My
Keynesian critic asserts that the “cut in nominal wages which was one of the
reasons we got deflation…” This is nonsense. The deflation was triggered when
the London funds started restricting credit in order to build up their
reserves. The result was a massive contraction from March 1929 to September
1931 that saw M1 drop by 27.2 per cent and demand deposits by a whopping 33
per cent. This should not even have to be said but the cuts in nominal wages
were in response to the deflation and in no way contributed to it. Moreover,
it is ludicrous to even suggest that a fall in nominal wages could under any
circumstances be deflationary. A deflation is a strictly monetary phenomenon1.
He is
right, however, in stating that the appalling increase in the unemployment
rate was largely due to the increase in real wages. However, his assertion
that as other countries got inflation immediately after they devalued then
the devaluation of the Australian pound in January 1931 must also have been
followed by inflation is flat out wrong2. A picture, as they say,
is worth a thousand words. Although Australia devalued in January 1931 chart
1 shows that retail prices continued their fall from 1929 and did not start
rising again until 1934, three years from the devaluation.
Wholesale prices started a staggered decline which was not
reversed until the second quarter of 1933, some 30 months after the
devaluation while manufacturing prices did not start rising until 1937-38,
some seven years or so after the devaluation. Moreover, instead of falling,
real wages remained basically flat, as shown by chart 2. We can see that the
real wage never fell below its 1928 level. Therefore, the assertion that the
devaluation generated an inflation that put people back to work by cutting
real wages is patently false3. A number of economists and
historians have studied this period. To my knowledge not one of them argued
that real wages fell. For example, Professor R. G. Gregory, a Keynesian,
wrote:
During
the depression, real wages measured in terms of consumer prices were above
their historical trend. Real wages…did not vary significantly during the
1930s4.
This
fact was confirmed by Commonwealth statisticians who stated that
real
production per person engaged implies a high real wage for those in
employment, and is consistent with available information concerning rate of
effective or real wages, which more than
maintained in recent years the high level reached in the years 1927 to 19295.
(Emphasis added).
Because price indexes consist of a basket of goods they
can be misleading. In general raw material prices for manufacturing fell by
some 33 per cent or so from 1928 to 1935. For example, the period 1931 to
1936 saw prices for coal and metals, important manufacturing inputs, fall by
14.2 per cent6. Costs were further reduced by the substantial
gains that the steel and iron industry made in productivity while
productivity in general increased by approximately 1.5 per cent annually. As
the real factory wage
fell, while the real wage remained comparatively flat, the demand for factory
labour steadily rose7, as one can see from chart 3.
The
real factory wage (the ratio of the factory money wage to the money value of
factory output) peaked at 130 and then started to fall. At this point the
rapid fall in the money value of output slowed and factory employment
levelled out. (The vertical black lines mark these turning points) As soon as
the value of factory output began to rise the fall in the real factory wage
rapidly declined.
The
result was an immediate increase in the demand for labour that continued to
1938 when there was a slight reversal after which unemployment continued to
fall. (In September 1939 the country was at war). So what Australia had was a
major reduction in manufacturing costs that led to a production-driven
recovery8, all the more remarkable considering the amount of
imported inputs that manufacturing used9, that rapidly reduced the
unemployment rate. What all of this means, as an economist would put it, is
that the supply curve shifted to the right.
There
appears to be a gross misunderstanding of the devaluation. The Australian
pound was great overvalued against sterling and other currencies. In other
words, Australia’s price level was out of kilter with those of its trading
partners. The devaluation merely brought the Australian price level into line
with other price levels, though it might have overshot somewhat. Therefore,
the devaluation brought Australian industry to the stage where it should have
been in any case if the currency had not been overvalued.
Another
way of putting it is to say that the exchange rate was adjusted to reflect
purchasing power parity. Every classical economist fully understood this fact
and knew that a devaluation was not a weapon to reduce costs — particularly
real wages — but a process of bringing international prices into alignment.
Anyone acquainted with the Bullion Controversy would know this. (It should be
obvious that there is a fundamental difference between a genuine devaluation
and inflation-driven depreciations specifically designed to drive down the
exchange rate).
It is
also important to note that Australia’s recovery did not begin until about
fifteen months after the devaluation. This is a very long stretch for the
devaluation to have worked the magic my critic claims for it10.
Furthermore, a mere twelve months after the devaluation the Australian pound
began to rise again as sterling strengthened. (This puts paid to any
suggestion that the full effects of the devaluation were fully maintained
throughout the remainder of the decade). In January 1931 the rate against
sterling was set at 130. Given that the British pound was also overvalued
when Australia tried to maintain parity it is no wonder that the country
underwent a massive exchange rate adjustment.
Now in
December 1932 the dollar exchange rate was $2.62 but by 1934 the exchange
rate had risen to over $4, a rise of more 50 per cent. Imports also started
to increase fairly soon after the devaluation. From 1932-33 to 1936-37 per
capita imports rose by more than 55 per cent. These facts are needed to put
the devaluation in some perspective. They should also disabuse anyone of the
notion that the devaluation meant that imports did not increase again during
the depression and that the Australian exchange rate did not rise against
other currencies.
There
is absolutely nothing inflationary about the devaluation process and it is
absurd to suggest otherwise. That there is a fundamental difference between
how a genuine devaluation works and how inflation operates is something my
critic, like so many others who push this line, completely fails to grasp.
No
matter what anyone might think the devaluation does not vindicate
Keynesianism. Even if the devaluation had been entirely responsible for the
drop in employment and the economic expansion it still would not justify
Keynesian policies because there is absolutely nothing Keynesian about
devaluations. I am against the devaluation explanation for recovery simply
because it does not fit the facts, specially when it comes to real wages.
What is
truly striking about Australia’s performance during the Great Depression and
the thing that really scares Keynesians is that the government cut spending
in the depths of the depression by 15 per cent and then ran surpluses until
WWII. The result was a rapid and continuing expansion in manufacturing
accompanied by a steady and continual drop in an unemployment rate that at
one point reached 30 per cent. According to Keynesians this policy should
have resulted in an appalling economic disaster.
To sum up: Devaluation did not trigger an
inflation and real wages did not fall. Moreover, the evidence clearly shows
that the recovery was production-driven. As someone once said: “Facts are
stubborn things”.
There
will be more on this subject in my next post in which I tackle Roosevelt’s
1937-1938 depression. I shall pay particular attention to the Keynesian
absurdity of blaming the contraction on the drop in federal spending.
* * * *
*
1Deflation
is a monetary contraction. It is associated with swelling inventories,
mounting bankruptcies, negative profit margins, widespread unemployment and
falling prices. Given these facts it is truly a marvel that a situation
where, thanks to technological improvements and entrepreneurial flair, prices
continually fall while prosperity rises and real profit margins are
maintained can be considered deflationary, even though the money supply is
increasing.
2The
worst a devaluation can do with respect to prices is bring about a one-off
increase. A continuing rise in prices requires an inflationary monetary
policy. To argue that the Australian devaluation was the means to lower costs
is a serious error and it is one that Sinclair Davidson and Julie Novak made
(Institute of Public Affairs: 5½ big things Kevin Rudd doesn’t understand about the
Australian economy).
The
effect of an overvalued currency is to artificially lower the prices of
imported goods relative to domestically produced goods. This means that
thanks to her overvalued pound Australian prices in terms of international
prices had been artificially increased. The devaluation merely restored the
market balance.
3That
inflation can increase the demand for labour by lowering real wages is no
Keynesian insight. Henry Thornton discussed this very point 210 years ago. He
clearly saw that this was done by allowing the money wage to fall behind the
general rise in prices. It was not a policy he approved of. (An Enquiry into the Nature and Effects of the Paper
Credit of Great Britain, 1802, Augustus M. Kelley, New York
1965, pp. 118, 189-90).
4Recovery from the Depression: Australia and the World
Economy in the 1930s, edited by R. G. Gregory and N. G. Butlin,
Cambridge University Press 1988, p. 218.
5Labour Report, 1938. No, 29. March,
1940, p.71.
6Official Year Book of the Commonwealth of Australia,
No. 32, 1939, p. 424.
7The
real wage is determined by dividing the nominal wage by the price level. But
employers hire people not according to this wage but the money wage they must
pay relative to the value of a worker’s product. Therefore, if the value of
the product rises relative to the wage rate the demand for labour will
increase.
This
thesis is confirmed when the money factory wage is divided by the money value
of factory output. The result is an inverse correlation of 0.978. As
expected, when the real factory wage fell relative to the value of the output
the demand for factory labour rose thereby confirming the standard economic
theory regarding wages and the demand for labour. It should also be noted
that by reducing the cost of labour relative to the value of the product an
increase in productivity would also strengthen the demand for labour.
8Steve
Kates has engaged the post-Keynesian Louis-Philippe Rochon in a debate
over Keynesianism and aggregate demand. I cannot see how Kates’ approach will
sway anyone who is not already committed. You cannot defeat Keynesians
without detailed historical examples to bolster your case. Kates is not doing
this. He has also failed to grasp the fact that the gross spending approach
that Austrians use destroys Rochon’s consumption-drives-demand argument. His
response to Rochon’s pent-demand argument regarding 1945 revealed an
appalling ignorance of the Keynesian argument regarding America’s post-WWII
economy. Worst of all, before the debate had really started Kates conceded a
Key point to Rochon: markets are unstable and that’s why we get these booms,
busts and financial crises.
9Australia
imported the great majority of its capital goods.
10My
critic claimed that “Gerry wants to believe the lag associated with the
devaluation was the longest recorded in economic history.” Nonsense. I said
nothing about historic records. I merely pointed out the very simple fact
that the lapse of time between the devaluation and the beginning of the
recovery weakens the devaluation argument. No more and no less than that.
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