The Accidental Theorist (11 page)

When the world’s second largest economy, after forty years of impressive economic growth, stagnates for six years with no real recovery in sight, one would think that people would regard the causes of that economic stagnation as a truly burning issue. Yet even now there is a strange casualness in the way that most people—including, unfortunately, many Japanese—discuss the nation’s problems. Instead of a serious, thoughtful analysis, all one usually hears is a long list of things wrong with Japan. The country, we are told, has a weak financial sector; it is overregulated; there is not enough competition; Japanese firms are moving production to Southeast Asia; and so on. All of these things are true; nonetheless, a list is not the same as a real analysis. And in fact the tendency to explain Japan’s problems in terms of a long list of factors does real harm, because it encourages a sort of fatalism in the face of economic stagnation. After all, if there are so many problems, we cannot expect a quick fix.

The truth, however, is that matters are not that complicated. Japan has many problems—but what country does not? The main obstacle to Japanese recovery right now is not the long list of structural difficulties but a simple lack of clear thinking and courage.

For one thing, most of the items on everybody’s list of what is wrong with Japan are things that make the economy inefficient. That is, all of these things reduce the ability of the economy to produce goods and services—they limit its supply capacity. But the immediate problem with the Japanese economy is not too little supply—it is too little demand. The problem is that the economy isn’t using the production capacity it already has—a problem for which many of the items on the usual list are simply irrelevant.

Now as a general rule modern economies are not supposed to suffer from prolonged periods of inadequate demand. There is usually nothing easier than increasing demand: Just have the central bank (i.e., the Bank of Japan) increase the money supply, or have the government spend more. Why, then, has Japan suffered from low demand for more than half a decade?

Well, there are some structural reasons. Japanese consumers still save an unusually high fraction of their income, which means that companies must correspondingly be persuaded to maintain a high investment rate if the economy is not to have too little demand. The problem is aggravated because the troubles of the banking system have restricted the flow of credit. So to push demand high enough to get the economy back to more or less full use of its capacity would require a big stimulus. Still, why not provide that stimulus?

The standard answer goes like this: Interest rates are already very low, so the Bank of Japan has done all it can. Meanwhile, the government has a severe fiscal problem, so it cannot increase spending or cut taxes. There is, in short, nothing to be done except pursue structural reforms and hope for an eventual turnaround.

This answer sounds hard-headed and responsible. In fact, however, it is based on a completely false premise—the idea that the Bank of Japan has reached the limits of what it can do.

The simple fact is that there is no limit on how much a central bank can increase the supply of money. Could the Bank of Japan, for example, double the amount of monetary base—that is, bank reserves plus cash in circulation—over the next year? Sure: just buy that amount of Japanese government debt. True, even such a large increase in the money supply might not drive down interest rates very much, since they are already so low. But an increase in Japan’s money supply could ease the economic problem in ways other than lower interest rates. It is possible that putting more cash in circulation will stimulate spending directly—that the extra money will simply “burn holes in people’s pockets.” Or banks, awash in reserves, might become more willing to lend; or individuals, with all that cash on hand, will bypass the banks and find other ways of investing. And even if none of these things happens, when the Bank of Japan increases the monetary base it does so by buying off government debt—and therefore makes room for spending increases or tax cuts.

So never mind those long lists of reasons for Japan’s slump. The answer to the country’s immediate problems is simple: PRINT LOTS OF MONEY.

But won’t that be inflationary? Well, remember that the Bank of Japan is supposed to be impotent: If it prints more money, people will simply hoard it rather than spend it. But printing money is only inflationary if people spend it, and if that spending exceeds the economy’s capacity to produce. You cannot first argue that monetary policy is ineffective as a way to increase demand, then reject a proposal to print more money on the grounds that it will cause inflation.

So why doesn’t the Bank of Japan just go out and print lots of money? The best theory I have heard is that the bureaucrats at the Bank of Japan and the Ministry of Finance are still mesmerized by the memory of the “bubble economy”—the wild speculation of the late 1980s, which pushed the prices of stocks and real estate to crazy levels (remember when the grounds of the Imperial Palace were supposedly worth more than the whole state of California?). They believe that loose monetary policy created that bubble—which may be true—and that the bursting of the bubble caused the slump of the 1990s—which may also be true. And so they are afraid to increase the money supply now for fear of repeating the experience.

There is an old joke that may be useful here: A driver runs over a pedestrian, who is left lying in the road behind his car. He looks back and says “I am so sorry—let me undo the damage”—and proceeds to back up his car, running over the pedestrian a second time. Japan’s economic managers are acting like that driver. They do not realize that 1997 is not 1987, and that doing the opposite of what they did then only compounds the country’s problems.

Books that propound theories of history—that is, that claim to find common patterns in events widely separated in time and space—have a deservedly dicey reputation among the professionals. When such books are good they can be very good: A classic like William McNeill’s
Plagues and Peoples
can permanently change the way you look at human affairs. Most bigthink books about history, however, turn out to offer little more than strained analogies mixed with pretentious restatements of the obvious; a few have been downright pernicious.

Still, the public has a powerful and understandable appetite for theories that seem to explain it all, and so they keep on coming. David Hackett Fischer’s
The Great Wave: Price Revolutions and the Rhythm of History
has already generated considerable buzz. Remarkably for a book that spends most of its five-hundred-plus pages dwelling on events centuries (and occasionally millennia) in the past, a good deal of the buzz comes from the business community, not usually noted for its interest in history. Indeed, Fischer is getting favorable mention from people who tell us in the next breath that we live in a New Economy to which old rules no longer apply.

There is a reason for this peculiar affinity between a historian with an eight-century perspective and business commentators obsessed with the new; what these pundits really want, it turns out, is to use his account of alleged patterns in the distant past as an excuse to ignore the lessons of more recent history.

Fischer’s book looks promising on the face of it. Inflation is a plausible candidate for a far-ranging search for parallels and common principles. And the book also starts well, with a stirring and eloquent defense of the role of quantification in history (although my favorite along these lines is still Colin McEvedy’s introduction to
The Penguin Atlas of Ancient History,
which contains this immortal sentence: “History being a branch of the biological sciences, its ultimate expression must be mathematical.”). I plan to keep
The Great Wave
on my shelf both as a useful source of facts and figures and as a guide to data sources; the author did do a lot of homework.

It is therefore a shame that the book turns out, in the end, to be quite wrong-headed. But let us not be too harsh: It is wrong-headed in interesting ways, and we can learn quite a lot by examining how and where Fischer went astray.

Fischer starts with an empirical observation: If you look at the history of prices in the Western world since the twelfth century, you can broadly divide that history into alternating periods of generally rising prices and of rough price stability. Everyone knows that the twentieth century has been an era of inflation, and the prolonged price rise from 1500 to 1700 is also well known; Fischer makes a good case, however, that there were also reasonably well-defined eras of price increase in pre–Black Death medieval Europe and in the eighteenth century.

What does conventional economic history have to say about these “price revolutions”? Well, the two familiar ones are both generally attributed to increases in the supply of money, but with those increases themselves driven by very different factors. The long inflation from 1500 to 1700 is mainly attributed to the flood of silver from Spain’s New World conquests; in the modern world governments can print money instead of mining it, and have done so repeatedly both to pay their bills and, more creditably, in an attempt to trade off higher prices for lower unemployment.

Fischer regards such explanations as inadequate. He insists both that inflation is only one symptom of a deeper process—one that also produces growing population, rising inequality, declining real wages, and ultimately a crisis—and that this process is repetitive, that in a qualitative sense all price revolutions are alike. In particular, the travails of the West in recent decades are typical of the end game of a price revolution—and we can take comfort from the fact that such difficult periods are inevitably followed by a prolonged “equilibrium.”

This thesis is both fun to contemplate and comforting in its implication that the worst may already be behind us. What is wrong with it? One problem with
The Great Wave
is that Fischer shares a common shortcoming of historical writers on matters economic: He would clearly rather spend a year hunting down facts than a day mastering a theory, even if only to learn enough to reject it. As a result, his accounts of what he imagines to be the conventional theories of inflation—theories that he claims to refute with his evidence—are wildly off-base, sometimes ludicrously so.

Fischer’s impatience with analytical thinking extends to his own ideas; the book contains quite a few whoppers, assertions that fall apart if given even a moment’s serious thought. An illuminating example involves his discussion of the origins of the great price rise after 1500. He points out correctly that prices in Europe began rising well before New World silver began to arrive—which he argues refutes any monetarist explanation. But there is no mystery here: As he admits, there was a surge in European silver production in the late fifteenth century, mainly from mines in Bohemia and Southern Germany. (Coins stamped at one of those mines, at Joachimsthal, were circulated so widely that “thaler” became a generic phrase for any silver coin—and eventually, with some slippage in spelling and pronunciation, for pieces of green paper bearing George Washington’s portrait.) Fischer insists, however, that the rise in European silver production was a result rather than a cause of inflation—that mines were opened and expanded to meet the “desperate need for liquidity” produced by rising prices.

Think about that for a minute. We can be sure that fifteenth-century German mineowners neither knew nor cared about Europe’s need for liquidity—they were simply trying to make a profit. Now ask yourself: Does inflation (a rise in the price of goods and services in terms of silver) make it more or less profitable to open a silver mine? The clear answer is that it makes the mine
less
profitable: A pound of silver extracted from the mine would buy fewer goods and services than before. Had Fischer devoted even a few minutes to thinking his story through, he would have realized that. Yet the claim that rising prices necessarily induce increased creation of money is crucial to his whole theory.

There is, however, an even bigger problem with
The Great Wave.
Like most efforts to derive lessons for the present from the broad sweep of history, Fischer’s thesis essentially involves denying that the Industrial Revolution led to any fundamental change in the way the world works. But the fact is that beginning in the eighteenth century there
was
a qualitative change in the nature not only of economic life but of human society in general, a change more profound than any since the rise of civilization itself. That does not mean that we have nothing to learn from earlier centuries; it does mean that we have to be very careful in drawing parallels.

There are many ways in which the preindustrial world was another planet from the one we now inhabit, but let me focus on two changes that are particularly crucial in this context.

First, for fifty-five out of the last fifty-seven centuries Malthus was right. What I mean is that for almost all of the history of civilization improvements in technology did not lead to sustained increases in living standards; instead, the gains were dissipated by rising population, with pressure on resources eventually driving the condition of the masses back to roughly its previous level. The subjects of Louis XIV were not noticeably better nourished than those of ancient Sumerian city-states; that is, while they had enough to survive and raise children in good times, they lived sufficiently close to the edge that the Four Horsemen could carry them off now and then, keeping the population more or less stable.

It was Malthus’s great misfortune that the power of his theory to explain what happened in most of human history has been obscured by the fact that the only two centuries of that history for which it does not work happen to be the two centuries that followed its publication. But this was, of course, not an accident. Malthus was a man of his time, and his musings were only one symptom of the rise of a rationalist, scientific outlook; another symptom of that rise was the Industrial Revolution.

Because Malthus was right, however, the Great Waves of economic activity in the preindustrial world, while they undoubtedly existed, were driven by forces that have little relevance to more recent fluctuations. In particular, the most important discipline for understanding long swings in preindustrial population and real wages is not macroeconomics but microbe economics. Now and then devastating new diseases would appear (often, as McNeill showed in
Plagues and Peoples,
as a result either of conquests or of the opening of new trade routes, both of which tended to bring formerly separated populations, and the germs that they harbored, into contact). Initially the population would plunge and real wages would soar. As microbes and humans coevolved into a new equilibrium, population and pressure on resources would rise again, and the increasingly malnourished masses would become vulnerable to the next plague. All this is fascinating; but its relevance to twenty-first-century economic prospects is questionable.

The other great change is the invention of the business cycle. Economic instability has, of course, always been with us. But economic downturns before 1800 were the result of “supply-side” events such as harvest failures and wars. They bore little resemblance to modern recessions, which are the result of slumps in monetary demand. To have a recession as we understand it today, you must have a structure of paper credit erected on top of or in place of the circulation of gold and silver—otherwise, the credit contraction so central to the phenomenon cannot get started in the first place. And you must also have a substantial part of the economy that is likely to respond to slumping demand by cutting production rather than prices—otherwise a financial contraction will lead to deflation, but not to an actual decline in output. Preindustrial economies could not have recessions as we know them, both because of the simplicity of their monetary systems and because they consisted mostly of farmers, who respond to a drop in demand mainly by cutting prices rather than by growing less.

Economic historians generally think that the first true recession was the slump that hit England after the end of the Napoleonic Wars—in other words, the first recession occurred, as one would expect, in the first industrial nation. Nations that industrialized later also had to wait for their chance to share the recession experience. My colleague, the distinguished economic historian Peter Temin, tells me that the United States did not experience a true recession until the Panic of 1873. Moreover, he has produced evidence that between 1820 and 1860 there was a clear difference in the behavior of the U.S. and U.K. economies: America was still a “classical” economy in which financial contractions might reduce prices but had little effect on growth, while England was already beginning to look recognizably Keynesian.

And that brings us both to the reason why people in the business community think that Fischer’s book is relevant to current events, and to the reason why it is in fact not relevant at all.

Anyone who reads the business press knows that the mood these days is one of what-me-worry optimism. After six years of fairly steady growth with surprisingly quiescent inflation, every major newspaper and magazine has either suggested or flatly declared that the business cycle is dead—that the recession of 1990–1991 was the last such slump we will see for many years to come.

Nay-sayers like myself try to puncture this serenity by insisting that it ignores the lessons of history. It was not that long ago that George Bush got the boot because of the economy, stupid; we had a truly vicious recession in the early 1980s; and for that matter Mexico, Japan, and even Canada (remember them? they’re that country next to us) can attest that the nineties have by no means been always and everywhere as placid as the last few years in the United States. Moreover, we’ve been here before: Near the end of another long recovery, in the late 1960s, pronouncements that the business cycle was dead were just as prevalent as they are today.

Why does the business cycle persist? Because, as the bumper stickers don’t quite say, stuff happens: The world refuses to stay put, and policy is always playing catch-up. To look at the causes of booms and slumps since the last time the business cycle was declared dead is to be awed at the sheer variety of curve balls history manages to throw at us. Who in 1969 imagined that a recession could be triggered by a war in the Middle East—let alone a fundamentalist revolution in Iran? Who would have thought that the ever-so-controlled Japanese economy could be whipsawed by a financial bubble that drove land and stock prices to ridiculous levels, then burst? Who could have predicted that two well-meaning projects—the political unification of Germany, and the monetary unification of Europe—would interact to produce a disastrous slump? True, we learn from experience: The stock market crash of 1987 didn’t play like that of 1929, because this time Alan Greenspan knew what to do. But as fast as we learn to cope with old sources of boom and slump, new sources emerge.

Some people tell us that the forces that used to drive many recessions have abated: We are no longer as much of a manufacturing economy, inventories have become less of an “accelerator” of slumps, and so on. And they are surely right: We will not have the same problems in the future that we had in the past. We will have different problems. And because the problems are new, we will handle them badly, and the business cycle will endure.

But this is not a message business pundits want to hear; and for them Fischer’s book is the perfect answer. Of course, they can now say, the business cycle has been with us for the last 150 years—but the long view tells us that while instability is the norm while you are passing through a price revolution, it is smooth sailing once you pass through the crisis and reach the new “equilibrium.” And guess what—we have just arrived at the promised land.