Lesson 2 of 7
The 1920s as the cause
The argument that the depression was the correction of the preceding decade, as Rothbard made it, with Hayek's own remark about what happened in 1927.
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
- The claim is that the cause lies in the credit expansion of the 1920s, and that 1929 is when the misallocation it produced became visible.
- Rothbard devotes a third of America's Great Depression to documenting the expansion and a third to arguing that the policy response after 1929 prolonged the correction.
- Hayek's own remark is more limited and more interesting: that an easy-money policy in 1927 prolonged a boom by about two years, which makes the episode hard to compare with earlier ones.
This is the account this track has been building the apparatus for. It is set out here as its authors make it, and judged against nothing yet.
Where each account puts the cause in time
- 1921 to 1929The Austrian accountCredit expansion misdirects capital towards the earlier stages of production. The error is made here.
- October 1929Galbraith's subjectThe market breaks. On this account a symptom, not a cause.
- 1930 to 1933The monetarist accountBank failures collapse the money stock. On that account this is where a recession became a depression.
- 1930 to 1933Bernanke's additionBroken lending relationships raise the real cost of credit, independently of the money stock.
- 1930 to 1933The Keynesian accountThe marginal efficiency of capital collapses and a lower interest rate cannot restore it.
The structure of Rothbard's argument
America's Great Depression, published in 1963, is organised in three parts and the organisation is the argument. Part one sets out the theory of the cycle. Part two is titled the inflationary boom and covers 1921 to 1929. Part three is the depression years.
The claim carried by that structure is that the explanatory work happens in part two. Part three is then about why the correction took so long, and its thesis is that the administration of 1929 to 1933, often described as committed to laissez-faire, in fact intervened extensively and that the intervention delayed the adjustment.
What the account has to establish
Two things, and it is worth separating them because they can fail independently.
That there was a credit expansion in the 1920s not matched by voluntary saving, which is a question about the money supply and its definition, and which Rothbard spends four chapters on.
And that the expansion produced the specific misallocation the theory predicts: resources shifted towards stages further from consumption, with the reversal afterwards. This is the harder claim, because as the structure course established, the stages are not observable and any test has to substitute an industry classification for them.
Hayek's narrower remark
Hayek's own comment on the episode, in the appendix to the second edition of Prices and Production, is more limited than Rothbard's book and is worth having beside it.
He says that up to 1927 he would have expected the subsequent depression to be mild, because prices had not risen during the preceding boom and had rather tended to fall. What changed his expectation was an action he describes as unprecedented: an easy-money policy inaugurated by the American monetary authorities as soon as symptoms of a reaction appeared, which in his judgement prolonged the boom by about two years beyond what would otherwise have been its natural end.
He adds that this makes it impossible to compare the effects of that boom on the subsequent depression with any previous experience, which is a caution his followers do not always repeat.
The objections, stated
The most obvious is timing. If the misallocation was in place by 1929, an account of the following three and a half years still has to explain why the contraction went so much deeper and lasted so much longer than the correction of a misallocation would seem to require. That is precisely the gap the next two accounts fill.
The second is measurement. Without an observable structure of production, the central claim is argued from the theory rather than tested against a series.
Both are taken at full strength in the course on the case against this theory.
Check yourself
Where does this account locate the cause?
- In the stock market crash of October 1929
- In the credit expansion of the 1920s, with 1929 as the point at which the resulting misallocation became visible
- In the banking panics of 1931
Show the answer
Answer: B.
Rothbard's book is organised to carry that claim: part two covers the inflationary boom of 1921 to 1929 and part three the depression.What did Hayek say about 1927?
- That the boom ended there
- That an easy-money policy begun when symptoms of a reaction appeared prolonged the boom by about two years beyond its natural end
- That the gold standard was abandoned
Show the answer
Answer: B.
He adds that this makes the episode impossible to compare with previous experience, and that up to 1927 he would have expected a mild depression because prices had not risen.What is the harder of the two claims this account must establish?
- That credit expanded in the 1920s
- That the expansion produced the specific shift of resources towards remote stages that the theory predicts
- That the crash occurred in October 1929
Show the answer
Answer: B.
The stages of production are not observable, so a test has to substitute an industry classification, and that substitution is a judgement rather than a measurement.Sources
- Rothbard, America's Great Depression, 1963, for the organisation of the argument across its three parts, for part two on the inflationary boom of 1921 to 1929 and the inflationary factors, and for part three on the depression years and the contention that the response of 1929 to 1933 was interventionist rather than laissez-faire.
- Hayek, 'Capital and Industrial Fluctuations: A Reply to a Criticism', Econometrica, April 1934, reprinted as the appendix to the second edition of Prices and Production, 1935, for his statement that up to 1927 he would have expected a mild depression because prices had not risen in the boom, for the unprecedented easy-money action of the American monetary authorities in that year, for the judgement that it prolonged the boom by about two years, and for the caution that this makes comparison with previous experience impossible.
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 timeline figure arranges the four accounts of this course by where each places the decisive cause. It is a summary of positions, not a record of events.
- This lesson states the account and names two objections to it. It does not establish the account, and the next three lessons give the rival accounts the same treatment.
- Rothbard's book also contains extensive policy argument, which is described in the previous course and endorsed nowhere in this academy.