Steve Hanke & Daniel Gross On The Great Depression

With many now fearing that we're heading towards a second Great Depression, there is increased interest in the history of the first Great Depression, the one in the 1930s. Those of you interested in the correct interpretation I recommend Murray Rothbard's "America's Great Depression" (available online here, can be bought in traditional paper form here (as well as a few other online book stores)). Although it is not perfect, it is certainly far superior to all other historical accounts of that period, and the inflationary boom that preceded it, while also describing the Austrian business cycle theory in a very good way.

The main point of this point is however not to again recommend that book, but rather to discuss to recent articles about the (first) Great Depression. The first is from Cato Institute fellow Steve Hanke, who unlike many others at Cato is fairly Fed critical and hard money oriented.

His article is mostly informative and interesting, although he starts of with a really grave error, namely measuring the depth of the Depression in terms of national income in nominal terms instead of real terms. Given the massive price deflation of the time, that greatly exaggerates just how bad the downturn was. Also, his statistics in general is completely inconsistent with the numbers you find at the statistical authority that publishes these statistics, the Bureau of Economic Analysis (BEA). He claims that nominal national income fell from $84.7 billion in 1929 to $39.4 billion in 1933, whereas the BEA says that it fell from $94.2 billion to $48.9 billion (Note that I don't think that Hanke deliberately tried to mislead. Most likely he simply relied on older data series that have now been revised)..

While his specific numbers are wrong, the general trends he describe is still more or less right. He describes how the Depression shifted national income from corporate profits to net interest, which is confirmed in the BEA numbers, although the shift was somewhat less dramatic than Hanke claimed. Another relative beneficiary by the way was labor income, which in the BEA numbers rose from 54.3% of national income to 60.5%.

Hanke explains the disappearance of profits with price deflation, and a theory of profits that they are created by buying something now and selling it later, which is more difficult during price deflation. There is a limited degree of truth in that, but it also misses the distinction between price deflation caused by higher productivity and price deflation caused by monetary deflation. If productivity is rising then it can in fact be profitable to buy now input and sell finished goods later, as is illustrated by the profits made in the technology sector despite falling prices there. What caused the decline in profits during the Depression was the shift from significant monetary inflation during the 1920s to significant monetary deflation in 1930-32.

Moreover, the main cause of the collapse in profits wasn't price deflation. Instead, it was the fact that too many industries only had the capacity to produce things which weren't in demand anymore, meaning capital goods including houses and durable consumer goods. In other words, the primary cause was the malinvestments predicted by Austrian theory in more capital intensive industries, which given the loss of purchasing power for workers and owners there spread even to non-durable consumer goods and services.

Hanke finishes by noting how the unpredictable behavior of policy makers during the New Deal slowed the recovery and the similarities with that and the erratic and unpredictable behavior of Hank Paulson with regard to how the bailout money should be used. A good point, although it must be emphasized that predictable bad policies wouldn't be good either....

The other column is from Daniel Gross in Newsweek, which argued that we need not fear another Depression (Gross BTW repeats Hanke's error of looking at national income in nominal and not real terms). Again, I agree with that in the sense that I don't think it is likely that the slump will be fully as deep as the one in 1929-33. But let's just say that Gross' arguments aren't exactly strengthening my conviction of that. They are in fact weakening them.

The reason why Gross argues that this slump won't be as bad as that in the 1930s is because in the 1930s the government allegedly believed in laissez faire, while now they believe in the welfare state and bailouts of banks. As anyone who has read the Rothbard book knows, the assertion that the Hoover administration believed in laissez faire is simply false. The quote from Treasury secretary Andrew Mellon completely overlooks the fact that Herbert Hoover (the man in charge) ignored his advice and despite the disastrous results was always eager to emphasize just how good it was that he contrary to Mellon's advice pursued massive government intervention in the economy.

Now, to be sure, the bank bailouts will likely limit the degree of monetary deflation, which in the short-term can limit how deep the slump will be. But this will instead likely mean that the crisis will be even more prolonged, just like for Japan during the 1990s. While the short-term slump for that reason will likely be less severe than in 1929-33, it means that the recovery will be much weaker and short-lived, similarly to what happened in the Japanese case.