The Early History of Macroeconomic Fluctuation Models
The history of debates about the sources of macroeconomic fluctuations began with the first appearance of actual fluctuations within the newly industrializing economies after the Napoleonic Wars.
There had always been economic fluctuations, but before the Industrial Revolution they were driven by agricultural production fluctuations that were in turn clearly driven by exogenous forces, particularly those related to climate - although these were sometimes seen as having elements of periodicity, such as the Jevons (1878) sunspot theory or the much earlier Joseph story, from Genesis in the Bible, about the seven fat years followed by the seven lean years. What was missing in these earlier phenomena was any sort of endogeneity of the cycles that might be there or not. The idea that such might be the case arose with the fluctuations of the industrializing economies where capital investment would play the leading role.There had been commercial crises prior to the post-Napoleonic wars recession, but they had not led to major disruptions of employment, nor did they lead any economists to discuss where they came from, although the discussion of speculative bubbles in particular had gotten the attention of such figures as Cantillon (1755) and Adam Smith (1776: 703-4) owing to the large-scale and dramatic nature of the linked Mississippi and South Sea bubbles of 1719-20. However, these discussions focused more on the stupidity of those participating in such events than on any underlying processes or broader economic repercussions, although Cantillon (1755: ch. 10) particularly emphasized the need for bullionism in order to avoid speculation. As it was, the post-Napoleonic Wars years after 1815 saw considerable disruptions and the appearance of unemployment in several core nations involved, particularly Britain and France. These events triggered a debate between Malthus and Ricardo over its causes that also involved such figures as Sismondi and Say on the sidelines.
Ricardo (1817: 265) argued that the disruptions were temporary adjustments arising from exogenous shocks, in particular, the beginning or ending of major wars that engender a microeconomic intersectoral misallocation. Given the time needed to make adjustments, this can lead to a “distress in trade”, with this later being understood to possibly involve chaotic dynamics (Bhaduri and Harris 1987).
It changes in a great degree the nature of employment to which the respective capitals of countries were before devoted; and during the interval while they are settling in the situations which new incentives have made most beneficial, much fixed capital unemployed, perhaps wholly lost, and labourers are without full employment. (Ricardo 1817: 165)
While this is the foundation for modern classical views, it is also perhaps more in the spirit of the Austrian School, which argues that fluctuations in interest rates lead to intersectoral misallocations. In any case, the disruption is temporary, and the system should adjust on its own in some reasonable time without any tendency to a longer-term general glut due to demand being insufficient to supply. On this latter point, the “law of markets” identified with J.B. Say (1803) would be invoked throughout the nineteenth century, even if the discussion by Keynes (1936) of “Say’s Law” and its role can be argued to be misguided, and Say himself did not see his law as universally holding and supported public works spending during the post-Napoleonic war recession.
On the other hand, Malthus argued for the possibility of general gluts owing to an insufficient aggregate demand, ultimately pointing to income inequality as a source of the underconsumption. “Commodities would be everywhere cheap. Capital would be seeking employment, but would not easily find it; and the profits of stock would be low. There would be no pressing and immediate demand for commodities” (Malthus 1836: 415). Ricardo and Malthus would go back and forth on this in their correspondence, but other elements came into the discussion.
In particular Sismondi (1819) became the first to hint at the possibility of endogenous cycles, or to be more precise, periodic crises that were linked, with one laying the groundwork for the next. His argument had many similarities to that of Malthus, particularly emphasizing the role of income inequality more than Malthus, even coining the term “class struggle” in this emphasis, but he made more of an effort to build a broader model with these general gluts chronically appearing without the need for some exogenous shock such as the beginning or end of a war.
Probably the most thorough codifier of the Ricardian defence against this Malthus- Sismondi critique was John Stuart Mill (1871). More than Ricardo he invoked Say, but he also allowed for temporary disruptions that could lead to temporary unemployment and output decline. He brought in other factors that could serve as sources of exogenous shocks besides war, such as bad crops or obstructions to imports. The major element he added to Ricardo was to emphasize the role of the financial sector and to see speculative bubbles as bringing about the disruption of the financial sector when they crash, thus leading to a fall in real investment that reduces output and employment temporarily. Many would say that speculative bubbles contain a strongly endogenous component, and once started a particular speculative bubble will clearly feed upon itself. However, Mill retained his classical perspective by emphasizing that the speculative bubble would be triggered by some initial shock to supply that would push up prices, this then triggering the bubble dynamic (Mill 1871: 526). After the crisis and crash, it would be simply a matter of time for the financial sector to reorganize and revive for things to return to normal. There would be no need for a “diminution of supply” but rather for “the restoration of confidence” (Mill 1871: 561). Each such event stands on its own with no cyclical aspect linking it to others.
Curiously, while Malthus did not pose a cyclical model in his response to the events after the Napoleonic wars, he had earlier posed the possibility of longer-run fluctuations tied to relations between population growth and the broader economy, although with these fluctuations possibly being erratic and combining both exogenous and endogenous elements, with Day (1983) and Day and Walter (1989) showing how a model based on this might produce longer run chaotic dynamics. Thus, from the first edition of his Essay on the Principle of Population (Malthus 1798: 33-4) we get:
Such a history would tend greatly to elucidate the manner in which the constant check upon population acts; and would probably prove the existence of the retrograde and progressive movements that have been mentioned; though the times of their vibration must necessarily be rendered irregular, from the operation of many interrupting causes; such as, the introduction or failure of certain manufactures; a greater or less prevalent spirit of agricultural enterprise; years of plenty, or years of scarcity; wars and pestilence; poor laws; the invention of process for shortening labour without the proportional extension of the market for the commodity; and particularly the difference between the nominal and the real price of labour; a circumstance, which has perhaps more than any other, contributed to conceal this oscillation from common view.
Marx drew on elements from both Mill and Malthus, although by way of Sismondi for the latter given his intense dislike of Malthus, particularly in volume III of Das Kapital (Marx 1894) and in part II of his Theories of Surplus Value (Marx 1969). While in volume I Marx laid out a vision of collapse of capitalism as a whole leading to revolution and socialism, volume II concentrated more on equilibrium models of steady state or expanded reproduction in which the consumption and capital goods sectors remain in balance. It was in volume III where Marx concerned himself more with the matter of the periodic outbreak of crises and the resulting pattern of repeated fluctuations.
He expressed doubt that one ever sees equilibrium in micro markets except accidentally for a second as a market moves from excess demand to excess supply and back again. Malthus was muddled in his formulation of the general glut, nevertheless, the problem of “surplus realization” periodically arose, and he dismissed Mill’s dismissal of the possibility of general gluts. Like Mill, he was aware of the problem of speculative bubbles appearing in capitalist financial markets and how they could lead to “regular and periodic” crises (Marx 1969: 500). Ultimately the problem would be that “the demand for the general commodity, money, exchange-value, is greater than the demand for all particular commodities” (Marx 1969: 505). A particular idea that he first developed which has reappeared since in many models of macro fluctuations, even in modern real business cycle models, is that of the echo boom, wherein a wave of investment at one time leads to the wearing out of that capital stock at the same time which then engenders another wave of replacement investment (Kydland and Prescott 1982).