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Sunday, December 24, 2017

America’s Great Depression and Austrian Business Cycle Theory

The capitalist system is a great engine of human prosperity.

When Murray Rothbard’s America’s Great Depression first appeared in print in 1963, the economics profession was still completely dominated by the Keynesian Revolution that began in the 1930s. Rothbard, instead, employed the “Austrian” approach to money and the business cycle to explain what caused the Great Depression, and to analyze the misguided and counterproductive policies that followed in the early 1930s, which, in fact, only intensified and prolonged the economic downturn.

To many of the economists in the early 1960s, Rothbard’s “Austrian” approach seemed out-of-step with the then generally accepted textbook, macroeconomic approach that focused on a highly “aggregate” analysis of economic changes and fluctuations on general output and employment as a whole. There was also the widely held presumption that governments could easily maintain economy-wide growth and stability through the use of a variety of monetary and fiscal policy tools.

We can now see that it represented the revival of the “Austrian” monetary tradition in the post-World War II period. However, in the early to mid-1930s, the Austrian explanation of the Great Depression was at the forefront of the theoretical and policy debates of the time. Ludwig von Mises (1881-1973) first developed the “Austrian” theory on the causes of inflations and depressions in his book, The Theory of Money and Credit (1912; 2nd revised ed., 1924) and then in his monograph, Monetary Stabilization and Cyclical Policy (1928).

But the Austrian theory’s international recognition and role in the business cycle debates and controversies in the 1930s were particularly due to Friedrich A. Hayek (1899-1992). His version of the theory was presented in his works, Prices and Production (1932), Monetary Theory and the Trade Cycle (1933), and Profits, Interest and Investment (1939).

A professor of economics at the London School of Economics throughout the 1930s and 1940s, Hayek was, at the time, considered by many to be the main competitor against John Maynard Keynes’s “New Economics” that emerged out of Keynes’s 1936 book, The General Theory of Employment, Interest and Money.

Ludwig von Mises restated and refined his version of the Austrian theory of the business cycle in his 1949 treatise, Human Action in a way that attempted to respond to many of the criticisms made against the theory in the 1930s. But by the end of the 1940s and into the early 1950s, the Austrian theory was soon submerged in the Keynesian tidal wave of macroeconomic aggregates and averages that swept away all alternative understandings of inflations and depressions.

Rothbard’s America’s Great Depression and the Revival of Austrian Economics

This is what especially marks off the significance of Murray Rothbard’s America’s Great Depression: We can now see that it represented the revival of the “Austrian” monetary tradition in the post-World War II period. It is true that the Austrian theory was restated by Rothbard a year earlier, in 1962, in a notable and clearly written chapter in his own major treatise, Man, Economy, and State, and within the wider context of a reformulation of the Austrian theory of capital and interest. But in America’s Great Depression, Rothbard summarized the Austrian theory of money and the business cycle and contrasted it to the older quantity theory of money formulated by Yale University economist, Irving Fisher, as well as to Keynes’s macro-theory, and that of Schumpeter’s theory of entrepreneurially driven cycles of market innovation.

Rothbard then proceeded to offer a crisp and highly readable interpretive narrative of how the monetary policy of the American central bank, the Federal Reserve, in the 1920s had brought about an imbalance between savings and investment through its manipulation of the supply of money and credit in the banking system as part of the elusive pursuit of price level stabilization. Rothbard went on to explain how the fiscal and interventionist policies of the Hoover Administration in the early 1930s only succeeded in preventing the necessary microeconomic relative price and wage adjustments, and resource and labor reallocations that would have restored balance and stability in the U.S. economy in a relatively short period of time.

This revival in the “Austrian” monetary and business cycle tradition was also stimulated by a series of conferences in the middle of the 1970s. In the process, Rothbard made the modern reader of the 1960s aware of a “lost” literature from the 1930s and 1940s that complemented the works by Ludwig von Mises and Friedrich Hayek, and that served as the analytical framework in the context of which Rothbard presented the Austrian theory of the business cycle. Specifically, Rothbard highlighted Gottfried Haberler’s lecture on “Money and the Business Cycle” (1932), Frederic Benham’s British Monetary Policy (1932), Lionel Robbins’ The Great Depression (1934), and Phillips, McManus, and Nelson’s Banking and the Business Cycle (1937), Fritz Machlup’s The Stock Market, Credit, and Capital Formation (1940), and Benjamin Anderson’s Economics and the Public Welfare (1946), all of which are carefully referenced by Rothbard in his book.

These works, and many others from the 1930s inspired by Mises’s and Hayek’s analysis, became the starting point for anyone interested in gaining a further and fuller grasp of the Austrian perspective on the Great Depression that Rothbard, himself, had obviously drawn upon in developing his own understanding of the period between the two World Wars.

This revival in the “Austrian” monetary and business cycle tradition was also stimulated by a series of conferences on Austrian Economics in the middle of the 1970s beginning with a conference in South Royalton, Vermont in June 1974. Since then there has developed a growing literature inspired by and continuing within the “Austrian” monetary framework that tries to address monetary and business cycle problems of our time, now, in the Twenty-First Century. (See my article, “The Rebirth of Austrian Economics.”)

The Fundamental Errors in Keynesian Economics

Keynes argued that the economy should be looked at in terms of a series of macroeconomic aggregates: total demand for all output as a whole, total supply of all resources and goods as a whole, and the average general levels of all prices and wages for goods and services and resources bought and sold on the overall market.

There is no such thing as aggregate demand, or aggregate supply, or output and employment as a whole. If, at the prevailing general level of wages, there is not enough aggregate demand for output as a whole to profitably employ all those interested and willing to work, then it is the task of the government and its central bank to ensure that sufficient money spending is injected into the economy. The idea is that at rising prices for final goods and services relative to the general wage level, it will again become profitable for businesses to employ the unemployed until full employment is restored.

Over the decades since Keynes first formulated this idea in his 1936 book, The General Theory of Employment, Interest, and Money, both his supporters and apparent critics have revised and reformulated parts of his argument and assumptions. But the general macro-aggregate framework and worldview used by economists to analyze problems of less than full employment nonetheless still focus on government policy and formulate it in terms of the levels of output and employment for the economy as a whole and changes in them.

The Fallacy of Macroeconomic Aggregates and Averages

In fact, however, there is no such thing as aggregate demand, or aggregate supply, or output and employment as a whole. They are statistical creations constructed by economists and statisticians, out of what really exists: the demands and supplies of multitudes of individual and distinct goods and services produced, and bought and sold on the various specific markets that make up the economic system of society.

Each of these individual and distinct goods and services has its own particular price in the marketplace. There are specific consumer demands for different kinds and types of hats, shoes, shirts, reading glasses, apples, and books or movies. No one demands just “output,” and no one creates just “employment.” When we go into the marketplace we are interested in buying the specific goods and services for which we have particular and distinct demands. And businessmen and entrepreneurs find it profitable to hire and employ particular workers with specific skills to assist in the manufacture, production, marketing, and sale of those distinct goods that individual consumers are interested in buying.

In turn, each of these individual and distinct goods and services has its own particular price in the marketplace, established by the interaction of the individual demanders with the individual suppliers offering them for sale.

The profitable opportunities to bring desired goods to market result in the demand for different resources and raw materials, specific types of machinery and equipment, and different categories of skilled and less-skilled individual workers to participate in the production processes that bring those desired goods into existence. The interactions between the individual businessmen and the individual suppliers of the factors of production generate the prices for their purchase, hire, or employment on, again, multitudes of individual markets in the economic system.

Austrian Microeconomic Market and Monetary Process Analysis

The macroeconomist and his statistician collaborator then add up, sum, and average all these different individual outputs, employments, and specific prices and wages into a series of economy-wide measured aggregates. But it should be fairly clear that in doing so, all the real economic relationships in the market, the actual structure of relative prices and wages, and all the multitude of distinct and interconnected patterns of actual demands and supplies are submerged and lost in the macroeconomic aggregates and totals.

Balanced production and sustainable employments in the economy as a whole clearly require coordination and balance between the demands and supplies of all the particular goods and services in each of the specific markets on which they are bought and sold. And parallel to that, there must be comparable coordination and balance between the businessmen’s demands for resources, capital equipment, and different types of labor in each production sector of the market and those supplying them.

But Rothbard’s additional point was to show that it was the failure of the American government. Such coordination, balance, and sustainable employment require adaptation to the ever-changing circumstance of market conditions through adjustment of prices and wages, and to shifts in supplies and demands in and between the various parts and sectors of the economy. In other words, it is rightly balanced and coordinated patterns between supplies and demands and their accompanying structures of relative prices and wages that ensure full employment and the efficient and effective use of available resources and capital; through these adaptations and adjustments, entrepreneurs and businessmen are constantly and continually tending to produce the goods we, the consumers, want and desire, and at prices that are covering competitive costs of production.

All that is lost from view when it is reduced to a handful of macro-aggregates of total demand and total supply and a statistical average price level for all goods relative to a statistical average wage level for all workers in the economy. An equally fundamental error and misconception in the macro-aggregate approach is its failure to appreciate and focus on the real impact of changes in the money supply that by necessity result in an unsustainable deviation of prices, profits, and resources and labor uses from a properly balanced coordination, the end result of which is more of the very unemployment that the monetary stimulus was meant to cure.

It is this “Austrian”-based microeconomic dynamic process analysis that serves as the analytical framework in the context of which Murray Rothbard explained how the monetary policies of the U.S. Federal Reserve in the 1920s brought about the imbalances and distortions between savings and investment and misallocations of labor, capital, and resources that meant that the economic “boom” before 1929 would result in the economic “bust” and depression of the early 1930s.

But Rothbard’s additional point, using the ideas first formulated by Mises and Hayek, was to show that it was the failure of the American government to allow competitive markets from fully operating without government interference that prevented and delayed an economic recovery that most likely would have happened sooner and without the high unemployment and falling output experienced during the 1930s.

Capitalism the Solution, Government the Stumbling Block

The capitalist system is a great engine of human prosperity. It creates the profit incentives for industry and innovation that just over the last quarter of a century has literally raised hundreds of millions of people out of poverty in what used to be called “the third world” of underdeveloped nations. The competitive process of supply and demand brings the productive activities of tens of thousands of businesses into balance with the demands of all of us as consumers, around the globe.

This would require the reversal of the premises, presumptions and political plundering of the modern interventionist-welfare state. There is no economic system in all of history that has had the same ability to do so much material and cultural good as the open, competitive free market. But the capitalist system cannot do its job if government interferes with its operation. Burdensome government taxes, heavy-handed government regulation, misguided government spending, and mismanagement of the monetary system only succeed in gumming up the works like so much sand in the machine.

The best pro-active policy that any government could follow once an economy has fallen into a recession would be to accept and admit that its own past monetary and fiscal policies had caused the economic crisis that is being experienced, and then leave the market alone to rebalance itself and reestablish the basis for sustainable growth and employment.

But, of course, this would require the reversal of the premises, presumptions and political plundering of the modern interventionist-welfare state, and its accompanying system of monetary central planning in the form of the U.S Federal Reserve. It would require a rejection of the collectivist ideological and policy perspectives that did and continue to dominate and direct all that governments do around the world.

However, in the meantime, Murray Rothbard’s insightful and historically important explanation of how government central banking and misguided interventionist policies caused and prolonged America’s Great Depression of the 1930s, now available with this volume in Chinese, offers an opportunity for the people of the world’s rising economic giant to better understand the dangers from trusting too much in the power of government to assure and maintain economic growth and stability. And it may help in better appreciating the importance of competitive free market institutions, even in the banking and financial sectors, to bring about long-run economic betterment for all in society.


This article is adapted from my introduction to a recently published Chinese translation of Murray N. Rothbard’s America’s Great Depression, which is now available in the People’s Republic of China.

  • Richard M. Ebeling is BB&T Distinguished Professor of Ethics and Free Enterprise Leadership at The Citadel in Charleston, South Carolina. He was president of the Foundation for Economic Education (FEE) from 2003 to 2008.