Posted on 09/24/2010 6:39:21 PM PDT by Kaslin
“The coup de grâce, so to speak, was the astonishing policy of the FED to decrease the money supply thus causing the devastating chain of bank closures and helped turn a recession into a full-blown depression.”
That would be an astonishing policy if it were true. But it’s not. In fact you have the chain of events backwards.
The money supply began contracting in 1930 as a result of cascading bank failures, not due to any action by the Fed. Fed inaction would be closer to the mark. The problem was that there was no Fed policy for dealing with a collapsing credit market.
The Fed failed to act partially because they didn’t know what they could or should do, and partially because the man who had chaired the Fed since its inception had died on the eve of the crisis and the Fed was without a leader.
When banks failed in the 30s it wasn’t just a bank’s stockholders that were ruined, it was every depositor as well. There was no FDIC. Account balances simply vanished when banks failed. As depositors’ balances evaporated the money supply did too. Milton Friedman said that the greatest innovation to come out of the Great Depression was the development of FDIC to protect depositors from being wiped out, which in turn protects the money supply. FDIC helps prevent some of the monetary destruction that contributed to the Great Depression. And today the Fed reacts to signs of deflation by purchasing debt, something it failed to do in the 30s.
You're partly right but you should take another look at your time line. I think you'll find that there was indeed a recession involving the stock-market crash and some bank failures.
But what the government did next moved a recession into a depression. The FED DID react by tightening money supply, there were resulting many more bank failures, and the depression was in full swing.
“But what the government did next moved a recession into a depression. The FED DID react by tightening money supply, there were resulting many more bank failures, and the depression was in full swing.”
Well I don’t know about that. I took most of my information from Friedman and Schwartz’s “A Monetary History of the United States”, in particular the chapter The Great Contraction. What I recall from reading the book some years ago is that they blamed the Fed solely for failing to react to the crisis, not for precipitating it. I just read over the portion of The Great Contraction that can be found here:
http://press.princeton.edu/chapters/s8754.pdf
and from what I see my memory of their work is accurate. They mention that the Fed provided reserves to alleviate the effect of the 1929 Crash. That the cascading bank failures that began a year later were the result of fear and panic among the public, combined with the unwillingness of Clearinghouse Banks to come to the aid of threatened banks, and a decision to not suspend the ability of the public to withdraw their deposits, something that had been used in pre-Fed days.
Rothbard as well disputes the idea that the Fed had contracted credit, in an even more explicit fashion. This is from Murray Rothbard’s “A History of Money and Banking in the United States”:
“Here we see, at the very beginning of the Hoover era, the spuriousness of the monetarist legend that the Federal Reserve was responsible for the great contraction of money from 1929 to 1933. On the contrary, the Fed and the administration tried their best to inflate, efforts foiled by the good sense, and by the increasing distrust of the banking system, of the American people.”
You’ll find that quote at page 275, the whole book can be downloaded here:
http://mises.org/books/historyofmoney.pdf
Now in fairness to your argument Richard Timberlake seems to share the view that Fed policy, promoted by Adolph Miller after Benjamin Strong’s death in 1928, was the causal factor leading to the Great Depression.
http://www.cato.org/pubs/journal/cj28n2/cj28n2-13.pdf
His view incorporates the absence of an operational gold standard after World War One and the double edged nature of Real Bills Doctrine. Timberlake would have the Fed target price stability. But the criticism of doing that comes from those, mostly Austrians, who argue that Strong’s price stability policy was fooled by “good defaltionary forces” into providing far too much credit during the 20s, and that this created a credit boom destined to result in the collapse that followed.
I’d be curious to see that when you get time, as that is quite different from what remember him writing in A Monetary History.
OK but it might be awhile. In the meantime, if you haven;t read those two books I mentioned, they are both really good and worthwhile reading.
http://www.thefreemanonline.org/featured/the-great-depression-according-to-milton-friedman/#
The quotes appear to repeat what Friedman said in A Monetary History, that it was the Fed's failure to act that was the crux of the problem.
In the 1950s, Friedman and Anna Schwartz began compiling historical data on monetary variables without any particular agenda or intention of overturning the dominant explanation of the Great Depression. But it became obvious that the data were at odds with the standard Keynesian explanation. So in their 1963 book, A Monetary History of the United States, 1867–1960, they presented the empirical evidence that led them to a completely different explanation.
As a result of examining more closely the key years between 1929 and 1933, Friedman and Schwartz first concluded that the Great Depression was not the necessary and direct result of the stock-market crash of October 1929, which they attribute to a speculative investment bubble. (The popping of the “bubble” may have been instigated by the Federal Reserve’s raising of the discount rate—the interest rate the Fed charges on loans to commercial banks—in August 1929. The cause of the speculative bubble that led to the crash is a somewhat controversial topic. Whereas Friedman and Schwartz accepted that the bubble was caused by investors, seemingly endorsing—at least partly—the Keynesian “animal spirits” explanation, Austrian economists have argued otherwise.) In fact, they believed that the economy could have recovered rather rapidly if only the Fed—the central bank of the United States —had not engaged in a series of disastrous policies in the aftermath of the crash.
The Fed had only been in existence for 15 years at the time of the crash, having opened its doors in 1914. The United States had two central banks before the Fed (the Bank of United States, 1792–1812; and the Second Bank of the United States, 1816–1836), but had been without a central bank of any sort for over 75 years until the creation of the Fed. It was created primarily to act as a “lender of last resort” from which private banks could borrow money in times of crisis. The need for a lender of last resort in the U.S. banking system was due to a systemic weakness caused unintentionally by state and federal banking regulations. (Canada, with a freer banking system, had no such systemic weakness and no need for a lender of last resort.) Weak banks are subject to crisis when their depositors are no longer confident that their bank holds sufficient reserves to satisfy all withdrawal demands at a certain time. This can trigger a “bank run,” where depositors attempt to get to the bank before the other depositors in order to withdraw their money before the bank’s limited reserves run out. A run on a bank can easily generate other bank runs as depositors become worried about the financial health of their own similarly weak banks.
The problem with bank runs is that when depositors withdraw money and stuff it under their mattresses rather than trust it to other banks, the money supply shrinks. To understand this phenomenon, we have to explain how we measure the money supply. The simplest measures include not only currency but also checking deposits, since they are commonly used to make payments. What complicates things is that fractional-reserve banking leads to a multiple expansion of deposits. When someone puts money in a bank his checking account reflects the deposit, but the bank does not keep all the money on hand—it’s not a warehouse. Instead, it keeps only a fraction as “reserves” and lends the rest to a borrower, who in turn buys goods or services. The seller then deposits her new income in a bank, where she gets a checking account. The money supply increases by the amount of the new deposit. This process will continue, though in ever-decreasing amounts since banks have to keep some part of the new deposits as reserves. Yet each cycle will increase the money supply by increasing the overall amount of deposits held at banks.
This process works in reverse too. When banks lose reserves due to bank runs, the economy experiences a multiple contraction of deposits. The deposits that are removed from the economy greatly exceed the additional currency that the public now holds, so the money supply decreases.
The stock-market crash of October 1929 made it more difficult for many businesses to repay their loans to the banks, and many banks found their balance sheets impaired as a result. But the most important cause of the bank runs that began in October 1930 was bad times in the farm belt, where the banks were especially weak and poorly diversified. The number of bank runs increased exponentially in December 1930—in that single month 352 banks failed. Most of the failing banks were in the Midwest , their failures caused by farmers who defaulted on their loans because they were hit hard by the economic downturn. No sooner did the first wave of bank runs subside than another got underway in the spring of 1931, creating what Friedman and Schwartz described as a “contagion of fear” among bank depositors. Bank crises continued to come in waves until the spring of 1933.
Roosevelt Comes In
FDR was inaugurated on March 4, 1933, and two days later he declared a “bank holiday,” allowing banks legally to refuse withdrawals by depositors; it lasted ten days. With his famous phrase, “The only thing we have to fear is fear itself,” he intended to dissuade depositors from running on their banks, but by then it was far too late. In 1929 there were a total of 25,000 banks in the United States. As the bank holiday ended, only 12,000 banks were operating (though another 3,000 were to reopen eventually). The effect on the money supply was equally dramatic. From 1929 to 1933 it fell by 27 percent—for every $3 in circulation in 1929 (whether in currency or deposits), only $2 was left in 1933. Such a drastic fall in the money supply inevitably led to a massive decrease in aggregate demand. People’s savings were wiped out so their natural response was to save more to compensate, leading to plummeting consumption spending. Naturally, total economic output also fell dramatically: GDP was 29 percent lower in 1933 than in 1929. And the unemployment rate hit its historic high of 25 percent in 1933.
Friedman and Schwartz argued that all this was due to the Fed’s failure to carry out its assigned role as the lender of last resort. Rather than providing liquidity through loans, the Fed just watched as banks dropped like flies, seemingly oblivious to the effect this would have on the money supply. The Fed could have offset the decrease created by bank failures by engaging in bond purchases, but it did not. As Milton and Rose Friedman wrote in Free to Choose:
The [Federal Reserve] System could have provided a far better solution by engaging in large-scale open market purchases of government bonds. That would have provided banks with additional cash to meet the demands of their depositors. That would have ended—or at least sharply reduced—the stream of bank failures and have prevented the public’s attempted conversion of deposits into currency from reducing the quantity of money. Unfortunately, the Fed’s actions were hesitant and small. In the main, it stood idly by and let the crisis take its course—a pattern of behavior that was to be repeated again and again during the next two years.
According to Friedman and Schwartz, this was a complete abdication of the Fed’s core responsibilities—responsibilities it had taken away from the commercial bank clearinghouses that had acted to mitigate panics before 1914—and was the primary cause of the Great Depression.
The obvious question is: Why didn’t the Fed act? We don’t know for sure, but Friedman and Schwartz proposed several possible explanations: 1) the Fed officials did not fully understand the disastrous consequences of letting so many banks go under. Friedman and Schwartz wrote that Fed officials may have “tended to regard bank failures as regrettable consequences of bank management or bad banking practices, or as inevitable reactions to prior speculative excesses, or as a consequence but hardly a cause of the financial and economic collapse in process”; 2) Fed officials may have been acting out of their own self-interest since many of them were affiliated with large Northeastern banks. Bank failures, at least in the early stages, “were concentrated among smaller banks and since the most influential figures in the system were big-city bankers who deplored the existence of smaller banks, their disappearance may have been viewed with complacency”; 3) The inactivity may have been caused by political infighting between the Federal Reserve Board in Washington, D.C., and regional Fed banks, in particular the New York district bank, which was the most important part of the system at that time. But we may never know the real reason.
I can see how you could conclude that Friedman blames the Fed for causing the Depression. In one quote he states that if the Fed had never been organized that banks would have used the methods they employed pre-Fed to fight panics, and that those methods would have worked. He writes that the mere existence of the Fed led private banks to shirk their own need to act, and that instead they relied solely on the Fed to fight the panic.
However when Friedman does put blame on the Fed he blames them for failing to act, for failing to do the job that they were organized to do in the first place. But he’s not blaming them for having implemented some policy that precipitated the Depression. Theirs was a sin of omission, not a sin of commission.
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