The American Economy is Not Depression Proof; H. Sennholz

Dr. Sennholz heads the Department of Eco nomics at Grove City College. and is a . noted writer and lecturer on monetary and economic principles and practices. The sincerity of their intentions is no more to be doubted than the good will of the policymakers of the Hoover and Roosevelt era who were engulfed by the Great Depres sion. But it may be questioned that we have learned to avoid the dread ful errors of policy that caused and prolonged the disaster. If we re peat the errors that generated the Great Depression, inexorable eco nomic .law assures that it must happen again. Have our policymakers learned the lessons of the Great Depres sion? Their explanations and in trepretations of economc decline differ little from those offered by the politicians of the 1920's and 1930's. And contemporary economic policies, although far more com prehensive and massive in scope and import, are similar to those cond ucted by the Hoover and Roosevelt Administrations.

Most economists echo the expla nation given by the most famous 1972 THE AMERICAN ECONOMY IS NOT DEPRESSION -PROOF 667 and influential economist of our century, John Maynard Keynes. Unemployment and depression are the inevitable resultof inadequate effective demand, according to Keynes. Therefore, monetary and fiscal policy should be employed to increase aggregate demand. The nominal amount of money should be increased, which in the short run would cause interest rates to fall, investments to increase, and income to rise. But in case mone tary policy would be ineffective, because falling money velocity may counteract an increase in the quantity of money, he recommended direct government investment through government tax cutting and deficit spending. 1 Influential Keynesian disciples, such as Alvin H. Hansen 2, Paul A. Samuelson 3, and Abba P.Lerner 4 1 John M. Keynes, General Theory of Employment, Interest and Money (N.Y.: Harcourt, Brace & World, Inc., 1936), p. 250; also Alvin H. Hansen, A Guide to Keynes (N.Y.: McGraw-Hill, Inc., 1953), pp. 21-22.

2 Monetary Theory and Fiscal Policy (N.Y.: McGraw-Hill, Inc., 1949); Busi ness Cycles and National Income (N.Y.: W. W. Norton & Co., Inc., 1951). 3 The Collected Scientific Papers of Paul A. Samuelson, ed. Joseph Stiglitz (Cambridge: M.LT. Press, 1966); Eco nomics, 8th ed. (N.Y.: McGraw-Hill, Inc., 1970). 4 "A Program for Monetary Stabil ity," in Proceedings, Conference on Sav ings and Residential Financing (Chi cago, Ill.: 1962); The Economics of Con trol (N.Y.: The Macmillan Co., 1944). played a major role in brInging the Keynesian system to America. They recommended that the gov ernment implement a continuous policy of full employment regard less of the state of the budget, which became the law of the land in the Full Employment Act of 1946. And all ·Federal administra tionsfrom Truman to Nixon have since then followed the policy rec ommendations of the "new eco nomics." Spendthrift Policies Most of the "new policies" were already being implemented during the 1920's and 1930's. The spec tacular crash of 1929 followed four years of considerable credit expansion by the Federal Reserve System under the Coolidge Admin istration. But it is futile to look back in history without the proper theoretical framework that ex plains causes and consequences.

The Keynesian historian views past experiences in his peculiar light and therefore quickly rejects all other interpretations. To him, the200-year history of business cycles is a long record of economic disequilibria that are caused by inadequate effective demand. This explanation, which has. ele vated inadequate demand or "un derconsumption" to the guiding principle of contemporary econom ic policy, has been the battle cry 668 THE FREEMAN November of the spendthrifts of all ages. And countless monarchs and princes rallied in ready acceptance of such doctrines that seemed to justify conspicuous consumption and deficit spending. But unfor tunately, their policies always re sulted not only in greater misery and poverty of the populace but also instability of state and soci ety. The major political and social upheavals in Western history nor mally followed years of general impoverishment through wasteful consumption by the monarch or ex pensive wars staged by the state.

Booms and depressions do not spring from economic freedom and the individual enterprise system. On the contrary, they inevitably result from government disturb ances of a peaceful market society. In particular, they follow policies of inflation and credit expansion that are designed to finance gov ernment deficit spending or to fa cilitate greater business expendi tures. Ludwig von Mises has clear ly shown how the creation of money and credit by our monetary authorities falsifies interest rates and thus misguides businessmen in their investment decisions. The boom phase of the trade· cycle is a period of maladj ustment in which economic resources are wasted and misused becau8e of false interest rates. Consumer choices and pref erences are ignored because the government, instead of the people, is giving the signals in the capi tal market. 5 When the economic boom finally causes business costs to soar and capital returns to fall until great losses are suffered, a recession in evitably sets in. It is unavoidable once monetary authorities have generated the maladjustment through deficit spending or credit expansion. The unemployment of labor and capital must continue as long as the economic structure re mains maladjusted through gov ernment intervention in the capi tal and labor markets. The. Great Depression taught us this very lesson at a horrendous price. 6 Booms Applauded, Recessions Deplored Representatives of the "new eco nomics" never obj ect to the boom phase of the cycle. In fact, they may applaud it as "great years of uninterrupted economic growth,"

or as a "new plateau," or "new stability." But when the economy finally begins to sag and unem ployment quickly rises, they re5 Cf. Ludwig von Mises, Human Ac tion (New Haven, Conn.: Yale Univer sity Press, 1949). p. 538 et seq.; also The Theory of Money and Credit (New Ha ven, Conn.: Yale University Press, 1953), p.339 et seq. 6 Cf. Murray Rothba'rd, America's Great Depression (Princeton, N.J.: D. Van Nostrand, 1963).

1972 THE AMERICAN ECONOMY IS NOT DEPRESSION-PROOF 669 member their Keynesian recipes: spend more and inflate more. Obviously, the maladjustment that was generated by government interference with the capital mar ket cannot be alleviated by more such interference. The drug addict vlho·is suffering painful withdraw al symptoms cannot be cured by prescribing larger doses of the same drug. But this is precisely the kind of advice Keynesian econ omists give to their governments. When the national economy be gins to falter, they call for more inflation and credit expansion, the very cause of the dilemma. True, the -creation and injection of new funds may temporarily prolong the boom by supporting the malad justments and generating new ones, as the injection of harder drugs in the human body may at first reduce the pain. But to ad minister ever harder drugs must finally kill the patient, as the in jection of ever larger quantities of new funds must destroy the cur rency through hyperinflation and economic disintegration.

In fact, after several decades of Keynesian policies, we seem to have reached the .point where only massive doses of inflation still stimulate-the economic patient. Previous rates of inflation, to which we have :grown ,·accustomed and 'learned to·a(ljast, no longer work as stimuli; businessmen immediately adjust to the rates they anticipate. A five per cent rate that has been foreseen well in ad vance no longer stimulates the economy when it is finally admin istered. Only higher rates than an ticipated still have such an effect. This is also why the Federal defi cits must get bigger and bigger. But while the rate of inflation must accelerate in order to pro vide the Keynesian stimulant, the monetary destruction also accele rates. In the end, government faces an inescapable alternative: to accele rate its spending and inflating to total monetary destruction, or abandon its policy and thereby save the currency. If it chooses the former, it precipitates a de pression through economic disin tegration; if it chooses the latter) the depression that was delayed for so long finally will erupt in full severity. No matter which course the government eventually chooses, the contra-cyclical policies are bound to fail. The Keynesian rec ipe does not make the economy de pression-proof. It merely post pones the depression through mon etary destruction and thereby makes it worse.

Government Safegutmls are ·llIu,OIV Tbe followers of K-e'ynesare not tfte6~ly .economists who are con vinced that a depression can never 670 THE FREEMAN November happen again. The monetarists, while rejecting .the contra-cyclical recipes of the "new economics," deny the possibility of economic depressions on other grounds. "There have been fundamental changes in institutions and atti tudes in the United States since the Great Depression," Prof. Friedman reassures us.7 They are rendering a. major depression in the United States "almost incon ceivable." Establishment of the Federal Deposit Insurance Corporation in 1933, we are told, was a basic change in American banking that made bank failures "almost a thing of the past." By converting all deposit liabilities of private banks into a Federal liability, the F.D.I.G. eliminated the basic cause for. runs on banks, which was the d.epositors' attempt to convert their claims into Federal currency.

Since· both deposits and currency are now Federal liabilities, an im portant cause of credit contrac tions and economic depressions is said to have been removed. These· economists err·.· in their basic assumption that a depression can be, avoided if only monetary contractions can be avoided. Once the malinvestments havebeenmade 7 "Why the American Economy is De pression-Proof" in Dollars and Deficits (Englewood Cliffs, N.J.: Prentice-Hall, Inc., 1968), p. 74. and the boom has run its course, the readjustment must necessarily be painful. The depression is an una voidable phase of the trade cycle once it has commenced. For the central bank then to embark upon credit expansion, in an at tempt to prevent the liquidation of malinvestment, can only delay the recovery and thus prolong. the depression. The Federal Deposit Insurance Corporation that, in effect, makes every bank deposit a government liability is designed to prevent the needed liquidation. Of course, it can do this successfully and thus delay the readjustment if newly created funds are used for the rescue action. But where would the government obtain the funds necessary to prevent massive li quidation of bank credit? From its central bank, of course. The stabilizing power of the F.D.I.C., in final analysis, is nothing but the government power to create and emit new money. Therefore,it is necessary to repeat the answer given to the Keynesian. spenders: more inflation can merely post pone a depression through mone tary destruction and ultimately make it worse.

Deficit financing Another change in banking structure that is said to assure economic stability has been the in1972 THE AMERICAN ECONOMY IS NOT DEPRESSION-PROOF 671 creased importance of government obligations; the phenomenal growth in government debt has made government liabilities an im portant part of bank assets, which afford greater stability to the stock of money and credit. This increased importance of government obligations as bank assets imparts such great con fidence to some economists. To others, however, it is a cause for anxiety. It is indicative not only of the changing role of American banking from mediators of credit to fiscal agents of the Federal treasury, but also of the great re liance on the inflationary powers of government. What would be the status of government obligations without the inflation powers to support them? Every budgetary deficit would send U.S. Treasury obligations to new discounts if it were not for the open-market pur chases by the Federal Reserve System. But this very support through monetary expansion, while it may succeed in the short run, tends to be self-defeating in the long run as it raises interest rates and thus reduces the market prices of fixed-income obligations.

This is why government securities in bank portfolios have been very poor investments ever since World War II, which banks endeavor to avoid wherever possible. In fact, long-term U.S. Treasury obligations have at times, when interest rates rose significantly, inflicted crushing losses on American banks, losses which dubious accounting practices endeavor to hide. The banking losses then provide an im portant motive for early resump tion of credit expansion. The Dethroning 01 Gold Finally, many of the monetarist economists rejoice about the sev ering of all links between gold and the internal supply of money. The "dethroning of gold" is said to reduce the sensitivity of the stock of money to changes in external conditions. Removal of gold from public circulation has made us in dependent at last from the va garies of foreign influence. There by we would avoid monetary con traction which is "an essential conditioning factor for the occur rence of a major depression."

What these economists call the "dethroning" of gold is rather· a "default" of paper. After all, it was the creation of massive quan.:. tities of money substitutes that caused central banks to default on their obligation to .. redeem their currencies iIi gold. But this de fault did not bring stability and prosperity. On the contrarY,it opened the gates for massive in flation and economic· instability. The fiat standard is more unstable than the gold-exchange .standard, 672 THE FREEMAN November which afforded less· stability than the gold-bullion standard, which in turn was less stable than the classical gold-coin standard. It is true, the default in gold payments did stop the runs on banks; no one in his right senses would want to run for paper money the supply of which is potentially unlimited. But the fiat standard does not make us independent of the va garies of foreign influence. It has made the international money mar ket more vulnerable than ever be fore. The U.S. dollar is stumbling from crisis to crisis, with grave dangers to international trade and cooperation and, ultimately, to the stability of the American economy itself.

It is not alone the new monetary structure that affords some econo mists so much confidence in the lasting stability of the American economy. There is also the fiscal structure. "There can be no dis agreement," Professor Friedman asserts, "that the fiscal structure is now an exceedingly important and' powerful 'built-in stabilizer' ."8 Government expenditures, both national and local, now amount to more than one-third of the nation al income. Although the relative growth of government casts som ber prospects for political free-dam, it is argued that the change in the character of both expendi8 Ibid., p. 86. tures and receipts has stabilizing effects on the business cycle. A broad program of social security, unemployment insurance, and a farm program that supports prod uct prices, all tend to increase government expenditures in de pression and to reduce them in prosperity. The same contra-cyc lical effects are derived from per sonal and corporation income taxa tion, which in boom or recession automatically creates budget sur pluses or deficits and thereby off sets from 30 to 40 per cent of any national income change. So goes their theory.

Loaded for Stability This doctrine of the built-in sta bilizers calls to mind the story of the farmer who, before leaving for the market in town, loaded his pack mule with an exceptionally heavy load of potatoes. When his neighbor inquired about the rea son for the heavy load the farmer retorted with a gesture of great learning: "On the muddy road to town the beast needs stability. The heavier the load the greater the . stability!" A bit of plain horse sense ought to tell us that the growing costs of government do. not afford stabil ity; on the contrary, they are making the "private sector" that' is carrying the growing burden of the "public sector" ever ~ore ane1972 THE AMERICAN ECONOMY IS NOT DEPRESSION-PROOF 673 roic and unstable. True, the heavy burdens can be lightened through massive monetary depreciation. The automatic deficits, from ris ing expenditures .and declining tax revenues during recession, can be financed through currency ex pansion. But as the Keynesian con tra-cyclical policies fail to impart stability to the American economy, so do the automatic fiscal stabil izers.

Finally, we are told that there has been an important change in the psychological climate of Amer ica. Before the Great Depression, according to this view, we were more afraid of inflation than of deflation; we wanted "hard mon ey" at all costs. But the Great Depression has changed all that. It has caused public opinion to swing from one extreme to the other. That is why today, after decades of rising prices and mone tary depreciation, the public is still seized by a real fear of depression. What the people may not realize, warn the monetarists, is that the ultimate destination of those who follow the path of infla tion is destruction of the currency. One may fully agree that the ultimate effect of these built-in stabilizers is monetary destruc tion. But what is one to make of the swinging theory? The Ameri can public has approved inflation and credit expansion ever since the Coolidge Administration, clung to easy money throughout the 1930's, endorsed rampant war time inflation during the 1940's, heralded the contra-cyclical poli cies during the 1950's, applauded the accelerator policies of the 1960's, and still continues to rely on massive deficit spending. The fe ver of inflation that has infected American economic thought and policy is rising steadily and dan gerously. And while it rages, nei ther the body politic nor the Amer ican economy is depression-proof.

I) IDEAS ON LIBERTY The Consumer Theory oj Prosperity THE USUAL effect of the attempts of government to encourage con sumption is merely to prevent saving; that is, to promote unpro ductive consumption at the expense of reproductive, and diminish the national wealth by the very means which were intended to increase it. JOHN STUART MILL, Essays on Some Unsettled Questions of Political Economy.