In the Robbins-Rothbard view, the Fed inflated throughout the
'20s, price indices notwithstanding, and then, in the early '30s, it did
everything it could to reflate, but the process didn't work, as Allen's book
suggests as well.* Instead, we got
deflation as a byproduct of causes other than Fed policy. The public lost
confidence in the banking system and began to increase its demand for money to
hold, including gold. The velocity of circulation fell, and so did prices.
Concurrent fiscal policy, as will be discussed momentarily, was probably as bad
as it has ever been in American history given the circumstances in which it was
carried out.
One of the major Fed problems during the late 1920s — the most heated
speculative period for stocks — was a disconnect, personal and professional,
between the New York Fed and the system's Board of Governors in the person of
NY's president, George Harrison, who had succeeded the legendary Benjamin Strong,
Harrison's board, and the Fed Board's chairman, Roy Young. The central
disagreement was over bank loans used for stock speculation, and what, if
anything, to do about it. The New York bank wanted to raise the discount rate and
voted to do so several times in 1929. The Board demurred, preferring to pursue a
policy it called "direct pressure," or verbally chastising those banks that
appeared to be funding "excessive" speculation. I don't want to engage in loose
speculation here, but this policy of direct pressure seems to have failed.
Eventually, the power struggle between the regional banks and the Board would
be settled by 1935's federal Banking Act, which gave full control to the Board in
Washington. FDR's handpicked chairman, Merriner Eccles, wouldn't have taken the
job otherwise; until then, this conflict played an important role, and should be
noted by anyone attempting to explain today what happened eight decades ago.
What was the Fed doing with monetary policy during the 1920s? We have to
remember that the structure and authority of the Fed was different from what it
is today. The Fed Board's head was the secretary of the Treasury, and Fed policy
was always subservient to the Treasury's. We were on a gold exchange standard.
Coordinated, national monetary policy was something the Fed had not been given
the power to do under the 1912 enabling act. And, it had not yet assumed the
ability to make national monetary policy, as it would later do, whether
authorized or not. During the 1920s, the Fed generally pursued policy based on
the doctrine that economists call "real bills."
| Milton Friedman has
argued that the Federal Reserve pursued inappropriate monetary policy during the
1930s and, by so doing, prolonged the Great Depression.
|
|
The real bills theory proposes that the money supply can be increased
proportionately to real output, since increases in real output can "back" new
money issues, therefore making inflation impossible. Under this view, inflation
is impossible so long as the money supply is tied to real, productive
transactions. The problem in the doctrine, not unknown even to 19th-century
economists — Henry Thornton is a famous example — is that, as prices
rise, the total dollar amount of transactions necessarily rises, which, according
to the theory, calls for money creation and a resultant increase in prices. The
fallacy of treating prices as given, when, in fact, they vary with the money
stock, makes the real bills doctrine a dangerous base upon which to try to
conduct price stabilization policy.
Unfortunately, the Federal Reserve Act seemed to enshrine this "pro-cyclical"
doctrine into the Fed's institutional structure. The Act provided for the system
to extend bank reserve credit via the Fed's rediscounting of eligible,
short-term, self-liquidating commercial paper presented to it by member banks.
The Fed's 10th annual report, issued in 1923, states: "It is the belief of the
Board that there is little danger that the credit created and distributed by the
Federal Reserve Banks will be in excessive volume if restricted to productive
uses." By this, the Board meant loans that financed the actual production and
marketing of real goods, the classic real bills definition.
Further, it was during the 1920s that the Fed began to do open-market
operations, even though these were not contemplated by the original enabling
legislation. And these early open-market operations were undertaken,
unfortunately, to "sterilize" gold inflows from England's over-valuation for its
pound sterling. Sterilization is the process by which the money supply is kept
constant regardless of the inflow of gold; ordinarily, under the international
gold exchange standard, in force at that time, the gold flow into the U.S. would
have caused monetization that would raise U.S. prices and make Britain more
competitive as its prices fell. The U.S. and France prevented this from
occurring. Both nations' gold stocks rose dramatically while, at the same time,
their central banks sold securities to reduce the monetary impact of the new gold
to zero. In fact, during the late 1920s, the U.S. should have experienced
inflation due to this gold inflow; but instead, it experienced a mild deflation
due to the sterilization policy.
Myth #2: "The Fed pursued a reckless policy of inflation between 1922 and the
crash."
By the late 1920s, Britain was desperate to get out from under its current
account deficit position. A meeting was held in 1927 between representatives of
the Bank of England, the Fed, and the U.S. Treasury. It was decided that the Fed
would lower interest rates in the U.S. rather than Britain raising them, since
Britain was already in a worsening economic condition. This monetary expansion
has been credited with precipitating the late '20s market boom by many, including
both the Friedman-Schwartz and Robbins-Rothbard camps. Note however that the
point of departure is 1927 and this policy lasted but a short time.
The joint policy agreed upon — and carried out in 1927 — failed for
several reasons. As the U.S. stock market boomed, money flowed in and capital
exporting fell. American banks were more interested in financing domestic stock
speculation than economic projects elsewhere in the world. This, in turn, slowed
trade and economic output in other nations, thus hurting England all the more. A
recession began there in 1929 as their interest rates rose, their money supply
tightened, their international exports declined, and their current account
position continued to weaken.
| The Fed tried to do
something about the looming crisis. It failed because it was trying to help
European economies instead of seeing to the United States' problems.
|
|
Both Robbins-Rothbard and Friedman-Schwartz see the looser policy beginning in
1927 as creating the crisis of 1929. For Friedman-Schwartz, the perfect
correlations between money and economic activity throughout the decade point to
changes in money supply being the prime cause of the downturn and the boom that
preceded it. For Robbins-Rothbard, the story is more complex because their model
of the cycle is based on the Austrian theory propounded by Ludwig von Mises. I
shall not elaborate fully on that model, but I can say that it is the view that
booms are caused by bank credit expansions that then distort the
consumption-saving-production time structure of the economy by sending an
incorrect interest rate signal to business owners and entrepreneurs. The
"artificial" boom, thus created, must be followed by a bust. A stable price level
in no way means that the boom is not underway, since prices might have been lower
than they were without the credit expansion, and therefore index stability merely
masks the ongoing, real inflation picture. Eventually, money and credit must be
tightened and the crash then looms. And that tightening came in the 1928–29
period so that, by August 1929, the recession had already begun, the market
peaking on Sept. 3.
Myth #3: "The stock market crash caused the Great Depression."
The crash was a symptom of things unique to mid-to-late 1929, not the cause of
what followed. Regardless of how the market crash occurred, and regardless of who
or what was to blame, the issue of whether post-crash policy helped or hurt the
prospects for recovery must be addressed. As Meltzer titled one of his book's
chapters: "Why Did Monetary Policy Fail in the Thirties?" This is not only an
important question, but a divisive one. There are many deeply held and
contradictory points of view among economists and historians.
One of the most prominent views is the Friedman-Schwartz view, echoed by
Meltzer, that monetary contraction between 1928 and 1933 produced deflation, and
deflation produced — in a vicious spiral — worsening depression. These
authors see a clear causal connection between the decline in the money supply and
the depression that followed. Others do not believe the causality runs that way.
They see the public's distrust of the financial system as leading to an increase
in the demand for money outside the banking system. The Fed's expansionary policy
was impotent because of a weird, non-Keynesian liquidity trap situation where,
due to public distrust and the Fed's "let them fail" policy toward banks, all
monetary expansions ended up hoarded as people and banks awaited better economic
conditions.
Some measures of the money supply shrank while others grew. The money supply
of the '30s was very different from today's M1 and M2. It included a variety of
competing paper notes, national notes, bank notes, and gold coin. As banking
crises arose, people drained their accounts and hoarded cash out of a
well-founded fear of the banking system's soundness. The Fed, the "lender of last
resort," allowed the banks to fail: 1,400 in 1930, 2,300 in 1931, almost 1,500 in
1932, and a staggering 4,000 more in 1933. The failure of the Bank of the United
States in New York City had particularly disastrous results. In retrospect, the
Fed probably should have lent assistance, but, realistically, that just wasn't
about to happen at that time. Thus, Robbins-Rothbard might be correct in
asserting that reflation was attempted by the Fed, but failed between
1930–33 because of the effects of ongoing occurrences.
To be fair to the Fed, we should survey factors that were contemporaneous with
the end of the bull market and the coming of depression, factors over which the
Fed had absolutely no control, including:
| One morning, FDR chose an
increase of $0.21 in the price of gold. Morgenthau asked him why. FDR replied,
"Because three times seven is 21, a lucky number."
|
|
- The enactment in 1929 of the Smoot-Hawley tariff, which led to a
contraction of international trade. U.S. exports fell by two-thirds between 1930
and 1933. This was precisely the sort of policy that ought not to have
been enacted at this time. Hoover wanted to protect Republican-leaning
agricultural interests, and he did — at a very high price for the nation.
- The Nazi Party's success in Germany's 1930 elections, which created havoc in
the international bond market.
- Hoover's wage policy, which was a misguided
attempt — agreed to by major corporations — to keep wages from
declining during a depression. Not surprisingly, this proved to be a surefire way
to create unemployment.
- Congress' raising of taxes during an economic
downturn in an attempt to balance the federal budget. This increased the tax
burden on citizens whose incomes were already falling. This perverse policy was
followed throughout the decade of the '30s, first during Hoover's and then FDR's
terms. Taxes were three times higher in 1939 than they had been in 1929: this was
utterly perverse macroeconomic policy.
- Anticipation, in 1932, that FDR would
abandon the gold standard if elected, and his failure to deny that rumor during
the campaign. This was also destabilizing. Of course, once elected, he did a
great deal more than simply abandon the standard. His administration outlawed the
private ownership of gold, and required all Americans to surrender any gold they
owned.
- A great surge in economic regulation, begun under Hoover, which grew
exponentially under FDR. This spooked entrepreneurs and investors throughout the
decade, aided by the capricious, back-and-forth court decisions on the
regulations' constitutionality and the always-changing policies that poured forth
from Washington during FDR's terms.
- England's leaving the gold standard in
1931. This caused a gold drain from the U.S. that the Fed fought by raising the
discount rate during the depression. In retrospect, it is hard to suggest that
the Fed could have done anything else given the legal-institutional parameters in
place at that time.
Whatever policies the Fed followed, or might have followed, between late 1929
and 1933, they were the last ones to matter until after WWII. The Treasury took
over economic policy, and the Fed played a much smaller role between 1934 and the
end of war than it had during the 1920s and early 1930s. What power remained at
the Fed as a whole shifted to the Board in Washington. The seeds for the
post-WWII Fed were sown by the Banking Act of 1935, finishing what the Banking
Act of 1933 had begun.
After WWII, the regional banks became a good deal less important than the
Washington Board, and policy became completely centralized. It is hardly
surprising that the Fed took a passive role during the New Deal — FDR was
not one to share power, and so his Treasury, over which he had total control,
became the center for national economic policy. It would be good if one could say
it did better than the Fed had done but, of course, it didn't, and hardly could
have given the economic capriciousness of FDR's attitudes and actions — all
of which flowed from his general ignorance of, and contempt for, market processes
and businesspeople.
An example of FDR's capriciousness was his foolish habit of personally setting
gold prices. Believing, after he read George Frederick Warren's peculiar argument
in his book "Prices," that the current gold price caused commodity prices to be
what they are, he set about inflating the price of gold and, ipso facto
depreciating the dollar. Having taken ownership of all gold previously in private
hands, and having prior contracts specifying payment in gold revoked by Congress,
FDR decided that the "correct" price for gold was $35 per ounce.
Along the way, he would meet in his White
House bedroom with Treasury Secretary Henry Morgenthau and set that day's price
for gold. One morning, FDR chose an increase of $0.21, and Morgenthau asked him
why. FDR replied, "because three times seven is 21, a lucky
number."* That's how the author of the
New Deal pursued and implemented important economic policy decisions. These
manipulations of gold stocks and gold prices had no positive economic impact, but
they did make the federal government the single greatest hoarder of gold in human
history. I suppose I should point out that many prominent economists at the time
had also advocated confiscation of gold and other gold manipulations. There was
the so-called Chicago Plan for banking reform — signed by such important
economists as Frank Knight, Aaron Director, Henry Simons, Lloyd Mints, Henry
Schultz, and Paul Douglas — which sought just such policies, without
anticipating, of course, Roosevelt setting prices from his bed.*
So we see that the Fed alone — Myth #4 — cannot be held responsible
for the Great Depression. Two presidential administrations and Congress played
important roles in virtually guaranteeing that the depression would worsen. And
so it did. In a way, we learned a great deal about economic policy during the
1930s. We learned pretty conclusively what doesn't work. And that's a very
valuable thing to know. Unfortunately, the nation as a whole paid a severe price
for this particular collection of truths, and we remain in the shadow of many
policy initiatives begun during the Great Depression that at best are dubious,
and at worst, might ultimately bankrupt us.
As for the Fed's responsibility, which of the two views mentioned above is
more correct? Perhaps we can do no better than to quote Frederick Lewis Allen on
the business cycle: "Fundamentally, perhaps, the business cycle is a
psychological phenomenon. Only when the memory of hard times has dimmed can
confidence fully establish itself; only when confidence has led to outrageous
excess can it be checked. It was as difficult for Mr. Hoover to stop the
psychological pendulum on the downswing as it had been for the Reserve Board to
stop it on the upswing."
|
| * | Friedman, Milton and Anna Schwartz. 1963. "A Monetary History
of the United States, 1867–1960" (Princeton: University Press). See also
Meltzer, Allan H. 2003. "A History of the Federal Reserve," Vol. 1 (Chicago:
University Press). |
BACK
| * | Prochnow, Hebert V. (ed). 1960. "The Federal Reserve System"
(NY: Harper and Row). Chapter 15. |
BACK
| * | Powell, Jim. 2003. "FDR's Folly" (NY: Crown Forum). p.
72. |
BACK
| * | Phillips, Ronnie J. (1992) "The Chicago Plan and New Deal
Banking Reform." Working Paper #76 (Avondale-on-Hudson, NY: The Jerome Levy
Institute). p. 8. |
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| | | |
