Have we learnt the lesson
of the Great Depression?
By *Dr Frank Shostak
No. 130, 16-22 Aug. 1999
Today's prevailing view is that central banks and other policy makers are knowledgeable enough to pre-empt severe economic slump. It is held that as long the central bank can succeed in stabilizing the price level nothing could threaten the economy. Furthermore, it is argued that in the 1930s central banks lacked the necessary flexibility to maneuver the economy away from the depression because of the gold standard. However, today central banks don't have this problem. If all that is required to create prosperity is greater monetary flexibility, why are so many economies today in the midst of a severe economic hardship? After all, every central bank has learnt by now how to pursue "flexible" monetary policies.
It seems that following in the footstep of John M. Keynes most economists have convinced themselves that money can grow the economy. The theory goes something like this: more money will stimulate the demand for goods, which in turn will give rise to a greater production of goods and services and — abracadabra! — economic prosperity will follow suit. It is overlooked that more money can only weaken and not strengthen the economy. It is precisely the lack of flexibility of the gold standard that politicians and central bankers dislike. It is precisely this lack of flexibility that is needed most, to revitalize world economies, including the US.
Notwithstanding the popular view, the US economy is severely out of balance. The reason for this is the prolonged loose monetary policies of the US central bank. The federal funds rate which stood at 17.6 per cent in April 1980 fell to the current level of 5 per cent. At one stage in 1992 the rate stood at 3 per cent. The money stock M3 climbed from $1824 billion in January 1980 to $6152 billion at the end of June 1999. In a time span of less than a decade it grew by over 200 per cent. Another indicator of the magnitude of monetary pumping is the Federal debt held by the US central bank. It jumped to $465 billion in the first quarter of 1999 from $117 billion in the first quarter 1980, a 300 per cent rise. Obviously the sheer dimension of the monetary pumping and the accompanied artificial lowering of interest rates has caused a massive misallocation of resources which ultimately will culminate in a severe economic slump.
The intensity of the misallocation of resources was further strengthened with the early 1980s financial de-regulation. The idea of financial deregulation was to free the financial system from the excessive controls of the central bank. It is held that freeing financial markets will permit a more efficient allocation of economy's scarce resources, thereby raising individual well being. It was argued that the overly controlled monetary system leads to more rather than less instability. Nonetheless, rather than producing more stability, the "liberated" system gave rise to more shocks.
The 1980s financial de-regulation resulted in a reduction of the central bank supervisory powers. The weakening in the central bank controls gave impetus to a greater competition in the financial sector. This in turn through the fractional reserve banking sparked the unrestrained creation of credit and money out of "thin air". The money out of "thin air" in turn has been further processed by creative entrepreneurs, who have converted this money into a great variety of financial products, thereby contributing to a wider dissemination of the monetary pollution .
The failure of financial de-regulation seemed to vindicate the view of interventionists and opponents of the free market economy, that the facts of reality dictate that markets must be tightly supervised. It is however, overlooked that all these reforms i.e. financial de-regulation have nothing to do with the true free market. For as Mises has shown, in a true free market no paper money can become independent of a commodity money gold, which was chosen by the market1. Furthermore, in a free unhampered market there is no place for the central bank.
The sudden collapse of the Japanese and South East Asian economies raised doubts about the potency of central banks and government policies. Notwithstanding, most economists are supportive of central banks pre-emptive policies. Consequently they are very critical of the Austrian view that the best cure for economic depression is for governments and central banks to cut their interference with the economy. For instance in an interview with the Barron's economics editor Gene Epstein,2 Milton Friedman has argued that to fix the current economic crisis in Asia Japan should pump up its money supply. During the interview Milton Friedman expressed strong misgivings about the hands-off approach of the Austrian school economic framework. Similarly, in his writings Keynes criticised those economists, labeling them "the so-called economists", who were advocating a hands-off approach to the great depression of the 1930s.3
It seems, therefore, that the chaotic state of world financial markets will continue to get worse unless gold is allowed to assume its monetary role. Notwithstanding that there is very little reason for being optimistic in the current economic climate, one can see some bright lights. These lights are the growing realization that the only viable alternative to the present chaotic monetary system is a true free market.
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