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Recessions: The Don't Do List

Tags Booms and BustsThe Fed

02/17/2013John P. Cochran

Listening to a new report on the just-released GDP numbers while reading Rothbard’s America’s Great Depression (AGD) made me realize how relevant and important this work is relative to today’s poorly performing economy. The book briefly summarizes Austrian Business Cycle Theory (ABCT) and applies the theory to the period of the Great Depression from 1929–1933. The book is especially relevant in that it provides policy guidance for dealing with an economic crisis, based on ABCT and historical evidence. The policy recommendations include actions to avoid as well as positive actions government could undertake to speed recovery. Unfortunately, the official reaction to the present crisis has been a virtual match to Rothbard’s “don’t do” list, while the positive actions have been conspicuous by their absence in most mainstream policy discussions. Even more important moving forward is the need for monetary reform, which is the key to preventing boom-bust cycles and thus avoiding depressions.

Preliminary GDP numbers for 4th quarter 2012 were just released and, as reported by the Wall Street Journal, indicated that the “[r]ecovery shows a soft spot” with GDP declining 0.1%. As Jeffrey Tucker reports in “The GDP Shock”:

Hardly anyone anticipated this. USA Today and other purportedly reliable venues immediately assured the world that this does not mean recession. Somehow after hanging onto to GDP numbers for three years—recovery is here despite your internal sense that the economy is still in a ditch—now we are told that the GDP figures are really just misleading. Recovery is still here, says the mainstream press.

Jon Hilsenrath in “Unusual Quarter of Contraction Doesn’t Mean Recession” provides a toned-down example of what Tucker is talking about:

A one quarter contraction of economic output doesn’t mean the economy is formally in recession, but it is unusual for such contractions to happen in the middle of economic expansions.

Austrian economists are keenly aware that “GDP figures are really just misleading.” Inclusion of government spending in any measure of economic growth is misleading. Business cycles are characterized by greater fluctuations in the capital goods industries relative to consumer goods. Malinvestment during the boom is followed by capital restructuring during the depression/recovery. Maintaining a coordinated structure of production is essential for maintaining a given level of prosperity, and lengthening the structure is a necessary condition for an improvement in the material standard of living. When one fully incorporates capital theory into macroeconomic analysis, it becomes clear that consumption is not the “engine of the economy” (see John Papola’s “Think Consumption Is The ‘Engine’ Of Our Economy? Think Again” in Forbes online, or Mark Skousen’s “Gross Domestic Expenditures (GDE): the Need for a New National Aggregate Statistic”). Per Rothbard (Americas Great Depression, pp. 58–59):

Savings, which go into investment, are therefore just as necessary to sustain the structure of production as consumption. Here we tend to be misled because national income accounting deals solely in net terms. Even “gross national product” is not really gross by any means; only gross durable investment is included, while gross inventory purchases are excluded. It is not true, as the underconsumptionists tend to assume, that capital is invested and then pours forth onto the market in the form of production, its work over and done. On the contrary, to sustain a higher standard of living, the production structure—the capital structure—must be permanently “lengthened.” As more and more capital is added and maintained in civilized economies, more and more funds must be used just to maintain and replace the larger structure. This means higher gross savings, savings that must be sustained and invested in each higher stage of production.

Even though GDP is a highly inaccurate measure of economic activity, and regardless of whether or not one quarter of negative growth in real GDP indicates an economy on the verge of a double dip recession, the number does provide further evidence of an economy struggling to recover from the depression which followed back-to-back Fed induced boom-bust cycles. This is an economy which has been essentially stagnating since the reported end of the “Great Recession” in June 2009, nearly four years ago.

Mainstream economists have given competing explanations of why this is the worst recovery since the Great depression. Many Keynesians, including Paul Krugman, have argued the recovery is slow, not because the policy response was wrong, but because it was not big enough. The policy response was strong enough to save the economy from a bigger disaster, but despite an $800 billion fiscal stimulus, deficits of over one trillion dollars leading to a public debt of over $16 trillion, and a tripling of the Fed’s balance sheet, the policy response was still too small. Carmen M. Reinhart and Kenneth Rogoff, also defend the policy response, but in This Time is Different, they argue that recoveries from recessions accompanied by a financial crisis have, based on historical evidence, always been slow compared to recessions not accompanied by financial crisis. While fiscal and monetary stimuli have not generated a speedy recovery, these policies did prevent the crisis from being even worse. According to Rana Foroohar in Time, “The Risks of Reviving a Revived Economy” [HT to Walter Block]:

Ironically, the stimulus is also a reason the recovery has been so slow and will continue to be for the next three to five years. Harvard economist Ken Rogoff, who along with his colleague Carmen Reinhart has been the best rune reader of the past few years, says that historically during financial crises, “to the extent that you act to slow the deep, sharp economic pain, you also slow the recovery.”

Contra Rogoff and Reinhart, Michael Bordo has done some excellent work showing that throughout US economic history, recovery has actually been quicker following financial crises. His work has been used by John B. Taylor to bolster his argument that policy activism and the accompanying policy uncertainty, both monetary and fiscal, have impeded business planning and recovery. Much of the debate can be accessed here. Austrian economists like Robert Higgs and myself and fellow travelers such as Mary L. G. Theroux have pushed the uncertainty argument even further to include regime uncertainty as the key element retarding recovery.

However, readers of Rothbard’s America’s Great Depression should not have been surprised that the recent bust was not a sharp depression followed quickly by a return to prosperity and sustainable growth, albeit not necessarily to the levels expected by those fooled by the false expectations created by monetary mismanagement due to malinvestments and wealth destruction during the previous two booms (see Salerno’s “A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis,” Ravier’s “Rethinking Capital-Based Macroeconomics,” and most recently Shostak’s “Fed’s policies expose mainstream fallacies”). While the first part of Rothbard’s great book is devoted to explaining the Austrian boom-bust theory of the business cycle, defending the theory from critics, and illustrating its applicability to the events leading up to the 1929 crisis/bust, the second part of the book is devoted to examining governmental interventions and policy errors that retarded recovery and turned a “garden variety recession” into a Great Depression.

Rothbard notes two things of significance for both then and now:

1. “[T]he longer the boom goes on the more wasteful the errors committed, and the longer and more severe will be the necessary depression readjustment” (p. 13). The current boom-bust had its roots in the boom during the late 1990s, which resulted in a bust/recession, recovery from which was aborted by aggressive Fed action beginning in 2003, which added new malinvestments and misdirections of production to the unresolved malinvestments left over from the previous boom (see Cochran’s “Hayek and the 21st Century Boom-Bust and Recession-Recovery”).

2. Unemployment, if recovery is not impeded by interventions, will be temporary. Per Rothbard (p. 14):

Since factors must shift from the higher to the lower orders of production, there is inevitable “frictional” unemployment in a depression, but it need not be greater than unemployment attending any other large shift in production. In practice, unemployment will be aggravated by the numerous bankruptcies, and the large errors revealed, but it still need only be temporary. The speedier the adjustment, the more fleeting will the unemployment be. Unemployment will progress beyond the “frictional” stage and become really severe and lasting only if wage rates are kept artificially high and are prevented from falling. If wage rates are kept above the free-market level that clears the demand for and supply of labor, laborers will remain permanently unemployed. The greater the degree of discrepancy, the more severe will the unemployment be.

When the crisis hit in 2007 and 2008, the correct policy would have been the response Rothbard recommended in 1982 in the introduction to the fourth edition (p. xxi) of America’s Great Depression:

The only way out of the current mess is to “slam on the brakes,” to stop the monetary inflation in its tracks. Then, the inevitable recession will be sharp but short and swift [emphasis added], and the free market, allowed its head, will return to a sound recovery in a remarkably brief time.

While, as mentioned above, Rothbard only briefly discusses ABCT (p. xxxviii), “a full elaboration being available in other works,” AGD, elaborates on the theory’s implication on government policy: “implications which run flatly counter to prevailing views [both then, 1963, and now].”

What are these implications? First and foremost (p. 19), “don’t interfere with the market’s adjustment process” [emphasis original]. The more government blocks market adjustments, the “longer and more grueling the depression will be, and the more difficult will be the road to complete recovery.” Rothbard argues it is possible to logically list the ways market adjustment could be aborted by government action and such a list would coincide well with the “favorite ‘anti-depression’ arsenal of government policy.” The list almost perfectly matches with policy responses to the crisis during both the Bush (see Thornton’s “Hoover, Bush, and Great Depressions”) and Obama administrations.

Here is Rothbard’s “Don't Do” list (pp. 19–20), with my comments in brackets:

1. Prevent or delay liquidation

“Lend money to shaky businesses, call on banks to lend further, etc.” [Done. Tarp, auto bailouts, and the Fed’s mondustrial policy. See recently John B. Taylor in the Wall Street Journal: “The low rates also make it possible for banks to roll over rather than write off bad loans, locking up unproductive assets.”]

2. Inflate further

“Further inflation blocks the necessary fall in prices, thus delaying adjustment and prolonging depression. Further credit expansion creates more malinvestments, which, in their turn, will have to be liquidated in some later depression. A government ‘easy money’ policy prevents the market's return to the necessary higher interest rates.” [Done in spades.]

3. Keep wage rates up

“Artificial maintenance of wage rates in a depression insures permanent mass unemployment. Furthermore, in a deflation, when prices are falling, keeping the same rate of money wages means that real wage rates have been pushed higher. In the face of falling business demand, this greatly aggravates the unemployment problem.”

4. Keep prices up

“Keeping prices above their free-market levels will create unsalable surpluses, and prevent a return to prosperity.” [3 and 4 are both direct results of current Fed actions, including price inflation targets near 2%.]

5. Stimulate consumption and discourage saving

“We have seen that more saving and less consumption would speed recovery; more consumption and less saving aggravate the shortage of saved-capital even further. Government can encourage consumption by ‘food stamp plans’ and relief payments. It can discourage savings and investment by higher taxes, particularly on the wealthy and on corporations and estates. As a matter of fact, any increase of taxes and government spending will discourage saving and investment and stimulate consumption, since government spending is all consumption. Some of the private funds would have been saved and invested; all of the government funds are consumed. Any increase in the relative size of government in the economy, therefore, shifts the societal consumption-investment ratio in favor of consumption, and prolongs the depression.” [The federal government has expanded from a bloated 18–20% of the economy to 23–25% of the economy under the current administration. The Bush fiscal stimulus in 2008 and the majority of the 2009 Obama stimulus supported consumption relative to investment as did the ineffective recently repealed temporary payroll tax cut.]

6. Subsidize unemployment

“Any subsidization of unemployment (via unemployment ‘insurance,’ relief, etc.) will prolong unemployment indefinitely, and delay the shift of workers to the fields where jobs are available.” [Does anything need added here?]

Rothbard (p. 21) argued these were “time-honored favorites of government policy” and the last part of AGD was devoted to showing how these were the policies adopted in 1929–1933. Current policy has followed the same path. We should not be surprised that the result has been similar, if not as yet quite as tragic. It is still not too late to change paths, but unfortunately such action, while possible is not likely to happen. Neither will the positive actions recommended by Rothbard (p. 22) to speed recovery be undertaken. Reducing the relative role of the government in the economy while reducing taxes, especially those that bear most heavily on saving and investment, are also, as I have argued previously in “Thoughts on Capital-Based Macroeconomics” (Part III), the correct actions to address the debt and size-of-government crisis.

We are again undone by the “Crisis of Authority,” the urge to action, the incorrect, but too often, as explained by Pierre Lemieux, unchallenged belief that Somebody in Charge1Somebody in Charge: A Solution for Recessions? is a solution to recessions. The correct government depression policy is “Nobody in Charge.” Laissez-faire is thus the untried alternative and the preventative of depression. Sound, free market money is the untried alternative to government money. Laissez-faire and sound money would replace the recurring boom-bust, and its attendant needless depression and unemployment, with sustainable growth and relative prosperity.

  • 1. The title of Pierre Lemieux’s excellent (but overly expensive) book on the financial crisis and its aftermath,

Contact John P. Cochran

John P. Cochran (1949-2015) was emeritus dean of the Business School and emeritus professor of economics at Metropolitan State University of Denver and coauthor with Fred R. Glahe of The Hayek-Keynes Debate: Lessons for Current Business Cycle Research. He was also a senior fellow of the Mises Institute and served on the editorial board of the Quarterly Journal of Austrian Economics.