What Should the Federal Reserve Done during the Great Depression?

Economics Economics Questions
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1

I am taking a class that examines the Great Depression through the lens of Austrian Economics. I have done a lot of research and have found a lot of good information about the causes of the Great Depression: the Federal Reserve and its policy of low interest rates.

However, what I have had trouble finding is, given the economic situation that the Federal Reserve helped to create by 1929, what prominent Austrian Economists of the day would have prescribed that it do (if anything) to help aid the situation.

Milton Friedman’s examination of the Great Depression (The Great Contraction, 1929-1933) places most of the blame for the duration and severity of the Great Depression on the Fed’s decision not to stop the deflation from occurring that then sent the economy into a deeper hole.

Even Hayek himself, who called for the Fed to not re-inflate the money supply later doubted and regretted this stance:

I am the last to deny – or rather, I am today the last to deny – that,
in these circumstances, monetary counteractions, deliberate
attempts to maintain the money stream, are appropriate.
I probably ought to add a word of explanation: I have to
admit that I took a different attitude forty years ago, at the
beginning of the Great Depression. At that time I believed that a
process of deflation of some short duration might break the rigidity
of wages which I thought was incompatible with a functioning
economy. Perhaps I should have even then understood that this
possibility no longer existed. … I would no longer maintain, as I
did in the early ‘30s, that for this reason, and for this reason only, a
short period of deflation might be desirable. Today I believe that
deflation has no recognizable function whatever, and that there is
no justification for supporting or permitting a process of deflation.

(Did Hayek&Robbins Deepen the Great Depression?) http://economics.sbs.ohio-state.edu/jmcb/jmcb/07056/07056.pdf

I am just confused as to what Austrian Economists really did recommend that the Federal Reserve do during this time, and also what the Federal Reserve actually did in response to the question. The Fed is often blamed for keeping interests rates low, but was this just in the years leading up to the bust?

Thanks for any help anyone can give me. I really appreciate it.

2

There was nothing that the central bank could do to stop the depression. It was the executive and congress that created it.

3

I would suggest Murray Rothbard’s America’s Great Depression. You can read the relevant text here: Credit Inflation during the Hoover Administration. There is a critique on how Rothbard accumulated statistics, but I lost the link to it and I haven’t actually listened to it myself. Hayek’s opinion fluctuated. Someone told me that after he published the comment you posted he rescinded and went back to his original position that the Federal Reserve tried to re-inflate the money supply. This is the opinion he holds in Monetary Theory and the Trade Cycle:

If, however, the deflation is not a cause but an effect of the unprofitableness of industry, then it is surely vain to hope that by reversing the deflationary process, we can regain lasting prosperity. Far from following a deflationary policy, central banks, particularly in the United States, have been making earlier and more far-reaching efforts than have ever been undertaken before to combat the depression by a policy of credit expansion — with the result that the depression has lasted longer and has become more severe than any preceding one. (Pp. 5–6 )

When you read that excerpt within the context of the entire paragraph, you will see that he is talking about the current depression, which at the time of the writing was the Great Depression; the preface was signed in 1932.

On the other hand, several free bankers hold that had the banks responded to the demand for money the worst of the depression could have been averted. I, unfortunately, have not had the time to properly learn and analyze their argument, and so I can offer you no informed position on this theory (and, it is quite a shame because the great depression is one of my favorite topics).

I would also suggest reading Garet Garrett’s The Bubble That Broke the World, that deals with credit expansion during the Great Contraction. But it focuses mostly on credit extension to Europe, not within the United States to combat deflation.

EDIT: If it helps any, I briefly address the theory that the Federal Reserve caused the Recession of 1937 through purposeful monetary contraction here: Dangerous Lessons of 1937. Although not related, at all, to the Great Contraction, it is another case in which the events were out of the Federal Reserve’s control.

4

Is this class in public school? State University? I have never heard of such a class in the mainstream. I’m curious, who is teaching it?

I recommend using the search feature on the home page and on the Literature page. These might help get you started:

The Fed Tried to Inflate in 1930.

The Causes of the Economic Crisis - 1931 by Ludwig von Mises

America’s Great Depression

5

I have a different take than most austrians. I agree with friedman for a different reason.

In my opion, if artificially low interest rates can give the illusion that there are more resources available to be invested than really exist (causing the business cycle), then it should also be possible that artificially high interest rates would give the illusion that less resources are available to be invested than really are available. Thus artifically high interest rates would slow economic recovery.

In the aftermath of the crash, the money supply was contracting rapidly do to people taking their money out of the fractional reserve system, which would in my opion would cause artificially high interest rates and thus stunt recovery.

If you accept that fractional reserve banking should exist (which obviously we don’t), then it would have been correct for the Fed to inflate the money supply to keep interest rates at the natural level (which technically impossible to calculate).

The problem is after you inflate the money supply, you end up with a glut of reserves. As soon as the economy recovers, people put their money back into the fractional reserve system, which is added to all they newly printed money, and potentially could cause hyper-inflation. Which is exactly the problem we are facing now.

The best alternative of course is get rid of fractional reserve banking.

6

This does not hold true when you take into consideration that prior to the credit contraction there was surplus credit, or interest rates were held artificially low. If credit is contracting to achieve a return to the natural rate of interests, then that is a natural response to credit extension. On the other hand, if credit is purposefully contracted by a central bank or bank then there would be negative repercussions for the economy as a whole.

7

I am actually a senior at the University of Notre Dame and am taking an “Independent Study” class. So basically I just choose a professor to work with for the semester and I read what I want and come up with my own curriculum. Unfortunately over my time here I never heard the words “Austrian Economics” mentioned except when I would ask my teacher about it personally. However, I spent a semester in Australia where the college I was at offered a class called “The History of Austrian Economics”.

8

jkoop, this is GREAT! There are so many resources here it’s like standing under Niagra Falls with a bucket. There are several “scholars” around this forum that can guide you. Maybe you can copy your curriculum to a post.

I think it would be interesting if you could update us from time to time with your progress. Good luck!

9

The same thing it should do at any other time: not exist.

10

Speaking of the free bankers, Professor Steve Horowitz’ letter to Reason was published today, and that sums the free-banker’s position pretty well:

Penn Bullock’s otherwise good article on Ben Bernanke (“Bernanke’s Philosopher,” December) leaves the impression that all Austrian economists reject Milton Friedman’s view that the Fed’s contraction of the money supply during the early 1930s was an important cause of the Great Depression and that all Austrians reject the notion that expanding the money supply is ever justified. Both of these impressions are incorrect.

There is no inconsistency in claiming that a Fed-generated inflation during the 1920s and a deflationary over-correction in the early 1930s were both factors in the onset and depth of the Great Depression. One can’t explain the current recession by invoking only the Fed’s inflation since 2001.

A number of Austrian school economists (including myself, Lawrence H. White, George Selgin, and Roger Garrison) also believe that the ideal monetary system should adjust the supply of money to the public’s demand to hold money. Thus when the demand for money rises economy-wide, as it did in the early 1930s and in the fall of 2008, the proper response is to provide additional money so as to avoid the monetary deflation and potential banking system collapse we saw in the 1930s.

This group of Austrians also believes that central banks will not be very good at doing this, which is why we support the separation of banking and the state in the form of a system of competitive money production. Our proposed “free banking” system would use market forces to adjust the supply of money up and down as determined by demand, just like markets do with other goods and services.

My own view is that while the Fed responded appropriately by providing more liquidity in the fall of 2008, it overdid it. In particular, the Federal Reserve did not need additional powers. Its standard tools would have done the trick and kept the expansion in check. The powers it has acquired and the massive increase in the monetary base they generated are dangerous mistakes that create a high probability of significant inflation in years to come. This misbehavior lends support to one idea that Bullock rightly notes all Austrians do agree on: We need to get rid of the Fed.

I think I ought to re-read Rothbard. Does anybody have a link to that media file where some economist criticizes Rothbard’s analysis of the Great Contraction?

11

I must first admit that I am not 100% familar with the exact monetary circumstances surrounding the great depression, but let me give you an example of how you could be wrong. This may not apply to the great depression - i would have to do more reserach to find out if it is the case.

If the fed inflates the money supply causing the business cycle. The “bust” usually happens onces the reality that too few resources exist to fund these new investments. This “reality” ultimately drives the interest rate back up to the natural rate. Which is exactly what causes the bust.

After the rate is back to normal and people witness the collapse of the economy, they then go and take their money out of their fractional reserve accounts. This causes the money supply to contract violently (ex. 1 dollar withdraw from a frb may cause 100 dollars of money to disappear). Now rates were already at the natural level due to the adjustment that caused the bust, if the money supply contracts further as I have said, then the interest rate is not going back up to the normal level, but rather it is going artificially higher than the normal level.

This artficially high rate causes resources to sit on the sidelines instead of being used.

Again this is predicated on the idea that the interest rates adjust back to normal at the start of the bust, the new higher quantity of money becomes the new equillibrium because the market has already adjusted. If a large contraction of the money supply happens after this adjustment, it is not taking the money supply back down to the equillibrium level, but rather below the equillibrium level, causing artifically high interest rates.

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If it has the information, which I assume it does, try to lower the interest rate down to the saving’s rate as much as possible. However I would like it if someone adressed that Hayek quote in the OP

14

“Today I believe that deflation has no recognizable function whatever, and that there is
no justification for supporting or permitting a process of deflation.”

I found Hazlitt’s book, Inflation [available free of course] very enlightening on this point.

He hates deflation too. However, he writes in Chapter 23:

"Yet a lot of people have come to believe sincerely that
unless the supply of money can be increased “propor-
tionately” to the supply of goods and services there will not
only be a decline in prices, but that this will bring on
“deflation” and depression. This idea will not stand analysis.

If the quantity and quality of money remained fixed, and
per capita industrial and agricultural productivity showed a
constant tendency to rise, there would, it is true, be a tend-
ency for money prices to fall. But it does not at all follow
that this would bring about more net unemployment or a
depression, for money prices would be falling because real
(and money) costs of production were falling. Profit mar-
gins would not necessarily be threatened. Total demand
would still be sufficient to buy total output at lower prices.

The incentive and guide to production is relative profit
margins. Relative profit margins depend, not on the abso-
lute level of prices, but on the relationship of different prices
to each other and of costs of production (factor prices) to
prices of finished goods.

An outstanding example of pros-
perity with falling prices occurred between 1925 and 1929,
when full industrial activity was maintained with an average
drop in wholesale prices of more than 2 per cent a year.

The idea that the supply of money must be constantly
increased to keep pace with an increased supply of goods
and services has led to absence of concern in the face of a
constant increase in the money supply in the last twelve
years. From the end of 1947 to the end of 1959 the supply
of bank deposits and currency increased $79 billion, or 46
per cent. And since the end of 1947 average wholesale prices
have increased nearly 24 per cent, in spite of an increase in
the industrial production index of 60 per cent."

So what is the terrible deflation that leads to disaster?

He talks about the defaltion caused by England going back to the gold standard in 1925 as the classic example.

Here’s what he say about it [with bolded parts being his words, and my font]:

"The case of Great Britain is clear. It had gone off gold
in World War I. The pound had dropped from a gold
parity of $4.86 to a low of $3.18 in February 1920, and had
returned in late 1924 to approximately 10 per cent below the
gold parity. But wholesale prices in Britain in 1924 were
still 70 per cent above their prewar level.

The British Government decided to resume the gold standard at the old
par in 1925. The result was a steady fall in wholesale prices
over the next seven years from an index number of 171.1
(1913 equals 100) in January 1925 to 99.2 in September 1931,
the month in which England abandoned the gold standard.

As the British all during this period were unwilling to make
corresponding cuts in retail prices and wage rates, the result
was falling exports, stagnation, and unemployment.

And it was the gold standard itself, not the false rate (or the in-
ternal inflexibility of wages), that got the blame."

So there you have it. Bottom line: Deflation [=decrease in amount of paper flying around, or if there is a gold standard, the rise of the value of the currency in terms of gold] is not in an of itself a bad thing. Lower prices ar not a bad thing, nor are lower wages, if prices of everything goes down.

The trouble with deflation happens when it is induced from the outside, with something like reintroducing the gold standard [without taking appropriate steps, as Hazlitt details in the book]. Even then all it does is lead to lower prices of everything, and that is not neccesarily bad either.

The real horror of deflation is because people are unwilling to make
corresponding cuts in retail prices and wage rates. This of course, results
in stagnation, and unemployment.

[I left out “falling exports” in the summary, because I don’t really get what’s wrong wirh falling exports. Maybe he means that other countries are unwilling to trade, which is of course, a bad thing].

My guess is that a sharp cookie and movie star like Hayek meant the same thing.

15

Thanks for all the great info! It really gives me a lot to think about and digest.

The class itself doesnt really have any concrete curriculum. I just went to my professor with an idea that I wanted to explore (viewing the Great Depression–its causes and the reasons for its length-- through the lens of Austrian economics). Since he himself is not really at all familiar with Austrian economics I’ve had to do most of the research and finding sources to look at on my own, so if anyone has any other advice I’d love to hear it. I asked Thomas Woods for any help and he directed me to this forum, and it looks like it has given me some good places to look.

Basically for my class I have been reading journal articles and books that I have been able to find and writing an analysis on each one and how it does/doesnt fit into the Austrian explanation. I have looked at cases where an Austrian policy prescription was followed (the 1920 recession) as well as were Keynesian predictors failed (1946 and the end of WWII). The plan is for me to finish up the class with a 20-30 page analysis or something like that by putting all the information together.

Two other questions:

1.) Where would I be able to find the Federal Reserve discount rates for this time period? I think there was a list at the end of Robbins’ Great Depression, but I dont really know what to compare them to, or what would be deemed as not “artificially low”.

2.) My professor, while intrigued by the Austrian theory, is concerned about what would happen if the Fed were abolished and there was no lender of last resort. He claims that without some institution providing this backing, good banks would fail. For example, he says that if Bank 1 makes poor decisions and finds itself without money and fails, then (because of imperfect consumer information) then a person who belongs to Bank 2 would become afraid that his bank was doing similar things and would, thus create a run on Bank 2–a perfectly good institution. How would you rebut this claim? Is this then a question of fractional reserve banking which the Austrians would also say to do away with?

Thanks a lot.

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This is so wrong in so many ways. OK lets analyze:

17

To echo what SmilingDave said. Why does your professor say that Bank 2 is “perfectly good”? If the depositors want their deposits back, then the bank should be able to provide such deposits, on demand, as agreed. If the depositors see that the bank is solid after asking for their own money back, then the depositor’s fears would be calmed and the money would stay put. Just because a bank’s loans are “good”, doesn’t mean we can ignore the other side of the balance sheet, the demand deposits. It is the central bank that allows a fractional reserve system to grow into the monster that destroys the economy.

We’ve had a central bank since 1913, and it started doing open market operations in earnest beginning in 1922. So, 86 years of open market operations, lender of last resort. Then Sept. 08 happened. How is the lender of last resort theory doing? Does he realize that the entire banking system collapsed in Sept '08? The only thing that gives the illusion of soundness at this moment is that the FDIC (the taxpayer) guaranteed all non-individual demand deposits in the entire system without limit in December, '08 (the TAG program). The taxpayer is the lender of last resort. If your professor is fine with that, then OK. But, he probably believes that the financial crisis was caused by the lack of regulation (“We need more regulation”, etc). And that’s fine too, if that’s what he believes, but the lack of regulation did not cause the system to fail.

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jkoop, is your degree in economics? Is your professor for this class an economics professor?

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Yes, my degree is in Economics and also in Political Science, and yes he is an economics professor.

Also, he has been very sympathetic to the Austrian view and willing to engage in a real discussion about the topic, and really posed these questions as things to think about and to encourage me to look more deeply into the federal reserve.

I responded to his question about banking with the standard “the Fed creates moral hazard” answer and he agreed in principle.

If banks do away with fractional reserve lending they are still able to make money, correct? How exactly would this happen?

20

On demand deposits, they can charge warehousing fees. On savings account, they can claim part of the profits made through interest [or they can lend out their own capital, and make full profits made through interest].