The Great Depression: The Austrian Explanation – Two Wrongs Don’t Make a Right…Except When They Do.

Disclaimer: Economic Theory is not a strong suit of this researcher. This is my understanding of Austrian Economic Theory and its application to the Great Depression’s causes and termination.

The Austrian theory of business apparently begins with the interest rate and relies upon noninterference by outside agencies to ensure a robust economy. 

With higher rates of interests, people will save their funds rather than purchasing items now that may be more expensive than their paychecks can handle – i.e. the people are not willing to get loans to buy or invest now.  The opposite is true for when interest rates go down – the people become willing to get loans/or to buy/invest now with the funds they have or can borrow.  Interest rates therefore effect savings, consumption, and investment opportunities.  In a “natural state,” the people choose to save money, investment goes down based on low consumption; a low interest rate.  If people choose to consume, people will spend less investing, interest is high.  The interest rate ebbs and flows based upon the peoples’ choices.  The Austrian theory sees interference with the interest rate as detrimental to the economy and removing the choice from the peoples’ hands. 

 When central banks manipulate the supply of money or the lending rates, this leads to a negative repercussion for the natural state of interest and the economy overall.  Follow this line for a moment:  The Central Bank arbitrarily raises the interest rate.  How does this effect Real Estate?  Real Estate does not include just land trade, but: construction, and all of its supply chain – wood, metal for nails, concrete, transportation of materials, and labor; furniture, and all of its supply chain – wood, metal, fabrics, chemicals for dyes, and labor; appliances, and all of its supply chain – materials, chemicals, gas, and labor; and the retailers, labor, who sell these items to the consumers (builders or homeowner).  The suppliers and consumers up and down the supply chain.  The complimentary industries matter to the overall picture.  If consumption of Real Estate goes down due to an imposition of a higher interest rate by an outside force, the central bank, the entirety of the complimentary industry suffers from the same lack of sales caused by the higher interest rate.    People no longer buy homes, items for homes, or land because they cannot afford to get loans to buy the product.  The choice was imposed upon them when they were not “ready.”

People no longer buy either the end product or the complimentary products, incomes go down throughout the supply chain.  Suppliers seek to save their own money by reducing labor, leading to less people even having an income.  Leading to even less people either saving (investing) for the future since they have no excess money or having money to spend on items they need – the consumer goods like food, clothing, medical care, etc.  Since people have no money to spend, now industries not even associated to Real Estate becomes negatively affected, leading them to reduce costs by laying people off, leading to less money in circulation, less investment, less purchasing, less demand, i.e. less interest. 

The interest rate should go down because of low consumption and high savings, as people are forced to save to purchase anything.  Because the outside force, the central bank, imposed this arbitrary high interest rate, the peoples’ ability to change the interest rate based upon their purchasing power remains low or nothing, leading to continued inability to purchase, leading to an extended depression of the economy.  The Austrian answer to this problem indicates the removal of the outside force, the central bank and/or government from the equation.  The people, and their choices to consume or save, should set the interest rate.[1]   

So now that I have explained how I understand the theory – how does this theory apply to the Great Depression? 

In 1928, the Federal Reserve raised the interest rate on loans.  This caused banks, especially western banks, to call in their farm loans.[2]  This raising of rates and the calling in of loans causing some of the borrowers to cease buying goods associated to farming, reducing labor cost by not hiring farm hands, and begins to set the stage for saving money.  To curb speculation in the stock market, the Federal Reserve raised the interest rates again in 1929.[3]  The raising of interest rates caused people to preserve their money, not spend, and not hire.  This impacted all sectors of the economy – the farms were first, but few noticed.  When the manufacturers and big businesses on Wall Street took a hit, the impact was much greater upon the economy overall.  National business, instead of simply local businesses, felt the impact.  People across the nation faced the repercussion of money saving measures leading to a cycle of loss after loss.  People needed money to buy household goods still though and began pulling savings (investments) from their holdings – banks and stocks.  This further decreased money available to big businesses leading to further cutbacks on their parts.  This also pulled money from the banks, who in turn sought help from the Federal Reserve as the lender of last resort.  But with interest rates high, the banks could not afford to borrow and so no money made it down to the consumer, the people. 

It took other actions by the government to solve the dilemma.  One of which was the final end of the gold standard and a transition to fiat money – money back by nothing but the government’s word, faith-based money.[4]  This meant the government now printed money without a physical commodity backing the economy.  The only commodity being the faith the people had in their ability to buy the goods they needed or wanted.  The government answered the Great Depression by printing money unattached to any commodity.  To solve the problem of interference by an outside entity, raising the interest rate, the government stepped in, changing the entire economic infrastructure.  Two wrongs according the Austrian Theory.

The Austrian Theory explains a potential cause for the Great Depression: the interference of the Federal Reserve with the interest rates.  An outside force not conducting laissez-faire and letting the market dictate the interest rate.  The Austrian Theory fails to explain the solution of the Great Depression.  It took another (albeit larger) outside force interfering to remove the commodity-based monetary standard and increase the amount of money available to the people.  The government changed the entire economy to fiat money.  Thus, the Austrian Theory provides only evidence proving outside interference in the market can ruin the market.  The Austrian Theory seems to imply once the interference has been conducted the market will adjust to the “new normal” without further interference from outside forces.  This explanation of a corrective action fails to prove its point in the face of historic evidence.  

When you think about it, fiat money based economies should reflect the ultimate application the Austrian Theory. Faith in money is a personal choice. Using it is a personal choice. Saving it, the same. Fiat technically puts the money, and the economy, directly in the hands of the people. Their level of interest would establish the rates of exchange, leading back to the basis of the Austrian Theory, interest.

[1] Fred E. Foldvary, “The Austrian Theory of the Business Cycle,” American Journal of Economics and Sociology vol 74, no.2 (March, 2015), pp. 278-297.  

[2] “Lenroot Pleads Republican Cause Speech Here; Raps Gov. Smith for Lack of Knowledge of Issues,” Leader-Telegram, October 23, 1928, https://www.newspapers.com/image/267111131/?match=1&terms=%22federal%20reserve%20board%20raise%22

[3] “Here and There,” Goldendale Sentinel, September 5, 1929, https://www.newspapers.com/image/944546482/?match=1&terms=%22federal%20reserve%20board%20raise%22.

[4] James Chen, “Fiat Money: What It Is, How It Works, Example, Pros & Cons,” Investopedia.com, updated July 2, 2024, https://www.investopedia.com/terms/f/fiatmoney.asp.