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The Fault Lines

Mises Daily: Tuesday, February 27, 2001 by


A friend recently emailed me about my recent column on Mises.org about the economist Paul Krugman. Why, he wanted to know, "don’t so many mainstream economists realize that tinkering with the economy actually screws it up?" 

It’s a good question and one that could be answered in many ways, with each answer containing an element of truth to it. The fact is that this is a question on which some of the brightest minds in my profession disagree. The situation is simply another instance in which intelligent and well-meaning men and women sharply diverge.

The disagreement flows from two contrary interpretations of the macroeconomy. One side of the debate is dominated by the various breeds of Keynesian economists (and a few monetarists) who argue that markets are inherently unstable. They believe that they require anywhere between occasional to constant intervention by the state to protect it from its natural inclination toward recession and depression, income inequality, and price volatility. 

On the other side, free-market economists, many writing in the Austrian and New Classical tradition, argue that markets are inherently stable, and that in fact attempts to manipulate specific market outcomes impose instability in the macroeconomy. 

My own belief is that while some government intervention may seem to bring short run benefits, it always makes matters worse. There are an infinite number of examples that support this contention. Here is one.

If the government is constantly putting more money into the economy to increase consumer demand for goods, then firms don't have to pay as much of a cost for their mismanagement or poor market decisions. Say you and I both make the same product, but you are more efficient and can sell it for $5 each. I am not more efficient and waste my capital and labor resources. If I didn't, I could sell it for $5 as well, but I'm not, so I sell it for $6.

Assume that the consumer is indifferent about where he buys the product.  Since people, in general, are getting more money due to the expansionary government policy, they are less price conscious. They value their last dollar less than they otherwise would because money is less scarce relative to the available goods on the market.  This means that I don’t suffer for my inefficiency because consumers have more money.

During the economic boom, I am happy because consumers are earning money and there are policies in place to promote spending it.  But when the inevitable bust hits and people have less money to spend, I am forced to change business practices because people are now price conscious. 

This is a good thing.  It makes me clear the deadwood, not waste capital and labor resources, and free up those resources for others who can use them more efficiently.  It is easier to avoid these reforms when the market is doing well.

If policies are in place to never allow recessions, no matter what, then this process doesn't happen and my inefficiency is multiplied throughout the economy. James Grant, the financial journalist, has written that the cost of such business cycle stability, whether or not it is effective, is weaker growth. "It may not be entirely coincidental that economic growth has become less robust as governments … have become more expansive," he writes in his splendid financial history, The Trouble with Prosperity. "Milder down cycles have coincided with weaker up cycles." These policies reduce the necessary effects of market corrections. They distort the structure of production, allowing firms to avoid market penalty for resource misallocation, and this puts a drag on their output. 

Indeed, a particularly harsh recession may be exactly what the economy needs to reallocate resources to uses that are more efficient and to fully correct for the effect of past interventions.

But many mainstream economists, however, strongly believe that such cyclical fluctuations reflect the market’s natural penchant for instability and that it needs these interventions.  It is a myth that came from the Depression.  At that time, the majority of economists accepted the idea that the market system would crash if left to its own devices.  

That message was the dominant message of macroeconomics for the 30 years following World War II.  Except for Murray Rothbard’s book on the Depression, virtually all economists taught that the market system was sick in the 1930s, Roosevelt’s benevolent New Deal policies rejuvenated it, World War II fully restored it, and since then, steady life-supporting treatments from the government has thwarted its natural tendency back toward instability.

However, there has been much research, especially in the last 20 years or so, that has made a revisionist case.  A good deal of it has come from the Austrians.  This research argues that, in the very least, there are holes in the mainstream’s Depression story.  For instance, this research points out that the 1920 crash was remarkably similar to the 1929 crash, except that while the former crash rebounded rather quickly, the latter grew worse and worse.  

(Interestingly, the popular press’s take on the October 1929 crash in the days following it was that it was an unfortunate but hardly a new phenomenon.  The Wall Street Journal even expressed hope that the economy would rebound by Christmas.) 

This research suggests that the cause of both crashes resulted from monetary policies that were too expansionary before the crash, both of which were heavily influenced by Fed Chairman Benjamin Strong.  This idea is becoming increasingly accepted because the data support it.  But it was a new idea to the mainstream macro crowd.

This research also suggests that the reason why the 1929 crash grew worse (while past "panics" were short-lived) was due to unprecedented intervention in the market process, first by Hoover, and then by Roosevelt.  There was an explicit effort to stop prices and wages from falling, like they always had after previous corrections. This was the purpose of all of the White House conferences, Blue Eagle programs, and New Deal and pro-union regulations.  When these interventions proved ineffective, they were expanded throughout the 1930s.

This research also points out that if FDR’s programs were so successful, then why was the economy still languishing in 1938?  It suggests that World War II simply moved people from the soup lines to the battle lines in Europe and Asia, and that the Depression didn’t really end until Truman bowed to popular disgust with the New Dealers and kicked them out of government.  Most of those programs were dismantled, and when that happened, private property was safe again and economic recovery finally commenced, as efforts to manipulate labor and goods markets were reduced considerably.

But the myth of market instability persisted for a long time, but it is invoked to provide a moral justification for state intervention in markets to this day.  The idea that such policy is the cause of market instability, either in 1929 or in 2001, is foreign to them. One simply has to listen to the attacks on the market system as the cause of the California energy crisis, as well as the call for complete public provision of electrical power, as a recent example of the strength of this myth. 

Its believers are no dummies, however, and they would strongly object to my characterization of macro history or that their strongly held tenets are simply myths.  They have their own historical and empirical arguments to support their views about the market. But they would agree that their intellectual dominance is not what it once was, and that other schools of thought have gained as a result.  


Christopher Westley teaches economics at Jacksonville State University. See his archive and send him MAIL.