Below is an extract from a commentary originally posted at www.speculative-investor.com on 9th October, 2008.

In an essay first published in 1969 and recently re-published at http://mises.org/story/3127, Murray Rothbard summarises the causes and cures of economic depressions by drawing on the Business Cycle theory developed by the great Austrian economist Ludwig von Mises. Here's an excerpt from this essay:

"Mises, then, pinpoints the blame for the cycle on inflationary bank credit expansion propelled by the intervention of government and its central bank. What does Mises say should be done, say by government, once the depression arrives? What is the governmental role in the cure of depression? In the first place, government must cease inflating as soon as possible. It is true that this will, inevitably, bring the inflationary boom abruptly to an end, and commence the inevitable recession or depression. But the longer the government waits for this, the worse the necessary readjustments will have to be. The sooner the depression-readjustment is gotten over with, the better. This means, also, that the government must never try to prop up unsound business situations; it must never bail out or lend money to business firms in trouble. Doing this will simply prolong the agony and convert a sharp and quick depression phase into a lingering and chronic disease. The government must never try to prop up wage rates or prices of producers' goods; doing so will prolong and delay indefinitely the completion of the depression-adjustment process; it will cause indefinite and prolonged depression and mass unemployment in the vital capital goods industries. The government must not try to inflate again, in order to get out of the depression. For even if this reinflation succeeds, it will only sow greater trouble later on. The government must do nothing to encourage consumption, and it must not increase its own expenditures, for this will further increase the social consumption/investment ratio. In fact, cutting the government budget will improve the ratio. What the economy needs is not more consumption spending but more saving, in order to validate some of the excessive investments of the boom. [Emphasis added]

Thus, what the government should do, according to the Misesian analysis of the depression, is absolutely nothing. It should, from the point of view of economic health and ending the depression as quickly as possible, maintain a strict hands off, "laissez-faire" policy. Anything it does will delay and obstruct the adjustment process of the market; the less it does, the more rapidly will the market adjustment process do its work, and sound economic recovery ensue."

Clearly, in response to the current financial crisis the US government -- and most other governments, for that matter -- is doing exactly what Mises and other great economists of the "Austrian School" claim should NOT be done. Specifically, the US government is trying to prop up unsound business situations; it is bailing out and lending money to business firms in trouble; it is attempting to prop up prices; it is trying to inflate again in order to boost the economy; and it is rapidly increasing its own expenditures.

The "Austrians" have considerable credibility because their basic theories have never been logically refuted and have been validated, time and time again, by real world occurrences. For example, in early 1929 the two leading Austrian economists of the day, Mises and Hayek, predicted that a great crash was about to occur. Mises, at the time, turned down a prestigious job with a bank because he foresaw a global banking crisis and did not want his name associated with any bank. After the crash the Austrians then warned that the large increases in spending and the various other government interventions implemented in order to stimulate the economy would turn a financial collapse into a very lengthy depression. They were again proven right. As an aside, it is often stated, as if it were a fact, that President Hoover employed a hands-off approach in response to the financial collapse of 1929-1932, thus sowing the seeds of the drawn-out depression that followed. However, nothing could be further from the truth. The fact is that Hoover was not a true believer in free markets and in response to the crash he ramped up the US Government's involvement in the economy, so much so that during the 1932 Presidential election campaign Hoover was labeled a "spendthrift" by F.D.Roosevelt, his opponent. Of course, the 16% increase in government indebtedness on Hoover's watch during 1931-1932 now looks miserly compared to the 1200% increase in Federal debt presided over by Roosevelt during 1933-1945, but at the time it was one of the largest peace-time increases ever.

There were many financial crises in the US prior to the 1930s. The main factor that differentiated the 1930s from earlier periods of crisis -- the thing that transformed a financial collapse into an economic depression lasting more than a decade -- was the government's response to the crisis. Never before had the government tried so hard to fight the contraction by ramping up its own spending, and never before had the US economy performed so poorly. Strangely, most economists seem incapable of linking the dismal economic performance with the large increase in government intervention, and, as a result, most economists still think that increased government intervention and spending is the answer (although they often disagree on the details). The Japanese thought it was the answer during the 1990s, and thus managed to transform what should have been a sharp 1-3 year adjustment into a 10-15 year period of economic stagnation. And now it's widely considered to be the appropriate response to the current woes in the US.

Given that it is being 'egged on' by high-profile economists, investors, hedge-fund managers, businessmen, journalists, TV personalities, politicians and even newsletter writers of almost all stripes, it's a virtual certainty that the US government will continue to 'fight' the current crisis by implementing inflationary policies and inserting itself ever-deeper into the fabric of the economy. In fact, it is now rare for a week to go by without the announcement of some new large-scale government intervention. This week's main intervention -- to date, anyway, but there are still three days left in the week -- is the decision of the Fed/Treasury combination to provide an unlimited amount of short-term funding to non-financial companies via the Commercial Paper market.

The world's financial markets are embroiled in a crisis of epic proportions, but with or without government 'help' the financial crisis will soon become less intense. Perhaps the many actions being taken by the government in an effort to 'soften the blow' will cause the immediate crisis to dissipate earlier than would otherwise be the case, but these actions will certainly do longer-term damage by siphoning real savings into non-productive endeavours. Always bear in mind that the government doesn't have any real savings of its own, so the only way the government can help an unhealthy corporation is to divert savings away from healthy corporations. This diversion often occurs via inflation (increasing the money supply), and is therefore unseen by most observers.

We can't say for certain that the actions being taken to counteract the financial crisis will lead to a drawn-out economic depression, but we can say that the actions greatly increase the risk of such an outcome. Furthermore, we can say that similar policy moves have, in the past, been followed by drawn-out economic depressions.

Further to the above, we think it makes sense to prepare for a very lengthy period of slow, or no, economic growth. In general terms, this should involve strengthening one's balance sheet. More specifically, it SHOULD involve staying (or getting) out of debt and COULD involve building up exposure to gold and income-producing investments other than bonds (energy trusts, for instance). Fortunately, a good balance-sheet-strengthening opportunity is likely to present itself over the next 6 months because the immediate crisis will probably soon give way to a multi-month stock market rebound and the ILLUSION that policy-makers have managed to ignite a sustainable recovery.

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