Theories Developing in Conditions of War and Depression

The period between 1914 and 1945 marks years of turmoil in European history. Two world wars and the greatest economic crisis ever seen fit into this period. Borders in Europe changed.

Capitalism is also evolving along with the historical processes experienced. However, with the Bolshevik Revolution that took place during World War I, a system began to form against capitalism. Against capitalism, which was accepted to have been born scientifically in 1776 and developed afterwards, a system that went beyond the dimension of ideas and developed as an alternative was established for the first time.

Economics, in its scientific development explained in previous articles, changes the subjects it focuses on and analyzes according to the changing conditions over the years. Theory develops according to the conditions it lives in and tries to provide explanations for what is happening.

The production relations redefined by the 2nd Industrial Revolution increased the need and importance of capital. While it was important to own land and natural resources before the 1st Industrial Revolution, the concept that the 2nd Industrial Revolution brought to the forefront was capital.

The prominence of capital and the chaotic process experienced from the beginning to the middle of the 20th century brought about the intensive analysis of cyclical fluctuations in economic literature and the development of theory in this direction. The crises of 1873, 1907, and 1929, as well as the wars that occurred, resulted in capital constantly changing hands and geographies and left effects on the economies it reached and left. The variables on which these effects emerged and in what periods were reflected in the production of cyclical fluctuation theories in economics.

The importance of Europe from an academic perspective shifted to the United States, especially during World War II, when academics who fled from Europe to the United States continued their studies at American universities. By the 1940s, the center of gravity of academic studies was now in the United States.

Wassily Leontief (1906-1999) was a Russian who fled from St. Petersburg to Berlin and then to Harvard University. He tried to simplify Walras's general equilibrium analysis and tried to transfer the theory to the real economy. He laid the foundations for the studies that followed him with his input-output analyses, which are known in economic literature as the Leontief Matrix.

Joseph Alois Schumpeter places the entrepreneur at the center of the capitalist development process in his work "The Theory of Economic Development" published in 1912. His work covers a wider area than Leontief's input-output analysis.

Schumpeter explains that entrepreneurs are responsible for issues that imply innovation and increased efficiency in the economy, such as the production of new products, the creation of new supply sources, and the discovery of new production methods. He says that every innovation stimulates the existing balance and creates new profit opportunities. He explains that over time, the profit margin of the entrepreneur who created the innovation narrows as imitators come into play, and that a new balance point is reached in the economy when another entrepreneur creates an innovation. Within the framework of these ideas, he became interested in cyclical fluctuations in the 1930s and published his work Business Cycles in 1939.

Schumpeter's work "Business Cycles" received heavy criticism from Simon Kuznets (1901-1985), who was also interested in cyclical fluctuations. After the 1929 Depression, economic literature was heavily influenced by Keynes. Schumpeter's book would not be remembered as a very popular work during the period when the majority of people worked on Keynes' theory. However, the effects of his work "Capitalism, Socialism and Democracy (1943)" on economic literature would be extremely important. In a successful capitalist process, as Marx claimed, there would be no need for the working class to revolt. Because, with the work of the capitalist process, the working class's level of welfare would increase and there would be no need for it to revolt. However, according to Schumpeter, capitalism is a system that is constantly in motion and periodically destroys itself. However, this destruction will be the basis for re-creation. This process is called creative destruction. In summary, according to Schumpeter, capitalism represents a process that is constantly rising from its own ashes.

In the 1940s, the USA took control of economic literature. However, a group of academics in Cambridge were working on competition theory. Some of these academics were Piero Sraffa (1898-1983), Joan Robinson (1902-1983). They criticized Marshall. Sraffa also made a criticism that destroyed Neoclassical Economics. Germany, on the other hand, developed the theory of oligopoly with names such as Heinrich von Stackelberg (1904-1946) and Frederik Zeuthen.

Austria also made important contributions to studies on cyclical fluctuations. Ludwig von Mises (1881-1973) and Friedrich von Hayek (1899-1992) put forward important views on the development of capitalism with their views built on the cumulative process theory of Swedish Knut Wicksell. They particularly focused on Wicksell's concept of the natural interest rate. They stated that if the credit interest rate, which Wicksell defined as the monetary interest rate, was kept lower than the natural interest rate, a significant inflationary process would occur and the resource allocation in the economy would change. Because, they thought that entrepreneurs would invest in capital-intensive production processes due to the monetary interest rate being lower than the natural interest rate. They suggested that it would take a very long time to start earning returns from these investments by investing in capital-intensive production. They stated that in this case, the prices of capital goods would increase at a higher rate than the prices of consumer goods. Under these conditions, the economy's resources would be directed towards capital goods, but the return on capital goods would only come into play at the end of a long process, and there would be no point in postponing consumption demand for the consumer. This would bring about a significant increase in consumption expenditures and, as a result, a rise in prices.

Credit expansion would stop at some point. At the point where credit expansion stopped, interest rate increases would come to the agenda. Because the economy's resources would be used in capital-intensive investments and resources for investments would be consumed. An increase in interest rates would result in a slowdown in production and unemployment. These conditions would make capital-intensive investments, which were made during the period when the monetary interest rate was low and whose returns would be in question in the long term, unprofitable. The closure of capital-intensive investments that became unprofitable would come to the agenda.

Mises and Hayek’s assumptions may not make much sense when considering today’s conditions. However, economic theories should be evaluated under the conditions in which they were born. During the period when Mises and Hayek put forward their views, Germany was experiencing hyperinflationary conditions and the US economy collapsed as a result of a massive credit expansion. In the current period, capital is important and the tendency to invest in capital-intensive production is strong. Just as land and natural resources were of great importance during the First Industrial Revolution, and today knowledge and information-based technologies are of great importance, capital is also very important in that chaotic period of the 20th century.

Mises and Hayek were against the use of expansionary monetary policy. They thought that even under the conditions of the 1929 Depression, interest rates should be left alone rather than reduced. Production would automatically adjust to conditions where the money supply was not increased.

Mises and Hayek were being opposed from Stockholm. Erik Lindahl (1891-1960), Erik Lundberg (1907-1989), Gunnar Myrdal (1898-1987) and Bertil Ohlin (1899-1979) looked at Wicksell's theory from a completely different perspective. They criticized the Austrian School's perspective that saw the natural rate of interest as the productivity of capital. According to them, it was not possible to technically define the productivity of capital. Their approach was close to Irving Fisher's approach that saw capital as the value of future income streams. Therefore, future expectations determined the demand for credit. Their theories left some open-ended questions. On the other hand, they suggested the use of both monetary and fiscal policies together against economic crises.

We can say that behind the characterization of economics as theoretical lies the disregard for the comparison of today's conditions and the conditions of the period in which theories emerged. I think it is true that theories describe what has already happened and have difficulty shedding light on the future, and therefore economics has a vision problem, but the claim that theories are far from practice is not true. What needs to be done is to understand well under what conditions theories emerged in practice.

Source: https://www.economist.com/charlemagne/2014/07/25/the-war-and-the-panic?utm_medium=cpc.adword.pd&utm_source=google&ppccampaignID=18151738051&ppcadID=&utm_campaign=a.22brand_pmax&utm_content=conversion.direct-response.anonymous&gad_source=1&gclid=Cj0KCQiA0MG5BhD1ARIsAEcZtwSi88rARCJN3c0RhuTqvwr9D4K6xF-1Exbbdo_Wg0SBYzqaWVnDDW0aAh01EALw_wcB&gclsrc=aw.ds