I read an article in the Financial Times earlier this week (September 23, 2023) -…
Many readers have written to me asking me to explain the British Treasury view during the Great Depression. This view was really the product of several decades of literature which culminated in the political process during the 1929 British election where the number one issue of the day was mass unemployment. The Treasury View was thoroughly discredited in the immediate period after it was articulated and comprised one side of the famous Keynes versus the Classics debate. When propositions – such as the Earth was flat – are shown to be incorrect constructions of reality the ideas cease to be knowledge and instead become historical curiosities which allow us to benchmark how far our education systems have taken us. However, the same cannot be said for my profession.
Macroeconomics has returned to the discredited Treasury view with some modern embellishments (Ricardian equivalence etc). The major attacks on the of government fiscal stimulus to conquer unemployment now resonate almost exactly with the bunk that was trotted out by the conservatives during the 1929 British election campaign. The modern proponents (centred at Harvard and Chicago) also appear largely unaware of the arguments and seem content to peddle their nonsense oblivious that their “knowledge” ceased to be such 80 odd years ago.
I was thinking about the historical debate today when I read that Ireland is now double-dipping.
The overnight UK Guardian article by Larry Elliot (September 23, 2010) – Ireland’s austerity measures show us how not to do it – provides a good summary of how screwed up that nation has become under the guidance of the deficit terrorists.
Elliot notes that “Ireland is the poster child for deficit hawks” and key figures like ECB boss Jean-Claude Trichet praised their slash and burn approach to the crisis. He notes that they were being held out as a role model for Greece and other nations to follow – if they wanted to regain prosperity.
He notes that the newly-elected British government “bought this argument” and that is “why Britain had an emergency budget within six weeks of the election and is about to experience the deepest cuts in public spending since the 1920s”.
But the facts that are now unfolding tell us that the conservative position was wrong – insanely wrong – and amounts to vandalism and an abuse of human rights.
Elliot asks “how are things going across the Irish Sea?” and says:
Well, figures out today showed that the economy has bombed after briefly flickering into life in the first three months of 2010. There are rumours swirling around Dublin about the viability of Anglo Irish Bank. And the bond markets that were once impressed by the bravery of prime minister Brian Cowen’s government have now turned on Ireland with a vengeance.
The “yield on Irish government bonds and German bunds” has now “widened to a record level”. This was the key indicator that the conservatives were saying would improve.
It isn’t rocket science to understand what has happened. The “budget cuts have impaired the economy’s ability to grow”. You simply cannot withdraw (drastically) the main source of spending and not expect output to fall (dramatically).
Ireland is now enduring three years of negative growth and will take years to restore the confidence of households and firms which will be required to underpin growth in the face of a massive public net spending retreat.
The Irish case study is there for all to see. But they should never have gone down that path if they had fully understood the lessons from the Great Depression. In effect, they have been following the Treasury View which prevailed in the late 1920s in Britain and ensured that the British economy would endure a massive depression once private spending collapsed in 1929.
The following graph shows the evolution of unemployment in Britain from 1921 to 1938. Only the onset of World War II saw the rate drop substantially (Source).
During this campaign, the Opposition Liberal Party of the day came into the election campaign with a pledge to reduce unemployment by introducing large-scale public works. The plan was outlined in a speech that the Liberal leader Lloyd George made to all Liberal candidates on March 1, 1929 which is based on the simultaneous release of their manifesto We can conquer unemployment
Here is the scanned front cover of the British Liberal Party’s 1929 election manifesto “We can conquer unemployment”.
In that speech, George pledged:
If the nation entrusts the Liberal Party at the next General Election with the responsibilities of Government, we are ready with schemes of work which we can put immediately into operation, work of a kind which is not merely useful in itself but essential to the well-being of the nation. The work put in hand will reduce the terrible figures of the workless in the course of a single year to normal proportions, and will, when completed, enrich the nation and equip it for competing successfully with all its rivals in the business of the world. These Plans will not add one penny to national or local taxation. It will require a great and sustained effort to redeem this pledge, but some of us sitting at this table have succeeded in putting through even greater and more difficult tasks in the interests of the nation.
So they were arguing that within one year the cyclical unemployment would be resolved via public sector job creation. The plan was fairly bold in political terms and history tells us that the British electorate rejected the party and the Labour Party (who were barely distinguishable from the ruling Tories) took Britain into the Great Depression to the detriment of the nation.
The Liberal Party policies were being developed throughout the 1920s and were consolidated in the 1929 publication. In that publication, which was partly written by John Maynard Keynes, we read that:
THE word written to-day on the hearts of British people, and graven on their minds is Unemployment. For eight years, more than a million British workers, able and eager to work, have been denied the opportunity. At the end of 1928 the total reached a million and a half; a quarter of a million more than a year before. These workers with their dependants, represent four or five million souls. They are a very nation, denied the opportunity to earn their daily bread, condemned to hardship, to wearing anxiety and often to physical and mental demoralisation. What a tragedy of human suffering; what a waste of fine resources; what a bankruptcy of statesmanship!
And in thinking outside of the mainstream the book said:
Here, as elsewhere, we are obsessed by precedent and routine. But the present situation cannot be dealt with by precedent. It is unique in history, and it must be met by unique methods. The countries of Europe have displayed infinite courage, resource and initiative, in rebuilding the towns and areas which the war had ruined; and we must profit by their example, if we do not wish history to brand us as destitute of the high qualities that make reconstruction possible. At the moment, individual enterprise alone cannot restore the situation within a time for which we can wait. The State must therefore lend its aid and, by a deliberate policy of national development, help to set going at full speed the great machine of industry.
The book outlined in exhaustive detail the way in which work could be created by developing new roads, low-cost houses, new drainage systems, telephone network extensions, and enhanced electricity generating capacity.
The proposal argued that the government could raise the money needed by borrowing.
While articulating the direct employment effects of the public works programs, the publication also used the concept of the expenditure multiplier to outlined the indirect employment effects:
In all this, so far, we have taken no account of the large increase in employment everywhere resulting indirectly from the addition to the national purchasing power represented by the wages of those workers directly employed in this way. The income of everyone of these will have increased twice or thrice; arid this will be fleeted at once in a corresponding increase in expenditure on food, clothing, boots, housing, travelling, entertainment, and other amenities. As a result, a stimulus will be given to the whole of the industry and commerce of the country, reflected, in turn, in increased employment.
Keynes (with Hubert Henderson) followed up this publication with the small article – Stanley Baldwin was forced to present a formal attack. The document that the Treasury officials produced which was called Memoranda on Certain Proposals Relating to Unemployment, (Cmd 3331, Presented by the Minister of Labour to the Parliament, May 1929, H.M. Stationary Office) and, in effect, became the formal articulation of the Treasury view.
If you ever get a chance to read this response you will see the resonance with the way the conservatives argue today. The memoranda accused the Liberals of proposing a “dictatorship” and wanting to coerce workers into wasteful endeavours. I would be very rich if I was given a dollar for each time the conservatives have accused me in public lectures etc of advocating communism when I suggest we should introduce a Job Guarantee. Well well-off rather than rich!
Interestingly, the Labour Party in the same campaign was caught out by the bold Liberal plan. They produced their own document – How to Conquer Unemployment: Labour’s Reply to Lloyd George which among other things said the work would be ephemeral and unproductive and that the financial aspects were “madcap”. The Labour Party won the election easily and the conservatives were tossed out. But in a sense, the conservatives (Labour) just swapped places with the conservatives (Tories). Nothing much has changed has it – US Democrats are as bad as the Republicans; British Labour not much better than the Tories; Australian Labour as bad as the Conservative Coalition etc.
But what was the Treasury View?
The British Chancellor of the Exchequer in 1929 was none other than Winston Churchill.
As an aside, Churchill had earlier been a big supporter of the Job Guarantee concept. Take a look at this graphic which is borrowed from a Sydney Morning Herald article on November 29, 2006.
While the SMH article is about the allegation that Churchill who was a secret fan of science fiction, “borrowed some of his biggest ideas and most telling phrases from his favourite author, H. G. Wells.”, it is clear that both supported the Job Guarantee. The graphic above is an example of this. Accordingly Churchill gave a major speech early in his career (in 1906) which appeared to be taken from Well’s earlier work A Modern Utopia (1905). Churchill is alleged to have written to Wells just before making his speech and said:
There is so much in your writing that stimulates my fancy that I owe you a great debt.
Among those ideas is clearly a preference for a Job Guarantee as is depicted in the picture. However, that preference was gone by 1929.
The Treasury View stated that the government should always run a balanced budget and that deficits were not expansionary. The election manifesto of the Conservatives was captured by their slogan ‘Safety First’ and they argued that even though unemployment was starting to sky-rocket and bankruptcies were rising sharply, the best strategy was to continue to run orthodox budgets (balanced) and let the markets sort the developing crisis out.
I am sure you have heard similar irresponsible statements from the conservatives in the current crisis.
The Treasury Memoranda (known as the “White Paper”) claimed that there was only finite pool of savings available and if the government was drawing on it to finance the public works program then less would be available for private investment, in particular, foreign investment.
They concluded that the public works programs would not increase net employment because the increasing public employment would come at the expense of a decline in private employment as a result of the reduced private and foreign investment.
We know this argument today as the “crowding out” hypothesis which now no longer merits the status of a hypothesis because it has been categorically disproved over and over in the course of history. It is just a religious belief and I bear no insult to those who “believe” in things that are mythical. It is just that I would base economic policy on things we know work as cause and effect rather than any myths that are held to provide personal spiritual salvation and comfort.
The Treasury Memoranda refuted the Liberal idea that there were idle balances.
Churchill told the House of Commons in April 1929 that he supported:
…. the orthodox Treasury doctrine which has steadfastly held that, whatever might be the political and social advantages, very little additional employment, and no permanent additional employment can, in fact, and as a general rule, be created by state borrowing and state expenditure …
The result was that the newly-elected British Labour Government did not tackle the Great Depression with expansionary policies. It was clear that the archaic ideas held within the British Treasury were dominant and that they considered the gold standard and a balanced budget to be the source of prosperity (via free trade).
They considered unemployment to be the result of poor export performance which required industrial development (via private investment) and lower real wages. Accordingly, any policy that diverted what they thought was a “finite pool of savings” away from private investment would not improve the situation.
The Treasury View was demolished by Richard Kahn in 1931, who had studied under Keynes. He noted that total saving is a function of national income and so there is no fixed pool of saving over time unless we believe that income can never change.
At the time, the macroeconomic models in use (which were based on versions of Say’s Law) all assumed that full employment was achieved at all times with departures from that state being ephemeral.
So the Treasury attack on the public works programs were based on a denial of the rising unemployment. What Kahn showed formally was that when there are idle resources (that is, unemployed workers and machines) the reason was a lack of overall spending. An increase in say public investment spending (the public works program) will not only increase employment directly but when the wages are spent other industries benefit. These indirect employment effects arising from the consumption induced from the initial rise in income forms the basis of the idea of the expenditure multiplier.
Please read my blog – Spending multipliers – for more discussion on this point.
As consumption rises so does national saving and the multiplier process continues until the extra consumption (after each successive round) is zero. What we observe is that the final increase in national saving is exactly equal to the initial increase in investment.
Kahn showed categorically that it is total investment that determines total saving not the other way around. This point demolished the “loanable funds theory” that underpinned the crowding out claims. Much later, Pasinetti notes in one of his articles that “investment spending brings forth its own saving”.
The loanable funds doctrine posited that prior saving generated investment. But Kahn showed that is was the opposite and that if the government expanded net spending and simultaneously borrowed then once all the adjustments were exhausted an exactly equivalent amount of savings would be held in the non-government sector.
This was the basis of the belief by Lloyd George that “a budget deficit finances itself”.
I covered the flaws in the Loanable Funds doctrine which is still taught in macroeconomics course today in this recent blog – Budget deficits do not cause higher interest rates
From a Modern Monetary Theory (MMT) perspective, the main points are that from a macroeconomic flow of funds perspective, the funds (net financial assets in the form of reserves) that are the source of the capacity to purchase the public debt in the first place come from net government spending. Its what astute financial market players call “a wash”. The funds used to buy the government bonds come from the government!
This is the MMT equivalent of the statement “a budget deficit finances itself” – although proponents of MMT also point out that a sovereign government doesn’t need to finance its net spending anyway.
But given that governments voluntarily imposes such rules on themselves the funds they borrow are just the same funds they spend.
Further, there is also no finite pool of saving that is competed for. Loans create deposits so any credit-worthy customer can typically get funds. Reserves to support these loans are added later – that is, loans are never constrained in an aggregate sense by a “lack of reserves”. The funds to buy government bonds come from government spending! There is just an exchange of bank reserves for bonds – no net change in financial assets involved. Saving grows with income.
But importantly, deficit spending generates income growth which generates higher saving. It is this way that MMT shows that deficit spending supports or “finances” private saving not the other way around.
So given that the Treasury View was so categorically dismissed in the 1930s and waned during the full employment period, it is a surprise that it is coming back with so much vehemence in the current policy debate.
A modern proponent of the Treasury view is none other than “Mr Efficient Markets” Eugene Fama who is an academic at the University of Chicago. In this – article – written in early 2009 his reasoning brought back the haunting memories of the fallacious British Treasury reasoning.
As an aside, Fama rejects the claim that the financial crisis has exposed the flaws in his beloved efficient markets hypothesis. He claims that the crisis shows that markets are efficient. More about that nonsense another day.
Fama introduced a version of the sectoral balances framework. He provided the following macroeconomics identity:
PI = PS + CS + GS
So private investment (PI) equals the suum of private savings (PS), corporate savings (retained earnings) (CS), and government savings (GS) (the surplus).
He then recognises that “(i)n a global economy the quantities in the equation are global. This means the equation need not hold in a particular country, but it must hold in the world as a whole”.
He then says that:
Government bailouts and stimulus plans seem attractive when there are idle resources – unemployment. Unfortunately, bailouts and stimulus plans are not a cure. The problem is simple: bailouts and stimulus plans are funded by issuing more government debt. (The money must come from somewhere!) The added debt absorbs savings that would otherwise go to private investment. In the end, despite the existence of idle resources, bailouts and stimulus plans do not add to current resources in use. They just move resources from one use to another.
He also noted that “government investments are prone to inefficiency” whereas “private entities must invest in projects that generate more wealth than they cost” (his belief in efficient markets!).
So according to Fama the “stimulus spending must be financed, which means it displaces other current uses of the same funds, and so does not help the economy today.”
That is exactly the logic that underpinned the British Treasury view in 1929.
There are many ways you can refute the arguments as you have already seen.
If you think about the Treasury view as espoused by Fama you will note that the fiscal stimulus is assumed to change (GS – downwards) – that is undermine the fiscal surplus.
He also assumes a finite pool of savings so PS and CS are unchanged. In other words, the only other thing that can change is private investment (PI) which must fall by construction.
The flaw in Fama’s argument is of-course that saving is fixed.
Think about how the impact of a fall in private consumption spending might work in this model. So PS rises. The normal inventory-cycle view of what happens next goes like this. Output and employment are functions of aggregate spending. Firms form expectations of future aggregate demand and produce accordingly. They are uncertain about the actual demand that will be realised as the output emerges from the production process.
The first signal firms get that household consumption is falling is in the unintended build-up of inventories. That signals to firms that they were overly optimistic about the level of demand in that particular period.
Once this realisation becomes consolidated, that is, firms generally realise they have over-produced, output starts to fall. Firms layoff workers and the loss of income starts to multiply as those workers reduce their spending elsewhere.
As national income falls, so does overall saving (as some proportion of the loss of income).
The attempts by households overall to increase their saving ratio may be thwarted because income losses cause loss of saving in aggregate (the Paradox of Thrift). So while one household can easily increase its saving ratio through discipline, if all households try to do that then they will fail. This is an important statement about why macroeconomics is a separate field of study.
Typically, the only way to avoid these spiralling employment losses would be for an exogenous intervention to occur – in the form of an expanding public deficit or a boost to net export.
So total saving always adjusts to changes in income and if a budget deficit can initially increase income then it will not compromise the capacity of firms to invest in productive capacity.
The other point relates to what investment means in these national income accounting frameworks and there is a good treatment of that by Brad Delong HERE, which provided some amusement today (it is funny!).
DeLong’s conclusion is apt:
These mistakes are, literally, elementary ones. They were elementary when R.G. Hawtrey and the other staffers of the British Treasury made them in the 1920s.
They carry the implication not just that government cannot stimulate or depress the economy, but that no set of private investment or savings decisions can stimulate or depress the economy either, and thus that there can be no business cycle fluctuations from any source whatsoever–because every action that shifts savings or investment simply moves resources from one use to another.
What is extraordinary is that these mistakes are being rederived today, at the end of the 2000s–without any consciousness of their past or of the refutations of them made by past theory and history.
I think it is time to draw a line in the sand: no more economists who know nothing about the economic history of the world or the history of economic thought.
We should all drink to that!
The Saturday Quiz will be back sometime tomorrow – about as hard as it was last week!
That is enough for today!