Economic Theories about the Great Depression - The Monetarist Theory

 

     The Great Depression, which began in 1929 and lasted until about 1939, significantly affected the United States and impacted the economy globally. While there still is no agreement on the exact causes of this phenomenon, government officials, economists, and historians have tried to analyze, define, and explain it in the almost one hundred years since. These experts named several related economic theories. For the purposes of this blog, the focus is on one of those economic theories – the monetarist theory – as a cause of the Great Depression and its ultimate demise.

    So, what is the monetarist theory generally? Governments use monetary policies to affect economic performance. These policies may include adjusting interest rates, increasing the money supply, or changing bank reserve requirements to control the amount of money in the economy. Those who use the monetarist theory believe that monetary policies are the best way to manage the rate of the country’s money supply. The total amount of money in an economy is the principal factor related to the Gross Domestic Product (GDP) in the short term and the price levels over the longer term.[1]

     Specifically related to the causes of the Great Depression, the monetarist theory blames the U.S. government and the Federal Reserve System, specifically, for not doing enough to manage the money supply and protect the economy. Economists Milton Friedman and Anna Schwartz used this theory to explain the causes of the Great Depression, described in a 1963 book, A Monetary History of the United States, 1867-1960. Between August 1929 and March 1933, the stock of money decreased by over thirty-four percent. The Federal Reserve System’s policy mistakes, including not lowering interest rates or not adding money into the economy to help the commercial banking system, worsened the overall economic situation. They wrote that the Federal Reserve System should have managed the monetary system and prevented commercial banking panics, but instead chose to ignore banking sector issues.[2]

     In a 1995 article, “The Macroeconomics of the Great Depression: A Comparative Approach,” Ben Bernanke agreed that U.S. government policies related to “monetary factors played an important causal role, both in the worldwide decline in prices and output and in their eventual recovery.”[3] However, he emphasized that decisions related to the gold standard were the most significant aspects of the monetary factors.[4]

     The Federal Reserve System did not begin until 1913, following economic panics in the 1900s, especially in 1907. With economic changes in the United States and around the world driven by World War I, including moving away from the gold standard, the Federal Reserve System was still working through establishing policies and procedures in the 1920s. Unlike today’s centralized process, each of the twelve Federal Reserve District Banks could and did make decisions independently, meaning inconsistent policies across the country. Federal Reserve District Banks set their own rates and sold government securities differently. So, when the Stock Market collapsed in October 1929 and the United States entered the Great Depression, leaders in the Federal Reserve System disagreed about how to react. This limited the Federal Reserve System’s responsiveness to the U.S.’s economic instability.[5]

     Even after the Great Depression started, the Federal Reserve System was not moved towards consolidated policy change. Even by 1931, the Federal Reserve System continued inaction towards the commercial banking system and remained focused on other policies including defending the dollar against external threats. Meanwhile, commercial banks continued to close; 522 banks closed in just October 1931.[6] In a 2002 speech, Bernanke admitted, “[A]s an official representative of the Federal Reserve…. Regarding the Great Depression. You're right, we did it. We're very sorry…we won't do it again.”[7]

     As for what brought about the demise of the Great Depression, Christina Romer wrote that government policies, including decreased interest rates and increased money supply, contributed to the reverse of Depression. The turning point was the commercial banking system collapse in March 1933 and President Franklin D. Roosevelt declared a national banking holiday as part of the Emergency Banking Act.[8] Roosevelt’s New Deal programs included monetary policy reforms to end the Great Depression. The Banking Act of 1933 added the Federal Deposit Insurance Corporation to insure banks and their depositors. The Banking Act of 1935 gave more specified power to the Federal Reserve Board, including the power to control the quantity of money and the power to control the price and use of credit. It standardized the buying and selling of government securities. It also changed the name of the Board to the Board of Governors of the Federal Reserve System, and consolidated leadership[9]

     A combination of factors, including poor government policies and inaction by the Federal Reserve System, contributed to the Great Depression’s severity and lasting impact on the U.S. and the greater global economy. Only after the commercial banking system collapsed, New Deal programs introduced, and monetary policies changed, did the economy start to improve. The Great Depression prompted fundamental changes in economic institutions including the Federal Reserve System.


     [1] Sarwat Jahan and Chris Papageorgiou, “What Is Monetarism?” Finance & Development 51 vol. 1 (March 2014), https://www.imf.org/external/pubs/ft/fandd/2014/03/basics.htm.

     [2] Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867-1960, Princeton University Press, 1963, 299, 367, 374, 408-419, https://www.jstor.org/stable/j.ctt7s1vp.

     [3] Ben S. Bernanke, “The Macroeconomics of the Great Depression: A Comparative Approach,” Journal of Money, Credit and Banking 27, no. 1 (February 1995), 3, https://www.jstor.org/stable/2077848.

     [4]  Bernanke, “The Macroeconomics of the Great Depression: A Comparative Approach,” 3-7.

     [5] “History and Purpose of the Federal Reserve,” Federal Reserve Bank of St. Louis, accessed June 15, 2024, https://www.stlouisfed.org/in-plain-english/history-and-purpose-of-the-fed#:~:text=What%20led%20to%20the%20creation,system%20and%20a%20healthy%20economy, David C. Wheelock, “The Fed's Formative Years,” Federal Reserve History, November 22, 2013, https://www.federalreservehistory.org/essays/feds-formative-years.

     [6] Ben S. Bernanke, “Remarks at the Conference to Honor Milton Friedman,” Speech, University of Chicago, Chicago, Illinois, November 8, 2002, Federal Reserve Board, https://www.federalreserve.gov/boarddocs/speeches/2002/20021108/default.htm.

     [7] Bernanke, “Remarks at the Conference to Honor Milton Friedman.”

     [8] Christina D. Romer, “What Ended the Great Depression?” Journal of Economic History 52, no. 4 (December 1992), 757, 782, https://www.jstor.org/stable/2123226.

     [9] Friedman and Schwartz, A Monetary History of the United States, 446-448.


SOURCE LIST

Bernanke, Ben S. “The Macroeconomics of the Great Depression: A Comparative Approach.” Journal of Money, Credit and Banking 27, no. 1 (February 1995), 1-28. https://www.jstor.org/stable/2077848.

Bernanke, Ben S. “Remarks at the Conference to Honor Milton Friedman.” Speech, University of Chicago, Chicago, Illinois. November 8, 2002. Federal Reserve Board. https://www.federalreserve.gov/boarddocs/speeches/2002/20021108/default.htm.

Friedman, Milton and Anna Jacobson Schwartz. A Monetary History of the United States, 1867-1960. Princeton University Press, 1963. https://www.jstor.org/stable/j.ctt7s1vp.

“History and Purpose of the Federal Reserve.” Federal Reserve Bank of St. Louis. Accessed June 15, 2024. https://www.stlouisfed.org/in-plain-english/history-and-purpose-of-the-fed#:~:text=What%20led%20to%20the%20creation,system%20and%20a%20healthy%20economy.

Jahan, Sarwat and Chris Papageorgiou. “What Is Monetarism?” Finance & Development 51 vol. 1 (March 2014). https://www.imf.org/external/pubs/ft/fandd/2014/03/basics.htm.

Romer, Christina D. “What Ended the Great Depression?” Journal of Economic History 52, no. 4 (December 1992), 757-784. https://www.jstor.org/stable/2123226.

Wheelock, David C. “The Fed's Formative Years.” Federal Reserve History. November 22, 2013. https://www.federalreservehistory.org/essays/feds-formative-years.

Wheelock, David C. “Monetary Policy in the Great Depression: What the Fed Did, and Why.” Federal Reserve Bank of St. Louis, March/April 1992. https://fraser.stlouisfed.org/files/docs/meltzer/whemon92.pdf.

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