Introduction by Prodos
Dear Fellow Students,
A while ago, I attended a meeting where the keynote speaker was a prominent Australian economist. Sitting next to me in the audience was another economist, a friend of mine. I asked my friend what he knew of the forthcoming speaker. He replied: “I’ll let you know after I hear his take on the trade cycle”.
My friend contended that you can know most of what an economist thinks once you know his approach to the trade cycle. It’s that fundamental.
So when Mr Jackson informed the Economics Workshop that he’d be writing an article for us to study about the trade cycle, I was thrilled.
What makes this article especially interesting (and demanding), however, is that it confines itself to examining a particular question: What is the real “classical school of economics” theory of the trade cycle? And why it matters, of course.
Comparing recent writings about Classical trade cycle theory with the historic literature of economics, this article demonstrates that a fundamental misunderstanding of the Classical School’s theory of the trade cycle prevails today — and seeks to set the record straight.
Especially surprising is what Mr Jackson reveals about the approach of John Stuart Mill — commonly assumed to be a pillar of the Classical School — and how his account of the trade cycle was refuted by the now lesser known Colonel Robert Torrens who followed the classical school’s monetary explanation of this phenomenon.
The vital significance of understanding the “currency school” versus the “banking school” is also made clear — and why these schools need to always be kept in mind when discussing or debating trade cycle theory.
This article is not light reading. In under 1,000 words (plus that much again in references) it covers an enormous scope of historic arguments, individuals, and literature — with extensive references — all worth careful follow-up in their own right.
Here we go!
The real classical school theory of the trade cycle
By Gerard Jackson
The left thrives on economic myths and the greatest and probably the most effective of these is its myth of the trade cycle1. Unfortunately most mainstream economists also share this belief — and Australian economists are no different.
Every Australian author I have read on this topic stated without reservation that “boom and bust are part of the natural order of capitalism”2, that “capitalism is guilty of generating booms and busts”3 and that “recessions are the result of systematic, economy-wide errors in production decisions”4 that are inevitable given the nature of a market economy. Confronted by this phalanx of dogmatic certainty it is no wonder the left remains unchallenged in this area.
Regrettably another egregious economic error is taking root among Australia’s establishment right. Steve Kates has successfully promoted the notion that the classical theory of the trade cycle “was essentially a theory based on the structure of production being out of phase with the structure of demand”5 created by undue optimism of businessmen. I am at a complete loss as to how any person with a passing knowledge of the contemporary literature could draw this conclusion. At the end of the day this just leaves us with Keynes’ meaningless “animal spirits”.
From the early part of the nineteenth century until the 1850s6 the currency school’s monetary theory of the boom bust cycle was the one that dominated contemporary thinking.
According to the theory the banking system lowered interest rates by expanding the money supply. This encouraged excess business investments, fuelled “insane speculation”7 and created disproportionalities8 This was a straightforward and pretty good theory that exonerated the market while fingering reckless banking as the real culprit9.
That this theory was the generally accepted one was confirmed by George Warde Norman, a prominent director of the Bank of England and an opponent of the monetary theory. In a letter to Charles Wood MP, who was chairing the Committee of the House of Commons on the Note Issue, Norman lamented the fact that public opinion stood behind the monetary theory of booms and busts10
Ironically, this very point was stressed by Marx. In an effort to make capitalism solely responsible for the existence of the so-called trade cycle Marx adopted the banking school explanation (which really should be called the Tooke-Mill theory) of this monetary-driven phenomenon, arguing that
This brings us to Colonel Robert Torrens.
Apparently influenced by James Pennington Torrens abandoned his earlier and purely descriptive and misleading approach to the boom-bust phenomenon12 and in 1837 joined the currency school with an astonishing pamphlet that laid out the monetary theory of the cycle, complete with a description of the money multiplier13. It was a tour de force and a scathing indictment of the Bank of England. Dripping with sarcasm, Torrens asked the Bank and its supporters:
His analysis left no doubt where he thought the blame lay for the recurring financial crises that plagued the country. The pamphlet immediately made Torrens the currency school’s leading theoretician. Unfortunately, he failed to persuade most of its members to agree with him that demand deposits were money and should be included in their definition of the money supply. (On the other hand, the banking school recognised that deposits were indeed money. This was the only thing it did get right.) Torrens’ views on money and the trade cycle also put him completely at loggerheads with John Stuart Mill, who had become a leading supporter of the banking school.
In 1848 Torrens published14 a damning repudiation of the monetary views of Mill and Thomas Tooke. He also took Mill to task over his misleading criticism of the currency school’s theory of the trade cycle. Ten years later Torrens once again brought the subject into the public arena with a roaring defence of the monetary theory of the boom-bust cycle that was almost Austrian in its analysis15.
It was a full-blooded assault on the fallacies of Tooke, John Fullarton, James Wilson and John Stuart Mill. Unfortunately for economics and the world the attack came too late to prevent the fallacious Tooke-Mill ‘theory’ of the trade cycle, which assumes that the money supply is passive, from overshadowing the currency school theory. Given these facts is it any wonder I find it totally incomprehensible how any informed person could place Torrens in the same camp as Mill.
The Tooke-Mill explanation of the trade cycle does not deserve to be called a theory. Moreover, its emergence as the dominant explanation for booms and busts helped bring about the Great Depression: the result is that we now have to endure the sight of Keynesian cultists publically declaring:
Since capitalism’s beginnings, the market economy has been subject to fluctuations — to booms and busts. Capitalist economies are not self-adjusting: Market forces might restore eventually an economy of full employment, as economist John Maynard Keynes said, but, in the long run, we are all dead. (Taipei Times, Joseph Stiglitz, The IMF is slow to recognize its errors or Keynes’ correctness, 3 June 2002.)
This dangerous nonsense will continue unabated until the true theory of the trade cycle is restored to its rightful place and the currency school given full recognition for its contribution to economics16
Footnotes & References
- Like the classical economists I am referring to a specific economic phenomenon and not to economic fluctuations in general. [↩]
- Jonson, P. D. Capitalism, Connor Court Publishing, Pty, LTD, 2011 (p. 282). [↩]
- Smith, Peter Bad Economics, Connor Court Publishing, Pty, LTD, 2012 (p. 82). [↩]
- Kates, Steven Free Market Economics, Edward Elgar Publishing Limited, 2011 (p. 43). [↩]
- Kates, Steven Says Law and the Keynesian Revolution: How Macroeconomic Theory Lost its Way, Edward Elgar Publishing Inc., 2009 (p. 121). [↩]
- It was the 1847 financial crisis combined with John Stuart Mill’s standing as an economist that caused the currency school’s theory to be eclipsed by what can only be described as the Pollyanna theory. This is where capitalists go to bed on Sunday night with realistic expectations of the future but then, for some unaccountable reason, they awake in the morning full of irrational optimism that causes them to pour huge sums of borrowed funds into unprofitable ventures, creating malinvestments throughout the economy while sparking a frenzied speculation which ends very, very badly. [↩]
- Arbuthnot, George Sir Robert Peel’s Act of 1844, Regulating the Issue of Bank Notes, Vindicated, London: Longman, Brown, Green , Longmans, and Roberts, 1857, (p. 92). This work was a devastating attack on the views of Thomas Tooke and the banking school. It is certainly the equal of Torrens’ takedown of Tooke and Mill. [↩]
- Classical economists linked the emergence of disproportionalities directly to the idea of circulating capital being converted into fixed capital. James Wilson, founder of the Economist, discussed this issue in his magazine. The article in question was later published in his book Capital, Currency and Banking as Article XI, The Crisis, The Money Market. Wilson’s opinion that “railway mania” caused excess investment by converting circulating capital into fixed capital was supported by John Stuart Mill (Principles of Political Economy, Vol. II, University of Toronto Press, Routledge & Kegan Paul, 1965, p. 543.) Colonel Torrens was also in full agreement, stating that “[t] he railways were rapidly absorbing the circulating capital of the country, and outbidding commerce in the discount market”. (The Principles and Practical Operation of Peel’s Act of 1844 Explained and Defended, London: Longman, Brown, Green, Longmans, and Roberts, 1857, p. 74.) Ricardo also raised the question of converting circulating capital into fixed capital (Principles of Political Economy and Taxation, ch. XXXI, On Machinery.) However, Malthus was much better than Ricardo on this issue (Principles of Political Economy, Augustus M. Kelley, Publishers, Clifton 1974, pp. 236-7). There is also Malthus’ remarkable article on forced saving that explains the emergence of disproportionalities (Edinburgh Review, February 1811, pp. 363-372). It’s unfortunate that these economists failed to develop a theory that directly linked the phenomena of forced saving, disproportionalities, the rate of interest and the conversion of circulating capital into fixed capital to the role of time in production. [↩]
- Mushet, Robert An Attempt to Explain from The Facts the Effects of the Issues of the Bank of England upon Its Own Interests, Public Credit and Country Banks, London: Baldwin, Craddock, and Joy, Paternoster Row, 1826. This is a remarkable and highly detailed work that should be compulsory reading for every economist and economic historian. [↩]
- Letter To Charles Wood, Esq., M.P., On Money, And The Means Of Economizing The Use Of It, London: Pelham Richardson, 1841 (p. 85). [↩]
- Karl Marx, Capital Vol. I, Chicago: Charles H. Kerr & Co. 1909, (p. 695). Marx’s opinion that the money supply is passive is pure Tooke. In fact, there is no fundamental difference between the Took-Mill theory of the trade cycle and Marx’s theory. [↩]
- An Essay on the Production of Wealth, Longman, Hurst, Rees, Orme, and Brown, Paternoster Row, 1821. In this work Torrens drew attention to the fact that using inflation to cut real wages raised the demand for labour and accelerated the process of capital accumulation. (p. 326.) This naturally raises the question of forced saving. Thomas Malthus expressed brilliant insights into the process of forced saving (Edinburgh Review, February 1811, No. XXXIV, pp. 363-372). I’ll deal with this phenomenon in later articles. [↩]
- A Letter to the Right Honourable Lord Viscount Melbourne on the Causes of the Recent Derangement in the Money Market, and on Bank Reform, London: Longman, Rees, Orme, Brown, & Green, Paternoster Row, 1837. [↩]
- The Principles and Practical Operation of Sir Robert Peel’s Act of 1844, Explained and Defended, London: Longman, Brown, Green, Longman’s, Paternoster Row, 1848. [↩]
- The Edinburgh Review, or Critical Journal, January 1858 – April 1858 (pp. 248-93). Torrens’ attack always brings to mind Sir William Clay’s proto-Austrian analysis of the business cycle published in 1837. Clay, like Colonel Torrens, was also a member of the Political Economy Club. [↩]
- For the life of me, I just cannot see how someone could write about the “classical theory of the trade cycle” without making a single reference to the existence of the currency school or the banking school. [↩]