A Virtual Debate - "Resolved: Unfettered Capitalism Caused the Great Depression"
by Bradley Doucet[The Great Crash: 1929, John Kenneth Galbraith, Mariner Books, 194 pp., $14.00 (paperback); America's Great Depression, Murray N. Rothbard, Ludwig von Mises Institute, 368 pp., $29.00 ]
Our current financial crisis has elicited repeated comparisons with the start of the Great Depression in 1929. Commentators joke that the one thing booming in this downturn is books about that mother of all financial crises. Indeed, it would behoove us to understand what went wrong back then, in order that we not repeat the mistakes of the past.
With that purpose in mind, I recently set about reading two famous books written when the memory of those terrible days was still relatively fresh. The Great Crash (1955) is by John Kenneth Galbraith (1908–2006), a progressive Keynesian economist who taught at Harvard for many years and served in the administrations of Franklin D. Roosevelt, Harry S. Truman, John F. Kennedy, and Lyndon B. Johnson. America’s Great Depression (1963) is by Murray N. Rothbard (1926–95), a libertarian economist of the Austrian school who studied under Ludwig von Mises and taught at the Polytechnic Institute of New York University, Brooklyn, and at the University of Nevada, Las Vegas.
The Great Crash
The singular feature of the great crash of 1929 was that the worst continued to worsen. What looked one day like the end proved on the next day to have been only the beginning. Nothing could have been more ingeniously designed to maximize the suffering, and also to insure that as few as possible escaped the common misfortune.
—John Kenneth Galbraith
Despite a relatively short-lived recession at the start of the decade, the 1920s were a good time in America. Employment was high, and although many were still poor, more people were well-off or rich than ever before. Yet by the end of the decade, the best of times had become the worst of times. What was responsible for turning so many dreams to dust?
John Kenneth Galbraith opens his book with some words from outgoing President Calvin Coolidge praising, in 1928, the current prosperity and looking forward with optimism. Coolidge pointed to “the integrity and character of the American people” as the crucial ingredient upon which present and future blessings rested. Galbraith notes, however, that along with the American people’s fine character traits, they “were also displaying an inordinate desire to get rich quickly with a minimum of physical effort.” He presents the Florida real estate boom and bust of the mid-twenties—which served as a stage for none other than Mr. Charles Ponzi himself—as an example of this inordinate desire and as a taste of what was to come.
When did the stock market boom really begin? Stocks began to rise in the mid 1920s, but it was in 1927 that the rise began in earnest. England was going back to pre-WWI gold-standard exchange rates, and it asked the Federal Reserve to cut interest rates. That would have the effect of keeping gold from fleeing the United Kingdom for the United States. The Fed obliged the Brits, and the added liquidity led to increased stock market speculation. So, too, did low margin requirements, which allowed speculators to put up only a fraction of the price of the stocks they were buying.
But Galbraith believes that plentiful and cheap credit need not always lead to wild speculation. It was something else, something in the mood of the people, which led them to abandon customary caution. Galbraith writes, “Early in 1928, the nature of the boom changed. The mass escape into make-believe, so much a part of the true speculative orgy, started in earnest.”
If the people themselves were responsible for wanting to make a quick buck, the authorities were responsible, according to Galbraith, for not reining in the irresponsible masses. Neither President Coolidge nor his Treasury Secretary, Andrew Mellon, would take an unpopular stand against the boom, so responsibility fell to the Federal Reserve Board and Federal Reserve Banks. But they, too, failed to tighten credit, allowing the boom to continue.
In Galbraith’s opinion, neither open-market operations nor manipulation of the rediscount rate would have done much good. One thing the Fed could have done, though, was ask Congress for the authority to set margin requirements; it could then have used that authority to set the requirements higher—up to 100 percent if necessary, eliminating margin buying altogether. Even simpler, the Fed could have relied on moral suasion to break the spell. In fact, a rather timid statement in February of 1929 did check the stock market boom somewhat, but this was short-lived, and the policy of moral suasion was needlessly abandoned.
On October 24, 1929, dubbed “Black Thursday,” stocks finally plummeted. There was a rally in the afternoon as big banks organized to support the market, though this was cold comfort to the many who were ruined that day. But surely, people said (not for the first time), the worst was now over. Yet the following Monday was another terrible day, and the day after that, Tuesday, October 29, was the worst day the New York stock market had ever seen.
The Austrian Business Cycle Theory
The chief impact of the Great Depression on American thought was universal acceptance of the view that “laissez-faire capitalism” was to blame… Yet, on closer analysis, the common reaction is by no means self-evident. It rests, in fact, on an unproven assumption.
—Murray N. Rothbard
People acting foolishly and government actors failing to restrain their foolishness is the general picture that emerges from Galbraith’s account of the stock market crash. Murray Rothbard, on the other hand, while also castigating government actors for not reining in the boom, argues that the government was responsible for causing the problem in the first place. Indeed, the Austrian theory of the business cycle rejects the idea that economy-wide boom-and-bust cycles are a natural feature of free markets that need to be ironed out by wise government policies. Instead, this theory locates the blame for all such cycles in expansionary monetary policies pursued by government-abetted banking systems.
Modern societies are constantly changing in myriad ways. Tastes change, resources are discovered or used up, technologies emerge, crops are affected by weather, and so on. The job of entrepreneurs in a free market, writes Rothbard, is to anticipate these changes. The more successful entrepreneurs are rewarded with greater profits, while the least successful fall by the wayside.
Specific industries also rise and fall with longer-term societal changes. But none of these changes requires any special explanation, and none of them is powerful enough to set off a general boom and bust. The real puzzle of a general business collapse is why so many entrepreneurs—whose job it is to anticipate changes, and whose least successful forecasters are constantly being weeded out—are suddenly revealed all to have made serious forecasting errors at the same time.
The key to the puzzle is monetary expansion. By inflating the money supply, the banking system makes it seem as if there are increased savings to be invested. Businesses therefore borrow the newly available funds and invest them. The effect is to shift production away from consumer goods and toward capital goods. This would be fine if people really had decided to save a greater share of their incomes, but since it is a purely monetary illusion, capital goods industries will eventually discover that their investments are actually malinvestments, and do not represent what the people did in fact demand. These malinvestments will need to be liquidated in order to return the economy to a sounder footing, and that is precisely what happens when the boom turns to bust.
Are monetary inflation and subsequent malinvestments a plausible explanation for the boom and subsequent crash of the 1920s? At first glance, it seems as if inflation could not have played a major role, because prices remained fairly stable throughout the decade. In fact, though, monetary expansion was taking place, and not just in 1927 either. According to Rothbard, during the eight years of the boom (mid-1921 to mid-1929) the money supply increased by 61.8 percent, a substantial inflation. What kept prices stable was the very real increase in productivity that was also taking place at the time.
“In a purely free-market society,” writes Rothbard, “increasing productivity will increase the supply of goods and lower costs and prices, spreading the fruits of a higher standard of living to all consumers. But this tendency was offset by the monetary inflation which served to stabilize prices.” Many thought, and continue to think, that such price stability is a desirable goal in and of itself, but Rothbard points out that (a) it prevented the real productivity gains of the 1920s from being widely shared, and (b) it generated the boom-and-bust cycle that led to so much misery.
The Herbert Hoover Myth
Galbraith and Rothbard have different explanations for the cause of the boom and crash, but these accounts are not mutually exclusive. On the one hand, Rothbard admits that speculation on the stock market was a problem, but he denies that the financing of business investment by individuals who borrow to buy stocks is any worse than the more direct borrowing methods businesses use to fund investment. The real problem arises only with the expansion of the money supply that feeds malinvestment.
Galbraith, for his part, admits that businesses had likely misjudged demand by the end of the 1920s, but he does not see this as a puzzle in need of explanation. Instead, he chalks it up to “the characteristic enthusiasm of good times.” He also sees that while productivity had increased substantially, wages and prices had remained stable with increased profits mostly invested in capital goods. Crucially, though, he does not identify this as malinvestment, nor does he identify monetary inflation as the main culprit.
But if their respective accounts of the boom and crash overlap somewhat, their explanations of the severity and long duration of the ensuing depression diverge spectacularly. Along with the widespread notion that unfettered capitalism was to blame for causing the stock market crash, there is the equally common belief that President Herbert Hoover, who took over from Coolidge in early 1929, was a strong supporter of free markets. His allegedly laissez-faire convictions are said to have kept him from intervening after the crash, thereby needlessly prolonging the pain and suffering of the American people.
Galbraith is among those who accuse Hoover of having done too little. The only good things the President did, according to Galbraith, were to cut taxes early on and to encourage business leaders to keep up their investments and to maintain wages. But he complains that the tax cuts were negligible for most people, and that the business leaders were not bound by law to keep their promises, rendering those promises ineffective.
Aside from these early minor efforts, Galbraith says, Hoover kept his hands off, letting ideology trump rational thought. He writes, “The rejection of both fiscal (tax and expenditure) and monetary policy amounted precisely to a rejection of all affirmative government economic policy.” An obsession with balancing the budget and staying on the gold standard, he argues, kept the government from coming to the rescue.
Rothbard rejects this interpretation in no uncertain terms: “To scoff at Hoover’s tragic failure to cure the depression as a typical example of laissez-faire is drastically to misread the historical record. The Hoover rout must be set down as a failure of government planning and not of the free market.” Rothbard spends the entire second half of his book picking apart the Hoover myth.
Good Intentions and the Road to Hell
Hoover had, indeed, ‘placed humanity before money, through the sacrifice of profits and dividends before wages,’ but people found it difficult to subsist and prosper on ‘humanity.’
– Murray N. Rothbard
On its face, blaming the unusual severity and duration of the Great Depression on laissez-faire is somewhat odd. After all, an unusual outcome requires that we look for an unusual cause, but laissez-faire had been the usual (and effective) reaction to previous downturns. With little government intervention, recessions prior to 1929 had been short. The liquidation of malinvestment had largely been allowed to run its course and the resulting frictional unemployment had been merely transitory, just as the Austrian theory of the business cycle predicts. No past downturn had ever come close to inflicting the kind of prolonged and intense suffering seen in the 1930s. Thus, contrary to popular belief, the unusual nature of the Great Depression suggests that there was a marked departure from the usual, laissez-faire reactions of past governments. And that is just what the historical record shows.
Rothbard takes the time to trace the development of Hoover’s interventionism from his days in the Harding and Coolidge administrations. One thing that was evident early on was what Rothbard calls Hoover’s use of “the velvet glove on the mailed fist,” which is to say, his use of ostensibly “voluntary” measures backed by the threat of compulsory controls. This suggests that the pledges to maintain investment and wages that Hoover managed to extract from businesses in 1929 were in fact far more significant than Galbraith makes them out to be by referring to them as the “no-business meetings.” Galbraith writes that:
- [B]usinessmen who promised to maintain investment and wages, in accordance with a well-understood convention, considered the promise binding only for the period within which it was not financially disadvantageous to do so. As a result investment outlays and wages were not reduced until circumstances would in any case have brought their reduction.
It is curious that Galbraith, who thought moral suasion would have been effective in reining in stock market speculation, thought it was basically useless in this other context. At any rate, regardless of whether it was due to the threat of compulsory action or to the pure effect of moral suasion, it is clear that these and subsequent meetings were all too effective. While Galbraith provides no numbers to back up his bald assertion, Rothbard shows that monetary wage rates in 25 leading manufacturing industries resisted downward pressure through to the middle of 1931. Since there was price deflation during this period—despite the Fed’s best efforts—this means that real wage rates, in constant dollars, actually rose by over ten percent in these industries. Subsequent drops in nominal monetary wages over the next two years barely eroded any of these gains in real wage rates.
Allowing wage rates to fall is an important part of the adjustment process after an inflationary boom has led to so much malinvestment. On the other hand, the cost of maintaining and even raising real wage rates during a depression is to boost unemployment, and by the end of Hoover’s term, the unemployment rate for the economy as a whole had hit an astonishing and unprecedented 25 percent. To quote Rothbard in a slightly different context, the growing ranks of the unemployed were made to suffer so that those who were lucky enough to have jobs could be maintained “in the style to which they insisted on becoming accustomed.”
Galbraith is also wrong to say that holding these meetings was practically the only action Hoover took to address the crisis. On the contrary, he supported increases in public works programs, increased assistance to farmers, and encouraged the Fed to pursue a largely inflationary monetary policy. With Gross National Product (GNP) falling steadily from $104 billion in 1929 to $58 billion in 1932, total government (local, state, and federal) expenditures remained roughly constant. This of course meant that government’s total share of the economy grew enormously, by one measure from 16 percent to 29 percent over Hoover’s single four-year term.
As Rothbard notes, John Maynard Keynes himself, after a visit to America in 1931, “hailed the American record of maintaining wage rates,” and “found the attitude of the Federal Reserve authorities ‘thoroughly satisfactory,’ i.e., satisfactorily inflationist.” If the government failed to inflate the money supply, especially toward the end of Hoover’s term, it was not for lack of trying. But, understandably shaken by all the bank failures taking place, the surviving banks preferred to shore up their reserves rather than expand lending.
This actually proves that Galbraith is technically correct when he says that easy credit does not always lead to a speculative boom. During a depression, for instance, banks can resist the inflationary pressure of the central bank and the administration, and borrowers can as well. But even if easy credit does not always precipitate an immediate boom, it is still possible (and in fact highly plausible) that these booms are nonetheless always preceded by and dependent upon easy credit. Galbraith is therefore cheating when he tries to dismiss the critics of inflationary policy so quickly.
To be fair, Galbraith does condemn one of Hoover’s interventionist policies, namely the Smoot-Hawley Tariff. Raising tariffs even higher than they had already risen in the 1920s was an effort to help domestic industries by protecting them from foreign competition. Of course, if Americans refrain from buying foreign products, foreigners will have no dollars with which to buy American products either. That is how a tax on imports becomes a tax on exports, harming rather than helping American interests. The fact that Galbraith opposed such a measure is no surprise, though, as the evil of protectionism is one of the few things upon which economists of all stripes tend to agree. In fact, an overwhelming majority of the nation’s economists urged Hoover to veto the Smoot-Hawley Tariff, advice that the President disregarded.
Galbraith also condemns Hoover’s 1932 tax hikes. These were prompted by the President’s desire to try to balance the budget, after having run a $2.2 billion deficit the year before, the largest peacetime deficit in American history to that date. A Keynesian economist like Galbraith should have at least praised Hoover for his efforts through 1931. Raising deficits, though, erodes the people’s savings. Rothbard would have instead advised lowering both taxes and government spending, in order to accelerate the liquidation of malinvestments in capital goods and the return to actual consumer preferences.
Conclusion: The Wrong Lessons
Finally, there has been a modest accretion of economic knowledge. A developing depression would not now be met with a fixed determination to make it worse.
– John Kenneth Galbraith
Writing in 1955, Galbraith thought that one of the prime lessons of the Great Depression was that laissez-faire had been tried and had failed. It is a lesson that many have indeed absorbed. But it is one that Galbraith can only maintain by ignoring the facts and arguments that do not fit neatly with his thesis. By avoiding inconvenient counter-evidence and dismissing rather than truly engaging their intellectual opponents, he and others like him have done the world a great disservice.
To sum up, President Hoover worked hard to keep wage rates high, to prop up farm prices, to increase public works, to inflate the money supply, and to increase government’s share in the economy. Galbraith either underplays these salient details or fails to mention them altogether. These are the policies, however, that led to massive unemployment, precipitous drops in production, delayed liquidation of malinvestment, and loss of business confidence. Hoover was, of course, surpassed as an interventionist by his successor, Franklin Delano Roosevelt. But FDR mostly expanded upon the precedents Hoover had set—with the predictable result that the Great Depression persisted for many more years.
Looking ahead, Galbraith saw hope in the strengthened Federal Reserve Board, but in fact, the Fed over the years has in no way prevented the monetary inflation and malinvestment that cause boom-and-bust cycles. He also saw hope in the more equitable distribution of income that was coming into being, but if Rothbard is right that inflationary policies prevent productivity gains from being widely shared by keeping prices from falling, then inflation hampers rather than helps the spread of prosperity.
Federal insurance of bank deposits, Galbraith writes, has dissolved “the fear which operated so efficiently to transmit weakness” in the late 1920s and early 1930s. “As a result, one grievous defect of the old system, by which failure begot failure, was cured.” It is also possible, though, that as a result of this and similar measures, lenders and borrowers have been encouraged to become less cautious, and weaknesses are now allowed to accumulate to truly catastrophic levels, until toxic debt is ubiquitous.
Other features, like expanded farm support, unemployment compensation, government pensions and welfare, Galbraith saw as bulwarks against loss of purchasing power in any future downturns. But spending is not the foundation of prosperity; production is. As transfers from more-productive to less-productive sectors of society, these measures (whatever their pretended benefits) can only delay needed adjustments during a downturn.
Thus, the business cycles have continued, and in reaction to the latest bust, we again blame the free market; we again resist the liquidation of malinvestments; we again pump money into failing banks and car companies; we again plan huge public works schemes; we again unfurl the protectionist banner; and we again run up record-breaking deficits. We want to avoid the damage of depression, but the damage was done during the boom. Like Wile E. Coyote, we simply failed to realize at the time that we were standing on thin air. Delaying needed adjustments from taking place only prolongs the pain.
In the introduction to his Philosophy of History, G. W. F. Hegel wrote: “What experience and history teach is this—that people and governments never have learned anything from history.” That is surely too cynical, but we clearly have not learned the right lessons from the Great Depression. If we had learned the lessons taught by the Austrian school of economics, we would have insisted on sound money and forsworn inflationary government policies. That would have brought an end to boom-and-bust cycles and ensured even greater prosperity, and far greater security, than we currently enjoy.
Having read these two competing accounts, my conclusion is that unfettered capitalism did not cause the Great Depression, despite the prevailing popular opinion. But what can we do to prevent history from repeating itself? For one thing, we can get informed. Reading these two books is a good way to learn both about the case against capitalism and about the laissez-faire response. And once we are informed, then we can talk it up. With the current crisis affecting every segment of society, is there a more important issue?
Editor’s Note: The Great Crash 1929 is scheduled to be re-issued in paperback by Houghton Mifflin Harcourt this September. America’s Great Depression is available as a free download at www.mises.org.