Friedman Schwartz The Great Contraction Economics 639 American

Friedman & Schwartz “The Great Contraction” Economics 639 / American University / Vaughan 1 - 16

Overview “The Great Contraction” • Chapter 7 of Friedman and Schwartz’s magisterial A Monetary History of the United States, 1867 -1960. • One of two most important macroeconomics books of 20 th century (along with Keynes’ General Theory). – Dispelled notion money is macroeconomic “sideshow. ” – Documented prominent role of money in Great Depression. • Seminal contributions include: – Consistent money-supply series for 93 years of U. S. history. – Empirical link between (i) money & output (short run) and (ii) money & prices (long run). – “Natural experiments” show money often causal. 2 - 16

Background Bank Balance Sheet • Checkable deposits are demandable at par (“first come, first served”). • U. S. banks must hold 10% of checkable deposits as vault cash or deposits at Fed (“reserves”). – Reserves held above required levels are called “excess reserves. ” • Banks hold securities as “secondary” reserves to provide liquidity. • Capital is owner’s stake in bank. – Losses on loans/securities subtracted from capital – Risk appetite varies indirectly with capital. 3 - 16

Background Multiple Deposit Creation • Banks earn profit from loans (return exceeds that on reserves and securities). • Assume member of public deposits $1 of currency. Bank must hold 10% of deposit as reserves, so 90 cents of new dollar of deposits will be lent. • Mechanically, bank makes loan by adding amount of loan to “loans” on asset side of balance sheet and “checkable deposits” on liability side (i. e. , funds placed in loan customer’s checking account). • When loan customer spends proceeds (90 cents), that amount will end up deposited in another bank. – RESULT: Total deposits created by banking system “creates” are multiple of original $1 in currency deposited. 4 - 16

Background How Fed Manipulates Money Supply • Money: Financial asset used for transactions (narrowly – currency and checkable deposits). • Open-Market Operations: Fed purchase or sale of securities, transaction settled with bank reserves. – Fed purchases of securities increase bank reserves, leads to multiple deposit creation (Ms↑). – Fed sales of securities decreases bank reserves, leads to multiple deposit destruction (Ms↓). 5 - 16

Background Drivers of Money Supply = Money Multiplier x Monetary Base • Monetary Base (also “high-powered money”) = currency-in-circulation + reserves held by banks ‒ Base under central-bank control (in discretionary policy regime) • Money Multiplier: Maximum supply of “money” that can be created with monetary base – Depends on public preference for currency (C) over deposits (D) and bank preference for holding reserves (R) over lending. Ø Greater public preference for currency → Smaller money multiplier Ø Greater bank preference for reserves → Smaller money multiplier 6 - 16

Money and Output in Great Depression What caused money stock to collapse? 7 - 16

Monetary Contraction in 1930 s Were Panics Driving? NOTE • Stock-market crash did not “cause” large decline in money stock. • Money-stock decline became more pronounced with each panic. 8 - 16

Panics and Money Supply, 1929 -33 Base or Multiplier? • Logically, moneystock decline must come from fall in (i) money multiplier, (ii) monetary base or (iii) both. August 1929 – March 1933 Monetary Base↑ 25. 7% • Monetary base did not drive 1929 -1933 decline in money stock. 9 - 16

Panics and Money Supply, 1929 -33 Base or Multiplier? Great Contraction August Culprit: 1929 Money – March Multiplier! 1933 M 2 Money 1929 Multiplier ↓ 1933 48. 7% August – March Money Multiplier↓ 44. 9% But how did panics cause money-multiplier collapse? 10 - 16

Bank Panics and Money Multiplier 1929 -1933 “Failures” • Fed created to supply banks with emergency liquidity to stop panics. ‒ No longer private institutions to contain panics. • In four 1930 -33 panics, public converted deposits (D) to currency (C) to avoid losses from bank failures (Result: D/C↓) and banks horded reserves (R) to prevent insolvency (Result: D/R↓). 11 - 16

Panics and Multiplier Components NOTE: • • Deposit-Currency Ratio (D/C) and Deposit-Reserves Ratio (D/R) did not start declining significantly until first banking panic began (November 1930). With each successive panic, rate of decline increased. 12 - 16

Panics and Money Supply, 1929 -33 Summing Up Note: • Money multiplier drove overall 1929 -33 money stock decline. • Bulk of 1929 -33 money-stock decline took place after start of first panic. • Panics caused both deposit-currency ratio (D/C) and deposit-reserve ratio (D/R) to tumble. 13 - 16

What Should Fed Have Done? According to F&S Congress pressured System to buy $1 billion in securities from April to June 1932 - temporarily halting money-stock decline but not turning economy around (too little, too late). Doing same thing earlier might have worked wonders: • First Ten Months of 1930: Purchases would have made banking crisis less likely by (i) reducing severity of contraction and (ii) increasing bank reserves (i. e. , increasing ability to meet deposit outflow). • First Eight Months of 1931: Purchases would have increased base enough to offset decline in D/R and D/C, leaving money supply unchanged (rather than 5% decline). • Four Months Following Britain’s Departure from Gold in 1931: Purchases would have increased base enough to offset most of drop in D/R and D/C, thereby cutting money-supply decline in half. – Had drop in D/C been moderate, money supply would not have fallen (rather than decline 12%). 14 - 16

Why Didn’t Fed Intervene Aggressively to Stop Panics / Boost Money Supply? • F&S: System responded belatedly/weakly to failures because of poor understanding of connection among bank failures, bank runs, deposit contraction, and money supply. • Other factors cited by F&S: – – – Fed cared little about non-member banks (bulk of failures). Most failures small banks; big-city bankers dominated System. Few large banks that did fail badly managed. Intellectual vacuum in Fed after Benjamin Strong’s death (1928) Fed focused on maintaining dollar’s value in gold. • Other factors not cited by F&S: – No panics in New York City – Low nominal interest rates wrongly seen as “easy money. ” Ø Problem of identifying stance of monetary policy persists! 15 - 16

Concluding Thoughts Subsequent research has: • De-emphasized 1930 failure of Bank of United States in triggering panic. ‒ Catalyst: Failure of Caldwell & Company (Nashville (caused by bad real-estate loans). • Shown 1930 -32 runs were regional, not national. • Indicated runs mostly “rational, ” not indiscriminate panic. • Traced February 1933 runs to bad policy (state bank holidays). 16 - 16