Transcript Great Contraction

Great Contraction
 Causes
 Mal-distribution
of wealth
 WWI (costs and debt)
 Conspiracy of Bankers
 Stock Market practices
 Government policies (Federal Reserve)
 Over-production
 The gold standard
Great Contraction
 Explanations
 Single
of causes
cause
 Multiple causes
 American
 European
 Business cycles
Great Contraction
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Two opposing economic theories
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Keynesian (John Maynard Keynes
Austrian (Friedrich Hayek)
Keynes
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The General Theory of Employment, Interest, and
Money (1936)
Macroeconomics
Demand side economics
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Aggregate demand is the primary source of
business cycle instability
Circular flow of income and expenditure
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My expenditure is your income
Great Contraction
 Circular
flow
 Too
much wealth
 Wealth is passed back and forth too
rapidly
Economy "heats up”
 Money and credit become worth less
 Prices of commodities rise
 Inflation
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Great Contraction
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Too little money and credit
Wealth moves too slowly from hand to hand
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Value of money and credit increases
Price of commodities fall
Recession/Depression
Government responsible for keeping the right
amount of money and credit in circulation
Rate of circulation such that the economy
would neither "heat up" nor "cool off“
Great Contraction
 How
can the government influence
cycle?
 Deficit
spending, putting more money
into the economy than it took out,
during recessions or depressions
 Reduce taxes
 Print more money and so go into debt
Great Contraction
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Keynes & the depression
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Capitalism inherently unstable
Free market causes high unemployment
Depression caused by laissez faire capitalism
Only massive governmental spending (WWII)
relieved the Great Depression
Long term effects of Keynesian
economics
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Government controlled economy
Fiat money
Open door to welfare state
Great Contraction
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Priming the pump
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Money used, if possible, for public works and
economic infrastructure (such as improved
railroads, hydroelectric dams, flood control
projects, bridges, irrigation canals, and the
like) that would increase production in the long
run and should get money into the hands of
the consumers so that they would begin to buy
again in the short run
Great Contraction
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Austrian School
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Friedrich A. von Hayek
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The Road to Serfdom
Chicago School
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Friedman and Schwartz
A Monetary History of the United States
Two events
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The crash
The “contraction”
The Great Contraction
 Friedman
 Crash
minor element in cause of
depression
 1929-1930 major economic contraction
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Facilitated by Federal Reserve Board
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Widespread bank failures
Led to reduction in quantity of money
“From the cyclical peak in August 1929 to a
cyclical trough in March 1933 the stock of money
fell by over a third.”
The Great Contraction
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Attempts by the Federal Reserve to put
the economy back on track were to blame
for the contraction
 Gold Standard
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Cause for Fed’s actions?
“The gold standard is not a limiting factor, and
the federal reserve at all times had enough
gold so they could have maintained the
requirements of the gold standard at the same
time they expanded the quantity of money.”
Great Contraction
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The “Fed”
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Created in Wilson’s administration
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Federal Reserve Act of 1913
Created for the purpose of stabilizing the banking
system and, thereby, the overall economy by
functioning as a lender of last resort
Provide the economy with a “Supreme Court of
Finance” that would ensure the liquidity for economic
growth and prosperity
Massive destruction of liquidity began when the
Federal Reserve responded to the 1929 stock market
crash by allowing the quantity of money to decline by
2.6 percent over the next year
Great Contraction
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This extremely tight monetary policy put
the economy into severe recession.
 All that was needed to turn the economy
around was for the Federal Reserve to add
to bank reserves by purchasing
government securities. This would have
expanded the money supply and was the
policy called for by the Federal Reserve’s
charter. Instead, the Federal Reserve made
another mistake.
Great Contraction
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The most important charge in the Federal
Reserve’s charter is to be a lender of last
resort. This means that when a bank is in
trouble and cannot meet its depositors’
demands for cash, the Federal Reserve
must provide the liquidity. Otherwise,
panic from inability to withdraw funds can
spread throughout the banking system,
forcing banks to disrupt business and
shrink the money supply by calling loans
and reducing deposits.
Great Contraction
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When a bank exhausts its vault cash, it
needs to raise more by selling
(discounting) its loans to the Federal
Reserve or by selling bonds from its
investment portfolio to the Federal
Reserve. The most direct way the Federal
Reserve can provide liquidity is to
conduct open market operations and
purchase bonds from the banking system.
Great Contraction
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The Federal Reserve was derelict in this
responsibility during the three banking crises that
culminated in the Great Depression. Indeed, more
often than not the Federal Reserve sold bonds
and raised the discount rate, thus reducing
banking liquidity when it should have increased
liquidity. The first banking crisis began in the
autumn of 1930 when the Federal Reserve stood
aside and permitted banks to fail in the South and
Midwest. The result was to undermine confidence
in banks. Runs on banks spread as depositors
rushed to convert their deposits into currency.
Great Contraction
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By December the Bank of the United States in
New York closed from inability to meet
depositors’ demand for cash. The bank was
sound, as evidenced by its ability to pay off
depositors 92.5 cents on the dollar when it was
liquidated during the worst of the Depression. If
the Federal Reserve had done its job, the bank
would have remained open. The bank’s size and
official-sounding name meant that its failure
frightened depositors all over the country and led
to a general run on banks. By the time it was over,
hundreds of banks had failed, reducing the
money supply by the amount of their deposits.
Great Contraction
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The second banking crisis began in the spring of 1931
when the Fed stood aside negligently while banks reduced
their lending in order to meet their depositors’ demands for
cash. By August commercial bank deposits had shrunk by
7 percent, a further contraction in the supply of money.
Then in September, in response to the British leaving the
gold standard, the Fed further deflated a deflating economy
by pushing through the biggest hike in the discount rate in
history. This extraordinary mistake caused commercial
banks to stop their use of the discount window and to
hoard cash in order to meet rising withdrawals stemming
from the public’s declining confidence in banks. As Milton
Friedman and Anna Schwartz put it, this put the famous
multiple expansion of bank reserves into vicious reverse.
By January 1932 bank deposits had declined another 15
percent. Large monthly declines in the money supply
continued through June 1932.
Great Contraction
 Two
competing ideas of causality for
the same phenomenon