THE FEDERAL RESERVE AND THE GREAT DEPRESSION

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thelivyjr
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THE FEDERAL RESERVE AND THE GREAT DEPRESSION

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MARCH/APRIL 1992

David C. Wheelock, assistant professor of economics at the University of Texas-Austin, is a visiting scholar at the Federal Reserve Bank of St. Louis.

David H. Kelly provided research assistance.

Monetary Policy in the Great Depression: What the Fed Did, and Why

SIXTY YEARS AGO the United States — indeed; most of the world — was in the midst of the Great Depression.

Today, interest in the Depression's causes and the failure of government policies to prevent it continues, peaking whenever the stock market crashes or the economy enters a recession.

In the 1930s, dissatisfaction with the failure of monetary policy to prevent the Depression, or to revive the economy, led to sweeping changes in the structure of the Federal Reserve System.

One of the most important changes was the creation of the Federal Open Market Committee (FOMC) to direct open market policy.

Recently Congress has again considered possible changes in the Federal Reserve System. 1

This article takes a new look at Federal Reserve policy in the Great Depression.

Historical analysis of Fed performance could provide insights into the effects of System organization on policymaking.


The article begins with a macroeconomic overview of the Depression.

It then considers both contemporary and modern views of the role of monetary policy in causing the Depression and the possibility that different policies might have made it less severe.

Much of the debate centers on whether monetary conditions were "easy" or "tight" during the Depression — that is, whether money and credit were plentiful and inexpensive, or scarce and expensive.

During the 1930s, many Fed officials argued that money was abundant and "cheap," even "sloppy," because market interest rates were low and few banks borrowed from the discount window.

Modern researchers who agree generally believe neither that monetary forces were responsible for the Depression nor that different policies could have alleviated it.


Others contend that monetary conditions were tight, noting that the supply of money and price level fell substantially.

They argue that a more aggressive response would have limited the Depression.

Among those who conclude that contractionary monetary policy worsened the Depression, there has been considerable debate about why. 1

The Monetary Policy Reform Act of 1991 (S. 1611) would have abolished the FOMC and thereby ended the voting on open market policy by Federal Reserve Bank presidents.

Although hearings on the bill were held, it was not brought to a vote before Congress adjourned at the end of 1991.

The Banking Act of 1935 established the present form of the FOMC, whose members include the Board of Governors of the Federal Reserve System and the 12 Reserve Bank presidents.

Five of the presidents vote on policy on a rotating basis.

Federal Reserve officials failed to respond appropriately.

Most explanations fall into two categories.

One holds that Fed officials, though well-intentioned, failed to understand that more aggressive action was needed.


Some researchers, like Friedman and Schwartz (1963), argue that the Fed's behavior during the Depression contrasted sharply with its behavior during the 1920s.

They contend that the death of Benjamin Strong in 1928 led to a redistribution of authority within the System that caused a distinct deterioration in Fed performance.

Strong, who was Governor of the Federal Reserve Bank of New York from the System's founding in 1914 until his death, dominated Federal Reserve policy-making in the years before the Depression. 2

These researchers argue that authority was dispersed after his death among the other Reserve Banks, whose officials were less knowledgeable and failed to recognize the need for aggressive policies.

Other researchers, like Wicker (1966), Brunner and Meltzer (1968), and Temin (1989), contend that Strong's death caused no change in Fed performance.

They argue that Strong had not developed a countercyclical policy and that he would have failed to recognize the need for vigorous action during the Depression.

In their view, Fed errors were not due to organizational flaws or changes, but simply to continued use of flawed policies.

A second category of explanations holds that the Fed's contractionary policy was deliberate.


Epstein and Ferguson (1984) and Anderson, Shughart and Tollison (1988) contend that Fed officials understood that monetary conditions were tight.

Epstein and Ferguson assert that the Fed believed a contraction was necessary and inevitable.

When it did act, they argue, it was to promote the interests of commercial banks, rather than economic recovery.

Anderson, Shughart and Tollison emphasize even more the Fed's interest in aiding its member banks.

They argue that monetary policy was designed to cause the failure of nonmember banks, which would enhance the long-run profits of member banks and enlarge the System's regulatory domain.


TO BE CONTINUED ...
thelivyjr
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Re: THE FEDERAL RESERVE AND THE GREAT DEPRESSION

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Monetary Policy in the Great Depression: What the Fed Did, and Why, concluded ...

AN OVERVIEW OF THE GREAT DEPRESSION

Analysts generally agree that the economic collapse of the 1930s was extremely severe, if not the most severe in American history.

To provide a sense of the Depression, Figures 1-3 plot GNP, the price level and the unemployment rate from 1919 to 1939.

As the figures show, after eight years of nearly continuous expansion, nominal (current dollar) GNP fell 46 percent from 1929 to 1933.

Real (constant dollar) GNP fell 33 percent and the price level declined 25 percent.

The unemployment rate went from under 4 percent in 1929 to 25 percent in 1933. 3

Real GNP did not recover to its 1929 level until1937.

The unemployment rate did not fall below 10 percent until World War II. 4

Few segments of the economy were unscathed.

Personal and firm bankruptcies rose to unprecedented highs.

In 1932 and 1933, aggregate corporate profits in the United States were negative.

Some 9,000 banks, with $6.8 billion of deposits, failed between 1930 and 1933 (see figure 4).

Since some suspended banks eventually reopened and deposits were recovered, these figures overstate the extent of the banking distress. 5

Nevertheless, bank failures were numerous and their effects severe, even compared with the 1920s, when failures were high by modern standards.

Much of the debate about the causes of the Great Depression has focused on bank failures. 2

Until changed by the Banking Act of 1935, the chief executive officers of the Reserve Banks held the title "governor."

Today these officers are titled "president," while members of the Board of Governors, which replaced the Federal Reserve Board in 1935, now hold the title "governor." 3

The appendix provides a list of sources for the data used in this article.

The GNP and unemployment series used here are standard, but Romer (1986a,1986b) presents new estimates of GNP and unemployment for the 1920s.

Both new estimates exhibit less variability than those traditionally used; Romer's estimate of the unemployment rate in 1929 is 4.6 percent, compared with 3.2 percent plotted here. 4

Darby (1976) argues that the unemployment rate series considerably overstates the true rate after 1933 because it takes persons employed on government relief projects as unemployed.

Kesselman and Savin (1978) offer an opposing view.

Regardless of which argument is accepted, unemployment during the 1930s was exceptionally severe, particularly since there were relatively few multi-income households. 5

There was no deposit insurance in these years.

The Banking Act of 1933 created federal deposit insurance.

During the 19th and early 20th centuries a number of states experimented with insurance plans for their state-chartered banks, but none was still in existence by 1930.

See, Calomiris (1989) for a survey of the state systems.

https://fraser.stlouisfed.org/files/doc ... emon92.pdf
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