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The Depression, World War II, And What They Really Mean

Nearly a century after the fact, the Great Depression remains THE object lesson for virtually every branch of economics. To monetarists the fact that the US money supply fell by nearly a third in the 1930s illustrates the need for a central bank to maintain steady money growth. To Keynesians the Depression’s depth and duration proved that capitalist systems are inherently unstable and need a big, powerful government to manage them. World War II, in this framework, saved the US economy from permanent 25% unemployment.

To Austrians, meanwhile, the Depression demonstrated that 1) the best way to prevent a bust is to avoid the preceding boom, which is another way of saying that the size and composition of the national balance sheet is the key to everything, and 2) the best way to get through a bust is to let market forces liquidate the bad debt as quickly as possible.

A September 14 DollarCollapse column took the Austrians’ side in the debate and illustrated the point with the following chart, which depicts the massive deleveraging of the 1930s.

Debt during depression

Not surprisingly, since the Depression means so much to so many, this generated some conflicting comments, the most challenging of which came from reader Eric Original:

The spike in debt/GDP in the 30′s was due to the collapse in GDP. Basic math. It’s a ratio. And therefore, the supposed deleveraging prior to WW2 is baloney as well. Just like your entire last paragraph, and pretty much the whole article, as usual.

You hard money Austrian econ goons need to come out of your caves and get a life.

This is response-worthy both because the final spike in debt/GDP was indeed partially caused by GDP shrinking faster than debt, and because it gets at some of the deeper, more interesting parts of the story. So, here goes:

During the initial stages of a credit bubble debt soars but debt/GDP rises more slowly, because the proceeds from all those new loans get spent, thus producing “growth” which shows up as rising GDP. In other words both the numerator and denominator of the ratio go up. But — and this, I think, is the crucial fact for Austrians — extremely easy money leads people to buy things and make investments that they wouldn’t otherwise buy or make. This “malinvestment” pumps up growth in the near-term but doesn’t generate sufficient cash flow thereafter to service the related debt.

So the initial debt-driven pop in GDP is an illusion. Later, when those bad investments can’t cover their interest payments and go bust the economy shrinks, for a time, faster than societal debt, which causes debt/GDP to spike. But the actual spike in debt/true GDP happened earlier. It isn’t reflected in official statistics because there’s no way, in the heat of an asset bubble, to separate good investments from bad. As Warren Buffett likes to say, it’s only when the tide goes out that you see who’s swimming naked.

But if the above chart could be constructed using 20-20 hindsight, the late 1920s would show a huge increase in debt/true GDP and the early 1930s would show a quick deleveraging rather than a gradual one lasting a decade. By 1939, not only would debt be a smaller part of the economy than in 1929, but the quality of the remaining debt would be far higher. That society would be ready to grow again, regardless of whether or not there’s a war.

The other thing that keeps this debate alive is the assumption that there are painless alternatives to deleveraging after a credit bubble. Keynesians (who are now mostly running things) believe that if the government borrows to make up for the private sector’s deleveraging — or convinces the private sector to keep borrowing to replace those old bad debts — growth will resume without the need for layoffs and bankruptcies.

Variations on this strategy are being tried by virtually every major country. Japan has been at it since the 1990s and has lately added extreme debt monetization to its ongoing huge deficits. The US since 2008 has gone the same route, expanding government debt by enough to offset the credit card and mortgage debt that’s been written off, while buying back several trillion dollars of bonds with newly-created dollars. Now Europe is getting ready to do something equally big (see OECD slashes growth forecasts, urges aggressive ECB action).

So far the results aren’t encouraging: Japan is stagnant while continuing to pile up government debt, and now appears to be out of options. The US is reporting official GDP growth and falling unemployment but the case can be made that those numbers are largely fictitious (full-time jobs continue to decline, for instance, which means real unemployment continues to increase) and in any event a rising dollar is threatening even that modest momentum. Europe seems to be beyond saving, but the ECB is still going to try.

The mainstream response of “well, we just need more debt and faster money printing” is disturbing both because it fits the common definition of mental illness (repeating the same behavior while expecting a different outcome) and because it magnifies the consequences of failure. If, as Austrians believe, there is no alternative to deleveraging after a boom — in other words, if booms and busts are two sides of the same event and therefore by definition have to occur together — then the extra $100 or so trillion dollars the world has taken on since the tech stock bust of 2000 makes the resulting, inevitable, deleveraging that much scarier.

11 thoughts on "The Depression, World War II, And What They Really Mean"

  1. “And for the crowd who think all government spending is wasteful, there are no examples of wealthy countries without good public educational and health systems, transportation and energy infrastructure, safe water, regulation to prevent corruption and graft, etc. These things lower the costs of doing business for everyone. Just try to take advantage of the low wage costs in Mozambique!”

    I do not disagree entirely. Let’s return the federal government to it’s pre-1930s role, and do away with the federal reserve and ALL income tax. We were a truly wealthy, and more importanly, FREE, nation then.

  2. “And for the crowd who think all government spending is wasteful, there are no examples of wealthy countries without good public educational and health systems, transportation and energy infrastructure, safe water, regulation to prevent corruption and graft, etc. These things lower the costs of doing business for everyone. Just try to take advantage of the low wage costs in Mozambique!”

    Yeah, the gold standard of efficient Govt spending are USPS and military contractors. You enjoy the efficient markets of the US while you can, OK?

    1. Actually I’m against military spending altogether.
      Don’t live in the US. But don’t see you profiting from low taxes and wage costs in Mozambique. Many “private” corporations have wasteful spending, and much government spending is ill-conceived. The qualitiy of investments and governance is paramount, regardless of the party making the decisions. But that is something entirely different to having no public assets. In a land with no public assets, there will be no common good, no common cause, and no commonwealth, nor will there be a rule of law, since the only difference between owners and serfs would be: “Who is in power right now?” Public roads, beaches, forests, and water are fundamental to any idea of a common realm where rules and their enforement are more than a simple contest of who can bring the most force to bear.

  3. Whenever I see someone mentioning “Government Spending” it always comes across as “the government just happened to find some extra cash”: “so we will now spend it on infrastructure and things that are beneficial to the average citizen.” What they actually mean is “The government (parasite) needs to grow and protect itself while accruing to itself maximum benefit and then and only then will it spend money in the most vote catching way AND usually in the most inefficient way to gain approval and votes from the people to perpetuate it’s existence.” Governments never own up to the fact that they never earned this money but took it by force from their own people. As they never earned it they never consider how efficiently and without corruption they can spend it. They know there is always more they can suck from host while the country is still prosperous. Government is the most inefficient and wasteful way of providing benefits for their own citizens.
    One day there may just be a country that has rights for the individual (that can’t be taken away) and a small government who’s only concern is protecting their citizens from external forces whilst having an internal police force and legal system that protects the rights and safety of the individual. A government that acts rather like an unbiased umpire rather than a totalitarian dictator.
    The first thing any new government should do is get rid of debt based money and fractional banking.

  4. The example Austrians often use to illustrate malinvestment is the man who would build a house but does not have the wherewithal to complete. He has only a shell but not roof, so the house is not useful and was a waste of the work and materials that went into building it. The bible even has a story about a builder who would build a great house but was mocked when unable to complete it.
    The problem with monetary inflation and twiddling interest rates is that it robs people of the possibility of calculating costs and benefits on a longer time scale, often punishing savers and prudence and rewarding borrowers and speculation.

    But the basic idea of Keynesianism gets a bad rap. The original Keynesian was Joseph, who stockpiled grain in the seven fat years only to disburse it (earning handsomely for the Pharaoh) in the seven lean years. The idea of the government acting anti-cyclally is sound: saving and slowing the boom in good times, and evening out investments in bad times. Slow and steady wins the race. There are of course two important caveats:
    1. Saving in good times is the opposite to always stimulating.
    2. The spending should take the form of investments in public assets and infrastructure. If the spending is just consumption, there will be no return, and you are just buying time and putting off the day of reckoning.

    It’s all quite simple, really, and that’s why it’s usually beter to put finances in the hands of a good housewife than in the hands of economists.

    And for the crowd who think all government spending is wasteful, there are no examples of wealthy countries without good public educational and health systems, transportation and energy infrastructure, safe water, regulation to prevent corruption and graft, etc. These things lower the costs of doing business for everyone. Just try to take advantage of the low wage costs in Mozambique!

    1. Read history to understand the backdrop to our problems with bankers using the government to protect their bad loans to third world countries and then you’ll understand that the whole Austrian vs Keynesian thing is just rubbish in the dust bin of how economics effects economies. I’ve gotten quit tired of the debate because it has no end, and most importantly, it has no relevance to why we are in our position. So read the book, “All The Presidents Bankers,” by Nomi Prins and get to the hart of the problem: TOO BIG TO FAIL BANKS are in debt up to their hindquarters and killing the economy.

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