Economic Depressions: Their Cause and Cure, by Murray N. Rothbard, originally published as a minibook by the Constitutional Alliance of Lansing, Michigan, 1969. (response)
Day 6 of Robert Wenzel's 30 Day Reading List on Libertarianism
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In Economic Depressions: Their Cause and Cure, Murray N. Rothbard argues that the Keynesian theory of demand-driven depressions is falsified by experience. Instead, Rothbard attributes the negative consequences of the business cycle exclusively to government intervention. Rothbard's cure is simple: the government should simply stop intervening in the economy and act essentially like a household with an exogenously limited budget.
Rothbard notes a number of flaws in Keynesian economic theory. First, Rothbard asserts that Keynesian theory fails to explain why businesses, normally very good at predicting the economic future, suddenly become curiously inept at doing so, which triggers the depression. Moreover if depressions were caused by underconsumption, then Rothbard asks why depressions typically feature a fall in capital spending before a fall in consumer spending. If depressions were caused by consumers not spending enough, then we would expect to see consumer spending fall first, and then retail providers scaling back their capital spending. Keynesian theory just doesn't seem to fit the facts.
Rothbard offers an alternative theory. He argues that the proximate cause of inflationary and recessionary gaps is bank credit created by private fractional reserve banking. When the bank loans money it doesn't have, i.e. creates more demand notes presumptively redeemable in gold (or silver) than it actually has. This private fiat money lowers the interest rate from its natural equilibrium, leading to excess capital investment. As more money flows into the national economy, inflation rises, causing domestic goods to become relatively more expensive than foreign goods, which leads to increased imports. But foreign governments don't want to hold domestic bank notes, so they demand redemption in gold. The banks' gold reserves fall relative to notes outstanding, until the fraction of gold reserved falls below safe levels. Furthermore, workers are receiving higher real wages (because excess capital investment causes a shortage of labor), but because they still have the same time preference for consumer goods now rather than later, and because the interest rate is artificially low, they do not save and invest their higher real wages, so bank reserves do not increase domestically. Banks then deleverage: they refuse to extend more credit and reduce existing credit, leading to deficient capital investment and a depression. Eventually, deleveraging runs its course, the banks have adequate gold reserves, and they begin the cycle anew. Although the banks are private, Rothbard claims this boom and bust cycle could not happen without a government-supported central bank. Without the central bank, banks would just start runs on competitors' banks, demolishing the fractional reserve system. The central bank, by acting as a lender of last resort, allows all domestic banks to extend excess credit in tandem, until international pressure finally collapses the whole system.
Rothbard's cure is simple: the government should not support banks or currency at all. Without the support of the central bank, fractional reserve banking will collapse. There may be considerable pain as the economy recovers a true equilibrium based on sound money, but when the lingering aftereffects of government intervention finally wither away, the economy, because all the signals are purely reality-based, will proceed without the boom and bust cycles caused by government supported credit.