Lessons from the Long Depression

A version of this post appeared on Pieria in December 2013. 

In my post “The desert of plenty”, I described a world in which goods and services are so cheap to produce that less and less capital is required for investment , and so easy to produce that less and less labour is required to produce them. Prices therefore go into freefall and there is a glut of both capital and labour. This is deflation.

There are two kinds of deflation. There is the “bad” kind, where asset prices go into a tailspin and banks and businesses fail in droves, bankrupting households and governments and resulting in massive unemployment, poverty and social collapse. America experienced this in the Great Depression and narrowly avoided it in the Great Recession. More recently, at least one European country has felt the effects of this catastrophe.

But there is also another kind. This is where falling costs and increasing efficiency of production create a glut of consumer goods and services. In other words, supply persistently exceeds demand. This is the world described by Larry Summers – a demand-constrained world. He describes it as “secular stagnation”.

Some people regard this sort of deflation as benign. After all, consumer prices are falling, people need less money in order to live well….what’s not to like? Well, it depends on your perspective. In this world, if you are fortunate to have a well-paid job, you can indeed live well. But this sort of deflation causes unemployment. Or if it doesn’t, it pushes down wages in lower-skill jobs. After all, for production costs to fall, either there must be fewer people earning wages, or wages must be lower. So we end up with a bifurcated labour market – those in high-skill, well-paid jobs, who enjoy a rising standard of living, and those who are either unemployed or in poorly-paid low-skill jobs, who become increasingly dependent on state support. Government welfare expenditure therefore rises. However, the well-off don’t like paying taxes to support the unemployed and the low-paid, so they use their electoral muscle to pressure governments to cut welfare bills. As welfare bills are cut, poverty rises among the unemployed and poorly paid. Governments may adopt draconian measures to force the unemployed into work, even at starvation wages, and to quash civil unrest.

We have seen this sort of deflation before. During the “Long Depression” in the latter part of the 19th Century – the period regarded as a “golden age” by supporters of the pre-1913 gold standard - labour markets in Europe and the US were actually depressed. As this paper explains, the second Industrial Revolution vastly increased production, resulting in falling consumer prices across the developed world. Wages were very low and there was widespread unemployment: US unemployment in 1873-4 touched 25%.

Nowadays we would not call the Long Depression a “depression” at all, since there was never negative growth as such. In Europe it is perhaps more correctly described as a Long Stagnation, and in the US….well, the US experienced growth of 3-5% throughout that period. It’s just that the benefits of that growth did not reach the unemployed and people on very low wages – exactly as is happening now.

So what happened? There was widespread civil unrest over unemployment. In response to this, countries adopted protectionist measures to support domestic employment, and searched desperately for new export markets to unload their excess supply. In Europe this took the form of imperial expansion.

But monetary policy was unsupportive. The US tightened monetary policy in order to return to the Gold Standard after the civil war. And the entire period was characterised by scarcity of gold, not just in the US. France was particularly hard hit because it was paying reparations to Germany after losing the Franco-Prussian war, and was therefore borrowing heavily even before the stock market crash that signalled the start of the Long Depression*. The failure of aggregate demand at that time was a combination of what we might call supply-side extravagance with tight monetary policy.

So how does this relate to today? We have high unemployment and a bifurcated labour market. We have supply-side extravagance in consumer goods and services, though not in essential goods such as energy, food and housing. And we have failure of aggregate demand, which stubbornly refuses to recover despite the loosest monetary policy in history - except in the Eurozone, of course, where they are operating a monetary system that looks like a Gold Standard on steroids and the central bank is in a fiscal and political straitjacket. The continuing failure of aggregate demand is the reason for the “secular stagnation” theory.

If there was tight monetary policy in the Long Depression, and loose monetary policy now, why does the outcome appear to be the same? Could it be that the monetary policy stance is actually irrelevant? And if that is the case, then what is the real cause of the failure of aggregate demand, and what should we do about it?

In “The desert of plenty”, I observed that governments desperate to create jobs, and investors desperately searching for yield, are crowding into the same waterholes. In other words, when prices are generally falling due to over-supply, there is competition between governments and private sector asset holders for increasingly scarce value. The loose monetary stance of recent years amounts to an attempt by governments to hijack the waterholes and crowd out investors. This is supposed to force investors to invest productively, generating new business and jobs. But the falling prices that depress demand by definition also depress return on investment, and central banks’ actions depress that return still further. On this basis, therefore, “loose” monetary policy appears deflationary.

But central banks’ interventions have two sides. Low interest rates and unconventional policy instruments depress returns on investment, but they also support asset prices. Investors lose on yield, but they gain on price. Or, putting it another way, investors may be crowded out of the waterholes that central banks want to occupy, but that doesn’t mean they are forced into a deflationary desert. On the contrary, when the central bank forces them out of one waterhole it obligingly provides them with another. We therefore see pockets of rising prices, mostly in various classes of asset. However, not all investors trust centrally-managed waterhole allocation, so some are creating new waterholes of their own: Bitcoin, for example. If investors don’t want to make the desert bloom, because they can’t see that there’s anything in it for them, they won’t. They will create new waterholes and defend them against all comers.

What doesn’t seem to happen much is leakage of the contents of the waterholes into the desert. If anything, the movement is the other way – the surrounding area is drained to create the waterholes. So, for example, rising property prices benefit existing homeowners but make housing more expensive for everyone else. This depresses demand in the wider economy, as those who have to pay more for their housing cut other spending. Indirectly, therefore, the property market becoming a waterhole for investors has a deflationary effect, although the direct effect appears inflationary as housebuyers are forced out to cheaper areas, pushing up prices there. Similarly, when commodities become waterholes, prices rise in essential goods such as fuel and foodstuffs, depressing demand in other sectors. And the most draining waterhole of all is Bitcoin, which is currently wasting enough energy to power a small country - energy that could be put to much more productive uses. 

The deflation associated with a persistent excess of supply over demand is anything but benign, and as the Long Depression shows, it is surprisingly difficult to deal with – not least because the “winners” in such an environment are asset holders and those with high incomes, whose political power enables them to oppose measures that really would address the aggregate demand problem, such as a basic income, public sector investment to replace the investment that the private sector refuses to do, and punitive taxation of rents.

We have played this scene before. And last time, it ended very badly indeed. The imperial expansion and trade wars of the late 19th century ended with a cataclysmic war: war, after all, is a highly effective (though destructive) demand stimulus. A lot of people stand to lose in the desert of plenty – and they are not voiceless. We might perhaps escape war, but we already appear to be in the throes of some kind of revolution - and revolutions don’t tend to end well.

The unemployment, poverty and inequality of the “desert of plenty” are not a failure of monetary policy. They are, above all, a political failure.

Related reading:

Keynes and the death of capitalism
A very British disease
The parable of water – FT Alphaville

*France was the principal driver of punitive reparations imposed on Germany after WWI, and the principal enforcer, too: it was French seizure of the Ruhr after Germany defaulted on its reparations that triggered the worst period of the Weimar hyperinflation. Memories are long: I wonder if France’s treatment of Germany at that time arose from resentment of the reparations it had previously paid to Germany itself.

Image of flowers in the desert is from Wikipedia. 


  1. "war, after all, is a highly effective (though destructive) demand stimulus." Sinking new warships, new warplanes, new tanks in the ocean without ever having used them would still be a great demand stimulus. So why not sink the money in infrastructure etc. ?

    1. That is likely the logic behind the belt-and-road initiative

  2. I always thought that the Long Depression of 1873-1896 was more relevant to the current situation than the Great Depression of 1929-1939, and am therefore pleased to see you investigate the topic.

    "But monetary policy was unsupportive. [...] And the entire period was characterised by scarcity of gold, not just in the US."

    How could that be? Gold production had increased massively thanks to the new mines in California and Australia (in the 1840s-1850s) -- yearly production had become a multiple of what it was previously. Gold production would undergo further superlative increases with mining in Russia and South Africa in the 1880s-1890s, and somewhat later in Canada. One reason why all this was not enough was the sudden shift from the widespread bi-metallic standard to a strict gold standard.

    In 1872-1873, Germany, the USA, Sweden and Denmark switched to the gold standard, demonetizing their silver coinage -- a deflationary policy, just before or at the time of the generalized 1873 stock exchange crash. At the same time, Germany imposed huge war reparations on France, to be paid in gold, as you mention. The financial system was thus destabilized throughout the industrial world.

    Looking at macroeconomic data (e.g. the Angus Maddison series), it appears that after a deep depression the economy was rebounding by 1878 -- before plunging again in 1879. Why? Well, then the Latin Monetary Union abandoned its bi-metallic policy and switched to the gold standard. In 1878, two major industrial countries, Belgium and France, as well as Switzerland, did so. The deflationary consequences must have been significant, as France in particular was the anchor (or a kind of "market maker") for the bimetallic system in Europe. Other countries followed suit during the 1880s (Italy, Greece...)

    "the second Industrial Revolution vastly increased production, resulting in falling consumer prices across the developed world."

    The economy crashed in 1873 -- in the very initial years of the second Industrial Revolution, so while the 2nd IR could have prolonged the depression, it cannot have been its fundamental cause in the first place.

    In fact, as shown e.g. by Paul Bairoch, European economies were already suffering from a latent demand depression because of the free trade policies enacted from 1860 onwards. Free trade encompassed not just industrial and consumer goods, but also agricultural produce -- and this was the problem. European markets were now open to the exports of a few countries which relied on extensive production by miserably paid labourers on vast properties: the USA, Russia and Hungary. In France, the Netherlands, Germany or Italy, the agriculture was structured around comparatively small farmsteads, more intensive and hence more expensive exploitation, and were therefore at a serious competitive disadvantage. Their income diminished inexorably, depressing the demand in the provincial regions of those countries. Of course, the peasantry no longer constituted the majority of the employed population, but was still substantial so that its declining buying power, added to speculation and deflationary monetary policies, would fatally undermine the demand side in the economy at large.

    So, "the failure of aggregate demand at that time was a combination of what we might call supply-side extravagance with tight monetary policy" is actually incomplete: at the core was persistent, long-term failing demand for a subset, but a significant one, of the population because of falling income.

    1. Gold supply was tight throughout the Gilded Age because although there was increased supply, there was a far greater increase in demand for gold due to its worldwide adoption as the monetary anchor and the demonetisation of silver. There was also significant gold hoarding by European central banks, commercial banks and the rich. Reading William Jennings Bryan's "cross of gold" speech is instructive.

      There was never "free trade from 1860 onwards." It is a myth. France and the UK entered into a free trade agreement in 1860, and this was followed by free trade agreements between other European countries. But the idea that the Gilded Age was a golden age of free trade is simple nonsense. European countries that tried to pursue free trade suffered badly from the stupidity of free trade policies when other countries have tariffs of up to 50%.

      There were periodic financial and economic crashes throughout the Gilded Age. Doesn't change the fact that in the US, economic growth averaged 3-5%. The Long Depression is a European phenomenon.

    2. "Gold supply was tight throughout the Gilded Age because although there was increased supply, there was a far greater increase in demand for gold due to its worldwide adoption as the monetary anchor and the demonetisation of silver. "

      Isn't this what I said? The general switch to the gold standard with the concomitant demonetization of silver more than countered the increase of gold extracted from new sources.

      "European countries that tried to pursue free trade suffered badly from the stupidity of free trade policies "

      I do not think we disagree. There was widespread free trade from 1860 onwards in Europe -- while other countries (significantly the USA) maintained protectionist measures. Free trade countries suffered a lot -- especially in the agricultural sector. I never characterized that period as a "golden age".

      "The Long Depression is a European phenomenon."

      Just like the USA, Australia grew quite nicely without any crisis during that time -- before its economy entered a crisis towards the end of the long depression, after tariffs on agricultural produce had been raised throughout Europe.

  3. "In response to this, countries adopted protectionist measures to support domestic employment"

    Protectionist measures became widespread again in the 1890s, and targeted foremost agricultural products -- they were somewhat differentiated for consumer and industrial goods.

    Till the late 1880s, the French socialists held firmly on free trade -- because it actually reduced the cost of living for the working class, which had to devote a very large part of it to food. In fact, urban populations had indeed benefited from free trade (at least initially) in all countries. The passage of protectionist measures was thus largely motivated by the need for governments to maintain the loyalty of the peasantry -- which was typically conservative and voted accordingly. It is one thing to let Mr. Siemens be commercially successful, it is another to ruin all those Junkers who are living off the estates inherited from their forefathers, and who form your political base (and military cadres).

    Once (partial) protectionist measures were introduced, economies recovered throughout Europe, and they returned to their cyclical variations around a steady long-term trend.

    Only the UK held on to absolute free trade, despite a very strong, but ultimately unsuccessful movement to introduce protectionism in the decade 1900-1910.

    "and searched desperately for new export markets to unload their excess supply. In Europe this took the form of imperial expansion."

    Colonies only represented a small fraction of the foreign trades of European colonial powers -- except perhaps for the UK. While other countries were busily (re-)constituting colonial empires, the UK had already the Raj -- a huge, protected market, forcefully configured to represent no competition for its domestic industry. France had its own, incomparably smaller equivalent in Algeria (conquered in 1830, but finally pacified only after the last major uprising in 1871).

    As markets, new colonies were not particularly well-suited for expansion anyway -- Africa for instance lost one third of its entire population (one half in some regions, such as Congo) with the survivors losing income and wealth during the "scramble". Demographically, but not economically, African populations recovered after WWI.

    "The imperial expansion and trade wars of the late 19th century ended with a cataclysmic war:"

    If those were the reasons, then the increasingly aggressive policies of Japan -- which conquered Taiwan, Korea, and a part of Russia -- and was seriously working to compete economically with European and American powers in Asia, should have provoked a major war there and then. It did not (not until 1931).

    Neither imperial expansion, nor trade wars were the causes of WWI.

    The cause was instead inexorable imperial disaggregation (Ottoman, Austro-Hungarian, and to some extent Russian, empires).

    1. During the Gilded Age, US tariffs averaged 40-50%.

      France had a free trade agreement with the UK from 1860 onwards.

      I disagree that the passing of protectionist measures was to quell unrest among the peasantry. If it were, then protectionist measures would have been introduced in 1848, when unrest was much greater. Imho the rise of protectionism in the late 19th century was to protect farmers, not peasants. It was in response to the US's very high tariff barriers, especially in agricultural products in which it was becoming increasingly dominant at the expense of European farmers. The Long Depression particularly affected agriculture.

      I agree that World War I was really about the collapse of four empires (weirdly you ignore the Prussian empire) - indeed I have written about this myself, though the piece is not currently available. However, it is impossible to have imperial disaggregation without previously having had imperial expansion.

      I did not say that trade wars caused World War I. "Ended with" does not imply causation.

    2. "Imho the rise of protectionism in the late 19th century was to protect farmers, not peasants."

      Yes, and this is what I meant (see the reference to Germany).

      But the case of France was a bit different. There socialists held on to free trade, especially for agricultural goods, till 1887. Apart from farmers (conservative voters), there were very small farmers ruined by free trade (besides other peasantry and day labourers) who could be enticed to vote for them. So they gave up their opposition to protectionism -- on the condition that it would be accompanied by a tax reform, so that price increases would not just benefit large farmers to the detriment of workers (Jean Jaurès was quite vocal about that). The introduction of the Méline tariffs in 1892 ended the free trade policy of France without including such a reform.

      "weirdly you ignore the Prussian empire"

      Till WWI, the Prussian empire was solid and in no risk of disaggregation whatsoever. Its disaggregation was a consequence of WWI, not a cause of it.

      The Ottoman empire had been rotting away for quite a while, and the squabbling between countries trying to get chunks of it led to the 2nd Balkan war and then to WWI. One of those countries was Austria-Hungary, which was itself riddled by increasing centrifugal nationalist tensions. So was Russia in the West (Finland, Baltic countries and Poland), also suffering from severe socio-political fracturing throughout, as it was itself no longer expanding, but had been amputated from some Eastern territories by Japan. The disaggregation of those empires (on-going or menacing) were the reason for WWI.

      ""Ended with" does not imply causation."

      All right. You used that expression to express a pure temporal succession, I understood it as the final step in a process.

    3. As noted, the Prussian Empire was not crumbling and in a weird way ended up better off politically as the empire finally realized German unification when states such as Bavaria and Wurtemberg after some thoughts and fighting didn’t reclaim their independence. As for WWII, it ended creating a German nation as refugees and expelled Volksdeutchen mixed and unified Germany culturally. As for WWI, it can be viewed as a badly out of control 3rd Balkan wars. Was it Bismarck who said that half of mankind’s problems come from the abuse of alcohol and the rest come from the Balkans?

  4. "for production costs to fall, either there must be fewer people earning wages, or wages must be lower."

    Or you make more from financial investments than sales. Since r > g, it is more rational to become an investment company and just do real sales on the side, for show.

    It is weird that no one mentioned the Greenback Party. The Greenback Party elected enough representatives to get an inflation bill through Congress; Grant vetoed it in 1874, ushering back in the hard money era.


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