Austrian Cycle Theory: What Caused (& Partially Fixed) the Great Depression?

In 1929, the crash of the United States stock market kicked off a decade-long, worldwide economic disaster that would come to be known as the Great Depression. Following shortly after the crushing disaster that was World War I, the Great Depression directly led to the failure of major banks across the country, caused a record high 1932 unemployment rate of 23% in the United States, and while “unemployment spiraled up, production [went] down,” further exacerbating the economic problems.[1]  This research uses primary and secondary sources to explore how the Austrian school theory of the business cycle (hereafter referred to as “The Austrian Cycle Theory” or “A.T.C.”) helps explain the cause and ultimate demise of the Great Depression. 

Research Methodology

This research uses primary and secondary sources including an executive order, employment and money supply statistics, and secondary academic sources which provide context, perspective, and analysis. These resources are accessible online through databases such as JSTOR and The American Presidency Project. Analysis includes a quantitative assessment of available information. There are no apparent ethical concerns in this research besides the constant pursuit of objectivity. A limitation to consider is that the research is assessing if this theory is supported by the evidence, but it is still a theory and just one of many. 

Analysis

While one might argue that American capitalism operates in vacuum void of governmental oversight, the reality is that monetary and fiscal policies affected the American economy in the early twentieth century and continue to do so today. The Austrian Cycle Theory argues that when the government uses monetary policy to implement artificial increases in the money supply it ultimately leads to economic booms and busts. The reason for this is that artificial increases in the money supply cause the interest rates – or cost of borrowing – to decrease temporarily leading to “excessive investment in capital goods of long duration.”[2] When the interest rates eventually rise again, the investments become unprofitable, and an economic downturn occurs.[3]  Ludwig von Mises, a noteworthy twentieth-century economist associated with the Austrian school of economics, theorized that “when interest rates are pushed down by a monetary authority, the structure of capital goods becomes distorted.”[4]  Mises recognized the “intimate relation[ship] between money, inflation, and crisis” and incorporated that into the Austrian school of thought.[5] 

This theory helps to explain a potential cause of the Great Depression. During the 1920s, in the wake of World War II, the United States government artificially increased the money supply and lowered interest rates by purchasing a significant number of bonds from the public. This resulted in the banks having higher reserves and the ability to lend money at lower interest rates.[6]  Murray Rothbard, an Austrian school economist, reported that “the money supply of the United States increased by 62 percent during the 1920s boom.”[7]  This substantial artificial expansion of the money supply contributed to the so-called “Roaring Twenties” immediately before the Great Depression. Thus, the 1920s were characterized by economic prosperity, lavish consumer spending, speculative investments in the stock market, and extensive use of credit to support unprecedented levels of construction in cities such as Chicago.[8]  According to the premise of the A.C.T., however, when the federal reserve used monetary policy again in the late 1920s to raise interest rates and effectively reduce the money supply, it contributed to the failure of many banks and the ultimate onset of the Great Depression.

To turn things around, the government – this time the Roosevelt Administration – again turned to monetary policy, just as the A.C.T. describes. The administration’s 1933 decision to break with the gold standard and allow a large inflow of unsterilized gold into the economy was a deliberate effort to promote an “increase in the monetary gold stock …[and] stimulate the depressed economy.”[9]  Their monetary policy efforts succeeded in helping the economy recover, but historians such as Larry Schweikart would argue that, at least in part, it was really “World War II [that] got us out of the Great Depression … because it insured full employment [and] forced people to save.”[10]  Regardless, it is clear that the American government consistently used monetary policy to try to fix problems that were, at least in part, the result of previous monetary policies.

Conclusion

In summary, the Austrian Cycle Theory argues that a government’s monetary policy efforts can trigger artificial increases in the money supply that ultimately lead to economic booms and busts. The 1920s and 1930s are an excellent example of the problematic effect of American monetary policy on the national money supply, interest rates, and growth or decline of the economy. The Austrian school, therefore, contends that governments should stop meddling in the money supply through monetary policy and allow economies to self-regulate. 

Footnotes

[1] Robert J. Samuelson, “Revisiting the Great Depression,” The Wilson Quarterly 36, no. 1 (2012): 38, 40, http://www.jstor.org/stable/41484425.

[2] Fred E. Foldvary, “The Austrian Theory of the Business Cycle,” The American Journal of Economics and Sociology 74, no. 2 (2015): 278. http://www.jstor.org/stable/43818666.

[3] Ibid.

[4] Ibid., 284.

[5] Hansjoerg Klausinger, “The Austrian School of Economics and Its Global Impact,” in Global Austria: Austria’s Place in Europe and the World, edited by Günter Bischof, Fritz Plasser, Anton Pelinka, and Alexander Smith (University of New Orleans Press, 2011), 100.

[6] Fordvary, “The Austrian…,” 284-285.

[7] Ibid., 293; see also, Murray N. Rothbard, America’s Great Depression (Sheed and Ward, 1975), 86.

[8] Foldvary, “The Austrian…,” 293-294.

[9] Christina D. Romer, “What Ended the Great Depression?” The Journal of Economic History 52, no. 4 (1992): 781. http://www.jstor.org/stable/2123226; see also, Franklin D. Roosevelt, Executive Order 6102: Forbidding the Hoarding of Gold Coin, Gold Bullion, and Gold Certificates, April 5, 1933, The American Presidency Project, accessed November 24, 2024, https://www.presidency.ucsb.edu/node/208042.

 [10] Larry Schweikart, "The Economic Impact of War on Business," video, Liberty University, 2020.