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Monetary Central Planning and the State, Part 10: Austrian Business Cycle Theory and the Causes of the Great Depression


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In June 1931, British economist Lionel Robbins wrote a forward for Austrian economist Friedrich A. Hayek’s new book, Prices and Production. Professor Robbins explained the “marvelous renaissance” the Austrian school of economic thought had experienced since the end of the First World War under the leadership of such economists as Ludwig von Mises. Among the Austrian school’s most important recent contributions, he said, was its theory of the business cycle, to which Hayek’s small volume was meant to be an introduction for the English-speaking world. Professor Robbins pointed out:

“Most monetary theorists seem to have failed utterly to apprehend correctly the nature of the forces operative in America before the coming of the [great] depression, thinking apparently that the relative stability of the price level indicated a state of affairs necessarily free from injurious monetary influences. The Austrian theory, of which Dr. Hayek is such a distinguished exponent, can claim at least this merit, that no one who really understood its principal tenets could have cherished for a moment such vain delusions.”

Historical events are never the result of one influencing factor, even a strongly dominating one. And this was no less true in the case of the political and economic influences at work before the Great Depression began in 1929. The First World War had disrupted all of the normal economic and political relationships around the globe. Vast quantities of physical capital and human labor were consumed and destroyed in the four years of war. Wartime and postwar inflations tore apart the social and cultural fabrics of several major countries in Europe, especially Germany and Austria. The institutions of civil and liberal society were severely weakened and replaced with interventionist and socialist political regimes that limited or abolished civil and economic liberties.

New nations rose up in Central and Eastern Europe with the collapse of the German, Austrian, and Russian empires. All of them to one degree or another followed the path of economic nationalism — imposing protectionist trade barriers; subsidizing agriculture and various privileged industries; nationalizing entire sectors of the economy; instituting artificial foreign exchange rates and exchange controls; and establishing welfare-statist programs.

Germany’s reparations payments were a peculiar mechanism of financial musical chairs, with the United States lending money to the Germans, so they could meet their payments to the Allied powers, including America: American and other European trade barriers had made it difficult for the Germans to earn the necessary sums through exports to fulfill all their financial obligations under the terms of the peace treaty that had ended the war.

The monetary system of the world — the international gold standard — was fatally weakened by government inflationary policies during and after the war. In spite of all the weaknesses of the gold standard and in spite of abuses of the gold standard by the governments that managed it in the decades before 1914, it had brought about a high degree of monetary stability that had fostered a global economic environment conducive to savings, investment, international trade, and capital formation. In the 1920s, however, the monetary systems of the major nations of Europe were increasingly fiat currencies more directly controlled and manipulated by government, even when they remained nominally “linked” to gold.

In the United States, the establishment of the Federal Reserve System in 1913 created a new centralized engine for monetary expansion. In this setting, the American Federal Reserve System undertook its experiment in the monetary stabilization of the price level. (See “Monetary Central Planning and the State: Part IV,” Freedom Daily, April 1997.)

In the 1920s, as we have seen, Ludwig von Mises had demonstrated the fundamental weakness in all attempts to stabilize an economy through price-level stabilization by explaining the inherent non-neutrality of money. Changes in the money supply necessarily arise from the injection of additional sums of the medium of exchange at some particular points in the market. These additions to the money supply then affect the rest of the economy through the particular temporal-sequential process through which the new money is spent by each individual and group of suppliers and demanders who receive it over time.

The end result is a change in the general purchasing power or value of money. But in the process of bringing about that result, the structure of relative prices, wages, and income, as well as the allocation of resources, also are modified. And if the monetary injections occur through the banking system, a business cycle might very well be set in motion. (See “Monetary Central Planning and the State: Part IX,” Freedom Daily, September 1997.)

But it was Mises’s young Austrian colleague, Friedrich A. Hayek, who detailed why stabilizing the price level could distort the structure of relative prices in such a manner that a business cycle was likely to be set in motion. In Monetary Theory and the Trade Cycle (1929), Hayek argued that the role of the rate of interest in a market economy was to ensure that the amount and the time horizons of investment activities were kept in balance with the available savings in the economy. Unless the rate of interest was permitted to perform its role on the basis of normal market-competitive forces, savings and investment could get out of balance.

In an economy experiencing increases in productivity and capital formation, the resulting cost efficiencies and increased productive capacities in various industries would tend over time to put downward pressure on prices because of the increased supplies of goods offered to consumers on the market. The price of each of these goods would decrease to the extent required to ensure that the market in which each good was sold was kept in balance. In the markets in which consumer demand was fairly responsive, or “elastic,” to the increase in the available supplies, the individual prices might have to decline only moderately. In other markets, in which consumer demand was noticeably less responsive, or “inelastic,” to an increase in the available supplies, the individual prices would have to decrease to a greater extent to keep the greater supply in balance with the demand.

Over time, the average level of prices as measured by some statistical price index would record that there had occurred a “deflation” of prices. But such a price deflation was not only not harmful in its effects, but was essential if the market-determined structure of relative prices was to keep the supply and demand for each individual good in balance with each other through time. (See “Monetary Central Planning and the State: Part VII,” Freedom Daily, July 1997).

But instead of allowing this downward trend in prices to naturally occur, the Federal Reserve increased the supply of money in the American economy to counteract the normal process of price deflation. In aggregate terms, the amount of money demand for goods and services was increased just enough to match the increase in the quantity of those goods and services offered on the market to maintain the general statistical average of prices at a fairly “stable” level throughout most of the 1920s, as measured by the wholesale price index.

But, argued Hayek in Monetary Theory and the Trade Cycle,

“The rate of interest which equilibrates the supply of real savings and the demand for capital cannot be a rate of interest which also prevents changes in the price level. In this case, stability of the price level presupposes change in the supply of money. . . . The rate of interest at which, in an expanding economy, the amount of new money entering circulation is just sufficient to keep the price-level stable, is always lower than the rate which would keep the amount of available loan-capital equal to the amount simultaneously saved by the public: and thus, despite the stability of the price-level, it makes possible a development leading away from the equilibrium position.”

Increases in the money supply, institutionally, are introduced in the form of increased reserves supplied to the banking system by the Federal Reserve, on the basis of which additional loans may be extended. But the only way banks can induce potential borrowers to take up the increased sums of lendable funds is to lower the rate of interest at which the banks offer to lend them.

The lower rate of interest decreases the cost of borrowing relative to the expected rate of return from various investment projects. But the rate of interest is not only a measure of the cost of loans; it is also the factor by which the prospective value of an investment is capitalized in terms of its present value. The lower rate of interest also acts, therefore, as a stimulus for the undertaking of longer-term investment projects involving time horizons further into the future than would have been the case at the higher rate of interest that would have prevailed on the loan market if not for the increase in the money supply.

Thus, in the 1920s, beneath the apparent calm of a stable price level, Federal Reserve policy was creating a structure of relative price and profit relationships that induced a number of longer-term investments that was in excess of actual savings to sustain them in the long run. Why were they unsustainable in the long run? Because, as the new money was spent on new and expanded investment projects, the additional money eventually passed into the hands of factors of production drawn into those employments as higher money incomes. As the higher money incomes were then spent in the market, the demands for consumer goods increased as well, acting as a counterpull to attract production and resources back to consumer goods production and investment projects with shorter time-horizons. Only with further injections of additional quantities of money into the banking system was the Federal Reserve able to keep market rates of interest below their proper equilibrium levels and thus able to temporarily maintain the profitabilities of the longer-term investment projects set into motion by the attempt to keep the price level stable.

Finally, in 1928, under the pressure of this monetary expansion, the price level began to rise. The Federal Reserve, fearful of creating an absolute inflationary rise in prices, reined in the money supply. But with the end to the monetary expansion, interest rates began to rise to their real market-clearing levels. Some of the longer-term investment projects that either had been brought to completion or were still in progress were shown to be unprofitable at the higher rates of interest. The investment “boom” collapsed, with its first major indication being the “break” in the stock market in October 1929.

In 1932, in an article entitled “The Fate of the Gold Standard,” Hayek summarized what he considered to be the lessons of the 1920s:

“Instead of prices being allowed to fall slowly, to the full extent that would have been possible without inflicting damage on production, such volumes of additional credit were pumped into circulation that the level of prices was roughly stabilized. . . . Whether such inflation merely serves to keep prices stable, or whether it leads to an increase in prices, makes little difference. Experience has now confirmed what theory was already aware of; that such inflation can also lead to production being misdirected to such an extent that, in the end, a breakdown in the form of a crisis becomes inevitable. This, however, also proves the impossibility of achieving in practice an absolute maintenance of the level of prices in a dynamic economy.”

Corrective forces in the market were set in motion, once the monetary expansion had come to an end. But the depth and duration of the Great Depression turned out to be far greater and longer than would have normally seemed to be required for economy-wide balance to be restored. The reasons for the Great Depression’s severity were not, however, to be found in any inherent failure of the market economy, but rather in the political ideologies and government policies of the 1930s.

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    Dr. Richard M. Ebeling is the BB&T Distinguished Professor of Ethics and Free Enterprise Leadership at The Citadel. He was formerly professor of Economics at Northwood University, 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).