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These posts are the creation of Doran L. Barton (AKA Fozziliny Moo). To learn more about Doran, check out his website at fozzilinymoo.org.

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The cause of depressions - an echo from 46 years ago

Posted: 27 March 2009 at 15:50:37

I am reading "Capitalism: The Unknown Ideal" by Ayn Rand. It is a collection of essays by Rand and other academics from the school of Objectism. One essay, "Common Fallacies About Capitalsm," written in 1963 by Nathaniel Branden, grabbed my attention in a particularly intense manner.

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.