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Source link: http://archive.mises.org/8672/economic-depressions-their-cause-and-cure/

Economic Depressions: Their Cause and Cure

October 2, 2008 by

It is the preceding inflation that makes the depression phase necessary. 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. 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.

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. FULL ARTICLE

{ 15 comments }

Dither October 2, 2008 at 10:08 am

Wow. The degree to which this article could plausibly have been written today, as a response to current conditions, is astounding. It is a testament to the soundness of the Austrian theory of the business cycle, as well as to the arrogance and foolishness of the state.

Maturin October 2, 2008 at 10:12 am

Take the fourth and fifth from last paragraphs, and substitute Clinton/Bush years for Coolidge, and Obama for Hoover.

We are in deep trouble, folks! The 2008 Bailout will deepen and prolong the malinvestment cycle. The Great Depression of the twenty-teens is unavoidable!

curio October 2, 2008 at 12:02 pm

What an enlightening article, particularly for someone like myself who was never taught this “side” of economics in college. For that, I must say I feel cheated. I was wondering how Austrian economics explained boom/bust cycles, knowing it had something to do with banks. The “Ah-ha” moment was the explanation about how current banks are NOT functioning as truly private banks would.

However, one thing I don’t understand is why the Federal Reserve was created in the first place, well before the Great Depression. Presumably it was created to prevent boom/bust cycles, which evidently were occurring before the US had a “central bank” and the country was still on the gold standard. So why did these cycles exist previously?

David Spellman October 2, 2008 at 12:31 pm

Great article and very timely publication.

Substitute Clinton for Coolidge, Bush for Hoover, and place your bets on Obama for Roosevelt.

Everything about the economy today lines up with the events preceding the great depression, including the predictable government responses that mirror Hoover’s debacle.

Did you know that there was also the equivalent of the dot com bubble in the 1920′s that featured the same vaporous companies and dizzying stock manipulation? That boom was Radio!

Thousands of companies were created to provide infrastructure, services, and content for the brand new hot radio industry. There was even an Amazon.com equivalent stock–RCA. RCA stock was valued at over $200 a share back when that was real money.

So the 1920′s mirror the first decade of this century to a truly stupefying degree. We are living the Roaring decade over again, and we are about to slide down the slope into the Depression decade. But maybe this time the money mongers will try hyperinflation as a new twist on financial chaos.

Eric October 2, 2008 at 1:37 pm

“[don't understand] … why the Federal Reserve was created in the first place”

Curio: The FED was created by bankers for bankers. As noted in the article, the banks couldn’t long inflate since as soon as one bank inflated, other banks would do a sort of “run” on the larger inflater.

But this was not what the big bankers wanted. They wanted all the banks to inflate at the same rate, hence, they needed a central authority.

For the rest of the FED “conspiracy” story, you should look at “The creature from Jekyll Island”. Rothbards other works, such as “the case against the fed”, also describe this. This can be found on line here or you can buy the book.

fundmentalist October 2, 2008 at 1:44 pm

Warren Buffet sums it up pretty well: “…all the major institutions in the world trying to deleverage. And we want them to deleverage, but they’re trying to deleverage at the same time. Well, if huge institutions are trying to deleverage, you need someone in the world that’s willing to leverage up. And there’s no one that can leverage up except the United States government.”

Of course, I disagree that the US gov has to “leverage up.”

Eric October 2, 2008 at 2:16 pm

I have one problem with this article. I have read numerous times that Rothbard and Mises use a-priori logic and don’t like empirical theory i.e. theory created to explain data.

The two are forever arguing that one cannot use math and that all can be proven with pure logic coming from the single postulate: Humans act. It is claimed that all economic truths can be logically deduced from this postulate alone.

Ok, then what is Rothbard doing when he says that the theory preceding Mises did not account for the cluster of errors hitting the capital equipment businesses the hardest? This is saying that the older theory did not explain this empirical result.

In addition, I don’t see the proof that it is the higher order producers that get hit the hardest. It’s easy to say this, but is it really so? Why wouldn’t a lower order producer also be able to get loans to hire more consumer oriented workers, such as a larger sales force, given that the new money got spent at his store?

I don’t see that it must follow that the new money goes first to the machine tool producers. What if the workers who get the higher wages go out and buy cars? Wouldn’t this affect the car dealers?

And getting back to my first point, wouldn’t this mean that the only way to tell is to look at the data? I really don’t see any way to prove this simply by deduction from “Humans Act”.

fundamentalist October 2, 2008 at 3:25 pm

Eric: “I have read numerous times that Rothbard and Mises use a-priori logic and don’t like empirical theory i.e. theory created to explain data.”

It is a little confusing at first, but I think Hayek clears it up. Historical data is so vast that you can prove any idea you want if you fish in it long enough. If you have ever tried to follow any of the debates over simple things like do hand guns reduce crime, you’ll see what a hopeless swamp that people swim in when trying to prove their side of the argument strictly from historical data. All that Austrians are saying is that you must have sound theory first in order to organize and make sense of vast historical data. Theory is like a road map. It keeps you from getting lost in the vast wilderness.

On the other hand, if your theory is correct, you would obviously expect to find historical evidence for it. In other words, the map should get you to where you want to go because it is an accurate description of the landscape. So the historical data illustrates the accurcy of the map, or the theory.

But Hayek adds that as the theory becomes more specific, tests against the empirical data are important for tweeking theory, but only at the detailed level. Mises describes this process when he talks about the formation of the ABCT. He wrote that when forming the trade cycle theory, economists noticed that the major swings in business activity generally took place in the capital goods intensive industries. So in forming the ABCT, historical data spurred theoretical thinking and refined it.

I have an example from personal experience. I was working with the marketing department of a trucking company trying to determine the effect of price increases on demand. The regression equations kept coming up with positive signs for the coefficient of price, suggesting that price increases raise demand. Of course that doesn’t make sense, so I tried to add variables and adjust lags to get a negative sign. The young marketer I worked with asked if I wasn’t guilty of fudging the data to get what I expected. I said yes. I was guilty of that because no one could convince me that price increases cause increases in demand in spite of the data. I eventually showed him that seasonality was a big factor. Demand was strong during the summer and weak in winter. The company had a habit of raising prices during the summer after demand had increased. Once I factored in seasonality, the equation made sense.

curio October 2, 2008 at 5:51 pm

Thanks Eric. Do those readings you suggested explain why there were boom/bust cycles before creation of the Fed? I am more interested in that, because I believe that is what the rationalization for the Fed creation was all about.

So again, why did these cycles exist even in the absence of a (essentially) central bank? Why were banks still overextending themselves, and the competition was not demanding immediate settling of the accounts? Or were they, and there really is something inherent in a market economy that causes boom/bust cycles?

Christopher Hightower October 2, 2008 at 7:02 pm

Great article. I wish more “average joes” like me would take the time to read Rothbard.

Stanley Pinchak October 2, 2008 at 8:43 pm

curio,
There were cycles prior to the federal reserve because even before the Federal Reserve the banks had ways of artificially creating credit which has the effect of artificially lowering the interest rate. The exact same problems that the Fed causes were caused previously by individual banks operating in a fractional reserve manner. Everything goes fine for the savers and bankers until a couple of big borrowers or a bunch of small borrowers default on a loan. The default causes the reserves to lessen and can lead to an inability of a bank to redeem banknotes or checkbook money in gold/silver. Once word gets out, bank runs will occur all around town and across the country. The banks have been acting fraudulently and get caught with their pants down. Savers get their savings stolen and the money supply shrinks drastically. This is the classic deflation that often occurs in a bust. Once credit gets tighter and consumer demand drops, all of the misallocated investments are exposed and need to be reallocated to their next best uses. See ABCT for the gory details. You may want to read Jesus Huerta de Soto’s book. It is available in pdf if you like that format. It covers the history of fractional reserve banking (and 100% reserve banking), and covers ABCT. It is quite readable for the layman.

Jeremy October 3, 2008 at 4:02 am

Eric & Curio -

I second Stanley’s recommendation.

Both of your questions are answered by an adequate treatment of the Austrian Theory of the Business Cycle and its opposing theories throughout the ages.

I have read no clearer or more thorough account than Jesus Huerta de Soto’s Money, Bank Credit, and Economic cycles. Here’s the link for the PDF from the Mises institute:

http://mises.org/books/desoto.pdf

Alan Dunn October 3, 2008 at 8:38 am

Two points.

1. Mr Rothbard gives an excellent account of why throwing more fuel into the fire GW Bush style is never the answer.

2. The economics of Keynes in his little book and that of the Keynesians such as Hicks or Hansen have little if any relationship to the “General Theory”.

curio October 6, 2008 at 2:10 pm

Thanks all.

cam October 14, 2008 at 8:40 am

great article, really explains why we keep going through this issue every couple of years. and why the interventions don’t “work” in the sense that they only prolong the inevitable and only make it worse. i’m gonna also read desotos’ book. thanks guys

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