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Monetary Central Planning and the State, Part 12: The Austrian Analysis and Solution for the Great Depression


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In February 1931, Austrian economist Ludwig von Mises delivered a lecture before a group of German industrialists entitled “The Causes of the Economic Crisis.” He explained to his audience that the economic depression through which they were living had its origin in the misguided monetary policies of the 1920s. The leading central banks of the major industrial countries had followed a policy of monetary expansion that had created an artificial boom that finally came to an end in 1929.

But after the downturn began, this depression was much more severe and prolonged than many similar business cycles in the past. A unique circumstance was present that prevented the normal process of economic recovery. The unique circumstance was the pervasiveness of government interventionist policies:

“If everything possible is done to prevent the market from fulfilling its function of bringing supply and demand into balance, it should come as no surprise that a serious disproportionality between supply and demand persists, that commodities remain unsold, factories stand idle, many millions are unemployed, destitution and misery are growing and that finally, in the wake of all these, destructive radicalism is rampant in politics. . . . With the economic crisis, the breakdown of interventionist policy — the policy being followed today by all governments, irrespective of whether they are responsible to parliaments or rule openly as dictatorships — becomes apparent. . . . Hampering the functions of the market and the formation of prices does not create order. Instead it leads to chaos, to economic crisis.”

For the Austrian economists, the Great Depression had been caused in the United States by the attempt to stabilize the price level through monetary expansion. The monetary expansion had artificially lowered interest rates, and that in turn had induced an investment boom in excess of real savings in the economy. Capital, resources, and labor had been misdirected into longer-term investment projects that now, with the end of the monetary inflation, were found to be unprofitable and economically unsustainable to varying degrees. Capital had been malinvested, labor had been misdirected, and the structure of relative prices and wages had been distorted in comparison with the pattern of prices and wages that would have ensured proper balance between the actual supplies and demands for goods and services in the market.

Governments in the major industrial countries, including the United States, had responded to the economic crisis by introducing a vast spider’s web of interventionist regulations, controls, and restrictions on both domestic and international trade, as well as numerous public works projects. Rather than alleviating the Depression, the interventionist measures had only made the situation worse. Governmental attempts to maintain prices and wages at levels inconsistent with real market conditions resulted in falling production and rising unemployment as goods went unsold and workers were released from their jobs.

The imbalances that began in some markets soon spread to others. The reason for this can be found in the fundamental truth that economists since Jean-Baptiste Say in the early 19th century have called “the law of markets.” No one can demand what others have for sale in the market unless he has something to supply in exchange. Each potential demander, therefore, has to offer in trade some good or service that others are interested in buying and at a price they are willing to pay. Supplying a good that others are not interested in buying or pricing it so high that few are willing to purchase it limits the money income that can be earned from sales; and that, in turn, limits the amount of goods and services that can be bought from others.

Wrong prices — “disequilibrium prices,” in the jargon of the economist — resulted in products’ and workers’ being priced out of the market once the Depression began in 1929. The resulting decreased revenues from the sale of goods and the resulting falling income from loss of employment meant that both businessmen and workers had to cut back their purchases of goods and services that were offered for sale by others. These others, when they were unwilling to sufficiently lower their prices and wages in the face of falling demand, saw, in turn, a decrease in their sales and employment.

The failure of prices and wages to adjust downwards in the face of changing market conditions generated a “cumulative contraction” of output and employment, which put further downward pressure on prices and wages in a widening circle of related markets. As the famous English economist Edwin Cannan concisely put it in 1932, “General unemployment is the result of a general asking too much” by people who are offering goods and labor services for sale.

In 1933, Ludwig von Mises summarized the nature of the problem:

“The duration of the present crisis is caused primarily by the fact that wage rates and certain prices have become inflexible, as a result of union wage policy and various [government] price support activities. Thus, the rigid wage rates and prices do not fully participate in the downward movement of most prices, or do so only after a protracted delay. . . . The continuing mass unemployment is a necessary consequence of the attempts to maintain wage rates above those that would prevail on the unhampered market.”

Mises explained that now that interventionist policies had resulted in mass unemployment, governments proposed to get around the consequences of their own policies by resorting to a policy of reflation. Governments hoped that if prices were raised through a new monetary expansion, unions would not immediately demand higher money wages to compensate for any lost purchasing power resulting from the increase in the cost of living.

If money wages were relatively unchanged while selling prices of goods and services were rising, it would mean that the real wages of workers would be cut, and employers might find it once again profitable to hire the unemployed. But, Mises argued, even if money wages did not immediately increase, the new monetary expansion would be merely setting the stage for another “bust” after a new temporary “boom.”

The inevitability of this result was explained by the British economist Lionel Robbins (a proponent of Austrian economics) in the pages of Lloyd’s Bank Review in 1932:

“It is perhaps natural that the wish should arise to meet deflation by a counter inflation: to get around cost rigidities by acting on prices. And no doubt if inflation simply meant the simultaneous and definitive marking up of prices, as by a Government decree, there would be much to be said for this procedure. Unfortunately, inflation does not work this way. It is the essence of inflation that it affects some prices before others, that its final effects are different from its impact effects, and that production is affected differently at different stages of the process. In an inflationary boom, it is this unequal incidence of the inflation which gives rise to the maladjustments, which eventually produce the slump. Entrepreneurs are encouraged by artificially cheap money to embark on enterprises which can only be profitable provided costs do not rise. As the new money works through the system, costs do rise, and their enterprise is thus rendered unprofitable. For the time being, trade seems good but when the full effects of the inflation have manifested themselves there comes a crisis and subsequently depression.”

What then was the way out of the Great Depression? For the Austrian economists, it required the reversal of the interventionist policies that had only exacerbated the economic crisis and the forgoing of any monetary manipulation as a method for trying to overcome the dilemma of unemployment. On the latter point, Friedrich Hayek, writing in 1932, was clear:

“To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection of production, we want to create further misdirection — a procedure which can only lead to a much more severe crisis as soon as the credit expansion comes to an end.”

On the issue of interventionist policies that were preventing the market from normally and competitively functioning to restore economic balance, Lionel Robbins was also clear in 1932:

“It is impossible to get back to a state of true prosperity until the real underlying causes of the present stagnation are removed — barriers to international trade, in the shape of tariffs, quota systems, exchange restrictions and the like obstacles to internal adjustments in the shape of cost rigidities and bad debts, which should be written off. . . . But, above all, policy must be directed to restoring the freedom of the market in the widest sense of the term. By this I mean not only the lowering of tariffs and the abolition of trade restrictions but also the removal of all those causes which produce internal rigidity — rigid wages, rigid prices, rigid systems of production. . . . It is this inflexibility of the economic system at the present day which is at the root of most our troubles.”

For Austrian economists such as Ludwig von Mises, Friedrich Hayek, and Lionel Robbins, the Great Depression was the fruit of the interventionist state. Beginning with the First World War, throughout the 1920s and into the Depression years of the early 1930s, the classical liberal world of free markets, free trade, and sound money under the gold standard had been undermined, weakened, and finally broken. In its place had arisen government-imposed systems of domestic regulation, nationalistic trade protectionism, price and wage rigidities, production subsidies, and state-sponsored monopolies and cartels.

The pre-World War I gold standard, though operated by government central banks, had more or less kept monetary and artificial credit expansions within narrow bounds. By the early and mid 1930s, the monetary systems of most countries were paper money systems or monetary systems nominally still gold-based but manipulated and abused by governments to serve interventionist domestic policies.

The Austrian economists attempted to show the dead end to which these policies had led. Unfortunately, their logical arguments and reasoned appeal fell on deaf ears. Instead, the United States and other nations moved further down the interventionist road. By 1933, this road took America to the New Deal, and it took Germany to the National Socialist state.

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    Richard M. Ebeling is a professor of economics at Northwood University. He was formerly president of The Foundation for Economic Education (2003–2008), was the Ludwig von Mises Professor of Economics at Hillsdale College (1988–2003) in Hillsdale, Michigan, and served as vice president of academic affairs for The Future of Freedom Foundation (1989–2003).