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Bill Brown

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The Federal Reserve and the Great Depression


With few exceptions, every theory expounded regarding the cause of the Great Depression is wrong. More exactly, they all lack fundamentality—they can be explained by deeper causes. Nearly all place the blame squarely on the shoulders of the private sector—whether the stock market, monopolists, or the commercial banks. A deeper examination of the facts and a skeptical attitude towards the conventional wisdom are all that are necessary to expose the true protagonist: the government.

Conventional wisdom holds that government is what got America out of the Great Depression. Furthermore, a lack of governmental activism during the preceding decade is frequently cited as a contributing factor. Promiscuous speculation in the stock market and real estate are viewed as results of federal passivity during the Harding, Coolidge, and Hoover Administrations. Overproduction is seen as the fault of greedy businessmen, seeking to foist their products on an avaricious public. The collapse of the banking system is attributed to laxity of government oversight.

As with most of conventional wisdom, there is an element of truth to each of these assertions. Indeed, there was rampant stock and real estate speculation, but it did not arise from federal inaction. Overproduction did stagnate American companies, but it was not caused by businessmen or a spendthrift public. Finally, the banks did collapse—and this is very significant—but it was not because of regulatory incompetence. Each of these three very important was the result of precisely the thing most people would say was missing: government intervention.

The federal government has had a long and varied history of meddling with the money supply. Previous interference pales in comparison to the paradigm shift that occurred in 1913 with the passage of the Federal Reserve Act. The Federal Reserve System, in a single sweep, changed both the scope and the magnitude of government intervention in the banking and monetary systems. It had the power to regulate the size and growth of the money supply, thereby causing inflation or deflation in the economy. It is my contention that, through manipulation of credit, the Federal Reserve system empowered a credit expansion the likes of which were previously thought impossible. When the steadily expanding credit bubble finally burst—with the crash of the overinflated stock market it had created—the consequent credit contraction was more severe than any before.

Why should we study the Great Depression? Of what use is history? History is the study of the human past with an eye towards an application of its lessons to the our future. Ideas are the prime movers of history. As the philosopher Ayn Rand said, "If you know a man's convictions, you can predict his actions. If you understand the dominant philosophy of a society, you can predict its course."1 If we can understand the ideas and philosophy behind the Great Depression, we can seek to eradicate those ideas from our midst in order to stave off a repetition of their enaction. By examining the facts surrounding the monetary interventionism, we can see the logical consequences of the underlying ideas. We can then compare the past situation to our present and apply the lessons learnt from a study of the past to the reality of today. History is not a trivial, ivory tower study of past minutiæ. It is a useful endeavor essential to a long-range consciousness—a conceptual being.

Before we can examine the philosophical underpinnings of monetary interventionism, it is crucial to understand the concept of money. Money came about when men realized the limitations of barter—viz., that you had to find someone who had what you wanted and wanted what you had. This double coincidence of wants does not happen often. Therefore, people found something that everyone wanted that could be used in general exchanges. What this thing was varied, from stones to shells. Eventually, though, most civilizations latched onto gold as money since it is durable, divisible, and rare. This use of gold as money was not imposed on men by authorities; it was freely chosen.

It was accepted because every man recognized what it represented: productive work. When you accept payment via money for your services or product sold, you are implicitly operating under the assumption that you can then use that money received to purchase the fruits of someone else's labor. You are trusting in the integrity of that money and that is the basis of the sound money school of economics.

The abandonment of the gold standard made it possible for the welfare statists to use the banking system as a means to an unlimited expansion of credit. They have created paper reserves in the form of government bonds which—through a complex series of steps—the banks accept in place of tangible assets and treat as if they were an actual deposit, i.e., as the equivalent of what was formerly a deposit of gold. The holder of a government bond or of a bank deposit created by paper reserves believes that he has a valid claim on a real asset. But the fact is that there are now more claims outstanding than real assets.2

What most of today's economists forget or overlook is that credit is not money. Where money allowed individuals to split a transaction physically—thus avoiding the double coincidence of wants—credit allows them to split a transaction temporally. "Credit is the promise to pay one trader accepts in lieu of immediate payment."3 There are many differences between credit and money. Most notably, it can be created at will between two traders. One trader gives another the fruits of his labor in exchange for a promise of repayment plus some amount to compensate for the risk the credit-granter is undertaking. It is non-transferable, being an obligation between two parties solely. Credit expansion does not devalue existing credit, as inflation does to the money supply. To sum, credit is simply a promise to repay the lender out of the future earnings of the debtor over a specific period of time.

When government debases the currency, either by running the presses or through seigniorage, it is subverting the very cornerstone of economic transactions. As Keynes said, "There is no subtler, no surer means of overturning the existing basis of society that to debauch the currency."4 Capitalism is the social system which recognizes the individual's rights to life, liberty, and property. It is a system the hallmark of which is the right of traders to freely negotiate to their mutual benefit—the trader principle. Its antipode—statism—holds that the state is supreme and that what rights you possess are granted by the state. The state can intervene however, whenever, and on whomever it pleases in whatever manner it finds expedient.

This political philosophy can be seen as the dominant trend of the twentieth century—properly called the Age of Statism. For our purposes, we will examine the intervention in one specific area: the money supply. By intervention, we are really talking about an abrogation of the property rights of individuals "specifically of those individuals who own banks and indirectly of those individuals who do business with banks."5

First, I will enumerate the means by which such interventions are effected. Second, I will show the results of such meddling in various sectors—banking, commerce, investments—during the Great Depression. Third, I will summarize alternative explanations for the Great Depression and their respective analytical failings. Finally, I will present the lessons to be learned for today.

Interventions of the Fed—Theory

The Federal Reserve System—enacted by Congress in 1913—was an attempt to smooth out the little-understood business cycles that plagued the American economy and were especially troubling to the banking system. It was charged with ensuring the appropriate reserves of its member banks, lending to shaky financial institutions to prevent closure, issuing government securities, and regulating the overall banking industry. Throughout the seventy-four year history of the System, the American currency and monetary system has undergone many changes, going from a relatively pure gold standard at its inception to an adulterated standard in the forties and finally eliminating any gilded ties in the seventies.

The Fed—as it is colloquially called—has assumed many more responsibilities than the drafters of the original legislation envisioned. Even so, its operations have changed very little over time. The most important, for our purposes, of its roles are: setter of reserve requirements, lender of last resort, and regulator of the money supply. It is through these three functions that the government manipulates the economy most fundamentally. Let's examine each function in greater detail.

Individuals lend banks money in the form of deposits. The banks issue the depositors something conveying a promise to pay on demand. Since the bank now owns this money, it can lend the money to others to earn some interest. In case the depositor wants his money back, the bank needs to hold some money back from its lending activities. These deposits held back are called reserves. The higher its reserves, the less it has to fear when there is a fluctuation in the daily needs. However, if the reserves are kept too high, the loan portfolio is not productive and profitable enough. Therefore, a balance must be struck.

Prior to the Federal Reserve, each bank had to be responsible for maintenance of its reserves—although there was an established legal floor. If the bank misjudged its needs, it either had to call its loans or cease transacting business. Poor judgment led to what is known as a run—which occurs when depositors lose confidence in the bank's ability to meet its obligations and seek to withdraw their money. If this happens with any prevalence, this can shake the stability of the banking system.

The central bank theorists presume that the bankers—if left to their own judgment—will stay fully loaned up to the legal reserve requirement floor, rather than maintaining a equalizing balance between loans and reserves. For this reason, the Federal Reserve System was granted the authority to centrally alter the reserve requirements of every bank. Far more important than this ability is its power to determine what constitutes reserves. Previously, individual banks kept reserves in their vaults and the reserves were simply gold or silver specie, depending on the era. With the advent of the Federal Reserve System, banks were compelled to maintain their reserves at the regional Federal Reserve Bank.

In so doing, the Fed also altered the nature of such reserves. As stated prior, reserves had taken the form of deposits withheld from lending operations. Shortly after its inception, the Fed allowed reserves to be kept in Federal Reserve notes (ostensibly representing a corresponding amount of gold) and government securities at a ratio fixed by the Board of Governors of the Federal Reserve. This alteration accomplished two objectives: banks could purchase various vehicles for use as reserves and still be able to lend their deposits and the government had a ready buyer for any new issues of securities.

One cannot understate the importance of this fundamental change in the American system. Government expenditures could soar high above revenues and the Federal Reserve would aggressively market the deficit spending to an avaricious banking system eager to expand its ability to extend credit. Or, put another way, the government could create fiat money out of thin air—effectively, an edict by expenditure. Previously, the only means by which government expenditures could increase were by the politically-inexpedient tax hike. Now, it had the Federal Reserve as its overdraft protection and the Fed could draw from the productivity and wealth of the entire American banking system.

By manipulating the reserves of the banks, however, the Federal Reserve also contributed to the banking system's unsoundness. The last thing a bank needs is an aura of insolvency, yet that is precisely what the Federal Reserve System engenders. The Fed issues its Notes at an arbitrary ratio to its gold holdings; the banks then use these Federal Reserve Notes as reserves in another arbitrary ratio to its deposit base. Or, the banks use government securities—created out of thin air—as reserves and lend against them at a large multiple. The problem in this activity is that the underlying value of the reserves has gone from significant (in the case of actual money stored in a bank's vault) to insignificant (in the case of gold-based Notes) to none (in the case of fiat government securities). In the banking industry, this is called lower quality of liquidity.

Not only that, but the Fed also sets the reserve requirements in a vacuum of information. Bankers, by virtue of their daily contact and intimate knowledge of the local business community, are better able to assess the bank's balance sheet and respond accordingly.6 That is the way it attracts depositors and customers, by a reputation for fiscal soundness. When a bank is free to fail, the bank has an interest in maintaining liquidity. Its management must balance the assets and liabilities carefully and prudently. But the Fed acts in the aggregate in setting reserve requirements, thereby punishing the most able bankers (by setting their reserve requirement above what they would have) and rewarding the incompetent (by allowing them to keep lower reserves than necessary).

The Fed, in its original legislation, was charged with operating as "the lender of last resort." This meant that, if a bank found itself in an illiquid position, it could borrow from the Fed to see it through the situation. Initially, the bank had to pledge some valuable asset—such as commercial paper—as collateral to the Fed, but that requirement was soon dropped and now anything is eligible. Under this guise, the Federal Reserve sought to prevent the bank runs and systemic bank failures of past times. In effect, the Fed would prop up the banking system using its monopoly on money creation.

This, again, ties in with the above discussion on reserve requirements, since the lender of last resort function kicks in when the bank is in a jam. Each of these seeks to correct a "failure" of the nineteenth century's free-banking system. The former to forestall bank insolvency and the latter to avert bank panics. As with reserve requirements, there are considerable unforeseen consequences to the lender of last resort function. The first—and most obvious—problem is that it makes no distinction between illiquid banks and insolvent banks. The former are in a bind; the latter are in dire straits. The Federal Reserve qua lender of last resort would come to the rescue of each equally.7 The effect, then, is to further destabilize an already problematic situation.

Another problem is that this policy favors the risk-takers. Traditionally, bankers are viewed as a rather conservative lot. They invest depositor's funds in stable, safe instruments. This is true of most financial institutions; there are some, however, in search of higher yields and quicker returns that—armed with the knowledge that the Fed would bail them out—invest in riskier ventures. The Federal Reserve, as I said, does not differentiate between the temporarily illiquid and the fundamentally bankrupt.

The final function of the Federal Reserve that we will consider is its unique position as regulator of the money supply. A cursory examination of financial news coverage yields many pundits prognosticating the pronouncements of Greenspan. Measured answers to Congressional committees by the Fed Chairman can bring the bond market to its knees. The Fed determines interest rates; the Fed expands or contracts credit; the Fed inflates or deflates the money supply. All of these actions have inestimable consequences in the economy.

It is important to remember that credit is not necessarily a bad thing. It is simply a splitting of a transaction across time. It does not result in inflation, i.e., an increase in the money supply. If it is caused by production, it is perfectly legitimate and may be expanded indefinitely without any ill effects on the economy. Where credit runs into trouble is when it is caused by artificial and arbitrary reserve manipulations. As mentioned previously, when the reserve quality is diluted or the reserve ratios inappropriately lowered, money is conjured up and lent irresponsibly. For now, when I speak of credit expansions, I am dealing with the interventionist variety.

The Federal Reserve can affect credit levels of the banking industry through two means: the rediscount and open-market operations. During the period in consideration—1913 to 1933—the rediscount was the primary means of expanding the availability of credit. In that time, commercial loans were generally short-term. The bank would take its interest off the top of the loan, before it was ever given to the customer. This was called the discount. The customer was then responsible for paying the full value of the loan, i.e., what he borrowed plus the interest. While this loan was on the books of the bank, it tied up deposits that must be reserved. If the bank were hard-pressed to meet its transactional obligations, the Fed could purchase the loan at another discount, or rediscount, and relieve the reserve pressure. If the bank was seeking more loans, it had to wait for the loan to come due and then relend it. Or, it could use the rediscounting ability of the Fed to free up its reserves for another loan. "A rate below the market rate encourages borrowing, not merely for reserve compensation, but for acquiring excess reserves to relend at a profit."8 If the discount rate of the Fed is less than the prime rate at which the bank lends to its best customers, it can make further profit off the spread between the two rates and repay the Fed with the money from the new loan.9

This is an efficient way of expanding credit but, due to the short-term nature of the original loan, the rediscounting does not have much effect unless such pyramiding of loans is more or less constantly applied. If the discount rate is non-punitive, then it becomes profitable for the bank to sell all its loans to the Fed. However, "[t]he tradition had grown that a bank should not borrow for the purpose of relending at a profit. The tradition was strong that great city banks did not like to be in debt at all to the Federal Reserve banks…."10 Later we will revisit rediscounting as these traditions broke down.

By far the most prevalent means of credit manipulation is through open-market operations.11 This circumlocution simply designates the purchase or sale of government securities in the market, rather than through direct infusions from the Treasury. Since government securities fulfill the reserve requirements of the Fed, their accumulation enables credit expansion. Moreover, these operations establish a ready market for the rapid distribution of government debt. In its capacity as buyer and seller of the securities, the Federal Reserve obtains liquidity and stability for the government. Previous bond issues had to be publicly promoted and took awhile to be sold. The secondary trade was haphazard and done through commissioned agents.

With government spending becoming increasingly profligate, the power of the Federal Reserve System to absorb the deficit through purchases of government securities becomes increasingly more important. As show prior, though, such financing comes with a price far greater than the interest charged. The excess reserves thus generated are converted into available credit, which is lent to economic agents. As Dr. Anderson says,

When there is an excess of bank credit used as a substitute for savings, when bank credit goes in undue amounts into capital uses and speculative uses, impairing the liquidity of bank assets, or when the total volume of money and credit is expanded far beyond the growth of production and trade, disequilibria arise, and, above all, the quality of credit is impaired. Confidence may be suddenly shaken and a countermovement may set in.12

Cheap money—an effect of the open market operations—sends erroneous signals to whomever uses it. When interest rates are artificially low, which occurs with credit flooding, individuals believe that it is a sign of good times and a promising outlook on the future. Interest rates are a measure of risk and low ones signal good fortune. Therefore, investments are made based on this information. A "boom" ensues. This is followed, depending on the amount of credit expansion, by a burst, as the needle of disequilibrium pops the bubble of false expectations. In our examination of the period leading up to the Great Depression, we will see how this process unfolded and ultimately resulted in all the problems associated with that time.

Interventions of the Fed—Practice

Given the pervasiveness of the Fed's activity and the purview of the banking system in the American economy, the effects of the aforementioned practices is incredible. Three particular sectors stand out for further scrutiny: banking, commerce, and finance. These correspond to the most visible and memorable afflictions of the Great Depression: bank closures, unemployment, and the stock market crash, respectively. Each of these three effects of inflationary credit expansion have been alleged to have caused the Great Depression. As I shall make clear, they contributed to the severity of the Depression, but were not fundamental enough to be causal.

The enactment of the Federal Reserve brought almost immediate changes to the American banking system. Prior to the Federal Reserve Act, banks kept their own reserves in their own vaults. The reserve ratio hovered around 21.1 percent.13 By 1917, the Act had legislated the reserve requirement to a mere 10 percent.14 Furthermore, the gold standard was devalued, since the Federal Reserve was only required to keep gold reserves of 40 percent against the Federal Reserve Notes and 35 percent against its members' deposits.15 This all occurred within five years of the System's inception. The expansion amounted to $5.8 billion in deposits and $7 billion in loans and investments.16 This accommodated the financing of World War I in lieu of increased taxation and, at least, had some justification. What happened next is best summarized by Dr. Anderson:

We watched bank credit with fear and trembling as it expanded during World War I, because we knew then what we seem since to have forgotten, the dangers of overexpanded bank credit. We held it down all we could. But a great expansion was needed and we made it. It was enough. An expansion of $5.8 billion in deposits, with $7 billion in loans and investments, was enough.

Between the middle of 1922 and April 1928, without need, without justification, lightheartedly, irresponsibly, we expanded bank credit by more than twice as much, and in the years which followed we paid a terrible price for this.17

The episode he spoke of—the 1922-28 credit expansion—began in 1922 with the first large open-market purchase of government securities, increasing the holdings of government securities by the Federal Reserve from $250 million to approximately $650 million—an increase of 260 percent!18 This first large-scale operation was instigated, not for credit expansion or interest rate suppression, because rediscounting had slackened after the war and Federal Reserve reserves were faltering. The heady, unintended credit expansion was too profitable to make it a one-time deal. Consequently, two more major open-market purchases of government securities occurred in 1924 and 1927, each amounting to hundreds of millions of dollars—a scale unprecedented in the history of the United States. Plus, due to the multiplying effect of securities qua reserves, billions of dollars became available for lending—again, out of thin air. These purchases were motivated solely by credit expansion, without any thought to the "dangers of overexpanded bank credit."

By these open-market operations and reserve fiddling, bank credit had expanded $11.5 billion in only five years.19 If it had reflected a genuine need by businesses, it would have been welcome and salutary. Since commerce had no use for the available credit, banks sought other venues in which to channel the funds. The three primary vehicles were mortgages, financial instruments, and foreign loans. Each of these represented a deviation from traditional banking practices, viz., the financing of short-term commercial requests. Short-term, because it helped to maintain the liquid position of the bank; commercial, because these tended to be the borrowers best able to repay. Mortgages and financial instruments—like bonds and securities—are particularly susceptible to fluctuations in value. Loans made to foreign governments—predominantly Latin American ones— were risky, since revolution and instability were the norm.

Moreover, each of these types of loans is ineligible for rediscounting. Since rediscounting was the primary secondary reserve of the whole System, this meant that a significant portion of the bank's assets were constrained. As of June 30, 1926, the Federal Reserve released the following statement, "Of the total loans and investments of all member banks on June 30, 1926, sixteen percent was eligible for rediscount at the reserve banks…."20 With increased long-term holdings and decreased potential for rediscounting, the banks were in a pretty precarious position by the end of twenties. All that was needed was a scaling-down of the expansion—maybe even a contraction— thereby allowing banks to liquidate imprudent investments gradually. This could be accomplished by setting the rediscount rate above the market rate and strictly limiting the use of open-market operations.21

This, however, was exactly what the Federal Reserve Board did not do. In 1927, the Federal Reserve Board, under the Chairmanship of Benjamin Strong, inaugurated a new policy of cheap money to help the farmer.22 The Fed lowered the buying rate on acceptances—essentially future loan drafts—in the summer of 1927; sharply increased—by $320 million—its purchase of government securities through November; and lowered its systemwide rediscount rate to 3.5 percent by September of that year.23

This time, the credit expansion was funneled almost exclusively into stocks. While further comment will be reserved for later, it bears mention that this growth in stock market investment that started in 1927 continued right up until the Crash. The Federal Reserve authorities desperately tried to reverse their mistake, increasing the rediscount rate to five percent by July 1928 and selling over $400 million worth of government securities by June 1928. This divestiture reduced bank reserves, necessitating over $600 million in rediscounting—though not enough to fully account for the reduction in reserves.24

In the week following the stock market crash, the Fed doubled its holdings of government securities. The Fed was trying desperately to increase its reserve situation, but could barely keep its head above water due to the continuous outflow of gold to other nations.25 Throughout the crisis period—1929 to 1933—the Federal Reserve continued its inflationary policies in a futile attempt to initiate another boom akin to that of the twenties.

By the end of 1930, however, the fundamental instability of the Federal Reserve System became apparent. "The number of commercial banks in the United States stood at 29,087 on June 30, 1920 … [and] at 15,353 on June 30, 1934."26 In the period 1930-33 alone, a total of 9,106 banks failed.27 Bank failures had always been endemic to the Federal Reserve System, though, averaging 166 per year between 1913-1922 and 692 per year between 1923-1929.28 The reason for this should by now be clear.

In creating money from nothing for banks to lend, the government distorts the market processes that regulate the economy. Credit arises from production. It cannot be overextended by private institutions, since they do not possess the power to counterfeit and debase."The creation of credit by banks is a productive enterprise in which all participating parties hope to benefit, and in which non-participating parties are not directly affected."29 Banks, in selecting where to extend credit, must necessarily be choosy. They must maintain liquidity at all costs, while maximizing the return on their investments.

Under the Federal Reserve, however, the banks find themselves awash in credit, regardless of the financial needs of their customers. They feel pressure to lend, without the assistance of a customer seeking a loan. Thus, they seek out anyone willing to take the credit off their hands. In the competitive world of banking, quality and creditworthiness are luxuries they cannot afford to consider. As one banking historian put it, "numerous examiner reports cited bank failures as due to 'generosity to borrowers'…with insufficient attention paid to discipline, the result of which is detrimental to both borrowers and lenders in the long run."30 The banks end up carrying a portfolio of speculative stock and real estate loans, long-term mortgages, and loans to impoverished countries. When the public loses confidence in the financial establishment, the banking industry bleeds to death until wholesale liquidation ensues.

That is, unless the government frees the banking industry from meeting its obligations—through the banking holiday—or unless the government sets the money supply adrift—through the abandonment of the gold standard. Both of these things happened in 1933. These two events, then, were the culmination and the pinnacle of intervention in the banking system. They represent the logical outcome of manipulations of the type previously enumerated.

Another part of the economy that is deeply affected by Federal Reserve policies, albeit indirectly, is the private business sector. I am not speaking of any particular industry, but commerce as a whole. When we think of businesses in the Great Depression, we think of joblessness and overproduction. Not unemployment or large inventories on an individual, localized level, but on a nationwide scale. One must ask the question: how is it that problems can occur so? How can so many individual businessmen make erroneous judgments at the same time? This points to a more fundamental issue, one that can uniformly lead to miscalculation.

Once again, we find that the source of dislocation is expansion of bank credit divorced from any real source of expansion. In the boom, or inflationary, period, the businessman engages in a process of predicting the future return or value of present projects. One of the factors entering into his calculations is the interest rate—a measure of the cost of future goods versus present consumption. The drop in interest rates inherent in an inflationary environment31 interferes with the businessman's planning.32 It implies an increase in the rate of thrift—traditionally the source of available capital—by individuals and corporations. This causes a shift by the businessman from investment in consumer goods to investment in higher-order capital goods.33 "[A]n expansion in the production facilities and the production of the heavy industries, and in the production of durable producers' goods, is the most conspicuous mark of the boom."34

As the bubble fills, productive capacity is expanded. Capital goods are acquired and implemented. Money flows into the capital goods industry. This money, remember, is not the result of increased savings, but from "forced" savings, i.e., artificial creation of money by the government in the form of credit expansion. But this boom is illusory.

For, once workers in the higher-order industries receive income in the form of wages and salaries, 'they would immediately attempt to expand consumption to the usual proportions.' This sudden surge in consumption demand undercuts the demand for the still incomplete projects involving higher-order producer goods far removed from consumption, resulting in a slump in the capital-goods industries.35

In other words, because the savings qua capital is not genuine, the money sunk into higher-order goods is spent according to existing consumption/thrift ratios. Or: the money spent by the misinformed entrepreneur is ultimately transferred to the consumer goods industries, shifting demand for the capital good. That is, unless the borrowing firm returns to the bank for more credit and temporary salvation. The greater the credit expansion the longer it will last. When the expansion ceases, the boom complies. "The longer the boom goes on the more wasteful the errors committed, and the longer and more severe will be the necessary depression readjustment."36

If we look to the historical record, we see that the facts bear this analysis out. Productivity per person-hour increased 63 percent from 1920 to 1929.37 Stock prices quadrupled during the twenties—stock being the primary source of capital. Durable goods, as well as steel production, increased approximately 160 percent. Non-durables, largely consumer goods, increased only 60 percent. Moreover, wages in the capital goods industries were higher than wages in the consumer goods industries. According to the Conference Board index, hourly wages in manufacturing industries—such as meat packing, hardware, and clothing—increased an average of 12 percent while those in the capital goods industries rose even higher—12 percent in machine tools, 19 percent in lumber, 22 percent in chemicals, and 25 percent in steel.38

The period after the boom also corroborates Mises' and Rothbard's cycle theory. Industrial production was 114 in August 1929 and 54 in March 1933. Business construction totaled $8.7 billion in 1929 and $1.4 billion in 1933. There also occurred a 77 percent decline in durable goods manufacturing in the same four-year period. Unemployment rose from 3.2 percent in 1929 to 24.9 percent in 1933.39 Furthermore, from 1929 to 1932, the money supply was contracting, "and since wages are less elastic than prices, real wages were rising (unbeknownst to most workers), making it extremely difficult for business to employ people."40

Our last sector of concern is the investment sector, as distinct from the banking industry. Here I am talking about the the stock market, its brokerage houses, and individual investors. The image that comes to mind immediately is that of the Crash of 1929. It occurred because the general price-to-earnings ratios—a common estimate of value in a security—had soared far above any representation in reality. The reason for this inordinate rise was due to speculative fever within the general public. Everyone wanted a piece of the action and, largely, was able to buy into it. Again, a cursory examination of the situation yields this information and nothing more. Further probing finds the specter of the Fed artificially propping the market.

The Fed's purchase of government securities in 1924 already mentioned was the first instance when the additional bank credit was almost exclusively channeled into securities—partly into direct bond purchases by banks and partly into stock/bond collateral loans. "This immense expansion of bank credit, added to the ordinary sources of capital, created the illusion of unlimited capital and made it easy for our markets to absorb gigantic quantities of foreign securities as well as a greatly increased volume of American security issues."41 Although the 1924 issue was not the first instance of influence in the stock market, it was most definitely not the last.

The aforementioned 1927 cheap money policy of the Fed was the final turn that opened the floodgates of giddy speculation. By lowering the rediscount rates, the Fed allowed the member banks to lower their own interest rates on stock and bond collateral loans as well as brokers' loans. When the Fed reversed its policy late in 1927, it was too late. The psychological intoxication of the boom had taken hold of the American public.

Eager speculators ignored increasing interest rates and took greater volumes of brokers' loans. Even as member banks dried up the speculative security loans, new sources were utilized, viz., brokers' loans 'for account of others.'42 Previously, brokers' loans would be made for the bank's account or an out-of-town's account, with an occasional brokers' loan for other customers. At the beginning of 1926, such loans accounted for $564 million of a total of $3.141 billion in brokers' loans. By the summer of 1929, these loans totaled $3.372 billion of the total $6.085 billion in brokers' loans.43 Furthermore, call loan rates rarely exceeded 10 percent, except just prior to the Crash, when they finally were raised to 20 percent. This also served as a fresh source of speculation money.44

The effects of such ubiquitous investment were astounding. On November 15, 1922, the Dow-Jones Industrial Average closed at $95.11. By August 29, 1929, the Average had risen to $376.18. The Standard & Poor's Common Stocks Indices showed similar fantastic gains: the industrials, rails, and public utilities indices had risen from 44.4, 156.0, and 66.6, respectively, in 1921 to 172.5, 384.1, and 272.2 just six years later.45

When the bubble finally burst—in October of 1929—it shattered confidence in the economy. The intoxication of seven years of giddy inflationary credit expansion had resulted in an economic hangover of heretofore unseen proportions. The following year, 1930, marked a watershed. The government's response to the failings of the Federal Reserve would determine the severity of the necessary liquidation and recession. If the government allowed the market to correct itself, through interest rate hikes and bankruptcy, the consequent recession would be severe but brief. If, however, the government misjudged the nature of the market, the country would be in for a slow, arduous bloodletting and, ultimately, a future littered with cyclical depressions.

These three areas of the economy are the most important sectors and the ones most influenced by arbitrary credit expansion by the Federal Reserve. In each one, government monetary intervention led to dislocations, distortions, and disequilibria. However, it would be foolish to imply that the Federal Reserve System was the sole factor in the playing out of the Great Depression. For the purposes of this paper, though, I will specifically omit the sometimes drastic effects of the Hawley-Smoot Tariff of 1930, Britain's abandonment of the gold standard, reparations from defeated Germany, and other international elements that contributed to the extent and severity of the Depression of 1929-1940.


To be sure, historians and economists have not flocked to the Federal Reserve as fundamental determinant of the Depression. Except for the few authors whose works I have cited, the conventional wisdom holds that the Federal Reserve had little to do with the economic downturn. Although I think I have presented an airtight antithetical argument, I also believe it is important to survey other's contributions to the field for the purpose of contrariety and objectivity.

As I see it, there are two primary alternative explanations for causation of the Great Depression. First of the alternates is the theory that the maldistribution of income prevalent in American society prior to the Depression created a lack of purchasing power that shook the economy to its foundations. Second, that general overproduction resulted in systemic dislocations. I will now examine each in turn.

The first theory, best explicated by Robert S. McElvaine, asserts that there exists a general maldistribution of wealth in American society and that this inequity causes the economy to be reliant on significant spending by the well-to-do. As he puts it, "no cause of the Great Depression was of larger importance."46 The argument goes that, because total supply must equal total demand for the economy to be in equilibrium, a disparate burden was placed on the wealthy—as holders of a disproportionate share of income—to consume. But the wealthy spend only a small portion of their income in consumer goods, preferring to invest or save their money. But since the masses do not have the wealth necessary to purchase the residues of the total supply left unbought, the economy is easily destabilized. "If something caused a sudden loss of confidence by these affluent Americans, the whole economic structure might collapse…."47 The Crash of 1929 engendered just such a loss of confidence.

The major problem with this underconsumption theory is that it posits a zero-sum game. Any increase in the wealth of an individual must come from the wealth of another. This is simply not the case. The economy is dynamic and productive. The quantity of wealth is likewise not static; it can and is created readily through production. Moreover, the money that the wealthy accumulate is not acquired by theft, but by honest work and production. This is the true meaning of Say's Law: production causes consumption, for money cannot be spent without its being earned first—except when it is counterfeited or created by issuance of paper IOUs by the government. Thus in the long run total supply will equal total demand, providing the money supply is not tampered with, even though short-term supply and demand can fluctuate wildly.

Another objection, and no less important than the previous one, is that the historical record contradicts this theory. As I stated earlier, in a boom, capital goods industries prosper relative to consumer goods. In the subsequent depression, the situation is reversed and the capital goods industries falter proportionally to consumer goods. The underconsumption theory, however, posits that the consumer goods industries experience terrific surpluses in a depression, while the capital goods industries experience productivity increases and prosperity.48

Another significant explanation for the cause of the Great Depression is found in the flip side of the underconsumption coin: overproduction. Factories run full tilt during the boom period and sit idle during the bust, along with the workers and the inventories. Gradually and systematically, production is ceased and excess inventories are siphoned off until equilibrium is again attained and the process repeats.

What this theory ignores is the fact that such overproduction can still be sold. Price can be reduced to such a level that inventories would clear. So long as there still exists some money, this scenario can be curtailed. Even more important, the overproduction reeks of malinvestment. At some previous point in time, the producer thought that the stagnant endeavor would yield profits, i.e., the seller thought that future prices would cover costs of production. As we have seen, the significant cause of such miscalculation is artificial credit expansion and its concomitant malinvestments.49


As I stated in the Introduction, if we can understand the ideas and underlying philosophy the Great Depression, we can seek to eradicate those ideas from our midst and stave off a repetition of their actualization. The fundamental idea behind the Federal Reserve System is statism. It is the subjugation of individual freedoms and choices to the will and interests of the state or "public good."

In the case of the Federal Reserve, we can see that the Federal Reserve essentially dictates to the banking system what it can and cannot do. Consequently, individual depositors experience a reduction in choice among financial institutions, since they all are treated uniformly and it becomes impossible to determine the reserve quality and sufficiency of an individual bank. Furthermore, bankers are denied the possibility of issuing banknotes against real reserves and the element of control this encompasses. Businessmen are given mixed—and sometimes false—signals regarding the future cost of activities, leading to malinvestment and wasted capital. Finally, individuals are unable to assess the underlying value of the stock market, due to the dislocations produced by credit expansion on the part of the Fed. And volatility is officially sanctioned through the inflationary mechanism.

The lesson, then, of the Great Depression is that statism leads to unintended consequences and undesirable effects. It illustrates the fact that the government has no business interfering in the private dealings of individuals. If the government had adopted the laissez-faire program it is alleged to have adopted, the economy would have contracted, certainly, but its result would have been an economy strengthened and sounder. By its end, banks would have found appropriate reserve ratios and liquidated imprudent loans. Businesses would have converted misguided endeavors into productive uses and shaken off inefficiencies. Investors would be left with more accurately valued stockholdings and a renewed confidence in the financial status of the nation.

This, then, is the proper policy to follow in adjusting to a depression. It should be similarly obvious the method by which depressions may be averted. It is time for a separation of bank and state, akin to the separation of church and state and for the same reasons. An examination of free banking is beyond the scope of this essay, but suffice it to say that "[d]epositors lost more money in th[e] early phase of central banking (1913-1933) than earlier depositors had lost in the entire 75-year free banking period (1838-1913)."50

1 Rand, Ayn. "Is Atlas Shrugging?" The Objectivist Newsletter, August 1964, 6.

2 Greenspan, Alan. "Gold and Economic Freedom." Capitalism: The Unknown Ideal. Signet: 1966, p. 101.

3 Jackson, Robin. Rational Economics. Philosophical Library: 1987, p. 50.

4 Spahr, Walter E. "Our Irredeemable Currency System."

5 Jackson, p. 76.

6 Salsman, Richard M. Breaking the Banks: Central Banking Problems and Free Banking Solutions. American Institute for Economic Research: 1990, p. 20.

7 Ibid., p. 23.

8 Selgin, George A. The Theory of Free Banking: Money Supply under Competitive Note Issue. Rowman & Littlefield: 1988, pp. 117-8.

9 Rothbard, Murray N. The Mystery of Banking. Richardson & Snyder: 1983, p. 154.

10 Anderson, Benjamin M. Economics and the Public Welfare: A Financial and Economic History of the United States, 1914-1946. LibertyPress: 1979, p. 154.

11 Rothbard, Murray N. America's Great Depression. Nash Publishing: 1972, p. 124.

12 Anderson, pp. 385-6.

13 Salsman, p. 43.

14 Rothbard, Mystery, p. 139.

15 Salsman, p. 43.

16 Anderson, p. 145.

17 Ibid., p. 146.

18 Anderson, p. 96

19 Anderson, p. 182. An excellent discussion of the effects of the cheap money policy during this period follows.

20 Thirteenth Annual Report of the Federal Reserve Board for the Year 1926. Government Printing Office, p.9. cited in Anderson, p. 183.

21 Anderson, p. 153.

22 In reality, the purpose of this new cheap money policy was to staunch the flow of gold from Great Britain by making it less profitable for gold to leak. Anderson, pp. 189-91.

23 Anderson, p. 191.

24 There was also a concomitant gold stock reduction, due to the return of France to the gold standard, that also affected bank reserves. It represented about $300 million in reserve depletions. Anderson, p. 193.

25 Rothbard, Great Depression, pp. 191-3.

26 Anderson, p. 309.

27 Salsman, p. 45.

28 Ibid., p. 44.

29 Jackson, p. 74.

30 Trescott, Paul B. Financing American Enterprise: The Story of Commercial Banking. Harper & Row: 1963, p. 111. cited in Salsman, p. 49.

31 A simple application of the law of supply and demand.

32 "What induces an entrepreneur to embark upon definite projects is neither high prices nor low prices as such, but a discrepancy between the costs of production, inclusive of interest on the capital required, and the anticipated prices of the products. A lowering of the gross market rate of interest as brought about by credit expansion always has the effect of making some projects appear profitable which did not appear so before." Mises, Ludwig von. Human Action. Yale University Press: 1949, pp. 558-9.

33 Rothbard, Great Depression, p. 19.

34 Mises, p. 557.

35 Skousen, Mark. The Structure of Production. New York University Press: 1990, p. 46-7. Skousen is citing Hayek, Frederich A. von. Prices and Production. George Routledge: 1935, p. 57.

36 Rothbard, Great Depression, p. 20.

37 McElvaine, Robert S. The Great Depression: America, 1929-1941. Times Books: 1993, p. 17. McElvaine also notes a general spendthrift trend present in the twenties, thus underscoring the "forced" nature of the savings.

38 Rothbard, Great Depression, pp. 154-5.

39 Johnson, Paul. Modern Times: The World from the Twenties to the Eighties. Harper & Row: 1983, p. 246.

40 Katz, Howard S. "Unemployment in the Depression."

41 Anderson, pp. 127-8.

42 Anderson, pp. 192-6.

43 Ibid., p. 200.

44 Rothbard, Great Depression, p. 116.

45 Anderson, p. 202.

46 McElvaine, p. 38.

47 Ibid., p. 41.

48 Rothbard, Great Depression, pp. 56-8.

49 Ibid., pp. 55-6.

50 Salsman, p. 44.