The Mysteries of the Great Depression Finally Solved

Friedman, Higgs, and Other Scholars Have Disproven Commonly Held Views

Dr. Skousen is an economist at Rollins College, Department of Economics, Winter Park, Florida 32789, and editor of Forecasts & Strategies, one of the largest investment newsletters in the country.

The depression . . . was endemic to the system: the economy was not self-regulating and needed to be controlled.

—David Colander and Harry Landreth[1]

The Great Depression of the 1930s may be a dim memory now, but its impact is still being felt in policy and theory. The prolonged depression created an environment critical of laissez-faire policies and favorable toward ubiquitous state interventionism throughout the Western world. The depression led to the Welfare State and boundless faith in Big Government. It caused most of the Anglo-American economics profession to question classical free-market economics and to search for radical anti-capitalist alternatives, eventually converting to the new economics of Keynesianism and demand-side economics.

Prior to the Great Depression, most Western economists accepted the classical virtues of thrift, limited government, balanced budgets, the gold standard, and Say’s Law. While most economists continued to defend free enterprise and free trade on a microeconomic scale, they rejected traditional views on a macroeconomic level in the postwar period, advocating consumption over saving, fiat money over the gold standard, deficit spending over a balanced budget, and active state interventionism over limited government. They bought the Keynesian argument that a free market was inherently unstable and could result in high levels of unemployed labor and resources for indefinite periods. They blamed the causes of the Great Depression on laissez-faire capitalism and contended that only massive government spending during World War II saved the capitalist system from defeat. In short, the depression opened the door to widespread collectivism in the United States and around the world.

Fortunately, free-market economists have gradually punctured holes in these arguments and the pendulum has slowly shifted toward a re-establishment of classical free-market economics. Three questions needed to be addressed: What caused the Great Depression? Why did it last so long? Did World War II restore prosperity? Economic historian Robert Higgs had dubbed these three arenas of debate the Great Contraction, the Great Duration, and the Great Escape.

The Cause of the Great Contraction

Many free-market economists had attempted to answer the first question, including Benjamin M. Anderson and Murray N. Rothbard,[2] but none had the impact equal to Milton Friedman’s empirical studies on money in the early 1960s. His was the first effective effort to destroy the argument that the Great Depression was the handiwork of an inherently unstable capitalistic system. Friedman (and his co-author, Anna J. Schwartz) demonstrated forcefully that it was not free enterprise, but rather government—specifically the Federal Reserve System—that caused the Great Depression. In a single sentence underlined by all who read it, Friedman and Schwartz indicted the Fed: From the cyclical peak in August 1929 to a cyclical trough in March 1933, the stock of money fell by over a third.[3] (This statement was all the more shocking because until Friedman’s work, the Fed didn’t publish money supply figures, such as M1 and M2!)

Friedman and Schwartz also proved that the gold standard did not cause the depression, as some Keynesian economists have alleged. During the early 1930s, the U.S. gold stock rose even as the Fed perversely raised the discount rate and allowed the money supply to shrink and banks to collapse.[4]

The Prolonged Slump

Economic activity and employment stagnated throughout the 1930s, causing a paradigm shift from classical economics to Keynesianism. Friedrich Hayek, the Austrian economist who challenged Keynes in the thirties, was so disheartened about the state of the free-world economy that he abandoned the study of economics in favor of political philosophy.

Why did the depression last so long? Many free-market economists have picked up where Murray Rothbard’s America’s Great Depression left off, at the time Franklin Delano Roosevelt took office in 1933. Gene Smiley (Marquette University) attempted an Austrian perspective on the perverse role of fiscal policy in the 1930s. I summarized the causes of stagnation and persistent unemployment, such as the Smoot-Hawley Tariff, tax increases, government regulation and controls, and pro-labor legislation.[5]

More recently, Robert Higgs of the Independent Institute has made an in-depth study of the 1930s’ malaise and focused on the lack of private investment during this period. According to Higgs, private investment was greatly hampered by New Deal initiatives that destroyed investor and business confidence, the key to recovery.[6] In short, the New Deal prolonged the depression.

What Got Us Out?

In another brilliant study, Higgs attacked the commonly held view that World War II saved us from the depression and restored the economy to full employment. The war gave only the appearance of recovery, when in reality private consumption and investment declined while Americans fought and died for their country. A return to genuine prosperity—the true Great Escape—did not occur until after the war ended, when most of the wartime controls were abolished and most of the resources used in the military were returned to civilian production.[7] Only after the war did private investment, business confidence, and consumer spending return to form.

In sum, it has been a long and hard-fought war to restore the case for free-market capitalism. Finally, through the pathbreaking work of Friedman, Rothbard, Smiley, Higgs, and other scholars, we can now say the battle has been won.


1. David C. Colander and Harry Landreth, eds., The Coming of Keynesianism to America (Edward Elgar, 1996), p. 16.

2. Benjamin M. Anderson, Economics and the Public Welfare (Indianapolis: Liberty Press, 1979 [1949]) and Murray N. Rothbard, America’s Great Depression (Princeton: D. Van Nostrand, 1963).

3. Milton Friedman and Anna J. Schwartz, A Monetary History of the United States, 1867-1960 (Princeton: Princeton University Press, 1963), p. 229.

4. Friedman and Schwartz, Monetary History, pp. 360-361. See also my May 1995 Freeman column, Did the Gold Standard Cause the Great Depression?

5. Gene Smiley, Some Austrian Perspectives on Keynesian Fiscal Policy and the Recovery of the Thirties, Review of Austrian Economics (1987), 1:146-79, and Mark Skousen, The Great Depression, in Peter Boettke, ed., The Elgar Companion to Austrian Economics (Edward Elgar, 1994), pp. 431-439.

6. Robert Higgs, Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed After the War, The Independent Review (Spring 1997), 1:4, pp. 561-590.

7. Robert Higgs, Wartime Prosperity? A Reassessment of the U.S. Economy in the 1940s, Journal of Economic History 52 (March 1992), pp. 41-60. See also Richard K. Vedder and Lowell Gallaway, The Great Depression of 1946, Review of Austrian Economics 5:2 (1991), pp. 3-31.

Further Reading

{{article.Title}}

{{article.BodyText}}