One thing will be agreed upon by all libertarians: that the Great Depression and subsequent ‘Great Recession’ were caused by government. However, this is where the agreement ceases; there are monetarist libertarians who say that the cause was ‘government inaction’ and a failure to inflate the money supply whereas the Austrian school libertarians will say that the cause of a recession is the inflation of the money supply during the boom. I am of the latter persuasion and I’m rather concerned that more people are not. Indeed, many readers of this site are monetarists, as was indicated when 33 people ‘liked’ it when our Facebook page posted a video of Milton Friedman’s explanation of the Great Depression.

To begin, I will briefly attempt to explain Austrian business cycle theory and then I will quote an article of Mark Thornton, senior fellow of the Mises Institute, on how to avoid another depression.

ABCT (Easy as One, Two, Three)

With the Austrians, the explanation of a downturn starts a little earlier than the conventional explanations. The Austrian school states that the problem starts with the boom period itself and that the longer it goes on for, the more severe the bust will be. Central to an understanding of the theory is an understanding of money, credit and the role of interest rates as co-ordinators of different people’s time preferences - if you borrow money, you have a higher time preference for money and if you save money then you have a lower one.

The role of interest rates is to harmonise consumption and investment in the economy. In a proper functioning economy, interest rates are high enough to get people to save money, and low enough to allow people to borrow money. If all is well, if rates are at an ‘equilibrium’ rate, then, to put it very plainly, there won’t be ‘too much’ consumption or investment - or ‘unsustainable patterns’ of them.

Interest rates have another important role: they indicate to entrepreneurs whether they can invest in projects for the future, or not. If people are saving lots of money, then that implies that they will spend money in the future - this is indicated by a low interest rate - and entrepreneurs will then be able to borrow money and facilitate their future demand rather than present ones. If interest rates are high, then conversely, people are spending all their money now and the banks are trying to get them to save more of it by offering them higher interest - if interest rates are high, then entrepreneurs can’t see any profitability in investing for the future a) because loans aren’t cheap and b) because people are spending their money now.

So, we can see how interest rates should ideally function; we can see how things can go right, now let’s look at how they can go wrong - to paraphrase Hayek himself. Central banks aren’t in the business of setting ‘equilibrium’ rates, they instead try to aim for arbitrary rates of inflation or unemployment. This can mean that the rates are too high or too low, generally they set them too low. Why? Because lower interest rates means a) higher consumption as the incentive to save is gone b) more investment in projects that will pay off in the future as loans are cheaper. This leads to higher prices across the economy as consumers and investors are both spending more, and in an unsustainable way. Capital goods like oil will rocket in price as present consumption is higher and investment in oil-related projects is also up - the supply of oil has not increased.

Eventually, the bust comes. When entrepreneurs think that their projects will pay off, they don’t as people weren’t saving their money for the future. Instead, the investments undertaken in the boom will fail and a period of re-adjustment is necessary to ensure that it doesn’t happen again. A good analogy is one of a builder: he believes he has 20,000 bricks and he plans accordingly. In fact, he has 19,000 bricks, but the keynesians and monetarists would wait until the last minute to tell him this whereas the Austrians would make sure that he knew from the start how many bricks were available thus saving him the time and effort, and money, that would otherwise be wasted.

Now I will share a nearly 5 year old article by Mark Thornton which I believe is just as relevant to the present day and to the UK as it was to the US in 2008. He gave the site the permission to share this article:

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How to Avoid Another Depression

“Great Depression” is a strong term, but what exactly does it mean? Depressions are a normal part of a business cycle that are now often called recessions, downturns, or corrections. They occur in any economy where the financial markets are based on fractional-reserve banking.

Depressions only become “great” when normal to severe depressions are used as excuses for massive increases in government intervention. Murray Rothbard’s America’s Great Depression clearly demonstrates this phenomenon. The three great depressions in the history of the United States are the Progressive Era (1907–1922), the Great Depression (1929–1945), and the Great Stagflation (1970–1982).

The year 2008 marks the beginning of the next recession, correction, or depression. All the statistical indicators are pointing in that direction. All market indicators point in that direction as well. Ask any noneconomist and you will get that same answer. We only have to wait for the folks at the National Bureau of Economic Research to officially confirm what we already know.

The reason for the depression is the bust in the housing market — we all know that too. Austrians reported on the housing bubble throughout the boom. Beginning in early 2003, Frank Shostak, Christopher Meyer, Lew Rockwell, Robert Blumen, Jeff Scott of Wells Fargo Bank, and others, including this author, were writing and lecturing about the housing bubble. We identified the cause of the bubble as the Federal Reserve and its inevitable consequences of a bust in the housing market and the overall economy.

Homebuilder stocks peaked in mid-2005 and it’s been like watching a train wreck in slow motion ever since. When the overall stock market peaked one year ago we could finally celebrate the beginning of the correction phase of the business cycle even though most of us suspected it would be a severe one. Several mortgage dealers went bankrupt in 2007 and the increased number of foreclosures signaled that the correction was finally under way.

By late 2007 there were definite signs of major corrective forces acting in financial markets. However, whenever such corrections seemed to be ready to take place they were circumvented by government intervention. On December 12, 2007, the Fed announced the Term Auction Facility which would auction reserves at the Discount Window for a “broader range of counterparties” and against a “broader range of collateral” than open-market operations and without identifying the borrowers. This was the first extraordinary intervention.

Then in March, Paulson and Bernanke orchestrated the weekend purchase of Bear Sterns by J.P. Morgan, providing Morgan with a $30 billion, ten-year loan. This certainly was an extraordinary intervention. It also helped set a pattern of intervention that sends exactly the wrong signals to the market. Government officials at the Fed, Treasury, and elsewhere have been telling us that everything is fine in the economy and then, when bad economic news is announced, they claim that “it’s not as bad as we anticipated.” Then, when markets react to this misinformation, government comes in with some massive bailout in the form of a brand new, extraordinary intervention.

In July, Secretary Paulson told Congress that he saw no need for additional legislation to address problems at Fannie and Freddie and then, less than one week later, he announced that the Treasury would “backstop” the two megamortgage lenders. This essentially reversed what Treasury secretaries have been saying for decades, that they do not stand behind or guarantee the securities and debts and obligations of these government-sponsored entities.

Now an even more radical step by the Treasury has essentially nationalized Fannie and Freddie. Of course this does not help troubled homeowners or prospective buyers. It does not help homebuilders. Essentially, it hurts all those people because it puts them as taxpayers at risk for several trillion dollars in potential losses.

Most commentators think this takeover of Fannie and Freddie was the right thing to do: unfortunate, but necessary to prevent a financial crisis. This is all wrongheaded. It might delay a financial crisis, but it only makes the overall economic crisis even worse. History has well demonstrated that government intervention only lengthens the economic crisis and increases its overall cost. Just ask the Japanese about their experience.

Given the extraordinary nature of interventions that have been taken so far and the precedents that have been set, we have all the makings of the next great depression.

In the absence of all these government interventions, it is likely that the corrective phase of the business cycle would already be over and we would be in recovery mode. To be sure, housing would remain in a slump for some time to come, but restorative market forces would already be at work creating the next generation of companies and jobs.

If we want to avoid the next great depression, all such government interventions should cease. The Treasury Department should revise their recent action and turn their proposed conservatorship of Fannie and Freddie into a bankruptcy receivership that would ultimately liquidate the corporation and their liabilities. Meanwhile the Fed should announce its intent to stop Term Auction Facilities and close the discount window to all but its traditional customers. To reduce the negative impact of the recession, government should cease foreign hostilities, reduce military spending, balance the budget, and cut taxes and regulations.

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The above article, from 10th September 2008, can alternatively be read here.