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Herbert Hoover didn’t cut spending

Posted By Russ Roberts On June 3, 2011 @ 3:15 pm In State of Macro,Stimulus | Comments Disabled

Brad DeLong critiques Arnold Kling’s view that the economy has a recalculation problem and says it’s all about aggregate demand:

…when it comes to business-cycles–to recessions and depressions and downturns–we don’t need to model 140 million workers, 10 million firms, and 20 million commodities: we only need to model two: (OK, four): currently-produced goods and services on the one hand, and (perhaps three types of) financial assets on the other. A business-cycle downturn comes when–for any of a number of possible reasons–there is an excess demand for financial assets and a corresponding deficient demand for currently-produced goods and services, which leads to rising inventories, falling sales, rising unemployment, falling incomes, and multiplies itself into general deficient demand for pretty much all currently-produced goods and services in the economy. The downturn comes to an end when incomes have fallen so far that households and businesses are so strapped that they cease trying to build up their stocks of financial assets, and the aggregate supply-aggregate demand balance comes to an end. The depressed state of the economy comes to an end when an excess supply of financial markets induces an excess demand for currently-produced goods and services that pushes inventories down, sales up, unemployment down, incomes up, and multiplies itself into general prosperity.

In the background the market system is trying as best as it can to find the best uses and production plans for 140 million workers, 10 million firms, and 20 million commodities given the state of aggregate demand. But that is not of the essence in understanding low capacity utilization and high unemployment. The aggregate demand shortfall is.

When you ask believers in “recalculation” what pattern of production and trade proved to be unsustainable in 2007, they answer: “building so many houses.” When you ask believers why the market economy has been unable to sort out this problem in three years, they answer with nothing–silence. When you say that OK, there were $300 billion of excess houses at the start of 2007 but now construction has been so depressed for so long that there are $1 trillion fewer of houses than trend and why isn’t the 2007 pattern of production and trade sustainable again, they answer once again with nothing–silence.

That annoys me.

It is possible to find in history economic catastrophes produced by the disruption of patterns of sustainable specialization and trade–the Bengal famine of 1942 comes immediately to mind. But there is literally no evidence at all that we have such a problem right now. Our problem right now is that demand is low because incomes are low, and incomes right now are low because demand is low, and demand is not rising because there is no excess supply of financial assets to goose people to spend more. If you want to argue that there is a disruption of patterns of sustainable specialization and trade, you need to point to such a disruption right now that is large enough to produce an 8% shortfall in spending. Nobody has. Nobody has because nobody can.

The other thing that annoys me is that this is presented as something new when it is actually something very old–and it is presented without acknowledgement of the arguments made against it in the 1930s and, indeed, in the 1840s when it was made before. Friedrich Hayek and Andrew Mellon claimed–and Mellon dragged Herbert Hoover along into policies of austerity, of tax increases and spending cuts during the Great Depression–that as a result of lax monetary policy in the 1920s the economy in 1930s had too much plant and equipment and too many workers employed making capital goods, and had to suffer from a “prolonged liquidation” in order to productively redeploy resources into the consumer goods industries where they really should be. Joseph Schumpeter cheered them on, claiming that without the boom-and-bust cycle the economy would die, for it was its “respiration.” But if Hayek were correct we should see depressions both when the economy is switching resources from capital to consumer goods and when the economy is switching resources form consumer to capital goods, and we don’t: while an economy making too little in the way of consumption goods is ripe for a downturn, an economy making too little in the way of capital goods is ripe for a boom.

There is a lot to write about here, but I want to focus on two issues raised by DeLong. The first:

When you ask believers in “recalculation” what pattern of production and trade proved to be unsustainable in 2007, they answer: “building so many houses.” When you ask believers why the market economy has been unable to sort out this problem in three years, they answer with nothing–silence. When you say that OK, there were $300 billion of excess houses at the start of 2007 but now construction has been so depressed for so long that there are $1 trillion fewer of houses than trend and why isn’t the 2007 pattern of production and trade sustainable again, they answer once again with nothing–silence.

Silence. Hmmm. (Arnold responds here [1].)

I’m not sure what exactly DeLong is saying with respect to Arnold’s recalculation argument. He appears to be saying that there was an excess supply of houses and that excess supply has gotten even larger. Presumably, he thinks that’s because of insufficient aggregate demand rather the challenges of creating a new pattern of sustainable specialization and trade. He presumes that Arnold has nothing to say in response. I doubt it. But let me take a shot at it. When there is excess supply of something, its price usually falls. And the price of housing has fallen since the peak. But it hasn’t fallen enough, probably, because the government has been very eager to stop the price of housing from falling. Interest rates have been kept close to zero and the government has worked very hard to keep the flow of credit going by nationalizing Fannie and Freddie and keeping them in business to provide liquidity to the housing market. That in turn has made sure that the excess supply of houses is not mopped up by eager buyers. And that means that new housing starts are going to be anemic. And that means that unemployed carpenters and electricians will remain unemployed. Some have been tempted to find a new occupation. Others are going to wait, hoping the housing market will recover. It should have recovered or at least be on the path to recovery but the government has stymied the adjustment process.

Then there is this:

Friedrich Hayek and Andrew Mellon claimed–and Mellon dragged Herbert Hoover along into policies of austerity, of tax increases and spending cuts during the Great Depression–that as a result of lax monetary policy in the 1920s the economy in 1930s had too much plant and equipment and too many workers employed making capital goods, and had to suffer from a “prolonged liquidation” in order to productively redeploy resources into the consumer goods industries where they really should be.

I don’t know anything about Mellon’s influence on Hoover. Or Hayek’s. But whatever it was, it didn’t yield spending cuts. Here are the levels of federal government spending (from here [2], Series Y 457-465) between 1924 and 1934 in billions of dollars

1924 $2.9
1925 $2.9
1926 $2.9
1927 $2.9
1928 $3.0
1929 $3.1
1930 $3.3
1931 $3.6
1932 $4.7
1933 $4.6

Hoover took office in March of 1929. FDR took office in March of 1933. The data on spending are fiscal years, that ended in June 30 for this period. So Hoover’s budgets are roughly 1930 through 1933. Of course you have to correct for inflation. Or deflation as the case may be. In those years it was deflation. Prices of government purchases of goods and services (from here [3], Table 41) fell between 1930 and 1933 by roughly 10%. So Hoover actually increased spending by over 50% in real terms.

Maybe I am misinterpreting the data. If so, I look forward to hearing from DeLong about the correct source for his claim that Hoover cut spending during the Great Depression. I would hate to be answered with silence.

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[1] here: http://econlog.econlib.org/archives/2011/06/why_do_depressi.html

[2] here: http://www2.census.gov/prod2/statcomp/documents/CT1970p2-12.pdf

[3] here: http://fraser.stlouisfed.org/publications/scb/1957/download/5746/SCB_071957.pdf

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