The Great Depression: Lack of Supply, or Lack of Demand?

Economics Economics Questions
1

I was told in history class that the Depression was caused by a sudden drop in demand, which caused many businesses to store their products in giant surpluses and drove their prices through the floor. Deflation, basically.

But I would imagine that a “bust” trend like the Depression would raise demand, since uneasy economic times would naturally give solid commodities (gold, food, other tangible products) more value (subjectively, of course). However, the demand could not be fulfilled without a sufficient amount of exchange in the market. Would this be a lack of supply, at least in terms of purchasing power?

2

If you want to put in terms of aggregates, it is simply a miscoordination between demand and supply.

3

Would you elaborate please?

4

There was no aggregate problem in the adjustment process of the depression other than government interference. The only problem was the messed up capital structure of the wasteful '20s

5

Credit expansion leads to lower interest rates, which in turn means that entrepreneurs opt for capital-goods or higher-order goods. This lengthens the structure of production. The structure of production should only lengthen when savings increase, but as the interest rate was depreciated artificially it means that consumers did not forego present consumption for future consumption. As a result, there is neither the resources to complete the longer production processes, nor the money saved to demand the final goods.

So, it’s not a problem of low demand or low supply per sé; just that there was a discoordination between the two caused by credit expansion.

6

the question you should ask is, what was the bubble that the federal reserve bursted right before the great depression?

Which, I don’t have the answer to…perhaps someone else does?

Didn’t the government inflate currency supplies in the 20’s? What industrial sectors did they inject this new money into?

7

It’s similar to a realtor saying today, “Well, for some weird reason the housing market collapsed. The cause of this whole problem was a drop in home prices, so we’ve got to keep home prices up at all costs”.

Of course, they are saying that now and the administration is trying their best to keep prices artificially high. The underlying issue has not been addressed.

That’s why the Depression was Great. Instead of realizing the error, they compounded it. “Oh, prices are dropping, this must stop!”. So they decided to prop up prices which only exascerbated the problem. The propping up of wages, which was an explicit aim of both Hoover and FDR, kept unemployment. Adding to the cost of labor through SS, minimum wage laws and the like helped lead to the recession in 1937.

Textbooks should use that era as an example of what not to do, but for some Godforsaken reason they think it helped. It boggles the mind.

8

Say’s law and Warlas’ law both dictate that there can be no general glut. Instead, there can only be excess supply in some markets which is offset by excess demand in other markets. This means that recessions occurs when there is a “mismatch of supply and demand,” meaning that some markets have excess supply while others have excess demand. This occurs when individuals restore their time preferences after a distortion caused by credit expansion.

9

“…meaning that some markets have excess supply while others have excess demand.”

Can you give examples of markets during the Great Depression where there was excess demand?

10

“Credit expansion leads to lower interest rates.”

Isn’t it that lower interest leads to credit expansion, not the other way around? What is the correct flow of logic here?

11

This is a pretty complicated question which I could have answered, with absolute certainty, a few months ago. But let me see if I can help.

We have to first distinguish between reducing the interest rate in absolute terms on the one hand, and in relative terms on the other (relative to the natural or equilibrium rate). Central banks can reduce interest rates in absolute terms by increasing or creating bank reserves which (ceteris paribus) shift the supply curve to the right (also known as the liquidity effect). A banking cartel (no competition) could also reduce the interest rate in absolute terms simply by decree. In both scenarios, they (a) reduce the interest rate both in absolute and relative terms, and (b) create additional demand for credit. If, on the other hand, there is competition, and there is no central bank, then credit expansion does not reduce interest rates in absolute terms, but may do so in relative terms. If the natural rate rises, for whatever reason (technological innovation for example) then the banks can facilitate this increased demand for capital by expanding the supply of fiduciary media (bank money/credit). This will keep the interest rate “stable” in nominal terms, but actually reduce it relative to the natural rate.

Example:

T1: Market rate Natural Rate

4% 4%

T2: Market rate Natural rate

4% 7%

In period T2 there is some shock which elevates the demand for real capital (elevates the equilibrium or natural rate), and instead of allowing the market rate to rise along with the natural rate, the banks increase the supply of money via credit expansion (out-ward shift in supply), maintaining the same market rate, but reducing it relative to the natural rate (inter-temporal disequilibria).

12

krazy kaju,

Below is what Leland Yeager has to say about Say’s law.

Say’s law, or a crude version of it, rules out general overproduction: an excess supply of some things in relation to the demand for them necessarily constitutes an excess demand for some other things in relation to their supply…

The catch is this: while an excess supply of some things necessarily mean an excess demand for others, those other things may, unhappily, be money. If so, depression in some industries no longer entails boom in others…

[T]the quantity of money people desire to hold does not always just equal the quantity they possess. Equality of the two is an equilibrium condition, not an identity. Only in… monetary equilibrium are they equal. Only then are the total value of goods and labor supplied and demanded equal, so that a deficient demand for some kinds entails and excess demand for others.

Say’s law overlooks monetary disequilibrium. If people on the whole are trying to add more money to their total cash balances than is being added to the total money stock (or are trying to maintain their cash balances when the money stock is shrinking), they are trying to sell more goods and labor than are being bought. If people on the whole are unwilling to add as much money to their total cash balances as is being added to the total money stock (or are trying to reduce their cash balances when the money stock is not shrinking), they are trying to buy more goods and labor than are being offered

The most striking characteristic of depression is not overproduction of some things and underproduction of others, but rather, a general “buyers’ market,” in which sellers have special trouble finding people willing to pay more for goods and labor. Even a slight depression shows itself in the price and output statistics of a wide range of consumer-goods and investment-goods industries. Clearly some very general imbalance must exist, involving the one thing–money–traded on all markets. In inflation, an opposite kind of monetary imbalance is even more obvious.

If we wish to include money as its own distinct market, then a general glut of all other goods can emerge when there is an excess demand for money.

13

Individuals have time preferences. From these individuals, we can basically construct an aggregated time preference. When credit expansion occurs, that artificially shifts the time preference higher: thus resources are taken out of lower order industries and put into higher order industries. But the resulting capital structure produced does not support the actual demands of the public. The public has a lower time preference, which means there is excess demand for lower order goods and excess supply of higher order goods. The result is a recession, when higher order industries go bust.

14

In other words, the market rate is elevated above the natural rate.

15

An excess demand for money means that people will sell their bonds in order to hold more cash (thus, the real rate of interest in the aggregate economy would rise). That basically entails a time preference shift that is less future-oriented, which would lead to an increase in real consumption at the expense of real investment.

16

“Below is what Leland Yeager has to say about Say’s law…”

Fascinating. Let me try my hand at a rebuttal.

Say admits there can be a TEMPORARY glut of everything. Hazlitt in Failure of New Economics, in the chapter on Say’s Law, emphasizes this. And that the old scoundrel, Keynes, misinterpreted Say on this point. Yeager’s argument explains very nicely how there could be a temporary glut of everything but money.

HOWEVER, this can’t be permanent. Sonner or later, people have to eat. Sooner or later, the really big amounts of cash will tire of lying under the mattress. They will look for a place to be invested. Of course, to make it seem like people will never spend their money, the excuse is made up that they will hoard it, anticipating lower prices. But reality shows this just ain’t so. Did you wait many years for the price of your cellphone, laptop, ipod, whatever, to go down? And reality shows that even during the Great Depression, only a very very tiny amount of money was hidden under the mattress [Hazlitt, Eco in One Lesson].

**BTW, Say’s Law, I just found out, is really the heart and soul of a rebuttal to Keynes. One of its corrolaries is “**The same principle leads to the conclusion, that the encouragement of mere consumption is no benefit to commerce; for the difficulty lies in supplying the means, not in stimulating the desire of consumption; and we have seen that production alone, furnishes those means. Thus, it is the aim of good government to stimulate production, of bad government to encourage consumption.”

Now it is obvious why Keynes resorted to every trick in the book to refute Say, including, of course, distorting what Say actually said. And why his disciples wrote that refuting Say’s law alone places keynes with the immortals.

17

Smiling Dave,

You are correct that an excess demand for money cannot last indefinitely. Holding the supply and demand for money constant, a reduction in the general level of prices can restore equilibrium; holding the supply of money and the general level of prices constant, a fall in the demand for money can restore equilibrium; and holding the demand for money and the general level of prices constant, an expansion of the money supply can restore equilibrium. Therefore, we have three possible corrections of an excess demand for money: a reduction in the general level of prices, a fall in the demand for money, or an expansion of the money supply. It is quite probable that each is operating simultaneously to bring the supply and demand for money back into equilibrium.

It is my contention that in a free market for money and banking, the supply of money would adjust to offset changes in demand. Trying to artificially stimulate spending (i.e. reduce money demand), as the Keynesians tend to advocate, or holding the money supply constant and allowing deflation to take its course, as the Austrians tend to advocate, are both unnecessarily disruptive and wasteful.

18

I have something to say about that. I admit in advance being an amateur, so pardon some really basic q’s.

  1. If someone really goes ahead and puts his money under matress, with intent to keep it there for a few years, has that not reduced the supply of money? And if a hoarder decides that he will spend it, does that not increase the supply? So that the word “supply” means two different things. In the phrase “a constant money supply” means the total amount of money in the country, wherever it may be, mattress or no mattress. But when we talk about “supply and demand for money”, that kind of supply can change even as the total amount of money in the country remains the same.

  2. Given that, in a free market, the supply of money, in the sense of “supply and demand” changes all the time. So there is no need to creater or destroy any money to change supply, i.e no need to change the total amount of money in the country. Which is why the Austrians say “No need to do anything.”

  3. I’m not even sure what other way there is, besides hoarding and dishoarding, to change the money supply. Say our money is silver and gold. How can you make more of it [past a certain small increase]? How can you destroy it once it’s out there? And if we are using paper money, who is printing it in a free market for money and banking? Who makes the decision to do so? Whoever it is, the very existence of that person with the power to make paper money means you don’t have a free market for money. Because a free market means “I can do whatever I want with my property, but not with someone else’s.” And this guy with the printing press is controlling everyones money. Not to mention that his decision cannot possibly be influenced by the market, because how does he know what people want? After all, there are loans being made all the time. All the borrowers want inflation, all the lenders want deflation. So that this guy is going against the wishes of half the people, whatever he does.

  4. The only alternative I can see is if banks, influenced by the market conditions, meaning seeing how many people are walking in asking for loans, change the interest rate. That is, in a sense, changing the supply of money available. But Austrians are perfectly OK with that.

  5. You write that allowing deflation to take its course, which is indeed what Austrians advocate, is disruptive and wasteful. I don’t see why. My position on this q is just Rothbard’s in What Has Govt Done to Our Money, Chapters 10 and 11. [Book is available for free on this site. Both Chapters are short and sweet.]