The Notion that Caused the Great Depression

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The Great Depression, 1929-1941, was two distinct periods in U.S. economic history. First came the Great Contraction, 1929-1933, during which prices fell 8% per year, the stock market crashed – declining much more than prices, the economy’s stock of money fell 25%, real national income fell 30%, unemployment increased to a high of 25% of the workforce, and business

confidence fell to almost zero. No one knew what had happened, but everyone had a “theory” and a scapegoat.

Most people today think, as most thought then, that some kind of fatal and untreatable weakness in the private enterprise market economy suddenly manifested itself and had to run its course. Their key indicator is the horrendous decline in the stock market, an indicator that is right out in plain sight for every layman to analyze.

Since most of the collapse in the economy occurred during the administration of President Herbert Hoover, his administration and the Republican Congresses of that period have received everlasting popular condemnation for the debacle. While the policies of Hoover and his administration certainly did not help matters, neither did they have anything to do with the fundamental cause of the collapse, or its persistence.

The ensuing Great Depression, 1933-1941, coincided with the election and administration of Franklin Delano Roosevelt. Since the economy was already bottoming out when he took office in 1933, FDR’s subsequent policies could not have caused the Great Contraction either.

The fundamental cause of the Great Contraction, the only event I discuss here, was the evolving monetary policy of the Federal Reserve Board and Federal Reserve Banks. Most interestingly, it was One Big Idea – a dogmatic belief guiding Fed policymakers – that caused the economic downturn in 1929, and continued the deflationary pressure for four long years.

That policy dogma, and not a gold standard, nor any brand of political activism, nor the stock market collapse, nor a misguided tariff policy, nor any other popular scapegoat such as “big” corporations, powerful labor unions, international Jew-ish bankers, or “economic royalists,” was the root cause of what happened.

The One Big Idea to which I refer was a policy norm that monetary economists label the Real Bills Doctrine. It is a theory of banking and banking policy that has been around for as long as fractional reserve commercial banks – about 300 years. As a principle for a commercial bank’s lending operations, it is harmless; but as a theory for central bank monetary policy, it is disastrous. Unfortunately, in late 1928 and early 1929, the Real Bills Doctrine became the dominant and unconstrained principle of Federal Reserve policy.

The Gold Standard and the Real Bills Doctrine

The place to begin an examination of monetary affairs in the 20th century is with the functioning international gold standard that was in place before World War I. A gold standard provides for a supply of money in the economy. 1£ the gold standard is international, it provides for supplies of money to all the countries committed to it.

A gold standard law typically describes a gold coin of some convenient denomination containing a weight of gold of specific fineness, and rules that this coin is legal tender for all debt payments public and private. Mints, either public. or private, then monetize any and all gold brought to them by coining it on the, fixed terms that the law stipulates. In the United States, for example, Congress defined a ten-dollar gold Eagle as a coin weighing 247 grains (slightly less than half a troy ounce), and 0.900 fine (pure), as the standard.

Once the legislature puts the gold standard machinery in place, no additional law ever needs to limit, constrain, or promote gold coinage. The system works on the principles of spontaneous order. Nobody manages it. Rather, everyone who lives under it “manages” it within the rule-based framework. It is the money-market heart of a market system.

Under a gold standard banks hold gold reserves to redeem the checkbook accounts of depositors. On the basis of their gold reserves, the banks make loans to households and business firms, thereby generating deposit moneys that are their demand liabilities. The amount they create depends fundamentally on how much gold they hold as reserves.

By way of contrast, real bills – no, not those things that come at the end of the month, as one lady friend suggested to me – come into existence when banks make loans to businessmen who need credit to finance their prospective productions of goods and services. Borrowers and banks agree that such forthcoming productions serve as collateral for the dollar value of the loans. When the business borrower sells the new goods, he pays off the bank and thereby consummates the loan.

From such conventional and unexciting beginnings, many bankers and a goodly number of economists of the pre-1935 era took the next step. They argued that if bankers extend bank credit only on the basis of these loans – that is, on the money value of real bills – the dollar value of the new credit and bank money (checking deposits) will exactly equal the dollar value of the new goods and services. This twist is what makes ordinary harmless real bills into the real bills doctrine — an advised policy for gearing the creation of new money to the money value of new goods and services. What could be cooler than that?

However, bank monetization of real bills, unlike bank monetization of gold, cannot be done on fixed dollar terms. A bank loan to a borrower must always include the banker’s estimate of the dollar value of the real goods or services that the borrower offers as collateral to secure the loan, as well

Most people think some kind of fatal and untreatable weakness in the private enterprise market economy suddenly manifested itself and had to run its course.


as the likelihood.of repayment. The interest rate the bank charges reflects this judgment. If bankers are too optimistic, they overextend credit, thereby oversupplying deposits. New loans and deposits exceed the market value of the goods and services that the borrowers can generate, and monetary inflation results. If bankers are overly pessimistic, creation of bank money is insufficient to maintain prices at their current level, and deflation follows. These rising and falling prices raise and lower the dollar value of the real bills collateral that constitutes the basis for the creation or destruction of bank money.

Once the legislature puts the gold standard machinery in place, the system works on the principles of spontaneous order. Nobody manages it.

Consequently, when the system is put into motion, it does not move toward equilibrium. Several economic studies have emphasized this dynamic instability (Mints, Humphre)’, Girton).

Fortunately, a genuine gold standard, if it is in good working order, and if it is the dominant monetary institution, will not allow banks to generate too much or too little money for very long, no matter how much credence bankers attach to the real bills doctrine. The stock and rate of increase of monetary gold, under a true gold standard, determine the stock of common mone)’, the price level, and the trends in both. If bank credit based on real bills tends to generate too little money relative to what the gold standard demands, bankers’ reserves continue to be excessive, and banker pessimism moderates. If bankers allow too much bank credit, gold flows out of the monetary system, depleting bank reserves and bringing bank lending up short; The important principle here is that no matter how invalid the real bills doctrine is as a basis for creating the “right” quantity of mone)’, the system’s higher ranking commitment to an operational gold standard completely overrides any weaknesses in that doctrine (Schumpeter 721- 722, Andrew 114-115).

Appearance of the Federal Reserve System

Both a gold standard and a real bills doctrine are means for supplying money to the economy. A central bank does likewise. So, let’s see how a central bank, such as the Federal Reserve System, fits into the picture.

The Federal Reserve System, the central bank of the United States, came on the scene in 1912-1913. This new system consisted of twelve super-commercial banks that would hold the gold and other (legal tender) reserves for the national and qualified “member” commercial banks in their districts. Fed Banks were to be gold-standard reserve banks. Besides holding the gold reserves of their “member banks,” they would occasionally provide additional bank credit and bank deposits as needed, in step with seasonal peaks and troughs in the productions of goods and services. Acting also as lenders of last resort, Fed Banks would supply extra reserves to their district member banks by making loans – conventionally called “discounts” or “rediscounts,” from which interest charges are deducted up front when the loan is made – whenever the banks’ depositors for any reason redeemed unusual amounts of checkbook balances into gold. Fed Banks rationed the supply of credit among the commercial banks they served by increasing or decreasing the interest (discount or rediscount) rate that they charged the banks to borrow. To expand bank loans and deposits, Fed Banks would lower their rates; to restrict lending due to anticipated inflation, they would raise rates. Each Fed Bank had charge of its own discount rate, but all Banks’ policies were”subject to the review and determination” of the Fed Board in Washington.

To function properly, a Reserve Bank was supposed to limit its loans to “eligible paper,” which the Federal Reserve Act defined as “notes, drafts, and bills of exchange arising out of actual commercial transactions … issued or drawn for agricultural, industrial, or commercial purposes” (1961,43). “Eligible” also meant short-term and self-liquidating. “Eligible paper,” therefore, was just another name for “real bills.”

The Stable Price Level Policy After World War I

During World War I, the government’s wartime fiscal needs forced Fed Banks to adjust their policies to the dictates of the Treasury. Not until 1921, three years after the end of the war, were Fed Banks able to shake themselves free of Treasury dominance.

Fed policy in the years from 1922 to 1928 operated independently of Treasury pressures, but also without the constraints of a gold standard. The original Act had stated that Fed Banks were “to furnish an elastic currency/’ which meant that they would discount commercial paper of member banks for gold, or other legal tender. By this means, Fed Banks would prevent undesirable reductions in the total quantity of money. Such action was also complementary to the notion in everyone’s mind of Fed Banks serving as lenders of last resort for solvent but illiquid banks in a financial crisis, to prevent a collapse in the existing level of bank credit and deposits (Timberlake, 111). In accordance with these principles, Fed Banks would keep their discount rates higher than general market rates, so that they would become financially active only in a liquidity pinch, i.e., as lenders of last resort (Hepburn, 531-534).

The policies and reports of the Fed Banks and the Board of Governors during the 1920s, however, reflect anything but such a defensive role. Starting in 1922, the New York Fed, the largest and most important bank in the system, formed an Open Market Investment Committee (OMIC) with some of the other Fed Banks to coordinate purchases and sales of government securities in New York’s financial market. By this means, the Fed as a federated central bank gained decisive control over the economy’s stock of money.

The purpose of the OMIC was to make money tight or easy depending on what the OMIC managers thought the financial and productive sectors of the economy needed. Their unofficial indicator for stability was the general level of prices, which they wanted to keep close to constant. They also insist- ed that this policy was not official and would be terminated when political authorities in the trading world could re-establish a functioning international gold standard.

Fed Banks at this time, particularly the Fed Bank of New York, were inundated with gold reserves, which is why gold was not a constraint on their operations. Indeed, to prevent current gold monetization and gold inflation – yes, there is such a thing – and a subsequent deflation when the gold returned to European banking systems, Fed policymakers “sterilized” the gold that had come into the U.S. as a result of WWI financing. Instead of letting the additional gold become reserves for new money creation, Fed Banks sold off their holdings of government securities and the loans they had made to commercial member banks, and were thus able to sequester the redundant gold without monetizing it. Had they not done that, the additional gold would have inflated U.s. prices significantly. As it was, U.S. prices were remarkably stable between 1922 and 1928, and gold did not flow back to Europe. In short, the Fed as a central bank operating in lieu of a gold standard prevented the gold from being monetized into bank reserves, and then by the banking system into money. It thereby avoided what would have been a gold inflation in the United States. Consequently, throughout the 1920s the Fed Banks had a huge volume of excess gold reserves – more than double the amount that the Federal Reserve Act required of them – to back their outstanding Federal Reserve notes and the reserve-deposit accounts they held for their member banks.

The principal driving force behind Fed policy at this time was Benjamin Strong, governor of the New York Fed. Strong was instrumental in forming the OMIC; he was its chairman, and he particularly favored price level stabilization. Besides his practical experience as a banker who had witnessed private clearinghouse operations that stabilized the financial markets during the Panic of 1907, Strong had the counsel of several competent economists who recommended price· stabilization by central bank control of the quantity of money. Strong once remarked, “No influence upon prices is so great in the long run as is the influence of changes in the quantity of money” (Strong, 175). At the same time, he felt that a law requiring price level stabilization was inappropriate – that the gold standard was the only lawful institution to control the quantity of money, and that it was the proper means for preventing the government from assuming undesirable control over monetary policy. He and his associates anticipated the full restoration of an operational gold standard when the current period of instability had ended. Furthermore, Strong pointedly and emphatically rejected all aspects of the real bills doctrine as either a guide to or a norm for effective policy. His disavowal of that doctrine, however, did not speak for the opinions of the Fed Board and many of the Fed Bank governors (Chandler, ch. vi).

The Shift in Policy from Stability to Real Bills

By 1928, three operating methods and supporting arguments had appeared in Federal Reserve policy: the gold standard, in remission throughout the world since 1914, but still the ultimate norm in official discourse; price level stabiliza-

tion by quantitative control of bank reserves through open-market operations; and the real bills doctrine that argued for credit control under the discretion of the Board of Governors and the Reserve Banks, using the Fed Banks’ discount rate as the controlling mechanism. When Strong died of tuberculosis in October 1928, real bills policymakers within the system moved to take charge of the policy machinery. Unfortunately, they succeeded.

Both the administrations of the twelve Reserve Banks and the Federal Reserve Board, which was based in the U.S. Treasury Building in Washington, had policymaking powers. The Board operated as a supervisory-and-review body, and had a veto power over discount rates set by individual Reserve Banks. It also made the final determination of the “character of paper eligible for discount,” and could set other regulations and limitations on discounting (Board of Governors, 1961, 44-48).

Besides its proscriptive powers over Fed Bank discount rates and the eligibility of commercial paper, the Board also had extensive emergency powers that it could use in a crisis. Most importantly, it could order the suspension of “any [gold] reserve requirements specified in this Act” for a period of 30 days, and it could renew such suspensions every 15 days thereafter for an indefinite period (Board of Governors, 1961, 34-35; emphasis added). This reasonable provision gave the Board the power to let the Reserve Banks use all their gold, if need be, to maintain gold payments for their paper currency as long as they had any gold. It emphasized that the Fed was designed to be a gold-standard central bank. If the Fed Banks had run out of gold, they could not have “failed.” Their existence did not depend on their gold holdings. They simply would no longer have had decisive control over the quantity of money.

The Fed Board in Washington, however, had no tradition of active policy, and most of the other Reserve Banks were mainly concerned with local affairs. Most important was the theory under which both Board and Banks operated. With the exception of the New York Fed, all of them were steeped in the real bills doctrine – as the Federal Reserve Act suggested they should be.

An especially prominent member of the Board, who had served on it from the date of its establishment in 1914, was Adolph C. Miller, a conventional academic economist with a master’s degree in political economy. Both Miller and another economist, H. Parker Willis, were instrumental in writing real bills norms into the Fed Act when it was passed. Both had been students of J. Laurence Laughlin, who began as a histori-

Had Fed authorities allowed “their” gold reserves to run down, the monetary contraction would have been halted.


an (Ph.D., Harvard, 1876), but osmosed into economics. By the time he became head of the economics department at the new University of Chicago in 1892, Laughlin was the most influential and dogmatic real bills proponent in the economics profession. He subsequently appointed both Miller and Willis as his colleagues in academic positions. Both shared Laughlin’s real bills prejudices. Willis received his doctorate in economics (1898) under Laughlin, and contributed chapters to two of Laughlin’s books. Miller managed to get appointed Assistant Secretary of the Interior in 1912, and then to the Fed Board by President Wilson in 1914.

Another major player in real bills doctrine was Congressman Carter Glass from Virginia. When the Federal Reserve bill came before Congress in 1912-1913, Willis – who had taught economics to Glass’ two sons at Washington and Lee University around 1910 – had become the resident expert in monetary policy for the congressman, who· was Chairman of the House·Banking and Currency Committee, and thereby the most influential·voice in the formulation and passage of the Federal Reserve Act. The Real Bills Doctrine thus became the dominant theme of the Federal Reserve Act (Bornemann, 1940; White, 1983). At one point in time, 1918-1920, Miller was on the Fed Board; Glass was Secretary of the Treasury, and, therefore, Chairman of the Fed Board; Willis was Secretary to the Fed Board, and Laughlin was basking in retirement from his prestigious position at the University of Chicago. Real Billers were in the ascendancy!

As a member of the Fed Board, Miller was instrumental in writing the Board’s Tenth Annual Report in 1923, which is virtually a prescription for real bills policy. Again, during Congress’ Stabilization Hearingsin 1928, Miller displayed his Real Bills dogma. “The total volume of money in circulation,’ he declared, “is determined by the [productive activity of the] community. The Federal reserve system has no appreciable control over that and no disposition to interfere with it.” Miller was particularly opposed to the price level stabilization policies of Governor Strong, and was almost indiscreet in charging that Strong was one of those “amateur economists” who “constitute one of [the System’s] dangerous elements.” A few months after Strong’s death, Miller, who had been on the Board since1914, was able to establish his effective leadership over Fed policy.

Besides emphasizing that banks and central banks should buy only real bills, the real bills doctrine has an important negative aspect: it fundamentally opposes and prohibits several other forms of bank .lending – long-term loans, mortgages, government bonds, and especially speculative loans that support real estate bubbles and stock market frenzies. Fed Board governors now in charge of monetary affairs were determined, under Miller’s urging, to wage an active crusade against “speculation.”

In accordance with the precedent Strong had unwittingly set in promoting a stable price level policy without heed to the Fed’s gold assets, real bills proponents could proceed equally unconstrained in implementing their policy ideal, also without heed to the Fed’s gold assets. System policy in 1928-29 consequently shifted from active price level stabilization to active antispeculation. “The” gold standard remained where it had been – nothing but official window dressing, waiting an opportune time to reappear.

The Real Bills Central Bank in Operation

Fortunately for the record, Miller had the temerity to write an article for· the American Economic Review of February 1935, “Responsibility for Federal Reserve Policies, 1927-1929,” in which he confirmed his assumption of leadership over Fed policy in 1929 and the Board’s subsequent directive of a massive anti-speculation policy for the Fed Banks.

Miller noted critically that the district Fed Banks during 1927-1929 had taken no initiative to check the growing tide of speculation in the stock market. The leadership of the Fed

No one blamed Federal Reserve managers and their operational emphasis on the real bills doctrine: only a scattered handful of economists and Fed officials knew how the monetary machinery functioned.


Bank of New York under Strong, he charged, “proved to be unequal to the situation … in this period of optimism gone wild and cupidity gone drunk” (453).

In 1929, with Strong no longer on the scene, Miller recounts that the Fed Board’s “anxiety reached a point where it felt that it must itself assume the responsibility for intervening … in the speculative situation menacing the welfare of the country” (454). On Feb. 2, 1929, by which time Miller was controlling Board policy, the Board sent a letter to all Fed Banks stating that the Board had the “duty” to correct current financial conditions, “which in the immediate financial situation, means to restrain the use of federal reserve credit facilities in aid of the growth of speculative credit”(454). To do so, he continued, it ordered the Fed Banks to initiate “the policy of I direct pressure,'[which]restrictedborrowingsfrom the federal reserve banks by those member banks which were increasingly disposed to lend funds for speculative purposes” (454).

Miller initiated “direct pressure.” In 1929-1930, when Fed Banks already had in place higher than normal discount rates, “direct pressure” added a major hurdle to the discount rate. It enjoined the Fed Banks not to lend, even at a “high” discount rate, if the potential borrowing bank had brokers’ loans or anything else in its portfolio that might have contributed to the “high” prices of stock market securities (Warburton, 320). “It put the member bank,” Miller argued, “which was seeking federal reserve credit facilities in order to support or increase its extensions of credit for speculative uses, under pressure by obliging it to show that it was entitled to accommodation. It was, a method of exercising a discriminating control over the extension of federal reserve credit such as the purely technical and impartial method of bank rate could not do” (455-456, emphasis added).

Monetary historian Clark Warburton, writing some years later, emphasized the viciousness of the direct pressure tactics. In the early 1930s, Warburton wrote,

Fed Banks . . . virtually stopped rediscounting or otherwise acquiring”eligible” paper. This [policy] was not due to any lack of eligible paper … Nor was this virtual stoppage … due to any forces outside the Federal Reserve System. It was due to “direct pressure” [from the Federal Reserve Board] so strong as to amount to virtual prohibition of rediscounting for banks which were making loans for security speculation, and a hard-boiled attitude towards banks in special need of rediscounts because of deposit withdrawals…. Federal Reserve authorities had discouraged discounting almost to the point of prohibition. (339-340)

“Direct pressure,” under a Federal Reserve Board that did not know what it did not know even in the presence of the catastrophe it had created, was a means of making the Fed Banks’ formal discount rate irrelevant. The true discount rate under “direct pressure” was whatever the central bank authority wanted it to be. If a bank seeking accommodation had a speculative taint, it could not borrow from the Fed Bank at any rate: the applicable discount rate was infinite.

Ironically, the policy of “direct pressure” violated the positive side of the real bills doctrine that had played such an important role in the writing of the Federal Reserve Act! The Fed Board’s anti-speculative compulsion crowded out legitimate lending to needy banks that actually had “real bills” to discount, thereby causing the very condition that the Federal Reserve System was supposed to prevent.

Significantly, nothing in Miller’s account refers to gold or the gold standard. That institution clearly was not viable as a policy issue, either in Miller’s view or in anyone else’s. Miller made no bones about who was responsible for the new restrictive policy. “It is not without significance,” he remarked proudly, “that … the five members of the Board who took the responsibility of formulating the attitude and policy for the federal reserve system were opposed by a minority of their own membership, including the Secretary of the Treasury [An- drew Mellon], the governor and vice-governor of the Board, by the twelve federal reserve banks, the Federal Advisory Council, and by many of the largest member banks. Nonetheless, the Board adhered to its position [I]” (456, emphasis added). Five members of the heroic Federal Reserve Board against the Sinful Speculative World!

Meanwhile, Fed Banks continued to pile up gold. Fed gold reserves peaked at $3.5 billion in 1931 (from $3.1 billion in 1929), an amount that was 81% of outstanding Fed demand liabilities, and much more than double the gold reserves required by the Federal Reserve Act (Timberlake, 270).

Even in March 1933, Fed Banks had almost $1 billion of excess gold reserves, which could have been accounted even higher by simple bookkeeping adjustments. As Friedman and Schwartz state: “The conclusion seems inescapable that a shortage of free gold did not in fact seriously limit the alternatives open to the System. The amount was ample at all

To say that neither the general public, nor government officials, nor many economists, nor soothsayers understood what had happened to the monetary system, and then to the economy, is an understatement.


times to support large open market purchases….The ‘problem’ of free gold was largely an ex-post justification for policies followed, not an ex-ante reason for them” (Friedman & Schwartz, 406).

Neither were the Fed’s legally required reserves – never mind the “free gold” – a line in the sand. As explained above, the Fed Board had the absolute power to suspend gold reserve requirements entirely so that the Fed Banks could use all of their gold if necessary by lending to member banks, thereby providing the currency (Federal Reserve notes) and bank reserves that the situation required. People and institutions, including foreigners, would not necessarily have demanded the gold to redeem the money the Fed had created. If they had, however, the Fed Banks had 5,900 tons of gold to satisfy them.* Instead, the Fed Banks and Board sat on the gold, including the”excess,” while the economy disintegrated. Fed Banks had more gold in early 1933 than they had in the fall of1929! Had Fed authorities allowed “their” gold reserves to rt1-n down, not only would the monetary contraction have been halted, but the rest of the world’s monetary systems would also have been able to expand as their central banks received theFed’s outgoing gold flows through trade and capital exchanges (Friedman & Schwartz, 412; Timberlake, 272).

General Misunderstanding and Innocence of the Gold Standard

To say that neither the general public, nor government officials, nor many economists, nor soothsayers understood what had happened to the monetary system, and then to the econ- om~ is an understatement. Everyone had a favorite scapegoat or whipping boy. No one, however, blamed Federal Reserve managers and their operational emphasis on the real bills doctrine: only a scattered handful of economists and Fed officials knew how the monetary machinery functioned, and none of them realized how adherence to the antispeculative policy had propagated the current disaster. Moreover, all Fed officials had an obvious vested interest in blaming other factors. The make- believe-gold-standard-that-wasn’t was one such factor. (See Higgs, “Crisis and Leviathan,” and Powell, “FDR’s Folly,” for

The authentic gold-standard provided both to the United States and to the world a long-term stability unmatched by any other monetary system before or since.


the wholesale misconceptions that appeared, and the Great Leap Forward to collectivist policies and institutions that characterized the 1930s and after.)

Since the nightmare of the 1930s, some progress toward a proper understanding of the event has occurred.

First, most present-day economists agree that the Great Contraction was largely a failure of monetary policy and of institutional arrangements that allowed monetary policy to provoke such a disaster. Second, they agree that the Great Contraction·initiated the Great Depression, and.most deny that the capitalist free-market economy in any way caused the catastrophe.

Given these agreements, however, economists still record some major differences on just how monetary policy went

*1£ the 5,900 tons of gold had been loaded into 590 ten-ton trucks, with 100 feet between the midpoint of each truck, the convoy would have stretched 11.2 miles.

awry and just what was the crux of the problem. Somehow, the data omissions on gold stocks and the untreated role of the real bills doctrine have gone unnoticed, or at least unstressed. The profession is, therefore, working with some fundamentally

Gold imposes restrictions upon governments or bureaucracies that are much more powerful than parliamentary criticism. It is both the badge and the guarantee of bourgeois freedom.


flawed historical analysis, and the section of the general public that remembers the event is still misinformed and bewildered. One thing is certain: The gold standard should be exonerated forever from having any part in the disaster.

Given the huge amount of Fed-controlled gold, even a seat-of-the-pants understanding of the situation in 1931-1933 should have convinced Fed Banks to carry out some degree of monetary expansion. Data from Friedman and Schwartz’s Monetary History indicate that as of August 1932, the M2 money stock was $34 billion and the monetary base $7.85 billion, giving a money-supply a multiplier of 4.33 (Friedman & Schwartz, table A-I, 713). At the same time, the Fed Banks and Treasury held $2.91 billion in gold (Board of Governors, 1943, table 93, 347-349). If Fed Banks and Board had spent all their gold discounting paper for member banks, so that the monetary base had increased by this amount ($2.91 billion), the increase in the base would have expanded M2 to $46.6 billion, the amount of M2-money that the economy actually had in July 1929. Spending would have increased correspondingly.

Of course, Fed expansion never would have had to go that far, for a spending dynamic would have set in and restored all the major monetary vitals long before the Fed’s gold had dissipated. Moreover, if expansion had occurred earlier, say in 1930 before the banking crises and the great increase in the real demand for currenc~ the money supply multiplier would have been very much greater, and the Fed’s expansion procedure would have been much more effectual.

The Real Culprit: the Real Bills Doctrine

Looking closely at the history of the Federal Reserve from the Fed’s beginnings in 1914, it is clear that an operational gold standard, either in its pure form or in the mode intended by the Federal Reserve Act, virtually never constrained or determined Fed policies. During WWI, Treasury compulsions ruled the Fed’s actions. In the 1920s, Strong’s price level stabilization policies were dominant. After Strong’s death, with A.C. Miller and other real bills central bankers in charge, the Great Contraction devastated both the monetary and economic systems. As the Great Contraction ended, Roosevelt became president, and the wild swings of the New Deal took center stage. Gold became a political football; Congress hyper-devalued the gold dollar; the Supreme Court allowed the abrogation of contracts in gold; and the Banking Act of 1935 left gold as a useless adornment on Treasury and Federal Reserve balance sheets. Today the U.S. Treasury claims it has 8,125 tons of gold (15.4 miles of la-ton gold-loaded trucks with their midpoints 100 feet apart, or more than one ton of gold for every word in this article) sequestered in heavily guarded vaults. This gold has no functional relationship at all to the U.S. monetary system, and no other purpose than to furnish jobs for its government custodians.

The negotiations and machinations of the world’s central bankers in the 1920s, as they tried to provide human design for the world’s monetary systems in place of the gold standard, did not work. Their blueprint retained only the outward and visible signs remaining from the working gold standard of a previous era; it abandoned the inward and spiritual grace of that system. Central bank “management of the gold standard” simply denied that whatever was being managed was a gold standard.

The damage done both materially and ideologically was inestimable. Ignorant political reactions to the debacle resulted in vast expansions of counterproductive governmental powers and programs that no Supreme Court could stop. Even worse, the common misperception of a market system that had “failed” provoked a popular ethos of anti-free-market regulation and governmental intervention that have increased exponentially with no end in sight.

The present-day Federal Reserve System has no relationship to the real-bills central bank of 1929-1933. It has in later years come (partway) back to the stable price level norms of Benjamin Strong. But it may be too late. The huge unfunded liabilities of the federal government, as they come due, are going to require the U.s. Treasury to pay them. The Treasury will have to borrow the money to do so. It will ask the Fed for help in keeping interest rates down. Whereupon the Fed, unless it has a chairman made of steel, will buy those Treasury securities in the open market – yes, holding interest rates down temporarily, but thereby creating new money and initiating an ongoing central bank inflation that will see interest rates skyrocket. The German model of 1923 will be only too applicable.

The authentic gold standard within the context of a relatively free market system provided long-term stability both to the United States and to the world, a stability unmatched by any other monetary system before or since. Joseph Schumpeter stated the case most elegantly and convincingly. “An ‘automatic’ gold currency,” he wrote,

“is part and parcel of a laissez-faire and free-trade economy. It links every nation’s money rates and price levels with the money-rates and price levels of all the other nations that are “on gold.” It is extremely sensitive to government expenditure and even to attitudes or policies that do not involve expenditure directly, for example, to foreign policy, to certain policies of taxation, and, in general, to precisely all those policies that violate the principles of [classical] liberalism. This is the reason why gold is so un- popular now [1950] and also why it was so popular in a bourgeois era. It imposes restrictions upon governments or bureaucracies that are much more powerful than parliamentary criticism. It is both the badge and the guarantee of bourgeois freedom – of freedom not simply of the bourgeois interest, but of freedom in the bourgeois sense. From this standpoint, a man may quite rationally fight for it, even if fully convinced of the validity of all that has ever been urged against it on economic grounds. From the standpoint of etatisme and planning, a man may not less rationally condemn it, even if fully convinced of the validity of all that has ever been urged for it on economic grounds. (405-406)”


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