Contraction or Deflation Jude Wanniski November 30, 2001

To: SSU Students
From: Jude Wanniski
Re: The Great Depression

This lesson, which first appeared here on December 17, 1997, addresses a question that has separated me from the other supply-siders, including those who first taught me economics, Bob Mundell and Art Laffer: Could the Great Depression have been reduced in its severity if the Federal Reserve had been more adroit in its management of monetary policy? I say no, in the sense that I can find no evidence in the material I have sifted through that tells me the Fed had any choice but to manage as it did. There are no arguments among historians that I find persuasive. The question is not a trivial one, but goes to the heart of the argument I have been almost alone making since 1997 about the global dollar deflation. In other words, I believe the Great Depression was a contraction brought about by tariff and tax blunders and that the Fed had no powers to overcome those errors. In the December 22, 1997 issue of Forbes there is an interview with Milton Friedman, now 85 years old, who argues more expansively than ever that deflations can always be ended by printing more money, and that the Great Depression would have ended if the Fed had simply expanded the money supply. Of course I disagree with that emphatically, as do all other supply-siders, [even those] who find errors elsewhere in Fed policy. In the same article, though, Friedman argues that the monetary aggregates in Japan currently indicate Japan is in a deflation, and that it could easily end that by having the Bank of Japan buy government bonds from the banks (another way of saying "printing money.") Here, I happily agree with Friedman, although where he looks at Japan's money supply, I look at the yen price of gold.

This is a point worth making: There are many times in the course of an economy's development when the theoreticians will find themselves accidentally in alignment, advocating the same policy for different reasons. This is the case now with Japan's deflation, although Friedman and I would disagree sharply with my argument that the U.S. economy is now well into a minor monetary deflation which should be corrected by "printing money," by having the Fed buy bonds from the banking system, thereby injecting the reserves that are transformed into "money." The monetarists are now not concerned about the economy because the "M" money supply aggregates have been growing at a double-digit clip, which tells the monetarists that there is no dearth of liquidity. Why is the gold price a better signal than the "Ms"? It is because the dollar gold price is at the intersection of the supply of dollars and the demand for dollars. That is, it incorporates both supply and demand. When the gold price is falling, it tells us the demand for dollars is rising for some reason or reasons, and that the Fed can accommodate that demand simply by buying bonds, thus monetizing debt. When gold is rising, we know it is reflecting a decrease in the demand for dollars -- for whatever reason -- and the Fed can easily deal with this problem by selling bonds from its portfolio, extinguishing dollars.

Milton Friedman and the Mundellians absolutely agree that the Fed should not raise interest rates to "tighten" money, nor should it lower interest rates to "ease money." The proper method is to directly add or subtract liquidity by buying or selling bonds to the banks. Monetarism breaks down as a serious competitor to the supply-side analytical framework because "the money supply" does not tell us anything about the demand for money. In the primary monetarist equation, the "money supply" multiplied by the "velocity" of money equals "prices" multiplied by "transactions." (MV=PT). There is nothing wrong with the equation, only the uncertainty of determining "V," velocity, which represents the willingness of the people who use "M" to hold onto it. In an inflation, V increases as people want to get rid of the depreciating asset, buying commodities or some asset that pays an interest rate that will protect the asset against inflation. In a deflation, V decreases, as people find it profitable to hold it, selling commodities and assets that have investment returns lower than the deflation rate.

In the 1963 book Friedman wrote with Anna Schwartz, A Monetary History of the United States, 1867-1960, Friedman observed in that long stretch a stability in the velocity of money. This led him to build his Monetarist doctrines around the assumption that velocity can be treated as a constant. In the book, he is also careful not to offer a hypothesis as to why Wall Street crashed in October 1929, but rather calls it a "panic." He is also a bit more circumspect about arguing that the Depression could have been avoided simply by printing money, because of course he knows the Federal Reserve could not have expanded the money supply unless it abandoned the gold standard. He is critical of the Fed for not having allowed its gold reserves to run down in order to put more dollar liquidity into the system during 1930-32, when banks were failing rapidly. His assumption, of course, is that the market wanted liquidity, or at least that the banks would have been forced to lend their reserves against doubtful collateral.

There is muted criticism in the book of the Fed for having made the gold standard its highest priority, and one assertion, on P. 692, that if Fed Chairman Benjamin Strong had not died in 1928, "we might have ended the depression in 1930." He doesn't tell us what Strong would have done, except to infer that Strong would have acted promptly to expand the money supply or aggressively rediscount commercial paper. This is because twice before in the 1920s Strong had the Fed step in during financial soft spots, but the paper being discounted was of high quality.

Friedman notes that Strong's successor as chairman, George L. Harrison, tried to prod the board of governors into "expansionary" policies, but failed, except for one break under congressional prodding in 1932. What Friedman does not tell us is that this brief expansion caused a gold outflow and was accompanied by a steady decline in the Dow Jones Industrial Average. What Friedman also fails to tell us is that in September 1931, Britain went off the gold standard and that five weeks later President Herbert Hoover decided to demonstrate his resolve by backing an increase in income-tax rates, returning to the level of 1924. Indeed, in the index to Friedman's 860-page book, there is no reference to "taxes" or "tariffs." In monetarism, money is all that counts.

The chief criticism of the Fed by supply-siders has been that when it was chartered in 1913, it was to have been the lender of last resort to the banking system, but that it failed to do so, and thereby deepened the Depression. I can't find this argument in Friedman's monetary history, but Professor Reuven Brenner of McGill tells me Friedman makes it in a later work and that he, Reuven, always assumed it was correct. Prior to my discovery that the Crash of 1929 had been caused by the market's excellent guess that the Smoot-Hawley Tariff Act would become law in 1930, all the classical economists of the time struggled with Crash theories that involved inefficiencies in the market, either too rapid money creation or too rapid credit creation. Ludwig von Mises, though, largely dismissed the "too rapid money creation," instead pushing his credit-bubble idea, which really absolves the Fed and blames private bankers for their excesses. He must have always known this thesis was pretty weak, I think, given the magnitude of the Crash and the depth of the Depression, and if he were alive I think he would embrace my Smoot-Hawley discovery.

Another book that is worth having in your library is also by a monetarist, Richard H. Timberlake's A "Monetary Policy in the United States," which covers more years than Friedman and gets into the early 1970s. It is here that I found a better discussion of the argument that the Fed failed to perform its function as a lender of last resort, to save the banks. I'd really love to take a year off and research and write a book on this topic alone, but I don't have a year. Timberlake's book is really quite good until he gets to the 1930s, when he follows Friedman's lead down a blind alley. The relevant passage, to me, is on P. 276, where Timberlake notes that Hoover was setting up the Reconstruction Finance Corporation (RFC) to become a lender of last resort. Hoover's Treasury Secretary, Ogden Mills, explained that the RFC would "put the credit of the Government itself back of the total credit structure... Take the banks for purposes of illustration." In rescuing banks from failure, the RFC also "helps the manufacturer to keep his small business going." It also makes "the credit facilities of the Federal Reserve System available to member banks, whose eligible paper has been exhausted, by permitting them to borrow on sound [in contrast to "eligible"] assets." Timberlake then notes:

Just a year earlier, [Treasury] Secretary [Andrew] Mellon had stated that the banks had $3.2 billion of eligible paper and $4.5 billion in U.S. government securities, all of which would serve "as a basis for additional Federal Reserve Bank accommodation." Clearly, the banks' eligible paper had not been "exhausted." It had simply been reclassified by Federal Reserve Bank Loan Committees, who had reassessed the "eligibility" of the paper in the light of the depressed state of business. The absurdity of this burgeoning of institutions is immediately apparent. Why should an RFC have been necessary for making loans to needy banks when an elaborate Federal Reserve System had been in place for twenty years to do just that? The RFC, at best, had no net leverage on the monetary system; it could not create monetary base materials.

This is what disturbs me about the casual arguments that the Fed screwed up. A lender of last resort should not be expected to lend assets against ineligible commercial paper, by which we mean paper that is not worth the paper it is written on. Yes, Andrew Mellon in January of 1931 said there was $3.2 billion of eligible paper that could be identified, but Timberlake is unfair in blaming the loan committees for reclassifying it as ineligible a year later, a year in which the Dow Jones Industrial Average fell by 50% and put a lot of assets under water. And yes, the banks had $4.5 billion in U.S. government securities in early 1931, according to Mellon, but we are not told what happened to them.

A few paragraphs later, we are reminded that only a month after the RFC act became law, on February 27, 1932, the Glass-Steagall Act passed. "This act allowed the Fed banks to ‘compete' with the new RFC by relaxing the type of collateral security required for member bank discounts at Fed banks. It also permitted Fed banks to use government securities as collateral for the issue of Federal Reserve notes, thereby establishing a formal basis for monetization of the government's recurring fiscal deficits, a large fraction of which resulted from the federal government's outlays for the RFC."

Well, now. First we are told the Fed fiendishly reclassified eligible paper as being ineligible. Then we are advised it was not until February of 1932, after the RFC became law, that the Fed could monetize government securities. Worse yet, Timberlake complains about the RFC being set up to bail out banks and businesses, when the Fed had been set up for 20 years to do just that... and the RFC could not leverage its dollars by creating "base materials," meaning cash and bank reserves.

Whoa! Obviously the Fed had no intention of creating base money, because it would have only undermined the banking system with a horrendous inflation. Even the small "easing" in early 1932 caused not only a gold outflow, but also a run-down of equity prices. In the one period of "expansionary monetary policy" that both Milton Friedman and Timberlake celebrate in the early 1930s, from April to August of 1932, the Dow Jones Industrial Average declined from 170 to 41. Timberlake inexplicably seems not to understand that it is precisely because the RFC must raise its bailout money from the taxpayers, instead of having the Fed wave its magic wand, that this course was taken. There is nothing wrong with borrowing resources from one set of producers to help another, in a period of economic distress. That's quite different from having the central bank print money and shovel it into the banks, which is the equivalent of shoveling it out of airplanes and hoping the people who find it will buy unsold inventories of goods.

At every turn in his monetary history's discussion of the "Great Contraction," Friedman asks us to simply ignore the arguments made by other historians about the limitations of the central bank in dealing with the economic decline. On P. 400, for example, Friedman quotes from the1951 book by E.A. Goldenweiser, American Monetary Policy, pointing out that the author worked for the Fed during the depression:

More serious was the fact that the System did not extend sufficient aid to member banks through discounting their commercial paper and that it failed to pursue a vigorous policy of purchases in the open market. For this failure of the System to give more help in an emergency the major blame is on the law which prescribed rigid rules for the eligibility of paper for discount and also barred government securities from collateral acceptable for Federal Reserve notes.

In other words, the law explicitly required that Federal Reserve notes be backed by 40% gold and 60% gold or eligible paper, and that U.S. government bonds were not eligible until Glass-Steagall passed on February 27, 1932. The Fed banks were prohibited from doing what Friedman and Timberlake say they should have done anyway! In this vein, Friedman denounces Benjamin Anderson for opposing "open-market purchases" in a September 1930 report of the Chase Economic Bulletin, in which he defends the gold standard with an argument that there is not enough "free gold to justify artificially cheap money." On the evidence, Anderson was certainly right, in that when the Fed began to monetize government debt in April of 1932, gold drained out of the Treasury at a rate indicating the market did not want liquidity, ending the experiment. It was not until 1934 that President Roosevelt made another gesture to the monetarists of the era, agreeing to devalue the dollar by 41% in 1934, to $35/oz. from $20.67/oz. The theory was to take pressure off debtors by making their debts cheap, but as part of the New Deal legislation, Americans had to turn in all their bullion for cash. At what price? $20.67 per ounce! What an outrage! The citizens turn in their gold at the low price, then the government announces a high price, which means FDR took $4 billion in wealth out of the economy in order to show increased revenues on the government's books. To tell you the truth, I only made this discovery in reading part of the Timberlake book I'd not read before. I'd always assumed the citizens got $35 for the gold they were turning in.

The more I look through these arguments and these numbers, the more I realize how lucky the world was to have these Fed governors clinging to the rock of gold, while they were constantly beaten upon by the politicians and the cheap money monetarists of the day, to inflate the economy out of the Depression. Friedman of course wrote his monetary history 35 years ago and still clings to its thesis. But we have learned an awful lot since1963 about what happens when gold is ignored and the scientific principles of monetarism are applied. Had the government done what Friedman says it should have done in the early 1930s, the Great Deflation would have been the Great Stagflation. The monetary inflation would have run up effective tax rates faster than Roosevelt did and the world economy would have been even uglier. Even World War II might have turned out differently, as the fascist powers would never have made the monetary mistakes that the monetarists think we should have made.