Truth in Data

The April 1999 issue of The Freeman includes this astonishing claim in Richard Timberlake's article "Money in the 1920s and 1930s" (pp. 37-42):

"Many Austrian economists believe that [the Great Depression] started with a central bank 'inflation' in the 1920s... The late Murray Rothbard was the chief proponent of this argument. Rothbard's problem is manifest in his book America's Great Depression. After endowing the useful word 'inflation' with a new and unacceptable meaning, Rothbard ‘discovered' that the Federal Reserve had indeed provoked an inflation in the 1921-1929 period. The money supply he examined for the period included not only hand-to-hand currency and all deposits in commercial banks adjusted for inter-bank holdings–the conventional M2 money stock–but also savings and loan share capital and life insurance net policy reserves. Consequently, where the M2 money stock increased 46 percent over the period, or at an annual rate of about 4 percent, the Rothbard-expanded 'money stock' increased by 62 percent, or about 7 percent per year. Here, Rothbard mistakes some elements of financial wealth with money." (P. 38)

Refutation of Timberlake

Timberlake's claim, which essentially boils down to an accusation that Rothbard phonied up the data to back up his Misesian theory, deserves an answer.

Fortunately, it already has been answered, by Joseph T. Salerno, in the Fall 1996 Austrian Economics Newsletter:

SALERNO: Rothbard argued that the stock market crash was not a market failure, but a consequence of inflationary Federal Reserve Policy during the 1920s. Monetary inflation had caused distortions in the real capital structure, and the crash and depression were the inevitable correction. Milton Friedman merely blames the Fed for not rescuing banks once they started to fail.

For the Austrian theory to apply, Rothbard had to demonstrate that a significant inflation had occurred in the 1920s. That's how the debate turned to the definition of money. Friedman understood how high the stakes were.

AEN: And this is how the accusation began that Rothbard fudged his numbers?

SALERNO: This is a longstanding Friedmanite canard. But it's made the rounds, even among some Austrians. The idea is that Rothbard cheated by including the cash surrender value of life insurance policies in his money supply. Ironically, this view is perpetuated by positivists who would include peanut butter in their monetary aggregates if it helped them "explain" nominal income.

In fact, many Keynesian economists writing after the Second World War characterized life-insurance reserves as highly liquid financial assets that perform monetary functions. When this subject last came up, I pulled some older money and banking texts off my shelf at random. Four out of six treated insurance reserves this way, on grounds that they can be withdrawn at any time and are thus readily spendable dollars.

Besides, it turns out not to matter in Rothbard's theory. Including life-insurance policies, the increase in Rothbard's money aggregate between mid-1921 and the end of 1928 totaled about 61%, yielding an annual rate of monetary inflation of 6.5%, compounded annually. Leave them out, and we get 55% over the period, or 6.0% per annum. For comparison, in the highly inflationary 1970s, the money stock grew at an average annual rate of 6.35%, including the double-digit Carter years.

In other words, it doesn't matter for Rothbard's theory whether these are included or excluded. A Hayekian-style treatment of the same events by Phillips, McManus, and Nelson does not include insurance reserves, and concludes that the Austrian explanation is the correct one. The key point is not that the banks weren't bailed out in the early thirties, but that the Fed inflated in the 1920s, even though it didn't show up in increased prices.

AEN: The dispute about the Great Depression and the business cycle goes beyond the numbers, doesn't it?

SALERNO: It goes to the core of economic theory. For most mainstream economists, inflation is not a matter of money and bank credit expansion; it is essentially a price phenomenon. If prices don't rise, there is no inflation. It doesn't matter what the monetary data say. In the 1920s, there was no substantial change in prices, due to enormous productivity and output increases. But to them, that is sufficient evidence that they don't need to look any deeper.

Only Austrians truly believe inflation is a monetary phenomenon. When you increase the amount of money in circulation, it brings many more changes than just price increases. We see a fall in the loan rate of interest. We see a boom in real estate as a higher-order good. We see a boom in the stock market, which trades titles to higher-order goods, that is, capital goods. To focus on inflation as price increases means we don't capture the fullness of the inflationary phenomenon.