All Commentary
Wednesday, November 1, 1972

The American Economy Is NOT Depression-Proof

Dr. Sennholz heads the Department of Economics at Grove City College and is a noted writer and lecturer on monetary and economic principles and practices.

Most contemporary economists are fully convinced that a major depression of the 1929-1941 variety cannot happen again. It is inconceivable, they say, that the American economy should fall again into such an abyss of despair when more than 13 million Americans were unemployed, when banks and businesses failed by scores and countless farmers lost their land, when nearly everyone suffered painful losses of wealth and income. The tragedy of the Great Depression lives on as a nightmare that frightens everyone especially during periods of recession or stagnation. But our politicians and their learned advisors, the economists, assure us almost in unison that they will not let it happen again. They are solemnly pledging the awesome power of government to prevent another depression.

The sincerity of their intentions is no more to be doubted than the good will of the policymakers of the Hoover and Roosevelt era who were engulfed by the Great Depression. But it may be questioned that we have learned to avoid the dreadful errors of policy that caused and prolonged the disaster. If we repeat the errors that generated the Great Depression, inexorable economic law assures that it must happen again.

Have our policymakers learned the lessons of the Great Depression? Their explanations and interpretations of economic decline differ little from those offered by the politicians of the 1920′s and 1930′s. And contemporary economic policies, although far more comprehensive and massive in scope and import, are similar to those conducted by the Hoover and Roosevelt Administrations.

Most economists echo the explanation given by the most famous and influential economist of our century, John Maynard Keynes. Unemployment and depression are the inevitable result of inadequate effective demand, according to Keynes. Therefore, monetary and fiscal policy should be employed to increase aggregate demand. The nominal amount of money should be increased, which in the short run would cause interest rates to fall, investments to increase, and income to rise. But in case monetary policy would be ineffective, because falling money velocity may counteract an increase in the quantity of money, he recommended direct government investment through government tax cutting and deficit spending.1 played a major role in bringing the Keynesian system to America. They recommended that the government implement a continuous policy of full employment regardless of the state of the budget, which became the law of the land in the Full Employment Act of 1946. And all Federal administrations from Truman to Nixon have since then followed the policy recommendations of the “new economics.”

Spendthrift Policies

Most of the “new policies” were already being implemented during the 1920′s and 1930′s. The spectacular crash of 1929 followed four years of considerable credit expansion by the Federal Reserve System under the Coolidge Administration. But it is futile to look back in history without the proper theoretical framework that explains causes and consequences. The Keynesian historian views past experiences in his peculiar light and therefore quickly rejects all other interpretations. To him, the 200-year history of business cycles is a long record of economic disequilibria that are caused by inadequate effective demand.

This explanation, which has elevated inadequate demand or “under consumption” to the guiding principle of contemporary economic policy, has been the battle cry of the spendthrifts of all ages. And countless monarchs and princes rallied in ready acceptance of such doctrines that seemed to justify conspicuous consumption and deficit spending. But unfortunately, their policies always resulted not only in greater misery and poverty of the populace but also instability of state and society. The major political and social upheavals in Western history normally followed years of general impoverishment through wasteful consumption by the monarch or expensive wars staged by the state.

Booms and depressions do not spring from economic freedom and the individual enterprise system. On the contrary, they inevitably result from government disturbances of a peaceful market society. In particular, they follow policies of inflation and credit expansion that are designed to finance government deficit spending or to facilitate greater business expenditures. Ludwig von Mises has clearly shown how the creation of money and credit by our monetary authorities falsifies interest rates and thus misguides businessmen in their investment decisions. The boom phase of the trade cycle is a period of maladjustment in which economic resources are wasted and misused because of false interest rates. Consumer choices and preferences are ignored because the government, instead of the people, is giving the signals in the capital market.5

When the economic boom finally causes business costs to soar and capital returns to fall until great losses are suffered, a recession inevitably sets in. It is unavoidable once monetary authorities have generated the maladjustment through deficit spending or credit expansion. The unemployment of labor and capital must continue as long as the economic structure remains maladjusted through government intervention in the capital and labor markets. The Great Depression taught us this very lesson at a horrendous price.6

Booms Applauded, Recessions Deplored

Representatives of the “new economics” never object to the boom phase of the cycle. In fact, they may applaud it as “great years of uninterrupted economic growth,” or as a “new plateau,” or “new stability.” But when the economy finally begins to sag and unemployment quickly rises, they remember their Keynesian recipes: spend more and inflate more.

Obviously, the maladjustment that was generated by government interference with the capital market cannot be alleviated by more such interference. The drug addict who is suffering painful withdrawal symptoms cannot be cured by prescribing larger doses of the same drug. But this is precisely the kind of advice Keynesian economists give to their governments. When the national economy begins to falter, they call for more inflation and credit expansion, the very cause of the dilemma. True, the creation and injection of new funds may temporarily prolong the boom by supporting the maladjustments and generating new ones, as the injection of harder drugs in the human body may at first reduce the pain. But to administer ever harder drugs must finally kill the patient, as the injection of ever larger quantities of new funds must destroy the currency through hyperinflation and economic disintegration.

In fact, after several decades of Keynesian policies, we seem to have reached the point where only massive doses of inflation still stimulate the economic patient. Previous rates of inflation, to which we have grown accustomed and learned to adjust, no longer work as stimuli; businessmen immediately adjust to the rates they anticipate. A five per cent rate that has been foreseen well in advance no longer stimulates the economy when it is finally administered. Only higher rates than anticipated still have such an effect. This is also why the Federal deficits must get bigger and bigger. But while the rate of inflation must accelerate in order to provide the Keynesian stimulant, the monetary destruction also accelerates.

In the end, government faces an inescapable alternative: to accelerate its spending and inflating to total monetary destruction, or abandon its policy and thereby save the currency. If it chooses the former, it precipitates a depression through economic disintegration; if it chooses the latter, the depression that was delayed for so long finally will erupt in full severity. No matter which course the government eventually chooses, the contra-cyclical policies are bound to fail. The Keynesian recipe does not make the economy depression-proof. It merely postpones the depression through monetary destruction and thereby makes it worse.

Government Safeguards are Illusory

The followers of Keynes are not the only economists who are convinced that a depression can never happen again. The monetarists, while rejecting the contra-cyclical recipes of the “new economics,” deny the possibility of economic depressions on other grounds. “There have been fundamental changes in institutions and attitudes in the United States since the Great Depression,” Prof. Friedman reassures us.7 They are rendering a major depression in the United States “almost inconceivable.”

Establishment of the Federal Deposit Insurance Corporation in 1933, we are told, was a basic change in American banking that made bank failures “almost a thing of the past.” By converting all deposit liabilities of private banks into a Federal liability, the F.D.I.C. eliminated the basic cause for runs on banks, which was the depositors’ attempt to convert their claims into Federal currency. Since both deposits and currency are now Federal liabilities, an important cause of credit contractions and economic depressions is said to have been removed.

These economists err in their basic assumption that a depression can be avoided if only monetary contractions can be avoided. Once the malinvestments have been made and the boom has run its course, the readjustment must necessarily be painful. The depression is an unavoidable phase of the trade cycle once it has commenced. For the central bank then to embark upon credit expansion, in an attempt to prevent the liquidation of malinvestment, can only delay the recovery and thus prolong the depression.

The Federal Deposit Insurance Corporation that, in effect, makes every bank deposit a government liability is designed to prevent the needed liquidation. Of course, it can do this successfully and thus delay the readjustment if newly created funds are used for the rescue action. But where would the government obtain the funds necessary to prevent massive liquidation of bank credit? From its central bank, of course. The stabilizing power of the F.D.I.C., in final analysis, is nothing but the government power to create and emit new money. Therefore, it is necessary to repeat the answer given to the Keynesian spenders: more inflation can merely postpone a depression through monetary destruction and ultimately make it worse.

Deficit Financing

Another change in banking structure that is said to assure economic stability has been the increased importance of government obligations; the phenomenal growth in government debt has made government liabilities an important part of bank assets, which afford greater stability to the stock of money and credit.

This increased importance of government obligations as bank assets imparts such great confidence to some economists. To others, however, it is a cause for anxiety. It is indicative not only of the changing role of American banking from mediators of credit to fiscal agents of the Federal treasury, but also of the great reliance on the inflationary powers of government. What would be the status of government obligations without the inflation powers to support them? Every budgetary deficit would send U.S. Treasury obligations to new discounts if it were not for the open-market purchases by the Federal Reserve System. But this very support through monetary expansion, while it may succeed in the short run, tends to be self-defeating in the long run as it raises interest rates and thus reduces the market prices of fixed-income obligations. This is why government securities in bank portfolios have been very poor investments ever since World War II, which banks endeavor to avoid wherever possible. In fact, long-term U.S. Treasury obligations have at times, when interest rates rose significantly, inflicted crushing losses on American banks, losses which dubious accounting practices endeavor to hide. The banking losses then provide an important motive for early resumption of credit expansion.

The Dethroning of Gold

Finally, many of the monetarist economists rejoice about the severing of all links between gold and the internal supply of money. The “dethroning of gold” is said to reduce the sensitivity of the stock of money to changes in external conditions. Removal of gold from public circulation has made us independent at last from the vagaries of foreign influence. Thereby we would avoid monetary contraction which is “an essential conditioning factor for the occurrence of a major depression.”

What these economists call the “dethroning” of gold is rather a “default” of paper. After all, it was the creation of massive quantities of money substitutes that caused central banks to default on their obligation to redeem their currencies in gold. But this default did not bring stability and prosperity. On the contrary, it opened the gates for massive inflation and economic instability. The fiat standard is more unstable than the gold-exchange standard, which afforded less stability than the gold-bullion standard, which in turn was less stable than the classical gold-coin standard. It is true, the default in gold payments did stop the runs on banks; no one in his right senses would want to run for paper money the supply of which is potentially unlimited. But the fiat standard does not make us independent of the vagaries of foreign influence. It has made the international money market more vulnerable than ever before. The U.S. dollar is stumbling from crisis to crisis, with grave dangers to international trade and cooperation and, ultimately, to the stability of the American economy itself.

It is not alone the new monetary structure that affords some economists so much confidence in the lasting stability of the American economy. There is also the fiscal structure. “There can be no disagreement,” Professor Friedman asserts, “that the fiscal structure is now an exceedingly important and powerful ‘built-in stabilizer’.”8 Government expenditures, both national and local, now amount to more than one-third of the national income. Although the relative growth of government casts somber prospects for political freedom, it is argued that the change in the character of both expenditures and receipts has stabilizing effects on the business cycle. A broad program of social security, unemployment insurance, and a farm program that supports product prices, all tend to increase government expenditures in depression and to reduce them in prosperity. The same contra-cyclical effects are derived from personal and corporation income taxation, which in boom or recession automatically creates budget surpluses or deficits and thereby offsets from 30 to 40 per cent of any national income change. So goes their theory.

Loaded for Stability

This doctrine of the built-in stabilizers calls to mind the story of the farmer who, before leaving for the market in town, loaded his pack mule with an exceptionally heavy load of potatoes. When his neighbor inquired about the reason for the heavy load the farmer retorted with a gesture of great learning: “On the muddy road to town the beast needs stability. The heavier the load the greater the stability!”

A bit of plain horse sense ought to tell us that the growing costs of government do not afford stability; on the contrary, they are making the “private sector” that is carrying the growing burden of the “public sector” ever more anemic and unstable. True, the heavy burdens can be lightened through massive monetary depreciation. The automatic deficits, from rising expenditures and declining tax revenues during recession, can be financed through currency expansion. But as the Keynesian contra-cyclical policies fail to impart stability to the American economy, so do the automatic fiscal stabilizers.

Finally, we are told that there has been an important change in the psychological climate of America. Before the Great Depression, according to this view, we were more afraid of inflation than of deflation; we wanted “hard money” at all costs. But the Great Depression has changed all that. It has caused public opinion to swing from one extreme to the other. That is why today, after decades of rising prices and monetary depreciation, the public is still seized by a real fear of depression. What the people may not realize, warn the monetarists, is that the ultimate destination of those who follow the path of inflation is destruction of the currency.

One may fully agree that the ultimate effect of these built-in stabilizers is monetary destruction. But what is one to make of the swinging theory? The American public has approved inflation and credit expansion ever since the Coolidge Administration, clung to easy money throughout the 1930′s, endorsed rampant wartime inflation during the 1940′s, heralded the contra-cyclical policies during the 1950′s, applauded the accelerator policies of the 1960′s, and still continues to rely on massive deficit spending. The fever of inflation that has infected American economic thought and policy is rising steadily and dangerously. And while it rages, neither the body politic nor the American economy is depression-proof.



The Consumer Theory of Prosperity

The usual effect of the attempts of government to encourage consumption is merely to prevent saving; that is, to promote unproductive consumption at the expense of reproductive, and diminish the national wealth by the very means which were intended to increase it.

JOHN STUART MILL, Essays on Some Unsettled Questions of Political Economy. 

  • Hans F. Sennholz (1922-2007) was Ludwig von Mises' first PhD student in the United States. He taught economics at Grove City College, 1956–1992, having been hired as department chair upon arrival. After he retired, he became president of the Foundation for Economic Education, 1992–1997.