Some excellent remarks from Steven Kates, Chief Economist of the Australian Chamber of Commerce & Industry (Hayek-L posting):
"My intent was not to argue that the world has changed so much since the 1930s that the theories developed then are no longer relevant. My intent was instead to argue that the theories that have developed since the 1930s are vastly inferior to the ones that were current at the time and before.
My point was basically that pre-Keynesian models of the cycle that were based on misdirected production are superior to the models which have come since, virtually all of which have a large demand-side component. And while Martin Wolf may think that these are theories that were developed during the 1920s and 30s, they have a much longer provenance than that. As just one example from the hundreds that might be culled, let me quote briefly from Walter Bagehot writing in Lombard Street published in 1873.
In Chapter VI Bagehot specifically deals with the business cycle, and notes that with the division of labour, one must anticipate what others will be willing to buy with the ever-present danger that producers will miscalculate. He wrote:
'A produces what he thinks B wants, but it may be a mistake, and B may not want it. A may be able and willing to produce what B wants, but he may not be able to find B - he may not know of his existence'.
If miscalculation occurs on a large scale, the consequences spill across the economy: Bagehot therefore continued as follows:
'No single large industry can be depressed without injury to other industries; still less can any great group of industries. Each industry when prosperous buys and consumes the produce probably of most (certainly of very many) other industries, and if industry A fail and is in difficulty, industries B, and C, and D, which used to sell to it, will not be able to sell that which they had produced in reliance on A's demand, and in future they will stand idle till industry A recovers, because in default of A there will be no one to buy the commodities which they create.'
This was written without any reference to money, but then with the introduction of credit, it is still miscalculation on the part of producers which leads to recession:
'The state of credit is thus influential, because of the two principles which have just been explained. In a good state of credit, goods lie on hand a much less time than when credit is bad; sales are quicker; intermediate dealers borrow easily to augment their trade, and so more and more goods are more quickly and more easily transmitted from the producer to the consumer.
'These two variable causes are causes of real prosperity. They augment trade and production, and so are plainly beneficial, except where by mistake the wrong things are produced, or where also by mistake misplaced credit is given, and a man who cannot produce anything which is wanted gets the produce of other people's labour upon a false idea that he will produce [what other people want].
To this form of miscalculation Bagehot adds the greater potential for catastrophe which occurs through large-scale speculation, which is usually induced and encouraged by inflation, very similar to the argument on bubbles put by Martin Wolf. According to Bagehot, higher prices encourage a false optimism which eventually is overtaken by the actual facts of the situation. Higher prices induce misjudgements, the ultimate outcome of which is an economic crisis and recession. Nor is Bagehot describing a process which is in any way ephemeral or without pain. He wrote that 'it takes two or three years to produce this full calamity, and the recovery from it takes two or three years also'.
The interesting aspect in reading Martin Wolf's article is to see that such theories are coming back into use, undoubtedly because current models based on AS/AD or ISLM are so incompetent to deal with current economic conditions. Such models, built on demand considerations, assume that the answers lie in higher levels of spending and that deficits can contribute to growth. No classical economist would have made this mistake."
Posted by Greg Ransom
