The Causes of the Great Depression

In a mere 34 pages, Mises presented a concise and penetrating analysis of the crisis. He pointed out that the market economy was regulated by the requirement that entrepreneurs satisfy consumer preferences. Inflation disrupts this self-regulation of the market. It induces businessmen to overestimate the possibilities for profitable investment, so that they make bad investment decisions and squander resources. These errors become apparent in a crisis—the U.S. stock market crash of 1929, in this case. The market participants now revise their plans and adopt more sober views on economic conditions. Employment opportunities and capital goods are shifted from the unsustainable production projects to those firms and industries that are now most important to consumers and therefore most profitable. The unemployed find new jobs at lower wages, production resumes, and the economy grows again.

Mises stressed that this scenario, while typical for previous business cycles, did not exactly fit the conditions of the present one. Before, there was virtually no unemployment in the boom phase, and even during the bust unemployment and stagnation were temporary. They lasted only as long as it took market participants to find the most profitable new division of labor. But this time, Mises observed, things were markedly different—so much so that he had to adjust his business cycle theory. This time, despite enormous inflation, there was no corresponding general boom economy in Europe.

In light of past experience and of our theory one should have assumed that the crisis would therefore be milder. But it is far more severe and, it seems, business conditions will not improve anytime soon.¹⁴

It would have been plausible to assume that the present bust would not be as painful as it would have been in the case of a more sweeping boom. The relatively weak boom should have induced a relatively moderate bust. But this was not the case. Why? Mises answered that the present stagnation was the combined result of two causes layered one over the other. The current business cycle had merely aggravated the problems of unemployment and the lack of profitability. But these problems had existed, and continued to exist independent of the cycle.

Both the lack of profitability and unemployment are being intensified right now through the general depression. However, in the postwar period they have become lasting phenomena that have not disappeared entirely even in the upswing. We are confronted here with a new problem, one that cannot be answered by the theory of cyclical changes alone.¹⁵

What were the causes of the permanent postwar crisis? Mises argued that there were several. Each one, however, was an instance of government intervention. Mises thus explained the Great Depression by combining his theory of business cycles with his theory of interventionism. The least controversial of his candidate causes was the nefarious influence of price controls and public finance. Most economists agreed that price ceilings created shortages of consumers' goods and that price floors resulted in unmarketable surpluses without benefiting anyone. They also accepted that the growth of the state increased the costs of production and that taxation of capital induced capitalists to consume rather than reinvest their wealth. More controversial, however, was Mises's stance on the labor market, where he was one of the few economists with the courage to stand fast on the law of supply and demand, even as it applies to employment and wages. The main cause of unemployment was clear: government-supported labor unions.¹⁶

On the unhampered market, he argued, unemployment could only be a temporary phenomenon. There are “probably always a certain number of job-seekers... just as on the unhampered housing market there are always unoccupied apartments and apartment-seekers.”¹⁷ Today we would say that search costs cause a certain amount of natural unemployment.¹⁸Except for this natural residue, however, the market cleared at a wage rate resulting from a competitive demand by entrepreneurs and a competitive supply of workers. “Now this self-regulation of the market is strongly obstructed through the intervention of the labor unions acting under the protection and support of government power.” The labor unions seek to establish the wage rates of their members at higher than market rates. “This goal the unions pursue by the use of violence.” Mises went on to explain:

Only those workers who belong to the union, who demand the wage rates prescribed by the union, and who do their work in the manner prescribed by the union are permitted to work in the firms. Should the entrepreneur refuse to accept the conditions of the union, a strike ensues. Those workers who wish to work despite the union's imposed ban will be forced by acts of violence to refrain from their plan. These union tactics naturally presuppose that the government tolerates this behavior, at the least. Were it to proceed in its usual way and interfere with the criminals who abuse jobseekers and vandalize the machines and other of the entrepreneurs' facilities, then circumstances would be different. But that it has capitulated to the unions is the precise feature that characterizes the modern state.¹⁹

Owing to this position of power, which enables them to abuse the property rights of the capitalists as well as the human rights of workers and would-be workers, the unions can push wages above the market rate. But at this higher level it is impossible to hire all those who would have found employment otherwise. The result is unemployment and the concomitant misery of a great many people. For some time, the masses might tolerate their immiseration, but sooner or later they would demand jobs. Even the unions could not resist such a large-scale popular movement and therefore the institution of tax-financed unemployment relief was created. He concludes:

Unemployment as a permanent and mass phenomenon results from the labor-union policy of pushing up wage rates. Without unemployment relief, this policy would long since have collapsed. Unemployment relief is therefore not, as misguided public opinion assumes, a measure to alleviate emergencies caused by unemployment. To the contrary, it is an element in the chain of causes that create unemployment as a permanent and mass phenomenon in the first place.²⁰

In short, the crisis had turned into a great depression through government interventionism. And this economic calamity in turn accentuated political antagonism within states and between states, spurring yet another round of destructive policies.²¹

How to break out of the vicious circle? Mises argued that ultimately there was no choice but to abolish all government intervention and to confront union power head on. The confrontation had better be sooner rather than later. The longer it is delayed—for example, through inflation—the more capital will be consumed, which in turn causes ever-decreasing wages and living standards.²² And yet this idea continued to enjoy great popularity. As Mises wrote some months after publication of his lecture to a friend in Paris:

Today, with the exception of a dozen or two reasonable individuals, the whole world is in complete agreement on two points: debts should remain unpaid, and the economy should be stimulated through strong inflation.²³

Not all criticisms of his views were based on this opinion, however. Some critics charged Mises with one-sidedness. Some of his colleagues in the Kammer thought it was illegitimate to focus only on the problems of government interventionism. There was also something like entrepreneurial interventionism, which brought about very similar problems.²⁴ The nub of Mises's response to this argument is contained in a letter he wrote to Kammer colleague Rudolf von Bermann, who agreed with Mises on questions of government interference, but insisted that the government was not the only agency to engage in interventionism.²⁵ In his answer, Mises stressed the particular features of the selection process of the market:

It is certain that entrepreneurs too commit errors; this has never been denied. But the characteristic feature of the capitalist economy is that the entrepreneur diminishes his own position as entrepreneur and property owner to the very extent to which he commits errors.... A capitalist social order unhampered by interventions, therefore, provides for a permanent selection among the capitalists and entrepreneurs.... Why can incompetent people in the German Reich and in Austria remain CEOs for many years? Because in an interventionist state these executives are selected primarily in regard to whether they enjoy a good reputation with the higher authorities (which possibly are the “lower” ones) and because firms that are long since bankrupt are artificially carried along for years, under the pressure of all sorts of interventions.²⁶

The most popular alternative explanation of unemployment in those days, at least in intellectual circles, was the one that Emil Lederer had published in the same series in which Mises's brochure appeared. Lederer ridiculed “the primitive notion that, faced with unemployment, one could always restore equilibrium by reducing wage-rates.” He argued that the crisis was a consequence of fast technological progress—so fast indeed that an adjustment of the market participants was somehow intrinsically impossible. As long as innovations applied only to consumer products, according to Lederer, unemployment would not result: the new industries would absorb any remaining idle labor. But when innovations occurred in the form of fast technological progress, which replaced labor by cheaper machinery at such a speed that entrepreneurs could not keep pace, unemployment ensued.²⁷

The problem with this argument was not only its implicit premise that entrepreneurial speculation could not possibly keep up with fast technological progress, but the even deeper assumption that technological progress could somehow take place independent of entrepreneurs. In a chapter that Mises contributed to a festschrift for the Dutch professor C.A. Verreijn Stuart, he discussed why the very idea of technological progress outpacing adjustments was completely baseless.²⁸ Mises pointed out that capital was inherently conservative in the sense that the value of the existing capital structure forced the entrepreneurs constantly to weigh its maintenance against its displacement. It is not the case that any new technology, merely by virtue of being technologically superior to those presently in use, would displace the older ones. Such a complete replacement would occur only if it were warranted by market prices.

While Lederer, Conrad, and others had tried to counter Mises's analysis of the causes of the crisis by proposing alternative explanations, other economists confronted his main thesis head-on. They criticized Mises's argument that in an unhampered economy nothing prevents the clearing of the market through price adjustments. Erich Carell claimed that each change of supply and demand would induce cumulative (Wicksellian) effects that amplified the initial disequilibrium.²⁹ And Wilhelm Röpke argued:

In the present phase of the crisis it seems to me it is wrong to expect that a reduction of the level of wages would re-establish equilibrium. This is wrong because, given the total paralysis of investment, each reduction of prices and incomes would lead to a continued sterilization of means of payment—in the form of an increase of the liquidity of the banking system—and thus to an extended disequilibrium. Mises and his fellow-travelers apparently do not sufficiently take account of the fact that today we have monstrous productive reserves that are unused; in other words, we have a gigantic “capital surplus” that requires credit expansion to become visible. For this reason it is not correct that government investment would deprive the private economy of its means. The paradoxical fact, which cannot be grasped on the basis of purely static ideas, is that the means of the private economy would thereby be multiplied.³⁰

Mises had anticipated this line of argument in “The Causes of the Economic Crisis.” He noticed that some economists had come up with a new theory of how inflation could be beneficial. These economists knew full well that unemployment resulted from excessive wage rates. But rather than confronting the unions with the demand to stop their harmful practices, they “suggest to cheat the unions.” Mises summarized the argument and identified its crucial flaw:

In the next inflation, nominal wage rates shall not be changed, which would be equivalent to a reduction of real wage rates. This blithely assumes that in the next boom the unions will not demand further wage increases, but quietly contemplate a reduction of real wages.³¹

It was not reasonable to expect such union behavior. Mises's refutation of the new pro-inflation argument was grounded in common sense. And by analogy it also applied to the owners of all other “monstrous productive reserves that are unused,” as Röpke had claimed. It was unreasonable to assume that these owners would quietly contemplate a reduction of the real prices they obtained for selling or renting out their resources. But in the heated atmosphere of the early 1930s, with growing economic problems and a ruling statist ideology presenting government action as a panacea, reasonable argument was rare and dissenters were highly unpopular. As one reviewer of “The Causes of the Economic Crisis” explained:

The labor unions have become so powerful and such an important political factor in state and public opinion that nobody ventures to tell the truth—neither the journals, which seek to avoid being accused of antisocial sympathies, nor the government, which is afraid of becoming unpopular and of exposing itself to the unfettered demagoguery of all those parties that, not surprisingly, attract the masses with their bellicose cries against any reduction of wages.³²

The plague of political correctness existed well before the end of the twentieth century. Some of Mises's critics could not help admiring his courageous stance faced with overwhelming opposition. Eugen Altschul, while calling Mises “one of the most extreme representatives of liberalism,” admitted that he was unafraid to argue consistently.³³ Another reviewer said, “the Vienna professor Mises, who has been called the ‘last knight of liberalism,’ fights indefatigably against government intervention in the market process.”³⁴

Even an otherwise fearless ally like Fritz Wolfrum criticized him for stressing labor-union intervention as the primary factor responsible for the crisis. Wolfrum would have preferred Mises to stress other factors such as price controls “because everybody is better at recognizing a fault in others and, after all, our purpose must be to enlighten the broad masses.”³⁵

Enlightenment of the broad masses! Often, Mises felt that it was precisely the elites who were in need of more light. A case in point was his 1931 trip to the United States and Canada, where he took part in a congress of the International Chamber of Commerce (ICC) and met many other colleagues and economists.³⁶

The trade policy of the United States was one of the top problems discussed at the ICC meeting. In June 1930, the U.S. Congress had passed, and President Hoover had signed into law, the Smoot-Hawley Tariff Act, which authorized the highest tariffs on imports of agricultural products and manufactured items in the history of the United States. Within a year, it was already obvious that the act was devastating for international trade. It protected the farmers and manufacturers who produced for domestic markets, but hurt the consumers and farmers and manufacturers who produced for foreign markets. It undermined the international gold-exchange standard. The American political leadership would not admit this. The president, Congress, and the American representatives at the ICC meeting were firmly committed to the cause of what some of them called the “new economics”—rescuing the capitalist economy through more government intervention (fighting the disease by torturing the patient). A few months later, Hoover signed the 1932 Revenue Act, which brought about the largest peacetime increase of tax rates in the history of the United States, but this did not raise the absolute amount of taxes collected and did not keep Hoover from losing reelection at the end of that year. Starting in 1933, the new president, Franklin Delano Roosevelt, would intensify the New Deal policies that had begun with Smoot-Hawley.³⁷

At the 1931 Washington meeting of the ICC, the interventionist spirit that produced these policies was evident. Mises wrote in correspondence:

at the Congress I saw again how difficult it is today to battle against increasing protectionism. The US government and political parties energetically oppose all attempts to impose a moderation of US tariffs.³⁸

What I saw in America was not very pleasant. The official circles of the United States hold fast to a policy of high tariffs.... To be certain, the United States pursues the most pernicious interventionist ideas in its domestic and foreign economic policies.³⁹

But the situation in Austria was certainly no better and declined quickly. In March, at the general meeting of the stockholders of Oesterreichische Nationalbank, Mises had publicly pointed out that the bank had succeeded in stabilizing the exchange rate of the schilling.⁴⁰ That was probably the best thing that could be said about Austrian finance. But he knew that grave problems lay ahead. Several times he had rejected executive positions with some of the major banks, because he believed they were bankrupt and it was only a matter of time before this state of bankruptcy would become apparent.

In early May 1931, the day of reckoning came. The default of Austria's largest bank, the Rothschild-dominated Credit-Anstalt, put the Austrian payments system into immediate jeopardy.⁴¹ Upon his return to Vienna, Mises had to decline several invitations to comment on the event and its implications for the Austrian government's efforts to balance its budget, saying such public statements could not be reconciled with his position as secretary of the Kammer. A penal lawsuit was brought against the executives of the bank, and Austrian law prohibited any initiative to influence public opinion before the verdict of the judges.⁴² Too big to fail, the Credit-Anstalt was bailed out by Reisch's central bank. In exchange, it and other leading banks were coopted into reintroducing foreign exchange controls through the backdoor.⁴³ They were asked to hamper any gold exports of their customers. Mises must have felt this resurgence of mercantilist ideas was the beginning of the end. To the editor of Deutsche Wirtschafts-Zeitung, one of the journals that had solicited a comment, he confided:

Our financial situation is far worse than the official view admits. And yet parliament opposes any hardhitting measures out of concern for the voters—in particular, the many civil servants.⁴⁴

The reluctance of “the official view” to admit the true extent of Austria's socialist plight stemmed also from the corruption of the media. This concerned in particular reports on the city of Vienna, which had become an international showcase for communal socialism. As Mises pointed out in correspondence with a fellow Rotary Club member from the Netherlands, none of the Vienna newspapers dared oppose rent control or criticize the budget and other financial reports of the city of Vienna because the newspapers depended in so many ways on the city administration.⁴⁵ Few economists were critical enough to see through the public propaganda, and even fewer dared to speak out against it. Again it was the group around Mises that filled this gap, most notably when Hayek published his study on rent control.⁴⁶

Mises was so convinced that all the major Austrian banks were bankrupt⁴⁷ that he kept personal bank accounts elsewhere. These prophecies materialized at an amazing speed. Bankruptcy of the Credit-Anstalt could be prevented only with help from the Rothschild banks in Paris and London. Few other establishments had saviors from abroad. Within two months, financial collapse spread throughout Austria, and on Black Monday, July 13, 1931, it reached Germany. One of the best-reputed German banks, the Darmstädter und Nationalbank closed its counters, triggering a chain reaction that quickly involved all payments within Germany. When the government decreed a compulsory holiday for the banks and the capital markets, international payments came to a halt.