The federal reserve's role in the great contraction and the subprime crisis.

• Author: Timberlake, Richard H.
• Position: Report

Milton Friedman liked to recall that his experience with the Great Depression as a young man living in New York had a major effect on his career decision to study economics. So, we can count at least one good thing that came out of that tragic, unnecessary experience.

I had about the same reaction to the Depression as Milton Friedman, as did many others who were born early enough to witness the prosperity of the 1920s and experience the inexplicable poverty of the 1930s. Several of my fellow students and I, who were lucky enough to have studied under Friedman at the University of Chicago, subsequently concentrated our professional research on monetary economics to find out just what made the monetary system tick, and especially what circumstances made it go awry. The 1929 experience was the worst, but not the only one.

Milton Friedman's and Anna Schwartz's epic account of the Great Contraction (1929-33) in their Monetary History tells most of what happened (Friedman and Schwartz 1963: chap. 7). It is empirical and analytic economics at its best. Anyone who followed in their footsteps has had this superb model of economic research to guide his own efforts.

Despite the evidence in the Monetary History, misconceptions about the Great Contraction still abound in laymen's minds, more so in popular media accounts, and, to some extent, even among economists. Here, I summarize an important unpublicized incident of that period to emphasize the policy decision that triggered the Depression, and what the experience should have taught policymakers to do and not to do. My brief review is meant to emphasize how that Fed-provoked disaster speaks to Federal Reserve policy in the recent state of disequilibrium in financial markets.

The Gold Standard

A myth that seems to have no ending is that "the" gold standard was the behind-the-scenes villain that promoted the Great Contraction. This contention is preposterous and cannot stand even simple empirical review. Nevertheless, it serves as a convenient scapegoat for apologists who have not looked closely enough at the monetary data, and at some of other peculiar determinants of Fed policy that occurred in 1929-30.

The operational gold standard ended forever at the time the United States became a belligerent in World War I. After 1917, the movements of gold into and out of the United States no longer even approximately determined the economy's stock of common money. The contention that Federal Reserve policymakers were "managing" the gold standard is an oxymoron--a contradiction in terms. A "gold standard" that is being "managed" is not a gold standard. It is a standard of whoever is doing the managing. Whether gold was managed or not, the Federal Reserve Act gave the Fed Board complete statutory power to abrogate all the reserve requirement restrictions on gold that the Act specified for Federal Reserve Banks (Board of Governors 1961). If the Board had used these clearly stated powers anytime after 1929, the Fed Banks could have stopped the Contraction in its tracks, even if doing so exhausted their gold reserves entirely.

Strong's Stable Price Level Policy

As the Monetary History recounts, from 1922 to 1928 the Federal Reserve Bank of New York, under the aegis of Benjamin Strong, promoted what amounted to a stable price level policy for the U.S. economy. The New York Fed was in the right financial environment to implement this policy; the postwar U.S. economy after the 1920-22 recession was the right time to begin it; and Benjamin Strong was the right man to run this showcase model of central bank policy. It lasted from 1922 until late 1928, when Strong died of tuberculosis (Chandler 19,58: 194-206; Friedman and Schwartz 1963: 251, 411-15).

With Strong's death, a scramble began for control of the monetary machinery. While the Monetary History provides much documentary evidence on the personalities vying for control on the Federal Reserve Board and in the Fed Banks, and on the critical policy decisions that occurred, the issue of who replaced Strong as the major power figure in Fed decisions is somewhat unclear. What is clear is that the successor to Strong at the New York Fed, George Harrison, lacked the commitment and the personality to continue Strong's tradition...