Many who are familiar with Austrian economics become familiar with the Great Depression through the work of Murray Rothbard. Rothbard claimed that the Great Depression was the fault of the Federal Reserve. Excessive money creation by the Federal Reserve during the Roaring Twenties led to an unsustainable excess. The boom sowed the seeds of its own demise. While this story is attractive to supporters of Austrian business cycle theory (ABCT), it ought to be regarded with suspicion.
Rothbard supported a revised version of ABCT that identified the central bank as the prime culprit behind depressions. “In the purely free and unhampered market,” Rothbard comments, “there will be no cluster of errors, since trained entrepreneurs will not all make errors at the same time” (1963, 9). Economic depression is a government-created phenomenon.
In its original form, ABCT identified the tendency of a fractional-reserve banking system to temporarily depress interest rates as expansion of credit leads to a boom. This leads to investment in ventures that are profitable only because of the artificial lowering of the interest rate below the natural rate, which represents an unsustainable lowering of the cost of lending. When the interest rate returns to the natural rate, entrepreneurs involved in these ventures incur losses. Economic activity slows as resources are reallocated toward more-profitable uses.
Rothbard’s preferred formulation of ABCT — and one later made clear and popular by Roger Garrison’s geometric exposition — points to artificial expansion by the central bank as a prime driver of business cycles of this sort. Central bank expansion makes it appear as though the level of savings in the economic system has increased. The new money filters through a fractional-reserve banking system as it is lent, redeposited, lent again, and so forth. The financial system funnels resources toward investments that will prove unprofitable in the long run.
While both versions of ABCT are legitimate, Rothbard’s application of it is misguided. Between 1921 and 1929, “the money supply increased by $28.0 billion, a 61.8% increase over the eight-year period.… The entire monetary expansion took place in money-substitutes, which are products of credit expansion” (95). While this may seem like a lot, neither was it a great inflation, nor was the money creation unjustified. It amounts to an annual increase of just over 6 percent. From its lowest point in 1921, real GNP grew at nearly the same rate, with an increase of 60 percent during the same period. Increases in the broader stock of money were largely a response to increases in transaction demand driven by an increase in productivity. Further, the quantity of credit appears to have grown in sync with the quantity of base money; neither figures increased dramatically after the middle part of the decade.
Rothbard blamed Federal Reserve policy for the expansion of credit during the ’20s. He claimed credit expansion was the result of an artificial expansion of base money. If one takes into account changes in the deposit-reserve and deposit-currency ratios, these changes are close to proportional with changes in the stock of base money. Changes in the base money stock tended to be driven by gold flows. The Federal Reserve worked against these changes. In fact, the non-gold portion of the base — that portion that was controlled directly by Federal Reserve policy — tended to respond inversely to gold flows throughout the decade. When the quantity of gold in the U.S. increased, the Federal Reserve contracted the non-gold portion of the base, thus sterilizing the effect of gold on prices and real income.
Of concern to Rothbard are major asset purchases made by the Fed during 1922, 1924, and 1927 (112-14). But Rothbard ignored the nature of Fed activity throughout the decade. Between June 1921 and June 1929, transactions involving Fed credit — “bills discounted," “bills bought," “U.S government securities," and “other credit” — actually summed to a negative $696 million. Meanwhile, gold flowed to the United States from Europe because European central banks expanded the monetary base during and after World War I. According to Rothbard’s own estimates, $1,305 million worth of gold flowed to the United States between June 1921 and July 1927. By June 1929, the amount fell only slightly to $1,103 million (109). Rothbard avoids this issue, however, by claiming that total gold reserves represent “the official figure for gold reserve minus the value of gold certificates outstanding” (94). Instead of an increase of over $1.1 billion in gold, according to Rothbard gold increased by only $0.4 billion.
For Rothbard, any increase in dollars greater than the increase in physical gold represents the creation of “counterfeited” dollars. Thus, even gold inflows to the U.S. did not merit a proportional expansion by the Federal Reserve. Having no evidence to show that the Fed engaged in substantial expansion of the money stock during the 1920s and no reasonable standard by which to judge the effects of monetary expansion, he used peculiar categories, describing monetary components as controlled and uncontrolled, where any purchase made by the Federal Reserve was a controlled source of inflation, but any maturation of securities held by the Federal Reserve was uncontrolled. Aided by arbitrary categories, Rothbard’s theoretical construction is more artificial than the boom he decried.
Rothbard’s analysis stands in distinction to the analysis of Milton Friedman and Anna Schwartz in A Monetary History of the United States (1963). At the close of their chapter on the 1920s, Friedman and Schwartz wrote:
The economic collapse from 1929 to 1933 has produced much misunderstanding of the twenties. The widespread belief that what goes up must come down and hence also that what comes down must do so because it earlier went up, plus the dramatic stock market boom, have led many to suppose that the United States experienced severe inflation before 1929 and the Reserve System served as an engine of it. Nothing could be further from the truth. (298)
The argument against Rothbard here supports this finding. The price level was relatively stable during the 1920s. This should come as no surprise considering that credit appeared to be expanding in sync with real income. Even if we presume that Rothbard was correct that this represented a misallocation of resources, money creation was far from excessive and certainly does not seem a more significant factor initiating the Depression than the contraction begun in 1929 by the Federal Reserve and the French repatriation of gold starting even earlier in 1927. Obsession with a single explanation obscured the macroeconomic significances of these phenomena from Rothbard’s view. One methodical Austrian theorist — Friedrich Hayek — did eventually take note of the shortcoming of such an obsession. Such care by those supposed to be expositors of truth is indispensable for intellectual progress.