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Home , Carl Menger, Irving Fisher, Joseph Schumpeter, Knut Wicksell

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FEDERAL RESERVE BANK OF DALLAS VOLUME 9, NUMBER 1 The Birth of Modern

For many years, the Federal Reserve Johan Gustav Knut Wicksell was born in 1851 in . His mother has used influence on short-term rates died when he was 6, and his father, a to contain inflationary pressure in the Amer- moderately successful businessman and real estate , died when Knut ican and promote growth and was 15. His father’s estate provided suf- . The genesis of this approach and ficient funds for him to enroll at the University of Uppsala in 1869, where its theoretical foundation both lie in the work he studied mathematics and physics. of Knut Wicksell, one of the 20th century’s Within two years, he had taken his first degree and gone on to graduate work. more colorful and eclectic . He passed two of the three required Wicksell was a free thinker, a lifelong examinations for a doctorate in mathe- matics in 1875 but waited until 1885 to socialist, a mentor to several justifiably finish the third. By then, Wicksell had , Lund, famous Swedish economists who followed become a well-known social critic and lecturer, and his had changed him, and one of the most influential econo- to the social sciences, and to econom- mists of his time. His ongoing exchanges over ics in particular. Early in his life, Wicksell had stud- Knut Wicksell the role of in generating changes in ied the Bible at great length and even —a dispute in which he and American contemplated a religious calling. But as resulted in much publicity for Wicksell, he read social science tracts in college, who used his notoriety to earn a mea- were the central including George Drysdale’s influential ger living by speaking publicly, then players—predated the mid-20th century The Elements of Social Science, his call- writing his speeches for publication. ing as a social scientist became clear. In 1885, funded by the sale of clash between Keynesian and monetarist His interests turned to controversial top- some family-owned properties, Wicksell views of cycles and correct ics such as human sexuality and birth was able to spend a year in London control, discussed at length in Drys- reading the major works of the classical stabilization policy. dale’s essentially Malthusian tome.1 economists. During his stay, a small, For those interested in the early work In 1880, Wicksell gave his first obscure foundation—the Victor Lorén public address on such a topic at Foundation—awarded him a three- done on the , the Uppsala. The lecture was titled “The year grant to study in relationship between interest rates, money, Most Common Causes of Habitual Germany and . Although the Drunkenness and How to Remove Lorén will was contested, it was settled prices and real factors, and the ways in which Them.” At the time, the ideas Wicksell in Wicksell’s favor in 1887, and he they might affect the macro economy, we offer expressed in this lecture about the rela- received the promised funds. Had it tionship between worker alienation, not been for this grant, Wicksell might you this issue of Economic Insights. poverty, and the social ills of alcohol well not have become an economist. and prostitution were considered radi- — Bob McTeer In , Wicksell heard lectures President cal, even socialist. The controversial by Austrian economist . He Federal Reserve Bank of Dallas nature of this and subsequent lectures also attended lectures at the Univer- Finance, published in 1896, was a Is Money a Commodity? groundbreaking application of margi- Money’s and nal thinking to such issues as progres- In passing, there is a point to be noticed. sive taxation, optimum tax prices for The growth in the use of money, and the in- public and semipublic , public All practical proposals for the improve- ment of systems actually proceed, crease in monetary stocks, tends more and more and characterized by to reduce the significance of the commodity though more or less consciously, from the cartel behavior. Interest and Prices, a desire to guarantee this stability of value. When characteristics of money. On the other hand, work on , was pub- the development of the monetary system re- it is said that Governments or banks should lished in 1898. sults in a displacement of specie by credit in- seek to provide enough money of full value, or struments and so-called money substitutes, and On the strength of his published a monetary system at once sound and flexible, there exists, therefore, an important tendency economic work, Wicksell applied to the all that is really meant is that the value of towards a strengthening of the commodity University of Uppsala for a doctorate in money should be protected against violent fluc- aspect of money and of its influence on prices. economics. One was finally granted, with tuations, either downwards in the form of the It is sometimes said to be feasible to base honors, in 1896. He was still denied an depreciation of money or upwards in the form a monetary system upon gold and yet to dis- economics professorship, however, be- of a fall in commodity prices: this includes a pense entirely, or almost entirely, with the cause at that time in Sweden economics demand for the preservation of the stability of value of money in space, i.e. the maintenance employment of gold both in circulation and in was taught in law school, and Wicksell the banks’ reserves. This would be done by of the currency unit of one country at the same lacked a law degree. So he borrowed level as that of another. extending the use of cheques, by the issue of money and moved his family to Uppsala, notes of which the cover is of a purely banking Sometimes, it is true, we hear it said that where he finished the four-year law nature, and so on. This view, which is held by certain changes in the value of money, espe- some of the most prominent writers on mone- degree in two years. He became a lec- cially a gradual decline or a progressive rise in tary questions, must be regarded as utopian. In turer at the University of Uppsala, but commodity prices, might be preferred under such a system the value of money would be his income there depended solely on certain circumstances to complete stability. directly exposed to the effects of every fortu- the number of students who took his Rising prices would act as a stimulus to enter- itous incident on the side of the production of tutorials. In 1900, at the age of 49, he prise and a falling value of money would free the precious metal and every caprice on the finally received a teaching position in debtors from the burden of obligations side of its . It would undergo the economics at the University of Lund, thoughtlessly incurred. This view is, however, evidently naïve. It need only be said that if this same violent fluctuations as do the values of although the position was not fully most other commodities. fall in the value of money is the result of our funded until 1904. own deliberate policy, or indeed can be antici- But it would be quite possible to maintain University life was productive for a stable value of money without the use of pated and foreseen, then these supposed ben- Wicksell. In addition to teaching classes reserves of a precious metal. Only it would be eficial effects will never occur, since the necessary for the metal to cease to serve as a in tax , he wrote approaching rise in prices will be taken into Lectures on (volumes account in all transactions by reasonably intel- standard of value. I 1 and 2, 1901 and 1906) and numerous ligent people. What is contemplated is, there- —Interest and Prices, 34–35; articles on pre– and post– fore, unforeseen rises in price. The result of original emphasis policy issues. He favored a mild form of this would seem to be that we should cross our , achieved gradually and built arms and wait in order not to frustrate the ben- eficial workings of nature. But nature does not sities of Strassburg, Berlin and Paris. He on the foundations of a . always guarantee rising prices; falling prices Sweden came to represent precisely this then returned to Sweden, but his radi- also occur. cal reputation prevented him from get- vision as the 20th century unfolded. I ting a position at the University of In 1908, in a stand for free speech —Lectures on Political Economy, Stockholm. and against the advice of friends, he gave vol. 2, 128–29; In the summer of 1887, Wicksell a lecture that satirized the Immaculate original emphasis took a common-law wife, Anna Bugge. Conception. The lecture, which Wicksell By 1893, he had two sons but still no intended as a test case, resulted in a later became famous in their own right, permanent position with which to sup- two-month jail sentence. He served the such as and joint Nobel port his family. During the 1890s, his term in 1910 after a lower court’s deci- Prize winner (with F. A. Hayek) Gun- work in economics—some of it path- sion was upheld on appeal. nar Myrdal. He died in Stockholm in breaking, such as Value, and After retiring from Lund in 1916, May 1926 while working on an article Rent (1892), his first major work— Wicksell and his wife moved to Stock- on the theory of interest that was to be went largely unnoticed. But his radical holm, where he continued to write pro- included in a book honoring Austrian speeches continued to earn him fusely and advise the government on economist . another sort of notice. banking and financial issues. He also Many of Wicksell’s theoretical Wicksell’s second major economic supervised doctoral dissertations in extensions went unrecognized during work, Studies in the Theory of , often for students who his lifetime. It was only after his death

tween Wicksell and the Austrians is Emergence of the Modern Theory of Value: Marginal straightforward: In the Austrian busi- ness cycle theory, a boom emerges In other words, the value in use, according to [John Stuart] Mill, constitutes the upper limit of when the is value in exchange. But on further consideration it appears that the value in exchange cannot be lower higher than the rate, which is than the value in use either, for exchange presupposes two exchanging parties, and while no one will subject to manipulations by humans buy a commodity which has a value in exchange higher than its value in use, no one will sell a com- using sophisticated financial institu- modity whose exchange value is lower. We thus seem to arrive at the remarkable result that value in tions and credit instruments that drive use is, at one and the same time, the upper and the lower limit of exchange value; or, in other words, the market rate below the natural, equi- is its exact equivalent. This, however, is contrary to experience; neither is it easy to understand how, under such circumstances, any exchanges whatever could be effected. The obvious explanation is the librium rate. well-known fact that the same thing may possess different degrees of utility for different persons, so This is Wicksell’s “cumulative pro- that the relative values in use can, at the same moment, be greater or less than the relative exchange cess” model of business cycles. When values for one or other of the exchanging parties respectively. If we follow up this train of thought, we the loan (market) rate of interest is be- shall easily see that a thing may have quite different degrees of utility for one and the same person low the natural rate, the demand for under different conditions. The most important circumstance in this connection is evidently, at least in loans by entrepreneurs exceeds the a primitive economy, the quantity of the commodity in one’s possession—or of other commodities quantity of in the economy. which can, to a greater or lesser degree, replace it. In a more advanced economy, the determining con- Banks expand credit by creating check- dition will be the possession, or accessibility, of a certain quantity of the …. But ing accounts (demand deposits) rather what sets the standard in both cases is, in the last resort, the quantities of the various commodities than by supplying savings, and an eco- which the person in question is in a position to consume in a given unit of time. nomic expansion occurs that must, other Value in use is, therefore, by its very nature, something variable. Value in exchange, on the con- trary, is always, or always tends to be, constant and invariable for each commodity throughout the mar- things being equal, drive up prices. Al- ket. The question then becomes: which of these possible, or conceivable, degrees of value in use deter- though Wicksell’s process does not de- mines (or, to express ourselves more cautiously, is related to) the actual exchange value of the mand a monetary change to begin, it is commodity? The answer must evidently be: the degree of utility which it possesses for the exchanging perfectly consistent with—and this is parties at the moment the exchange is effected…. I what the Austrians later emphasized— a lowering of the market —Lectures on Political Economy, vol. 1, 29–30; original emphasis through monetary injec- tions. and Hayek took that his major works were translated “integrating general equilibrium theory Wicksell’s cumulative cycle process and appreciated, leading Mark Blaug, [learned from Leon Walras], the Aus- much further.3 They combined it with one of the foremost historians of eco- trian theory of capital [learned from the doctrine of forced savings to create nomic thought, to proclaim that Wick- Eugen von Böhm-Bawerk’s 1884 classic a monetary theory of cycles in which sell “more or less founded modern Capital and Interest: History and Cri- the money interest rate divergence ” (Blaug 1986, 274). tique of Interest Theories] and interest, from the natural rate, generated by and the marginal theory of expansionary central bank policy or by Major Contributions to Economics income distribution [learned from David an unanticipated inflow of gold specie Wicksell’s work is linked directly to Ricardo’s 1817 treatise On the Princi- working its way through the banking three major traditions in economic the- ples of Political Economy and Tax- system, creates a distortion in the time ory: ation].” While working on his grand structure of production between capital • the quantity theory of money and synthesis of these three theoretical ap- goods and consumer goods that cannot its implications for allowing an proaches, Wicksell made improvements be maintained. This results in a neces- analysis of aggregate macro out- to each for which he is remembered sary economic downturn during which comes as well as their appropri- today. The most important is probably all of the boom’s “malinvestments” ate monetary policies; his distinction between the natural and have to be liquidated. The Austrians’ • the Austrian theory of business money rates of interest.2 extension of Wicksell’s analysis was the cycles, which uses Wicksell’s con- The money, or market, rate of in- major theory cept of a natural rate of interest; terest is the observed rate at which banks before wrote • and the modern pa- carry on credit transactions. The natural The General Theory of Employment, radigm in public finance, which rate is a bit more complicated. Wicksell Interest and Money in 1936, and it re- is based on Wicksell’s conten- variously defined it as the rate that is mains an alternative money-generated tions regarding interest groups in neutral for commodity prices and the cycle theory today.4 . rate at which the for Understood within the context of According to Blaug (1986, 272), capital are in equilibrium in an economy Wicksell’s model, the interest rate di- Wicksell’s work was an attempt at not using money at all. The tie-in be- vergence phenomenon was crucial for

understanding the differences between gained at others’ expense. His policy Humphrey, Thomas M. (1993), “The Origins Wicksell’s treatment of the quantity rule was simple: If prices were rising, of Velocity Functions,” Federal Reserve Bank theory of money and the view held by then interest rates were too low; if of Richmond Economic Quarterly, vol. 79, his main rival, American economist prices were falling, then rates were too no. 4 (Fall), 1–17. Irving Fisher. For Fisher, changes in the high. His exposition and extension of quantity of money fully explained the quantity and marginal productivity ——— (1997), “Fisher and Wicksell on the changes in long-run prices; for theories ensure him a permanent place Quantity Theory,” Federal Reserve Bank of Wicksell, the quantity of money was in the development of modern macro- Richmond Economic Quarterly, vol. 83, but one aspect of the mechanism that economic thought. I no. 4 (Fall), 71–90. changed prices because the flow of worked its way — Robert L. Formaini ——— (2002), “Knut Wicksell and Gustav through the economy by first changing Senior Economist Cassel on the Cumulative Process and the interest rates. Price-Stabilizing Policy Rule,” Federal Keynes no doubt read and appre- Reserve Bank of Richmond Economic ciated Wicksell’s approach and then Notes Quarterly, vol. 88, no. 3 (Summer), 59–83. built on it, stressing that cycles were 1 (1766–1834) authored generated by changes in real factors his famous “An Essay on the Principle of Laidler, David (1991), The Golden Age of such as spending and inter- Population” in 1798. In this essay, Malthus the Quantity Theory: The Development of est rates and not by monetary changes. argued that population growth is limited by Neoclassical Monetary Economics, The seeds of the Keynesian–monetarist the supply of food and that because popula- 1870–1914 (Princeton, N.J.: Princeton debates that began in the 1960s were tion grows faster (geometrically) than the University Press). planted first in the differences between food supply (arithmetically), poverty is not a Fisher and Wicksell. Nonetheless—and curable but an inevitable, long-run condition. Uhr, C. G. (1987), “Johan Gustav Knut surprisingly—despite Fisher’s and Wick- Because social reformers’ schemes to better Wicksell,” in The New Palgrave: A Dictionary sell’s seemingly disparate theoretical ap- the lot of humanity seemed to run aground of Economics, ed. John Eatwell, Murray proaches, both men reached the same on Malthus’ dreary predictions about starva- Milgate and Peter Newman, vol. 4 (London: implied policy conclusion: A nation’s tion and poverty, all such reformers, includ- Macmillan Press), 901–8. central bank does bear the responsibility ing Wicksell, had to effectively deal with for controlling the long-run .5 Malthus’ pessimistic contention in their own Wicksell, Knut (1965), Interest and Prices Another important Wicksell theo- work. Today, those who hold the view that (New York: Augustus M. Kelley), orig. pub. retical element connecting major econ- overpopulation and environmental degrada- 1898, trans. pub. 1936. omists is the “real shock” cyclic view, tion are an increasing concern are often also emphasized by Austrian economist referred to as neo-Malthusians. ——— (1970), Value, Capital and Rent , who saw innova- 2 The natural rate was also called, in Wicksell’s (New York: Augustus M. Kelley), orig. pub. tors and entrepreneurs as an often various writings, “neutral,” “normal” and 1893, trans. pub. 1954. destabilizing shock to the market econ- “real.” The money rate was also sometimes omy, giving rise to what he called “cre- called the “market” rate. ——— (1977), Lectures on Political Economy, ative destruction.” In this sense, there is 3 For more information, see Robert Formaini, vol. 1 (Fairfield, N.J.: Augustus M. Kelley), a continuous thread that runs from “Ludwig von Mises,” Federal Reserve Bank orig. pub. 1901, trans. pub. 1934. Wicksell, through Schumpeter, and on of Dallas Economic Insights, vol. 6, no. 4, to Keynes’ influential nonmonetary and “Hayek,” Economic Insights, vol. 4, ——— (1978), Lectures on Political Economy, model of business cycles. The modern no. 1. vol. 2 (Fairfield, N.J.: Augustus M. Kelley), Keynesian–monetarist dispute over the 4 See Laidler (1991), 146. For a modern orig. pub. 1906, trans. pub. 1935. role of money and its effects on the exposition of the Austrian economic theory, macroeconomy has its roots in the ear- see Roger W. Garrison (2001), Time and Economic Insights is a publication of the Federal Reserve Bank of Dallas. The views lier Fisher–Wicksell differences con- Money: The Macroeconomics of Capital expressed are those of the authors and should cerning the nature and causes of Structure (London: Routledge). not be attributed to the Federal Reserve System. cycles. 5 Humphrey (1997), 72. Wicksell perfectly anticipated mod- Please address all correspondence to ern central bank monetary policy when Sources and Suggested Reading Economic Insights Public Affairs Department he argued that interest rates must be Blaug, Mark (1986), Great Economists before Federal Reserve Bank of Dallas changed to control prices. He favored Keynes: An Introduction to the Lives and P.O. Box 655906 price-level stabilization because he felt Works of One Hundred Great Economists of Dallas, TX 75265-5906 that and were unfair the Past (New York: Cambridge University Visit our web site at www.dallasfed.org. income redistributive events, where some Press), 272–75.