Mises’s Explanation of the Great Depression: A Critique

Ludwig von Mises lived through the Great Depression as Keynes did, and produced his own explanation of it. I present a critique of Mises’s explanation of the Great Depression below.

First, some background. Around 1930 Mises joined an Austrian government economic commission to study the causes of the depression in Austria, along with (interestingly enough) the future Austro-fascist leader Engelbert Dollfuss (Hülsmann 2007: 614), to whom Mises was later to give economic advice (see below on this). The report of the committee blamed (1) inflationary expectations in Austria and (2) rises in taxation and government spending and increased wage rates (which had all squeezed business profits) for the inability of Austria to attract foreign capital needed to facilitate quicker adjustment and recovery from the depression (Hülsmann 2007: 614–615).

But Mises was not satisfied with the report (Hülsmann 2007: 615), and formed his own explanations for the depression, which were published as various articles and papers (see Mises 2006 [1931]; Mises 2002a [1931]; Mises 2002b [1932]).

On February 28, 1931, Mises gave a lecture called “The Causes of the World Economic Crisis” in Czechoslovakia (Mises 2006 [1931]).

In the published version of that lecture, Mises expounded his Austrian business cycle theory (ABCT) (Mises 2006 [1931]): 160–162), with its belief in monetary expansion driving the market rate of interest below its Wicksellian natural level, causing malinvestment which is physically unsustainable. This theory is, of course, false and untenable, for reasons explained here (in the links in section 32). Amongst the many reasons why the theory is wrong is that there is no such thing as a Wicksellian natural rate of interest, and neither the Great Depression nor booms and busts in general are explained by the ABCT because banks cannot push interest rates below a non-existent natural rate.

However, it is interesting that Mises thought that his Austrian monetary theory of the cycle could not adequately explain the severity and length of the Great Depression (as also noted by Hülsmann 2007: 617–618):

“The crisis from which we are now suffering is also the outcome of a credit expansion. The present crisis is the unavoidable sequel to a boom. Such a crisis necessarily follows every boom generated by the attempt to reduce the ‘natural rate of interest’ through increasing the fiduciary media. However, the present crisis differs in some essential points from earlier crises, just as the preceding boom differed from earlier economic upswings. The most recent boom period did not run its course completely, at least not in Europe. Some countries and some branches of production were not generally or very seriously affected by the upswing which, in many lands, was quite turbulent. A bit of the previous depression continued, even into the upswing. On that account—in line with our theory and on the basis of past experience—one would assume that this time the crisis will be milder. However, it is certainly much more severe than earlier crises and it does not appear likely that business conditions will soon improve.

The unprofitability of many branches of production and the unemployment of a sizable portion of the workers can obviously not be due to the slowdown in business alone. Both the unprofitability and the unemployment are being intensified right now by the general depression. However, in this postwar period, they have become lasting phenomena which do not disappear entirely even in the upswing. We are confronted here with a new problem, one that cannot be answered by the theory of cyclical changes alone.” (Mises 2006 [1931]: 163–164).

Mises saw the answer in his belief that (1) the high unemployment of the depression was caused by trade unions forcing wages up above market clearing levels (confirmed in Hülsmann 2007: 620), (2) governments had allegedly “capitulated to the labor unions,” and (3) the state provision of unemployment relief had allowed wage rates to remain high:

“The unions now have the power to raise wage rates above what they would be on the unhampered market. However, interventions of this type evoke a reaction. At market wage rates, everyone looking for work can find work. Precisely this is the essence of market wages—they are established at the point at which demand and supply tend to coincide. If the wage rates are higher than this, the number of employed workers goes down. Unemployment then develops as a lasting phenomenon. At the wage rates established by the unions, a substantial portion of the workers cannot find any work at all. Wage increases for a portion of the workers are at the expense of an ever more sharply rising number of unemployed.

Those without work would probably tolerate this situation for a limited time only. Eventually they would say: ‘Better a lower wage, than no wage at all.’ Even the labor unions could not withstand an assault by hundreds of thousands, or millions of would-be workers. The labor union policy of holding off those willing to work would collapse. Market wage rates would prevail once again. It is here that unemployment relief is brought into play and its role [in keeping workers from competing on the labor market] needs no further explanation.

Thus, we see that unemployment, as a long-term mass phenomenon, is the consequence of the labor union policy of driving wage rates up. Without unemployment relief, this policy would have collapsed long ago. Thus, unemployment relief is not a means for alleviating the want caused by unemployment, as is link in the chain of causes which actually makes unemployment a long-term mass phenomenon.” (Mises 2006 [1931]: 167–168).

The solution, then, for Mises was eliminating unemployment relief (presumably forcing the unemployed to starve and accept lower wages), cutting government spending and taxes (Mises 2006 [1931]: 175), and not only to cut wages but also to make wage determination free from labour unions (Mises 2006 [1931]: 169).

How suppression of trade unions was to be achieved and their freedom of association restricted was left understated, and Mises’s feeble hope that the “formation of wage rates should be hampered neither by the clubs of striking pickets nor by government’s apparatus of force” (Mises 2006 [1931]: 169) rings hollow.

How else could such suppression of trade unions be realistically achieved except by government coercion?

Mises hints at the solution in a passage where unions are themselves blamed as perpetrators of all sorts of evil:

“If the government were to proceed against those who molest persons willing to work and those who destroy machines and industrial equipment in enterprises that want to hire strikebreakers, as it normally does against the other perpetrators of violence, the situation would be very different. However, the characteristic feature of modern governments is that they have capitulated to the labor unions.” (Mises 2006 [1931]: 167).

This is the point in the essay where Mises may as well have been winking at his audience to indicate what his words imply: that governments should break up and repress unions and restore labour market freedom.

It comes as no surprise that Mises had praised Mussolini’s fascism in 1927 because it had (according to Mises) “saved European civilization.” Mises also contended that the “merit that Fascism … [had] thereby won for itself will live on eternally in history.” Part of the reason for this sickening praise was no doubt that Italian fascism had smashed independent trade unions. And, if that wasn’t enough, Mises was himself in the 1930s to become an economic adviser to the Austro-fascist Engelbert Dollfuss (Chancellor of Austria from 1932), who did indeed smash independent trade unions in Austria.

But to return to the point at hand. Why was Mises’s wage rate explanation wrong?

The reason is that capitalist investment and demand for labour is not a simple function of the wage rate or interest rate, as naïve, ignorant and incompetent Austrian ideologues like Mises thought, and many still think.

The propensity to invest is a complex phenomenon involving many factors, not just interest rates and the wage rate, but fundamentally the level of demand for output, the degree of uncertainty of capitalists about the future, the expectations of business people, the general state of expectations, and the state of the financial system and credit markets, and so on. Above all, the first three factors – demand for output, uncertainty and expectations – must be considered fundamental causes of the inducement to invest for many businesses, especially those that are mark-up price enterprises with excess capacity and inventories.

In the Great Depression, business expectations were shattered in an unprecedented way, as was demand for output. Simply reducing wages was no reliable or effective cure for unemployment in the 1930s (or indeed during recessions in general) when business expectations were deeply pessimistic, demand was stagnant and uncertainty about the future deep. If we also add to this the fact that many nations had banking crises and lending practices would have become deeply conservative, Mises’s focus on wages as the main cause of 1930s unemployment can be seen as the folly it was.

Whatever lowering of demand for labour that might have been caused by higher wage rates during the depression could have been overcome and rendered irrelevant by effective expansion of aggregate demand.

Furthermore, Mises’s economic analysis was just as flawed when he came to analyse prices:

“The demand that a reduction in prices be tied in with the reduction in wage rates ignores the fact that wage rates appear too high precisely because wage reductions have not accompanied the practically universal reduction in prices. Granted, the prices of many articles could not join the drop in prices as they would on an unhampered market, either because they were protected by special governmental interventions (tariffs, for instance) or because they contained substantial costs in the form of taxes and higher than unhampered market wage rates. The decline in the price of coal was held up in Germany because of the rigidity of wage rates which, in the mining of hard coal, come to 56 percent of the value of production. The domestic price of iron in Germany can remain above the world market price only because tariff policy permits the creation of a national iron cartel and international agreements among national cartels. Here too, one need ask only that those interferences which thwart the free market formation of prices be abolished. There is no need to call for a price reduction to be dictated by government, labor unions, public opinion or anyone else.” (Mises 2006 [1931]: 169–170).

Mises was blissfully unaware of what many economists were to discover in the 1930s and what Gardiner Means had already discovered: that real world price rigidities are mainly caused by the private sector itself, because most businesses adopt relatively inflexible mark-up/administered prices.

The type of price setting required by Mises’s economic theory is largely shunned by the private sector itself, so that the price flexibility Mises thought would clear markets cannot be attained.

Even though many nations saw price deflation in the Great Depression, even in the 1930s mark-up prices were significant and relatively inflexible as compared with other markets: Gardiner Means, for example, discovered that the administered pricing sector of the US economy had seen price declines of only about 10% during the depression, whereas the more competitive or flexprice sectors had seen price falls of about 40 to 60% (Means 1975) – a very clear disparity.

Finally, there is not a shred of evidence that Mises ever understood that even if wages and price were highly flexible, the existence of fixed nominal debt impedes and thwarts his imagined type of market clearing dynamics. For if debts remain fixed and wages and prices fall (or even more disastrously if wages fall but prices are less flexible), then it is likely that debtors will face severe problems as their burden of debt soars, and most probably deflation will induce bankruptcy of debtors and then bankruptcy of creditors and banks.

All in all, Mises’s analysis of the Great Depression was wrong, and he was ignorant of economics and economic reality. Austrians who still adhere to Mises’s ideas are just as ignorant and mistaken.

BIBLIOGRAPHY
Hülsmann, J. G. 2007. Mises: The Last Knight of Liberalism. Ludwig von Mises Institute, Auburn, Ala.

Means, Gardiner C. 1975. “Simultaneous Inflation and Unemployment: A Challenge to Theory and Policy,” in Gardiner C. Means et al., The Roots of Inflation: The International Crisis. Wilton House Publications, London.

Mises, Ludwig von. 2006 [1931]. “The Causes of the Economic Crisis,” in Percy L. Greaves (ed.). The Causes of the Economic Crisis, and Other Essays Before and After the Great Depression. Ludwig von Mises Institute, Auburn, Ala. 155–181.

Mises, L. von. 2002a [1931]. “The Economic Crisis and Capitalism,” in Richard M. Ebeling (ed.). 2002. Selected Writings of Ludwig von Mises: Between the Two World Wars: Monetary Disorder, Interventionism, Socialism, and the Great Depression (vol. 2). Liberty Fund, Indianapolis, Ind.

Mises, L. von. 2002b [1932]. “The Myth of the Failure of Capitalism,” in Richard M. Ebeling (ed.), Selected Writings of Ludwig von Mises: Between the Two World Wars: Monetary Disorder, Interventionism, Socialism, and the Great Depression (vol. 2). Liberty Fund, Indianapolis, Ind. 182–191.