What can we do? 

Robert Murphy demonstrates in this excellent book a penetrating ability to explain the essence of fallacious economic doctrines. As he notes, three theories offer competing explanations of the Great Depression: the Keynesian account, which stresses a lack of aggregate demand; Milton Friedman's monetarism, which ascribes the severity of the early years of the Depression to a drastic cut in the money supply by the Fed; and, of course, the Austrian theory that Murphy himself favors.

Herbert Hoover, though not under Keynes's influence, defended a version of the first theory. If wages were not kept high, purchasing power would be insufficient to restore prosperity. Accordingly, Hoover encouraged businesses to refrain from wage cuts.

Murphy quickly exposes the fallacy of this view:

High wages do not cause prosperity, they are rather an indication of prosperity. Ultimately, it doesn't matter how many green pieces of paper employers hand out to workers. Unless workers first physically produced the goods (and services), there will be nothing on the store shelves for them to buy when they attempt to spend their big fat paychecks. (p. 35, emphasis in original)

But, it may be countered, is not the level of production and employment determined by aggregate demand? Granted that prosperity requires real goods, will not businessmen decide how much to produce based on what they think they will be able to sell? If so, is not the problem in a depression that, forecasting that future demand will be low, they cut back production?

Murphy once more locates the fundamental fallacy. The problem in a depression is not that production is in general too low; it is rather that resources have not been put to their best uses and need to be shifted:

By focusing on aggregate monetary conditions such as "total wage payments," Hoover completely overlooked the fact that real, physical resources had to be rearranged in order to correct the imbalances in the economy. It wasn't that "business" was producing too much, but rather that some sectors were producing too much, while other sectors were producing too little, in light of the economy's supplies of resources, the skills and desires of its workers, and the tastes of its consumers. (p. 37)

Once more, Murphy holds that we need to concentrate on the physical goods rather than on total monetary demand.

The only way to rectify the situation — to transform the economy into a sustainable configuration — was to shuffle workers and resources. Some enterprises had to be shut down immediately, releasing their workers and freeing up the raw materials they would have consumed had they remained in business… But in a market economy, workers are free to choose their occupations, and the owners of raw materials can sell their property to whomever they desire. Yet with that freedom comes the unfortunate necessity of prolonged spells of unemployment and "idle resources," when the workers and raw materials are searching for a new home in the complex economy. (pp. 37–8)

Murphy dispatches the monetarist view with similar directness and ease. Here, if anything, his remarks are of even more vital significance, since Fed Chairman Ben Bernanke firmly embraces the monetarist account of the Great Depression.

He finds a simple way to illustrate the fallacy of the mainstream analysis of deflation. According to this view, if people anticipate falling prices, they will refrain from spending. Because they expect prices to fall, they think that that will do better to consume later. But this drop in consumption causes a further price fall, and the whole cycle repeats. Prices may spiral uncontrollably downward.

Murphy responds in this way:

One could construct an analogous argument for the computer industry, in which the government passes regulation to slow down improvements in operating systems and processing speed. After all, how can computer manufacturers possibly remain viable if consumers are always waiting for a faster model to become available? … The solution to this paradox, of course, is that consumers do decide to bite the bullet and buy a computer, knowing full well that they would be able to buy the same performance for less money, if they were willing to wait… (There's no point in holding out for lower prices but never actually buying!) (pp. 68–9)

Murphy's ingenious response can also be applied to combat George Akerlof's famous lemons model of the used-car market. Akerlof argued that because of asymmetric information, owners of good used cars would tend to be driven from the market. But, contrary to what his model suggests, good used cars do get sold. In like fashion to Murphy, one can say that just because owners of good cars may not be able to obtain as high a price as they would like, it does not follow that they will refuse to sell at all.

It might be helpful to add the "real balance effect" to Murphy's account. As prices fall, the value of money rises. People's demand to hold money can then be satisfied with less money. This in part explains why people will eventually spend, even when they expect prices to continue to fall.

Keynesians will object that even if spending does eventually revive, the process takes too long. People cannot be expected to wait until the market rights itself. But this is to ignore Murphy's vital point. The process of adjustment is just what is needed: a depression is exactly a situation in which bad investments are liquidated and resources moved elsewhere.

Murphy uncovers another flaw in the conventional assault on deflation. Money that is not spent need not be hoarded, as the opponents of deflation implicitly assume:

Many analysts who are terrified of deflation stress that in an environment of falling prices, cash stuffed under the mattress earns a positive return. This observation is certainly true, but nonetheless cash lent out earns an even greater return. Falling prices, then, encourage consumers to devote more of their income to savings, which in turn lowers interest rates and allows businesses to borrow and invest more. (p. 69)

As the author abundantly shows, historical evidence strikes decisive blows against both the Keynesian and monetarist theories. On the Keynesian account, increased spending, by reviving aggregate demand, will restore good times. If so, why did Hoover and Roosevelt's massive spending leave America mired in depression? To call Hoover a big spender may surprise many readers, but Murphy notes that there is no room for doubt:

Hoover's response to the stock market crash was an enormous increase in government spending, with the budget exploding by 42 percent over his first two years … it is true that Hoover blinked and tried to tame the unprecedented (at the time) peacetime deficits. But this was only after the "stimulus" approach failed horribly. (p. 48)

Keynesians will reply that government spending should have been even greater; but this is to add an epicycle to shore up a failed theory.

Murphy turns the tables on Milton Friedman, who emphasized statistical evidence, by showing that monetarism fails to explain the data.

So we see that immediately following the stock market crash, the Fed began flooding the market with liquidity and in fact brought its rates down to record lows…. If the ostensible cause of the Great Depression — the one factor that set it apart from all previous depressions — was the Fed's unwillingness to provide sufficient liquidity, then how could it possibly be that the Fed's recordrate cuts proved inadequate to solve "the problem?" (pp. 76–7)