Sumner, Skidelsky, Keynes and Liquidity Traps
by Mike Kimel
I was searching for some information and I stumbled on a post Scott Sumner wrote last year about Robert Skidelsky’s biography of John Maynard Keynes. I haven’t read Skidelsky’s book, nor do I know Skidelsky, and its been awful long time since I read Keynes, but this seems an odd complaint:
I’m afraid that his analysis is both misleading and inaccurate. The US gradually depreciated the dollar between April 1933 and February 1934. During that period unemployment was nearly 25% and T-bill yields were close to zero. Keynes argued that monetary stimulus would not be effective under those circumstances, and Skidelsky seems to accept his interpretation (which was published in the NYT during December 1933.)
[Note that Keynes certainly did believe in the “pushing on a string” theory–I frequently get commenters insisting that Keynes didn’t believe in liquidity traps.]
Unfortunately, Keynes and Skidelsky are wrong. The US Wholesale Price Index rose by more than 20% between March 1933 and March 1934. In the Keynesian model that’s not supposed to happen. The broader “Cost of Living” rose about 10%. Industrial production rose more than 45%.
Sumner goes on to impugn Skidelsky:
The “disappointing” results that Skidelsky mentions come from cherry-picking a few misleading data points.
All that seems very odd to me. If I were making an argument that conventional monetary policy doesn’t work in a liquidity trap, but that the traditional Keynesian prescription does, I’d start that argument with something very much like the sentences Sumner wrote right after stating “Unfortunately, Keynes and Skidelsky are wrong.”*
Using the graphing tool from FRED, the Federal Reserve Economic Database maintained by the St. Louis Fed, we can show the one year percentage change in both PPI (producer price index) and CPI (consumer price index) from January 1932 to December 1935.
Here’s what we see: after some massive deflation during the Great Depression, prices start to rise more or less when FDR took office. The annual percentage change in PPI peaked around 23% and change in February 1934, and the CPI peaked a few months later at about 5.6%.
Elsewhere, Sumner attributes that to:
We all know what happened next (well not exactly, but I’ll explain that in another post), so let’s jump ahead to 1933. FDR takes office in March, promising to boost wholesale prices back up to pre-Depression levels. He uses several tools, but the most effective was loosely based on Irving Fisher’s “compensated dollar plan.” Fisher’s plan was to raise the price of gold one percent each time the price level fell one percent. An obscure agricultural economist named George Warren was a big fan of Fisher’s idea, and sold it to FDR with all sorts of fancy charts.
And it worked.
We learned when we went to visit Crediful.com that initially, it worked better than any other macroeconomic policy in American history. But at first the policy’s success was mostly accidental, just a matter of talking the dollar down, not enacting Fisher’s specific plan. Nevertheless, prices immediately began rising sharply. Industrial production rose 57% between March and July, regaining over half the ground lost in the previous 3 1/2 years. Then in late July FDR decided to cartelize the economy and sharply raised wages (the NIRA) and industrial output immediately began falling. By late October FDR was desperate for another dose of inflation, and asked Warren to come up with a plan. They decided to have the US government buy gold at a price that would be continually increased in order to reflate the price level.
Sumner even helpfully tells us:
It was a very confusing plan, as they never bought enough gold to equate the government buying price with the free market price in London.
I agree that what Sumner describes is confusing. And yes, the times were desperate, and FDR was flailing around throwing all sorts of things against a wall to see what would work, but when I look at the graph above, and take into account the extremely rapid economic growth that took place during the New Deal era, I see a much simpler story.
- Aggregate demand was very slack when FDR took office.
- FDR showed up in Washington with a plan to start spending a lot of money and thus boost aggregate demand.
- The immediate effect was to convince factories they’d be running down their inventories. That boosted producer prices. It had a much smaller effect on consumer prices because everyone knew the gubmint was going to buy a heck of a lot more producer goods than consumer goods. (The government did buy some consumer goods for the various programs, plus there was a spillover effect, but as the graph clearly shows, the action was on the producer side.)
- After a bit of time, the public realized FDR wasn’t planning just a one-off, but rather a sustained program of purchases of industrial items. That led them to start using some of their idle capacity, which meant not just selling the fixed amount that was in inventory. The rate of price increases thus dropped.
- GDP increased at the fastest rate in the United States peacetime history since data has been kept. There was a big hiccup, of course, in 1937 when the government cut back on spending for a while.
By contrast, here’s Sumner explaining his theory:
There is a great deal of evidence that I won’t get into here that suggests the suspension of the gold standard in March 1933, and gradual devaluation between April and February 1934, almost certainly explain most of the increase in goods prices, stock prices, and industrial production during that period. But why? Not because it boosted our trade balance, which actually worsened as the rapid recovery pulled in imports.
Both Gauti and I believe that only the rational expectations hypothesis can explain these events. He focuses on how the regime change led to higher inflation expectations, and thus reduced real interest rates. I prefer to think in terms of specific policy signals sent as rising gold prices changed the future expected gold price, and hence the future expected money supply. I don’t see any non-Ratex explanation that can account for the extraordinary rise in prices and output during March-July 1933. Nominal interest rates didn’t change much, and open market purchases in 1932 (under the constraint of the gold standard) had accomplished little or nothing.
So…. his story requires the devaluation of the currency to worsen the trade balance, and rational expectations to cause a one time explosion in industrial prices and a rather smaller recovery in consumer prices. Rational expectations, however, that came an abrupt halt, at roughly the same amount of time one would predict companies might decide that demand will be sustained enough to start producing more rather than just selling off inventory sitting in warehouses. And his story doesn’t explain why growth was so much faster during the New Deal era than any other period of peacetime since the US began keeping data, nor why there was the big hiccup in 1937.
Sumner is essentially trying to tell a story about an unusual set of events, but his story seems to assume that most extraordinary events of the era (and what sets that era apart) kind of just happened to occur for no particular reason so he misses the big picture and ends up focusing on details. With all due respect to Sumner, I prefer to think the US economy is not Forrest Gump.
*I can imagine a “monetary” prescription that I think would help tremendously in a liquidity trap, but it doesn’t look at all like what was done in the 1930s, or what was done since 2007, or from what I can tell, what Sumner suggests. That can be a post for another time.
Nice post. One quibble.
“It had a much smaller effect on consumer prices because everyone knew the gubmint was going to buy a heck of a lot more producer goods than consumer goods.”
Well, that and the well known tendency of consumer prices toward less volatility than wholesale prices. Even if the government had purchased only consumer goods, the demand that would create for wholesale goods would be very likely to boost wholesale prices more than consumer prices. You need a special set of circumstances for consumer prices to move more than wholesale prices.
Beyond that, yeah, Sumner seems unable to “see any non-Ratex explanation that can account for the extraordinary rise in prices and output during March-July 1933” because he doesn’t want to see any other explanation. The policy change in 1937 does, as you suggest, represent an excellent test for the two views presented here. Sumner’s view only works best at explaining the facts if one is unable to fairly consider other models.
Minor quibble: Scott Sumner isn’t quoting Skidelsky’s biography of Keynes, he’s quoting the Project Syndicate piece he links to. But Scott Sumner does have an odd way of reading Keynes; he attaches great significance to a few of Keynes’s letters while largely ignoring the General Theory.
kharris,
Good point about CPI, but I suspect its less true in an environment of economic turmoil as in 1933-1934.
Well, Sumner also seems to miss the whole extremely fast real growth, including 3 years of over 10% real growth in peacetime thing or the huge cuts in taxes and regulation over a decade leading to August 1929.
I think I remember seeing hm referring to the last three decades of so as the best economic performance the US has had… which makes no sense considering how poor growth has been during the last few decades.
Kevin Donoghue,
Ah… I missed the fact that he was quoting the Project Syndicate piece. Otherwise, I mostly agree with you. I would add he doesn’t just miss Keynes’ General Theory, he misunderstands classical economics: if there’s a big increase in the demand for a specific good or service, and supply doesn’t change, its usually accompanied by a price increase.
Mike,
The big hiccup in 1937. I’ve read something recently that suggests this was primarily a result of sterilizing gold reserves, which contracted the money supply. Here’s a link to Skidelsky’s site if you are interested. Robert Skidelsky – Academic papers
nanute,
This is why academics have an “ivory tower” reputation. There’s a forest for the trees thing that leaves people outside academia scratching their heads once they translate big words into English.
When you have a gold standard, if you have a trade surplus, gold flows into the country. Since that can lead to inflation, the monetary authority or the Treasury (as I recall, the story by Douglas Irwin is that this was done by the Treasury in the US) takes steps to prevent that added gold from hitting the money supply, say by increasing the reserve requirements of private banks or stashing that gold somewhere, say, deep underground.
Which leads us to 1937. Or rather, 1935 and 1936. As I recall from the Irwin paper, gold was flowing into the country from early in the FDR administration. But it wasn’t because of a trade surplus. The country ran a trade deficit in 1935 and 1936 according to NIPA Table 1.1.5. Which means that while gold was flowing in, it wasn’t doing so in a way that would increase the money supply. If it wasn’t being paid for by a trade surplus, it was paid for in currency.
Put another way, for all practical purposes, the gold inflows were self-sterilizing (and more) in 1935 and 1936. Which means, simply put, if sterilization was the issue, we would have seen the hiccup start in 1935 and last through 1938.
Mike,
Thanks. I’m still scratching my head. If as you say, gold inflows in 35′, 36′ were self sterlizing, the question is how much was the money supply being increased to offset the “cost.” Could one argue that there was a significant amount of money added during the same period to offest the decrease in money supply? Were inflows of gold in 37′ the result of the same cause, or were they related to trade surplus? i think the inflation fears in 37′ along with the sterilization, if it were a policy choice, might have had more of an effect on money supply and the resulting downturn in the economy. Or, was there just a lag from 35′ 36′ catching up?
nanute,
I’ll be honest. I’d have to spend a fair amount more time looking up the precise chain of events, and the data (which isn’t easy to assemble) again.
But I looked up the Irwin paper (http://www.dartmouth.edu/~dirwin/1937.pdf)
Figure 1 is pretty damning, and makes his case, and Figure 2 is equally effective.
So here’s where are… assuming the figures Irwin presents are correct (and I would assume they are), there are two sets of facts that fit the 1937-1938 downturn: the reduction in spending by the gov’t and the sterilization program.
Now, its possible both have an effect, and I wouldn’t be surprised, but which predominates?
So… what about the rest of the period. How is it explained by the two competing theories?
I wandered over to Fraser and found this document that looks at gold reserves in the US: http://fraser.stlouisfed.org/publications/bms/issue/61/download/134/section14.pdf
See page 537. Notice that gold reserves just about doubled from January to Feb 1934. (the Gold Reserve Act came at the tail end of January). Since that was just the transfer of Gold from the Fed to the Treasury, it shouldn’t have affected growth. Otherwise, gold reserves grew by less than 11% during the year (I’m going February to December to leave out the big transfer)
But over the same period, in 1935, the gold reserves increased by 19%. And yet growth in 1934 was faster than in 1935. (http://www.bea.gov/national/xls/gdpchg.xls) Gold reserves grew more slowly in 1936, and yet the economy grew faster than in 1934 or 1935.
Now, maybe there were lags or whatnot, but the graphs that Irwin put up seem to indicate very immediate starts and stops.
And then there’s the flipside. I don’t have foreign data, but this gold was flowing in, in large part, from Europe. Was there a corresponding decrease in the growth rate in the countries losing their gold? Somehow I suspect not.
Mike,
Thanks again. I looked at the Irwin paper after my last post and before your comment. I’m going to look at the Fraser doc and think a bit more before commenting further. Just wanted to acknowledge your thoughtful response.
nanute,
In case I don’t come back, as the thread is getting old and will soon fall off the front page, feel free to contact me directly “mike” and a period and “kimel” and then at gmail.com with questions or comments.