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Government Caused

February 9, 1999

George Selgin (University of Georgia), Review of:
The Great Depression: An International Disaster of Perverse Economic Policies
by Thomas Hall and David Ferguson (University of Michigan Press, 1998)
Southern Economic Journal
Jan. 1999. Vol. 65, No. 3. pp 653-656.

Many people-some economists included-still view the Great Depression as
proof of the failure of the capitalist system and of the corresponding
need for big government. According to them, the depression was the price
the public paid when their governments subscribed to laissez-faire economic
doctrines. Recovery required governments to play a more active part in
directing economic activity.

One problem with this popular way of thinking about the Great Depression
is its implicit assumption that governments can be guilty only of sins
of omission by failing to play a large enough role in economic affairs.
In truth, governments can also be guilty of sins of commission - acting
perversely and thereby making things worse than they might have been had the governments
let market forces do their thing.

Miami University economists Thomas E. Hall and J. David Ferguson argue
that the Great Depression is best understood as the consequence of "an
incredible sequence of . . . misguided economic policies." Although Hall
and Ferguson believe that classical laissez-faire policies and institutions
(adherence to the gold standard in particular) played an important part
in generating depression, they also find many cases in which government
intervention made the depression deeper and longer lasting than it might
otherwise have been. Indeed, government errors were so extensive as to
make one wonder whether the depression was inevitable and whether it would
have earned the epithet "Great" had governments limited themselves to a
classical "hands-off" approach.

Hall and Ferguson trace the roots of the depression to World War I, when
the belligerent nations of Europe abandoned the gold standard. Gold payments
were resumed during the 1920s but at parities that were generally inconsistent
with international equilibrium: The pound was overvalued while the dollar
and franc were undervalued, causing a gold outflow from Britain that was
worsened by American and French attempts to sterilize gold inflows. Although
the Fed did switch to an expansionary policy, for Britain's sake during
1927, it reversed policy a year later in response to gold outflows and
advancing stock prices. This reversal is supposed to have initiated the
depression by triggering the U.S. stock market crash. The depression then
continued to deepen because of falling stock prices and in response to
a continuing decline in the quantity of money, which the Fed (influenced
by the real-bills doctrine) failed to prevent. In the meantime, Congresspassed the Smoot-Hawley tariff, dealing a serious blow to international
trade. Overseas, Austrian and German bank failures added to deflationary

Faced with massive declines in aggregate demand, depressed nations could
hope to recover either by reviving spending through aggressive monetary
or fiscal actions or by allowing prices and wages to decline to levels
consistent with fallen demand. Germany, one of the two hardest hit nations,
expanded both its money stock and government spending (in the unfortunate
form of Nazi-sponsored militarization programs).
The United States, also hard-hit, took some steps (including the bank holiday and later devaluation
of the dollar) to restore its money stock and aggregate spending, but simultaneously instituted the National Recovery Act (NRA), which tended to raise prices and wages, undermining the output and employment gains that demand expansion might otherwise have achieved.

Although the NRA was declared unconstitutional in May 1935, the Wagner
Act was passed that same year and was declared constitutional in 1937.
This act also placed upward pressure on wages, thwarting employment growth
even during a period of fiscal and monetary expansion. Then, in 1937, the
money stock and aggregate spending contracted anew in response to the Fed's
perverse decision to raise bank reserve requirements while sterilizing
gold inflows. The result was a severe "secondary" depression that delayed
recovery from the original depression for another year when monetary expansion
resumed. Hall and Ferguson claim that this belated monetary expansion,
combined with increased government spending following the outbreak of World
War II, was what finally brought the depression to a close.

Hall and Ferguson deserve praise for their success at summarizing a large
body of depression research in clear and easy prose and for the forthright
manner in which they present and defend their thesis. They succeed in showing
how many aspects of the depression can be understood by means of elementary
economic theory, notwithstanding macroeconomists' tendency to emphasize
(correctly, I think) the need for still more research on this topic. Hall
and Ferguson themselves, despite claiming that macroeconomics "made a great
leap forward" thanks to Keynes's contributions, get more mileage out of
the "classical" (i.e., pre-Keynesian) concepts of supply and demand and
Irving Fisher's equation of exchange than they get from any tools of analysis
contained in the General Theory.

On the other hand, Hall and Ferguson have little sympathy for pre-Keynesian
endorsements of the gold standard. They consider such a standard both
expensive and inherently unstable to the point of being unworthy of the "support
of. . grown-ups." But the expense and instability of the gold standard
must be judged not relative to some imaginary ideal but relative to theexpense and stability of fiat money. Nothing boosts the real price of gold
(which determines the extent of gold mining) like the inflation that has
characterized so many fiat money regimes; and central banks still hold
vast quantities of gold. (The authors themselves observe that the U.S.
Treasury owns more gold today than it did in 1929.)

The resource costs of modern fiat money regimes are, in short, not obviously lower than those
of the historical gold standard. As for gold's inherent instability (the
authors imagine a crisis arising in response to a run on gold by jewelry-
craving teenagers!), it must be compared to the instabilities of fiat moneys whose
supply is subject to the whims of central bankers and their sponsoring
governments. The gold standard struck many adult economists and policymakers
in the 1920s as being less fatally flawed than a "managed" fiat money—a
perfectly understandable opinion given the recently experienced horrors
of German hyperinflation and the gold standard's relatively good performance
before the war.

The authors correctly observe that, whatever its inherent flaws, the gold
standard worked best if governments (and their central banks) followed
"the rules of the game," allowing the stock of central bank notes and deposits
to vary along with the stock of monetary gold. One may well question how
closely these "rules" were followed before World War I (see Bloomfield
1959); but there seems to be little doubt that the "restored" gold standard
of the 1920s relaxed the rules even further.

Hall and Ferguson place great emphasis on the sterilization of gold inflows by the United States and
France during the 1920s as having short-circuited the gold standard in
a deflationary manner. However, they neglect other devices aimed at
sustaining an artificially large British money stock, including the replacement of
former gold-coin standards with gold-exchange (sterling or dollar) standards.

Rothbard (1998) [see a review] argues persuasively that, by means of these and other
arrangements, Britain was able for some time to avoid the monetary contraction and deflation
that would otherwise have been required by its unfortunate 1925 decision
to restore the prewar pound, and the world economy as a whole was able
to create a larger stock of monetary liabilities than it would otherwise
have done. A major mid-1920s deflationary crisis, centered in Britain,
was thus avoided for half a decade, but only by setting the stage for a
more severe worldwide collapse later on.

Many contemporary writers believed that, sterilization notwithstanding,
world monetary arrangements were more inflationary during the mid-1920s
than they would have been had the rules of the gold standard been followed.
They also viewed the first phase of the post - 1929 collapse as a consequence
of prior overexpansion.

Although Hall and Ferguson devote an entire chapter
to this "payback" hypothesis, they unnaccountably overlook its most famous
and influential proponents: the Austrian economists Ludwig von Mises and
Friedrich Hayek as well as their LSE champion Lionel Robbins. The Austrian
theory of the business cycle had won many converts during the early 1930s,
only to be cast aside by most of them in favor of the views contained in
the General Theory. More recently, important aspects of the Austrian analysis
have been rediscovered by New Classical business-cycle theorists, making
it all the more difficult to understand Hall and Ferguson's neglect of
the older theory in favor of Galbraith's far less influential alternative.

The Austrian theory fell into neglect in large part because some of its
principal proponents insisted on treating the full extent of deflation
during the early 1930s as having been an inescapable consequence of prior
overexpansion, as if the stock of money, having once been excessive, could
never be deficient. However, the monetary collapse of the 1930s was more
than an undoing of previous monetary expansion. It was a crisis in its
own right, stemming from a general loss of confidence in banks in Germany,
Austria, and the United States.

In the United States, at least the collapse
might have been avoided had the Fed expanded its balance sheet enough to
restore confidence (or make up for its absence). Concerning this matter,
the monetarists certainly have the better arguments, and Hall and Ferguson
are right to follow them. I only wish they had noted that the weakness
of the U.S. banking system was itself due largely to departures from laissez-
and especially to the government's failure to allow free interstate trade
in banking services. Canada, which allowed its banks to branch nationwide,
did not suffer a single bank failure during the depression era. Had the
authors taken note of these facts, they might have refrained from endorsing
government deposit insurance - a poor and dangerous substitute for structural
reform of the banking industry.

One of the more tenacious myths about the Great Depression is the claim
that it would have been worse had it not been for the New Deal. The truth,
as Hall and Ferguson document, is quite the opposite. Classical theory
teaches that, when demand for goods and labor is deficient, prices and
wages need to fall. The New Dealers turned this formula upside down, claiming
deficient demand to be a consequence of falling prices. The result was
a set of New Deal policies - especially the NRA, the AAA, and the Wagner
Act-that aimed at fixing, sometimes even raising, prices and wage rates.
As Hall and Ferguson point out, "the combination of cartels, wage hikes,
and regulation of agriculture" sponsored by these and other New Deal agencies
served not to hasten but to hinder recovery

* * * * *

(Thank you to Greg Ransom for alerting us to this review. He runs the F.A. Hayek Scholar's Page.)

Not to be missed: A great article by Robert Higgs on How FDR Made the Great Depression Worse.

For a financial history of the beginnings of the Great Depression, see Benjamin Anderson's Economics and the Public Welfare.

For a fuller treatment of the issue of wages in the Great Depression, see Vedder and Gallaway's Out of Work.

The same authors offer a compelling case to underscore Selgin's main case, by comparing problems of economic transition in 1930 with 1946, which was a mythical depression. (This article is in PDF format.)

For a different Austrian account of the monetary debate over the depression's early stages, see the Austrian Economics Newsletter's interview with Joseph Salerno.

Finally, for a good introduction to the theoretical framework of the Austrian Theory of the Business cycle, see the Ebeling and Garrison edited collection, The Austrian Theory of the Trade Cycle and Other Essays.

Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.

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