Mises Daily : Mises Institute on Austrian Economics and Libertarianism

The History of Our Movement

Fri, 17 May 2013 00:00:00 -0500

Through the Oral History Project, the Mises Institute is preserving the personal recollections and wisdom of the great men and women of our movement for the students and scholars of the future. Mises Institute faculty sat down this year to discuss the past and the future with champions of the Austrian tradition including economist Leland B. Yeager and Mises’s long-time assistant Bettina Bien Greaves. These are two of the many life stories we hope to record. The recorded interviews will be archived on mises.org and transcribed to text so they will be easily accessible, searchable, and usable to researchers everywhere.

In February, David Gordon spoke with the foremost historian of classical liberalism, Ralph Raico, about his life and career, including insights into the views and personalities of Rand, Hayek, and Rothbard. David Gordon provides a bit of a sneak peek at the Raico interview (below).

Raico grew up in the Bronx, but in contrast with the leftist views common in his family’s apartment building and neighborhood, he acquired from an early age a sympathetic grasp of the isolationist wing of the Republican Party. In high school, he joined Youth for Taft, where he encountered George Reisman. While still in high school, Raico and Reisman became interested in Mises, and Raico describes their hilarious attempt to meet Mises, in the guise of door-to-door salesmen for The Freeman.

The attempt failed, but they soon were able to join Mises’s famous seminar at New York University. Here Raico met someone who became one of the dominant intellectual influences on his life—Murray Rothbard. The incredible range of Rothbard’s scholarship, as well as his enthusiasm and humor, impressed Raico deeply. Rothbard was the first person Raico had met who defended “a fully voluntary society—nudge, nudge.”

Raico, along with Reisman, Ronald Hamowy, and several others, became members of the Circle Bastiat and met regularly with Rothbard. When Ayn Rand’s Atlas Shrugged appeared in 1957, Rothbard and his followers met for a while with Rand and her group, “The Collective,” but Rothbard and the Randians soon clashed. He refused their demand that he divorce his wife Joey, who had committed the unpardonable sin of being a Christian.

Raico did his graduate work at the Committee on Social Thought of the University of Chicago, with Friedrich Hayek as his major professor. He found Hayek “more interested in his own research than teaching” and, although friendly, somewhat remote. While at Chicago, he founded the New Individualist Review, which became one of the best of all classical-liberal journals. He was able to attract such luminaries as Hayek and Milton Friedman to contribute.

(Click below to listen)

Listeners to the recording will catch the nostalgia Raico feels for his first teaching position at Wabash College; the quality of the students there was never matched in his later career at Buffalo State College. Raico also describes his many trips to Europe, and listeners will especially enjoy his account of the Gaudi buildings in Barcelona. While in Europe, he lectured widely. Raico became the foremost expert on the history of nineteenth-century German liberalism and published Classical Liberalism and the Austrian School.

Like Rothbard, Raico has been very closely associated with the Mises Institute. The recording conveys a clear impression of Raico’s intelligence and wit. Listening to it is almost like meeting Ralph Raico in person.

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David Gordon covers new books in economics, politics, philosophy, and law for The Mises Review, the quarterly review of literature in the social sciences, published since 1995 by the Mises Institute. He is author of The Essential Rothbard, available in the Mises Store. Send him mail. See David Gordon's article archives.

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FDR: Sowing the Seeds of Chaos

Thu, 16 May 2013 00:00:00 -0500

(Excerpt from THE GREAT DEFORMATION: The Corruption of Capitalism in America by David A. Stockman. Published by PublicAffairs.)

When FDR Got the Gold

The long-lasting imprint from FDR’s famous “Hundred Days” did not stem from the bank holiday, national industrial recovery act, the farm adjustment act, the Tennessee Valley Authority, or the public works administration.

Instead, it is lodged in the footnotes of standard histories; namely, FDR’s April 1933 order confiscating every ounce of gold held by private citizens and businesses throughout the United States. Shortly thereafter he also embraced the Thomas Amendment, giving him open-ended authority to drastically reduce the gold content of the dollar; that is, to trash the nation’s currency.

These actions did not constitute merely a belated burial of the “barbarous relic.” In the larger scheme of monetary history, they marked a crucial tipping point. They initiated a process of monetary deformation that led straight to Nixon’s abomination at Camp David, Greenspan’s panic at the time of the 1998 Long-Term Capital Management crisis, and the final destruction of monetary integrity and financial discipline during the BlackBerry Panic of 2008.

The radical nature of this break with the past is underscored by a singular fact virtually unknown in the present era of inflationary central bank money; namely, that the dollar’s gold content had been set at $20.67 per ounce in 1832 and had never been altered. There had been zero net domestic inflation for a century and the dollar’s gold value in international commerce had never varied except during war.

The Thomas Amendment nullified this rock-solid monetary foundation and instead permitted the president on his own whim to cut the dollar’s gold content by up to 50 percent. So doing, it signaled that money would no longer exist fixed, immutable, and outside the machinations of the state, but would now be an artifact of its whims and expedients.

It was a shocking deviation from FDR’s own repeated campaign pledges to preserve “sound money at all hazards” and contradicted the pro–gold standard views of even his own party’s mainstream. Likewise, the removal of gold from circulation entirely had never before been seriously proposed, not even by William Jennings Bryan, the populist Democrat presidential candidate best known for his “Cross of Gold” speech.

Self-evidently, bank notes and checkbook money had long been a more convenient means of payment than gold coins, but the function of gold was financial discipline, not hand-to-hand circulation. Redeemability of bank notes and deposits gave the people an ultimate check on the monetary depredations of the state and its central banking branch. Indeed, the public’s freedom to dump its everyday money in favor of gold coins and bullion was what kept official currency and bank money honest.

At the time, however, the shell-shocked nation—even the conservative opposition—scarcely understood that the Rubicon had been crossed. The most notable clarion call, in fact, came from Lewis Douglas, FDR’s own budget director and key economic advisor. Hearing on April 18, 1933, of the president’s intention to endorse the Thomas Amendment, Douglas famously declared, “This is the end of western civilization.”

Douglas was at least eighty years premature with respect to timing but his sense of the implication was profoundly correct. In one fell swoop, FDR’s capricious actions launched the Democrats down the road to a government-manufactured currency and a purely national form of money.

It thereby repudiated the internationalist hard-money stand of the 1932 Democratic platform, the pro–gold standard candidacies of Al Smith in 1928, John Davis in 1924, and the James Cox—Franklin Roosevelt ticket of 1920. It also nullified the pro-gold principles of Carter Glass and the Democratic majority that had instituted the Federal Reserve Act in 1913 and the Cleveland, Jackson, and Jefferson Democrats who had gone before.

In short, amid the atmosphere of public fear and alarm from his self-inflicted banking crisis, and owing to his willful insouciance in single-handedly scrapping the nation’s deep and bipartisan gold standard tradition, FDR essentially parted the waters of monetary history. Until June 1933, virtually everyone believed that gold-redeemable money was the foundation of capitalism, yet within months such convictions had gone stone-cold dormant.

It would, of course, take time for the resulting monetary vacuum to be filled by an aggrandizing central bank and a credit-money-based financial system cut loose from the discipline of gold. In the interim, the Great Depression quashed inflationary expectations and speculative instincts for decades to come, and produced a generation of conservative commercial and central bankers who earnestly attempted to replicate its discipline.

Nevertheless, it was only a matter of circumstances before the policy vacuum was filled by less wholesome propensities. Eventually, Nixonian cynicism and Professor Milton Friedman’s alluring but dangerously naïve doctrines of floating exchange rates and the quantity theory of money picked up where FDR left off. Notwithstanding Friedman’s aura of intellectual respectability, Nixon’s crass political maneuvers amounted to a primitive economic nationalism that harkened back to the worst of the disaster that FDR had first sown in the 1930s.

FDR’S London Conference Bombshell: The End of the Liberal International Order

After Roosevelt effectively suspended convertibility in the bastion of the world gold standard, money was essentially nationalized. Most of the world’s major economies, including the United States’s, retreated into separate silos of autarky and stagnation, which in turn bred ultra-nationalism, rearmament, and finally world war. But this outcome was not inevitable.

To be sure, the survival of a liberal international economic order had been in doubt throughout the 1920s, as the world struggled to repair the inflationary mayhem of the Great War and resume convertibility of national currencies. Between 1925 and 1928, huge strides toward normalization of exchange rates, capital markets, and trade were accomplished as England, Belgium, Sweden, and even Japan (1930) restored gold standard money.

But all of this tenuous progress had been seriously jeopardized by England’s abandonment in September 1931 of the very gold exchange standard it had spent a decade promoting under the auspices of the League of Nations. So prospects for resumption of the fabulously stable and prosperous pre-1914 liberal international order were hanging by a thread. In this context, historians are agreed that it was FDR who personally delivered the coup de grâce with his famous “bombshell” message to the London Economic Conference in July 1933.

FDR capriciously defied all of his advisors, to the very last man, including the then-chief of his brain trust, Raymond Moley. Flying by the seat of his own pants, he airily dismissed the warnings of his budget director, the brilliant industrialist and financial scholar Lewis Douglas. He also disregarded the firm pro-gold viewpoint of James Warburg, his most senior financial advisor with Wall Street and international finance experience. Moreover, FDR had failed to even solicit the opinion of Senator Carter Glass. Under the circumstances, that was not merely a telling omission; it was damning.

For the better part of three decades, the legendary Virginia senator, also former secretary of the treasury under Woodrow Wilson and principal author of the Federal Reserve Act, had been the Democratic Party’s paragon of authority on matters of money and banking. Glass had been an unwavering proponent of the gold standard and had personally written the 1932 Democratic platform in such a manner as to leave no doubt that the Democrats would not resort to easy money and inflationist expedients.

For several weeks before his March 4 inauguration, Roosevelt pleaded with Glass to become his secretary of the treasury. Yet hardly sixty days after Glass finally refused the job, FDR did not even bother to consult him when launching what were epochal monetary policy actions. In essence, FDR’s April 1933 gold machinations repudiated the life’s work of the very financial statesman he first picked for the single most important job in his government.

Roosevelt’s flip-flopping on Glass and gold was a defining moment. It showed that on the raging economic crisis of the hour, Roosevelt’s insouciance knew no boundaries; he could believe almost any contradiction that came his way.

It thus happened that after the Hundred Days of emergency actions was completed in late June, FDR headed off to vacation on Vincent Astor’s yacht. He sent Moley as his personal emissary to the London conference, which by then had come to be viewed as literally the last hope for retaining an open international trading and monetary order.

The conference had the good fortune that its presiding officer was Secretary of State Cordell Hull. A former Democratic senator from Tennessee and a splendid statesman, Hull had been a staunch advocate of free trade, the gold standard, and an open international economy.

Most of the assembled financial officials, including Hull, recognized that restoration of some semblance of exchange-rate stability was the key to the rest of the conference agenda, especially to rolling back the protectionist trade barriers which were rapidly choking off world trade. The latter had sprung up everywhere after Smoot-Hawley and were being compounded by beggar-thy-neighbor currency manipulation after the sterling-based gold exchange system broke down.

After long and arduous negotiations, the framework for such a monetary stabilization agreement was reached soon after Moley arrived in London. The US delegation, Great Britain, and the French-led gold bloc nations had all managed to find common ground. While Moley had been a strident voice of nationalistic autarky in the Roosevelt inner circle, even he was persuaded by Hull and the British to endorse the tentative internationalist agreement.

The heart of the plan was repegging the dollar to pound exchange rate in a narrow band about 20 percent below the old parity (i.e., at about $4.00 versus $4.86 per pound sterling). From that pivot point, the French franc and other major currencies would be fixed to the dollar.

The significance of this breakthrough cannot be gainsaid. All sides recognized that floating currencies would poison the international trading system, encourage destructive currency speculation, and fuel violent movements of “hot money” among financial centers. The latter would continuously destabilize both national money markets and confidence in the international trading system as a whole.

In one of the great misfortunes of history, however, FDR was literally incommunicado during the hours when a global consensus to reboot the international financial system briefly flickered. Alone on Astor’s luxurious yacht, the Nourmahal, the president had the advice of only his wealthy dilettante chum Vincent Astor and Louis Howe, his butler and glorified White House “secretary.”

When Moley finally found a navy ship to track down the Nourmahal and deliver a radio message outlining the nascent London agreement, Roosevelt, Howe, Astor, and perhaps also the yacht’s captain, as it were, gathered around a kerosene lamp on the deck. There they scribbled out a handwritten response and turned it over to the navy for radio dispatch back to London.

Roosevelt’s message was undoubtedly among the most intemperate, incoherent, and bombastic communiqués ever publicly issued by a US president. It not only stunned the assembled world leaders gathered in London and killed the monetary stabilization agreement on the spot, but it also locked in a destructive worldwide régime of economic nationalism that eventually led to war.

High tariffs and trade subsidies, state-dominated recovery and rearmament programs, and manipulated fiat currencies became universal after the London conference failed. In the months which followed, Sweden, Holland, and France were driven off the gold standard, leaving international financial markets demoralized and chaotic.

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At the end of the day, it was only the outbreak of war in 1939–1940 which pulled the world out of the rut of economic nationalism and stagnation to which FDR’s quixotic action had condemned it. It also meant that the domestic economy had now been cut off from its vital export markets, condemning the nation to a halting recovery and to continuous and mostly ineffectual New Deal doctoring that succeeded primarily in planting the seeds of welfare state expansion and crony capitalism.

Roosevelt’s deplorable action from the deck of the Nourmahal tends to be dismissed by historians as a forgivable bad hair day early in the reign of the economic-savior president. In fact, it was the very opposite: FDR’s single-handed sabotage of the London conference was one bookend of a thirty-eight-year epoch. The other end was bounded by Richard Nixon’s equally impudent destruction of Bretton Woods in August 1971.

In each case the modus operandi was the same. Both Roosevelt and Nixon were aggressive politicians who lacked any enduring convictions about economic policy. Neither had any compunction at all, however, about using the taxing, spending, regulatory, and money-printing powers of the state to achieve their domestic political and electoral objectives. In the great scheme of modern financial history FDR and Tricky Dick were peas in a statist pod.

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David Stockman was director of the Office of Management and Budget under President Ronald Reagan, serving from 1981 until August 1985. He was the youngest cabinet member in the 20th century. See David Stockman's article archives.

Prohibition Caused the Greatness of Gatsby

Wed, 15 May 2013 00:00:00 -0500

[Mark Thornton is available for interviews. Send him email.]

The new adaptation of F. Scott Fitzgerald’s The Great Gatsby is a good movie, but it is no indictment against capitalism, as some may contend. It is rather an implicit condemnation of government prohibition.

When I read the book in high school I did not like it. I found it hard to read, not because it was overly complicated or poorly done, but because of the subject matter. The book (as well as the movie) dwells on decadence, licentiousness, promiscuity, and recklessness, or what was called “luxury” in the old days. I have an aversion to all that, and there was only so much I could take.

There is an important difference between wealth and luxury (in the modern sense) on one hand and the type of riotous over-the-top behavior on display in movies like The Great Gatsby, Moulin Rouge!, and Leaving Las Vegas.

Having written my dissertation on the economics of prohibition, I now understand the value of The Great Gatsby much better. The decadence on display serves, not merely as titillation for the reader/viewer, but as an object lesson in the evils of prohibition.

The whole plot is intimately tied to the prohibition of alcohol accomplished by the18^th Amendment to the Constitution. In particular, many aspects of the plot are driven by the black market that developed in the 1920s.

Prohibition made alcohol illegal, but it did not eliminate it. Illegal producers known as moonshiners sold their illegal product to illegal distributors known as bootleggers, who in turn sold it to illegal retail establishments known as speakeasies. Everything had to be secretive. The process was overseen by organized crime syndicates and street gangs who paid bribes to corrupt politicians and law enforcement. Respect for the law sank to an all-time low.

In the world of this black market, property rights were protected with machine guns rather than judges and juries. The stigma against young women drinking in bars at night was displaced by the allure of an exciting night out on the town drinking and listening to jazz. Instead of these profits going to competing entrepreneurs, the money was going into the pockets of thugs and wannabes. Social order was replaced by chaos. This cultural decay was the ironic fruit of the puritanically-motived prohibition movement.

The central character of the story is Jay Gatsby. Gatsby comes from a dirt-poor family and is a big dreamer, as well as a big risk taker. He keeps his past shrouded in a web of lies and half-truths as he sets out to remake himself into a person of wealth and prominence. This is the ideal personality for making it big in black markets.

The mysterious Jay Gatsby indeed does become “filthy” rich by selling illegal booze. During Prohibition doctors could prescribe “medicinal liquor” for their patients for literally dozens of ailments, including alcoholism. Gatsby sees this as an opportunity and establishes a chain of drugstores with the help of organized crime and corrupt politicians.

Alcohol has been an effective remedy for treating a variety of medical problems throughout the centuries. During Prohibition, doctors were paid well for writing the prescriptions and drug stores were also very well compensated for selling “medicinal alcohol.” I could not find records of how many prescriptions were written, but the one I have framed in my office is number E362545 which was issued on 8/13/31 and cancelled in 1932. Here is an image of a prescription from Wikipedia.

This was the heyday for pharmacies. The Walgreen’s chain of drugstores started in the 1920s with 20 stores in the Chicago area, but ended the decade with over 500. I have to believe that it was not so much their great milkshakes, but the pints of Old Grand Dad that they were able to sell at high prices that contributed to its success.

The thing about legal outlets for otherwise illegal products is that there tends to be “diversion.” In other words, a drug store that can legally acquire and sell alcohol can also sell their products illegally to speakeasies which would then resell the alcohol to their customers by the drink. This was clearly happening with Gatsby’s drug stores.

Prior to prohibition most Americans were accustomed to drinking their whiskey “straight” or with water. However, much of the moonshine and bathtub gin that was produced during Prohibition was of high potency, but poor quality. The diverted whiskey, during the Roaring 20s, would therefore have fetched high prices making enormous profits for drug store owners like Gatsby.

To deal with the high potency, bad taste, and sometimes bad smells, the speakeasies experimented with “cocktails,” which combined alcohol with juices, dairy products, and food items. As a result, thousands of different cocktails were invented as the speakeasies competed against one another for the customer’s money.

The Age of the Cocktail might be the only silver lining to come from Prohibition, other than Fitzgerald’s The Great Gatsby—a testament to how twisted society can become, and how the Jay Gatsbys of the world can reach the stars, with the help of government prohibition.

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Mark Thornton is a senior resident fellow at the Ludwig von Mises Institute in Auburn, Alabama, and is the book review editor for the Quarterly Journal of Austrian Economics. He is the author of The Economics of Prohibition, coauthor of Tariffs, Blockades, and Inflation: The Economics of the Civil War, and the editor of The Quotable Mises, The Bastiat Collection, and An Essay on Economic Theory. Send him mail. See Mark Thornton's article archives.

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Stable Prices, Unstable Markets

Tue, 14 May 2013 00:00:00 -0500

According to European Central Bank Governing Council member Ewald Nowotny, Federal Reserve Chairman Ben Bernanke sees no risk of inflation in the United States. According to Nowotny, Bernanke had given a “very optimistic” portrayal of the US outlook.

“They see absolutely no danger of an expansion in inflation,” Nowotny said. Bernanke had said US inflation should be 1.3 percent this year.

Fed forecasts put inflation by the end of this year in a range of 1.3 to 1.7 percent. The yearly rate of growth of the consumer price index (CPI) stood at 1.5 percent in March against 2 percent in February and 2.7 percent in March last year.

Also the growth momentum of the core CPI (the CPI less food and energy) has eased in March from the month before. Year-on-year the rate of growth has softened to 1.9 percent from 2 percent in February and 2.3 percent in March last year.

For Bernanke and most experts, the key factor that sets the foundation for healthy economic fundamentals is a stable price level as depicted by the consumer price index.

According to this way of thinking, a stable price level doesn’t obscure the visibility of the relative changes in the prices of goods and services, but enables businesses to see clearly market signals that are conveyed by the relative changes in the prices of goods and services. Consequently, it is held, this leads to the efficient use of the economy’s scarce resources and hence results in better economic fundamentals.

For instance, let us say that a relative strengthening in people’s demand for potatoes versus tomatoes took place. This relative strengthening, it is held, is going to be depicted by the relative increase in the prices of potatoes versus tomatoes.

Now in a free market, businesses pay attention to consumer wishes as manifested by changes in the relative prices of goods and services. Failing to abide by consumer wishes will lead to the wrong production mix of goods and services and will lead to losses.

Hence in our case businesses, by paying attention to relative changes in prices, are likely to increase the production of potatoes versus tomatoes.

According to this way of thinking, if the price level is not stable, then the visibility of the relative price changes becomes blurred and consequently, businesses cannot ascertain the relative changes in the demand for goods and services and make correct production decisions.

This leads to a misallocation of resources and to the weakening of economic fundamentals. In short, unstable changes in the price level obscure changes in the relative prices of goods and services. Consequently, businesses will find it difficult to recognize a change in relative prices when the price level is unstable.

Based on this way of thinking it is not surprising that the mandate of the central bank is to pursue policies that will bring price stability, i.e., a stable price level.

By means of various quantitative methods, the Fed’s economists have established that at present, policy makers must aim at keeping price inflation at 2 percent. Any significant deviation from this figure constitutes deviation from the growth path of price stability (or at least stability in the rate of price-level increase).

Observe that Fed policy makers are telling us that they have to stabilize the price level in order to allow the efficient functioning of the market economy. Obviously this is a contradiction in terms, since any attempt to manipulate the so-called price level implies interference with markets, and hence leads to false signals as conveyed by changes in relative prices.

By means of setting targets to interest rates and by means of monetary pumping it is not possible to strengthen economic fundamentals, but on the contrary it only makes things much worse. Here is why.

Policy of price stability leads to more instability

Let us say that the so-called price level is starting to exhibit a visible decline in growth momentum. To prevent this decline, the Fed starts to aggressively push money into the banking system.

As a result of this policy, after a time lag the price level has stabilized. Should we regard this as a successful monetary policy action? The answer is categorically no.

Given that monetary pumping sets in motion the diversion of wealth from wealth generating activities to non-wealth generating activities, obviously this leads to the weakening of the wealth generation process and to economic impoverishment.

Note that the economic impoverishment has taken place despite price level stability. Also, note that in order to achieve price stability, the Fed had to allow an increase in the growth momentum of its balance sheet and consequently in the growth momentum of the money supply.

It is the fluctuations in the balance sheet and the subsequent fluctuations in the growth momentum of the money supply that matter here. It is this that sets in motion the menace of the boom-bust cycle, regardless of whether the price level is stable or not.

While increases in the money supply are likely to be revealed in general price increases, this need not always be the case. Prices are determined by both real and monetary factors.

Consequently, it can occur that if the real factors are pulling things in an opposite direction to monetary factors, no visible change in prices might take place.

In other words, while money growth is buoyant, prices might display low increases.

Clearly, if we were to pay attention to the so-called price level, and disregard increases in the money supply, we would reach misleading conclusions regarding the state of the economy.

On this, Rothbard wrote,

“The fact that general prices were more or less stable during the 1920s told most economists that there was no inflationary threat, and therefore the events of the great depression caught them completely unaware” (America’s Great Depression, Mises Institute, 2001 [1963], p. 153).

From 1926 to 1929, the alleged stability of the price level caused most economic experts, including the famous American economist Irving Fisher, to conclude that US economic fundamentals were doing fine and that there was no threat of an economic bust.

The yearly rate of growth of the CPI displayed stability during 1926 to 1929 (see chart). Most experts have ignored the fact that the yearly rate of growth of the US central bank balance sheet jumped to 42 percent by June 1928 from minus 14 percent in February 1927.

The sharp fall in the growth momentum of the Fed’s balance sheet after June 1928 (see chart) set in motion an economic bust and the Great Depression.

At present, the Fed continues to push money aggressively into the banking system with its balance sheet standing at $3.3 trillion at the end of April against $0.9 trillion in January 2008. We suggest however that a fall in the growth momentum of AMS since October 2011 raises the likelihood of a bust in the months ahead.

If one adds to all this the possibility that the process of real wealth generation has been badly damaged by the Fed’s loose policies, it shouldn’t surprise us that we could enter a severe slump in the months ahead.

Summary and conclusion

For most economists, the key to healthy economic fundamentals is price stability. A stable price level, it is held, leads to the efficient use of the economy’s scarce resources and hence results in better economic fundamentals. It is not surprising that the mandate of the Federal Reserve is to pursue policies that will generate price stability. We suggest that by means of monetary policies that aim at stabilizing the price level the Fed actually undermines economic fundamentals.

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Frank Shostak is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org. His consulting firm, Applied Austrian School Economics, provides in-depth assessments and reports of financial markets and global economies. See Frank Shostak's article archives.

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‘Real’ Reinforcement for Austrian Arguments

Mon, 13 May 2013 00:00:00 -0500

In a recent article, “The Hoover-Roosevelt Depression Revisited,” work by Cole and Ohanian was highlighted because it comes to conclusions similar to, and thus reinforces historical work previously done by Austrians or fellow travelers (especially Murray Rothbard, Robert Higgs, and Richard Vedder and Lowell Gallaway), which explained the length of the Hoover-Roosevelt Depression.

Why is this work important to Austrians? The work, appearing in journals that even top mainstream economists cannot ignore, adds more evidence that the Austrians were right about the cause of the length of Great Depression, as well as the depth of unemployment and stagnation that was characteristic of the Great Depression. The Austrian explanation of the Hoover-Roosevelt Depression is historically accurate.

Just as in the 1930s, recovery from the Great Recession has been hampered by harmful government interventions, monetary and fiscal actions that impede market liquidation and reallocation of resources, and polices and rhetoric that generate regime uncertainty.[1] Explanations which make this case, based on similar Austrian microeconomic foundations should be given strong consideration. Such explanations best reflect actual cause and effect, and thus are better guides to the appropriate policy responses to the crisis and necessary monetary reform needed to prevent renewed occurrences of harmful boom-bust cycles.

The work by Cole and Ohanian is from within the framework developed by two Nobel-winning economists, Finn Kyland and Edward Prescott. The framework is known as real business cycle theory (RBC). The modeling is a subset of equilibrium business cycle models which, in general, have been legitimately criticized by Austrians.[2] But some of the results developed by RBC proponents, can supplement the Austrian business cycle theory (ABCT), and add to our understanding of cycle phenomena and other fluctuations in economic activity (see “Capital-Based Macroeconomics: Recent Developments and Extensions of Austrian Business Cycle Theory” or “Capital Based Macroeconomics: Boom and Bust in Japan and the US”).[3]

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RBC theorists see the pattern of expansion and contraction present in economic data as the economy’s response to exogenous productivity shocks. These “modern theories of business cycles attribute cyclical fluctuations to cumulative shocks and disturbances that continually buffet the economy. In other words, without shocks there are no cycles.” Money and central bank policy are largely irrelevant with respect to economic expansions and downturns. Changes in money, as in some of the free banking literature and Post-Keynesian analysis, is assumed to be endogenous. Despite these errors, RBC makes a claim that Austrians should be comfortable with: countercyclical policies are counterproductive and entail costs in excess of benefits.[4]

Prescott makes the case that the application of the term “business cycle” to describe the observed movements is “unfortunate.” He argues that economists mistakenly attempt to explain cycle phenomena independently from the growth component, and that the phenomena are better understood by the use of a unified theory of growth and fluctuations. Mises, Hayek, and Rothbard took a similar methodical approach — a single unified economic theory. But in Austrian or capital-based macroeconomics, the theory explains not only fluctuations, but also boom-bust phenomena. In Monetary Theory and the Trade Cycle, Hayek (1933, 54-60) differentiates cyclical fluctuations from shocks (fluctuations à la real business cycle models or other exogenous shock approaches). The shock interpretation of economic fluctuations is essentially a “non-economic” — but not necessarily unimportant — explanation of economic change:

The simple fact that economic development does not go on quite uniformly, but periods of relatively rapid change alternate with periods of relative stagnation, does not in itself constitute a problem. It is sufficiently explained by the adjustments of the economic system to irregular changes in the data — changes whose occurrence we always have to assume and which cannot be further explained by economic science.

But the boom-bust cycle presents the theorist with a different challenge: The phenomena of the upward trend of the trade cycle and of the culminating boom constitute a problem only because they inevitably bring about a slump in sales — i.e., a falling-off of economic activity — which is not occasioned by any corresponding change in the original economic data.

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Proponents of RBC conclude that their model can account for about 70 percent of the postwar business cycle phenomena [fluctuations]. But critics contend there is “no independent corroborating evidence for the large technology shocks that are assumed to drive business cycles.” A capital-based macroeconomic model helps better interpret historical evidence, even evidence created by other methods, and thus better identify “shocks” while recognizing the harmful effects of monetary and credit creation, which enables one to better separate “shocks” (changes in real economic activity emphasized by RBC and Hayek) from money and credit created cycles as emphasized in ABCT.

Growth rates and the level of productive activity vary and fluctuate in response to shocks, as suggested by the RBC literature. But it should be kept in mind that boom-bust cycles do occur around the shifting growth paths. The boom-bust cycle is always generated by circulation credit. How and when the created credit enters the system can lead to significant historical variations in the boom-bust pattern. But in general, the stylized facts presented by RBC proponents, which show there is greater variability regarding time-related decisions — investment, including variations in inventories, and consumer durable purchases relative to total output and consumption — is consistent with what ABCT predicts as the consequences of credit creation.

At a lower level of aggregation, what looks like an economy’s response to a “positive technology” shock may be in fact an economy’s response to credit creation. The apparent productivity increase is, in reality, a money/credit-induced artificial boom.

Another common and likely scenario is a combined response; the economy is subjected to a truly exogenous productivity shock in new knowledge or improved production techniques. The greater potential productivity of new investment projects of all types increases the demand for credit, but the higher demand for credit is partially accommodated by credit creation.

In either case, the economy-wide response will be a combination of sustainable and unsustainable growth. Part of the expansion of investment during the response period will be malinvestment. As the malinvestments are discovered and corrected, the production structure will shorten, productivity will decline, and the aggregate data will pick up a negative productivity shock. The money and credit creation during the expansion, rather than being a harmless endogenous response of banks to changing market conditions, sets the stage for the boom-bust pattern of the cycle.

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While business cycle phenomena may be caused by exogenous shocks or inappropriately tight monetary policy, much of the actual cyclical activity is best interpreted as the consequence of credit-created unsustainable growth. This type of cyclical activity is preventable with an appropriate monetary framework, but may be difficult to correct with short-run macroeconomic policy. A monetary policy based on the principle of sound — not stable — money would accommodate sustainable growth without generating endogenous instabilities and unsustainable growth.

Another reason to highlight the work of Cole and Ohanian, as well as the RBC work in general, is effectively argued by J. Robert Subrick and Andrew T. Young in “Nobelity [sic] and novelty: Finn Kydland and Edward Prescott’s contributions viewed from Vienna” (link gated):

The awarding of the Nobel Prize in Economics in 2004 to Finn Kydland and Edward Prescott represents an opportunity to evaluate their contributions in light of Austrian economics. We lay out the basics of their contributions — the general equilibrium approach to economic fluctuations and the game theoretic approach to policy — and argue that they have tenets similar to those of Austrianism. We argue that their methodology parallels Austrian methodology in several significant ways that have gone unnoticed. We conclude that Kydland and Prescott’s Nobel Prize suggests Austrian approaches can have a more prominent impact than they have had in the past.

Properly understanding historical events is an important, even essential, component of a strategic defense of liberty. Cole’s and Ohanian’s work should be another tool in the arsenal, but much work needs to be done. Vedder’s and Gallaway’s work needs to be extended to include the Great Moderation, the Great Recession, and the current stagnation. Austrians should take up Ohanian’s suggested task for future researchers. Revisit the Hoover-Roosevelt Depression and integrate the impact of all government interventions, including but not limited to cartelization (and crony capitalism), regime uncertainty, and inappropriate fiscal and monetary policies. A similar study of recent events is also warranted. Austrians should take up the challenge of Subrick and Young. Austrians can and should make a more prominent impact especially given the two disastrous boom-busts that occurred post-1998.

Comment on this article.

John P. Cochran is 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 is also a senior scholar for the Mises Institute and serves on the editorial board of the Quarterly Journal of Austrian Economics. Send him mail. See John P. Cochran's article archives.

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Notes

[1] See “Capital in Disequilibrium: Understanding the “Great Recession’ and Potential for Recovery.” The Quarterly Journal of Austrian Economics , 13, no. 3, 42-63 or “Are the Austrians Too Harsh?”.

[2] See Cochran, John P. and Glahe, Fred R. (1992). "The Use and Abuse of Equilibrium in Business Cycle Theory: A Praxeological Approach" [gated]. Cultural Dynamics 5(3): 356-70 which is also Chapter 11 of The Hayek-Keynes Debate: Lessons for Current Business Cycle Research.

[3] Some of what immediately follows draws heavily on these sources with references omitted.

[4] See The Fraud of Macroeconomic Stabilization Policy another very important paper by Vedder and Gallaway, which appeared in a leading Austrian journal, but has been unfortunately most ignored.

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Summary and conclusion

&lsquo;Real&rsquo; Reinforcement for Austrian Arguments

Notes

‘Real’ Reinforcement for Austrian Arguments