Most monetary economists, particularly those of the Austrian School, have observed the relationship between the supply of money and the pace and sustentation of economic activity. When the central bank increases the supply of money and credit, i.e., generates inflation, interest rates initially fall. Businesses invest this “easy money” and a boom, particularly in the capital goods sector, commences. As the boom matures businesses’ costs increase, interest rates readjust upward and profit margins are squeezed (see Interest Rates, Corporate Debt and the Business Cycle). These effects of central banks’ easy-money policy subsequently dissipate; and the monetary authorities, fearing price inflation, slow the growth of – or even contract – the money supply. In either case, the manipulation of interest rates distorts or falsifies price signals sufficiently to remove the shaky supports underlying the boom (see Inflation and Deflation: Some Dissenting Thoughts for Value Investors).

This crude outline of the business cycle applies (albeit imperfectly) to the late 1920s, late 1990s and other boom-bust sequences (see in particular Great Myths of the Great Depression by the Mackinac Centre for Public Policy). Hence the most fundamental (but hardly the sole) causes of the excesses of the business cycle, including the Great Depression, are fractional reserve banking and central banks. Murray Rothbard’s America’s Great Depression (1963, 2000, Ludwig von Mises Institute, ISBN: 0945466056) is perhaps the most thorough and meticulously documented account of the inflationary actions of the U.S. Federal Reserve during the 1920s. Using a broad measure that includes currency, demand and time deposits, Rothbard estimated that the supply of money in the U.S. grew more than 60 per cent between mid-1921 to mid-1929.The breakneck expansion of money and credit constitutes what Benjamin Anderson (Economics and the Public Welfare: Financial and Economic History of the United States, 1914-1946, Liberty Fund, 1937, 1980, ISBN: 091396669X) called “the beginning of the New Deal.”

During the 1920s, American monetary authorities actively manipulated the business cycle. They sought to stimulate a boom at home and to assist the Bank of England’s desire to maintain the £ at the rate of exchange that prevailed before the First World War. The resultant flood of credit depressed interest rates, inflated the prices of securities to unprecedented levels and unleashed the “Roaring Twenties.” Producers and consumers made merry, and the Federal Reserve helpfully spiked the punch.

Rothbard shows how the relatively stable prices of the 1920s to a great extent masked the Fed’s inflation and thereby induced many people to think that the gilded prosperity could continue indefinitely. At the same time, technological advancements and entrepreneurial discoveries introduced cheaper ways to produce better goods for more people. This veritable explosion of productivity counteracted much of the upward pressure upon prices generated by the Fed’s policy of inflation. Alas, the distortions and “malinvestments” fostered by the inflation of the money supply cannot continue indefinitely. Every artificial expansion of money and credit introduces imbalances in economic relationships that send false price signals, induce a cluster of entrepreneurial and consumer error and thus set the stage for the downward leg of the business cycle (see, for example, Is Australia Really a Low-Inflation Country?).

This fall is made worse when, by the process outlined in Part III, an increase of the money supply is succeeded by a sudden and severe contraction.In 1928, the Federal Reserve began to raise interest rates. Its discount rate (the rate charged to member banks for short-term loans) was increased four times, from 3.5 per cent to 6 per cent, between January 1928 and August 1929; and for the next three years it presided over a reduction of the money supply of approximately 30% (see also Milton Friedman and Anna Schwartz, A Monetary History of the United States, 1867-1960, Princeton University Press, 1971, ISBN: 0691003548; and Allan H. Meltzer, A History of the Federal Reserve: Volume 1: 1913-1951, University of Chicago Press, 2003, ISBN: 0226519996). Such a sharp deflation, following so quickly on the heels of the previous inflation, wrenched the economy from tremendous boom to colossal bust. A few analysts contend that the Fed intended this dreadful deflation, but most believe that it badly miscalculated. The result in either case was a manifest failure of monetary policy.

Yet the length and severity of the Great Depression cannot be laid solely at the feet of central bankers: they had much help from politicians. Rothbard’s America’s Great Depression details the many errors of Herbert Hoover (president from 1929 to 1933). His successor, Franklin D. Roosevelt, continued and compounded Hoover’s blunders. FDR was one of the first major political leaders to derive many of his most senior advisers from prestigious academic institutions. These intellectuals rejected the nineteenth century inheritance of black letter law, small government, laissez-faire and the gold standard. Instead, they believed that the U.S. should become a collectivist democracy and therefore that it should embark upon an extensive and intensive program of national economic planning and administrative discretion.

The presidential election campaign of 1936 and the years 1936-1941 introduced overt class warfare into American politics (see also John T. Flynn, The Roosevelt Myth, Fox & Wilkes, 1948, 1998, ISBN: 0930073274 and Thomas Fleming, The New Dealers’ War: FDR and the War Within World War II, Basic Books, 2002, ISBN: 0465024653).

Roosevelt’s acceptance speech for the Democratic nomination was widely regarded as a declaration of war against free enterprise. He charged that “economic royalists” were attempting to regain the power they had held until the Depression, and that at every step they were blocking and negating the needed reforms he proposed. FDR’s strategy was to gain the support of workers, farmers and blacks (where they could vote). His tactics included attacks on “big business” and “organised money.” Roosevelt’s 1936 campaign tended to divide and generate fear among the public. The Democratic candidates for president in 1924 and 1928, John W. Davis and Al Smith respectively, publicly deserted FDR and supported his Republican challenger. So too did Roosevelt’s first director of the budget. FDR’s strategy, tactics and policies had very unfortunate economic consequences.

According to Gene Smiley, “the primary explanation for [America’s] slow recovery can be found in the concept of ‘regime uncertainty.’ Especially from 1935 on, the New Deal ravaged the confidence of businessmen. As they became less and less certain that private property rights in their capital and its income stream would be protected and maintained – in other words, uncertain about the continuation of the current ‘regime’ of private property rights – they became less and less willing to make investments, especially longer-term investments in structures and long-lived machinery. Increasingly, only short-term investments with quick payoffs were viewed as desirable. Threats to private property rights may come from many sources, including tax increases, new taxes, confiscation of private property, and business regulation that reduces an owner’s rights over property.”