What Causes Economic Depressions?

HT: Kairos Journal for this article on the cause of economic depressions:

What Causes Economic Depressions?
In his testimony before a congressional committee in 1930, American Communist Party leader, William Z. Foster, declared: “What is the cause of this starvation, misery and hardship of the millions of workers in the United States? Is it because some great national calamity has destroyed the food, clothing and shelter available for the people? No, on the contrary. Millions of workers must go hungry because there is too much wheat. Millions of workers must go without clothes because the warehouses are full to overflowing with everything that is needed. Millions of workers must freeze because there is too much coal. This is the logic of the capitalist system . . .”¹

This statement, made at the beginning of the Great Depression of the 1930s, typifies the widespread view that, in the absence of government intervention and regulation, free-market economies are inherently unstable, lurching from boom to bust, from inflation to unemployment. But is this really true? Not according to the great 20th century “classical liberal” economist Ludwig von Mises,² who was one of the few economists to predict, in the 1920s, the coming of the Great Depression, and who had been similarly prescient regarding the great German hyperinflation and collapse of 1919-1923. In fact, von Mises, and, fellow “Austrian school” economist and Nobel prize-winner, Friedrich A. Hayek³ argue that it is precisely government mismanagement of the monetary system and government controls on production and trade, which are responsible for boom-and-bust cycles and prolonged depressions.⁴

Like so much of economics, the “Austrian school” views are complex, but in a nutshell they maintain that in a free-enterprise economy—with free competition, open markets, and freely moving prices and wages—prices send crucial signals, telling businessmen what to produce, counseling workers where to offer their labor, and influencing what people consume. In this way the supply and demand for goods and services in all different markets (including the market for labor) tend to balance each other continually. In addition, the search for profit and the pressure of competition encourage entrepreneurs to forecast the future conditions in their respective markets correctly. For these reasons, there cannot, in normal circumstances, be a general overproduction of goods and services and hence a general slump in business activity.

What then causes boom-bust cycles like the Great Depression? The “Austrians” blame the government, charging that state-induced inflation, brought about by an excessive increase in the quantity of money and credit by state-controlled central banks, skews important market price signals. As a result, rising prices and asset values fool businessmen into making investment decisions not sustainable in real terms. Eventually and inevitably, confidence collapses, businessmen stop investing, and there is a major slump in business activity. The result is widespread unemployment of labor and resources.

Furthermore, they argue, once the “drug” of inflation has been removed, a slump will be corrected most quickly if prices and wages are allowed to freely adjust downwards, back to what true market conditions demand. Governments and unions may attempt to alleviate the pain of the depression through official controls over prices, dividends, wage rates, and through guiding production and investment decisions, but this, say the Austrian economists, will only artificially and unnecessarily prolong it—as happened in the 1930s.

It is odd that many who would not trust the national government to “fine tune” families, schools, and churches would applaud state attempts to tinker with the market. And this despite clear evidence that such tinkering undermines market stability and robs businessmen of the necessary confidence to commit capital for long-term investments.

Footnotes:

1	Clarence B. Carson, The Welfare State 1929-1985, in A Basic History of the United States, vol. 5 (Phenix City, AL: American Textbook Committee, 1986), 10.
2	See Ludwig von Mises, The Theory of Money and Credit (New York: The Foundation of Economic Education, 1971). This was first published in German in 1912 and in English in 1934. See also (for a more popular audience) von Mises, Planning For Freedom, 3rd edition (South Holland, IL: Libertarian Press, 1974).
3	Friedrich A. Hayek, Prices and Production (London: G. Routledge & Sons, 1931), and Monetary Theory and the Trade Cycle (New York: Harcourt, Brace & Co, 1933). See also Murray Rothbard, America’s Great Depression, 3rd edition (Kansas City: Sheed & Ward, 1975) and (for a more popular audience) For A New Liberty: A Libertarian Manifesto, revised edition (New York: Collier Macmillan, 1978), chapter 9.
4	See also von Mises, Haberler, Rothbard, Hayek, The Austrian Theory of the Trade Cycle and Other Essays, in Occasional Papers Series 8 (New York: Center for Libertarian Studies, 1978). A similar view is held, for slightly different reasons, by the monetarist economist Milton Friedman. See Milton Friedman, and Anna J. Schwartz, A Monetary History of the United States, 1867-1960 (New Jersey: Princeton University Press, 1963); and Friedman, Capitalism and Freedom (Chicago: University of Chicago Press, 1962), chapter 3.