Viewpoint: Why We're in a Depression


All parts of the political and economic spectrum agree that our economy is in an unprecedented economic mess. The mess is both acute and chronic. Acute: We are in the biggest depression (that's right, depression) since the greatest of them all in the 1930s. Chronic: We don't seem to be able to get out of this depression, and what's more, we have been in a grinding stagnation—lack of economic growth—since at least 1979. (Officially, we experienced a boom in 1980, getting us out of a recession, but the boom was brief and fitful, lasting only until Reaganomics plunged us into another depression in 1981.)

It is true that inflation has fallen from about 12 percent to 5 percent per year, but this is cold comfort, since the biggest depression since the '30s should have ended inflation altogether instead of simply slowing it down. For what happens when a boom returns? All this means that the economy is suffering from chronic inflation, punctuated by severe recessions or depressions and overall stagnation.

There are various schools of thought purporting to explain the mess and, as a corollary, counseling us on how to get out of it. The Keynesian school, arrogantly riding high from the 1930s to the mid-'70s, came a cropper during the great 1973–75 recession. For Keynesianism decrees that recessions are caused by underspending and inflations by overspending. So Papa Government is supposed to step in to stabilize the economy by pumping up spending via budget deficits during recessions and by taking in spending via surpluses during inflationary booms.

But what happens when there is inflation and recession at the same time, as in 1973–75—and since? The Keynesian answer is that it can't happen, but unfortunately for the Keynesians, it did. Since even the Keynesians can't produce a deficit and a surplus at the same time, their theory was discredited once and for all among objective observers.

It was perhaps too much to expect, however, that the Keynesians would fold up their tents and leave quietly. They are still around plaguing us, except now they are confused instead of arrogant. They are powerful in the Reagan administration and are still tinkering wildly with the deficit, hoping that something good will turn up. If a bigger deficit doesn't seem to work, then a smaller one might do, and so we have the economic monstrosity (which would send Keynes or any other economist worth his salt up the wall) of imposing a massive tax increase during a recession—probably the single dumbest economic act since a similar blunder by the unlamented Herbert Hoover.

The Reagan administration also, however, brought two newer schools of thought to the fore. One is monetarism (or "Friedmanism"), which took total control of the Treasury Department and working control of the Council of Economic Advisers and managed to bludgeon its control over the Federal Reserve. Monetarism has no theory of depressions but claims that a gradual and steady decline in the rate of growth of the money supply will lower inflation without causing a recession. Apparently, recession is only the result of a sudden shock and does not inhere deeply in the economic system.

But the facts of 1981–82 dealt a body blow to the arrogant claims of monetarism. Inflation was brought down all right, but the gradual slowing of money growth precipitated a whopper of a depression, while real interest rates skyrocketed, blocking any possibility of early recovery.

The other new school of economics—the "supply side"—got a great deal of publicity but received only lip service from the administration. The supply-siders did not want to lower government spending at all. Neither did they wish to stop inflating at the old rates. Instead, they placed all their reliance on a massive tax (especially income tax) cut.

On the resultant deficits, either they profess not to care about deficits at all or else they trot out the famous Laffer Curve as the nostrum that will provide all the three contradictory goodies that the public wants: keeping up the level of government spending and hence the handouts obtained from Washington, drastically lowering income taxes, and getting a balanced budget. According to the Laffer Curve, tax-rate cuts will so stimulate energy, work, and investment that total revenue will rise enough to effect a balanced budget. But suppose that the federal government decided to impose a 30 percent tax increase? Does anyone in his right mind think that federal revenues would fall?

We are left with another school of thought, one that has not enjoyed anything like the publicity or influence of the others. This is the "Austrian school," so named after the land of its founders, the late Ludwig von Mises and Friedrich A. Hayek. Like the monetarists, the Austrians place the root of the inflationary evil in the Fed's printing of new money. But unlike the monetarists, they don't believe that anything can be accomplished by gradualist tinkering by the Fed. For unlike the monetarists, Austrians have an explanation of recession and even of inflationary recession.

The Fed's creation of money and bank credit causes price inflation. But it also causes something else: a dislocation of investment and production. Interest rates are pushed below their free-market level, stimulating excessive and unsound investment in capital goods, industrial raw materials, construction, machine tools.

But these unsound investments must be liquidated, must be leached out of the system, and labor, land, and capital brought back to the most efficient service of consumers. The longer and more intense an inflationary boom, the more extensive must be such liquidation. For Austrians, this liquidation is the business cycle recession. Recession is paying the piper; it is the necessary adjustment of the economy to wash out the destructive malinvestments of the boom.

This summer the Wall Street Journal, in an editorial, mentioned the Austrian theory in passing as holding that recessions are necessary for economic progress. Not true. They are only made necessary by inflationary booms generated by governments' central banks.

In contrast to the monetarists, then, this means that recessions are not something to be avoided, delayed, mitigated by gradualism. On the contrary, they should be left alone to work out their adjustment process as quickly as possible. There are only two alternatives: either a short, sharp recession that liquidates quickly and generates a rapid recovery (such as the intense but very brief depression of 1920–21, the last recession in which the government refused to intervene); or a chronic stagnation, neither fish nor fowl, with recession lingering interminably. That is what we suffered in the 1930s, and this is what the gradualist Thatcher and Reagan regimes have wrought.

And so the Austrian counsel is: the Fed must stop inflating; it must slam the brakes on its own destructive inflationary policies. And then the government must keep hands off the inevitable recession. The only way that real interest rates will come down is when the public and the market stop anticipating imminent reinflation, and they will only do so when the Fed is drastically shackled by radical reform. Preferably this reform would return us to a gold standard, to a commodity money provided by the market and not by the Federal Reserve printing press.

A freezing (or better yet, abolition) of the Fed, coupled with a return to a gold standard, would so invigorate the market and so end the specter of chronic inflation that real interest rates would fall and saving and investment would be stimulated. The resulting prosperity might so overshadow the final, liquidating recession that it might be as unnoticeable as anything any gradualist could hope for.

Murray Rothbard is a professor of economics at Brooklyn Polytechnic Institute of New York and the author of numerous articles and books on economics, history, and the libertarian movement.