The New Deal Was No Deal (part IV)


It is very important to reveal the weaknesses of many explanations of the Great Depression since this event is claimed as the “founding myth of Keynesism, of macroeconomy, of interventionism”. The last part of this article analyses a few alternative theories of the New Deal and the Great Depression, as formulated by Milton Friedman and Ben Bernanke, among others.

[This is part IV of an article previously published in Procesos de Mercado, vol. VII, no. 2, autumn 2010. Read part I, part II, part III]

Some alternative theories of the Great Depression

It is very important to reveal the weaknesses of many explanations of the Great Depression since this event is claimed as the “founding myth of Keynesism, of macroeconomy, of interventionism.” (Spiridon (2005), p. 15)

Most scholars group theories alternative to the explanation given above in two main categories: Keynesian and Monetarist. Both these paradigms share in empiricism, pretending to take a theory-free look at the data. The empiricist approach is falsely based on the idea that the blank human mind can face reality and then derive valid causal relationships. The truth is the other way round: reality is explained though prior causal relationships.[1] We may join George Selgin[2] in saying that

Mises would have insisted that all of the lasting discoveries of the classical and neoclassical economists in the realm of pure theory were in fact results of the method described by praxeology; but this was by no means the acknowledged procedure of those schools of thought.[…]

Indeed, denial of apodictic certainty involves a denial of necessity and causation that “would lead to the abandonment of all theoretical and historical pursuits.” (Selgin (1990), pg. 51, n. 17) This is precisely the reason why we continue to take into consideration these theories, although we accuse them outright of unrealistic and disingenuous procedures. Thus, these economists find themselves in a state of methodological sloppiness. Many seem to share a view of the human person as an “interchangeable black box”[3] whose main raison d’être is to be introduced into mathematical models sporting absurd assumptions, or used as a government revenue maximization function. This approach gives such a broad theoretical leeway that some social thinkers working under its sway derive ridiculous conclusions while others reach a fairly good interpretation of reality. Therefore, besides separating alternative theories into Keynesian and Monetarist, we can separate them into completely untenable, on the one hand, and acceptable with amendments, on the other.

Friedman’s position

The classical monetarist position on the Great Depression is best represented by Milton Friedman and Anna G. Schwartz, in their renowned treatment, The Great Contraction. While Friedman is generally perceived as an advocate of laissez-faire[4] he and Schwartz advance here the quintessential monetarist thesis that the main cause of the Great Depression was the Fed’s inability to continue a price stabilizing inflation policy, and to avoid deflation.

Price stabilization is a misguided policy. Increasing productivity matched by politically increased inflows of money tend to lead to growth a parallel malinvestment into unsustainable channels. The errors thus induced are revealed later and further inflows of money after the crisis cannot possibly revert a waste of real scarce resources but will seed further discoordination and waste.

Nevertheless, Friedman and Schwartz make a series of historical correlations —with the help of “natural experiments”[5] that serve as benchmarks for testing hypotheses— showing that depression is indeed correlated with prior monetary deflation. All problems would have gone away had Hoover been able to reinflate the monetary bubble. The conclusion is that the central bank should be led by a charismatic person with strong interventionist powers that should adapt the monetary expansion to the growth of productivity. Huerta de Soto[6] accuses Friedman of neoclassical kinship with the Keynesians, denoted by his lack of a capital theory. Because he cannot understand the havoc wrought by monetary expansion into the intra- and inter-temporal coordination of the capital structure, he cannot understand that even with a moderate inflation the economy suffers for no reason. Indeed, the fear of deflation is widely shared across the discipline but for no good reason. Beautiful profits can be made and harmonious growth can be attained in the context of decreasing prices. Entrepreneurs have the ability to anticipate spreads among falling prices and engage in arbitrage. Temporary differentials can develop between sinking prices for final goods and increasing prices for factors of production, and so much more in the case of a general decreasing tendency. Joseph T. Salerno[7] points out that Friedman’s hypothesis is shattered to pieces by a recent study on the correlation between deflation and depression. The empirical research[8] of Atkeson and Kehoe show that in the Great Depression only 8 out of 16 countries showed a correlation between deflation and depression, while exclusive of that period, out of 73 episodes with deflation only 8 have a correlated depression. That means in 90% of the cases, Friedman’s hypothesis is rejected. The authors observe, on the other hand, that “inflation is actually negatively related to output growth in the post-WWII data.”(Andrew Atkeson; Patrick J. Kehoe, 2004, p. 5) Salerno concludes about the Friedman-Schwartz hypothesis that

With the validity of their correlations now called into serious question by a study using well over 100 years of data from seventeen different countries, we may yet see the deflation-depression link follow another supposedly ironclad empirical relation, the Phillips Curve, into well-deserved oblivion. (Salerno, (2004))

His monetary position aside, Friedman gives a negative verdict[9] to a large part of Roosevelt’s New Deal:

Roosevelt’s policies were very destructive. Roosevelt’s policies made the depression longer and worse than it otherwise would have been. What pulled us out of the depression was the natural resilience of the economy + WW2. […] The problem was that you had unemployed machines and unemployed people. How do you get them together by forming industrial cartels and keeping prices and wages up? That’s what Roosevelt’s policies in the New Deal amounted to. Essentially, increasing the role of government, enhancing the monopolistic position of labor, and creating […] the equivalent of price fixing cartels made things worse. So most of his policies were counterproductive.

However, the above passage denotes another wide-spread fallacy[10] about the Great Depression, namely that it ended with the advent of the Second World War.

Bernanke goes beyond

This monetarist thesis is further nuanced by a series of authors. The most famous of them is Ben Bernanke. He claims that, in addition to the monetary scarcity created by the unwillingness of the Fed to inflate —that he identifies along with Friedman and Schwartz as the main cause of the Great Depression—, there were other, additional effects caused by the “problems in the financial sector.” He accuses the lack of a “theory of monetary effects on the real economy than can explain protracted nonneutrality.” This statement could be strikingly surprising to the student of the Austrian theory of the business cycle. Nevertheless, let us see Bernanke’s arguments[11].

The disruptions of the 1930-1933 […] reduced the effectiveness of the financial sector as a whole in performing these services. As the real costs of intermediation increased, some borrowers (especially households, farmers, and small firms) found credit to be expensive and difficult to obtain.

First, let us observe that Bernanke makes an economies-of-scale argument: because of relatively increased overhead cost of borrowing it became less profitable to lend small amounts and more profitable to lend large amounts. He would have to clear out of his demonstration’s path the well-known “trickle down”[12] practice, noted by Higgs:

[T]he agencies channeled federal money into large institutions rather than directly into the hands of the suffering masses. Hoover’s strategy […] was to feed the sparrows by feeding the horse.

This strategy would suggest “crowding out” rather than perverse economies of scale. But even if it would be so, Bernanke does not suggest that it would have been preferable to hit the big businesses instead of the small ones. He views the problem in the overall insufficiency of credit.

Therefore, what Bernanke states in this article is that monetary deflation per se had a first negative impact on output, but the persistence of monetary deflation has more to explain. In other words, the banking industry was not so swift as to inundate the market with paper credit irrespective of the actions of the Fed. Here he seems to second Rothbard in reaching the conclusion that the uncontrollable part of the banking system worked against Fed’s resolution to reinflate[13]. Only that, against Rothbard, Bernanke assumes that pump priming is desirable (as Friedman apparently demonstrated). In addition Bernanke suggests that banks had legislative and bureaucratic barriers to expand credit, e.g. bankruptcy proceedings.

Bernanke shifts between two concepts under the “nonmonetary” label. First, nonmonetary effects understood as that part of the multitude of consequences of monetary-driven changes that is not explained by the Friedman-Schwartz correlations. They are monetary in origin, but do not coincide with what Chicago monetarism understands usually as monetary. Second, he derives a notion of opportunity cost under the expression “cost of credit intermediation” (CCI). This notion is also monetary in the sense that the CCI is not divorced from the banking realities and it is the product of an economy operating with money and calculating in monetary prices. But the CCI cannot be directly seen in realized prices. This is counterfactual analysis proper. This second notion is much akin to the subjective opportunity cost used in what we consider to be the correct economic analysis. Let us see where it leads.

After stating in mainstream slang what would amount to a correct conclusion from an implicit time-preference theory of saving: the “pure substitution effect (of future for present consumption)” (p. 267), Bernanke goes on to state[14]:

…an increase in the cost of credit intermediation reduces the total quantity of goods and services currently demanded. That is, the aggregate demand curve, drawn as a function of the safe rate, is shifted downward by a financial crisis. In any macroeconomic model one cares to use, this implies lower output and lower safe interest rates.

Now, “any macroeconomic model” built in the conditions of a capital theory vacuum leads to the stated conclusions. But if one uses the realistic concept of a capital structure, the perspective changes radically and renders the last statement plainly wrong. Increased saving and lower “aggregate” consumption mean higher availability of labor, natural resources and produced goods for production processes to feed on now and yield later in the final goods markets, for increased abundance. Just as Bernanke admits, credit was indeed available, but only for production processes considered reliable by the bankers: “money was easy for a few safe borrowers, but difficult for everyone else.” (p. 266)

Moreover, since Bernanke is so apt as to understand that not all economically relevant events can be grasped by combing through realized prices and that the whole economic picture is completed by considering what was not seen, one can not avoid thinking how important a correct capital theory would be. Maybe with a capital theory at his disposal he would have second thoughts about the idea that 1933 meant a turn toward recovery, rather than a false start spurred by devalued paper, conserving the errors manifested in the capital structure and leading towards more discoordination. Why, then, praise the intensified seeding of greater subsequent capital destruction?

Let us now join Bernanke in making the completely absurd assumption that all the financial resources possessed by the agents of the financial sector are at their free disposal, irrespective of private property contractual terms, as he does, for example, by choosing to consider the relevance of a “ratio of loans outstanding to the sum of demand and time deposits.” (See legend to table on p. 262) The bankers’ judgment about the best destination of “their” resources, held as universally valid until the crisis, is suddenly found wanting during and after the crisis for their ghastly impulse to scramble for their own liquidity.

The solution to this paradox lies in recognizing that economic institutions, rather than being a “veil,” can affect costs of transactions and thus market opportunities and allocations. Institutions which evolve and perform well in normal times may become counterproductive during periods when exogenous shocks or policy mistakes drive the economy off course. (p. 275)

The negative role of the gold standard with its incorrectly ascribed inherent instability, active still at international level after its 1933 internal repudiation, is now transferred to the free but inefficient market. Fed’s tightwad partners in credit expansion were no longer reliable. The regressions show it now and the “providential” president knew it then. So Bernanke identifies the solution: Roosevelt’s FSLIC, HOLC, RFC, to the rescue of the credit-dry market:

To the extent that the home mortgage market did function in the years immediately following 1933, it was largely due to the direct involvement of the federal government. Besides establishing some important new institutions (such as the FSLIC and the system of federally chartered savings and loans), the government “readjusted” existing debts, made investments in the shares of thrift institutions, and substituted for recalcitrant private institutions in the provision of direct credit. […I]t seems safe to say that the return of the private financial system to normal conditions after March 1933 was not rapid; and that the financial recovery would have been more difficult without extensive government intervention and assistance.[15]

We have here post-monetarism in a few words: the economy needs markets free of regulations and bureaucracy and that suffices as long as prices are stable under a moderated inflationary regime. But let a crisis come and the judgments based on private property arrangements, with their “nonmonetary” credit-draught effects are to be overruled by the direct might of the Treasury and its annexed Federal Reserve.

This is exactly what happened since September 2008 with Bernanke governing the Fed. The interpretation he gives of the Great Depression is utterly wrong. It is a false rationale to put a more interventionist situation in place of prior inefficient interventionist arrangements.

To summarize, the deflation, or lack of inflationist adjustment of money and credit, has the effect of throwing the economic machine in disarray. This is the Friedman-Schwartz thesis. It was proved wrong time and again, by theory and by history. But even if the Fed had been more than willing to crank out money and credit in the Great Depression, and Rothbard has proved beyond doubt that it made desperate efforts to do it, the architecture of the monetary and banking system allowed for a “schizoid” behavior.

The Fed controlled a primary inverted pyramid, printing paper dollars in excess of the backing volume of gold. Then, the rest of the banking industry was supposed to further pyramid “deposits” of various kinds as a liability against gold and paper. This latter part of relatively independent member banks and a plethora of small and autonomous “unit” banks should have indulged in the whims of the Fed and abstain from accumulating excess reserves, injecting credit into the economy instead. It prudently didn’t.

The grand Federal Reserve System was not versatile enough and this is what Bernanke bemoans when he accuses nonmonetary effects of the financial crisis. It did not irrigate the money markets as it should and this deepened the Great Depression. This is what he meant when he apologized famously about the role of the Federal Reserve: “I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it.”[16]

His response to the credit friction was radical monetary aggression. The golden privilege[17] of the banking class, privilege extended by the robbery of people’s gold in 1933, could be insufficient in times of need. The exit pointed rather to the direct involvement of the federal government by all type of interventions. The society of private property owners, with their “exogenous” prudence regarding their labor and material wealth are not to be deemed a sufficient reason to stop the crusade lead by the President and his “sage” counselors.

Managed Expectations

Another explanation of the Great Depression is related to what could be called “the new macroeconomics of anticipation.” Bernanke is once again[18] at it:

[L]ow and stable inflation has not only promoted growth and productivity, but it has also reduced the sensitivity of the economy to shocks. One important mechanism has been the anchoring of inflation expectations. When the public is confident that the central bank will maintain low and stable inflation, shocks such as sharp increases in oil prices or large exchange rate movements tend to have at most transitory price-level effects and do not result in sustained inflationary surges.

The decades of macroeconomic modeling assuming a convenient representative agent have gone. Now it is time for macroeconomics to postulate an equally unrealistic concept of human rationality, as in rational expectations. Policy can no longer ignore the fact that agents anticipate. Anticipations are a real phenomenon and their role in the formation of prices or on the effects of economic policies is a legitimate concern for the economic theoretician. However, the above passage is symptomatic for the prevailing literature on rational expectations. What we are dealing with here is a fallacy cubed. The concept analyzed is the formation of subjective value —an ordinal phenomenon— with respect to a future configuration of reality. Not even in the case of one person studied separately could the external observer offer a pattern of how his valuations will change over time. To say something to the contrary is an elementary fallacy. Subjective valuation also means the value some person attaches to a good cannot be compared with the value other person attaches to the same good. We already have tremendous problems when we consider that intrapersonal and interpersonal valuation processes can be studied and introduced in economic modeling.[19] That would be a fallacy squared. But the worst error comes when one assumes away completely the freedom of human choice, because that is precisely what we are talking about when discussing “expectation anchoring.” The cubing of the fallacy comes with the idea that valuation, or choice, as manifested in anticipations, or expectations, can somehow be predicted, measured, aggregated and then controlled indirectly, though different political measures. Man’s freedom of choice is in fact rendered illusory under this arrangement.

Thus, expectations are “rational” as long as the public behaves according to the postulated model or the desired public policy. When human liberty plays out the events in the undesired direction, then “rational” expectations evaporate, anticipations are actually unhinged, irrational and a source of exogenous shocks, carrying the blame for the failure of the Procustean economic modeling. We can see that under the analytical framework of rational expectations the human actor does not escape the fate of being an interchangeable black box in macroeconomics. The rational expectations theory should be interpreted as just another decoy before the eventual loss of credibility of an older erroneous paradigm. We can join Nikolay Gertchev in saying that

It is evident that rational expectations are a catch-all hypothesis, which may indiscriminately cling to any model in order to justify its conclusions as being derived directly from human rationality. It is sufficient to postulate beliefs about the actual relation between economic variables, and then to presume these beliefs rational, in order to arrive at the conclusion that the relation is true and objectively revealed immediately. The RE hypothesis […] goes much beyond its purpose. It does not circumscribe the real influence of expectations, it postulates that everything depends upon expectations. However, rational expectations does not explain why this is so, it merely claims that subjective beliefs shape reality in the pattern presumed by the model-builder. The RE hypothesis thus greatly contributes to the persisting split of economic science in various schools, each finding support in this approach of modeling expectations. It is nevertheless evident that the presumed relationship between beliefs and reality is unsustainable.[20]

Another example of this set of arguments focusing on the idea of managing anticipation is revealed by Temin and Wigmore in their effort to explain the Great Depression and justify a certain type of political action, in the article titled The End of One Big Deflation.[21] They state that nothing really explains the turn in the year 1933 better than a regime change bringing along a change of public perception about the political determination to devalue the dollar and impose all the other measure thus swinging the economy out of depression. Economic recovery thus depended on Roosevelt’s credibility. They work on the false assumption that deflation implies depression. From their perspective, as long as there is inflation, big taxation and big spending, expectations must go along. A proof of expectations changing for the better is the rise of the stock market. Economics seems a lot easier when one can recite the expectation mantra: all general increases in price mean a change in expectations for the better and thus sustainable growth.

Of course, all action is directed toward the future, it anticipates, and therefore all changes in prices can be interpreted as an effect of changing expectations. However, to say that increased prices are the effect of a regime bent on devaluation and inflation only amounts to a tautology. Temin and Wigmore can say about the Great Depression that the

value of the dollar [is] a key index of the Roosevelt administration commitment to its new policy regime. When he hesitated expectations fell and production faltered. Fortunately, the dollar resumed its fall and the recovery was not aborted. ” (Temin, Peter; Wigmore, Barry A., 1992, p. 352)

The stake of the expectation macroeconomics is to show that inflationism changes expectations about the course of the real economy, as opposed to the nominal, but since it relies on prices to measure expectations it cannot show that. It can only demonstrate that it can swirl around in circular reasoning.

The Dynamics of Interventionism

As we have seen, a more realistic view of the Great Depression is held by Cole and Ohanian. Their model suggests that the effects of NIRA alone have prolonged the depression with so much as 7 years. However, they consider that there still was a “good part of the New Deal” and plead for keeping in place institutions such as regulation of the financial and manufacturing sectors, anti-trust policies, increased public revenues and spending and “specific” planning of stimulus packages. Thus, Social Security, deposit insurance and the SEC should be here to stay.

Regarding wide-spread regulations and anti-trust, suffice it to say that interventionism is unstable. Its inherent dynamic asks for complete retraction or otherwise it leads to more interventionism and ultimately to full-blown socialism. The advocates for regulation, therefore, have ultimately two choices: the private property order or the socialist chaos. A case in point is FDIC (The Federal Deposit Insurance Company). We have said above that deposit insurance spurs already existing profligacy in banking. Prior to FDIC, the banks were unstable because they were enjoying the privilege of appropriating the property of the depositors as if it was an unowned resource. They were thus already engaging in a fraudulent conduct that led to further economic woes in the form of economic cycles. The FDIC was the next step in the dynamic of banking interventionism and in exacerbating the problems, by letting the taxpayers support the deposit losses that were, until then, the responsibility of the bankers. Under FDIC, the individual banker would not extend credit according to what he perceives as the maximum level allowed by his resources, but would extend it according to the level of bail-out he expects to obtain from the deposit „insurance” funds guaranteed by the state.

Therefore, the only laws that should be left in place are the laws protecting private property. Such a system would also imply the abolishment of the banking privileges and thus deposit insurance would be a private matter, not a source of moral hazard.

While it may be argued that insurance and old age pensions are welcome and should be as widespread as possible, the architecture of the Social Security is nothing but a big redistribution arrangement. Building pension funds through insurance companies means authentic saving, whereas the state social security is taxation with another name. Robert Murphy clarifies:

However, the crucial difference between Social Security and a genuine retirement plan is that through decades of legitimate savings and investment, retirees in a private system have provided more capital equipment for the younger workers who take their place. Their savings enhance the productivity of the next generation of workers, and so there is a greater total crop out of which the retirees get their cut. In contrast, under FDR’s scheme, FICA payroll deductions are spent the moment the government receives them […and] simply used to enlarge the government’s consumption. (Murphy, 2009, pg. 139-140)

What is left of the Cole and Ohanian recommendations, then, are taxation and redistribution, to increase revenues and specifically plan the stimulus packages. The only problem is that this recommendation in itself would amount to bringing through the back-door all the measures criticized before. If government regulation and planning of cartels, prices and wages is destined to prolong depressions by entire years, why would the forceful depredation of private funds and their redirection into channels considered better by the government apparatus, but obviously not by the free market, be any better? Bureaucracy cannot lead the market to a situation considered better by the public at large, and many times not even by the members of the bureaucracy. It is paradoxical, then, to address the government for pro-market measures when it is the spring of arbitrary social conduct leading to injustice and impoverishment, not to speak of added immorality. Rather, the solution to the Great Depression and any depression will come about through the real framework of social harmony, the free-market based on private property.


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[1] Mises (1985), Hoppe (1995).

[2] Selgin (1990), p. 22.

[3] Expression used by Cristian Comănescu, cited in Topan, Foreword to Mises (2007), fn. 9.

[4] This view is subject to contention. See Rothbard (2002).

[5] Bernanke in Friedman, Schwartz (2009), p. 247.

[6] Huerta de Soto (2006), chapter 8.

[7] Salerno (2004), cited in Spiridon (2005).

[8] Atkeson, Kehoe (2004).

[9] Hawkins (2003).

[10] For a critique of this idea, see Higgs (2009) and Murphy (2009).

[11] Bernanke (1983), p. 257.

[12] Higgs (1987), p. 165.

[13] Rothbard (2000), Salerno (1999).

[14] Bernanke (1983), p. 268.

[15] Bernanke (1983), pp. 273-274.

[16] Stated at a Conference to Honor Milton Friedman’s 90th birthday. See Bernanke in Friedman, Schwartz (2009), p. 247.

[17] Huerta de Soto (2006).

[18] Bernanke (2004), p. 214.

[19] On interpersonal comparisons of utility and their implications for neoclassical modeling, see: Leoni, Frola (1977), Block (1999), Hülsmann (1999), Guerrien (1993).

[20] Gertchev (2007), p. 327.

[21] Temin, Wigmore (1992).

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