After typing for quite some time, I would like to present an excerpt from this essay: a section titled “Depression”. Boldface emphasis has been added by me.
Question: Are periodic depressions inevitable in a system of Laissez-Faire
Capitalism?
It is characteristic of the enemies of capitalism that they denounce it for
evils which are, in fact, the result not of capitalism but of statism: evils
which result from and are made possible only by government intervention
into the economy.
I have discussed a flagrant example of this policy: the charge that
capitalism leads to the establishment of coercive monopolies. The most
notorious instance of this policy is the claim that capitalism, by its
nature, inevitably leads to periodic depressions.
Statists repeatedly assert that depressions (the phenomenon of the
so-called business cycle of “boom and bust”) are inherent in laissez-faire,
and that the great rash of 1929 was the final proof of the failure of an
unregulated, free-market economy. What is the truth of the matter?
A depression is a large-scale decline in production and trade; it is
characterized by a sharp drop in productive output, in investment, and in
the value of capital assets (plants, machinery, etc.). Normal business
fluctuations, or a temporary decline in the rate of industrial expansion,
do not constitute a depression. A depression is a nation-wide contraction
of business activity—and a general decline in the value of capital
assets—of major proportions.
There is nothing in the nature of a free-market economy to cause such an
event. The popular explanations of depression as caused by
“over-production,” “under-consumption,” monopolies, labor-saving decides,
maldistribution, excessive accumulations of wealth, etc., have been
exploded as fallacies many times.
Readjustments of economic activity, shifts of capital and labor from one
industry to another, due to changing conditions, occur constantly under
capitalism. This is entailed in the process of motion, growth, and progress
that characterizes capitalism. But there always exists the possibility of
profitable endeavor in one field or another, there is always the need and
demand for goods, and all that can change is the kind of goods it becomes
most profitable to produce.
In any one industry, it is possible for supply to exceed demand, in the
context of all the other existing demands. In such a case, there is a drop
in prices, in profitableness, in investment, and in employment in that
particular industry; capital and labor tend to flow elsewhere, seeking more
rewarding uses. Such an industry undergoes a period of stagnation as a
result of unjustified, that is, uneconomic, unprofitable, unproductive
investment.
In a free economy that functions on a gold standard, such unproductive
investment is severely limited; unjustified speculation does not rise,
unchecked, until it engulfs an entire nation. In a free economy, the supply
of money and credit needed to finance business ventures is determined by
objective economic factors. it is the banking system that acts as the
guardian of economic stability. The principles governing money supply
operate to forbid large-scale unjustified investment.
Most businesses finance their undertakings, at least in part, by means of
bank loans. Banks function as an investment clearing house, investing the
savings of their customers in those enterprises which promise to be most
successful. Banks do not have unlimited funds to loan; they are limited in
the credit they can extend by the amount of their gold reserves. In order
to remain successful, to make profits and thus attract the savings of
investors, banks much make their loans judiciously: they must seek out
those ventures which they judge to be most sound and potentially profitable.
If, in a period of increasing speculation, banks are confronted with an
inordinate number of requests for loans, then, in response to the shrinking
availability of money, they (a) raise their interest rates, and (b)
scrutinize more severely the ventures for which loans are requested setting
more exacting standards of what constitutes a justifiable investment. As a
consequence, funds are more difficult to obtain, and there is a temporary
curtailment and contraction of business investment. Businessmen are often
unable to borrow the funds they desire and have to reduce plans for
expansion. The purchase of common stocks, which reflects the investors’
estimates of the future earnings of companies is similarly curtailed;
overvalued stocks fall in price. businesses engaged in credit, are obliged
to close their doors; a further waste of productive factors is stopped and
economic errors are liquidated.
At worst, the economy may experience a mild recession, i.e. a slight
general decline in investment and production. In an unregulated economy,
readjustments occur quite swiftly, and then production and investment begin
to rise again. The temporary recession is not harmful but beneficial; it
represents an economic system in the process of correcting its errors, of
curtailing disease and returning to health.
The impact of such a recession may be significantly felt in a few
industries, but it does not wreck an entire economy. A nation-wide
depression, such as occurred in the United States in the thirties, would
not have been possible in a fully free society. It was made possible only
by government intervention in the economy—more specifically, by government
manipulation of the money supply.
The government’s policy consisted, in essence, of anesthetizing the
regulators, inherent in a free banking system, that prevent runaway
speculation and consequent economic collapse.
All government intervention in the economy is based on the belief that
economic laws need not operate, that principles of cause and effect can be
suspended, that everything in existence is “flexible” and “malleable,”
except a bureaucrat’s whim, which is omnipotent; reality, logic, and
economics much not be allowed to get in the way.
This was the implicit premise that led to the establishment, in 1913, of
the Federal Reserve System—an institution with control (through complex
and often indirect means) over the individual banks throughout the country.
The Federal Reserve undertook to free individual banks from the
“limitations” imposed on them by the amount of their own individual
reserves, to free them from laws of the market—and to arrogate to
government officials the right to decide how much credit they wished to
make available at what times.
A “cheap money” policy was the guiding idea and goal of these officials.
Banks were no longer to be limited in making loans by the amount of their
gold reserves. Interest rates were no longer to rise in response to
increasing speculation and increasing demands for funds. Credit was to
remain readily available—until and unless the Federal Reserve decided
otherwise.
The government argued that by taking control of money and credit out of
the hands of private bankers, and by contracting or expanding credit at
will, guided by considerations other than those influencing the “selfish”
bankers, it could—in conjunction with the other interventionist
policies—so control investment as to guarantee a state of virtually
constant prosperity. Many bureaucrats believed that the government could
keep the economy in a state of unending boom.
To borrow an invaluable metaphor from Alan Greenspan: if, under
laissez-faire, the banking system and the principles controlling the
availability of funds act as a fuse that prevents a blowout in the
economy—then the government, through the Federal Reserve System, put a
penny in the fuse-box. The result was the explosion known as the Crash of
1929.
Throughout most of the 1920’s, the government compelled banks to keep
interest rates artificially and uneconomically low. As a consequence, money
was poured into every sort of speculative venture. By 1928, the warning
signals of danger were deeply apparent: unjustified investment was rampant
and stocks were increasingly overvalued. The government chose to ignore
these danger signals.
A free banking system would have been compelled, by economic necessity, to
put the brakes on this process of runaway speculation. credit and investment,
in such a case, would be drastically curtailed; the banks which made
unprofitable investments, the enterprises which proved unproductive, and
those who dealt with them, would suffer—but that would be all; the
country as a whole would not be dragged own. However, the “anarchy” of a
free banking system had been abandoned—in favor of “enlightened”
government planning.
The boom and the wild speculation—which had preceded every major
depression—were allowed to rise unchecked, involving, in a widening
network of malinvestments and miscalculations, the entire economic
structure of the nation. People were investing in virtually everything and
making fortunes overnight—on paper. Profits were calculated on
hysterically exaggerated appraisals of the future earnings of companies.
Credit was extended with promiscuous abandon, on the premise that somehow
the goods would be there to back it up. It was like the policy of a man who
passes out rubber checks, counting on the hope that he will somehow find a
ay to obtain the necessary money and to deposit it in the bank before
anyone presents his checks for collection.
But A is A—and reality is not infinitely elastic. In 1929, the country’s
economic and financial structure had become impossibly precarious. By
the time the government finally and frantically raised the interest rates,
it was too late. It is doubtful whether anyone can state with certainty what
events first set off the panic—and it does not matter: the crash had
become inevitable; any number of events could have pulled the trigger. But
when the news of the first bank and commercial failures began to spread,
uncertainty spread across the country in widening waves of terror. People
began to sell their stocks, hoping to get out of the market with their
gains, or to obtain the money they suddenly needed to pay bank loans that
were being called in—and other people, seeing this, apprehensively began
to sell their stocks—and, virtually overnight, an avalanche hurled the
stock market downward, prices collapsed, securities became worthless, loans
were called in, many of which could not be paid, the value of capital
assets plummeted sickeningly, fortunes were wiped out, and, by 1932,
business activity had come almost to a halt. the law of causality had
avenged itself.
Such, in essence, was the nature and cause of the 1929 depression.
It provides one of the most eloquent illustrations of the disastrous
consequences of a “planned” economy. In a free economy, when an individual
businessman makes an error of economic judgment, he (and perhaps those
who immediately deal with him) suffers the consequences; in a controlled
economy, when a central planner makes an error of economic judgment, the
whole country suffers the consequences.
But it was not the Federal Reserve, it was not the government intervention
that took the blame for the 1929 depression—it was capitalism.
Freedom—cried statists of every breed and sect—had had its chance and had
failed. The voices of the few thinkers who pointed to the real cause of the
evil were drowned out in the denunciation of businessmen, of the profit
motive, of capitalism.
Had men chosen to understand the cause of the crash, the country would have
been spared much of the agony that followed. The depression was prolonged
for tragically unnecessary years by the same evil that caused it: government
controls and regulations.
Contrary to popular misconception, controls and regulation began long
before the New Deal; in the 1920’s, the mixed economy was already an
established fact of American life. But the trend toward statism began to
move faster under the Hoover Administration—and, with the advent of
Roosevelt’s New Deal, it accelerated at an unprecedented rate. The economic
adjustments needed to bring the depression to an end were prevented from
taking place—by the imposition of strangling controls, increased taxes,
and labor legislation. This last had the effect of forcing wage rates to
unjustifiably high levels, thus raising the businessman’s costs at
precisely the time when costs needed to be lowered, if investment and
production were to revive.
The National Industrial Recovery Act, the Wagner Act, and the abandonment
of the gold standard (with the government’s subsequent plunge into
inflation and an orgy of deficit spending) were only three of the many
disastrous measures enacted by the New Deal for the avowed purpose of
pulling the country out of the depression; all had the opposite effect.
As Alan Greenspan points out in “Stock Prices and Capital Evaluation,” the
obstacle to business recovery did not consist exclusively of the specific
New Deal legislation passed; more harmful still was the general atmosphere
of uncertainty engendered by the Administration. Men had no way to know
what law or regulation would descend on their heads at any moment; they had
no way to know what sudden shifts of direction government policy might
take; they had no way to plan long-range.
To act and produce, businessmen require knowledge, the possibility of
rational calculation, not “faith” and “hope”—above all, not “faith” and
“hope” concerning the unpredictable twistings within a bureaucrat’s head.
Such advances as business was able to achieve under the New Deal collapsed
in 1937—as a result of intensification of uncertainty regarding what the
government might choose to do next. Unemployment rose to more than ten
million and business activity fell almost to the low point of 1932, the
worst year of the depression.
It is part of the official New Deal mythology that Roosevelt “got us out of
the depression.” How was the problem of the depression finally “solved”? By
the favorite expedient of all statists in times of emergency: a war.
The depression precipitated by the stock market crash of 1929 was not the
first in American history—though it was incomparably more severe than
anything that had preceded it. If one studies the earlier depressions, the
same basic cause and common denominator will be found: in one form or
another, government manipulation of the money supply. It is typical the
manner in which interventionism grows that the Federal Reserve System was
instituted as a proposed antidote against those earlier depressions—which
were themselves products of monetary manipulation by the government.
The financial mechanism of an economy is the sensitive center, the living
heart, of business activity. In no other area can government intervention
produce quite such disastrous consequences. For a general discussion of the
business cycle and its relation to government manipulation of the money
supply, see Ludwig von Mises, Human Action.
One of the most striking facts of history is men’s failure to learn from
it.
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