“Liquidation” Cycles and the Great Depression

1. “Liquidation” Cycles and the Great Depression Bradford De Long

2. Liquidation Mindset • Was prolific in the Great Depression, Economic minds such as Hayek, Robbins and Schumpeter were strong supporters and used it to influence policy. • Let the private sector work things out on their own. And avoid inflation at all costs • Mellon’s Quote: • ‘Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate, It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people’.

3. Liquidation in the Depression • The Federal Reserve did not use open market operations to keep the nominal money supply from falling. Instead, its only significant systematic use of open market operations was in the other direction: to raise interest rates and discourage gold outflows after the United Kingdom abandoned the gold standard in the fall of 1931. • The Federal Reserve wanted the private sector to handle the Depression

4. Liqudation in the Depression • Harvard Economist Seymour Harris argued that just because the banking system was near collapse was no reason for the Federal Reserve to buy bonds for cash: “Open market operations are not the most effective method of dealing with… bank failures, any more than the proper way of filling numerous small holes on the surface of the earth is to flood the earth with water.”

5. Liquidation Argument • To much capital (or wrong capital) investment lead to speculation. • Liquidate the improper use of capital and reallocate to other business sectors. • If the original gamble (investment) fails, then it should be reallocated to spur new innovation. Without future resources being allocated to investment. • “The Depression could have been good medicine for the economy” • Let those who are going to fail… fail.

6. Liquidation Theory • Productivity growth is expected to decrease, liquidate the inefficient capital, move from point A to point B then with the reallocation of capital move to point C.

7. Liquidation Theory • If government steps in with stimulative policies. Curve will move right until stimulative policy ends. Huge amount of excess capital creates shift from D to E. Then a much longer move from E to C.

8. Reason for Believing in Liquidation Theory: Recessions before the Depression could be accounted for by business cycles, but the Depression was far to big

9. Implications • Liquidationist hold tight and let the economy fix itself theory prolonged the Depression. • Depression was not caused by an overhang of unproductive capital, and thus the advice Hayek, Robbins and Schumpeter gave was detrimental to the Economy. • Potential corrective policies were ignored due to the liquidation mind set.