The following is an updated and revised version of the penultimate section of my paper with Ron Batchelder “Pre-Keynesian Theories of the Great Depressison: What Ever Happened to Hawtrey and Cassel?” which I am now preparing for publication. The previous version is available on SSRN.
In the 1950s and early 1960s, empirical studies of the effects of money and monetary policy by Milton Friedman, his students and followers, rehabilitated the idea that monetary policy had significant macroeconomic effects. Most importantly, in research with Anna Schwartz Friedman advanced the seemingly remarkable claim that the chief cause of the Great Depression had been a series of policy mistakes by the Federal Reserve. Although Hawtrey and Cassel, had also implicated the Federal Reserve in their explanation of the Great Depression, they were unmentioned by Friedman and Schwartz or by other Monetarists.[1]
The chief difference between the Monetarist and the Hawtrey-Cassel explanations of the Great Depression is that Monetarists posited a monetary shock (bank failures) specific to the U.S. as the primary, if not sole, cause of the Depression, while Hawtrey and Cassel considered the Depression a global phenomenon reflecting a rapidly increasing international demand for gold, bank failures being merely an incidental and aggravating symptom, specific to the U.S., of a more general monetary disorder.
Arguing that the Great Depression originated in the United States following a typical business-cycle downturn, Friedman and Schwartz (1963) attributed the depth of the downturn not to the unexplained initial shock, but to the contraction of the U.S. money stock caused by the bank failures. Dismissing any causal role for the gold standard in the Depression, Friedman and Schwartz (359-60) acknowledged only its role in propagating, via PSFM, an exogenous, policy-driven, contraction of the U.S. money stock to other gold-standard countries. According to Friedman and Schwartz, the monetary contraction was the cause, and deflation the effect.
But the causation posited by Friedman and Schwartz is the exact opposite of the true causation. Under the gold standard, deflation (i.e., gold appreciation) was the cause and the decline in the quantity of money the effect. Deflation in an international gold standard is not a local phenomenon originating in any single country; it occurs simultaneously in all gold standard countries.
To be sure the banking collapse in the U.S. exacerbated the catastrophe. But the collapse was the localized effect of a more general cause: deflation. Without deflation, neither the unexplained 1929 downturn nor the subsequent banking collapse would have occurred. Nor was an investment boom in the most advanced and most productive economy in the world unsustainable as posited, with no evidence of unsustainability other than the subsequent economic collapse, by the Austrian malinvestment hypothesis.
Friedman and Schwartz based their assertion that the monetary disturbance that caused the Great Depression occurred in the U.S. on the observation that, from 1929 to 1931, gold flowed into, not out of, the U.S. Had the disturbance occurred elsewhere, they argued, gold would have flowed out of, not into, the U. S.
Table 1 shows the half-year changes in U.S., French, and world gold reserves starting in June 1928, when the French monetary law re-establishing the gold standard was enacted.
| TABLE 1: Gold Reserves in US, France, and the World June 1928-December 1931 (measured in dollars) | |||||
| Date | World Reserves | US Reserves | US Share (percent) | French Reserves | French Share (percent) |
| June 1928 | 9,749 | 3,732 | 38.3 | 1,136 | 11.7 |
| Dec. 1928 | 10,057 | 3,746 | 37.2 | 1,254 | 12.4 |
| 2nd half 1928 change | 312 | 14 | -1.1 | 118 | 0.7 |
| June 1929 | 10,126 | 3,956 | 39.1 | 1,436 | 14.2 |
| 1st half 1929 change | 69 | 210 | 1.9 | 182 | 1.8 |
| Dec. 1929 | 10,336 | 3,900 | 37.7 | 1,633 | 15.8 |
| 2nd half 1929 change | 210 | -56 | -1.4 | 197 | 1.6 |
| June 1930 | 10,671 | 4,178 | 39.2 | 1,727 | 16.2 |
| 1st half 1930 change | 335 | 278 | 1.5 | 94 | 0.4 |
| Dec. 1930 | 10,944 | 4,225 | 38.7 | 2,100 | 19.2 |
| 2nd half 1930 change | 273 | 47 | -0.5 | 373 | 3.0 |
| June 1931 | 11,264 | 4593 | 40.8 | 2,212 | 19.6 |
| 1st half 1931 change | 320 | 368 | 2.1 | 112 | 0.4 |
| Dec. 1931 | 11,323 | 4,051 | 35.8 | 2,699 | 23.8 |
| 2nd half 1931 change | 59 | -542 | -5.0 | 487 | 4.2 |
| June 1928-Dec. 1931 change | 1,574 | 319 | -2.5 | 1,563 | 12.1 |
| Source: H. C. Johnson, Gold, France and the Great Depression |
In the three-and-a-half years from June 1928 (when gold convertibility of the franc was restored) to December 1931, gold inflows into France exceeded gold inflows into the United States. The total gold inflow into France during the June 1928 to December 1931 period was $1.563 billion compared to only $319 billion into the United States.
However, much of the difference in the totals stems from the gold outflow from the U.S. into France in the second half of 1931, reflecting fears of a possible U.S. devaluation or suspension of convertibility after Great Britain and other countries suspended the gold standard in September 1931 (Hamilton 2012). From June 1928 through June 1931, the total gold inflow into the U.S. was $861 billion and the total gold inflow into France was $1.076 billion, the U.S. share of total reserves increasing from 38.3 percent to 40.6 percent, while the total French share increased from 11.7 percent to 19.6 percent.[2]
In the first half of 1931, when the first two waves of U.S. bank failures occurred, the increase in U.S. gold reserves exceeded the increase in world gold reserves. The shift by the public from holding bank deposits to holding currency increased reserve requirements, an increase reflected in the gold reserves held by the U.S. The increased U.S. demand for gold likely exacerbated the deflationary pressures affecting all gold-standard countries, perhaps contributing to the failure of the Credit-Anstalt in May 1931 that intensified the European crisis that forced Britain off the gold standard in September.
The combined increase in U.S. and French gold reserves was $1.937 billion compared to an increase of only $1.515 billion in total world reserves, indicating that the U.S. and France were drawing reserves either from other central banks or from privately held gold stocks. Clearly, both the U.S. and France were exerting powerful deflationary pressure on the world economy, before and during the downward spiral of the Great Depression.[3]
Deflationary forces were operating directly on prices before the quantity of money adjusted to the decline in prices. In some countries the adjustment of the quantity of money was relatively smooth; in the U.S. it was exceptionally difficult, but, not even in the U.S., was it the source of the disturbance. Hawtrey and Cassel understood that; Friedman did not.
In explaining the sources of his interest in monetary theory and the role of monetary policy, Friedman (1970) pointedly distinguished between the monetary tradition from which his work emerged and the dominant tradition in London circa 1930, citing Robbins’s (1934) Austrian-deflationist book on the Great Depression, while ignoring Hawtrey and Cassel. Friedman linked his work to the Chicago oral tradition, citing a lecture by Jacob Viner (1933) as foreshadowing his own explanation of the Great Depression, attributing the loss of interest in monetary theory and policy by the wider profession to the deflationism of LSE monetary economists. Friedman went on to suggest that the anti-deflationism of the Chicago monetary tradition immunized it against the broader reaction against monetary theory and policy, that the Austro-London pro-deflation bias provoked against monetary theory and policy.
Though perhaps superficially plausible, Friedman’s argument ignores, as he did throughout a half-century of scholarship and research, the contributions of Hawtrey and Cassel and especially their explanation of the Great Depression. Unfortunately, Friedman’s outsized influence on economists trained after the Keynesian Revolution distracted their attention from contributions outside the crude Keynesian-Monetarist dichotomy that shaped his approach to monetary economics.
Eclectics like Hawtrey and Cassel were neither natural sources of authority, nor obvious ideological foils for Friedman to focus upon. Already forgotten, providing neither convenient targets, nor ideological support, Hawtrey and Cassel, could be easily and conveniently ignored.
[1] Meltzer (2001) did mention Hawtrey, but the reference was perfunctory and did not address the substance of his and Cassel’s explanation of the Great Depression.
[2] By far the largest six-month increase in U.S. gold reserves was in the June-December 1931 period coinciding with the two waves of bank failures at the end of 1930 and in March 1931 causing a substantial shift from deposits to currency which required an increase in gold reserves owing to the higher ratio of required gold reserves against currency than against bank deposits.
[3] Fremling (1985) noted that, even during the 1929-31 period, the U.S. share of world gold reserves actually declined. However, her calculation includes the extraordinary outflow of gold from the U.S. in the second half of 1931. The U.S. share of global gold reserves rose from June 1928 to June 1931.
Uneasy Money 
David,
As has been your practice when discussing gold and the Great Depression, you focus solely on the accumulation of gold by the US and France in the late 1920s. Of course, you are not the only commentator on the Great Depression that does. It seems to be de rigueur.
After providing the gold reserves figures you go on to intimate that this was the cause of great financial dislocation and the major cause of the Great Depression.
As I have pointed out several times to you over the last few years, the French accumulation appears to be accounted for by new gold production of the period.
The main losers of gold in the period were the agricultural producing countries, including Japan, whose trade balances had collapsed. (Agricultural product prices had been falling, mainly due to the huge increases in agricultural production fostered by the technological innovations of the early 1920s.)
The Europeans did not lose gold during this period, in fact gold holdings increased in the main economies. The loser in Europe was Germany owing to its war reparations obligations.
British gold holdings were relatively stable until 1931 when speculation regarding a possible devaluation of sterling destabilized gold.
So where was the great monetary destabilization caused by US and French gold accumulation?
There was no doubt that the US and French gold accumulation pressured the world monetary system. There was no doubt that the Gold Standard was deflationary – it had worked in this way since the early 1920s. It was not solely a feature of the late 1920s.
The collapse of Credit Anstalt had probably more to do with the politics of the German reparations.
While you have at various times referred to the undervaluation of the Franc you virtually ignore the other side of the coin – the Pound’s overvaluation. In his testimony before the Macmillan Committee, Hawtrey admitted that the setting of British interest rates at a higher level than necessary, in defence of the Pound, was the cause of deflation in world prices. It even lead to the British accumulating gold in some years along with the US and France during the late 1920s.
Your singular focus on US and France leads you to over-exaggeration of the causes of the Great Depression.
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David,
You mention Flemling’s paper of 1985.
While she disagreed with Friedman/Schwartz on international monetary transmission, she concluded that it was possible that “the United States could have prevented or mitigated the world-wide depression through appropriate monetary policies.”
The causes of the Great Depression are not as plain as you make out.
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You seem to think that Fleming’s remark is somehow inconsistent with my position. I think Fleming and I are in perfect accord.
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David,
I wasn’t saying that.
Just adding to the idea that the Great Depression was not just about US and French gold accumulation.
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I don’t disagree with that either. But the US and France were the chief culprits.
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“But the US and France were the chief culprits.”
But of what?
It’s not as if the other major economies of the world lost mountains of gold during the period of interest, in fact, they gained gold.
The gold heading towards the US and France can be accounted for by new gold production and the gold sucked from the agricultural exporters (Australia, Brazil, Canada etc.) because their trade accounts collapsed.
No-one looks at these facts.
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Take a look at the trend in interest rates in the relevant period up to the crisis in Sterling, as at June of the years from 1927 to 1930 and April 1931, in various countries (using various instruments as reported in the US Federal Reserve Bulletins of the era – where ranges are shown in the original statistics, the lower figure is taken).
US – NY Fed Res dis. rate – 3.5, 5, 5 (peaked at 6.25 in Oct/Nov), 3, 1.5
UK – 3 months bankers acceptances – 4.34, 3.82, 5.32, 2.31, 2.58
France – private discount rate – 2.25, 2.9, 3.5, 3.5, 2.57
Germany – private discount rate – 5.39, 6.59, 7.5, 3.58, 4.65
Netherlands – private discount rate – 3.57, 4.18, 5.3, 1.89, 1.5
Switzerland – private discount rate – 3.42, 3.4, 3.26, 2.06, 1.06
Italy – private discount rate – 7.6, 5.25, 6.75, 5.5, 5.48
Belgium – private discount rate – 4.17, 4.27, 3.94, 2.78, 2.25
Austria – private discount rate – 5 2/3, 5 11/16, 7 3/16, 4 1/2, 3 7/8
Hungary – prime commercial paper – 7, 7 1/8, 8 3/4, 5 1/2, 5 1/2 (March)
Sweden – 3 month loans – 4, 4, 4 1/2, 3 1/2, 3
Japan – discounted bills – 6.57, 4.38, 5.48, 5.48, 5.29 (March)
The rates generally peak in the years 1928 and 1929 and thereafter declined.
US and French gold accumulation proceeded well into 1931. If the gold accumulation by the US and France was pressuring the finances of other major industrial countries it would be expected to see interest rates continue to rise across the spectrum. They did not.
The general peaking of rates in 1928/1929 coincide with the tightening of the policy rate in the US and declined as the US policy rate fell thereafter.
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David,
you write that deflation caused by a rise in gold caused the money supply to contract.
Just what was the cause of such as sudden rise in gold’s value?
The reserve demand by the bank of france?
This is unplausible under fractional reseve banking prevailing at the time, i.e. a fractional reserve system can easily adjust to this type of demand shifts (leaving aside certain limiting cases).
As you yourself write, reserves of the Fed did not decline as the French were accumulating gold, which means that US banks were under no obligation to contract, yet we know that the depresson, albeit global, was most severe in the US…
The question remains unanswered in your post:
Why did the depression start, and was most severe, in the US which never lost gold to France?
The Austrians would say that it is because the preceeding boom had been most pronounced in the US…(although I agree that unsustainability is not adequately defined)…
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Vienna Capitalist,
Here is one explanation based on Irving Fisher’s debt deflation analysis of the Great Depression.
Suppose you are a farmer with a mortgage on your farm that you pay a nominal interest rate on. Suppose the prices that you receive on your crops start falling – what do you do to ensure that you are able to make your mortgage payments? You could plant more crops hoping that the excess supply you are creating doesn’t drive prices further down or you could plant fewer crops hoping that prices you are receiving for your crops rise enough to still make your mortgage payments.
But you are not the only farmer. As a for instance, There are two hundred thousand other farmers spread across the nation that are faced with the same dilemma.
Now suppose that 190,000 of those farmers with mortgages (uncoordinated with each other) decide to plant more crops hoping that prices stabilize, but instead prices fall faster making debt service more difficult for each farming trying to service his / her own debts. This process was exacerbated by the tariffs put in place under President Hoover as global markets for US agricultural crops shrunk.
This description doesn’t explain how the deflation first began, but instead tries to explain how the process accelerates.
This scenario led to the passage of the Agricultural Adjustment Act in 1933 under President Franklin Delano Roosevelt.
“The Austrians would say that it is because the preceeding boom had been most pronounced in the US…(although I agree that unsustainability is not adequately defined)…”
The sustainability of credit at that time was in large part a function of new gold discoveries. Even with fractional reserve banking, gold placed a limit on the amount of new loans / money that could be created.
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@ Frank,
Thank you.
Unfortunately, Fisher’s description doesn’t explain anything, i..e it leaves out the most important thing: why do all these faermers err in their future estimate of demand? And they seem to err in one direction…
In a competitive market (many farmers) those with good judgement as to future demand/price conditions cancell the negative effect from those with bad judgement. The lucky ones should be roughly equal to the unlucky ones (that is what you see absent a boom or depression)…
So why do so many farmers have debt they cannot serve?
Because they were induced by false price signals (interest rate, underwriting conditions ) to expand collectively…
Fisher describes the historical process, doesn’t explain the phenomenon, though…
As for tariffs:
I am very sympathetic to nonmonetary explainations of depression(severity), but would focus on the monetary factors first…
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ViennaCapitalist,
“Thank you. Unfortunately, Fisher’s description doesn’t explain anything, i..e it leaves out the most important thing: why do all these farmers err in their future estimate of demand? And they seem to err in one direction…”
Prices fall (generally speaking) when supply exceeds demand. So suppose demand was growing by 3% per year BUT supply (courtesy of productivity improvements such as motorized farm equipment) was growing by 6% per year. Prices still fall even though demand is growing.
That is why farmers AND economists err – because they only look at demand. It’s not that farmers err in their future estimate of demand, they err in their estimate of future production relative to future demand.
Can an individual farmer predict into the future about the invention of motorized farm equipment or government actions?
“In a competitive market (many farmers) those with good judgement as to future demand/price conditions cancel the negative effect from those with bad judgement.”
What is meant by good judgement?
We are talking about predictions of both future supply and future demand.
If I am a farmer and I see demand growing by 3% per year (as per my example) I am going to try to increase my output by 3% per year.
What I don’t know about is my farmer neighbor 50 miles away that just purchased a motorized combine harvester that enables him to increase output 9% per year.
What I don’t know about is my federal government is going to kill demand for my goods overseas by initiating tariffs.
“The lucky ones should be roughly equal to the unlucky ones (that is what you see absent a boom or depression)…”
It has nothing to do with luck. It has everything to do with how monetary and fiscal policy are implemented even to this day.
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VC,
“……but would focus on the monetary factors first”
Why?
Look how steeply the Dow Jones rose through the course of the 1920s as a result of the technology investment boom that was underway. It wasn’t called the “Roaring Twenties” for nothing. This technology investment boom was all pervasive and unsustainable. The Fed, wanting to quell the boom, began to increase interest rates in 1928. This eventually took the heat out of the markets in a big way, as we all know. The markets were ripe for a pull back.
In the background, was also the tight UK monetary policy designed to defend the pound at its old parity. The UK, at that stage, was still a powerful force in the world economy.
The collapse was a huge shock and was followed by credit restriction and a collapse in spending. The effects of this shock reverberated all the way into 1932 by which time the Dow Jones had lost 90% of its value.This was a “real” phenomenon, not monetary, but with an initial monetary cause.
It seems every problematic trend in the world economy – the collapse of output and prices – began in earnest in 1929.
Many would say the other (monetary) factor was the shortage of gold. It could be argued there was no shortage of gold in the late 1920s. Cassel and Kitchin had previously calculated, that to sustain the gold standard, new gold production had to increase at around 3% pa. This was mostly the case. There was no shortage of gold.
Was there a mal-distribution of gold? David and many others would yes. But the numbers show that while the US and France markedly increased their gold reserves during the late 1920s, the industrial countries of Europe increased their gold holdings. The only countries to lose gold were the large agricultural exporters (Australia, Canada, Brazil etc.) and Japan. These countries lost gold because their trade balances were in a mess.
If the dire world economic situation of the late 1920s was the result of monetary factors, why is it that the world economy continued to deteriorate in the face of the substantial and sustained easing of world interest rates?
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Henry,
“This technology investment boom was all pervasive and unsustainable.”
Because?? Some Austrian said so??
“If the dire world economic situation of the late 1920s was the result of monetary factors, why is it that the world economy continued to deteriorate in the face of the substantial and sustained easing of world interest rates?”
The easing of short term interest rates does nothing for the borrower if he / she is locked into a long term fixed rate borrowing agreement. I don’t believe that adjustable rate mortgages (ARMs) existed back them.
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Frank,
“Because?? Some Austrian said so??”
No Austrians, just plain fact.
The development of the vacuum tube opened a new era of radio communications and entertainment as did the development of the film industry. The development of the internal combustion engine opened a new era of transport and travel and mechanization. The development of aeronautics contributed to this new era of transport and travel. Mass production had revolutionized industrial methods. Industrialized chemistry brought its own raft of new products. So many new horizons of economic potential were now apparent. Einstein’s General Theory of Relativity and the nascent Quantum Mechanics Theory had blasted science on to an elevated plain. The 1920s would have been completely unrecognizable to anyone stepping into the new century in 1901, just 20 years previously.
“The easing of short term interest rates does nothing…”
You focus on a narrow aspect. The fact is there was a general easing of monetary conditions in the late 1920s.
You raised Fisher’s debt deflation theory above. You have answered your point yourself.
The debt question is more of a real phenomenon that it is monetary. It impacts directly on spending capacity and plans/expectations.
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@ Frank,
…That is why farmers AND economists err – because they only look at demand. It’s not that farmers err in their future estimate of demand, they err in their estimate of future production relative to future demand….
have to disagree here, entrepreneurs do try to take supply conditions into account. In a commodity business (farming) you would do this by guesstimating the wheather, inventories, etc.) of course: the individual farmer will be wrong, but typically these things cancell each other out (which is why we do not see depressions that oftern..). I see this happening constantly in every commodity market I follow…
…If I am a farmer and I see demand growing by 3% per year (as per my example) I am going to try to increase my output by 3% per year.
What I don’t know about is my farmer neighbor 50 miles away that just purchased a motorized combine harvester that enables him to increase output 9% per year….
It is not so easy to increase your demand and buy a combine harvester. Someone has to lend you the money, to buy more land and equipment.
You might be an optimistt, but the bank director has to agree with your forecast and believe that loaning you the money is the best use of his funds. And in our example he is not just lending to one farmer, but to many of them. – again…This collective error in judgement -because rare – is what needs to be explained, not the fact that producitivty will cause prices to fall…
I do not say that tariffs did not play a role, however, I do believe there is a monetary effect which I wantet to focus on.
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@ Henry,
I am not sure as to what point you are trying to make. I do not ignore non-monetary factors. I explicitly write that I believe them to be generally underappreciateted in explaining the GD.
Increases in productivity, i.e. the natural interest rate, are indeed needed to ignite the sort of lending that starts the boom bust cycle….(if you accept this theory)
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VC,
“I do not ignore non-monetary factors.”
I misunderstood you – it sounded as if you were only looking to monetary factors.
“Increases in productivity, i.e. the natural interest rate, are indeed needed to ignite the sort of lending that starts the boom bust cycle…”
I don’t know I would exactly put it that way but I guess that is a reasonable way to look at it and the part I don’t get is your reference to the natural rate of interest.
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@ Henry
As Wicksell (indeed Tooke before him) theorized (then taken over by the Austrians):
the absolute level of interest is less important than the relationship betwenn the natural rate (unobservable) and the bank, i.e. market rate. This relationship determines whether fiduciary media expand or contract…
What is the natural rate?
It is the marginal return on real capital, i.e. the outlook for profits.
When you have positive productivity shock the natural rate rises (under certain circumstances taking into account leads and lags).
If the bank rate (and voluntary savings) doesn’t rise accordingly what you get is a boom…
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Vienna Capitalist,
“What is the natural rate of interest?”
“It is the marginal return on real capital.”
https://en.wikipedia.org/wiki/Capital_(economics)
“In economics, capital consists of human-created assets that can enhance one’s power to perform economically useful work. For example, a stone arrowhead is capital for a hunter-gatherer who can use it as a hunting instrument; similarly, roads are capital for inhabitants of a city. Capital is distinct from land and other non-renewable resources in that it can be increased by human labor, and does not include certain durable goods like homes and personal automobiles that are not used in the production of saleable goods and services. Adam Smith defined capital as that part of man’s stock which he expects to afford him revenue. In economic models, capital is an input in the production function.”
Nope, the natural rate of interest is the returns on time, not “real capital”.
This can be seen in the units used for any rate of interest, such and such percent per month or such and such percent per year.
If we all lived forever, then the natural rate of interest would be ZERO regardless of the returns on real capital.
It is time that is the precious resource (each of us are only given a fixed amount of it) not “real capital”.
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@ Frank
There are several definitions, which is confusing, I know. Natural rate in a money economy and barter economy are best kept separated…
You are referring to time preference As Bawerk showed, market interest rates are simultaneoulsy detemined by productivity (related to RoA) and time preference….
I have reffered to the definition used by Wicksell to describe the workings of a money (as opposed to barter) economiy…. (he and most other economists, at the time, settlet for this definition – including Hayek and Mises after long debates, hence the confusion)
Why did Economists introduce the natural rate?
Because they observed in the 19th century that lending might be subdued DESPITE low interest rates and abundant reserves.
Wicksell explained this puzzle by introducing the natural rate, i.e. basically the outlook for profits.
It is really simple (and logical):
No good profit opportunities for businessmen (for whatever reason), no new lending, indeed volumes might (and did) even contract (deflation)…
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@ Frank
another point. Real capital does not yield a return per se.
If you invest in a country with no property rights (say one day before a communist takeover) or with a high degree of revolutionary violence, then your real capital would yield a (certain) loss….
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VC,
You responded to me:
“It is the marginal return on real capital, i.e. the outlook for profits.”
You responded to Frank:
“Nope, the natural rate of interest is the returns on time, not “real capital”.”
Are these two statements consistent?
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Henry,
Two slightly different world views here.
VC describes the natural rate of interest as the marginal return on real capital. I responded that the natural rate of interest is the returns on time, not “real capital.”
I feel that defining interest as the returns on time is a broader more encompassing definition.
The two statements are not inconsistent if one minor modification is made to VC’s statement:
“The natural rate of interest is the marginal return on real capital over time.”
We need the time variable to properly define any interest rate. Suppose that some company doubles it’s real output over five years. Now suppose that another company (producing the same goods) doubles it’s real output over 30 years.
Both have doubled output, but the rate of return on real capital is higher for the first company. An economy full of companies like the first one will have a higher natural rate of interest than an economy full of companies like the second.
There are enterprises that benefit from productivity improvements through technological innovation but where profitability is a secondary goal – things like medical care, education, etc.
There are enterprises where the primary “real capital” is the human mind – literature, music, artistic works, etc – not the tools that are used to create such works.
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@ Henry
Frank’s last comment is spot on.
BTW, this part was not written by me:
Nope, the natural rate of interest is the returns on time, not “real capital”.”
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VC,
My apologies.
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VC,
“@ Frank, There are several definitions, which is confusing, I know. Natural rate in a money economy and barter economy are best kept separated…”
What should be said is that natural rate in a credit based monetary economy and natural rate in a barter economy should be kept separated.
Numerous real goods have served as “money” over time (gold, silver, sea shells, large stone tablets, etc.) even in barter economies.
The important part is to distinguish between interest charged in a lender / borrower arrangement and interest charged in a trade separated by time.
In a borrower / lender arrangement, the good that is lent out must also be returned in kind.
Obviously when a bank lends me $1000 in twenties or hundreds, they don’t expect me to return the exact same twenties or hundreds because currency is fungible.
We can say the same thing about a lot of goods – ounce of gold, silver – bushel of wheat, apples, corn – ton of lumber, iron, salt – with a uniform measuring stick / set of scales, many goods can be considered fungible.
In a trade separated by time (for instance I give you $100 now for a couple of bushels of apples a year from now), there is a rate of interest applied as well. You see it in the spread between spot and futures markets.
In a credit based monetary economy consisting of apples and dollars as the only two goods, there are a couple of interest rates:
1. Dollars now for dollars in the future (%D) – Borrower / lender arrangement
2. Apples now for apples in the future (%A) – Borrower / lender arrangement
3. Dollars now for apples in the future (%DA) – Trade arrangement
The “real” rate of interest %A is equal to the nominal rate of interest %D minus the inflation rate %DA.
The “real” rate of interest is not directly observed since in a credit based monetary economy, individuals borrow money under #1 and then buy goods under #3 without resorting to apples now for apples later lending arrangements.
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The question you need to ask yourself is why would the real interest rate ever go negative?
That means that in my example above – %A is negative.
Why would anyone pay more apples now for fewer apples in the future?
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@ Frank
why would it go negative?
assume you are facing an comunist takeover tommorrow, i..e you are facing expropriation?
what is your marginal expected real return on capital in that scenario?
How much demand for investment loans is there going to be in that case?
Who can pay you, your desired positive real interest rate?
There would never be capital consumption of the expected real natural rate of interest is positive (unless you have a super high timer preference society)
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Viennacapitalist,
“Why would it go negative?”
“What is your marginal expected real return on capital in that scenario?”
The answer is that I am forced / coerced to lend my apples even when my expected real return on those apples is negative. (See central bank financed wars, bank bailouts, extended unemployment benefits, among other numerous examples).
“Who can pay you, your desired positive real interest rate?”
Someone who can take the seeds from my apples that I lend, plant apple trees, and harvest the new apples.
“There would never be capital consumption if the expected real natural rate of interest is positive.”
??? Huh ??? As long as marginal returns on investment (particularly the after tax variety) exceed the real natural rate (expected or otherwise), then there most definitely will be capital consumption.
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@ Frank
Not sure you got my point.
I did not assume forced lending, I assumed a negative marginal return on capital, via expropriation (say, a 100 percent tax rate on profits)
In that scenario, NOBODY will lend, because nobody will ask for funds…..
I repeat: in that scenario, there is nobody who will take your seed and plant an apple tree (whose fruit will not belong to him anyway) and therefore NOBODY who will pay you sour time preference – that’s what you call a marginally negative return on capital. Capital consumption occurs, as it is more rational to shrink (get poorer) than to grow (effort without reward)…
You asked my for an example for negative natural rates (where nobody will lend or plant a seed corn) and I gave you an (extreme) one – we even have historical examples for that…
.
You are confusing equilibrium conditions with disequilibrium, as well as the natural rate with time preference (they are not the same)
Yes, in equilibrium the marginal return on capital (natural rate) and the time preference that determine savings are equal that’s when they coincide. The world, however, is never at equilibrium, as every Austrian should know…
This is also evident in your last paragrhaph. Capital consumption occurs (on average, of course) when the expected marginal return on capital is BELOW the MARKET interest rate.
The marginal return on capital and the natural rate (both unobservable) are the same thing (as defined by Wicksel, to whom Mises and Hayek refer)…
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Viennacapitalist,
“Not sure you got my point.”
I didn’t realize there was a point to be had. Your post was a list of questions.
“I did not assume forced lending…”
That’s fine, but forced lending is the answer to my question – “Why would the real interest rate ever go negative?”
“I assumed a negative marginal return on capital, via expropriation (say, a 100 percent tax rate on profits). In that scenario, NOBODY will lend, because nobody will ask for funds….. ”
And that is fine as well – but in the United States we don’t have a 100% tax rate of profits. We DO have forced / coerced lending. See primary dealer banks / FOMC.
“Capital consumption occurs, as it is more rational to shrink (get poorer) than to grow (effort without reward)…”
No, capital consumption occurs because of depreciation – most goods that are produced are eventually going to malfunction, corrode, and deteriorate. That will happen IRREGARDLESS of time preference or the marginal return on capital. The person I am lending apples to will consume some of the apples he grows lest he starves, dies, and turns to dust. The apples themselves will eventually do the same.
“You asked my for an example for negative natural rates (where nobody will lend or plant a seed corn) and I gave you an (extreme) one – we even have historical examples for that…”
When nobody lends, a natural rate of interest doesn’t exist at all – the term becomes meaningless. I asked for an example of where lending does occur at a negative real rate of interest – and the only example I can point to is forced / coerced lending.
“Capital consumption occurs (on average, of course) when the expected marginal return on capital is BELOW the MARKET interest rate.”
No, capital consumption occurs primarily because all individuals must consume to survive and most goods deteriorate / depreciate over time.
Additionally, you are forgetting about equity. The person I am lending apples to can instead obtain apples to start an orchard by selling equity claims against the future production from that orchard. The person operating the orchard can then either consume (eat) excess apple production OR use the excess to grow additional apples IRREGARDLESS of the market interest rate.
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“The person I am lending apples to can instead obtain apples to start an orchard by selling equity claims against the future production from that orchard.”
Now I know where the term “seed capital” came from. 🙂
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@ Frank,,
There is no forced lending in the US, nor in Europe. Nobody is pointing a gun at the corporations and households to lever up and buy houses – The incentives are there, yes, but definitively no forced lending…
I used a 100 percent tax rate as a thought experiment (albeit one that has already happened) – that’s what you do in economics Austrian and otherwise. In practice it is a continuum. Increasing costs of doing business (regulations, taxes, etc.) definitevely have the potential to render the marginal return on capital negative..
Depreciation is not the explaination for capital consumption. As you write, deprecdiation occurs anyway, hence cannot explain periods of capital consumption and build up. You have to explain why capital is NOT REPLACED in one scenario and IS replaced in another. Please think through my statement above…
The natural rate is unobservable (I repeat), and it, of course also applies to equity financing.
Faced with increasing costs of doing business, equity owners might decide not to reinvest depreciation and rather consume their seed corn – it has happened in the past and, I believe, it is happening now…
Most important concepts for you to take away:
The natural rate is (typically) defined as the expected (therefore unobservable) MARGINAL RETURN ON CAPITAL….
The natural rate is UNOBSERVABLE and not necessariily equal to the marktet rate (althhoug one might try to infer it from market rates)
Depreciation is NOT the reason for capital consumption, rather, and more precisely,, a negattive expected return on investment adjusted for risk and timer preference is….
And: our current system doesn’t feature forced lending, rather it can best be described by incentivizing people to take out loans (as crazy as that is)…
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Viennacapitalist,
“There is no forced lending in the US, nor in Europe.”
“And: our current system doesn’t feature forced lending, rather it can best be described by incentivizing people to take out loans (as crazy as that is)…”
First, lookup primary dealers:
https://en.wikipedia.org/wiki/Primary_dealer
Then ask yourself – can a government bond auction fail?
Meaning no one submits bids to lend the federal government money.
Primary dealer banks are forced / coerced into lending the federal government money and that is why government bond auctions don’t
fail.
– Depreciation is not the explanation for capital consumption.
Yes it is. If I built a machine and it never wore out, why would I ever build a replacement? Why would I re-invest in a new machine if the first one that I build lasts forever?
See:
https://www.economicshelp.org/blog/glossary/capital-consumption/
“This is the loss of capital equipment due to depreciation. Depreciation can occur due to the machines wearing out, getting lost or breaking down. Capital can also become obsolete through advances in technology.”
“Capital consumption can also occur due to a shift in demand. E.g. rise in demand for computers made the investment in producing typewriters obsolete.”
– As you write, depreciation occurs anyway, hence cannot explain periods of capital consumption and build up. You have to explain why capital is NOT REPLACED in one scenario and IS replaced in another. Please think through my statement above…
-Faced with increasing costs of doing business, equity owners might decide not to reinvest depreciation and rather consume their seed corn – it has happened in the past and, I believe, it is happening now…
The question you are asking is given the choice between re-investment (replacing capital) and closing shop (eating seed corn or just letting it sit in a field and rot), what drives that decision. And I would answer, the same factors that drove the decision to invest in the first place.
“Most important concepts for you to take away: The natural rate is (typically) defined as the expected (therefore unobservable) marginal return on capital OVER TIME.”
We have been over this already. If all goods last forever and we each live forever, then time becomes an infinite resource. That is why depreciation is drives capital consumption.
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Viennacapitalist,
I tried this post once with active hyperlinks but it appears to have been rejected. Add https:// to the wikipedia and economicshelp links below.
– There is no forced lending in the US, nor in Europe.
– And: our current system doesn’t feature forced lending…
Yes, forced / coerced lending does happen in the United States – see:
en.wikipedia.org/wiki/Primary_dealer
This is why government bond auctions never fail – irrespective of the interest rate.
– Depreciation is not the explanation for capital consumption.
– Depreciation is NOT the reason for capital consumption, rather, and more precisely,, a negative expected return on investment adjusted for risk and time preference is….
Yes it is. If I built a machine and the machine lasted forever, why would I ever build a replacement? Or if I plant an apple tree and it lives forever, why would I ever need to replace the apple tree (re-invest my capital)?
See:
http://www.economicshelp.org/blog/glossary/capital-consumption/
Definition of Capital Consumption
This is the loss of capital equipment due to depreciation. Depreciation can occur due to the machines wearing out, getting lost or breaking down. Capital can also become obsolete through advances in technology.
Capital consumption can also occur due to a shift in demand. E.g. rise in demand for computers made the investment in producing typewriters obsolete.
In my description above, I neglected to include obsolescence – my mistake. My machine may last and operate for 100 years, but better technology may make my machine obsolete in 30 years.
– Most important concepts for you to take away:
The natural rate is (typically) defined as the expected (therefore unobservable) marginal return on capital OVER TIME.
We went over this once already. It is time that is the limiting factor.
You, I, a machine, an apple tree will last / live on for a fixed amount of time.
If we all lived forever and all goods were persistent then capital consumption would fall to zero.
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Viennacapitalist,
In the movie “Interstellar”, there are some great lines. Included among those is this comment by Anne Hathaway’s character Dr. Amelia Brand:
“We need to think of time as a resource, like oxygen and food.”
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I apologize for not having replied to any comments for almost three months as I was busy trying to complete the final manuscript of my book to be published (I hope) before the end of 2021 by Palgrave Macmillan. I will try to respond to at least some of the recent comments directed toward these past three months.
Henry, you said:
“It’s not as if the other major economies of the world lost mountains of gold during the period of interest, in fact, they gained gold.
The gold heading towards the US and France can be accounted for by new gold production and the gold sucked from the agricultural exporters (Australia, Brazil, Canada etc.) because their trade accounts collapsed.”
From the end of June 1928, just prior to France’s resumption of gold convertibility till the end of 1931, total world gold reserves increased by $1.574 billion. French gold reserves increased by $1.563 billion, US gold reserves by $319 million, the combined gold reserves of Belgium, Netherlands and Switzerland by $792 million while the combined reserves of the rest of the world decreased by $1.1 billion. I seriously doubt that Australia, Canada and Brazil account for all of that $1.1 billion reduction in gold reserves.
More importantly, the fall in commodity prices was a reflection of the deflation caused by the accumulation of gold by the US and France (most of the increase in Belgian, Dutch and Swiss reserves reflects speculation after the UK suspended the gold standard which moved gold from the US to France and the other 3 countries at the end of 1931. You can’t dismiss the gold accumulation that caused deflation by saying it was just the result of deflation.
Similarly you can’t cite the decline in interest rates caused by raging deflation to say that policy was not deflationary. Given deflationary expectations caused by deflationary policy, any positive interest rate was contractionary in the absence of an explicit policy of reflation, which is precisely what the French and the US were resisting until FDR abandoned the gold standard in
April 1933 and adopted reflation as the goal of policy, immediately triggering the fastest recovery in history.
viennacapitalist,
You wrote:
“you write that deflation caused by a rise in gold caused the money supply to contract.
Just what was the cause of such as sudden rise in gold’s value?
The reserve demand by the bank of france?
This is unplausible under fractional reseve banking prevailing at the time, i.e. a fractional reserve system can easily adjust to this type of demand shifts (leaving aside certain limiting cases).”
You misunderstand the causality here. The increase in the value of gold causes prices to fall because under a gold standard the price level corresponds to the value of gold. When prices fall, a constant real demand for money implies a reduced nominal demand for money. When the nominal demand for money falls, the fractional reserve banking system responds by supplying a reduced nominal quantity of corresponding to the reduce nominal demand for money.
Frank and viennacapitalist,
Farmers can only guess what prices they will receive for the products they harvest (which is also uncertain given fluctuations in the weather and other environmental variables). Their guesses about prices are about the relative prices of their products. In the Great Depression they were devastated not only by optimistic relative price expectations, but more seriously by incorrect price-level expectations that resulted not from the environment but by the worldwide deflation caused by the confluence of a mismanaged restoration of the gold standard and the anti-social policies of the Bank of France and the Fed, which intolerably increased the real value of their fixed debt obligations by at least 25%.That was the essence of Fisher’s Debt Deflation theory, which was incomplete only in not fully spelling out the malign role of the Bank of France and the Fed.
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David,
“Farmers can only guess what prices they will receive for the products they harvest (which is also uncertain given fluctuations in the weather and other environmental variables). Their guesses about prices are about the relative prices of their products. In the Great Depression they were devastated not only by optimistic relative price expectations…”
https://www.mnopedia.org/agricultural-depression-1920-1934
After the US entered the war in 1917 and continuing into the post-war years, 40 million acres of uncultivated land in the US went under the plow, including 30 million acres in the wheat- and corn-producing states of the Midwest. In Kittson County alone, wheat acreage increased from 93,000 acres prewar to 146,000 acres. Minnesota farmers had nearly 18.5 million acres under cultivation by 1929. The demand for land inflated the price of farm real estate, regardless of quality. The average price of Minnesota farm land more than doubled between 1910 and 1920, from $46 to $109 per acre.
After the end of the war, relief efforts kept the demand for US agricultural products high. Gross exports of all grains in 1918–1919 totaled 525,461,560 bushels. During that period, the US shipped more than 2.9 billion pounds of pork, 1.1 billion pounds of beef, and nearly 8.8 million pounds of dairy products to allied countries, various relief programs, and American Expeditionary Forces overseas.
Farmers continued to produce more, expecting demand and prices to remain stable. As Europe began to recover from the war, however, the US farm economy began a long downward trend that reached a crisis during the Great Depression. Minnesota farmers’ gross cash income fell from $438 million in 1918 to $229 million in 1922. In 1932, it fell to $155 million.
With heavy debts to pay and improved farming practices and equipment making it easier to work more land, farmers found it hard to reduce production. The resulting large surpluses caused farm prices to plummet. From 1919 to 1920, corn tumbled from $1.30 per bushel to forty-seven cents, a drop of more than 63 percent. Wheat prices fell to $1.65 per bushel. The price of hogs dropped to $12.90 per hundred pounds.
As surpluses mounted, the federal government promoted lowering production. It also created programs designed to help stabilize prices. The goal was to achieve parity – to bring prices back to prewar levels and equalize the prices farmers received with the prices they paid for goods.
The passage of the Capper-Volstead Act on February 18, 1922 legalized the sale of farm commodities through farmer-owned cooperatives. Co-ops cut out the middlemen who often underpaid farmers for their products. Congress passed the Agricultural Appropriations Act later that year, creating the US Bureau of Agricultural Economics for economic research.
Foreign trade restrictions, such as the Fordney–McCumber Tariff (1922) and the Hawley-Smoot Tariff (1930), imposed high taxes on imports in an attempt to protect US farms and industry. International trading partners reacted by increasing import fees on American goods. US export of farm products declined, surpluses grew, and prices continued to drop. In 1932, Minnesota corn prices fell to twenty-eight cents per bushel, wheat dropped to forty-four cents per bushel, and the price of hogs fell 75 percent to $3.20 per hundred pounds.
With less demand for land, real estate values plunged to an average of $35 per acre by the late 1930s. Farmers struggled to repay loans for land that had lost its value. Rising property taxes, freight rates, and labor costs added to the financial hardships facing many farmers. In Minnesota, the average tax per acre increased from forty-six cents in 1913 to $1.45 in 1930.
The west-central counties of Minnesota suffered from the severe drought conditions of 1933–1934. A combination of poor farming methods and drought caused extensive soil erosion. A grasshopper infestation compounded crop losses in many western counties.
Farmers across the country began to default on their loans. An estimated sixty of every 1,000 farmers in the US either lost their farms or filed for bankruptcy. From 1926 to 1932, 1,442 farms totaling 258,587 acres were lost to foreclosure in Minnesota. Marshall County had the highest number of foreclosures during this period with 191. It was followed by Kittson County with 127 and Pennington County with 123. From 1922 to 1932, 2,866 Minnesota farmers declared bankruptcy.
“….and the Fed, which intolerably increased the real value of their fixed debt obligations.”
Because the Fed produces goods in competition with farmers?
Because the Fed was buying a lot of farm goods during the boom times and then stopped buying? Was it the Fed that was recovering from World War I and bought less and less farm goods from the US?
Was it the Fed that instituted the 1922 and 1930 Tariffs?
Was it the Fed that caused drought conditions or a grasshopper infestation from 1933-1934?
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Frank, Thanks for providing a lot of interesting historical background. The Fed’s effect on the indebtedness of farmers was achieved entirely through its effect on the price level that in real terms increased the indebtedness of US farmers by at least 25%. I did not assert and did not mean to imply that the Fed did so because it meant to harm farmers; the effect on farmers was, I assume, merely an unintended consequence of policy decisions that the Fed made for reasons largely independent of the effect on farmers. Tariffs in 1922 and 1930, and grasshoppers in 1933-34 occurred without any input by the Fed
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David,
“The Fed’s effect on the indebtedness of farmers was achieved entirely through its effect on the price level that in real terms increased the indebtedness of US farmers by at least 25%.”
Read a little closer.
“From 1919 to 1920, corn tumbled from $1.30 per bushel to forty-seven cents, a drop of more than 63 percent. Wheat prices fell to $1.65 per bushel. The price of hogs dropped to $12.90 per hundred pounds.”
Prices were falling for farm goods (deflation) well before any actions that you attribute to the Fed or the Bank of France occurred.
My own suspicions are that when the Fed raised short term rates to 6.5%, that put a lot of private banks into an inverted yield curve situation – they (private banks) were holding a lot of long term mortgages paying 4-5% while their short term cost of debt service rose to the short term rate.
That happens regardless of whether the US is on or off a gold standard and was a contributing reason for the creation of the quasi-governmental agencies (Sallie Mae, Freddie Mac, Fannie Mae).
Fisher (under the Chicago Plan) advocated that banks fund the creation of risky assets (mortgages) through the sale of equity shares or through retained earnings.
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Frank, the drop in farm prices from 1919 to 1920 was at least partially caused by the deflation deliberately caused by the Fed to reverse the rapid postwar inflation of 1919. It is true that the 1920s were difficult times for farmers. Not all of those difficulties were caused by monetary policy, but clearly some of them were. The 1920-21 deflation and 1929-33 deflation were caused by monetary policy. That’s all I was saying and I was not asserting that monetary policy was solely responsible for those difficulties.
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“Frank, the drop in farm prices from 1919 to 1920 was at least partially caused by the deflation deliberately caused by the Fed…”
??? The Federal Reserve wasn’t created until 1913 and the US remained on the Gold Standard both throughout and after the war (1914-1918). What did the Fed do from 1919 to 1920 that caused the deflation ???
https://inflationdata.com/articles/inflation-consumer-price-index-decade-commentary/inflation-cpi-consumer-price-index-1920-1929/
“However, not everyone enjoyed the boom. Over 50% of the American population still lived on farms, and didn’t own stocks. The twenties was a terrible time for farmers. World War I had allowed farmers in the U.S. to boost production to feed war torn Europe.”
“To meet this increased demand many farmers had taken out large loans to buy tractors and increase acreage under cultivation. But as the war ended, European farmers began producing again and American farmers suddenly faced a glut of agricultural products which resulted in falling prices (deflation) for commodities like corn, wheat and cotton.”
“For many in rural America the Great Depression began not with the stock market crash in 1929 but a full ten years earlier with the agricultural product crash in 1920. The 1920’s had a much greater divide between haves and have-nots than we have today. There was a great divide between the prosperity of the cities and the poverty of the country. And for those in the country the poverty continued for roughly two decades from 1920 through 1940.”
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Frank,
US inflation was rapid during WWI even before the US entered the War, and increased after US entry. The NY Fed’s discount rate was 4.5% despite rapid inflation at the end of the war and inflation increased after the war until the Fed raised interest rates with the explicit goal of reversing the postwar
deflationinflation. In the spring of 1920 the NY Fed raised its interest rate to a record 7% and deflation started immediately and did not stop until the Fed started reducing rates in 1921. This is all well-known and uncontroversial.I don’t dispute that the 1920s were tough for farmers, so I don’t know what you think you are accomplishing by quoting material that says that farmers were having tough times. That doesn’t mean that a 25% increase in the debt burden of farmers while further reducing the demand for their products by the rest of the economy did not greatly worsen the already difficult situation in which they found themselves.
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“The NY Fed’s discount rate was 4.5% despite rapid inflation at the end of the war and inflation increased after the war until the Fed raised interest rates with the explicit goal of reversing the postwar deflation.”
I believe you mean the “explicit goal of reversing the postwar inflation”.
The question is if the magic interest rate for rapid inflation was 4.5% and for deflation was 7.0%, why didn’t the rapid inflation resume after the NY Fed reduced it’s discount rate back to 4.5% starting in 1921?
The point I am trying to get across is that the Fed always and forever sets a nominal interest rate. It really doesn’t matter whether a gold standard exists or not. The relationship between the interest rate that the central bank lends at and the inflation rate is dubious at best (too many other factors at play).
Why weren’t farmers able to raise their prices 25% to cover the increase in debt service costs when the discount rate rose from 4.5% to 7.0%?
Some information I was able to dig up on farm credit in the early 1910’s and 1920’s.
https://www.fca.gov/about/history-of-fca
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Frank,
Yes, that’s what I meant. Thanks for catching that mistake, which I’ve now corrected.
You’ve been a long-time and valued reader of this blog, so I’m surprised to see that you aren’t aware or have forgotten that I’ve long said that whether an interest rate set by a central bank is tight or loose not in absolute terms but relative to current conditions and expectations. By sharply raising interest rates from a rate that was very low relative to current and expected inflation to an all-time high and announcing that it was seeking to reduce the price level at least part way to the prewar level, the Fed succeeded in changing the monetary environment and reversing expectations from inflation to deflation and presided over one of the sharpest and deepest deflations in American and world history as most other countries fell in line with the US deflation. The reduction in the interest rate from 7 to 4.5% interest rate in 1921 after that steep deflation signaled that the Fed was not seeking further deflation. And the deflation stopped.
It did matter whether there is a gold standard under pre-Word War I conditions. But after World War I, the US controlled 40% of the world’s gold reserves, so the US determined the price level for the world (at least the countries on trying to get back on the gold standard) because the US controlled the real value of gold. So it was as much a dollar standard as a gold standard.
Farmers are price takers not price searchers. They can’t decide what price they will sell at unless they are able to organize a cartel that controls the amount of agricultural products that farmers produce. There were some attempts made in that direction in the 1920s but those efforts were overwhelmed by the deflationary conditions in which farmers were operating.
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