Grand Pursuit

by Sylvia Nasar

  Unused to thinking like mathematicians, the Brains Trusters found the notion that huge disturbances might have trivial causes counterintuitive. FDR’s economic advisors were more inclined to blame the depression on traditional Democratic nemeses: income inequality, monopolies, and, as had Fisher, the Smoot-Hawley tariff. FDR himself was intrigued by popular theories of overproduction and underconsumption that blamed the depression on either too much wealth or too much poverty. In a speech in May 1932 at Atlanta’s Oglethorpe University, the candidate decried the “haphazardness” and “gigantic waste” in the American economy, along with the “superfluous duplication of productive facilities,” and called for thinking “less about the producer and more about the consumer.” He also predicted that the American economy was nearing its limits and that “our physical economic plant will not expand in the future at the same rate at which it has expanded in the past.”55

  David Kennedy observes that FDR’s speech at the Commonwealth Club of San Francisco on September 23, 1932, reflected the “eclecticism and fluidity” of the candidate’s views:

  A mere builder of more industrial plants, a creator of more railroad systems, an organizer of more corporations is as likely to be a danger as a help. The day of the great promoter or the financial Titan, to whom we granted everything if only he would build, or develop, is over.”

  Extraordinary as it sounds, at a time when one-third of the nation was destitute, FDR blamed the depression on too much rather than too little production:

  It is the soberer, less dramatic business of administering resources and plants already in hand, of seeking to reestablish foreign markets for our surplus production, of meeting the problem of under-consumption, of adjusting production to consumption, of distributing wealth and products more equitably.56

  Naturally, FDR’s advisors had their own political agendas too. Berle promoted the notion that the economic crisis had created a unique window for enacting major social reforms. Kennedy points out that the economic recovery program on which FDR campaigned “was difficult to distinguish from many of the measures that Hoover, even if somewhat grudgingly, had already adopted: aid for agriculture, promotion of industrial cooperation [price fixing], loans to business, support for the banks, and a balanced budget.”57 The first budget bill FDR sent to Congress cut the federal budget far more than Hoover had dared.

  Keynes and Fisher both considered the candidate’s emphasis on social welfare reforms before the economy had been stabilized wrongheaded and risky. A few weeks before FDR’s inaugural, Keynes sent the president a letter warning against mixing long-run reforms with the recovery program and advocating “open market operations to reduce the long term rate of interest.”58 Fisher urged FDR to announce a retreat from the gold standard on inauguration day, arguing that it “would reverse the present deflation overnight and would set us on the path toward new peaks of prosperity.”59 At the end of 1933, Keynes wrote an open letter to FDR, published in the New York Times, to reiterate his argument. “Even wise and necessary reform may . . . impede and complicate recovery. For it will upset the confidence of the business world and weaken their existing motives to action.”60 Fisher shared Keynes’s reservations about the New Deal:

  It’s all a strange mixture. I’m against the restriction of acreage and production but much in favor of reflation. Apparently FDR thinks of them as similar—merely two ways of raising prices! But one changes the monetary unit to restore it to normal, while the other spells scarce food and clothing when many are starving and half naked.61

  The single exception to the continuation of Hoover’s policies was a very large one: FDR’s decision to abandon the gold standard. This was the step that Keynes and Fisher had been urging in one form or another since the 1929 crash. In practical terms, going off gold meant that the Federal Reserve would not push up interest rates to prevent the dollar’s exchange rate against the pound and other foreign currencies from falling. The first beneficiaries would be farmers and miners, since a cheaper dollar meant that their grain and ore became more competitive abroad, and then businesses and households that borrowed to buy houses or make capital improvements.

  After Roosevelt announced that the United States would go off gold on April 19, 1933, Keynes praised the president for being “magnificently right.” Fisher once again let his hopes rise. He wrote to Maggie: “Now I am sure—so far as we ever can be sure of anything—that we are going to snap out of this depression fast.”62 This time, Fisher’s economic forecast proved prescient. The US economy hit bottom within a month of Roosevelt’s inauguration, marking the beginning of a recovery. On the other hand, Fisher’s hope that his personal finances could be mended was not realized. Going hat in hand to his sister-in-law was the least of the humiliations he was to suffer. Had Yale University not agreed to buy his New Haven home and let him live there rent free, he would have been evicted from it. The Fishers’ summer cottage at the shore was handed over to Caroline Hazard, who forgave the rest of the debt in her will. Without income from dividends, Fisher had to support himself with directors’ fees.

  • • •

  Keynes met FDR for the first time at 5:15 in the evening on May 28, 1934. After days of dawn-to-dusk meetings with cabinet members, Brain Trusters, NRA bureaucrats, and other officials, he had finally gotten in to chat with the president for an hour. Afterward he reported to Felix Frankfurter, now an advisor to FDR, that he had told him that if the government increased federal stimulus spending from $300 million a month to $400 million a month, the United States would have a satisfactory recovery.63 The president said that he had a “grand talk with Keynes and liked him immensely” but complained that he talked like a “mathematician.”64 The next day, the New York Times ran another open letter from Keynes to the president praising the New Deal and calling for deficit spending to the tune of 8 percent of GDP. “This, he promised, might

  directly or indirectly, increase the national income by at least three or four times this amount . . . Most people greatly underestimate the effect of a given emergency expenditure, because they overlook the Multiplier—the cumulative effect of increased individual incomes, because the expenditure of these incomes improves the incomes of a further set of recipients and so on.65

  The next evening, Keynes attended a dinner at New York’s New School for Social Research with Fisher and Schumpeter.66 In his talk he spelled out his theory of deficit-financed public works spending, including his notion that the cumulative effect of $1 of such spending could be much greater than $1. Whereas Fisher never departed from his conviction that the Great Depression was the result of monetary blunders, that “of all things tried, monetary policies have succeeded most,” and that “the only sure and rapid recovery is through monetary means,” Keynes had clearly suffered a crisis of faith in the potency of monetary stimulus.67 Fisher listened in bemused silence. “His paper was interesting but to me—and I think to everyone else—rather obscure and unconvincing,” he wrote to Maggie afterward. “He was very skillful in answering questions and objections but seemed to get nowhere.”68

  As the Great Depression dragged on, Keynes’s faith in the effectiveness of monetary policy ebbed further. By the time A Treatise on Money appeared, he was beginning to pose a theory of the causes of unemployment. Cambridge undergraduates were his first audience. The nub of the new theory was that, as he put it in an article published in the American Economic Review in December 1933, “circumstances can arise, and have recently arisen, when neither control of the short-rate of interest nor control of the long-rate will be effective, with the result that direct stimulation of investment by government is a necessary means.”69

  In the severe depression, prices fell even faster than interest rates. So reductions in nominal rates did not prevent real rates from climbing. Once nominal rates fell to zero, there was nothing further that the central bank could do to make borrowing cheaper or to ease debt burdens and thus to end the depression—with incalculable political consequences, what Keynes called The
Liquidity Trap. As he had once observed, “The inability of the interest rate to fall has brought down empires.”70 Once monetary policy was rendered ineffectual, the only option for shoring up demand was getting money into the hands of those who could spend it.

  All past teaching has . . . been either irrelevant, or else positively injurious. We have not only failed to understand the economic order under which we live, but we have misunderstood it to the extent of adopting practices which operate most harshly to our detriment, so that we are tempted to cure ills arising out of our misunderstanding by resort to further destruction in the form of revolution.71

  Keynes finished the first draft of A General Theory of Employment, Interest and Money in 1934 after returning from the United States. He began circulating the manuscript in early 1935. To George Bernard Shaw, he wrote that he believed he was “writing a book on economic theory which will largely revolutionize—not I suppose at once but in the course of the next ten years—the way the world thinks about economic problems.”72

  The prime innovation in the General Theory was to show that in severe depressions, monetary policy would not work. Economists grounded in classical models were like

  Euclidean geometers in a non-Euclidean world who, discovering that in experience straight lines apparently parallel often meet, rebuke the lines for not keeping straight as the only remedy for the unfortunate collisions that are occurring. Yet, in truth, there is no remedy except to throw over the axiom of parallels and to work out a non-Euclidean geometry. Something similar is required today in economics.

  His innovation has sometimes been misunderstood. It was not that governments should spend more in bad times or run deficits in a slack economy. Beatrice Webb, Winston Churchill, and Herbert Hoover had all embraced deficit spending before Keynes. It was also not that wise behavior on the part of an individual can be self-defeating if everyone behaves similarly. Nor that the classical proposition that excess supply or insufficient demand for labor could always be cured by a fall in wages or interest rates:

  As many of us were forced by the logic of events to realize, the economics of the system as a whole differs profoundly from the economics of the individual; that what is economically wise behavior on the part of a single individual may on occasion be suicidal if engaged in by all individuals collectively; that the income of the nation is but the counterpart of the expenditures of the nation. If we all restrict our expenditures, this means restricting our incomes, which in turn is followed by a further restriction in expenditures.73

  As Herbert Stein, the economist, pointed out, Keynes asked a very different question from the one posed by Hayek and Schumpeter. In explaining depressions in terms of the preceding booms, the Austrians were trying to figure out how the economy had gotten there. Keynes was less interested in the genesis of slumps than in the more basic puzzle of how high unemployment and slack capacity could persist for long in a free market economy with unrestricted competition.

  Not only should unemployment be temporary under standard economic assumptions, but, by and large, it had been. In Fisher’s hydraulic machine—as well as in economic models in the heads of Marx, Marshall, and Schumpeter—a bad harvest, a war, a strike, an innovation, or some other “shock” could produce a temporary imbalance between supply and demand that, if large enough relative to the size of the economy, could result in unemployment. But, in that event, competition among workers and among lenders should drive down pay and interest rates until it was once again profitable to hire and invest.

  Say’s law, which stated that supply creates its own demand, was already considered out of date by the mid-nineteenth century. Based on the truism that every purchase creates an equivalent income, the law presumed that income was earned solely so that it could be spent. But saving was, of course, also an important motive, and even in the Victorian era the saving of working-class households was significant. As soon as the possibility of spending less than one earned was acknowledged, Say’s law became obsolete.

  What Keynes did, writes Skidelsky, was essentially to avert his eyes from market-clearing equilibrium. Instead he let money flows (such as income) functionally determine other money flows (such as consumption). The denial of supply-demand equilibrium is what Schumpeter simply could not stomach. Thus what made the General Theory so radical was Keynes’s proof that it was possible for a free market economy to settle into states in which workers and machines remained idle for prolonged periods of time—that there were depressions that, unlike the garden-variety ones, were not brief and didn’t end of their own accord as a result of falling prices and interest rates, or, at an extreme, that free market economies tended naturally to stagnate even when there were idle workers and machines available. In such depressions, unfreezing credit flows through monetary policy didn’t provide a sufficient stimulus, because even zero-percent interest rates could not tempt businesses to borrow while prices were falling and there was reason to think that demand would recover. The only way to revive business confidence and get the private sector spending again was by cutting taxes and letting businesses and individuals keep more of their income so that they could spend it. Or, better yet, having the government spend more money directly, since that would guarantee that 100 percent of it would be spent rather than saved. If the private sector couldn’t or wouldn’t spend, then the government had to do it. For Keynes, the government had to be prepared to act as the spender of last resort, just as the central bank acted as the lender of last resort.

  James Tobin has pointed out that Fisher came close to producing the elements of a general theory in his 1930 book The Theory of Interest. He had a theory of investment and savings, as well as how production and prices are determined in the short run. In Booms and Depressions, in 1932, he introduced the role of debt in self-reinforcing slumps. But, unlike Keynes, Fisher never combined these separate components into a single unified model that showed how interest rates, the price level, output, and, therefore, employment were determined.

  As often happens with novel doctrines, most of the measures urged by Fisher and Keynes, except for the abandonment of gold, were not adopted in either the UK or the United States. Still, in England, the worst was over by August 1932, when the economy began slowly expanding. By 1937, Japan’s economy had been growing for a half dozen years. In Germany, where the economic collapse was as bad as in the United States, unemployment had virtually disappeared by 1936. Keynes noted the bitter irony of Nazi Germany and Fascist Italy achieving full employment by engaging in massive deficit spending, repudiating their foreign debts, and letting their currencies depreciate. The same was true of Imperial Japan. Of course, the goal of these governments was to wage war and to pay off their debts by exploiting their victims.

  In the United States, however, the depression had come roaring back with a vengeance in 1937—largely, it seems, because of blunders by the administration and especially by the Federal Reserve. In 1936, after three years of recovery, FDR raised taxes and scaled back spending on New Deal programs such as the WPA. A onetime bonus payment for World War I veterans in June 1936 briefly pumped up the federal deficit, but federal spending fell sharply thereafter. Meanwhile, the Social Security Act of 1935 created a payroll tax that began in 1937. Together these two ill-timed actions brought the federal budget into virtual balance by late 1937.

  Early in the Depression the Federal Reserve had remained passive in the face of a traumatized banking system and credit markets. The Banking Act of 1935 gave the Fed authority to change reserve requirements. Between August 1936 and May 1937, the Federal Reserve, worried about growing excess reserves and inflationary pressures, abruptly doubled reserve requirements. As excess reserves fell, so did the stock of money. From May 1937 to June 1938, the US economy contracted by one-fifth, industrial output plummeted by one-third, and unemployment, which had fallen to 10 percent, jumped back to 13 percent. The official rate, which excluded temporary government jobs, rose from 15 percent to nearly 20 percent. The stock market plunged too, comp
leting Irving Fisher’s financial ruin.

  Keynes, who invested heavily in depressed American stock in 1936 and hung on after the 1937 crash, recouped his losses and more. But his heart failed him. Keynes collapsed at his office in London and was diagnosed with a potentially fatal heart condition. He dropped out of public life, seemingly for good. Irving Fisher continued to speak and write but never established the rapport with the Roosevelt administration that he had enjoyed with the Hoover administration. His public reputation was as battered as his stock portfolio.

  • • •

  Hayek’s and Schumpeter’s predictions that doing nothing would lead to a recovery did not pan out either, and both wound up intellectually isolated and increasingly disheartened by the economic decline and the growing political extremism in Germany and Austria.

  But no economist there or anywhere else had a satisfactory theory in the early 1930s to explain the cascading global crisis. In the absence of such a theory, English economists quickly divided into two rival camps: an interventionist group led by Keynes and the “Cambridge Circus,” which included Keynes’s communist disciples Piero Sraffa, Joan Robinson, and Richard Kahn, and, on the other side of the divide, a group of young “liberals” at the London School of Economics led by the thirty-year-old Lionel Robbins. One of the few prominent British economists who was the son of a miner or had strong intellectual ties to Continental economics, Robbins had spent considerable time in Vienna with Ludwig von Mises and his circle. Not only did Robbins find Mises’s arguments in the debate over Socialism’s viability compelling, but he also shared Mises’s dismay over the seemingly inexorable trend toward government intervention in the economies of England and America.