Lesson 3 of 7
The money supply
Friedman and Schwartz argue a severe recession became a depression because the stock of money collapsed, and that the Federal Reserve had the power to stop it.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- The claim is that an ordinary recession was converted into a depression by a collapse in the stock of money, which fell 35.2 percent between 1929 and 1933.
- Friedman and Schwartz trace the mechanism through bank failures: the public converted deposits into currency, banks scrambled for liquidity, and both ratios fell.
- Their strongest statement is about capability. They hold that the Federal Reserve at all times had the power to prevent the decline, and almost certainly without threatening the gold standard.
This is the account that displaced every other in the profession's general opinion for several decades, and it is the one the previous lesson has to answer.
The mechanism, as Friedman and Schwartz describe it
- 1Mild decline, 1929 to 1930The money stock falls with Federal Reserve credit outstanding
- 2Bank failures from late 1930The decline becomes sharp
- 3Deposits into currencyThe public withdraws, so the deposit to currency ratio falls
- 4Banks scramble for liquidityThe deposit to reserve ratio falls too
- 5Deflationary action after September 1931Following Britain's departure from gold, more failures and sharper declines
The claim
Friedman and Schwartz set out the argument at length in chapter 7 of A Monetary History of the United States, 1867 to 1960, published in 1963, a chapter Princeton reprinted on its own in 1965 under the title The Great Contraction, 1929 to 1933. Their compact statement of the same argument is in a paper published in 1963 and reprinted in a National Bureau volume in 1965.
There they describe the sequence in the figure above. An initial mild decline in the money stock from 1929 to 1930, accompanying a decline in Federal Reserve credit outstanding, converted into a sharp decline by a wave of bank failures beginning in late 1930. Those failures produced widespread attempts by the public to convert deposits into currency, and a scramble for liquidity by the banks. The decline was intensified after September 1931 by deflationary action on the part of the Federal Reserve System in response to Britain's departure from gold, which led to further bank failures.
The sentence that carries the weight
Immediately after that sequence they state that the Federal Reserve at all times had the power to prevent the decline in the money stock, or to increase it to any desired degree, by providing enough high-powered money to satisfy the banks' desire for liquidity, and almost surely without any serious threat to the gold standard.
That is not a claim about what happened. It is a claim about what could have happened, and it is what makes their account an indictment rather than a description.
What the account is built on
Size. Their own tabulation lists every period since 1867 in which the money stock fell, and 1929 to 1933 is 35.2 percent against a next largest of 5.1 percent. On their reading a monetary change of that magnitude is not something a theory can treat as incidental.
They also argue from timing. The money stock's rate of change turns early relative to the reference cycle, which they present as evidence that money is doing work rather than merely responding.
Where it is contested
On direction of causation, which they were pressed on throughout their careers: whether the money stock fell because output fell rather than the other way around. They address it by distinguishing changes attributable to contemporaneous cyclical conditions from those that are not.
And on sufficiency. Bernanke's 1983 paper, which is the fifth lesson of this course, says there is much support for the monetary view but that the reductions in the money supply in this period seem quantitatively insufficient to explain the subsequent falls in output, and that no theory of monetary effects can explain non-neutrality lasting that long.
Check yourself
What is the central claim of this account?
- That the stock market crash caused the depression
- That a collapse in the stock of money converted a recession into a depression
- That the gold standard was the binding constraint
Show the answer
Answer: B.
They report the stock of money falling 35.2 percent between 1929 and 1933, against a next largest fall of 5.1 percent in their record since 1867.What do they say about the Federal Reserve's capability?
- That it was constrained by the gold standard from acting
- That it had the power at all times to prevent the decline or reverse it, and almost surely without seriously threatening the gold standard
- That it lacked the legal authority
Show the answer
Answer: B.
That claim is what turns the account from a description of events into an indictment of a policy choice.What is Bernanke's objection to the account's sufficiency?
- That the money stock did not actually fall
- That the monetary reductions seem quantitatively insufficient for the output falls, and no theory of monetary effects explains non-neutrality lasting that long
- That bank failures were unimportant
Show the answer
Answer: B.
He is explicit that there is much support for the monetary view and that his own approach is complementary to it rather than a replacement.Sources
- Friedman and Schwartz, 'Money and Business Cycles', Review of Economics and Statistics, 1963, reprinted in the National Bureau of Economic Research volume The State of Monetary Economics, 1965, for the 1929 to 1933 sequence of an initial mild decline converted into a sharp one by bank failures from late 1930, for the conversion of deposits into currency and the banks' scramble for liquidity, for the intensification after September 1931 following Britain's departure from gold, for the statement that the Federal Reserve at all times had power to prevent the decline without serious threat to the gold standard, and for the table of major exceptions to the money stock's rising trend.
- Friedman and Schwartz, A Monetary History of the United States, 1867 to 1960, 1963, chapter 7, is where the argument is made at length. Princeton University Press reprinted that chapter separately in 1965 as The Great Contraction, 1929 to 1933.
- Bernanke, 'Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression', National Bureau of Economic Research working paper 1054, January 1983, introduction, for the statement that there is much support for the monetary view and for the two reservations about its sufficiency.
What this leaves out
- This is a heterodox tradition. The mainstream account of the same phenomenon differs, and nothing here is a forecast or a view on any security.
- Chapter 7 of A Monetary History was not read for this lesson. Everything attributed to Friedman and Schwartz above comes from their 1963 paper, which states the same argument compactly, and the chapter is named as the place it is set out at length.
- The two ratios in the example are described generically. No bank is described.
- This lesson states the account and names the main objections to it. It does not adjudicate between this account and the others in this course.