America/'s Great Depression
America’s Great Depression
Fifth Edition
America’s Great Depression
Fifth Edition
Murray N. Rothbard
MISES
INSTITUTE
Copyright © 1963, 1972 by Murray N. Rothbard
Introduction to the Third Edition Copyright © 1975 by Murray N. Rothbard
Introduction to the Fourth Edition Copyright © 1983 by Murray N. Rothbard
Introduction to the Fifth Edition Copyright © 2000 by The Ludwig von Mises
Institute
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Elton B. Fox (The Fox Foundation), Capt. and Mrs. Maino des Granges,
Christopher J. Hackett, John A. Halter, John R. Harper, Frank W. Heemstra,
Douglas M. Joy, Michael G. Keller, D.O., Robert N. Kennedy,
Richard J. Kossmann, M.D., David Kramer, Steven R. Krause,
Gary R. Letsinger, Diana Lewis, J. Edward Martin, Norbert McLuckie,
Samuel Mellos, Joseph Edward Paul Melville, Robert Mish,
Dr. Dorothy Donnelley Moller, Jerry W. Moore,
Keith E. Moore, D.M.D., Reed W. Mower, Brantley I. Newsom,
Professor and Mrs. Stanley E. Porter, James A. Reichert, Thomas S. Ross,
Conrad Schneiker, Roy Schroeder, William V. Stephens,
Charles Toops, II (Mo-Ark Guide Service),
Robert H. Walker (Walker Die Casting Company),
Mr. and Mrs. Victor Zadikov, Jeannette Zummo
Introduction
v
vi
America’s Great Depression
Acknowledgments
While the problem of 1929 has long been of interest to
myself as well as most Americans, my attention was
first specifically drawn to a study of the Great
Depression when Mr. Leonard E. Read, President of the
Foundation for Economic Education, asked me, some years ago, to
prepare a brief paper on the subject. I am very grateful to Mr. Read
for being, in this way, the sparkplug for the present book. Having
written the article, I allowed the subject to remain dormant for
several years, amid the press of other work. At that point, on the
warm encouragement of Mr. Richard C. Cornuelle, now of the
Foundation for Voluntary Welfare, I proceeded on the task of
expansion to the present work, an expansion so far-reaching as to
leave few traces of the original sketch. I owe a particular debt to
the Earhart Foundation, without whose aid this study could never
have been written.
My supreme debt is to Professor Ludwig von Mises, whose
monumental theory of business cycles I have used to explain the
causes of the otherwise mysterious 1929 depression. Of all
Professor Mises’s notable contributions to economic science, his
business cycle theory is certainly one of the most significant. It is
no exaggeration to say that any study of business cycles not based
upon his theoretical foundation is bound to be a fruitless under-
taking.
The responsibility for this work, of course, is entirely my own.
vi
Introduction
vii
viii
America’s Great Depression
Contents
Introduction to the Fifth Edition.........................................................xi
Introduction to the Fourth Edition..................................................xvii
Introduction to the Third Edition....................................................xxv
Introduction to the Second Edition.................................................xxxi
Introduction to the First Edition....................................................xxxv
PART I: BUSINESS CYCLE THEORY
1 THE POSITIVE THEORY OF THE CYCLE.........................3
Business cycles and business fluctuations............................................4
The problem: the cluster of error........................................................8
The explanation: boom and depression...............................................9
Secondary features of depression: deflationary credit
contraction...................................................................................14
Government depression policy: laissez-faire.....................................19
Preventing depressions......................................................................23
Problems in the Austrian theory of the
trade cycle.....................................................................................29
2 KEYNESIAN CRITICISMS OF THE THEORY..................37
The liquidity “trap”...........................................................................39
Wage rates and unemployment.........................................................42
3 SOME ALTERNATIVE EXPLANATIONS OF
DEPRESSION: A CRITIQUE....................................................55
General overproduction....................................................................56
Underconsumption............................................................................57
The acceleration principle.................................................................60
viii
Introduction
ix
Dearth of “investment opportunities”...............................................68
Schumpeter’s business cycle theory...................................................72
Qualitative credit doctrines...............................................................75
Overoptimism and overpessimism....................................................80
PART II: THE INFLATIONARY BOOM: 1921–1929
4 THE INFLATIONARY FACTORS...........................................85
The definition of the money supply...................................................87
Inflation of the money supply, 1921–1929........................................91
Generating the inflation, I: reserve requirements.............................95
Generating the inflation, II: total reserves......................................101
Treasury currency.............................................................................116
Bills discounted................................................................................117
Bills bought–acceptances.................................................................126
U.S. government securities..............................................................133
5 THE DEVELOPMENT OF THE INFLATION................137
Foreign lending................................................................................137
Helping Britain................................................................................142
The crisis approaches.......................................................................159
6 THEORY AND INFLATION: ECONOMISTS AND
THE LURE OF A STABLE PRICE LEVEL.........................169
PART III: THE GREAT DEPRESSION: 1929–1933
7 PRELUDE TO DEPRESSION: MR. HOOVER
AND LAISSEZ-FAIRE................................................................185
The development of Hoover’s interventionism:
unemployment...........................................................................188
The development of Hoover’s interventionism:
labor relations.............................................................................199
8 THE DEPRESSION BEGINS:
PRESIDENT HOOVER TAKES COMMAND...................209
The White House conferences........................................................210
Inflating credit.................................................................................214
Public works.....................................................................................216
The New Deal Farm Program........................................................217
Contents
x
9 1930.................................................................................................239
More inflation..................................................................................239
The Smoot–Hawley Tariff...............................................................241
Hoover in the second half of 1930...................................................243
The public works agitation..............................................................250
The fiscal burdens of government...................................................253
10 1931—“THE TRAGIC YEAR”.................................................257
The American monetary picture.....................................................260
The fiscal burden of government....................................................263
Public works and wage rates............................................................264
Maintaining wage rates....................................................................267
Immigration restrictions..................................................................270
Voluntary relief................................................................................271
Hoover in the last quarter of 1931...................................................272
The spread of collectivist ideas in the business world.....................277
11 THE HOOVER NEW DEAL OF 1932..................................285
The tax increase...............................................................................286
Expenditures versus economy..........................................................288
Public works agitation......................................................................292
The RFC..........................................................................................296
Governmental relief.........................................................................300
The inflation program.....................................................................301
The inflation agitation.....................................................................308
Mr. Hoover’s war on the stock market.............................................316
The home loan bank system............................................................317
The bankruptcy law..........................................................................318
The fight against immigration.........................................................319
12 THE CLOSE OF THE HOOVER TERM..................................321
The attack on property rights: the final currency failure................323
Wages, hours, and employment during the depression...................330
Conclusion: the lessons of Mr. Hoover’s record.............................336
APPENDIX: GOVERNMENT AND THE NATIONAL
PRODUCT, 1929–1932...................................................................339
INDEX.............................................................................................349
xi
America’s Great Depression
TABLES
TABLE 1: Total Money Supply of the United States,
1921–1929.........................................................................92
TABLE 2: Total Dollars and Total Gold Reserves............................94
TABLE 3: Member Bank Demand Deposits.....................................98
TABLE 4: Demand and Time Deposits............................................99
TABLE 5: Time Deposits.................................................................100
TABLE 6: Member Bank Reserves and Deposits............................102
TABLE 7: Changes in Reserves and Causal Factors . . .
1921–1929................................................................................109
TABLE 8: Per Month Changes in Reserves and Causal
Factors . . . 1921–1929..............................................................110
TABLE 9: Factors Determining Bank Reserves
July–October 1929....................................................................166
TABLE I: National Product.............................................................341
TABLE II: Income Originating in Government.............................342
TABLE III: Private Product.............................................................342
TABLE IV: Government Expenditures...........................................343
TABLE V: Expenditures of Government Enterprises.....................345
TABLE VI: Expenditures of Government and
Government Enterprises..........................................................345
TABLE VII: Receipts of Government and
Government Enterprises..........................................................346
TABLE VIII: Government and the Private Product......................347
xii
America’s Great Depression
Introduction to the Fifth Edition
The Wall Street collapse of September–October 1929 and
the Great Depression which followed it were among the
most important events of the twentieth century. They
made the Second World War possible, though not inevitable, and
by undermining confidence in the efficacy of the market and the
capitalist system, they helped to explain why the absurdly ineffi-
cient and murderous system of Soviet communism survived for so
long. Indeed, it could be argued that the ultimate emotional and
intellectual consequences of the Great Depression were not final-
ly erased from the mind of humanity until the end of the 1980s,
when the Soviet collectivist alternative to capitalism crumbled in
hopeless ruin and the entire world accepted there was no substitute
for the market.
Granted the importance of these events, then, the failure of his-
torians to explain either their magnitude or duration is one of the
great mysteries of modern historiography. The Wall Street plunge
itself was not remarkable, at any rate to begin with. The United
States economy had expanded rapidly since the last downturn in
1920, latterly with the inflationary assistance of the bankers and
the federal government. So a correction was due, indeed overdue.
The economy, in fact, ceased to expand in June, and it was
inevitable that this change in the real economy would be reflected
in the stock market.
The bull market effectively came to an end on September 3,
1929, immediately the shrewder operators returned from vacation
and looked hard at the underlying figures. Later rises were merely
xii
Introduction
xiii
hiccups in a steady downward trend. On Monday October 21, for
the first time, the ticker tape could not keep pace with the news of
falls and never caught up. Margin calls had begun to go out by
telegram the Saturday before, and by the beginning of the week
speculators began to realize they might lose their savings and even
their homes. On Thursday, October 24, shares dropped vertically
with no one buying, and speculators were sold out as they failed to
respond to margin calls. Then came Black Tuesday, October 29,
and the first selling of sound stocks to raise desperately needed liq-
uidity.
So far all was explicable and might easily have been predicted.
This particular stock market corrective was bound to be severe
because of the unprecedented amount of speculation which Wall
Street rules then permitted. In 1929 1,548,707 customers had
accounts with America’s 29 stock exchanges. In a population of 120
million, nearly 30 million families had an active association with
the market, and a million investors could be called speculators.
Moreover, of these nearly two-thirds, or 600,000, were trading on
margin; that is, on funds they either did not possess or could not
easily produce.
The danger of this growth in margin trading was compounded
by the mushrooming of investment trusts which marked the last
phase of the bull market. Traditionally, stocks were valued at about
ten times earnings. With high margin trading, earnings on shares,
only one or two percent, were far less than the eight to ten percent
interest on loans used to buy them. This meant that any profits
were in capital gains alone. Thus, Radio Corporation of America,
which had never paid a dividend at all, went from 85 to 410 points
in 1928. By 1929, some stocks were selling at 50 times earnings. A
market boom based entirely on capital gains is merely a form of
pyramid selling. By the end of 1928 the new investment trusts were
coming onto the market at the rate of one a day, and virtually all
were archetype inverted pyramids. They had “high leverage”—a
new term in 1929—through their own supposedly shrewd invest-
ments, and secured phenomenal stock exchange growth on the
basis of a very small plinth of real growth. United Founders
Corporation, for instance, had been created by a bankruptcy with
Introduction to the Fifth Edition
xiv
an investment of $500, and by 1929 its nominal resources, which
determined its share price, were listed as $686,165,000. Another
investment trust had a market value of over a billion dollars, but its
chief asset was an electric company which in 1921 had been worth
only $6 million. These crazy trusts, whose assets were almost
entirely dubious paper, gave the boom an additional superstructure
of pure speculation, and once the market broke, the “high lever-
age” worked in reverse.
Hence, awakening from the pipe dream was bound to be painful,
and it is not surprising that by the end of the day on October 24,
eleven men well-known on Wall Street had committed suicide.
The immediate panic subsided on November 13, at which point
the index had fallen from 452 to 224. That was indeed a severe cor-
rection but it has to be remembered that in December 1928 the
index had been 245, only 21 points higher. Business and stock
exchange downturns serve essential economic purposes. They have
to be sharp, but they need not be long because they are self-adjust-
ing. All they require on the part of the government, the business
community, and the public is patience. The 1920 recession had
adjusted itself within a year. There was no reason why the 1929
recession should have taken longer, for the American economy was
fundamentally sound. If the recession had been allowed to adjust
itself, as it would have done by the end of 1930 on any earlier anal-
ogy, confidence would have returned and the world slump need
never have occurred.
Instead, the stock market became an engine of doom, carrying
to destruction the entire nation and, in its wake, the world. By
July 8, 1932, New York Times industrials had fallen from 224 at the
end of the initial panic to 58. U.S. Steel, the world’s biggest and
most efficient steel-maker, which had been 262 points before the
market broke in 1929, was now only 22. General Motors, already
one of the best-run and most successful manufacturing groups in
the world, had fallen from 73 to 8. These calamitous falls were
gradually reflected in the real economy. Industrial production,
which had been 114 in August 1929, was 54 by March 1933, a fall
of more than half, while manufactured durables fell by 77 percent,
nearly four-fifths. Business construction fell from $8.7 billion in
1929 to only $1.4 billion in 1933.
Introduction
xv
Unemployment rose over the same period from a mere 3.2 per-
cent to 24.9 percent in 1933, and 26.7 percent the following year.
At one point, 34 million men, women, and children were without
any income at all, and this figure excluded farm families who were
also desperately hit. City revenues collapsed, schools and universi-
ties shut or went bankrupt, and malnutrition leapt to 20 percent,
something that had never happened before in United States his-
tory—even in the harsh early days of settlement.
This pattern was repeated all over the industrial world. It was
the worst slump in history, and the most protracted. Indeed there
was no natural recovery. France, for instance, did not get back to its
1929 level of industrial production until the mid-1950s. The world
economy, insofar as it was saved at all, was saved by war, or its
preparations. The first major economy to revitalize itself was
Germany’s, which with the advent of Hitler’s Nazi regime in
January, 1933, embarked on an immediate rearmament program.
Within a year, Germany had full employment. None of the others
fared so well. Britain began to rearm in 1937, and thereafter unem-
ployment fell gradually, though it was still at historically high levels
when war broke out on September 3, 1939. That was the date on
which Wall Street, anticipating lucrative arms sales and eventually
U.S. participation in the war, at last returned to 1929 prices.
It is a dismal story, and I do not feel that any historian has sat-
isfactorily explained it. Why so deep? Why so long? We do not
really know, to this day. But the writer who, in my judgment, has
come closest to providing a satisfactory analysis is Murray N.
Rothbard in America’s Great Depression. For half a century, the con-
ventional, orthodox explanation, provided by John Maynard
Keynes and his followers, was that capitalism was incapable of sav-
ing itself, and that government did too little to rescue an intellec-
tually bankrupt market system from the consequences of its own
folly. This analysis seemed less and less convincing as the years
went by, especially as Keynesianism itself became discredited.
In the meantime, Rothbard had produced, in 1963, his own
explanation, which turned the conventional one on its head. The
severity of the Wall Street crash, he argued, was not due to the unre-
strained license of a freebooting capitalist system, but to government
Introduction to the Fifth Edition
xvi
insistence on keeping a boom going artificially by pumping in
inflationary credit. The slide in stocks continued, and the real
economy went into freefall, not because government interfered too
little, but because it interfered too much. Rothbard was the first to
make the point, in this context, that the spirit of the times in the
1920s, and still more so in the 1930s, was for government to plan,
to meddle, to order, and to exhort. It was a hangover from the First
World War, and President Hoover, who had risen to worldwide
prominence in the war by managing relief schemes, and had then
held high economic office throughout the twenties before moving
into the White House itself in 1929, was a born planner, meddler,
orderer, and exhorter.
Hoover’s was the only department of the U.S. federal govern-
ment which had expanded steadily in numbers and power during
the 1920s, and he had constantly urged Presidents Harding and
Coolidge to take a more active role in managing the economy.
Coolidge, a genuine minimalist in government, had complained:
“For six years that man has given me unsolicited advice—all of it
bad.” When Hoover finally took over the White House, he fol-
lowed his own advice, and made it an engine of interference, first
pumping more credit into an already overheated economy and,
then, when the bubble burst, doing everything in his power to
organize government rescue operations.
We now see, thanks to Rothbard’s insights, that the Hoover–
Roosevelt period was really a continuum, that most of the “inno-
vations” of the New Deal were in fact expansions or intensifica-
tions of Hoover solutions, or pseudo-solutions, and that Franklin
Delano Roosevelt’s administration differed from Herbert Hoover’s
in only two important respects—it was infinitely more successful
in managing its public relations, and it spent rather more taxpay-
ers’ money. And, in Rothbard’s argument, the net effect of the
Hoover–Roosevelt continuum of policy was to make the slump
more severe and to prolong it virtually to the end of the 1930s.
The Great Depression was a failure not of capitalism but of the
hyperactive state.
I will not spoil the reader’s pleasure by entering more deeply
into Rothbard’s arguments. His book is an intellectual tour de force,
Introduction
xvii
in that it consists, from start to finish, of a sustained thesis, pre-
sented with relentless logic, abundant illustration, and great elo-
quence. I know of few books which bring the world of economic
history so vividly to life, and which contain so many cogent les-
sons, still valid in our own day. It is also a rich mine of interesting
and arcane knowledge, and I urge readers to explore its footnotes,
which contain many delicious quotations from the great and the
foolish of those days, three-quarters of a century ago. It is not sur-
prising that the book is going into yet another edition. It has stood
the test of time with success, even with panache, and I feel honored
to be invited to introduce it to a new generation of readers.
PAUL JOHNSON
1999
Introduction to the Fourth Edition
There seems to be a cycle in new editions of this book. The
second edition was published in the midst of the 1969–71
inflationary recession, the third in the mighty inflationary
depression of 1973–75. The economy is now in the midst of
another inflationary depression at least as severe, and perhaps even
more so, than the 1973–75 contraction, which had been the worst
since the 1930s.
The confusion and intellectual despair we noted in the intro-
duction to the third edition has now intensified. It is generally con-
ceded that Keynesianism is intellectually bankrupt, and we are
treated to the spectacle of veteran Keynesians calling for tax
increases during a severe depression, a change of front that few
people consider worth noting, much less trying to explain.
Part of the general bewilderment is due to the fact that the cur-
rent, severe 1981–83 depression followed very swiftly after the
recession of 1979–80, so that it begins to look that the fitful and
short-lived recovery of 1980–81 may have been but an interlude in
the midst of a chronic recession that has lasted since 1979. Pro-
duction has been stagnating for years, the auto industry is in bad
shape, thrift institutions are going bankrupt by the week, and
unemployment has reached its highest point since the 1930s.
A notable feature of the 1981–83 depression is that, in contrast
to 1973–75, the drift of economic thought and policy has not been
toward collectivist planning but toward alleged free-market poli-
cies. The Reagan administration began with a fanfare of allegedly
drastic budget and tax cuts, all of which lightly masked massive
xviii
Introduction
xix
increases in taxes and spending, so that President Reagan is now
presiding over the largest deficits and the highest budgets in
American history. If the Keynesians and now the Reagan adminis-
tration are calling for tax increases to narrow the deficit, we find
the equally bizarre spectacle of veteran classical liberal economists
in the early days of the same administration apologizing for gov-
ernment deficits as being unimportant. While it is theoretically
true that deficits financed by sale of bonds to the public are not
inflationary, it is also true that the huge deficits (a) exert enormous
political pressure on the Fed to monetize the debt; and (b) cripple
private investment by crowding out private savings and channeling
them into unproductive and wasteful government boondoggles
which will also impose higher taxes on future generations.
The twin hallmarks of “Reaganomics” so far have been huge
deficits and remarkably high interest rates. While deficits are often
inflationary and always pernicious, curing them by raising taxes is
equivalent to curing an illness by shooting the patient. In the first
place, politically higher taxes will simply give the government
more money to spend, so that expenditures and therefore deficits
are likely to rise still further. Cutting taxes, on the other hand, puts
great political pressure on Congress and the administration to fol-
low suit by cutting spending.
But more directly, it is absurd to claim that a tax is any better
from the point of view of the consumer–taxpayer than a higher
price. If the price of a product rises due to inflation, the consumer
is worse off, but at least he still enjoys the services of the product.
But if the government raises taxes in order to stave off that price
rise, the consumer is getting nothing in return. He simply loses his
money, and obtains no service for it except possibly being ordered
around by government authorities he has been forced to subsidize.
Other things being equal, a price rise is always preferable to a tax.
But finally, inflation, as we point out in this work, is not caused
by deficits but by the Federal Reserve’s increase of the money sup-
ply. So that it is quite likely that a higher tax will have no effect on
inflation whatsoever.
Deficits, then, should be eliminated, but only by cutting gov-
ernment spending. If taxes and government spending are both
Introduction to the Fourth Edition
xx
slashed, then the salutary result will be to lower the parasitic burden
of government taxes and spending upon the productive activities of
the private sector.
This brings us to a new economic viewpoint that has emerged
since our last edition—“supply-side economics” and its extreme
variant, the Laffer Curve. To the extent that supply-siders point
out that tax reductions will stimulate work, thrift, and productiv-
ity, then they are simply underlining truths long known to classical
and to Austrian economics. But one problem is that supply-siders,
while calling for large income-tax cuts, advocate keeping up the
current level of government expenditures, so that the burden of
shifting resources from productive private to wasteful government
spending will still continue.
The Laffer variant of the supply-side adds the notion that a
decline in income tax rateswill so increase government revenues from
higher production and income that the budget will still be balanced.
There is little discussion by Lafferites, however, of how long this
process is supposed to take, and there is no evidence that revenue will
rise sufficiently to balance the budget, or even will rise at all. If, for
example, the government should now raise income tax rates by 30
percent, does anyone really believe that total revenue would fall?
Another problem is that one wonders why the overriding goal
of fiscal policy should be to maximize government revenue. A far
sounder objective would be to minimize the revenue and the
resources siphoned off to the public sector.
At any rate, the Laffer Curve has scarcely been tested by the
Reagan administration, since the much-vaunted income tax cuts,
in addition to being truncated and reduced from the original Rea-
gan plan, were more than offset by a programmed rise in Social
Security taxes and by “bracket creep.” Bracket creep exists when
inflation wafts people into higher nominal (but not higher real)
income brackets, where their tax rates automatically increase.
It is generally agreed that recovery from the current depression
has not yet arrived because interest rates have remained high,
despite the depression-borne drop in the rate of inflation. The
Friedmanites had decreed that “real” interest rates (nominal rates
Introduction
xxi
minus the rate of inflation) are always hovering around 3 percent.
When inflation fell sharply, therefore, from about 12 percent to 5
percent or less, monetarists confidently predicted that interest
rates would fall drastically, spurring a cyclical recovery. Yet, real
interest rates have persisted at far higher than 3 percent. How
could this be?
The answer is that expectations are purely subjective, and can-
not be captured by the mechanistic use of charts and regressions.
After several decades of continuing and aggravated inflation, the
American public has become inured to expect further chronic infla-
tion. Temporary respites during deep depressions, propaganda and
political hoopla, can no longer reverse those expectations. As long
as inflationary expectations persist, the expected inflation incorpo-
rated into interest rates will remain high, and interest rates will not
fall for any substantial length of time.
The Reagan administration knew, of course, that inflationary
expectations had to be reversed, but where they miscalculated was
relying on propaganda without substance. Indeed, the entire pro-
gram of Reaganomics may be considered a razzle-dazzle of show-
manship about taxes and spending, behind which the monetarists,
in control of the Fed and the Treasury Department, were supposed
to gradually reduce the rate of money growth. The razzle-dazzle
was supposed to reverse inflationary expectations; the gradualism
was to eliminate inflation without forcing the economy to suffer the
pain of recession or depression. Friedmanites have never under-
stood the Austrian insight on the necessity of a recession to liqui-
date the unsound investments of the inflationary boom. As a result,
the attempt of Friedmanite gradualism to fine-tune the economy
into disinflation-without-recession went the way of the similar
Keynesian fine-tuning which the monetarists had criticized for
decades. Friedmanite fine-tuning brought us temporary “disinfla-
tion” accompanied by another severe depression.
In this way, monetarism fell between two stools. The Fed’s cut-
back in the rate of money growth was sharp enough to precipitate
the inevitable recession, but much too weak and gradual to bring
inflation to an end once and for all. Instead of a sharp but short
recession to liquidate the malinvestments of the preceding boom,
Introduction to the Fourth Edition
xxii
we now have a lingering chronic recession coupled with a grind-
ing, continuing stagnation of productivity and economic growth. A
pusillanimous gradualism has brought us the worst of both worlds:
continuing inflation plus severe recession, high unemployment,
and chronic stagnation.
One of the reasons for the chronic recession and stagnation is
that the market learns. Inflationary expectations are a response
learned after decades of inflation, and they place an inflationary
premium on pure interest rates. As a result, the time-honored
method of lowering interest rates—the Fed’s expanding the supply
of money and credit—cannot work for long because that will sim-
ply raise inflationary expectations and raise interest rates instead of
lowering them. We have gotten to the point where everything the
government does is counterproductive; the conclusion, of course,
is that the government should do nothing at all, that is, should
retire quickly from the monetary and economic scene and allow
freedom and free markets to work.
It is, furthermore, too late for gradualism. The only solution
was set forth by F.A. Hayek, the dean of the Austrian School, in his
critique of the similarly disastrous gradualism of the Thatcher
regime in Great Britain. 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,
and the free market, allowed its head, will return to a sound recov-
ery in a remarkably brief time. Only a drastic and credible slam-
ming of the brakes can truly reverse the inflationary expectations
of the American public. But wisely the public no longer trusts the
Fed or the federal government. For a slamming on of the brakes to
be truly credible, there must be a radical surgery on American
monetary institutions, a surgery similar in scope to the German
creation of the rentenmark which finally ended the runaway infla-
tion of 1923. One important move would be to denationalize the
fiat dollar by returning it to be worth a unit of weight of gold. A
corollary policy would prohibit the Federal Reserve from lowering
reserve requirements or from purchasing any assets ever again;
Introduction
xxiii
better yet, the Federal Reserve System should be abolished, and
government at last totally separated from the supply of money.
In any event, there is no sign of any such policy on the horizon.
After a brief flirtation with gold, the Presidentially appointed U.S.
Gold Commission, packed with pro-fiat money Friedmanites abet-
ted by Keynesians, predictably rejected gold by an overwhelming
margin. Reaganomics—a blend of monetarism and fiscal Keyne-
sianism swathed in classical liberal and supply-side rhetoric—is in
no way going to solve the problem of inflationary depression or of
the business cycle.
But if Reaganomics is doomed to be a fiasco, what is likely to
happen? Will we suffer a replay, as many voices are increasingly
predicting, of the Great Depression of the 1930s? Certainly there
are many ominous signs and parallels. The fact that Reaganomics
cannot bring down interest rates for long puts a permanent brake
on the stock market, which has been in chronic trouble since the
mid-1960s and is increasingly in shaky shape. The bond market is
already on the way to collapse. The housing market has at last been
stopped short by the high mortgage rates, and the same has hap-
pened to many collectibles. Unemployment is chronically higher
each decade, and is now at the highest since the Great Depression,
with no sign of improvement. The accelerating inflationary boom
of the three decades since the end of World War II has loaded the
economy with unsound investments and with an oppressive moun-
tain of debt: consumer, homeowner, business, and international. In
recent decades, business has in effect relied on inflation to liqui-
date the debt, but if “disinflation” (the lessening of inflation in
1981 and at least the first half of 1982) is to continue, what will
happen to the debt? Increasingly, the answer will be bankruptcies,
and deeper depression. The bankruptcy rate is already the highest
since the Great Depression of the 1930s. Thrift institutions caught
between high interest rates to their depositors and low rates earned
on long-time mortgages, will increasingly become bankrupt or be
forced into quasi-bankrupt mergers with other thrifts which will
be dragged down by the new burdens. Even commercial banks,
Introduction to the Fourth Edition
xxiv
protected by the safety blanket of the FDIC for half a century, are
now beginning to go down the drain, dragged down by their
unsound loans of the past decade.
Matters are even worse on the international front. During the
great credit boom, U.S. banks have recklessly loaned inflated dol-
lars to unsound and highly risky governments and institutions
abroad, especially in the Communist governments and the Third
World. The Depository Control Act of 1980, which shows no signs
of being repealed by the Reagan administration, allows the Federal
Reserve to purchase unlimited amounts of foreign currency (or any
other assets) or to lower bank reserve requirements to zero. In
other words, it sets the stage for unlimited monetary and credit
inflation by the Fed. The bailing out of the Polish government, and
the refusal by the U.S. to declare it bankrupt so that the U.S. tax-
payer (or holder of dollars) can pick up the tab indefinitely, is an
omen for the future. For only massive inflation will eventually be
able to bail out foreign debtors and U.S. creditor banks.
Since Friedmanite gradualism will not permit a sharp enough
recession to clear out the debt, this means that the American econ-
omy will be increasingly faced with two alternatives: either a mas-
sive deflationary 1929-type depression to clear out the debt, or a
massive inflationary bailout by the Federal Reserve. Hard money
rhetoric or no rhetoric, the timidity and confusion of Reaganomics
make very clear what its choice will be: massive inflation of money
and credit, and hence the resumption of double-digit and perhaps
higher inflation, which will drive interest rates even higher and
prevent recovery. A Democratic administration may be expected to
inflate with even more enthusiasm. We can look forward, there-
fore, not precisely to a 1929-type depression, but to an inflation-
ary depression of massive proportions. Until then, the Austrian
program of hard money, the gold standard, abolition of the Fed,
and laissez-faire, will have been rejected by everyone: economists,
politicians, and the public, as too harsh and Draconian. But Aus-
trian policies are comfortable and moderate compared to the eco-
nomic hell of permanent inflation, stagnation, high unemploy-
ment, and inflationary depression that Keynesians and Friedman-
ite neo-Keynesians have gotten us into. Perhaps, this present and
Introduction
xxv
future economic holocaust will cause the American public to turn
away from failed nostrums and toward the analysis and policy con-
clusions of the Austrian School.
MURRAY N. ROTHBARD
Stanford, California
September 1982
Introduction to the Third Edition
America is now in the midst of a full-scale inflationary
depression. The inflationary recession of 1969–71 has
been quickly succeeded by a far more inflationary depres-
sion which began around November 1973, and skidded into a seri-
ous depression around the fall of 1974. Since that time, physical
production has declined steadily and substantially, and the unem-
ployment rate has risen to around 10 percent, and even higher in
key industrial areas. The desperate attempt by the politico-eco-
nomic Establishment to place an optimistic gloss on the most
severe depression since the 1930s centers on two arguments: (a)
the inadequacy of the unemployment statistics, and (b) the fact that
things were much worse in the post-1929 depression. The first
argument is true but irrelevant; no matter how faulty the statistics,
the rapid and severe rise in the unemployment rate from under 6
percent to 10 percent in the space of just one year (from 1974 to
1975) tells its own grisly tale. It is true that the economy was in
worse shape in the 1930s, but that was the gravest depression in
American history; we are now in a depression that is certainly not
mild by any pre-1929 standards.
The current inflationary depression has revealed starkly to the
nation’s economists that their cherished theories—adopted and
applied since the 1930s—are tragically and fundamentally incor-
rect. For forty years we have been told, in the textbooks, the eco-
nomic journals, and the pronouncements of our government’s eco-
nomic advisors, that the government has the tools with which it
can easily abolish inflation or recession. We have been told that by
xxvi
Introduction
xxvii
juggling fiscal and monetary policy, the government can “fine-
tune” the economy to abolish the business cycle and insure perma-
nent prosperity without inflation. Essentially—and stripped of the
jargon, the equations, and the graphs—the economic
Establishment held all during this period that if the economy is
seen to be sliding into recession, the government need only step on
the fiscal and monetary gas—to pump in money and spending into
the economy—in order to eliminate recession. And, on the con-
trary, if the economy was becoming inflationary, all the govern-
ment need do is to step on the fiscal and monetary brake—take
money and spending out of the economy—in order to eliminate
inflation. In this way, the government’s economic planners would
be able to steer the economy on a precise and careful course
between the opposing evils of unemployment and recession on the
one hand, and inflation on the other. But what can the government
do, what does conventional economic theory tell us, if the econo-
my is suffering a severe inflation and depression at the same time?
Now can our self-appointed driver, Big Government, step on the
gas and on the brake at one and the same time?
Confronted with this stark destruction of all their hopes and
plans, surrounded by the rubble of their fallacious theories, the
nation’s economists have been plunged into confusion and despair.
Put starkly, they have no idea of what to do next, or even how to
explain the current economic mess. In action, all that they can do
is to alternate accelerator and brake with stunning rapidity, hoping
that something might work (e.g., President Ford’s call for higher
income taxes in the fall of 1974, only to be followed by a call for
lower income taxes a few months later). Conventional economic
theory is bankrupt: furthermore, with courses on business cycles
replaced a generation ago by courses on “macroeconomics” in
graduate schools throughout the land, economists have now had to
face the stark realization that business cycles do exist, while being
in no way equipped to understand them. Some economists, union
leaders, and businessmen, despairing of any hope for the free-mar-
ket economy, have in fact begun to call for a radical shift to a col-
lectivized economy in America (notably, the Initiative Committee
for National Economic Planning, which includes in its ranks
Introduction to the Third Edition
xxviii
economists such as Wassily Leontief, union leaders such as
Leonard Woodcock, and business leaders such as Henry Ford II).
In the midst of this miasma and despair, there is one school of
economic thought which predicted the current mess, has a cogent
theory to explain it, and offers the way out of the predicament—a
way out, furthermore, which, far from scrapping free enterprise in
favor of collectivist planning, advocates the restoration of a purely
free enterprise system that has been crippled for decades by gov-
ernment intervention. This school of thought is the “Austrian”
theory presented in this book. The Austrian view holds that per-
sistent inflation is brought about by continuing and chronic
increases in the supply of money, engineered by the federal gov-
ernment. Since the inception of the Federal Reserve System in
1913, the supply of money and bank credit in America has been
totally in the control of the federal government, a control that has
been further strengthened by the U.S. repudiating the domestic
gold standard in 1933, as well as the gold standard behind the dol-
lar in foreign transactions in 1968 and finally in 1971. With the
gold standard abandoned, there is no necessity for the Federal
Reserve or its controlled banks to redeem dollars in gold, and so the
Fed may expand the supply of paper and bank dollars to its heart’s
content. The more it does so, the more prices tend to accelerate
upward, dislocating the economy and bringing impoverishment to
those people whose incomes fall behind in the inflationary race.
The Austrian theory further shows that inflation is not the only
unfortunate consequence of governmental expansion of the supply
of money and credit. For this expansion distorts the structure of
investment and production, causing excessive investment in
unsound projects in the capital goods industries. This distortion is
reflected in the well-known fact that, in every boom period, capi-
tal goods prices rise further than the prices of consumer goods.
The recession periods of the business cycle then become
inevitable, for the recession is the necessary corrective process by
which the market liquidates the unsound investments of the boom
and redirects resources from the capital goods to the consumer
goods industries. The longer the inflationary distortions continue,
the more severe the recession-adjustment must become. During
Introduction
xxix
the recession, the shift of resources takes place by means of capital
goods prices falling relative to consumer goods. During the depres-
sion of 1974–75, we have seen this occur, with industrial raw mate-
rial prices falling rapidly and substantially, with wholesale prices
remaining level or declining slightly, but with consumer goods
prices still rising rapidly—in short, the inflationary depression.
What, then, should the government do if the Austrian theory is
the correct one? In the first place, it can only cure the chronic and
potentially runaway inflation in one way: by ceasing to inflate: by
stopping its own expansion of the money supply by Federal
Reserve manipulation, either by lowering reserve requirements or
by purchasing assets in the open market. The fault of inflation is
not in business “monopoly,” or in union agitation, or in the hunch-
es of speculators, or in the “greediness” of consumers; the fault is
in the legalized counterfeiting operations of the government itself.
For the government is the only institution in society with the
power to counterfeit—to create new money. So long as it contin-
ues to use that power, we will continue to suffer from inflation,
even unto a runaway inflation that will utterly destroy the curren-
cy. At the very least, we must call upon the government to stop
using that power to inflate. But since all power possessed will be
used and abused, a far sounder method of ending inflation would
be to deprive the government completely of the power to counter-
feit: either by passing a law forbidding the Fed to purchase any fur-
ther assets or to lower reserve requirements, or more fundamen-
tally, to abolish the Federal Reserve System altogether. We existed
without such a central banking system before 1913, and we did so
with far less rampant inflations or depressions. Another vital
reform would be to return to a gold standard—to a money based
on a commodity produced, not by government printing presses,
but by the market itself. In 1933, the federal government seized
and confiscated the public’s gold under the guise of a temporary
emergency measure; that emergency has been over for forty years,
but the public’s gold still remains beyond our reach at Fort Knox.
As for avoiding depressions, the remedy is simple: again, to
avoid inflations by stopping the Fed’s power to inflate. If we are in
a depression, as we are now, the only proper course of action is to
Introduction to the Third Edition
xxx
avoid governmental interference with the depression, and thereby
to allow the depression–adjustment process to complete itself as
rapidly as possible, and thus to restore a healthy and prosperous
economic system. Before the massive government interventions of
the 1930s, all recessions were short-lived. The severe depression of
1921 was over so rapidly, for example, that Secretary of Commerce
Hoover, despite his interventionist inclinations, was not able to
convince President Harding to intervene rapidly enough; by the
time Harding was persuaded to intervene, the depression was
already over, and prosperity had arrived. When the stock market
crash arrived in October, 1929, Herbert Hoover, now the presi-
dent, intervened so rapidly and so massively that the market–
adjustment process was paralyzed, and the Hoover–Roosevelt New
Deal policies managed to bring about a permanent and massive
depression, from which we were only rescued by the advent of
World War II. Laissez-faire—a strict policy of non-intervention by
the government —is the only course that can assure a rapid recov-
ery in any depression crisis.
In this time of confusion and despair, then, the Austrian School
offers us both an explanation and a prescription for our current ills.
It is a prescription that is just as radical as, and perhaps even more
politically unpalatable than, the idea of scrapping the free econo-
my altogether and moving toward a totalitarian and unworkable
system of collectivist economic planning. The Austrian prescrip-
tion is precisely the opposite: we can only surmount the present
and future crisis by ending government intervention in the econo-
my, and specifically by ending governmental inflation and control
of the money supply, as well as interference in any recession–
adjustment process. In times of breakdown, mere tinkering
reforms are not enough; we must take the radical step of getting
the government out of the economic picture, of separating gov-
ernment completely from the money supply and the economy, and
advancing toward a truly free and unhampered market and enter-
prise economy.
MURRAY N. ROTHBARD
Palo Alto, California
May 1975
Introduction to the Second Edition
In the years that have elapsed since the publication of the first
edition, the business cycle has re-emerged in the consciousness
of economists. During the 1960s, we were again promised, as
in the New Era of the 1920s, the abolition of the business cycle by
Keynesian and other sophisticated policies of government. The
substantial and marked recession which began around November,
1969, and from which at this writing we have not yet recovered,
has been a salutary if harsh reminder that the cycle is still very
much alive.
One feature of this current recession that has been particularly
unpleasant and surprising is the fact that prices of consumer goods
have continued to rise sharply throughout the recession. In the
classic cycle, prices fall during recessions or depressions, and this
decline in prices is the one welcome advantage that the consumer
can reap from such periods of general gloom. In the present reces-
sion, however, even this advantage has been removed, and the con-
sumer thus suffers a combination of the worst features of recession
and inflation.
Neither the established Keynesian nor the contemporary
“monetarist” schools anticipated or can provide a satisfactory
explanation of this phenomenon of “inflationary recession.” Yet
the “Austrian” theory contained in this book not only explains this
occurrence, but demonstrates that it is a general and universal ten-
dency in recessions. For the essence of recession, as the Austrian
theory shows, is a readjustment of the economy to liquidate the
distortions imposed by the boom—in particular, the overexpansion
xxxii
Introduction
xxxiii
of the “higher” orders of capital goods and the underinvestment in
consumer goods industries. One of the ways by which the market
redirects resources from the capital goods to the consumer goods
sphere is by prices declining relatively in the former category and
rising relatively in the latter category. Bankruptcies and relative
price and wage contractions in the overblown and malinvested
higher orders of capital goods will redirect land, labor, and capital
resources into consumer goods and thereby reestablish the effi-
cient responsiveness to consumer demands that is the normal con-
dition of an unhampered market economy.
In short, the prices of consumer goods always tend to rise, rel-
ative to the prices of producer goods, during recessions. The rea-
son that this phenomenon has not been noted before is that, in past
recessions, prices have generally fallen. If, for example, consumer
goods prices fall by 10 percent and, say, cement prices fall by 20
percent, no one worries about an “inflation” during the recession;
but, actually, consumer goods prices in this case, too, have risen
relative to the prices of producer goods. Prices in general fell dur-
ing recessions because monetary and banking deflation used to be
an invariable feature of economic contractions. But, in the last few
decades, monetary deflation has been strictly prevented by gov-
ernmental expansion of credit and bank reserves, and the phenom-
enon of an actual decline in the money supply has become at best a
dim memory. The result of the government’s abolition of defla-
tion, however, is that general prices no longer fall, even in reces-
sions. Consequently, the adjustment between consumer goods and
capital goods that must take place during recessions, must now
proceed without the merciful veil of deflation. Hence, the prices of
consumer goods still rise relatively, but now, shorn of general
deflation, they must rise absolutely and visibly as well. The gov-
ernment policy of stepping in to prevent monetary deflation,
therefore, has deprived the public of the one great advantage of
recessions: a falling cost of living. Government intervention
against deflation has brought us the unwelcome phenomenon of
inflationary recession.
Along with the renewed emphasis on business cycles, the late
1960s saw the emergence of the “monetarist” Chicago School,
Introduction to the Second Edition
xxxiv
headed by Milton Friedman, as a significant competitor to the
Keynesian emphasis on compensatory fiscal policy. While the
Chicago approach provides a welcome return to the pre-Keynesian
emphasis on the crucial role of money in business cycles, it is
essentially no more than a recrudescence of the “purely monetary”
theory of Irving Fisher and Sir Ralph Hawtrey during the 1910s
and 1920s. Following the manner of the English classical econo-
mists of the nineteenth century, the monetarists rigidly separate
the “price level” from the movement of individual prices; mone-
tary forces supposedly determine the former while supply and
demand for particular goods determine the latter. Hence, for the
monetarists, monetary forces have no significant or systematic
effect on the behavior of relative prices or in distorting the struc-
ture of production. Thus, while the monetarists see that a rise in
the supply of money and credit will tend to raise the level of gen-
eral prices, they ignore the fact that a recession is then required to
eliminate the distortions and unsound investments of the preced-
ing boom. Consequently, the monetarists have no causal theory of
the business cycle; each stage of the cycle becomes an event unre-
lated to the following stage.
Furthermore, as in the case of Fisher and Hawtrey, the current
monetarists uphold as an ethical and economic ideal the mainte-
nance of a stable, constant price level. The essence of the cycle is
supposed to be the rise and fall—the movements—of the price
level. Since this level is determined by monetary forces, the mon-
etarists hold that if the price level is kept constant by government
policy, the business cycle will disappear. Friedman, for example, in
his A Monetary History of the United States, 1867–1960 (1963), emu-
lates his mentors in lauding Benjamin Strong for keeping the
wholesale price level stable during the 1920s. To the monetarists,
the inflation of money and bank credit engineered by Strong led to
no ill effects, no cycle of boom and bust; on the contrary, the Great
Depression was caused by the tight money policy that ensued after
Strong’s death. Thus, while the Fisher–Chicago monetarists and
the Austrians both focus on the vital role of money in the Great
Depression as in other business cycles, the causal emphases and
policy conclusions are diametrically opposed. To the Austrians, the
Introduction
xxxv
monetary inflation of the 1920s set the stage inevitably for the
depression, a depression which was further aggravated (and
unsound investments maintained) by the Federal Reserve efforts to
inflate further during the 1930s. The Chicagoans, on the other
hand, seeing no causal factors at work generating recession out of
preceding boom, hail the policy of the 1920s in keeping the price
level stable and believe that the depression could have been quick-
ly cured if only the Federal Reserve had inflated far more inten-
sively during the depression.
The long-run tendency of the free market economy, unham-
pered by monetary expansion, is a gently falling price level, falling
as the productivity and output of goods and services continually
increase. The Austrian policy of refraining at all times from mon-
etary inflation would allow this tendency of the free market its
head and thereby remove the disruptions of the business cycle.
The Chicago goal of a constant price level, which can be achieved
only by a continual expansion of money and credit, would, as in the
1920s, unwittingly generate the cycle of boom and bust that has
proved so destructive for the past two centuries.
MURRAY N. ROTHBARD
New York, New York
July 1971
Introduction to the
First Edition
The year 1929 stands as the great American trauma. Its
shock impact on American thought has been enormous.
The reasons for shock seem clear. Generally, depressions
last a year or two; prices and credit contract sharply, unsound posi-
tions are liquidated, unemployment swells temporarily, and then
rapid recovery ensues. The 1920–1921 experience repeated a
familiar pattern, not only of such hardly noticeable recessions as
1899–1900 and 1910–1912, but also of such severe but brief crises
as 1907–1908 and 1819–1821.1 Yet the Great Depression that
ignited in 1929 lasted, in effect, for eleven years.
In addition to its great duration, the 1929 depression stamped
itself on the American mind by its heavy and continuing unem-
ployment. While the intensity of falling prices and monetary con-
traction was not at all unprecedented, the intensity and duration of
unemployment was new and shocking. The proportion of the
American labor force that was unemployed had rarely reached 10
percent at the deepest trough of previous depressions; yet it sur-
passed 20 percent in 1931, and remained above 15 percent until
the advent of World War II.
1The depression of 1873–1879 was a special case. It was, in the first place, a
mild recession, and second, it was largely a price decline generated by the mone-
tary contraction attending return to the pre-Civil War gold standard. On the
mildness of this depression, particularly in manufacturing, see O.V. Wells, “The
Depression of 1873–79,” Agricultural History 11 (1937): 240.
xxxvi
Introduction
xxxvii
If we use the commonly accepted dating methods and business
cycle methodology of the National Bureau of Economic Research,
we shall be led astray in studying and interpreting the depression.
Unfortunately, the Bureau early shifted its emphasis from the
study of the qualitatively important periods of “prosperity” and
“depression,” to those of mere “expansion” and “contraction.” In
its dating methods, it picks out one month as the peak or trough,
and thus breaks up all historical periods into expansions and con-
tractions, lumping them all together as units in its averages,
regardless of importance or severity. Thus, the long boom of the
1920s is hardly recognized by the Bureau—which highlights
instead the barely noticeable recessions of 1923 and 1926.
Furthermore, we may agree with the Bureau—and all other
observers—that the Great Depression hit its trough in 1932–1933,
but we should not allow an artificial methodology to prevent our
realizing that the “boom” of 1933–1937 took place within a con-
tinuing depression. When unemployment remains over 15 per-
cent, it is folly to refer to the 1933–1937 period as “prosperity.” It
is still depression, even if slightly less intense than in 1933.2
The chief impact of the Great Depression on American
thought was universal acceptance of the view that “laissez-faire
capitalism” was to blame. The common opinion—among econo-
mists and the lay public alike—holds that “Unreconstructed
Capitalism” prevailed during the 1920s, and that the tragic depres-
sion shows that old-fashioned laissez-faire can work no longer. It
had always brought instability and depression during the nine-
teenth century; but now it was getting worse and becoming
absolutely intolerable. The government must step in to stabilize
the economy and iron out the business cycle. A vast army of peo-
ple to this day consider capitalism almost permanently on trial. If
the modern array of monetary–fiscal management and stabilizers
cannot save capitalism from another severe depression, this large
group will turn to socialism as the final answer. To them, another
2Even taken by itself, the “contraction” phase of the depression, from
1929–1933, was unusually long and unusually severe, particularly in its degree of
unemployment.
Introduction to the First Edition
xxxviii
depression would be final proof that even a reformed and enlight-
ened capitalism cannot prosper.
Yet, on closer analysis, the common reaction is by no means
self-evident. It rests, in fact, on an unproven assumption—the
assumption that business cycles in general, and depressions in par-
ticular, arise from the depths of the free-market, capitalist econo-
my. If we then assume that the business cycle stems from—is
“endogenous” to—the free market, then the common reaction
seems plausible. And yet, the assumption is pure myth, resting not
on proof but on simple faith. Karl Marx was one of the first to
maintain that business crises stemmed from market processes. In
the twentieth century, whatever their great positive differences,
almost all economists—Mitchellians, Keynesians, Marxians, or
whatnot—are convinced of this view. They may have conflicting
causal theories to explain the phenomenon, or, like the
Mitchellians, they may have no causal theory at all—but they are
all convinced that business cycles spring from deep within the cap-
italist system.
Yet there is another and conflicting tradition of economic
thought—now acknowledged by only a few economists, and by
almost none of the public. This view holds that business cycles and
depressions stem from disturbances generated in the market by
monetary intervention. The monetary theory holds that money and
credit-expansion, launched by the banking system, causes booms
and busts. This doctrine was first advanced, in rudimentary form,
by the Currency School of British classical economists in the early
nineteenth century, and then fully developed by Ludwig von Mises
and his followers in the twentieth. Although widely popular in
early-nineteenth-century America and Britain, the Currency
School thesis has been read out of business cycle theory and rele-
gated to another compartment: “international trade theory.”
Nowadays, the monetary theory, when acknowledged at all, is
scoffed at as oversimplified. And yet, neither simplicity nor single-
cause explanation is a defect per se in science; on the contrary, other
things being equal, science will prefer the simpler to the more
complex explanation. And science is always searching for a unified
“single cause” explanation of complex phenomena, and rejoices
Introduction
xxxix
when it can be found. If a theory is incorrect, it must be combat-
ted on its demerits only; it must not be simply accused of being
monocausal or of relying on causes external to the free market.
Perhaps, after all, the causes are external—exogenous—to the mar-
ket! The only valid test is correctness of theoretical reasoning.
This book rests squarely on the Misesian interpretation of the
business cycle.3 The first part sets forth the theory and then refutes
some prominent conflicting views. The theory itself is discussed
relatively briefly, a full elaboration being available in other works.
The implications of this theory for governmental policy are also
elaborated—implications which run flatly counter to prevailing
views. The second and third parts apply the theory to furnish an
explanation of the causes of the 1929 depression in the United
States. Note that I make no pretense of using the historical facts to
“test” the truth of the theory. On the contrary, I contend that eco-
nomic theories cannot be “tested” by historical or statistical fact.
These historical facts are complex and cannot, like the controlled
and isolable physical facts of the scientific laboratory, be used to
test theory. There are always many causal factors impinging on
each other to form historical facts. Only causal theories a priori to
these facts can be used to isolate and identify the causal strands.4
For example, suppose that the price of zinc rises over a certain time
period. We may ask: why has it risen? We can only answer the
question by employing various causal theories arrived at prior to
our investigation. Thus, we know that the price might have risen
from any one or a combination of these causes: an increase in
demand for zinc; a reduction in its supply; a general increase in the
supply of money and hence in monetary demand for all goods; a
reduction in the general demand for money. How do we know
which particular theory applies in these particular cases? Only by
3It must be emphasized that Ludwig von Mises is in no way responsible for
any of the contents of this book.
4This is by no means to deny that the ultimate premises of economic theory,
e.g., the fundamental axiom of action, or the variety of resources, are derived
from experienced reality. Economic theory, however, is a priori to all other his-
torical facts.
Introduction to the First Edition
xl
looking at the facts and seeing which theories are applicable. But
whether or not a theory is applicable to a given case has no rele-
vance whatever to its truth or falsity as a theory. It neither confirms
nor refutes the thesis that a decrease in the supply of zinc will, ceteris
paribus, raise the price, to find that this cut in supply actually
occurred (or did not occur) in the period we may be investigating.
The task of the economic historian, then, is to make the relevant
applications of theory from the armory provided him by the eco-
nomic theorist. The only test of a theory is the correctness of the
premises and of the logical chain of reasoning.5
The currently dominant school of economic methodologists—
the positivists—stand ready, in imitation of the physical scientists,
to use false premises provided the conclusions prove sound upon
testing. On the other hand, the institutionalists, who eternally
search for more and more facts, virtually abjure theory altogether.
Both are in error. Theory cannot emerge, phoenixlike, from a
cauldron of statistics; neither can statistics be used to test an eco-
nomic theory.
The same considerations apply when gauging the results of
political policies. Suppose a theory asserts that a certain policy will
cure a depression. The government, obedient to the theory, puts
the policy into effect. The depression is not cured. The critics and
advocates of the theory now leap to the fore with interpretations.
5This “praxeological” methodology runs counter to prevailing views.
Exposition of this approach, along with references to the literature, may be found
in Murray N. Rothbard, “In Defense of ‘Extreme A Priorism’,” Southern Economic
Journal (January, 1957): 214–20; idem, “Praxeology: Reply to Mr. Schuller,”
American Economic Review (December, 1951): 943–46; and idem, “Toward A
Reconstruction of Utility and Welfare Economics,” in Mary Sennholz, ed., On
Freedom and Free Enterprise (Princeton, N.J.: D. Van Nostrand, 1956), pp. 224–62.
The major methodological works of this school are: Ludwig von Mises, Human
Action (New Haven, Conn.: Yale University Press, 1949); Mises, Theory and
History (New Haven, Conn.: Yale University Press, 1957); F.A. Hayek, The
Counterrevolution of Science (Glencoe, Ill.: The Free Press, 1952); Lionel Robbins,
The Nature and Significance of Economic Science (London: Macmillan, 1935), Mises,
Epistemological Problems of Economics (Princeton, N.J.: D. Van Nostrand, 1960);
and Mises, The Ultimate Foundation of Economic Science (Princeton, N.J.: D. Van
Nostrand, 1962).
Introduction
xli
The critics say that failure proves the theory incorrect. The advo-
cates say that the government erred in not pursuing the theory
boldly enough, and that what is needed is stronger measures in the
same direction. Now the point is that empirically there is no possible
way of deciding between them.6 Where is the empirical “test” to
resolve the debate? How can the government rationally decide
upon its next step? Clearly, the only possible way of resolving the
issue is in the realm of pure theory—by examining the conflicting
premises and chains of reasoning.
These methodological considerations chart the course of this
book. The aim is to describe and highlight the causes of the 1929
depression in America. I do not intend to write a complete eco-
nomic history of the period, and therefore there is no need to gath-
er and collate all conceivable economic statistics. I shall only con-
centrate on the causal forces that first brought about, and then
aggravated, the depression. I hope that this analysis will be useful
to future economic historians of the 1920s and 1930s in construct-
ing their syntheses.
It is generally overlooked that study of a business cycle should
not simply be an investigation of the entire economic record of an
era. The National Bureau of Economic Research, for example,
treats the business cycle as an array of all economic activities dur-
ing a certain period. Basing itself upon this assumption (and
despite the Bureau’s scorn of a priori theorizing, this is very much
an unproven, a priori assumption), it studies the expansion—con-
traction statistics of all the time-series it can possibly accumulate.
A National Bureau inquiry into a business cycle is, then, essential-
ly a statistical history of the period. By adopting a Misesian, or
Austrian approach, rather than the typically institutionalist
methodology of the Bureau, however, the proper procedure
becomes very different. The problem now becomes one of pin-
pointing the causal factors, tracing the chains of cause and effect,
and isolating the cyclical strand from the complex economic world.
6Similarly, if the economy had recovered, the advocates would claim success
for the theory, while critics would assert that recovery came despite the baleful
influence of governmental policy, and more painfully and slowly than would oth-
erwise have been the case. How should we decide between them?
Introduction to the First Edition
xlii
As an illustration, let us take the American economy during the
1920s. This economy was, in fact, a mixture of two very different,
and basically conflicting, forces. On the one hand, America expe-
rienced a genuine prosperity, based on heavy savings and invest-
ment in highly productive capital. This great advance raised
American living standards. On the other hand, we also suffered a
credit-expansion, with resulting accumulation of malinvested capi-
tal, leading finally and inevitably to economic crisis. Here are two
great economic forces—one that most people would agree to call
“good,” and the other “bad”—each separate, but interacting to
form the final historical result. Price, production, and trade indices
are the composite effects. We may well remember the errors of
smugness and complacency that our economists, as well as finan-
cial and political leaders, committed during the great boom. Study
of these errors might even chasten our current crop of economic
soothsayers, who presume to foretell the future within a small, pre-
cise margin of error. And yet, we should not scoff unduly at the
eulogists who composed paeans to our economic system as late as
1929. For, insofar as they had in mind the first strand—the genuine
prosperity brought about by high saving and investment—they
were correct. Where they erred gravely was in overlooking the
second, sinister strand of credit expansion. This book concentrates
on the cyclical aspects of the economy of the period—if you will,
on the defective strand.
As in most historical studies, space limitations require confin-
ing oneself to a definite time period. This book deals with the peri-
od 1921–1933. The years 1921–1929 were the boom period pre-
ceding the Great Depression. Here we look for causal influences
predating 1929, the ones responsible for the onset of the depres-
sion. The years 1929–1933 composed the historic contraction
phase of the Great Depression, even by itself of unusual length and
intensity. In this period, we shall unravel the aggravating causes
that worsened and prolonged the crisis.
In any comprehensive study, of course, the 1933–1940 period
would have to be included. It is, however, a period more familiar
to us and one which has been more extensively studied.
The pre-1921 period also has some claim to our attention.
Many writers have seen the roots of the Great Depression in the
Introduction
xliii
inflation of World War I and of the post-war years, and in the
allegedly inadequate liquidation of the 1920–1921 recession.
However, sufficient liquidation does not require a monetary or
price contraction back to pre-boom levels. We will therefore begin
our treatment with the trough of the 1920–1921 cycle, in the fall
of 1921, and see briefly how credit expansion began to distort pro-
duction (and perhaps leave unsound positions unliquidated from
the preceding boom) even at that early date. Comparisons will also
be made between public policy and the relative durations of the
1920–1921 and the 1929–1933 depressions. We cannot go beyond
that in studying the earlier period, and going further is not strict-
ly necessary for our discussion.
One great spur to writing this book has been the truly remark-
able dearth of study of the 1929 depression by economists. Very
few books of substance have been specifically devoted to 1929,
from any point of view. This book attempts to fill a gap by inquir-
ing in detail into the causes of the 1929 depression from the stand-
point of correct, praxeological economic theory.7
MURRAY N. ROTHBARD
7The only really valuable studies of the 1929 depression are: Lionel Robbins,
The Great Depression (New York: Macmillan, 1934), which deals with the United
States only briefly; C.A. Phillips, T.F. McManus, and R.W. Nelson, Banking and
the Business Cycle (New York: Macmillan, 1937); and Benjamin M. Anderson,
Economics and the Public Welfare (New York: D. Van Nostrand, 1949), which does
not deal solely with the depression, but covers twentieth-century economic his-
tory. Otherwise, Thomas Wilson’s drastically overrated Fluctuations in Income and
Employment (3rd ed., New York: Pitman, 1948) provides almost the “official”
interpretation of the depression, and recently we have been confronted with John
K. Galbraith’s slick, superficial narrative of the pre-crash stock market, The Great
Crash, 1929 (Boston: Houghton Mifflin, 1955). This, aside from very brief and
unilluminating treatments by Slichter, Schumpeter, and Gordon is just about all.
There are many tangential discussions, especially of the alleged “mature econo-
my” of the later 1930s. Also see, on the depression and the Federal Reserve
System, the recent brief article of O.K. Burrell, “The Coming Crisis in External
Convertibility in U.S. Gold,” Commercial and Financial Chronicle (April 23, 1959):
5, 52–53.
Part I
Business Cycle Theory
1
The Positive
Theory of the Cycle
Study of business cycles must be based upon a satisfactory
cycle theory. Gazing at sheaves of statistics without “pre-
judgment” is futile. A cycle takes place in the economic
world, and therefore a usable cycle theory must be integrated with
general economic theory. And yet, remarkably, such integration,
even attempted integration, is the exception, not the rule. Eco-
nomics, in the last two decades, has fissured badly into a host of
airtight compartments—each sphere hardly related to the others.
Only in the theories of Schumpeter and Mises has cycle theory
been integrated into general economics.1
The bulk of cycle specialists, who spurn any systematic integra-
tion as impossibly deductive and overly simplified, are thereby
(wittingly or unwittingly) rejecting economics itself. For if one
may forge a theory of the cycle with little or no relation to gen-
eral economics, then general economics must be incorrect, failing
as it does to account for such a vital economic phenomenon. For
institutionalists—the pure data collectors—if not for others, this
is a welcome conclusion. Even institutionalists, however, must use
theory sometimes, in analysis and recommendation; in fact, they
end by using a concoction of ad hoc hunches, insights, etc.,
1Various neo-Keynesians have advanced cycle theories. They are integrated,
however, not with general economic theory, but with holistic Keynesian systems—
systems which are very partial indeed.
3
4
America’s Great Depression
plucked unsystematically from various theoretical gardens. Few, if
any, economists have realized that the Mises theory of the trade
cycle is not just another theory: that, in fact, it meshes closely with
a general theory of the economic system.2 The Mises theory is, in
fact, the economic analysis of the necessary consequences of inter-
vention in the free market by bank credit expansion. Followers of
the Misesian theory have often displayed excessive modesty in
pressing its claims; they have widely protested that the theory is
“only one of many possible explanations of business cycles,” and
that each cycle may fit a different causal theory. In this, as in so
many other realms, eclecticism is misplaced. Since the Mises the-
ory is the only one that stems from a general economic theory, it
is the only one that can provide a correct explanation. Unless we
are prepared to abandon general theory, we must reject all pro-
posed explanations that do not mesh with general economics.
BUSINESS CYCLES AND BUSINESS FLUCTUATIONS
It is important, first, to distinguish between business cycles and
ordinary business fluctuations. We live necessarily in a society of
continual and unending change, change that can never be precisely
charted in advance. People try to forecast and anticipate changes as
best they can, but such forecasting can never be reduced to an
exact science. Entrepreneurs are in the business of forecasting
changes on the market, both for conditions of demand and of sup-
ply. The more successful ones make profits pari passus with their
accuracy of judgment, while the unsuccessful forecasters fall by the
wayside. As a result, the successful entrepreneurs on the free mar-
ket will be the ones most adept at anticipating future business con-
ditions. Yet, the forecasting can never be perfect, and entrepre-
neurs will continue to differ in the success of their judgments. If
this were not so, no profits or losses would ever be made in busi-
ness.
2There is, for example, not a hint of such knowledge in Haberler’s well-
known discussion. See Gottfried Haberler, Prosperity and Depression (2nd ed.,
Geneva, Switzerland: League of Nations, 1939).
The Positive Theory of the Cycle
5
Changes, then, take place continually in all spheres of the econ-
omy. Consumer tastes shift; time preferences and consequent pro-
portions of investment and consumption change; the labor force
changes in quantity, quality, and location; natural resources are dis-
covered and others are used up; technological changes alter pro-
duction possibilities; vagaries of climate alter crops, etc. All these
changes are typical features of any economic system. In fact, we
could not truly conceive of a changeless society, in which everyone
did exactly the same things day after day, and no economic data
ever changed. And even if we could conceive of such a society, it is
doubtful whether many people would wish to bring it about.
It is, therefore, absurd to expect every business activity to be
“stabilized” as if these changes were not taking place. To stabilize
and “iron out” these fluctuations would, in effect, eradicate any
rational productive activity. To take a simple, hypothetical case,
suppose that a community is visited every seven years by the seven-
year locust. Every seven years, therefore, many people launch
preparations to deal with the locusts: produce anti-locust equip-
ment, hire trained locust specialists, etc. Obviously, every seven
years there is a “boom” in the locust-fighting industry, which, hap-
pily, is “depressed” the other six years. Would it help or harm mat-
ters if everyone decided to “stabilize” the locust-fighting industry
by insisting on producing the machinery evenly every year, only to
have it rust and become obsolete? Must people be forced to build
machines before they want them; or to hire people before they are
needed; or, conversely, to delay building machines they want—all
in the name of “stabilization”? If people desire more autos and
fewer houses than formerly, should they be forced to keep buying
houses and be prevented from buying the autos, all for the sake of
stabilization? As Dr. F.A. Harper has stated:
This sort of business fluctuation runs all through our
daily lives. There is a violent fluctuation, for instance, in
the harvest of strawberries at different times during the
year. Should we grow enough strawberries in green-
houses so as to stabilize that part of our economy
throughout the year.3
3F.A. Harper, Why Wages Rise (Irvington-on-Hudson, N.Y.: Foundation for
Economic Education, 1957), pp. 118–19.
6
America’s Great Depression
We may, therefore, expect specific business fluctuations all the
time. There is no need for any special “cycle theory” to account for
them. They are simply the results of changes in economic data and
are fully explained by economic theory. Many economists, how-
ever, attribute general business depression to “weaknesses” caused
by a “depression in building” or a “farm depression.” But declines
in specific industries can never ignite a general depression. Shifts
in data will cause increases in activity in one field, declines in
another. There is nothing here to account for a general business
depression—a phenomenon of the true “business cycle.” Suppose,
for example, that a shift in consumer tastes, and technologies,
causes a shift in demand from farm products to other goods. It is
pointless to say, as many people do, that a farm depression will
ignite a general depression, because farmers will buy less goods,
the people in industries selling to farmers will buy less, etc. This
ignores the fact that people producing the other goods now favored
by consumers will prosper; their demands will increase.
The problem of the business cycle is one of general boom and
depression; it is not a problem of exploring specific industries and
wondering what factors make each one of them relatively prosper-
ous or depressed. Some economists—such as Warren and Pearson
or Dewey and Dakin—have believed that there are no such things
as general business fluctuations—that general movements are but
the results of different cycles that take place, at different specific
time-lengths, in the various economic activities. To the extent that
such varying cycles (such as the 20-year “building cycle” or the
seven-year locust cycle) may exist, however, they are irrelevant to
a study of business cycles in general or to business depressions in
particular. What we are trying to explain are general booms and
busts in business.
In considering general movements in business, then, it is imme-
diately evident that such movements must be transmitted through
the general medium of exchange—money. Money forges the con-
necting link between all economic activities. If one price goes up
and another down, we may conclude that demand has shifted from
one industry to another; but if all prices move up or down together,
some change must have occurred in the monetary sphere. Only
The Positive Theory of the Cycle
7
changes in the demand for, and/or the supply of, money will cause
general price changes. An increase in the supply of money, the
demand for money remaining the same, will cause a fall in the pur-
chasing power of each dollar, i.e., a general rise in prices; con-
versely, a drop in the money supply will cause a general decline in
prices. On the other hand, an increase in the general demand for
money, the supply remaining given, will bring about a rise in the
purchasing power of the dollar (a general fall in prices); while a fall
in demand will lead to a general rise in prices. Changes in prices in
general, then, are determined by changes in the supply of and
demand for money. The supply of money consists of the stock of
money existing in the society. The demand for money is, in the
final analysis, the willingness of people to hold cash balances, and
this can be expressed as eagerness to acquire money in exchange,
and as eagerness to retain money in cash balance. The supply of
goods in the economy is one component in the social demand for
money; an increased supply of goods will, other things being equal,
increase the demand for money and therefore tend to lower prices.
Demand for money will tend to be lower when the purchasing
power of the money-unit is higher, for then each dollar is more
effective in cash balance. Conversely, a lower purchasing power
(higher prices) means that each dollar is less effective, and more
dollars will be needed to carry on the same work.
The purchasing power of the dollar, then, will remain constant
when the stock of, and demand for, money are in equilibrium with
each other: i.e., when people are willing to hold in their cash bal-
ances the exact amount of money in existence. If the demand for
money exceeds the stock, the purchasing power of money will rise
until the demand is no longer excessive and the market is cleared;
conversely, a demand lower than supply will lower the purchasing
power of the dollar, i.e., raise prices.
Yet, fluctuations in general business, in the “money relation,”
do not by themselves provide the clue to the mysterious business
cycle. It is true that any cycle in general business must be trans-
mitted through this money relation: the relation between the stock
of, and the demand for, money. But these changes in themselves
explain little. If the money supply increases or demand falls, for
8
America’s Great Depression
example, prices will rise; but why should this generate a “business
cycle”? Specifically, why should it bring about a depression? The
early business cycle theorists were correct in focusing their atten-
tion on the crisis and depression: for these are the phases that puzzle
and shock economists and laymen alike, and these are the phases
that most need to be explained.
THE PROBLEM: THE CLUSTER OF ERROR
The explanation of depressions, then, will not be found by
referring to specific or even general business fluctuations per se.
The main problem that a theory of depression must explain is: why
is there a sudden general cluster of business errors? This is the first
question for any cycle theory. Business activity moves along nicely
with most business firms making handsome profits. Suddenly,
without warning, conditions change and the bulk of business firms
are experiencing losses; they are suddenly revealed to have made
grievous errors in forecasting.
A general review of entrepreneurship is now in order. Entre-
preneurs are largely in the business of forecasting. They must
invest and pay costs in the present, in the expectation of recouping
a profit by sale either to consumers or to other entrepreneurs fur-
ther down in the economy’s structure of production. The better
entrepreneurs, with better judgment in forecasting consumer or
other producer demands, make profits; the inefficient entrepre-
neurs suffer losses. The market, therefore, provides a training
ground for the reward and expansion of successful, far-sighted
entrepreneurs and the weeding out of inefficient businessmen. As
a rule only some businessmen suffer losses at any one time; the
bulk either break even or earn profits. How, then, do we explain
the curious phenomenon of the crisis when almost all entrepre-
neurs suffer sudden losses? In short, how did all the country’s
astute businessmen come to make such errors together, and why
were they all suddenly revealed at this particular time? This is the
great problem of cycle theory.
It is not legitimate to reply that sudden changes in the data are
responsible. It is, after all, the business of entrepreneurs to forecast
The Positive Theory of the Cycle
9
future changes, some of which are sudden. Why did their forecasts
fail so abysmally?
Another common feature of the business cycle also calls for an
explanation. It is the well-known fact that capital-goods industries
fluctuate more widely than do the consumer-goods industries. The capi-
tal-goods industries—especially the industries supplying raw mate-
rials, construction, and equipment to other industries—expand
much further in the boom, and are hit far more severely in the
depression.
A third feature of every boom that needs explaining is the
increase in the quantity of money in the economy. Conversely,
there is generally, though not universally, a fall in the money sup-
ply during the depression.
THE EXPLANATION: BOOM AND DEPRESSION
In the purely free and unhampered market, there will be no
cluster of errors, since trained entrepreneurs will not all make
errors at the same time.4 The “boom-bust” cycle is generated by
monetary intervention in the market, specifically bank credit
expansion to business. Let us suppose an economy with a given
supply of money. Some of the money is spent in consumption; the
rest is saved and invested in a mighty structure of capital, in vari-
ous orders of production. The proportion of consumption to sav-
ing or investment is determined by people’s time preferences—the
degree to which they prefer present to future satisfactions. The less
they prefer them in the present, the lower will their time preference
4Siegfried Budge, Grundzüge der Theoretische Nationalökonomie (Jena, 1925),
quoted in Simon S. Kuznets, “Monetary Business Cycle Theory in Germany,”
Journal of Political Economy (April, 1930): 127–28.
Under conditions of free competition . . . the market is . . . dependent
upon supply and demand . . . there could [not] develop a disproportional-
ity in the production of goods, which could draw in the whole economic
system . . . such a disproportionality can arise only when, at some decisive
point, the price structure does not base itself upon the play of only free
competition, so that some arbitrary influence becomes possible.
Kuznets himself criticizes the Austrian theory from his empiricist, anti-cause
and effect-standpoint, and also erroneously considers this theory to be “static.”
10
America’s Great Depression
rate be, and the lower therefore will be the pure interest rate, which
is determined by the time preferences of the individuals in society.
A lower time-preference rate will be reflected in greater propor-
tions of investment to consumption, a lengthening of the structure
of production, and a building-up of capital. Higher time prefer-
ences, on the other hand, will be reflected in higher pure interest
rates and a lower proportion of investment to consumption. The
final market rates of interest reflect the pure interest rate plus or
minus entrepreneurial risk and purchasing power components.
Varying degrees of entrepreneurial risk bring about a structure of
interest rates instead of a single uniform one, and purchasing-
power components reflect changes in the purchasing power of the
dollar, as well as in the specific position of an entrepreneur in rela-
tion to price changes. The crucial factor, however, is the pure
interest rate. This interest rate first manifests itself in the “natural
rate” or what is generally called the going “rate of profit.” This
going rate is reflected in the interest rate on the loan market, a rate
which is determined by the going profit rate.5
Now what happens when banks print new money (whether as
bank notes or bank deposits) and lend it to business?6 The new
money pours forth on the loan market and lowers the loan rate of
interest. It looks as if the supply of saved funds for investment has
increased, for the effect is the same: the supply of funds for invest-
ment apparently increases, and the interest rate is lowered. Busi-
nessmen, in short, are misled by the bank inflation into believing
that the supply of saved funds is greater than it really is. Now,
when saved funds increase, businessmen invest in “longer
processes of production,” i.e., the capital structure is lengthened,
especially in the “higher orders” most remote from the consumer.
5This is the “pure time preference theory” of the rate of interest; it can be
found in Ludwig von Mises, Human Action (New Haven, Conn.: Yale University
Press, 1949); in Frank A. Fetter, Economic Principles (New York: Century, 1915),
and idem, “Interest Theories Old and New, ” American Economic Review (March,
1914): 68–92.
6“Banks,” for many purposes, include also savings and loan associations, and
life insurance companies, both of which create new money via credit expansion to
business. See below for further discussion of the money and banking question.
The Positive Theory of the Cycle
11
Businessmen take their newly acquired funds and bid up the prices
of capital and other producers’ goods, and this stimulates a shift of
investment from the “lower” (near the consumer) to the “higher”
orders of production (furthest from the consumer)—from con-
sumer goods to capital goods industries.7
If this were the effect of a genuine fall in time preferences and
an increase in saving, all would be well and good, and the new
lengthened structure of production could be indefinitely sustained.
But this shift is the product of bank credit expansion. Soon the new
money percolates downward from the business borrowers to the
factors of production: in wages, rents, interest. Now, unless time
preferences have changed, and there is no reason to think that they
have, people will rush to spend the higher incomes in the old con-
sumption–investment proportions. In short, people will rush to
reestablish the old proportions, and demand will shift back from
the higher to the lower orders. Capital goods industries will find
that their investments have been in error: that what they thought
profitable really fails for lack of demand by their entrepreneurial
customers. Higher orders of production have turned out to be
wasteful, and the malinvestment must be liquidated.
A favorite explanation of the crisis is that it stems from “under-
consumption”—from a failure of consumer demand for goods at
prices that could be profitable. But this runs contrary to the com-
monly known fact that it is capital goods, and not consumer goods,
industries that really suffer in a depression. The failure is one of
entrepreneurial demand for the higher order goods, and this in turn
is caused by the shift of demand back to the old proportions.
In sum, businessmen were misled by bank credit inflation to
invest too much in higher-order capital goods, which could only be
prosperously sustained through lower time preferences and greater
savings and investment; as soon as the inflation permeates to the mass
7On the structure of production, and its relation to investment and bank cred-
it, see F.A. Hayek, Prices and Production (2nd ed., London: Routledge and Kegan
Paul, 1935); Mises, Human Action; and Eugen von Böhm-Bawerk, “Positive
Theory of Capital,” in Capital and Interest (South Holland, Ill.: Libertarian Press,
1959), vol. 2.
12
America’s Great Depression
of the people, the old consumption–investment proportion is reestab-
lished, and business investments in the higher orders are seen to have
been wasteful.8 Businessmen were led to this error by the credit
expansion and its tampering with the free-market rate of interest.
The “boom,” then, is actually a period of wasteful misinvest-
ment. It is the time when errors are made, due to bank credit’s tam-
pering with the free market. The “crisis” arrives when the con-
sumers come to reestablish their desired proportions. The
“depression” is actually the process by which the economy adjusts
to the wastes and errors of the boom, and reestablishes efficient
service of consumer desires. The adjustment process consists in
rapid liquidation of the wasteful investments. Some of these will be
abandoned altogether (like the Western ghost towns constructed
in the boom of 1816–1818 and deserted during the Panic of 1819);
others will be shifted to other uses. Always the principle will be not
to mourn past errors, but to make most efficient use of the exist-
ing stock of capital. In sum, the free market tends to satisfy volun-
tarily-expressed consumer desires with maximum efficiency, and
this includes the public’s relative desires for present and future
consumption. The inflationary boom hobbles this efficiency, and
distorts the structure of production, which no longer serves con-
sumers properly. The crisis signals the end of this inflationary dis-
tortion, and the depression is the process by which the economy
returns to the efficient service of consumers. In short, and this is a
highly important point to grasp, the depression is the “recovery”
process, and the end of the depression heralds the return to nor-
mal, and to optimum efficiency. The depression, then, far from
being an evil scourge, is the necessary and beneficial return of the
economy to normal after the distortions imposed by the boom.
The boom, then, requires a “bust.”
Since it clearly takes very little time for the new money to filter
down from business to factors of production, why don’t all booms
come quickly to an end? The reason is that the banks come to the
rescue. Seeing factors bid away from them by consumer goods
8“Inflation” is here defined as an increase in the money supply not consisting of an
increase in the money metal.
The Positive Theory of the Cycle
13
industries, finding their costs rising and themselves short of funds,
the borrowing firms turn once again to the banks. If the banks
expand credit further, they can again keep the borrowers afloat. The
new money again pours into business, and they can again bid factors
away from the consumer goods industries. In short, continually
expanded bank credit can keep the borrowers one step ahead of
consumer retribution. For this, we have seen, is what the crisis and
depression are: the restoration by consumers of an efficient econ-
omy, and the ending of the distortions of the boom. Clearly, the
greater the credit expansion and the longer it lasts, the longer will
the boom last. The boom will end when bank credit expansion
finally stops. Evidently, the longer the boom goes on the more
wasteful the errors committed, and the longer and more severe will
be the necessary depression readjustment.
Thus, bank credit expansion sets into motion the business cycle
in all its phases: the inflationary boom, marked by expansion of the
money supply and by malinvestment; the crisis, which arrives when
credit expansion ceases and malinvestments become evident; and
the depression recovery, the necessary adjustment process by
which the economy returns to the most efficient ways of satisfying
consumer desires.9
What, specifically, are the essential features of the depression-
recovery phase? Wasteful projects, as we have said, must either be
abandoned or used as best they can be. Inefficient firms, buoyed up
by the artificial boom, must be liquidated or have their debts scaled
down or be turned over to their creditors. Prices of producers’
goods must fall, particularly in the higher orders of production—
this includes capital goods, lands, and wage rates. Just as the boom
was marked by a fall in the rate of interest, i.e., of price differentials
between stages of production (the “natural rate” or going rate of
9This “Austrian” cycle theory settles the ancient economic controversy on
whether or not changes in the quantity of money can affect the rate of interest. It
supports the “modern” doctrine that an increase in the quantity of money lowers
the rate of interest (if it first enters the loan market); on the other hand, it supports
the classical view that, in the long run, quantity of money does not affect the inter-
est rate (or can only do so if time preferences change). In fact, the depression-read-
justment is the market’s return to the desired free-market rate of interest.
14
America’s Great Depression
profit) as well as the loan rate, so the depression-recovery consists
of a rise in this interest differential. In practice, this means a fall in
the prices of the higher-order goods relative to prices in the con-
sumer goods industries. Not only prices of particular machines
must fall, but also the prices of whole aggregates of capital, e.g.,
stock market and real estate values. In fact, these values must fall
more than the earnings from the assets, through reflecting the
general rise in the rate of interest return.
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 attend-
ing 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 artifi-
cially 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 unem-
ployment be.
SECONDARY FEATURES OF DEPRESSION:
DEFLATIONARY CREDIT CONTRACTION
The above are the essential features of a depression. Other sec-
ondary features may also develop. There is no need, for example,
for deflation (lowering of the money supply) during a depression.
The depression phase begins with the end of inflation, and can
proceed without any further changes from the side of money.
Deflation has almost always set in, however. In the first place, the
inflation took place as an expansion of bank credit; now, the finan-
cial difficulties and bankruptcies among borrowers cause banks to
pull in their horns and contract credit.10 Under the gold standard,
10It is often maintained that since business firms can find few profitable
opportunities in a depression, business demand for loans falls off, and hence loans
The Positive Theory of the Cycle
15
banks have another reason for contracting credit—if they had
ended inflation because of a gold drain to foreign countries. The
threat of this drain forces them to contract their outstanding loans.
Furthermore the rash of business failures may cause questions to
be raised about the banks; and banks, being inherently bankrupt
anyway, can ill afford such questions.11 Hence, the money supply
will contract because of actual bank runs, and because banks will
tighten their position in fear of such runs.
Another common secondary feature of depressions is an increase
in the demand for money. This “scramble for liquidity” is the result
of several factors: (1) people expect falling prices, due to the
depression and deflation, and will therefore hold more money and
spend less on goods, awaiting the price fall; (2) borrowers will try
to pay off their debts, now being called by banks and by business
creditors, by liquidating other assets in exchange for money; (3)
the rash of business losses and bankruptcies makes businessmen
cautious about investing until the liquidation process is over.
With the supply of money falling, and the demand for money
increasing, generally falling prices are a consequent feature of most
and money supply will contract. But this argument overlooks the fact that the
banks, if they want to, can purchase securities, and thereby sustain the money
supply by increasing their investments to compensate for dwindling loans.
Contractionist pressure therefore always stems from banks and not from business
borrowers.
11Banks are “inherently bankrupt” because they issue far more warehouse
receipts to cash (nowadays in the form of “deposits” redeemable in cash on
demand) than they have cash available. Hence, they are always vulnerable to bank
runs. These runs are not like any other business failures, because they simply con-
sist of depositors claiming their own rightful property, which the banks do not
have. “Inherent bankruptcy,” then, is an essential feature of any “fractional
reserve” banking system. As Frank Graham stated:
The attempt of the banks to realize the inconsistent aims of lending cash,
or merely multiplied claims to cash, and still to represent that cash is avail-
able on demand is even more preposterous than . . . eating one’s cake and
counting on it for future consumption. . . . The alleged convertibility is a
delusion dependent upon the right’s not being unduly exercised.
Frank D. Graham, “Partial Reserve Money and the 100% Proposal,”
American Economic Review (September, 1936): 436.
16
America’s Great Depression
depressions. A general price fall, however, is caused by the second-
ary, rather than by the inherent, features of depressions. Almost all
economists, even those who see that the depression adjustment
process should be permitted to function unhampered, take a very
gloomy view of the secondary deflation and price fall, and assert
that they unnecessarily aggravate the severity of depressions. This
view, however, is incorrect. These processes not only do not aggra-
vate the depression, they have positively beneficial effects.
There is, for example, no warrant whatever for the common
hostility toward “hoarding.” There is no criterion, first of all, to
define “hoarding”; the charge inevitably boils down to mean that
A thinks that B is keeping more cash balances than A deems
appropriate for B. Certainly there is no objective criterion to
decide when an increase in cash balance becomes a “hoard.” Sec-
ond, we have seen that the demand for money increases as a result
of certain needs and values of the people; in a depression, fears of
business liquidation and expectations of price declines particularly
spur this rise. By what standards can these valuations be called
“illegitimate”? A general price fall is the way that an increase in the
demand for money can be satisfied; for lower prices mean that the
same total cash balances have greater effectiveness, greater “real”
command over goods and services. In short, the desire for
increased real cash balances has now been satisfied.
Furthermore, the demand for money will decline again as soon
as the liquidation and adjustment processes are finished. For the
completion of liquidation removes the uncertainties of impending
bankruptcy and ends the borrowers’ scramble for cash. A rapid
unhampered fall in prices, both in general (adjusting to the
changed money-relation), and particularly in goods of higher
orders (adjusting to the malinvestments of the boom) will speedily
end the realignment processes and remove expectations of further
declines. Thus, the sooner the various adjustments, primary and
secondary, are carried out, the sooner will the demand for money
fall once again. This, of course, is just one part of the general eco-
nomic “return to normal.”
Neither does the increased “hoarding” nor the fall of prices at all
interfere with the primary depression-adjustment. The important
The Positive Theory of the Cycle
17
feature of the primary adjustment is that the prices of producers’
goods fall more rapidly than do consumer good prices (or, more
accurately, that higher order prices fall more rapidly than do those of
lower order goods); it does not interfere with the primary adjust-
ment if all prices are falling to some degree. It is, moreover, a com-
mon myth among laymen and economists alike, that falling prices
have a depressing effect on business. This is not necessarily true.
What matters for business is not the general behavior of prices, but
the price differentials between selling prices and costs (the “natural
rate of interest”). If wage rates, for example, fall more rapidly than
product prices, this stimulates business activity and employment.
Deflation of the money supply (via credit contraction) has fared
as badly as hoarding in the eyes of economists. Even the Misesian
theorists deplore deflation and have seen no benefits accruing from
it.12 Yet, deflationary credit contraction greatly helps to speed up
the adjustment process, and hence the completion of business
recovery, in ways as yet unrecognized. The adjustment consists, as
we know, of a return to the desired consumption-saving pattern.
Less adjustment is needed, however, if time preferences themselves
change: i.e., if savings increase and consumption relatively declines.
In short, what can help a depression is not more consumption, but,
on the contrary, less consumption and more savings (and, con-
comitantly, more investment). Falling prices encourage greater
savings and decreased consumption by fostering an accounting
illusion. Business accounting records the value of assets at their
original cost. It is well known that general price increases distort
the accounting-record: what seems to be a large “profit” may only
be just sufficient to replace the now higher-priced assets. During
an inflation, therefore, business “profits” are greatly overstated,
and consumption is greater than it would be if the accounting illu-
sion were not operating—perhaps capital is even consumed without
the individual’s knowledge. In a time of deflation, the accounting
illusion is reversed: what seem like losses and capital consumption,
12In a gold standard country (such as America during the 1929 depression),
Austrian economists accepted credit contraction as a perhaps necessary price to
pay for remaining on gold. But few saw any remedial virtues in the deflation
process itself.
18
America’s Great Depression
may actually mean profits for the firm, since assets now cost much
less to be replaced. This overstatement of losses, however, restricts
consumption and encourages saving; a man may merely think he is
replacing capital, when he is actually making an added investment
in the business.
Credit contraction will have another beneficial effect in pro-
moting recovery. For bank credit expansion, we have seen, distorts
the free market by lowering price differentials (the “natural rate of
interest” or going rate of profit) on the market. Credit contraction,
on the other hand, distorts the free market in the reverse direction.
Deflationary credit contraction’s first effect is to lower the money
supply in the hands of business, particularly in the higher stages of
production. This reduces the demand for factors in the higher
stages, lowers factor prices and incomes, and increases price dif-
ferentials and the interest rate. It spurs the shift of factors, in short,
from the higher to the lower stages. But this means that credit con-
traction, when it follows upon credit expansion, speeds the mar-
ket’s adjustment process. Credit contraction returns the economy
to free-market proportions much sooner than otherwise.
But, it may be objected, may not credit contraction overcom-
pensate the errors of the boom and itself cause distortions that
need correction? It is true that credit contraction may overcom-
pensate, and, while contraction proceeds, it may cause interest rates
to be higher than free-market levels, and investment lower than in
the free market. But since contraction causes no positive mal-
investments, it will not lead to any painful period of depression and
adjustment. If businessmen are misled into thinking that less capi-
tal is available for investment than is really the case, no lasting dam-
age in the form of wasted investments will ensue.13 Furthermore, in
13Some readers may ask: why doesn’t credit contraction lead to malinvest-
ment, by causing overinvestment in lower-order goods and underinvestment in
higher-order goods, thus reversing the consequences of credit expansion? The
answer stems from the Austrian analysis of the structure of production. There is
no arbitrary choice of investing in lower or higher-order goods. Any increased
investment must be made in the higher-order goods, must lengthen the structure
of production. A decreased amount of investment in the economy simply reduces
higher-order capital. Thus, credit contraction will cause not excess of investment
The Positive Theory of the Cycle
19
the nature of things, credit contraction is severely limited—it can-
not progress beyond the extent of the preceding inflation.14 Credit
expansion faces no such limit.
GOVERNMENT DEPRESSION POLICY: LAISSEZ-FAIRE
If government wishes to see a depression ended as quickly as pos-
sible, and the economy returned to normal prosperity, what course
should it adopt? The first and clearest injunction is: don’t interfere with
the market’s adjustment process. The more the government intervenes
to delay the market’s adjustment, the longer and more grueling the
depression will be, and the more difficult will be the road to com-
plete recovery. Government hampering aggravates and perpetu-
ates the depression. Yet, government depression policy has always
(and would have even more today) aggravated the very evils it has
loudly tried to cure. If, in fact, we list logically the various ways
that government could hamper market adjustment, we will find
that we have precisely listed the favorite “anti-depression” arsenal
of government policy. Thus, here are the ways the adjustment
process can be hobbled:
(1) Prevent or delay liquidation. Lend money to shaky businesses,
call on banks to lend further, etc.
(2) Inflate further. Further inflation blocks the necessary fall in
prices, thus delaying adjustment and prolonging depression. Fur-
ther credit expansion creates more malinvestments, which, in their
turn, will have to be liquidated in some later depression. A gov-
ernment “easy money” policy prevents the market’s return to the
necessary higher interest rates.
(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
in the lower orders, but simply a shorter structure than would otherwise have
been established.
14In a gold standard economy, credit contraction is limited by the total size of
the gold stock.
20
America’s Great Depression
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.
(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 invest-
ment 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.15 Any
increase in the relative size of government in the economy, there-
fore, shifts the societal consumption–investment ratio in favor of
consumption, and prolongs the depression.
(6) Subsidize unemployment. Any subsidization of unemployment
(via unemployment “insurance,” relief, etc.) will prolong unem-
ployment indefinitely, and delay the shift of workers to the fields
where jobs are available.
15In recent years, particularly in the literature on the “under-developed coun-
tries,” there has been a great deal of discussion of government “investment.”
There can be no such investment, however. “Investment” is defined as expendi-
tures made not for the direct satisfaction of those who make it, but for other, ulti-
mate consumers. Machines are produced not to serve the entrepreneur, but to
serve the ultimate consumers, who in turn remunerate the entrepreneurs. But
government acquires its funds by seizing them from private individuals; the
spending of the funds, therefore, gratifies the desires of government officials.
Government officials have forcibly shifted production from satisfying private
consumers to satisfying themselves; their spending is therefore pure consumption
and can by no stretch of the term be called “investment.” (Of course, to the extent
that government officials do not realize this, their “consumption” is really waste-
spending.)
The Positive Theory of the Cycle
21
These, then, are the measures which will delay the recovery
process and aggravate the depression. Yet, they are the time-hon-
ored favorites of government policy, and, as we shall see, they were
the policies adopted in the 1929–1933 depression, by a govern-
ment known to many historians as a “laissez-faire” administration.
Since deflation also speeds recovery, the government should
encourage, rather than interfere with, a credit contraction. In a
gold-standard economy, such as we had in 1929, blocking deflation
has further unfortunate consequences. For a deflation increases the
reserve ratios of the banking system, and generates more confi-
dence in citizen and foreigner alike that the gold standard will be
retained. Fear for the gold standard will precipitate the very bank
runs that the government is anxious to avoid. There are other val-
ues in deflation, even in bank runs, which should not be over-
looked. Banks should no more be exempt from paying their obli-
gations than is any other business. Any interference with their
comeuppance via bank runs will establish banks as a specially priv-
ileged group, not obligated to pay their debts, and will lead to later
inflations, credit expansions, and depressions. And if, as we con-
tend, banks are inherently bankrupt and “runs” simply reveal that
bankruptcy, it is beneficial for the economy for the banking system
to be reformed, once and for all, by a thorough purge of the frac-
tional-reserve banking system. Such a purge would bring home
forcefully to the public the dangers of fractional-reserve banking,
and, more than any academic theorizing, insure against such bank-
ing evils in the future.16
The most important canon of sound government policy in a
depression, then, is to keep itself from interfering in the adjust-
ment process. Can it do anything more positive to aid the adjust-
ment? Some economists have advocated a government-decreed
wage cut to spur employment, e.g., a 10 percent across-the-board
reduction. But free-market adjustment is the reverse of any
“across-the-board” policy. Not all wages need to be cut; the degree
of required adjustments of prices and wages differs from case to
16For more on the problems of fractional-reserve banking, see below.
22
America’s Great Depression
case, and can only be determined on the processes of the free and
unhampered market.17 Government intervention can only distort
the market further.
There is one thing the government can do positively, however:
it can drastically lower its relative role in the economy, slashing its
own expenditures and taxes, particularly taxes that interfere with sav-
ing and investment. Reducing its tax-spending level will automati-
cally shift the societal saving-investment–consumption ratio in favor
of saving and investment, thus greatly lowering the time required for
returning to a prosperous economy.18 Reducing taxes that bear most
heavily on savings and investment will further lower social time pref-
erences.19 Furthermore, depression is a time of economic strain.
Any reduction of taxes, or of any regulations interfering with the
free market, will stimulate healthy economic activity; any increase
in taxes or other intervention will depress the economy further.
In sum, the proper governmental policy in a depression is strict
laissez-faire, including stringent budget slashing, and coupled per-
haps with positive encouragement for credit contraction. For
17See W.H. Hutt, “The Significance of Price Flexibility,” in Henry Hazlitt,
ed., The Critics of Keynesian Economics (Princeton, N.J.: D. Van Nostrand, 1960),
pp. 390–92.
18I am indebted to Mr. Rae C. Heiple, II, for pointing this out to me.
19Could government increase the investment–consumption ratio by raising
taxes in any way? It could not tax only consumption even if it tried; it can be shown
(and Prof. Harry Gunnison Brown has gone a long way to show) that any osten-
sible tax on “consumption” becomes, on the market, a tax on incomes, hurting
saving as well as consumption. If we assume that the poor consume a greater pro-
portion of their income than the rich, we might say that a tax on the poor used to
subsidize the rich will raise the saving–consumption ratio and thereby help cure
a depression. On the other hand, the poor do not necessarily have higher time
preferences than the rich, and the rich might well treat government subsidies as
special windfalls to be consumed. Furthermore, Harold Lubell has maintained
that the effects of a change in income distribution on social consumption would be
negligible, even though the absolute proportion of consumption is greater among
the poor. See Harry Gunnison Brown, “The Incidence of a General Output or a
General Sales Tax,” Journal of Political Economy (April, 1939): 254–62; Harold
Lubell, “Effects of Redistribution of Income on Consumers’ Expenditures,”
American Economic Review (March, 1947): 157–70.
The Positive Theory of the Cycle
23
decades such a program has been labelled “ignorant,” “reac-
tionary,” or “Neanderthal” by conventional economists. On the
contrary, it is the policy clearly dictated by economic science to
those who wish to end the depression as quickly and as cleanly as
possible.20
It might be objected that depression only began when credit
expansion ceased. Why shouldn’t the government continue credit
expansion indefinitely? In the first place, the longer the inflation-
ary boom continues, the more painful and severe will be the nec-
essary adjustment process, Second, the boom cannot continue
indefinitely, because eventually the public awakens to the govern-
mental policy of permanent inflation, and flees from money into
goods, making its purchases while the dollar is worth more than it
will be in future. The result will be a “runaway” or hyperinflation, so
familiar to history, and particularly to the modern world.21 Hyper-
inflation, on any count, is far worse than any depression: it destroys
the currency—the lifeblood of the economy; it ruins and shatters
the middle class and all “fixed income groups”; it wreaks havoc
unbounded. And furthermore, it leads finally to unemployment and
lower living standards, since there is little point in working when
earned income depreciates by the hour. More time is spent hunting
goods to buy. To avoid such a calamity, then, credit expansion must
stop sometime, and this will bring a depression into being.
PREVENTING DEPRESSIONS
Preventing a depression is clearly better than having to suffer it.
If the government’s proper policy during a depression is laissez-
faire, what should it do to prevent a depression from beginning?
20Advocacy of any governmental policy must rest, in the final analysis, on a
system of ethical principles. We do not attempt to discuss ethics in this book.
Those who wish to prolong a depression, for whatever reason, will, of course,
enthusiastically support these government interventions, as will those whose
prime aim is the accretion of power in the hands of the state.
21For the classic treatment of hyperinflation, see Costantino Bresciani–
Turroni, The Economics of Inflation (London: George Allen and Unwin, 1937).
24
America’s Great Depression
Obviously, since credit expansion necessarily sows the seeds of
later depression, the proper course for the government is to stop
any inflationary credit expansion from getting under way. This is
not a very difficult injunction, for government’s most important
task is to keep itself from generating inflation. For government is an
inherently inflationary institution, and consequently has almost
always triggered, encouraged, and directed the inflationary boom.
Government is inherently inflationary because it has, over the cen-
turies, acquired control over the monetary system. Having the
power to print money (including the “printing” of bank deposits)
gives it the power to tap a ready source of revenue. Inflation is a
form of taxation, since the government can create new money out
of thin air and use it to bid away resources from private individu-
als, who are barred by heavy penalty from similar “counterfeiting.”
Inflation therefore makes a pleasant substitute for taxation for the
government officials and their favored groups, and it is a subtle
substitute which the general public can easily—and can be encour-
aged to—overlook. The government can also pin the blame for the
rising prices, which are the inevitable consequence of inflation,
upon the general public or some disliked segments of the public,
e.g., business, speculators, foreigners. Only the unlikely adoption
of sound economic doctrine could lead the public to pin the
responsibility where it belongs: on the government itself.
Private banks, it is true, can themselves inflate the money sup-
ply by issuing more claims to standard money (whether gold or
government paper) than they could possibly redeem. A bank
deposit is equivalent to a warehouse receipt for cash, a receipt
which the bank pledges to redeem at any time the customer wishes
to take his money out of the bank’s vaults. The whole system of
“fractional-reserve banking” involves the issuance of receipts
which cannot possibly be redeemed. But Mises has shown that, by
themselves, private banks could not inflate the money supply by a
great deal.22 In the first place, each bank would find its newly
22See Mises, Human Action, pp. 429–45, and Theory of Money and Credit (New
Haven, Conn.: Yale University Press, 1953).
The Positive Theory of the Cycle
25
issued uncovered, or “pseudo,” receipts (uncovered by cash) soon
transferred to the clients of other banks, who would call on the
bank for redemption. The narrower the clientele of each bank,
then, the less scope for its issue of pseudo-receipts. All the banks
could join together and agree to expand at the same rate, but such
agreement would be difficult to achieve. Second, the banks would
be limited by the degree to which the public used bank deposits or
notes as against standard cash; and third, they would be limited by
the confidence of the clients in their banks, which could be
wrecked by runs at any time.
Instead of preventing inflation by prohibiting fractional-reserve
banking as fraudulent, governments have uniformly moved in the
opposite direction, and have step-by-step removed these free-mar-
ket checks to bank credit expansion, at the same time putting
themselves in a position to direct the inflation. In various ways,
they have artificially bolstered public confidence in the banks,
encouraged public use of paper and deposits instead of gold (finally
outlawing gold), and shepherded all the banks under one roof so
that they can all expand together. The main device for accom-
plishing these aims has been Central Banking, an institution which
America finally acquired as the Federal Reserve System in 1913.
Central Banking permitted the centralization and absorption of
gold into government vaults, greatly enlarging the national base
for credit expansion:23 it also insured uniform action by the banks
through basing their reserves on deposit accounts at the Central
Bank instead of on gold. Upon establishment of a Central Bank,
each private bank no longer gauges its policy according to its par-
ticular gold reserve; all banks are now tied together and regulated
by Central Bank action. The Central Bank, furthermore, by pro-
claiming its function to be a “lender of last resort” to banks in trou-
ble, enormously increases public confidence in the banking system.
23When gold—formerly the banks’ reserves—is transferred to a newly estab-
lished Central Bank, the latter keeps only a fractional reserve, and thus the total
credit base and potential monetary supply are enlarged. See C.A. Phillips, T.F.
McManus, and R.W. Nelson, Banking and the Business Cycle (New York:
Macmillan, 1937), pp. 24ff.
26
America’s Great Depression
For it is tacitly assumed by everyone that the government would
never permit its own organ—the Central Bank—to fail. A Central
Bank, even when on the gold standard, has little need to worry
about demands for gold from its own citizens. Only possible drains
of gold to foreign countries (i.e., by non-clients of the Central
Bank) may cause worry.
The government assured Federal Reserve control over the
banks by (1) granting to the Federal Reserve System (FRS) a
monopoly over note issue; (2) compelling all the existing “national
banks” to join the Federal Reserve System, and to keep all their
legal reserves as deposits at the Federal Reserve24; and (3) fixing
the minimum reserve ratio of deposits at the Reserve to bank
deposits (money owned by the public). The establishment of the
FRS was furthermore inflationary in directly reducing existing
reserve-ratio requirements.25 The Reserve could then control the
volume of money by governing two things: the volume of bank
reserves, and the legal reserve requirements. The Reserve can gov-
ern the volume of bank reserves (in ways which will be explained
below), and the government sets the legal ratio, but admittedly
control over the money supply is not perfect, as banks can keep
“excess reserves.” Normally, however, reassured by the existence of
a lender of last resort, and making profits by maximizing its assets
and deposits, a bank will keep fully “loaned up” to its legal ratio.
While unregulated private banking would be checked within
narrow limits and would be far less inflationary than Central Bank
24Many “state banks” were induced to join the FRS by patriotic appeals and
offers of free services. Even the banks that did not join, however, are effectively
controlled by the System, for, in order to obtain paper money, they must keep
reserves in some member bank.
25The average reserve requirements of all banks before 1913 was estimated at
approximately 21 percent. By mid-1917, when the FRS had fully taken shape, the
average required ratio was 10 percent. Phillips et al. estimate that the inherent
inflationary impact of the FRS (pointed out in footnote 23) increased the expan-
sive power of the banking system three-fold. Thus, the two factors (the inherent
impact, and the deliberate lowering of reserve requirements) combined to inflate
the monetary potential of the American banking system six-fold as a result of the
inauguration of the FRS. See Phillips, et al., Banking and the Business Cycle, pp. 23ff.
The Positive Theory of the Cycle
27
manipulation,26 the clearest way of preventing inflation is to out-
law fractional-reserve banking, and to impose a 100 percent gold
reserve to all notes and deposits. Bank cartels, for example, are not
very likely under unregulated, or “free” banking, but they could
nevertheless occur. Professor Mises, while recognizing the supe-
rior economic merits of 100 percent gold money to free banking,
prefers the latter because 100 percent reserves would concede to
the government control over banking, and government could eas-
ily change these requirements to conform to its inflationist bias.27
But a 100 percent gold reserve requirement would not be just
another administrative control by government; it would be part
and parcel of the general libertarian legal prohibition against
fraud. Everyone except absolute pacifists concedes that violence
against person and property should be outlawed, and that agencies,
operating under this general law, should defend person and prop-
erty against attack. Libertarians, advocates of laissez-faire, believe
that “governments” should confine themselves to being defense
agencies only. Fraud is equivalent to theft, for fraud is committed
when one part of an exchange contract is deliberately not fulfilled
after the other’s property has been taken. Banks that issue receipts
to non-existent gold are really committing fraud, because it is then
impossible for all property owners (of claims to gold) to claim their
rightful property. Therefore, prohibition of such practices would
not be an act of government intervention in the free market; it
would be part of the general legal defense of property against attack
which a free market requires.28, 29
26The horrors of “wildcat banking” in America before the Civil War stemmed
from two factors, both due to government rather than free banking: (1) Since the
beginnings of banking, in 1814 and then in every ensuing panic, state govern-
ments permitted banks to continue operating, making and calling loans, etc. with-
out having to redeem in specie. In short, banks were privileged to operate with-
out paying their obligations. (2) Prohibitions on interstate branch banking (which
still exist), coupled with poor transportation, prevented banks from promptly call-
ing on distant banks for redemption of notes.
27Mises, Human Action, p. 440.
28A common analogy states that banks simply count on people not redeeming
all their property at once, and that engineers who build bridges operate also on
28
America’s Great Depression
What, then, was the proper government policy during the
1920s? What should government have done to prevent the crash?
Its best policy would have been to liquidate the Federal Reserve
System, and to erect a 100 percent gold reserve money; failing
that, it should have liquidated the FRS and left private banks
unregulated, but subject to prompt, rigorous bankruptcy upon fail-
ure to redeem their notes and deposits. Failing these drastic meas-
ures, and given the existence of the Federal Reserve System, what
should its policy have been? The government should have exer-
cised full vigilance in not supporting or permitting any inflation-
ary credit expansion. We have seen that the Fed—the Federal
Reserve System—does not have complete control over money
because it cannot force banks to lend up to their reserves; but it
does have absolute anti-inflationary control over the banking sys-
tem. For it does have the power to reduce bank reserves at will, and
thereby force the banks to cease inflating, or even to contract if
necessary. By lowering the volume of bank reserves and/or raising
reserve requirements, the federal government, in the 1920s as well
as today, has had the absolute power to prevent any increase in the
total volume of money and credit. It is true that the FRS has no
direct control over such money creators as savings banks, savings
and loan associations, and life insurance companies, but any credit
the principle that not everyone in a city will wish to cross the bridge at once. But
the cases are entirely different. The people crossing a bridge are simply request-
ing a service; they are not trying to take possession of their lawful property, as are the
bank depositors. A more fitting analogy would defend embezzlers who would
never have been caught if someone hadn’t fortuitously inspected the books. The
crime comes when the theft or fraud is committed, not when it is finally revealed.
29Perhaps a libertarian legal system would consider “general deposit war-
rants” (which allow a warehouse to return any homogeneous good to the depos-
itor) as “specific deposit warrants,” which, like bills of lading, pawn tickets, dock-
warrants, etc. establish ownership to specific, earmarked objects. As Jevons stat-
ed, “It used to be held as a general rule of law, that any present grant or assign-
ment of goods not in existence is without operation.” See W. Stanley Jevons,
Money and the Mechanism of Exchange (London: Kegan Paul, 1905), pp. 207–12.
For an excellent discussion of the problems of a fractional-reserve money, see
Amasa Walker, The Science of Wealth (3rd ed., Boston: Little, Brown, 1867), pp.
126–32, esp. pp. 139–41.
The Positive Theory of the Cycle
29
expansion from these sources could be offset by deflationary pres-
sure upon the commercial banks. This is especially true because
commercial bank deposits (1) form the monetary base for the
credit extended by the other financial institutions, and (2) are the
most actively circulating part of the money supply. Given the Fed-
eral Reserve System and its absolute power over the nation’s
money, the federal government, since 1913, must bear the com-
plete responsibility for any inflation. The banks cannot inflate on
their own; any credit expansion can only take place with the sup-
port and acquiescence of the federal government and its Federal
Reserve authorities. The banks are virtual pawns of the govern-
ment, and have been since 1913. Any guilt for credit expansion and
the consequent depression must be borne by the federal govern-
ment and by it alone.30
PROBLEMS IN THE AUSTRIAN THEORY
OF THE TRADE CYCLE
The “Assumption” of Full Employment
Before proceeding to discuss alternative business cycle theories,
several problems and time-honored misconceptions should be
cleared up. Two standard misconceptions have already been
refuted by Professor Mises: (1) that the Austrian theory “assumes”
the previous existence of “full employment,” and therefore does
not apply if the credit expansion begins while there are unem-
ployed factors, and (2) that the theory describes the boom as a
period of “overinvestment.” On the first point, the unemployed fac-
tors can either be labor or capital-goods. (There will always be
unemployed, submarginal, land available.) Inflation will only put
unemployed labor factors to work if their owners, though otherwise
30Some writers make a great to-do over the legal fiction that the Federal
Reserve System is “owned” by its member banks. In practice, this simply means
that these banks are taxed to help pay for the support of the Federal Reserve. If
the private banks really “own” the Fed, then how can its officials be appointed by
the government, and the “owners” compelled to “own” the Federal Reserve
Board by force of government statute? The Federal Reserve Banks should simply
be regarded as governmental agencies.
30
America’s Great Depression
holding out for a higher real wage than the free market can pro-
vide, stupidly settle for a lower real wage if it is camouflaged in the
form of a rise in the cost of living. As for idle capital goods, these
may have been totally and hopelessly malinvested in a previous
boom (or at some other time) and hopelessly lost to profitable pro-
duction for a long time or forever. A credit expansion may appear
to render submarginal capital profitable once more, but this too
will be malinvestment, and the now greater error will be exposed
when this boom is over. Thus, credit expansion generates the busi-
ness cycle regardless of the existence of unemployed factors.
Credit expansion in the midst of unemployment will create more
distortions and malinvestments, delay recovery from the preceding
boom, and make a more grueling recovery necessary in the future.
While it is true that the unemployed factors are not now diverted
from more valuable uses as employed factors would be (since they
were speculatively idle or malinvested instead of employed), the
other complementary factors will be diverted into working with
them, and these factors will be malinvested and wasted. Moreover,
all the other distorting effects of credit expansion will still follow,
and a depression will be necessary to correct the new distortion.31
“Overinvestment” or Malinvestment?
The second misconception, given currency by Haberler in his
famous Prosperity and Depression, calls the Misesian picture of the
boom an “overinvestment” theory.32 Mises has brilliantly shown
the error of this label. As Mises points out:
[A]dditional investment is only possible to the extent
that there is an additional supply of capital goods avail-
able. . . . The boom itself does not result in a restriction
but rather in an increase in consumption, it does not
31See Mises, Human Action, pp. 576–78. Professor Hayek, in his well-known
(and excellent) exposition of the Austrian theory, had early shown how the theo-
ry fully applies to credit expansion amidst unemployed factors. Hayek, Prices and
Production, pp. 96–99.
32Haberler, Prosperity and Depression, chap. 3.
The Positive Theory of the Cycle
31
procure more capital goods for new investment. The
essence of the credit-expansion boom is not overinvest-
ment, but investment in wrong lines, i.e., malinvestment
. . . on a scale for which the capital goods available do
not suffice. Their projects are unrealizable on account
of the insufficient supply of capital goods. . . . The
unavoidable end of the credit expansion makes the faults
committed visible. There are plants which cannot be
utilized because the plants needed for the production of
the complementary factors of production are lacking;
plants the products of which cannot be sold because the
consumers are more intent upon purchasing other
goods which, however, are not produced in sufficient
quantities.
The observer notices only the malinvestments which are
visible and fails to recognize that these establishments
are malinvestments only because of the fact that other
plants—those required for the production of the com-
plementary factors of productions and those required
for the production of consumers’ goods more urgently
demanded by the public—are lacking. . . . The whole
entrepreneurial class is, as it were, in the position of a
master-builder [who] . . . overestimates the quantity of
the available supply [of materials] . . . oversizes the
groundwork . . . and only discovers later . . . that he lacks
the material needed for the completion of the structure.
It is obvious that our master-builder’s fault was not over-
investment, but an inappropriate [investment].33
Some critics have insisted that if the boom goes on long
enough, these processes might finally be “completed.” But this
takes the metaphor too literally. The point is that credit expansion
distorts investment by directing too much of the available capital
into the higher orders of production, leaving too little for lower
33Mises, Human Action, pp. 556–57. Mises also refutes the old notion that the
boom is characterized by an undue conversion of “circulating capital” into “fixed
capital.” If that were true, then the crisis would reveal a shortage of circulating
capital, and would greatly drive up the prices of, e.g., industrial raw materials. Yet,
these materials are precisely among the ones revealed by the crisis to be over-
abundant, i.e., resources were malinvested in “circulating” as well as in “fixed”
capital in the higher stages of production.
32
America’s Great Depression
orders. The unhampered market assures that a complementary
structure of capital is harmoniously developed; bank credit expan-
sion hobbles the market and destroys the processes that bring
about a balanced structure.34 The longer the boom goes on, the
greater the extent of the distortions and malinvestments.
Banks: Active or Passive?
During the early 1930s, there was a great deal of interest, in the
United States and Great Britain, in Mises’s theory of the trade
cycle, an interest unfortunately nipped in the bud by the excite-
ment surrounding the “Keynesian Revolution.” The adherents had
split on an important question: Mises asserting that the cycle is
always generated by the interventionary banking system and his
followers claiming that often banks might only err in being passive
and not raising their interest charges quickly enough.35 The fol-
lowers held that for one reason or another the “natural rate” of
interest might rise, and that the banks, which after all are not
omniscient, may inadvertently cause the cycle by merely maintain-
ing their old interest rate, now below the free-market rate.
In defense of the Mises “anti-bank” position, we must first
point out that the natural interest rate or “profit rate” does not
suddenly increase because of vague improvements in “investment
opportunities.” The natural rate increases because time prefer-
ences increase.36 But how can banks force market interest rates
34For a stimulating discussion of some of these processes, see Ludwig M.
Lachmann, Capital and Its Structure (London: London School of Economics,
1956).
35For the “pro-bank” position on this issue, see F.A. Hayek, Monetary Theory
and the Trade Cycle (New York: Harcourt, Brace, 1933), pp. 144–48; Fritz
Machlup, Stock Market, Credit, and Capital Formation (New York: Macmillan,
1940), pp. 247–48; Haberler, Prosperity and Depression, pp. 64–67. On the other
side, see the brief comments of Mises, Human Action, pp. 570, 789n.; and Phillips
et al., Banking and the Business Cycle, pp. 139ff.
36The error of the followers stems from their failure to adopt the pure time-
preference theory of interest of Fetter and Mises, and their clinging to eclectic
“productivity” elements in their explanation of interest. See the references men-
tioned in footnote 5 above.
The Positive Theory of the Cycle
33
below the free-market rates? Only by expanding their credit! To
avoid the business cycle, then, it is not necessary for the banks to
be omniscient; they need only refrain from credit expansion. If
they do so, their loans made out of their own capital will not
expand the money supply but will simply take their place with
other savings as one of the determinants of the free-market inter-
est rate.37
Hayek believes that Mises’s theory is somehow deficient
because it is exogenous—because it holds that the generation of
business cycles stems from interventionary acts rather than from
acts of the market itself. This argument is difficult to fathom.
Processes are either analyzed correctly or incorrectly; the only test
of any analysis is its truth, not whether it is exogenous or endoge-
nous. If the process is really exogenous, then the analysis should
reveal this fact; the same holds true for endogenous processes. No
particular virtue attaches to a theory because it is one or the other.
Recurrence of Cycles
Another common criticism asserts that Mises’s theory may
explain any one prosperity–depression cycle, but it fails to explain
another familiar phenomenon of business cycles—their perpetual
recurrence. Why does one cycle begin as the previous one ends?
Yet Mises’s theory does explain recurrence, and without requiring
us to adopt the familiar but unproven hypothesis that cycles are
“self-generating,”—that some mysterious processes within a cycle
lead to another cycle without tending toward an equilibrium con-
dition. The self-generating assumption violates the general law of
the tendency of the economy toward an equilibrium, while, on the
other hand, the Mises theory for the first time succeeds in inte-
grating the theory of the business cycle into the whole structural
design of economic theory. Recurrence stems from the fact that
37Mises points out (Human Action, p. 789n.) that if the banks simply lowered
the interest charges on their loans without expanding their credit, they would be
granting gifts to debtors, and would not be generating a business cycle.
34
America’s Great Depression
banks will always try to inflate credit if they can, and government
will almost always back them up and spur them on. Bank profits
derive mainly from credit expansion, so they will tend to inflate
credit as much as they can until they are checked.38 Government,
too, is inherently inflationary. Banks are forced to halt their credit
expansion because of the combined force of external and internal
drains, and, during a deflation, the drains, and their fears of bank-
ruptcy, force them to contract credit. When the storm has run its
course and recovery has arrived, the banks and the government are
free to inflate again, and they proceed to do so. Hence the contin-
ual recurrence of business cycles.
Gold Changes and the Cycle
On one important point of business cycle theory this writer is
reluctantly forced to part company with Mises. In his Human
Action, Mises first investigated the laws of a free-market economy
and then analyzed various forms of coercive intervention in the
free market. He admits that he had considered relegating trade-
cycle theory to the section on intervention, but then retained the
discussion in the free market part of the volume. He did so because
he believed that a boom–bust cycle could also be generated by an
increase in gold money, provided that the gold entered the loan
market before all its price-raising effects had been completed. The
potential range of such cyclical effects in practice, of course, is
severely limited: the gold supply is limited by the fortunes of gold
mining, and only a fraction of new gold enters the loan market before
influencing prices and wage rates. Still, an important theoretical
38Walker, The Science of Wealth, pp. 145ff.; also see p. 159.
[B]anks must be constantly desirous of increasing their loans, by issuing
their own credit in the shape of circulation and deposits. The more they
can get out, the larger the income. This is the motive power that ensures
the constant expansion of a mixed [fractional reserve] currency to its high-
est possible limit. The banks will always increase their indebtedness when
they can, and only contract it when they must.
The Positive Theory of the Cycle
35
problem remains: can a boom–depression cycle of any degree be
generated in a 100 percent gold economy? Can a purely free mar-
ket suffer from business cycles, however limited in extent? One
crucial distinction between a credit expansion and entry of new
gold onto the loan market is that bank credit expansion distorts the
market’s reflection of the pattern of voluntary time preferences;
the gold inflow embodies changes in the structure of voluntary time
preferences. Setting aside any permanent shifts in income distri-
bution caused by gold changes, time preferences may temporarily
fall during the transition period before the effect of increased gold
on the price system is completed. (On the other hand, time pref-
erences may temporarily rise.) The fall will cause a temporary
increase in saved funds, an increase that will disappear once the
effects of the new money on prices are completed. This is the case
noted by Mises.
Here is an instance in which savings may be expected to
increase first and then decline. There may certainly be other cases
in which time preferences will change suddenly on the free market,
first falling, then increasing. The latter change will undoubtedly
cause a “crisis” and temporary readjustment to malinvestments,
but these would be better termed irregular fluctuations than regu-
lar processes of the business cycle. Furthermore, entrepreneurs are
trained to estimate changes and avoid error. They can handle
irregular fluctuations, and certainly they should be able to cope
with the results of an inflow of gold, results which are roughly pre-
dictable. They could not forecast the results of a credit expansion,
because the credit expansion tampered with all their moorings, dis-
torted interest rates and calculations of capital. No such tampering
takes place when gold flows into the economy, and the normal
forecasting ability of entrepreneurs is allowed full sway. We must,
therefore, conclude that we cannot apply the “business cycle” label
to any processes of the free market. Irregular fluctuations, in
response to changing consumer tastes, resources, etc. will certainly
occur, and sometimes there will be aggregate losses as a result. But
the regular, systematic distortion that invariably ends in a cluster
of business errors and depression—characteristic phenomena of
36
America’s Great Depression
the “business cycle”—can only flow from intervention of the bank-
ing system in the market.39
39For a somewhat similar analysis of international gold flows, see F.A. Hayek,
Monetary Nationalism and International Stability (New York: Longmans, Green,
1937), pp. 24f. Also see Walker, The Science of Wealth, p. 160.
2
Keynesian Criticisms of the Theory1
There are two standard Keynesian criticisms of the Mises
cycle theory. One charge takes the followers of Mises to
task for identifying saving and investment. Saving and
investment, the Keynesians charge, are two entirely separate
processes, performed by two sets of people with little or no link
between them; the “classical” identification of saving and invest-
ment is therefore illegitimate. Savings “leak” out of the consump-
tion-spending stream; investments pour in from some other phase
1F.A. Hayek subjected J.M. Keynes’s early Treatise on Money (now relatively
forgotten amid the glow of his later General Theory) to a sound and searching cri-
tique, much of which applies to the later volume. Thus, Hayek pointed out that
Keynes simply assumed that zero aggregate profit was just sufficient to maintain
capital, whereas profits in the lower stages combined with equal losses in the
higher stages would reduce the capital structure; Keynes ignored the various
stages of production; ignored changes in capital value and neglected the identity
between entrepreneurs and capitalists; took replacement of the capital structure
for granted; neglected price differentials in the stages of production as the source
of interest; and did not realize that, ultimately, the question faced by businessmen
is not whether to invest in consumer goods or capital goods, but whether to invest
in capital goods that will yield consumer goods at a nearer or later date. In gener-
al, Hayek found Keynes ignorant of capital theory and real-interest theory, par-
ticularly that of Böhm-Bawerk, a criticism borne out in Keynes’s remarks on
Mises’s theory of interest. See John Maynard Keynes, The General Theory of
Employment, Interest, and Money (New York: Harcourt, Brace, 1936), pp. 192–93;
F.A. Hayek, “Reflections on the Pure Theory of Money of Mr. J.M. Keynes,”
Economica (August, 1931): 270–95; and idem, “A Rejoinder to Mr. Keynes,”
Economica (November, 1931): 400–02.
37
38
America’s Great Depression
of spending. The task of government in a depression, according to
the Keynesians, is accordingly to stimulate investments and dis-
courage savings, so that total spendings increase.
Savings and investment are indissolubly linked. It is impossible
to encourage one and discourage the other. Aside from bank
credit, investments can come from no other source than savings
(and we have seen what happens when investments are financed by
bank credit). Not only consumers save directly, but also consumers
in their capacity as independent businessmen or as owners of cor-
porations. But can’t savings be “hoarded”? This, however, is an
artificial and misleading way of putting the matter. Consider a
man’s possible allocation of his monetary assets:
He can (1) spend money on consumption; (2) spend on invest-
ment; (3) add to cash balance or subtract from previous cash bal-
ance. This is the sum of his alternatives. The Keynesians assume,
most contrivedly, that he first decides how much to consume or
not, calling this “not-consumption” saving, and then decides how
much to invest and how much to “leak” into hoards. (This, of
course, is neo-Keynesianism rather than pure Keynesian ortho-
doxy, which banishes hoarding from the living room, while read-
mitting it by the back door.) This is a highly artificial approach and
confirms Sir Dennis Robertson’s charge that the Keynesians are
incapable of “visualizing more than two margins at once.”2 Clearly,
our individual decides at one and the same stroke about allocating
his income in the three different channels. Furthermore, he allo-
cates between the various categories on the basis of two embracing
utilities: his time preferences decide his allocation between con-
sumption and investment (between spending on present vs. future
consumption); his utility of money decides how much he will keep in
his cash balance. In order to invest resources in the future, he
must restrict his consumption and save funds. This restricting is
2Dennis H. Robertson, “Mr. Keynes and the Rate of Interest,” in Readings in
the Theory of Income Distribution (Philadelphia: Blakiston, 1946), p. 440. Also see
the article by Carl Landauer, “A Break in Keynes’s Theory of Interest,” American
Economic Review (June, 1937): 260–66.
Keynesian Criticisms of the Theory
39
his savings, and so saving and investment are always equivalent.
The two terms may be used almost interchangeably.
These various individual valuations sum up to social time-pref-
erence ratios and social demand for money. If people’s demand for
cash balances increases, we do not call this “savings leaking into
hoards”; we simply say that demand for money has increased. In
the aggregate, total cash balances can only rise to the extent that
the total supply of money rises, since the two are identical. But real
cash balances can increase through a rise in the value of the dollar.
If the value of the dollar is permitted to rise (prices are permitted to
fall) without hindrance, no dislocations will be caused by this
increased demand, and depressions will not be aggravated. The
Keynesian doctrine artificially assumes that any increase (or
decrease) in hoards will be matched by a corresponding fall (or rise)
in invested funds. But this is not correct. The demand for money is
completely unrelated to the time-preference proportions people
might adopt; increased hoarding, therefore, could just as easily
come out of reduced consumption as out of reduced investment. In
short, the savings-investment–consumption proportions are deter-
mined by time preferences of individuals; the spending-cash bal-
ance proportion is determined by their demands for money.
THE LIQUIDITY “TRAP”
The ultimate weapon in the Keynesian arsenal of explanations
of depressions is the “liquidity trap.” This is not precisely a cri-
tique of the Mises theory, but it is the last line of Keynesian
defense of their own inflationary “cures” for depression. Keyne-
sians claim that “liquidity preference” (demand for money) may be
so persistently high that the rate of interest could not fall low
enough to stimulate investment sufficiently to raise the economy
out of the depression. This statement assumes that the rate of
interest is determined by “liquidity preference” instead of by time
preference; and it also assumes again that the link between savings
and investment is very tenuous indeed, only tentatively exerting
itself through the rate of interest. But, on the contrary, it is not a
question of saving and investment each being acted upon by the
40
America’s Great Depression
rate of interest; in fact, saving, investment, and the rate of interest
are each and all simultaneously determined by individual time pref-
erences on the market. Liquidity preference has nothing to do with
this matter. Keynesians maintain that if the “speculative” demand
for cash rises in a depression, this will raise the rate of interest. But
this is not at all necessary. Increased hoarding can either come
from funds formerly consumed, from funds formerly invested, or
from a mixture of both that leaves the old consumption–invest-
ment proportion unchanged. Unless time preferences change, the
last alternative will be the one adopted. Thus, the rate of interest
depends solely on time preference, and not at all on “liquidity
preference.” In fact, if the increased hoards come mainly out of
consumption, an increased demand for money will cause interest
rates to fall—because time preferences have fallen.
In their stress on the liquidity trap as a potent factor in aggra-
vating depression and perpetuating unemployment, the Keyne-
sians make much fuss over the alleged fact that people, in a finan-
cial crisis, expect a rise in the rate of interest, and will therefore
hoard money instead of purchasing bonds and contributing toward
lower rates. It is this “speculative hoard” that constitutes the “liq-
uidity trap,” and is supposed to indicate the relation between liq-
uidity preference and the interest rate. But the Keynesians are here
misled by their superficial treatment of the interest rate as simply
the price of loan contracts. The crucial interest rate, as we have
indicated, is the natural rate—the “profit spread” on the market.
Since loans are simply a form of investment, the rate on loans is
but a pale reflection of the natural rate. What, then, does an expec-
tation of rising interest rates really mean? It means that people
expect increases in the rate of net return on the market, via wages
and other producers’ goods prices falling faster than do consumer
goods’ prices. But this needs no labyrinthine explanation; investors
expect falling wages and other factor prices, and they are therefore
holding off investing in factors until the fall occurs. But this is old-
fashioned “classical” speculation on price changes. This expecta-
tion, far from being an upsetting element, actually speeds up the
adjustment. Just as all speculation speeds up adjustment to the
proper levels, so this expectation hastens the fall in wages and
other factor prices, hastening the recovery, and permitting normal
Keynesian Criticisms of the Theory
41
prosperity to return that much faster. Far from “speculative”
hoarding being a bogy of depression, therefore, it is actually a wel-
come stimulant to more rapid recovery.3
Such intelligent neo-Keynesians as Modigliani concede that
only an “infinite” liquidity preference (an unlimited demand for
money) will block return to full-employment equilibrium in a free
market.4 But, as we have seen, heavy speculative demand for
money speeds the adjustment process. Moreover, the demand for
money could never be infinite because people must always continue
consuming, on some level, regardless of their expectations. Since
people must continue consuming, they must also continue pro-
ducing, so that there can be adjustment and full employment
regardless of the degree of hoarding. The failure to juxtapose
hoarding and consuming again stems from the Keynesian neglect of
more than two margins at once and their erroneous belief that
hoarding only reduces investment, not consumption.
In a brilliant article on Keynesianism and price-wage flexibility,
Professor Hutt points out that:
No condition which even distinctly resembles infinite
elasticity of demand for money assets has even been rec-
ognized, I believe, because general expectations have
always envisaged either (a) the attainment in the not too
3For more on the equilibrating effects of wage reductions in a depression see
the following section.
4Some of the most damaging blows to the Keynesian system have come from
friendly, but unsparing, neo-Keynesian sources; e.g., Franco Modigliani,
“Liquidity Preference and the Theory of Interest and Money,” in Henry Hazlitt,
ed., The Critics of Keynesian Economics (Princeton, N.J.: D. Van Nostrand, 1960),
pp. 131–84; Erik Lindahl, “On Keynes’ Economic System,” Economic Record (May
and November, 1954): 19–32, 159–71. As Hutt sums up:
[T]he apparent revolution wrought by Keynes after 1936 has been
reversed by a bloodless counterrevolution conducted unwittingly by high-
er critics who tried very hard to be faithful. Whether some permanent
benefit to our science will have made up for the destruction which the rev-
olution left in its train, is a question which economic historians of the
future will have to answer.
W.H. Hutt, “The Significance of Price Flexibility,” in Hazlitt, The Critics of
Keynesian Economics., p. 402.
42
America’s Great Depression
distant future of some definite scale of prices, or (b) so
gradual a decline of prices that no cumulative postpone-
ment of expenditure has seemed profitable.
But even if such an unlikely demand arose:
If one can seriously imagine [this situation] . . . with the
aggregate real value of money assets being inflated, and
prices being driven down catastrophically, then one may
equally legitimately (and equally extravagantly) imagine
continuous price coordination accompanying the emer-
gence of such a position. We can conceive, that is, of
prices falling rapidly, keeping pace with expectations of
price changes, but never reaching zero, with full utiliza-
tion of resources persisting all the way.5
WAGE RATES AND UNEMPLOYMENT
Sophisticated Keynesians now admit that the Keynesian theory
of “underemployment equilibrium” does not really apply (as was
first believed) to the free and unhampered market: that it assumes,
in fact, that wage rates are rigid downward. “Classical” economists
have always maintained that unemployment is caused precisely by
wage rates not being allowed to fall freely; but in the Keynesian
system this assumption has been buried in a mass of irrelevant
equations. The assumption is there, nevertheless, and it is crucial.6
The Keynesian prescription for unemployment rests on the per-
sistence of a “money illusion” among workers, i.e., on the belief
that while, through unions and government, they will keep money
wage rates from falling, they will also accept a fall in real wage rates
via higher prices. Governmental inflation, then, is supposed to
eliminate unemployment by bringing about such a fall in real wage
rates. In these times of ardent concentration on the cost-of-living
5Hutt, “The Significance of Price Flexibility,” pp. 397n. and 398.
6See Modigliani, “Liquidity Preference and the Theory of Interest and
Money,” and Lindahl, “On Keynes’ Economic System,” ibid.
Keynesian Criticisms of the Theory
43
index, such duplicity is impossible and we need not repeat here the
various undesirable consequences of inflation.7
It is curious that even economists who subscribe to a general
theory of prices balk whenever the theory is logically applied to
wages, the prices of labor services. Marginal productivity theory,
for example, may be applied strictly to other factors; but, when
wages are discussed, we suddenly read about “zones of indetermi-
nacy” and “bargaining.”8 Similarly, most economists would readily
admit that keeping the price of any good above the amount that
would clear the market will cause unsold surpluses to pile up. Yet,
they are reluctant to admit this in the case of labor. If they claim
that “labor” is a general good, and therefore that wage cuts will
injure general purchasing power, it must first be replied that “gen-
eral labor” is not sold on the market; that it is certain specific labor
that is usually kept artificially high and that this labor will be
unemployed. It is true, however, that the wider the extent of the
artificially high wage rates, the more likely will mass unemploy-
ment be. If, for example, only a few crafts manage, by union or
government coercion to boost the wage rate in their fields above
the free-market rate, displaced workers will move into a poorer
line of work, and find employment there. In that case, the remain-
ing union workers have gained their wage increase at the expense
of lower wage rates elsewhere and of a general misallocation of
productive factors. The wider the extent of the rigid wages, how-
ever, the less opportunity there will be to move and the greater will
be the extent and duration of the unemployment.
In a free market, wage rates will tend to adjust themselves so
that there is no involuntary unemployment, i.e., so that all those
desiring to work can find jobs. Generally, wage rates can only be
kept above full-employment rates through coercion by government,
7See L. Albert Hahn, The Economics of Illusion (New York: Squier, 1949), pp. 50ff.,
166ff.
8Actually, zones of indeterminacy are apt to be wide where only two or three
people live on a desert island and narrow progressively the greater the population
and the more advanced the economic system. No special zone adheres to the
labor contract.
44
America’s Great Depression
unions, or both. Occasionally, however, the high wage rates are
maintained by voluntary choice (although the choice is usually
ignorant of the consequences) or by coercion supplemented by
voluntary choice. It may happen, for example, that either business
firms or the workers themselves may become persuaded that main-
taining wage rates artificially high is their bounden duty. Such per-
suasion has actually been at the root of much of the unemployment
of our time, and this was particularly true in the 1929 depression.
Workers, for example, become persuaded of the great importance
of preserving the mystique of the union: of union solidarity in “not
crossing a picket line,” or not undercutting union wage rates.
Unions almost always reinforce this mystique with violence, but
there is no gainsaying the breadth of its influence. To the extent
that workers, both in and out of the union, feel bound by this mys-
tique, to that extent will they refuse to bid wages downward even
when they are unemployed. If they do that, then we must conclude
that they are unemployed voluntarily, and that the way to end their
unemployment is to convince them that the mystique of the union
is morally absurd.9 However, while these workers are unemployed
voluntarily, as a consequence of their devotion to the union, it is
highly likely that the workers do not fully realize the consequences
of their ideas and actions. The mass of men are generally ignorant
of economic truths. It is highly possible that once they discovered
that their unemployment was the direct result of their devotion to
union solidarity, much of this devotion would quickly wither away.
Both workers and businessmen may become persuaded by the
mistaken idea that artificial propping of wage rates is beneficial.
This factor played a great role in the 1929 depression. As early as
the 1920s, “big” businessmen were swayed by “enlightened” and
“progressive” ideas, one of which mistakenly held that American
prosperity was caused by the payment of high wages (rates?) instead
of the other way round. As if other countries had a lower standard
of living because their businessmen stupidly refused to quadruple
or quintuple their wage rates! By the time of the depression, then,
9It is immaterial to the argument whether or not the present writer believes
the mystique to be morally absurd.
Keynesian Criticisms of the Theory
45
businessmen were ripe for believing that lowering wage rates
would cut “purchasing power” (consumption) and worsen the
depression (a doctrine that the Keynesians later appropriated and
embellished). To the extent that businessmen become convinced of
this economic error, they are responsible for unemployment, but
responsible, be it noted, not because they are acting “selfishly” and
“greedily” but precisely because they are trying to act “responsi-
bly.” Insofar as government reinforces this conviction with cajolery
and threat, the government bears the primary guilt for unemploy-
ment.
What of the Keynesian argument, however, that a fall in wage
rates would not help cure unemployment because it would slash
purchasing power and therefore deprive industry of needed
demand for its products? This argument can be answered on many
levels. In the first place, as prices fall in a depression, real wage
rates are not only maintained but increased. If this helps employ-
ment by raising purchasing power, why not advocate drastic
increases in money wage rates? Suppose the government decreed,
for example, a minimum wage law where the minimum was triple
the going wage rates? What would happen? Why don’t the Key-
nesians advocate such a measure?
It is clear that the effect of such a decree would be total mass
unemployment and a complete stoppage of the wheels of produc-
tion. Unless . . . unless the money supply were increased to permit
employers to pay such sums, but in that case real wage rates have
not increased at all! Neither would it be an adequate reply to say
that this measure would “go too far” because wage rates are both
costs to entrepreneurs and incomes to workers. The point is that
the free-market rate is precisely the one that adjusts wages—costs
and incomes—to the full-employment position. Any other wage
rate distorts the economic situation.10
The Keynesian argument confuses wage rates with wage
incomes—a common failing of the economic literature, which often
10Maximum wage controls, such as prevailed in earlier centuries and in the
Second World War, created artificial shortages of labor throughout the econo-
my—the reverse of the effect of minimum wages.
46
America’s Great Depression
talks vaguely of “wages” without specifying rate or income.11 Actu-
ally, wage income equals wage rate multiplied by the amount of time
over which the income is earned. If the wage rate is per hour, for
example, wage rate will equal total wage income divided by the
total number of hours worked. But then the total wage income
depends on the number of hours worked as well as on the wage
rate. We are contending here that a drop in the wage rate will lead
to an increase in the total number employed; if the total man-hours
worked increases enough, it can also lead to an increase in the total
wage bill, or payrolls. A fall in wage rate, then, does not necessarily
lead to a fall in total wage incomes; in fact, it may do the opposite.
At the very least, however, it will lead to an absorption of the
unemployed, and this is the issue under discussion. As an illustra-
tion, suppose that we simplify matters (but not too drastically) and
assume a fixed “wages fund” which employers can dispense to
workers. Clearly, then, a reduced wage rate will permit the same
payroll fund to be spread over a greater number of people. There
is no reason to assume that total payroll will fall.
In actuality, there is no fixed fund for wages, but there is rather
a fixed “capital fund” which business pays out to all factors of pro-
duction. Ultimately, there is no return to capital goods, since their
prices are all absorbed by wages and land rents (and interest,
which, as the price of time, permeates the economy). Therefore,
what business as a whole has at any time is a fixed fund for wages,
rents, and interest. Labor and land are perennial competitors.
Since production functions are not fixed throughout the economy,
a widespread reduction in wage rates would cause business to sub-
stitute labor for land, labor now being relatively more attractive
vis-à-vis land than it was before. Consequently, aggregate payrolls
would not be the same; they would increase, because of the substi-
tution effect in favor of labor as against land. The aggregate
demand for labor would therefore be “elastic.”12
11See Hutt, “The Significance of Price Flexibility,” pp. 390ff.
12Various empirical studies have maintained that the aggregate demand for
labor is highly elastic in a depression, but the argument here does not rest upon
them. See Benjamin M. Anderson, “The Road Back to Full Employment,” in
Keynesian Criticisms of the Theory
47
Suppose, however, that the highly improbable “worst” occurs,
and the demand for labor turns out to be inelastic, i.e., total pay-
rolls decline as a result of a cut in wage rates. What then? First,
such inelasticity could only be due to businesses holding off from
investing in labor in expectation that wage rates will fall further.
But the way to meet such speculation is to permit wage rates to fall
as quickly and rapidly as possible. A quick fall to the free-market
rate will demonstrate to businessmen that wage rates have fallen
their maximum viable amount. Not only will this not lead businesses
to wait further before investing in labor, it will stimulate businesses
to hurry and invest before wage rates rise again. The popular ten-
dency to regard speculation as a commanding force in its own right
must be avoided; the more astute as forecasters and diviners of the
economy the businessmen are, the more they will “speculate,” and
the more will their speculation spur rather than delay the natural
equilibrating forces of the market. For any mistakes in specula-
tion—selling or buying goods or services too fast or too soon—will
directly injure the businessmen themselves. Speculation is not self-
perpetuating; it depends wholly and ultimately on the underlying
forces of natural supply and consumer demand, and it promotes
adjustment to those forces. If businessmen overspeculate in inven-
tory of a certain good, for example, the piling up of unsold stock
will lead to losses and speedy correction. Similarly, if businessmen
wait too long to purchase labor, labor “shortages” will develop and
businessmen will quickly bid up wage rates to their “true” free-
market rates. Entrepreneurs, we remember, are trained to forecast
the market correctly; they only make mass errors when govern-
mental or bank intervention distorts the “signals” of the market
and misleads them on the true state of underlying supply and
demand. There is no interventionary deception here; on the con-
trary, we are discussing a return to the free market after a previous
intervention has been eliminated.
If a quick fall in wage rates ends and even reverses withholding
of the purchase of labor, a slow, sluggish, downward drift of wage
Paul T. Homan and Fritz Machlup, eds. Financing American Prosperity (New York:
Twentieth Century Fund, 1945), pp. 20–21.
48
America’s Great Depression
rates will aggravate matters, because (a) it will perpetuate wages
above free market levels and therefore perpetuate unemployment;
and (b) it will stimulate withholding of labor purchases, thereby
tending to aggravate the unemployment problem even further.
Second, whether or not such speculation takes place, there is
still no reason why unemployment cannot be speedily eliminated.
If workers do not hold out for a reserve price because of union
pressure or persuasion, unemployment will disappear even if total
payroll has declined.
The following diagram will illustrate this process: (see Figure 1).
Quantity of Labor is on the horizontal axis; wage rate on the verti-
cal. DLDL is the aggregate demand for Labor; IE is the total stock
of labor in the society; that is, the total supply of labor seeking
work. The supply of labor is represented by vertical line SLSL
rather than by the usual forward-sloping supply curve, because we
Keynesian Criticisms of the Theory
49
may abstain from any cutting of hours due to falling wage rates,
and more important, because we are investigating the problem of
involuntary unemployment rather than voluntary. Those who wish
to cut back their hours, or quit working altogether when wage
rates fall, can hardly be considered as posing an “unemployment
problem” to society, and we can therefore omit them here.
In a free market, the wage rate will be set by the intersection of
the labor supply curve SLSL and the demand curve DLDL, or at
point E or wage rate 0I. The labor stock IE will be fully employed.
Suppose, however, that because of coercion or persuasion, the
wage rate is kept rigid so that it does not fall below 0A. The supply
of labor curve is now changed: it is now horizontal over AC, then
rises vertically upward, CSL. Instead of intersecting the demand for
labor at point E the new supply of labor curve intersects it at point
B. This equilibrium point now sets the minimum wage rate of 0A,
but only employs AB workers, leaving BC unemployed. Clearly,
the remedy for the unemployment is to remove the artificial prop
keeping the supply of labor curve at AC, and to permit wage rates
to fall until full-employment equilibrium is reached.13
Now, the critic might ask: suppose there is not only speculation
that will speed adjustment, but speculation that overshoots its mark.
The “speculative demand for labor” can then be considered to be
DsDs, purchasing less labor at every wage rate than the “true”
demand curve requires. What happens? Not unemployment, but
full employment at a lower wage rate, 0J. Now, as the wage rate
falls below underlying market levels, the true demand for labor
becomes ever greater than the supply of labor; at the new “equi-
librium” wage the gap is equal to GH. The enormous pressure of
this true demand leads entrepreneurs to see the gap, and they
begin to bid up wage rates to overcome the resulting “shortage of
labor.” Speculation is self correcting rather than self aggravating,
and wages are bid up to the underlying free-market wage 0I.
If speculation presents no problems whatever and even helps
matters when wage rates are permitted to fall freely, it accentuates
13See Hutt, “The Significance of Price Flexibility,” p. 400.
50
America’s Great Depression
the evils of unemployment as long as wages are maintained above
free-market levels. Keeping wage rates up or only permitting them
to fall sluggishly and reluctantly in a depression sets up among
businessmen the expectation that wage rates must eventually be
allowed to fall. Such speculation lowers the aggregate demand
curve for labor, say to DsDs. But with the supply curve of labor still
maintained horizontally at AC, the equilibrium wage rate is
pushed farther to the left at F. and the amount employed reduced
to AF, the amount unemployed increased to FC.14
Thus, even if total payrolls decline, freely falling wage rates will
always bring about a speedy end to involuntary unemployment.
The Keynesian linkage of total employment with total monetary
demand for products implicitly assumes rigid wage rates downward;
it therefore cannot be used to criticize the policy of freely-falling
wage rates. But even if full employment is maintained, will not the
declining demand further depress business? There are two answers
to this. In the first place, what has happened to the existing money
supply? We are assuming throughout a given quantity of money
existing in the society. This money has not disappeared. Neither,
for that matter, has total monetary spending necessarily declined.
If total payrolls have declined, something else has gone up: the
total retained by entrepreneurs, or by investors, for example. In
fact, given the total money supply, the total flow of monetary
spending will only decline if the social demand for money has increased.
In other words, if “hoarding” has increased. But an increase in
hoarding, in total demand for money, is, as we have seen, no social
14Note that, in Figure 1, the SL SL line stops before reaching the horizontal
axis. Actually, the line must stop at the wage yielding the minimum subsistence
income. Below that wage rate, no one will work, and therefore, the supply curve
of labor will really be horizontal, on the free market, at the minimum subsistence
point. Certainly it will not be possible for speculative withholding to reduce wage
rates to the subsistence level, for three reasons: (a) this speculative withholding
almost always results in hoarding, which reduces prices all-round and which will
therefore reduce the equilibrium money wage rate without reducing the equilib-
rium real wage rate—the relevant rate for the subsistence level, (b) entrepreneurs
will realize that their speculation has overshot the mark long before the subsis-
tence level is reached; and (c) this is especially true in an advanced capitalist econ-
omy, where the rates are far above subsistence.
Keynesian Criticisms of the Theory
51
calamity. In response to the needs and uncertainties of depression,
people desire to increase their real cash balances, and they can only
do so, with a given amount of total cash, by lowering prices.
Hoarding, therefore, lowers prices all around, but need exert no
depressing effect whatever upon business.15 Business, as we have
pointed out, depends for its profitability on price differentials
between factor and selling prices, not upon general price levels.16
Decrease or increase in total monetary spending is, therefore,
irrelevant to the general profitability of business.
Finally, there is the Keynesian argument that wage earners con-
sume a greater proportion of their income than landlords or entre-
preneurs, and therefore that a decreased total wage bill is a
calamity because consumption will decline and savings increase. In
the first place, this is not always accurate. It assumes (1) that the
laborers are the relatively “poor” and the nonlaborers the relative
“rich,” and (2) that the poor consume a greater proportion of their
income than the rich. The first assumption is not necessarily cor-
rect. The President of General Motors is, after all, a “laborer,” and
so also is Mickey Mantle; on the other hand, there are a great many
poor landlords, farmers, and retailers. Manipulating relations
between wage earners and others is a very clumsy and ineffective
15On the other hand, wage rates maintained above the free-market level will
discourage investment and thereby tend to increase hoarding at the expense of
saving–investment. This decline in the investment–consumption ratio aggravates
the depression further. Freely declining wage rates would permit investments to
return to previous proportions, thus adding another important impetus to recov-
ery. See Frederic Benham, British Monetary Policy (London: P.S. King and Son,
1932), p. 77.
16It has often been maintained that a failing price level injures business firms
because it aggravates the burden of fixed monetary debt. However, the creditors
of a firm are just as much its owners as are the equity shareholders. The equity
shareholders have less equity in the business to the extent of its debts. Bond-hold-
ers (long-term creditors) are just different types of owners, very much as pre-
ferred and common stock holders exercise their ownership rights differently.
Creditors save money and invest it in an enterprise, just as do stockholders.
Therefore, no change in price level by itself helps or hampers a business; credi-
tor–owners and debtor–owners may simply divide their gains (or losses) in differ-
ent proportions. These are mere intra-owner controversies.
52
America’s Great Depression
way of manipulating relations between poor and rich (provided we
desire any manipulation at all). The second assumption is often,
but not necessarily, true, as we have seen above. As we have also
seen, however, the empirical study of Lubell indicates that a redis-
tribution of income between rich and poor may not appreciably
affect the social consumption–saving proportions. But suppose
that all these objections are waved aside for the moment, and we
concede for the sake of argument that a fall in total payroll will
shift the social proportion against consumption and in favor of sav-
ing. What then? But this is precisely an effect that we should
highly prize. For, as we have seen, any shift in social time prefer-
ences in favor of saving and against consumption will speed the
advent of recovery, and decrease the need for a lengthy period of
depression readjustment. Any such shift from consumption to sav-
ings will foster recovery. To the extent that this dreaded fall in con-
sumption does result from a cut in wage rates, then, the depression
will be cured that much more rapidly.
A final note: The surplus “quantity of labor” caused by artifi-
cially high wage rates is a surplus quantity of hours worked. This
can mean (1) actual unemployment of workers, and/or (2) reduc-
tion in working time for employed workers. If a certain number of
labor hours are surplus, workers can be discharged outright, or
many more can find their weekly working time reduced and their
payroll reduced accordingly. The latter scheme is often advanced
during a depression, and is called “spreading the work.” Actually,
it simply spreads the unemployment. Instead of most workers
being fully employed and others unemployed, all become under-
employed. Universal adoption of this proposal would render arti-
ficial wage maintenance absurd, because no one would be really
benefitting from the high wage rates. Of what use are continuing
high hourly wage rates if weekly wage rates are lower? The hour-
reduction scheme, moreover, perpetuates underemployment. A
mass of totally unemployed is liable to press severely on artificial
wage rates, and out-compete the employed workers. Securing a
greater mass of under-employed prevents such pressure—and this,
indeed, is one of the main reasons that unions favor the scheme. In
many cases, of course, the plea for shorter hours is accompanied by
Keynesian Criticisms of the Theory
53
a call for higher hourly wage rates to “keep weekly take-home pay
the same”; this of course is a blatant demand for higher real wage
rates, accompanied by reduced production and further unemploy-
ment as well.
Reduction of hours to “share the work” will also reduce every-
one’s real wage rate and the general standard of living, for produc-
tion will not only be lower but undoubtedly far less efficient, and
workers all less productive. This will further widen the gap between
the artificially maintained wage rate and the free-market wage rate,
and hence further aggravate the unemployment problem.
3
Some Alternative Explanations
of Depression: A Critique
Some economists are prepared to admit that the Austrian the-
ory could “sometimes” account for cyclical booms and
depressions, but add that other instances might be explained
by different theories. Yet, as we have stated above, we believe this
to be an error: we hold that the Austrian analysis is the only one
that accounts for business cycles and their familiar phenomena.
Specific crises can, indeed, be precipitated by other government
action or intervention in the market. Thus, England suffered a cri-
sis in its cotton textile industry when the American Civil War cut
off its supply of raw cotton. A sharp increase in taxation may
depress industry and the urge to invest and thereby precipitate a
crisis. Or people may suddenly distrust banks and trigger a defla-
tionary run on the banking system. Generally, however, bank runs
only occur after a depression has already weakened confidence,
and this was certainly true in 1929. These instances, of course, are
not cyclical events but simple crises without preceding booms. They
are always identifiable and create no mysteries about the underly-
ing causes of the crises. When W.R. Scott investigated the business
annals of the early modern centuries, he found such contemporary
explanations of business crises as the following: famine, plague,
seizure of bullion by Charles I, losses in war, bank runs, etc. It is
the fact that no such obvious disaster can explain modern depres-
sions that accounts for the search for a deeper causal theory of
55
56
America’s Great Depression
1929 and all other depressions. Among such theories, only Mises’s
can pass muster.1
GENERAL OVERPRODUCTION
“Overproduction” is one of the favorite explanations of depres-
sions. It is based on the common-sense observation that the crisis
is marked by unsold stocks of goods, excess capacity of plant, and
unemployment of labor. Doesn’t this mean that the “capitalist sys-
tem” produces “too much” in the boom, until finally the giant pro-
ductive plant outruns itself? Isn’t the depression the period of rest,
which permits the swollen industrial apparatus to wait until
reduced business activity clears away the excess production and
works off its excess inventory?
This explanation, popular or no, is arrant nonsense. Short of
the Garden of Eden, there is no such thing as general “overpro-
duction.” As long as any “economic” desires remain unsatisfied, so
long will production be needed and demanded. Certainly, this
impossible point of universal satiation had not been reached in
1929. But, these theorists may object, “we do not claim that all
desires have ceased. They still exist, but the people lack the money
to exercise their demands.” But some money still exists, even in the
steepest deflation. Why can’t this money be used to buy these
“overproduced” goods? There is no reason why prices cannot fall
low enough, in a free market, to clear the market and sell all the
goods available.2 If businessmen choose to keep prices up, they are
simply speculating on an imminent rise in market prices; they are,
in short, voluntarily investing in inventory. If they wish to sell their
“surplus” stock, they need only cut their prices low enough to sell
all of their product.3 But won’t they then suffer losses? Of course,
1See the discussion by Scott in Wesley C. Mitchell, Business Cycles: The
Problem and its Setting (New York: National Bureau of Economic Research, 1927),
pp. 75ff.
2See C.A. Phillips, T.F. McManus, and R.W. Nelson, Banking and the Business-
Cycle (New York: Macmillan, 1937), pp. 59–64.
3In the Keynesian theory, “aggregate equilibrium” is reached by two routes:
profits and losses, and “unintended” investment or disinvestment in inventory.
Some Alternative Explanations of Depression: A Critique
57
but now the discussion has shifted to a different plane. We find no
overproduction, we find now that the selling prices of products are
below their cost of production. But since costs are determined by
expected future selling prices, this means that costs were previ-
ously bid too high by entrepreneurs. The problem, then, is not one
of “aggregate demand” or “overproduction,” but one of cost–price
differentials. Why did entrepreneurs make the mistake of bidding
costs higher than the selling prices turned out to warrant? The
Austrian theory explains this cluster of error and the excessive bid-
ding up of costs; the “overproduction” theory does not. In fact,
there was overproduction of specific, not general, goods. The mal-
investment caused by credit expansion diverted production into
lines that turned out to be unprofitable (i.e., where selling prices
were lower than costs) and away from lines where it would have been
profitable. So there was overproduction of specific goods relative to
consumer desires, and underproduction of other specific goods.
UNDERCONSUMPTION
The “underconsumption” theory is extremely popular, but it
occupied the “underworld” of economics until rescued, in a sense,
by Lord Keynes. It alleges that something happens during the
boom—in some versions too much investment and too much pro-
duction, in others too high a proportion of income going to upper-
income groups—which causes consumer demand to be insufficient
to buy up the goods produced. Hence, the crisis and depression.
There are many fallacies involved in this theory. In the first place,
as long as people exist, some level of consumption will persist. Even
if people suddenly consume less and hoard instead, they must con-
sume certain minimum amounts. Since hoarding cannot proceed
so far as to eliminate consumption altogether, some level of con-
sumption will be maintained, and therefore some monetary flow of
consumer demand will persist. There is no reason why, in a free
market, the prices of all the various factors of production, as well as
But there is no unintended investment, since prices could always be cut low
enough to sell inventory if so desired.
58
America’s Great Depression
the final prices of consumer goods, cannot adapt themselves to this
desired level. Any losses, then, will be only temporary in shifting to
the new consumption level. If they are anticipated, there need be
no losses at all.
Second, it is the entrepreneurs’ business to anticipate consumer
demand, and there is no reason why they cannot predict the con-
sumer demand just as they make other predictions, and adjust the
production structure to that prediction. The underconsumption
theory cannot explain the cluster of errors in the crisis. Those who
espouse this theory often maintain that production in the boom
outruns consumer demand; but (1) since we are not in Nirvana,
there will always be demand for further production, and (2) the
unanswered question remains: why were costs bid so high that the
product has become unprofitable at current selling prices? The
productive machine expands because people want it so, because
they desire higher standards of living in the future. It is therefore
absurd to maintain that production could outrun consumer
demand in general.
One common variant of the underconsumption theory traces
the fatal flaw to an alleged shift of relative income to profits and to
the higher-income brackets during a boom. Since the rich pre-
sumably consume less than the poor, the mass does not then have
enough “purchasing-power” to buy back the expanded product.
We have already seen that: (1) marginally, empirical research sug-
gests a doubt about whether the rich consume less, and (2) there is
not necessarily a shift from the poor to the rich during a boom. But
even granting these assumptions, it must be remembered that: (a)
entrepreneurs and the rich also consume, and (b) that savings con-
stitute the demand for producers’ goods. 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 mar-
ket in the form of production, its work over and done. On the
Some Alternative Explanations of Depression: A Critique
59
contrary, to sustain a higher standard of living, the production
structure—the capital structure—must be permanently “length-
ened.” As more and more capital is added and maintained in civi-
lized economies, more and more funds must be used just to main-
tain and replace the larger structure. This means higher gross sav-
ings, savings that must be sustained and invested in each higher
stage of production. Thus, the retailers must continue buying from
the wholesalers, the wholesalers from the jobbers, etc. Increased
savings, then, are not wasted, they are, on the contrary, vital to the
maintenance of civilized living standards.
Underconsumptionists assert that expanding production exerts
a depressing secular effect on the economy because prices will tend
to fall. But falling prices are not depressant; on the contrary, since
falling prices due to increased investment and productivity are
reflected in lower unit costs, profitability is not at all injured.
Falling prices simply distribute the fruits of higher productivity to
all the people. The natural course of economic development, then,
barring inflation, is for prices to fall in response to increased capi-
tal and higher productivity. Money wage rates will also tend to fall,
because of the increased work the given money supply is called
upon to perform over a greater number of stages of production.
But money wage rates will fall less than consumer goods prices,
and as a result economic development brings about higher real
wage rates and higher real incomes throughout the economy. Con-
trary to the underconsumption theory, a stable price level is not the
norm, and inflating money and credit in order to keep the “price
level” from falling can only lead to the disasters of the business
cycle.4
If underconsumption were a valid explanation of any crisis,
there would be depression in the consumer goods industries,
where surpluses pile up, and at least relative prosperity in the pro-
ducers’ goods industries. Yet, it is generally admitted that it is the
4We often come across the argument that the money supply must be
increased “in order to keep up with the increased supply of goods.” But goods and
money are not at all commensurate, and the entire injunction is therefore mean-
ingless. There is no way that money can be matched with goods.
60
America’s Great Depression
producers’, not the consumers’ goods industries that suffer most dur-
ing a depression. Underconsumptionism cannot explain this phe-
nomenon, while Mises’s theory explains it precisely.5, 6 Every crisis is
marked by malinvestment and undersaving, not underconsumption.
THE ACCELERATION PRINCIPLE
There is only one way that the underconsumptionists can try to
explain the problem of greater fluctuation in the producers’ than
the consumer goods’ industries: the acceleration principle. The
acceleration principle begins with the undeniable truth that all
production is carried on for eventual consumption. It goes on to
state that, not only does demand for producers’ goods depend on
consumption demand, but that this consumers’ demand exerts a
multiple leverage effect on investment, which it magnifies and
accelerates. The demonstration of the principle begins inevitably
with a hypothetical single firm or industry: assume, for example,
that a firm is producing 100 units of a good per year, and that 10
machines of a certain type are needed in its production. And
assume further that consumers demand and purchase these 100
units. Suppose further that the average life of the machine is 10
years. Then, in equilibrium, the firm buys one new machine each
year to replace the one worn out. Now suppose that there is a 20
percent increase in consumer demand for the firm’s product. Con-
sumers now wish to purchase 120 units. If we assume a fixed ratio
of capital to output, it is now necessary for the firm to have 12
machines. It therefore buys two new machines this year, purchasing
a total of three machines instead of one. Thus, a 20 percent
increase in consumer demand has led to a 200 percent increase in
5For a brilliant critique of underconsumptionism by an Austrian, see F.A.
Hayek, “The ‘Paradox’ of Saving,” in Profits, Interest, and Investment (London:
Routledge and Kegan Paul, 1939), pp. 199–263. Hayek points out the grave and
neglected weaknesses in the capital, interest, and production–structure theory of
the underconsumptionists Foster and Catchings. Also see Phillips, et al., Banking
and the Business Cycle, pp. 69–76.
6The Keynesian approach stresses underspending rather than undercon-
sumption alone; on “hoarding,” the Keynesian dichotomization of saving and
investment, and the Keynesian view of wages and unemployment, see above.
Some Alternative Explanations of Depression: A Critique
61
demand for the machine. Hence, say the accelerationists, a general
increase in consumer demand in the economy will cause a greatly
magnified increase in the demand for capital goods, a demand
intensified in proportion to the durability of the capital. Clearly, the
magnification effect is greater the more durable the capital good
and the lower the level of its annual replacement demand.
Now, suppose that consumer demand remains at 120 units in
the succeeding year. What happens now to the firm’s demand for
machines? There is no longer any need for firms to purchase any
new machines beyond those necessary for replacement. Only one
machine is still needed for replacement this year; therefore, the
firm’s total demand for machines will revert, from three the previous
year, to one this year. Thus, an unchanged consumer demand will gen-
erate a 200 percent decline in the demand for capital goods. Extend-
ing the principle again to the economy as a whole, a simple increase
in consumer demand has generated far more intense fluctuations in
the demand for fixed capital, first increasing it far more than propor-
tionately, and then precipitating a serious decline. In this way, say the
accelerationists, the increase of consumer demand in a boom leads to
intense demand for capital goods. Then, as the increase in consump-
tion tapers off, the lower rate of increase itself triggers a depression
in the capital goods industries. In the depression, when consumer
demand declines, the economy is left with the inevitable “excess
capacity” created in the boom. The acceleration principle is rarely
used to provide a full theory of the cycle; but it is very often used as
one of the main elements in cycle theory, particularly accounting for
the severe fluctuations in the capital-goods industries.
The seemingly plausible acceleration principle is actually a tis-
sue of fallacies. We might first point out that the seemingly obvi-
ous pattern of one replacement per year assumes that one new
machine has been added in each of the ten previous years; in short,
it makes the highly dubious assumption that the firm has been
expanding rapidly and continuously over the previous decade.7
7Either that, or such an expansion must have occurred in some previous
decade, after which the firm—or whole economy—lapsed into a sluggish stationary
state.
62
America’s Great Depression
This is indeed a curious way of describing an equilibrium situation;
it is also highly dubious to explain a boom and depression as only
occurring after a decade of previous expansion. Certainly, it is just
as likely that the firm bought all of its ten machines at once—an
assumption far more consonant with a current equilibrium situa-
tion for that firm. If that happened, then replacement demand by
the firm would occur only once every decade. At first, this seems
only to strengthen the acceleration principle. After all, the replace-
ment-denominator is now that much less, and the intensified
demand so much greater. But it is only strengthened on the sur-
face. For everyone knows that, in real life, in the “normal” course
of affairs, the economy in general does not experience zero demand
for capital, punctuated by decennial bursts of investment. Overall,
on the market, investment demand is more or less constant during
near-stationary states. But if, overall, the market can iron out such
rapid fluctuations, why can’t it iron out the milder ones postulated
in the standard version of the acceleration principle?
There is, moreover, an important fallacy at the very heart of the
accelerationists’ own example, a fallacy that has been uncovered by
W.H. Hutt.8 We have seen that consumer demand increases by 20
percent—but why must the two extra machines be purchased in a
year? What does the year have to do with it? If we analyze the mat-
ter closely, we find that the year is a purely arbitrary and irrelevant
unit even within the terms of the example itself. We might just as
well take a week as the time period. Then we would aver that con-
sumer demand (which, after all, goes on continuously) increases 20
percent over the first week, thus necessitating a 200 percent
increase in demand for machines in the first week (or even an infi-
nite increase if replacement does not occur in the first week) fol-
lowed by a 200 percent (or infinite) decline in the next week, and
stability thereafter. A week is never used by the accelerationists
because the example would then clearly not apply to real life, which
8See his brilliant critique of the acceleration principle in W.H. Hutt,
“Coordination and the Price System” (unpublished, but available from the
Foundation for Economic Education, Irvington-on-Hudson, New York, 1955)
pp. 73–117.
Some Alternative Explanations of Depression: A Critique
63
does not see such enormous fluctuations in the course of a couple
of weeks, and the theory could certainly not then be used to explain
the general business cycle. But a week is no more arbitrary than a
year. In fact, the only non-arbitrary time-period to choose would
be the life of the machine (e.g. ten years).9 Over a ten-year period,
demand for machines had previously been ten and in the current
and succeeding decades will be ten plus the extra two, e.g., 12: in
short, over the ten-year period, the demand for machines will
increase in precisely the same proportion as the demand for consumer
goods—and there is no ramification effect whatever. Since busi-
nesses buy and produce over planned periods covering the lives of
their equipment, there is no reason to assume that the market will
not plan production accordingly and smoothly, without the erratic
fluctuations manufactured by the accelerationists’ model. There is,
in fact, no validity in saying that increased consumption requires
increased production of machines immediately; on the contrary, it
is increased saving and investment in machines, at points of time
chosen by entrepreneurs strictly on the basis of expected prof-
itability, that permits future increased production of consumer
goods.10
There are other erroneous assumptions made by the accelera-
tion principle. Its postulate of a fixed capital–output ratio, for
example, ignores the ever-present possibility of substitution, more
or less intensive working of different factors, etc. It also assumes
that capital is finely divisible, ignoring the fact that investments are
“lumpy,” and made discontinuously, especially those in a fixed
plant.
There is yet a far graver flaw—and a fatal one—in the acceler-
ation principle, and it is reflected in the rigidity of the mechanical
model. No mention whatever is made of the price system or of
9This is not merely the problem of a time lag necessary to produce the new
machines; it is the far broader question of the great range of choice of the time
period in which to make the investment. But this reminds us of another fallacy
made by the accelerationists: that production of the new machines is virtually
instantaneous.
10The accelerationists habitually confuse consumption with production of
consumer goods, and talk about one when the other is relevant.
64
America’s Great Depression
entrepreneurship. Considering the fact that all production on the
market is run by entrepreneurs operating under the price system,
this omission is amazing indeed. It is difficult to see how any eco-
nomic theory can be taken seriously that completely omits the
price system from its reckoning. A change in consumer demand
will change the prices of consumer goods, yet such reactions are
forgotten, and monetary and physical terms are hopelessly
entwined by the theory without mentioning price changes. The
extent to which any entrepreneur will invest in added production
of a good depends on its price relations—on the differentials
between its selling price and the prices of its factors of production.
These price differentials are interrelated at each stage of produc-
tion. If, for example, monetary consumer demand increases, it will
reveal itself to producers of consumer goods through an increase
in the price of the product. If the price differential between selling
and buying prices is raised, production of this good will be stimu-
lated. If factor prices rise faster than selling prices, production is
curtailed, however, and there is no effect on production if the
prices change pari passus. Ignoring prices in a discussion of pro-
duction, then, renders a theory wholly invalid.
Apart from neglecting the price system, the principle’s view of
the entrepreneur is hopelessly mechanistic. The prime function of
the entrepreneur is to speculate, to estimate the uncertain future by
using his judgment. But the acceleration principle looks upon the
entrepreneur as blindly and automatically responding to present data
(i.e., data of the immediate past) rather than estimating future data.
Once this point is stressed, it will be clear that entrepreneurs, in an
unhampered economy, should be able to forecast the supposed
slackening of demand and arrange their investments accordingly. If
entrepreneurs can approximately forecast the alleged “acceleration
principle,” then the supposed slackening of investment demand,
while leading to lower activity in those industries, need not be depres-
sive, because it need not and would not engender losses among busi-
nessmen. Even if the remainder of the principle were conceded,
therefore, it could only explain fluctuations, not depression—not the
cluster of errors made by the entrepreneurs. If the accelerationists
claim that the errors are precisely caused by entrepreneurial failure
Some Alternative Explanations of Depression: A Critique
65
to forecast the change, we must ask, why the failure? In Mises’s
theory, entrepreneurs are prevented from forecasting correctly
because of the tampering with market “signals” by government
intervention. But here there is no government interference, the
principle allegedly referring to the unhampered market. Further-
more, the principle is far easier to grasp than the Mises theory.
There is nothing complex about it, and if it were true, then it
would be obvious to all entrepreneurs that investment demand
would fall off greatly in the following year. Theirs, and other peo-
ple’s, affairs would be arranged accordingly, and no general depres-
sion or heavy losses would ensue. Thus, the hypothetical invest-
ment in seven-year locust equipment may be very heavy for one or
two years, and then fall off drastically in the next years. Yet this
need engender no depression, since these changes would all be dis-
counted and arranged in advance. This cannot be done as effi-
ciently in other instances, but certainly entrepreneurs should be
able to foresee the alleged effect. In fact, everyone should foresee
it; and the entrepreneurs have achieved their present place pre-
cisely because of their predictive ability. The acceleration principle
cannot account for entrepreneurial error.11
One of the most important fallacies of the acceleration princi-
ple is its wholly illegitimate leap from the single firm or industry
to the overall economy. Its error is akin to those committed by the
great bulk of Anglo-American economic theories: the concentra-
tion on only two areas—the single firm or industry, and the econ-
omy as a whole. Both these concentrations are fatally wrong,
because they leave out the most important areas: the interrelations
between the various parts of the economy. Only a general economic
theory is valid—never a theoretical system based on either a par-
tial or isolated case, or on holistic aggregates, or on a mixture of
the two.12 In the case of the acceleration principle, how did the 20
11The “Cobweb Theorem” is another doctrine built on the assumption that
all entrepreneurs are dolts, who blindly react rather than speculate and succeed in
predicting the future.
12Anglo-American economics suffers badly from this deficiency. The
Marshallian system rested on a partial theory of the “industry,” while modern
66
America’s Great Depression
percent increase in consumption of the firm’s product come about?
Generally, a 20 percent increase in consumption in one field must
signify a 20 percent reduction of consumption somewhere else. In
that case, of course, the leap from the individual to the aggregate
is peculiarly wrong, since there is then no overall boom in con-
sumption or investment. If the 20 percent increase is to obtain over
the whole economy, how is the increase to be financed? We cannot
simply postulate an increase in consumption; the important ques-
tion is: how can it be financed? What general changes are needed
elsewhere to permit such an increase? These are questions that the
accelerationists never face. Setting aside changes in the supply or
demand for money for a moment, increased consumption can only
come about through a decrease in saving and investment. But if
aggregate saving and investment must decrease in order to permit
an aggregate increase in consumption, then investment cannot
increase in response to rising consumption; on the contrary, it must
decline. The acceleration principle never faces this problem because
it is profoundly ignorant of economics—the study of the working
of the means–ends principle in human affairs. Short of Nirvana, all
resources are scarce, and these resources must be allocated to the
uses most urgently demanded by all individuals in the society. This
is the unique economic problem, and it means that to gain a good
of greater value, some other good of lesser value to individuals
must be given up. Greater aggregate present consumption can
only be acquired through lowered aggregate savings and invest-
ment. In short, people choose between present and future con-
sumption, and can only increase present consumption at the
expense of future, or vice versa. But the acceleration principle neg-
lects the economic problem completely and disastrously.
economics fragments itself further to discuss the isolated firm. To remedy this
defect, Keynesians and later econometric systems discuss the economy in terms
of a few holistic aggregates. Only the Misesian and Walrasian systems are truly
general, being based themselves on interrelated individual exchanges. The
Walrasian scheme is unrealistic, consisting solely of a mathematical analysis of an
unrealizable (though important) equilibrium system.
Some Alternative Explanations of Depression: A Critique
67
The only way that investment can rise together with consump-
tion is through inflationary credit expansion—and the accelera-
tionists will often briefly allude to this prerequisite. But this admis-
sion destroys the entire theory. It means, first, that the acceleration
principle could not possibly operate on the free market. That, if it
exists at all, it must be attributed to government rather than to the
working of laissez-faire capitalism. But even granting the necessity
of credit expansion cannot save the principle. For the example
offered by the acceleration principle deals in physical, real terms.
It postulates an increased production of units in response to
increased demand. But if the increased demand is purely monetary,
then prices, both of consumer and capital goods, can simply rise
without any change in physical production—and there is no accel-
eration effect at all. In short, there might be a 20 percent rise in
money supply, leading to a 20 percent rise in consumption and in
investment—indeed in all quantities—but real quantities and price
relations need not change, and there is no magnification of invest-
ment, in real or monetary terms. The same applies, incidentally, if
the monetary increase in investment or consumption comes from
dishoarding rather than monetary expansion.
It might be objected that inflation does not and cannot increase
all quantities proportionately, and that this is its chief characteris-
tic. Precisely so. But proceed along these lines, and we are back
squarely and firmly in the Austrian theory of the trade cycle—and
the acceleration principle has been irretrievably lost. The Austrian
theory deals precisely with the distortions of market adjustment to
consumption–investment proportions, brought about by inflation-
ary credit expansion.13 Thus, the accelerationists maintain, in
effect, that the entrepreneurs are lured by increased consumption
to overexpand durable investments. But the Austrian theory
13Another defect of the accelerationist explanation of the cycle is its stress on
durable capital equipment as the preeminently fluctuating activity. Actually, as we
have shown above, the boom is not characterized by an undue stress on durable
capital; in fact, such non-durable items as industrial raw materials fluctuate as
strongly as fixed capital goods. The fluctuation takes place in producers’ goods
industries (the Austrian emphasis) and not just durable producers’ goods (the
accelerationist emphasis).
68
America’s Great Depression
demonstrates that, due to the effect of inflation on prices, even
credit expansion can only cause malinvestment, not “overinvest-
ment.” Entrepreneurs will overinvest in the higher stages, and
underinvest in the lower stages, of production. Total investment is
limited by the total supply of savings available, and a general
increase in consumption signifies a decrease in saving and therefore
a decline in total investment (and not an increase or even magnified
increase, as the acceleration principle claims).14 Furthermore, the
Austrian theory shows that the cluster of entrepreneurial error is
caused by the inflationary distortion of market interest rates.15
DEARTH OF “INVESTMENT OPPORTUNITIES”
A very common tendency among economists is to attribute
depression to a dearth, or “saturation,” of “investment opportuni-
ties.” Investment opportunities open themselves up during the
boom and are exploited accordingly. After a while, however, these
opportunities disappear, and hence depression succeeds the boom.
The depression continues until opportunities for investment reap-
pear. What gives rise to these alleged “opportunities”? Typical are
the causal factors listed in a famous article by Professor Hansen,
who attributed the depression of the 1930s to a dearth of invest-
ment opportunities caused by an insufficient rate of population
growth, the lack of new resources, and inadequate technical
14See Hutt, “Coordination and the Price System,” p. 109.
15The acceleration principle also claims to explain the alleged tendency of the
downturn in capital goods to lead downturns in consumer goods activity.
However, it could only do so, even on its own terms, under the very special—and
almost never realized—assumption that the sale of consumer goods describes a
sine-shaped curve over the business cycle. Other possible curves give rise to no
leads at all.
On the acceleration principle, also see L. Albert Hahn, Common Sense
Economics (New York: Abelard–Schuman, 1956), pp. 139–43; Ludwig von Mises,
Human Action (New Haven, Conn.: Yale University Press, 1949), pp. 581–83; and
Simon S. Kuznets, “Relation Between Capital Goods and Finished Products in the
Business Cycle,” in Economic Essays in Honor of Wesley C. Mitchell (New York:
Columbia University Press, 1935), pp. 209–67.
Some Alternative Explanations of Depression: A Critique
69
innovation.16 The importance of this doctrine goes far beyond
Hansen’s “stagnation” theory—that these factors would behave in
the future so as to cause a permanent tendency toward depression.
For the “refuters” of the stagnation theory tacitly accepted
Hansen’s causal theory and simply argued empirically that these
factors would be stronger than Hansen had believed.17 Rarely have
the causal connections themselves been challenged. The doctrine
has been widely assumed without being carefully supported.
Whence come these causal categories? A close look will show
their derivation from the equilibrium conditions of the Walrasian
system which assumes a constant and evenly rotating economy,
with tastes, technological knowledge, and resources considered
given. Changes can only occur if one or more of these givens
change. If new net investment is considered the key to depression
or prosperity, then, knowing that new investment is zero in equi-
librium (i.e., there is only enough investment to replace and main-
tain capital), it is easy to conclude that only changes in the ultimate
givens can lead to new investment. Population and natural
resources both fall under the Walrasian “resource” category.
Hansen’s important omission, of course, is tastes. The omission of
tastes is enough to shatter the entire scheme. For it is time prefer-
ences (the “tastes” of the society for present vis-à-vis future con-
sumption) that determines the amount that individuals will save
and invest. Omitting time preferences leaves out the essential
determinant of saving and investment.
New natural resources, a relatively unimportant item, is rarely
stressed. We used to hear about the baleful effects on the “closing
of the frontier” of open land, but this frontier closed long before the
1930s with no ill effects.18 Actually, physical space by itself provides
16Alvin H. Hansen, “Economic Progress and Declining Population Growth,”
in Readings in Business Cycle Theory (Philadelphia: Blakiston, 1944), pp. 366–84.
17For an example, see George Terborgh, The Bogey of Economic Maturity
(Chicago: Machinery and Allied Products Institute, 1945).
18Curiously, these same worriers did not call upon the federal government to
abandon its conservation policies, which led it to close millions of acres of public
70
America’s Great Depression
no assurance of profitable investment opportunities. Population
growth is often considered an important factor making for pros-
perity or depression, but it is difficult to see why. If population is
below the optimum (maximum real income per capita), its further
growth permits investment to increase productivity by extending
the division of labor. But this can only be done through greater
investment. There is no way, however, that population growth can
stimulate investment, and this is the issue at hand. One thesis holds
that increased population growth stimulates demand for residen-
tial construction. But demand stems from purchasing power,
which in turn stems ultimately from production, and an increase in
babies may run up against inability to produce enough goods to
demand the new houses effectively. But even if more construction
is demanded, this will simply reduce consumption demand in other
areas of the economy. If total consumption increases due to popula-
tion growth (and there is no particular reason why it should), it will
cause a decline in saved and invested funds rather than the reverse.
Technology is perhaps the most emphatically stressed of these
alleged causal factors. Schumpeter’s cycle theory has led many
economists to stress the importance of technological innovation,
particularly in great new industries; and thus we hear about the
Railroad Boom or the Automobile Boom. Some great technologi-
cal innovation is made, a field for investment opens up, and a boom
is at hand. Full exploitation of this field finally exhausts the boom,
and depression sets in. The fallacy involved here is neglect of the
fact that technology, while vitally important, is only indirectly, and
not directly, involved in an investment. At this point, we see again
why the conditions of Misesian rather than Walrasian equilibrium
should have been employed. Austrian theory teaches us that invest-
ment is always less than the maximum amount that could possibly
exploit existing technology. Therefore, the “state of technical
knowledge” is not really a limiting condition to investment. We
can see the truth of this by simply looking about us; in every field,
in every possible line of investment, there are always some firms
domain permanently. Nowadays, outer space will presumably provide “frontier”
enough.
Some Alternative Explanations of Depression: A Critique
71
which are not using the latest possible equipment, which are still
using older methods. This fact indicates that there is a narrower
limit on investment than technological knowledge. The backward
countries may send engineers aplenty to absorb “American know-
how,” but this will not bring to these countries the great amount
of investment needed to raise their standard of living appreciably.
What they need, in short, is saving: this is the factor limiting
investment.19 And saving, in turn, is limited by time preference:
the preference for present over future consumption. Investment
always takes place by a lengthening of the processes of production,
since the shorter productive processes are the first to be developed.
The longer processes remaining untapped are more productive,
but they are not exploited because of the limitations of time-pref-
erence. There is, for example, no investment in better and new
machines because not enough saving is available.
Even if all existing technology were exploited, there would still
be unlimited opportunities for investment, since there would still
not be satiation of wants. Even if better steel mills and factories
could not be built, more of them could always be built, to produce
more of the presently produced consumer goods. New technology
improves productivity, but is not essential for creating investment
opportunities; these always exist, and are only limited by time pref-
erences and available saving. The more saving, the more invest-
ment there will be to satisfy those desires not now fulfilled.
Just as in the case of the acceleration principle, the fallacy of the
“investment opportunity” approach is revealed by its complete
neglect of the price system. Once again, price and cost have disap-
peared. Actually, the trouble in a depression comes from costs being
greater than the prices obtained from sale of capital goods; with
costs greater than selling prices, businessmen are naturally reluc-
tant to invest in losing concerns. The problem, then, is the rigidity
of costs. In a free market, prices determine costs and not vice versa,
so that reduced final prices will also lower the prices of productive
19Saving, not monetary expansion. A backward country, for example, could
not industrialize itself by issuing unlimited quantities of paper money or bank
deposits. That could only bring on runaway inflation.
72
America’s Great Depression
factors—thereby lowering the costs of production. The failure of
“investment opportunity” in the crisis stems from the overbidding
of costs in the boom, now revealed in the crisis to be too high rel-
ative to selling prices. This erroneous overbidding was generated
by the inflationary credit expansion of the boom period. The way
to retrieve investment opportunities in a depression, then, is to
permit costs—factor prices—to fall rapidly, thus reestablishing
profitable price-differentials, particularly in the capital goods
industries. In short, wage rates, which constitute the great bulk of
factor costs, should fall freely and rapidly to restore investment
opportunities. This is equivalent to the reestablishment of higher
price-differentials—higher natural interest rates—on the market.
Thus, the Austrian approach explains the problem of investment
opportunities, and other theories are fallacious or irrelevant.
Equally irrelevant is all discussion in terms of specific industries
—an approach very similar to the technological opportunity doc-
trine. Often it is maintained that a certain industry—say construc-
tion or autos—was particularly prosperous in the boom, and that
the depression occurred because of depressed conditions in that
particular industry. This, however, confuses simple specific busi-
ness fluctuations with general business cycles. Declines in one or sev-
eral industries are offset by expansion in others, as demand shifts
from one field to another. Therefore, attention to particular indus-
tries can never explain booms or depressions in general business—
especially in a multi-industry country like the United States.20 It is,
for example, irrelevant whether or not the construction industry
experiences a “long cycle” of twenty-odd years.
SCHUMPETER’S BUSINESS CYCLE THEORY
Joseph Schumpeter’s cycle theory is notable for being the only
doctrine, apart from the Austrian, to be grounded on, and integrated
20The economic fortunes of a small country producing one product for the
market will of course be dominated by the course of events in that industry.
Some Alternative Explanations of Depression: A Critique
73
with, general economic theory.21 Unfortunately, it was grounded
on Walrasian, rather than Austrian, general economics, and was
thus doomed from the start. The unique Schumpeterian element
in discussing equilibrium is his postulate of a zero rate of interest.
Schumpeter, like Hansen, discards consumer tastes as an active ele-
ment and also dispenses with new resources. With time preference
ignored, interest rate becomes zero in equilibrium, and its positive
value in the real world becomes solely a reflection of positive prof-
its, which in turn are due to the only possible element of change
remaining: technological innovations. These innovations are
financed, Schumpeter maintains, by bank credit expansion, and
thus Schumpeter at least concedes the vital link of bank credit
expansion in generating the boom and depression, although he
pays it little actual attention. Innovations cluster in some specific
industry, and this generates the boom. The boom ends as the inno-
vatory investments exhaust themselves, and their resulting
increased output pours forth on the market to disrupt the older
firms and industries. The ending of the cluster, accompanied by
the sudden difficulties faced by the old firms, and a generally
increased risk of failure, bring about the depression, which ends as
the old and new firms finally adapt themselves to the new situation.
There are several fallacies in this approach:
1. There is no explanation offered on the lack of accurate fore-
casting by both the old and new firms. Why were not the difficul-
ties expected and discounted?22
21Schumpeter’s pure theory was presented in his famous Theory of Economic
Development (Cambridge, Mass.: Harvard University Press, 1934), first published
in 1911. It later appeared as the “first approximation” in an elaborated approach
that really amounted to a confession of failure, and which introduced an abun-
dance of new fallacies into the argument. The later version constituted his Business
Cycles, 2 vols. (New York: McGraw–Hill, 1939).
22To be sure, the Schumpeterian “Pure Model” explicitly postulates perfect
knowledge and therefore absence of error by entrepreneurs. But this is a fla-
grantly self-contradictory assumption within Schumpeter’s own model, since the
very reason for depression in the Pure Model is the fact that risks increase, old
firms are suddenly driven to the wall, etc., and no one innovates again until the
situation clears.
74
America’s Great Depression
2. In reality, it may take a long time for a cluster of innovations
in a new industry to develop, and yet it may take a relatively short
time for the output of that industry to increase as a result of the
innovations. Yet the theory must assume that output increases after
the cluster has done its work; otherwise, there is no boom nor bust.
3. As we have seen above, time preferences and interest are
ignored, and also ignored is the fact that saving and not technol-
ogy is the factor limiting investment.23 Hence, investment
financed by bank credit need not be directed into innovations, but
can also finance greater investment in already known processes.
4. The theory postulates a periodic cluster of innovations in the
boom periods. But there is no reasoning advanced to account for
such an odd cluster. On the contrary, innovations, technological
advance, take place continually, and in most, not just a few, firms.
A cluster of innovations implies, furthermore, a periodic cluster of
entrepreneurial ability, and this assumption is clearly unwarranted.
And insofar as innovation is a regular business procedure of
research and development, rents from innovations will accrue to
the research and development departments of firms, rather than as
entrepreneurial profits.24
5. Schumpeter’s view of entrepreneurship—usually acclaimed
as his greatest contribution—is extremely narrow and one-sided.
He sees entrepreneurship as solely the making of innovations, set-
ting up new firms to innovate, etc. Actually, entrepreneurs are con-
tinually at work, always adjusting to uncertain future demand and
supply conditions, including the effects of innovations.25
23Schumpeter wisely saw that voluntary savings could only cause simple eco-
nomic growth and could not give rise to business cycles.
24See Carolyn Shaw Solo, “Innovation in the Capitalist Process: A Critique of
the Schumpeterian Theory,” Quarterly Journal of Economics (August, 1951):
417–28.
25This refutes Clemence and Doody’s defense of Schumpeter against
Kuznets’s criticism that the cluster of innovations assumes a cluster of entrepre-
neurial ability. Clemence and Doody identified such ability solely with the mak-
ing of innovations and the setting up of new firms. See Richard V. Clemence and
Francis S. Doody, The Schumpeterian System (Cambridge, Mass.: Addison Wesley
Some Alternative Explanations of Depression: A Critique
75
In his later version, Schumpeter recognized that different spe-
cific innovations generating cycles would have different “periods
of gestation” for exploiting their opportunities until new output
had increased to its fullest extent. Hence, he modified his theory
by postulating an economy of three separate, and interacting,
cycles: roughly one of about three years, one of nine years, and one
of 55 years. But the postulate of multi-cycles breaks down any the-
ory of a general business cycle. All economic processes interact on
the market, and all processes mesh together. A cycle takes place
over the entire economy, the boom and depression each being gen-
eral. The price system integrates and interrelates all activities, and
there is neither warrant nor relevance for assuming hermetically-
sealed “cycles,” each running concurrently and adding to each
other to form some resultant of business activity. The multi-cycle
scheme, then, is a complete retreat from the original Schumpeter-
ian model, and itself adds grievous fallacies to the original.26
QUALITATIVE CREDIT DOCTRINES
Of the theories discussed so far, only the Austrian or Misesian
sees anything wrong in the boom. The other theories hail the
boom, and see the depression as an unpleasant reversal of previous
prosperity. The Austrian and Schumpeterian doctrines see the
depression as the inevitable result of processes launched in the
boom. But while Schumpeter considers “secondary wave” defla-
tion unfortunate and unsettling, he sees the boom–bust of his pure
model as the necessary price to be paid for capitalist economic
development. Only the Austrian theory, therefore, holds the infla-
tionary boom to be wholly unfortunate and sees the full depression
Press, 1950), pp. 52ff; Simon S. Kuznets, “Schumpeter’s Business Cycles,”
American Economic Review (June, 1940): 262–63.
26Schumpeter also discusses a “secondary wave” superimposed on his pure
model. This wave takes into account general inflation, price speculation, etc., but
there is nothing particularly Schumpeterian about this discussion, and if we dis-
card both the pure model and the multicycle approach, the Schumpeterian theo-
ry is finished.
76
America’s Great Depression
as necessary to eliminate distortions introduced by the boom. Var-
ious “qualitative credit” schools, however, also see the depression
as inevitably generated by an inflationary boom. They agree with
the Austrians, therefore, that booms should be prevented before
they begin, and that the liquidation process of depression should
be allowed to proceed unhampered. They differ considerably,
however, on the causal analysis, and the specific ways that the
boom and depression can be prevented.
The most venerable wing of qualitative credit theory is the old
Banking School doctrine, prominent in the nineteenth century and
indeed until the 1930s. This is the old-fashioned “sound banking”
tradition, prominent in older money-and-banking textbooks, and
spearheaded during the 1920s by two eminent economists: Dr.
Benjamin M. Anderson of the Chase National Bank, and Dr. H.
Parker Willis of the Columbia University Department of Banking,
and editor of the Journal of Commerce. This school of thought, now
very much in decline, holds that bank credit expansion only gen-
erates inflation when directed into the wrong lines, i.e., in assets
other than self-liquidating short-term credit matched by “real
goods,” loaned to borrowers of impeccable credit standing. Bank
credit expansion in such assets is held not to be inflationary, since
it is then allegedly responsive solely to the legitimate “needs of
business,” the money supply rising with increased production, and
falling again as goods are sold. All other types of loans—whether
in long-term credit, real estate, stock market, or to shaky borrow-
ers—are considered inflationary, and create a boom–bust situation,
the depression being necessary to liquidate the wasteful inflation of
the boom. Since the bank loans of the 1920s were extended largely
in assets considered unsound by the Banking School, these theo-
rists joined the “Austrians” in opposing the bank credit inflation of
the 1920s, and in warning of impending depression.
The emphasis of the Banking School, however, is invalid. The
important aspect of bank credit expansion is the quantity of new
money thrown into business lending, and not at all the type of busi-
ness loans that are made. Short-term, “self-liquidating” loans are just
as inflationary as long-term loans. Credit needs of business, on the
other hand, can be financed by borrowing from voluntary savings;
Some Alternative Explanations of Depression: A Critique
77
there is no good reason why short-term loans in particular should
be financed by bank inflation. Banks do not simply passively await
business firms demanding loans; these very demands vary inversely
to the rate of interest that the banks charge. The crucial point is
the injection of new money into business firms; regardless of the
type of business loan made, this money will then seep into the
economy, with the effects described in the Austrian analysis. The
irrelevance of the type of loan may be seen from the fact that busi-
ness firms, if they wish to finance long-term investment, can
finance it indirectly from the banks just as effectively as from direct
loans. A firm may simply cease using its own funds for financing
short-term inventory, and instead borrow the funds from the
banks. The funds released by this borrowing can then be used to
make long-term investments. It is impossible for banks to prevent
their funds being used indirectly in this manner. All credit is inter-
related on the market, and there is no way that the various types of
credit can be hermetically sealed from each other.27 And even if
there were, it would make no economic sense to do so.
In short, the “self-liquidating” loan is just as inflationary as any
other type of loan, and the only merit of this theory is the indirect
one of quantitatively limiting the lending of banks that cannot find
as many such loans as they would like. This loan does not even
have the merit of speedier retirement, since short-term loans can
and are renewed or reloaned elsewhere, thus perpetuating the loan
for as long a time as any “long-term” loan. This emphasis of the
Banking School weakened its salutary effect in the 1920s, for it
served to aggravate the general over-emphasis on types of loans—in
27Thus, during the late 1920s, when banks, influenced by qualitative credit
doctrines, tried to shut off the flow of credit to the stock market specifically, the
market was able to borrow from the swollen funds of non-bankers, funds swollen
by years of bank credit inflation.
On the fallacies of the qualitative credit theorists, and of their views on the
stock market, see the excellent study by Fritz Machlup, who at that time was a
leading Austrian School theorist, The Stock Market, Credit and Capital Formation
(New York: Macmillan, 1940).
78
America’s Great Depression
particular the stock market—as against the quantity of money out-
standing.
More dangerous than the Banking School in this qualitative
emphasis are those observers who pick out some type of credit as
being particularly grievous. Whereas the Banking School opposed
a quantitative inflation that went into any but stringently self-liq-
uidating assets, other observers care not at all about quantity, but
only about some particular type of asset—e.g., real estate or the
stock market. The stock market was a particular whipping boy in
the 1920s and many theorists called for restriction on stock loans
in contrast to “legitimate” business loans. A popular theory
accused the stock market of “absorbing” capital credit that would
otherwise have gone to “legitimate” industrial or farm needs.
“Wall Street” had been a popular scapegoat since the days of the
Populists, and since Thorstein Veblen had legitimated a fallacious
distinction between “finance” and “industry.”
The “absorption of capital” argument is now in decline, but
there are still many economists who single out the stock market for
attack. Clearly, the stock market is a channel for investing in indus-
try. If A buys a new security issue, then the funds are directly
invested; if he buys an old share, then (1) the increased price of
stock will encourage the firm to float further stock issues, and (2)
the funds will then be transferred to the seller B, who in turn will
consume or directly invest the funds. If the money is directly
invested by B, then once again the stock market has channelled
savings into investment. If B consumes the money, then his con-
sumption or dissaving just offsets A’s saving, and no aggregate net
saving has occurred.
Much concern was expressed in the 1920s over brokers’ loans,
and the increased quantity of loans to brokers was taken as proof
of credit absorption in the stock market. But a broker only needs a
loan when his client calls on him for cash after selling his stock;
otherwise, the broker will keep an open book account with no need
for cash. But when the client needs cash he sells his stock and gets
out of the market. Hence, the higher the volume of brokers’ loans
from banks, the greater the degree that funds are leaving the stock
market rather than entering it. In the 1920s, the high volume of
Some Alternative Explanations of Depression: A Critique
79
brokers’ loans indicated the great degree to which industry was
using the stock market as a channel to acquire saved funds for
investment.28
The often marked fluctuations of the stock market in a boom
and depression should not be surprising. We have seen the Aus-
trian analysis demonstrate that greater fluctuations will occur in
the capital goods industries. Stocks, however, are units of title to
masses of capital goods. Just as capital goods’ prices tend to rise in a
boom, so will the prices of titles of ownership to masses of capi-
tal.29 The fall in the interest rate due to credit expansion raises the
capital value of stocks, and this increase is reinforced both by the
actual and the prospective rise in business earnings. The discount-
ing of higher prospective earnings in the boom will naturally tend
to raise stock prices further than most other prices. The stock
market, therefore, is not really an independent element, separate
from or actually disturbing, the industrial system. On the contrary,
the stock market tends to reflect the “real” developments in the
business world. Those stock market traders who protested during
the late 1920s that their boom simply reflected their “investment
in America” did not deserve the bitter comments of later critics;
their error was the universal one of believing that the boom of the
1920s was natural and perpetual, and not an artificially-induced
prelude to disaster. This mistake was hardly unique to the stock
market.
Another favorite whipping-boy during recent booms has been
installment credit to consumers. It has been charged that installment
loans to consumers are somehow uniquely inflationary and
unsound. Yet, the reverse is true. Installment credit is no more
inflationary than any other loan, and it does far less harm than
business loans (including the supposedly “sound” ones) because it
28On all this, see Machlup, The Stock Market, Credit, and Capital Formation. An
individual broker might borrow in order to pay another broker, but in the aggre-
gate, inter-broker transactions cancel out and total brokers’ loans reflect only
broker-customer relations.
29Real estate values will often behave similarly, real estate conveying units of
title of capital in land.
80
America’s Great Depression
does not lead to the boom–bust cycle. The Mises analysis of the
business cycle traces causation back to inflationary expansion of
credit to business on the loan market. It is the expansion of credit to
business that overstimulates investment in the higher orders, mis-
leads business about the amount of savings available, etc. But loans
to consumers qua consumers have no ill effects. Since they stimu-
late consumption rather than business spending, they do not set a
boom–bust cycle into motion. There is less to worry about in such
loans, strangely enough, than in any other.
OVEROPTIMISM AND OVERPESSIMISM
Another popular theory attributes business cycles to alternating
psychological waves of “overoptimism” and “overpessimism.” This
view neglects the fact that the market is geared to reward correct
forecasting and penalize poor forecasting. Entrepreneurs do not
have to rely on their own psychology; they can always refer their
actions to the objective tests of profit and loss. Profits indicate that
their decisions have borne out well; losses indicate that they have
made grave mistakes. These objective market tests check any psy-
chological errors that may be made. Furthermore, the successful
entrepreneurs on the market will be precisely those, over the years,
who are best equipped to make correct forecasts and use good
judgment in analyzing market conditions. Under these conditions,
it is absurd to suppose that the entire mass of entrepreneurs will
make such errors, unless objective facts of the market are distorted
over a considerable period of time. Such distortion will hobble the
objective “signals” of the market and mislead the great bulk of
entrepreneurs. This is the distortion explained by Mises’s theory of
the cycle. The prevailing optimism is not the cause of the boom; it
is the reflection of events that seem to offer boundless prosperity.
There is, furthermore, no reason for general overoptimism to shift
suddenly to overpessimism; in fact, as Schumpeter has pointed out
(and this was certainly true after 1929) businessmen usually persist
in dogged and unwarranted optimism for quite a while after a
depression breaks out.30 Business psychology is, therefore, derivative
30See Schumpeter, Business Cycles, vol. 1, chap. 4.
Some Alternative Explanations of Depression: A Critique
81
from, rather than causal to, the objective business situation. Eco-
nomic expectations are therefore self-correcting, not self-aggravat-
ing. As Professor Bassic has pointed out:
The businessman may expect a decline, and he may cut
his inventories, but he will produce enough to fill the
orders he receives; and as soon as the expectations of a
decline prove to be mistaken, he will again rebuild his
inventories . . . the whole psychological theory of the
business cycle appears to be hardly more than an inver-
sion of the real causal sequence. Expectations more
nearly derive from objective conditions than produce
them. The businessman both expands and expects that
his expansion will be profitable because the conditions
he sees justifies the expansion . . . . It is not the wave of
optimism that makes times good. Good times are almost
bound to bring a wave of optimism with them. On the
other hand, when the decline comes, it comes not
because anyone loses confidence, but because the basic
economic forces are changing. Once let the real support
for the boom collapse, and all the optimism bred
through years of prosperity will not hold the line. Typi-
cally, confidence tends to hold up after a downturn has
set in.31
31V. Lewis Bassic, “Recent Developments in Short-Term Forecasting,” in
Short-Term Forecasting, Studies in Income and Wealth (Princeton, N.J.: National
Bureau of Economic Research, 1955), vol. 17, pp. 11–12. Also see pp. 20–21.
Part II
The Inflationary Boom: 1921–1929
4
The Inflationary Factors
Most writers on the 1929 depression make the same grave
mistake that plagues economic studies in general—the
use of historical statistics to “test” the validity of eco-
nomic theory. We have tried to indicate that this is a radically
defective methodology for economic science, and that theory can
only be confirmed or refuted on prior grounds. Empirical fact
enters into the theory, but only at the level of basic axioms and
without relation to the common historical–statistical “facts” used
by present-day economists. The reader will have to go elsewhere—
notably to the works of Mises, Hayek, and Robbins—for an elab-
oration and defense of this epistemology. Suffice it to say here that
statistics can prove nothing because they reflect the operation of
numerous causal forces. To “refute” the Austrian theory of the
inception of the boom because interest rates might not have been
lowered in a certain instance, for example, is beside the mark. It
simply means that other forces—perhaps an increase in risk, per-
haps expectation of rising prices—were strong enough to raise
interest rates. But the Austrian analysis, of the business cycle con-
tinues to operate regardless of the effects of other forces. For the
important thing is that interest rates are lower than they would have
been without the credit expansion. From theoretical analysis we know
that this is the effect of every credit expansion by the banks; but
statistically we are helpless—we cannot use statistics to estimate
what the interest rate would have been. Statistics can only record
past events; they cannot describe possible but unrealized events.
85
86
America’s Great Depression
Similarly, the designation of the 1920s as a period of inflation-
ary boom may trouble those who think of inflation as a rise in
prices. Prices generally remained stable and even fell slightly over
the period. But we must realize that two great forces were at work
on prices during the 1920s—the monetary inflation which pro-
pelled prices upward and the increase in productivity which low-
ered costs and prices. In a purely free-market society, increasing
productivity will increase the supply of goods and lower costs and
prices, spreading the fruits of a higher standard of living to all con-
sumers. But this tendency was offset by the monetary inflation
which served to stabilize prices. Such stabilization was and is a goal
desired by many, but it (a) prevented the fruits of a higher standard
of living from being diffused as widely as it would have been in a
free market; and (b) generated the boom and depression of the
business cycle. For a hallmark of the inflationary boom is that
prices are higher than they would have been in a free and unham-
pered market. Once again, statistics cannot discover the causal
process at work.
If we were writing an economic history of the 1921–1933 period,
our task would be to try to isolate and explain all the causal threads
in the fabric of statistical and other historical events. We would
analyze various prices, for example, to identify the effects of credit
expansion on the one hand and of increased productivity on the
other. And we would try to trace the processes of the business
cycle, along with all the other changing economic forces (such as
shifts in the demand for agricultural products, for new industries,
etc.) that impinged on productive activity. But our task in this book
is much more modest: it is to pinpoint the specifically cyclical
forces at work, to show how the cycle was generated and perpetu-
ated during the boom, and how the adjustment process was ham-
pered and the depression thereby aggravated. Since government
and its controlled banking system are wholly responsible for the
boom (and thereby for generating the subsequent depression) and
since government is largely responsible for aggravating the depres-
sion, we must necessarily concentrate on these acts of government
intervention in the economy. An unhampered market would not
generate booms and depressions, and, if confronted by a depression
The Inflationary Factors
87
brought about by prior intervention, it would speedily eliminate the
depression and particularly eradicate unemployment. Our con-
cern, therefore, is not so much with studying the market as with
studying the actions of the culprit responsible for generating and
intensifying the depression—government.
THE DEFINITION OF THE MONEY SUPPLY
Money is the general medium of exchange. On this basis, econ-
omists have generally defined money as the supply of basic cur-
rency and demand deposits at the commercial banks. These have
been the means of payment: either gold or paper money (in the
United States largely Federal Reserve Notes), or deposits subject
to check at the commercial banks. Yet, this is really an inadequate
definition. De jure, only gold during the 1920s and now only such
government paper as Federal Reserve Notes have been standard or
legal tender. Demand deposits only function as money because
they are considered perfect money-substitutes, i.e., they readily take
the place of money, at par. Since each holder believes that he can
convert his demand deposit into legal tender at par, these deposits
circulate as the unchallenged equivalent to cash, and are as good as
money proper for making payments. Let confidence in a bank dis-
appear, however, and a bank fail, and its demand deposit will no
longer be considered equivalent to money. The distinguishing fea-
ture of a money-substitute, therefore, is that people believe it can
be converted at par into money at any time on demand. But on this
definition, demand deposits are by no means the only—although
the most important—money-substitute. They are not the only
constituents of the money supply in the broader sense.1
In recent years, more and more economists have begun to
include time deposits in banks in their definition of the money
1See Lin Lin, “Are Time Deposits Money?” American Economic Review (March,
1937): 76–86. Lin points out that demand and time deposits are interchangeable
at par and in cash, and are so regarded by the public. Also see Gordon W.
McKinley, “The Federal Home Loan Bank System and the Control of Credit,”
Journal of Finance (September, 1957): 319–32, and idem, “Reply,” Journal of
Finance (December, 1958): 545.
88
America’s Great Depression
supply. For a time deposit is also convertible into money at par on
demand, and is therefore worthy of the status of money. Opponents
argue (1) that a bank may legally require a thirty-day wait before
redeeming the deposit in cash, and therefore the deposit is not
strictly convertible on demand, and (2) that a time deposit is not a
true means of payment, because it is not easily transferred: a check
cannot be written on it, and the owner must present his passbook
to make a withdrawal. Yet, these are unimportant considerations.
For, in reality, the thirty-day notice is a dead letter; it is practically
never imposed, and, if it were, there would undoubtedly be a
prompt and devastating run on the bank.2 Everyone acts as if his
time deposits were redeemable on demand, and the banks pay out
their deposits in the same way they redeem demand deposits. The
necessity for personal withdrawal is merely a technicality; it may
take a little longer to go down to the bank and withdraw the cash
than to pay by check, but the essence of the process is the same. In
both cases, a deposit at the bank is the source of monetary pay-
ment.3 A further suggested distinction is that banks pay interest on
2Governor George L. Harrison, head of the Federal Reserve Bank of New
York, testified in 1931 that any bank suffering a run must pay both its demand and
savings deposits on demand. Any request for a thirty-day notice would probably
cause the state or the Comptroller of Currency to close the bank immediately.
Harrison concluded: “in effect and in substance these [time] accounts are
demanded deposits.” Charles E. Mitchell, head of the National City Bank of New
York, agreed that “no commercial bank could afford to invoke the right to delay
payment on these deposits.” And, in fact, the heavy bank runs of 1931–1933 took
place in time deposits as well as demand deposits. Senate Banking and Currency
Committee, Hearings on Operations of National and Federal Reserve Banking Systems,
Part I (Washington, D.C., 1931), pp. 36, 321–22; and Lin Lin, “Are Time
Deposits Money?”
3Time deposits, furthermore, are often used directly to make payments.
Individuals may obtain cashier’s checks from the bank, and use them directly as
money. Even D.R. French, who tried to deny that time deposits are money,
admitted that some firms used time deposits for “large special payments, such as
taxes, after notification to the bank.” D.R. French, “The Significance of Time
Deposits in the Expansion of Bank Credit, 1922–1928,” Journal of Political Economy
(December, 1931): 763. Also see Senate Banking–Currency Committee, Hearings,
pp. 321–22; Committee on Bank Reserves, “Member Bank Reserves” in Federal
Reserve Board, 19th Annual Report, 1932 (Washington, D.C., 1933), pp. 27ff; Lin
Lin, “Are Time Deposits Money?” and Business Week (November 16, 1957).
The Inflationary Factors
89
time, but not on demand, deposits and that money must be non-
interest-bearing. But this overlooks the fact that banks did pay
interest on demand deposits during the period we are investigat-
ing, and continued to do so until the practice was outlawed in
1933.4 Naturally, higher interest was paid on time accounts to
induce depositors to shift to the account requiring less reserve.5
This process has led some economists to distinguish between time
deposits at commercial banks from those at mutual savings banks,
since commercial banks are the ones that profit directly from the
shift. Yet, mutual savings banks also profit when a demand depos-
itor withdraws his account at a bank and shifts to the savings bank.
There is therefore no real difference between the categories of
time deposits; both are accepted as money-substitutes and, in both
cases, outstanding deposits redeemable de facto on demand are
many times the cash remaining in the vault, the rest representing
loans and investments which have gone to swell the money supply.
To illustrate the way a savings bank swells the money supply,
suppose that Jones transfers his money from a checking account at
a commercial bank to a savings bank, writing a check for $1,000 to
his savings account. As far as Jones is concerned, he simply has
$1,000 in a savings bank instead of in a checking account at a com-
mercial bank. But the savings bank now itself owns $1,000 in the
checking account of a commercial bank and uses this money to
lend to or invest in business enterprises. The result is that there are
now $2,000 of effective money supply where there was only
$1,000 before—$1,000 held as a savings deposit and another
$1,000 loaned out to industry. Hence, in any inventory of the
money supply, the total of time deposits, in savings as well as in
4See Lin Lin, “Professor Graham on Reserve Money and the One Hundred
Percent Proposal,” American Economic Review (March, 1937): 112–13.
5As Frank Graham pointed out, the attempt to maintain time deposits as both
a fully liquid asset and an interest-bearing investment is trying to eat one’s cake
and have it too. This applies to demand deposits, savings-and-loan shares, and
cash surrender values of life insurance companies as well. See Frank D. Graham,
“One Hundred Percent Reserves: Comment,” American Economic Review (June,
1941): 339.
90
America’s Great Depression
commercial banks, should be added to the total of demand
deposits.6
But if we concede the inclusion of time deposits in the money
supply, even broader vistas are opened to view. For then all claims
convertible into cash on demand constitute a part of the money
supply, and swell the money supply whenever cash reserves are less
than 100 percent. In that case, the shares of savings-and-loan asso-
ciations (known in the 1920s as building-and-loan associations),
the shares and savings deposits of credit unions, and the cash sur-
render liabilities of life insurance companies must also form part of
the total supply of money.
Savings-and-loan associations are readily seen as contributing
to the money supply; they differ from savings banks (apart from
their concentration on mortgage loans) only in being financed by
shares of stock rather than by deposits. But these “shares” are
redeemable at par in cash on demand (any required notice being a
dead letter) and therefore must be considered part of the money
supply. Savings-and-loan associations grew at a great pace during the
1920s. Credit unions are also financed largely by redeemable shares;
they were of negligible importance during the period of the infla-
tionary boom, their assets totaling only $35 million in 1929. It might
be noted, however, that they practically began operations in 1921,
with the encouragement of Boston philanthropist Edward Filene.
Life insurance surrender liabilities are our most controversial
suggestion. It cannot be doubted, however, that they can suppos-
edly be redeemed at par on demand, and must therefore, accord-
ing to our principles, be included in the total supply of money. The
chief differences, for our purposes, between these liabilities and
others listed above are that the policyholder is discouraged by all
manner of propaganda from cashing in his claims, and that the life
6See McKinley, “The Federal Home Loan Bank System and the Control of
Credit,” pp. 323–24. On those economists who do and do not include time
deposits as money, see Richard T. Selden, “Monetary Velocity in the United
States,” in Milton Friedman, ed., Studies in the Quantity Theory of Money (Chicago:
University of Chicago Press, 1956), pp. 179–257.
The Inflationary Factors
91
insurance company keeps almost none of its assets in cash—
roughly between one and two percent. The cash surrender liabili-
ties may be approximated statistically by the total policy reserves of
life insurance companies, less policy loans outstanding, for policies
on which money has been borrowed from the insurance company
by the policyholder are not subject to immediate withdrawal.7
Cash surrender values of life insurance companies grew rapidly
during the 1920s.
It is true that, of these constituents of the money supply,
demand deposits are the most easily transferred and therefore are
the ones most readily used to make payments. But this is a ques-
tion of form; just as gold bars were no less money than gold coins,
yet were used for fewer transactions. People keep their more active
accounts in demand deposits, and their less active balances in time,
savings, etc. accounts; yet they may always shift quickly, and on
demand, from one such account to another.
INFLATION OF THE MONEY SUPPLY, 1921–1929
It is generally acknowledged that the great boom of the 1920s
began around July, 1921, after a year or more of sharp recession,
and ended about July, 1929. Production and business activity
began to decline in July, 1929, although the famous stock market
crash came in October of that year. Table 1 depicts the total money
supply of the country, beginning with $45.3 billion on June 30,
1921 and reckoning the total, along with its major constituents,
7In his latest exposition of the subject, McKinley approaches recognition of
the cash surrender value of life insurance policies as part of the money supply, in
the broader sense. Gordon W. McKinley, “Effects of Federal Reserve Policy on
Nonmonetary Financial Institutions,” in Herbert V. Prochnow, ed., The Federal
Reserve System (New York: Harper and Bros., 1960), pp. 217n., 222.
In the present day, government savings bonds would have to be included in
the money supply. On the other hand, pension funds are not part of the money
supply, being simply saved and invested and not redeemable on demand, and nei-
ther are mutual funds—even the modern “open-end” variety of funds are
redeemable not at par, but at market value of the stock.
92
America’s Great Depression
The Inflationary Factors
93
roughly semiannually thereafter.8 Over the entire period of the
boom, we find that the money supply increased by $28.0 billion, a
61.8 percent increase over the eight-year period. This is an aver-
age annual increase of 7.7 percent, a very sizable degree of infla-
tion. Total bank deposits increased by 51.1 percent, savings and
loan shares by 224.3 percent, and net life insurance policy reserves
by 113.8 percent. The major increases took place in 1922–1923,
late 1924, late 1925, and late 1927. The abrupt leveling off
occurred precisely when we would expect—in the first half of
1929, when bank deposits declined and the total money supply
remained almost constant. To generate the business cycle, inflation
must take place via loans to business, and the 1920s fit the specifi-
cations. No expansion took place in currency in circulation, which
totaled $3.68 billion at the beginning, and $3.64 billion at the end,
of the period. The entire monetary expansion took place in
money-substitutes, which are products of credit expansion. Only a
negligible amount of this expansion resulted from purchases of
government securities: the vast bulk represented private loans and
investments. (An “investment” in a corporate security is, econom-
ically, just as much a loan to business as the more short-term cred-
its labeled “loans” in bank statements.) U.S. government securities
held by banks rose from $4.33 billion to $5.50 billion over the
period, while total government securities held by life insurance
companies actually fell from $1.39 to $1.36 billion. The loans of
savings-and-loan associations are almost all in private real estate,
and not in government obligations. Thus, only $1 billion of the
new money was not cycle-generating, and represented investments
in government securities; almost all of this negligible increase
occurred in the early years, 1921–1923.
The other non-cycle-generating form of bank loan is consumer
credit, but the increase in bank loans to consumers during the
8Data for savings-and-loan shares and life-insurance reserves are reliable only
for the end-of-the-year: mid-year data are estimated by the author by interpola-
tion. Strictly, the country’s money supply is equal to the above data minus the
amount of cash and demand deposits held by the savings and loan and life insur-
ance companies. The latter figures are not available, but their absence does not
unduly alter the results.
94
America’s Great Depression
1920s amounted to a few hundred million dollars at most; the bulk
of consumer credit was extended by non-monetary institutions.9
As we have seen, inflation is not precisely the increase in total
money supply; it is the increase in money supply not consisting in,
i.e., not covered by, an increase in gold, the standard commodity
money. In discussions of the 1920s, a great deal is said about the
“gold inflation,” implying that the monetary expansion was simply
the natural result of an increased supply of gold in America. The
increase in total gold in Federal and Treasury reserves, however,
was only $1.16 billion from 1921–1929. This covers only a negli-
gible portion of the total monetary expansion—the inflation of
dollars.
Specifically, Table 2 compares total dollar claims issued by the
U.S. government, its controlled banking system, and the other
TABLE 2
TOTAL DOLLARS AND TOTAL GOLD RESERVES*
(billions of dollars)
Total Dollar
Total Gold
Total Uncovered
Claims
Reserve
Dollars
June, 1921
44.7
2.6
42.1
June, 1929
71.8
3.0
68.8
*“Total dollar claims” is the “total money supply” of Table 1 minus that por-
tion of currency outstanding that does not constitute dollar claims against the gold
reserve: i.e., gold coin, gold certificates, silver dollars, and silver certificates.
“Total gold reserve” is the official figure for gold reserve minus the value of gold
certificates outstanding, and equals official “total reserves” of the Federal Reserve
Banks. Since gold certificates were bound and acknowledged to be covered by 100
percent gold backing, this amount is excluded from our reserves for dollar claims,
and similarly, gold certificates are here excluded from the “dollar” total. Standard
silver and claims to standard silver were excluded as not being claims to gold, and
gold coin is gold and a claim to gold. See Banking and Monetary Statistics (Wash-
ington, D.C.: Federal Reserve System, 1943), pp. 544–45, 409, and 346–48.
9On the reluctance of banks during this era to lend to consumers, see Clyde W.
Phelps, The Role of the Sales Finance Companies in the American Economy(Baltimore,
Maryland: Commercial Credit, 1952).
The Inflationary Factors
95
monetary institutions (the total supply of money) with the total
holdings of gold reserve in the central bank (the total supply of the
gold which could be used to sustain the pledges to redeem dollars
on demand). The absolute difference between total dollars and
total value of gold on reserve equals the amount of “counterfeit”
warehouse receipts to gold that were issued and the degree to
which the banking system was effectively, though not de jure, bank-
rupt. These amounts are compared for the beginning and end of
the boom period.
The total of uncovered, or “counterfeited,” dollars increased
from $42.1 to $68.8 billion in the eight-year period, an increase of
63.4 percent contrasting to an increase of 15 percent in the gold
reserve. Thus, we see that this corrected measure of inflation yields
an even higher estimate than before we considered the gold inflow.
The gold inflow cannot, therefore, excuse any part of the inflation.
GENERATING THE INFLATION, I:
RESERVE REQUIREMENTS
What factors were responsible for the 63 percent inflation of
the money supply during the 1920s? With currency in circulation
not increasing at all, the entire expansion occurred in bank
deposits and other monetary credit. The most important element
in the money supply is the commercial bank credit base. For while
savings banks, saving and loan associations, and life insurance com-
panies can swell the money supply, they can only do so upon the
foundation provided by the deposits of the commercial banking
system. The liabilities of the other financial institutions are
redeemable in commercial bank deposits as well as in currency, and
all these institutions keep their reserves in the commercial banks,
which therefore serve as a credit base for the other money-cre-
ators.10 Proper federal policy, then, would be to tighten monetary
10As McKinley says:
Just as the ultimate source of reserve for commercial banks
consists of the deposit liabilities of the Federal Reserve Banks,
so the ultimate source of the reserves of non-bank institutions
consist of the deposit liabilities of the commercial banks. The
96
America’s Great Depression
restrictions on commercial banks in order to offset credit expan-
sion in the other areas; failing, that is, the more radical reform of
subjecting all of these institutions to the 100 percent cash reserve
requirement.11
What factors, then, were responsible for the expansion of com-
mercial bank credit? Since banks were and are required to keep a
minimum percentage of reserves to their deposits, there are three
possible factors—(a) a lowering in reserve requirements, (b) an
increase in total reserves, and (c) a using up of reserves that were
previously over the minimum legal requirement.
On the problem of excess reserves, there are unfortunately no
statistics available for before 1929. However, it is generally known
that excess reserves were almost nonexistent before the Great
Depression, as banks tried to keep fully loaned up to their legal
requirements. The 1929 data bear out this judgment.12 We can
safely dismiss any possibility that resources for the inflation came
from using up previously excessive reserves.
We can therefore turn to the other two factors. Any lowering of
reserve requirements would clearly create excess reserves, and
money supply [is] . . . two inverted pyramids one on top of the
other. The Federal Reserve stands at the base of the lower
pyramid, and . . . by controlling the volume of their own
deposit liabilities, the FRBs influence not only the deposit lia-
bilities of the commercial banks but also the deposit liabilities
of all those institutions which use the deposit liabilities of the
commercial banks as cash reserves.
“The Federal Home Loan Bank,” p. 326. Also see Donald Shelby, “Some
Implications of the Growth of Financial Intermediaries,” Journal of Finance
(December, 1958): 527–41.
11It might be asked, despairingly: if the supposedly “savings” institutions (sav-
ings banks, insurance companies, saving and loan associations, etc.) are to be sub-
ject to a 100 percent requirement, what savings would a libertarian society per-
mit? The answer is: genuine savings, e.g., the issue of shares in an investing firm,
or the sale of bonds or other debentures or term notes to savers, which would fall
due at a certain date in the future. These genuinely saved funds would in turn be
invested in business enterprise.
12Banking and Monetary Statistics, pp. 370–71. The excess listed for 1929 aver-
ages about forty million dollars, or about two percent of total reserve balances.
The Inflationary Factors
97
thereby invite multiple bank credit inflation. During the 1920s,
however, member bank reserve requirements were fixed by statute
as follows: 13 percent (reserves to demand deposits) at Central
Reserve City Banks (those in New York City and Chicago); 10 per-
cent at Reserve City banks; and 7 percent at Country banks. Time
deposits at member banks only required a reserve of 3 percent,
regardless of the category of bank. These ratios did not change at
all. However, reserve requirements need not only change in the
minimum ratios; any shifts in deposits from one category to
another are important. Thus, if there were any great shift in
deposits from New York to country banks, the lower reserve
requirements in rural areas would permit a considerable net over-
all inflation. In short, a shift in money from one type of bank to
another or from demand to time deposits or vice versa changes the
effective aggregate reserve requirements in the economy. We must
therefore investigate possible changes in effective reserve require-
ments during the 1920s.
Within the class of member bank demand deposits, the impor-
tant categories, for legal reasons, are geographical. A shift from
country to New York and Chicago banks raises effective reserve
requirements and limits monetary expansion; the opposite shift
lowers requirements and promotes inflation. Table 3 presents the
total member bank demand deposits in the various areas in June,
1921, and in June, 1929, and the percentage which each area bore
to total demand deposits at each date.
We see that the percentage of demand deposits at the country
banks declined during the twenties, from 34.2 to 31.4, while the
percentage at urban banks increased, in both categories. Thus, the
shift in effective reserve requirements was anti-inflationary, since
the urban banks had higher legal requirements than the country
banks. Clearly, no inflationary impetus came from geographical
shifts in demand deposits.
What of the relation between member and non-member bank
deposits? In June, 1921, member banks had 72.6 percent of total
demand deposits; eight years later they had 72.5 percent of the
total. Thus, the relative importance of member and non-member
98
America’s Great Depression
banks remained stable over the period, and both types expanded in
about the same proportion.13
TABLE 3
MEMBER BANK DEMAND DEPOSITS*
Central
Date
Reserve City
Reserve City
Country
Total
(in billions of dollars)
June 30, 1921
5.01
4.40
4.88
14.29
June 30, 1929
6.87
6.17
5.96
19.01
(in percentages)
June 30, 1921
35.7
30.8
34.2
100.0
June 29, 1929
36.1
32.5
31.4
100.0
*Banking and Monetary Statistics (Washington, D.C.: Federal Reserve Board,
1943), pp. 73, 81, 87 93, 99. These deposits are the official “U.S. Government”
plus “other demand” deposits. They are roughly equal to “net demand deposits.”
“Demand deposits adjusted” are a better indication of the money supply and are
the figures we generally use, but they are not available for geographic categories.
The relation between demand and time deposits offers a more
fruitful field for investigation. Table 4 compares total demand and
time deposits:
13Banking and Monetary Statistics, pp. 34 and 75. The deposits reckoned are
“demand deposits adjusted” plus U.S. government deposits. A shift from member
to non-member bank deposits would tend to reduce effective reserve require-
ments and increase excess reserves and the money supply, since non-member
banks use deposits at member banks as the basis for their reserves. See Lauchlin
Currie, The Supply and Control of Money in the United States (2nd ed., Cambridge,
Mass.: Harvard University Press, 1935), p. 74.
The Inflationary Factors
99
TABLE 4
DEMAND AND TIME DEPOSITS
(in billions of dollars)
Percent
Demand
Time
Demand Deposits
Date
Deposits
Deposits
of Total
June 30, 1921
17.5
16.6
51.3
June 29, 1929
22.9
28.6
44.5
Thus, we see that the 1920s saw a significant shift in the rela-
tive importance of demand and time deposits: demand deposits
were 51.3 percent of total deposits in 1921, but had declined to
44.5 percent by 1929. The relative expansion of time deposits sig-
nified an important lowering of effective reserve requirements for
American banks: for demand deposits required roughly 10 percent
reserve backing, while time deposits needed only 3 percent reserve.
The relative shift from demand to time deposits, therefore, was an
important factor in permitting the great monetary inflation of the
1920s. While demand deposits increased 30.8 percent from 1921
to 1929, time deposits increased by no less than 72.3 percent!
Time deposits, during this period, consisted of deposits at com-
mercial banks and at mutual savings banks. Mutual savings banks
keep only time deposits, while commercial banks, of course, also
provide the nation’s supply of demand deposits. If we wish to ask to
what extent this shift from demand to time deposits was deliberate,
we may gauge the answer by considering the degree of expansion of
time deposits at commercial banks. For it is the commercial banks
who gain directly by inducing their customers to shift from
demand to time accounts, thereby reducing the amount of
required reserves and freeing their reserves for further multiple
credit expansion. In the first place, time deposits at commercial
banks were about twice the amount held at mutual savings banks.
And further, commercial banks expanded their time deposits by
79.8 percent during this period, while savings banks expanded
100
America’s Great Depression
theirs by only 61.8 percent. Clearly, commercial banks were the
leaders in the shift to time deposits.
This growth in time deposits was not accidental. Before the
establishment of the Federal Reserve System, national banks were
not legally permitted to pay interest on time deposits, and so this
category was confined to the less important state banks and savings
banks. The Federal Reserve Act permitted the national banks to
pay interest on time deposits. Moreover, before establishment of
the Federal Reserve System, banks had been required to keep the
same minimum reserve against time as against demand deposits.
While the Federal Reserve Act cut the required reserve ratio
roughly in half, it reduced required reserves against time deposits
to 5 percent and, in 1917, to 3 percent. This was surely an open
invitation to the banks to do their best to shift deposits from the
demand to the time category.
TABLE 5
TIME DEPOSITS
(in billions of dollars)
All
Central
Savings Commercial Member
Reserve
Reserve
Country
Date
Banks
Banks
Banks City Banks City Banks Banks
June 30, 1921
5.5
10.9
6.3
.4
2.1
3.8
June 29, 1929
8.9
19.6
13.1
2.2
4.8
6.8
During the 1920s, time deposits increased most in precisely those
areas where they were most active and least likely to be misconstrued
as idle “savings.” Table 5 presents the record of the various categories
of time deposits. The least active time accounts are in savings
banks, the most active in the large city commercial banks. Bearing
this in mind, below are the increases over the period in the various
categories:
The Inflationary Factors
101
Savings Banks
61.8%
Commercial Banks
79.8
Member Banks
107.9
Country Banks
78.9
Reserve City Banks
128.6
Central Reserve City Banks
450.0
Thus, we see that, unerringly, the most active categories of time
deposits were precisely the ones that increased the most in the 1920s,
and that this correlation holds for each category. The most active—
the Central Reserve City accounts—increased by 450 percent.14
GENERATING THE INFLATION, II: TOTAL RESERVES
Two influences may generate bank inflation—a change in effec-
tive reserve requirements and a change in total bank reserves at the
Federal Reserve Bank. The relative strength of these two factors in
the 1920s may be gauged by Table 6.
Clearly, the first four years of this period was a time of greater
monetary expansion than the second four. The member bank con-
tribution to the money supply increased by $6.9 billion, or 37.1
percent, in the first half of our period, but only by $3.9 billion or
15.3 percent in the second half. Evidently, the expansion in the
first four years was financed exclusively out of total reserves, since
the reserve ratio remained roughly stable at about 11.5 : 1. Total
reserves expanded by 35.6 percent from 1921 to 1925, and member
bank deposits rose by 37.1 percent. In the later four years, reserves
expanded by only 8.7 percent, while deposits rose by 15.3 percent.
This discrepancy was made up by an increase in the reserve ratio
14On time deposits in the 1920s, see Benjamin M. Anderson, Economics and the
Public Welfare (New York: D. Van Nostrand, 1949), pp. 128–31; also C.A. Phillips,
T.F. McManus, and R.W. Nelson, Banking and the Business Cycle (New York:
Macmillan, 1937), pp. 98–101.
102
America’s Great Depression
TABLE 6
MEMBER BANK RESERVES AND DEPOSITS*
Reserves
Member Bank
Date
Member Bank
Deposits
Reserve Ratio
June 30, 1921
1.60
18.6
11.6 : 1
June 30, 1925
2.17
25.5
11.7 : 1
June 29, 1929
2.36
29.4
12.5 : 1
*Column 1 is the total legal member bank reserves at the Fed, excluding vault
cash (which remained steady at about $500 million throughout). Column 2 is
member bank deposits, demand and time. Column 3 is the ratio of deposits to
reserves.
from 11.7 : 1 to 12.5 : 1, so that each dollar of reserve carried more
dollars in deposits. We may judge how important shifts in reserve
requirements were over the period by multiplying the final reserve
figure, $2.36 billion, by 11.6, the original ratio of deposits to
reserves. The result is $27.4 billion. Thus, of the $29.4 billion in
member bank deposits in June, 1929, $27.4 billion may be
accounted for by total reserves, while the remaining $2 billion may
be explained by the shift in reserves. In short, a shift in reserves
accounts for $2 billion out of the $10.8 billion increase, or 18.5
percent. The remaining 81.5 percent of the inflation was due to
the increase in total reserves.
Thus, the prime factor in generating the inflation of the 1920s
was the increase in total bank reserves: this generated the expan-
sion of the member banks and of the non-member banks, which
keep their reserves as deposits with the member banks. It was the
47.5 percent increase in total reserves (from $1.6 billion to $2.36
billion) that primarily accounted for the 62 percent increase in the
total money supply (from $45.3 to $73.3 billion). A mere $760 mil-
lion increase in reserves was so powerful because of the nature of
our governmentally controlled banking system. It could roughly
generate a $28 billion increase in the money supply.
The Inflationary Factors
103
What then caused the increase in total reserves? The answer to
this question must be the chief object of our quest for factors
responsible for the inflationary boom. We may list the well-known
“factors of increase and decrease” of total reserves, but with special
attention to whether or not they can be controlled or must be uncon-
trolled by the Federal Reserve or Treasury authorities. The uncon-
trolled forces emanate from the public at large, the controlled stem
from the government.
There are ten factors of increase and decrease of bank reserves.
1. Monetary Gold Stock. This is, actually, the only uncontrolled
factor of increase—an increase in this factor increases total reserves
to the same extent. When someone deposits gold in a commercial
bank (as he could freely do in the 1920s), the bank deposits it at the
Federal Reserve Bank and adds to its reserves there by that
amount. While some gold inflows and outflows were domestic, the
vast bulk were foreign transactions. A decrease in monetary gold
stock causes an equivalent decrease in bank reserves. Its behavior
is uncontrolled—decided by the public—although in the long run,
Federal policies influence its movement.
2. Federal Reserve Assets Purchased. This is the preeminent con-
trolled factor of increase and is wholly under the control of the Fed-
eral Reserve authorities. Whenever the Federal Reserve purchases
an asset, whatever that asset may be, it can purchase either from
the banks or from the public. If it purchases the asset from a (mem-
ber) bank, it buys the asset and, in exchange, grants the bank an
increase in its reserve. Reserves have clearly increased to the same
extent as Federal Reserve assets. If, on the other hand, the Federal
Reserve buys the asset from a member of the public, it gives a
check on itself to the individual seller. The individual takes the
check and deposits it with his bank, thus giving his bank an
increase in reserves equivalent to the increase in Reserve assets. (If
the seller decides to take currency instead of deposits, then this
factor is exactly offset by an increase in money in circulation out-
side the banks—a factor of decrease.)
Gold is not included among these assets; it was listed in the first
category (Monetary Gold Stock) and is generally deposited in,
104
America’s Great Depression
rather than purchased by, the Federal Reserve Banks. The major
assets purchased are “Bills Bought” and “U.S. Government Secu-
rities.” U.S. Government Securities are perhaps the most publi-
cized field of “open-market operations”; Federal Reserve pur-
chases add to bank reserves and sales diminish them. Bills Bought
were acceptance paper which the Federal Reserve bought outright in
a policy of subsidy that practically created this type of paper de novo
in the United States. Some writers treat Bills Bought as an uncon-
trolled factor, because the Federal Reserve announced a rate at
which it would buy all acceptances presented to it. No law, how-
ever, compelled it to adopt this policy of unlimited purchase; it
therefore must be counted as a pure creation of Federal Reserve
policy and under its control.
3. Bills Discounted by the Federal Reserve. These bills are not pur-
chased, but represent loans to the member banks. They are redis-
counted bills, and advances to banks on their IOUs. Clearly a fac-
tor of increase, they are not as welcome to banks as are other ways
of increasing reserves, because they must be repaid to the System;
yet, while they remain outstanding, they provide reserves as effec-
tively as any other type of asset. Bills Discounted, in fact, can be
loaned precisely and rapidly to those banks that are in distress, and
are therefore a powerful and effective means of shoring up banks
in trouble. Writers generally classify Bills Discounted as uncon-
trolled, because the Federal Reserve always stands ready to lend to
banks on their eligible assets as collateral, and will lend almost
unlimited amounts at a given rate. It is true, of course, that the
Federal Reserve fixes this rediscount rate, and at a lower rate when
stimulating bank borrowing, but this is often held to be the only
way that the System can control this factor. But the Federal
Reserve Act does not compel, it only authorizes, the Federal
Reserve to lend to member banks. If the authorities want to exer-
cise an inflationary role as “lender of last resort” to banks in trou-
ble, it chooses to do so by itself. If it wanted, it could simply refuse
to lend to banks at any time. Any expansion of Bills Discounted,
then, must be attributed to the will of the Federal Reserve author-
ities.
The Inflationary Factors
105
On the other hand, member banks themselves have largely con-
trolled the speed of repayment of Reserve loans. When the banks
are more prosperous, they generally reduce their indebtedness to
the Federal Reserve. The authorities could compel more rapid
repayment, but they have decided to lend freely to banks and to
influence banks by changing its rediscount charges.
To separate controlled from uncontrolled factors as best we can,
therefore, we are taking the rather drastic step of considering any
expansion of Bills Discounted as controlled by the government, and
any reduction as being uncontrolled, and determined by the banks. Of
course, repayments will be partly governed by the amount of pre-
vious debt, but this seems to be the most reasonable division. We
must take this step, therefore, even though it complicates the his-
torical record. Thus, if Bills Discounted increase by $200 million
over some three-year period, we may call this a controlled increase
of $200 million, if we consider only this overall record. On the
other hand, if we break down the record from year to year, it may
be that Bills Discounted first increased by $500 million, then were
reduced by $400 million, and then increased again by $100 million
the final year. When we consider a year-to-year basis, then, con-
trolled increase of reserves for the three years was $600 million
and uncontrolled decrease was $400 million. The finer we break
down the record, therefore, the greater the extent both of con-
trolled increases by the government, and of uncontrolled declines
prompted by the banks. Perhaps the best way of resolving this
problem is to break down the record to the most significant peri-
ods. It would be far simpler to lump all Bills Discounted as con-
trolled and let it go at that, but this would distort the historical
record intolerably; thus, in the early 1920s it would give the Fed-
eral Reserve an undeserved accolade for reducing member bank
debts when this reduction was largely accomplished by the banks
themselves.
We may therefore divide Bills Discounted into: New Bills Dis-
counted (controlled factor of increase) and Bills Repaid (uncon-
trolled factor of decrease).
4. Other Federal Reserve Credit. This is largely “float,” or checks
on banks remaining temporarily uncollected by the Federal
106
America’s Great Depression
Reserve. This is an interest-free form of lending to banks and is
therefore a factor of increase wholly controlled by the Federal
Reserve. Its importance was negligible in the 1920s.
5. Money in Circulation Outside the Banks. This is the main fac-
tor of decrease—an increase in this item decreases total reserves to
the same extent. This is the total currency in the hands of the pub-
lic and is determined wholly by the relative place people wish to
accord paper money as against bank deposits. It is therefore an
uncontrolled factor, decided by the public.
6. Treasury Currency Outstanding. Any increase in Treasury cur-
rency outstanding is deposited with the Federal Reserve in the
Treasury’s deposit account. As it is spent on government expendi-
tures, the money tends to flow back into commercial bank
reserves. Treasury currency is therefore a factor of increase, and is
controlled by the Treasury (or by Federal statute). Its most impor-
tant element is silver certificates backed 100 percent by silver bul-
lion and silver dollars.
7. Treasury Cash Holdings. Any increase in Treasury cash hold-
ings represents a shift from bank reserves, while a decline in Trea-
sury cash is spent in the economy and tends to increase reserves. It
is therefore a factor of decrease and is controlled by the Treasury.
8. Treasury Deposits at the Federal Reserve. This factor is very
similar to Treasury cash holdings; an increase in deposits at the
Reserve represents a shift from bank reserves, while a decrease means
that more money is added to the economy and swells bank reserves.
This is, therefore, a factor of decrease controlled by the Treasury.
9. Non-member Bank Deposits at the Federal Reserve. This factor
acts very similarly to Treasury deposits at the Federal Reserve. An
increase in non-member bank deposits lowers member bank
reserves, for they represent shifts from member banks to these
other accounts. A decline will increase member bank reserves.
These deposits are mainly made by non-member banks, and by
foreign governments and banks. They are a factor of decrease, but
uncontrolled by the government.
10. Unexpended Capital Funds of the Federal Reserve. They are
capital funds of the Federal Reserve not yet expended in assets
The Inflationary Factors
107
(largely bank premises and expenses of operation). This capital is
drawn from commercial banks, and, therefore, if unexpended, is a
withdrawal of reserves. This is almost always a negligible item; it
is clearly under the control of the Federal Reserve authorities.
Summing up, the following are the factors of change of mem-
ber bank reserves:15
Factors of Increase
Monetary Gold Stock...................................................uncontrolled
Federal Reserve Assets Purchased....................................controlled
Bills Bought
U.S. Government Securities
New Bills Discounted.......................................................controlled
Other Federal Reserve Credit..........................................controlled
Treasury Currency Outstanding.......................................controlled
Factors of Decrease
Outside Money in Circulation......................................uncontrolled
Treasury Cash Holdings...................................................controlled
Treasury Deposits at the Federal Reserve........................controlled
Unexpended Capital Funds of the Federal Reserve........controlled
Non-member Bank Deposits at the Federal
Reserve......................................................................uncontrolled
Bills Repaid...................................................................uncontrolled
An overall survey of the entire 1921–1929 period does not give
an accurate picture of the broad forces behind the movements in
total reserves. For a while total reserves continued to increase.
15The well-known category of “Federal Reserve Credit” consists of Federal
Reserve Assets Purchased and Bills Discounted.
108
America’s Great Depression
There were continual fluctuations within the various categories,
with some increasing and other decreasing in any one period and
different factors predominating at different times. Tables 7 and 8
depict the forces causing changes in total reserves during the
1920s. Table 7 breaks down 1921–1929 into 12 subperiods, shows
the changes in each causal factor, and the consequent changes in
member bank reserves, for each subperiod. Table 8 transforms the
data of Table 7 into per-month figures, thus enabling comparison
of the relative rates of change for the various periods.
Member bank reserves totaled $1604 million on June 30, 1921,
and reached $2356 million eight years later. Over the 12 subperi-
ods, uncontrolled reserves declined by $1.04 billion, while con-
trolled reserves increased by $1.79 billion. By themselves, then,
uncontrolled factors were deflationary; the inflation was clearly
precipitated deliberately by the Federal Reserve. The plea that the
1920s was simply a “gold inflation” that the Federal Reserve did
not counter actively is finally exploded. Gold was never the major
problem, and in not one subperiod did it provide the crucial factor
in increasing reserves.
In the 12 subperiods, uncontrolled factors declined seven times
and increased five times. Controlled factors, on the other hand, rose
in eight periods and declined in four. Of the controlled factors, Bills
Bought played a vital role in changing reserves in nine periods, Gov-
ernment Securities in seven, Bills Discounted in five, and Treasury
Currency in three (the first three). If we add up, regardless of arith-
metic sign, the total impact of each controlled factor on reserves
over the twelve periods, we find Government Securities in the lead
(with $2.24 billion), Bills Bought slightly behind ($2.16 billion), and
New Discounts behind that ($1.54 billion).
At the start of the eight-year period, Bills Discounted totaled
$1.75 billion, Bills Bought were $40 million, U.S. Government
Securities held were $259 million, Treasury Currency Outstanding
totaled $1.75 billion, Monetary Gold Stock was $3 billion, and
Money in Circulation was $4.62 billion.
Tables 7 and 8 are organized as follows. Bills Discounted, Bills
Bought, Government Securities held by the Federal Reserve, and
The Inflationary Factors
109
XII
Dec. 1928–
June 1929
XI
July 1928–
Dec. 1928
X
Dec. 1927–
July 1928
IX
July 1927–
Dec. 1927
VIII
Oct. 1926–
July 1927
VII
Nov. 1925–
Oct. 1926
VI
Nov. 1924–
Nov. 1925
V
June 1924–
Nov. 1924
IV
Oct. 1923–
June 1924
III
Dec. 1922–
Oct. 1923
II
July 1922–
Dec. 1922
I
June 1921-
July 1922
Factors
110
America’s Great Depression
XII
Dec. 1928–
June 1929
XI
July 1928–
Dec. 1928
X
Dec. 1927–
July 1928
IX
July 1927–
Dec. 1927
VIII
Oct. 1926–
July 1927
VII
Nov. 1925–
Oct. 1926
VI
Nov. 1924–
Nov. 1925
V
June 1924–
Nov. 1924
IV
Oct. 1923–
June 1924
III
Dec. 1922–
Oct. 1923
II
July 1922–
Dec. 1922
I
June 1921–
July 1922
Factors
The Inflationary Factors
111
Other Credit constitute Federal Reserve Credit. Changes in Fed-
eral Reserve Credit (except for net reductions in Bills Discounted),
plus changes in Treasury Currency, Treasury Cash, Treasury
Deposits at the Federal Reserve, and Unexpended Capital Funds
of the Reserve constitute the controlled changes in member bank
reserves. Changes in Monetary Gold Stock, Money in Circulation,
and Other Deposits at the Federal Reserve constitute the uncon-
trolled changes, and the resultant effect constitutes the changes in
bank reserves. The arithmetic signs of the actual changes of factors
of decrease are reversed to accord with their effects on reserves;
thus, a reduction of $165 million in Money in Circulation from
1921–1929 is listed in the table as a change of plus 165 on reserves.
Any division into historical periods is to a degree arbitrary. Yet
the divisions of Tables 7 and 8 were chosen because the author
believes they accord best with the most significant subperiods of
the 1920s, subperiods which differ too much to be adequately
reflected in any overall assessment. The following are the unique
characteristics of each of these subperiods.
I. June 1921–July 1922(dates are all end-of-the-month). Bills
Discounted, which had been falling since 1920, continued
a precipitate decline, from $1751 million in June 1921 to a
bottom of $397 million in August 1922. Total Reserve
Credit also fell to reach a bottom in July 1922, as did
Money in Circulation, which reached its bottom in July
1922. July was therefore chosen as the terminal month.
II. July 1922–December 1922. Total Reserve Credit climbed
upward sharply, hitting a peak in December, as did total
reserves. Bills Discounted reached a peak in November.
III. December 1922–October 1923. Bills Discounted continued
to climb, reaching a peak in October. In the meanwhile,
U.S. Government Securities fell sharply to reach a
trough of 92 million in October, a trough for the whole
period.
IV. October 1923–June 1924. Bills Bought fell abruptly, to
reach a trough in July. Total Reserve Credit reached a
trough in June.
112
America’s Great Depression
V. June 1924–November 1924. Bills Discounted, which had
been falling since October 1923, continued to fall,
reaching bottom in November 1924. U.S. Government
Securities climbed to a peak in the same month. The
Monetary Gold Stock also reached a peak in November
1924. Bills Bought climbed to a peak in December 1924,
as did total Reserve Credit and total reserves.
VI. November 1924–November 1925. Bills Discounted
climbed again to a peak in November. U.S. Securities fell
to a trough in October, and total Reserve Credit reached
a peak in December.
VII. November 1925–October 1926. U.S. Government Securi-
ties reached a trough in October, and Bills Discounted a
peak in the same month. Clearly, both items milled
around during this period.
VIII. October 1926–July 1927. Bills Bought fell to a trough in
July, and Bills Discounted reached a trough in August.
Total Reserve Credit reached its trough in May.
IX. July 1927–December 1927. U.S. Government Securities
climbed to a peak in December, as did Bills Discounted,
total Reserve Credit, and total reserves.
X. December 1927–July 1928. Bills Bought fell to a low in
July, as did U.S. Government Securities, total Reserve
Credit, and total reserves. Bills Discounted climbed to a
peak in August.
XI. July 1928–December 1928. Bills Bought reached a peak in
December, as did total reserves, while Bills Discounted
and Reserve Credit reached a peak in November.
XII. December 1928–June 1929. Concludes the period under
study.
Using these subperiods and their changes, we may now analyze
precisely the course of the monetary inflation in the 1920s.
In Period I (June 1921–July 1922) a superficial glance would
lead one to believe that the main inflationary factor was the heavy
gold inflow, and that the Federal Reserve simply did not offset this
The Inflationary Factors
113
influx sufficiently. A deeper analysis, however, shows that the banks
paid off their loans at such a rapid rate that uncontrolled factors fell
by $303 million. If the government had remained completely pas-
sive, therefore, member bank reserves would have declined by
$303 million. Instead, the government actively pumped in $462
million of new reserves, yielding a net increase of $157 million.
(Subtraction differences come from rounding.) The major chan-
nels of this increase were purchase of U.S. Government Securities
($278 million), Treasury currency ($115 million), and Bills Bought
($100 million).
Period II (July 1922–December 1922) saw a rapid acceleration
of the inflation of reserves. Increasing at an average rate of $12
million per month in Period I, reserves now increased at a rate of
$35 million per month. Once again, uncontrolled factors declined
by $295 million, but they were more than offset by increases in
controlled reserves pumped into the economy. These consisted of
Bills Discounted ($212 million), Bills Bought ($132 million), and
Treasury Currency ($93 million).
Periods III and IV (December 1922–June 1924) saw the infla-
tion come roughly to a halt. Reserves actually fell slightly (by $4
million per month) in Period III (December 1922–October 1923),
and rose only slightly (by $6 million per month) in Period IV.
Simultaneously, bank deposits remained about level, member bank
demand deposits staying at about $13.5 billion. Total deposits and
total money supply, however, rose more in this period, with banks
shifting to time deposits to permit increases. (Demand deposits
rose by $450 million from June 1923 to June 1924, but time
deposits rose by $1.5 billion). Total money supply rose by $3 bil-
lion. The economy responded to the slowdown of inflation by
entering upon a mild minor recession, from May 1923 to July
1924.
The slight fall in reserves during Period III was brought about
by selling U.S. Government Securities (-$344 million) and reduc-
ing the amount of bills held (-$67 million). This, indeed, was a
positive decline, more than offsetting uncontrolled factors, which
had increased by $132 million. The decline in reserves would have
been even more effective, if the Federal Reserve had not increased
114
America’s Great Depression
its discounts ($266 million) and Treasury currency had not
increased ($47 million).
Period IV (October 1923–June 1924), however, began to repeat
the pattern of Period I and resume the march of inflation. Uncon-
trolled factors this time fell by $149 million, but they were more
than offset by a controlled increase of $198 million, led by the
heavy purchase of government securities ($339 million)—the
heaviest average monthly buying spree yet seen in the 1920s ($42.4
million).
Period V was the most rapid reserve inflation to date, over-
reaching the previous peak of late 1922. Reserves increased by
$39.8 million per month. Once again, the inflation was deliberate,
uncontrolled factors declining by $262 million, but offset by a
deliberate increase of $461 million. The critical factors of inflation
were Bills Bought ($277 million) and U.S. Securities ($153 mil-
lion).
The pace of inflation was greatly slowed in the next three periods,
but continued nevertheless. From December 31, 1924 to June 30,
1927, reserves increased by $750 million; demand deposits
adjusted, of all banks, rose by $1.1 billion. But time deposits rose
by $4.3 billion during the same period, underscoring the banks’
ability to induce customers to shift from demand to time deposits,
while savings-and-loan shares and life-insurance reserves rose by
another $4.3 billion. In 1926, there was a decided slowing down of
the rate of inflation of the money supply, and this led to another
mild economic recession during 1926 and 1927.
In Period VI (November 1924–November 1925), a tendency of
uncontrolled reserves to decline was again more than offset by an
increase in controlled reserves; these were Bills Discounted ($446
million) and Bills Bought ($45 million).
Period VII (November 1925–October 1926) was the first time
after Period III that uncontrolled factors acted to increase reserves.
But, in contrast, this time, the Federal Reserve failed to offset these
factors sufficiently, although the degree of inflation was very slight
(only $2.4 million per month).
The Inflationary Factors
115
In Period VIII (October 1926–July 1927), the degree of infla-
tion was still small, but, ominously, the Federal Reserve stoked the
fires of inflation rather than checked them; controlled factors
increased, as did the uncontrolled. The culprits this time were the
U.S. Government’s Securities ($91 million) and Other Credit ($30
million).
Period IX (July 1927–December 1927), was another period of
accelerated and heavy inflation, surpassing the previous peaks of
latter 1922 and 1924. The per-monthly reserve increase in latter
1927 was $42.0 million. Once again, uncontrolled factors declined,
but were more than offset by a very large increase in controlled
reserves, emanating from Bills Bought ($220 million), U.S. Gov-
ernment Securities ($225 million), and Bills Discounted ($140 mil-
lion).
Period X was the sharpest deflationary period (in reserves) in the
1920s. Uncontrolled factors rose, but were more than offset by a
controlled decrease. Bills Discounted rose ($409 million), but the
deflationary lead, was taken by U.S. Government Securities (-$402
million) and Bills Bought (-$230 million). The decline of over
$200 million in reserves generated a decline of about $600 million
in member bank demand deposits. Time deposits rose by over $1
billion, however, and life-insurance reserves by $550 million, so
that the total money supply rose substantially, by $1.5 billion, from
the end of 1927 to mid-1928.
With the boom now well advanced in years, and developing
momentum, it was imperative for the Fed to accelerate its defla-
tionary pressure, if a great depression was to be avoided. The
deflation of reserves in the first half of 1928, as we have seen, was
not even sufficient to offset the shift to time deposits and the other
factors increasing the money supply. Yet, disastrously, the Fed
resumed its inflationary course in latter 1928. In Period XI, a ten-
dency of uncontrolled reserves to decrease, was offset by a positive
and deliberate increase ($364 million of controlled reserves,
against -$122 million of uncontrolled). The culprit in this program
was Bills Bought, which increased by $327 million, while all the
other reserve assets were only increasing slightly. Of all the periods
116
America’s Great Depression
of the 1920s, Period XI saw the sharpest average monthly rise in
Bills Bought ($65.4 million).
In the final Period XII, the tide, at last, definitely and sharply
turned. Uncontrolled factors increased by $390 million, but were
offset by no less than a $423 million decrease in controlled
reserves, consisting almost wholly of a reduction of $407 million in
Bills Bought. Total reserves fell by $33 million. Member bank
demand deposits, which also reached a peak in December, 1928,
fell by about $180 million. Total demand deposits fell by $540 mil-
lion.
So far, we have seen no reason why this deflation should have
had any greater effect than the deflation of Period X. Indeed, total
reserves fell by only $33 million as against $228 million in the for-
mer period. Member bank deposits fell by less ($180 million as
against $450 million), and total demand deposits fell by about the
same amount ($540 million against $470 million). The crucial dif-
ference, however, is this: in Period X, time deposits rose by $1.1
billion, insuring a rise in the nation’s total currency and deposits of
$600 million. But in Period XII, time deposits, far from rising,
actually fell by $70 million. Total deposits, therefore, fell by $510
million, while the total money supply rose very slightly, impelled
by continued growth in life insurance reserves. Time deposits no
longer came to the rescue, as in 1923 and 1928, and total money
supply rose only from $73 billion at the end of 1928, to $73.26 bil-
lion in mid-1929. For the first time since June 1921, the money
supply stopped increasing, and remained virtually constant. The
great boom of the 1920s was now over, and the Great Depression
had begun. The country, however, did not really discover the
change until the stock market finally crashed in October.
TREASURY CURRENCY
An increase in Treasury currency played a considerable role in
the inflation in the early years from 1921–1923. It is unusual for
Treasury currency to change considerably, as we see from its
behavior over the rest of the 1921–1929 period. The surprising
increase in 1921–1923 consisted almost exclusively of silver
The Inflationary Factors
117
certificates, representing silver bullion held in the Treasury at 100
percent of its value. (Of the $225 million increase in Treasury cur-
rency during Periods I–III, $211 million was silver certificates.) In
1918, the Pittman Act had permitted the United States govern-
ment to sell silver to Britain as a wartime measure, and the silver
stock of the Treasury, as well as the silver certificates based 100
percent upon them, was reduced as a consequence. In May, 1920,
however, in accordance with its obligation under the Act to buy sil-
ver bullion at the inflated price of one dollar per ounce until its
stock had been replenished, the Treasury began to buy silver bul-
lion, and this subsidy to domestic silver miners swelled bank
reserves. This silver purchase policy effectively ended by mid-
1923. The Treasury was forced to embark upon the silver purchase
program by the terms of the Pittman Act of 1918, the responsibil-
ity of the Wilson administration. The Harding administration,
however, could have repealed the Pittman Act if it had had the
desire to do so. It must therefore bear its share of the blame for the
silver purchase policy.16
BILLS DISCOUNTED
We have seen the important role played by discounted bills in
spurring the inflation. In 1923, 1925, and 1928, bills discounted
came to the rescue of the banks at periods when the Fed was try-
ing to exert anti-inflationary pressure by selling government secu-
rities, and, in 1923 and 1928 at least, reducing its holding of
acceptances. In each instance, bills discounted was responsible for
continuing the inflationary surge. The main trouble lay in the Fed-
eral Reserve’s assumption of the role of “lender of last resort,”
more or less passively waiting to grant discounts to any banks that
apply. But this was a policy adopted by the Fed, and it could have
been changed at any time. The Fed allowed itself to affect dis-
counts merely by setting and changing its rediscount rate.
16For the Pittman Act, see Edwin W. Kemmerer, The ABC of the Federal Reserve
System (9th ed., Princeton, N.J.: Princeton University Press, 1932), pp. 258–62.
118
America’s Great Depression
The bulk of discounts consisted of rediscounted business paper
(including commercial, agricultural, and industrial), and advances
to banks on their promissory notes secured by U.S. government
securities as collateral. When our period began, maximum legal
maturity on discounts was 90 days, except for agricultural paper,
which could be discounted for six months. In March, 1923, Con-
gress extended the special privilege to agricultural paper to nine
months, and the Fed was also granted authority to rediscount agri-
cultural paper held by the newly established Federal Intermediate
Credit Banks. More important, the FRB changed its original idea
of making careful credit analyses of the original borrowers, and
instead relied on the apparent solvency of the discounting banks,
or else directly bailed out banks in distress.17 This relaxation per-
mitted a greater quantitative level of rediscounts.
If the Federal Reserve induced changes in discounts through
the rediscount rate, it should certainly have always set it at a
“penalty rate,” i.e., high enough so that the banks would lose
money by borrowing from it. If a bank earns 5 percent on its loan
or investment, for example, and the Reserve sets its rediscount rate
above that, say at 8 percent, then a bank will only borrow in the
direst emergency when it desperately needs reserves. On the other
hand, if the rediscount rate is set below the market, the bank can
make a pleasant career out of borrowing, say, at 4 percent and
relending the money at 5 percent. To discourage bank discounting,
then, a permanent penalty rate above the market is essential.
There was considerable opinion in the early 1920s that the FRB
should maintain penalty rates in accord with British central bank-
ing tradition, but unfortunately the proponents only wanted rates
above the lowest-yielding loans—prime commercial paper. Such a
penalty rate would have been rather ineffectual, since the banks
could still profit by discounting and relending to their riskier bor-
rowers. A truly effective penalty rate would keep the rediscount
rate above the rates of all bank loans.
17H. Parker Willis, “Conclusions,” in H. Parker Willis, et al., “Report of an
Inquiry into Contemporary Banking in the United States” (typewritten ms., New
York, 1925), vol. 7, pp. 16–18.
The Inflationary Factors
119
Opinions clashed within the government in the early years on
proposals for a mild penalty rate above prime commercial paper.
The three main centers of monetary power were the Treasury, the
Federal Reserve Board, and the New York Federal Reserve Bank,
the latter two institutions clashing over power and policy through-
out our period. At first, the Federal Reserve leaders favored
penalty rates, and the Treasury was opposed: thus, the annual Fed-
eral Reserve Board report of 1920 promised establishment of the
high rates.18 By mid-1921, however, the Federal Reserve began to
weaken, with Governor W.P.G. Harding, Chairman of the Federal
Reserve Board, shifting his views largely for political reasons. Ben-
jamin Strong, very powerful Governor of the Federal Reserve
Bank of New York, also changed his mind at about the same time,
and, as a result, penalty rates were doomed, and were no longer an
issue from that point on.
Another problem of discount policy was whether the Federal
Reserve should lend continuously to banks or only in emergencies.19
While anti-inflationists must frown on either policy, certainly a
policy of continuous lending is more inflationary, since it stokes
the fires of monetary expansion continuously. The original theory
of the Federal Reserve was to promote continuous credit, but for a
while in the early 1920s, the Reserve shifted to favoring emergency
credit only. Indeed, in an October, 1922 conference, FRB author-
ities approved the proposal of New York Federal Reserve Bank
official, Pierre Jay, that the Federal Reserve should only supply
seasonal and emergency credit and currency, and that even this
should be restrained by the necessity of preventing credit inflation.
By early 1924, however, the Federal Reserve abandoned this doc-
trine, and its Annual Report of 1923 supported the following dis-
astrous policy:
The Federal Reserve banks are the . . . source to which
the member banks turn when the demands of the busi-
ness community have outrun their own unaided
18See Seymour E. Harris, Twenty Years of Federal Reserve Policy (Cambridge,
Mass.: Harvard University Press, 1933), vol. 1, pp. 3–10, 39–48.
19Ibid., pp. 108ff.
120
America’s Great Depression
resources. The Federal reserve supplies the needed
additions to credit in times of business expansion and
takes up the slack in times of business recession.20
If the Federal Reserve is to extend credit during a boom and
during a depression, it follows quite clearly that the Reserve’s pol-
icy was frankly to promote continuous and permanent inflation.
Finally, in early 1926, Pierre Jay himself repudiated his own
doctrine, and the “emergency” theory was now dead as a dodo.
Not only did the FRB, throughout the 1920s, keep rediscount
rates below the market and lend continuously, it also kept delaying
much needed raises in the rediscount rate. Thus, in 1923 and in
1925 the Fed sabotaged its own attempts to restrict credit by fail-
ing to raise the rediscount rate until too late, and it also failed to
raise the rate sufficiently in 1928 and 1929.21 One of the reasons
for this failure was the Federal Reserve’s consistent desire to sup-
ply “adequate” credit to business, and its fear of penalizing “legit-
imate business” through raising rates of interest. As soon as the
Fed was established, in fact, Secretary of the Treasury William G.
McAdoo trumpeted the policy which the Federal Reserve was to
continue pursuing throughout the 1920s and during the Great
Depression:
The primary purpose of the Federal Reserve Act was to
alter and strengthen our banking system that the
enlarged credit resources demanded by the needs of
business and agricultural enterprises will come almost
automatically into existence and at rates of interest low
enough to stimulate, protect and prosper all kinds of
legitimate business.22
Thus did America embark on its disastrous twentieth-century pol-
icy of inflation and subsequent depression—via a stimulation of
legalized counterfeiting for special privilege conferred by govern-
ment on favored business and farm enterprises.
20Federal Reserve, Annual Report, 1923, p. 10; cited in ibid., p. 109.
21See Phillips, et al., Banking and the Business Cycle, pp. 93–94.
22Harris, Twenty Years, p. 91.
The Inflationary Factors
121
As early as 1915 and 1916, various Board Governors had urged
banks to discount from the Federal Reserve and extend credit, and
Comptroller John Skelton Williams urged farmers to borrow and
hold their crops for a higher price. This policy was continued in
full force after the war. The inflation of the 1920s began, in fact,
with an announcement by the Federal Reserve Board (FRB) in
July, 1921, that it would extend further credits for harvesting and
marketing in whatever amounts were legitimately required. And,
beginning in 1921, Secretary of Treasury Andrew Mellon was pri-
vately urging the Fed that business be stimulated, and discount
rates reduced; the records indicate that his advice was heeded to
the full. Governor James, of the FRB, declared to his colleagues in
1926 that the “very purpose” of the Federal Reserve System “was
to be of service to the agriculture, industry and commerce of the
nation,” and no one was apparently disposed to contradict him.
Also in 1926, Dr. Oliver M.W. Sprague, economist and influential
advisor to the Federal Reserve System, prophesied no immediate
advances in the rediscount rate, because business had naturally
been assuming since 1921 that plenty of Federal Reserve credit
would always be available. Business, of course, could not be let
down.23 The Federal Reserve’s very weak discount policy in 1928
and 1929 was caused by its fear that a higher interest rate would no
longer “accommodate” business sufficiently.
An inflationary, low-discount-rate policy was a prominent and
important feature of the Harding and Coolidge administrations.
Even before taking office, President Harding had urged reduction
of interest rates, and he repeatedly announced his intention of
reducing discount rates after he became President. And President
Coolidge, in a famous pre-election speech on October 22, 1924,
declared that “It has been the policy of this administration to
reduce discount rates,” and promised to keep them low. Both Pres-
idents appointed FRB members who favored this policy.24 Eugene
23Oliver M.W. Sprague, “Immediate Advances in the Discount Rate
Unlikely,” The Annalist (1926): 493.
24See H. Parker Willis, “Politics and the Federal Reserve System,” Banker’s
Magazine (January, 1925): 13–20; idem, “Will the Racing Stock Market Become
122
America’s Great Depression
Meyer, chairman of the War Finance Corporation, warned the
banks that by advertising that they do not discount with this farm
loan agency, they were being “injurious to the public interest.”25
While such men as the head of the Merchants’ Association of New
York warned Coolidge about Federal Reserve credit to farmers,
others pressed for more inflation: a Nebraska congressman pro-
posed loans in new Treasury Notes at one-half percent to farmers,
Senator Magnus Johnson urged a maximum rediscount rate of 2
percent, and the National Farmer–Labor Party called for the
nationalization of all banking. Driven by their general desire to
provide cheap and abundant credit to industry, as well as their pol-
icy (as we shall see below) of helping Britain avoid the conse-
quences of its own monetary policies, the Federal Reserve sought
constantly to avoid raising discount rates. In latter 1928 and 1929,
with the need clearly evident, the FRB took refuge in the danger-
ous qualitative doctrine of “moral suasion.” Moral suasion was an
attempt to keep credit abundant to “legitimate” industry, while
denying it to “illegitimate” stock market speculators. As we have
seen, such attempts to segregate credit markets were inevitably self
defeating, and were mischievous in placing different ethical tags on
equally legitimate forms of business activity.
Moral suasion emerged in the famous February, 1929, letter of
the FRB to the various Federal Reserve Banks, warning them that
member banks were beyond their rights in making speculative
loans, and advising restraint of Federal Reserve credit speculation,
while maintaining credit to commerce and business. This step was
A Juggernaut?” The Annalist (November 24, 1924): 541– 42; and The Annalist
(November 10, 1924): 477.
25The War Finance Corporation had been dominant until 1921, when
Congress expanded its authorized lending power and reorganized it to grant cap-
ital loans to farm cooperatives. In addition, the Federal Land Bank system, set up
in 1916 to make mortgage loans to farm associations, resumed lending, and more
Treasury funds for capital were authorized. And finally, the farm bloc pushed
through the Agricultural Credits Act of 1923, which established twelve govern-
mental Federal Intermediate Credit Banks to lend to farm associations. See
Theodore Saloutos and John D. Hicks, Agricultural Discontent in the Middle West,
1900–1939 (Madison: University of Wisconsin Press, 1951), pp. 324–40.
The Inflationary Factors
123
taken in evasive response to persistent urging by the New York
Federal Reserve Bank to raise the rediscount rate from 5 to 6 per-
cent, a feeble enough step that was delayed until the latter part of
1929. Whereas, the New York Bank was the more inflationary
organ in 1927 (as we shall see below), after that the New York Bank
pursued a far more sensible policy: general credit restraint, e.g.,
raising the rediscount rate, while the Federal Reserve Board fell
prey to qualitative credit fallacies at a peculiarly dangerous
period—1929. The FRB went so far as to tell the New York Bank
to lend freely and abundantly for commercial purposes.26 The late
Benjamin Strong had always held that it was impossible to earmark
bank loans, and that the problem was quantitative and not qualita-
tive. The New York Bank continued to stress this view, and refused
to follow the FRB directive, repeating that it should not concern
itself with bank loans, but rather with bank reserves and deposits.27
The refusal of the New York Bank to follow the FRB directive of
moral suasion finally drew a letter from the FRB on May 1, listing
certain New York member banks that were borrowing continu-
ously from the Federal Reserve, and were also carrying “too many”
stock loans, and requesting that the New York Bank deal with
them accordingly. On May 11, the New York Bank flatly refused,
reiterating that banks have a right to make stock loans, and that
there was no way to determine which loans were speculative. By
June 1, the FRB succumbed, and dropped its policy of moral sua-
sion. It did not raise the rediscount rate until August, however.28
26See Harris, Twenty Years, p. 209.
27Charles E. Mitchell, then head of the National City Bank of New York, has
been pilloried for years for allegedly defying the FRB and frustrating the policy
of moral suasion, by stepping in to lend to the stock market during the looming
market crisis at the end of March. But it now appears that Mitchell and the other
leading New York banks acted only upon approval of the Governor of the New
York Federal Reserve Bank and of the entire Federal Reserve Board, which thus
clearly did not even maintain the courage of its own convictions. See Anderson,
Economics and the Public Welfare, p. 206.
28See Charles O. Hardy, Credit Policies of the Federal Reserve System
(Washington, D.C.: Brookings Institution, 1932), pp. 122–38. Dr. Lawrence E.
Clark, a follower of H. Parker Willis, charged that Mr. Gates McGarrah,
Chairman of the New York Federal Reserve Bank at the time, opposed moral
124
America’s Great Depression
Apart from the actions of the New York Bank, the policy of
moral suasion failed, even on its own terms, for non-bank lenders
used their bank-derived funds to replace bank lenders in the stock
market. This inevitable result surprised and bewildered the quali-
tativists, and the stock market boom continued merrily onward.29
While stock market loans are no worse than any other form of
loan, and moral suasion was a fallacious evasion of the need for
quantitative restriction, any special governmental support for a cer-
tain type of loan is important in two ways: (1) government encour-
agement of one type of loan is apt to swell the overall quantity of
bank loans; and (2) it will certainly overstimulate the particular
loan and add to its readjustment difficulties in the depression
phase. We must therefore examine the important instances of par-
ticular governmental stimulation to the stock market in the 1920s.
While not as important as the increase in reserves and the money
supply, this special aid served to spur the quantitative increase, and
also created particular distortions in the stock market which caused
greater troubles in the depression.
One important aid to stock market inflation was the FRS policy
of keeping call loan rates (on bank loans to the stock market) par-
ticularly low. Before the establishment of the Federal Reserve Sys-
tem, the call rate frequently rose far above 100 percent, but since
its inception, the call rate never rose above 30 percent, and very
rarely above 10 percent.30 The call rates were controlled at these
suasion because he himself was engaged in stock market speculation and in bank
borrowing for that purpose. If this were the reason, however, McGarrah would
hardly have been—as he was—the main force in urging an increase in the redis-
count rate. Instead, he would have been against any check on the inflation. See
Lawrence E. Clark, Central Banking Under the Federal Reserve System (New York:
Macmillan, 1935), p. 267n.
29The moral suasion policy was searchingly criticized by former FRB
Chairman W.P.G. Harding. The policy continued on, however, probably at the
insistence of Secretary of the Treasury Mellon, who strongly opposed any increase
in the rediscount rate. See Anderson, Economics and the Public Welfare, p. 210.
30See Clark, Central Banking, p. 382. The call rate rarely went above 8 percent
in 1928, or above 10 percent in 1929. See Adolph C. Miller, “Responsibility for
Federal Reserve Policies: 1927–1929,” American Economic Review (September, 1935).
The Inflationary Factors
125
low levels by the New York Federal Reserve Bank, in close cooper-
ation with, and at the advice of, a Money Committee of the New
York Stock Exchange. The New York Fed also loaned consistently
to Wall Street banks for the purpose of regulating the call rate.
Another important means of encouraging the stock market
boom was a rash of cheering public statements, designed to spur
on the boom whenever it showed signs of flagging. President
Coolidge and Secretary of Treasury Mellon in this way acted as the
leading “capeadores of Wall Street.”31 Thus, when the emerging
stock market boom began to flag, in January, 1927, Secretary Mel-
lon drove it onward. The subsequent spurt in February leveled off
in March, whereupon Mellon announced the Treasury’s intention
to refinance the 43 percent Liberty Bonds into 32 percent notes
the next November. He predicted lower interest rates (accurately,
due to the subsequent monetary inflation) and urged low rates
upon the market. The announcement drove stock prices up again
during March. The boom again began to weaken in the latter part
of March, whereupon Mellon once more promised continued low
rediscount rates and pictured a primrose path of easy money. He
said, “There is an abundant supply of easy money which should
take care of any contingencies that might arise.” Stocks continued
upward again, but slumped slightly during June. This time Presi-
dent Coolidge came to the rescue, urging optimism upon one and
all. Again the market rallied strongly, only to react badly in August
when Coolidge announced he did not choose to run again. After a
further rally and subsequent recession in October, Coolidge once
more stepped into the breach with a highly optimistic statement.
Further optimistic statements by Mellon and Coolidge trumpeting
the “new era” of permanent prosperity repeatedly injected tonics
into the market. The New York Times declared on November 16
that Washington was the source of most bullish news and noted
the growing “impression that Washington may be depended upon
to furnish a fresh impetus for the stock market.”
31Ralph W. Robey, “The Capeadores of Wall Street,” Atlantic Monthly
(September, 1928).
126
America’s Great Depression
BILLS BOUGHT–ACCEPTANCES
Tables 7 and 8 show the enormous importance of Bills Bought
in the 1920s. While purchase of U.S. securities has received more
publicity, Bills Bought was at least as important and indeed more
important than discounts. Bills Bought led the inflationary parade
of Reserve credit in 1921 and 1922, was considerably more impor-
tant than securities in the 1924 inflationary spurt, and equally
important in the 1927 spurt. Furthermore, Bills Bought alone con-
tinued the inflationary stimulus in the fatal last half of 1928.
These Bills Bought were all acceptances (and almost all bankers’
acceptances), and the Federal Reserve policy on acceptances was
undoubtedly the most curious, and the most indefensible, of the
whole catalog of Federal Reserve policies. As in the case of securi-
ties, acceptances were purchased on the open market, and thus
provided reserves to banks outright with no obligation to repay (as
in discounting). Yet while the FRS preserved its freedom of action
in buying or selling U.S. securities, it tied its own hands on accept-
ances. It insisted on setting a very low rate on acceptances, thus
subsidizing and indeed literally creating the whole acceptance mar-
ket in this country, and then pledging itself to buy all the bills
offered at that cheap rate.32 The Federal Reserve thus arbitrarily
created and subsidized an artificial acceptance market in the
United States and bought whatever was offered to it at an artifi-
cially cheap rate. This was an inexcusable policy on two counts—
its highly inflationary consequences, and its grant of special privi-
lege to a small group at the expense of the general public.
In contrast to Europe, where acceptances had long been a
widely used form of paper, the very narrow market for them in this
country, and its subsidization by the FRS, led to the Reserve’s becom-
ing the predominant buyer of acceptances.33 It was a completely
32Acceptances are sold by borrowers to acceptance dealers or “acceptance
banks,” who in turn sell the bills to ultimate investors—in this case, the Federal
Reserve System.
33Thus, on June 30, 1927, over 26 percent of the nation’s total of bankers’
acceptances outstanding was held by the FRS for its own account, and another 20
percent was held for its foreign accounts (foreign central banks). Thus, 46 percent
The Inflationary Factors
127
Federal Reserve-made market, and used only in international
trade, or in purely foreign transactions. In 1928 and 1929, banks
avoided borrowing from the Fed by making acceptance loans
instead of straight loans, thus taking advantage of the FRS market
and cheap acceptance rates. When the Federal Reserve bought the
acceptance, the bank now acquired a reserve less expensively than
by discounting, and without having to repay. Hence the inflation-
ary role of acceptances in 1929 and its sabotaging of other Federal
Reserve attempts to restrain credit.
In addition to acceptances held by the FRS on its own account,
it also bought a large amount of acceptances as agent for foreign
Central Banks. Moreover, the Reserve’s buying rate on acceptances
for foreign account was lower than for its own, thus subsidizing
these foreign governmental purchases all the more. These hold-
ings were not included in “Bills Bought,” but they were endorsed
by the FRS, and, in times of crisis, such endorsement could
become a liability of the Federal Reserve; it did in 1931. The
Reserve’s acceptances were purchased from member banks, non-
member banks, and private acceptances houses—with the bills for
foreign account bought entirely from the private dealers.34
The first big investment in acceptances came in 1922, coincid-
ing with the FRB’s allowing the New York Reserve Bank to con-
trol acceptance policy. Federal Reserve holdings rose from $75
million in January to $272 million in December of that year.
Despite the fact that the Federal Reserve kept its buying rate on
acceptances below its rediscount rate, Paul Warburg, America’s
leading acceptance banker and one of the founders of the Federal
Reserve System, demanded still lower buying rates on accept-
ances.35 Undersecretary of the Treasury Gilbert, on the other
hand, was opposed to the specially privileged acceptance rates, but
of all bankers’ acceptances were held by the Federal Reserve, and the same pro-
portion held true in June, 1929. See Hardy, Credit Policies, p. 258.
34See Senate Banking and Currency Committee, Hearings On Operation of
National and Federal Reserve Banking Systems (Washington, D.C., 1931), Appendix,
Part 6, p. 884.
35See Harris, Twenty Years, p. 324n.
128
America’s Great Depression
the Federal Reserve continued its policy of subsidy, directed
largely by the New York Bank.36 It was, indeed, only in the first half
of 1929 that the Federal Reserve partially abandoned its subsidiz-
ing, and at least pushed its buying rate on acceptances above the
rediscount rate, thereby causing a sharp reduction in its acceptance
holdings. In fact, the decline in acceptances was almost the sole
factor in the decline of reserves in 1929 that brought the great
inflation of the 1920s to its end.
Why did the Federal Reserve newly create and outrageously
subsidize the acceptance market in this country? The only really
plausible reason seems to center around the role played by Paul M.
Warburg, former German investment banker who came to Amer-
ica to become a partner of Kuhn, Loeb and Company, and be one
of the founders of the Federal Reserve System. Warburg worked
for years to bring the rather dubious blessings of central banking
to the hitherto backward United States. After the war and during
the 1920s, Warburg continued to be chairman of the highly influ-
ential Federal Advisory Council, a statutory group of bankers
advising the Federal Reserve System. Warburg, it appears, was a
principal beneficiary of the Federal Reserve’s pampering of the
acceptance market. From its inception in 1920, Warburg was
Chairman of the Board of the International Acceptance Bank of
New York, the world’s largest acceptance bank. He also became a
director of the important Westinghouse Acceptance Bank and of
several other acceptance houses, and was the chief founder and
Chairman of the Executive Committee of the American Acceptance
Council, a trade association organized in 1919. Surely, Warburg’s
leading role in the Federal Reserve System was not unconnected
with his reaping the lion’s share of benefits from its acceptance pol-
icy. And certainly, there is hardly any other way adequately to
explain the adoption of this curious program. Indeed, Warburg
himself proclaimed the success of his influence in persuading the
36About half of the acceptances in the Federal Reserve System were held in
the Federal Reserve Bank of New York; more important, almost all the purchases
of acceptances were made by the New York Bank, and then distributed at definite
proportions to the other Reserve Banks. See Clark, Central Banking, p. 168.
The Inflationary Factors
129
Federal Reserve to loosen eligibility rules for purchase of accept-
ances, and to establish subsidized rates at which the Federal
Reserve bought all acceptances offered.37 And finally, Warburg was
a very close friend of Benjamin Strong, powerful ruler of the New
York Bank which engaged in the subsidy policy.38
The Federal government progressively widened the scope of
the acceptance market from the very inception of the Federal
Reserve Act. Before then, national banks had been prohibited from
purchasing acceptances. After the Act, banks were permitted to
buy foreign trade acceptances up to a limit of 50 percent of a bank’s
capital and surplus. Subsequent amendments raised the limit to
100 percent of capital and surplus, and then 150 percent, and
allowed other types of acceptances—“dollar exchange,” and
domestic acceptances. Furthermore, English acceptance practice
had been strictly limited to documentary exchange, representing
definite movements of goods. The Federal Reserve Board at first
tried to limit acceptance to such exchanges, but in 1923 it suc-
cumbed to the pressure of the New York Reserve Bank and per-
mitted “finance bills” without documents. Wider powers were also
granted to the New York and other Reserve Banks in 1921 and
1922 to purchase purely foreign acceptances, and their permissible
maturity was raised from three to six months. In 1923, as part of
the agricultural credit program, the Fed was permitted to redis-
count agricultural-based acceptances up to six months.39 In 1927,
37See a presidential address by Warburg before the American Acceptance
Council, January 19, 1923, in Paul M. Warburg, The Federal Reserve System (New
York: Macmillan, 1930), vol. 2, p. 822. Of course, Warburg would have preferred
an even larger subsidy. Even Warburg’s perceptive warning on the developing
inflation in March 1929, was marred by his simultaneous deploring of our “inabil-
ity to develop a country-wide bill market.” Commercial and Financial Chronicle
(March 9, 1929): 1443–44; also see Harris, Twenty Years, p. 324.
38See Lester V. Chandler, Benjamin Strong, Central Banker (Washington,
D.C.: Brookings Institution, 1958), p. 39 and passim. It was only on the insistence
of Warburg and Henry Davison of J.P. Morgan and Company, that Strong had
accepted this post.
39See H. Parker Willis, “The Banking Problem in the United States,” in
Willis, et al., “Report of an Inquiry into Contemporary Banking in the United
States,” pp. 1, 31–37.
130
America’s Great Depression
bills were made eligible even if drawn after the goods had been
moved.40
With the rules relaxed, purely foreign acceptances, represent-
ing goods stored in or shipped between foreign points, rose from
nothing to the leading role in Federal Reserve acceptance holdings
during the crucial 1928–1929 period. Foreign acceptance pur-
chases played a large part, especially in the latter half of 1929, in
frustrating all attempts to check the boom. Previous credit restric-
tions had been on the way to ending the inflationary boom in
1928. But in August, the Federal Reserve deliberately reversed its
tight money policy on the acceptance market, and the Board
authorized the Federal Reserve Banks to buy heavily in order to
accommodate credit needs.41 The reasons for this unfortunate
reversal were largely general: the political pressure for easier credit
in an election year, and the fear of repercussions on Europe of high
interest rates in the United States, played the leading roles. But
there was also a more specific cause connected with the foreign
acceptance market.
In contrast to older types of acceptance, the purely foreign
acceptances were bills representing stored goods awaiting sale,
rather than goods in transit between specific buyers and sellers.42
The bulk was used to finance the storage of unsold goods in Central
Europe, particularly Germany.43 How did this increase in the hold-
ing of German acceptances come about? As the result of a spec-
tacular American boom in foreign loans, financed by new issues of
foreign bonds. This boom flourished from 1924 on, reaching a
peak in mid-1928. It was the direct reflection of American credit
expansion, and particularly of the low interest rates generated by
40See A.S.J. Baster, “The International Acceptance Market,” American
Economic Review (June, 1937): 298.
41See Charles Cortez Abbott, The New York Bond Market, 1920–1930
(Cambridge, Mass.: Harvard University Press, 1937), pp. 124ff.
42See Hardy, Credit Policies, pp. 256–57. Also Hearings, Operation of Banking
Systems, Appendix, Part C, pp. 852ff.
43Sterling bills were also purchased by the Fed to help Great Britain, e.g., $16
million in late 1929 and $10 million in the summer of 1927. See Hardy, Credit
Policies, pp. 100ff.
The Inflationary Factors
131
that expansion. As we shall see further below, this result was delib-
erately fostered by the Federal Reserve authorities. Germany was
one of the leading borrowers on the American market during the
boom. Germany was undoubtedly short of capital, bereft as she
was by the war and then by her ruinous inflation, culminating in
late 1923. However, the German bonds floated in the United
States did not, as most people thought, rebuild German capital.
For these loans were largely extended to German local and state
governments, and not to private German business. The loans made
capital even scarcer in Germany, for the local governments were
now able to compete even more strongly with private business for
factors of production.44 To their great credit, many German
authorities, and especially Dr. Hjalmar Schacht, head of the
Reichsbank, understood the unsoundness of these loans, and they
together with the American Reparations Agent, Mr. S. Parker
Gilbert, urged the New York banking community to stop lending
to German local governments.45 But American investment
bankers, lured by the large commissions on foreign government
loans, sent hundreds of agents abroad to urge prospective borrow-
ers to float loans on the American market. They centered their
attention on Germany.46
The tide of foreign lending turned sharply after mid-1928. Ris-
ing interest rates in the United States, combined with the steep
44The boom in loans to Germany began with the 1924 “Dawes loan,” part of
the Dawes Plan reparations, with $110 million loaned to Germany by an invest-
ment banking syndicate headed by J.P. Morgan and Company.
45Schacht personally visited New York in late 1925 to press this course on the
banks, and he, Gilbert, and German Treasury officials sent a cable to the New
York banks in the same vein. The securities affiliate of the Chase National Bank
did comply with these requests. See Anderson, Economics and the Public Welfare,
pp. 150ff. See also Garet Garrett, A Bubble That Broke the World (Boston: Little,
Brown, 1932), pp. 23–24, and Lionel Robbins, The Great Depression (New York:
Macmillan, 1934), p. 64.
46“In late 1925, the agents of fourteen different American investment bank-
ing houses were in Germany soliciting loans from the German states and munic-
ipalities.” Anderson, Economics and the Public Welfare, p. 152. Also see Robert
Sammons, “Capital Movements,” in Hal B. Lary and Associates, The United States
in the World Economy (Washington, D.C.: U.S. Government Printing Office,
1943), pp. 95–100; and Garrett, A Bubble That Broke the World, pp. 20, 24.
132
America’s Great Depression
stock exchange boom, diverted funds from foreign bonds to
domestic stocks. German economic difficulties aggravated the
slump in foreign lending in late 1928 and 1929. In consequence,
German banks, finding their clients unable to float new bonds in
the United States, obtained loans in the form of acceptance cred-
its from the New York Reserve Bank, to cover the cost of carrying
unsold stocks of cotton, copper, flour, and other commodities in
German warehouses.47 Those American banks that served as
agents of foreign banks sold great quantities of foreign (largely
German) acceptances to other American banks and to the FRS.48
This explains the rise in Reserve holdings of German acceptances.
Other acceptances flourishing in 1928 and 1929 represented
domestic cotton and wheat awaiting export, and exchange bills
providing dollars to South America. In early 1929, there was also a
rash of acceptances based on the import of sugar from Cuba, in
anticipation of a heavier American tariff on sugar.49
Not only did the Federal Reserve—in effect the New York
Bank—subsidize the acceptance market, it also confined its subsi-
dizing to a few large acceptance houses. It refused to buy any
acceptances directly from business, insisting on buying them from
acceptance dealers as intermediaries—thus deliberately subsidizing
the dealers. Further, it only bought acceptances from the few deal-
ers with a capital of one million dollars and over. Another special
privilege was the Federal Reserve’s increasing purchase of accept-
ances under repurchase agreements. In this procedure, the New
York Bank agreed to buy acceptances from a few large and recog-
nized acceptance dealers who had the option to buy them back in
15 days at a currently fixed price. Repurchase agreements varied
from one-tenth to almost two-thirds of acceptance holdings.50 All
this tends to confirm our hypothesis of the Warburg role.
47See Clark, Central Banking, p. 333. As early as 1924, the FRB had suggest-
ed that American acceptance credits finance the export of cotton to Germany.
48See H. Parker Willis, The Theory and Practice of Central Banking (New York:
Harper and Bros., 1936), pp. 210–12, 223.
49Hearings, Operation of Banking Systems, pp. 852ff.
50Clark, Central Banking, pp. 242–48, 376–78; Hardy, Credit Policies, p. 248.
The Inflationary Factors
133
In short, the Federal Reserve granted virtual call loans to the
acceptance dealers, as well as unrestricted access at subsidized rates
and accorded these privileges to dealers who were not, of course,
members of the Federal Reserve System. In fact, as unincorporated
private bankers, the dealers did not even make public reports. So
curiously jealous was the New York Bank of the secrecy of its
favorites that it arrogantly refused to give a Congressional investi-
gating committee either a list of the acceptance dealers from
whom it had bought bills, or a breakdown of foreign acceptances
by countries. The officials of the New York Bank were not cited for
contempt by the committee.51
U.S. GOVERNMENT SECURITIES
Member bank reserves increased during the 1920s largely in
three great surges—one in 1922, one in 1924, and the third in the
latter half of 1927. In each of these surges, Federal Reserve pur-
chases of government securities played a leading role. “Open-mar-
ket” purchases and sales of government securities only emerged as
a crucial factor in Federal Reserve monetary control during the
1920s. The process began when the Federal Reserve tripled its
stock of government securities from November, 1921, to June,
1922 (its holdings totaling $193 million at the end of October, and
$603 million at the end of the following May). It did so not to
make money easier and inflate the money supply, these relation-
ships being little understood at the time, but simply in order to add
to Federal Reserve earnings. The inflationary result of these pur-
chases came as an unexpected consequence.52 It was a lesson that
was appreciatively learned and used from then on.
51Hearings, Operation of Banking Systems, Appendix, Part 6, pp. 847, 922–23.
52Yet not wholly unexpected, for we find Governor Strong writing in April,
1922 that one of his major reasons for open-market purchases was “to establish a
level of interest rates . . . which would facilitate foreign borrowing in this coun-
try . . . and facilitate business improvement.” Benjamin Strong to Under-
Secretary of the Treasury S. Parker Gilbert, April 18, 1922. Chandler, Benjamin
Strong, Central Banker, pp. 210–11.
134
America’s Great Depression
If the Reserve authorities had been innocent of the consequences
of their inflationary policy in 1922, they were not innocent of
intent. For there is every evidence that the inflationary result was
most welcome to the Federal Reserve. Inflation seemed justified as
a means of promoting recovery from the 1920–1921 slump, to
increase production and relieve unemployment. Governor Adolph
Miller, of the Federal Reserve Board, who staunchly opposed the
later inflationary policies, defended the 1922 inflation in Congres-
sional hearings. Typical of Federal Reserve opinion at this time was
the subsequent apologia of Professor Reed, who complacently
wrote that bank credit “was being productively employed and that
goods were being prepared for the consumer at least as rapidly as
his money income was expanding.”53
Open-market policy was then well launched, and played a
major role in the 1924 and 1927 inflationary spurts and therefore
in the overall inflation of the 1920s.
The individual Reserve Banks at first bought the securities on
their own initiative, and this decentralized policy was resented by
the Treasury. On the initiative of the Treasury, and seconded by Ben-
jamin Strong, the Governors of the various Reserve Banks formed an
Open-Market Committee to coordinate Reserve purchases and
sales. The Committee was established in June, 1922. In April,
1923, however, this Governors’ Committee was dissolved and a
new Open-Market Investment Committee was appointed by the
Federal Reserve Board. Originally, this was a coup by the Board to
exert leadership over open-market policy in place of the growing
power of Strong, Governor of the New York Bank. Strong was ill
throughout 1923, and it was during that year that the Board man-
aged to sell most of the FRB holdings of government securities. As
soon as he returned to work in November, however, Strong, as
chairman of the Open-Market Investment Committee, urged pur-
chases of securities without hesitation should there be even a
threat of business recession.
53Harold L. Reed, Federal Reserve Policy, 1921–1930 (New York:
McGraw–Hill, 1930), pp. 20, and 14–41. Governor Miller agreed “that though
prices were moving upward, so was production and trade, and sooner or later pro-
duction would overtake the rise of prices.” Ibid., pp. 40–41.
The Inflationary Factors
135
As a result of Strong’s new accession to power, the Federal
Reserve resumed within two months a heavy purchase of govern-
ment securities, and the economy was well launched on its dan-
gerous inflationary path. As Strong’s admiring biographer puts it:
“This time the Federal Reserve knew what it was doing, and its
purchases were not earnings but for broad policy purposes,” i.e.,
for inflation. Ironically, Benjamin Strong had now emerged as
more powerful than ever, and in fact from that time until his retire-
ment, the FRS’s open-market policy was virtually controlled by
Governor Strong.54 One of Strong’s first control devices was to
establish a “Special System Investment Account,” under which, as
in the case of acceptances, Reserve purchases of governments were
made largely by the New York Bank, which then distributed them
pro rata to those other Reserve Banks that wanted the securities.
Another new and important feature of the 1920s was the main-
tenance of a large volume of floating, short-term government debt.
Before the war, almost all of the U.S. debt had been funded into
long-term bonds. During the war, the Treasury issued a myriad of
short-term bills, only partially funded at a later date. From 1922
on, one half to one billion dollars of short-term Treasury debt
remained outstanding in the banks, and had to be periodically refi-
nanced. Member banks were encouraged to carry as much of these
securities as possible: the Treasury kept deposits in the banks, and
they could borrow from the Federal Reserve, using the certificates
as collateral. Federal open-market purchases also helped make a
market in government securities at low interest rates. As a result,
banks held more government debt in 1928 than they had held dur-
ing the war. Thus the Federal Reserve, by employing various
means to bolster the market for Federal floating debt, added to the
impetus for inflation.55
54See Chandler, Benjamin Strong, Central Banker, pp. 222–33, esp. p. 233. Also
see Hardy, Credit Policies, pp. 38–40; Anderson, Economics and the Public Welfare,
pp. 82–85, 144–47.
55See H. Parker Willis, “What Caused the Panic of 1929?” North American
Review (1930): 178; and Hardy, Credit Policies, p. 287. Tax exemption on income
from government bonds also spurred the banks’ purchases. See Esther Rogoff
Taus, Central Banking Functions of the United States Treasury, 1789–1941 (New
York: Columbia University Press, 1943), pp. 182ff.
5
The Development of the Inflation
We have seen how the leading factors in the changing of
reserves played their roles during the boom of the
1920s. Treasury currency played a considerable part in
the early years, due to the silver purchase policy inherited from the
Wilson Administration. Bills discounted were deliberately spurred
throughout the period by the Federal Reserve’s violation of central
banking tradition in keeping rediscount rates below the market.
Acceptances were subsidized outrageously, with the Federal
Reserve deliberately keeping acceptance rates very low and buying
all the acceptances offered at this cheap rate by the few leading
acceptance houses. Open-market purchase of government securi-
ties began as a means of adding to the earning assets of the Federal
Reserve Banks, but was quickly continued as a means of promot-
ing monetary expansion. We may now turn from the anatomy of
the inflation of the 1920s, to a genetic discussion of the actual
course of the boom, including an investigation of some of the rea-
sons for the inflationary policy.
FOREIGN LENDING
The first inflationary spurt, in late 1921 and early 1922—the
beginning of the boom—was led, as we can see in Table 7, by Fed-
eral Reserve purchases of government securities. Premeditated or
not, the effect was welcome. Inflation was promoted by a desire to
speed recovery from the 1920–1921 recession. In July, 1921, the
137
138
America’s Great Depression
Federal Reserve announced that it would extend further credits for
harvesting and agricultural marketing, up to whatever amounts
were legitimately required. Soon, Secretary Mellon was privately
proposing that business be further stimulated by cheap money.1
Another motive for inflation was one we shall see recurring as a
constant and crucial factor in the 1920s: a desire to help foreign
governments and American exporters (particularly farmers). The
process worked as follows: inflation and cheap credit in the United
States stimulated the floating of foreign loans in the U.S. One of
Benjamin Strong’s major motives for open-market purchases in
1921–1922 was to stimulate foreign lending. Inflation also helped
to check the inflow of gold from Europe and abroad, an inflow
caused by the fiat money inflation policies of foreign countries,
which drove away gold by raising prices and lowering interest
rates. Artificial stimulation of foreign lending in the U.S. also
helped increase or sustain foreign demand for American farm
exports.
The first great boom in foreign borrowing therefore coincided
with the Federal Reserve inflation of latter 1921 and early 1922.
The fall in bond yields during this period stimulated a surge in for-
eign lending, U.S. government yields falling from 5.27 percent in
June 1921 to 4.24 percent in June, 1922 (corporate bonds fell from
7.27 percent to 5.92 percent in the same period). Foreign bond
flotations, about $100 million per quarter-year during 1920, dou-
bled to about $200 million per quarter in the latter part of 1921.
This boom was helped by “a deluge of statements from official,
industrial, and banking sources setting forth the economic neces-
sity to the United States of foreign lending.”2
The 1921–1922 inflation, in sum, was promoted in order to
relieve the recession, stimulate production and business activity,
and aid the farmers and the foreign loan market.
1Seymour E. Harris, Twenty Years of Federal Reserve Policy (Cambridge, Mass.:
Harvard University Press, 1933), vol. 1, p. 94.
2Robert L. Sammons, “Capital Movements,” in Hal B. Lary and Associates,
The United States in the World Economy (Washington, D.C.: Government Printing
Office, 1943), p. 94.
The Development of the Inflation
139
In the spring of 1923, the Federal Reserve substituted credit
restraint for its previous expansion, but the restraint was consider-
ably weakened by an increase in Reserve discounts, spurred by the
rediscount rate being set below the market. Nevertheless, a mild
recession ensued, continuing until the middle of 1924. Bond yields
rose slightly, and foreign lending slumped considerably, falling
below a rate of one hundred million dollars per quarter during
1923. Particularly depressed were American agricultural exports to
Europe. Certainly part of this slump was caused by the Fordney–
McCumber Tariff of September 1922, which turned sharply away
from the fairly low Democratic tariff and toward a steeply protec-
tionist policy.3 Increased protection against European manufac-
tured goods delivered a blow to European industry, and also served
to keep European demand for American exports below what it
would have been without governmental interference.
To supply foreign countries with the dollars needed to purchase
American exports, the United States government decided, not sen-
sibly to lower tariffs, but instead to promote cheap money at home,
thus stimulating foreign borrowing and checking the gold inflow
from abroad. Consequently, the resumption of American inflation
on a grand scale in 1924 set off a foreign lending boom, which
reached a peak in mid-1928. It also established American trade,
not on a solid foundation of reciprocal and productive exchange,
but on a feverish promotion of loans later revealed to be unsound.4
Foreign countries were hampered in trying to sell their goods to
the United States, but were encouraged to borrow dollars. But
afterward, they could not sell goods to repay; they could only try
to borrow more at an accelerated pace to repay the loans. Thus, in
an indirect but nonetheless clear manner, American protectionist
policy must shoulder some of the responsibility for our inflationist
policy of the 1920s.
3See Abraham Berglund, “The Tariff Act of 1922,” American Economic Review
(March, 1923): 14–33.
4See Benjamin H. Beckhart, “The Basis of Money Market Funds,” in
Beckhart, et al., The New York Money Market (New York: Columbia University
Press, 1931), vol. 2, p. 70.
140
America’s Great Depression
Who benefitted, and who was injured, by the policy of protec-
tion cum inflation as against the rational alternative of free trade
and hard money? Certainly, the bulk of the American population
was injured, both as consumers of imports and as victims of infla-
tion and poor foreign credit and later depression. Benefitted were
the industries protected by the tariff, the export industries uneco-
nomically subsidized by foreign loans, and the investment bankers
who floated the foreign bonds at handsome commissions. Cer-
tainly, Professor F.W. Fetter’s indictment of America’s foreign eco-
nomic policy in the 1920s was not overdrawn:
Producers in those lines in which foreigners were com-
peting with us were “taken care of” by high tariffs,
promises of still higher tariffs from the Tariff Commis-
sion if “needed,” and those interested in foreign trade
were told how the Department of Commerce was going
to open up huge foreign markets. Foreign loans were
glorified by the same political leaders who wanted big-
ger and better trade restrictions, entirely oblivious to
the problems involved in the repayment of such loans. .
. . A tremendous volume of foreign loans made possible
exports far in excess of imports . . . and Secretary Mel-
lon and other defenders of this tariff policy pointed the
finger of ridicule at those who had prophesied that the
Fordney–McCumber Act would have an injurious effect
upon our foreign trade.5
The Republican administration, often wrongly considered to be
a “laissez-faire” government, actually intervened actively in for-
eign lending throughout the 1920s. Foreign loans had been rare in
the United States before the World War, and the United States
government had no statutory peacetime authority to interfere with
them in any way. And yet the government did intervene, though
5Frank W. Fetter, “Tariff Policy and Foreign Trade,” in J.G. Smith, ed.,
Facing the Facts (New York: G.P. Putnam’s Sons, 1932), p. 83. Also see George E.
Putnam, “What Shall We Do About Depressions?” Journal of Business (April,
1938): 130–42, and Winthrop W. Aldrich, The Causes of the Present Depression and
Possible Remedies (New York, 1933), pp. 7–8.
The Development of the Inflation
141
illegally. On May 25, 1921, President Harding and his cabinet held
a conference with several American investment bankers, at the
instigation of Secretary of Commerce Hoover, and Harding asked
to be informed in advance of all public flotations of foreign bonds,
so that the government “might express itself regarding them.”6
The bankers agreed. The state had been set for this meddling at a
Cabinet meeting five days before, where:
The Cabinet discussed the problem of favoring exports
and the desirability of the application of the proceeds of
foreign loans made in our own financial markets for the
purpose of exporting our commodities.7
In short, the Cabinet wished that banks floating foreign loans pro-
vide that part of the proceeds be spent in the United States. And
Herbert Hoover was so enthusiastic about subsidizing foreign
loans that he commented that even bad loans helped American
exports and thus provided a cheap form of relief and employ-
ment—a “cheap” form that later brought expensive defaults and
financial distress.8
In January, 1922, Secretary of Commerce Hoover prevailed on
American investment bankers to agree that agents of the Depart-
ment of Commerce would first investigate conditions in countries
requesting foreign loans, whether the would-be borrowers were
private or public. The applicant would also have to promise to pur-
chase materials in the United States, and the fulfillment of this
agreement would be inspected by an American commercial attachè
in the borrowing country. Happily, little came of this agreement.
In the meanwhile, the Harding request was repeatedly ignored,
and consequently the State Department sent a circular letter to the
investment bankers in March, 1922, repeating the Presidential
6Jacob Viner, “Political Aspects of International Finance,” Journal of Business
(April, 1928): 170. Also see Herbert Hoover, The Memoirs of Herbert Hoover (New
York: Macmillan, 1952), vol. 2, pp. 80–86.
7Jacob Viner, “Political Aspects of International Finance, Part II,” Journal of
Business (July, 1928): 359.
8Harris Gaylord Warren, Herbert Hoover and the Great Depression (New York:
Oxford University Press, 1959), p. 27.
142
America’s Great Depression
request, admitting that it was legally unenforceable, but declaim-
ing that “national interests” required that the State Department
offer its objections to any bond issue. During April and May, Sec-
retary Hoover protested the bankers’ reluctance, and urged that
banks be ordered to establish his desired rules for foreign loans,
else Congress would assume control. Harding and Coolidge, how-
ever, contented themselves with a far milder form of informal
intimidation.
Often the government, when challenged, denied any attempt at
dictation over foreign loans. But the State Department admitted
several times that it was exercising beneficial control, and admitted
it had objected to a number of loans. The most noteworthy ban was
on all loans to France, a punishment levied because France was still
in debt to the American government. It was a ban which the bankers
were often able to evade. Secretary of State Kellogg favored, but
could not obtain, outright legal regulation of foreign lending.
Knowing that the State Department was intervening in foreign
lending, the American public erroneously began to believe that
every foreign loan had the Federal government’s seal of approval
and was therefore a good buy. This, of course, stimulated reckless
foreign lending all the more.
The foreign lending of the 1920s was almost all private. In
1922, however, in a harbinger of much later developments, Secre-
tary of State Hughes urged Congress to approve a direct govern-
mental loan of five million dollars to Liberia, but the Senate failed
to ratify it.
HELPING BRITAIN
The great expansion of 1924 was designed not only to stimulate
loans to foreign countries but also to check their drains of gold to
the United States.9 The drains arose, primarily, from the inflation-
ary policies of the foreign countries. Great Britain, in particular,
faced a grave economic problem. It was preparing to return to the
9As we have indicated above, a third motive for the 1924 credit expansion was
to promote recovery in agriculture and business from the mild 1923 recession.
The Development of the Inflation
143
gold standard at the pre-war par (the pound sterling equaling
approximately $4.87), but this meant going back to gold at an
exchange rate higher than the current free-market rate. In short,
Britain insisted on returning to gold at a valuation that was 10–20
percent higher than the going exchange rate, which reflected the
results of war and postwar inflation. This meant that British prices
would have had to decline by about 10 to 20 percent in order to
remain competitive with foreign countries, and to maintain her all-
important export business. But no such decline occurred, primarily
because unions did not permit wage rates to be lowered. Real-wage
rates rose, and chronic large-scale unemployment struck Great
Britain. Credit was not allowed to contract, as was needed to bring
about deflation, as unemployment would have grown even more
menacing—an unemployment caused partly by the postwar estab-
lishment of government unemployment insurance (which permit-
ted trade unions to hold out against any wage cuts). As a result,
Great Britain tended to lose gold. Instead of repealing unemploy-
ment insurance, contracting credit, and/or going back to gold at a
more realistic parity, Great Britain inflated her money supply to
offset the loss of gold and turned to the United States for help. For
if the United States government were to inflate American money,
Great Britain would no longer lose gold to the United States. In
short, the American public was nominated to suffer the burdens of
inflation and subsequent collapse in order to maintain the British
government and the British trade union movement in the style to
which they insisted on becoming accustomed.10
The American government lost no time in rushing to the aid of
Britain. The “isolationism” of U.S. foreign policy in the 1920s is
almost wholly a myth, and nowhere is this more true than in eco-
nomic and financial matters. The 1927 conference between the
leading central bankers that led to the inflation of that year has
become famous; less well known is the fact that close collaboration
between Benjamin Strong, Governor of the Federal Reserve Bank
10See Lionel Robbins, The Great Depression (New York: Macmillan, 1934),
pp. 77–87; Sir William Beveridge, Unemployment, A Problem of Industry (London:
Macmillan, 1930), chap. 16; and Frederic Benham, British Monetary Policy
(London: P.S. King and Son, 1932).
144
America’s Great Depression
of New York, and Montagu Norman, head of the Bank of England,
began much earlier. On Norman’s appointment as Governor dur-
ing the War, Strong hastened to promise him his services. In 1920,
Norman began taking annual trips to America to visit Strong, and
Strong took periodic trips to visit Europe. All of these consulta-
tions were kept highly secret and were always camouflaged as “vis-
iting with friends,” “taking a vacation,” and “courtesy visits.” The
Bank of England gave Strong a desk and a private secretary for
these occasions, as did the Bank of France and the German Reichs-
bank. These consultations were not reported to the Federal Reserve
Board in Washington.11 Furthermore, the New York Bank and the
Bank of England kept in close touch via weekly exchange of private
cables.
As the eminent French economist Charles Rist, who repre-
sented the Bank of France at some of the important inter-Central
Bank conferences, has declared:
The idea of cooperation among the central banks of dif -
ferent countries, to arrive at a common monetary policy,
was born rather soon after the war. Before then, this
cooperation had only been exceptional and sporadic.12
As early as 1916, Strong began private correspondent relations
with the Bank of England, as well as with other European Central
Banks. In the summer of 1919, Strong was already contemplating
a secret conference of central bankers, and, moreover, was already
worried about American interest rates being higher than the
British, and thinking of arrangements with the Bank of England to
remedy this condition, thus foreshadowing the later agreements to
inflate in America in order to aid Britain.13 In November, 1921
Strong offered Norman a dollar-stabilization scheme, in the course
of which the Federal Reserve would lend dollars to Britain, Holland,
11Lawrence E. Clark, Central Banking Under the Federal Reserve System (New
York: Macmillan, 1935), pp. 310ff.
12Charles Rist, “Notice Biographique,” Revue d’Économie Politique (November–
December, 1955): 1005. (Translation mine.)
13Lester V. Chandler, Benjamin Strong, Central Banker (Washington, D.C.:
Brookings Institution, 1958), pp. 147–49.
The Development of the Inflation
145
Scandinavia, Japan, and Switzerland; but Norman turned the pro-
posal down.14
In 1925, the year Britain returned to the gold standard, the
United States helped greatly. As a direct measure, the New York
Bank extended Britain a line of credit for gold of up to $200 mil-
lion.15 At the same time, J.P. Morgan and Company authorized a
similar credit of $100 million to the British government, a loan
that would have been subsidized (if it had ever been used) by the
Federal Reserve. Both loans were arranged by Strong and Norman
in early January, 1925, and were warmly approved by Secretary of
Treasury Mellon, Governor Crissinaer, and unanimously by the
Federal Reserve Board.16 Similar lines of credit were extended to
bolster the Central Banks of Belgium ($10 million in 1926),
Poland ($5 million in 1927), and Italy ($15 million in 1927).
More insidious and damaging was aiding Britain by inflating in
the U.S. The 1924 expansion in America was much more than
coincidence with preparation for Britain’s return to gold. For the
pound sterling had fallen to $4.44 in mid-1922, and by mid-1924
was in even worse shape at $4.34. At that point,
matters took a decisive turn. American prices began to
rise [due to the American inflation]. . . . In the foreign
14Sir Henry Clay, Lord Norman (London: Macmillan, 1957), pp. 140–41.
15Former Assistant Secretary of the Treasury Oscar T. Crosby perceptively
attacked this credit at the time as setting a dangerous precedent for inter-govern-
mental lending. Commercial and Financial Chronicle (May 9, 1925): 2357ff.
16The Morgan credit was apparently instigated by Strong. See Chandler,
Benjamin Strong, Central Banker, pp. 284ff, 308ff, 312ff. Relations between the
New York Fed and the House of Morgan were very close throughout this period.
Strong had worked closely with the Morgan interests before assuming his post at
the Federal Reserve. It is therefore significant that “J.P. Morgan and Company
have been the fiscal agents in this country of foreign governments and have had
‘close working agreements’ with the Federal Reserve Bank of New York.” Clark,
Central Banking Under the Federal Reserve System, p. 329. In particular, the
Morgans were agents of the Bank of England. Also see Rist, “Notice
Biographique.” To their credit, however, Morgans refused to go along with a
Strong–Norman scheme to lend money to the Belgian government in order to
prop up the Belgian exchange rate at an overvalued level, and thus subsidize infla-
tionary Belgian policies.
146
America’s Great Depression
exchange markets a return to gold at the old parity was
anticipated. The sterling-dollar exchange appreciated
from $4.34 to $4.78. In the spring of 1925, therefore, it
was thought that the adjustment between sterling and
gold prices was sufficiently close to warrant a resump-
tion of gold payments at the old parity.17
That this result was brought about deliberately through credit
expansion in America, is clear from a letter from Strong to Mellon
in the spring of 1924, outlining the necessity of raising American
price levels relative to Great Britain’s and of lowering American
interest rates, to enable Britain to return to gold. For higher
American price levels would divert foreign trade balances from the
United States to England, while lower interest rates would simi-
larly divert capital balances. Lower interest rates, being a more
immediate outcome of credit expansion, received more attention.
Strong concluded this letter as follows:
the burden of this readjustment must fall more largely
upon us than upon them [Great Britain]. It will be diffi-
cult politically and socially for the British Government
and the Bank of England to face a price liquidation in
England . . . in face of the fact that their trade is poor
and they have over a million unemployed people receiv -
ing government aid.18
It is clear that by late 1924, the foreign exchange market saw that
the United States was inflating in order to help Britain, and, antic-
ipating success, raised the pound nearly up to its prewar par—an
appreciation caused by governmental action rather than by the
fundamental economic realities. The Federal Reserve certainly
kept its part of the rather one-sided bargain. Whereas throughout
1922 and 1923 the interest rate on bills in New York had been
above the rate in London, the Federal Reserve managed to push
these rates below those of London by mid-1924. As a result, the
gold inflow into the United States, of which about 40 percent had
17Robbins, The Great Depression, p. 80.
18Strong to Mellon, May 27, 1924. Quoted in Chandler, Benjamin Strong,
Central Banker, pp. 283–84, 293ff.
The Development of the Inflation
147
been coming from Great Britain, was checked for a time.19 As we
have seen, U.S. lending abroad was also greatly stimulated, thus
providing Europe with longer-term funds.
Inflationary measures to aid foreign governments also spurred
farm exports, since foreign countries could now expand their pur-
chases of American farm products. Farm prices rose in the latter
half of 1924, and the value of farm exports increased by over 20
percent from 1923–1924 to 1924–1925. Yet, despite all the aid, we
cannot say that the farmers particularly benefited from the foreign
economic policies of the 1920s as a whole, since the protective tar-
iff injured foreign demand for American products.
Instead of being grateful to the United States for its monetary
policy, Europe carped continually during the 1920s because Amer-
ica wasn’t inflating enough. Even in the intimate Norman–Strong
partnership, it is clear that, in the early years especially, Norman
was continually trying to prod Strong into a more inflationary
stance. In the 1919–1920 era, before the joint inflationary policy
had begun, Norman’s Treasury colleague Basil Blackett urged
Strong to let American prices “rise a little more”—and this in the
middle of a postwar boom in America. Later, the British urged
looser credit conditions in the U.S., but Strong was rather reluc-
tant during this early period.
In February, 1922, Norman hailed the easy credit in America
during the previous few months, and urged a further inflationary
fall in interest rates to match the burgeoning credit expansion in
Britain. At that time, Strong refused to inflate further, and Nor-
man continued to pepper Strong during 1922 and 1923 with
expressions of his displeasure at the American failure to expand
credit. But in 1924, helped by the siren song of Britain’s return to
the “gold standard” and by a mild recession at home, Strong capit-
ulated, so much so that by October Norman was jauntily telling
Strong, “You must continue with easy money and foreign loans
and we must hold on tight until we know . . . what the policy of this
19See Benjamin H. Beckhart, “Federal Reserve Policy and the Money Market,
1923–1931,” in The New York Money Market, vol. 4, p. 45.
148
America’s Great Depression
country is to be.”20 And yet, Norman was not fully satisfied with
his American servitor. Privately, he joined the general European
opinion in criticizing the United States for violating the alleged
“rules of the gold standard game,” by not inflating in multiple pro-
portion to the gold flowing into its coffers.21
This standard argument, however, completely misconceives the
role and function of the gold standard and governmental responsi-
bility under it. The gold standard is not some sort of “game,” to be
played among several countries according to some mythical
“rules.” Gold is simply the monetary medium, and the duty of gov-
ernment is to leave the people free to do with the gold as they see
fit. It is therefore its corollary duty not to inflate the money sup-
ply beyond the gold stock or to stimulate and encourage such infla-
tion. If the money supply is already inflated, it is at least its respon-
sibility not to inflate further. Whether money should be deflated
back to the gold level is a more difficult question which we need
not discuss here. If gold flows into a country, the government
should welcome the opportunity to raise the gold deposit ratio,
and thereby reduce the counterfeit proportion in the nation’s sup-
ply of money. Countries “lose gold” (since the drain is voluntary it
cannot be a true “loss”) as a consequence of inflationary policies by
their governments. These policies induce heavy domestic spending
abroad (necessarily with gold) and discourage the nation’s export
trade. If European countries disliked losing gold to the United
States, their governments should have contracted and not inflated
their money supply. Certainly it is absurd, though convenient, to
pin the blame for the consequences of a government’s unsound
policies upon the relatively sounder policies of another government.
The nobility of the American aim to help Europe return to the
gold standard becomes even more questionable when we realize
that Europe never did return to a full gold standard. Instead, it
adopted a “gold bullion” standard, which prohibited gold coinage,
20Norman to Strong, October 16, 1924. Cited in Chandler, Benjamin Strong,
Central Banker, p. 302.
21Norman to Hjalmar Schacht, December 28, 1926. Cited in Clay, Lord
Norman, p. 224.
The Development of the Inflation
149
thus restricting gold convertibility to heavy bars suitable only for
large international transactions. Often it chose a “gold exchange”
standard, under which a nation keeps its reserves not in gold but in
a “hard” currency like dollars. It then redeems its units only in the
other country’s harder currency. Clearly, this system permits an
international “pyramiding” of inflation on the world’s given stock
of gold. In both the gold bullion and the gold exchange standards,
the currency is virtually fiat, since the people are de facto prohibited
from using gold as their medium of exchange. The use of the term
“gold standard” by foreign governments in the 1920s, then, was
more of a deception than anything else. It was an attempt to draw
to the government the prestige of being on the gold standard,
while actually failing to abide by the limitations and requirements
of that standard. Great Britain, in the late 1920s, was on a gold bul-
lion standard, and most other “gold standard countries” were on
the gold exchange standard, keeping their titles to gold in London
or New York. The British position, in turn, depended on Ameri-
can resources and lines of credit, since only America was on a true
gold standard.
Thus, the close international Central Bank collaboration of the
1920s created a false era of seemingly sound prosperity, masking a
dangerous worldwide inflation. As Dr. Palyi has declared, “The
gold standard of the New Era was managed enough to permit the
artificial lengthening and bolstering of the boom, but it was also
automatic enough to make inevitable the eventual failure.”22 The pre-
war standard, Palyi points out, had been autonomous; the new gold
standard was based on the political cooperation of central banks,
which “impatiently fostered a volume of credit flow without regard
to its economic results.” And Dr. Hardy justly concluded, “Interna-
tional cooperation to support the gold standard . . . is the mainte-
nance of a cheap money policy without suffering the loss of gold.”23
22Melchior Palyi, “The Meaning of the Gold Standard,” Journal of Business
(July, 1941): 300–01. Also see Aldrich, The Causes of the Present Depression and
Possible Remedies, pp. 10–11.
23Palyi, “The Meaning of the Gold Standard,” p. 304; Charles O. Hardy,
Credit Policies of the Federal Reserve System (Washington, D.C.: Brookings
Institution, 1932), pp. 113–17.
150
America’s Great Depression
The fountainhead and inspiration of the financial world of the
1920s was Great Britain. It was the British government that con-
ceived the system of inter-central bank cooperation, and that per-
suaded the United States to follow its lead. Britain originated the pol-
icy as a means of (temporarily) evading its own economic dilemmas,
yet proclaimed it in the name of “humanitarian reconstruction.”
England, like the United States, also used cheap credit to lend
widely to Continental Europe and thus promote its own flagging
export market, hobbled by high costs imposed by excessive union
wage rates.
In addition, Great Britain persuaded other European countries
to adopt the gold exchange standard instead of the full gold stan-
dard, in order to promote its own “economic imperialism,” i.e., to
spur British exports to the Continent by inducing other countries
to return to gold at overvalued exchange rates. If other countries
overvalued their currencies vis-à-vis sterling, then British exports
would be bolstered. (Britain showed little concern that exports
from the Continent would be correspondingly hampered.) The
abortive and inflationary gold exchange standard permitted coun-
tries to return to gold (at least nominally) earlier and at a higher
exchange rate than they otherwise would have essayed.24 Other
countries were pressured by Great Britain to remain on the gold
bullion standard, as she was, rather than proceed onward to restore
a full gold-coin standard. To cooperate in international inflation, it
was necessary to keep gold from domestic circulation, and to hoard
it instead in Central Bank vaults. As Dr. Brown wrote:
In some countries the reluctance to adopt the gold bul-
lion standard was so great that some outside pressure
was needed to overcome it . . . i.e., strong representa-
tions on the part of the Bank of England that such
action would be a contribution to the general success of
24“The ease with which the gold exchange standard can be instituted, espe-
cially with borrowed money, has led a good many nations during the past decade
to ‘stabilize’ . . . at too high a rate.” H. Parker Willis, “The Breakdown of the
Gold Exchange Standard and its Financial Imperialism,” The Annalist (October
16, 1931): 626f. On the gold exchange standard, see also William Adams Brown,
Jr., The International Gold Standard Reinterpreted, 1914–1934 (New York: National
Bureau of Economic Research, 1940), vol. 2, pp. 732–49.
The Development of the Inflation
151
the stabilization effort as a whole. Without the informal
pressure . . . several efforts to return in one step to the
full gold standard would undoubtedly have been made.25
One important example of such pressure, joined in force by
Benjamin Strong, occurred in the spring of 1926, when Norman
induced Strong to support him in fiercely opposing a plan of Sir
Basil Blackett’s to establish a full gold-coin standard in India.
Strong went to the length of traveling to England to testify against
the measure, and was backed up by Andrew Mellon and aided by
economists Professor Oliver M.W. Sprague of Harvard, Jacob Hol-
lander of Johns Hopkins, and W. Randolph Burgess and Robert
Warren of the New York Reserve Bank. The American experts
warned that the ensuing gold drain to India would cause deflation
in other countries (i.e., reveal their existing over-inflation), and sug-
gested instead a gold exchange standard and domestic “economiz-
ing” of gold (i.e., economizing for credit expansion). In addition,
they urged wider banking and central banking facilities in India
(i.e., more Indian inflation), and advocated continued use of a silver
standard in India so as not to disrupt American silver interests by
going off silver and thus lowering the world silver price.26
Norman was grateful to his friend Strong for helping defeat the
Blackett Plan for a full Indian gold standard. To the objections of
some Federal Reserve Board members to Strong’s meddling in
purely foreign affairs, the formidable Secretary Mellon ended the
argument by saying that he had personally asked Strong to go to
England and testify.
To his great credit, Dr. Hjalmar Schacht, in addition to oppos-
ing our profligate loans to local German governments, also sharply
criticized the new-model gold standard. Schacht vainly called for a
return to the true gold standard of old, with capital exports
25William Adams Brown, Jr., The International Gold Standard Reinterpreted,
1914–1934 (New York: National Bureau of Economic Research, 1940), vol. 1,
p. 355.
26This is not to endorse the entire Blackett Plan, which also envisioned a £100
million gold loan to India by the U.S. and British governments. See Chandler,
Benjamin Strong, Central Banker, pp. 356ff.
152
America’s Great Depression
financed by genuine voluntary savings, and not by fiat bank
credit.27
A caustic but trenchant view of the financial imperialism of
Great Britain in the 1920s was expressed in the following entry in
the diary of Emile Moreau, Governor of the Bank of France:
England having been the first European country to
reestablish a stable and secure money has used that
advantage to establish a basis for putting Europe under
a veritable financial domination. The Financial Com-
mittee [of the League of Nations] at Geneva has been
the instrument of that policy. The method consists of
forcing every country in monetary difficulty to subject
itself to the Committee at Geneva, which the British
control. The remedies prescribed always involve the
installation in the central bank of a foreign supervisor
who is British or designated by the Bank of England, and
the deposit of a part of the reserve of the central bank at
the Bank of England, which serves both to support the
pound and to fortify British influence. To guarantee
against possible failure they are careful to secure the
cooperation of the Federal Reserve Bank of New York.
Moreover, they pass on to America the task of making
some of the foreign loans if they seem too heavy, always
retaining the political advantage of these operations.
England is thus completely or partially entrenched in
Austria, Hungary, Belgium, Norway, and Italy. She is in
the process of entrenching herself in Greece and Portu-
gal. . . . The currencies [of Europe] will be divided into
two classes. Those of the first class, the dollar and the
pound sterling, based on gold, and those of the second
class based on the pound and dollar—with a part of their
gold reserves being held by the Bank of England and the
Federal Reserve Bank of New York, the latter moneys
will have lost their independence.28
27See Beckhart, “The Basis of Money Market Funds,” p. 61.
28Entry of February 6, 1928. Chandler, Benjamin Strong, Central Banker,
pp. 379–80. Norman did not insist on League of Nations control, however, when
he and Strong agreed, in December 1927, to finance the stabilization of the
Italian lira, by jointly extending a $75 million credit to the Bank of Italy ($30 mil-
lion from the New York Bank), along with a $25 million credit by Morgan’s and
an equal loan by other private bankers in London. The Federal Reserve Board, as
well as Secretary Mellon, approved of these subsidies. Ibid., p. 388.
The Development of the Inflation
153
The motives for the American inflation of 1924, then, were to
aid Great Britain, the farmers, and, in passing, the investment
bankers, and finally, to help reelect the Administration in the 1924
elections. President Coolidge’s famous assurance to the country
about low discount rates typified the political end in view. And cer-
tainly the inflation was spurred by the existence of a mild recession
in 1923–1924, during which time the economy was trying to adjust
to the previous inflation of 1922. At first, the 1924 expansion
accomplished what it had intended—gold inflow into the United
States was replaced by a gold drain, American prices rose, foreign
lending was stimulated, interest rates were lowered, and President
Coolidge was triumphantly reelected. Soon, however, with the
exception of the last-named, the effects of the expansion dissi-
pated, and prices in America began to fall once more, gold flowed
in heavily again, etc. American farm product prices, which had
risen from an index of 100 in 1924 to 110 the year later, dropped
back again to 100 in 1926. Exports for farm and food products,
which had reached a peak during 1925, also fell sharply in the fol-
lowing year. In sum, the American economy entered into another
mild recession in the fall of 1926, continuing on into 1927. Britain
was in particularly bad straits, addicted to cheap credit, yet suffer-
ing chronic unemployment and continual drains of gold. But
Great Britain insisted on continuing its policy of cheap money and
credit expansion—an insistence of the British government rather
than its private bankers.29
Britain’s immediate problem stemmed directly from her insis-
tence on continuing cheap money. The Bank of England had low-
ered its discount rate from 5 percent to 42 percent in April, 1927,
in a vain attempt to stimulate British industry.30 This further weak-
ened the pound sterling, and Britain lost $11 million in gold during
29See Benjamin M. Anderson, Economics and the Public Welfare (New York: D.
Van Nostrand, 1949), p. 167.
30During the fall of 1925, Norman had similarly reduced Bank Rate. At that
time, Strong had been critical, and was also led by the American boom to raise
discount rates at home. By December, Britain’s Bank Rate was raised again to its
previous level.
154
America’s Great Depression
the next two months, and the Bank of France, in a strong creditor
position, tried to redeem its sterling in gold.31 Instead of tighten-
ing credit and raising interest rates sharply to meet this gold drain,
as canons of sound monetary policy dictated, Great Britain turned
to its old partner in inflation, the Federal Reserve System. The
stage was clearly set once more, according to the logic of the
American and British money managers, for another great dose of
credit expansion in the United States.
Accordingly, Governor Montagu Norman, the Mephistopheles
of the inflation of the 1920s, conferred with Strong and Moreau,
of the Bank of France, in Paris. He tried a variety of pressures dur-
ing 1927 to dissuade the Bank of France from selling its sterling
balances for gold—balances which, after all, were of little use to
the French.32 Norman also tried to induce the French to do some
inflating themselves, but Moreau was not a Benjamin Strong.
Instead, he not only remained adamant, but urged Norman to
allow Britain’s loss of gold to tighten credit and raise interest rates
in London (thus checking British purchase of francs). But Norman
was committed to a cheap money policy.
Strong, on the contrary, leaped to Britain’s aid. Trying to bol-
ster sterling, he used American gold to ease the gold premium in
Britain and also purchased some sterling bills to aid his ally. And,
furthermore, Strong and Norman organized the famous inter-cen-
tral bank conference at New York, in July, 1927. The conference
was held in camera, and included Norman, Strong, and representa-
tives from the Bank of France and the German Reichsbank:
Deputy Governor Charles Rist, and Dr. Schacht respectively.
Strong ran the American side with an iron hand, and even refused
to permit Mr. Gates McGarrah, Chairman of the Board of the
Federal Reserve Bank of New York, to attend the meeting. The
Federal Reserve Board in Washington was left in the dark, and was
31Much of its sterling balances were accumulated as the result of a heavy
British credit expansion in 1926.
32The Bank of France had acquired these balances in a struggle to stabilize
the franc at too low a rate, but without yet declaring gold convertibility. The lat-
ter step was finally taken in June, 1928.
The Development of the Inflation
155
allowed only a brief courtesy call from the distinguished guests.
The conference was held at the Long Island estates of Undersec-
retary of the Treasury Ogden Mills and of Mrs. Ruth Pratt of the
wealthy Standard Oil family.
Norman and Strong tried mightily to induce Rist and Schacht
to go along with a general four-country inflation, but the latter two
vigorously declined. Schacht continued his determined opposition
to inflation and artificially cheap money, and expressed his alarm at
the inflationary trend. Rist demurred also, and both Rist and
Schacht left for home. Rist agreed, however, to buy gold from New
York instead of London, thus easing the pressure on England to
redeem its obligations. The New York Reserve Bank, in turn,
agreed to supply France with gold at a subsidized rate: as cheap as
the cost of buying it from England, despite the higher transport
costs.
Remaining to weld their inflationary pact, Norman and Strong
agreed to embark on a mighty inflationary push in the United
States, lowering interest rates and expanding credit—an agree-
ment which Rist maintains was concluded before the four-power
conference had even begun. Strong had gaily told Rist that he was
going to give “a little coup de whiskey to the stock market.”33 Strong
also agreed to buy $60 million more of sterling from the Bank of
England.
The British press was delighted with this fruit of the fast Nor-
man–Strong friendship, and flattered Strong fulsomely. As early as
mid-1926, the influential London journal, The Banker, had said of
Strong that “no better friend of England” existed, had praised the
“energy and skillfullness that he has given to the service of Eng-
land,” and had exulted that “his name should be associated with
that of Mr. [Walter Hines] Page as a friend of England in her
greatest need.”34
33Rist, “Notice Biographique,” pp. 1006ff.
34See Clark, Central Banking Under The Federal Reserve System, p. 315. Paul
Warburg’s tribute to Strong was even more lavish. Warburg heralded Strong as the
pathfinder and pioneer in “welding the central banks together into an intimate
group.” He concluded that “the members of the American Acceptance Council
156
America’s Great Depression
In response to the agreement, the Federal Reserve promptly
launched a great burst of inflation and cheap credit in the latter
half of 1927. Table 8 shows that the rate of increase of bank
reserves was the greatest of the 1920s, largely because of open-
market purchases of government securities and of bankers’ accept-
ances. Rediscount rates were also lowered. The Federal Reserve
Bank of Chicago, not under the domination of the Bank of Eng-
land, balked vigorously at lowering its rate, but was forced to do so
in September by the Federal Reserve Board. The Chicago Tribune
called angrily for Strong’s resignation, and charged that discount
rates were being lowered in the interests of Great Britain. The
regional Reserve Banks were told by Strong that the new burst of
cheap money was designed to help the farmers rather than Eng-
land, and this was the reason proclaimed by the first bank to lower
its discount rate—not New York but Kansas City. The Kansas City
Bank had been picked by Strong as the “stalking-horse” of the new
policy, in order to give as “American” a flavor as possible to the
entire proceeding. Governor Bailey of the Kansas City Bank had
no inkling of the aid-to-Britain motive behind the new policy, and
Strong took no pains to enlighten him.35
Perhaps the sharpest critic of the inflationary policies within
the Coolidge administration was Secretary Hoover, who privately
did his best to check the inflation from 1924 on, even going so far
as to denounce Strong as a “mental annex to Europe.” Hoover was
overruled by Strong, Coolidge, and Mellon, with Mellon
denouncing Hoover’s “alarmism” and interference. Mellon was
Strong’s staunchest supporter in the administration throughout
would cherish his memory.” Paul M. Warburg, The Federal Reserve System (New
York: Macmillan, 1930), vol. 2, p. 870.
In the autumn of 1926, a leading banker admitted that bad consequences
would follow the cheap money policy, but said: “that cannot be helped. It is the
price we must pay for helping Europe.” H. Parker Willis, “The Failure of the
Federal Reserve,” North American Review (1929): 553.
35See Anderson, Economics and the Public Welfare, pp. 182–83; Beckhart,
“Federal Reserve Policy and the Money Market,” pp. 67ff.; and Clark, Central
Banking Under the Federal Reserve System, p. 314.
The Development of the Inflation
157
the entire period. Unfortunately for later events, Hoover—like
most of Strong’s academic critics—attacked only stock-market
credit expansion rather than expansion per se.
The reasons for Strong’s devious and secret methods, as well as
the motives for his inflationary policies, have been no better
described than in a private memorandum by one of Strong’s staff.
In the spring of 1928, Strong firmly rejected the idea of an open,
formal conference of world central banks, and, in the words of his
assistant:
He [Strong] was obliged to consider the viewpoint of
the American public, which had decided to keep the
country out of the League of Nations to avoid interfer-
ences by other nations in its domestic affairs, and which
would be just as opposed to having the heads of its cen-
tral banking system attend some conference or organi-
zation of the world banks of issue. . . . To illustrate how
dangerous the position might become in the future as a
result of the decisions reached at the present time and
how inflamed public or political opinion might easily
become when the results of past decisions become evi-
dent, Governor Strong cited the outcry against the spec-
ulative excesses now being indulged in on the New York
market. . . . He said that very few people indeed realized
that we were now paying the penalty for the decision
which was reached early in 1924 to help the rest of the
world back to a sound financial and monetary basis.36
In short, in our supposed democracy, if the people were allowed
to know what had been transacted in their name and what penal-
ties they were subsequently being forced to pay, they would rise up
in their wrath. Better to keep the people in ignorance. This, of
course, is the familiar attitude of the bureaucrat in power. But what
of the fundamental question it raises for democracy itself: how can
the people decide upon issues or judge their presumed representa-
tives, if the latter insist on keeping vital information from them?
Strong himself, furthermore, did not realize how heavy a
penalty the American public would be forced to pay in 1929. He
36O. Ernest Moore to Sir Arthur Salter, May 25, 1928. Quoted in Chandler,
Benjamin Strong, Central Banker, pp. 280–81.
158
America’s Great Depression
died before the crisis came. If the public had at last been let in on
the truth of Strong’s actions and their consequences, perhaps, dur-
ing the depression, they would have become “inflamed” against
inflationary government intervention rather than against the capi-
talist system.
After generating the 1927 inflation, the New York Federal
Reserve Bank, for the next two years, bought heavily in prime
commercial bills of foreign countries, bills endorsed by foreign
central banks. The purpose was to bolster foreign currencies, and
to prevent an inflow of gold to the United States. The New York
Bank frankly described its policy as follows:
We sought to support exchanges by our purchases and
thereby not only prevent the withdrawal of further
amounts of gold from Europe but also, by improving
the position of the foreign exchanges, to enhance or sta-
bilize Europe’s power to buy our exports.
Those decisions were taken by the New York Reserve Bank
alone, and the foreign bills were then distributed pro rata to the
other Reserve Banks.37
While the New York Reserve Bank was the main generator of
inflation and cheap credit, the Treasury also did its part. As early as
March 1927, Secretary Mellon assured everyone that “an abundant
supply of easy money” was available—and in January 1928, the
Treasury announced that it would refund a 43 percent Liberty
Bond issue, falling due in September, into 32 percent notes.38
Again, the inflationary policy was temporarily successful in
achieving its goals. Sterling was strengthened, the American gold
inflow was sharply reversed and gold flowed outward. Farm prod-
uct prices rose from 99 in 1927 to 106 the following year. Farm and
food exports spurted upward, and foreign loans were stimulated to
37Clark, Central Banking Under the Federal Reserve System, p. 198. We have
seen that sterling bills were bought in considerable amount in 1927 and 1929.
38See Harold L. Reed, Federal Reserve Policy, 1921–1930 (New York:
McGraw–Hill, 1930), p. 32.
The Development of the Inflation
159
new heights, reaching a peak in mid-1928.39 But by the summer of
1928, the pound sterling was sagging again. American farm prices
fell slightly in 1929, and the value of agricultural exports also fell
in the same year. Foreign lending slumped badly as both domestic
and foreign funds poured into the booming American stock mar-
ket. The higher interest rates caused by the boom could no longer
be lower than in Europe, unless the FRS was prepared to continue
inflating, perhaps at an accelerated rate. Instead, as we shall see
below, it tried to curb the boom. As a result, funds were attracted
to the United States, and by mid-1928, gold began to flow in again
from abroad. And, by this time, England was back in its familiar
mess, but now more aggravated than before.
THE CRISIS APPROACHES
By now, the final phase of the great American boom was under
way, led by the stock market. While a stock market loan is no more
inflationary than any other type of business loan, it is equally infla-
tionary, and therefore credit expansion in the stock market
deserves censure in precisely the same way, and to the same extent,
as any other quantity of inflated credit. Hence, the mischievous
inflationary effect of the 1927 statements by Coolidge and Mellon
who functioned as the “capeadores” of the bull market. We have
also seen that the Federal Reserve Bank of New York effectively set
the call rates for loans to the stock market, in cooperation with the
money committee of the New York Stock Exchange, its policy
being to furnish any funds necessary to enable the banks to lend
readily to the market. The Bank, in short, used Wall Street banks
to pour funds into the stock market. The call rate, as we have
noted, stayed very far below its prewar levels and peaks.
Alarmed at the burgeoning boom, and at the stock prices that
rose about 20 percent in the latter half of 1927, the Fed reversed
39Clark points out that the cheap credit particularly succeeded in aiding the
financial, investment banking, and speculative interests with whom Strong and his
associates were personally affiliated. Clark, Central Banking Under the Federal
Reserve System, p. 344.
160
America’s Great Depression
its policy in the spring of 1928, and tried to halt the boom. From
the end of December 1927, to the end of July 1928, the Reserve
reduced total reserves by $261 million. Through the end of June,
total demand deposits of all banks fell by $471 million. However,
the banks managed to shift to time deposits and even to overcom-
pensate, raising time deposits by $1.15 billion. As a result, the
money supply still rose by $1.51 billion in the first half of 1928, but
this was a relatively moderate rise. (This was a rise of 4.4 percent
per annum, compared to an increase of 8.1 percent per annum in
the last half of 1927, when the money supply rose by $2.70 billion.)
A more stringent contraction by the Federal Reserve—one
enforced, for example, by a “penalty” discount rate on Reserve
loans to banks—would have ended the boom and led to a far
milder depression than the one we finally attained. In fact, only in
May did the contraction of reserves take hold, for until then the
reduction in Federal Reserve credit was only barely sufficient to
overcome the seasonal return of money from circulation. Thus,
Federal Reserve restrictions only curtailed the boom from May
through July.
Yet, even so, the vigorous open market sales of securities and
drawing down of acceptances hobbled the inflation. Stock prices
rose only about 10 percent from January to July.40 By mid-1928,
the gold drain was reversed and a mild inflow resumed. If the Fed-
eral Reserve had merely done nothing in the last half of 1928,
reserves would have moderately contracted, due to the normal sea-
sonal increase in money in circulation.
At this point, true tragedy struck. On the point of conquering
the boom, the FRS found itself hoisted by its own acceptance pol-
icy. Knowing that the Fed had pledged itself to buy all acceptances
offered, the market increased its output of acceptances, and the
Fed bought over $300 million of acceptances in the last half of
1928, thus feeding the boom once more. Reserves increased by
40Anderson (Economics and the Public Welfare) is surely wrong when he infers
that the stock market had by this time run away, and that the authorities could do
little further. More vigor would have ended the boom then and there.
The Development of the Inflation
161
$122 million, and the money supply increased by almost $1.9 bil-
lion to reach its virtual peak at the end of December 1928. At this
time, total money supply had reached $73 billion, higher than at
any time since the inflation had begun. Stock prices, which had
actually declined by 5 percent from May to July, now really began
to skyrocket, increasing by 20 percent from July to December. In
the face of this appalling development, the Federal Reserve did
nothing to neutralize its acceptance purchases. Whereas it had
boldly raised rediscount rates from 32 percent at the beginning of
1928 to 5 percent in July, it stubbornly refused to raise the redis-
count rate any further, and the rate remained constant until the end
of the boom. As a result, discounts to banks increased slightly rather
than declined. Furthermore, the Federal Reserve did not sell any of
its more than $200 million stock of government securities; instead
it bought a little on net balance in the latter half of 1928.
Why was Federal Reserve policy so supine in the latter part of
1928? One reason was that Europe, as we have noted, had found
the benefits from the 1927 inflation dissipated, and European
opinion now clamored against any tighter money in the U.S.41 The
easing in late 1928 prevented gold inflows into the U.S. from get-
ting very large. Great Britain was again losing gold and sterling
was weak once more. The United States bowed once again to its
overriding wish to see Europe avoid the inevitable consequences of
its own inflationary policies. Governor Strong, ill since early 1928,
had lost control of Federal Reserve policy. But while some disci-
ples of Strong have maintained that he would have fought for
tighter measures in the latter half of the year, recent researches
indicate that he felt even the modest restrictive measures pursued
in 1928 to be too severe. This finding, of course, is far more con-
sistent with Strong’s previous record.42
41See Harris, Twenty Years of Federal Reserve Policy, vol. 2, pp. 436ff.; Charles
Cortez Abbott, The New York Bond Market, 1920–1930 (Cambridge, Mass.:
Harvard University Press, 1937), pp. 117–30.
42See Strong to Walter W. Stewart, August 3, 1928. Chandler, Benjamin
Strong, Central Banker, pp. 459–65. For a contrary view, see Carl Snyder,
Capitalism, the Creator (New York: Macmillan, 1940), pp. 227–28. Dr. Stewart, we
162
America’s Great Depression
Another reason for the weak Federal Reserve policy was politi-
cal pressure for easy money. Inflation is always politically more
popular than recession, and this, let us not forget, was a presiden-
tial election year. Furthermore, the Federal Reserve had already
begun to adopt the dangerously fallacious qualitativist view that
stock credit could be curbed at the same time that acceptance
credit was being stimulated.43
The inflation of the 1920s was actually over by the end of 1928.
The total money supply on December 31, 1928 was $73 billion.
On June 29, 1929, it was $73.26 billion, a rise of only 0.7 percent
per annum. Thus, the monetary inflation was virtually completed
by the end of 1928. From that time onward, the money supply
remained level, rising only negligibly. And therefore, from that
time onward, a depression to adjust the economy was inevitable.
Since few Americans were familiar with the “Austrian” theory of
the trade cycle, few realized what was going to happen.
A great economy does not react instantaneously to change.
Time, therefore, had to elapse before the end of inflation could
reveal the widespread malinvestments in the economy, before the
capital goods industries showed themselves to be overextended,
etc. The turning point occurred about July, and it was in July that
the great depression began.
The stock market had been the most buoyant of all the mar-
kets—this in conformity with the theory that the boom generates
particular overexpansion in the capital goods industries. For the
stock market is the market in the prices of titles to capital.44 Riding
on the wave of optimism generated by the boom and credit expan-
sion, the stock market took several months after July to awaken to
might note, had shifted easily from being head of the Division of Research of the
Federal Reserve System to a post of Economic Advisor to the Bank of England a
few years later, from which he had written to Strong warning of too tight restric-
tion on American bank credit.
43See Review of Economic Statistics, p. 13.
44Real estate is the other large market in titles to capital. On the real estate
boom of the 1920s, see Homer Hoyt, “The Effect of Cyclical Fluctuations upon
Real Estate Finance,” Journal of Finance (April, 1947): 57.
The Development of the Inflation
163
the realities of the downturn in business activity. But the awaken-
ing was inevitable, and in October the stock market crash made
everyone realize that depression had truly arrived.
The proper monetary policy, even after a depression is under-
way, is to deflate or at the least to refrain from further inflation.
Since the stock market continued to boom until October, the
proper moderating policy would have been positive deflation. But
President Coolidge continued to perform his “capeadore” role
until the very end. A few days before leaving office in March he
called American prosperity “absolutely sound” and stocks “cheap
at current prices.”45 The new President Hoover was unfortunately
one of the staunch supporters of the sudden try at “moral suasion”
in the first half of 1929, which failed inevitably and disastrously.
Both Hoover and Governor Roy Young of the Federal Reserve
Board wanted to deny bank credit to the stock market while yet
keeping it abundant to “legitimate” commerce and industry. As
soon as Hoover assumed office, he began the methods of informal
intimidation of private business which he had tried to pursue as
Secretary of Commerce.46 He called a meeting of leading editors
and publishers to warn them about high stock prices; he sent
Henry M. Robinson, a Los Angeles banker, as emissary to try to
restrain the stock loans of New York banks; he tried to induce
Richard Whitney, President of the New York Stock Exchange, to
curb speculation. Since these methods did not attack the root of
the problem, they were bound to be ineffective.
Other prominent critics of the stock market during 1928 and
1929 were Dr. Adolph C. Miller, of the Federal Reserve Board,
Senator Carter Glass (D., Va.), and several of the “progressive”
Republican senators. Thus, in January, 1928, Senator LaFollette
attacked evil Wall Street speculation and the increase in brokers’
loans. Senator Norbeck counseled a moral suasion policy a year
45Significantly, the leading “bull” speculator of the era, William C. Durant,
who failed ignominiously in the crash, hailed Coolidge and Mellon as the leading
spirits of the cheap money program. Commercial and Financial Chronicle (April 20,
1929): 2557ff.
46Hoover, The Memoirs of Herbert Hoover, vol. 2, pp. 16ff.
164
America’s Great Depression
before it was adopted, and Federal Reserve Board member Charles S.
Hamlin persuaded Representative Dickinson of Iowa to introduce
a bill to graduate bank reserve requirements in proportion to the
speculative stock loans in the banks’ portfolios. Senator Glass pro-
posed a 5 percent tax on sales of stock held less than 60 days—
which, contrary to Glass’s expectations, would have driven stock
prices upward by discouraging stockholders from selling until two
months had elapsed.47 As it was, the federal tax law, since 1921, had
imposed a specially high tax rate on capital gains from those stocks
and bonds held less than two years. This induced buyers to hold on
to their stocks and not sell them after purchase since the tax was on
realized, rather than accrued, capital gains. The tax was a factor in
driving up stock prices further during the boom.48
Why did the Federal Reserve adopt the “moral suasion” policy
when it had not been used for years preceding 1929? One of the
principal reasons was the death of Governor Strong toward the
end of 1928. Strong’s disciples at the New York Bank, recognizing
the crucial importance of the quantity of money, fought for a
higher discount rate during 1929. The Federal Reserve Board in
Washington, and also President Hoover, on the other hand, con-
sidered credit rather in qualitative than in quantitative terms. But
Professor Beckhart adds another possible point: that the “moral
suasion” policy—which managed to stave off a tighter credit pol-
icy—was adopted under the influence of none other than Montagu
Norman.49 Finally, by June, moral suasion was abandoned, but dis-
count rates were not raised, and as a result the stock market boom
continued to rage, even as the economy generally was quietly but
inexorably turning downward. Secretary Mellon trumpeted once
again about our “unbroken and unbreakable prosperity.” In
47See Joseph Stagg Lawrence, Wall Street and Washington (Princeton, N.J.:
Princeton University Press, 1929), pp. 7ff., and passim.
48See Irving Fisher, The Stock Market Crash—And After (New York:
Macmillan, 1930), pp. 37ff.
49“The policy of ‘moral suasion’ was inaugurated following a visit to this
country of Mr. Montagu Norman.” Beckhart, “Federal Reserve Policy and the
Money Market,” p. 127.
The Development of the Inflation
165
August, the Federal Reserve Board finally consented to raise the
rediscount rate to 6 percent, but any tightening effect was more
than offset by a simultaneous lowering of the acceptance rate, thus
stimulating the acceptance market yet once more. The Federal
Reserve had previously ended the acceptance menace in March by
raising its acceptance buying rate above its discount rate for the
first time since 1920. The net effect of this unprecedented “strad-
dle” was to stimulate the bull market to even greater heights. The
lowering of the Federal Reserve buying rate for acceptances from
53 percent to 5c percent, the level of the open market, stimulated
market sales of acceptances to the Federal Reserve. If not for the
acceptance purchases, total reserves would have fallen from the
end of June to October 23 (the day before the stock market crash)
by $267 million. But the Federal Reserve purchased $297 million
of acceptances during this period, raising total reserves by $21 mil-
lion. Table 9 tells the story of this period.
What was the reason for this peculiarly inflationary policy
favoring the acceptance market? It fitted the qualitative bias of the
administration, and it was ostensibly advanced as a stup to help the
American farmer. Yet, it appears that the aid-to-farmers argument
was used again as a domestic smokescreen for inflationary policies.
In the first place, the increase in acceptance holdings, as compared
with the same season the year before, was far more heavily con-
centrated in purely foreign acceptances and less in acceptances based
on American exports. Second, the farmers had already concluded
their seasonal borrowing before August, so that they did not ben-
efit one iota from the lower acceptance rates. In fact, as Beckhart
points out, the inflationary acceptance policy was reinstituted fol-
lowing “closely upon another visit of Governor Norman.”50 Thus,
once again, the cloven hoof of Montagu Norman exerted its bale-
ful influence upon the American scene, and for the last time Nor-
man was able to give an added impetus to the boom of the 1920s.
Great Britain was also entering upon a depression, and yet its infla-
tionary policies had resulted in a serious outflow of gold in June and
July. Norman was then able to get a line of credit of $250 million
50Ibid., pp. 142ff.
166
America’s Great Depression
TABLE 9
FACTORS DETERMINING BANK RESERVES
JULY–OCTOBER 1929
(in millions of dollars)
July 29
October 23
Net Change
Federal Reserve Credit
1400
1374
-26
Bills discounted
1037
796
-241
Bills bought
82
379
297
U.S. Govts.
216
136
-80
All Other
65
63
-2
Treasury Currency
2019
2016
-3
Treasury Cash
204
209
-5
Treasury Deposits
36
16
20
Unexpected Capital Funds
374
393
-19
Monetary Gold Stock
4037
4099
62
Money in Circulation
4459
4465
-6
Other Deposits
28
28
0
Controlled Reserves
206
Uncontrolled Reserves
-185
Member Bank Reserves
2356
2378
22
from a New York banking consortium, but the outflow continued
through September, much of it to the United States. Continuing
to help England, the New York Federal Reserve Bank bought
heavily in sterling bills, from August through October. The new
subsidization of the acceptance market, then, permitted further aid
to Britain through purchase of sterling bills. Federal Reserve pol-
icy during the last half of 1928 and 1929 was, in brief, marked by
a desire to keep credit abundant in favored markets, such as
acceptances, and to tighten credit in other fields, such as the stock
market (e.g., by “moral suasion”). We have seen that such a policy
can only fail, and an excellent epitaph on these efforts has been
penned by A. Wilfred May:
Once the credit system had become infected with cheap
money, it was impossible to cut down particular outlets
of this credit without cutting down all credit, because it
The Development of the Inflation
167
is impossible to keep different kinds of money separated
in water-tight compartments. It was impossible to make
money scarce for stock-market purposes, while simulta-
neously keeping it cheap for commercial use. . . . When
Reserve credit was created, there was no possible way
that its employment could be directed into specific uses,
once it had flowed through the commercial banks into
the general credit stream.51
And so ended the great inflationary boom of the 1920s. It
should be clear that the responsibility for the inflation rests upon
the federal government—upon the Federal Reserve authorities
primarily, and upon the Treasury and the Administration—sec-
ondarily.52 The United States government had sowed the wind and
the American people reaped the whirlwind: the great depression.
51A. Wilfred May, “Inflation in Securities,” in H. Parker Willis and John M.
Chapman, eds., The Economics of Inflation (New York: Columbia University Press,
1935), pp. 292–93. Also see Charles O. Hardy, Credit Policies of the Federal Reserve
System (Washington, D.C.: Brookings Institution, 1932) pp. 124–77; and Oskar
Morgenstern “Developments in the Federal Reserve System,” Harvard Business
Review (October, 1930): 2–3.
52For an excellent contemporary discussion of the Federal Reserve, and of its
removal of the natural checks on commercial bank inflation, see Ralph W. Robey,
“The Progress of Inflation and ‘Freezing’ of Assets in the National Banks,” The
Annalist (February 27, 1931): 427–29. Also see C.A. Phillips, T.F. McManus, and
R.W. Nelson, Banking and the Business Cycle (New York: Macmillan, 1937), pp.
140–42; and C. Reinold Noyes, “The Gold Inflation in the United States,”
American Economic Review (June, 1930): 191–97.
6
Theory and Inflation: Economists
and the Lure of a Stable Price Level
One of the reasons that most economists of the 1920s did
not recognize the existence of an inflationary problem was
the widespread adoption of a stable price level as the goal
and criterion for monetary policy. The extent to which the Federal
Reserve authorities were guided by a desire to keep the price level
stable has been a matter of considerable controversy. Far less con-
troversial is the fact that more and more economists came to con-
sider a stable price level as the major goal of monetary policy. 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 com-
pletely unaware.
Actually, bank credit expansion creates its mischievous effects
by distorting price relations and by raising and altering prices
compared to what they would have been without the expansion.
Statistically, therefore, we can only identify the increase in money
supply, a simple fact. We cannot prove inflation by pointing to
price increases. We can only approximate explanations of complex
price movements by engaging in a comprehensive economic his-
tory of an era—a task which is beyond the scope of this study. Suf-
fice it to say here that the stability of wholesale prices in the 1920s
was the result of monetary inflation offset by increased productiv-
ity, which lowered costs of production and increased the supply of
169
170
America’s Great Depression
goods. But this “offset” was only statistical; it did not eliminate the
boom–bust cycle, it only obscured it. The economists who empha-
sized the importance of a stable price level were thus especially
deceived, for they should have concentrated on what was happen-
ing to the supply of money. Consequently, the economists who
raised an alarm over inflation in the 1920s were largely the quali-
tativists. They were written off as hopelessly old-fashioned by the
“newer” economists who realized the overriding importance of the
quantitative in monetary affairs. The trouble did not lie with par-
ticular credit on particular markets (such as stock or real estate);
the boom in the stock and real estate markets reflected Mises’s
trade cycle: a disproportionate boom in the prices of titles to cap-
ital goods, caused by the increase in money supply attendant upon
bank credit expansion.1
The stability of the price level in the 1920s is demonstrated by
the Bureau of Labor Statistics Index of Wholesale Prices, which
fell to 93.4 (100 = 1926) in June 1921, rose slightly to a peak of
104.5 in November 1925, and then fell back to 95.2 by June 1929.
The price level, in short, rose slightly until 1925 and fell slightly
thereafter. Consumer price indices also behaved in a similar man-
ner.2 On the other hand, the Snyder Index of the General Price
Level, which includes all types of prices (real estate, stocks, rents,
and wage rates, as well as wholesale prices) rose considerably dur-
ing the period, from 158 in 1922 (1913 = 100) to 179 in 1929, a rise
of 13 percent. Stability was therefore achieved only in consumer
and wholesale prices, but these were and still are the fields consid-
ered especially important by most economic writers.
1The qualitative aspect of credit is important to the extent that bank loans
must be to business, and not to government or to consumers, to put the trade cycle
mechanism into motion.
2The National Industrial Conference Board (NICB) consumer price index rose
from 102.3 (1923 = 100) in 1921 to 104.3 in 1926, then fell to 100.1 in 1929; the
Bureau of Labor Statistics (BLS) consumer good index fell from 127.7 (1935–1939 =
100) in 1921 to 122.5 in 1929. Historical Statistics of the U.S., 1789–1945 (Washington,
D.C.: U.S. Department of Commerce, 1949), pp. 226–36, 344.
Theory and Inflation: Economists and the Lure of a Stable Price Level
171
Within the overall aggregate of wholesale prices, foods and
farm products rose over the period while metals, fuel, chemicals,
and home furnishings fell considerably. That the boom was largely
felt in the capital goods industries can be seen by (a) the quadrupling
of stock prices over the period, and by (b) the fact that durable goods
and iron and steel production each increased by about 160 percent,
while the production of non-durable goods (largely consumer
goods) increased by only 60 percent. In fact, production of such
consumer items as manufactured foods and textile products
increased by only 48 percent and 36 percent respectively, from
1921 to 1929. Another illustration of Mises’s theory was that wages
were bid up far more in the capital goods industries. Overbidding
of wage rates and other costs is a distinctive feature of Mises’s
analysis of capital goods industries in the boom. Average hourly
earnings, according to the Conference Board Index, rose in
selected manufacturing industries from $.52 in July 1921 to $.59 in
1929, a 12 percent increase. Among this group, wage rates in con-
sumer goods’ industries such as boots and shoes remained con-
stant; they rose 6 percent in furniture, less than 3 percent in meat
packing, and 8 percent in hardware manufacturing. On the other
hand, in such capital goods’ industries as machines and machine
tools, wage rates rose by 12 percent, and by 19 percent in lumber,
22 percent in chemicals, and 25 percent in iron and steel.
Federal Reserve credit expansion, then, whether so intended or
not, managed to keep the price level stable in the face of an
increased productivity that would, in a free and unhampered mar-
ket, have led to falling prices and a spread of increased living stan-
dards to everyone in the population. The inflation distorted the
production structure and led to the ensuing depression–adjust-
ment period. It also prevented the whole populace from enjoying
the fruits of progress in lower prices and insured that only those
enjoying higher monetary wages and incomes could benefit from
the increased productivity.
There is much evidence for the charge of Phillips, McManus,
and Nelson that “the end-result of what was probably the greatest
price-level stabilization experiment in history proved to be, simply,
172
America’s Great Depression
the greatest depression.”3 Benjamin Strong was apparently converted
to a stable-price-level philosophy during 1922. On January 11, 1925,
Strong privately wrote:
that it was my belief, and I thought it was shared by all
others in the Federal Reserve System, that our whole
policy in the future, as in the past, would be directed
toward the stability of prices so far as it was possible for
us to influence prices.4
When asked, in the Stabilization Hearings of 1927, whether the
Federal Reserve Board could “stabilize the price level to a greater
extent” than in the past, by open-market operations and other con-
trol devices, Governor Strong answered,
I personally think that the administration of the Federal
Reserve System since the reaction of 1921 has been just
as nearly directed as reasonable human wisdom could
direct it toward that very object.5
It appears that Governor Strong had a major hand, in early
1928, in drafting the bill by Representative James G. Strong of
Kansas (no relation) to compel the Federal Reserve System to pro-
mote a stable price level.6 Governor Strong was ill by this time and
out of control of the System, but he wrote the final draft of the bill
along with Representative Strong. In the company of the Con-
gressman and Professor John R. Commons, one of the leading the-
oreticians of a stable price level, Strong discussed the bill with
3C.A. Phillips, T.F. McManus, and R.W. Nelson, Banking and the Business
Cycle (New York: Macmillan, 1937), pp. 176ff.
4Lester V. Chandler, Benjamin Strong, Central Banker (Washington, D.C.:
Brookings Institution, 1958), p. 312. In this view, Strong was, of course, warmly
supported by Montagu Norman. Ibid., p. 315.
5Also see ibid., pp. 199ff. And Charles Rist recalls that, in his private conver-
sations, “Strong was convinced that he was able to fix the price level, by his inter-
est and credit policy.” Charles Rist, “Notice Biographique,” Revue d’Èconomie
Politique (November–December, 1955): 1029.
6Strong thus overcame his previous marked skepticism toward any legislative
mandate for price stabilization. Before this, he had preferred to leave the matter
strictly to Fed discretion. See Chandler, Benjamin Strong, Central Banker, pp. 202ff.
Theory and Inflation: Economists and the Lure of a Stable Price Level
173
members of the Federal Reserve Board. When the Board disap-
proved, Strong felt bound, in his public statements, to go along
with them.7 We must further note that Carl Snyder, a loyal and
almost worshipful follower of Governor Strong, and head of the
Statistical Department of the Federal Reserve Bank of New York,
was a leading advocate of monetary and credit control by the Fed-
eral Reserve to stabilize the price level.8
Certainly, the leading British economists of the day firmly
believed that the Federal Reserve was deliberately and successfully
stabilizing the price level. John Maynard Keynes hailed “the suc-
cessful management of the dollar by the Federal Reserve Board
from 1923 to 1928” as a “triumph” for currency management.
D.H. Robertson concluded in 1929 that “a monetary policy con-
sciously aimed at keeping the general price level approximately
stable . . . has apparently been followed with some success by the
Federal Reserve Board in the United States since 1922.”9 Whereas
Keynes continued to hail the Reserve’s policy a few years after the
depression began, Robertson became critical,
Looking back . . . the great American “stabilization” of
1922–1929 was really a vast attempt to destabilize the
value of money in terms of human effort by means of a
colossal program of investment . . . which succeeded for
a surprisingly long period, but which no human ingenu-
ity could have managed to direct indefinitely on sound
and balanced lines.10
7See the account in Irving Fisher, ibid., pp. 170–71. Commons wrote of
Governor Strong: “I admired him both for his open-minded help to us on the bill
and his reservation that he must go along with his associates.”
8See Fisher’s eulogy of Snyder, Stabilised Money, pp. 64–67; and Carl Snyder,
“The Stabilization of Gold: A Plan,” American Economic Review (June, 1923):
276–85; idem, Capitalism the Creator (New York: Macmillan, 1940), pp. 226–28.
9D.H. Robertson, “The Trade Cycle,” Encyclopaedia Britannica, 14th ed.
(1929), vol. 22, p. 354.
10D.H. Robertson, “How Do We Want Gold to Behave?” in The International
Gold Problem (London: Humphrey Milford, 1932), p. 45; quoted in Phillips, et al.,
Banking and the Business Cycle, pp. 186–87.
174
America’s Great Depression
The siren song of a stable price level had lured leading politi-
cians, to say nothing of economists, as early as 1911. It was then
that Professor Irving Fisher launched his career as head of the “sta-
ble money” movement in the United States. He quickly gained the
adherence of leading statesmen and economists to a plan for an
international commission to study the money and price problem.
Supporters included President William Howard Taft, Secretary of
War Henry Stimson, Secretary of Treasury Franklin MacVeagh,
Governor Woodrow Wilson, Gifford Pinchot, seven Senators, and
economists Alfred Marshall, Francis Edgeworth, and John May-
nard Keynes in England. President Taft sent a special message to
Congress in February, 1912, urging an appropriation for such an
international conference. The message was written by Fisher, in
collaboration with Assistant Secretary of State Huntington Wil-
son, a convert to stable money. The Senate passed the bill, but it
died in the House. Woodrow Wilson expressed interest in the plan
but dropped the idea in the press of other matters.
In the spring of 1918, a Committee on the Purchasing Power
of Money of the American Economic Association endorsed the
principle of stabilization. Though encountering banker opposition
to his stable-money doctrine, led notably by A. Barton Hepburn of
the Chase National Bank, Fisher began organizing the Stable
Money League at the end of 1920, and established the League at
the end of May, 1921—at the beginning of our inflationary era.
Newton D. Baker, Secretary of War under Wilson, and Professor
James Harvey Rogers of Cornell were two of the early organizers.
Other prominent politicians and economists who played leading
roles in the Stable Money League were Professor Jeremiah W.
Jenks, its first president; Henry A. Wallace, editor of Wallace’s
Farmer, and later Secretary of Agriculture; John G. Winant, later
Governor of New Hampshire; Professor John R. Commons, its
second President; George Eastman of the Eastman–Kodak family;
Lyman J. Gage, formerly Secretary of the Treasury; Samuel Gom-
pers, President of the American Federation of Labor; Senator
Carter Glass of Virginia; Thomas R. Marshall, Vice-President of
the United States under Wilson; Representative Oscar W. Under-
wood; Malcolm C. Rorty; and economists Arthur Twining Hadley,
Theory and Inflation: Economists and the Lure of a Stable Price Level
175
Leonard P. Ayres, William T. Foster, David Friday, Edwin W.
Kemmerer, Wesley C. Mitchell, Warren M. Persons, H. Parker
Willis, Allyn A. Young, and Carl Snyder.
The ideal of a stable price level is relatively innocuous during a
price rise when it can aid sound money advocates in trying to check
the boom; but it is highly mischievous when prices are tending to
sag, and the stabilizationists call for inflation. And yet, stabilization
is always a more popular rallying cry when prices are falling. The
Stable Money League was founded in 1920–1921, when prices
were falling during a depression. Soon, prices began to rise, and
some conservatives began to see in the stable money movement a
useful check against extreme inflationists. As a result, the League
changed its name to the National Monetary Association in 1923,
and its officers continued as before, with Professor Commons as
President. By 1925, the price level had reached its peak and begun
to sag, and consequently the conservatives abandoned their sup-
port of the organization, which again changed its name to the Sta-
ble Money Association. Successive presidents of the new associa-
tion were H. Parker Willis, John E. Rovensky, Executive Vice-
President of the Bank of America, Professor Kemmerer, and
“Uncle” Frederic W. Delano. Other eminent leaders in the Stable
Money Association were Professor Willford I. King; President
Nicholas Murray Butler of Columbia University; John W. Davis,
Democratic candidate for president in 1924; Charles G. Dawes,
Director of the Bureau of the Budget under Harding, and Vice-
President under Coolidge; William Green, President of the Ameri-
can Federation of Labor; Charles Evans Hughes, Secretary of State
until 1925; Otto H. Kahn, investment banker; Frank O. Lowden,
former Republican Governor of Illinois; Elihu Root, former Secre-
tary of State and Senator; James H. Rand, Jr.; Norman Thomas, of
the Socialist Party; Paul M. Warburg and Owen D. Young. Enlist-
ing from abroad came Charles Rist of the Bank of France; Eduard
Benes of Czechoslovakia, Max Lazard of France; Emile Moreau of
the Bank of France; Louis Rothschild of Austria; and Sir Arthur
Balfour, Sir Henry Strakosch, Lord Melchett, and Sir Josiah Stamp
of Great Britain. Serving as honorary vice-presidents of the Asso-
ciation were the Presidents of the following organizations: the
176
America’s Great Depression
American Association for Labor Legislation, American Bar Associa-
tion, American Farm Bureau Federation, American Farm Economic
Association, American Statistical Association, Brotherhood of Rail-
road Trainmen, National Association of Credit Men, National Con-
sumers’ League, National Education Association, American Coun-
cil on Education, United Mine Workers of America, the National
Grange, the Chicago Association of Commerce, the Merchants’
Association of New York, and Bankers’ Associations in 43 states and
the District of Columbia.
Executive director and operating head of the Association with
such formidable backing was Norman Lombard, brought in by
Fisher in 1926. The Association spread its gospel far and wide. It
was helped by the publicity given to Thomas Edison and Henry
Ford’s proposal for a “commodity dollar” in 1922 and 1923. Other
prominent stabilizationists in this period were professors George F.
Warren and Frank Pearson of Cornell, Royal Meeker, Hudson B.
Hastings, Alvin Hansen, and Lionel D. Edie. In Europe, in addi-
tion to the above mentioned, advocates of stable money included:
Professor Arthur C. Pigou, Ralph G. Hawtrey, J.R. Bellerby, R.A.
Lehfeldt, G.M. Lewis, Sir Arthur Salter, Knut Wicksell, Gustav
Cassel, Arthur Kitson, Sir Frederick Soddy, F.W. Pethick-
Lawrence, Reginald McKenna, Sir Basil Blackett, and John May-
nard Keynes. Keynes was particularly influential in his propaganda
for a “managed currency” and a stabilized price level, as set forth
in his A Tract on Monetary Reform, published in 1923.
Ralph Hawtrey proved to be one of the evil geniuses of the
1920s. An influential economist in a land where economists have
shaped policy far more influentially than in the United States,
Hawtrey, Director of Financial Studies at the British Treasury,
advocated international credit control by Central Banks to achieve
a stable price level as early as 1913. In 1919, Hawtrey was one of
the first to call for the adoption of a gold-exchange standard by
European countries, tying it in with international Central Bank
cooperation. Hawtrey was one of the prime European trumpeters
of the prowess of Governor Benjamin Strong. Writing in 1932, at
a time when Robertson had come to realize the evils of stabiliza-
tion, Hawtrey declared: “The American experiment in stabilization
Theory and Inflation: Economists and the Lure of a Stable Price Level
177
from 1922 to 1928 showed that an early treatment could check a
tendency either to inflation or to depression. . . . The American
experiment was a great advance upon the practice of the nine-
teenth century,” when the trade cycle was accepted passively.11
When Governor Strong died, Hawtrey called the event “a disaster
for the world.”12 Finally, Hawtrey was the main inspiration for the
stabilization resolutions of the Genoa Conference of 1922.
It was inevitable that this host of fashionable opinion should be
translated into legislative pressure, if not legislative action. Rep.
T. Alan Goldsborough of Maryland introduced a bill to “Stabilize
the Purchasing Power of Money” in May, 1922, essentially Pro-
fessor Fisher’s proposal, fed to Goldsborough by former Vice-
President Marshall. Witnesses for the bill were Professors Fisher,
Rogers, King, and Kemmerer, but the bill was not reported out of
committee. In early 1924, Goldsborough tried again, and Rep.
O.B. Burtness of North Dakota introduced another stabilization
bill. Neither was reported out of committee. The next major effort
was a bill by Rep. James G. Strong of Kansas, introduced in Janu-
ary, 1926, under the urging of veteran stabilizationist George H.
Shibley, who had been promoting the cause of stable prices since
1896. Rather than the earlier Fisher proposal for a “compensated
dollar” to manipulate the price level, the Strong Bill would have
compelled the Federal Reserve System to act directly to stabilize the
price level. Hearings were held from March 1926 until February
1927. Testifying for the bill were Shibley, Fisher, Lombard, Dr.
William T. Foster, Rogers, Bellerby, and Commons. Commons, Rep.
Strong, and Governor Strong then rewrote the bill, as indicated
11Ralph O. Hawtrey, The Art of Central Banking (London: Longmans, Green,
1932), p. 300.
12Leading stabilizationist Norman Lombard also hailed Strong’s alleged
achievement: “By applying the principles expounded in this book . . . he [Strong]
maintained in the United States a fairly stable price level and a consequent con-
dition of widespread economic well-being from 1922 to 1928.” Norman
Lombard, Monetary Statesmanship (New York: Harpers, 1934), p. 32n. On the
influence of stable price ideas on Federal Reserve policy, see also David A.
Friedman, “Study of Price Theories Behind Federal Reserve Credit Policy,
1921–29” (unpublished M.A. thesis, Columbia University, 1938).
178
America’s Great Depression
above, and hearings were held on the second Strong Bill in the
spring of 1928.
The high point of testimony for the second Strong Bill was that
of Sweden’s Professor Gustav Cassel, whose eminence packed the
Congressional hearing room. Cassel had been promoting stabi-
lization since 1903. The advice of this sage was that the govern-
ment employ neither qualitative nor quantitative measures to
check the boom, since these would lower the general price level. In
a series of American lectures, Cassel also urged lower Fed reserve
ratios, as well as world-wide central bank cooperation to stabilize
the price level.
The Strong Bill met the fate of its predecessors, and never left
the committee. But the pressure exerted at the various hearings for
these bills, as well as the weight of opinion and the views of Gov-
ernor Strong, served to push the Federal Reserve authorities into
trying to manipulate credit for purposes of price stabilization.
International pressure strengthened the drive for a stable price
level. Official action began with the Genoa Conference, in the
spring of 1922. This Conference was called by the League of
Nations, at the initiative of Premier Lloyd George, who in turn
was inspired by the dominant figure of Montagu Norman. The
Financial Commission of the Conference adopted a set of resolu-
tions which, as Fisher puts it, “have for years served as the potent
armory for the advocates of stable money all over the world.”13
The resolutions urged international central bank collaboration to
stabilize the world price level, and also suggested a gold -exchange
standard. On the Financial Commission were such stabilizationist
stalwarts as Sir Basil Blackett, Professor Cassel, Dr. Vissering, and
Sir Henry Strakosch.14 The League of Nations, indeed, was
quickly taken over by the stabilizationists. The Financial Commit-
tee of the League was largely inspired and run by Governor Mon-
tagu Norman, working through two close associates, Sir Otto
13Fisher, Stabilised Money, p. 282. Our account of the growth of the stable
money movement rests heavily upon Fisher’s work.
14While Hawtrey was the main inspiration for the resolutions, he criticized
them for not going far enough.
Theory and Inflation: Economists and the Lure of a Stable Price Level
179
Niemeyer and Sir Henry Strakosch. Sir Henry was, as we have
indicated, a prominent stabilizationist.15 Furthermore, Norman’s
chief adviser in international affairs, Sir Charles S. Addis, was also
an ardent stablizationist.16
In 1921, a Joint Committee on Economic Crises was formed by
the General Labour Conference, the International Labour Office
(I.L.O.) of the League of Nations, and the Financial Committee of
the League. On this Joint Committee were three leading stabiliza-
tionists: Albert Thomas, Henri Fuss, and Major J.R. Bellerby. In
1923, Thomas’s report warned that a fall in the price level “almost
invariably” causes unemployment. Henri Fuss of the I.L.O. prop-
agandized for stable price levels in the International Labour Review
in 1926. The Joint Committee met in June, 1925, to affirm the
principles of the Genoa Conference. In the meanwhile, two private
international organizations, the International Association for
Labour Legislation and the International Association on Unem-
ployment, held a joint International Congress on Social Policy, at
Prague, in October, 1924. The Congress called for the general
adoption of the principles of the Genoa Conference, by stabilizing
the general price level. The International Association for Social
Progress adopted a report at its Vienna meeting in September,
1928, prepared by stabilizationist Max Lazard of the investment
banking house of Lazard Frères in Paris, calling for price level sta-
bility. The I.L.O. followed suit in June, 1929, terming falling
prices a cause of unemployment. And, finally, the Economic Con-
sultative Committee of the League endorsed the Genoa principles
in the summer of 1928.
Just as Professors Cassel and Commons wanted no credit
restraint at all in 1928 and 1929, so Representative Louis T.
McFadden, powerful chairman of the House Banking and Cur-
rency Committee, exerted a similar though more powerful brand
of pressure on the Federal Reserve authorities. On February 7,
1929, the day after the Federal Reserve Board’s letter to the Federal
15See Paul Einzig, Montagu Norman (London: Kegan Paul, 1932), pp. 67, 78.
16Sir Henry Clay, Lord Norman (London: Macmillan, 1957), p. 138.
180
America’s Great Depression
Reserve Banks warning about stock market speculation, Represen-
tative McFadden himself warned the House against an adverse
business reaction from this move. He pointed out that there had
been no rise in the commodity price level, so how could there be
any danger of inflation? The Fed, he warned skittishly, should not
concern itself with the stock market or security loans, lest it pro-
duce a general slump. Tighter money would make capital financ-
ing difficult, and, coupled with the resulting loss of confidence,
would precipitate a depression. In fact, McFadden declared that
the Fed should be prepared to ease money rates as soon as any fall
in prices or employment might appear.17 Other influential voices
raised against any credit restriction were those of W.T. Foster and
Waddill Catchings, leading stabilizationists and well known for
their underconsumptionist theories. Catchings was a prominent
investment banker (of Goldman, Sachs and Co.), and iron and steel
magnate, and both men were close to the Hoover Administration.
(As we shall see, their “plan” for curing unemployment was
adopted, at one time, by Hoover.) In April, 1929, Foster and
Catchings warned that any credit restriction would lower the price
level and hurt business. The bull market, they assured the public—
along with Fisher, Commons, and the rest—was grounded on a
sure foundation of American confidence and growth.18 And the
bull speculators, of course, echoed the cry that everyone should
“invest in America.” Anyone who criticized the boom was consid-
ered to be unpatriotic and “selling America short.”
Cassel was typical of European opinion in insisting on even
greater inflationary moves by the Federal Reserve System. Sir
Ralph Hawtrey, visiting at Harvard during 1928–1929, spread the
gospel of price-level stabilization to his American audience.19
17Cited in Joseph Stagg Lawrence, Wall Street and Washington (Princeton,
N.J.: Princeton University Press, 1929), pp. 437–43.
18Commercial and Financial Chronicle (April, 1929): 2204–06. Also see Beckhart,
“Federal Reserve Policy and the Money Market,” in Beckhart et al., The New York
Money Market (New York: Columbia University Press, 1931), vol. 2, pp. 99ff.
19See Joseph Dorfman, The Economic Mind in American Civilization (New
York: Viking Press, 1959), vol. 4, p. 178.
Theory and Inflation: Economists and the Lure of a Stable Price Level
181
Influential British Labourite Philip Snowden urged in 1927 that
the United States join in a world plan for price stabilization, to
prevent a prolonged price decline. The London Statist and the
Nation (London) both bemoaned the Federal Reserve “deflation.”
Perhaps most extreme was a wildly inflationist article by the
respected economist Professor Allyn A. Young, an American then
teaching at the University of London. Young, in January 1929,
warned about the secular downward price trend, and urged all
Central Banks not to “hoard” gold, to abandon their “high gold
reserve-ratio fetish,” and to inflate to a fare-thee-well. “Central
banks of the world,” he declared, “appear to be afraid of prosper-
ity. So long as they are they will exert a retarding influence upon
the growth of production.”20
In an age of folly, Professor Young’s article was perhaps the
crowning pièce de résistance—much more censurable than the super-
ficially more glaring errors of such economists as Irving Fisher and
Charles A. Dice on the alleged “new era” prosperity of the stock
market. Merely to extrapolate present stock market conditions is,
after all, not nearly as reprehensible as considering deflation the
main threat in the midst of a rampantly inflationary era. But such
was the logical conclusion of the stabilizationist position.
We may conclude that the Federal Reserve authorities, in
promulgating their inflationary policies, were motivated not only
by the desire to help British inflation and to subsidize farmers, but
were also guided—or rather misguided—by the fashionable eco-
nomic theory of a stable price level as the goal of monetary manip-
ulation.21
20Allyn A. Young, “Downward Price Trend Probable, Due to Hoarding of
Gold by Central Banks,” The Annalist (January 18, 1929): 96–97. Also see, “Our
Reserve Bank Policy as Europe Thinks It Sees It,” The Annalist (September 2,
1927): 374–75.
21Seymour Harris, Twenty Years of Federal Reserve Policy (Cambridge, Mass.:
Harvard University Press, 1933), vol. 1, 192ff., and Aldrich, The Causes of the
Present Depression and Possible Remedies (New York, 1933), pp. 20–21.
Part III
The Great Depression: 1929–1933
7
Prelude to Depression:
Mr. Hoover and Laissez-Faire
If government wishes to alleviate, rather than aggravate, a
depression, its only valid course is laissez-faire—to leave the
economy alone. Only if there is no interference, direct or
threatened, with prices, wage rates, and business liquidation will
the necessary adjustment proceed with smooth dispatch. Any
propping up of shaky positions postpones liquidation and aggra-
vates unsound conditions. Propping up wage rates creates mass
unemployment, and bolstering prices perpetuates and creates
unsold surpluses. Moreover, a drastic cut in the government
budget—both in taxes and expenditures—will of itself speed
adjustment by changing social choice toward more saving and
investment relative to consumption. For government spending,
whatever the label attached to it, is solely consumption; any cut in
the budget therefore raises the investment–consumption ratio in
the economy and allows more rapid validation of originally waste-
ful and loss-yielding projects. Hence, the proper injunction to gov-
ernment in a depression is cut the budget and leave the economy
strictly alone. Currently fashionable economic thought considers
such a dictum hopelessly outdated; instead, it has more substantial
backing now in economic law than it did during the nineteenth
century.
Laissez-faire was, roughly, the traditional policy in American
depressions before 1929. The laissez-faire precedent was set in
185
186
America’s Great Depression
America’s first great depression, 1819, when the federal govern-
ment’s only act was to ease terms of payment for its own land
debtors. President Van Buren also set a staunch laissez-faire
course, in the Panic of 1837. Subsequent federal governments fol-
lowed a similar path, the chief sinners being state governments
which periodically permitted insolvent banks to continue in oper-
ation without paying their obligations.1 In the 1920–1921 depres-
sion, government intervened to a greater extent, but wage rates
were permitted to fall, and government expenditures and taxes
were reduced. And this depression was over in one year—in what
Dr. Benjamin M. Anderson has called “our last natural recovery to
full employment.”
Laissez-faire, then, was the policy dictated both by sound the-
ory and by historical precedent. But in 1929, the sound course was
rudely brushed aside. Led by President Hoover, the government
embarked on what Anderson has accurately called the “Hoover
New Deal.” For if we define “New Deal” as an antidepression pro-
gram marked by extensive governmental economic planning and
intervention—including bolstering of wage rates and prices,
expansion of credit, propping up of weak firms, and increased gov-
ernment spending (e.g., subsidies to unemployment and public
works)—Herbert Clark Hoover must be considered the founder of
the New Deal in America. Hoover, from the very start of the
depression, set his course unerringly toward the violation of all the
laissez-faire canons. As a consequence, he left office with the econ-
omy at the depths of an unprecedented depression, with no recov-
ery in sight after three and a half years, and with unemployment at
the terrible and unprecedented rate of 25 percent of the labor
force.
Hoover’s role as founder of a revolutionary program of govern-
ment planning to combat depression has been unjustly neglected
by historians. Franklin D. Roosevelt, in large part, merely elabo-
rated the policies laid down by his predecessor. To scoff at
1For an appreciation of the importance of this fact for American monetary
history, see Vera C. Smith, The Rationale of Central Banking (London: P.S. King
and Son, 1936).
Prelude to Depression: Mr. Hoover and Laissez-Faire
187
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.
To portray the interventionist efforts of the Hoover adminis-
tration to cure the depression we may quote Hoover’s own sum-
mary of his program, during his Presidential campaign in the fall
of 1932
we might have done nothing. That would have been
utter ruin. Instead we met the situation with proposals
to private business and to Congress of the most gigantic
program of economic defense and counterattack ever
evolved in the history of the Republic. We put it into
action. . . . No government in Washington has hitherto
considered that it held so broad a responsibility for lead-
ership in such times. . . . For the first time in the history
of depression, dividends, profits, and the cost of living,
have been reduced before wages have suffered. . . . They
were maintained until the cost of living had decreased
and the profits had practically vanished. They are now
the highest real wages in the world.
Creating new jobs and giving to the whole system a
new breath of life; nothing has ever been devised in our
history which has done more for . . . “the common run
of men and women.” Some of the reactionary econo-
mists urged that we should allow the liquidation to take
its course until we had found bottom. . . . We deter-
mined that we would not follow the advice of the bitter-
end liquidationists and see the whole body of debtors of
the United States brought to bankruptcy and the savings
of our people brought to destruction.2
2From his acceptance speech on August 11, and his campaign speech at Des
Moines on October 4. For full account of the Hoover speeches and anti-depres-
sion program, see William Starr Myers and Walter H. Newton, The Hoover
Administration (New York: Scholarly Press, 1936), part 1; William Starr Myers,
ed., The State Papers of Herbert Hoover, (New York. 1934), vols. 1 and 2. Also see
Herbert Hoover, Memoirs of Herbert Hoover (New York: Macmillan, 1937), vol. 3.
188
America’s Great Depression
THE DEVELOPMENT OF HOOVER’S
INTERVENTIONISM: UNEMPLOYMENT
Hoover, of course, did not come upon his interventionist ideas
suddenly. It is instructive to trace their development and the simi-
lar development in the country as a whole, if we are to understand
clearly how Hoover could so easily, and with such nationwide sup-
port, reverse the policies that had ruled in all previous depressions.
Herbert Clark Hoover was very much the “forward-looking”
politician. We have seen that Hoover pioneered in attempts to
intimidate investment bankers in placing foreign loans. Character-
istic of all Hoover’s interventions was the velvet glove on the
mailed fist: i.e., the businessmen would be exhorted to adopt “vol-
untary” measures that the government desired, but implicit was
the threat that if business did not “volunteer” properly, compul-
sory controls would soon follow.
When Hoover returned to the United States after the war and
a long stay abroad, he came armed with a suggested “Reconstruc-
tion Program.” Such programs are familiar to the present genera-
tion, but they were new to the United States in that more innocent
age. Like all such programs, it was heavy on government planning,
which was envisaged as “voluntary” cooperative action under “cen-
tral direction.”3 The government was supposed to correct “our
marginal faults”—including undeveloped health and education,
industrial “waste,” the failure to conserve resources, the nasty habit
of resisting unionization, and seasonal unemployment. Featured in
Hoover’s plan were increased inheritance taxes, public dams, and,
significantly, government regulation of the stock market to elimi-
nate “vicious speculation.” Here was an early display of Hoover’s
hostility toward the stock market, a hostility that was to form one
of the leitmotifs of his administration.4 Hoover, who to his credit
3See Joseph Dorfman, The Economic Mind in American Civilization (New York:
Viking Press, 1959), vol. 14, p. 27.
4Hoover, Memoirs, vol. 2, p. 29. Hoover’s evasive rhetoric is typical: “I insist-
ed that these improvements could be effected without government control, but
the government should cooperate by research, intellectual leadership [sic], and
prohibitions upon the abuse of power.”
Prelude to Depression: Mr. Hoover and Laissez-Faire
189
has never pretended to be the stalwart of laissez-faire that most
people now consider him, notes that some denounced his program
as “radical”—as well they might have.
So “forward-looking” was Hoover and his program that Louis
Brandeis, Herbert Croly of the New Republic, Colonel Edward M.
House, Franklin D. Roosevelt, and other prominent Democrats
for a while boomed Hoover for the presidency.5
Hoover continued to expound interventionism in many areas
during 1920. Most relevant to our concerns was the conference on
labor–management relations that Hoover directed from 1919 to
1920, on appointment by President Wilson and in association with
Secretary of Labor William B. Wilson, a former official of the
United Mine Workers of America. The conference—which included
“forward-looking” industrialists like Julius Rosenwald, Oscar Straus,
and Owen D. Young, labor leaders, and economists like Frank W.
Taussig—recommended wider collective bargaining, criticized
“company unions,” urged the abolition of child labor, and called for
national old-age insurance, fewer working hours, “better housing,”
health insurance, and government arbitration boards for labor dis-
putes. These recommendations reflected Hoover’s views.6
Hoover was appointed Secretary of Commerce by President
Harding in March, 1921, under pressure from the left wing of the
Republican Party, led by William Allen White and Judge Nathan
Miller of New York. (Hoover was one of the first of the modern
breed of politician, who can find a home in either party.) We
have seen that the government pursued a largely laissez-faire
policy in the depression of 1920–1921, but this was not the doing
of Herbert Hoover. On the contrary, he “set out to reconstruct
5Cf. Arthur M. Schlesinger, Jr., The Crisis of the Old Order, 1919–1933 (Boston:
Houghton Mifflin, 1957), pp. 81ff.; Harris Gaylord Warren, Herbert Hoover and
the Great Depression (New York: Oxford University Press, 1959), pp. 24ff.
6Hoover records that the “extreme right” was hostile to these proposals—
and understandably so—and notably the Boston Chamber of Commerce. Also
see Eugene Lyons, Our Unknown Ex-President (New York: Doubleday, 1948),
pp. 213–14.
190
America’s Great Depression
America.”7 He only accepted the appointment on the condition
that he would be consulted on all economic policies of the federal
government. He was determined to transform the Department of
Commerce into “the economic interpreter to the American people
(and they badly need one).”8 Hardly had Hoover assumed office
when he began to organize an economic conference and a com-
mittee on unemployment. The committee established a branch in
every state having substantial unem
