Steven Horwitz

Lars Christensen's post on Rothbard's America's Great Depression over at Market Monetarist serves as a useful reminder about what the Austrian cycle theory can and cannot do.

Christensen takes issue, as others have over the years, with Rothbard's interpretation of monetary policy in the 1920s. Lars argues that, at best, one could claim that only the period 1925-27 involved any sort of inflation and that the length and degree of that expansionary policy was surely not enough to explain the disaster that followed in 1929. This, along with some other points he raises, leads him to some deep skepticism about the Austrian cycle theory.

Rather than address all of his criticisms, I want to raise one point that I made in the comments over there. Both critics and adherents of the ABCT misunderstand it if they think it is some sort of comprehensive theory of the boom, breaking point, and length/depth of the bust. It isn't. As Roger Garrison has long insisted, the theory by itself is a theory of the unsustainable boom. It is a theory that explains why driving the market rate of interest below the natural rate through expansionary monetary policy produces a boom that contains endogenous processes that will cause that boom to turn to a bust. Again, it's a theory of the unsustainable boom.

ABCT tells us nothing about exactly when the boom will break and the precise factors that will cause it. The theory claims that eventually costs will rise in such a way that make it clear that the longer-term production processes falsely induced by the boom will not be profitable, leading to their abandonment. But it says nothing about which projects will be undertaken in which markets and which costs (other than perhaps the loan rate) will rise, and it tells us nothing about the timing of those events. We know it has to happen, but the where and when are unique, not typical, features of business cycles.

Once the turning point is reached, ABCT tells us little to nothing about how the bust will play out. Yes, we know that further inflation and interventionist attempts to prevent the necessary reallocation of resources will make matters worse, but the theory by itself doesn't tell us a priori how this will play out in any given historical circumstance. The ABCT is not a theory of the causes of the length and depth of recessions/depressions, but a theory of the unsustainable boom.

To turn to Christensen's particular example: the ABCT cannot explain the entirety of the Great Depression. It simply can't. And adherents of theory who make the claim that it can are not doing the theory any favors. What ABCT can explain (at least potentially, if the data support it) is why there was a recession at all in 1929. It argues that it was the result of an unsustainable boom initiated by an excess supply of money at some point in the 1920s. Yes, the bigger the boom, cet. par., the worse the bust, but even that doesn't tell us much. Once the turning point is reached, there's not a lot that ABCT can say other than to let the healing process unfold unimpeded.

In the context of the Great Depression, one has to invoke other theories to explain why the bust, whose onset the ABCT explains, became so deep and so long. And that is where Friedman and Schwartz's work on the 1929-33 period along with awful policies of the Hoover administration, ably documented by Rothbard in AGD and updated in this Cato piece of mine from last year, are required to explain why things got so bad so quickly. These are not parts of the ABCT; they are additional theoretical devices that help us explain the historical evidence.

We can also make use of other work to explain the length of the Great Depression, especially Bob Higgs' work on "regime uncertainty" and other analyses of the interventionism of the FDR era. These can explain why even a recession as deep as the one exacerbated by Hoover and the Fed became a decade-long Great Depression. Here too, these are not Austrian Business Cycle Theory but other devices we need.

The same can be said of the most recent boom and bust, where ABCT can help us explain why the boom was unsustainable and necessitated a bust, but it cannot, by itself, explain why the housing market was front and center and why it turned into a financial crisis as well. Nor can it explain the lingering slow recovery in and of itself. Note that if the ABCT is a theory of the unsustainable boom, then a recession caused by other factors would not invalidate the ABCT - e.g. a monetary deflation that brings on a recession would not invalidate ABCT.

In language that O'Driscoll and Rizzo gave us a few decades ago, the ABCT can explain the typical features of the unsustainable boom, but the unique features require auxiliary theoretical devices along with good, close empirical work to understand all of the institutional factors in play during the cycle in question. (See my papers with Gene Callahan and Will Luther for more on ABCT and the Great Recession. Those have both since been published.)

Friends of ABCT do it no favors when they argue that it is a comprehensive explanation of "the Great Depression" or anything else. It isn't. It also opens the theory up to the sorts of criticisms that Christensen offers. The ABCT is very valuable for explaining what it purports to explain: why excess supplies of money will lead to an unsustainable boom characterized by malinvestment in long-term interest-sensitive production processes. Mises and Hayek and others developed the theory precisely because that sort of boom was typical of those seen in the late 19th and early 20th century.

But it remains a theory of the unsustainable boom. Explaining the unique features of booms and why busts are more or less deep or more or less long, however, requires that we bring other theories into the story to complement the ABCT. Keeping our claims about the explanatory power of the ABCT to a level of modesty consistent with what the theory can and cannot do is both good economics and a good way to protect it from unjustified criticism.