• Economic Depressions: Their Cause and Cure

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    We live in
    a world of euphemism. Undertakers have become “morticians,” press
    agents are now “public relations counsellors” and janitors have
    all been transformed into “superintendents.” In every walk of life,
    plain facts have been wrapped in cloudy camouflage.

    No less has
    this been true of economics. In the old days, we used to suffer
    nearly periodic economic crises, the sudden onset of which was called
    a “panic,” and the lingering trough period after the panic was called
    “depression.”

    The most famous
    depression in modern times, of course, was the one that began in
    a typical financial panic in 1929 and lasted until the advent of
    World War II. After the disaster of 1929, economists and politicians
    resolved that this must never happen again. The easiest way of succeeding
    at this resolve was, simply to define “depressions” out of existence.
    From that point on, America was to suffer no further depressions.
    For when the next sharp depression came along, in 1937–38,
    the economists simply refused to use the dread name, and came up
    with a new, much softer-sounding word: “recession.” From that point
    on, we have been through quite a few recessions, but not a single
    depression.

    But pretty
    soon the word “recession” also became too harsh for the delicate
    sensibilities of the American public. It now seems that we had our
    last recession in 1957–58. For since then, we have only had
    “downturns,” or, even better, “slowdowns,” or “sidewise movements.”
    So be of good cheer; from now on, depressions and even recessions
    have been outlawed by the semantic fiat of economists; from now
    on, the worst that can possibly happen to us are “slowdowns.” Such
    are the wonders of the “New Economics.”

    For 30 years,
    our nation’s economists have adopted the view of the business cycle
    held by the late British economist, John Maynard Keynes, who created
    the Keynesian, or the “New,” Economics in his book, The
    General Theory of Employment, Interest, and Money
    , published
    in 1936. Beneath their diagrams, mathematics, and inchoate jargon,
    the attitude of Keynesians toward booms and bust is simplicity,
    even navet, itself. If there is inflation, then the cause is supposed
    to be “excessive spending” on the part of the public; the alleged
    cure is for the government, the self-appointed stabilizer and regulator
    of the nation’s economy, to step in and force people to spend less,
    “sopping up their excess purchasing power” through increased taxation.
    If there is a recession, on the other hand, this has been caused
    by insufficient private spending, and the cure now is for the government
    to increase its own spending, preferably through deficits, thereby
    adding to the nation’s aggregate spending stream.

    The idea that
    increased government spending or easy money is “good for business”
    and that budget cuts or harder money is “bad” permeates even the
    most conservative newspapers and magazines. These journals will
    also take for granted that it is the sacred task of the federal
    government to steer the economic system on the narrow road between
    the abysses of depression on the one hand and inflation on the other,
    for the free-market economy is supposed to be ever liable to succumb
    to one of these evils.

    All current
    schools of economists have the same attitude. Note, for example,
    the viewpoint of Dr. Paul W. McCracken, the incoming chairman of
    President Nixon’s Council of Economic Advisers. In an interview
    with the New York Times shortly after taking office [January
    24, 1969], Dr. McCracken asserted that one of the major economic
    problems facing the new Administration is “how you cool down this
    inflationary economy without at the same time tripping off unacceptably
    high levels of unemployment. In other words, if the only thing we
    want to do is cool off the inflation, it could be done. But our
    social tolerances on unemployment are narrow.” And again: “I think
    we have to feel our way along here. We don’t really have much experience
    in trying to cool an economy in orderly fashion. We slammed on the
    brakes in 1957, but, of course, we got substantial slack in the
    economy.”

    Note the fundamental
    attitude of Dr. McCracken toward the economy – remarkable only
    in that it is shared by almost all economists of the present day.
    The economy is treated as a potentially workable, but always troublesome
    and recalcitrant patient, with a continual tendency to hive off
    into greater inflation or unemployment. The function of the government
    is to be the wise old manager and physician, ever watchful, ever
    tinkering to keep the economic patient in good working order. In
    any case, here the economic patient is clearly supposed to be the
    subject, and the government as “physician” the master.

    It was not
    so long ago that this kind of attitude and policy was called “socialism”;
    but we live in a world of euphemism, and now we call it by far less
    harsh labels, such as “moderation” or “enlightened free enterprise.”
    We live and learn.

    What, then,
    are the causes of periodic depressions? Must we always remain agnostic
    about the causes of booms and busts? Is it really true that business
    cycles are rooted deep within the free-market economy, and that
    therefore some form of government planning is needed if we wish
    to keep the economy within some kind of stable bounds? Do booms
    and then busts just simply happen, or does one phase of the cycle
    flow logically from the other?

    The currently
    fashionable attitude toward the business cycle stems, actually,
    from Karl Marx. Marx saw that, before the Industrial Revolution
    in approximately the late eighteenth century, there were no regularly
    recurring booms and depressions. There would be a sudden economic
    crisis whenever some king made war or confiscated the property of
    his subject; but there was no sign of the peculiarly modern phenomena
    of general and fairly regular swings in business fortunes, of expansions
    and contractions. Since these cycles also appeared on the scene
    at about the same time as modern industry, Marx concluded that business
    cycles were an inherent feature of the capitalist market economy.
    All the various current schools of economic thought, regardless
    of their other differences and the different causes that they attribute
    to the cycle, agree on this vital point: That these business cycles
    originate somewhere deep within the free-market economy. The market
    economy is to blame. Karl Marx believed that the periodic depressions
    would get worse and worse, until the masses would be moved to revolt
    and destroy the system, while the modern economists believe that
    the government can successfully stabilize depressions and the cycle.
    But all parties agree that the fault lies deep within the market
    economy and that if anything can save the day, it must be some form
    of massive government intervention.

    There are,
    however, some critical problems in the assumption that the market
    economy is the culprit. For “general economic theory” teaches us
    that supply and demand always tend to be in equilibrium in the market
    and that therefore prices of products as well as of the factors
    that contribute to production are always tending toward some equilibrium
    point. Even though changes of data, which are always taking place,
    prevent equilibrium from ever being reached, there is nothing in
    the general theory of the market system that would account for regular
    and recurring boom-and-bust phases of the business cycle. Modern
    economists “solve” this problem by simply keeping their general
    price and market theory and their business cycle theory in separate,
    tightly-sealed compartments, with never the twain meeting, much
    less integrated with each other. Economists, unfortunately, have
    forgotten that there is only one economy and therefore only one
    integrated economic theory. Neither economic life nor the structure
    of theory can or should be in watertight compartments; our knowledge
    of the economy is either one integrated whole or it is nothing.
    Yet most economists are content to apply totally separate and, indeed,
    mutually exclusive, theories for general price analysis and for
    business cycles. They cannot be genuine economic scientists so long
    as they are content to keep operating in this primitive way.

    But there are
    still graver problems with the currently fashionable approach. Economists
    also do not see one particularly critical problem because they do
    not bother to square their business cycle and general price theories:
    the peculiar breakdown of the entrepreneurial function at times
    of economic crisis and depression. In the market economy, one of
    the most vital functions of the businessman is to be an “entrepreneur,”
    a man who invests in productive methods, who buys equipment and
    hires labor to produce something which he is not sure will reap
    him any return. In short, the entrepreneurial function is the function
    of forecasting the uncertain future. Before embarking on any investment
    or line of production, the entrepreneur, or “enterpriser,” must
    estimate present and future costs and future revenues and therefore
    estimate whether and how much profits he will earn from the investment.
    If he forecasts well and significantly better than his business
    competitors, he will reap profits from his investment. The better
    his forecasting, the higher the profits he will earn. If, on the
    other hand, he is a poor forecaster and overestimates the demand
    for his product, he will suffer losses and pretty soon be forced
    out of the business.

    The market
    economy, then, is a profit-and-loss economy, in which the acumen
    and ability of business entrepreneurs is gauged by the profits and
    losses they reap. The market economy, moreover, contains a built-in
    mechanism, a kind of natural selection, that ensures the survival
    and the flourishing of the superior forecaster and the weeding-out
    of the inferior ones. For the more profits reaped by the better
    forecasters, the greater become their business responsibilities,
    and the more they will have available to invest in the productive
    system. On the other hand, a few years of making losses will drive
    the poorer forecasters and entrepreneurs out of business altogether
    and push them into the ranks of salaried employees.

    If, then, the
    market economy has a built-in natural selection mechanism for good
    entrepreneurs, this means that, generally, we would expect not many
    business firms to be making losses. And, in fact, if we look around
    at the economy on an average day or year, we will find that losses
    are not very widespread. But, in that case, the odd fact that needs
    explaining is this: How is it that, periodically, in times of the
    onset of recessions and especially in steep depressions, the business
    world suddenly experiences a massive cluster of severe losses? A
    moment arrives when business firms, previously highly astute entrepreneurs
    in their ability to make profits and avoid losses, suddenly and
    dismayingly find themselves, almost all of them, suffering severe
    and unaccountable losses – How come? Here is a momentous fact that
    any theory of depressions must explain. An explanation such as “underconsumption”
    – a drop in total consumer spending – is not sufficient,
    for one thing, because what needs to be explained is why businessmen,
    able to forecast all manner of previous economic changes and developments,
    proved themselves totally and catastrophically unable to forecast
    this alleged drop in consumer demand. Why this sudden failure in
    forecasting ability?

    An adequate
    theory of depressions, then, must account for the tendency of the
    economy to move through successive booms and busts, showing no sign
    of settling into any sort of smoothly moving, or quietly progressive,
    approximation of an equilibrium situation. In particular, a theory
    of depression must account for the mammoth cluster of errors which
    appears swiftly and suddenly at a moment of economic crisis, and
    lingers through the depression period until recovery. And there
    is a third universal fact that a theory of the cycle must account
    for. Invariably, the booms and busts are much more intense and severe
    in the “capital goods industries” – the industries making machines
    and equipment, the ones producing industrial raw materials or constructing
    industrial plants – than in the industries making consumers’
    goods. Here is another fact of business cycle life that must be
    explained – and obviously can’t be explained by such theories
    of depression as the popular underconsumption doctrine: That consumers
    aren’t spending enough on consumer goods. For if insufficient spending
    is the culprit, then how is it that retail sales are the last and
    the least to fall in any depression, and that depression really
    hits such industries as machine tools, capital equipment, construction,
    and raw materials? Conversely, it is these industries that really
    take off in the inflationary boom phases of the business cycle,
    and not those businesses serving the consumer. An adequate theory
    of the business cycle, then, must also explain the far greater intensity
    of booms and busts in the non-consumer goods, or “producers’ goods,”
    industries.

    Fortunately,
    a correct theory of depression and of the business cycle does
    exist, even though it is universally neglected in present-day economics.
    It, too, has a long tradition in economic thought. This theory began
    with the eighteenth century Scottish philosopher and economist David
    Hume, and with the eminent early nineteenth century English classical
    economist David Ricardo. Essentially, these theorists saw that another
    crucial institution had developed in the mid-eighteenth century,
    alongside the industrial system. This was the institution of banking,
    with its capacity to expand credit and the money supply (first,
    in the form of paper money, or bank notes, and later in the form
    of demand deposits, or checking accounts, that are instantly redeemable
    in cash at the banks). It was the operations of these commercial
    banks which, these economists saw, held the key to the mysterious
    recurrent cycles of expansion and contraction, of boom and bust,
    that had puzzled observers since the mid-eighteenth century.

    The Ricardian
    analysis of the business cycle went something as follows: The natural
    moneys emerging as such on the world free market are useful commodities,
    generally gold and silver. If money were confined simply to these
    commodities, then the economy would work in the aggregate as it
    does in particular markets: A smooth adjustment of supply and demand,
    and therefore no cycles of boom and bust. But the injection of bank
    credit adds another crucial and disruptive element. For the banks
    expand credit and therefore bank money in the form of notes or deposits
    which are theoretically redeemable on demand in gold, but in practice
    clearly are not. For example, if a bank has 1000 ounces of gold
    in its vaults, and it issues instantly redeemable warehouse receipts
    for 2500 ounces of gold, then it clearly has issued 1500 ounces
    more than it can possibly redeem. But so long as there is no concerted
    “run” on the bank to cash in these receipts, its warehouse-receipts
    function on the market as equivalent to gold, and therefore the
    bank has been able to expand the money supply of the country by
    1500 gold ounces.

    The banks,
    then, happily begin to expand credit, for the more they expand credit
    the greater will be their profits. This results in the expansion
    of the money supply within a country, say England. As the supply
    of paper and bank money in England increases, the money incomes
    and expenditures of Englishmen rise, and the increased money bids
    up prices of English goods. The result is inflation and a boom within
    the country. But this inflationary boom, while it proceeds on its
    merry way, sows the seeds of its own demise. For as English money
    supply and incomes increase, Englishmen proceed to purchase more
    goods from abroad. Furthermore, as English prices go up, English
    goods begin to lose their competitiveness with the products of other
    countries which have not inflated, or have been inflating to a lesser
    degree. Englishmen begin to buy less at home and more abroad, while
    foreigners buy less in England and more at home; the result is a
    deficit in the English balance of payments, with English exports
    falling sharply behind imports. But if imports exceed exports, this
    means that money must flow out of England to foreign countries.
    And what money will this be? Surely not English bank notes or deposits,
    for Frenchmen or Germans or Italians have little or no interest
    in keeping their funds locked up in English banks. These foreigners
    will therefore take their bank notes and deposits and present them
    to the English banks for redemption in gold – and gold will
    be the type of money that will tend to flow persistently out of
    the country as the English inflation proceeds on its way. But this
    means that English bank credit money will be, more and more, pyramiding
    on top of a dwindling gold base in the English bank vaults. As the
    boom proceeds, our hypothetical bank will expand its warehouse receipts
    issued from, say 2500 ounces to 4000 ounces, while its gold base
    dwindles to, say, 800. As this process intensifies, the banks will
    eventually become frightened. For the banks, after all, are obligated
    to redeem their liabilities in cash, and their cash is flowing out
    rapidly as their liabilities pile up. Hence, the banks will eventually
    lose their nerve, stop their credit expansion, and in order to save
    themselves, contract their bank loans outstanding. Often, this retreat
    is precipitated by bankrupting runs on the banks touched off by
    the public, who had also been getting increasingly nervous about
    the ever more shaky condition of the nation’s banks.

    The
    bank contraction reverses the economic picture; contraction and
    bust follow boom. The banks pull in their horns, and businesses
    suffer as the pressure mounts for debt repayment and contraction.
    The fall in the supply of bank money, in turn, leads to a general
    fall in English prices. As money supply and incomes fall, and English
    prices collapse, English goods become relatively more attractive
    in terms of foreign products, and the balance of payments reverses
    itself, with exports exceeding imports. As gold flows into the country,
    and as bank money contracts on top of an expanding gold base, the
    condition of the banks becomes much sounder.

    This, then,
    is the meaning of the depression phase of the business cycle. Note
    that it is a phase that comes out of, and inevitably comes out of,
    the preceding expansionary boom. It is the preceding inflation that
    makes the depression phase necessary. We can see, for example, that
    the depression is the process by which the market economy adjusts,
    throws off the excesses and distortions of the previous inflationary
    boom, and reestablishes a sound economic condition. The depression
    is the unpleasant but necessary reaction to the distortions and
    excesses of the previous boom.

    Why, then,
    does the next cycle begin? Why do business cycles tend to be recurrent
    and continuous? Because when the banks have pretty well recovered,
    and are in a sounder condition, they are then in a confident position
    to proceed to their natural path of bank credit expansion, and the
    next boom proceeds on its way, sowing the seeds for the next inevitable
    bust.

    But if banking
    is the cause of the business cycle, aren’t the banks also a part
    of the private market economy, and can’t we therefore say that the
    free market is still the culprit, if only in the banking
    segment of that free market? The answer is No, for the banks, for
    one thing, would never be able to expand credit in concert were
    it not for the intervention and encouragement of government. For
    if banks were truly competitive, any expansion of credit by one
    bank would quickly pile up the debts of that bank in its competitors,
    and its competitors would quickly call upon the expanding bank for
    redemption in cash. In short, a bank’s rivals will call upon it
    for redemption in gold or cash in the same way as do foreigners,
    except that the process is much faster and would nip any incipient
    inflation in the bud before it got started. Banks can only expand
    comfortably in unison when a Central Bank exists, essentially a
    governmental bank, enjoying a monopoly of government business, and
    a privileged position imposed by government over the entire banking
    system. It is only when central banking got established that the
    banks were able to expand for any length of time and the familiar
    business cycle got underway in the modern world.

    The central
    bank acquires its control over the banking system by such governmental
    measures as: Making its own liabilities legal tender for all debts
    and receivable in taxes; granting the central bank monopoly of the
    issue of bank notes, as contrasted to deposits (in England
    the Bank of England, the governmentally established central bank,
    had a legal monopoly of bank notes in the London area); or through
    the outright forcing of banks to use the central bank as their client
    for keeping their reserves of cash (as in the United States and
    its Federal Reserve System). Not that the banks complain about this
    intervention; for it is the establishment of central banking that
    makes long-term bank credit expansion possible, since the expansion
    of Central Bank notes provides added cash reserves for the entire
    banking system and permits all the commercial banks to expand their
    credit together. Central banking works like a cozy compulsory bank
    cartel to expand the banks’ liabilities; and the banks are now able
    to expand on a larger base of cash in the form of central bank notes
    as well as gold.

    So now we see,
    at last, that the business cycle is brought about, not by any mysterious
    failings of the free market economy, but quite the opposite: By
    systematic intervention by government in the market process. Government
    intervention brings about bank expansion and inflation, and, when
    the inflation comes to an end, the subsequent depression-adjustment
    comes into play.

    The Ricardian
    theory of the business cycle grasped the essentials of a correct
    cycle theory: The recurrent nature of the phases of the cycle, depression
    as adjustment intervention in the market rather than from the free-market
    economy. But two problems were as yet unexplained: Why the sudden
    cluster of business error, the sudden failure of the entrepreneurial
    function, and why the vastly greater fluctuations in the producers’
    goods than in the consumers’ goods industries? The Ricardian theory
    only explained movements in the price level, in general business;
    there was no hint of explanation of the vastly different reactions
    in the capital and consumers’ goods industries.

    The correct
    and fully developed theory of the business cycle was finally discovered
    and set forth by the Austrian economist Ludwig von Mises, when he
    was a professor at the University of Vienna. Mises developed hints
    of his solution to the vital problem of the business cycle in his
    monumental Theory
    of Money and Credit
    , published in 1912, and still, nearly
    60 years later, the best book on the theory of money and banking.
    Mises developed his cycle theory during the 1920s, and it was brought
    to the English-speaking world by Mises’s leading follower, Friedrich
    A. von Hayek, who came from Vienna to teach at the London School
    of Economics in the early 1930s, and who published, in German and
    in English, two books which applied and elaborated the Mises cycle
    theory: Monetary
    Theory and the Trade Cycle
    , and Prices
    and Production
    . Since Mises and Hayek were Austrians, and
    also since they were in the tradition of the great nineteenth-century
    Austrian economists, this theory has become known in the literature
    as the “Austrian” (or the “monetary over-investment”) theory of
    the business cycle.

    Building on
    the Ricardians, on general “Austrian” theory, and on his own creative
    genius, Mises developed the following theory of the business cycle:

    Without bank
    credit expansion, supply and demand tend to be equilibrated through
    the free price system, and no cumulative booms or busts can then
    develop. But then government through its central bank stimulates
    bank credit expansion by expanding central bank liabilities and
    therefore the cash reserves of all the nation’s commercial banks.
    The banks then proceed to expand credit and hence the nation’s money
    supply in the form of check deposits. As the Ricardians saw, this
    expansion of bank money drives up the prices of goods and hence
    causes inflation. But, Mises showed, it does something else, and
    something even more sinister. Bank credit expansion, by pouring
    new loan funds into the business world, artificially lowers the
    rate of interest in the economy below its free market level.

    On the free
    and unhampered market, the interest rate is determined purely by
    the “time-preferences” of all the individuals that make up the market
    economy. For the essence of a loan is that a “present good” (money
    which can be used at present) is being exchanged for a “future good”
    (an IOU which can only be used at some point in the future). Since
    people always prefer money right now to the prospect of getting
    the same amount of money some time in the future, the present good
    always commands a premium in the market over the future. This premium
    is the interest rate, and its height will vary according to the
    degree to which people prefer the present to the future, i.e., the
    degree of their time-preferences.

    People’s
    time-preferences also determine the extent to which people will
    save and invest, as compared to how much they will consume. If people’s
    time-preferences should fall, i.e., if their degree of preference
    for present over future falls, then people will tend to consume
    less now and save and invest more; at the same time, and for the
    same reason, the rate of interest, the rate of time-discount, will
    also fall. Economic growth comes about largely as the result of
    falling rates of time-preference, which lead to an increase in the
    proportion of saving and investment to consumption, and also to
    a falling rate of interest.

    But what happens
    when the rate of interest falls, not because of lower time-preferences
    and higher savings, but from government interference that promotes
    the expansion of bank credit? In other words, if the rate of interest
    falls artificially, due to intervention, rather than naturally,
    as a result of changes in the valuations and preferences of the
    consuming public?

    What happens
    is trouble. For businessmen, seeing the rate of interest fall, react
    as they always would and must to such a change of market signals:
    They invest more in capital and producers’ goods. Investments, particularly
    in lengthy and time-consuming projects, which previously looked
    unprofitable now seem profitable, because of the fall of the interest
    charge. In short, businessmen react as they would react if savings
    had genuinely increased: They expand their investment in
    durable equipment, in capital goods, in industrial raw material,
    in construction as compared to their direct production of consumer
    goods.

    Businesses,
    in short, happily borrow the newly expanded bank money that is coming
    to them at cheaper rates; they use the money to invest in capital
    goods, and eventually this money gets paid out in higher rents to
    land, and higher wages to workers in the capital goods industries.
    The increased business demand bids up labor costs, but businesses
    think they can pay these higher costs because they have been fooled
    by the government-and-bank intervention in the loan market and its
    decisively important tampering with the interest-rate signal of
    the marketplace.

    The problem
    comes as soon as the workers and landlords – largely the former,
    since most gross business income is paid out in wages – begin
    to spend the new bank money that they have received in the form
    of higher wages. For the time-preferences of the public have not
    really gotten lower; the public doesn’t want to
    save more than it has. So the workers set about to consume most
    of their new income, in short to reestablish the old consumer/saving
    proportions. This means that they redirect the spending back to
    the consumer goods industries, and they don’t save and invest enough
    to buy the newly-produced machines, capital equipment, industrial
    raw materials, etc. This all reveals itself as a sudden sharp and
    continuing depression in the producers’ goods industries.
    Once the consumers reestablished their desired consumption/investment
    proportions, it is thus revealed that business had invested too
    much in capital goods and had underinvested in consumer goods. Business
    had been seduced by the governmental tampering and artificial lowering
    of the rate of interest, and acted as if more savings were available
    to invest than were really there. As soon as the new bank money
    filtered through the system and the consumers reestablished their
    old proportions, it became clear that there were not enough savings
    to buy all the producers’ goods, and that business had misinvested
    the limited savings available. Business had overinvested in capital
    goods and underinvested in consumer products.

    The inflationary
    boom thus leads to distortions of the pricing and production system.
    Prices of labor and raw materials in the capital goods industries
    had been bid up during the boom too high to be profitable once the
    consumers reassert their old consumption/investment preferences.
    The “depression” is then seen as the necessary and healthy phase
    by which the market economy sloughs off and liquidates the unsound,
    uneconomic investments of the boom, and reestablishes those proportions
    between consumption and investment that are truly desired by the
    consumers. The depression is the painful but necessary process by
    which the free market sloughs off the excesses and errors of the
    boom and reestablishes the market economy in its function of efficient
    service to the mass of consumers. Since prices of factors of production
    have been bid too high in the boom, this means that prices of labor
    and goods in these capital goods industries must be allowed to fall
    until proper market relations are resumed.

    Since the workers
    receive the increased money in the form of higher wages fairly rapidly,
    how is it that booms can go on for years without having their unsound
    investments revealed, their errors due to tampering with market
    signals become evident, and the depression-adjustment process begins
    its work? The answer is that booms would be very short lived if
    the bank credit expansion and subsequent pushing of the rate of
    interest below the free market level were a one-shot affair. But
    the point is that the credit expansion is not one-shot;
    it proceeds on and on, never giving consumers the chance to reestablish
    their preferred proportions of consumption and saving, never allowing
    the rise in costs in the capital goods industries to catch up to
    the inflationary rise in prices. Like the repeated doping of a horse,
    the boom is kept on its way and ahead of its inevitable comeuppance,
    by repeated doses of the stimulant of bank credit. It is only when
    bank credit expansion must finally stop, either because the banks
    are getting into a shaky condition or because the public begins
    to balk at the continuing inflation, that retribution finally catches
    up with the boom. As soon as credit expansion stops, then the piper
    must be paid, and the inevitable readjustments liquidate the unsound
    over-investments of the boom, with the reassertion of a greater
    proportionate emphasis on consumers’ goods production.

    Thus, the Misesian
    theory of the business cycle accounts for all of our puzzles: The
    repeated and recurrent nature of the cycle, the massive cluster
    of entrepreneurial error, the far greater intensity of the boom
    and bust in the producers’ goods industries.

    Mises, then,
    pinpoints the blame for the cycle on inflationary bank credit expansion
    propelled by the intervention of government and its central bank.
    What does Mises say should be done, say by government, once the
    depression arrives? What is the governmental role in the cure of
    depression? In the first place, government must cease inflating
    as soon as possible. It is true that this will, inevitably, bring
    the inflationary boom abruptly to an end, and commence the inevitable
    recession or depression. But the longer the government waits for
    this, the worse the necessary readjustments will have to be. The
    sooner the depression-readjustment is gotten over with, the better.
    This means, also, that the government must never try to prop up
    unsound business situations; it must never bail out or lend money
    to business firms in trouble. Doing this will simply prolong the
    agony and convert a sharp and quick depression phase into a lingering
    and chronic disease. The government must never try to prop up wage
    rates or prices of producers’ goods; doing so will prolong and delay
    indefinitely the completion of the depression-adjustment process;
    it will cause indefinite and prolonged depression and mass unemployment
    in the vital capital goods industries. The government must not try
    to inflate again, in order to get out of the depression. For even
    if this reinflation succeeds, it will only sow greater trouble later
    on. The government must do nothing to encourage consumption, and
    it must not increase its own expenditures, for this will further
    increase the social consumption/investment ratio. In fact, cutting
    the government budget will improve the ratio. What the economy needs
    is not more consumption spending but more saving, in order to validate
    some of the excessive investments of the boom.

    Thus, what
    the government should do, according to the Misesian analysis of
    the depression, is absolutely nothing. It should, from the point
    of view of economic health and ending the depression as quickly
    as possible, maintain a strict hands off, “laissez-faire”
    policy. Anything it does will delay and obstruct the adjustment
    process of the market; the less it does, the more rapidly will the
    market adjustment process do its work, and sound economic recovery
    ensue.

    The Misesian
    prescription is thus the exact opposite of the Keynesian: It is
    for the government to keep absolute hands off the economy and to
    confine itself to stopping its own inflation and to cutting its
    own budget.

    It has today
    been completely forgotten, even among economists, that the Misesian
    explanation and analysis of the depression gained great headway
    precisely during the Great Depression of the 1930s – the very depression
    that is always held up to advocates of the free market economy as
    the greatest single and catastrophic failure of laissez-faire
    capitalism. It was no such thing. 1929 was made inevitable by the
    vast bank credit expansion throughout the Western world during the
    1920s: A policy deliberately adopted by the Western governments,
    and most importantly by the Federal Reserve System in the United
    States. It was made possible by the failure of the Western world
    to return to a genuine gold standard after World War I, and thus
    allowing more room for inflationary policies by government. Everyone
    now thinks of President Coolidge as a believer in laissez-faire
    and an unhampered market economy; he was not, and tragically, nowhere
    less so than in the field of money and credit. Unfortunately, the
    sins and errors of the Coolidge intervention were laid to the door
    of a non-existent free market economy.

    If Coolidge
    made 1929 inevitable, it was President Hoover who prolonged and
    deepened the depression, transforming it from a typically sharp
    but swiftly-disappearing depression into a lingering and near-fatal
    malady, a malady “cured” only by the holocaust of World War II.
    Hoover, not Franklin Roosevelt, was the founder of the policy of
    the “New Deal”: essentially the massive use of the State to do exactly
    what Misesian theory would most warn against – to prop up wage
    rates above their free-market levels, prop up prices, inflate credit,
    and lend money to shaky business positions. Roosevelt only advanced,
    to a greater degree, what Hoover had pioneered. The result for the
    first time in American history, was a nearly perpetual depression
    and nearly permanent mass unemployment. The Coolidge crisis had
    become the unprecedentedly prolonged Hoover-Roosevelt depression.

    Ludwig von
    Mises had predicted the depression during the heyday of the great
    boom of the 1920s – a time, just like today, when economists
    and politicians, armed with a “new economics” of perpetual inflation,
    and with new “tools” provided by the Federal Reserve System, proclaimed
    a perpetual “New Era” of permanent prosperity guaranteed by our
    wise economic doctors in Washington. Ludwig von Mises, alone armed
    with a correct theory of the business cycle, was one of the very
    few economists to predict the Great Depression, and hence the economic
    world was forced to listen to him with respect. F. A. Hayek spread
    the word in England, and the younger English economists were all,
    in the early 1930s, beginning to adopt the Misesian cycle theory
    for their analysis of the depression – and also to adopt, of
    course, the strictly free-market policy prescription that flowed
    with this theory. Unfortunately, economists have now adopted the
    historical notion of Lord Keynes: That no “classical economists”
    had a theory of the business cycle until Keynes came along in 1936.
    There was a theory of the depression; it was the classical
    economic tradition; its prescription was strict hard money and laissez-faire;
    and it was rapidly being adopted, in England and even in the United
    States, as the accepted theory of the business cycle. (A particular
    irony is that the major “Austrian” proponent in the United States
    in the early and mid-1930s was none other than Professor Alvin Hansen,
    very soon to make his mark as the outstanding Keynesian disciple
    in this country.)

    What swamped
    the growing acceptance of Misesian cycle theory was simply the “Keynesian
    Revolution” – the amazing sweep that Keynesian theory made
    of the economic world shortly after the publication of the General
    Theory in 1936. It is not that Misesian theory was refuted
    successfully; it was just forgotten in the rush to climb
    on the suddenly fashionable Keynesian bandwagon. Some of the leading
    adherents of the Mises theory – who clearly knew better –
    succumbed to the newly established winds of doctrine, and won leading
    American university posts as a consequence.

    But now the
    once arch-Keynesian London Economist has recently proclaimed
    that “Keynes is Dead.” After over a decade of facing trenchant theoretical
    critiques and refutation by stubborn economic facts, the Keynesians
    are now in general and massive retreat. Once again, the money supply
    and bank credit are being grudgingly acknowledged to play a leading
    role in the cycle. The time is ripe – for a rediscovery, a
    renaissance, of the Mises theory of the business cycle. It can come
    none too soon; if it ever does, the whole concept of a Council of
    Economic Advisors would be swept away, and we would see a massive
    retreat of government from the economic sphere. But for all this
    to happen, the world of economics, and the public at large, must
    be made aware of the existence of an explanation of the business
    cycle that has lain neglected on the shelf for all too many tragic
    years.

    This essay
    was originally published as a minibook by the Constitutional Alliance
    of Lansing, Michigan, 1969.

    Murray
    N. Rothbard
    (1926–1995) was dean of the Austrian School,
    founder of modern libertarianism, and chief academic officer of
    the Mises Institute. He was
    also editor — with Lew Rockwell — of The
    Rothbard-Rockwell Report
    , and appointed Lew as his literary
    executor. See
    his books.

    The
    Best of Murray Rothbard

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