US Economy and the Lessons of History

By: Gerard Jackson | Mon, Jul 30, 2007
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In 1929 Hoover's Committee on Recent Economic Changes, under the chairmanship of Mr. Arch Shaw, wisely observed: "Each generation believes itself to be on the verge of a new economic era, an era of fundamental change". Unfortunately, the committee then went on to give support to the theory of underconsumption, one of the most -- and certainly extremely dangerous -- egregious economic fallacies. Considering the tragic events that gave rise to the Great Depression it is worth quoting the committee's opinion at some length.

They [the committee] reported that, from an increase in production efficiency of some 30 per cent per person during the 1920's, very little had gone to decrease prices of industrial products. The average price level had remained about the same from 1922 to 1929. The Committee found that about three-fourths of the gains from increased efficiency and decreasing costs had gone to increased industrial wages and one-fourth to increased profits. The buying power of the industrial workers had been increased, and increased profits had become a stimulant to speculation. But as labor and business absorbed the benefits of increased efficiency, such other groups as the farmers and the "white-collar" classes benefited only by a small increase in buying power. Therefore, these groups could not absorb the increased production of industry. To put it another way, had there been a decrease in price levels, the nonindustrial groups could have bought more goods, thus sustaining production. (Herbert Hoover, The Memoirs of Herbert Hoover: The Great Depression 1929-1941, The Macmillan Company: New York 1952, p.14).

The on valid observation here is the insight that a falling price level would have been of great benefit to consumers -- and just "farmers and the 'white-collar' classes". The rest of the quote clearly shows that the committee utterly failed to recognise the enormous role that 'price stability' played in bring about the depression. More perceptive economic observers emerged later on. For example, it was pointed out that the current

...difficulties are viewed largely as the inevitable aftermath of the world's greatest experiment with a "managed currency" within the gold standard, and, incidentally, should provide interesting material for consideration by those advocates of a managed currency which lacks the saving checks of a gold standard to bring to light excesses of zeal and errors of judgment. (C. A. Phillips, T. F. McManus and R. W. Nelson, Banking and the Business Cycle, Macmillan and Company 1937, p. 56).

What the committee overlooked is that if there underconsumption thesis was correct then the downturn would have first made itself felt in the lower stages of production, those closest to the point of production. It follows from this view that consumption should have been particularly hard hit. Yet the production data clearly shows that it was the higher stages of production, those furthest removed from the point of consumption, that took the full brunt of the depression. Moreover, consumption remained 'buoyant' relative to the capital goods industries. The very opposite of what the committee claimed.

(The underconsumption approach leads to the appalling -- but well-entrenched -- fallacy that it is consumption that drives an economy and not business spending).

If we look back on the recession that President Bush inherited (despite the malicious efforts of lefty journalists to claim otherwise) from the Clinton administration we discover the interesting fact that consumer spending continued to grow uninterrupted. This raises the obvious question: If consumer spending really is the engine that drives an economy -- as the vast majority of economists claim -- why is it that it did not save the US economy from recession?

What all of this really amounts to is that the real lesson of history -- political and economic -- is that few people ever learn from it. A dismal fact that scholars -- of which there are very few -- have sadly reflected upon. The question, as always, is why? This something that history cannot teach. If it were that easy then its lessons would never be forgotten, making life much better for the rest of us.

But history, alas, needs to be interpreted, which brings us to the role that economic history should play. When it comes to this subject observers tend to focus on two events: the Industrial Revolution and the Great Depression. Both were seminal and both have been greatly misunderstood. The former is being used to dismiss concerns about the possibility that American manufacturing is declining in real terms. The latter is used to promote huge government spending programs, high levels of taxation and all manner of manner of interventions in market processes

The blasé attitude that come free market commentators display about the relative decline of US manufacturing is largely due to the mistaken idea that because agriculture as a proportion of GDP fell during the Industrial Revolution as manufacturing's share rose it doesn't matter if manufacturing shrinks in real terms so long as spending on services rise.

This is a dangerous delusion.

A strong manufacturing base is vital to America's prosperity, just as it is to Australia's. The idea that an economy can remain prosperous by exchanging information is sheer nonsense. Those who peddle this dangerous myth obviously do not realise technical knowledge can only be applied through capital. Computers, for example, need chips and a whole range of other parts. All of these parts involve an incredibly complex chain of manufacturing processes involving thousands of stages of production, which brings us to the concept of capital as a structure.

If anyone mapped out the production structure that makes computers possible they would be literally staggered by its size and ever changing complexity. Even something as apparently simple as a loaf of bread requires a highly complex production structure that is far beyond the mind of any human being to fully comprehend. Unfortunately the role of manufacturing in raising living standards does not seem to be greatly understood. As David Friedman pointed out:

Manufacturing has helped equalize US income distribution by creating relatively well-paid jobs for America's less educated but motivated workers. Service industries, especially investor-driven New Economy companies, have thus far been unable to play a similar role in maintaining a balanced labor force. (THE ECONOMY: The Neglected U.S. Depression, Los Angeles Times 12 August 2001).

The classical economists were able to say with confidence that the "demand for commodities was not the demand for labour" because they understood that in the long run spending on consumption does nothing to increase productivity and hence real wage rates. And yet the lesson has not been learnt. Claudia Goldin, for example, believes that the wage gap was narrowed in the first part of the 20th century by a process that changed schools that once taught ancient Greek into schools that taught the children of the masses how to read blueprints. (Goldin based her conclusions on 75-year-old state reports that had been locked up in Harvard University's Monroe C. Gutman Library)

On the other hand, the Austrian school of economics would argue that the narrowing of the wage gap was brought about by lengthening the production structure which in turn raised the real demand for labour. This supports Friedman's view on the role of manufacturing in equalising incomes. The truth is that no matter how well educated a labour force is, its living standards will be at an appalling level if it has no capital to work with. A rather lengthy quote from Ludwig von Mises will explain why:

Let us look at the condition of a country suffering from scarcity of capital. Take, for instance, the state of affairs in Rumania about I 860. What was lacking was certainly not technological knowledge. There was no secrecy concerning the technological methods practiced by the advanced nations of the West. they were described in innumerable books and taught at many schools. The elite of Rumanian youth had received full information about them at the technological universities of Austria, Switzerland, and France. Hundreds of foreign experts were ready to apply their knowledge and skill in Rumania. What was wanting was the capital goods needed for a transformation of the backward Rumanian apparatus of production, transportation, and communication according to Western patterns. (Human Action, 3rd revised edition, Henry Regnery Company, 1966, p. 496).

If America's capital structure were to be increasingly skewed towards consumption then one would expect the real growth in wages to turn negative. In addition, a widening wage gap would also emerge. (One would also expect Democrats to demand higher tax rates -- particularly on capital gains -- and more and more government intervention. In short, they would implement policies guaranteed to savage living standards).

The rapid development of new technologies are always disruptive, leading to capital losses and gains. They also tend to be marked by a significant demand for certain types of skills which will, because of the rapid rise of the industry, result in a labour shortage leading to rapidly rising incomes for the fortunate few. Eventually, however, this process will, if no artificial barriers are erected, tend to be reversed when newly trained labour eliminates the shortage. This process, however, doesn't necessarily mean that the previous earnings differentials will be restored.

What needs to be stressed is that inflationary booms have undesirable 'distributive income effects' which cannot be reversed. This is to say that once the boom has collapsed and the malinvestments have been liquidated the resulting pattern of incomes and wealth will not be the same as the one that preceded the boom. Some if not most of those who amassed huge fortunes due to opportunities created by the Fed's inflationary policy of credit expansion will live to enjoy their good fortune. Who knows, perhaps they will even celebrate by donating generously to the Democrat Party?

Unfortunately, what passes for economics and economic history today is simply unable to correctly interpret economic events even as they unfold before their eyes. The same thing happened in the 1920s and 1930s, with the exception of men like Hayek, Mises, C. A. Phillips, T. F. McManus and R. W. Nelson. All in all, the last boom and its aftermath should not lead observers to ignore the vital role that manufacturing plays in the US economy.



Author: Gerard Jackson

Gerard Jackson

Gerard Jackson is Brookes economics editor.

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