Boom, Bust, and Recovery: Testing Austrian Business Cycle Theory Against the Great Depression

 

1. Introduction: Looking Beyond the Crash

The Great Depression is typically associated with the stock market crash of 1929, but the crash alone cannot account for why the recession became so severe or continued for so long. Banks failed, prices dropped, investment stopped, unemployment rose rapidly, and people's confidence vanished. Since so many problems occurred simultaneously, historians and economists have spent many decades debating which of the causes was the most important.

Austrian Business Cycle Theory provides a useful explanation of the years that preceded the crisis. As Fred Foldvary points out, if credit expands too readily and interest rates are lowered below sustainable levels, then businesses and investors are led into making long-term commitments which may appear profitable only so long as cheap credit remains. When credit becomes more restricted, it turns out that some of these investments were mistakes. When this theory is applied to the late 1920s, it shows that the prosperity enjoyed during that decade had weaknesses which were not apparent while money and credit were still being supplied.

The theory may be useful, but it doesn't account for all the facts. The historical evidence actually lends strong support to the Austrian view in the case of the boom prior to 1929; however, it is less convincing when it comes to explaining why the collapse turned out to be so severe or why recovery eventually occurred.

2. Methodology and Sources: Testing the Theory

The analysis examines Austrian Business Cycle Theory in light of current evidence and subsequent academic work. The Federal Reserve's reports from the late 1920s are useful since they indicate what the policymakers themselves perceived at that time. These reports mention the rapid increase in loans and credit for securities together with a growing worry about speculation. Moreover, they reveal that the Federal Reserve intentionally tightened its policy in 1928 and 1929 in order to curb what it regarded as excessive use of credit.

The scholarship in question helps ensure that the theory does not turn into a one-sided explanation. Rather than presenting the Great Depression as a historical issue with a single definitive answer, Michael Bernstein views it as a problem shaped by a number of different and conflicting interpretations. Robert Samuelson stresses the significance of debt, deflation, the weakness of the banking system, and the international gold standard. Christina Romer concentrates on the recovery and maintains that monetary expansion had a major part in bringing about the end of the Depression. Robert Higgs, on the other hand, goes beyond consideration of output and unemployment to examine the permanent expansion of government power during times of crisis. Taken together, these studies offer a useful means of evaluating the Austrian theory: it can be compared not only with the onset of the Depression but also with its severity, length, and aftermath.

3. Analysis: Where the Austrian Explanation Fits and Where It Struggles

The Austrian view is most convincing when one considers the late 1920s. Foldvary contends that easy access to credit can distort investment by making projects seem more profitable than they actually are. Before 1929 there was a rapid expansion of securities lending, stock prices rose, and the policymakers grew more concerned about the idea that credit was being used for speculation. Once the Federal Reserve had tightened up monetary conditions, the situation of easy credit changed. From an Austrian point of view, the tightening did not cause all of the fundamental weaknesses; rather, it revealed the investments and expectations which had been based on unusually favorable credit conditions.

It does make sense as an explanation of the boom and the first phase of the correction; the problem arises once the downturn starts. The Depression didn't end with failed investments or falling stock prices; in fact, thousands of banks stopped operating, prices kept on falling and it became more difficult to repay debt. It is important here to refer to Samuelson's account of debt-deflation and the gold standard since it illustrates how the downturn became self-reinforcing: as prices fell the real burden of debt increased, which in turn led to more defaults and liquidations, and the banking failures then damaged the financial system even more.

Austrian theory starts to appear incomplete here. While correcting bad investments is one matter, a general collapse of confidence and money is something quite different. Reports prepared by the Federal Reserve in the early 1930s show that the banking system was under serious pressure. By 1933 the number of bank suspensions had hit crisis levels. This evidence indicates that the economy was not merely overcoming earlier mistakes in investment; financial panic and monetary contraction had now become problems by themselves.

The fact that the recovery has occurred presents an even greater difficulty. In the event that liquidation and market adjustment had been sufficient, it would have been reasonable to expect the economy to recover through the disappearance of inefficient investments and as prices came back to normal. However, Romer's research suggests a different view. She maintains that monetary expansion played a major role in causing the recovery before World War II, since the inflows of gold, changes in monetary policy, and the lower real interest rates all helped to promote investment and the purchase of durable goods. While this does not invalidate the Austrian explanation of the 1920s boom, it does make it more difficult to defend a theory that relies solely on liquidation.

Higgs introduces another element of complexity: the Depression did not only alter patterns of private investment but also affected the relationship between citizens, markets, and the federal government. According to his 'ratchet' idea, crises can have the effect of permanently increasing government power and of changing people's expectations regarding the role of government. Although Austrian theory says very little about this institutional legacy, it has become one of the most significant long-term consequences of the Depression.

4. Conclusion: Useful, but Not Sufficient

Austrian Business Cycle Theory provides an explanation of a key aspect of the Great Depression. It illustrates why the prosperity experienced in the late 1920s could be deceptive and why a boom based on credit might have serious flaws before these flaws were generally noticed. The Federal Reserve's concern about credit in securities and its shift towards a more restrictive monetary policy are reasonably in line with that explanation.

At the same time, the theory fails to fully account for why the downturn had such a destructive effect. Factors such as banking failures, debt-deflation, the gold standard, monetary contraction, and the collapse of confidence all drove the economy well beyond what would be expected in a normal recovery. The evidence regarding recovery is also hard to ignore. According to Romer's research, monetary expansion was involved to a far greater extent in bringing output back to normal than a simple process of liquidation and adjustment would suggest.

Austrian theory is therefore more suitable as a component of an explanation than as the complete explanation; it is particularly helpful for understanding the unstable boom before 1929. Yet when we look at the deeper history of the Depression it becomes clear that after the crisis had started, monetary, financial, international, and political forces determined how far it sank and how the economy eventually recovered.

Bibliography

Primary Sources

Federal Reserve Bank of New York. Fourteenth Annual Report of the Federal Reserve Bank of New York for the Year Ended December 31, 1928. New York: Federal Reserve Bank of New York, 1929.

Federal Reserve Board. Sixteenth Annual Report of the Federal Reserve Board Covering Operations for the Year 1929. Washington, DC: Government Printing Office, 1930.

Federal Reserve Board. Twentieth Annual Report of the Federal Reserve Board Covering Operations for the Year 1933. Washington, DC: Government Printing Office, 1934.

Roosevelt, Franklin D. “Fireside Chat on Banking.” March 12, 1933.

Secondary Sources

Bernstein, Michael A. “The Great Depression as Historical Problem.” OAH Magazine of History 16, no. 1 (2001): 3–10.

Foldvary, Fred E. “The Austrian Theory of the Business Cycle.” The American Journal of Economics and Sociology 74, no. 2 (2015): 278–97.

Higgs, Robert. “Crisis, Bigger Government, and Ideological Change: Two Hypotheses on the Ratchet Phenomenon.” Explorations in Economic History 22, no. 1 (1985): 1–28.

Romer, Christina D. “What Ended the Great Depression?” The Journal of Economic History 52, no. 4 (1992): 757–84.

Samuelson, Robert J. “Revisiting the Great Depression.” The Wilson Quarterly 36, no. 1 (2012): 36–43.