Getting The Great Depression (Almost) Right, And Totally Wrong – OpEd


By Joshua Mawhorter

There are others, besides the Austrians, who acknowledge the crucial role of monetary policy and even blame the Federal Reserve for the Great Depression. Some scholars, which we can greatly appreciate, even go so far as to rightly criticize Franklin D. Roosevelt’s New Deal policies for prolonging the Great Depression: Jim Powell’s bookFDR’s Folly, Burton Folsom’s book New Deal or Raw Deal?, and the scholarly work of University of California, Los Angeles economists Harold L. Cole and Lee E. Ohanian “How Government Prolonged the Great Depression.”

Economists from Paul Krugman to Milton Friedman critically misdiagnose the causes of the Great Depression, even if they rightly blame the Fed and government. They, and many others, simultaneously diagnose the cause of boom-bust cycles correctly and incorrectly; they blame the right thing for the wrong reasons. For example, in a book unironically titled The Return of Depression Economics, Paul Krugman writes, “Nowadays practically the whole spectrum of economists, from Milton Friedman leftward, agrees that the Great Depression was brought on by a collapse of effective demand and that the Federal Reserve should have fought the slump with large injections of money.”

Krugman, too, may be incorrect on the causes, but he is basically correct about the fact that the consensus of many mainstream economists regarding the Depression is that it was caused by monetary contraction and because the Federal Reserve failed to inflate enough. This is the critical error made by most mainstream economists.

Milton Friedman: The Chicago-Monetarists

In praise of Milton Friedman’s legacy, especially his contributions toward the study of the Great Depression, Ben Bernanke once admitted, “Regarding the Great Depression. You’re right, we [the Federal Reserve] did it. We’re very sorry. But thanks to you, we won’t do it again.” While this is a stunning admission, Bernanke is merely acknowledging the Fed’s fault in the Depression regarding the raising of interest rates and contractionary monetary policy, not the expansionary monetary policy which caused the artificial boom in the first place. Monetary contraction and lowering interest rates were only the proximate cause of the Depression, not the ultimate cause.

Milton Friedman and Anna Schwartz, coauthors of the invaluable bookA Monetary History of the United States, 1867–1960, believed that the Fed should have continued expansionary monetary policy and lowering interest rates. In other words, the Fed just didn’t inflate enough. Friedman argued that the Great Depression was caused by the Fed’s monetary contraction and that the proper monetary policy would have been to continue to expand money-credit to continue to lower interest rates: “The contraction is in fact a tragic testimonial to the importance of monetary forces. . . . Prevention or moderation of the decline in the stock of money, let alone the substitution of monetary expansion, would have reduced the contraction’s severity and almost as certainly its duration.” (italics added)

Jim Powell: FDR’s Folly

Most other non-Keynesian economists, especially conservatives, have generally followed Friedman, but that means they often followed him in his errors. For example, Jim Powell blames the Fed for similar reasons as Friedman: “These Federal Reserve policies began a monetary contraction. As the contraction became more severe, it brought on a depression in output, employment, and income. If nothing else had happened, there would have been a depression because of the severe monetary contraction” (italics added).

Powell continues, “The bank holidays and the monetary contraction were embarrassing indictments of the Federal Reserve System, which had been established November 16, 1914, to keep America’s financial system going even in bad times” (italics added).

Again, only monetary contraction is blamed rather than artificial-inflationary monetary expansion necessarily followed bymonetary contraction. Powell notes Friedman’s critical role in identifying the importance of identifying monetary causes in business cycles: “Meanwhile, Friedman seems to have convinced most economists that changes in the money supply have at least some influence on changes in the economy, even if not everybody considers money the most important single factor.”

Austrians, too, recognize the vital importance of the role of money and credit in business cycles. In fact, it is key to Austrian business cycle theory. But the Austrian economist has a different definition of money, the money supply, inflation, and the role of inflation in a business cycle.

Burton Folsom: New Deal or Raw Deal?

Folsom wrote, “The Fed, which was created to prevent a banking crisis, helped create one.”

Austrians would generally agree on this statement devoid of context; however, they would not agree on the reason for the statement as to how the Fed contributed to the Great Depression. In this one phrase, Folsom is correct. However, he blames the right thing for the wrong reasons. Folsom begins his analysis too late, only focusing on the monetary contraction and nonintervention of the Fed:

In practice, the Fed had raised interest rates four times, from 3.5 to 6 percent, during 1928 and 1929. That made it harder for businessmen to borrow money to invest, which hindered economic growth. This contributed to the October 1929 stock market crash, the race by customers to get their money out of their banks, and the closing of many banks. In the early 1930s, the Fed dithered and let the runs on banks continue. (italics added)

Folsom continues,

The Federal Reserve could have slowed or possibly even halted this crisis by lending money to cash-hungry banks. Instead the Fed let the runs continue; it let hundreds of banks collapse. And by 1932, the quantity of money in the United States had fallen by about one-third in three years. The money, like the unpaid loans, simply vanished. As banks failed, their assets disappeared. Many advisors in the Federal Reserve system urged the Fed to intervene, but they did not prevail; the Fed, which was created to prevent a banking crisis, helped create one. (italics added)

By beginning the analysis only at the bust rather than the expansionary boom, many economists and economic historians miss the decade of inflationary monetary expansion and Fed intervention prior to the Depression.

Neoclassical: Harold L. Cole and Lee E. Ohanian

In their economic-historical research, economists Cole and Ohanian determined that not only was there no vigorous recovery as had been the case in previous cycles, but that the New Deal actually prolonged the Great Depression. This is a bold break with the standard retelling of the Great Depression and the New Deal. They ask a crucial question which they are willing to face honestly: “Why wasn’t the Depression followed by a vigorous recovery, like every other cycle?”

While insightful and informative in their critique of the New Deal and demonstrating the empirical validity of the claim that these programs hampered the hoped-for recovery, Cole and Ohanian’s reasons as to why they think there ought to have been a vigorous recovery are questionable at best. For example, they summarized their position in the Wall Street Journal in 2009:

Why wasn’t the Depression followed by a vigorous recovery, like every other cycle? It should have been. The economic fundamentals that drive all expansions were very favorable during the New Deal. Productivity grew very rapidly after 1933, the price level was stable, real interest rates were low, and liquidity was plentiful. We have calculated on the basis of just productivity growth that employment and investment should have been back to normal levels by 1936. Similarly, Nobel Laureate Robert Lucas and Leonard Rapping calculated on the basis of just expansionary Federal Reserve policy that the economy should have been back to normal by 1935. (italics added)

Rightly, Cole and Ohanian note that there ought to have been economic recovery from the Great Depression sooner rather than later but for the imposition of the New Deal. They correctly observe that the prolongation of the Great Depression was the outlier or anomaly among other depressions and economic recoveries, therefore identifying the key difference in the massive government response from the Hoover-Roosevelt administrations as the unique variable that hampered recovery.

Incorrectly, however, they identify certain “fundamentals” of economic growth—a stable price level, (artificially) low interest rates, plentiful “liquidity” (credit/fiduciary media), and expansionary Federal Reserve policy. The expectation that these are the indicators of stable economic growth betrays a fundamental misunderstanding (or lack) of capital theory, the structure of production, the role of money and prices, the role of credit, the role of inflation, and business cycles.

All these names, like the Austrians, have acknowledged the role of the United States government and Federal Reserve in the Great Depression, but unlike the Austrians, they blame contractionary monetary policy alone rather than expansionary monetary policy necessarily followed by contractionary monetary policy. While we can benefit from these contributions to the extent that they continue to misdiagnose the causes of the Great Depression, they will continue to arrive at the false cure and actual cause of the disease—inflationary monetary policy.


The Mises Institute, founded in 1982, teaches the scholarship of Austrian economics, freedom, and peace. The liberal intellectual tradition of Ludwig von Mises (1881-1973) and Murray N. Rothbard (1926-1995) guides us. Accordingly, the Mises Institute seeks a profound and radical shift in the intellectual climate: away from statism and toward a private property order. The Mises Institute encourages critical historical research, and stands against political correctness.

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