Economic Depressions Rothbard

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EconomicDepressions:Their Cause and Cure


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Murray N. Rothbard


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2009 by the Ludwig von Mises Institute

and published under the Creative Commons

Attribution License 3.0.

http://creativecommons.org/licenses/by/3.0/

Ludwig von Mises Institute

518 West Magnolia AvenueAuburn, Alabama 36832

www.mises.org

ISBN: 978-1-933550-50-3


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...banks would never be able to

expand credit in concert were it not for

the intervention and encouragement

of government.

Murray N. Rothbard


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Economic Depressions: Their Cause and Cure 7

WE LIVE in a world of euphe-

mism. Undertakers havebecome morticians, press

agents are now public rela-

tions 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 econom-

ics. In the old days, we used to suffer


7

This essay was originally published as a minibookby the Constitutional Alliance of Lansing, Michi-

gan, 1969. It is also included in The Austrian The-ory of the Trade Cycle and Other Essays, RichardM. Ebeling, ed. (Auburn, Ala.: Ludwig von MisesInstitute, 2006).


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8 Economic Depressions: Their Cause and Cure

nearly periodic economic crises, the sud-den onset of which was called a panic,and the lingering trough period after the

panic was called depression.

The most famous depression in moderntimes, of course, was the one that began ina typical financial panic in 1929 and lasteduntil the advent of World War II. After thedisaster of 1929, economists and politi-

cians resolved that this must never happenagain. The easiest way of succeeding atthis resolve was, simply to define depres-sions out of existence. From that point on,America was to suffer no further depres-sions. For when the next sharp depression

came along, in 193738, the economistssimply refused to use the dread name, andcame up with a new, much softer-sound-ing word: recession. From that point on,we have been through quite a few reces-sions, but not a single depression.

But pretty soon the word recessionalso became too harsh for the delicatesensibilities of the American public. Itnow seems that we had our last recessionin 195758. For since then, we have only


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had downturns, or, even better, slow-downs, or sidewise movements. So beof good cheer; from now on, depressions

and even recessions have been outlawedby the semantic fiat of economists; fromnow on, the worst that can possibly hap-pen to us are slowdowns. Such are thewonders of the New Economics.

For 30 years, our nations economists

have adopted the view of the businesscycle held by the late British economist,John Maynard Keynes, who created theKeynesian, or the New, Economics inhis book, The General Theory of Employ-ment, Interest, and Money, published in

1936. Beneath their diagrams, mathe-matics, and inchoate jargon, the attitudeof Keynesians toward booms and bust issimplicity, even naivete, itself. If there isinflation, then the cause is supposed to beexcessive spending on the part of the

public; the alleged cure is for the govern-ment, the self-appointed stabilizer andregulator of the nations economy, to stepin and force people to spend less, sop-ping up their excess purchasing power


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through increased taxation. If there is arecession, on the other hand, this has beencaused by insufficient private spending,

and the cure now is for the governmentto increase its own spending, preferablythrough deficits, thereby adding to thenations aggregate spending stream.

The idea that increased governmentspending or easy money is good for

business and that budget cuts or hardermoney is bad permeates even the mostconservative newspapers and magazines.These journals will also take for grantedthat it is the sacred task of the federal gov-ernment to steer the economic system on

the narrow road between the abysses ofdepression on the one hand and inflationon the other, for the free-market economyis supposed to be ever liable to succumbto one of these evils.

All current schools of economists have

the same attitude. Note, for example, theviewpoint of Dr. Paul W. McCracken, theincoming chairman of President NixonsCouncil of Economic Advisers. In aninterview with theNew York Times shortly


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after taking office (January 24, 1969),Dr. McCracken asserted that one of themajor economic problems facing the new

administration is how you cool downthis inflationary economy without at thesame time tripping off unacceptably highlevels of unemployment. In other words,if the only thing we want to do is cool offthe inflation, it could be done. But our

social tolerances on unemployment arenarrow. And again: I think we have tofeel our way along here. We dont reallyhave much experience in trying to cool aneconomy in orderly fashion. We slammedon the brakes in 1957, but, of course, wegot substantial slack in the economy.

Note the fundamental attitude of Dr.McCracken toward the economyremarkable only in that it is shared byalmost all economists of the present day.The economy is treated as a potentially

workable, but always troublesome andrecalcitrant patient, with a continual ten-dency to hive off into greater inflation orunemployment. The function of the gov-ernment is to be the wise old manager


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and physician, ever watchful, ever tinker-ing to keep the economic patient in goodworking order. In any case, here the eco-

nomic patient is clearly supposed to bethe subject, and the government as phy-sician the master.

It was not so long ago that this kindof attitude and policy was called social-ism; but we live in a world of euphe-

mism, and now we call it by far less harshlabels, such as moderation or enlight-ened free enterprise. We live and learn.

What, then, are the causes of periodicdepressions? Must we always remainagnostic about the causes of booms andbusts? Is it really true that business cyclesare rooted deep within the free-marketeconomy, and that therefore some form ofgovernment planning is needed if we wishto keep the economy within some kind ofstable bounds? Do booms and then busts

just simply happen, or does one phase ofthe cycle flow logically from the other?

The currently fashionable attitudetoward the business cycle stems, actually,


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from Karl Marx. Marx saw that, beforethe Industrial Revolution in approximatelythe late eighteenth century, there were no

regularly recurring booms and depres-sions. There would be a sudden economiccrisis whenever some king made war orconfiscated the property of his subject;but there was no sign of the peculiarlymodern phenomena of general and fairly

regular swings in business fortunes, ofexpansions and contractions. Since thesecycles also appeared on the scene at aboutthe same time as modern industry, Marxconcluded that business cycles were aninherent feature of the capitalist marketeconomy. All the various current schools

of economic thought, regardless of theirother differences and the different causesthat they attribute to the cycle, agree onthis vital point: That these business cyclesoriginate somewhere deep within the free-market economy. The market economy

is to blame. Karl Marx believed that theperiodic depressions would get worse andworse, until the masses would be movedto revolt and destroy the system, whilethe modern economists believe that the


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government can successfully stabilizedepressions and the cycle. But all par-ties agree that the fault lies deep within

the market economy and that if anythingcan save the day, it must be some form ofmassive government intervention.

There are, however, some criticalproblems in the assumption that the mar-ket economy is the culprit. For general

economic theory teaches us that supplyand demand always tend to be in equi-librium in the market and that thereforeprices of products as well as of the factorsthat contribute to production are alwaystending toward some equilibrium point.

Even though changes of data, which arealways taking place, prevent equilib-rium from ever being reached, there isnothing in the general theory of the mar-ket system that would account for regu-lar and recurring boom-and-bust phases

of the business cycle. Modern econo-mists solve this problem by simplykeeping their general price and markettheory and their business cycle theory inseparate, tightly-sealed compartments,


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with never the twain meeting, much lessintegrated with each other. Economists,unfortunately, have forgotten that there

is only one economy and therefore onlyone integrated economic theory. Neithereconomic life nor the structure of theorycan or should be in watertight compart-ments; our knowledge of the economy iseither one integrated whole or it is noth-

ing. Yet most economists are content toapply totally separate and, indeed, mutu-ally exclusive, theories for general priceanalysis and for business cycles. Theycannot be genuine economic scientists solong as they are content to keep operatingin this primitive way.

But there are still graver problemswith the currently fashionable approach.Economists also do not see one particu-larly critical problem because they do notbother to square their business cycle and

general price theories: the peculiar break-down of the entrepreneurial function attimes of economic crisis and depression.In the market economy, one of the mostvital functions of the businessman is to


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be an entrepreneur, a man who investsin productive methods, who buys equip-ment and hires labor to produce some-

thing which he is not sure will reap himany return. In short, the entrepreneurialfunction is the function of forecasting theuncertain future. Before embarking onany investment or line of production, theentrepreneur, or enterpriser, must esti-

mate present and future costs and futurerevenues and therefore estimate whetherand how much profits he will earn fromthe investment. If he forecasts well andsignificantly better than his business com-petitors, he will reap profits from hisinvestment. The better his forecasting,the higher the profits he will earn. If, onthe other hand, he is a poor forecaster andoverestimates the demand for his product,he will suffer losses and pretty soon beforced out of the business.

The market economy, then, is a profit-and-loss economy, in which the acumenand ability of business entrepreneurs isgauged by the profits and losses they reap.The market economy, moreover, contains


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a built-in mechanism, a kind of naturalselection, that ensures the survival and theflourishing of the superior forecaster and

the weeding-out of the inferior ones. Forthe more profits reaped by the better fore-casters, the greater become their businessresponsibilities, and the more they willhave available to invest in the productivesystem. On the other hand, a few years of

making losses will drive the poorer fore-casters and entrepreneurs out of businessaltogether and push them into the ranks ofsalaried employees.

If, then, the market economy has abuilt-in natural selection mechanism for

good entrepreneurs, this means that, gen-erally, we would expect not many busi-ness firms to be making losses. And, infact, if we look around at the economy onan average day or year, we will find thatlosses are not very widespread. But, in

that case, the odd fact that needs explain-ing is this: How is it that, periodically, intimes of the onset of recessions and espe-cially in steep depressions, the businessworld suddenly experiences a massive


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cluster of severe losses? A momentarrives when business firms, previouslyhighly astute entrepreneurs in their abil-

ity to make profits and avoid losses, sud-denly and dismayingly find themselves,almost all of them, suffering severe andunaccountable losses? How come? Hereis a momentous fact that any theory ofdepressions must explain. An explanation

such as underconsumptiona drop intotal consumer spendingis not suffi-cient, for one thing, because what needs tobe explained is why businessmen, able toforecast all manner of previous economicchanges and developments, proved them-selves totally and catastrophically unableto forecast this alleged drop in consumerdemand. Why this sudden failure in fore-casting ability?

An adequate theory of depressions,then, must account for the tendency of

the economy to move through successivebooms and busts, showing no sign of set-tling into any sort of smoothly moving,or quietly progressive, approximation ofan equilibrium situation. In particular, a


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theory of depression must account for themammoth cluster of errors which appearsswiftly and suddenly at a moment of

economic crisis, and lingers through thedepression period until recovery. Andthere is a third universal fact that a the-ory of the cycle must account for. Invari-ably, the booms and busts are muchmore intense and severe in the capital

goods industriesthe industries mak-ing machines and equipment, the onesproducing industrial raw materials orconstructing industrial plantsthan inthe industries making consumers goods.Here is another fact of business cyclelife that must be explainedand obvi-

ously cant be explained by such theoriesof depression as the popular undercon-sumption doctrine: That consumers arentspending enough on consumer goods. Forif insufficient spending is the culprit, thenhow is it that retail sales are the last and

the least to fall in any depression, and thatdepression really hits such industries asmachine tools, capital equipment, con-struction, and raw materials? Conversely,it is these industries that really take off


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in the inflationary boom phases of thebusiness cycle, and not those businessesserving the consumer. An adequate the-

ory of the business cycle, then, must alsoexplain the far greater intensity of boomsand busts in the non-consumer goods, orproducers goods, industries.

Fortunately, a correct theory of depres-sion and of the business cycle does exist,

even though it is universally neglectedin present-day economics. It, too, has along tradition in economic thought. Thistheory began with the eighteenth cen-tury Scottish philosopher and econo-mist David Hume, and with the eminent

early nineteenth century English classi-cal economist David Ricardo. Essentially,these theorists saw that another crucialinstitution had developed in the mid-eigh-teenth century, alongside the industrialsystem. This was the institution of bank-

ing, with its capacity to expand credit andthe money supply (first, in the form ofpaper money, or bank notes, and later inthe form of demand deposits, or checkingaccounts, that are instantly redeemable in


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cash at the banks). It was the operationsof these commercial banks which, theseeconomists saw, held the key to the mys-

terious recurrent cycles of expansion andcontraction, of boom and bust, that hadpuzzled observers since the mid-eigh-teenth century.

The Ricardian analysis of the businesscycle went something as follows: The

natural moneys emerging as such on theworld free market are useful commodi-ties, generally gold and silver. If moneywere confined simply to these commodi-ties, then the economy would work in theaggregate as it does in particular mar-

kets: A smooth adjustment of supplyand demand, and therefore no cycles ofboom and bust. But the injection of bankcredit adds another crucial and disrup-tive element. For the banks expand creditand therefore bank money in the form

of notes or deposits which are theoreti-cally redeemable on demand in gold, butin practice clearly are not. For example,if a bank has 1,000 ounces of gold in itsvaults, and it issues instantly redeemable


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warehouse receipts for 2,500 ouncesof gold, then it clearly has issued 1,500ounces more than it can possibly redeem.

But so long as there is no concerted runon the bank to cash in these receipts, itswarehouse-receipts function on the mar-ket as equivalent to gold, and thereforethe bank has been able to expand themoney supply of the country by 1,500

gold ounces.The banks, then, happily begin to

expand credit, for the more they expandcredit the greater will be their profits. Thisresults in the expansion of the money sup-ply within a country, say England. As the

supply of paper and bank money in Eng-land increases, the money incomes andexpenditures of Englishmen rise, and theincreased money bids up prices of Englishgoods. The result is inflation and a boomwithin the country. But this inflationary

boom, while it proceeds on its merry way,sows the seeds of its own demise. Foras English money supply and incomesincrease, Englishmen proceed to purchasemore goods from abroad. Furthermore,


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as English prices go up, English goodsbegin to lose their competitiveness withthe products of other countries which

have not inflated, or have been inflatingto a lesser degree. Englishmen begin tobuy less at home and more abroad, whileforeigners buy less in England and moreat home; the result is a deficit in the Eng-lish balance of payments, with English

exports falling sharply behind imports.But if imports exceed exports, this meansthat money must flow out of England toforeign countries. And what money willthis be? Surely not English bank notes ordeposits, for Frenchmen or Germans orItalians have little or no interest in keep-

ing their funds locked up in English banks.These foreigners will therefore take theirbank notes and deposits and present themto the English banks for redemption ingoldand gold will be the type of moneythat will tend to flow persistently out of

the country as the English inflation pro-ceeds on its way. But this means that Eng-lish bank credit money will be, more andmore, pyramiding on top of a dwindlinggold base in the English bank vaults. As


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the boom proceeds, our hypothetical bankwill expand its warehouse receipts issuedfrom, say 2,500 ounces to 4,000 ounces,

while its gold base dwindles to, say, 800.As this process intensifies, the banks willeventually become frightened. For thebanks, after all, are obligated to redeemtheir liabilities in cash, and their cash isflowing out rapidly as their liabilities pile

up. Hence, the banks will eventually losetheir nerve, stop their credit expansion,and in order to save themselves, contracttheir bank loans outstanding. Often, thisretreat is precipitated by bankrupting runson the banks touched off by the public,who had also been getting increasinglynervous about the ever more shaky condi-tion of the nations banks.

The bank contraction reverses the eco-nomic picture; contraction and bust followboom. The banks pull in their horns, and

businesses suffer as the pressure mountsfor debt repayment and contraction. Thefall in the supply of bank money, in turn,leads to a general fall in English prices.As money supply and incomes fall, and


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English prices collapse, English goodsbecome relatively more attractive in termsof foreign products, and the balance of

payments reverses itself, with exportsexceeding imports. As gold flows into thecountry, and as bank money contracts ontop of an expanding gold base, the condi-tion 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 precedingexpansionary boom. It is the precedinginflation that makes the depression phasenecessary. We can see, for example, that

the depression is the process by whichthe market economy adjusts, throws offthe excesses and distortions of the previ-ous inflationary boom, and reestablishesa sound economic condition. The depres-sion is the unpleasant but necessary reac-tion to the distortions and excesses of theprevious boom.

Why, then, does the next cycle begin?Why do business cycles tend to be recur-rent and continuous? Because when the


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banks have pretty well recovered, and arein a sounder condition, they are then in aconfident position to proceed to their nat-

ural path of bank credit expansion, andthe next boom proceeds on its way, sow-ing the seeds for the next inevitable bust.

But if banking is the cause of the busi-ness cycle, arent the banks also a part ofthe private market economy, and cant we

therefore say that the free market is stillthe culprit, if only in the banking segmentof that free market? The answer is No,for the banks, for one thing, would neverbe able to expand credit in concert wereit not for the intervention and encour-

agement of government. For if bankswere truly competitive, any expansion ofcredit by one bank would quickly pile upthe debts of that bank in its competitors,and its competitors would quickly callupon the expanding bank for redemption

in cash. In short, a banks rivals will callupon it for redemption in gold or cash inthe same way as do foreigners, except thatthe process is much faster and would nipany incipient inflation in the bud before it


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got started. Banks can only expand com-fortably in unison when a Central Bankexists, essentially a governmental bank,

enjoying a monopoly of government busi-ness, and a privileged position imposedby government over the entire bankingsystem. It is only when central bankinggot established that the banks were ableto expand for any length of time and the

familiar business cycle got underway inthe modern world.

The central bank acquires its controlover the banking system by such gov-ernmental measures as: Making its ownliabilities legal tender for all debts and

receivable in taxes; granting the cen-tral bank monopoly of the issue of banknotes, as contrasted to deposits (in Eng-land the Bank of England, the govern-mentally established central bank, had alegal monopoly of bank notes in the Lon-

don area); or through the outright forc-ing of banks to use the central bank astheir client for keeping their reserves ofcash (as in the United States and its Fed-eral Reserve System). Not that the banks


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complain about this intervention; for it isthe establishment of central banking thatmakes long-term bank credit expansion

possible, since the expansion of CentralBank notes provides added cash reservesfor the entire banking system and per-mits all the commercial banks to expandtheir credit together. Central bankingworks like a cozy compulsory bank cartel

to expand the banks liabilities; and thebanks are now able to expand on a largerbase of cash in the form of central banknotes as well as gold.

So now we see, at last, that the businesscycle is brought about, not by any myste-

rious failings of the free market economy,but quite the opposite: By systematicintervention by government in the marketprocess. Government intervention bringsabout bank expansion and inflation, and,when the inflation comes to an end, thesubsequent depression-adjustment comesinto play.

The Ricardian theory of the businesscycle grasped the essentials of a correctcycle theory: The recurrent nature of the


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phases of the cycle, depression as adjust-ment intervention in the market rather thanfrom the free-market economy. But two

problems were as yet unexplained: Whythe sudden cluster of business error, thesudden failure of the entrepreneurial func-tion, and why the vastly greater fluctua-tions in the producers goods than in theconsumers goods industries? The Ricard-

ian theory only explained movements inthe price level, in general business; therewas no hint of explanation of the vastlydifferent reactions in the capital and con-sumers goods industries.

The correct and fully developed theory

of the business cycle was finally discov-ered and set forth by the Austrian econ-omist Ludwig von Mises, when he wasa professor at the University of Vienna.Mises developed hints of his solution tothe vital problem of the business cycle

in his monumental Theory of Money andCredit, published in 1912, and still, nearly60 years later, the best book on the the-ory of money and banking. Mises devel-oped his cycle theory during the 1920s,


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and it was brought to the English-speak-ing world by Misess leading follower,Friedrich A. von Hayek, who came from

Vienna to teach at the London School ofEconomics in the early 1930s, and whopublished, in German and in English, twobooks which applied and elaborated theMises cycle theory:Monetary Theory andthe Trade Cycle, and Prices and Produc-

tion. Since Mises and Hayek were Austri-ans, and also since they were in the tradi-tion of the great nineteenth-century Aus-trian economists, this theory has becomeknown in the literature as the Austrian(or the monetary over-investment) the-ory of the business cycle.

Building on the Ricardians, on generalAustrian theory, and on his own cre-ative genius, Mises developed the follow-ing theory of the business cycle:

Without bank credit expansion, supply

and demand tend to be equilibrated throughthe free price system, and no cumulativebooms or busts can then develop. But thengovernment through its central bank stim-ulates bank credit expansion by expanding


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central bank liabilities and therefore the

cash reserves of all the nations commercial

banks. The banks then proceed to expand

credit and hence the nations money sup-ply 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, bypouring 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, theinterest rate is determined purely by the

time-preferences of all the individualsthat make up the market economy. For theessence of a loan is that a present good(money which can be used at present) isbeing exchanged for a future good (anIOU which can only be used at some point

in the future). Since people always prefermoney right now to the present prospect ofgetting the same amount of money sometime in the future, the present good alwayscommands a premium in the market over


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the future. This premium is the interestrate, and its height will vary according tothe degree to which people prefer the pres-

ent to the future, i.e., the degree of theirtime-preferences.

Peoples time-preferences also deter-mine the extent to which people will saveand invest, as compared to how muchthey will consume. If peoples time-pref-

erences should fall, i.e., if their degreeof preference for present over futurefalls, then people will tend to consumeless now and save and invest more; atthe same time, and for the same reason,the rate of interest, the rate of time-dis-

count, will also fall. Economic growthcomes about largely as the result of fall-ing rates of time-preference, which leadto an increase in the proportion of savingand investment to consumption, and alsoto a falling rate of interest.

But what happens when the rate ofinterest falls, not because of lower time-preferences and higher savings, but fromgovernment interference that promotes theexpansion of bank credit? In other words,


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if the rate of interest falls artificially, dueto intervention, rather than naturally, asa result of changes in the valuations and

preferences of the consuming public?

What happens is trouble. For business-men, seeing the rate of interest fall, reactas they always would and must to sucha change of market signals: They investmore in capital and producers goods.

Investments, particularly in lengthy andtime-consuming projects, which previ-ously looked unprofitable now seem prof-itable, because of the fall of the interestcharge. In short, businessmen react asthey would react if savings had genuinely

increased: They expand their investmentin durable equipment, in capital goods,in industrial raw material, in constructionas compared to their direct production ofconsumer goods.

Businesses, in short, happily borrow

the newly expanded bank money that iscoming to them at cheaper rates; theyuse the money to invest in capital goods,and eventually this money gets paid outin higher rents to land, and higher wages


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to workers in the capital goods industries.The increased business demand bids uplabor costs, but businesses think they can

pay these higher costs because they havebeen fooled by the government-and-bankintervention in the loan market and itsdecisively important tampering with theinterest-rate signal of the marketplace.

The problem comes as soon as the

workers and landlordslargely the for-mer, since most gross business income ispaid out in wagesbegin to spend the newbank money that they have received in theform of higher wages. For the time-pref-erences of the public have not really got-

ten lower; the public doesnt wantto savemore than it has. So the workers set aboutto consume most of their new income, inshort to reestablish the old consumer/sav-ing proportions. This means that they redi-rect the spending back to the consumer

goods industries, and they dont save andinvest enough to buy the newly-producedmachines, capital equipment, industrialraw materials, etc. This all reveals itself asa sudden sharp and continuing depression


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in the producers goods industries. Oncethe consumers reestablished their desiredconsumption/investment proportions, it is

thus revealed that business had investedtoo much in capital goods and had under-invested in consumer goods. Business hadbeen seduced by the governmental tam-pering and artificial lowering of the rateof interest, and acted as if more savings

were available to invest than were reallythere. As soon as the new bank money fil-tered through the system and the consum-ers reestablished their old proportions, itbecame clear that there were not enoughsavings to buy all the producers goods,

and that business had misinvested the lim-ited savings available. Business had over-invested in capital goods and underin-vested in consumer products.

The inflationary boom thus leads to dis-tortions of the pricing and production sys-

tem. Prices of labor and raw materials inthe capital goods industries had been bidup during the boom too high to be profit-able once the consumers reassert their oldconsumption/investment preferences. The


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depression is then seen as the necessaryand healthy phase by which the marketeconomy sloughs off and liquidates the

unsound, uneconomic investments of theboom, and reestablishes those proportionsbetween consumption and investment thatare truly desired by the consumers. Thedepression is the painful but necessaryprocess by which the free market sloughs

off the excesses and errors of the boomand reestablishes the market economy inits function of efficient service to the massof consumers. Since prices of factors ofproduction have been bid too high in theboom, this means that prices of labor and

goods in these capital goods industriesmust be allowed to fall until proper mar-ket relations are resumed.

Since the workers receive the increasedmoney in the form of higher wages fairlyrapidly, how is it that booms can go on

for years without having their unsoundinvestments revealed, their errors due totampering with market signals becomeevident, and the depression-adjustmentprocess begins its work? The answer is


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that booms would be very short lived ifthe bank credit expansion and subsequentpushing of the rate of interest below the

free market level were a one-shot affair.But the point is that the credit expan-sion is notone-shot; it proceeds on andon, never giving consumers the chanceto reestablish their preferred proportionsof consumption and saving, never allow-

ing the rise in costs in the capital goodsindustries to catch up to the inflationaryrise in prices. Like the repeated doping ofa horse, the boom is kept on its way andahead of its inevitable comeuppance, byrepeated doses of the stimulant of bankcredit. It is only when bank credit expan-

sion must finally stop, either because thebanks are getting into a shaky conditionor because the public begins to balk atthe continuing inflation, that retributionfinally catches up with the boom. As soonas credit expansion stops, then the piper

must be paid, and the inevitable readjust-ments liquidate the unsound over-invest-ments of the boom, with the reassertionof a greater proportionate emphasis onconsumers goods production.


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Thus, the Misesian theory of the busi-ness cycle accounts for all of our puz-zles: The repeated and recurrent nature

of the cycle, the massive cluster of entre-preneurial error, the far greater intensityof the boom and bust in the producersgoods industries.

Mises, then, pinpoints the blame for thecycle on inflationary bank credit expan-

sion propelled by the intervention of gov-ernment and its central bank. What doesMises say should be done, say by govern-ment, once the depression arrives? Whatis the governmental role in the cure ofdepression? In the first place, government

must cease inflating as soon as possible.It is true that this will, inevitably, bringthe inflationary boom abruptly to an end,and commence the inevitable recessionor depression. But the longer the govern-ment waits for this, the worse the neces-

sary readjustments will have to be. Thesooner the depression-readjustment isgotten over with, the better. This means,also, that the government must never tryto prop up unsound business situations;


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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 alingering and chronic disease. The gov-

ernment 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 pro-longed depression and mass unemploy-

ment in the vital capital goods industries.

The government must not try to inflate

again, in order to get out of the depres-

sion. 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 consump-

tion/investment ratio. In fact, cutting the

government budget will improve the ratio.What the economy needs is not more con-

sumption spending but more saving, in

order to validate some of the excessive

investments of the boom.


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Thus, what the government shoulddo, according to the Misesian analysisof the depression, is absolutely nothing.

It should, from the point of view of eco-nomic health and ending the depressionas quickly as possible, maintain a stricthands off, laissez-faire policy. Any-thing it does will delay and obstruct theadjustment process of the market; the less

it does, the more rapidly will the mar-ket adjustment process do its work, andsound economic recovery ensue.

The Misesian prescription is thus theexact opposite of the Keynesian: It is forthe government to keep absolute hands

off the economy and to confi

ne itself tostopping its own inflation and to cuttingits own budget.

It has today been completely forgotten,even among economists, that the Misesianexplanation and analysis of the depression

gained great headway precisely duringthe Great Depression of the 1930sthevery depression that is always held up toadvocates of the free market economy asthe greatest single and catastrophic failure


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only by the holocaust of World War II.Hoover, not Franklin Roosevelt, wasthe founder of the policy of the New

Deal: essentially the massive use of theState to do exactly what Misesian the-ory would most warn againstto propup wage rates above their free-marketlevels, prop up prices, inflate credit, andlend money to shaky business positions.

Roosevelt only advanced, to a greaterdegree, what Hoover had pioneered. Theresult for the first time in American his-tory, was a nearly perpetual depressionand nearly permanent mass unemploy-ment. The Coolidge crisis had become

the unprecedentedly prolonged Hoover-Roosevelt depression.

Ludwig von Mises had predictedthe depression during the heyday of thegreat boom of the 1920sa time, justlike today, when economists and politi-

cians, armed with a new economics ofperpetual inflation, and with new toolsprovided by the Federal Reserve Sys-tem, proclaimed a perpetual New Eraof permanent prosperity guaranteed by


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our wise economic doctors in Washing-ton. Ludwig von Mises, alone armed witha correct theory of the business cycle,

was one of the very few economists topredict the Great Depression, and hencethe economic world was forced to listento him with respect. F. A. Hayek spreadthe word in England, and the youngerEnglish economists were all, in the early

1930s, beginning to adopt the Mise-sian cycle theory for their analysis of thedepressionand also to adopt, of course,the strictly free-market policy prescrip-tion that flowed with this theory. Unfortu-nately, economists have now adopted thehistorical notion of Lord Keynes: That

no classical economists had a theoryof the business cycle until Keynes camealong in 1936. There was a theory of thedepression; it was the classical economictradition; its prescription was strict hardmoney and laissez-faire; and it was rap-

idly being adopted, in England and evenin the United States, as the accepted the-ory of the business cycle. (A particularirony is that the major Austrian propo-nent in the United States in the early and


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mid-1930s was none other than Profes-sor Alvin Hansen, very soon to make hismark as the outstanding Keynesian disci-

ple in this country.)

What swamped the growing accep-tance of Misesian cycle theory was simplythe Keynesian Revolutionthe amaz-ing sweep that Keynesian theory made ofthe economic world shortly after the pub-

lication of the General Theory in 1936.It is not that Misesian theory was refutedsuccessfully; it was just forgotten in therush to climb on the suddenly fashionableKeynesian bandwagon. Some of the lead-ing adherents of the Mises theorywho

clearly knew bettersuccumbed to thenewly established winds of doctrine, andwon leading American university posts asa consequence.

But now the once arch-KeynesianLondon Economist has recently pro-

claimed that Keynes is Dead. Afterover a decade of facing trenchant theo-retical critiques and refutation by stub-born economic facts, the Keynesians arenow in general and massive retreat. Once



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again, the money supply and bank creditare being grudgingly acknowledged toplay a leading role in the cycle. The time

is ripefor 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 Eco-nomic 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 ofeconomics, and the public at large, mustbe made aware of the existence of anexplanation of the business cycle thathas lain neglected on the shelf for all toomany tragic years.


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Business cycle

Austrian, 29, 30, 43

Keynesian, 9

Marx, 13

Ricardian, 21, 28, 29

C

Central Bank, 27, 28Coolidge, Calvin, 41, 42

D

Depression

as a period ofadjustment, 28, 29, 36,39, 40

definition of, 8

following creditexpansion, 37, 38, 41

Great Depression, 40, 43

length and depth of, 25

price level during, 29

prolonged by wage andprice rigidity, 39

theory of, 9, 29, 30

E

Entrepreneurship, 16

Federal Reserve System,

27, 41, 42

G

Gold standard, 21, 22, 23,

24, 25, 26, 28, 41

Great Depression

See Depression

H

Hayek, F.A.

Monetary Theory and

the Trade Cycle,

and Prices and

Production, 30

proponent ofAustrian business

cycle, 30

Hoover, Herbert, 41, 42

Hume, David, 20

I

Industrial Revolution, 13

Inflation

causes of, 9

effects of, 22

overspending in

Keynesian analysis, 9

Index

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solutions to, 29

squelched in a

competitive banking

industry, 26

Interest rate

allocation of resources,

38

manipulation, 3135

natural, or real, 3132,

37

K

Keynes, John Maynard

General Theory of

Employment, Interest,

and Money, 9

government intervention

in the economy, 10

Keynesianism, 9, 43, 44

Keynesian revolution, 44L

Laissez-faire policy, 40,

41, 43

M

Marx, Karl, 13

McCracken, Paul, 10, 11

Mises, Ludwig von, 29,

30, 31, 38, 42, 43, 44, 45

on business cycles, 29

on government

intervention during

economic crises, 40

on the GreatDepression, 40

Theory of Money andCredit, 29

N

New Deal, 42

Nixon, Richard, 10

P

Prices

general level of, 14

relative, 25

stabilization, 9Price theory, 14

Production

time element in, 16

R

Recession, 8, 9, 10, 17, 38

Ricardo, David, 20

Roosevelt, FranklinDelano, 42

S

Socialism, 12

T

Time preference, 31, 34

U

Unemployment, 11, 39, 42

WWages

government manip-ulation of, 33, 39

increasing as a result ofcredit inflation, 33, 42



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Economic Depressions Rothbard

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