The Great Depression formally began in August 1929, two months before Black Tuesday. Initially, the economic downturn that began late that Summer gave no signs that it was the start of what was to become – and, so far, remain – the greatest economic calamity in United States history.
Just a decade earlier there occurred another severe downturn, described by Milton Friedman and Anna Schwartz as “one of the most rapid declines on record.” The 1920-1921 downturn witnessed a fall in industrial production, from its peak in January 1920 to its trough 14 months later, of 33 percent. In contrast, in the first 14 months of the Great Depression industrial production fell by ‘only’ 24 percent.
Yet despite its severity, the 1920-21 downturn is today largely forgotten. Indeed, the financial writer James Grant calls that downturn the “forgotten depression” – reasonably so because that deep downturn was quickly followed by a rapid and full recovery. The Great Depression, in contrast, is of course anything but forgotten. Despite a formal recovery in 1933, the US economy remained mired in severe depression until at least the US entered WWII.
Why did the Great Depression, unlike earlier downturns, become unprecedentedly bad? And why did it last so long?
The best answer to the first question was supplied by Friedman and Schwartz, who documented the Federal Reserve’s disastrous policy of allowing the money supply to contract by more than 30 percent between 1929 and 1933. Calling it “the Great Contraction,” Friedman and Schwartz identify this collapse of the money supply as the chief cause of the US economy sinking so very deeply into depression in the early 1930s.
Regime Uncertainty
The answer to the second question is less well-known than the Friedman-Schwartz answer to the first question, but it is no less compelling. That answer was given by Robert Higgs in his research into what he calls “regime uncertainty,” which Higgs defines as “the likelihood that investors’ private property rights in their capital and the income it yields will be attenuated by further government action.” Franklin Roosevelt’s and the other New Dealers’ hostility to free markets fueled both rhetoric and regulations that scared investors. Unlike the downturn of 1920-1921, which Grant described as “America’s last governmentally unmedicated depression,” during the Great Depression, the sick patient was aggressively treated by quack physicians. Both Herbert Hoover and, especially, FDR oversaw a hyperactive, highly intrusive government. Would contractual obligations be upheld? Would tax rates become so high, and regulatory burdens so heavy, as to drain potential profits from risky investments? Would property rights be respected? When investors are haunted by such concerns, they remain on the sidelines.
Higgs marshals data and other evidence to make a case that investors were indeed haunted by such concerns throughout the 1930s. They remained on the sidelines, thus preventing recovery. (Higgs also argues that recovery didn’t come until after WWII. But that’s a tale for another time.)
As noted above, Higgs’s account of the reality and role of regime uncertainty is compelling. But it raises this question: If investors are put off by uncertainty stirred up by government, might they also be put off by the uncertainty that naturally inheres in an entrepreneurial market economy?
Investors care about the expected returns on their investments, p x R – where p is the probability of reaping a return of R. Investors shouldn’t care about what particular events cause p to rise or fall. As Higgs documents, p might be reduced by government intervention. But p might be reduced also by economic occurrences such as increasingly rapid technological innovation that renders investments in specific forms of capital goods obsolete. A 25 percent chance of an investment losing 40 percent of its value next year due to government intervention is no worse for investors than a 25 percent chance of an investment losing 40 percent of its value next year due to an unanticipated technological innovation. At first glance, it appears as if the latter prospect should stifle investment spending no less than does the former.
Mainstream neoclassical economics essentially assumes this problem away by refusing to incorporate entrepreneurship into its analysis. With no entrepreneurship, there’s no genuine innovation. And with no innovation, there’s no real change generated within markets. The future isn’t perfectly predictable, but it’s sufficiently discernible to allow market participants to reliably estimate the probabilities of each of the various possible outcomes. In a neoclassical economy, there is regime risk, but no regime uncertainty. Able to attach probability estimates to all possible outcomes, market participants can fully plan for the future.
Market Uncertainty
Yet, of course, entrepreneurship not only exists in real-world markets; it’s an essential feature of modern capitalism. And because entrepreneurs unleash real change – change that’s unforeseeable – entrepreneurs unleash real uncertainty. Why is it the case, then, that the uncertainty that’s necessarily part of free, open, entrepreneurial markets does not discourage investment while the uncertainty that is necessarily part of a hyperactive interventionist state does discourage investment?
Part of the answer is that market uncertainty might well spook some investors in the same way as does regime uncertainty. Yet if even a small number of investors remain confident that consumers will embrace the entrepreneur’s better mousetrap, he gets the funding — and humanity gets a better mousetrap (sorry, mice!).
Is market uncertainty more likely than regime uncertainty to leave at least some investors sufficiently unfazed that funding will continue to flow to entrepreneurs and businesses that put it to productive, pro-growth uses? Seems so.
Market uncertainty is uncertainty about how private economic actors – consumers, business executives, entrepreneurs, and investors – will spend their own money. In contrast, regime uncertainty is uncertainty about how government officials will spend other people’s money. The relevance of this distinction is found in the fact that the range of actions that a person will plausibly take is significantly narrowed by tightly tying that person’s material well-being to the actions that he decides to take. These actions thus become more predictable than they would absent such a tie. To use an extreme example, I might get great satisfaction by publicly proclaiming a belief that magic crystals outperform modern medicine at curing people of injuries. But if my child is seriously injured in an automobile accident, I’m likely to bring my child to a hospital rather than to a new-age healer. And you, as an outside observer familiar with human nature, will predict my response with great confidence.
Being human themselves, as well as being participants in the market, investors can with some confidence distinguish opportunities that have plausible prospects of being successful (the parent’s use of modern medicine) from prospects that are implausible (the parent’s use of magic healing crystals). Choosing only among plausible investment opportunities, investors thereby reduce their exposure to market uncertainty. The five-to-ten-year future created by genuine consumer and entrepreneurial choice, while open-ended, isn’t wholly unpredictable.
Much more difficult is the attempt to predict the actions of people whose personal, material self-interests are not very much affected by the decisions they make. Modern government officials do not put their own personal material welfare at risk when making decisions that affect millions of strangers. And so government officials sincerely committed to an ideological agenda hostile to markets can pursue that agenda largely on other people’s dimes – as, for example, Donald Trump and Peter Navarro are doing today with their agenda of protectionism.
And if the climate of public opinion also features hostility toward commerce and creative destruction, even the constraints posed by the need for reelection become a positive inducement to destructive assaults on free-market activities. The range of government interventions that might undermine the security of property and contract rights is thus very wide, bounded not by the relatively tight constraints imposed by private interests but, instead, only by the imaginations of ideologically motivated officials and voters.
Not only is the range of potential government interventions that threaten the value of private investments wider than is the range of market activities that threaten the value of private investments, but the duration of destructive government interventions is longer. No one likes to discover that he made a mistake. But recognition of mistakes is faster among market participants than among government officials. The reason is that the more quickly market participants recognize their errors, the more they save of their own money. The entrepreneur who was confident that consumers would have a high demand for anchovy-flavored breakfast cereal will be embarrassed to learn of his error, but even more eager to reverse course from that error.
In stark contrast to private market actors, government officials are not only less likely to recognize their errors quickly but also, even when such recognition dawns on them, less likely to act quickly to correct these errors. After all, continuing with erroneous policies generally costs the government officials responsible for those policies personally very little. But also at work is an even more perverse incentive: government officials – again, spending other people’s money – often have incentives to double down on their errors.
For politicians to admit failure as quickly as failure is admitted by market actors is for politicians to expose themselves as ordinary human beings and, thus, as individuals different from the secular saviors they were portrayed to be on the campaign trail. Able for a time – hopefully, at least to the next election – to paper over with other people’s money the ill consequences of misguided polices, too many politicians persist with bad policies or even to pursue these policies more intensely. When such policies threaten the security of property and contract rights – as in practice many do – investors rationally predict that these destructive policies will be kept in place indefinitely and perhaps even expanded. In such a political environment, private investment is naturally unattractive.
Uncertainty is an inherent part of economic activity. And both modern governments and modern markets intensify it. But only the uncertainty unleashed by governments results in a net decline in productive investment. It did so in the 1930s and will do so in the future if government’s discretionary power isn’t reined in.