DRI-135 for week of 1-4-15: Flexible Wages and Prices: Economic Shock Absorbers

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Flexible Wages and Prices: Economic Shock Absorbers

At the same times that free markets are becoming an endangered species in our daily lives, they enjoy a lively literary existence. The latest stimulating exercise in free-market thought is The Forgotten Depression: 1921 – The Crash That Cured Itself. The author is James Grant, well-known in financial circles as editor/publisher of “Grant’s Interest Rate Observer.” For over thirty years, Grant has cast a skeptical eye on the monetary manipulations of governments and central banks. Now he casts his gimlet gaze backward on economic history. The result is electrifying.

The Recession/Depression of 1920-1921

The U.S. recession of 1920-1921 is familiar to students of business cycles and few others. It was a legacy of World War I. Back then, governments tended to finance wars through money creation. Invariably this led to inflation. In the U.S., the last days of the war and its immediate aftermath were boom times. As usual – when the boom was the artifact of money creation – the boom went bust.

Grant recounts the bust in harrowing detail.  In 1921, industrial production fell by 31.6%, a staggering datum when we recall that the U.S. was becoming the world’s leading manufacturer. (The President’s Conference on Unemployment reported in 1929 that 1921 was the only year after 1899 in which industrial production had declined.) Gross national product (today we would cite gross domestic product; neither statistic was actually calculated at that time) fell about 24% in between 1920 and 1921 in nominal dollars, or 9% when account is taken of price changes. (Grant compares this to the figures for the “Great Recession” of 2007-2009, which were 2.4% and 4.3%, respectively.) Corporate profits nosedived commensurately. Stocks plummeted; the Dow Jones Industrial average fell by 46.6% between the cyclical peak of November, 1919 and trough of August, 1921. According to Grant, “the U.S. suffered the steepest plunge in wholesale prices in its history (not even eclipsed by the Great Depression),” over 36% within 12 months. Unemployment rose dramatically to a level of some 4,270,000 in 1921 – and included even the President of General Motors, Billy Durant. (As the price of GM’s shares fell, he augmented his already-sizable shareholdings by buying on margin – ending up flat broke and out of a job.) Although the Department of Labor did not calculate an “unemployment rate” at that time, Grant estimates the nonfarm labor force at 27,989,000, which would have made the simplest measure of the unemployment rate 15.3%. (That is, it would have undoubtedly included labor-force dropouts and part-time workers who preferred full-time employment.)

A telling indicator of the dark mood enveloping the nation was passage of the Quota Act, the first step on the road to systematic federal limitation of foreign immigration into the U.S. The quota was fixed at 3% of foreign nationals present in each of the 48 states as of 1910. That year evidently reflected nostalgia for pre-war conditions since the then-popular agricultural agitation for farm-price “parity” sought to peg prices to levels at that same time.

In the Great Recession and accompanying financial panic of 2008 and subsequently, we had global warming and tsunamis in Japan and Indonesia to distract us. In 1920-1921, Prohibition had already shut down the legal liquor business, shuttering bars and nightclubs. A worldwide flu pandemic had killed hundreds of thousands. The Black Sox had thrown the 1919 World Series at the behest of gamblers.

The foregoing seems to make a strong prima facie case that the recession of 1920 turned into the depression of 1921. That was the judgment of the general public and contemporary commentators. Herbert Hoover, Secretary of Commerce under Republican President Warren G. Harding, who followed wartime President Woodrow Wilson in 1920, compiled many of the statistics Grant cites while chairman of the President’s Conference on Unemployment. He concurred with that judgment. So did the founder of the study of business cycles, the famous institutional economist Wesley C. Mitchell, who influenced colleagues as various and eminent as Thorstein Veblen, Milton Friedman, F. A. Hayek and John Kenneth Galbraith. Mitchell referred to “…the boom of 1919, the crisis of 1920 and the depression of 1921 [that] followed the patterns of earlier cycles.”

By today’s lights, the stage was set for a gigantic wave of federal-government intervention, a gargantuan stimulus program. Failing that, economists would have us believe, the economy would sink like a stone into a pit of economic depression from which it would likely never emerge.

What actually happened in 1921, however, was entirely different.

The Depression That Didn’t Materialize

We may well wonder what might have happened if the Democrats had retained control of the White House and Congress. Woodrow Wilson and his advisors (notably his personal secretary, Joseph Tumulty) had greatly advanced the project of big government begun by Progressive Republicans Theodore Roosevelt and William Howard Taft. During World War I, the Wilson administration seized control of the railroads, the telephone companies and the telegraph companies. It levied wage and price controls. The spirit of the Wilson administration’s efforts is best characterized by the statement of the Chief Price Controller of the War Industries Board, Robert Brookings. “I would rather pay a dollar a pound for [gun]powder for the United States in a state of war if there was no profit in it than pay the DuPont Company 50 cents a pound if they had 10 cents profit in it.” Of course, Mr. Brookings was not actually himself buying the gunpowder; the government was only representing the taxpayers (of whom Mr. Brookings was presumably one). And their attitude toward taxpayers was displayed by the administration’s transformation of an income tax initiated at insignificant levels in 1913 and to a marginal rate of 77% (!!) on incomes exceeding $1 million.

But Wilson’s obsession with the League of Nations and his 14 points for international governance had not only ruined his health, it had ruined his party’s standing with the electorate. In 1920, Republican Warren G. Harding was elected President. (The Republicans had already gained substantial Congressional majorities in the off-year elections of 1918.) Except for Hoover, the Harding circle of advisors was comprised largely of policy skeptics – people who felt there was nothing to be done in the face of an economic downturn but wait it out. After all, the U.S. had endured exactly this same phenomenon of economic boom, financial panic and economic bust before in 1812, 1818, 1825, 1837, 1847, 1857, 1873, 1884, 1890, 1893, 1903, 1907, 1910 and 1913. The U.S. economy had not remained mired in depression; it had emerged from all these recessions – or, in the case of 1873, a depression. If the 19th-century system of free markets were to be faulted, it would not be for failure to lift itself out of recession or depression, but for repeatedly re-entering the cycle of boom and bust.

There was no Federal Reserve to flood the economy with liquidity or peg interest rates at artificially low levels or institute a “zero interest-rate policy.” Indeed, the rules of the gold-standard “game” called for the Federal Reserve to raise interest rates to stem the inflation that still raged in the aftermath of World War I. Had it not done so, a gold outflow might theoretically have drained the U.S. dry.  The Fed did just that, and interest rates hovered around 8% for the duration. Deliberate deficit spending as an economic corrective would have been viewed as madness. As Grant put it, “laissez faire had its last hurrah in 1921.”

What was the result?

In the various individual industries, prices and wages and output fell like a stone. Auto production fell by 23%. General Motors, as previously noted, was particularly hard hit. It went from selling 52,000 vehicles per month to selling 13,000 to 6,150 in the space of seven months. Some $85 million in inventory was eventually written off in losses.

Hourly manufacturing wages fell by 22%. Average disposable income in agriculture, which comprised just under 20% of the economy, fell by over 55%. Bankruptcies overall tripled to nearly 20,000 over the two years ending in 1921. In Kansas City, MO, a haberdashery shop run by Harry Truman and Eddie Jacobson held out through 1920 before finally folding in 1921. The resulting personal bankruptcy and debt plagued the partners for years. Truman evaded it by taking a job as judge of the Jackson County Court, where his salary was secure against liens. But his bank accounts were periodically raided by bill collectors for years until 1935, when he was able to buy up the remaining debt at a devalued price.

In late 1920, Ford Motor Co. cut the price of its Model T by 25%. GM at first resisted price cuts but eventually followed suit. Farmers, who as individuals had no control over the price of their products, had little choice but to cut costs and increase productivity – increasing output was an individual’s only way to increase income. When all or most farmers succeeded, this produced lower prices. How much lower? Grant: “In the second half of [1920], the average price of 10 leading crops fell by 57 percent.” But how much more food can humans eat; how many more clothes can they wear? Since the price- and income-elasticities of demand for agricultural goods were less than one, this meant that agricultural revenue and incomes fell.

As noted by Wesley Mitchell, the U.S. slump was not unique but rather part of a global depression that began as a series of commodity-price crashes in Japan, the U.K., France, Italy, Germany, India, Canada, Sweden, the Netherlands and Australia. It encompassed commodities including pig iron, beef, hemlock, Portland cement, bricks, coal, crude oil and cotton.

Banks that had speculative commodity positions were caught short. Among these was the largest bank in the U.S., National City Bank, which had loaned extensively to finance the sugar industry in Cuba. Sugar prices were brought down in the commodity crash and brought the bank down with them. That is, the bank would have failed had it not received sweetheart loans from the Federal Reserve.

Today, the crash of prices would be called “deflation.” So it was called then and with much more precision. Today, deflation can mean anything from the kind of nosediving general price level seen in 1920-1921 to relatively stable prices to mild inflation – in short, any general level of prices that does not rise fast enough to suit a commentator.

But there was apparently general acknowledgment that deflation was occurring in the depression of 1921. Yet few people apart from economists found that ominous. And for good reason. Because after some 18 months of panic, recession and depression – the U.S. economy recovered. Just as it had done 14 times previously.


It didn’t merely recover. It roared back to life. President Harding died suddenly in 1923, but under President Coolidge the U.S. economy experienced the “Roaring 20s.” This was an economic boom fueled by low tax rates and high productivity, the likes of which would not be seen again until the 1980s. It was characterized by innovation and investment. Unfortunately, in the latter stages, the Federal Reserve forgot the lessons of 1921 and increases the money supply to “keep the price level stable” and prevent deflation in the face of the wave of innovation and productivity increases. This helped to usher in the Great Depression, along with numerous policy errors by the Hoover and Roosevelt administrations.

Economists like Keynes, Irving Fisher and Gustav Cassel were dumbfounded. They had expected deflation to flatten the U.S. economy like a pancake, increasing the real value of debts owed by debtor classes and discouraging consumers from spending in the expectation that prices would fall in the future. Not.

There was no economic stimulus. No TARP, no ZIRP, no QE. No wartime controls. No meddlesome regulation a la Theodore Roosevelt, Taft and Wilson. The Harding administration and the Fed left the economy alone to readjust and – mirabile dictu – it readjusted. In spite of the massive deflation or, much more likely, because of it.

The (Forgotten) Classical Theory of Flexible Wages and Prices

James Grant wants us to believe that this outcome was no accident. The book jacket for the Forgotten Depression bills it as “a free-market rejoinder to Bush’s and Obama’s Keynesian stimulus applied to the 2007-9 recession,” which “proposes ‘less is more’ with respect to federal intervention.”

His argument is almost entirely empirical and very heavily oriented to the 1920-1921 depression. That is deliberate; he cites the 14 previous cyclical contractions but focuses on this one for obvious reasons. It was the last time that free markets were given the opportunity to cure a depression; both Herbert Hoover and Franklin Roosevelt supervised heavy, continual interference with markets from 1929 through 1941. We have much better data on the 1920-21 episode than, say, the 1873 depression.

Readers may wonder, though, whether there is underlying logical support for the result achieved by the deflation of 1921. Can the chorus of economists advocating stimulative policy today really be wrong?

Prior to 1936, the policy chorus was even louder. Amazing as it now seems, it advocated the stance taken by Harding et al. Classical economists propounded the theory of flexible wages and prices as an antidote to recession and depression. And, without stating it in rigorous fashion, that is the theory that Grant is following in his book.

Using the language of modern macroeconomics, the problems posed by cyclical downturns are unemployment due to a sudden decline in aggregate (effective) demand for goods and services. The decline in aggregate demand causes declines in demand for all or most goods; the decline in demand for goods causes declines in demand for all or most types of labor. As a first approximation, this produces surpluses of goods and labor. The surplus of labor is defined as unemployment.

The classical economists pointed out that, while the shock of a decline in aggregate demand could cause temporary dislocations such as unsold goods and unemployment, this was not a permanent condition. Flexible wages and prices could, like the shock absorbers on an automobile, absorb the shock of the decline in aggregate demand and return the economy to stability.

Any surplus creates an incentive for sellers to lower price and buyers to increase purchases. As long as the surplus persists, the downward pressure on price will remain. And as the price (or wage) falls toward the new market-clearing point, the amount produced and sold (or the amount of labor offered and purchases) will increase once more.

Flexibility of wages and prices is really a two-part process. Part one works to clear the surpluses created by the initial decline in aggregate demand. In labor markets, this serves to preserve the incomes of workers who remain willing to work at the now-lower market wage. If they were unemployed, they would have no wage, but working at a lower wage gives them a lower nominal income than before. That is only part of this initial process, though. Prices in product markets are decreasing alongside the declining wages. In principle, fully flexible prices and wages would mean that even though the nominal incomes of workers would decline, their real incomes would be restored by the decline of all prices in equal proportion. If your wage falls by (say) 20%, declines in all prices by 20% should leave you able to purchase the same quantities of goods and services as before.

The emphasis on real magnitudes rather than nominal magnitudes gives rise to the name given to the second part of this process. It is called the real-balance effect. It was named by the classical economist A. C. Pigou and refined by later macroeconomist Don Patinkin.

When John Maynard Keynes wrote his General Theory of Employment Interest and Income in 1936, he attacked classical economists by attacking the concepts of flexible wages and prices. First, he attacked their feasibility. Then, he attacked their desirability.

Flexible wages were not observed in reality because workers would not consent to downward revisions in wages, Keynes maintained. Did Keynes really believe that workers preferred to be unemployed and earn zero wages at a relatively high market wage rather than work and earn a lower market wage? Well, he said that workers oriented their thinking toward the nominal wage rather than the real wage and thus did not perceive that they had regained their former position with lower prices and a lower wage. (This became known as the fallacy of money illusion.) His followers spent decades trying to explain what he really meant or revising his words or simply ignoring his actual words. (It should be noted, however, that Keynes was English and trade unions exerted vastly greater influence on prevailing wage levels in England that they did in the U.S. for at least the first three-quarters of the 20th century. This may well have biased Keynes’ thinking.)

Keynes also decried the assumption of flexible prices for various reasons, some of which continue to sway economists today. The upshot is that macroeconomics has lost touch with the principles of price flexibility. Even though Keynes’ criticisms of the classical economists and the price system were discredited in strict theory, they were accepted de facto by macroeconomists because it was felt that flexible wages and prices would take too long to work, while macroeconomic policy could be formulated and deployed relatively quickly. Why make people undergo the misery of unemployment and insolvency when we can relieve their anxiety quickly and compassionately by passing laws drafted by macroeconomists on the President’s Council of Economic Advisors?

Let’s Compare

Thanks to James Grant, we now have an empirical basis for comparison between policy regimes. In 1920-1921, the old-fashioned classical medicine of deflation, flexible wages and prices and the real-balance effect took 18 months to turn a panic, recession and depression into a rip-roaring recovery that lasted 8 years.

Fast forward to December, 2007. The recession has begun. Unfortunately, it is not detected until September, 2008, when the financial panic begins. The stimulus package is not passed until January, 2009 – barely in time for the official end of the recession in June, 2009. Whoops – unemployment is still around 10% and remains stubbornly high until 2013. Moreover, it only declines because Americans have left the labor force in numbers not seen for over thirty years. The recovery, such as it is, is so anemic as to hardly merit the name – and it is now over 7 years since the onset of recession in December, 2007.


It is no good complaining that the stimulus package was not large enough because we are comparing it with a case in which the authorities did nothing – or rather, did nothing stimulative, since their interest-rate increase should properly be termed contractionary. That is exactly what macroeconomists call it when referring to Federal Reserve policy in the 1930s, during the Great Depression, when they blame Fed policy and high interest rates for prolonging the Depression. Shouldn’t they instead be blaming the continual series of government interventions by the Fed and the federal government under Herbert Hoover and Franklin Roosevelt? And we didn’t even count the stimulus package introduced by the Bush administration, which came and went without making a ripple in term of economic effect.

Economists Are Lousy Accident Investigators 

For nearly a century, the economics profession has accused free markets of possessing faulty shock absorbers; namely, inflexible wages and prices. When it comes to economic history, economists are obviously lousy accident investigators. They have never developed a theory of business cycles but have instead assumed a decline in aggregate demand without asking why it occurred. In figurative terms, they have assumed the cause of the “accident” (the recession or the depression). Then they have made a further assumption that the failure of the “vehicle’s” (the economy’s) automatic guidance system to prevent (or mitigate) the accident was due to “faulty shock absorbers” (inflexible wages and prices).

Would an accident investigator fail to visit the scene of the accident? The economics profession has largely failed to investigate the flexibility of wages and prices even in the Great Depression, let alone the thirty-odd other economic contractions chronicled by the National Bureau of Economic Research. The work of researchers like Murray Rothbard, Vedder and Galloway, Benjamin Anderson and Harris Warren overturns the mainstream presumption of free-market failure.

The biggest empirical failure of all is one ignored by Grant; namely, the failure to demonstrate policy success. If macroeconomic policy worked as advertised, then we would not have recessions in the first place and could reliably end them once they began. In fact, we still have cyclical downturns and cannot use policy to end them and macroeconomists can point to no policy successes to bolster their case.

Now we have this case study by James Grant that provides meticulous proof that deflation – full-blooded, deep-throated, hell-for-leather deflation in no uncertain terms – put a prompt, efficacious end to what must be called an economic depression.

Combine this with the 40-year-long research project conducted on Keynesian theory, culminating in its final discrediting by the early 1980s. Throw in the existence of the Austrian Business Cycle Theory, which combines the monetary theory of Ludwig von Mises and interest-rate theory of Knut Wicksell with the dynamic synthesis developed by F. A. Hayek. This theory cannot be called complete because it lacks a fully worked out capital theory to complete the integration of monetary and value theory. (We might think of this as the economic version of the Unified Field Theory in the natural sciences.) But an incomplete valid theory beats a discredited theory every time.

In other words, free-market economics has an explanation for why the accident repeatedly happens and why its effects can be mitigated by the economy’s automatic guidance mechanism without the need for policy action by government. It also explains why the policy actions are ineffective at both remedial and preventive action in the field of accidents.

James Grant’s book will take its place in the pantheon of economic history as the outstanding case study to date of a self-curing depression.

DRI-420: It’s Official: The Recovery is Receding

Coping with change is famously difficult. The first stage of the adjustment is recognition. It’s hard to adjust to something when you don’t realize – or won’t acknowledge – its reality. That is the problem most people have adjusting to the current state of the economy. They can’t or won’t acknowledge that we are undergoing an unprecedented transformation rather than merely another business cycle.

We periodically review the performance of Access Advertising’s Driver Recruiting Index (DRI) as a tool to gauge the ex ante demand for commercial drivers. We juxtapose it alongside other indices of trucking and transportation to review their performance and assess the state of the economy. Two salient points emerge from our latest review.

First, the economy in general and the transportation (and trucking) sector in particular are caught in a limbo that is neither recession nor expansion. Second, experts who have been slow to recognize this fact are now belatedly doing so.

The DRI’s Spring Plateau

In 2011, the DRI began its annual climb up the ladder in mid-January, then took off sharply in February. It plateaued in April and May, only to accelerate again in June and July. Total upward movement from January to July was dramatic.

This year, after one of the warmest winters on record, the DRI began with its usual vigor in February. But in early March, it reached a plateau from which it seldom deviated through mid-June – a most unusual seasonal performance under any circumstances and even more so now. The index never came within hailing distance of last year’s spring highs and remains mired at least 10% below the values on comparable dates last year.

It is not unusual for the DRI to increase at certain times of the year or in appropriate circumstances, or for it to decrease at other times. But plodding consistency during a season and circumstances in which rapid increase would be expected is unusual. Moreover, this mimics the DRI’s trance-like behavior early last fall, when the increases in trucking activity normally associated with preparation for the end-of-year retail rush did not materialize.

Our recognition of this uncharacteristic lassitude by the DRI and the economy in general is on record. Now, however, we are part of a chorus of mainstream commentators on transportation and the economy.

The ATA Gets on Board

A longtime trucking bellwether is the American Trucking Associations’ (ATA) Monthly Truck Tonnage Index. This seasonally adjusted index of trucking volume backed up its 1.1% decline in April with a 0.7% fall in May.

ATA’s Chief Economist Bob Costello is a reliable go-to guy for a quote on the economy in general and trucking in particular. He is reliably mainstream in his views – which are favorable to big business and big government. He is consistently cautious in his projections – which is to say, not given to dramatics or overstatement.

So when Costello calls the Truck Tonnage Index’s recent dips “reflective of the broader economy, which has slowed,” you need look no further to discern the consensus of the forecasting fraternity. Costello’s lineup of suspected culprits for the slowdown is predictable – Eurozone turmoil and U.S. electoral uncertainty. This double whammy clouds crystal balls and turns corporate planners into chickens who sit clucking atop cash instead of hatching new investments.


The Transportation Services Index (TSI) of the Bureau of Labor Statistics is another familiar index of transportation activity. The Truck Tonnage Index is a component of this broader survey of the overall transportation picture, compiled under the auspices of the Department of Transportation.

Not surprisingly, the federal government moves slower than the world it governs. Consequently, the most recent month available for the TSI is April, during which the freight index rose at the snail’s pace of 0.2%. The DOT summarized recent movements of the index thusly: “Plateauing of the freight TSI since January appears to reflect slowing growth in the general economy.”

The Cass Index

The Cass Index is yet another transportation index of long standing. It compiles separate indices for volume and expenditures. The volume index has increased throughout 2012, but the increases have been steadily decreasing in magnitude – 2.5% in February, 2.3% in March, 1.9% in April and 1.8% in May.

Commenting on this record in the June 5, 2012 posting of Logistics Management, industry analyst Jeff Berman observed “…a dearth of people that truly have real confidence in the economy,” noting that “volumes are still not close to 2007 [e.g., pre-recession] levels.” The economy, he concludes, “remains in teeter-totter mode.”

The Ceridian PCI

The Ceridian Pulse of Commerce Index (PCI) is the brainchild of UCLA econometrician and forecaster Edward Leamer. It captures real-time data on the diesel-fuel consumption of over-the-road trucks at some 7000 locations across the U.S. from the transactions cleared through stored-value card provider Ceridian.

Like most transportation indices, the PCI has registered slowing growth in early 2012 – 0.7% in February, 0.3% in March and 0.1% in April. At first glance, May seemed to reverse this trend with 0.8% growth. But there are reasons to take even this modest piece of good news with a grain of salt.

For one thing, as pointed out by Jeff Berman in Logistics Management on June 7, the May figure still represented a year-over-year decline of 0.6%. Even more telling is the fact that the volume of diesel-fuel purchases reacts strongly to diesel-fuel prices. These, in turn, depend on oil prices and the health of diesel-dependent economies like China and India. Recent downturns in both the above indicators are good news for diesel-fuel consumption specifically, but they are something of a mixed blessing for overall U.S. economic activity.

A decline in oil prices caused by an increased supply of oil is an unambiguous benefit for us. This increases the amount of resources available for production purposes, and the reduction in oil prices translates into lower costs for countless production processes in which oil is an input. But if the decline results from a reduced demand for oil at home and abroad, it is a harbinger of recession. The lower demand will result in less oil being purchased and used in production, leading to less output of derivative goods and services. Moreover, less demand for oil abroad means lower incomes and less demand for U.S. exports, which will ultimately lower our incomes and imports as well.

We are experiencing both effects – the former due to improved recovery methods like fracking and horizontal drilling and sources like shale oil, the latter due to a myriad of influences including Eurozone woes, Chinese recession and our own slogging-through-molasses economic climate. At the moment, the bad tends to outweigh the good. In turn, this tends to mitigate the significance of upturns in the PCI.

Leamer himself is just as lukewarm about our prospects as other transportation forecasters. In Berman’s piece, he characterizes trucking as “soft generally” because “growth in the components of the economy that depend on trucking is not strong.”

Light Dawneth at Last

The current consensus has been slow in forming. In the three years since the official end to the Great Recession in June 2009, mainstream commentators like Bob Costello and Edward Leamer have continually insisted that prosperity was just around the corner. In effect, they have assumed that the United States was living through a typical business cycle, characterized by a downturn that eventually hit bottom, followed by an upturn that picked up steam until it became a full-fledged expansion. Cycles might differ in detail, with respect to trajectory of contraction or expansion and duration of recovery, but not in terms of their general character.

When the rate of GDP growth began to increase somewhat in 2010, Costello confidently asserted that growth would soon accelerate and unemployment would start to fall. After all, he reminded us, unemployment is a lagging indicator and usually is the last symptom of recession to abate once expansion sets in. Late last year, Leamer reacted to a favorable monthly PCI by reading into it the long-awaited resurgence of trucking that would lift the economy off the mud flats and into the whitewater of fast-track growth.

Few economic indicators are as volatile as housing starts, but the slightest upward blip in housing over the last three years has invariably been touted as a neon arrow pointing unerringly at the promised land of full employment. Despite all economic logic to the contrary, the presumption has been that because housing was the most severely affected sector during the Great Recession, it must of necessity lift the general economy up to recovery on its shoulders.

In view of this record, the question isn’t so much how or why we all abruptly find ourselves on the same page. Instead, we should wonder why it took so long.

Revolution and Crisis

The science of macroeconomics (an oxymoronic term that is nonetheless useful) has reached a watershed moment. In his landmark study, The Structure of Scientific Revolutions, Thomas Kuhn decried the conventional view of science. A scientific theory or paradigm is not formulated, tested experimentally and formally accepted or rejected. Instead, it is adopted on the basis of practical usefulness and retained until supplanted by a more useful theory. Replacement is not effected by testing but rather in response to a crisis – the failure of the reigning theory to perform the tasks that made it useful originally.

We are now in the midst of such a crisis.

The reigning theory of macroeconomics was developed by John Maynard Keynes over 75 years ago using a combination of old and new ideas. The principal old idea was that capitalist economies suffered recurrent insufficiencies of spending that gave rise to depressions and unemployment. The principal new idea was that government could and should remedy these shortfalls by spending money and/or inducing citizens to increase spending. Eventually, economists borrowed the term stimulus from behavioral science to characterize these policies. The government spending should be funded by either borrowing or money creation. Induced private spending should be funded by either tax reductions or money creation. Increases in private investment should be induced by artificially lowering interest rates via money creation. Increases in employment should be induced by exploiting “money illusion” of workers – that is, by lowering the purchasing power of wages by money creation, fooling workers into thinking their real incomes had risen while persuading illusion-free businesses to hire more workers at lower real wages.

For over forty years, this theory was subjected to rigorous theoretical and empirical scrutiny and extensive practical application. By roughly 1980, the results were in. The theoretical scrutiny was unfavorable to the theory: no tendency toward underconsumption and unemployment was inherent in the system, government action would be unavailing, unnecessary or even counterproductive; and “money illusion” did not exist. Empirical studies were either unfavorable or equivocal. Practical application of the theory was widespread and remarkably consistent; it failed whenever and wherever tried.

In retrospect, this should not have been surprising. By 1980, the American economy had endured over 30 recessions. It had recovered from all of them without the application of the theory.

Still, the theory was not abandoned.

Macroeconomists claimed that the theory was still useful because government policy would work faster than allowing markets to recover from recession and depression unaided. Why suffer for two or three or four years when we can cure the problem in a few months or a year with the aid of government stimulus?

A Kuhnian explanation would instead find other ways in which a demonstrably wrong theory might nevertheless be useful. Government gradually took on the role of problem solver of first resort, not just in economic policy but in every nook and cranny of society. It actually solved few, if any, problems, but it was required to look as if it were trying to solve them. Trying hard.

Democrats, who had been the first party to advocate tax reductions as economic stimulus, eventually had to repudiate this policy because it supposedly enriched the rich. Republicans could not endorse a policy of government spending for economic- policy purposes because it would enlarge federal-government budget deficits. Both parties desperately needed a way to look busy. By default, they turned to monetary policy; e.g., money creation.

Ironically, Keynesian theory had originally rejected money creation as ineffective, but its practitioners had to abandon that stance for tactical reasons. Now they were backed into the corner of having to rely on it almost exclusively.

The economic theory that had proven utterly bankrupt as economics now became the sole policy tool of both political parties, virtually by default. It had never worked. Nobody in Washington, D.C. really expected it to work. Nobody cared all that much whether it worked or not.

Keynesian economics was in the same position as medicine prior to the eighteenth century. Doctors had few remedies that worked, but they continued to use the ones they had even though they seldom, if ever, cured anybody. If the doctors had admitted the truth, they would have had to stop being doctors. Macroeconomics had established a secure beachhead in the economics profession, with course offerings at every level of instruction, dedicated scholarly journals, major research grants, government positions and a public mission to make the world safe for markets. Admitting the truth about the theory that had midwived all that would have forfeited their gains.

What Time’s the Next Revolution?

So much for politicians, bureaucrats and academic economists. Where does that leave the rest of us? Essentially, it leaves us pacing the streets, looking around nervously, waiting for the next revolution. What we need is the next scientific revolution, and a theory to take the place of the failure being propped up by the Washington, D.C. policy Establishment – a composite version of Frank Morgan in The Wizard of Oz.

Heretofore we have been in denial. We have been telling ourselves that we went through a bad time in 2008, but the worse is over and we’re gradually getting over it now. Only it is now beginning to dawn on mainstream pundits that we’re not really getting over it – that, in fact, we may be getting ready to repeat some of the worst all over again.

We’re starting to realize that hardly a man is now alive who remembers the famous days and years when unemployment wobbled between eight and ten percent for over three years with no sign of relief. Interest rates have never been this low for this long – and what has it accomplished? Amend that slightly – what good has that accomplished? When in peacetime has government debt ever loomed so large? When has regulation bound so tightly? When has freedom seemed so tenuous?

When at last we have mustered the courage to admit the truth, the next stage will be to face the fact that Keynesian economics had no theory of the business cycle as such. Keynesian theory never asked why aggregate demand declined. The question didn’t seem to matter because the answer didn’t affect our course of action, which was to spend ourselves silly until things got better.

Well, we’re silly and they’re not better. Now it’s time to ask what really causes the business cycle. Wisdom begins when we acknowledge that the only time we faced a climate of recurrent limbo such as this one was in the 1930s – after both the Hoover and Roosevelt administration tried every interventionist nostrum under the sun to artificially cure the recession that began in 1929. As Roosevelt’s Treasury Secretary, Henry Morganthau, admitted to his diary, they ended up in 1939 worse off than when they started. Only when FDR himself forsook “Dr. New Deal” for “Dr. Win-the-War” were the chains hobbling American business broken. After World War II, with Roosevelt dead and no sponsor for the New Deal, a Republican Congress and tax cuts ushered in the greatest one-year boom in U.S. economic history.

If we went to the doctor to be treated for a serious illness and he offered us a new drug, how would we react? Would we not ask if it had been tried out? Would we not expect to find a history of successful use? If we found just the reverse – a history of failure – would we not reject the drug? If the only rebuttal argument the doctor could muster was, “Well, we can’t just stand here and do nothing,” wouldn’t we at the very least have the gumption to fire back, “Oh, yeah? Why not?”

This much can be done by any intelligent layman. No Ph.D. in economics is required. Afterward will be the time to grapple with the complexities of intertemporal capital theory and dynamic adjustment, to penetrate the mysteries of the structure of production. You have to learn to crawl before you can walk.

DRI-444: And the Beat of the Economic Greek Chorus Goes On

Early in 2012, broad indices of income and employment turned upward. Although not dramatic, the upturn raised hopes that at long last the economic recovery was about to shift out of low gear and into overdrive.

Of course, there were nagging problems with this optimistic scenario. For one thing, the transportation sector did not participate in the upturn. Trucking in particular languished. This seemed odd in view of the fact that roughly two-thirds of all freight travels by truck. While puzzled by this seeming anomaly, commentators like Edward Leamer of UCLA voiced optimism that trucking would soon get with the program. And it seemed unlikely that the pace of trucking activity could long lag that of the general economy.

Well, one quarter later, trucking’s rate of growth has lined up with that of the overall economy. But convergence has not been effected by a growth spurt in trucking. Instead, it is the overall economy that has dropped back into line with the dismal growth rate of the trucking sector.

What might account for the seemingly inexplicable pattern of economic fluctuations that have plagued the Great Recession and its stunted offspring, the Little Recovery? Can we identify the keynotes that distinguish this Great Recession from past business cycles?

The Greek Chorus on the Economy

In ancient, classical drama, the Greek chorus served the function of narrator and commentator on the events depicted. Over the last few years, economic commentators have formed their own Greek chorus. This suits the dramatic quality of world economic history ever since the financial crisis of 2008 – crisis following crisis, the major industrial nations bleakly eyeing a wall of worry. No sooner has one fraught moment passed than another pops up.

The Greek Chorus may be theatrically effective, but they are analytically deficient. They lack the experience and assurance needed to ad lib an explanation for this, the least conventional business cycle of them all.

The traditional model of the business cycle posits wave-like movements of economic activity joined by high (peak) and low (trough) points. The falling portion of the wave is the contraction phase. The rising part is the expansion. This roughly corresponds to the experience of living Americans. But the current Great Recession is new and different.

At the outset, the recession began in December 2007, but few would have made book on its existence until the meltdown came in the fall of 2008 – at which point the economy nosedived like a crooked prizefighter. The official end of the recession in June 2009 came and went without notice; unemployment remained sky-high for months afterward.

Eventually, it became apparent that a recovery was underway. Make that an apparent recovery – two or three months of modest growth was succeeded by a backslide in income and employment. This is hardly a classic business cycle scenario and it’s no way to run a railway to economic growth. You can travel between two points by dancing a box step but it’s not an efficient way to traverse the distance.

But the Greek Chorus could only sing its part from a script. It could moralize about the Greeks and their woes, and how those woes would wound the West if we weren’t careful. It could sing about morality – greed and inequality and protest and such. It could narrate a familiar tale about the business cycle. But it couldn’t analyze. It lacked a theoretical framework in which to look beyond history and tradition to ask why this episode differed from all that had gone before.

The Greek Chorus Sings the Same Song, Different Verse

In the fourth quarter of 2011, the U.S. economy achieved annualized growth of 3.0% and unemployment fell to 8.3%. The Greek Chorus raised its voices in hosannas of praise and thanksgiving. In January, employment jumped further. This was an “unmistakable” sign that we had turned the corner.

Alas, first quarter of 2012 simply repeated the same song heard ever since 2009. This verse featured reduced annualized growth of 2.2% and slightly lower unemployment, culminating in an 8.1% rate in April, 2012.

Unfortunately, even a lower unemployment rate became a mixed message. While the number of unemployed persons fell by 175,000 between March and April, 2012, the number of employed persons also fell, by 165,000. The job gain of 115,000 was well below the 200,000 job gain usually considered necessary to absorb increases in population and labor-force growth in a typical month. Of course, this month was anything but typical – the civilian labor force fell by 342,000. Since the unemployment rate is calculated by dividing the number of unemployed (12,500,000) by the total number of people in the labor force (154,365,000), the resulting 8.1% was only a razor-thin improvement over the previous month (12,675,000 divided by 154,707,000 equals 8.2%). The total number of employed people was 141,865,000 – up from 137,968,000 in December 2009 but well behind the 146,595,000 in 2007, before the recession started.

Once again, the “unmistakable” signs of recovery had become mistakable.

Why the Greek Chorus Sings Off-Key

In its narrative role, the Greek Chorus is not performing but instead “phoning in” its performance by relying on pre-digested Keynesian platitudes and bromides, as if it had substituted a pre-recorded instrumental for live performance. And that instrumental is like an old phonograph needle stuck in a crack, playing the same notes over and over again.

The Greek Chorus excoriated Wall Street for the failures of its “rocket scientists,” who developed complex derivative securities and relied on statistical databases to develop safety ratings for mortgage-backed securities. Rightly so, for radically changed credit standards had made the databases worthless for evaluating creditworthiness in today’s environment. But now the Chorus fails to recognize that the textbook business-cycle model cannot describe today’s reality, in which policymakers manipulate markets in vain efforts to make miracles or buy time in which to maneuver.

The simple business-cycle model only worked when markets were allowed to work. Today, the economy functions like an automobile whose fuel supply is impaired by some flaw such as a clogged filter. The vehicle lurches forward, stutters, stops, and lunges forward again. Something is obviously wrong, even if the source is not quite clear.

Insofar as they have any economic training at all, most people are trained to look to aggregate demand, or total spending, as the key to all mysteries. But that is not the problem.

In a functioning economy, markets tend to reconcile diverse perspectives of different people by providing objective knowledge about reality. People rely on that. Each of us knows that we don’t know everything, so we rely on what markets tell us and we rely on our ability to get information on the future and in the future. We can’t do that today because we all know that today’s economy is not “real.”

The best example is the “zero interest rate” policy (ZIRP) followed by the Federal Reserve. Everybody knows that interest rates do not reflect the actual saving and investing desires of consumers and businesses. We all know that ZIRP cannot go on forever, and when it ends the interest-rate environment will change drastically. We know that all those drastic changes will have tremendous effects on most of the economic choices we make now and in the immediate future.

In effect, most of the country is living with one ear attuned to daily life and the other one keenly listening for the other shoe to drop – that is, for any sign of the change that we know is coming. Obviously, we can’t live in a state of suspended animation. But just as obviously, it’s in our interest to do the minimum necessary to get by until this state of massive uncertainty clarifies.

And guess what? Everybody “doing the minimum necessary” translates into an economy with minimal growth and confused direction. Long-term investment is attractive only when the circumstances are absolutely ideal – or when political corruption or cronyism tips the scales in favor of action. Hiring is analogous to long-term investment because it entails assumption of so many costs and because firing has become correspondingly difficult. It’s no wonder, then, that we’re in the fix we’re in.

Waiting – But Not for Godot

Some other paralysis-inducing factors are related to ZIRP. Current and future projected spending at the federal level is producing unprecedented peacetime accounting deficits. These require federal borrowing. Interest payments on the necessary bonds threaten to eat up the entire federal-government budget before the decade ends. Everybody knows that this process cannot continue. Everybody knows that its termination will require massive dislocations. Some of these might be large spending cuts, huge tax increases, elimination of federal-government agencies and departments, privatization of government functions, and large-scale reductions in federal employment. Nobody can dispute the stunning impact of these measures. Everybody is waiting to see what will happen.

Many state and local governments are in bad financial shape as well. Included among them are some of our largest and most populous states, such as California, Illinois and New York. Most people realize that the promises made to many public-employee unions regarding retirement pension and health-care benefits have placed government finance in an untenable position. Once again, the necessary remedial actions will have dramatic effects on all the affected parties. Everybody is waiting to see what will happen.

In Europe, Americans can watch a preview of coming distractions. The European welfare state is imploding. Whether the implosion becomes an explosion will depend on where the charges are set and on their strength. Greece is facing default on its public debt and withdrawal from the European Monetary Union. In an unprecedented action, Spain is about to bail out its largest bank. Everybody suspects that the stronger European countries are rapidly running out of time to deal with the depredations of the weaker ones. Deep in our hearts and heads, we know that Germans will not work until age 67 so as to pay higher taxes whose revenues will allow Greeks to retire at age 50.

We are waiting to see what happens.

The Federal Reserve has created astounding amounts of money by purchasing both new and existing federal debt. Instead of entering the flow of income and expenditure via the loan process, most of this created money has sat on bank balance sheets in the form of excess reserves, drawing interest paid by the Treasury. This policy was deliberately contrived by the Fed and Chairman Bernanke, presumably because of fears that many banks required bolstering to forestall insolvency and couldn’t be expected to bear the risks of normal operations. Everybody knows that this situation cannot continue indefinitely. Everybody knows that if this flood of money is injected via the usual loan process, hyperinflation will result. Everybody knows that hyperinflation would throw the U.S. economy into chaos. We are waiting to see what happens.

Tune Out the Greek Chorus

All this “waiting to see what happens” is frighteningly real. It cannot be quantified into a simple model like the Keynesian multiplier of income and expenditure, so it is beyond the ken of the Greek Chorus. It requires economic analysis of a kind that went out of fashion at the point when economics became “scientific” by relying exclusively on mathematics and statistics. We are beset by radical uncertainty, a term that is qualitative rather than quantitative. We cannot meaningfully assign probability values to possible outcomes, so the so-called economic theory of uncertainty is mostly useless here.

The solution, counterintuitive though it may be to so many of us, is to step back and allow markets to work. Every single source of radical uncertainty listed above is caused by policymakers either trying to overwhelm the market or trying to buy time to decide what to do next. Only time and markets can lift the fog of uncertainty, because only markets can generate and collate the objective information necessary to dispel the uncertainty that currently paralyzes us. In the meantime, we should ignore the Greek Chorus. If necessary, use earplugs.