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The Roots of the Great Depression

The Roots of the Great Depression

10 Mins
October 21, 2010

January 2001 -- [INTERVIEW]: "Old myths never die; they just keep showing up in college economics and political science textbooks," writes Lawrence W. Reed, president of the Mackinac Center, in his 1999 Freeman article, "Great Myths of the Great Depression." "Students today are frequently taught that unfettered free enterprise collapsed of its own weight in 1929, paving the way for a decade-long economic depression full of hardships and misery.

President Herbert Hoover is presented as an advocate of 'hands-off,' or laissez-faire, economic policy, while his successor, Franklin Roosevelt, is the economic savior whose policies brought recovery. This popular account of the Depression belongs in a book of fairy tales and not in a serious discussion of economic history, as a review of the facts demonstrates."

Many economists and political scientists have worked to present an objective view of the Great Depression. Of particular interest to classical liberals is the work of Murray Rothbard, especially America's Great Depression, which discusses how manipulation of the money supply led to the crash of 1929 and how Hoover's anti-free market policies worsened the situation. However, there is still much disagreement amongst classical liberals as to precisely how to interpret the events that led up to, and occurred during, the Depression, as evidenced by the recent debate between economists Richard H. Timberlake and Joseph Salerno published by the Foundation for Economic Education.

Timberlake is a former professor of economics at the University of Georgia, where he taught monetary economics from 1964 to 1990. He is an expert on the Federal Reserve, monetary policy, and the history of central banking. He is the author of, most recently, Monetary Policy in the United States (University of Chicago Press, 1993). Timberlake has also published a multitude of articles and has had entries appear in several economic encyclopedias, including The New Palgrave Dictionary of Money and Finance and The Encyclopedia of Business History and Biography.

In this interview, Timberlake explores how the government helped cause and prolong the Great Depression by unnaturally manipulating the money supply.

Navigator: Austrian economists, such as Murray Rothbard, often place the blame for the Great Depression on an increase of the money supply by the Federal Reserve from 1921-29. Was that the case?

Timberlake: No. As I explained in my first article in a series for The Freeman [see Money in the 1920s and 1930s, The Freeman, April, 1999. pp. 37-42], Rothbard and his supporters are wrong on three counts. First, the policy attitude of the Federal Reserve Banks in that era was decidedly restrained, and even contractionary. The active assets of the Fed Banks - the loans and discounts they make to commercial banks on which the banks create money - declined at an average rate of 1.6 percent per year. Second, the stock of money, M1, which includes the outstanding amounts of hand-to-hand currency and bank deposits subject to check, increased only nominally over this period - 2.5 percent per year. M2, which includes M1 plus time deposits in commercial banks, increased 4.6 percent per year. Such a modest rate of increase, in conjunction with the outstanding productivity of that era, made price inflation virtually impossible. Third, Rothbard presumed unconventional definitions of both "inflation" and "the money supply." I hesitate to elaborate on his usage of these terms because it would take up a lot of space and try the readers' patience. I will elaborate on these points if it seems productive. No economists accept his concepts of these terms.

Navigator: Do we then see a contraction in the supply of money during the 1920s?

Timberlake: The stock of money in the hands of the public, M1, did not contract during the 1920s. It increased at the very modest rate noted above, in spite of the fact that the Federal Reserve Banks' inputs to the monetary system fell. The net increase in money in existence was due to an inflow of gold into the United States resulting from favorable balances of international payments. Goods and services, capital movements, and reparation payments all contributed to the build-up of gold in the U.S. Treasury.

Navigator: As I understand it, the Federal Reserve has the authority to dictate the reserve ratio - the amount of depositors' assets that must be held in reserve (as opposed to loaned to others) - to which member institutions must adhere. This ratio was not the same for all types of banks and accounts; for example, rural banks had lower reserve ratios than did urban banks, and time deposits (such as certificates of deposit) had lower reserve ratios than demand deposits (such as checking accounts). In the 1920s, there seems to have been a shift towards accounts that required lower reserve ratios. Why was that?

Timberlake: You are right that the overall reserve-deposit ratio of banks declined [as people shifted to lower reserve accounts]. This kind of change is typical of a cyclical economic expansion. . . . During a business expansion, both people and banks are willing to give up some measure of secure liquidity in the assets they hold in favor of improved earnings and less liquidity.

Navigator: What effect did this shift in account types (and consequently in reserve ratios) have on the monetary supply?

Timberlake: For the period as a whole, the decline in the reserve-deposit ratio was a force that would tend to increase the overall money stock. However, this ratio is just one factor that acted on the money stock. The increase in total bank reserves and hand-to-hand currency was 27 percent, and the increase in the ratio of checking deposits to hand-to-hand currency was 54 percent. All three of these factors tended to increase the stock of money people used for transactions, but the inflow of gold that increased currency and bank reserves was the fundamental factor. Had gold increases not furnished the new money that the period witnessed, Fed Banks could have provided the necessary increases by purchasing interest-bearing assets from the member commercial banks. In fact, the Fed had to adopt a somewhat contractionary policy because the gold increases by themselves would have been mildly inflationary.

Navigator: In a recent article for The Freeman you characterized the period from 1929 to 1933 as a "deflationary disaster." What, precisely, does this mean?

Timberlake: It was "deflationary" because Federal Reserve policy allowed the economy's money stock to decline through three major banking crises and it was "disastrous" because of the magnitude of the decline.

Navigator: Did the Federal Reserve act to turn around this contraction in the monetary supply?

Timberlake: The Fed did not act to turn around the contraction but allowed it to continue for more than four years. Fed officials were operating under a flawed policy model called "the real bills doctrine." According to this notion, the economy's production preceded the creation of new money to pay for the new product. Given a decline in the output of goods and services, less money was "needed." Consequently, Fed policy makers allowed the economy to spiral downwards as they "successfully" managed an ongoing reduction in the money stock. Prices, wages, incomes, and output spun down toward zero as Fed officials grimly held to their strategy. Without a central bank interfering, the traditional gold standard and clearinghouse adjustments in the form of accommodation to the commercial banks would have righted the economy as early as 1931.

Navigator: In your previous writings, you have noted that Federal Reserve policy prevented much of the gold coming into the United States from directly entering into the money supply through a process called "sterilization." How, precisely, did the Federal Reserve "sterilize" incoming gold? And why was this policy put in place?

Timberlake: A central bank operating under a gold standard can always freeze incoming gold so that the gold has no monetary effect. It does so by selling interest-earning assets from its portfolio of assets in conjunction with the inflow of gold. Then the new gold, which would have duly propagated new money by becoming an additional asset of the central bank, is neutralized. The central bank has more gold assets but fewer other assets on which to base its money. Only a central bank can carry out such an operation, and its power to do so distinguishes it as a central bank.


Navigator: In America's Great Depression, Rothbard asserts that American isolationism in the 1920s is almost wholly a myth, especially with regards to economic activity. No where is this more evident than in the Federal Reserve's attempt to return Britain's pound sterling to a pre-World War I value. Could you please detail American attempts to do this?

Timberlake: I would not deny that "isolationism" was a myth. Certainly, Fed policy makers would like to have seen the British pound sterling redeemable again in gold. However, British policymakers called for returning the pound to its pre-war value of $4.865. (During the 1920s, the pound's value fluctuated between $4.40 and $4.80.) The pre-war parity could not be reached unless (1) the British price level was brought down from its wartime level to something near its pre-war value, or (2) the price level of Britain's major trading partner, the United States, increased by approximately the same amount. Otherwise, gold would not stay in Britain and be the reserve for the pound sterling. The ongoing attempt to raise the gold value of the pound resulted in this constant pressure to lower money prices, which had a depressive effect on employment, income, and output.

No matter what the pious statements of American policymakers, they were not about to inflate the American price level in order to provide a pound redeemable in gold at the pre-war value. Their deflationary policy, including gold sterilization during the 1920s, confirms their resistance to British efforts to get them to inflate.

If British policymakers had abandoned the notion of returning to the pre-war parity and allowed a slightly reduced gold price for the pound sterling, the problem would have disappeared. Apparently, the humiliation of reducing the gold value of the pound even by a small amount was too much for their pride, so the easy way out did not materialize. Of course, this kind of devaluation soon became commonplace. The British government did it anyway in 1931, and it became very popular from then on.

Navigator: What impact did our assistance to Britain have on the American economy?

Timberlake: The only "assistance" the Fed gave to the British during the 1920s was verbal. The reality of Fed policy was decidedly negative to any inflationary actions. Gold was sterilized to prevent the inflation the British desired. This constrained approach carried on into the 1930s, albeit on a different basis. Nonetheless, the common theme of Fed policy in the 1920s and 1930s was very restrictive even when it should not have been, for example, after 1931.

Navigator: Winston Churchill was Chancellor of the Exchequer (the minister responsible for treasury activities) at this time. What role - if any - did he have in the attempts to prop up the pound sterling?

Timberlake: I am not familiar with Churchill's actions. No doubt he supported Bank of England policy under Montagu Norman, Governor of the Bank of England. No matter, U.S. policy makers would not adopt the British inflation. The evidence for this fact can be deduced from price-level data in both the United States and England.


Navigator: According to Murray Rothbard in America's Great Depression, President Herbert Hoover embarked on extensive governmental planning and intervention, including bolstering wages and prices, expanding credit, and propping up weak firms through the Reconstruction Finance Corporation. How did such policies (which would seemingly lead to price and wage inflation) affect the economy?

Timberlake: Rothbard is correct that Hoover was an interventionist, promoting New Deal policies before there was a New Deal. The Reconstruction Finance Corporation was simply another government institution put into place to carry out policies that the Federal Reserve Banks seemingly were unable to effect. Since Fed policy was so tight, and the Fed Banks not under any direct governmental authority, Hoover and the Congress created this new surrogate for the Fed Banks. If the Fed had acted like a proper central bank, and not contracted credit and the money supply so disastrously, the RFC might never have happened - likewise much more of the "alphabet soup" of the next ten years. However, these agencies had very little if any effect on prices and wages generally, because they could not do anything about the monetary system. They distorted relative prices and wages by promoting a misallocation of resources, but they did not raise (or lower) the price and wage level significantly.

Navigator: Some analysts have said that the 1932 elections threw a great deal of uncertainty into the business community. This prompted large investors to shift their holdings of wealth from cash and stocks into more stable commodities, such as gold, land, and diamonds. What effect, if any, did this trend have on the monetary situation?

Timberlake: Cash and stocks are not parallel assets. If a person is going from common stocks into cash, he is trying to avoid stock losses. When prices are falling, cash is a good investment. Neither are gold, land, and diamonds in the same camp. Every 'gold standard' law fixed the official price of gold, so its real value appreciated as all money prices fell. Dollar devaluation then began to look more and more probable. But land would have been a risky acquisition during the Great Contraction. Diamonds were probably also a good investment.

One should understand, however, that if some people were buying, say, more gold, they must have been buying it from someone. When money is spent on various hedges, it does not go out of existence. The money one person spends another person receives. It is true that the great uncertainty of the times, the general public's ignorance of monetary affairs, and the Federal Reserve's ghastly contraction of the monetary and banking system provoked, additionally, a decided reduction in the rate at which money was spent-what is termed "the velocity of money." However, the significant decline in velocity was an after-effect of the previous decline in the quantity of money, and the corresponding deflation of prices.


Navigator: How was the Federal Reserve structured in the 1930s? Did it have the same structure and array of powers as it does today, or was it fundamentally different in character?

Timberlake: Until 1935, the Fed had its original structure - powers, operating procedures, and physical properties. However, the Banking Act of 1935, which should have been titled, "The Central Banking Act of 1935," radically changed the original Federal Reserve System. It converted the Fed from a system of regional super-commercial banks with powers to assist local banks to a true central banking system with complete control over the monetary system. The act vested the Board of Governors in Washington with greatly enhanced authority. It also made a sham of the gold standard. From this point on, central bankers, not the gold standard, determined the outstanding money stock in the United Sates.

Navigator: Who was on the Federal Reserve's Board of Governors in the 1930s? Were they mostly Roosevelt appointees?

Timberlake: The Federal Reserve Board changes constantly through time. The President appoints all seven members of the Board. An appointment comes up once every other year, and is for a term of fourteen years. So Franklin Roosevelt, by being president for thirteen years, was able to appoint at least six members, including the chairman. In practice, members also retire or die before their terms expire, so usually a president appoints more than one member every other year. Additionally, when Congress passed the act of 1935, it changed the name of the Board (insignificantly) and therefore President Roosevelt had the opportunity to appoint the whole "new" board.

Navigator: How did the Federal Reserve and the Department of Treasury interact in the 1930s? Was the Fed treated as an autonomous entity, or was it simply being used as a tool of the Treasury Department?

Timberlake: The new Chairman of the Fed Board in 1935, Marriner Eccles, was a confirmed fiscalist. He was a protégé of Henry Morgenthau, the secretary of the treasury, and was appointed at Morgenthau's urging. He readily assumed a subservient role for monetary policy, thereby letting Treasury policy dominate Fed policy. However, the Treasury has almost always bullied the Fed anyway, partly because the secretary of the treasury was ex officio chairman of the Board of Governors until 1935. More fundamentally, the Treasury is a critical office in the executive branch and has more political incentive to see its big spending policies enhanced through expansive monetary policies. I doubt that any secretary of the treasury ever urged Fed policy makers to tighten up the monetary structure so as toprevent inflation. The thought is politically absurd.

Navigator: What was the Gold Reserve Act of 1934, and why was it significant? What effect did it have on the economy?

Timberlake: A joint resolution of Congress on June 5, 1933, abrogated all gold clauses in all contracts public and private. In addition, the Thomas Amendment to the Agricultural Adjustment Act, passed a few weeks earlier, gave the President the power to devalue the gold dollar by as much as 60 percent. (However, Roosevelt did not use all of this power; he only devalued the dollar by 59 percent-no power-mad ruler he.) Then, on January 30, 1934, Congress passed the Gold Reserve Act, which allowed the president to call in all domestic gold and pay for it at the legal mint price ($20.67 per ounce).

The purpose behind all this legislation was to promote a program that would swell the government's gold stock, and thereby allow an increase in the economy's stock of money. The official myth was that gold had become "scarce"-and it had, but primarily because the federal government had sequestered so much of it. The U.S. Treasury held it, and the Federal Reserve banks had title to it. Because the Fed banks were operating under a virtual prohibition to lend to their member banks under the fatally flawed real bills doctrine, the economy's stock of money had atrophied far more than during any other downturn in the history of the country. At the same time, the Fed Banks' gold stocks were far in excess of any legal requirements.

The path was now clear for the federal government to call in all the gold, revalue it by 59 percent in terms of dollars, and put it in the ground under heavy guard so that no one could use it, touch it, or even see it! And that is what happened. By 1940, the federal government had over nineteen thousand tons of gold. If this gold had been loaded on ten-ton trucks, and each truck, including spaces between trucks, took up one hundred feet, the gold convoy would have included 1,900 trucks, and would have stretched thirty-six miles!

Navigator: What effect did the change in reserve requirements (which resulted from the Banking Act of 1935) have on the monetary supply? Was there a resulting collapse of credit, or simply strong deflationary tendencies?

Timberlake: Ordinarily, a central bank, or other monetary "authority," sets reserve requirements at conventional levels, that is, where the commercial banks would set them anyway. The imposition of reserve requirements preceded the Federal Reserve Act by 50 years. (Their first official appearance was in the National Banking Act, 1863-65.) Prior to 1935, the reserve requirements for the member banks were statutory (fixed) and relatively modest. However, the act of 1935 established a range of requirements over which the Federal Reserve Board had discretionary authority. The lower value of the range was the set of reserve requirements then in force - 7 percent for country banks, 10 percent for banks in reserve (larger) cities, and 13 percent for banks in central reserve cities - New York and Chicago. Thus, the range of discretion introduced by the 1935 Act became 7 to 14 percent, 10 to 20 percent, and 13 to 26 percent.

At first the Federal Reserve Board continued the old ratios. However, the great inflow of gold, together with the large increase in the official price for gold-from $20.67 per ounce to $35 per ounce-greatly increased commercial bank reserves, and made possible a huge increase in the conventional money stock. This "overhang" of potential money so frightened the masterminds in the Treasury and Fed that they started pushing panic buttons, trying to control, ex post, the avalanche of money before it happened. The Federal Reserve Board raised reserve requirements from the minimum to the maximum values in a period of nine months. Meanwhile, the Treasury started its own gold sterilization program. It kept the new incoming gold in a separate account so that the gold would not go to Fed Banks and provide an enlarged base for additional bank credit and more money.

What these policymakers did not consider was the fact that the commercial banking system was shell-shocked to the point of paralysis. When bankers first experienced the crises of the early 30s, 'their' Fed Banks had not supported them by supplementing their reserves by appropriate policies. So, thousands of them failed. The conservative residual, who were by now even more conservative, relied on their 'excess' reserves to protect them from further crises. But here came 'their' Federal Reserve Board with new restrictions that thwarted their careful efforts to provide themselves with adequate reserve protection. In addition, the business sector was still in a disastrous depression and had no tendency at all to expand by seeking new bank loans. In short, neither banks nor business firms were in any kind of an inflationary mode. Even if inflation subsequently emerged, the Fed had plenty of power and time to stop and reverse such a development. Most important, the banks needed the excess legal reserves they were now holding. Even though the reserves were "excess" in a legal sense, to most bankers the reserves were a hedge against the uncertainties of the times stemming from the whims and machinations of the Roosevelt administration. Therefore, when the Fed doubled reserve requirements and the Treasury sterilized new gold, the recovery that had been ongoing, in spite of the many counterproductive policies of the federal government, ground to a screeching halt. This episode was one case where the reserves the bankers wanted to keep were significantly more than the stated legal requirements.

Navigator: How did their actions to control this perceived rise in aggregate price affect the monetary situation?

Timberlake: The incoming gold had been fostering regular and desirable increases in the stock of common money through 1934-36. Commercial banks were cautiously expanding loans, and businesses were starting to recover. However, when the Treasury-Federal Reserve gold and bank reserve restrictions became manifest, the recovery stopped dead in its tracks. Professor Gary Dean Best noted some other factors, such as new taxes for the Social Security program, which also restricted the recovery [See the July/August, 2000, Navigator]. However, the wet blanket that the Treasury and Fed Board threw over the banking system added insult to injury and stopped this "second" recovery in its tracks.

Navigator: Many historians have discussed a 1937 "price-wage spiral" that resulted from the National Industrial Recovery Act. Could you please comment on this?

Timberlake: There is no such thing as a "price-wage spiral," or a "wage-price spiral." Wages are money prices for labor. Prices are money values for finished goods and services, and capital. While a change in a specific wage may cause a rise or fall in the money price of a specific good, it cannot effect a change in the level (or average) of all money prices. A change in the general price-wage level is almost wholly dependent on a preceding change in the economy's existing quantity of money. So the "spiral," properly understood, is an excess-quantity-of-money-all-money-prices-and-wages spiral.

When the NIRA artificially raised wages or prices in one sector of the economy, prices in other sectors of the economy compensated reciprocally through market channels. Such acts distorted economic behavior and misallocated resources, but had very little if any effect on the general price level.

The inverse of the general price level is the value of a unit of money. If a dollar will buy an apple, an apple will buy one dollar. If the number of dollars in people's hands doubles, and the number of apples stays constant, one apple will buy two dollars, or it will take two dollars to buy an apple. The same principle applies to hiring labor. Thus, a study of the price level must be a study of what is happening to the number of dollars in the economy. Those who profess a "wage-price spiral" are not allowing for economic reactions and adjustments throughout the economy, nor are they taking sufficient account of what is happening in and to the monetary system.

Navigator: You note that by 1941 the price level was still below its 1929 counterpart and unemployment was still hovering around 10 percent, thus lending credibility to John Maynard Keynes's theory that heavy government spending was needed, from time to time, to bolster an ailing economy. Did a more widespread adoption of Keynesian theories result from this phenomenon?

Timberlake: Certainly, the heavy government spending that occurred throughout the industrial world after 1935 seemed to be patterned on Keynesian policies. However, the policy of spend-spend-spend (and ultimately tax-tax-tax) preceded Keynes's writings. Anyone who reads Keynes's book, which calls for "socialization of investment" and "autonomous" government spending, will wonder that any policymakers could ever understand what the man was talking about. The book is very difficult to read and interpret, even if one is versed in economic lore. It is also an excellent example of theorizing without recourse to, and substantiation from, the facts of economic life. In most economists' opinion, the big government spending policies that came to be ubiquitous around the world were more a pragmatic political attempt to deal with the disastrous situation of the times, without government planners and policymakers understanding what had happened.

The great bulk of the world's problems - severe depression, unemployment, stagnant production, and all the rest resulted from the monetary policies of the Federal Reserve System in the United States. Since legislators, media people, and the man-in-the-street have no idea how the monetary system works and how money affects wages, prices, and incomes, central-bank mistakes are not readily observed or understood. I would not blame Keynesian theory for the terribly bad judgements of the policymakers in the U.S. government, particularly those in the Federal Reserve System and the U.S. Treasury Department. In fact, they had no real idea of Keynes's theories or analysis.

Navigator: Since the 1930s, have there been any periods of monetary mismanagement comparable to those evident in interwar America? If so, what effects did they have?

Timberlake: The record of policy management from 1946 to the present shows no episodes anywhere near as bad-disastrous-as that of the 1930s. Neither was Fed policy of the 1920s comparable to the Fed debacle of the 1930s. The period of the 1930s was unique. What is most important to understand is that the Contraction and Depression were not economic events, but the fruits of political decisions made by agencies of the federal government. The private U.S. economy did the best it could to adjust to the gross monetary mismanagement of the times, but too much is too much even for an economy with a good market system. The central bankers learned something, of course. But they were and always will be central bankers, intent on furthering their own self-interests just like all other economic men and women.

Some periods of the post-war era have been benignly stable, for example, 1953-65, and 1982-2000. Even the unstable period, 1966-81, was not intolerable. The central bankers of the period were too willing to provoke and excuse the inflation of the era, but they did not generate a hyperinflation or a downward spiraling contraction. So we may give them one cheer.

A central bank, in the present state of economic knowledge, can supply money to an economy with a good market system without undue disruption. Federal Reserve policy since 1988 is probably the best monetary policy we can hope for from a central bank. And to be fair, it has been a policy that we can live with, and one that has had no serious economic consequences.

However, what I have labeled in other contexts, "the great monetary dilemma" remains and will probably persist into the foreseeable future. The given conditions of the 'dilemma' are, first, that the institution of money arose spontaneously in primitive communities in all times and places. And second, governments had no role, ever, in the initiation of moneys. Yet, everywhere in the world today (and most yesterdays, too), governments through their central banks and treasuries have obtained monopoly control over the production of money.

The obvious question at the root of the dilemma is this: How can any government improve on an economic device that has arisen through the emergence of market processes and has become accepted voluntarily by both buyers and sellers? The short answer, which is also sufficient, is: It can't. No government can anymore improve the quality of privately produced money than it can improve privately produced computers, automobiles, or a health care system. A competitive private enterprise monetary system is the optimum "design" for the production of money.

To go further with this idea would extend this interview beyond its reasonable limit, so I will stop here. However, the idea of private enterprise in the production of money should be appealing to anyone who is convinced of the efficacy of private production for all other goods and services.

This article was originally published in the January 2001 issue of Navigator magazine, The Atlas Society precursor to The New Individualist.

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