Posted by: Dirk | July 17, 2014

Wicksell (1898) on financial crises

Knut Wicksell in his 1898 [1936] Interest and Prices discusses financial booms and busts over some pages in chapter 7 (87-101). He discusses three possible mechanisms which can lead to a rise in prices of capital goods. These are always discussed as changes in relative prices given some level of loan demand. The section name is a hint: B. Simplest Hypothesis. Variations of the Rate of Interest when the Market Situation Remains otherwise Unaltered. On page 92 he writes:

If railway companies could issue debentures at 3 per cent, instead of 4 per cent., they would be able, ceteris paribus, to pay almost 33.1/3 per cent, more for all their requirements: 4 per cent, on 100 million marks comes to the same thing as 3 per cent on 133.1/3 million marks.

A fall in the interest rate thus has an effect on some goods prices, those that are used as inputs in the production of railways and railway equipment. Prices of inputs, land rents and wages go up, but so does the price of whatever the entrepreneur produces. So, the entrepreneur will pay more and more for his inputs since the rising prices given some interest rate increase his profits. As long as the interest rate remains at its level, prices move up cumulatively. This is classic Wicksell, only price effects at work and no changes in demand or supply. This whole episode reminds me a bit of Tobin’s q. However, Wicksell does not assume that changes in relative prices cause any quantity adjustments, as Tobin said. Wicksell continues to discuss house prices and expectations (p. 96):

An abnormally large amount of investment will now probably be devoted to durable goods. There may result a relative over- production of such things as houses and a relative under-production of other commodities. […]

We may go further. The upward movement of prices will in some measure “create its own draught”. When prices have been rising steadily for some time, entrepreneurs will begin to reckon on the basis not merely of the prices already attained, but of a further rise in prices. The effect on supply and demand is clearly the same as that of a corresponding easing of credit.

The second paragraph clearly is about expectations. Wicksell notes that the effect of expectations of rising house prices have the same effect on the market as ‘a corresponding easing of credit’. This is especially interesting in the European context, where real estate bubbles had developed in some countries (Spain, Ireland) but not in others. Finally, on page 97/98, Wicksell takes on speculation:

The matter takes on an entirely different aspect in the case where the market is under the influence of speculation proper. Goods are now bought, not merely to be passed on to other producers and to be distributed to consumers by the normal methods, but to be hastily disposed of to other speculators. The time element, which normally plays a decisive part, now ceases to be of any great significance; and it becomes impossible to make even the roughest kind of estimate of the probable rise in prices. Insecure sentiment governs the market; as prices continue to soar and profits are easily earned, the movement may rapidly reach fever-point. There is almost no limit to the rise in prices in spite of the fact that credit becomes more and more expensive. But when prices ultimately come to rest, and the prospect of further profits disappears, the credit position is so strained and the rate of interest is so high as immediately to bring about a contrary movement, which proceeding in analogous fashion may rapidly drag down prices even below their normal level.

The idea that prices are overshooting in the boom and undershooting in the bust phase of the business cycle is widely understood today, of course. Nevertheless, Wicksell’s 1898 monograph might still be a good starting point for those interested in interest and prices and other things macroeconomic, like endogenous money.

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