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Lessons from the Great Depression

The handouts we received (and hopefully read) in preparation for Thursday’s class discuss Milton Friedman and his analysis of inflation and unemployment. Accordingly, Friedman’s views on monetary policy are mentioned a number of times, but are not discussed in much detail. For instance, in Brad Delon’s obituary for Friedman, he differentiates between Keynes’ interpretation of policy in the Great Depression and Friedman’s. Keynes, he says, was “convinced…that central bankers alone could not rescue and stabilize the market economy” while Friedman believed the Great Depression “could have been rapidly alleviated by skillful monetary management alone”. What exactly, in Friedman’s view, constitutes “skillful monetary management”? I thought it would be helpful to examine in more depth what Friedman saw as the problem with central banking during the Great Depression, as well as what changes Friedman suggests could have mitigated it. I came across an article entitled “Monetary Policy in the Great Depression: What the Fed Did, and Why” (link provided below) which outlines various opposing arguments for what caused the Great Depression to be so severe as well as what appropriate policy responses would have been.

Economists have long argued about the cause of the Great Depression. Keynesian explanations dismissed the role of monetary forces in the Great Depression, citing declining business investment and household consumption (a decline in aggregate demand) as the primary cause. Another group, known as the liquidationists, argued that expansionary policy used by the Fed in the two minor recessions prior to the Great Depression had caused over borrowing and speculation in the private sector-essentially supporting businesses that a free market would have prohibited-and thus the Great Depression was the market’s way of correcting itself. Still another view, which Friedman belonged to, held that monetary conditions were too “tight” at the time and the Fed could have acted more aggressively to restore confidence and liquidity to the market. According to Friedman, the Great Depression was caused by banking panics that allowed the money supply to fall, which caused a decline in economic activity (Wheelock, 6).

What makes this debate interesting is that there seems to be evidence to support each argument. The principal question at the time revolved around whether monetary conditions were too “easy” or too “tight,” and depending on what data you examine you could make an argument for both (Wheelock, 3). Liquidationists argued that low market interest rates and a lack of demand for reserves by banks signaled “easy money” or “easy credit”. Many Fed officials at the time prescribed to this belief. The implications of which were that credit was already cheap so monetary easing was not necessary and could even fuel a speculative bubble. Further, once Great Britain got off the gold standard, investors feared the US would do the same, which triggered an outflow of reserves from the US. To reverse this the Fed actually increased interest rates (contractionary policy during a depression? ouch). Others, including Friedman, argued that monetary conditions were too “tight” citing the decreasing money supply, deflation, and the real interest rate (nominal interest rates may have been low but when adjusted for falling prices were actually much higher). What the market needed, then, was an increase in the money supply, which would prevent banking panics and encourage lending.

I think it is pretty clear that the liquidationist view was incorrect at the time. But what about Friedman and Keynes? Would expansionary monetary policy have been enough to prevent the Great Depression as Friedman argued? Or did we need a larger intervention by the government to boost aggregate demand as Keynes argued?

These questions are extremely relevant in these times. Compare the Great Depression to the Great Recession we face today, the two are eerily similar. Cheap credit in the early 21st century fueled a housing market bubble; cheap credit in the 1920’s led to two recessions and, ultimately (according to the liquidationists), the Great Depression. So what of the Fed now? Is embarking on a new round of asset purchases an appropriate policy move? Will this lead to a growth in the money supply and more lending by financial institutions? Or could low interest rates for years on end fuel another bubble? Should our number one priority in this election be reigning in the Federal deficit? Or should we boost spending to increase aggregate demand?


  1. poetzsch poetzsch

    At a certain point I think the Federal deficit is going to become a big enough problem to start really impacting today’s economy. One hypothesis I have on how is that the low interest rates could start another bubble – a government spending bubble fueled by increasing interest rates. Since the government can borrow money at such low rates, this could lead to increased government spending to attempt to increase aggregate demand in the near term. Once interest rates do turn higher, the government will struggle to pay the interest on new loans and will in turn have to issue new loans. This could create a downward cycle of increased government loans just to finance itself which would undoubtedly be bad for the country.

    So in response to your last question, yes, I think the Federal deficit is a problem that needs to be addressed now, while we still may have a chance to correct it before it gets out of control.

    • Well, since monetary policy can’t encourage people to invest in a period of low demand, the only realistic hope from the monetary policy front is for another bubble. But that’s independent of deficit / debt levels — and it’s not clear you can generate a bubble unless we encourage banks to make bad loans (which I really don’t think we want to do!).

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