In consecutive issues of The Freeman, Richard
Timberlake has contributed an interesting trilogy of articles advancing
a monetarist critique of the conduct of US. monetary policy during the
1920s and 1930s.1 In the first of these articles, Timberlake
disputes the late Murray Rothbard's "Austrian" account of the boom-bust
cycle of the 1920s and 1930s. Timberlake contends that Rothbard proceeds
on the basis of a "new and unacceptable meaning" for the term
"inflation" and a contrived definition of the money supply to "invent" a
Fed-orchestrated inflation of the 1920s that, in fact, never occurred.
Moreover, Timberlake alleges, Rothbard's account was marred by a
"mis-measurement of the central bank's monetary data" as well as by a
misunderstanding of the nature and operation of the Fed-controlled
pseudo-gold standard by which U.S. dollars were created during this
period.
In the two subsequent articles, Timberlake also takes
issue, respectively, with the U.S. Treasury's policy of neutralizing
gold inflows and the Fed's policy of sharply raising reserve
requirements in the mid-1930s, arguing that these complementary policies
aborted an incipient economic recovery and brought on the recession of
1937-38. In what follows I will address the weighty charges brought
against Rothbard and, in the process, offer an evaluation of the Federal
Reserve System's culpability for the economic events of these tragic
years that diverges radically from Timberlake's.
The Meaning of "Inflation"
Let me begin with Timberlake's contention that Rothbard
imputes a meaning to the word "inflation" that is both new and
unacceptable. In fact Rothbard's definition of inflation as "the
increase in money supply not consisting in, i.e., not covered by, an
increase in gold," is an old and venerable one. It was the definition
that was forged in the theoretical debate between the hard-money British
Currency School and the inflationist British Banking School in the
mid-nineteenth century. According to the proto-Austrian Currency School,
which triumphed in the debate, the gold standard was not sufficient to
prevent the booms and busts of the business cycle, which had continued
to plague Great Britain despite its restoration of the gold standard in
1821.2
Briefly, according to the Currency School, if
commercial banks were permitted to issue bank notes via lending or
investment operations in excess of the gold deposited with them this
would increase the money supply and precipitate an inflationary boom.
The resulting increase in domestic money prices and incomes would
eventually cause a balance-of-payments deficit financed by an outflow of
gold. This external drain of their gold reserves and the impending
threat of internal drains due to domestic bank runs would then induce
the banks to sharply restrict their loans and investments, resulting in
a severe contraction of their uncovered notes or "fiduciary media" and a
decline in the domestic money supply accompanied by economy-wide
depression.
To avoid the recurrence of this cycle, the Currency
School recommended that all further issues of fiduciary media be
rigorously suppressed and that, henceforth, the money supply change
strictly in accordance with the inflows and outflows of gold through the
nation's balance of payments. The latter provided a natural,
non-cycle-generating mechanism for distributing the world's money supply
strictly in accordance with the international pattern of monetary
demands.
Following the triumph of the Currency School doctrine
and the implementation of its policy prescription by the Bank of
England, its definition of inflation became accepted in the
English-speaking world, especially in the United States, where there
existed a much more radical and analytically insightful American branch
of the School. The term "inflation" was now used strictly to denote an
increase in the supply of money that consisted in the creation of
currency and bank deposits un-backed by gold. Thus for example, the
American financial writer Charles Holt Carroll wrote in 1868 that "The
source of inflation, and of the commercial crisis, is in the nature of
the system which pretends to lend money, but creates currency by
discounting such bills when there is no such money in
existence."3 Even earlier, in 1858, Carroll had written,
"Instead of using gold and silver for currency they are merely used as
the basis of the greatest possible inflation by the banks," and that "we
should prevent any artificial increase of currency to prevent a future
... catastrophe."4 So it was the "artificial increase of
currency" only - through the creation of un-backed bank notes and
deposits - that constituted inflation.
The leading monetary theorist in the United States in
the last quarter of the nineteenth century was Francis A. Walker.
According to Walker, writing in 1888. 5A permanent excess of
the circulating money of a country, over that country's distributive
share of the money of the commercial world is called inflation.
While this version of the definition is applicable to
inconvertible paper fiat currency, Walker also believed that inflation
was an inherent feature of the issuance of convertible bank notes and
deposits that lacked gold backing. In Walker's words, "there resides in
bank money, even under the most stringent provisions for convertibility,
the capability of local and temporary inflation."6
Unfortunately, however, because the writers of the
British Currency School, unlike their American cousins, neglected to
consider bank deposits as part of the money supply, their policies as
adopted in Great Britain failed to prevent inflation and the business
cycle. Consequently, and tragically, the School's doctrines and policies
fell into profound disrepute by the late nineteenth century, and its
definition of inflation was replaced by that of the opposing Banking
School, which saw inflation as a state in which the money supply exceeds
the needs of trade.
Early American quantity theorists following the
proto-monetarist Irving Fisher, in particular, seized upon and adapted
this definition to their peculiar analytical perspective. Thus, Edwin
Kemmerer wrote in 1920 that, "Although the term inflation in current
dis-cussion is used in a variety of meanings, there is one idea common
to most uses of the word, namely, the idea of a supply of circulating
media in excess of trade needs."7 Kemmerer went on to define
inflation as a state in which, "at a given price level, a country's
circulating media-money and deposit currency-increase relatively to
trade needs. " From here it was a short step to the currently prevailing
definition of inflation as an increase in the price level.8
So Rothbard's theory is surely not new and to say that
it is "unacceptable" is simply to express one's agreement with the
long-entrenched preference among orthodox quantity theorists, including
contemporary monetarists, for the Banking School over the Currency
School.
Defining Money
Timberlake also challenges Rothbard's statistical
definition of the money supply for including savings and loan share
capital and life insurance net policy reserves, alleging that Rothbard
contrived this definition in order to make the rate of monetary growth
appear larger than it actually was during the 1920s. Timberlake argues
that the two items in question are not money because "they cannot be
spent on ordinary goods and services. To spend them, one needs to cash
them in for other money-currency or bank drafts."9 Let us
take these items one at time.
In the case of savings and loan share capital, there
are two responses to Timberlake. First, the "share accounts" offered by
savings and loan associations are and always have been economically
indistinguishable from the savings deposits offered by commercial banks,
included in the older (pre- 1980) definition of M2 that Timberlake
apparently upholds as the appropriate definition of the money
supply.10 In practice depositors could withdraw their savings
deposits from commercial banks on demand, because the law that permitted
the banks to insist on a waiting period was rarely if ever invoked.
Similarly, while savings and loan associations were contractually
obligated to "repurchase" their "shares" at par on request of the
shareholder, they could legally delay such repurchase for shorter or
longer periods depending on their individual bylaws. Nonetheless such
delays rarely occurred and "for many years savings and loan associations
have made the proud boast 'every withdrawal paid upon demand' or some
similar statement."11
Moreover, while Timberlake is right that "shareholders"
had to trade their share accounts in for currency or bank drafts (at par
and on demand) before they could spend them on goods and services, this
was equally true of savings depositors at commercial banks. Thus the
public has always considered dollars held in savings and loan share
accounts or savings accounts as readily spendable as dollars held in
commercial bank savings deposits.
Second, Timberlake curiously does not object to
Rothbard's inclusion of the savings deposits of mutual savings banks in
the money supply, although they also are not included in the M2
definition he favors.12 What makes Timberlake's position even
more puzzling is that mutual savings banks were practically identical in
economic function to savings and loan associations and were also
technically "mutually" owned by their depositors.13 So why,
then, does Timberlake insist so vehemently on treating the liabilities
of these two institutions differently?
A resolution of this mystery can perhaps be found in
the work of Milton Friedman and Anna Schwartz, who excluded the share
accounts of savings and loans (and of credit unions) from their
definition of the money supply on the grounds that these institutions
are technically not banks as defined "in accordance with the definition
of banks agreed upon by federal bank supervisory agencies" since
"holders of funds in these institutions are for the most part
technically shareholders, not depositors." Despite this legal
technicality, however, even Friedman and Schwartz were forced to admit
that those who place funds with these institutions "clearly ... may
regard such funds as close substitutes for bank deposits, as we define
them."14
Life Insurance Reserves
This brings us to the issue of the net policy reserves
of life insurance companies. Rothbard claimed that the cash surrender
values of life insurance companies, that is, the immediately cashable
claims possessed by policyholders against life insurance companies,
statistically approximated by the companies' net policy reserves,
represent a source of currently spendable dollars and should be included
in the money supply. Once again the question is not whether insurance
companies superficially resemble banks or can be technically classified
as such according to some arbitrary regulatory definition. It is whether
they essentially function like depository institutions, receiving funds
from the public with which to make loans and investments, while
contractually promising that such funds are available for withdrawal on
demand by the policyholder. In Rothbard's view, the policyholder is
economically in precisely the same position as a bank depositor (and
thrift institution shareholder) in holding an immediately cashable
par-value claim to dollars.
Now admittedly, Rothbard's inclusion of this item in
the money supply is controversial, much more so than his inclusion of
savings and loan share accounts. However, he was hardly alone in
maintaining this position. A number of mainstream writers of money and
banking textbooks in the 1960s and 1970s recognized that cashable life
insurance reserves possessed some of the characteristics of money. For
example, Walter W, Haines characterized insurance companies as "savings
institutions" and noted that these savings "can be withdrawn at any
time" simply by allowing the policy to lapse, a feature that marks them
as a "near-money" on a par with savings accounts.15 M,L.
Burstein maintained that the cash value of a life insurance policy
offered "ready convertibility" into cash, was "almost as liquid as a
mattressful of currency," and satisfied the "precautionary motive" for
holding liquid assets no less than savings and loan accounts and savings
bonds. 16 Albert Hart and Peter Kenen included the "net cash
values of life insurance" in the broadest class of financial assets
possessing the attribute of ''money-ness," while Thomas F. Cargill
ranked them on a liquidity spectrum immediately below large certificates
of deposit, which are included in the current M3 definition of the money
supply.17
More important, however, even if we grant for the sake
of argument that net life insurance reserves should be excluded from the
money supply, we find that it makes very little difference to Rothbard's
characterization of the 1920s as an inflationary decade. With this item
included, the increase in Rothbard's M between mid-1921 and the end of
1928 totaled about 61 percent, yielding an annual rate of monetary
inflation of 8.1 percent a year; with this item left out (but savings
and loan share accounts included), the money supply increased by about
55 percent over the period or at an annual rate of 7.3 percent.18
Mirabile dictu, by using a definition of the money stock that
arbitrarily excludes savings and loan share accounts while including
mutual savings bank deposits on the basis of an inexplicable adherence
to a legalistic regulatory definition of banks, it turns out that it is
Timberlake (and Friedman and Schwartz) who have mismeasured money supply
growth during the 1920s.
Flawed Institutions
Timberlake also criticizes Rothbard for "ignorance of
the flawed institutional framework within which the gold standard and
the central bank generated money" and also of "mis-measurement of the
central bank's monetary data."19 But this is surely a curious
charge to level against Rothbard, steeped as he was in Currency School
doctrine. In fact, Rothbard was quite cognizant that the U.S. monetary
regime of the 1920s and 1930s was not a genuine gold standard in which
the supply of money was determined exclusively by market forces, that
is, by the balance of payments and the mining of gold, but a hybrid
system in which the Fed possessed substantial power to manipulate the
money supply by pyramiding paper bank reserves atop its stock of gold
reserves. Indeed, Rothbard went much further than Timberlake in
rigorously and completely separating those factors affecting the money
supply that were subject to Fed control from those that the Fed had no
control over.20
In analyzing the central bank monetary data, Timberlake
starts with the monetary base or "Total Fed," which is equal to currency
in circulation plus member bank reserves. From this aggregate he
properly subtracts the Fed's legal-tender reserves, mainly the gold
stock, whose size depends on balance-of-payments flows and is not under
the immediate control of the Fed. What remains is the "net monetary
obligations" of the Fed or "Net Fed," which, according to Timberlake,
"faithfully indicates the intent of Fed policy."21 From 1921
to 1929, this aggregate declined by 8 percent per year, leading
Timberlake to conclude that the intent of Fed policy was decidedly
deflationary during this period. The motive for this deflationary policy
bias was, Timberlake suggests, to aid Great Britain in re-establishing
and maintaining gold convertibility for the pound sterling.
However, as important as it is, the gold stock is not
the only factor that lay beyond the Fed's control. For as Rothbard
points out, currency in circulation, which improperly remains in
Timberlake's Net Fed aggregate, is not controlled by the Fed at all but
by the banking public. Any time a depositor withdraws cash from a bank,
currency in circulation increases and bank reserves decline, dollar for
dollar. Under a fractional-reserve banking system, this loss of reserves
causes a multiple contraction of bank deposits that far exceeds the
original increase in currency in circulation that induced it and
therefore results in a net deflation of the money supply. Conversely, a
decline in the amount of currency held by the public causes an overall
increase in bank reserves and an overall inflation of the money supply.
This is not all, however - Timberlake also ignores the
fact that under the prevailing policy regime the banks themselves could
autonomously reduce the amount of bank reserves and thus the quantity of
money in existence by deliberately reducing their indebtedness to the
Fed. During this period, it was the chosen policy of the Fed to lend
liberally and continuously to all banks at an interest, or "discount,"
rate below the market rate. While the Fed was legally authorized to make
such loans to its member banks, it was not mandated to do so.
Furthermore, it also retained complete power to set the "discount rate"
it charged on these loans. Hence, if it had chosen to, the Fed could
have restricted its lending to emergency situations and charged a
penalty rate substantially above the market rate, so as to discourage
all but the most seriously troubled banks from applying for loans. In
short, it could have almost completely neutralized the inflationary
impact of its discounting operations. This "emergency lending" policy
had been urged by some prominent officials within the Fed establishment
itself. 22
The fact that the Fed chose instead to pursue a
"continuous lending" policy meant that the increase in bank reserves
that resulted from the origination of new Fed loans to member banks via
the rediscounting of business bills or advances on collateralized bank
promissory notes was under the exclusive control of the Fed. But it also
meant that the reduction in bank reserves entailed by the net repayment
of discounted bills was uncontrolled by the Fed, because it depended
solely on the decisions of the banks. Given the Fed's indiscriminate,
below-market rate discount policy, the banks were always in a position
to maintain or augment their debts to the Fed if they so desired simply
by discounting additional bills with the Fed. Thus, as Rothbard
concluded, when "Bills Repaid" exceeded "New Bills Discounted," banks
were deliberately and autonomously diminishing their level of
indebtedness to the Fed and this must be counted as an uncontrolled
deflationary influence on bank reserves.
Real Fed Intent
If we follow Rothbard, then, in identifying currency in
circulation and the reduction of bank indebtedness to the Fed along with
the gold stock as the main "uncontrolled" factors affecting bank
reserves, we get a picture of the Fed's intent during the 1920s and
early 1930s that is poles apart from the one suggested by Timberlake.
Indeed, we find that from the inception of the monetary inflation in
mid-1921 to its termination at the end of 1928, "uncontrolled reserves"
decreased by $1.430 billion while controlled reserves increased by
$2.217 billion. Since member bank reserves totaled $1.604 billion at the
beginning of this period, this means that controlled reserves shot up by
138 percent or 18.4 percent per year during this seven-and-one-half year
period, while uncontrolled reserves fell by 89 percent or 11.9 percent
per year. Thus Rothbard correctly concluded that the 1920s were an
inflationary decade and that it was indeed the intention of the Federal
Reserve System that it be so.23
The Fed's inflationary intent is perfectly consistent,
moreover, with its motive of helping Great Britain re-establish and
maintain the pre-war parity between gold and the British pound. While
Timberlake properly recognizes this motive underlying Fed policy, he is
incorrect in suggesting that it necessitates a deflationary policy on
the part of the Fed. In fact, the precise opposite is required. The
British pound in the mid--1920s was overvalued vis-à-vis gold and the
U.S. dollar, causing British products to appear relatively overpriced in
world markets. As a result, Great Britain experienced imports
chronically in excess of exports accompanied by persistent
balance-of-payments deficits and outflows of gold reserves. Had the Fed
deflated the U.S. money supply, thus lowering U.S. prices even more
relative to British prices as Timberlake claims was its intention, it
would have exacerbated, and not resolved, Great Britain's gold drain.
Clearly, then, the Fed's desire to aid Britain in reversing its
balance-of-payments deficits and rebuilding its gold stocks called for
an inflationary policy intended to pump up U.S. prices, thereby
rendering British products relatively cheap and enhancing the demand for
them on world markets.24
This point about the motive for the Fed's easy-money
policy in the 1920s was not only advanced by Rothbard, but by other
economists, including monetarists such as Kenneth Weiher. According to
Weiher:
Great Britain was calling for help [in 1924] and
Benjamin Strong [president of the New York Fed] heard the call.
Expansionary monetary policy in the U. S. would drive prices up and
interest rates down in this country, which would tend to send gold
flowing toward Great Britain, where prices were lower and interest rates
higher. These changes would help America's ally build up its stock of
gold.... [T]here can be no question that the Fed would not have moved
when it did were it not for concern over the gold standard and the
plight of Great Britain. . . . By 1927, the stagnant British economy
needed help from the United States and the rest of Europe.... Just as
had been the case in 1924, monetary policy was shifted to an
expansionary program in an effort to aid Great Britain's struggles to
return to the gold standard.25
Rothbard's reinterpretation of the monetary data also
cuts against Timberlake's claim that the Fed "monetarily starved the
country into the worst economic crisis it has ever experienced
."26 On the contrary, the factors controlled by the Fed
continued to exercise a highly inflationary impact on bank reserves and
the money supply from late 1929 through 1932, as the Fed attempted
desperately toward off the depression precipitated by the termination of
the bank credit inflation that it had orchestrated in the 1920s.
The deflation of the money supply, therefore, was
caused wholly by factors beyond the control of the Fed. First, there was
a loss of confidence in the Fed-dominated phony gold standard among the
domestic public and foreign investors. As a result there occurred an
increase in currency in circulation and a decline in the Fed's gold
stock, both of which caused bank reserves to decline. Second, U.S. banks
prudently attempted to save themselves and their depositors by
restricting their loans to overcapitalized and failing businesses and
instead using these funds to pay down their indebtedness to the Fed,
which gave further impetus to the "uncontrolled" reduction of bank
reserves. Third, in the second quarter of 1932, the banks also began to
increase their liquid reserves beyond the legal minimum. The
accumulation of "excess reserves," as they were called, constituted a
separate uncontrolled factor that reinforced the deflationary influence
of the uncontrolled decline in bank reserves on the money supply.
From the end of December 1929 to the end of December
1931, bank reserves fell from $2.36 billion to $1.96 billion causing RM
(for Rothbard's money supply) to drop from $73.52 billion to $68.25
billion or at an annual rate of 3.6 percent. But this monetary deflation
was not caused by the Fed, which pumped up controlled reserves by $672
million or at an annual rate of 17 percent during the period, while
uncontrolled reserves declined by $1,063 million or by 27 percent per
year. During 1932, RM continued to decline, falling to $64.72 billion or
by 5.2 percent. But bank reserves increased sharply during the year from
$1.96 billion to $2.51 billion, as the Fed furiously inflated controlled
reserves. In the last ten months of the year, controlled reserves rose
by a staggering $1,165 million, or at an annual rate of 76 percent.
Fortunately, this attempted massive inflation of the money supply was
undone by the domestic public, foreign investors, and the banks as
uncontrolled reserves dwindled by $495 million and banks began to
accumulate substantial excess reserves.
The story was much the same in 1933 as a determined
inflationary campaign conducted by the Fed in the early part of the
year-controlled reserves rose by $785 million in February alone - was
defeated by the public and the banks, and RM declined by over $3
billion, or by almost 5 percent.27
So once the data have been properly arranged and
interpreted, it becomes clear that the Fed does not deserve praise for
the bank credit deflation of 1930-1933. This honor goes to private
dollar-holders, domestic and foreign, who attempted to reclaim their
rightful property from a central bank-manipulated and inflationary
financial system masquerading as a gold standard that had repeatedly
betrayed their trust.
"Sterilizing" Gold
In two follow-up articles, Timberlake extends his
attack on what he considers to be the "deflationary" monetary policies
pursued by the Treasury and Fed in the mid-1930s. In particular, he
criticizes the Treasury's policy of "neutralizing' " or "sterilizing,"
the effect of the inflow of gold on bank reserves from late 1936 to
early 1938 and the Fed's policy of increasing reserve requirements in
1936 and 1937. But neither of these policies caused a contraction of the
money supply. They merely temporarily interrupted a massive monetary
inflation caused by the abolition of the gold standard and subsequent
devaluation of the dollar engineered by the Roosevelt administration.
It is important to recognize that this influx of gold
was not a result of the "uncontrolled" operation of the gold standard,
which had been abolished in 1933. Rather, it was the result of the
deliberate and steady increase in the price at which gold was purchased
by the US. Treasury and the Reconstruction Finance Corporation. By
January 1934, the price of gold had risen from $20.67 to $35.00 per
ounce, or by almost 70 percent, where it was officially pegged by the
Gold Reserve Act of 1934. The Treasury was now legally mandated to
maintain this devalued exchange rate between gold and the dollar by
freely purchasing all the gold offered to it at this price. In effect,
then, Treasury gold purchases were now economically identical to
inflationary Fed open market purchases, substituting demonetized gold
for government securities. Consequently, in response to this unilateral
increase in the price of gold above its world price, there occurred a
prodigious influx of gold into the United States - a "golden avalanche"
it was called at the time - which vastly increased bank reserves. The
result was an unprecedented inflation of the money supply (M2) during
1934, 1935, and 1936 at annual rates of 14 percent, 14.8 percent, and
11.4 percent, respectively.28
With respect to its influence on the supplies of bank
reserves and money, the demonetized gold stock thus had been transformed
into a factor "controlled" by monetary - in this case Treasury - policy.
Given that the use and ownership of gold money by the public had been
legally suppressed, gold was effectively demonetized and its continued
purchase by the Treasury was purely a matter of discretionary monetary
policy. Accordingly - and contrary to Timberlake's assertion - when
during 1937 the Treasury began to finance its purchases of gold in a
manner that neutralized their effect on bank reserves, it was not
engaging in deflation. The simultaneous sales of government securities
to finance these purchases were simply and properly eliminating any
extraneous effects of a demonetized asset on the money supply.
Even if gold were permitted to continue in its monetary
function, however, Timberlake would still be wrong in criticizing the
policy of neutralizing its effect on bank reserves. For under a genuine,
Currency School-type gold standard, a country's money supply would
increase by exactly the amount of the gold inflow from abroad. This is
not inflationary and represents precisely the proper amount by which the
money supply should expand, because it is the outcome of the deliberate
actions of the country's residents who are decreasing their purchases of
foreign imports and increasing their sales of exports in order to
satisfy their desires for greater money holdings. This
balance-of-payments mechanism is a natural part of the market economy
and works continually on all levels-including the region, state, town,
and even household-to efficiently adapt money supply to relative changes
in money demand.
A problem arises, however, when these benign, money
demand-driven gold inflows are used, as they were in the 1920s and early
1930s, as bank reserves to create un-backed notes and deposits. In this
case, as F. A. Hayek has so aptly described, international gold flows
will regularly cause a serious distortion of the free-market interest
rate and investment pattern in the affected countries, leading to a
business cycle.29 The reason is that the needed adjustment in
national money supplies upward or downward now entails creating or
destroying fiduciary media by expanding or contracting bank loans in
defiance of the preferences of the economy's consumers and savers. Thus,
a policy of neutralizing the effect of gold flows on bank reserves in
the context of a fractional-reserve banking system dominated by a
central bank does not constitute a gross violation of the rules of the
gold standard; to the contrary, it tends to facilitate the operation of
the natural money-supply mechanism that prevails under a genuine gold
standard.
Not surprisingly, in the third article of the trilogy,
Timberlake also objects to the Fed's policy of raising reserve
requirements in 1936 and 1937, which was undertaken to mop up the
massive amounts of excess reserves held by the banking system.
Timberlake advances two criticisms against this policy. First, the
policy was unnecessary because, even if all the excess reserves that
existed on the eve of its implementation were subsequently fully loaned
out by the banks, the inflationary potential was relatively minor.
Appealing to the Banking School definition of inflation, Timberlake
pronounces the 52 percent increase in the money supply that would have
resulted as only mildly inflationary because the larger money supply
would have exceeded the needs of trade of a fully employed economy by
5.6 percent at 1929 prices, which were about 25 percent higher than
prices prevailing in June 1936.30 In plain language,
Timberlake is literally defining away a potential money and price
inflation of gargantuan proportions because of its perceived expedience
in expanding employment and output and extricating the economy from a
depression. But as Timberlake himself admits in a footnote - and as
Rothbard and other Austrians have never ceased to argue - what impeded
the economy's natural and non-inflationary recovery from the depression
was the existence of "government programs [that] had actively worked
against money price declines for ten years."31
Growing Money Supply
In his second criticism, Timberlake contends that the
increase in reserve requirements went beyond closing off a potential
avenue of recovery for the economy and "turned what had been an ongoing
recovery into another cyclical disaster." But if we once again turn to
Timberlake's data we find that the money supply (M2) continued to grow,
from $43.3 to $45.2 billion or by 4.4 percent, between June 30, 1936,
and June 30, 1937, the year in which this policy was implemented. Even
if we focus on the last six months of the period, there was hardly a
wrenching deflation, as the money supply increased at an annual rate of
0.8 percent.32 Even from Timberlake's monetarist standpoint,
then, it is difficult to blame the "recession within a depression" of
1937-1938 on deflationary Fed policy.
Unfortunately Timberlake's strained and narrow emphasis
on Fed deflationism as the cause of all the woes of the 1930s causes him
to ignore a plausible "Austrian" explanation of the relapse of 1937. As
a result of a spurt of union activity due to the Supreme Court's
upholding of the National Labor Relations Act of 1935, money wages
jumped 13.7 percent in the first three quarters of 1937. This sudden
jump in the price of labor far outstripped the rise in output prices
and, with labor productivity substantially unchanged, brought about a
sharp decline in employment beginning in late 1937.33 The
large upward spurt in excess reserves and the accompanying decrease in
the money supply that we observe in Timberlake's data between June 30,
1937, and June 30, 1938, therefore, can be explained as the result, and
not the cause, of the recession.34 As business profits were
squeezed by the run-up of labor costs and the economy slipped into
recession, banks prudently began to contract their loans and pile up
liquid reserves to protect themselves against prospective loan defaults
and bank runs. To offset this uncontrolled decline of the money supply,
beginning in mid-1938 the Fed (and the Treasury) once again resorted to
an inflationary policy, reversing the reserve requirement increase and
allowing gold inflows to once again pump up bank reserves. As a result,
M2 increased by 5.9 percent, 10. 1 percent, and 12.5 percent in 1938,
1939, and 1940, respectively.35
Our conclusion, then, is that the Fed's monetary
policy, except for very brief periods in 1929 and 1936-1937 when it
turned mildly dis-inflationist, was consistently and unremittingly
inflationist in the 1920s and 1930s. This inflationism was the cause of
the Great Depression and one of the reasons why it was so protracted.
At the time of the original publication, Joseph
Salerno was a professor of economics in the Lubin School of Business
at Pace University.
1. Richard H. Timberlake, "Money in the 1920s and
1930s," The Freeman, April 1999, pp. 37-42; "Gold Policy in the 1930s,"
The Freeman, May 1999, pp. 36-41; and "The Reserve Requirement Debacle
of 1935-1938," The Freeman, June 1999, pp. 23-29.
2. For a review of this debate, see Murray N. Rothbard,
Classical Economics: An Austrian Perspective on the History of Economic
Thought, Volume II (Brookfield, Vt.: Edward Elgar Publishing Company,
1995), pp. 225-74.
3. Charles Holt Carroll, Organization of Debt into
Currencv andOther Papers, ed. Edward C. Simmons (Princeton: D. Van
Nostrand Company, Inc., 1964), p. 333.
4. Ibid., p. 91.
5. Francis A. Walker, Political Economy (New York:
Henry Holt and Company, 1888), p. 15 1.
6. Ibid., p. 171.
7. Edwin Walter Kemmerer, High Prices and Deflation
(Princeton: Princeton University Press, 1920), p. 3.
8. Ibid., p. 4.
9. Timberlake, "Money in the 1920s and 1930s," p. 38.
For Rothbard's explanation and defense of his broader definition of the
money supply, see Murray N, Rothbard, America's Great Depression (Los
Angeles: Nash Publishing Corporation, 1972 [1963]), pp. 83-86.
10. I say "apparently," because he states that "No
basis exists for a more inclusive money stock than M2" (ibid., p. 42, n.
3). It should be pointed out that, since February 1980, savings accounts
of savings and loan associations and credit unions have been included,
along with savings deposits of commercial and mutual savings banks in
the new M2, an official Fed statistic that is today considered to be the
most reliable indicator of movements in the money supply by many
economists.
11. John G. Ranlett, Money and Banking: An Introduction
to Analysis and Policy (New York: John Wiley & Sons, Inc., 1969), p.
251.
12. Paul A. Meyer, Monetary Economics and Financial
Markets (Homewood, III.: Richard D. Irwin, Inc., 1982), pp. 31-32.
13. Walter A. Haines, Money, Prices, and Policy (New
York: McGraw-Hill Book Company, Inc., 1961), pp. 249-50.
14. Milton Friedman and Anna Jacobson Schwartz, A
Monetary History of the United States, 1867-1960 (Princeton: Princeton
University Press, 1963), p. 4, fin. 4. The essential economic - as
opposed to the technical legal - identity between commercial bank
deposits and all kinds of instantaneously cashable savings accounts held
at the various non-depository or thrift institutions was established
many years before Friedman and Schwartz wrote, in 1937, in a brilliant
but neglected article by Lin Lin ("Are Time Deposits Money?" American
Economic Review, March 1937, pp. 76-86). This article was not cited by
Friedman and Schwartz but greatly influenced Rothbard.
15. Haines, pp. 253-54, 31-32.
16. M. L. Burstein. Money (Cambridge, Mass.: Schenkman
Publishing Company, Inc., 1963), p.111.
17. Albert Gaylord Hart and Peter B. Kenen, Money,
Debt, and Economic Activity (Englewood Cliffs, N.J.: Prentice-Hall,
Inc., 196 1), pp. 4-6; Thomas F. Cargill, Money, the Financial System
and Monetary Policy (Englewood Cliffs, N.J.: Prentice-Hall, Inc., 1979),
P. 11.
18. I have based this calculation on Rothbard's data.
See Rothbard, America's Great Depression, p. 88.
19. Timberlake, "Money in the 1920s and 1930s," p. 38.
20. Rothbard, America's Great Depression, pp. 94-100.
21. Timberlake, "Money in the 1920s and 1930s," p. 40.
22. On the Fed's discount policy in the 1920s, see
Rothbard, America's Great Depression, pp. 111-16.
23. For an analysis of the factors involved in the
development of the monetary inflation of the 1920s, see ibid., pp. 10
1-25.
24. On the desire to help Great Britain restore the
gold standard at an overvalued gold parity without having to endure the
consequences of deflating its economy as an important motive driving the
Fed's inflationary monetary policy in the 1920s, see ibid., pp. 131-45.
25. Kenneth Weiher, America's Search for Economic
Stability: Monetary and Fiscal Policy Since 1913 (New York: Twayne
Publishers, 1992), pp. 48-49.
26. Timberlake, "Gold Policy in the 1930s," p. 36.
27. On the factors responsible for the monetary
deflation of the early 1930s, see Rothbard, America's Great Depression,
pp. 186-295 passim.
28. Weiher, pp. 75, 79-82.
29. F. A. Hayek, Monetary Nationalism and International
Stability (New York: Augustus M. Kelley Publishers, 1971 [1937]), pp. 25
32.
30. These figures are calculated from Timberlake's
data. See Timberlake, "The Reserve Requirement Debacle," p. 27.
31. Ibid., p. 29, n. 11.
32. Ibid., p. 27.
33. Richard K. Vedder and Lowell E. Gallaway, Out of
Work: Unemployment and Government in Twentieth-Century America (New
York: Holmes and Meier, Publishers, Inc., 1993), pp. 129-36. For a
similar explanation of the 1937 slump, see Benjamin M. Anderson,
Economics and the Public Welfare: A Financial and Economic History of
the United States, 1914 1946 (Indianapolis: LibertyPress, 1979 [1949]).
pp. 432-38.
34. Timberlake, "The Reserve Requirement Debacle," p.
27.
35. Weiher, pp. 75-86.
Reprinted with permission from The
Freeman, a publication of The Foundation for Economic Education, Inc.,
October 1999, Vol. 49, No. 10.
Yourname@libertyhaven.com
