Subject: Re: Rothbard's _America's Great Depression_

From: [email-masked]
Date: Mon, 1 Jul 1996 16:46:55 -0700

Bryan Caplan wrote:

>Instead he focused on the Austrian theory of the business cycle, which
>makes less and less sense the more I think about it.  I think Jeff
>Hummel wrote a critique where he said that it is really a theory of
>sectoral shifts rather than depression.  If, as in the Austrian theory,
>initial consumption/investment preferences "re-assert themselves,"
>why don't the consumption goods industries enjoy a huge boom?

As a matter of fact they do, if by "boom" in consumer industries you mean an
increase in consumer demand relative to demand for producer's goods.  When
the crunch comes, the prices of consumer goods do rise relative to prices of
producer goods.  In the 1929-type of situation, where the crunch is coupled
with a sharp decline in the money supply, both consumer and producer prices
decline in absolute terms, but the decline in capital prices is much sharper
than for consumer prices (In AGD, Rothbard does document this phenomena
occuring during the Great Depression).  Under the fiat money system we have
now, the money supply is not allowed to fall as the credit contracts, and
can even increase while the depression is underway.  Thus, it is possible
for a depression to take place even in the midst of sharp increases in
consumer prices (as in the stagflations of the 1970s).  No non-Austrian
theory even begins to coherently explain the existence of inflationary
depressions, which is part of the reason why Austrianism regained
intellectual respectability during the 1970s.

The key point to keep in mind here is that it is the relative, not absolute,
demands for producer and consumer goods that are associated with the trade
cycle phenomena.  A "boom" or a "bust" is indeed a sectoral shift where the
capital structure first deviates from the market time preferences and then
returns.  The empirical data for the U.S. suggests that booms and busts are
not uniform economy-wide, but are concentrated specifically in the most
capital-intensive sectors of the economy precisely as Austrian theory
predicts.  Any attempt to define "depression" apart from sectoral shifts
misses one of the most crucial aspects of real-world trade cycles.

The apparent asymmetry between booms and busts is that in the short-run most
of us like booms a lot better than we like busts.  From the point-of-view of
the typical wage worker, it's rather nice to have employers suddenly flush
with cheap credit bid more for your services.  The harmful effects of
diverting capital and labor to more time-consuming lines of production
become evident only at a later point in time, when consumer goods seem to be
getting more expensive and/or investments seem to be earning paltry rates of
return and/or rates of loan defaults start to go up.  As the errors of the
inflationary malinvestment are revealed in the marketplace, entrepreneurs
shift their diminished demand for producer goods back to the shorter
production processes.  For this to occur, the capital-intensive industries
that previously bid up wages, initiated lengthy/higher stage production
processes, etc. must now cut their losses by dismissing their workers and
perhaps abandoning some of their capital.  There is a real cost associated
with the waste of capital and productive effort on longer-term production
projects at the expense of more highly desired shorter-term projects.  These
costs cannot be avoided by "fine tuning" or "soft-landings" or other
manipulations of money and credit by the Fed Open Market Committee; sooner
or later the malinvestments have to be accounted for.  Sectoral shifts
always have a cost, and shifts caused by money and credit manipulations
create severe economy-wide costs.  Unlike shifts induced by market forces,
however, the widespread shifts induced by an inflationary credit expansion
and the subsequent correction have no offsetting benefits in terms of
increasing long-term productivity. 

The trade cycle is by no means the only factor in explaining the Great
Depression, but in fairness to Rothbard it should be acknowledged that he
does go into great detail explaining how other government policies of the
time served to severely aggravate and prolong the economic downturn.
Indeed, AGD is as much an indictment of non-monetary forms of
interventionism as it is of central bank manipulation of credit.  Rothbard
argues at length in AGD, for example, that pre-1930s downturns did not have
such disasterous consequences as the 1929 crash because of the anti-Laissez
Faire policies introduced by Hoover and other statist Republicans in
response to the crash.  The theoretical focus on the trade cycle theory in
the early part of the book is primarily a means for explaining how such an
economic calamity could have occured been initiated at the end of the
apparently stable and productive 1920s, but is by no means the sole focus of
Rothbard's analysis.

>Moreover, I can't figure out why Rothbard thinks businessmen are so
>incompetent at forecasting government policy.  He credits them with
>entrepreneurial foresight about all market-generated conditions, but
>curiously finds them unable to forecast government policy, or even
>to avoid falling prey to simple accounting illusions generated by
>inflation and deflation.  Even if simple businessmen just use
>current market interest rates in a completely robotic way, why doesn't
>arbitrage by the credit-market insiders make long-term interest
>rates a reasonable prediction of actual policies?  The problem is
>supposed to be that businessmen just look at current interest rates,
>figure out the PDV of possible investments, and due to artificially
>low interest rates (which can't persist foreover) they wind up
>making malinvestments.  But why couldn't they just use the money
>market's long-term interest rates for forecasting profitability instead
>of stupidly looking at current short-term rates?

Four reasons.  First, the credit expansion affects all interest rates,
whether they be long or short term, so arbitrage between them doesn't
"predict" what the inflation premium should be. Arbitrage simply takes some
of the funds that have been injected into the short term market (or the
Treasury bond market, or the international bond market, or the Warburg trade
acceptances, or the Florida real estate market, etc.), and redistributes
them to other types of investments.  Second, the mind of a Benjamin Strong
or an Alan Greenspan is not a predictable phenomenon.  Making something as
important as money and credit dependent on an elite few renders investor
anticipations of future monetary phenomena highly uncertain and vulnerable
to deliberate attempts by the insiders to fool the markets (in AGD, Rothbard
presents evidence of purely political motives and even outright corruption
as spurring the expansionary credit policy of the 1920s).

Third, credit markets and money are so pervasive throughout the economy that
any cluster of entrepreneurial errors are bound to be far more serious here
than anywhere else.  It is precisely the robotic investor who only watches
interest rates and doesn't pay attention to the possibility of a credit
contraction harming his investments who gets burned the worst by a credit
crunch.  How could a passive price-taker know when interest rates were too
high or too low, unless he could independently estimate what the equilibrium
rates should be (including a calculation of the default and inflation
risks)?  Fourth, few investors (or economists for that matter) understand
the trade cycle well enough to profit from it.  Presumably, a cluster of
errors could be avoided *if* many investors were fearful of artificial
credit expansions *and* they had timely information as to when they were
taking place.  If you read the financial press, however, you'll find that
such consciousness of credit and monetary issues is lamentably missing and
really useful information on the activities of the Fed absent.  Even with
direct access to a financial newspaper wire service with an archival search
engine (such as I have), one has to look awfully hard to find any useful
information for an Austrian trade cycle theorist to take advantage of.
Likewise, Austrian trade cycle theory is not exactly standard fare in Econ.
101 at most universities.

The Fed does publish its statistics (yes, I've used their web pages also),
but what use are they?  Not only are the numbers not very timely, one has to
be a real expert to make any sense out of them.  Their numbers obfuscate
critical information about bank reserves and credit and about components of
the money supply figures (which is necessary to eliminate the credit
instruments that clutter up M2 and get at the real money supply numbers).
Moreover, Fed numbers say nothing about overseas banks and other foreign
holders of dollars and dollar-denominated accounts.  When you consider that
the Bank of Japan is holding 10% of the Federal debt and has something like
$100 billion in U.S. dollar accounts, and the various major Japanese banks
control far more assets than banks of other industrialized countries, one
can begin to see that the lack of information on foreign holdings is fatal
to any worthwhile analysis of the monetary situation using traditional Fed data.

It is also worth remembering that investors of the 1920s had far less
macroeconomic information available to them than they do today.  Ironically,
it is the government's mania for collecting statistics beginning in the New
Deal era that has made the money illusion less effective because of the
"rational expectations" effect.  As lousy as some of the government numbers
are, investors  (particularly since the big dollar depreciation of the
1970s) watch them like hawks and thus shorten the time horizon for
government exploitation of the people via money supply increases.  Of
course, it shouldn't come as a suprise if the government were to try taking
advantage of the numbers junkies by cooking the numbers.  The recent attempt
to emasculate the consumer price index such serve as a cautionary warning
not to blindly trust government statisticians.

>I also can't overlook his bizarre claim that inflation prevents 
>the dispersion of productivity gains throughout the economy. It
>may lead to a _different_ dispersion that would otherwise occur,
>but that is a very different matter.

I don't recall Rothbard saying that.  I recall him saying that productivity
gains would normally result in falling prices for consumer goods, and that
an attempt to stabilize consumer prices via inflation would offset at least
some of the productivity gains by causing the malinvestment of capital and
other capital consumption effects.

>And while Rothbard grossly underrates the negative effects of the
>monetary contraction given wage rigidity, Friedman seems to 
>seriously underestimate the extent to which the Fed _did_ try
>to counter-act the monetary contraction.

Rothbard fully acknowledges the problems caused by inflexible wages in AGD.
He goes through the calculation of how real wage levels were increasing
through the early part of the Depression and even goes into an extended
discussion of how various stabilizationists and industrialists foolishly
advocated wage rigidity as an anti-Depression measure.  But linking the
problems of wage rigidity solely to monetary contraction is not necessarily
a valid interpretation of the Great Depression in that the money supply
didn't contract until the depression was well underway.  The Friedmanite
position fails to consider that the monetary contraction was *preceded* in
time by the downward pressures on the credit markets and the upsurge in
unemployment.  Indeed, there were some parts of the economy (notably in the
agricultural sector) in deep trouble well before the big stock market crash.
To fully explain this sequence of events, the Austrian trade cycle theory is
indispensible.

A Friedmanite would typically argue that the Fed should have done more to
counteract the contraction, but they fail to grasp that the contraction and
the eventual gold devaluation and demonetization of 1933 was the result of a
failure of the credit system that was backing the bank and thrift accounts.
People didn't repay their loans because the loans were unproductive (having
been used to purchase producer goods that were malinvested), not because
there was suddenly no money in circulation to enable borrowers to repay the
loans.  Only at a later time did the deflation begin to significantly
compound the credit defaults via reductions in borrower income.  But what
caused the initial wave of defaults and bank failures?  It is putting the
cart before the horse to say that the monetary contraction caused the credit
collapse.

Vincent Cook
[email-masked]
http://www.ucop.edu/ott/