Lesson 2 of 7
The damage was earlier
The tradition's most provocative claim: the bust reveals the error rather than causing it, and the depression is the adjustment rather than the disease.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- On this account the mistakes were made during the boom. The contraction is when they become visible, and the losses were already real before anyone recorded them.
- Rothbard puts it at its strongest: the boom is the period of wasteful misinvestment, the crisis is consumers reasserting their preferred proportions, and the depression is the adjustment.
- The claim is about the location of the error in time. It is not a claim that contractions are pleasant, and the next lesson refuses the readings that turn it into one.
This is the sentence that makes people either adopt the theory or dismiss it, so it is worth stating exactly, without the decoration it usually carries.
Where the error sits, on two accounts
The contraction as the problem
- Things were fine until demand collapsed.
- The collapse destroyed value that existed.
- Restoring demand restores the value.
- The boom is not the place to look.
The contraction as the revelation
- Capital was committed to processes people did not want.
- The value was already gone; the accounts had not caught up.
- Restoring demand does not make the wrong plant right.
- The boom is the only place to look.
Both accounts see the same balance sheets. They disagree about when the value went.
Rothbard's statement
He is the bluntest of them, in the first chapter of America's Great Depression, published in 1963. The boom, he writes, is a period of wasteful misinvestment, and it is the time when the errors are made. The crisis arrives when consumers reestablish their desired proportions. The depression is the process by which the economy adjusts to the wastes and errors of the boom.
He also identifies where the failure appears. It is not, on his account, underconsumption, because it is capital goods industries rather than consumer goods industries that suffer most. It is a failure of entrepreneurial demand for higher-order goods, caused by the shift of demand back to the earlier proportions.
And he states the principle he says should govern the adjustment: not to mourn past errors, but to make the most efficient use of the existing stock of capital.
What the claim is doing
Relocating a loss in time. An investor who buys a company at the top of a boom and watches the shares fall usually describes the fall as the loss. This account says the loss occurred when the capital was committed to something people did not want, and the price simply took a while to say so.
That is a claim an analyst can actually use, because it changes where you look. It sends you to what was built and why, rather than to the mood of the market that repriced it.
Where it is contested
In two places, and both are serious.
Whether the reallocation the theory describes actually occurred in any episode is an empirical question, and the previous course showed why it is hard to answer. Without that, the claim is a story rather than a diagnosis.
And whether the contraction adds damage of its own. The claim that the bust only reveals is separable from the claim that nothing bad happens during it. Hayek himself came to distinguish the two, and lessons four and five of this course are about exactly that.
Check yourself
Where does this account place the error?
- In the contraction, when investment collapses
- In the boom, when capital was committed to processes people did not want
- In the recovery, when firms rebuild too slowly
Show the answer
Answer: B.
Rothbard calls the boom the period of wasteful misinvestment and the depression the process of adjusting to it.What does Rothbard say the failure in a depression actually is?
- Underconsumption by households
- A failure of entrepreneurial demand for higher-order goods, caused by demand shifting back to the earlier proportions
- A shortage of money in circulation
Show the answer
Answer: B.
His evidence for rejecting underconsumption is that capital goods industries suffer more than consumer goods industries.Which two claims does this lesson insist on separating?
- That booms exist and that busts exist
- That the bust reveals an earlier error, and that nothing damaging happens during the bust itself
- That capital is heterogeneous and that it is specific
Show the answer
Answer: B.
Hayek came to distinguish them, and the lessons on secondary deflation and on his later position are about that separation.Sources
- Rothbard, America's Great Depression, 1963, part one, chapter 1, section on the explanation of boom and depression, for the boom as the period of wasteful misinvestment, the crisis as consumers reestablishing their proportions, the depression as the adjustment process, the rejection of underconsumption on the ground that capital goods industries suffer most, and the principle of making the most efficient use of the existing stock of capital rather than mourning past errors.
- Hayek, Prices and Production, first published 1931, second revised edition 1935, lecture III, section 8, for the sequence by which the long processes become unprofitable and their specific goods fall in price.
What this leaves out
- This is a heterodox tradition. The mainstream account of the same phenomenon differs, and nothing here is a forecast or a view on any security.
- The 300m impairment is an invented figure chosen to show two readings of one event. No company is described.
- This lesson reports the claim; it does not establish it. Whether the reallocation it assumes occurred in any particular episode is an empirical question the previous course showed is hard to settle.
- Rothbard's chapter also draws policy conclusions from this claim. Those are described in lesson six and endorsed nowhere in this academy.