Searching for a Better Understanding of Depressions
"But is it not conceivable that wants may some day be so completely satisfied as to become frozen forever after? Some implications of this case will presently be developed, but so long as we deal with what may happen during the next forty years we evidently need not trouble ourselves about this possibility."~ Joseph A. Schumpeter, Capitalism, Socialism and Democracy, p. 113.
Last year's stock-market plunge unsurprisingly generated a great deal of commentary about the possibility of an economic depression that would rival that experienced in the 1930s. And with the present troubles in mind, economists and commentators have sought to use what was supposedly learned in the 1920s and 1930s to draw correlations between the past and present, or to defend government policy to explain why the U.S. economy hasn't declined as much it did in the '30s.
For those who equate market crashes with recessions, the 1929 stock-market collapse was supposedly the driver of what became the Great Depression, and 2008's decline foretold economic problems experienced since. But it seems much of this analysis is overdone, or even incorrect.
The oldest law of economics tells us that human wants are unlimited, and arguably implies that depressions can't be predicted with any accuracy. In light of this most basic of economic laws, economic mistakes can't cause depressions, but governmental attempts to correct earlier mistakes can. Depressions can't so much be predicted as they can occur if governments increase the wedge between work and reward.
The man who predicted the Depression? In a recent Wall Street Journal opinion piece, prominent investor Mark Spitznagel observed that "The 1920s were marked by the brave new era of the Federal Reserve system promoting inflationary credit expansion and with it permanent prosperity." Even though falling commody prices in the '20s suggested monetary tightness rather than inflationary ease, Spitznagel asserted that legendary Austrian-School economist Ludwig Von Mises knew the allegedly inflationary rise of credit would lead to a banking collapse. As the visionary who foresaw this, Von Mises according to Spitznagel predicted the Great Depression.
But did he? Implicit in Spitznagel's argument is the notion that bank failures could create a scenario in which producers would be unable to fulfill unmet market needs thanks to a disappearance of capital. At first glance this makes sense, but on a second pass it's apparent that the substitution effect would have transformed firms outside the banking industry into finance companies in order to serve the financing needs of entrepreneurs formerly served by banks. As my H.C. Wainwright colleague David Ranson has noted, bank failures alone could not have been the cause of the Great Depression.
Also, while Spitznagel made the essential point that failed banks should be allowed to die, it's possible he glossed over the natural process of healing that occurs within economies no matter the calamities with economic origins. As John Stuart Mill long ago said about economic recovery, "The possibility of a rapid repair of their disasters mainly depends on whether the country has been depopulated." Bank failures in no way imply death or depopulation within an economic area, so Mill would not have expected the death of banks to cause a long-term output slump.
Instead, it should be said that while bank failures in the '20s and '30s destabilized lending for a time, the U.S. economy remained weak as a result of tariffs, tax increases and government intrusion into the private marketplace that was unprecedented in U.S. history. As that made productive activity even more difficult to pursue due to "regime uncertainty," an economy that could have righted many of its problems stalled until New Deal legislation essentially ceased in the late '30s.
The present is a period that Von Mises' past writings on easy credit seemingly predicted. Spitznagel avers a "script depicting our never ending story of government-induced credit expansion, inflation and collapse" that allegedly leads to another Great Depression. Implicit is the belief that yet another credit crisis and banking failure has put the U.S. economy on its back.
It seems that today Spitznagel's description of recession-inducing inflationary policy is more apt. No doubt a declining dollar this decade drove what Von Mises once termed an inflationary "flight to the real" that ended in tears. Still, it seems that at worst such a scenario would have led to a slowdown caused by capital flowing into hard, unproductive assets instead of productive assets and intellectual assets of the mind. Or put more simply, the inflationary housing boom was the cause of economic hardship, contrary to the widely held view that housing's subsequent price correction produced the recession.
To presume that this form of Austrian malinvestment caused a depression would be a reach. In a normal environment free of government meddling, the malinvestment would have been repaired by market actors seeking to reorient investment away from assets whose value was no longer rising.
If recessions are self-correcting, and history says they are, easy credit or inflation could not logically lead to long-term economic ill-health any more than over investment in the Internet sector back in the late '90s could have created an extended period of low output. It would be more realistic to say that Von Mises' thesis predicted a recession, rather than a depression as Spitznagel asserts.
Did the Bernanke Fed avert a Great Depression? According to USA Today, it did. As the newspaper's editorialists recently put it, "More than any institution, the Fed is responsible for the fact that the unemployment rate is only 10%. In the 1930s, it did not act aggressively as lender of last resort, as it has in the past year. That fact is often cited as a major cause of the Depression."
The argument made by USA Today is hardly new, and it's fair to say that the Fed's failure to pump up the money supply in the '30s is widely seen as a cause of the Great Depression. The problem is that basic monetary logic calls into question this broadly held supposition.
Money growth doesn't so much foretell economic growth as demand for and supply of money tend to increase as a result of economic growth. Conversely, in periods of sluggish economic growth, money supply tends to decrease as a decline in economic activity leads to lower output and reduced demand for money.
As Von Mises himself wrote in his 1912 book The Theory of Money and Credit, "No individual and no nation need fear at any time to have less money than it needs." Production itself creates money demand and will be met with money supply. So for central banks to create money to ensure the preservation of wealth is, in the words of Von Mises, "as unnecessary and inappropriate as, say, intervention to ensure a sufficiency of corn or iron or the like."
Furthermore, in aggressively creating money as though its mere existence would stave off depression, the Fed misunderstands the very purpose of money in any economy. Simply put, we're not trading money for products, but rather trading products for products with money as the medium of exchange. In order to grow, economies don't need excessive money; what they need is money whose price is stable so that producers can properly measure the value of the goods they're exchanging.
For the longest time it's been "settled logic" that the Fed's failure to increase the money supply in the 1930s prolonged the Great Depression. But this thinking fails on many levels. To quote Von Mises again, "Money is nothing but a medium of exchange," which means that no gains are achieved when central banks create money as though its increased quantity constitutes wealth.
Notably, Fed Chairman Bernanke has personally promoted the role of Washington and the Fed in averting a more substantial economic crisis. In a November 29 opinion piece for the Washington Post, he asserted that the government's actions "were unfortunately necessary to prevent a global economic catastrophe that could have rivaled the Great Depression in length and severity, with profound consequences for our economy and society. My colleagues at the Federal Reserve and I were determined not to allow that to happen."
Bernanke's argument seems to be that without the expansion of the Fed's balance sheet in concert with its various bank bailouts, economic Armageddon would have ensued with no recovery in sight. His assumptions ignore the anecdotal reality that many economies have bounced back from much worse destruction than mass bank failures (think of the Axis and Allied powers after World War II). Forgotten are the role of banking substitutes in any economy and, perhaps most important, the fact that the banks that should have been allowed to go bankrupt were contributing to the economy's ill health by virtue of their non-economic activities.
Business failure can't cause depressions. To see why, it first has to be remembered that failure is as much an integral part of capitalism as success is. Indeed, absent failure, entrepreneurs would lack business history to draw on in order to tell them what not to do. It is through bankruptcy that failed managers release capital (financial, human and physical) to managers possessing at least a stated objective to deploy those assets more effectively.
Too often we hear about certain financial institutions being "too big to fail." This is a misnomer. It could be more credibly stated that economic growth is too important to our health and happiness to be reduced by bailouts that lock up what is limited capital in the hands of managers least able to utilize it properly. More to the point, the bigger the failure, the greater the opportunity for prudent institutions to expand their market share.
But to understand best why business failure cannot realistically lead to long-term hardship, it's essential to return to the most basic of economic laws which tells us that human wants are unlimited. We should never fear prolonged economic hardship given the certainty that so long as we as individuals are unsatisfied with what we have - meaning forever - there will always be entrepreneurs eager to produce in ways that make us more satisfied and, most important, more productive.
Conclusion. Randolph Bourne once said that "War is the health of the state." If so, the addendum that "Economic crises are the state's oxygen" is also true. Throughout history governments have used economic crises of their own making to increase their role in the economy; their intervention frequently economically deadening as evidenced by the Great Depression.
In that sense, what economists, commentators and politicians refer to as economic "depression" is not really economic at all. Instead, it should be said that when economies incur prolonged downturns, they do so as a result of governments putting a wedge between the natural instinct to work, and reward for that same work.
In short, business failure of any kind logically could not lead to a lengthy recession thanks to the existence of entrepreneurs eager to fix that which hasn't worked in the past. Instead, the word "depression" can only be a governmental phenomenon whereby governments tax, regulate, inflate and generally reduce our ability to trade freely such that our economic freedoms are compromised, and entrepreneurial incentives are taken away.
Absent those four impositions on the incentive to produce, economies can only grow. Depressions result only from too much government, and never from too little.