Krugman contra Schumpeter

As we find on so many subjects, Jefferson said it best:

"We have time yet for consideration, before that question will press upon us; and the maxim to be applied will depend on the circumstances which shall then exist; for in so complicated a science as political economy, no one axiom can be laid down as wise and expedient for all times and circumstances, and for their contraries." (Jefferson, 1816)

Paul Krugman could have quoted Jefferson to good effect in his rebuke of Schumpeter this morning. He presents this passage from Schumpeter's "The Economics of the Recovery Program" (1934):

Krugman responds: "He lays out the extreme liquidationist position, arguing not just against the use of fiscal policy to fight unemployment but even against monetary policy, lest it get in the way of the “work of depressions”... But here we are, in 2010 — and something very much like that position is being forcefully advocated by Wolfgang Schauble, the government of China, Narayanan Kocherlakota, and Sarah Palin."

You might wonder, though, what "the two cases we analyzed" that Schumpeter refers to in the beginning are. Well if you read "The Economics of the Recovery Program" you'll learn he's refering to 1825 and 1873. Let's start with 1873, because this is where Jefferson comes in. The so called "long depression" following 1873 was nothing like the Great Depression that Schumpeter was commenting on, primarily because it wasn't really all that depressing! In the decade or two following 1873, the United States saw substantial improvements in productivity that lead to positive supply shocks. Prices, of course, went down. Now that deflation was painful for farming communities, etc., but aside from that sort of caveat this was good deflation and good growth. This is commented on extensively by Rothbard as well as Friedman and Schwartz. It is very broadly accepted history. But as I point out in this recent post, shifts in aggregate supply are very different from shifts in aggregate demand. I don't know if Schumpeter actually didn't realize this, or if he's just trying to play fast and loose with a less academic audience, or what but Jefferson's maxim here is especially important - you can't compare apples and oranges. You can take the experience of 1873 and use it to inform 1934*.

I don't know that much about the 1825 depression, so I did some looking. It turns out, this episode was very much comparable to the 1930s: a financial crisis caused an increase in money demand and a general glut. That would have been Keynes's diagnosis if he lived in 1825, and it was Jean Baptiste Say's diagnosis (he came around to Malthus's position eventually). A typical Keynesian solution would be fiscal and monetary stimulus, of course. Now, Schumpeter says of 1825 that "recovery came of itself" - without any artificial stimulus. Is he right about that? Again, I don't know the episode all that well, but appears he is quite wrong about this. Charles Hughs Smith in the Daily Finance writes that: "Walter Bagehot, the influential editor of The Economist in the 1860s and 70s, held the view that the first task of a central bank during a financial panic is to end the panic. In 1825, after some initial hesitancy, the Bank of England did exactly that by lending money to anyone with just about any sort of collateral -- not just sound assets but even illiquid assets. This flood of new lending staunched the panic, but the stock market slump and recession lasted into 1826."

So here's the situation: Schumpeter was right that "recovery came of itself" in 1873 but wrong that it was comparbale to the situation in 1934. Schumpeter was wrong that "recovery came of itself" in 1825, but right that it was comparable to the situation in 1934. This is why it matters to (1.) first and foremost get your history right, and (2.) think critically about how comparable historical episodes are. Not all recessions are created equal. We need to permanently dispell this myth that there is one process that causes fluctuations in economic activity. It's dangerous and it leads to bad policy.

- This is a Marxist perspective on 1825

- This is a commentary by Michael Bordo (Rutgers and NBER) on 1825, and

- This is an article by Richard Anderson (Federal Reserve Bank of St. Louis) on 1825

*I should note that there was a major monetary shock in 1873, and a financial panic that induced several bank runs and failures. So there were some very real problems in 1873 itself. But the "long depression" that followed does not appear to be a result of this - the only real thing that qualified the "long depression" as a depression was the price level changes. We experienced real growth after the initial, and very real, Panic of 1873.