In his writings, the leader of the monetarist school of thinking, Milton Friedman, blamed central bank policies for causing the Great Depression of 1930s. According to Friedman, the Federal Reserve failed to pump enough reserves into the banking system to prevent a collapse of the money stock. Because of this, Friedman held, the M1 money stock, which stood at $26.34 billion on March 1930, fell to $19 billion by April 1933—a decline of 27.9 percent.1
According to Friedman, as a result of the collapse in the money stock, economic growth also dropped off. By July 1932, industrial production had fallen by over 31 percent year on year (see chart). Also, year on year the Consumer Price Index (CPI) had plunged. By October 1932, the CPI had declined by 10.7 percent (see chart).
A closer examination of the historical data shows that the Fed was actually pursuing very easy monetary policy in its attempt to revive the economy.2
The Fed’s holdings of US government securities depict the extent of monetary injections. In October 1929, holdings of US government securities stood at $165 million. By December 1932, these holdings had surged to $2.432 billion—an increase of 1,374 percent (see chart).
Also, the three-month Treasury bill rate fell from almost 1.50 percent on April 1931 to 0.4 percent by July 1931 (see chart).
Another indication of the Fed’s loose monetary stance was the widening differential between the yield rates on the ten-year Treasury bond and the three-month Treasury bill. The differential increased from 0.04 percent in January 1930 to 2.80 percent by September 1931 (see chart; an upward-sloping yield curve indicates a loose monetary stance).
The sharp fall in the money stock during 1930–33 does not indicate that the Federal Reserve did not try to pump money. Instead, the decline in the money stock came because of the shrinking pool of savings brought about by the previous loose monetary policies of the Fed.
The yield curve between 1920 and 1924 reveals this easy stance by the Fed: the yield spread increased from –0.67 percent in October 1920 to 2 percent by August 1924.
The reversal of this stance by the Fed, which saw the yield spread decline from 2 percent in August 1924 to –1.45 percent by May 1929, finally burst the monetary bubble (see chart).
In addition to this, at some periods the monetary injections were nothing short of massive, contradicting Friedman’s claim. For instance, the yearly growth rate of M1 increased from –12.6 percent in September 1921 to 11 percent by January 1923, and then from –0.4 percent in February 1924 the yearly growth rate accelerated to 9.8 percent by February 1925. Such large monetary pumping amounted to a massive exchange of nothing for something.
The large monetary pumping resulted in the diversion of wealth from wealth generators to various nonproductive activities that emerged on the back of loose monetary policy. This wealth diversion resulted in the depletion of the pool of savings. (The pool of savings comprises final consumer goods.) As long as the pool of savings is expanding and banks are eager to expand credit, various nonproductive activities can continue to prosper. Whenever the extensive generation of credit out of “thin air” increases the pace of wealth consumption above the pace of wealth production, the flow of savings is arrested and a decline in the pool of savings is set in motion.
Consequently, the performance of various activities starts to deteriorate and banks’ bad loans start to pile up. In response to this, banks curtail their lending “out of thin air,” setting in motion a decline in the money stock. Note that the pool of savings is the heart of economic growth, sustaining various individuals that are employed in the various stages of production. Contrary to popular thinking, money as such has nothing to do with the economic growth; it only fulfills the role of medium of exchange.
After growing by 2.7 percent year on year in January 1930, bank loans had fallen by a massive 29 percent by March 1933 (see chart).
Now, when loaned money is fully backed by savings, on the day of the loan’s maturity it is returned to the original lender. Thus, Bob—the borrower of $100—will pay back the bank on the maturity date the borrowed sum plus interest. The bank in turn will pass to Joe, the lender, his $100 plus interest, adjusted for bank fees. The money makes a full circle and goes back to the original lender.
In contrast, credit generated out of “thin air” that is returned to the bank on the maturity date results in the withdrawal of money from the economy, i.e., to a decline in the money stock. The reason for this is that there was no original saver/lender, since this credit was generated out of “thin air.” (Again, savings did not support the credit being extended here.)
Observe that economic depressions are not caused by the collapse in the money stock but come in response to a shrinking pool of savings on account of the previous monetary pumping. A decline in the money stock is just the result of the fall in the pool of savings. And the decline in this pool due to the previous easy monetary policy of the central bank reflects a weakening in the process of wealth generation.
Consequently, even if the central bank were to be successful in preventing the decline of the money stock, this could prevent the economic depression if the pool of savings is declining. In addition, even if loose monetary policies were to succeed in raising prices and inflationary expectations, this could revive the economy as long as the pool of savings remains under pressure.
Those commentators who are of the view that by means of monetary pumping one can prevent economic depressions hold that this pumping is going to strengthen aggregate demand and that with the increase in demand, aggregate supply will follow suit. However without an expanding pool of savings that enhances and strengthens the infrastructure, it is not possible to increase the supply of goods and services. It is not possible to make something out of nothing.
Contrary to the popular thinking, economic depressions are not caused by a strong decline in the money stock, but are rather the result of the depleted pool of savings. This depletion emerges because of the previous loose monetary policies. A tighter monetary stance arrests the depletion of the pool of savings, thereby laying the foundation for an economic recovery.
1. Milton Friedman and Rose Friedman, Free to Choose: A Personal Statement (New York: Avon, 1981), p. 85.
2. Murray N. Rothbard, America’s Great Depression, 5th ed. (Auburn, AL: Ludwig von Mises Institute, 2000).