The Great Depression and Monetary Policy

The Stock Market Crash

It is a well known fact that the economy was booming in the 1920s. There was a high level of optimism that made economists believe that the United States Federal Reserve would be able to stabilize its economy. The Federal Reserve worried about extremely high and unstable level of the stock market, “It seemed better to the Federal Reserve in 1928 and 1929 to try to “cool off” the market by making borrowing money for stock speculation difficult and costly by raising interest rates. They accepted the risk that the increase in interest rates might bring on the recession that they hoped could be avoided if the market could be “cooled off”: all policy options seemed to have possible unfavorable consequences.” (http://econ161.berkeley.edu/TCEH/Slouch_Crash14.html) Sure enough on October 24 1929, also known as “Black Thursday,” a record of 12,894,650 shares were traded. Only five days later another catastrophic downturn of 16,410,000 shares were bought and sold.

Most people believe that the majority of Americans at the time owned stock, but in actuality less than 2% of population at the time of the crash held ownership in stock. So the question arises, why did the stock market crash have such an impact on the American people?

Effect on the American People

The crash undoubtedly generated uncertainty regarding future income. The uncertainty is said to be the reason why consumers and producers forwent purchases of durable goods. In agreement with the Keynesian mechanism, this decline in spending results in a drop of income.

GDP (A common measurement of national income) = C + I + G + (X – M)

According to Christina Romer, “there is indeed a statistically significant negative relationship between consumer spending on durables and stock market variability” (598)

According to this table one can see the negative affect the variability in the stock market has on consumer spending. Also the decline in purchases of durable goods is very evident. Purchases of perishable goods (food) rose immediately following the crash whereas purchases of durable goods plummeted and by Jan of 1930 automobile registrations were 24% lower than they were before the crash. Romer offers a very logical explanation for the decline of consumer purchases, “Consider a consumer deciding whether to buy a durable good that is available in varying levels of quality. When future income is temporarily uncertain and durables purchases are irreversible for long periods of time, there is a trade-off between purchasing the durable and waiting.” Therefore, if the consumer decides to make the purchase they may have bought the good at a quality level too luxurious or too modest for their future income level.

Business analysts conveyed their forecasts and thoughts about the future of the economy. In her article Romer takes a close look at the forecasts of five economists. She proves that there was obvious uncertainty among these forecasters. A forecaster from the Standard Traded stated, “With the opening of the new year, there is a wide conflict of opinion as to what is in store for the industry and commerce during the early part of 1930,” another forecaster stated, “Opinions may differ as to whether or not the stock market collapse… need necessarily by followed by a serious business recession.” The exposure to the forecaster’s conflicting opinions may have been a cause of the uncertainty among consumer and producers. Perhaps a reason for the conflicting predictions was due to Hoover’s response to the crash, “to promulgate optimistic forecasts and to encourage other to do so as well.” It is likely that several of the analysts participated in this positive propaganda. Other causes of the nationwide uncertainty were the “suspense and indecision created by the final outcome of the new rates included in the Hawley-Smoot tariff bill” and the “alarm about the continuing weakness in prominent commodity markets.”

Early Reaction to the Depression

Herbert Hoover, President of the United States from 1928 to 1932, believed that there should be little government intervention in the economic activity of the country. He felt that the Depression would be a temporary period and that the country would soon return to prosperity. Hoover did little to prevent or discourage the Stock Market crash of 1929. Due to his aversion to government regulation of business, Hoover also did not stop abusive business practices after the crash or institute much-needed financial reforms. Hoping for “Voluntary Cooperation” from businesses, Hoover felt that the economy would eventually stabilize on its own, but few businesses were willing to take risks during the Depression.

Secretary of the Treasury Andrew Mellon advised President Hoover to instate shock therapy, which called for the liquidation of all labor, stocks, farming, real estate, and other assets. Mellon wanted to reorganize the entire economy and hoped that the Depression would make people more hardworking with better morals who would work diligently to reconstruct the economy. Mellon and other supporters of liquidation feared that increasing the money supply would only lead to more speculation in the stock market and in the overall economy without creating any increase in output.

In 1932 Congress passes laws that allowed the government to begin helping businesses. One of these laws created the Reconstruction Finance Corporation which loaned money to banks and businesses to prevent them from going bankrupt. Although Hoover had hoped that state and local governments would provide the unemployed with jobs, towards the end of his presidency he began supporting public works programs that created more jobs.

Monetary Policy

Keynesian Theory

In the early 1930’s, economist John Maynard Keynes began constructing theories that advocated more government intervention as a way of getting out of the Depression. He theorized that the government should run high deficits during a depression in order to stimulate the growth of the economy. During the Depression the private sector was too hesitant to invest, so the government must heavily invest, for example in large public works programs, in order to create jobs and increase economic activity. As investment increases, aggregate demand will increase. As aggregate demand increases output will increase, eventually bringing the country back to equilibrium.

Although Roosevelt created public works programs to stimulate the economy, Keynesians argue that he did not invest enough money in the economy to stabilize it.

Milton Friedman

Friedman argues that the government should have used monetary policy to pull the country out of the Depression. Many banks collapsed during the Depression because they ran out of reserves. According to Friedman, the government should have increased the money supply in order to prevent bank closures as well as to increase loans to failing businesses and consumers. The sharp decrease in the money supply during the Depression lead to a decline in economic activity, and increasing the money supply would have enabled more economy activity.

Gold Standard

In the past most money was paper, as it is now, but governments were obligated, is asked, to redeem that paper for gold. This placed an upper limit on the amount of currency the government could print which prevented inflation. During World War I, most countries went off the gold standard and made it a major postwar aim to reinstate it. “Other countries backed their paper money not with gold, but with other currencies—mainly U.S. dollars and British pounds—that were convertible into gold. As a result flexibility of governments was limited. A loss of gold (or convertible currencies) often forced governments to raise interest rates. The higher interest rates discouraged conversion of interest-bearing deposits into gold and bolstered confidence that inflation would not break the commitment to gold.”(1)

The Federal Reserve was put to blame for allowing 2/5 of the nation’s bank to fail between 1929 and 1933. From this time, the money supply dropped by 1/3, causing interest to increase and making it impossible to for many individuals and businesses to invest or spend. ” Friedman and Schwartz argue that it was this drop in the money supply that strangled the economy. They consider the depression mainly an American affair that spread abroad.” (1) In 1933, Roosevelt prohibited US citizens from owning gold and using it as a form of money. This action forced citizens to sell their gold to the government at $20.67 per oz., in 1934 Roosevelt raised the price of gold to $35 per oz.

The issue of ending the depression and protecting the gold standard was something that the Federal Reserve came to faced with. They first issue was to enable easier credit and second was to tighten credit. “The mere hint that a country might abandon gold prompted speculators and international depositors to change local money into gold or a convertible currency. Deposit withdrawals spread panic and squeezed lending. It was a global process that ultimately forced all governments off gold. With the gold standard gone, governments had more freedom to stimulate their economies with an expansion of money and credit. The political inclination was to act sooner, rather than later, to halt a slump.” (1)

Rearmament Recovery

The massive rearmament policies to counter the threat from Nazi Germany helped stimulate the economies in Europe in 1937-39. By 1937, unemployment in Britain had fallen to 1.5 million. The mobilization of manpower following the outbreak of war in 1939 finally ended unemployment.

In the United States, the massive war spending doubled the GNP, masking the effects of the Depression. Businessmen ignored the mounting national debt and heavy new taxes, redoubling their efforts for greater output to take advantage of generous government contracts. Most people worked overtime and gave up leisure activities to make money after so many hard years. People accepted rationing and price controls for the first time as a way of expressing their support for the war effort. Cost-plus pricing in munitions contracts guaranteed businesses a profit no matter how many mediocre workers they employed or how inefficient the techniques they used. The demand was for a vast quantity of war supplies as soon as possible, regardless of cost. Businesses hired every person in sight, even driving sound trucks up and down city streets begging people to apply for jobs. New workers were needed to replace the 11 million working-age men serving in the military. These events magnified the role of the federal government in the national economy. In 1929, federal expenditures accounted for only 3% of GNP. Between 1933 and 1939, federal expenditure tripled, and Roosevelt's critics charged that he was turning America into a socialist state. However, spending on the New Deal was far smaller than on the war effort.

(http://www.martinfrost.ws/htmlfiles/aug2007/great_depression.html)

Strong’s Counter Cyclical Policy

Benjamin Strong was an experienced financial leader who became first governor of the Federal Reserve Bank of New York. “He chaired a committee of Federal Reserve Bank governors that coordinated System open market operations and represented the System in dealings with foreign central banks and Congress.(22) It is clear that, with his death, the Fed lost an experienced and forceful leader.” (2) Friedman and Schwartz would say that Strong’s policies may have prevented the monetary collapse and depression. Strong managed to discover how to maintain moderately stable price level through monetary policies in the U.S. and very few understood how. “Friedman and Schwartz agree with Fisher that Strong's death caused monetary policy to change significantly. They argue that Strong's aggressive open market purchases and discount rate reductions in 1924 and 1927 had quickly alleviated recessions, but that his death produced a sharply different policy during the Depression:

If Strong had still been alive and head of the New York Bank in the fall of 1930, he would very likely have recognized the oncoming liquidity crisis for what it was, would have been prepared by experience and conviction to take strenuous and appropriate measures to head it off, and would have had the standing to carry the System with him (pp. 412-13).” (2)

“The Fed's actions in 1924 mark its first use of open market operations to achieve general policy objectives. In that year, the Fed purchased $450 million of government securities and cut its discount rate (in three stages) from 4.5 percent to 3 percent. In testimony before the House Banking Committee in 1926, Benjamin Strong listed several reasons for these actions, including the following:

1) To accelerate the process of debt repayment to the Federal Reserve Banks by the member banks, so as to relieve this weakening pressure for loan liquidation.

2) To give the Federal Reserve Banks an asset which would not be automatically liquidated as the result of gold imports so that later, if inflation developed from excessive gold imports, it might at least be checked in part by selling these securities, thus forcing member banks again into debt to the Reserve Banks and making the Reserve Bank discount rate effective.

3) To facilitate a change in the interest relation between the New York and London markets... by establishing a somewhat lower level of interest rates in this country at a time when prices were falling generally and when the danger of a disorganizing price advance in commodities was at a minimum and remote.

4) By directing foreign borrowings to this market to create the credits which would be necessary to facilitate the export of commodities....

5) To render what assistance was possible by our market policy toward the recovery of sterling and the resumption of gold payment by Great Britain.

6) To check the pressure on the banking situation in the west and northwest and the resulting failures and disasters.(53)

The Fed undertook a second large purchase program in 1927, purchasing $300 million of government securities and reducing the discount rate again. Strong left no written justification for these operations.” (2)