TCS Daily

What Roosevelt Didn't Know

By Arnold Kling - June 5, 2007 12:00 AM

In late May [1934], Keynes, the British economist, visited with the president...Francis Perkins, whom Keynes saw afterward, would later recall that Keynes told her the session did not go well. Roosevelt gave a similar report, telling Perkins that Keynes had left him, disappointingly, with a "rigamarole of figures. He must be a mathematician rather than a political economist."
-- Amity Shlaes, The Forgotten Man

The U.S. economy survived the dotcom bubble and crash of 1999-2000 much better than it survived the stock market bubble and crash of 1929. One reason is that President Bush did a better job of sifting through economic advice than did President Roosevelt. (My early evaluation of the Bush record from a macro perspective still stands.)

One of the legends of the Great Depression is that no one knew what to do about it until John Maynard Keynes published The General Theory of Employment, Interest, and Money in 1936. One comes away from The Forgotten Man less convinced that the state of the art in economics was inadequate. Instead, it seems that Hoover and Roosevelt were not paying attention to the better economists of the day. Had there been a Council of Economic Advisers in 1930, the Great Depression might have been avoided, even though no member of the Council would have known Keynesian terminology. My current view is that The General Theory included more ideas than were necessary to diagnose and treat the problem of the 1930's.

Irving Fisher's Complaint

As part of the New Deal, the Roosevelt Administration ordered farmland taken out of production, grain to be held from the market, and young pigs slaughtered before they could become old enough to be part of the food supply. The goal was to raise the prices received by farmers by restricting output. The New Deal had similar programs to try to limit industrial production in order to boost prices.

Irving Fisher, the leading American economist, saw what was wrong with this policy. Amity Shlaes reports in her new book,

Fisher wrote to his son in Europe. His joy at contact with the president was moderated by his perception of Roosevelt's illogic. "I'm against the restriction of acreage and production, but much in favor of reflation. Apparently, FDR thinks of them as similar -- merely two ways of raising prices! But one changes the monetary unit to restore it to normal, while the other spells scarce food and clothing when many are starving and half naked!"

When I was growing up, the textbooks made Keynes the genius who figured out how to end the Depression, and they made Irving Fisher the goat. In reality, Fisher and Keynes were relatively close to one another in their understanding of the nature of the Depression. It was the policymakers under Presidents Hoover and Roosevelt who were the goats.

In the 1930's the advisers to Hoover and Roosevelt lacked good data -- and evidently Roosevelt was disconcerted by Keynes' use of "a rigamorole of figures." There were no standard measures of unemployment or consumer prices, as there are today. (Economists have since gone back and created historical estimates of this data.) As a result, in the middle of 1932, as the economy headed toward rock bottom, both Hoover the President and Roosevelt the challenger were troubled by, of all things, inflation. Had they possessed current data, it would have proven that deflation, not inflation, was the problem.

Ignorance of Concepts

Still, most of the ignorance that plagued policymakers during the 1930's was conceptual. They did not understand the difference between lost resources and under-utilized resources. They did not understand the relationship between financial markets and markets for goods and services. And they did not understand the issue of deflation.

Irving Fisher understood all of these things. Keynes understood them, also, and he had many additional theories. Nobel Laureate Robert Solow, who takes the view that Keynes invented macroeconomics, nonetheless said

The General Theory was and is a very difficult book to read. It contains several distinct lines of thought that are never quite made mutually consistent. It was an extraordinarily influential book for my generation of students...but we learned not as much from it - it was, as I said, almost unreadable - as from a number of explanatory articles that appeared on all our graduate-school reading lists. These articles reduced one or two of those trains of thought to an intelligible model, which for us became "Keynesian economics."

Note that Solow was a graduate student in the 1940's, so that by the time the Keynesian paradigm in macroeconomics could be solidified, the second World War had replaced the Great Depression as the number one policy concern.

Supply vs. Demand

Today, first-year macroeconomics includes a discussion of "aggregate demand and aggregate supply." I wish that the profession had chosen different terminology, but the concepts are important. If an automobile factory is shut down by a fire or a bombing, we say that it was hit with a supply disturbance. If the factory is shut down because dealers' lots are filled with unsold automobiles and they tell the manufacturer to stop shipping new cars, we say that the factory was hit by a demand disturbance.

Rather than the terminology of aggregate supply and demand, I prefer the terminology of productive capacity and capacity utilization. Today, we would say that most of the economic decline in the Depression reflected under-utilized resources, as indicated by the fact that the unemployment rate was often higher than 15 percent. This suggests a need for expansionary monetary and fiscal policy. Instead, if productive capacity is lost, then hard times are upon us, and we have to adapt. As I learned from reading The Forgotten Man and as I wrote in my previous essay, Roosevelt and many others saw the Depression through this "hard times are upon us" lens. Their ambition was to redistribute the pain, because they did not believe that the pain could be ended and the former prosperity restored. They acted as though productive capacity had been destroyed, as if by a war or a natural disaster.

Financial Markets and Goods Markets

Keynes stimulated economists to clarify the relationship between asset markets and goods markets. In asset markets, such as the stock market and the bond market, traders exchange claims on real assets. The claims are mere pieces of paper that represent the title to the underlying assets, which might be power plants or factories. The paper claims do not use up real resources. In goods markets, such as the market for haircuts or for drill presses, individuals and firms pay for goods and services that use up resources. What we buy in goods markets has to be produced. What we buy in asset markets are paper claims on capital that already has been produced.

A transaction in the goods market generates income. When we buy goods and services, the producers of those goods and services receive income.

In contrast, an exchange of assets generates no income. One can point out that buying stock generates brokerage fees. That is true, but those brokerage fees cover the service of facilitating the purchase and sale of stock. If we ignore brokerage fees, my purchase of 100 shares of IBM stock does not generate any income.

Among other things, this distinction between asset markets and goods markets says that speculation in asset markets does not detract from transactions in goods markets. In the aggregate, we can buy the same amount of haircuts and drill presses whether trading on Wall Street is active or inactive. True, if I buy shares of IBM from you, that gives me less cash to pay for my haircuts. But (a) I could now borrow to pay for haircuts, using my new shares as collateral, and (b) you have more cash to pay for your haircuts (although by the same token you now have fewer shares to use as collateral for borrowing). From the perspective of the goods market, the asset market transaction is a wash.

Thus, when Paul Krugman wrote recently that "Instead of investing in physical capital, many companies are using profits to buy back their own stock," he appeared to commit an elementary error. If a corporation speculates in the stock market by buying back its own shares (or by buying other companies' shares in a takeover bid or for a pension plan) it is not detracting from investment in drill presses or other forms of physical capital. I should note that in the past when Krugman has stated an economic proposition that on face value seemed incorrect, he usually has had in mind a more sophisticated analysis than what might fit into a typical column. I assume that was the case here.

Another way to see the distinction between asset markets and goods markets is in the definition of inflation. For example, a layman might look at an increase in stock prices or land prices as an example of inflation. Mainstream economists would measure inflation solely in terms of the prices of goods and services that are produced. The prices of pieces of paper that represent title to stocks or land are not part of the conventional price indexes. A change in the price of shares of stock does not change the amount of money income it takes to buy a haircut.

This separation of asset markets from goods markets means that, in principle, the economy can continue to produce goods and services, even if stock prices are low. The capacity to produce does not depend on the paper value of shares.

However, there are linkages between the behavior of asset prices and the behavior of the market for goods and services. For example, stock prices represent the market valuation of the capital owned by firms. This value reflects investors' hopes and expectations for the profitability of investment. If stock prices are high relative to the cost of adding new capital, then firms will determine that it is profitable to invest and expand. (Keynesian disciple and Nobel Laureate James Tobin elaborated on this idea, and mathematical macroeconomists refer to "Tobin's q.") When firms decide to invest, they increase their purchases of drill presses and other capital goods in the goods market. Thus, a rise in the price of shares in the asset market ought to induce an increase in purchases in the goods market.

Another link between financial markets and goods markets is that bank failures are contractionary. The failure of a bank effectively destroys the knowledge base embedded in the relationships between the bank and the businesses to which it lends money. It is difficult for a business to replace one source of funds with another, so that the bank failure serves to raise the cost of investment, and this reduces investment. Back when he was in academia, current Federal Reserve Board Chairman Ben Bernanke was one of the economists who explored this phenomenon.

The Meaning and Effects of Deflation

Inflation is a general decline in the purchasing power of money. Deflation is a general increase in the purchasing power of money.

It is easy to confuse general inflation or deflation with a change in the relative prices of goods. Thus, a spike in gasoline prices might be mis-labeled as inflation, while a drop in the price of wheat might be mis-labeled as deflation. A genuine inflation involves rising prices in most goods and services.

Inflations tend to be good for borrowers and bad for lenders -- at least at first. In the early 1970's, mortgage rates of 8 percent looked pretty steep to homebuyers. However, inflation accelerated later in the decade, and mortgage borrowers did really well, paying back their loans in much-cheaper dollars. Lenders, on the other hand, were crushed, with many going out of business between 1978 and 1982.

Conversely, deflations tend to be bad for borrowers. The farmer who borrows today to plant a crop for harvesting in six months cannot repay the loan if prices fall during the meantime.

Lenders can protect themselves from inflation, but borrowers cannot protect themselves from deflation. When lenders see inflation taking place, they can charge higher interest rates, and they can make loans for shorter periods of time. When borrowers see deflation taking place, they do not have the ability to demand appropriately low interest rates, because the appropriate interest rate might be less than zero. Lenders will hold onto money rather than lend it at negative interest rates.

Irving Fisher understood this. Even today, among economists, the relationship between inflation and interest rates is known as the Fisher effect.

Alternative History

There is no doubt that economists and policymakers know more about macroeconomic relationships than they did in the 1930's. Still, I am not convinced that better economic policies in the 1930's had to wait for the Keynesian revolution. I think that it was possible, even then, to have a better understanding of what was happening.

It seems to me that economists could have seen that the prosperity of the 1920's was not false. They could have portrayed a return to that level of production as a reasonable goal, not an impossible dream. They could have distinguished between the ups and downs of stock prices in the asset market and the productive capacity in the goods market.

It seems to me that economists could have seen, as Irving Fisher saw, that deflation was harmful. They could have understood, as Fisher understood, that curing deflation required expansionary monetary policy -- not an attempt to raise prices by restricting production.

The Forgotten Man tells us that the New Deal consisted of a mixture of business-bashing, pain-sharing, and attempted central planning. By today's standards, the results were abysmal. Even relative to what was known at the time, it was shockingly misguided and counterproductive.

The question arises, then, as to why the New Deal is so revered in memory. The Forgotten Man does not explain this. But reading it gave me an idea, which I will put forward in my next essay.

Arnold Kling is author of Learning Economics.


TCS Daily Archives