Why Bother Studying Economic History?

Among other things, it might get you a job!  From an interview with Diane Coyle, editor of the recent volume, “What’s the Use of Economics?”

Employers, including people in investment banking, were saying: “We don’t find that we can get the kind of graduates that we need in economics. We find that people have too narrow a perspective, and in particular at that time they were saying that young economists don’t have any understanding that there had been a depression in the 1930s, that there had been recessions before, because all their experience had been that very long boom that we had. We had a 13- or 15-year expansion, which was historically unprecedented, so people who’d been trained during that period just had no experience of things going wrong.

 

One of the strong themes to emerge from the book, and one of the triggers for arranging the conference, was this lack of appreciation of history, of the way in which context changes the way you think about economics.

Following the Yellow Brick Road

The Republican Party will include a “return to the gold standard” plank in its platform, which has me wondering what prompts all this (other than an effort to appease Ron Paul)?

Paul Krugman recently reiterated the point that many have made about the gold standard: we tried it, and it wasn’t quite as rosy as some would like to believe:

Faced with the kind of shock we’ve just experienced, the real price of gold would “want” to rise. But under a gold standard, the nominal price of gold would be fixed, so the only way that could happen would be through a fall in the general price level: deflation.

 

So if we’d had a gold standard operating in this crisis, there would have been powerful deflationary forces at work; not exactly what the doctor ordered.

 

Now, the gold bugs will no doubt reply that under a gold standard big bubbles couldn’t happen, and therefore there wouldn’t be major financial crises. And it’s true: under the gold standard America had no major financial panics other than in 1873, 1884, 1890, 1893, 1907, 1930, 1931, 1932, and 1933. Oh, wait.

 

The truth is that returning to gold is an almost comically (and cosmically) bad idea.

The advantage of a gold standard is long-run price stability (well, at least in the Classical gold standard period from 1880 to 1914), but that does not come without its own costs; in particular, there are resource costs of maintaing the standard, as Bernanke pointed out:

Gold Standards are far from perfect monetary systems… have to go to South Africa and dig up tons of gold, and move it to New York and put it in the basement of the Federal Reserve bank of New York.

The more important cost is the increased volatility of real output and the price level, and the removal of an important countercyclical policy tool from the toolkit.

Even Milton Friedman opposed a return to the gold standard –  here’s Murray Rothbard, criticizing Milton Friedman for advocating a break from the gold standard:

Milton Friedman is a radical advocate of cutting all current ties, however weak, with gold, and going onto a total and absolute fiat dollar standard, with all control vested in the Federal Reserve System.  Of course, Friedman would then advise the Fed to use that absolute power wisely…

And Friedman in his 1986 JME article with Anna Schwartz:

I regard a return to a gold standard as neither desirable nor feasible — with the one exception that it might become feasible if the doomsday predictions of hyperinflation under our present system should prove correct.

Friedman believed that the Fed’s efforts to defend the gold standard resulted in the disastrous bank failures of the early 1930s, which greatly exacerbated the depression.

James Hamilton has pointed out that short-term interest rates became much more stable after the establishment of the Federal Reserve, while the duration of recessions became shorter.  Those volatile short-term rates and long recessions occurred during the classical gold standard, from 1880 to 1914.

Hamilton reminds us that countries abandoning the gold standard during the depression were fastest to recover:

U.S. recovery began more or less immediately with the elimination in 1933 of the legal convertibility of dollars to gold at the price of $20.67. And our experience was not unique. The 14 countries that decided to abandon the gold standard two years earlier than the U.S. began their economic recovery in 1932…Countries that stayed on gold, by contrast, experienced an average output decline of 15% in 1932. The U.S. recovery began after we abandoned gold in 1933, the Italian recovery began after they went off in 1934, and the Belgian recovery began after they went off in 1935. The three countries that stuck with gold through 1936 (France, Netherlands, and Poland) saw a 6% drop in industrial production in 1935, while the rest of the world was experiencing solid growth.

Underlying the push for a return to gold is, of course, a desire for price stability.  Here is Mitt Romney (to his credit, he has not joined the goldbug movement), from a recent Reuters story:

I want to make sure the Federal Reserve focuses on maintaining the monetary stability that leads to a strong dollar and confidence that America is not going to go down the road that other nations have gone down, to their peril.

So, we want the Fed to maintain monetary and price stability.  Okay, is there any evidence that it has failed in that objective?  Even if one were to take the position that the Fed’s dual mandate should end, and that it should focus exclusively on price stability, is there any reason to claim that it has not achieved a relatively low and stable price level?  Quite simply, no.  Bernanke assumed the chairmanship of the Board of Governors in February 2006.  Using the all-items seasonally-adjusted CPI, the average inflation rate under his watch is a whopping 2.3 percent.

And under the much-admired Alan Greenspan, the inflation rate averaged almost a full percentage point higher, 3.1 percent.  Why were there no calls for Greenspan to be fired for his inflationary policies?  Far from it;  in the Republican primaries, Herman Cain claimed that Greenspan was the best Fed Chairman in 40 years (which prompted a memorable retort from Ron Paul that “he was a disaster!” – at least Paul is consistent).  Cain, by the way, later joined with Newt Gingrich in advocating that Bernanke be “fired.”

Let’s hope that this latest push to return to the 19th century is merely a manifestation of political silly-season, and that the rest of the campaign will be about the important problems that lie ahead.  Solutions in search of problems are not generally worth pursuing.

The Great Depression and Austrian Economics

Bruce Bartlett opines on the Great Depression and Austrian economic theory:

Representative Paul is here reciting the “Austrian” theory of the Great Depression. It says that even though there was no inflation during the 1920s, somehow or other inflation nevertheless caused the Great Depression. According to the Bureau of Labor Statistics, prices were either flat or falling throughout the 1920s – i.e., deflation.

 

But the Austrian school believes there was actually some sort of double-secret inflation because the money supply increased. They believe the same thing is happening right now.

One curious feature of the Austrian argument that Fed intervention is always undesirable is the fact that the Austrians who promote it never seem to ask the most basic economic question: might intervention be justified in cases where the costs of inaction are extraordinarily high?  In other words, why not think of government intervention in plain old cost/benefit terms as Friedman/Schwarz did in concluding that the Fed’s mistake was one of doing far too little to prevent the economic collapse in the 1930s?  Perhaps the Austrians do this and conclude that the benefits of intervention never outweigh the costs, but that seems highly implausible in scenarios like the Great Depression (if not then, when?).

And Bartlett is right – there was no inflation in the 192os to speak of.  Here’s the chart of CPI from 1920 to 1929 (from measuringworth.com):

The more troubling criticism for the Austrian theory of crises has long been articulated (most clearly by Bryan Caplan).  The Austrian theory relies on an unexplained irrationality among businessmen who are continually fooled by the Fed into believing that “artificially” low interest rates are the actual market interest rates.

As Caplan noted,

Even if simple businessmen just use current market interest rates in a completely robotic way, why doesn’t arbitrage by the credit-market insiders make long-term interest rates a reasonable prediction of actual policies? The problem is supposed to be that businessmen just look at current interest rates, figure out the PDV of possible investments, and due to artificially low interest rates (which can’t persist forever) they wind up making malinvestments. But why couldn’t they just use the credit market’s long-term interest rates for forecasting profitability instead of stupidly looking at current short-term rates?

There are other objections, of course.  See Marginal Revolution here and Paul Krugman here.

Romer’s Great Depression Reading List

Christina Romer gives her list of the best five books (well, four books plus one journal article) on the Great Depression here.  In short, they are:

1. A Monetary History of the United States, 1867-1960 by Friedman & Schwartz

2. Golden Fetters by Eichengreen

3. Essays on the Great Depression by Bernanke

4.  America’s Greatest Depression by Chandler

5. “The End of One Big Deflation” by Temin & Wigmore in Explorations in Economic History

It’s hard to argue with anything on Romer’s list, but I might add a few others including:

Lessons from the Great Depression by Temin

The World in Depression, 1929-1939 by Kindelberger

“The Debt Deflation Theory of Great Depressions” by Fisher

“Regime Uncertainty: Why the Great Depressions Lasted so Long and Why Prosperity Returned After the War,” by Higgs in The Independent Review

Stiglitz on the Great Depression

Here’s a nice summary of the new Stiglitz thesis on the Great Depression and the robust blogosphere response.  I was planning to offer up one of my own, but I apparently enjoyed my time off more than most, so it may be a little while.

The Roaring Thirties

Via Marginal Revolution, here is David Henderson’s review of Alexander Field’s new book, A Great Leap Forward:  1930s Depression and U.S. Economic Growth.  Among the intriguing findings in that new book:

• Real output was 33-40 percent higher in 1941 than in 1929 even though about as many people were working with about the same amount of capital in both years.  This implies annual productivity growth over that period of between 2.3 and 2.8 percent.
• One of the biggest sources of productivity growth was not innovation per se, but developments in the national road system.  While federal interstate highways did not appear until the Eisenhower administration, those interstate systems were typically built alongside or on top of the highways that had been constructed between 1919 and 1941.
• Productivity growth slowed down during World War Two.  There were huge increases in output during the war, of course, but Field attributes this to increases in the number of people employed, not to increases in productivity.