The economic crisis of 2009 has only one precedent in modern history: the Great Depression of the 1930s. The similarities are not only their depth and breadth, but their origins as well. Both resulted from an excessively easy monetary policy by the Federal Reserve that created economic distortions in both financial markets and the real economy. In each case, when the Fed tried to fix its mistake by tightening monetary policy, it went too far and created deflation—a falling price level, the opposite of inflation—that was most evident in the collapse of stock prices but was also seen in business bankruptcies and widespread unemployment.
Policymakers of the 1930s misunderstood the nature of the economic problem and were slow to pinpoint the Federal Reserve's policy as the primary source. By the time they did the economy had declined too much for an expansive monetary policy alone to turn it around. Simply lowering interest rates was not enough to encourage borrowing and spending, as it usually is during moderate economic downturns. Only by coupling an easy monetary policy with an aggressive fiscal expansion through federal spending and deficits was it possible to get the economy off a dead stop, end the deflation, and end the depression.
Unfortunately, it took Franklin D. Roosevelt and his advisers a long time and a lot of trial and error before the proper set of policies were in place. Many mistakes were made and setbacks suffered. Since history's errors often teach us more valuable lessons than its successes, knowledge of the Great Depression is essential if we are to avoid repeating those mistakes and get today's economy moving again.
As the nation coped with its second greatest economic crisis in early 2009, analogies to New Deal policies were common.1 The Obama administration was explicit in its belief that the mistakes that caused the Great Depression to be so long and so deep would not be repeated. Thus, Barack Obama's first major action in office was to ask for a huge stimulus bill that was enacted less than a month later. The Fed was also extremely aggressive in pursuing unorthodox policies of previously unthinkable magnitude, such as its announcement on March 18, 2009 that it was prepared to add an additional $ 1.2 trillion to the nation's money supply to unlock credit markets.
Throughout the 2008–2009 crisis, echoes of identical debates from the 1930s were common. Did low interest rates indicate a sufficiently easy Fed policy or did one also have to look at the money supply and pursue what the Fed calls “quantitative easing”? Was a stimulative fiscal policy essential to economic recovery or was it only necessary to wait for monetary policy to do its job? Was deflation the central economic problem or something inherent in the nature of financial markets?
I believe that revisiting the experience of the Great Depression—especially the arguments among top economists about its fundamental causes and the reactions of politicians and policymakers to the circumstances they faced as they faced them—can help us more clearly understand the nature of today's problem, avoid the errors that made the Great Depression so severe, and help restore prosperity as quickly as possible.
In the popular imagination, the stock market crash that began on October 24, 1929, known as “Black Thursday,” was the cause of the Great Depression. It is thought that it mainly resulted from a speculative bubble—excessive buying of stocks, pushing them to prices that were unjustified by economic fundamentals—not unlike those that had led to spectacular market crashes over the centuries.
Some saw it coming. One famous example is banker Paul M. Warburg, a founder of the Federal Reserve, who said in March 1929, “If orgies of unrestrained speculation are permitted to spread too far … the ultimate collapse is certain not only to affect the speculators themselves, but also to bring about a general depression involving the entire country.”2
Perhaps even more famous were the comments by Yale University economist Irving Fisher in September 1929 denying the possibility of a stock market collapse. Responding to a prediction by statistician Roger Babson that a sharp decline was imminent, Fisher said, “Stock prices are not too high and Wall Street will not experience anything in the nature of a crash.” As late as mid-October, Fisher asserted that the market had reached “a permanently high plateau” and would move higher in coming months. Even after the market started to break, Fisher remained optimistic, citing the economy's underlying strength.3
In truth, Fisher's analysis of the stock market was not unreasonable. Many studies have found that only a few stocks making up the Dow Jones Industrial Average had price-to-earnings ratios that appear to have been unsustainable. Most of the stocks were trading at very conservative ratios, and in fact could be considered undervalued based on earnings growth.4 This suggests that the market collapse was not the result of errors by investors but some change in the economic environment that fundamentally changed the rules of the game. Investors don't all make the same mistake at the same time otherwise.
As soon as the market broke, analysts immediately began searching for deeper causes. As with all major historical events, it was hard for those living through it to see all the pieces and their interrelationships. Even with the benefit of historical perspective, there are many details that remain contentious, and probably always will. That is why events like the Great Depression need to be studied and reexamined by each new generation in light of their own experience and the knowl edge gained from subsequent events.
On November 11, 1929, Frank Kent, a director of Bankers Trust, fingered the Smoot-Hawley Tariff, which was then making its way through the Senate, as a prime factor. He declared that growing support for the tariff had created unrest, fear that industry would be injured, prospects for higher unemployment, and general unease in the business community.5
Senator Reed Smoot of Utah and Representative Willis Hawley of Oregon, both Republicans, had initiated their tariff legislation in April. It proposed higher duties on a wide variety of industrial and agricultural products, and many products would have tariffs assessed on them for the first time. In those days, most Republicans were strong supporters of trade protection and believed that high tariffs were needed to insulate American farms and factories from cheap foreign imports. In May, Smoot-Hawley passed the House of Representatives, where Republicans had a large majority, by a wide margin. But free-traders held out hope that the legislation could be derailed or modified in the Senate, where a coalition of Democrats and liberal Republicans threatened passage. By October, however, it was clear from test votes that there was very little likelihood that Smoot-Hawley would fail to get majority support. This led Kent and other analysts to conclude that it was a central factor in triggering the Great Depression.6
Rather than respond to the substance of Kent's assessment, tariff supporters instead attacked Kent for lying about the cause of the market crash. Senators William E. Borah, Republican of Idaho, and Harry Hawes, Democrat of Missouri, demanded a congressional investigation of Kent and other tariff opponents. Senator Thaddeus Caraway, Democrat of Arkansas, called Kent's statement “propaganda” and said it was caused by “arrested mental development.” But Kent refused to back down.7
On November 19, Babson added his voice to those blaming the tariff for the market's malaise. He pointed out that if Congress was in effect going to prohibit nations heavily indebted to the United States from selling their goods here, then they would have no way of servicing their debts. Moreover, they would have no earnings with which to buy American goods, leading to reduced output and employment in exporting industries. Babson suggested that the best thing Congress could do to restore confidence would be to adjourn indefinitely.8
Some analysts maintain that Smoot-Hawley couldn't have been a factor in the stock market crash because it wasn't enacted into law until June 1930. However, financial markets routinely discount the impact of future actions, incorporating their effects into prices well before an action becomes effective. Economist Alan Reynolds carefully tracked movement of the tariff bill through Congress and observed that every time there was a legislative setback the market rallied, and whenever the prospects improved it fell.9
As to the tariff's economic effects, it has been argued that trade protection was already quite severe owing to the Fordney-McCumber Tariff enacted in 1922. Therefore, the additional Smoot-Hawley duties were not quantitatively significant. However, studies have shown that the marginal impact of Smoot-Hawley was in fact quite considerable and sharply reduced trade. It also led to a large decline in investment and a rise in trade protection among our trading partners, which further reduced exports.10
By itself, the Smoot-Hawley Tariff probably wouldn't have had that much impact on either the stock market or the economy. But monetary forces had already made the economic and financial environment very vulnerable to any shock. The tariff may have been the last straw, a trigger that pushed the stock market and the economy into a major downturn.
The Federal Reserve, our nation's central bank, had long been concerned about the outsized gains in the stock market in the 1920s that appeared to be potentially destabilizing. But it had to contend with the fact that its policy levers, mainly changes in short-term interest rates, were incapable of targeting just that one sector of the economy without spillover effects elsewhere. In other words, the price for bringing the stock market down to earth was that healthy sectors would also be brought down, creating unnecessary suffering for those not even involved in the market. As Yale University economist Robert Shiller explains:
One thing we do know about interest rate policy is that it affects the entire economy in fundamental ways, and that it is not focused exclusively on the speculative bubble it might be used to correct. It is whole-body irradiation, not a surgical laser. Moreover, the genesis of a speculative bubble … is a long, slow process, involving gradual changes in people's thinking. Small changes in interest rates will not have any predictable effect on such thinking; big changes might, but only because they have the potential to exert a devastating impact on the economy as a whole.11
Benjamin Strong, president of the Federal Reserve Bank of New York and the Fed's dominant figure through most of the 1920s, was deeply concerned about what he viewed as a stock market bubble but didn't know how to deal with it without bringing the whole economy down. As he put it in a 1927 letter, “I think the conclusion is inescapable that any policy directed solely to forcing liquidation in the stock loan account and concurrently in the prices of securities will be found to have a widespread and somewhat similar effect in other directions, mostly to the detriment of the healthy prosperity of this country.”12
By 1928, however, the Fed felt that it had to take some action to prick the stock market bubble and let some air out before it burst and brought the whole economy down. It began tightening monetary policy by raising the discount rate—the interest rate at which private banks borrow directly from the Fed. In February, it raised the rate from 3.5 percent to 4 percent. In May the rate was raised again to 4.5 percent and to 5 percent in July. There were concerns within the Fed that its monetary policy was endangering the economy as a whole—a cure worse than the disease. But the feeling seems to have been that the Fed could reverse course quickly if necessary.13
Unfortunately, Strong took ill and died in October 1928. This created a massive power vacuum at the Fed and left it effectively leaderless at a critical moment in time. Lacking anyone with the ability to change its direction, the Fed basically continued on automatic pilot. Seeing the stock market continue to rise in 1929, despite a tighter monetary policy, the Fed concluded that stronger action was needed. In February, it issued a statement warning against stock market speculation. Frustrated by the lack of impact from its jawboning, the Fed raised the discount rate to 6 percent in August. This proved to be one rate hike too many. Instead of cooling the stock market's speculative fever, the Fed induced a case of pneumonia that became evident a few months later on Black Thursday.14
Almost immediately some economists pointed their fingers at the Federal Reserve for causing the stock market collapse. Fisher said that the Fed had created the stock market bubble in the first place by running a monetary policy that was too easy during the mid-1920s.15 Columbia University economist H. Parker Willis, who had been deeply involved in creation of the Federal Reserve, said this was caused by two factors: first, an overreaction to the brief deflation resulting from the recession of 1920–1921; and second, a desire to help Great Britain get back on the gold standard by encouraging the outflow of gold from the United States. The Fed also hoped to shed what it viewed as excessive gold stocks, which had flowed into the country in search of a safe haven during and after the First World War. Ironically, the Fed viewed the excess gold as dangerously inflationary.16
In a classical gold standard, such as that which existed before the First World War, the money supply is tied directly to the quantity of gold reserves. Money in circulation automatically rose or fell as gold moved in or out of the country in response to changes in interest rates and inflationary expectations. If there were signs of inflation, gold flowed out, automatically shrinking the money supply and stopping the inflation. Deflation would draw gold inward, expanding the money supply and easing that problem. But after the war, this largely automatic mechanism was replaced by one that was more managed, giving central banks additional latitude to expand or contract the money supply while maintaining a linkage to gold. This is usually called a gold-exchange standard. While the gold-exchange standard did not provide as much monetary flexibility as exists today, there was much more central bank maneuvering room than is commonly believed.17
As a result of the sharp decline in stock prices and the growing slowdown in economic activity that was exacerbated by increased tariffs on imports, the demand for money fell and the supply of money contracted as banks folded, causing bank deposits to evaporate.18 (There was no deposit insurance in those days.) But the Fed allowed the money supply to shrink too much, bringing on a general deflation. Economists have long believed that there is a relationship between the quantity of money times its turnover, on the one hand, and the general level of prices times the quantity of goods and services, on the other. Thus, a shrinkage in the money supply necessarily requires either a decline in prices or a cutback in the production of goods and services.
Another important factor was a decline in the speed at which people were spending their money, which economists call velocity. When velocity increases, less money is needed for economic transactions; when it falls, more money may be needed. Indeed, because velocity is the ratio of the money supply to the gross domestic product, changes in velocity affect the economy exactly the same way changes in the money supply do. Since velocity also fell during this period, as families and businesses hoarded cash and held off making purchases or investments, it exacerbated the deflationary impact of the shrinking money supply.19
The impact of the money supply shrinkage was almost instantaneous. Dun and Bradstreet's commodity price index peaked in October 1929 at a level of 192.204 and fell almost continuously thereafter. By April 1930 the index was down to 179.294 and by December had fallen to 163.20—a decline of 15 percent in a little over a year.20 Changes in the general price level always show up first in sensitive commodity prices. Therefore, such a sharp decline in a broad range of commodities should have been a signal to the Fed that downward price pressure would soon be felt among industrial goods, real estate, and other sectors of the economy. However, the Fed took no action to add liquidity to the economy.
Economist Virgil Jordan of McGraw-Hill condemned the Fed for standing by passively while the money supply fell, thus bringing on a deflation that was paralyzing economic activity. Consumers were holding off making purchases while they waited for prices to drop further, he said, and businesses were incurring huge losses as they were forced to sell products for less than they cost to produce, which brought investment to a standstill. Jordan urged the Fed to immediately inject $ 250 million into the economy by buying Treasury securities.21 This would be about $ 34 billion in today's economy.
One problem is that the Fed was a relatively new institution in 1930, having only been created in 1913. The idea of using openmarket operations, as Jordan suggested, to expand money and credit was not yet well developed and was resisted by key members of the Fed's leadership.22 In such an operation, the Fed buys and sells U.S. Treasury securities. When they are bought, the Fed creates the money itself, thus expanding the money supply. When it sells securities, money flows into the Fed and the money supply contracts. In this way, the Fed can offset changes in the money supply resulting from changing economic and financial conditions. The Fed can also influence the money supply by changing the amount of reserves banks must hold as backing for deposits and by changing the discount rate.
The economy itself causes the bulk of changes in the money supply because most money is not in the form of cash (notes and coin), but bank deposits (checking accounts) and other forms of near-money. Depending on reserve requirements, every dollar deposited in a bank can be loaned out four or five times, thus expanding the money supply. Conversely, withdrawals force banks to cut back on lending and shrink the money supply. There is no formula that tells the Fed exactly how much money the economy needs at any given moment in time, so the Fed must use its judgment. When it is wrong and too much money is created, the result is inflation—a rise in the general price level. Too little money leads to deflation—a fall in the price level.
As an example of how poor the Fed's leadership was after the death of Benjamin Strong, Irving Fisher later recounted a discussion he had with Federal Reserve Board chairman Eugene Meyer in the summer of 1931 about shrinkage of the money supply. According to Fisher, Meyer had no idea that bank deposits constituted the bulk of the nation's money supply or that they had contracted sharply until Fisher brought this to his attention. In Fisher's words, Meyer “was like a chauffeur going blindfolded and running into the curb because he could not see the direction in which he was driving.”23
The continuation of deflation into 1931 brought forth additional calls for the Fed to ease monetary policy. By September, the commodity price index had fallen to 141.724—down 16 percent over the previous year and 26 percent from its October 1929 peak. This led University of Wisconsin economist John R. Commons to call upon the Fed to inject $ 1 billion of new money into the economy by purchasing Treasury securities (about $ 137 billion today). He said that it should have as a goal restoration of the general price level to its 1926 level.24
Other economists echoed Commons. On January 31, 1932, 24 prominent economists wrote a letter to Herbert Hoover recommending that the Federal Reserve “systematically pursue open-market operations with the double aim of facilitating necessary government financing and increasing liquidity of the banking structure.” That same month, a group of Harvard economists circulated a memorandum criticizing the Fed for effectively forcing a contraction in the money supply.25
Fisher was especially concerned that deflation had the effect of increasing the burden of debt because borrowers were forced to repay loans in dollars worth more than those they had borrowed. This rise in the real burden of debt discouraged new borrowing and prevented business expansion and credit circulation.
Under the procedures followed by the Fed in those days, it paid little attention either to prices or the quantity of money. Operationally, its main focus was on the stability of interest rates. If member banks were not borrowing at the discount window, the Fed assumed that credit conditions were adequate. Furthermore, because its focus was on market rates rather than real rates, the Fed was blinded to the massive rise in rates resulting from the deflation in commodity prices. Although market interest rates on short-term Treasury securities fell from 4.42 percent in 1929 to 2.23 percent in 1930, to 1.15 percent in 1931, and to 0.78 percent in 1932, the real (deflation-adjusted) rate actually rose sharply to 10.95 percent in 1932.26
In a period of inflation, interest rates can rise to whatever level is necessary to compensate for the decline in monetary value. If the natural rate of interest would be, say, 5 percent in a period of price stability and something changed that caused lenders to believe that prices would rise by 10 percent over the coming year, then market interest rates would likely jump to 15 percent. This way, lenders would still get 5 percent in inflation-adjusted terms. But with a large deflation, the reverse is not possible. If prices were expected to fall by 10 percent, the market interest rate would have to fall to negative 5 percent to compensate for the deflation. But lenders are never going to lend money at a negative nominal rate; they would instead just hold onto their cash and in effect make 10 percent by doing nothing. Because prices were falling by 10 percent, they would be able to buy 10 percent more in a year, the equivalent of getting 10 percent interest.
In this way, deflation becomes self-reinforcing beyond a certain point. The more people think prices will be lower in the future, the more they hoard cash and hold off making purchases. This causes veloc ity to fall, thus exacerbating the deflation and encouraging still more cash hoarding and so on. This was essentially the economy's problem in 2008 and 2009. Although the Fed tried to raise the money supply, people held off spending and investors parked their cash in Treasury bills even though the interest rate was barely above zero. The continuing decline in velocity counteracted the Fed's money supply increases, leaving the economy suffering from deflationary conditions.
Congress at least recognized the monetary roots of the economy's weakness in 1932, even if the Federal Reserve didn't, and enacted the first Glass-Steagall Act, which reduced the amount of gold the Fed was required to hold as backing for the dollar. This freed the Fed to inject about $ 1 billion of new money into the economy during the spring of 1932.27 This would be about $ 212 billion in today's economy.
This had an immediate effect in halting the slide in commodity prices. Dun and Bradstreet's index bottomed at 125.316 in July—a decline of 14.5 percent from the previous year and 35 percent from its peak. But during the balance of 1932, the index moved upward as the increased liquidity bid up commodity prices. By October, the index was up 9 percent to 136.555, an impressive increase in a short time. At a meeting of the American Statistical Association in September, economists praised the Fed's action and gave it full credit for halting and reversing the crippling deflation that was paralyzing industry.28
Unfortunately, the Fed prematurely halted its efforts to increase the money supply in June 1932, which ended the upward movement in prices a few months later. The Fed may have stopped the policy of injecting money into the economy because interest rates were falling too much for banks to make any money. Rates on 90-day commercial paper in New York fell from 2.88 percent in January 1932 to 0.38 percent by December. This led banks to exert intense pressure on the Fed to halt the monetary easing so that interest rates would rise and bank profits would be restored.29 By November the commodity index was again moving downward, and by March 1933 it was down 6.5 percent from its October 1932 high.
The Fed's easing in early 1932 might have been enough to turn the economy around had it been taken earlier. But more than two years into the deflation, it was too little, too late.30 The deflationary momentum was too strong at that point and required much more aggressive action to reverse its course. As Yale University economist James Harvey Rogers explained:
Taken in their incipient stages, both rises and falls—inflation and deflation—can even with mild measures apparently be checked.… When, however, the movement in either direction has gained momentum, not only is it much more difficult to check, but—what is apparently even more important—other problems … appear with such overwhelming impressiveness as to occupy the entire center of the stage. Thus when bold and vigorous action has become increasingly imperative, actual policies are apt to become confused and based much too largely upon relatively insignificant, though seemingly much more important, considerations.31
Rogers's point here is one also made by economists in 2008—the longer an economic downturn progresses without vigorous action to reverse its course, the harder it becomes to do so. A small amount of properly designed stimulus early in a downturn might be enough to arrest the decline, but may be grossly insufficient at a later date. It's possible that relatively modest action by Congress and the Fed in 1930 could have turned the economy around and made the Great Depression just a run-of-the-mill recession. But when no meaningful action was taken throughout the Hoover administration, the downward momentum by 1933, when Franklin D. Roosevelt took office, was very deep and required actions of greater orders of magnitude than what might have sufficed earlier.
So, too, many economists argued that had Congress enacted a stimulus package in the fall of 2008, it might have forestalled the need for a much bigger one in February 2009. Even after passage of the $ 787 billion fiscal stimulus in February, many economists continued to argue for more because the economic downturn had festered too long before the federal government took meaningful action.32
The fight over the Goldsborough bill in 1932 illustrates how difficult it was to focus the attention of key policymakers on the critical issue of monetary policy and its relationship to the deflation at the heart of the Great Depression. The bill was opposed not only by the Federal Reserve and the Hoover administration but also by the mainstream media. The fight shows that three years into the Great Depression there was still a widespread lack of understanding of its basic cause.
In early April 1932 Representative Thomas Goldsborough, Democrat of Maryland, got a subcommittee of the House Banking Committee to endorse a bill that would have required the Fed to add as much liquidity to the banking system as necessary to raise the general level of commodity prices to their previous level as quickly as possible. Federal Reserve Board chairman Meyer and George Harrison, president of the Federal Reserve Bank of New York, denounced the legislation in the strongest terms. The Treasury Department also voiced opposition and a veto by Hoover was promised.33 They all felt that maintaining the independence of the Federal Reserve, even in the face of its manifest failure, was more important than solving the nation's economic crisis.
Nevertheless, on April 22 the full Banking Committee reported the Goldsborough bill to the House of Representatives. The next day, the New York Times attacked the proposal as “prosperity by fiat.” Echoing the Fed, it said that such an effort would be futile, likening it to a hypothetical law requiring the Secretary of Commerce to double foreign trade.34 But the newspaper's analogy was totally inappropriate. The Commerce Department didn't have the power to double trade, but the Federal Reserve was in fact the only institution capable of stopping the deflation.
The House of Representatives voted in favor of the Goldsborough bill on May 2 by a remarkable vote of 289 to 60. Despite opposition from a Republican administration, a majority of Republicans joined virtually every Democrat in supporting the measure. Speaking in favor of his legislation, Goldsborough emphasized that deflation increased the real burden of debt, forcing individuals and businesses to repay loans in dollars that had far greater purchasing power than the dollars they borrowed. It was like having to pay back $ 1.60 for every dollar someone had borrowed, he said, plus interest.35
The Washington Post sharply criticized the Goldsborough bill, calling it “a cheap political move.” Barron's and the Wall Street Journal vigorously attacked the bill as dangerously inflationary. Their view seems to have been that it was perfectly all right for prices to fall drastically, but under no circumstances were they ever to rise from wherever they happened to be.36
Fisher tried to explain that there is a conceptual difference between “inflation” and “reflation.” The former indicates a rise in the price level from a position of stability. The latter refers to raising the price level back to its previously stable position after a period in which the price level had fallen. Deflation, Fisher said, was the central cause of the depression, mainly because it had the effect of magnifying debts. For example, farm mortgages were larger in terms of the fallen prices for wheat and cotton.37
On May 5, 1932, Hoover attacked the Goldsborough bill directly. The problem, he said, wasn't monetary, but fiscal. Hoover demanded a sharp reduction in government spending and a large increase in taxes in order to balance the federal budget. This would restore confidence, he said, and thereby lead to economic recovery.38 This was, of course, exactly the opposite of what the economy needed. Every economist today recognizes that raising taxes in the middle of an economic depression is insane and that Hoover's policy made a bad situation much worse.
In July 1932, the Senate effectively killed the Goldsborough bill by substituting a Fed-approved measure sponsored by Senator Carter Glass, Democrat of Virginia and former Secretary of the Treasury under Woodrow Wilson, that made it easier for banks to borrow from the Federal Reserve.39 While a useful measure, it was thin gruel compared to Goldsborough.
From the beginning of the Great Depression there were those who refused to see any governmental errors behind the calamity. Instead, they blamed workers and businessmen for excesses that needed to be purged before economic health could be restored. As Treasury Secretary Andrew Mellon famously remarked when Hoover asked him what should be done, “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. … It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people.”40
Among the strongest opponents of reflation were economist Benjamin M. Anderson of the Chase National Bank and Henry Hazlitt, an editor at the Nation magazine. Both repeatedly insisted that any effort to raise prices from where they were constituted inflation and nothing but inflation. Like a number of other economists and commentators during the early years of the depression, they felt that deflation was a nonproblem; if wages would simply fall by the same amount that commodity prices had fallen, then equilibrium would be restored and economic growth would resume. Workers would be no worse off because they would still be able to buy the same bundle of goods and services since their prices had fallen to the same degree.41
There was certainly truth in this argument. Where it went wrong was in thinking that labor is a commodity like wheat or copper, which are easily traded on exchanges and can fall in price very rapidly. But workers don't like pay cuts and employers don't like making them. Thus cuts in wages are much more difficult and more protracted than reductions in commodity prices.
The anti-reflation zealots also forgot that debts were fixed in nominal dollars. There was no easy mechanism for renegotiating them except through extremely time-consuming and painful bankruptcies. Although interest rates had fallen, debtors still had to pay off their debts with dollars that were worth much more than the dollars they had borrowed. Also, interest rates could not fall by enough to compensate for the deflation because they could not go below zero.42
Thus it is a mistake to view an equivalent inflation and deflation as symmetrical—as having equal and opposite economic effects. Because of the problem of debt, deflation is far worse. Small deflations can be offset by reducing market interest rates. But once the rate of deflation is greater than the rate of interest, as was the case in the early 1930s, the zero-percent floor becomes a huge barrier to readjustment. The only way out is to raise the price level. This approach was naturally opposed by bankers, who liked getting repaid in dollars worth more than those they had lent, and also by hardliners who saw every whiff of inflation as the first step toward hyperinflation and complete economic collapse, as occurred in Germany in the mid-1920s.43
The Fed faced precisely the same dilemma in 2008–2009 as it cut the interest rate it charged banks almost to zero, and rates on Treasury securities also approached zero. Under normal circumstances, giving banks access to virtually free money would have caused them to make new loans that would have led to increased buying, investment, and growth. But because of deflation, the real rate of interest was still quite high and the Fed was blocked from reducing rates further because it is impossible to reduce nominal rates below zero.44
The interaction between debt and deflation formed the core of Fisher's theory of the Great Depression, and it is why he thought that reflation was the best path to recovery. Since the Federal Reserve had the ability to increase liquidity and thereby raise the price level, responsibility for causing and curing the economic malaise basically belonged to the Fed alone. As Fisher put it, “If the debt-deflation theory of great depressions is essentially correct, the question of controlling the price level assumes a new importance; and those in the drivers' seats—the Federal Reserve Board and the Secretary of the Treasury … will in [the] future be held to a new accountability.”45
Fisher was aggressive in bringing his theory to the attention of Franklin D. Roosevelt, who defeated Hoover in the 1932 election. On February 25, 1933, Fisher wrote to the president-elect and explained how deflation was at the root of the economy's problems. “What we are fighting now is deflation. It needs to be stopped and reversed,” he stated. “We need a rise in the price level by the only means it can be raised … an increase in the quantity or velocity, or both, of the circulating medium whether credit, paper, or gold, or all three,” he said. Failure to act, Fisher continued, would be “ruinous economically, politically, socially.”46
Shortly after taking office on March 4, 1933, Roosevelt received a remarkably sophisticated memorandum from a lawyer named Benjamin Henry Inness-Brown that precisely outlined the monetary nature of the deflation underlying the economic crisis. Dated April 25, 1933, and transmitted to him through Col. Edward M. House, a former adviser to Woodrow Wilson and a close family friend of Roosevelt's, the memo noted that although the amount of currency in circulation had risen from $ 3.9 billion in June 1931 to $ 6.3 billion by March 1933, the collapse of demand deposits such as checking accounts was much greater. These had fallen from $ 25.2 billion to just $ 13 billion over the same period. The economic impact of this monetary contraction was all the greater because velocity had also declined sharply, reducing the effective money supply by $ 126.2 billion since 1929, according to the memo.47
Another sophisticated analysis of the economic situation was produced by University of Chicago economist Jacob Viner in April. He correctly identified the Federal Reserve as the source of the deflation that was at the root of the problem, observing that there had been a steady contraction of bank credit since 1929. Anticipating Keynesian economics, Viner pointed out that simply printing money might not do much good because it would likely be hoarded or substitute for bank credit. To really bring about the increase in the money supply that was essential to recovery, he said it was necessary for the federal government to greatly increase the budget deficit by increasing spending or reducing taxes and to finance the deficit with new money creation. Moreover, it might be necessary to engage in such an inflationary policy for some time in order to bring about a sufficient increase in liquidity, Viner said.48
Unfortunately, Roosevelt's recovery program failed to get at the root of the problem. His initial plan for staunching the deflation mainly involved price fixing and limitations on production. The regulatory system established by the National Industrial Recovery Act, enacted on June 16, 1933, prohibited businesses from lowering wages or prices. But by preventing prices from adjusting, which would have restored equilibrium, Roosevelt's effort actually inhibited recovery rather than fostering it.49
Roosevelt was not unaware of the monetary underpinnings of the deflation, but he thought the whole problem related to the price of gold. Both Roosevelt and Treasury Secretary Henry Morgenthau were strongly influenced by an economist named George F. Warren who had carefully studied the correlation between gold and commodity prices.50 Roosevelt and Morgenthau concluded from Warren's research that if the price of gold rose, then this alone would automatically raise prices for other commodities.
Roosevelt ordered the Reconstruction Finance Corporation, a government agency established by Hoover, to buy gold on the open market in order to raise its price. This policy didn't work very well for a variety of reasons, the main one being that the RFC had to borrow the money it used to buy the gold. Consequently, there was no net increase in liquidity—the borrowing took out of the financial system exactly what the gold purchase put in. While the price of gold increased, it was only a relative price change resulting from increased demand for that one particular commodity and did not have any effect at all on the general price level. This point was made to Roosevelt and Morgenthau when the Treasury's principal monetary economist, O.M.W. Sprague, resigned on November 16, 1933, to protest the gold-buying policy. In his letter of resignation, Sprague said it would neither induce greater demand for materials and labor nor increase domestic consumption.51 Sprague's point was seconded by University of Missouri economist Harry Gunnison Brown:
I insist that gold purchases, taken alone and without increase of circulating medium, cannot be counted on either to stimulate business or to raise the level of prices. … The fact is that the purchase of gold by the government has in itself no more tendency to raise the general price level or to promote recovery than would have the purchase of building or building stone or the purchase of rolltop desks. The truth is that our problem centers in the securing of expanded bank credit or additional money.52
Nevertheless, despite the fact that Roosevelt's gold-buying plan had absolutely no inflationary potential—and no inflationary impact—it was condemned in some quarters for being the first step in a total breakdown of the monetary system. Fifteen members of the Yale University economics department signed a letter attacking Roosevelt for attempting to secure an “artificially higher level of prices.” Among those not signing the letter was Fisher, who correctly noted that there is no level of prices that isn't inherently artificial.53
In November 1933 Harvard economist Lauchlin Currie published the best data to date on the decline of the money supply. Using a more comprehensive definition of money that included demand deposits and other financial instruments for which data was not generally available in those days, he found that the money supply had fallen from $ 26.7 billion in 1929 to $ 20.8 billion in 1932, a decline of 22 percent. Like the memo Roosevelt received in April, Currie's paper showed that cash in circulation had risen, from $ 3.9 billion in 1929 to $ 4.9 billion in 1932. But demand deposits held at banks fell sharply from $ 22.7 billion in 1929 to $ 15.9 billion in 1932, a 30.2 percent shrinkage.54
British economist John Maynard Keynes was among those who thought the Roosevelt program was on the wrong track because it did not get at the root cause of deflation.55 He outlined his objections in an open letter to the president that was published in the New York Times on New Year's Eve 1933. Regarding the National Recovery Administration, which administered the price-fixing arrangements at the base of Roosevelt's strategy, Keynes saw little value. “I cannot detect any material aid to recovery in the NRA,” he wrote. It “probably impedes recovery … in the false guise of being part of the technique of recovery.”
Keynes correctly observed that “output depends on the amount of purchasing power.” Rising prices were to be welcomed because they were normally a consequence of faster growth. But it was essential that additional output be accompanied by an increase in the money supply, he said. Without that, forcing up prices artificially only raised business costs without doing anything to stimulate growth. “Thus rising prices caused by deliberately increasing prime costs or by restricting output have a vastly inferior value to rising prices which are the natural result of an increase in the nation's purchasing power,” Keynes emphasized. He concluded that “national recovery as a whole will be retarded” by the Roosevelt plan.
A better approach, Keynes suggested, was to prime the pump by increasing government spending that should be financed by borrowing and accommodated by an easier monetary policy. This was necessary to mobilize money creation. Just adding new money to a destitute economic system was like trying to get fat by buying a larger belt, Keynes said. The additional government borrowing in financial markets caused by budget deficits would put upward pressure on nominal interest rates, but the Federal Reserve would be able to keep the rates down by buying the additional government bonds on the open market and paying for them with new money. In this way, the additional purchasing power would be induced to circulate and thereby jump-start the recovery. “The object is to start the ball rolling,” Keynes explained.56
Fisher quickly endorsed Keynes's analysis. The artificial price rise engineered by the NRA was retarding recovery, Fisher said. What was needed was monetary expansion. “A rise of prices at the expense of output, which practically means at the expense of the national income, is a different matter from a rise of the price level through monetary and credit reflation,” he emphasized. Economist Willford I. King of New York University agreed and added that it was critical for policymakers to understand that simply increasing the federal budget deficit was not expansionary unless accompanied by an increase in the money supply, because government borrowing alone would simply withdraw purchasing power from the economy to the same extent that government spending expanded it.57
In 2009 the debate on this point resurfaced as a number of conservative economists similarly argued against the Obama stimulus package on the grounds that fiscal stimulus was inherently ineffective. The government, they said, would just be taking with the one hand by running bigger deficits what it would be handing out with the other in the form of tax cuts and spending for various programs. The result would be a wash and that would fail to raise total spending or growth.58
Obama administration economists responded that there was ample empirical evidence in the historical record to show that budget deficits were stimulative. Perhaps for fear of appearing to speculate about Fed policy, however, they never drew a connection between fiscal expansion and monetary expansion. Nevertheless, it was clear from Federal Reserve statements that it viewed fiscal stimulus as critical to its efforts to expand liquidity.59
Among the most perceptive members of Congress in the early 1930s was Senator Elmer Thomas, Democrat of Oklahoma, who clearly saw monetary policy at the root of the nation's economic problems. As he explained:
The record before us demonstrates that we have but two possible roads open to travel. One is a continuation of deflation leading to bankruptcy and repudiation of debts, public and private. The other road is an expansion of the currency leading to more money; hence, cheaper money, higher prices for commodities, higher wages and salaries, and therefore added buying power for the people. More money means the payment of taxes, interest, and debts. More money means the saving of homes, farms, and factories. More money means the restoration of personal, corporate, city, county, state, and national solvency.60
The farm bill enacted in May 1933 included an amendment offered by Senator Thomas that gave the president the power to expand Federal Reserve credit by $ 3 billion, issue up to $ 3 billion in new Treasury notes (greenbacks), reduce gold backing for the currency by up to 50 percent, and monetize silver.61 These would have been helpful measures, but by the end of 1933, none of them had been utilized by Roosevelt.
Roosevelt finally acted on January 3, 1934, arbitrarily raising the official price of gold from $ 20.67 to $ 35 per ounce. But this action had essentially no monetary effect at all. Since, under previous laws and executive orders, the Treasury had come to own virtually all of the nation's monetary gold, its only effect was to create a paper profit for the Treasury of $ 2.8 billion (about $ 528 billion today). This money wasn't spent, however, but mostly retained by the Treasury. The net result of all this gold maneuvering, therefore, had virtually no economic effect in terms of stemming deflation or stimulating growth because it did nothing to increase the volume of money and credit. Economist H. Parker Willis tried to explain this to the Senate Banking Committee on January 20, 1934:
I refuse to accept the idea at all that a change in the theoretical weight of the dollar would have any effect whatever on prices.… I submit, with all due respect, that there is nothing in recent statistics or statistical experience in this country or abroad to show that the changing of the price of gold would also change at the same time, or shortly, the price of commodities. I believe that the expectation that this kind of stabilized dollar will bring a higher level of prices is entirely unwarranted, and I say with the utmost earnestness that I believe those who look forward to that will be seriously disappointed in the results.62
When George Warren testified before the same committee two days later, he insisted that the linkage between the price of gold and those of other commodities was direct and had nothing to do with the volume of money and credit. When asked why prices had fallen after 1929 despite no change in the price or volume of gold, Warren gave this incoherent response: “For some reason the gold-using world had a high price level, and having it, it could do nothing else than become adjusted to it. For some reason prices in gold-using countries collapsed.”63
A few days later on January 25, several Harvard economists including Currie sent a letter to Roosevelt agreeing with the necessity for ending a formal gold-dollar link, but at the same time confirming Willis's view that this action by itself would have no effect on the problem of deflation. Said the economists, “We do not believe there is any exact relationship between the price of gold and the prices of commodities and that a policy acting on such a belief is based on error.”64
In February, an exasperated Fisher suggested that monetary policy be taken away from the Federal Reserve altogether and placed in the Treasury Department. The Fed, by virtue of its governance by a committee structure and separate regional banks, was perpetually rife with “dissension and vacillation,” he said.65
In March, Russell Leffingwell, a partner at J. P. Morgan, gave one of the clearest explanations that appeared throughout this period on the true path to recovery. Unlike so many other analysts who were confused by gold, exchange rates, and other extraneous matters, he precisely fingered Federal Reserve policy as the central issue. As Leffingwell explained in a speech to the Academy of Political Science:
The future technique of dollar revaluation should follow the course of an orthodox cheap money policy: the expansion of credit and currency through the Federal Reserve banks; the purchase of government securities by them in the market, or even as ways and means advances to the Treasury if need be; the purchase by them of longer government bonds as well as short; and the maintenance by them of discount rates favorable to the borrower upon such securities. The Federal Reserve banks should be prepared to enlarge their portfolio of government securities, and of loans on government securities, at low rates of interest; to make credit cheap, and to finance at least a part of the government's deficit; until the stimulus of cheap money raises prices, and restores a profit to business, so that business can reemploy labor and will have more taxes to pay on increased incomes.66
In June 1934 Keynes visited the United States and met with Roosevelt and many of his advisers. Reiterating the views he expressed in his open letter six months earlier, Keynes urged abandonment of the NRA's price-fixing because it was only raising business costs without getting at the root of the deflation problem. He said that if government relief spending rose from $ 300 million per month to $ 400 million per month for a year it might be enough to end the depression ($ 100 million of extra spending would be equivalent to about $ 19 billion in today's economy, or about $ 220 billion per year). For his plan to work, however, Keynes said, it was essential that “continuous pressure” be brought upon the Treasury and Federal Reserve to monetize the deficit spending and to hold down interest rates.67
According to updated figures compiled by Currie, the narrow money supply fell to $ 19.9 billion in 1933, mainly owing to a further decline in bank deposits. Finally in 1934 came indications of improvement. The money supply jumped to $ 22.9 billion, almost all of it in bank deposits.68 Not surprisingly, the economy began to show the first real signs of recovery. According to current Commerce Department data, real GDP fell 8.6 percent in 1930, 6.4 percent in 1931, 13 percent in 1932, and 1.3 percent in 1933, but showed impressive growth of 10.8 percent in 1934.
Nevertheless, few economists felt that the country had turned a corner. In any case, a great deal of ground needed to be made up; real GDP would not achieve its 1929 level again until 1936. Fisher believed that the NRA was a key factor holding back the economy because it relied on restricting output to raise prices rather than on expanding liquidity—in effect destroying wealth to create wealth, a policy at war with itself. As he explained:
We may raise prices by making goods scarce or by making money abundant. The first way is followed when cotton fields are plowed up, wheat acreage limited, pigs slaughtered to reduce the food to be made of them, business paid to induce people not to produce. All of these and like measures reduce the national income, for that income consists of these very goods—bread from wheat, pork from hogs, clothes from cotton, and so on. Our income is our “daily bread”—our “bread and butter”—and we cannot get more of this real income by producing less of the elements of which it consists. Such a New Deal is a raw deal, however good the intentions and however it may relieve certain classes at the expense of other classes.
But putting more money into circulation to replace the $ 9 billion of checking deposits destroyed in the banks raises prices in a total opposite way, for it leads to more production, not less. Wherever such correct monetary policies have been tried … profit and so production and employment have increased. There is more, not less daily bread, more bread and butter and clothing.69
Although economists like Keynes, Fisher, Currie, and others had done yeoman work in explaining that the fundamental cause of the Great Depression was a deflation caused by inept Federal Reserve policy, five years into the economic malaise this fact was still only dimly understood. Furthermore, the length and depth of the depression meant that much more effort was needed to get the economy moving again than would have been required in the early years. Think of trying to push a car over a small rock. When it has even a little bit of momentum, you can push it over the rock easily. But if the car is at a dead stop, that small rock is a very difficult obstacle to overcome.
Across the Atlantic Ocean in England, Keynes pondered this problem as well. Looking at the growing problem of Nazi Germany, he knew that it was essential for the United States to pull itself out of its lethargy, which would be critical to England's survival in the event of war. In 1935, he finally figured out how to do it.