Thursday, December 14, 2006

Could The Great Depression Have Been Averted?

I had the opportunity to study the Great Depression while I was in grad school, and I put the meat and potatoes of a paper I did on the topic here in case you're interested in my take. I didn't do a fantastic job of keeping my citations in order, but I'm sure if you take the time to do it, you can fairly easily double-check the facts below.

The depression interests me. Our generation has never seen anything like this. The closest we got were the few years after the internet bubble burst circa 2000. That, coupled with the 2001 terrorist attacks, didn't even come close to the kind of broad scale havoc the depression wreaked on the people who lived through it.

I know we have our fail-safes in place. We have the triggers that close the markets down if a panic sets in, we have a more activist Federal Reserve, we have the FDIC etc... but has it all ever really been put to the test? Hopefully nothing like that ever happens in our time.

Anyway, this paper revisits the Fed's role around the time of the Great Depression and at the end I have the audacity to look in the rear view mirror and say if the Fed had acted differently, things might not have turned out as bad as they did.

The Goals of the Federal Reserve in the 1920s

The Federal Reserve System (also referred to as the “Fed”) was formed in 1914 to serve as the United States’ central bank. Its primary goal was to give the US government some measure of control over the money supply in order to dampen the impact of financial crises on the economy. Before the Fed was created, the government had little to no control over the money supply, which was tied to the gold standard.

In the 1920s and early 1930s, the Fed’s leaders said their primary purpose was to serve as “a system of productive credit.” This meant it existed to lend money to member banks for “productive” purposes involving only agricultural, industrial or commercial pursuits and not for what it called “speculative” or investment purposes. In this way, the Fed operated in what was for the most part a passive manner. In theory it could affect the money supply by setting interest rates to encourage or discourage bank borrowing, but it was up to the discretion of the banks whether or not they would borrow money from the Fed. The Fed shied away from use of its more active tool- open market activities, for reasons we will later discuss.

Another main goal of the Federal Reserve during this time period was to maintain the gold standard, keeping gold reserves on hand to collateralize the US dollar. By law, the Fed was required to maintain reserves equal to the value of at least 40% of the outstanding reserve notes, as well as 30% of deposits held at the Fed.

Reasons for Pursuing These Goals

The reason the Fed would have pursued these goals was the prevailing economic wisdom of the time. Most of the industrialized world had been on the gold standard for 200 years[1], and it was seen as the proper way to run an economy. With banks having experienced periodic liquidity problems in the past, the Fed wanted to be sure it could serve as a “lender of last resort” should a panic create the need for banks to return money to depositors beyond the level of their reserves. Monetary theory as we know it today was undeveloped during the period.

What the Fed Could Have Been Doing

An alternative goal the Fed might have pursued would have been to work at increasing aggregate demand and keeping the economy at full employment with low inflation. These are the Fed’s goals today, and would have meant taking a more active role to stimulate or restrain the economy via the money supply. At times, this would have meant more aggressively employing open market operations.

In the 20s, however, the Fed was generally wary of open market purchases, which it believed would serve to fuel “inflationary speculation, not increasing output of goods and services.” Keynes was only first beginning to publish his theories in the early 20s, and the idea of such active tinkering with the economy by a central bank had not been embraced. Even the most liberal Fed board members were generally opposed to open market purchases. As the case stated, they saw such purchases as a kind of “shotgun approach” and believed it would take more careful aim to respond to the problems they faced.

Factors responsible for the collapse of the money supply between 1929 and 1933

A number of factors were responsible for the collapse of the money supply during this period, when M1 fell 25%, from $26 billion to $19.5 billion.[2] These included:

An “internal drain” from bank deposits to currency. Following the stock market collapse in 1929 and the ensuing lack of faith in the financial system, there was a wave of bank failures in the fall of 1930, noticeably among smaller regional banks that had loaned to now-insolvent farmers. With the realization that bank deposits could disappear if banks failed, there was an increasing public desire to hold currency, and a rush to empty bank accounts. Since banks did not hold enough money to reimburse every depositor, these bank runs led to further bank failures. The resulting drop in deposits served as an “internal drain” on the money supply. With fewer deposits on reserve, the banks could loan out less money, due to their required reserve ratios.

An “external drain” of foreigners’ dollar deposits and gold from the US. Following Great Britain’s departure from the gold standard on October 21, 1931, worldwide attention turned to the United States. Worried that a financial crisis could hurt dollar investments in the United States and possibly bring about the demise of the gold standard there too, foreigners began to convert American bank deposits into gold.

As foreigners took money out of American bank accounts and redeemed dollars for gold, Fed gold reserves began to dwindle, falling over 15% between September 31 and October 28 of 1931. If outflows continued, the Fed would not be able to maintain the 40% gold reserve level required to support the value of its outstanding notes. In order to stem the gold outflow, and in response to increasing pressure from France in particular, the Fed raised bill buying and discount rates in October of 1931. The move did slow the outflow, but as is typically the case, higher interest rates also served to contract the money supply. This added further to the collapse.

The Fed’s avoidance of open market purchases. Though the lack of reliance on open market purchases was not in itself a cause of the declining money supply, it was a tool that could have been used to prevent the collapse. As described on page 6 of the HBS case, New York Fed Governor George S. Harrison “argued for more open market purchases” in 1930, but he was overruled by the heads of most of the other Fed banks, who felt that low bill buying rates (which had been reduced to 2% in 1930 and 1.5% in 1931) made credit easy to obtain, making further purchases undesirable.

Despite easy credit, borrowing from the Fed shrank by 83% between July 1929 and September 1930, highlighting the fact that interest rate adjustments were a passive tool. Lower rates as they might, the Fed could not force banks to borrow, and banks’ unwillingness to borrow served to keep the money supply from growing. The only way to “force” money into the system would have been through open market purchases, over which the Fed had complete discretion.

Did Monetary Forces Cause the Great Depression?

Due to the complexity of the US economic system, I would be hesitant to pin the great depression on monetary forces alone. However, I think that monetary forces played a large role in causing the depression, and greatly contributed to its length and severity.

The beginning of the great depression was associated with a deflationary trend that began in 1929. This deflation can be explained by the contraction in the money supply that began in 1929, due to reasons previously discussed. Deflation had a negative effect on the US economy by reducing consumer demand. Noticing that prices were falling, consumers delayed current purchases. This dropoff in demand led businesses to produce less and lay off workers, causing unemployment to jump from 3.2% in 1929 to 25.2% in 1933.

Bank failures were another large contributing factor to in the great depression, and it seems that the vicious circle of runs on bank deposits causing banks to fail and fueling further runs on banks could have been averted had the money supply been adequate to cover Americans’ desire to hold currency. When the first groups rushed to hold currency instead of savings deposits, the money supply failed them. Losing savings, or hearing about others losing savings, served to darken the spirits of consumers in a manner that economic statistics cannot adequately measure, compounding the other factors that weakened the economy at the time.

The contracting money supply also served to reduce income, and according to Keynsian theory, income determines consumption. This dropoff in consumption, combined with decreasing business output caused GDP to drop from $822.2 billion to $602.3 billion during the period.

It would take until 1936 for GDP to return to the $820 billion levels seen in 1929. I would argue that, had the Fed intervened in a more effective manner to prevent the collapse of the money supply over that critical 1929-1932 period, the impact on the economy would have been mitigated, and there is a possibility that “The Great Depression” would now be known only as “The Depression.”

[1] Siegel, Jeremy. “Stocks For the Long Run.” McGraw-Hill, 2002. p. 186.
[2] Godon, Robert. “Macroeconomics.” Pearson Education, 2003. p. A2.

No comments: