A lot of defenders of the Fed cite the panic of 1907 and previous panics booms and busts as being evidence that the central bank as lender of last resort is a necessary pseudo-governmental function. They say that booms and busts can be successfully and carefully managed by a central bank and that with it we can avoid crashes. This is obviously not true.
However, my question is: what exactly happened to alleviate crashes before there was a central bank?
I ask because obviously the country didn’t collapse without the existence of a central bank before 1913. And, more importantly, most of the financial crises of the last century have either been caused or made worse by Fed interference and/or existence. Essentially, the government guarantee of banks takes the risk out of making a deposit. I’m wondering how these crises were solved before a central bank to figure out if having a central bank has really been worth it.
"In addition to financial deregulation, notes historian Jeffrey Hummel, Van Buren “thwarted all attempts to use economic depression as an excuse for expanding government ‘s role Henry Clay and the Whigs (including a young Abraham Lincoln) viewed the depression as a political opportunity to get the federal government to enact their favorite pork-barrel schemes for “internal improvements,”…He also defeated the Whigs’ attempts to get the federal government to bailout the states, many of which had unwisely pursued Clay’s policy of issuing massive amounts of debt from “internal improvements” In fact, total federal government expenditures fell in absolute dollar terms during Van Buren’s term…” “How Capitalism Saved America” pg 159
What ends crises is always a return to profitability by businesses. The way businesses become profitable again is usually through cutting overhead expenses (e.g. wages/salaries/benefits) and cutting certain unprofitable activities (e.g. how GM sold Hummer). So what usually happened in previous crises was that the price level would fall, as businesses would have to cut worker compensation in order to become profitable again. Other businesses and households would simply have to declare bankruptcy, since they no longer would be able to remain competitive even after cutting costs in all possible areas. Once this happened, the businesses that cut costs enough to become profitable, would begin hiring and reinvesting with their new profits, returning the economy to a period of growth.
That’s basically what I’m trying to figure out. And maybe even more so, how our economy recovered when there was no central bank.
Also whether or not it’s been government at the heart of these crises. I know from reading popular delusions and madness of crowds that it’s usually a combination of government favors and massive credit expansion and expansion of the money supply that usually leads to overspeculation and malinvestment which then ends up in a bust and a credit/money supply contraction which causes a panic. And the Fed is supposed to exist to prevent bank runs but in the end, I think it creates the bubbles that it claims to be able to control. But we also don’t usually see bank runs anymore. So I don’t know, I’m trying to learn more about this.
I ordered a few books on financial panics of 1907 and then for the 19th century so hopefully I’ll be able to answer this question on my own eventually.
“What ends crises is always a return to profitability by businesses. The way businesses become profitable again is usually through cutting overhead expense…”
that sounds correct.
i am not sure to what extent the federal reserve created boom/busts and an non-fed government (various greenback explosions and destructions) differed from each other.
from what i have read paper claims were was outpacing a specie-money and led to malinvestment errors on top of already occurring errors in business judgement…
i dont think that is such an issue today though. paper currency/credit/central bank operations may create a differnt breed of ‘crisis’. i am not sure.
The belief that economic crises are caused by declining profitability because of falling prices is the Marxian explanation. Marx continues by explaining that, in the face of falling prices, and therefore declining profits, the firms will begin to lay off workers, replacing them with capital, and increasing their work load (labor reserve armies). Only after the “capitalists” cut enough workers, to the point where wage labor is once again profitable, will the bust end, and make way for the next boom. The Austrians showed that business cycles are not caused by declining profits (in the general sense), but because of hyper-activity caused by credit expansion (too much investment, and too much consumption). Furthermore, falling prices are not a problem at all, in fact, they should be welcomed.
The main difference is that the Marxists don’t believe in Say’s law, and as such, overproduction and under-consumption is the explanation (falling prices=>falling profits).
I believe that you have misinterpreted what Krazy Kaju said. The idea that nominal wages must fall when there is deflation is not a Marxist economic argument, and is in fact one expounded by such Austrian/neo-classical economists as Anderson, Vedder and Gallaway (see: Economics and the Public Welfare and Out of Work). Murray Rothbard also adhered to this principle in America’s Great Depression. I can see how Krazy Kaju’s post can be somewhat misleading, but I don’t think that it runs contrary to the Austrian theory of the credit cycle. I think he is simply saying that nominal wages will have to fall during the recession. It’s just the method by which the market readjusts wages to their market rate as credit contracts (in the two books previously mentioned, I think the theory focuses mostly on the post-1929 era with the introduction of minimum wage laws, et cetera, which caused wages to rise faster than prices, and so was a change in relative prices, although the point still stands).
We need to distinguish between the causes of the business cycle and the cause of recessions; they’re not the same. Unemployment is the result of wage rigidity.
I don’t think we are on the same page. In any type of economic downturn where there is deflation there has always been a need to readjust wages by pushing them down (see Rothbard’s America’s Great Depression). Nobody is talking about the "causes of a business cycle".
Kaju said, “what ends a crises.” But there are two types of crises: one caused by a divergence in the market rate and natural rate of interest, and one caused by too much consumption. The latter can occur without any kind of intervention whatsoever, and in this condition, real wages would fall and prices would rise.
Esuric, everything I said was completely in line with Austrian theory. Do you really need me to expand beyond the scope of this thread to explain myself?
(If yes, continue reading.)
Business cycles occur when credit is created out of thin air, causing interest rates to fall below their real market level. This causes mistaken price signals, as it provides information to entrepreneurs about the consumption/saving ratio that is not true. As a result, entrepreneurs are more likely to invest in higher order goods when interest rates are lower, since production of higher order goods becomes more profitable when interest rates are lower (which is because lower interest rates mean that more people can purchase more higher order goods and because lower interest rates make lower-yielding assets more profitable). However, when the newly created credit enters the economy, consumers spend more of it than they save, making higher order production less profitable than originally thought.
Producers of higher order goods, then, have to begin by either completely eliminating their investments or trying to return them to profitability. Either way, they usually end up either firing workers (if they have to completely liquidate some or all operations) or lowering worker compensation (if possible). This has an effect of reducing household income, which in turn reduces the level of consumption, which itself causes lower-order good producing businesses to become less profitable. When these lower order businesses become less profitable, then they too have to begin by cutting various costs, usually starting at worker compensation. Household income is again reduced. This cycle continues until businesses cut enough costs that they become profitable again. Then, they can begin rehiring and reinvesting.
Although, to a degree, I see where you’re coming from, I still think that you have misunderstood what he said (or maybe he didn’t state it quite as clearly as he should have). It may be a problem in terminology (i.e. the use of the word “recovery”, since the recovery really begins at the onset of the recession/depression, since that is when the market begins to clear malinvestments). It’s clear that an economy can only begin to resume stable growth once malinvestment is cleared by the market, and price levels (including the price of labor) fall to the original market rate without distortion through credit expansion, and this is what I think Krazy Kaju was referring to (he can correct me if I’m wrong).
I’m not sure how you are confusing “what ends a crisis” with “what begins a crisis”. I think that it was the use of terminology, such as a “return to profitability”. Maybe it should have been put as a return to “stable profitability”.
In any case, the question asked was how did the national economy “recover” from recessions before the Federal Reserve. Clearly, the answer is, “the same way they recovered under the Federal Reserve.” That is, with a return to profitable and stable investment, undistorted by credit expansion. This includes the process, during the recession, of falling prices for all services and commodities, including labor. The idea that if nominal wages are maintained artificially high during deflation then business costs will outstrip business profits, and businesses will fail. This idea is supported by Murray Rothbard and other neoclassical/Austrian scholars. It was one of the main criticisms behind Herbert Hoover’s decision to introduce a minimum wage as a method by which to maintain consumption (a product of the fallacious underconsumption theories).
Krazy Kaju said:
The way businesses become profitable again is usually through cutting overhead expenses (e.g. wages/salaries/benefits) and cutting certain unprofitable activities (e.g. how GM sold Hummer). So what usually happened in previous crises was that the price level would fall, as businesses would have to cut worker compensation in order to become profitable again.
This seems in line with Austrian theory. That is, poor assets (created through malinvestment) are liquidated, and the price of labor (originally propped up through inflation; i.e. see Reisman’s Capitalism) falls.
Profit doesn’t have anything to do with prices. It has to do with time preference. The boom creates illusory profits, which are exposed when inflation slows down, or stops entirely.
The crises comes to an end when savings increases and is funneled to higher order activity, and when the structure of production is allowed to adjust. Massive unemployment is not the remedy.
Too much consumption causes a recession. Hayek, Prices and production.