Sunday, January 26, 2014

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.

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.


  1. Von Mises is simply trotting out the tired old idea demolished by Keynes namely that one can apply the simple supply / demand idea to labour in the aggregate. As Keynes rightly pointed out, if everyone’s remuneration declines by X% in nominal terms, we’re all back where we started (apart from the Pigou effect which is a feeble effect).

    But Von Mises’s idea IS VALID (far as I can see) in that if wages are excessive compared to the rewards for being an entrepreneur, then there’ll be a shortage of entrepreneurs offering employment. I.e. the idea is valid in that it amounts to saying that if the share of GDP going to wages and profits is artificially distorted, aggregate employment will be hit.

    By the same token, if the wage of plumbers is raised artificially relative to the wage of other professions, then unemployment amongst plumbers, and hence also aggregate unemployment will be a bit higher.

    1. "But Von Mises’s idea IS VALID (far as I can see) in that if wages are excessive compared to the rewards for being an entrepreneur, then there’ll be a shortage of entrepreneurs offering employment."

      Yup, like in the 50s, a time when a single salary could support a family, almost no new businesses were started.

      Oh, wait...

  2. The real question is who decided that what is excessive and by what means?

    The idea of excessive is assumming apriori knowledge of the correct distribution which assumes a objective set of economic objective values which the Austrian school then claims doesn't exist as value is subjective.

    The Austrain school is nothing but class essentialism pretending to be a theory of economics as the solution is to attack the free association of workers i.e. people of a social class that Mises and his employs hated and wished to justify oppression via policy that would weaken them.

    The Austrian school is fascist economics and one simply has to read Hilter's speech to the Dusseldorf Industry Club.

    Quote from Hilter: " I may cite an example: you maintain, gentlemen, that German business life must be constructed on a basis of private property. Now such a conception as that of private property you can defend only if in some way or another it appears to have a logical foundation. This conception must deduce its ethical justification from an insight into the necessity which Nature dictates. It cannot simply be upheld by saying: 'It has always been so and therefore it must continue to be so.' For in periods of great upheavals within States, of movements of peoples and changes in thought, institutions and systems cannot remain untouched because they have previously been preserved without change. It is the characteristic feature of all really great revolutionary epochs in the history of mankind that they pay astonishingly little regard for forms which are hallowed only by age or which are apparently only so consecrated. It is thus necessary to give such foundations to traditional forms which are to be preserved that they can be regarded as absolutely essential, as logical and right. And then I am bound to say that private property can be morally and ethically justified only if I admit that men's achievements are different. Only on that basis can I assert: since men's achievements are different, the results of those achievements are also different. But if the results of those achievements are different, then it is reasonable to leave to men the administration of those results to a corresponding degree. It would not be logical to entrust the administration of the result of an achievement which was bound up with a personality either to the next best but less capable person or to a community which, through the mere fact that it had not performed the achievement, has proved that it is not capable of administering the result of that achievement. Thus it must be admitted that in the economic sphere, from the start, in all branches men are not of equal value or of equal importance. And once this is admitted it is madness to say: in the economic sphere there are undoubtedly differences in value, but that is not true in the political sphere. IT IS ABSURD TO BUILD UP ECONOMIC LIFE ON THE CONCEPTIONS OF ACHIEVEMENT, OF THE VALUE OF PERSONALITY, AND THEREFORE IN PRACTICE ON THE AUTHORITY OF PERSONALITY, BUT IN THE POLITICAL SPHERE TO DENY THE AUTHORITY OF PERSONALITY AND TO THRUST INTO ITS PLACE THE LAW OF THE GREATER NUMBER - DEMOCRACY."

  3. This is interesting but not for the reason advertised. What you've got here is von Mises describing the theory of prolonged unemployment after a recession due to sticky wages. Back in 1931. Priceless.

    I never cared much for his politics but his insight into markets was generally excellent and far ahead of his time. If you're a post-Keynesian in the usual sense you should know that Minsky's works are full of echoes of von Mises.

    1. (1) so in other words, you are saying that the absurd idea that demand for labour can be reduced to simple movements up and down demand curves is "priceless" and "far ahead of [its] time"?

      (2) I am not sure what the "echoes" of von Mises are in Minsky, but there are fundamental differences which separate Post Keynesianism from Austrian economics.

  4. No, I'm not saying that. I'm saying there is no fundamental difference between von Mises' explanation here of the reason for prolonged unemployment after recession and the later Keynesian theory of sticky wages. The only difference I can see is that the Keynesians expanded the reasons for sticky wages. Labor markets have changed and become more rigid in lots of ways von Mises didn't foresee. We do however still have day laborers waiting in known locations every morning, negotiating their wage for each job - though that's a niche, mostly illegal immigrant market. And the modern solution to GM and Chrysler's woes was for the government to bribe the unions to support two-tiered wages. I'm not sure if von Mises would have approved but it certainly fits his belief that recovery requires a drop in wages.

    Minsky's credit cycle theories are very similar to von Mises.

  5. "Minsky's credit cycle theories are very similar to von Mises."

    I disagree. Aside from the fact that they both hold that money is non-neutral and focus on credit, the differences are significant.

    Mises uses the Wicksellian natural rate of interest; Post Keynesians and Minsky reject such a thing.

    Mises thinks that boom is unsustainable because physical factor inputs are not available. Post Keynesians and Minsky focus on reckless speculation, ponzi financing, and demand failures.

    Mises had nothing to say about asset bubbles: for him the cycle was all about the real capital sector; Post Keynesians stress the destabilising role of bubbles.

    And the list goes on.

  6. Minsky's stages of the credit boom and bust are stages of malinvestment, with ponzi being the most extreme. Asset bubbles are a type of malinvestment. Minsky didn't only know Mises' early texts, he also knew traditions of elaboration.

    Minsky and post-Keynesians did not reject the Wicksellian natural rate of interest. They saw themselves as restoring genuine readings of Keynes after decades of astray interpretations, and rates above natural causing unemployment is central to Keynes' General Theory. I'm not sure it's possible to reject that and still be Keynesian.

    I got to know Austrian theory as an analyst of emerging markets, especially Eastern Europe, where Hayek is widely revered among liberals (as defined there). Some of these people are close to libertarian, but in a very different context, where, for example, it's taken for granted that healthcare should be universal. These people are not fascists. They see fascists and communists as peas from the same pod, which historically is a more accurate view than the standard American way of seeing them as opposites.

    I'm far from a libertarian myself. I read Austrian-inspired financial commentaries now and then, but I've never read any contemporary Austrian theorist. I read von Mises (and Keynes) as history of economics, not as contemporary economics. They lived in a gold standard world and didn't grasp for example how in modern financial systems credit expansions generate their own savings. I'm no fan of imagining an ideal and positing the actual to be deviant for whatever reason. I'm uncomfortable with statements that investment is greater than savings or vice versa - they differ by the current account, period.

    But I can still read von Mises and Keynes and appreciate the points they're making. I think you could understand von Mises too, if you tried. Your arguments against him seem to me to lack substance. What does it mean to reject the existence of a rate that was only ever posited as ideal? Whether it exists or not isn't the point. What matters is whether rates are sometimes disruptively high or low, for the reasons they state. If you get around his akward focus on lengths of production and boil what von Mises said down to its core - that overly rapid money supply growth causes excessive credit growth, overinvestment in fixed capital and unsustainable overconsumption - you'll find all sorts of examples throughout history. Indeed, global financial markets have been roiled for the past two weeks by worries that just such a bust is developing in emering markets.

    1. "Minsky and post-Keynesians did not reject the Wicksellian natural rate of interest. They saw themselves as restoring genuine readings of Keynes after decades of astray interpretations, and rates above natural causing unemployment is central to Keynes' General Theory. I'm not sure it's possible to reject that and still be Keynesian."

  7. Haha! I KNEW Krugman was reading the heterodox blogs...

    1. Congratulations on hitting the big time. Though I disagree with something like 75% of your views, I can't help but admire your diligence and persistence. I also cheer your success in influencing the mainstream as a welcome blow against credentialism.

      if debts remain fixed and wages and prices fall... then it is likely that debtors will face severe problems as their burden of debt soars

      If debt deflation is a large part of the problem, then what would be your criticism of encouraging more indexation of debt (to inflation, or better yet, NGDP)?

      Shiller: "I have proposed (2003, 2009) that nations adopt an indexed unit of account, like the unidad de fomento that was introduced in Chile in 1967 and that remains in wide use there today, that is sanctioned for use in setting prices and writing contracts. By giving an indexed unit of account a simple name, in their case the UF, they make indexation transparent and as easy as not indexing."

      Scott Sumner endorses Shiller's related idea of NGDP bonds (or Trills):

    2. Another approach is "quasi-real indexing," as described by David Eagle (via

      "Our research indicates that aggregate-supply-caused inflation is actually good; only aggregate-demand-caused inflation is bad. Quasi-real indexation filters out the bad inflation while leaving the good inflation intact.

      When all wages, prices, mortgages, bonds, and other contracts are quasi-real indexed; the economy becomes immune to fluctuations to nominal aggregate spending. In this sense quasi-real indexation immunizes an economy against recessions caused by drops in nominal aggregate spending. It also protects workers, employers, lenders, and borrowers from the uncertainties caused by unexpected changes in nominal aggregate spending. Hence, quasi-real indexation improves the economic efficiency of an economy."

    3. Obviously, if debts were really adjusted in this way then debt deflation could be minimised. But how would this system work? Would banks/creditors be legally obliged to recontact debts when prices chagne?

      Anyway, deflation is bad for other reasons, and monetary policy still isn't a reliable way to stimulate AD.

  8. "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."

    Not true, although it may have been well after the depression; he wrote about (debt) deflation in Human Action, if memory serves.

    Also interesting that Mundell (in his Nobel speech?) claims that Mises was one of only a handful of economists to predict the GD.

    That's as far as my defense of the man will go. :)