George Selgin (University of Georgia), Review of:
The Great Depression: An International Disaster of Perverse Economic Policies
by Thomas Hall and David Ferguson (University of Michigan Press, 1998)
Southern Economic Journal
Jan. 1999. Vol. 65, No. 3. pp 653-656.
Many people-some economists included-still view the Great Depression as proof of the failure of the capitalist system and of the corresponding need for big government. According to them, the depression was the price the public paid when their governments subscribed to laissez-faire economic doctrines. Recovery required governments to play a more active part in directing economic activity.
One problem with this popular way of thinking about the Great Depression is its implicit assumption that governments can be guilty only of sins of omission by failing to play a large enough role in economic affairs. In truth, governments can also be guilty of sins of commission - acting perversely and thereby making things worse than they might have been had the governments let market forces do their thing.
Miami University economists Thomas E. Hall and J. David Ferguson argue that the Great Depression is best understood as the consequence of “an incredible sequence of . . . misguided economic policies.” Although Hall and Ferguson believe that classical laissez-faire policies and institutions (adherence to the gold standard in particular) played an important part in generating depression, they also find many cases in which government intervention made the depression deeper and longer lasting than it might otherwise have been. Indeed, government errors were so extensive as to make one wonder whether the depression was inevitable and whether it would have earned the epithet “Great” had governments limited themselves to a classical “hands-off” approach.
Hall and Ferguson trace the roots of the depression to World War I, when the belligerent nations of Europe abandoned the gold standard. Gold payments were resumed during the 1920s but at parities that were generally inconsistent with international equilibrium: The pound was overvalued while the dollar and franc were undervalued, causing a gold outflow from Britain that was worsened by American and French attempts to sterilize gold inflows. Although the Fed did switch to an expansionary policy, for Britain’s sake during 1927, it reversed policy a year later in response to gold outflows and advancing stock prices. This reversal is supposed to have initiated the depression by triggering the U.S. stock market crash. The depression then continued to deepen because of falling stock prices and in response to a continuing decline in the quantity of money, which the Fed (influenced by the real-bills doctrine) failed to prevent. In the meantime, Congress passed the Smoot-Hawley tariff, dealing a serious blow to international trade. Overseas, Austrian and German bank failures added to deflationary pressures.
Faced with massive declines in aggregate demand, depressed nations could hope to recover either by reviving spending through aggressive monetary or fiscal actions or by allowing prices and wages to decline to levels consistent with fallen demand. Germany, one of the two hardest hit nations, expanded both its money stock and government spending (in the unfortunate form of Nazi-sponsored militarization programs). The United States, also hard-hit, took some steps (including the bank holiday and later devaluation of the dollar) to restore its money stock and aggregate spending, but simultaneously instituted the National Recovery Act (NRA), which tended to raise prices and wages, undermining the output and employment gains that demand expansion might otherwise have achieved.
Although the NRA was declared unconstitutional in May 1935, the Wagner Act was passed that same year and was declared constitutional in 1937. This act also placed upward pressure on wages, thwarting employment growth even during a period of fiscal and monetary expansion. Then, in 1937, the money stock and aggregate spending contracted anew in response to the Fed’s perverse decision to raise bank reserve requirements while sterilizing gold inflows. The result was a severe “secondary” depression that delayed recovery from the original depression for another year when monetary expansion resumed. Hall and Ferguson claim that this belated monetary expansion, combined with increased government spending following the outbreak of World War II, was what finally brought the depression to a close.
Hall and Ferguson deserve praise for their success at summarizing a large body of depression research in clear and easy prose and for the forthright manner in which they present and defend their thesis. They succeed in showing how many aspects of the depression can be understood by means of elementary economic theory, notwithstanding macroeconomists’ tendency to emphasize (correctly, I think) the need for still more research on this topic. Hall and Ferguson themselves, despite claiming that macroeconomics “made a great leap forward” thanks to Keynes’s contributions, get more mileage out of the “classical” (i.e., pre-Keynesian) concepts of supply and demand and Irving Fisher’s equation of exchange than they get from any tools of analysis contained in the General Theory.
On the other hand, Hall and Ferguson have little sympathy for pre-Keynesian endorsements of the gold standard. They consider such a standard both expensive and inherently unstable to the point of being unworthy of the “support of. . grown-ups.” But the expense and instability of the gold standard must be judged not relative to some imaginary ideal but relative to theexpense and stability of fiat money. Nothing boosts the real price of gold (which determines the extent of gold mining) like the inflation that has characterized so many fiat money regimes; and central banks still hold vast quantities of gold. (The authors themselves observe that the U.S. Treasury owns more gold today than it did in 1929.)
The resource costs of modern fiat money regimes are, in short, not obviously lower than those of the historical gold standard. As for gold’s inherent instability (the authors imagine a crisis arising in response to a run on gold by jewelry- craving teenagers!), it must be compared to the instabilities of fiat moneys whose supply is subject to the whims of central bankers and their sponsoring governments. The gold standard struck many adult economists and policymakers in the 1920s as being less fatally flawed than a “managed” fiat money—a perfectly understandable opinion given the recently experienced horrors of German hyperinflation and the gold standard’s relatively good performance before the war.
The authors correctly observe that, whatever its inherent flaws, the gold standard worked best if governments (and their central banks) followed “the rules of the game,” allowing the stock of central bank notes and deposits to vary along with the stock of monetary gold. One may well question how closely these “rules” were followed before World War I (see Bloomfield 1959); but there seems to be little doubt that the “restored” gold standard of the 1920s relaxed the rules even further.
Hall and Ferguson place great emphasis on the sterilization of gold inflows by the United States and France during the 1920s as having short-circuited the gold standard in a deflationary manner. However, they neglect other devices aimed at sustaining an artificially large British money stock, including the replacement of former gold-coin standards with gold-exchange (sterling or dollar) standards.
Rothbard (1998) [see a review] argues persuasively that, by means of these and other arrangements, Britain was able for some time to avoid the monetary contraction and deflation that would otherwise have been required by its unfortunate 1925 decision to restore the prewar pound, and the world economy as a whole was able to create a larger stock of monetary liabilities than it would otherwise have done. A major mid-1920s deflationary crisis, centered in Britain, was thus avoided for half a decade, but only by setting the stage for a more severe worldwide collapse later on.
Many contemporary writers believed that, sterilization notwithstanding, world monetary arrangements were more inflationary during the mid-1920s than they would have been had the rules of the gold standard been followed. They also viewed the first phase of the post - 1929 collapse as a consequence of prior overexpansion.
Although Hall and Ferguson devote an entire chapter to this “payback” hypothesis, they unnaccountably overlook its most famous and influential proponents: the Austrian economists Ludwig von Mises and Friedrich Hayek as well as their LSE champion Lionel Robbins. The Austrian theory of the business cycle had won many converts during the early 1930s, only to be cast aside by most of them in favor of the views contained in the General Theory. More recently, important aspects of the Austrian analysis have been rediscovered by New Classical business-cycle theorists, making it all the more difficult to understand Hall and Ferguson’s neglect of the older theory in favor of Galbraith’s far less influential alternative.
The Austrian theory fell into neglect in large part because some of its principal proponents insisted on treating the full extent of deflation during the early 1930s as having been an inescapable consequence of prior overexpansion, as if the stock of money, having once been excessive, could never be deficient. However, the monetary collapse of the 1930s was more than an undoing of previous monetary expansion. It was a crisis in its own right, stemming from a general loss of confidence in banks in Germany, Austria, and the United States.
In the United States, at least the collapse might have been avoided had the Fed expanded its balance sheet enough to restore confidence (or make up for its absence). Concerning this matter, the monetarists certainly have the better arguments, and Hall and Ferguson are right to follow them. I only wish they had noted that the weakness of the U.S. banking system was itself due largely to departures from laissez- faire and especially to the government’s failure to allow free interstate trade in banking services. Canada, which allowed its banks to branch nationwide, did not suffer a single bank failure during the depression era. Had the authors taken note of these facts, they might have refrained from endorsing government deposit insurance - a poor and dangerous substitute for structural reform of the banking industry.
One of the more tenacious myths about the Great Depression is the claim that it would have been worse had it not been for the New Deal. The truth, as Hall and Ferguson document, is quite the opposite. Classical theory teaches that, when demand for goods and labor is deficient, prices and wages need to fall. The New Dealers turned this formula upside down, claiming deficient demand to be a consequence of falling prices. The result was a set of New Deal policies - especially the NRA, the AAA, and the Wagner Act-that aimed at fixing, sometimes even raising, prices and wage rates. As Hall and Ferguson point out, “the combination of cartels, wage hikes, and regulation of agriculture” sponsored by these and other New Deal agencies served not to hasten but to hinder recovery
