The Cause and Recovery of the Great Depression; The Austrian School and its Adherents

Economic downturns have deleterious effects on a nation’s well-being and, can spread to other nations like a tornado wreaking havoc as it goes. The United States economy collapsed in 1929, and economists today describe it as a dramatic turn of events (rather than merely a recession) due to the totality of its results which included the numbers of lives impacted and how much money people lost.

These periods of decline in economies are analyzed statistically in the modern world and, they are often described as related to ‘boom-bust’ cycles. The graphical (x/y axes) representation of economic events in capitalist societies show a line that progresses chronologically and indicates upswings and downswings (otherwise known colloquially as peaks and valleys) of some sort of variable plotted on the y axis (e.g., GDP, unemployment) compared to months or years on the x axis.

Historians rely on economic data to allow them to compare time periods so they can describe past events accurately. There are many different theories that try and explain the causes and recovery of the Great Depression that occurred during the late 1920s and early 1930s. One economic school of thought that does this is called the Austrian School of Economic Theory. Carl von Menger (died 1921) was a Viennese Economist, and he was the founder of this School. He tutored Crown Prince Rudolf (committed suicide with his mistress) who was the heir to the Habsburg throne in Vienna. His seminal work was Principles of Economics (1871).¹

Two of the leading theorists in that school are Ludwig von Mises, who wrote The Theory of Money and Credit (1924), and Friedrich von Hayek, who wrote Monetary Theory and the Trade Cycle (1933).² Both of these economists lived through the Great Depression and well beyond. Both had ancestors who were German/Austrian Royals since we see “von” in their surnames. Von Hayek fought for the Austro-Hungarian Army in World War One and was a professor for a time at the University of Chicago (before that he analyzed Federal Reserve and American economic data with Professor Jenks at New York University when he was an assistant there).³ Von Mises emigrated to the United States and lived there until his death (1973) after having fled the Nazis (he was Jewish). Hayek shared the Nobel Prize in Economics in 1974 with Gunnar Myrdal.

There is no consensus about the causes of the Great Depression. The end of the use of the gold standard (during World War One) in the United States and Europe is often held liable for contributing to the economic problems during the Interwar Years. There is another popular belief that the Stock Market Crash in 1929 caused the Depression. Most economists hold that neither of these two concepts could have been blameworthy.

The Austrian School of Economics focuses upon several fundamental ideas that can be applied to an analysis of the causes of the Great Depression and its subsequent recovery. Mainly, it supports the concept that business cycles go through ‘booms’ and ‘busts’ due to government manipulation of interest rates (The Federal Reserve System). Too many low interest loans are allocated using lower credit worthiness standards. This profligate, wasteful lending fuels a ‘boom’ that cannot be sustained and the economy at some point later ‘busts.’ This is due to the fact that artificially lowered interest rates (not done by the market) fool investors into believing good investment opportunities exist, especially in capital goods. The Austrian School called this ‘malinvestment.’ At this point capital needs to be reallocated and liquidated (sold off) since the malinvestment creates poor allocation of resources.

The Austrian School theory of the causes of the Great Depression is referred to as ‘heterodox’ by modern economists since it is not considered mainstream (e.g., Keynesian or Monetarist Theory). Keynesians take a demand driven approach (consumption and investment were reduced by a lack of demand) while Monetarists see the Depression having been at first a typical recession that became exacerbated by a serious shrinking of the money supply.

According to Fred E. Foldvary in, The American Journal of Economics and Sociology, “The Austrian business cycle theorem begins with the interest rate. In
Austrian thought, the rate of interest is based on ‘time preference.’ As a fundamental premise of economics in general, time preference is the proposition that most people usually prefer to obtain goods sooner rather than later.”⁴ Included in this idea is that there is a ‘natural interest rate’ that is a correlate of time. It is common sense that if a purchase is delayed because a consumer has no access to money there would not be any interest paid at all. If they do not want to delay their purchase and they want a product immediately, but have no way to pay for it, they borrow money to do it. Hypothetically, with no central bank in a market that is entirely ‘free,’ the interest rate would reflect the value of the ‘real interest rate’ that people would pay based upon how much value they would receive by buying the good now rather than in the future.

The Austrian School believes that it is the inappropriate meddling with this interest rate in an artificial manner that causes recessions and depressions. Basically, money is lent ineffectively in the above scenario, and the real economy (rather than an imaginary one) gets adversely impacted with price and spending distortions. Hayek put it best when he said, “[t]he cause of cyclical fluctuations is that because of the elasticity of the value of money, the rate of interest is not always equal to the equilibrium rate but is in the short run determined by banking liquidity.”⁵ The Austrian School Economists believe the American Great Depression was caused by a distortion in the previous ‘boom’ in the 1920s due to the lowered interest rate policy of the Federal Reserve (prior to 1929). Ultimately, they held the economy recovered not by the actions of the American Government’s stimulus policies (they did not enact any), but it recovered on its own.

1. Menger, Carl. Principles of Economics. Trans. by James Dingwell and Bert Hoselitz. New York: New York University Press, 1976. ↩︎
2. Mises, Ludwig von. The Theory of Money and Credit. trans. by H.E. Batson. Indianapolis: Liberty Classics, 1924.; Hayek, Friedrich von. Monetary Theory and the Trade Cycle. Trans. by N. Kaldor and H. Croome. New York; Augustus M. Kelley, 1933. ↩︎
3. A.J. Tebble. F.A. Hayek. New York: Continuum International Publishing Group, 2010, p., 4-5. ↩︎
4. Foldvary, Fred E. “The Austrian Theory of the Business Cycle.” The American Journal of Economics and Sociology 74, no. 2 (2015): 278–97. http://www.jstor.org/stable/43818666. ↩︎
5. Hayek, Friedrich von. Monetary Theory and the Trade Cycle. Trans. by N. Kaldor and H. Croome. New York; Augustus M. Kelley, 1933. ↩︎