A Review of the Monetary Phase of the Great Depression
By:
Pablo Paniagua
Date:
7/12/2013
The Digital free PDF version of this essay is
here
The
Great Depression was without a doubt the most catastrophic event in economic
history ever since the
Black
Death in the XIV century. Frequently people see
the Great Depression (GD) as an isolated incident, specifically seeking to
identify a single culprit that might have caused or ignited the depression:
greed? Wall Street speculation? The Fed? Individuals usually seek to focus on a
myopic, simplistic view of the GD rather than seeing it as a complex historical
event that unveiled itself through almost two decades and that it contains
elements of both economic policy and public policies, which makes the GD a more
intricate and complex event. However as a matter of simplicity we can identify
four major phases (Reed, 1981) or aspects of the GD that can be analyzed
somewhat individually (although policies and phases do overlap). The first of
these four stages is the monetary phase and the business cycle period, which
encompasses 1922-1933. Subsequently the Hoover administration phase and the
paving of the road on public policy for the New Deal; this stage analyses the
Smoot-Hawley Tariff and other policies of the Hoover administration between
1930-1932. Third was the New Deal itself and FDR period, 1933-1938, and finally
The Wagner Act and WWII period. It is impossible to understand the severity of
the depression and why it lasted so long without having a holistic view of all
of these phases and the evolution of ever increasing catastrophic public and
monetary policies involved.
The
scope of this essay will be mainly to focus on the first phase of the Great
Depression in particular its monetary phase. We will review the monetary
policies in the 20s and 30s; specifically we will review the expansionary
monetary policies that influenced the late booming years in the 1920s and
finally the period of the
Great Contraction between 1929 and 1933. Most commentators start analyzing
the monetary phase of the depression from 1929 onwards; however we believe that
the booming period of 1922-1928 will be a great theoretical foundation to
understand the underlying disorganization and
structural problems that ignited the subsequent phase of monetary contraction
in 1929. These two periods of monetary policy are particularly characterized by
contrasting intellectual and policy positions that created two different policy
environments concerning money (Timberlake, 2013). The first part of the monetary phase is
marked by the (at the time) new regime of the
Federal Reserve
System, established on December 23, 1913 as a
centralized federal response to the national bank panic of 1907. By the
beginning of the 1920s, the Federal Reserve was just becoming self-aware of the
potential power they might possess in controlling the money supply, but already
by 1922 the Fed was actually very different from what the Federal Reserve Act
original intended (Timberlake, 2008). By that year, the Federal Reserve started
drastically changing their form of influencing the economy. The Fed moved from
utilizing the discount window towards utilizing open market operations on
government securities (Meltzer, 1976), this policy became in the twenties the
standard mechanism to influence the money supply.
By the
time the Fed was established,
Benjamin Strong had become the appointed governor of the Federal Reserve
Bank of New York, a position that he maintained until his death in 1928. He was
a sturdy first governor of the Federal Reserve Bank of New York and as well as a
substantial leader of the Federal Reserve System during the twenties. He
exercised a disproportionate prominence in the policy decision making of the
Fed during that decade, due to his relative importance as governor of the
Federal Reserve Bank of New York and his former presidency of the Banker’s
Trust.
As
mentioned before the monetary policy of the twenties under Strong was in
radical demarcation, both theoretically and practically, from the periods that
followed during the thirties. By 1922 the main instruments of monetary policy
started to radically change, under the leadership of Benjamin Strong, the
Federal Reserve started to move away from transmitting monetary policy only
through the
discount
window. The board wished to avoid the discount
rate to guide the lending activities of the banking system, and seek a way to
make the discount rate secondary, instead of the main Fed policy (Meltzer,
1976). The Strong policy framework then, shifted towards utilizing
open market
operations of purchases of government securities
to try to guide the lending activities and the money supply in the banking
system. Strong therefore led policies by 1922 onwards, deeply influenced in the
quantitative theory of money developed by Irving Fisher that aimed at a form of
price stability, in other words, Strong was seeking to control the expansion of
the quantity of money in order to maintain a measure of the Consumer Price
Index inflation stable. This decade was characterizing by solid and fast
economic growth and fairly stable prices, which led people to believe that the
U.S. had indeed entered a new era of stability and affluence. We have to
discuss this decade more in detail in order to understand why the new era of
affluence didn’t turn out to be viable. In order to do so, we will specifically
review how deep structural imbalances can form in the economy even if there is
an environment of price stability and then how these imbalances (once they
turned out to be unsustainable) led to particular instabilities in the banking
system and the stock market.
It is
important to stress that not the entire economic boom of the twenties was
unsustainable or excessive; as a matter of fact, much of the economic growth in
the first half of the decade was sustained by real economic reforms that led to
great increases in productivity and innovation.
The Coolidge era was particularly important in creating the political
framework to sustain this entrepreneurial driven era. Substantial reforms and
reductions on income taxes were implemented, Coolidge eliminated the income tax
for nearly two million Americans (Sobel, 1998), by 1927 only the wealthiest two
percent of Americans were paying income tax (Ferrel, 1998) and other commercial
tax reductions created a more propitious environment to enhance economic
activity. The policies fostered new consumption of the upcoming electric
appliances and improved the tax environment allowing more competition and
innovation.
Between
1923 and 1929 substantial reforms were similarly made on trade regulations and
substantial improvements on interstate commerce. In addition, Coolidge
substantially reduced Federal expenditures and retired nearly a quarter of the
Federal debt (Ferrel, 1998). Despite
these reforms, President Coolidge was by no means a laissez-faire president;
rather he was a deeply committed Federalist (Ferrel, 1998). We can see how
Coolidge’s policies were aimed at improving the business environment
substantially; the U.S. economy enlarged its real
GNP by 4.2 percent a year and its per capita GNP by 2.7
percent a year from 1920 to 1929 (Smiley, 2010). Therefore we must be very
careful in defining the Roaring Twenties as simply one big bubble, because
there was a real solid economic growth which only later in the decade became
“adulterated” to a certain degree through the Fed’s monetary policies.
By 1923
right after a mild recession of 1920-1921,
the
Fed started to sell securities and increased the discount rate from 4% in order
to “cool” the recovery that according to Strong was accelerating too rapidly in
early 1923. However by the end of that year there were some signs of a mild
contraction, due to exogenous shocks of international oil prices (Smiley,
2010)
; this problem manifested itself late again
in the decade in 1927, with a similar response by String. These oil shocks were
seen as potential threats to the US economy, and were ameliorated with
accommodative expansionary monetary policies. Benjamin Strong, through the
years 1923-1928, started using securities purchases to seek to ameliorate and
ease these exogenous threats to the economy. Therefore by 1923-1924 the Federal
Reserve started its expansionary polices with large security purchases and
reductions of the Federal
discount rate, which manifested
themselves in an increase of the securities holdings of the Fed by over $700
million in less than 4 years (Wheelock, 1992).
Following the 1923-1924 expansion, the Fed also reduced its
discount rate from 4.5 percent to 3 percent, allowing banks to borrow money from
the system at a lower discount rate. Another key element that contributed in
the years of the monetary expansions was Benjamin Strong’s international
economic commitments and international sensitivities. Strong was probably one
of the only American economists and policy makers deeply interested in the
troubled financial situation of Europe in the 1920s (Meltzer, 1976), particularly the 1925 British
attempt to move back to the gold standard and to return to the old pound/dollar
exchange rate of $4.85 that pushed Britain to a path of deep deflation
(Skidelsky, 2005). In order to achieve this policy of a higher exchange rate
Britain needed to keep gold reserves in Britain; this meant keeping interest
rates relatively high compared to the rest of the world in order to attract
gold reserves or to avoid them leaving the country. The higher interest rates
also led to heightened pressure in the economy (Skidelsky, 2005). Strong therefore helped sustained British
monetary policies by reducing American interest rates through lowering the bank
discount rate and increasing the supply of credit and lowering interest rates
in the Unites States. These polices helped to somewhat
reverse the flow of gold back to Great
Britain, helping Britain’s attempt to return to the gold standard (eventually Britain
broke from the gold standard in 1931).
By 1927
the Fed undertook its second biggest purchase program during its international
commitment to allow Britain and France to return to the gold standard. Strong
started adopting more severe expansionary measurers than the ones it had
adopted before in 1924 (Selgin, 2013). The Fed reduced the discount rate once
again and committed itself to large securities purchases, this time another
extra $300 million, allowing France to return to the gold standard with an
undervalued currency by 1928 and allowing Britain to contain the gold outflow
and meliorate their 1927 payment crisis (Wicker, 1966). Overall we can realize
how the period 1923-1928 was marked by a somewhat volatile and accommodative expansionary
monetary policy that allowed the money supply to grow quite rapidly compared to
the years 1921-1923. When these policies are seen as expansionary of a 5 year
trend, we can see that by the mid-20s part of the real growth that the US
economy was experimenting started to experience underlying assets inflation and
profound structural distortions on relative prices. On this perspective
according to Hayek and other Austrian economists, the twenties were a period in
which some of the expansive monetary policies started to create by the late 20s
a phase of unsustainable growth due to distortions on the relative prices and
alterations in the capital structure of business; this economic discoordination
was obscure and unintelligible due to the stable price policy enacted by Strong
and the exacerbated optimism of the rampant real growth experienced in the
early twenties. According to Hayek’s theory of the business cycle, these
underlying misallocations of capital and this disorganization due to monetary
expansion at some point had to be recognized by market forces, making a
correction unavoidable (Hayek, 1932). Now a recession according to Hayek’s view
would have been a form of restructuring business structures, capital formations
and investments time-frames, this liquidation does not have to entail general prices and income deflation driven
by monetary contraction, as a matter of fact Hayek never advocated liquidations and monetary contractions as a
solution to the restructuring of the business cycle (White, 2008). Hayek was as
antagonistic to monetary contractions as to disproportionate monetary
expansions (White, 2008).
Hence, following a
Monetarist policy of price stabilization through the quantifiable management of
the quantity of money through the open market operations which, was the
monetary policy proposed by the economist
Irving Fisher. The policies advocated by Fisher are currently known as
Monetarism, but at the time were known as the “
quantity theory of
money” (QTM), which looked at a macro level of
monetary aggregates to aim at a “desired policy” of a relative stable growth of
the money supply in order to keep inflation relatively low and under control.
Strong through the open market operations from 1923 onwards achieved this
macroeconomic goal quite successfully, maintaining a stable level of prices
between 1922 and 1928. In fact between 1922 and 1929 the Consumer's
Price Index (CPI) stayed practically constant, with a slight increase of 2.3
percent over those 7 years; in addition, the Wholesale Price Index actually
decreased by almost 2.3 percent (Timberlake, 2013).
Differing from these price
stabilization policies, the Austrians highlighted that by the 1924-1928 period
the U.S. had seen the Fed incurring quite large operations of monetary
expansion that started to overtake the real underlying growth of the economy,
beginning to plant the seeds of a possible economic restructuring or recession,
due to the distortions that this expansionary policy was creating on the
signaling mechanisms of the borrowing interest rates and the relative prices of
goods and capital. Hayek and Robbins opposed Strong’s price stabilization
policies, believing that the “U.S. price level should have been allowed to
decline as real output grew with productivity improvements of the 1920s.
Instead in their view, the price level has been artificially propped up by the
Federal Reserve’s credit expansion” (White, 2008, p.756). Following this
critique, in the words of professor Selgin: “According to several economists,
most notably Hayek and Lionel Robbins [at the time], the Great Depression began, not as a response to post-1929
deflation, but as the collapse of a prior ‘malinvestment’ boom fueled by the
Fed’s easy money policy of the latter 1920s” (Selgin, 2013, p.14, emphasis mine).
We have to note, from the
past statements, that the main critique to the “quantity theory of money” is
that a monetary policy that uniquely aims at a simple evaluation of broad
macroeconomic aggregates will evidently obscure and muddle our deep
understanding of the microeconomic foundations of the market signals,
specifically relative prices of goods and services and borrowing interest rates
that coordinate at a micro level the decisions of thousands of individuals. The
distortions engendered on the market signals are unfortunately unrecognized and
ignored under a broad macroeconomic approach such as the one advocated by Irwin
Fisher. Hayek during the 20s and 30s distanced himself from the QTM due to the
fact that the interaction of relative prices and the theory laid in a
comparative static approach that obscured the relevant facts of the dynamic
market process and coordination (O'Driscoll, 1977). In a nutshell Hayek and
other Austrian economists thought that a macro aggregated quantitative approach
to monetary policy had three major erroneous suppositions or implicit
suggestions:
“Firstly, that money
acts upon prices and production only if the general price level changes, and,
therefore, that prices and production are always unaffected by money, -that
they are at their “natural” level, -if the price level remains stable.
Secondly, that a rising price level tends always to cause an increase of
production, and a falling price level always a decrease of production; and
thirdly, that 'monetary theory might even be described as nothing more than the
theory of how the value of money is
determined” (O'Driscoll, p.46, 1977).
These erroneous
propositions then inhibited Strong in grasping the secular and accumulative
harmful effects that expansionary monetary policies carried on the capital
structure and on the overall capacity of the market of efficiently coordinating
value enhancing economic activities, which ended by eroding the healthy
economic growth of the early 20s. As a lesson of these 1920s problems with
monetarism, and later also in the 2000s, we can see as professor White points
out: “consumer price inflation [and other economic aggregates] is [are] not our
exclusive concern. The past decade has reminded us that, even with consumer
inflation rates around 2.5 percent or lower, we face the serious danger of
asset price bubbles and unsustainable credit booms under a central bank policy
of artificially low interest rates” (White, 2013, p.19). This comment by
Professor White is a clear reminder of the role of interest rates and prices in
coordinating the micro foundations and the capital structure in the real economy,
which could suffer from hampering processes of coordination that are
unfortunately unobservable through the aggregated measure of price inflation
indexes.
In
October 1928 Strong died of tuberculosis and finally a different intellectual
framework took over the Fed polices (Friedman and Schwartz,1963); the
monetarist policies of price stability led by Benjamin Strong, based on the
macro economic theories of Irwin Fisher were no longer fashionable at the Fed.
Consequently the
Real Bills Doctrine supporters on the Fed Board took control over the monetary
policy of the country by 1928. George Harrison, the successor of Strong at the
New York Fed, lacked the commitment and Strong’s intellectual framework to
continue Strong’s policies of monetary stability (Timberlake, 2008). The Real Bills
Doctrine, in the hands of Adolph C. Miller, a senior member of the Board of
Governors that openly had criticized Strong’s QTM policies during the mid-20s,
had started to emphasize a control of the money supply according to the “needs
of trade”. The Real Bills supporters believed in expanding credit whenever real
economic activity was booming and contracting credit whenever real trade and
commerce stagnated; in this fashion then “the stock of money and bank credit
rose in periods of economic expansion and declined in recessions” (Meltzer,
1976, p.3). In addition, this doctrine condemned banks for lending for
speculative motives and tried to discourage long term borrowing (Timberlake,
2008 and 2013) which, according to their views, might have fueled the stock
market and real state bubbles in the late 20s. The Federal Reserve, right after
Strong’s death, started contracting credit at discretion and started promoting
an anti-speculative agenda. On February 1929, the Fed Board sent a letter,
expressing Miller’s opinion to the rest of the Fed Banks, stating the Board’s
new duties:
“[Our new] duty . . . to restrain the use of Federal Reserve
credit facilities in aid of the growth of speculative credit.”[…] [They
initiated] “The policy of ‘direct pressure’ [which] restricted borrowings from
the Federal Reserve banks by those member banks which were increasingly
disposed to lend funds for speculative purposes” (Miller, 1935, p. 453 via
Timberlake, 2008).
This
new policy created a sturdy discriminatory bank borrowing procedure that led to
a huge systemic contraction in the borrowing capacity of banks that also
culminated in the transmission of a
great contraction of credit to the overall public, this created a sever
contraction in the supply of money and an overall massive contraction of the
money in circulation. The discriminatory and arbitrary lending procedures also
rendered the discount window of the Fed almost meaningless (Timberlake, 2008),
arbitrary decisions to whom to lend, created direct pressure on banks and
exacerbated bank failures. These arbitrary discriminatory policies of the Fed
Board of Governors created three consecutive banking crisis in 1930, 1931 and
1933 (Timberlake, 2013), contracting the money supply by nearly 30%, without a
significant recovery. Unemployment started to rise rapidly with the dreadful
monetary policies of the Fed, from 3.2% in 1929 to 8.9% by 1930 and arriving to
catastrophic levels of more than 25% by 1933. So what
could have been a mild recession in 1929 was, by 1933, already a debacle.
Unprecedented reckless and erroneous political and monetary policies
exacerbated what could have been only a normal recession and a short-lived
healthy restructuring of the sound real economic fundamentals of the early 20s.
However the Fed’s misguided policies turned the recession into a depression
never seen before in history, prolonging the self-inflicted liquidity crisis well
into the mid-30s. By 1933, “the
M1 and M2 money stocks
were 27 percent and 25 percent below their 1929 levels. Meanwhile, the Fed
Banks sat on their huge hoard of gold—the gold reserves legally required for
their current monetary output and the “excess” gold reserves that could have
provided significant monetary increases—and did . . . nothing!” (Timberlake,
1999). On this line of argument, Schwartz (1981) has
showed how since 1929 until the mid-30s the monetary growth was nonexistent and
this contraction in the money supply is the best evidence of a very tight
arbitrary monetary policy led by the Real Bills Doctrine. The money stock
therefore fell by almost one-third between 1929 and1933 (see Figure 1).
In consequence by 1928 the expansionary policies of
Benjamin Strong over the years 1923-1928 started to seem unsustainable and
dangerous under the Real Bills Doctrine framework. As a matter of fact
the rest of the Fed Board of governors, following the Real Bills Doctrine, saw cheap credit and long-term borrowing as something
inherently unhealthy and corrupt for the economy (Timberlake, 2013). Another
explanation of the failure of the Fed to provide liquidity during the 1929-1933
periods was according to Meltzer (1968 and 1976), the failure of the Fed
officials in distinguishing between the market interest rate and the real
interest rate and their role in the business activity. At the time, Meltzer argues,
the Real Bills Doctrine followed a classical approach
of monetary policy in which monetary interventions were supposed to affect
short-term nominal market interest rates. Nominal Market interest rates therefore were, for the
Real Bills Doctrine, the main indicator for
monetary policy. Whenever nominal market rates fell, then monetary policy was
considered expansive or loose; on the other hand, when nominal market rates were
relatively high, monetary policy was seen as contractionary. By the summer of
1930 the short-term nominal market interest rates were at their lowest levels in a
decade (Meltzer, 1968) and the short-term market rates of Treasury notes
continued to fall. However, this decline on the nominal market interest rate was mainly
due to price deflation, a severe decline of the monetary base, a severe decline
in the demand for business loans and a tight supply of liquidity (Meltzer,
1968). Unfortunately as market rates were falling, Fed officials interpreted
this as a reflection of secular accumulated “extremely easy” monetary policies,
which refrain them to increase the money supply at a moment the system needed
it the most:
“[…] most of the members of
the Open Market Conference believed that policy remained "easy." In
their view there was no reason to produce increased "ease." In fact,
several of the members believed that monetary policy was much too
"easy" during this period [1930-1931] and recommended a policy of
open market sales [contractionary policies].” (Meltzer, 1968, p. 12)
In addition to this failure of understanding the role of
interest rates by the Real Bills Doctrine, the Fed by 1928 started to
look with increasingly worries at the drain of its gold reserves and the faster
than ever rise in the stock market. The Fed therefore started to adopt
arbitrary contractionary polices through the selling of
securities and, in three steps, raised the discount rate from 3.5% to 5% by
July 1928. Discount rates were
finally raised again a fourth time to an unprecedented 6% percent in August of
1929. By that time the massive contraction of money had already begun and the
lack of liquidity in the banking system was already a systemic problem. In late
October the stock market crashed as a consequence of the monetary contraction, and this finally led to a catastrophic
collapse in nominal spending, real GNP fell from 1929 to 1933 by 33 percent and
the subsequent banking crisis that developed as liquidity by the Fed was drying
up (near 9,000 banks with $6.8 billion of deposits failed), sliding America
into the Great Depression (Wheelock, 1992).
The contrast of both of these
schools of thought that shaped the monetary policies of the U.S. could not have
been more accentuated. The clash of views, concerning how to manage the money
supply before 1928 and after 1928 is of extreme relevance to understanding money
and our human capacity to manage it. This point is of particular importance, as
Milton Friedman and Anna Schwartz’s Monetary
History have shown us, the clashing schools of thought concerning monetary
policies led to the most tumultuous times in our economic history. The great
American economist Irving Fisher testified before Congress in 1935 regarding the
Great Depression and stated: “Governor Strong had died and his policies died
with him […] I have always believed, if he had lived, we would have had a
different situation.” We clearly see the demarcation between schools of thought
regarding monetary policy, how they were represented by individuals at the Fed
and how they affected the Fed’s decisions. On one side, there was the
discretionary and extremely arbitrary Real Bills
Doctrine that conditioned credit at discretion, based on arbitrary
decisions of the Board of Governors. On the other side there was the less
discretionary more “quantitative based”, ‘technical’ price stability policy. How
these different schools of thought determined the destiny of the economic
system from 1923 until the mid-30s is an incredible case study of the power of
ideas and a lesson on the danger of centralized decisions concerning the money
supply; additionally under this centralized monetary system, the economy is
very susceptible to changes in the ideas and passions of fallible men rather
than being based on the real underlying market processes and fundamental
economic conditions.
From this experience we can see
that Monetarists such as Fisher and Friedman considered that if the Fed would
have continued to follow Strong’s monetary policies, the collapse of the
economy would have never been as severe as it was. On the other hand, Austrians
such as Hayek and Rothbard and other scholars argue that if Strong’s policies
would have continued, this would have only perpetuated a secular dreadful
negative underlying condition of price distortions and misallocation of
capital, which would have just keep accumulating and prolonging even more
harmful misallocation and economic discoordinations. Regardless of the
differences in views and policy, we believe that the major take away from these
ideological and theoretical problems concerning money is that the greatest danger
of using the incorrect monetary framework originates from the fact that
decision making was made in the 20s and 30s and is still very much used today
under a centralized intellectually monopolistic fashion. This creates the
danger of getting things wrong extremely dangerous, since the mistakes of few
man will have severe repercussions at a systemic level.
The best way to avoid large catastrophic
centralized mistakes on human decision making is through a monetary framework
which encourages decentralized decision making, minimizing human mistakes and
facilitating a learning process through which the banking industry can be extremely
benefited. When the Fed affects the money supply through centralized policies and
by relying excessively on the views and passions of a few men in order to make
complex decisions for the sake of the whole banking system (thus for the rest
of the economy), it puts, hazardously, extremely high faith on concentrated
decision making and increases the systemic risks that those few people could
make bad decisions for the rest of us. Instead a rather decentralized banking
system, although not perfect, could have coped better with the liquidity crises
through a dispersed system of trial and error in monetary policy making. This
sort of system would make additional but smaller less riskier strategies,
minimizing the jeopardy of enacting bad policies for a large part of the
banking community. This in turn increases the discovery and learning procedures
for the rest of the banking system, in which they can imitate or correct,
polices that would have worked better in order to provide systemic liquidity.
Friedman and Schwartz recognized this point emphatically when declaring: “[I]f the pre-1914 banking system rather than the
Federal Reserve System had been in existence in 1929, the money stock almost
certainly would not have undergone a decline comparable to the one that
occurred.” Friedman & Friedman in Free
to Choose again argued:
“Had the Federal Reserve System never been established, and had
a similar series of runs started, there is little doubt that the same measures
would have been taken as in 1907—a restriction of payments. […] restriction [of payments] would almost certainly have
prevented the subsequent series of bank failures in 1931, 1932, and 1933, just
as restriction in 1907 quickly ended bank failures then. . . . The panic over,
confidence restored, economic recovery would very likely have begun in early
1931, just as it had in early 1908” (Friedman & Friedman, 1990).
Following
this line of argument then, we see how prone
to failure a centralize banking system stands, and how systemically dangerous
is for an economy to allow excessive centralisms of fundamental market
functions on just elucidations and ideas of few “wise individuals”. Friedman
and Schwartz (1963) commented on this the following:
“It was a defect of the financial system that it was
susceptible to crises resolvable only with such leadership [of single
individuals]. The existence of such a financial system [a centralize one] is,
of course, the ultimate [and
fundamental] explanation for the financial collapse, rather than the shift of
power from New York to the other Federal Reserve Banks…”
It is worth mentioning that on neither of these monetary
policy theoretical environments (under Strong or under the Real Bills Doctrine),
the gold standard had a significant role to play (Timberlake, 2013), even if
the gold standard was the official monetary system of the Unites States. Ever
since 1913 the real monetary policies were being dictated capriciously by the
Federal Reserve Board despite of the gold standard, thus the gold standard was
de facto a façade, “[…] the
movements of gold into and out of the United States no longer even
approximately determined the economy’s stock of common money” (Timberlake,
2008). The stabilizing properties of the
dynamic adjustment process of the gold standard were not able to work during
the price stability policy led by Strong or during the Real Bills Doctrine after
1928. Thus the gold standard was neither capable of contracting credit in the
boom years nor supplying credit at the times of depression; gold was therefore
not the mechanism in which monetary policy was based upon. In other words: “If
a gold standard is managed by a Treasury Department or a central bank, it is no
longer a gold standard” (Timberlake, 2010). Under this perspective, the Great Depression
is hardly the gold standard’s fault but rather the fault of discretionary
expansions and contractions led by the Fed. As Leland Crabbe, a Board of
Governors staff member, mentioned at the time: “because the gold reserve
requirement [that the Fed possessed] rarely restrained policy between 1914 and
1933, the Federal Reserve had broad discretionary powers to manage the nation’s
money supply in the advancement of domestic [nationalistic] objectives”
(Selgin, 2013).
Thus
ever since the establishment of the Federal Reserve System in 1914, the Fed
started to evermore move towards a complete sense of management and control of
money: “mortal men and not the market were controlling the monetary policy and
while doing it, they imposed their biased beliefs and prejudices in front of
the gold standard, rendering the gold standard superfluous” (Timberlake, 2010).
(Although the gold reserves provided a mathematical limit concerning the Fed
Banks capacity of expanding credit). This finally created a system in which the
Fed, through their Fed banks, somewhat controlled the quantity of money. Immediately
following Strong’s death, if the U.S. would have moved to a real Gold Standard
by early 1929, then decentralize commercial banks would have had the control of
their own gold reserves and they would have expanded credit at their individual
discretion, counteracting the contraction (Timberlake, 2013). Instead the Real
Bills Doctrine at the Fed, centralized the hoarding of gold reserves at the Fed
banks and arbitrarily started to negate credit to sound banks on liquidity
troubles, violating their own regulatory ethos stated in the
Federal Reserve Act. This exacerbated the contraction in the direction of the Great
Depression and opened the gates for radical intellectual and social changes in
the United States. The nation then moved away from the gold standard and
the Federal government enacted the foundations of Social Security; it is beyond
doubt that the Great Depression changed our political, economic and
philosophical framework forever as a nation and this alone is enough to justify
the expression “money matters.”
Figure 1:
Source: Wheelock, 1992
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