Did FDR Make the Depression Great?

Robert Murphy demonstrates in this excellent book a penetrating ability to explain the essence of fallacious economic doctrines. As he notes, three theories offer competing explanations of the Great Depression: the Keynesian account, which stresses a lack of aggregate demand; Milton Friedman’s monetarism, which ascribes the severity of the early years of the Depression to a drastic cut in the money supply by the Fed; and, of course, the Austrian theory that Murphy himself favors.

Herbert Hoover, though not under Keynes’s influence, defended a version of the first theory. If wages were not kept high, purchasing power would be insufficient to restore prosperity. Accordingly, Hoover encouraged businesses to refrain from wage cuts.

Murphy quickly exposes the fallacy of this view:

High wages do not cause prosperity, they are rather an indication of prosperity. Ultimately, it doesn’t matter how many green pieces of paper employers hand out to workers. Unless workers first physically produced the goods (and services), there will be nothing on the store shelves for them to buy when they attempt to spend their big fat paychecks. (p. 35, emphasis in original)

But, it may be countered, is not the level of production and employment determined by aggregate demand? Granted that prosperity requires real goods, will not businessmen decide how much to produce based on what they think they will be able to sell? If so, is not the problem in a depression that, forecasting that future demand will be low, they cut back production?

Murphy once more locates the fundamental fallacy. The problem in a depression is not that production is in general too low; it is rather that resources have not been put to their best uses and need to be shifted:

By focusing on aggregate monetary conditions such as “total wage payments,” Hoover completely overlooked the fact that real, physical resources had to be rearranged in order to correct the imbalances in the economy. It wasn’t that “business” was producing too much, but rather that some sectors were producing too much, while other sectors were producing too little, in light of the economy’s supplies of resources, the skills and desires of its workers, and the tastes of its consumers. (p. 37)

Once more, Murphy holds that we need to concentrate on the physical goods rather than on total monetary demand.

The only way to rectify the situation — to transform the economy into a sustainable configuration — was to shuffle workers and resources. Some enterprises had to be shut down immediately, releasing their workers and freeing up the raw materials they would have consumed had they remained in business… But in a market economy, workers are free to choose their occupations, and the owners of raw materials can sell their property to whomever they desire. Yet with that freedom comes the unfortunate necessity of prolonged spells of unemployment and “idle resources,” when the workers and raw materials are searching for a new home in the complex economy. (pp. 37–8)

Murphy dispatches the monetarist view with similar directness and ease. Here, if anything, his remarks are of even more vital significance, since Fed Chairman Ben Bernanke firmly embraces the monetarist account of the Great Depression.

He finds a simple way to illustrate the fallacy of the mainstream analysis of deflation. According to this view, if people anticipate falling prices, they will refrain from spending. Because they expect prices to fall, they think that that will do better to consume later. But this drop in consumption causes a further price fall, and the whole cycle repeats. Prices may spiral uncontrollably downward.

Murphy responds in this way:

One could construct an analogous argument for the computer industry, in which the government passes regulation to slow down improvements in operating systems and processing speed. After all, how can computer manufacturers possibly remain viable if consumers are always waiting for a faster model to become available? … The solution to this paradox, of course, is that consumers do decide to bite the bullet and buy a computer, knowing full well that they would be able to buy the same performance for less money, if they were willing to wait… (There’s no point in holding out for lower prices but never actually buying!) (pp. 68–9)

Murphy’s ingenious response can also be applied to combat George Akerlof’s famous lemons model of the used-car market. Akerlof argued that because of asymmetric information, owners of good used cars would tend to be driven from the market. But, contrary to what his model suggests, good used cars do get sold. In like fashion to Murphy, one can say that just because owners of good cars may not be able to obtain as high a price as they would like, it does not follow that they will refuse to sell at all.

It might be helpful to add the “real balance effect” to Murphy’s account. As prices fall, the value of money rises. People’s demand to hold money can then be satisfied with less money. This in part explains why people will eventually spend, even when they expect prices to continue to fall.

Keynesians will object that even if spending does eventually revive, the process takes too long. People cannot be expected to wait until the market rights itself. But this is to ignore Murphy’s vital point. The process of adjustment is just what is needed: a depression is exactly a situation in which bad investments are liquidated and resources moved elsewhere.

Murphy uncovers another flaw in the conventional assault on deflation. Money that is not spent need not be hoarded, as the opponents of deflation implicitly assume:

Many analysts who are terrified of deflation stress that in an environment of falling prices, cash stuffed under the mattress earns a positive return. This observation is certainly true, but nonetheless cash lent out earns an even greater return. Falling prices, then, encourage consumers to devote more of their income to savings, which in turn lowers interest rates and allows businesses to borrow and invest more. (p. 69)

As the author abundantly shows, historical evidence strikes decisive blows against both the Keynesian and monetarist theories. On the Keynesian account, increased spending, by reviving aggregate demand, will restore good times. If so, why did Hoover and Roosevelt’s massive spending leave America mired in depression? To call Hoover a big spender may surprise many readers, but Murphy notes that there is no room for doubt:

Hoover’s response to the stock market crash was an enormous increase in government spending, with the budget exploding by 42 percent over his first two years … it is true that Hoover blinked and tried to tame the unprecedented (at the time) peacetime deficits. But this was only after the “stimulus” approach failed horribly. (p. 48)

Keynesians will reply that government spending should have been even greater; but this is to add an epicycle to shore up a failed theory.

Murphy turns the tables on Milton Friedman, who emphasized statistical evidence, by showing that monetarism fails to explain the data.

So we see that immediately following the stock market crash, the Fed began flooding the market with liquidity and in fact brought its rates down to record lows…. If the ostensible cause of the Great Depression — the one factor that set it apart from all previous depressions — was the Fed’s unwillingness to provide sufficient liquidity, then how could it possibly be that the Fed’s record rate cuts proved inadequate to solve “the problem?” (pp. 76–7)

Even if this is true, though, could not Friedman still say that the massive decline in the money supply in the early 1930s exacerbated the severity of the depression? Murphy, following Murray Rothbard, denies this:

Between 1839 and 1843 the money supply fell by 34 percent and wholesale prices fell by 42 percent. If the monetarists are right, and it was the Fed’s refusal to counteract the falling money supply in the early 1930s that gave us the Great Depression, then the 1839–1843 period should have been devastating. Yet Murray Rothbard (relying on Peter Temin’s historical research) reports otherwise. (p. 71)

If Keynesian and monetarist theories cannot cope with the historical evidence, does the Austrian theory fare better? In the Austrian view, depressions come about because expansion of bank credit results in malinvestments. Because these need to be liquidated, the government should follow a “do nothing” policy that allows the market to return to normal conditions. When this policy was followed, recovery from depression took no more than a few years, in the 1873 depression, in contrast to the total failure to recover during the New Deal. The results were even better in the 1920–1921 depression, when both Wilson and Harding slashed government spending: “the 1920–1921 depression was so short-lived that most Americans today are unaware of its existence.” (p. 71)

Murphy treats in thorough fashion the multifarious New Deal measures and their manifest failures. I shall confine myself to noting his searing condemnation of Roosevelt’s gold policy.

Ordering the public to turn over its gold — under penalty of a $10,000 fine and up to ten years in prison — was a clear-cut robbery.… Yet insidious as the explicit confiscation was, the cancellation of gold clauses in contracts was in a way a more fundamental violation of property rights … the private sector had no choice but to use unbacked green pieces of paper as the foundations of its transactions. Americans were now entirely at the mercy of those controlling the printing press. (pp. 128–29)

Murphy carries forward his discussion to the World War II period. Here he has been greatly influenced by Robert Higgs’s challenge to the conventional view that the war ended the Depression. (He also makes excellent use of Higgs’s “regime uncertainty” in his account of New Deal failure.) He contends that the follies of central planning extend to the conduct of war. Private enterprise could have handled production of military goods better than controls actually did.

It is a simple fact of engineering that the enormous production of tanks, airplanes, and other wartime goods in the 1940s necessitated a sharp curtailment in civilian consumption. Even so, the government did not need to impose direct rationing and other controls on the home front. Instead, the government could have simply raised taxes and issued new bonds in order to purchase its desired products from military contractors and other firms… Individual businesses, seeking only to maximize profit, would have been led by an Invisible Hand to retool away from civilian production and cater instead to the overall war effort. (pp. 158–59).

Murphy’s argument recalls Mises’s suggestion that the French would have fared much better in the war had they relied on private firms to procure armaments.[1]

In these days of massive government bailouts and intervention, the lessons of the Great Depression and New Deal have much more than historical significance. Murphy concludes on a melancholy note:

President Obama’s stimulus package and other “remedies” will not cure our economic woes any more than the New Deal cured the Great Depression. The real question is whether Barack Obama’s New Deal, building on the old one, will finally sink the American economy into the sands. (p. 177).

If enough people read Murphy’s hard-hitting book, we can strangle in its cradle Obama’s prescription for economic disaster.

Nothing contained in this blog is to be construed as necessarily reflecting the views of the Pacific Research Institute or as an attempt to thwart or aid the passage of any legislation.

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