After all, "the share market is forward looking". I'm afraid these people have confused forward looking with foresight. Never look to share markets as harbingers of growth or recession. Market watchers would know this if they paid more attention to history and less to charts. The American economy, for example, had already shown distinct signs of contracting several months before the Great Crash of 1929.

Although the Dow (which was more representative of the economy in the 1930s than it is now) rose from its low of 42.84 in June 1932 to 150.24 in December 1939, an increase of 250.7 per cent, unemployment averaged 16.7 per cent for that year against 3.3 per cent for 1929 while the industrial production index (1923-25) had fallen to 92 in April and May before rising to 103 the following August.

Roosevelt's economic policies — which were largely an extension of Hoover's — were a disaster that only a political cultist could ignore. This was a period of unprecedented government interventionism that severely crippled the US economy and triggered a process of capital consumption.

Professor Higgs estimated that from 1930 to 1940 net private investment was minus $3.1 billion. (Robert Higgs, Depression, War, and Cold War, The Independent Institute, 2006, p. 7). Arthur Lewis calculated that from 1929 to 1938 net capital formation plunged by minus 15.2 per cent (W. Arthur Lewis, Economic Survey 1919-1939, Unwin University Books, 1970, p. 205). Benjamin M. Anderson estimated that in 1939 there was more than 50 per cent slack in the economy. (Benjamin M. Anderson, Economics and the Public Welfare: A Financial and Economic History of the United States 1914-1946, LibertyPress, 1979, pp. 479-48).

A period of capital consumption would be marked by a continuing rise in the average age of machinery. This is precisely what we find. The amount of metal working machinery more than 10 years old rose from 48 per cent in 1930 to 70 per cent in 1940, an increase of 45.8 per cent. The reason why so many people think Roosevelt restored growth is because GDP rose under most of his presidency. These people have made the error of confusing a reduction in idle capacity leading to increased production with an increase in the amount of capital. As we have seen, there was no such increase.

One could argue that from June 1932 the rise in the Dow Jones was sustainable. And a 251 per cent increase in 7 years would seem to confirm that view. The problem is that there was no real recovery, from which we should draw the lesson that a rising stock market in itself does not necessarily signal a genuine revival in economic activity that would include the resumption of the process of capital formation. Too few commentators seem to be aware of the vital importance that monetary policy plays in driving the stock market. Even fewer stress that the ideal stock market is one driven by economic growth and not monetary expansion. (Share markets, equities and monetary policy). The following charts track M1 and the Dow.

It can be seen that from its peak in 1929 the Dow rapidly fell. What is not generally known is that the Fed froze the money supply in December 1928. From January 1930 to June 1933 the money supply fell by about 33 per cent. It was not until the second half of 1933 that it began to expand again. The big break in the Dow in August 1937 is usually attributed to a monetary tightening by the Fed. But as the Fed only reduced excess or 'idle' reserves — and then not all of them — it follows that there must be some other cause. In fact, the Dow's crash corresponded with a collapse in industrial production the index for which dived from 115 in August 1937 to 76 in May 1938. This was the result of a massive wage push — encouraged by the Roosevelt administration — that put the US economy into reverse.

Although the second chart is not clear on this point the Dow has been closely tracking M1 since 10 March. (The use of sweeps has caused M1 to be greatly understated). No matter which monetary measure one uses it seem pretty clear that Bernanke's criminally loose monetary policy is now driving the markets. But with an official unemployment rate of 9.5 per cent that is set to rise to 10 per cent or even higher can Bernanke's monetary assault on the economy drive this figure down again? (Bernanke appears to be still wedded to the discredited Philips curve).

Don't count on it. Manufacturing is still comatosed and there are still economic imbalances that need to be liquidated but which Bernanke and Obama are working to keep afloat. Combine that with Obama's insane energy policy and the Democrats' rising tide of tax increases that will sweep across the economy and it is quite possible that the economy will suffer another severe downturn

And then there is the tidal wave of money that has been built up. Unless it is permanently sterilised the US will be confronted with surging inflation, a falling dollar and rising unemployment. It won't be a pretty picture.