Haberler’s Taxonomy of Business Cycle Models in the Early Twentieth Century
The appearance of depressions in the 1870s and 1890s (with some arguing for the entire period to have been a depression), along with more crises in the early twentieth century and finally the Great Depression, led to many further developments in the theory of how macroeconomic fluctuations could occur.
One year after Keynes (1936) published his most important work attempting to explain the Great Depression as arising from failures of aggregate demand, Gottfried Haberler (1937) published the first edition of his Prosperity and Depression. Whereas Keynes sought to lay out a specific theory that incorporated a number of ideas that had been developed earlier by others, such as the multiplier effect (Johansen 1903; Kahn 1931), Haberler reviewed broad schools and views that had been developing since the end of the nineteenth century, some of them also adopted by Keynes, but some of them disagreeing with him to various degrees.The theories reviewed by Haberler are the purely monetary theory, the overinvestment theories (three of them), changes in cost or horizontal maladjustments or over-indebtedness, underconsumption, psychological theories, and harvest theories (which largely amounts to a discussion of the already mentioned sunspot theory of Jevons in 1878). Of these he spends the most time on the three over-investment theories. It must be noted also that not all of these theories are mutually exclusive and that in any particular fluctuation the effects described by more than one of them may be simultaneously at work.
For Haberler, the leading exponent of the purely monetary theory was R.G. Hawtrey (1913, 1932) who relies upon the quantity equation of exchange of Irving Fisher (1911) that Humphrey (1984) documents was developed by others earlier (Lubbok 1840), but who more strongly emphasizes the role of credit and interest rates and their impact on merchants.
He believed that there was instability in the credit system that led to cumulative movements away from equilibrium in either direction, accompanied by either deflation or inflation. Indeed, in his earliest writing he recognized the possibility of a complete freezing of credit in a sufficiently deflationary situation, in which monetary policy will be ineffective to stimulate the economy, rather resembling the liquidity trap of Keynes. Later the greatest champion of Hawtrey’s approach would be Milton Friedman (1956; Friedman and Schwartz 1963). While Friedman agreed with Hawtrey about shorter-term impacts of money on the economy, he also strongly emphasized the longer- run neutrality of money associated with the monetarist approach.The leaders of the monetary theory of over-investment tended to be of the Austrian School, notably von Mises (1934) and Hayek (1933), although they drew on the work of the Swedish economist Wicksell (1898), who also inspired the alternative to Keynes, the Swedish sequence analysis school (Lundberg 1937). While there is overlap with the monetarist theory, there is even greater emphasis on interest rates and their control by central banks. So, Wicksell posed the idea of the natural rate of interest. If interest rates were held below this rate, then there would be over-investment, particularly of longer time horizon projects, with this being followed by interest rates above the natural rate, which would lead to a crisis and decline of output while there was a shutting down of many now unprofitable projects.
The non-monetary over-investment theory’s leading advocate was Spiethoff (1902), who saw investment in fixed capital respond to a rise in demand for final goods, but that the boom that develops runs into an outright shortage of capital goods as that sector hits capacity limits. There is something of a production lag element to this such as one finds in the cobweb theorem dynamics of microeconomics (Cheysson 1887; Ezekiel 1938) with the crucial lag being in capital investment in the capital goods sector. However, this theory has roots in some of Marx’s arguments, and one of his followers, Tugan-Baranovsky (1901), argued for a periodicity and regularity to such a cycle, likening it to a steam engine.
The third over-investment theory depends on the acceleration principle that has investment responding to changes in consumer final goods demands, but overshooting the increase in capacity. Among those developing and applying this would be Carver (1903), Aftalion (1913), Clark (1917) and Harrod (1936). The related multiplier concept due to Johansen (1903 (under the pseudonym, “J.J.O. Lahn”)) and Kahn (1931) would be combined in the form of multiplier-accelerator models to show mathematically complete models of periodic and endogenous macroeconomic fluctuations (Samuelson 1939a, 1939b), with nonlinearity in the consumption function in the latter version making it susceptible to endogenously erratic fluctuations.
The horizontal maladjustment theory, or “error theory,” much resembles the explanation by Ricardo of what happened after the Napoleonic Wars. As argued by Mitchell (1924), this involved over-investment in particular sectors, and did not necessarily lead to general decline, although it could.
Irving Fisher (1933) developed the debt-deflation theory, which has influenced Minsky (1986) and Bernanke et al. (1996) since. Fisher did not support any ideas of periodicity of cycles, but saw each as an individual event. A deflation could expand the real value of debt, which in turn could drive down output as firms fail due to their rising real indebtedness. For later writers this would become the “financial accelerator”.
We have already encountered the under-consumption theory earlier from the work of Malthus and Sismondi. A later more detailed presentation was due to Hobson (1909), who placed special emphasis on the role of income inequality leading to the poor being unable to buy consumer goods. Haberler notes that at least conceptually this theory is similar to the over-investment theory, although the emphasis in the latter tends to be on the behaviour of the capitalists making overly large investments, whereas the under-consumption view focuses on the would-be consumers who do not buy enough to justify the investments that have taken place.
Finally, we have the psychological theory. Many observers mention psychological factors, including Spiethoff and Mitchell. But the main developers of this theory were Pigou (1927) and Keynes (1936). This theory more directly confronts the issue of expectations formation, with waves of mania and depression driving investment up and down, Keynes adopting the term “animal spirits” for these oscillations of mood. This theory also plays an enormous role in the work of Minsky (1986), who sees the swelling of optimism in an initially favourable equilibrium situation to destabilize it as a bubble develops leading to a crash. Kindleberger (1978) and Shiller (2015) have been followers of this approach, which easily fits in with some of the other theories, particularly the over-investment theories. An unresolved issue with this approach is the degree to which the psychological factors are exogenous or endogenous, with them conceivably exhibiting both characteristics. The modern theory of psychological variations being driven by arbitrary exogenous effects that themselves do not directly affect production are the sunspot theories of dynamic fluctuations (Azariadis 1981; Cass and Shell 1983), which contrast to the Jevons theory of direct influence on agricultural production from sunspot cycles.