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Misunderstanding the Causes of the Great Depression



Bob Murphy
Campaign for Liberty
October 11, 2008

As the financial crisis intensifies, the government keeps upping the ante, crossing more and more boundaries that would have been unthinkable--especially coming from "free market guys" like Bush and Paulson--just last year. Even more sickening is all the "free market" pundits who are cheerleading the literal nationalization of the US financial industry.

Of course, the justification for all of this is that it is "necessary to prevent another Depression." But this entirely misconstrues what caused the Great Depression.

The stock market crash of 1929 didn't cause the Depression. Even the Fed didn't cause the Depression. No, the Fed caused unsustainable malinvestments through the 1920s with artificially low interest rates (which went hand-in-hand with phony fiat credit getting pumped into capital markets). The stock market bubbled up, and then crashed in 1929.

At that point, if Herbert Hoover had simply kept his hands off, there would have been a sharp economic downturn--what was called a depression back in those days. It probably would have been the most severe up till that point in American history (because the newly created Fed had engineered the largest boom in American history during the preceding decade), but it would have been over within a few years at most. People would have been poorer because of the whole episode, but unemployment would have been in regular territory by, say, 1933. After all, in previous panics and depressions in US history, the recovery was usually underway after two years.

But we all know from our history classes that things were not back to normal by 1933. Nope, when FDR took office that year, unemployment stood at a staggering 24.9 percent. And then--despite claims that Roosevelt "got us out of the Depression"--the unemployment rate was still 19 percent five years later in 1938.

As I said above, this decade-long slump was not the fault of a stock market crash, or even the malinvestments of the 1920s caused by the new Fed. A relatively free market can handle huge disruptions. E.g. if an asteroid smashed into Chicago in 1929, that might have caused a sharp economic downturn too, but it wouldn't have caused double digit unemployment 10 years later.

So what did cause the severity and length of the Great Depression? The New Deal. (And let's realize too that Herbert Hoover was no laissez-faire guy; he did a New Deal-lite in the latter half of his presidency, and bragged about his ignoring the "liquidationist economists" on his stump speeches running against FDR.)

The New Deal represented the most comprehensive "war on depression" ever waged by the US government. And, just like the War on Drugs and the War on Terror(ism), the war on depression waged by FDR gave us the worst depression in US history.

All of the "unprecedented" measures that have been taken in the last 14 months are making things worse. Suppose Bernanke and Paulson had announced in September 2007, "Yep, a bunch of banks made goofy loans to unqualified applicants, and a bunch of whiz kids on Wall Street bundled them together with fancy models that, in retrospect, were totally wrong in their estimates of massive defaults. We feel your pain, fellas, but this is America where we have a profit and loss system. If you had been right, you would have kept your profits, and since you were wrong, you go belly up. Better luck next time."

That tough love would have been painful. Plenty of investment banks would have folded. The stock market would have tanked. The dollar would have gotten hammered in the foreign exchanges. But, on the bright side, major firms would have written off their multibillion dollar losses, capital would have been rearranged in light of the new information, and then economic growth would have resumed. There would have been a recession, but there have been lots of recessions over the years. Life would have gone on.

Instead of that, though, Bernanke and Paulson decided they were going to somehow magically erase all of the mistakes that bankers and investors made from 2001 to 2007. They were going to prevent a recession.

Guess what? All of the negative consequences (folding investment banks, tanking stock market, falling dollar) happened anyway. Recession, though postponed, is still coming.

And on top of that, the taxpayers are out at least a trillion dollars (and counting). Moreover, the banking system is about to be nationalized. Even if Ron Paul won the election, by this point so much harm has been done that investors around the world would still be spooked for years to come about investing in the US financial sector. Too many rules have been broken in the last few months. Nobody has any idea what crazy move the feds will take from one day to the next.

So it's true that we may suffer through a second Great Depression. But if we do, it will be because of the government's (ostensible) efforts to prevent it. A closing piece of evidence: We were told the bailout was necessary to thaw the credit markets and prevent panic on Wall Street. Well, we got the bailout (and paid a hefty price for it I might add), and the credit markets are still officially frozen, and the stock market just had its worst week in history.


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