Friedman & Schwartz
“The Great Contraction”
Economics 639 / American University / Vaughan
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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
20th 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.
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Background
Bank Balance Sheet
SIMPLIFIED BANK BALANCE SHEET
ASSETS
Reserves
Vault Cash
Deposits at Federal Reserve
Securities
Loans
LIABILITIES
Checkable Deposits
Time Deposits
Other Funding
EQUITY
Capital
• 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.
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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.
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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↓).
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Background
Drivers of Money Supply
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.
 Greater public preference for currency → Smaller money multiplier
 Greater bank preference for reserves → Smaller money multiplier
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Money and Output in Great Depression
Trends in Money and Industrial Production
August 1924 - December 1942
M2 Money Supply (Billions of Seasonally Adjusted Dollars);
Index of Industrial Production (Seasonally Adjusted, 2007 = 100)
15.0
14.0
DATE SOURCES
Federal Reserve Bank of St. Louis (FRED)
National Bureau of Economic Research
August 1929 – March 1933
$80.0
• M2↓ 35.2%
• Industrial Production↓ 51.7%
$75.0
12.0
$70.0
11.0
$65.0
Pre-1929 Trend Line,
Industrial Production
10.0
Industrial production reaches
1929 level (December 1936).
$60.0
9.0
$55.0
8.0
$50.0
7.0
$45.0
6.0
$40.0
Recession
Industrial Production
M2
5.0
4.0
3.0
Aug-24
Minor Tick = $2.5 Billion (Current Dollars)
Minor Tick = 0.5
13.0
$85.0
$35.0
$30.0
$25.0
Aug-26
Aug-28
Aug-30
Aug-32
Aug-34
Aug-36
Aug-38
Aug-40
Aug-42
Minor Tick = 1 Year
What caused money stock to collapse?
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Monetary Contraction in 1930s
Were Panics Driving?
Bank Panics and Money Supply (M2)
January 1929 - December 1933
$50
M2 = Currency Held by Public + Commercial Bank Demand and Time Deposits
$48
Onset of Third
Banking Panic
September 1931
$46
M2 in Billions of Dollars
(Minor Tick = $1 Billion)
$44
$42
$40
Great Contraction
Money Supply (M2)
$38
$36
$34
$32
$30
$28
Jan-1929
NOTE
Onset of
Fourth
Banking Panic
February 1933
Stock-Market
Crash
October 1929
Jul-1929
Jan-1930
Onset of
Second
Banking
Panic
April 1931
Onset of First
Banking Panic
November
1930
Jul-1930
Jan-1931 Jul-1931 Jan-1932
DATE SOURCES
Federal Reserve Bank of St. Louis (FRED)
National Bureau of Economic Research
Jul-1932
Jan-1933
Jul-1933
Minor Tick = 3 Months
• Stock-market crash did not “cause” large decline in money stock.
• Money-stock decline became more pronounced with each panic.
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Panics and Money Supply, 1929-33
Base or Multiplier?
Behavior of Monetary Base
January 1929 to December 1933
Source: Friedman & Schwartz (Table B-3)
10.0
• Logically, moneystock decline must
come from fall in
(i) money multiplier,
(ii) monetary base
or (iii) both.
• Monetary base did
not drive 1929-1933
decline in money
stock.
Great Contraction
9.0
Monetary Base
8.0
August 1929 – March 1933
Monetary Base↑ 25.7%
7.0
August 1929 - March 1933
Monetary Base↑ 17.6%
6.0
5.0
Jan-29
Jul-29
Jan-30
Jul-30
Jan-31
Jul-31
Jan-32
Jul-32
Jan-33
Jul-33
Minor Tick Mark = 3 Months
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Panics and Money Supply, 1929-33
Base or Multiplier?
Great Contraction
August
Culprit:1929
Money
– March
Multiplier!
1933
M2
Money1929
Multiplier
↓1933
48.7%
August
– March
Money Multiplier↓ 44.9%
But how did panics cause money-multiplier collapse?
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Bank Panics and Money Multiplier
1929-1933 “Failures”
Suspensions
Number of Each Year as
Number of Suspended % of 1930-33
U.S. Banks
Banks
Total
Year
Dec-1929
24,026
659
N/A
Dec-1930
22,172
1,350
14.8%
Dec-1931
19,375
2,293
25.2%
Dec-1932
17,802
1,453
16.0%
Dec-1933
14,440
4,000
44.0%
Total (1930-33) =
9,096
100.0%
% of 1929 Banks =
37.9%
N/A
Source: Wicker, The Banking Panics of the Great Depression, p.2.
• 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↓).
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Panics and Multiplier Components
Behavior of (D/R) and (D/C) during Great Contraction
January 1929 to December 1933
Source: Friedman & Schwartz (Table B-3)
15
Financial or Banking Shock
Deposits to Bank Reserves (D/R)
Deposits to Currency Held by Public (D/C)
12
9
StockMarket
Crash
First
Panic
Begins
Second
Panic
Begins
6
Third
Panic
Begins
3
Fourth
Panic
Begins
0
Jan-29
NOTE:
•
•
Jul-29
Jan-30
Jul-30
Jan-31
Jul-31
Jan-32
Jul-32
Jan-33
Jul-33
Minor Tick Mark = 3 Months
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.
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Panics and Money Supply, 1929-33
Summing Up
Money-Supply Components Before / After
Start of First Bank Panic (November 1930)
Component
August 1929 March 1933
August 1929 - November 1930 November 1930
March 1933
M2
-35.2%
-5.3%
-31.6%
Money Multiplier
-44.9%
-2.3%
-43.7%
D/C
-58.9%
1.1%
-59.4%
D/R
-35.7%
-5.9%
-31.7%
Monetary Base
17.6%
-3.1%
21.3%
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.
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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%).
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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.”
 Problem of identifying stance of monetary policy persists!
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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).
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