A debate is raging between Neo-Classical vs. Keynesian economic theory, about which model we should be following, and the pros and cons of each. We always talk about 1929 as when the Classical theory failed. However, one only needs to look to history to see the failure started allot earlier than that.
The idea of Capitalism was born in 1776 with the publishing of ‘The Wealth of Nations’ by Adam Smith. It took a few decades to alter the fabric of a young Economy around a new theory, but by 1800 the United States had a burgeoning Capitalist Economy. From the beginning, there seemed to be a slight problem with the system; it was very unstable. Every few years the economy would go through convulsions that the theory could not account for, and every few decades the convulsion was serious enough to be called a depression. They often used the term panic instead of recession back then, because that’s how most of the downturns began; in a state of panic. How many of these stories are being retold today.
The Panic of 1819 – Speculation in land created a run on real estate. This was followed by a contraction in the availability of credit. Unable to fuel the continued run on real estate with new debt, the bubble burst and the market crashed. Many banks were forced to close, and many fortunes were lost.
The Depression of 1832 – 800 banks close, and the entire banking system in the U.S. collapses. Unemployment in New York reaches 30%.
The Depression of 1836 – With the demise of the Federal Banking system, state banks start printing their own currency and run amuck. Attempting to rein the banks in creates another real estate crash.
The Depression of 1837- 1843 – English banks lose confidence in the U.S. Economy and raise interest rates. The cotton market is decimated for six years.
The panic of 1857 – Improved communications with the telegraph ushered in a new breed of investor; the speculator. Speculation created a bubble in railroads and real estate. At the end of the Crimean war, agriculture exports were reduced drastically, which led to a rush to sell railroads and real estate to cover debts. The stock market crashed. Crowds of starving unemployed flooded the streets of New York, demanding food and work.
Depression of 1869-1871 – Black Friday refers to September 24th, 1869 (not 1929). Speculators pushed gold up to 162 1/2, along with railroad stock to new highs. Then, in just 15 minutes gold dropped to 133 wiping out many investors. Railroad stock values shrank, and soon all businesses were paralyzed.
The panic of 1873 – The economy has expanded rapidly for two years, especially the railroads, which were being financed in part by Jay Cooke and Company, a large bank. On September 18, 1873 Jay Cooke and Company filed notice of bankruptcy. A panic ensues causing a three-year depression and over 10,000 businesses shutter their doors.
The panic of 1893 – Again the railroads which have been on a long run begin to show signs of weakness. A massive sell off ensues causing many railroads to go out of business and many large financial trusts start to collapse. The run quickly spreads to other sectors eventually hitting the banks causing 500 banks to close. The depression for the first time goes global, destroying huge amounts of wealth in all sectors of the world economy.
The panic of 1901 – The stock market had become a place for speculators, and gamblers. Men who had not a dime amassed fortunes. Most had taken to borrowing money to gamble with on the stock market; called leverage. When the market started to drop, panic selling took place as people tried to cover their bets and pay their debts. Many were reduced to paupers.
The depression of 1929 – The gamblers and speculators have returned to the stock market and are riding a long wave of good fortune that seems will never end. But all good things it seems come to an end. When the market started dropping, gamblers who were heavily leveraged started panic selling. They quickly went bust, and the banks who had loaned them the money to gamble with suddenly had a bunch of worthless loans. The banks started showing signs of stress as more and more loans became worthless, and soon a lack of confidence in the banks led to a run to get cash out before they too failed. This of course precipitated their failure. What really set this crash apart, was the fact that the market had become so popular, that every person who could scrape up a dime was getting in to get rich quick. Jesse Livermore, who got out in time, stated that when his house cleaner came to him asking for investment advice, he knew it was time to sell. The crash did not just wipe out a few get rich quick speculators, this time it hit businesses and people all across the country. Businesses closed and the national unemployment rate hit 25%.
Around this time, economists started trying to figure out what would cause such wild fluctuations in the economy. Why did the Great Depression happen? Will it happen again? The Economic models based on Classical theory state the market is self-correcting and should be stable. It was not just the U.S. either; every country that had adopted Adam Smith’s Capitalism went through the same turmoil of feast and famine cycles. In some countries, citizens became so disenchanted with the roller coaster cycles of capitalism, that they adopted radical alternatives such as communism and Fascism.
John Maynard Keynes was not a fan of socialism or its cousin Communism; however, he recognized that there were serious flaws in Classical Economics, which invariably led to wild cycles of boom and bust. These cycles were making it exceedingly hard to maintain a happy population. He formulated a new theory of economics designed to account for many factors that classical theory ignored, such as the importance of Demand, and the need for Government to create policies that would act like the governor on an economic engine to prevent the runaway effect of boom cycles that always end in a big bust. In this, it was postulated we could have relatively steady, albeit slightly slower growth without the wild swings.
Unfortunately, just a year after he published his seminal work, ‘The General Theory of Employment, Interest and Money’ in 1936, he suffered a heart attack. He survived, but being in ill health, he was not equipped to expand on and educate others about his theories. Many of his theories were poorly understood or misunderstood entirely. Therefore, what emerged as Keynesian Economics was actually a hybrid of Classical and Keynes theory. The parts of his theories that were implemented correctly, worked wonders with the economy. He stated for example, the role of government in a downturn was to stabilize employment through public works. The extra employment and income provided by the government would increase the demand for goods (something classical theory ignored completely), and with higher demand for their goods the producers could finally expand. A radical idea at the time, but it worked. He also stated that such big deficit spending should be reserved for times of extreme economic stress.
Over the years, his economic policies were weakened by classical ideals trying to creep back in. Lessons learned are quickly forgotten when short term profits are at stake. However, from 1936 through 1980 the U.S. suffered only minor recessions averaging 11 months down from 23 month prior to and including the Great Depression. The average time between events increased from every 4 years to 10 years.
The events in 74 when American oil production could no longer keep up with consumption, were used by proponents of Classical Economics to call Keynesian economics a failure, permitting those wishing a return to the good old days to reinstate their beloved theory throughout the developed world. Since 1980, the average time between recessions has dropped back down to 6 years. The old trend of boom and bust cycles is in full bloom. This is now forcing many economists throughout the world to suspect that they threw the baby out with the bath water in 1980, and to start re-evaluating the Keynesian school of economics. I can only hope that sanity prevails.