The Great Depression of the 1930s is still
considered by many to be a failure of the
free market and of the laissez-faire capitalism.
At a first glance, it may very well seem so.
After all, the American economy at the time
relied on savings and investments, and the
dollar was based on gold.
However, a deeper examination reveals a completely
different image of the underlying causes both
of the Great Depression, and of its transformation
from unassuming beginnings in an ordinary crisis.
We have discussed in the “Austrian Business
Cycle Theory” video that a crisis begins
with an artificial boom driven by an increase
in money supply and interest rates being set
far below their free-market level.
The Fed, established by the Federal Reserve
Act of 1913, has removed several free-market
restrictions on inflation from the banking
system (inflation understood as a general
increase in money supply).
Professor of economics Murray N. Rothbard
wrote:
“Only 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 purchasing power of each dollar,
i.e., a general rise in prices; conversely,
a drop in the money supply will cause a general
decline in prices.”
If the banking system is based on the fractional
reserve system, then the gold standard alone
does not protect against inflation.
The FED was created to keep the inflation
in control of the government.
Of course, inflation is beneficial both to
the government and the banks, so the phrase
“controlling inflation” is just a euphemism
for “causing inflation.”
Bank reserve ratio fell from around 21 percent
in 1913 to 10 percent in 1917.
The government was responsible for the reserve
requirement ratio at the time.
According to Rothbard, the Fed contributed
to a six-fold increase in the monetary potential
of the American banking system by making such
decisions as a deliberate reduction of the
reserve requirement ratio.
The Boom Period
The boom of the Roaring Twenties began in
1921 and lasted until 1929.
It was not entirely artificial.
The actual standard of living in the U.S.
did increase.
More and more Americans had electricity, cars
and other amenities such as toasters and vacuum cleaners.
Taxes were reduced as well.
This was due to the conservative fiscal policy
of Treasury Secretary Mellon and President Coolidge.
Unfortunately, at the same time something
was interfering with the economic growth.
It was Fed’s policy of flooding the market
with cheap money during practically the entire
1920s, thus disrupting production processes
and causing malinvestments to amass.
During the boom the money supply increased
from 45.3 billion dollars to 73.26 billion
dollars, that is by 61.8 percent.
The increase was not caused by printing money,
but by a credit expansion allowed by the fractional
reserve banking.
The amount of cash was fairly constant throughout
the period.
Instead, the increase in the money supply
applied to money substitutes, that is funds
normally treated by society as equal to cash.
These substitutes included demand, time and
other easily cashed out deposits.
Some argue that the inflation was caused by
an inflow of gold; but during the boom the
gold reserves increased only by 1.16 billion
dollars, which is negligible compared to 28
billion dollars of total money supply increase.
There were two factors causing inflation.
The first factor was a change in the effective
reserve requirement ratio.
It is true that the reserve requirement ratio
itself did not change in the 1920s.
Throughout the period, the ratio applied to
demand deposits was 13, 10 or 7 percent depending
on the bank, and the ratio applied to time
deposits was 3 percent regardless of the bank.
The change in the effective reserve requirement
ratio was caused by a significant increase
in the total amount of funds in time deposits
relative to demand deposits.
The funds in demand deposits increased by
approximately 31 percent, while the funds
in time deposits increased by approximately
72 percent.
If a reserve requirement ratio imposed on
a bank is 10 percent, then such a bank can
create 10 dollars out of each deposited dollar.
However, when time deposits are considered,
the bank must maintain only 3 percent in reserves,
and this allows for a much greater money creation.
Before the Fed was established, the banks
had to maintain the same reserves for both
kinds of deposits.
By passing the Federal Reserve Act, the government
not only caused the overall level of reserves
to fall greatly between 1913 and 1917, but
also brought about a second reserve requirement
ratio for time deposits.
Because banks profit from lending money, then
it should not come as a surprise that banks
strove to minimize their reserve requirements
by accruing more money in time deposits.
This shift in the effective reserve requirement
ratio was responsible for 18.5 percent of
money supply increase during the boom period.
The second and main factor causing inflation
was an increase in the total amount of bank reserves.
The total amount of bank reserves increased
from 1.6 billion dollars in 1921 to 2.36 billion dollars in 1929.
There were several factors responsible for
this increase.
Murray Rothbard analyzed this topic extensively
in his book, “America’s Great Depression”.
After analyzing individual factors, Rothbard
divided them into ones controlled by the Fed
and the Treasury Department, and ones uncontrolled
by the governmental.
According to Rothbard, in the analyzed period
the amount of uncontrolled reserves decreased
by about 1 billion dollars, while controlled
reserves swelled by 1.79 billion dollars.
This was done on purpose.
Secretary of the Treasury at the time of Fed’s
creation, William G. McAdoo, said:
“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.”
By keeping discount rates below market rates,
the Fed gave banks a permanent access to credit.
This was quite relevant to the overall increase
in reserves.
And the increase in total reserves was responsible
for 81.5 percent of money supply growth during the boom.
There is no doubt that the government was
in favor of inflationism.
The presidents of the period, Harding and
Coolidge, both supported keeping discount
rates low, and appointed Federal Reserve Board
governors accordingly.
The Federal Reserve System also lent money
for investments in stock market, charging
a much lower interest rate than it was before
the establishment of the Fed.
Moreover, President Coolidge’s and Secretary
of the Treasury Mellon’s public speeches
and policies further stimulated the artificial
stock market boom.
Up to a point, no effort was spared to keep
the boom from fading away.
Finally, the stock market boom and a significant
increase in stock prices in the second half
of 1927 caused the Fed officials to worry.
In 1928, they made a few clumsy attempts at
slowing the boom down.
The Fed started to increase interest rates
gradually from 3.5 percent in early 1928 to
6 percent in August, 1929.
While Fed officials tried to lower the reserves
and dealt with one factor of their increase,
another factor caused the reserves to swell,
thus increasing the money supply.
They managed to slow down the boom only between
May and July.
Later, however, the Fed was forced to buy
a large number of banker’s acceptances – to
which it had previously committed – thus
at the end of the year making money supply
reach the highest level since the inflation
began.
From this moment onward the money supply practically
ceased to grow.
In 1929, its growth was negligible.
After a few months without the monetary crutch,
the malinvestments made during the artificial
boom began to surface, and by July the Great
Depression began to wreak havoc.
The stock market crashed in October.
In the worst two days, called the Black Monday
and the Black Tuesday, the Wall Street lost
13 and 12 percent of its value, respectively.
Many people lost their belongings in the Stock
Market Crash and committed suicide.
The Great Depression
On March 4, 1929, shortly before the Great
Depression broke out, Herbert Hoover became
the President of the United States.
Today, many people view him as a laissezfairist
who stood by and did nothing to help the economy
when such help was needed.
This is a direct opposite of the truth.
As a trade secretary in the 1920s Hoover urged
the government to fight unemployment by reducing
working time and raising wage rates simultaneously,
and supported forming of trade unions.
He was a strong advocate of increasing government
spending on public works during economic slowdowns.
Hoover maintained that allowing the wages
to fall during the crisis causes the purchasing
power of the nation to decrease, and thus
exacerbates the crisis.
During the previous crises, American governments
did not interfere in the economy.
This made crises both milder and shorter.
After all, during crises it is best to let
malinvestments fail.
By supporting malinvestments the government
artificially takes away resources from other
more productive uses.
Wages should fall as any other prices, unless
we want huge unemployment such as during the
Great Depression.
During past crises, the economy, free of the
government intervention in wages, time and
again rapidly came back to full employment.
The laissezfairist government should also
cut taxes and government spending radically,
thus reducing the time the economy needs to
adjust to a crisis.
So, what actions Hoover did actually undertake
during the Great Depression?
This is what he had to say:
“the primary question at once arose as to
whether the President and the Federal government
should undertake to investigate and remedy
the evils.
... No President before had ever believed
that there was a governmental responsibility
in such cases.
No matter what the urging on previous occasions,
Presidents steadfastly had maintained that
the Federal government was apart from such
eruptions ... therefore, we had to pioneer
a new field.”
From the beginning it was certain that Hoover
was not going to be guided by the most effective
and well-tested laissez-faire remedies.
Propping Up Wages
Hoover inaugurated his presidency with a series
of White House conferences in which he persuaded
entrepreneurs not to decrease wage rates and
to continue to invest.
He said that it is necessary to keep wage
rates on high levels, and if they do fall,
then the fall shouldn't be greater that the
fall in the cost of living expenses.
Seemingly noble, though in fact economically
horrifying, Hoover’s idea was to shift the
blunt force of the Depression from the employees’
wages to the entrepreneurs’ profits.
Instead of standing down, the businesses in
the worst case were to cut down the work week.
Entrepreneurs agreed on the plan, seduced
by a then-fashionable theory of keeping wages
high in order to maintain the purchasing power
of society.
They were misguided in thinking that the cause
of the Depression was overproduction and subconsumption.
This was not the case, obviously, as the real
issue here was the disrupted structure of production.
Misallocation of resources stemming from interest
rates being too low caused some companies
to overproduce while others underproduced.
Maintaining high wage rates only made it more
difficult to properly reallocate the resource, i.e. work.
It was also agreed upon that instead of standing
down, the entrepreneurs would cut work hours
and distribute work among more employees.
This reduced the pressure on wage cuts even
further.
As a result, in the early 1930s nominal wage
rates were maintained, but real wages have
increased, because the prices of most goods
and services were falling.
In September 1930 immigration to the United
States was banned in order to maintain wages
and fight unemployment.
Work grew very expensive.
Keeping prices above free-market levels creates
unsalable surpluses.
In case of work the surplus is called unemployment.
During the Great Depression unemployment was
enormous, peaking at 28.3 percent in March 1933.
With falling production, turnover, prices,
and rising employment, propping up wages only
wreaked more havoc to the economy.
During the previous crisis unemployment peaked
at 11.7 percent in 1921, rapidly falling to
2.5 percent by 1923.
The difference was that in 1921 wage rates
decreased by 20 percent within a year.
The market returned to full employment without
government intervention in wages.
Tariff Policy
In 1930, Hoover raised already quite high
tariffs by signing a bill reported to him
by Congress.
The alleged goal of the bill was to help farmers.
The tariff rates were raised to the highest
levels in American history.
Tariffs hurt farmers producing for export,
entrepreneurs importing goods they needed
in their own production processes, and domestic
consumers who had to spend more money on imported goods.
The automotive industry is a good example
here.
The government imposed tariffs on 800 goods
used in the production of cars.
Moreover, car exports were hit by European
retaliatory tariffs.
In result, car sales fell from 5.3 million
dollars in 1929 to a meager 1.8 million dollars in 1932.
The tariffs along with the economic slowdown,
devastated American exports, which fell from
7 billion dollars to 2.5 billion dollars over
the 1929–1932 period.
Government Spending
According to an American economist Dr. Robert
Murphy, as far government spending is concerned,
Hoover in the first two years in office acted
like a model keynesian.
In the 1920s, the budgetary surpluses were
a good reason to cut taxes and pay off debt.
Hoover inherited from his predecessor a budget
surplus of 700 million dollars.
Given that the entire budget was worth 3.3
billion dollars, this was a big deal.
But during Hoover’s term this had changed
drastically.
In the fiscal year of 1932, 1.9 billion dollars
were collected from taxes, while the spending
climbed to 4.7 billion dollars.
The deficit expenses were indeed huge.
Finally, after a complete failure of using
deficit spending to cure the Depression, in
1932 Hoover gave it up.
By then, however, the unemployment already
exceeded 20 percent.
After a year, Hoover reduced the deficit,
albeit dubiously.
The deficit fell very slightly from 2.7 billion
dollars in 1932 to 2.6 billion dollars by
the next year.
55 percent of the amount was a result of a
huge tax increase, that (in accordance with
the Laffer curve) did not bring the expected
inflows.
The remaining 45 percent was due to an actual
spending cut.
Please note that during previous crises, all
of which certainly did not merit the name
“Great Depression,” the government actually
cut spending at the same time as the inflows
were declining.
Rescuing Farmers
Hoover fulfilled one his election promises
by creating the Federal Farm Board, or FFB.
Its aim was to grant all-purpose loans to
agricultural cooperatives at low interest
in order to maintain the prices of agricultural
products, and to manage any surpluses.
You have already learned of the results of
such a policy from our video on the price system.
As the FFB was managed by the representatives
of its own beneficiaries, that is the agricultural
cooperatives, the result, quite predictably,
was creation of an agricultural cartel.
After the crash, the FFB lent 150 million
dollars to the cooperatives to hold wheat
off the market and thus to increase its price.
The absurd idea was that people needed to
pay artificially high food prices just as
the Depression stifled the economy.
This pushed farmers to intensify grain production,
and thus the price of grain plunged down.
The next idea was to persuade the farmers
to reduce production in order to maintain
the proper price, but they simply refused.
This prompted the Farmers’ National Grain
Corporation created by the FFB to buy 7.2
million tons of wheat off the market, but
this intervention did nothing to stop the
prices from falling.
Rothbard estimated the losses in wheat and
cotton (where similar steps were undertaken
as well) at 300 million dollars, not to mention
the huge amounts of wheat and cotton given
for free to the Red Cross.
The Federal Farm Board also tried to control
the prices of wool, butter, and grapes, but
this was done on a smaller scale.
The government subsidized the production of
other products.
The FFB only managed to aggravate the agricultural
crisis, and was finally dismantled.
Yet after the FFB’s failure Hoover continued
his attempts at propping up the prices by
recommending that productive land be withdrawn
from cultivation, that crops be plowed under,
and that immature farm animals be slaughtered,
even though some citizens were suffering from hunger.
All this to reduce surplus.
This was destruction of wealth, plain and
simple.
The government failures led many people to
organize protests, demonstrations, and strikes
that were anything but peaceful.
By the end of 1930, Hoover boasted that everything
was fine, because even though the overall
prices of wheat and cotton fell by 40 percent,
and the prices of other agricultural products
fell by 20 percent, in the U.S., the wheat
price was 50 percent higher than in Canada,
and the price of wool was 80 percent higher
than in Denmark.
This meant that if not for the huge tariffs,
citizens would buy wheat 50 percent cheaper,
and wool 80 percent cheaper.
Not to mention that these products were impossible
to sell abroad due to their high price.
Public Works
A part of the huge deficit spending went to
public works designed to combat unemployment.
Hoover sent a message to the governors urging
expansion of public works.
Soon a special organization was established
to collaborate with state governments in the
implementation of public works.
There was a public construction department
created as well.
On July 3, 1930, the Congress approved spending
913 million dollars on a public works program
that included the famous Hoover Dam.
We have explained how ill-advised such an
idea is in the video “That Which is Seen,
and That Which is Not Seen.”
Hoover later bragged about how he persuaded
the federal and state governments during the
Depression to increase public works programs
by 1.5 billion dollars.
In only 4 years of his term Hoover spent more
money on this than his predecessors did in 30 years.
But the government had more ideas up its sleeve.
For example, an agency was established to
provide huge loans to financially troubled
banks and railways.
The loans, financed by taxpayer money, often
ended up in hands of well-connected people.
Last, but not least, there were bank runs.
During Hoover’s term some 11,000 banks went
bankrupt because people lost confidence in
the banking system.
Of course, this loss of trust was justified
by the fact that most of the time banks under
the fractional reserve system are actually
out of their clients’ money.
The loss of trust only exacerbated in a month
preceding Roosevelt's appointment due to rumors
of his plans to abolish the gold standard.
Unfortunately, instead of protecting the property
of the depositors, the government chose to
protect the banks, imposing “bank holidays”,
that allowed banks to simply refuse to pay
the just claims of their depositors.
Such decisions only aggravated the loss of
trust in the banking system.
Hoover’s policy shattered the economy, turning
a crisis into the Great Depression.
As you can see, Hoover abandoned the policy
of non-interventionism that has worked well
during previous crises.
Instead, he decided to take matters into his
own hands and to repair the alleged errors
of the free market, which, of course, were
actually government fault’s and the effect
of increasing money supply.
When he left his office, the country was in
a state of economic collapse.
Some believe that Roosevelt’s New Deal,
which actually was Hoover’s policy on steroids,
pulled America out of the Depression.
This is also untrue.
By 1935, unemployment exceeded 20 percent,
then fell to 14 percent during the next two
years only to rise again to 19 percent in
1938.
In the entire period until the end of the
1930s the unemployment never even got close
to its peak in the previous crisis, let alone
the average in the 1920s, that is 3.3 percent unemployment.
True, the GDP grew, but the economists Lee
E. Ohanian and Harold L. Cole estimated that
in 1939 it was 27 percent below its long-term
trend, meaning the economy was recovering
slower than it should have.
Moreover, it is also untrue that the second
world war pulled the U.S. out of the Depression.
I encourage you to explore these topics by
reading a book by Dr. Bob Murphy, “The Politically
Incorrect Guide to the Great Depression and
the New Deal.”
You will also greatly benefit from a thorough
analysis of the causes of the Great Depression
and of Hoover’s actions in Prof. Murray
Rothbard’s book “Americas Great Depression”,
available for free at the Mises Institute’s
website.
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