Why Stagnation?

The question “Why Stagnation?” has a rather special significance for me. I started my graduate work in economics exactly fifty years ago this year. The cyclical downturn which began in 1929 was nearing the bottom. Unemployment in that year, according to government figures, was 23.6 percent of the labor force, and it reached its high point in 1933 at 24.9 percent. It remained in the double-digit range throughout the decade. Still, a recovery began in 1933, and it turned out to be the longest on record up to that time. Even at the top in 1937, however, the unemployment rate was still 14.3 percent, and it jumped up by the end of the year. That also happens to be the year I got my Ph.D. Can you imagine a set of circumstances better calculated to impress upon a young economist the idea that the fundamental economic problem was not cyclical ups and downs but secular stagnation?

In the wake of the sharp recession of 1937, a debate over the causes of stagnation began to spread in the economics profession. The two most prominent protagonists were Alvin Hansen and Joseph Schumpeter, Harvard’s top economists of the 1930s. Hansen’s position was best summed up in his 1938 book Full Recovery or Stagnation?, Schumpeter’s in the last chapter of his two-volume 1939 treatise on Business Cycles.

Schumpeter labeled Hansen’s theory the “theory of vanishing investment opportunities,” and it is an apt characterization. According to this theory, the modern developed capitalist economy has an enormous capacity to save, both because of its corporate structure and because of the very unequal distribution of personal income. But if adequate profitable investment opportunities are lacking, this saving potential translates not into real capital formation and sustained growth but into lowered income, mass unemployment, and chronic depression, a condition summed up in the term stagnation. (The framework of this analysis was of course derived directly from Keynes’s General Theory, which was published in 1936, and of which Hansen was the best known interpreter and champion on this side of the Atlantic.)

To complete the theory, what was needed was an explanation of why there should be such a dearth of investment opportunities in the 1930s as compared to earlier times. Hansen’s attempt to fill this gap ran in terms of what he considered to be certain irreversible historical changes which had begun to build up in earlier decades and finally came to dominate the scene after what Schumpeter called the “world crisis” began in 1929. To oversimplify somewhat, these changes, according to Hansen, were (1) the end of geographical expansion, sometimes put in terms of the “closing of the frontier” but interpreted by Hansen in a wider global sense; (2) a decline in the rate of population growth; and (3) a tendency on the part of new technologies to be less capital-using than in earlier stages of capitalist development. In Hansen’s view, all these changes operated to restrict the demand for new capital investment and in this way transformed the system’s great capacity to save into a stagnation-producing force rather than an engine of rapid growth.

Hansen’s critics, including Schumpeter, could see little merit in this theory. Not that they denied the necessity for healthy capital formation to sustain growth and high employment: they just couldn’t accept the argument that the changes Hansen pointed to were real, or if they were real that they would necessarily entail a weakening of the demand for new investment. The end of geographical expansion in the United States came in the late nineteenth century: Why should it begin to have such adverse economic effects three or four decades later? Population growth doesn’t necessarily stimulate investment: it can just as well mean more unemployment, doubling up in housing, a lower standard of living. And the alleged nature and effect of changes in technological innovation were unproved and, according to the critics, unprovable.

Opposed to Hansen’s theory, Schumpeter put forward another one which he posed in a somewhat different way. Instead of asking what caused the stagnation of the 1930s, he asked why the cyclical upswing which began in 1933 came to an end so far short of what he and others had always assumed to be the “normal” situation at the end of the prosperity phase of the cycle—full employment, rising prices, tight credit, etc. Some of you will remember that Schumpeter classified economic cycles into three types, each named after an earlier investigator of these phenomena: “Kitchins” (very short, basically inventory cycles); “Juglars” (what most writers think of as the business cycle); and “Kondratieffs” (a supposed cycle of some fifty years duration, the reality of which Schumpeter believed in). The experience of the 1930s he described as “the disappointing Juglar.” Why?

Rejecting Hansen’s theory of vanishing investment opportunities, Schumpeter blamed the anti-business climate of the period—a climate, incidentally, which he thought was an inevitable byproduct of capitalist development. In a sense this might be called the “New Deal theory of stagnation,” and in one form or another it was shared by most political conservatives. But Schumpeter, as was his wont, gave it a special twist: for him the heart of the matter was not so much the content of New Deal legislation—which he recognized as being compatible with the normal functioning of capitalism—as the personnel who administered the legislation and what he considered the anti-business spirit in which they acted. These, he believed, had a dampening, repressive effect on entrepreneurs’ confidence and optimism, blighting their hopes for the future and inhibiting their investment activities in the present.

It was of course no accident that this debate over stagnation flourished in the aftermath of the sharp cyclical decline of 1937–38. Prior to that it seemed reasonable to hope that the long upswing that began in 1933 would continue to capacity production and full employment. The downturn therefore came as a rude shock. With the unemployment rate jumping up to 19 percent in 1938 and remaining over 17 percent in 1939, the grim reality of stagnation could no longer be denied. Hansen’s 1938 book and Schumpeter’s response of the next year were only the highlights of what gave every sign of becoming one of the classic controversies in the history of economic thought. Nor was it only economists who were involved: Franklin Delano Roosevelt, his once hopeful New Deal blighted by a new and unexpected economic calamity, appointed a high-level Temporary National Economic Committee (TNEC) to find out what went wrong and what could be done about it. But before the TNEC could even begin to report its (ultimately very meager) findings, the Second World War came along. Overnight the whole subject of stagnation dropped out of sight, never to be revived.

After the war, in 1952, one serious and important study of the subject was published in England, Maturity and Stagnation in American Capitalism, by Josef Steindl, an Austrian refugee who had spent the war years at the Oxford Institute of Statistics. But it was ignored by the economics profession, and the long period of postwar capitalist expansion, which was under way by the time the book appeared, seemed to have relegated the whole “problematic” of stagnation to the realm of historical curiosities.

More recent events, however, have shown that the burial of stagnation was, to say the least, premature. I hardly need to remind you that by the mid-1970s the problem was back again, this time with a new twist reflected in a new name, “stagflation.” Just when it reappeared could be the subject of debate. Perhaps it was the late 1950s, with the Vietnam War acting as a temporary postponing factor. Perhaps it was the early 1970s, following the Penn-Central credit crunch and Nixon’s formal abandonment of the gold standard and brief experiment with wage and price controls. Or perhaps the real return of stagnation should be dated from the recession of 1974–75. In any case the second half of the 1970s displayed the phenomenon in its new form of stagflation for all to see. And there can be little doubt that it has been getting worse since then, as two sets of facts eloquently testify. First, unemployment in the advanced capitalist world (24 OECD countries) is expected to reach 30 million this year, a rate of around 10 percent of the total labor force (with figures much higher of course for women, young people, and minorities). Second, in the United States there have been two recessions in successive years, with the present one quite possibly degenerating into a full-scale depression. (This is not to suggest that those who are expecting or predicting an upturn in the near future are necessarily wrong. There was a brief upturn in 1930 and of course the long recovery already alluded to from 1933 to 1937: indeed ups and downs around the trend, which itself may be up or down, are always not only possible but inevitable.)

I do not pretend to keep up with the latest economic literature as it appears, but it is my impression that the economics profession has not yet begun to resume the debate over stagnation which was so abruptly interrupted by the outbreak of the Second World War. I have the feeling that if you ask an economist how we got into the mess we are in, he or she, while not denying that it is indeed a mess, will reply by giving advice as to how to get out of it but will not have anything very enlightening to say about how we got into it. Leonard Silk, the well-informed, middle-of-the-road economics editor of the New York Times is a good example. In many of his columns lately he has been emphasizing the precariousness of the present economic situation, criticizing the policies of the Reagan administration and suggesting ways to do better. In one such column—in the “Business” section of the Sunday paper for March 14th—he even included a considerable amount of background material, centering on five charts dating to 1965, showing that the roots of the problem go back a long way. The headline on the piece is interesting: “What’s Happening Is Not a Depression. It’s a Chronic State of Unemployment and Industrial Slack. The Government Caused It.” At first glance this might seem to be both a description of stagnation and an explanation of it. But if you read the article, you won’t find much in the way of explanation. This is hardly surprising since there have been five different administrations since 1965 with a variety of ideologies and policies, and it would seem a priori rather unlikely that one would be able to distill out of the whole experience an entity deserving the name “the” government on which to place the blame. Nor does Leonard Silk really try to do so. One rather suspects that some harried editor wrote the headline without reading the article too carefully.

So we still have the question: “Why Stagnation?” It was raised and then dropped without any satisfactory answer in the 1930s. Reality is now posing it again. I think it is time to accept the challenge and resume the search for an answer.

I think we will do well if we begin where Hansen began in the 1930s. The structure of the economy in both its corporate and its individual dimensions is basically the same as it was a half century ago. Its saving potential is still enormous, and what changes have taken place have tended to make it greater rather than smaller in the intervening period. Corporate concentration has increased, and the distribution of individual incomes remains highly unequal. Moreover, changes in the tax structure have been more and more favorable to the corporations and the rich. As always under such conditions, a strong and sustained investment performance is needed to prevent the economy from falling into stagnation. And that is precisely what has been missing for a long time now, and especially in the last few years. So the immediate cause of stagnation is the same now as it was in the 1930s—a strong propensity to save and a weak propensity to invest.

Let me digress for a moment to point out that the fact that the overall performance of the economy in recent years has not been much worse than it actually has been, or as bad as it was in the 1930s, is largely owing to three causes: (1) the much greater role of government spending and government deficits; (2) the enormous growth of consumer debt, including residential mortgage debt, especially during the 1970s; and (3) the ballooning of the financial sector of the economy which, apart from the growth of debt as such, includes an explosion of all kinds of speculation, old and new, which in turn generates more than a mere trickledown of purchasing power into the “real” economy, mostly in the form of increased demand for luxury goods. These are important forces counteracting stagnation as long as they last, but there is always the danger that if carried too far they will erupt in an old-fashioned panic of a kind we haven’t seen since the 1929–33 period.

So at bottom we are back where the debate of the 1930s left off: Why is the incentive to invest so weak? Hansen’s answers are, I think, a good deal less, not more, persuasive today than they were when he first advanced them. And surely no one can follow the Schumpeter line of blaming anti-business policies for discouraging capitalists from investing in the years since the Second World War, least of all with an administration in power like the one we now have in Washington. We must look elsewhere.

I suggest that the answer is to be found in analyzing the long period—twenty-five years or so—which followed the Second World War, during which we did not have a problem of stagnation. In fact during that time the incentive to invest was strong and sustained, and the growth record of the economy was perhaps the best for any comparable period in the history of capitalism. Why?

The reason, I think, is that the war altered the givens of the world economic situation in ways that enormously strengthened the incentive to invest. I list in very summary form the main factors: (1) the need to make good wartime damage; (2) the existence of a vast potential demand for goods and services the production of which had been eliminated or greatly reduced during the war (houses, automobiles, appliances, etc.): a huge pool of purchasing power accumulated during the war by firms and individuals which could be used to transform potential demand into effective demand; (3) the establishment of U.S. global hegemony as a result of the war: the U.S. dollar became the basis of the international monetary system, prewar trade and currency blocs were dismantled, and the conditions for relatively free capital movements were created—all of which served to fuel an enormous expansion of international trade; (4) civilian spin-offs from military technology, especially electronics and jet planes; and (5) the building up by the United States of a huge peacetime armaments industry, spurred on by major regional wars in Korea and Indochina. Very important but often overlooked is the fact that these changes were in due course reflected in a fundamental change in the business climate. The pessimism and caution left over from the 1930s were not dissipated immediately, but when it became clear that the postwar boom had much deeper roots than merely repairing the damages and losses of the war itself, the mood changed into one of long-term optimism. A great investment boom in all the essential industries of a modern capitalist society was triggered: steel, autos, energy, ship-building, heavy chemicals, and many more. Capacity was built up rapidly in all the leading capitalist countries and in a few of the more advanced countries of the third world like Mexico, Brazil, India, and South Korea.

In tracing the causes of the re-emergence of stagnation in the 1970s, the crucial point to keep in mind is that every one of the forces which powered the long postwar expansion was, and was bound to be, self-limiting. This indeed is part of the very nature of investment: it not only responds to a demand, it also satisfies the demand. Wartime damage was repaired. Demand deferred during the war was satisfied. The process of building up new industries (including a peacetime arms industry) requires a lot more investment than maintaining them. Expanding industrial capacity always ends up by creating overcapacity.

To put the point differently: a strong incentive to invest produces a burst of investment which in turn undermines the incentive to invest. This is the secret of the long postwar boom and of the return of stagnation in the 1970s. As the boom began to peter out, stagnation was fought off for some years by more and more debt creation, both national and international, more and more frantic speculation, more and more inflation. By now these palliatives have become more harmful than helpful, and to the problem of stagnation has been added that of a rapidly deteriorating financial situation.

Does this mean that I am arguing or implying that stagnation has become a permanent state of affairs? Not at all. Some people—I think it would be fair to include Hansen in this category—thought that the stagnation of the 1930s was here to stay and that it could be overcome only by basic changes in the structure of the advanced capitalist economies. But, as experience demonstrated, they were wrong, and a similar argument today could also prove wrong. I do not myself believe that a new war could have the same consequences as it did last time (or as it did on a lesser scale after the First World War). If a new war were big enough to have a major impact on the economy, it would probably become a nuclear war, after which there might be little left to rebuild. But no one can say for sure that there will never be other new powerful stimuli to investment, such, for example, as were provided by the industrial revolution, the railroad, and the automobile in earlier times. What one can say, I think, is that nothing like that is visible on the horizon now. For those who understand this, the lesson is clear enough: rather than wait around for a miracle (or an irretrievable disaster), it is high time to dedicate our thoughts and energies to replacing the present economic system with one which operates to satisfy human needs and not as a mere byproduct of the presence or absence of investment opportunities attractive to a relative handful of socially irresponsible capitalists.

Let me close with a few remarks about the relevance of the foregoing analysis to a subject to which economists have been devoting increasing attention in the last few years, i.e., whether or not the history of capitalism has been characterized by a long cycle of some fifty years’ duration (what Schumpeter called the Kondratieff cycle). First, we should be clear that the issue here is not whether capitalist development takes place in an uneven fashion with periods of rapid expansion being succeeded by periods of slow (or even no) expansion and vice versa—what have often been referred to as long waves. The empirical existence of long waves in this sense is undeniable, and the ingenuity of statisticians operating with an almost infinite variety of possible statistical sources can be counted on to make out a case for a time sequence of accelerated and retarded growth rates compatible with the existence of an underlying cyclical mechanism.

But compatibility with the existence of a cyclical mechanism is entirely different from proof of the existence of such a mechanism. The reason for our acceptance of the idea that relatively short cycles exist (i.e., cycles of less than ten years’ duration, Schumpeter’s Kitchin and Juglar cycles) is that the mechanisms at work can be elucidated analytically as well as verified empirically. The important point is to be able to demonstrate that the two basic phases of the cycle, expansion and contraction, can each be shown to contain the seeds of its opposite. This principle lies at the core of all modern business-cycle theories. To quote what was long a standard textbook on the subject:

Business cycles consist of recurring alternations of expansion and contraction in aggregate economic activity….The economy seems to be incapable of remaining on an even keel, and periods of expanding activity always and all too soon give way to declining production and employment. Further, and this is the essence of the problem, each upswing or downswing is self-reinforcing. It feeds on itself and creates further movement in the same direction; once begun, it persists in a given direction until forces accumulate to reverse the direction. (Robert A. Gordon, Business Fluctuations, New York, 1952, p. 214)

The key phrase is “until forces accumulate to reverse the direction.” This occurs in both the expansion and the contraction phases of the normal business cycle, but the symmetry breaks down when it comes to long waves. As we have already noted in the case of the long expansion following the Second World War, the reversal does indeed take place: it is the nature of an investment boom to exhaust itself. But it is equally clear from the experiences of the 1930s and the 1970s that the stagnation phase of a long wave does not generate any “forces of reversal.” If and when such forces do emerge, they originate not in the internal logic of the economy but in the larger historical context within which the economy functions. It was the Second World War that brought the stagnation of the 1930s to an end. We still do not know what will bring the stagnation of the 1970s and 1980s to an end—or what kind of an end it will be.