Great ContractionCauses

Mal-distribution of wealth WWI (costs and debt) Conspiracy of Bankers Stock Market practices Government policies (Federal Reserve) Over-production The gold standard

Great ContractionExplanations of causes

Single cause Multiple causes American European Business cycles

Great Contraction Two opposing economic theories

Keynesian (John Maynard Keynes Austrian (Friedrich Hayek)

Keynes The General Theory of Employment, Interest, and

Money (1936) Macroeconomics Demand side economics

Aggregate demand is the primary source of business cycle instability

Circular flow of income and expenditure My expenditure is your income

Great ContractionCircular 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

Great Contraction Too little money and credit Wealth moves too slowly from hand to hand

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 ContractionHow 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 Keynes & the depression

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

Government controlled economy Fiat money Open door to welfare state

Great Contraction Priming the pump

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 Austrian School

Friedrich A. von Hayek The Road to Serfdom

Chicago School Friedman and Schwartz A Monetary History of the United States Two events

The crash The “contraction”

The Great ContractionFriedman

Crash minor element in cause of depression

1929-1930 major economic contraction Facilitated by Federal Reserve Board

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 Attempts by the Federal Reserve to put

the economy back on track were to blame for the contraction

Gold Standard 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 The “Fed”

Created in Wilson’s administration 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 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 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 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 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 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 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 ContractionTwo competing ideas of causality for

the same phenomenon