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Monetary Central Planning and the State, Part 22: The Chicago School Economists and the Great Depression


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In 1964, Keynesian economist Robert Lekachman edited a volume of essays entitled Keynes’ General Theory: Reports of Three Decades. Among the contributors was University of Chicago economist Jacob Viner. Added to the reprint of his 1936 review of Keynes’s General Theory was a comment updating his views on Keynes and Keynesian economics.

Viner still believed, as he had pointed out almost 30 years earlier, that Keynes had failed to give any “warning about the evil or the danger of inflation.” But he also stated, “My appreciation of the quality and originality of [ The General Theory 's] analysis as short-run analysis has grown since [1936] rather than shrunk.”

Viner explained that he had been trained as an “orthodox” economist whose eyes were always on the long run in his economic theorizing. But by 1930 or 1931, he had come to be dissatisfied with orthodox economic theory as a framework for understanding the nature and origins of business cycles. Viner said:

“A year or two of the Great Depression sufficed to convince me, ‘orthodox’ theorist though I was by training and temperament … that the greater the degree of [the economic] crisis, the greater was the relative importance of the forces whose impact was predominantly short-run in character…. Aside from details … I would have accepted the policy implications of the General Theory in the monetary and fiscal field were they presented as relating to short-run or cyclical fluctuations in employment [only].”

Indeed, Viner stated that the Keynesian formula that government should spend more and tax less in depressions and spend less and tax more in economic booms as a policy method to regulate economy-wide fluctuations in employment, output, and prices was one he had advocated in the early 1930s. He quoted from one of his own speeches from August 1931:

“Tax heavily, spend lightly, redeem debts, are sound Treasury principles during a period of dangerously rapid business expansion; tax lightly, spend heavily, borrow, are equally sound Treasury principles during a period of acute depression…. Really sound Treasury policy … should be a function of the state of business conditions and should be conducted so as to contribute to the smoothing out of business fluctuations.”

And Viner pointed out, “This formula may have been a discovery of Keynes, but … the idea was then commonplace in my academic surroundings of the time, and I cannot recall that any of my Chicago colleagues would have dissented, or that they needed to learn it from Keynes, or from me.”

Were the predominantly free-market economists at the University of Chicago in the 1930s advocates of “activist” monetary and fiscal policy by the United States government? In fact many of them were. This is most thoroughly documented in two books, L. Ronnie Davis’s New Economics and the Old Economists (1971) and William J. Barber’s From New Era to New Deal: Herbert Hoover, the Economists, and American Economic Policy, 1921 -1933 (1985).

In 1967, Milton Friedman observed that the views of many Chicago economists were very similar to Keynes’s in the early 1930s “as to the causes of the Great Depression, the impotence of monetary policy, and the need to rely extensively on fiscal policy.” He referred to a policy statement of Henry Simons, one of the outstanding figures of the Chicago school at that time, who in November 1933 argued for an “increase of expenditures or a reduction of taxes” through deficit spending by the federal government as a policy for an “effective raising of prices” to stimulate demand and employment in the American economy. Friedman pointed out that such views “were in the air at the University of Chicago in the early and mid-1930s” and basically explained why, for the Chicago economists, Keynes’s ideas in The General Theory came as no revelation.

In 1932, for example, Frank H. Knight, one of the most respected market-oriented Chicago economists in the United States, supported a proposal of Sen. Robert F. Wagner for federal budget deficits to finance public-works projects. Knight argued that “the government should spend as much and tax as little as possible, at a time such as this, using the expenditure in the way to do the most good in itself and also to point toward relieving the depression.” At the end of his review of Keynes’s General Theory in 1937, Knight said that as for “Mr. Keynes’s conception of inflation as the cure for depression and unemployment … I happen to be in sympathy.”

Also in 1932, 12 University of Chicago economists, including Aaron Director, Harry D. Gideonse, Frank Knight, Lloyd Mints, Henry Simons, and Jacob Viner, issued a memorandum advocating budget deficits as a method for getting out of the Great Depression; the memo also argued for the federal government’s no longer balancing its budget annually but instead over the phases of the business cycle. They admitted that the Depression could be overcome through appropriate adjustments in market prices and wages to reflect the actual underlying conditions of supply and demand in the various sectors of the economy. Given a “deflation of costs and elimination of fixed charges, business will discover opportunities for profitably increasing employment.”

But they insisted that to follow a market solution would involve “tremendous losses, in wastage of productive capacity, and in acute suffering” because wages and other prices had become downwardly rigid and unresponsive to significant market changes except with a prolonged lag. An economic upturn, instead, should be stimulated through “the form of generous Federal expenditures, financed without resort to taxes on commodities or transactions.”

These Chicago economists were certain that the budget deficit would take care of itself; as the economy improved under the initial stimulus of government deficit spending, a reflationary rise in prices and production would generate the private-sector revenue out of which higher taxes would move the government’s budget back into balance or even produce a surplus.

How should the federal government finance its anti-depression budget deficits? They proposed that the U.S. Treasury could issue new bonds to Federal Reserve Banks, for which the Treasury would receive new Federal Reserve Notes and additional bank deposits on the basis of which the government would increase its spending in the American economy. Thus, the total quantity of currency and bank deposit money in circulation would be increased.

What would this increase in currency and bank-deposit money mean for remaining on the gold standard, since the increase in notes and bank deposit claims redeemable on demand for the given available supply of gold could result in a gold drain out of the country, as well as a hoarding of gold at home? The Chicago economists replied: “Once a deliberate reflation is undertaken it must be carried through, whatever that policy may mean for gold.” In other words, if a policy of paper-money creation undertaken to pump up domestic demand and prices threatened the retention of the gold standard, then abandonment (at least temporarily) of the gold standard was a sacrifice they were willing to endorse.

Furthermore, rather than being fearful that federal deficit spending might go too far, they were more concerned that government spending wouldn’t be high enough. A danger, they argued, was that “measures of fiscal inflation may be too meager and too short lived…. We should be prepared to administer heavy doses of stimulant if necessary, to continue them until recovery is firmly established…. A courageous fiscal policy on the part of the central government” was essential, they insisted.

In 1933, the University of Chicago Press published a short monograph entitled Balancing the Budget, signed by several Chicago economists, including Jacob Viner and Henry Simons. The premise of their argument was that the government should balance its budget over several years, running deficits during economic downturns and running surpluses during economic booms:

“The balancing of budgets should be regarded as a series of long-term operations in which deficits will be incurred and debts increased during years of economic adversity while Treasury surpluses and the rapid retirement of the public debt will be planned for during years of prosperity…. When a series of annual budgets is thus put together, the result is the balancing of the long-term budget with reference to economic cycle periods. The equilibrium between revenue and expenditures is thus intentionally struck over a period of years rather than annually.”

Thus, in the early 1930s, the leading economists at the University of Chicago, scholars usually considered among the most outspoken defenders of a free-market order, had proposed and strongly defended deficit spending and paper-money inflation as the primary policy techniques for overcoming the unemployment and idle productive capacity of the Great Depression. They knew and had admitted that the cause for the duration and intensity of the Depression was that resource and labor costs were being held artificially above what would be market-clearing prices and wages. But rather than argue for the abolishment of those impediments to the competitive functioning of the market in the United States, they advocated the short-run expedient of inflation and government deficit spending.

In other words, many of the Chicago economists had held Keynesian-type policy positions several years before Keynes formalized the rationale for them in the theoretical scheme he developed in The General Theory. What, then, separated the economists of the Chicago school from Keynes and the Keynesians in the 1930s and 1940s? Whereas Keynes had seen the cause of the Depression and its persistence in the instability of private-sector “aggregate demand” for goods and services in the economy, the Chicago economists saw the cause of the Great Depression and its severity in the mismanagement of the monetary system by the Federal Reserve in the early 1930s.

But their proposed remedy called not for less government intervention and control over the monetary system. To the contrary, they desired even more and tighter government planning over money and banking in the United States. Theirs, in other words, was the case for an even greater degree of monetary central planning in America.

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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).