There is an accepted statistical definition of a recession, developed by the National Bureau of Economic Research, as the period from the peak to the trough of a range of cyclical economic data including “real GDP, real income, employment, industrial production, and wholesale-retail sales” (Hall et al. 2003). On this formal definition, the United States experienced thirty-two recessions in the one and a half centuries from 1854 till 2001, or roughly one recession of about one and a half year’s duration every five years. No such accepted statistical definition exists for the much more severe and infrequent phenomenon of a depression. At the minimum, depressions are recessions extended in either severity or duration; symptomatically, they are marked by financial crises and falling prices.
Figure 1 allows us to identify four periods since 1870 in which the United States has experienced the statistical symptoms of a depression: 1873–1878 (though real GDP rose slightly), 1892–1896, 1919–1921, and 1929–1938. In all four periods, output stagnated (and fell in per capita terms), prices fell, and money supply growth either ceased or became negative.
Similar events occurred roughly every two decades in the nineteenth century, with notable “financial panics” occurring in 1819, 1837, and 1857. A more recent instance of a depression in an advanced economy was Japan in the period from 1990 till 2005. The Great Depression was by far the most extreme such event, and most academic debate about the causes of depressions focuses upon it. However, debate about whether capitalism had an innate tendency toward either full employment or depression began at the dawn of economics.
The chief proponent of the full employment belief was Jean-Baptiste Say (1767–1832), whose proposition, which John Maynard Keynes (1883–1946) later paraphrased as “supply creates its own demand” (Keynes 1936, p. 18), became known as Say’s law. Say argued that “every producer asks for money in exchange for his products, only for the purpose of employing that money again immediately in the purchase of another product” (Say  1967, p. 105). A supply of one good was thus simultaneously a demand for others of an equivalent total value, and in the aggregate, demand was identical to supply—though individual markets, including the labor market, could have deficient or excess demand, due to disequilibrium pricing. Where any individual market had more supply than demand, the solution was for the suppliers to lower their asking price. The solution to widespread unemployment was thus to reduce wages.
Despite the fact that Say’s analysis proceeded from a subjective, utility-based theory of value, his macroeconomic arguments were accepted by David Ricardo
(1772–1823), who followed a classical theory of value. In contrast, Thomas Malthus (1766–1834) rejected Say’s analysis, and, in modern terms, argued that either excessive investment due to overoptimistic expectations, or hoarding, could lead to a general slump.
The most systematic nineteenth-century argument for the possibility of a general slump was given by Karl Marx (1818–1883), who divided demand into two “circuits”: the circuit of commodities C-M-C' and the circuit of capital M-C-M+. In the former, Say’s law in general applied; but in the latter, the capitalist’s aim “is not to equalize his supply and demand, but to make the inequality between them … as great as possible” (Marx 1885, pp. 120–121). Since aggregate demand was the sum of the two circuits, it was entirely possible for a “general glut”— or depression—to occur, if capitalist expectations of profit were depressed.
During the Great Depression itself, Keynes put forward an argument similar to Marx’s (and in a 1933 draft of his 1936 General Theory, Keynes cited Marx directly [Dillard 1984, p. 424]). Dividing effective demand into consumption demand D1 and investment demand D2, he argued that the sum could be insufficient to employ “the supply of labour potentially available at the existing real wage” (Keynes 1936, p. 30).
Irving Fisher (1867–1947) introduced a financial interpretation of the tendency to depression in 1933. Though Fisher had earlier developed the equilibrium model of finance, the rejection of equilibrium analysis was pivotal to his “debt deflation theory of great depressions.” It was, he argued, as absurd to assume that key economic variables were always at their equilibrium values as it was “to assume that the Atlantic Ocean can ever be without a wave” (Fisher 1933, p. 339).
Fisher argued that the Great Depression was caused by the confluence of two disequilibria: “over-indebtedness to start with and deflation following soon after” (Fisher 1933, p. 341). Excessive debt forced businesses to liquidate stock at distressed prices, leading to a fall in the price level that actually reduced the capacity to repay debt. This caused a “chain reaction” of further disturbances, including a decline in bank deposits, a fall in the velocity of circulation, unemployment, increased pessimism, an evaporation of investment, and “complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest” (Fisher 1933, p. 342).
The end product was Fisher’s paradox that “the more the debtors pay, the more they owe” (Fisher 1933, p. 344): the real debt burden rose because of deflation, even though nominal debt had been reduced by debt repayment. Fisher asserted that private debt fell by 20 percent between 1929 and 1933, but real debt rose 40 percent because of the impact of four years of steeply falling prices. He argued that the only policy that could engineer an escape from a depression was reflation, and for that reason he strongly supported Franklin D. Roosevelt’s New Deal.
The position that capitalism was innately stable, and that the Great Depression had been caused by government policy, was first put by Milton Friedman (1912–2006) and Anna Jacobson Schwartz. They claimed that the depression occurred because of deflationary policies pursued by the Federal Reserve that reduced the stock of money, and asserted that “the Federal Reserve at all times had power to prevent the decline in the money stock or to increase it to any desired degree, by providing enough high-powered money to satisfy the banks’ desire for liquidity” (Friedman and Schwartz 1963a, p. 52).
Today, neoclassical analysis of depressions is dominated by real business cycle theory, which argues that any economic outcome is the result of the actions of rational agents in a stochastically uncertain environment. In this view, the Great Depression was either the result of optimal responses by rational agents to less-than-optimal government policies, or it was the product of a monetary or productivity shock (Prescott 1999). However, since real business cycle models presume that a market economy rapidly returns to equilibrium after a shock, the slow speed of recovery from the Great Depression needs an explanation. Most theorists argue that the downward inflexibility of money wages, combined with deflation, kept real wages above equilibrium for a substantial period.
The modern representative of the “innate tendency to depression” argument is the financial instability hypothesis (FIH) developed by Hyman Minsky (1919–1996). Fisher’s debt-deflation hypothesis is one of its two pillars, the other being Joseph Schumpeter’s (1883–1950) vision of capitalism as innately cyclical. The FIH argues that capitalist economies have a cyclical tendency to accumulate excessive debt, and depressions are a runaway process in which interest on existing debt overwhelms the economy’s capacity to service debt.
There are thus two modern perspectives on the causes of depressions—neoclassical real business theory and the FIH—with fundamentally opposed analyses and policy prescriptions. Deciding which is right is therefore important, given that what one says will cure a depression, the other says will make it worse.
An essential premise of the neoclassical perspective is that the government controls the money supply. This not only makes the government a cause of depressions, but also gives it an easy means to overcome one. In the words of Federal Reserve Chairman Ben Bernanke, “If we do fall into deflation, however, we can take comfort that … sufficient injections of money will ultimately always reverse a deflation” (Bernanke 2002).
The FIH, on the other hand, argues that money is largely endogenous, so that attempting to increase liquidity by “the logic of the printing press” (Bernanke 2002) is, in effect, “pushing on a string.” Strictly, monetary attempts to reflate out of a depression will, in this theory’s view, probably fail. However, this model concurs that the government should attempt to maintain liquidity during a depression.
Since the neoclassical model sees sticky wages as part of the problem, its solution is to remove labor market institutions that prevent wages from falling sufficiently quickly. The debt-deflation model puts the contrary position that falling money wages will only lead to further falls in prices, which will exacerbate the problem of deflation. It recommends the opposite policy: that money wages should be increased to cause inflation and thus reduce the real debt burden.
Though neoclassical real business cycle theory dominates academic economics today, many papers in this tradition are candid about the empirical weakness of their models, with implausibly large productivity shocks or monetary reaction functions being required to fit the data. The Japanese depression of 1990 until 2005 also challenges the belief that deflation can be easily reversed by increasing base money. Very large changes in M1—at rates of up to 32 percent per annum—had little discernible impact on either the overall money supply (M2) or price levels (see Figure 2).
On this measure at least, the evidence appears to support the FIH perspective. However, given the dominant position of neoclassical analysis within economics, there is little doubt that, should a depression recur, the policies followed in the first instance will be neoclassical in nature.
SEE ALSO Business Cycles, Real; Business Cycles, Theories; Great Depression; Natural Rate of Unemployment; Recession; Say’s Law; Stagflation; Stagnation
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