Will the Pigou effect lead the world out of recession?

The current financial crisis has thrown up several economists in the limelight back from the dead. The most famous of them of course is John Maynard Keynes. But there was another economist that the world had forgotten, a contemporary of Keynes, and is gradually discovering now.

His name is Arthur Cecil Pigou, and he has been dead for over 50 years. Pigou was the Professor of Political Economy at the Cambridge University between 1908 and 1943. One of the first things he did was to provide private financial help to Keynes, to help Keynes’ work on probability theory. The two economists had great regard for each other, but professionally they saw things very differently.

“During the Great Depression, this Cambridge professor (Pigou) was kicked about by his former pupil, John Maynard Keynes. To Keynes, Pigou was just another fuddy-duddy who would not revise his economic models even though Britain was being ripped apart… This was trench warfare, and Pigou looked too genteel for the job,” writes Todd Buchholz in his essay Trust Fear and a Dead Economist.

Buchholz is former director of economic policy at the White House, a managing director of the $15 billion Tiger Hedge Fund, and an economics teacher at
Harvard. This essay is a part of Q Finance - The Ultimate Resource, a 2160-page encyclopedia on finance, published by Bloomsbury.  
Pigou lost out to Keynes. What Keynes basically said was that in recessionary times the government should pay people to dig holes in the ground and then fill them up.

His idea was that the government should intervene when a recession looms and give the economy a fiscal stimulus. This could be done through either printing or borrowing money, which could be spent on things like creating infrastructure, social reforms, etc.

Money spent was likely to create jobs which increased income in the hands of people. Once the income increased, people were likely to go out and spend money. And once they spend money the spectre of deflation could be avoided.

Deflation is essentially the opposite of inflation, when prices of goods and services continue to fall. When consumers know that prices are falling and are likely to continue to fall, they have an incentive to delay their purchases. Why buy something now when you know it will cost much less sometime later? This is known as a deflationary spiral, where prices continue to fall, leading to progressively lesser revenues and profits for companies.

Pigou did not agree with this logic. “Pigou had another take. He argued that falling prices can make us feel wealthier. And that if, when we go shopping, we feel as if we have more buying power, consumers can lead the country out of the recession,” writes Buchholz. “Unfortunately, this ‘Pigou Effect’ flopped in the early 1930s. Keynes declared the free market is dead, and Pigou’s theory slumped into a corner of our dusty textbooks.” If the Pigou effect had worked, falling prices during the Great Depression would have made people go out there and buy more things, which they did not.

Why did the Pigou effect fail? As Buchholz writes, “Because central bankers yanked the electrical cord out of their printing presses and sat on their hands. The Pigou effect basically takes the money supply and divides it by the price level. But during the 1930s both the money supply and the price level dove into a sinkhole. In the US, the money supply sank by 30%, as 40% of banks bolted their doors shut.” And so the effect did not work.

In the current crisis, central bankers all over the world have gone on a money printing drive.

“If the Federal Reserve Board can stomp on the money supply accelerator, the Pigou fraction can climb, and the economy can find some hope…Still collapsing gasoline and home heating oil prices should pump over $300 billion into the pockets of Americans, roughly $300 per month for a typical family. In the UK, a tank of petrol costs almost £20 less than the summer of 2008. Cheaper turkeys and chickens are flocking their way to the supermarket,” writes Buchholz.

Will this extra money lead to more consumer spending? That time will tell. As Buchholz writes, “We are witnessing a furious battle in the economy. On one side is the frightened consumer. She has more buying power via the Pigou effect. But she is fighting the fear of new job losses. Even in a very serious recession, about 90% of households will likely keep their jobs. Here’s the question, though: Will those 90% have the confidence to deploy their new spending power when the threat of layoffs glares from across the field?” Let’s wait and watch.