One of the most enduring and troublesome mysteries in
economics is money: how it is created, what sorts of institutions
initiate the process, what kinds of mystique and priestcraft central
bankers use in managing monetary systems, and what rules, laws, or
customs limit their actions.
Perhaps the common ignorance about money is harmless.
After all, the millions of people who use this money drive sophisticated
automobiles and manipulate complex computers without knowing much about
the technical properties of either. As long as cars, computers, and
money behave themselves, can we perhaps ignore them? The answer is that
we can for cars and computers but we should not for money.
For one thing, ignorance about money has side effects
that are not comparable to ignorance about technical equipment.
Competitive markets drive the production and sale of all household
durables, but the production of money in every country in the world
today (and yesterday, too) is the province of governments. Through the
offices of their associated central banks, states monopolize the
machinery of money. Each central bank determines within very close
tolerances just how much money an economy has and the rate at which the
current stock of money will change. Unquestionably and inevitably,
political pressures that are rarely visible even to experienced
observers influence these operations.
Because they have the power to create money without
license, governments also have the complementary incentive to claim that
depressions and inflations resulting from the mismanagement of money
occur because of unusual and unexpected economic developments -
"shocks," as they are labeled. The term implies a sense of impending and
inevitable drama. No such social catastrophes result from the public's
incomplete knowledge of computers and automobiles, nor of "shocks" that
might affect their production and distribution. However, neither do
governments monopolize that production and distribution, and therein
lies the difference.
Fateful Decades
Nowhere is monetary ignorance more apparent than in
bystander evaluations of the economic and monetary events of the 1920s
and 1930s. Although several decades have passed, the various popular
accounts continue to misinterpret the causes of the disequilibrium that
occurred and also the federal government's aggravation of the problem.
Government apologists of many persuasions not only argue that the
massive interventions of the 1930s were necessary; they also contend
that the lack of response in the private sector to the multitudinous
government programs put into place proved that the economic system was
moribund.
Nothing, they argue, could have prevented the debacle.
They encourage the popular belief that the market economy zealously
overextended itself in the 1920s. The boom, they contend, led to the
stock market crash in 1929, and to the several banking crises of the
early 1930s. These financial failures, the legend continues, provoked
exhausting industrial liquidations, and the other devastations of the
1930s. The role that the central bank-the Federal Reserve System-and its
managers played in the catastrophe of the 1920s and 1930s is largely
unknown and therefore unappreciated.
Other observers, for example, many Austrian economists,
believe that all the trouble started with a central bank "inflation" in
the 1920s. This "inflation" had to be invented because it is a necessary
element in the Austrian theory of the business cycle, which seems to
describe most Austrian economic disequilibria. Austrian "inflation" is
not limited to price level increases, no matter how "prices" are
estimated. Rather, it is any unnatural increase in the stock of money
"not consisting in, i.e., not covered by, an increase in
gold."1
Once the Austrian "inflation" is going, it provokes
over-investment and maladjustment in various sectors of the economy. To
correct the inflation-generated disequilibriurn requires a wringing-out
of the miscalculated investments. This purging became the enduring
business calamity of the 1930s.
The late Murray Rothbard was the chief proponent of
this argument. Rothbard's problem is manifest in his book America 's
Great Depression. After endowing the useful word "inflation" with a new
and unacceptable meaning, Rothbard "discovered" that the Federal Reserve
had indeed provoked an inflation in the 1921-1929 period. The money
supply he examined for the period included not only hand-to-hand
currency and all deposits in commercial banks adjusted for inter-bank
holdings-the conventional M2 money stock-but also savings and loan share
capital and life insurance net policy reserves. Consequently, where the
M2 money stock increased 46 percent over the period, or at an annual
rate of about 4 percent, the Rothbard-expanded ,'money stock" increased
by 62 percent, or about 7 percent per year. 2
Here, Rothbard mistakes some elements of financial
wealth with money. The latter two items he specifies as money are not
money. 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.
Increases in their quantity do not pervasively spill over into all other
markets causing serious macroeconomic disequilibrium. Their appearance
as financial assets in people's possession is just as likely to be
deflationary as not, because their purchase and sale require money that
would otherwise be used for transactions of conventional goods and
services.
Apologists for central banking, by way of contrast, see
stock market "speculation" instead of over-investment as the culprit.
They argue that the Federal Reserve System did all it could to
counteract the "inevitable" contraction that followed the 1929 stock
market boom, but that its best effort could not be good enough. Since
earnest and sophisticated men operated the federal government and the
Federal Reserve System, something had to be wrong with the economic
system itself. Markets just could not be trusted to provide full
employment and steady real growth.
The Mismeasure of Money
Careful scrutiny of the monetary system and its
associated monetary data reveals that neither of these views is
analytically correct. Their defects result from ignorance of the flawed
institutional framework within which the gold standard and the central
bank generated money. Both also suffer from mismeasurement of the
central bank's monetary data. Four definable institutions created the
money in use during the 1920s: the gold standard, the U.S. Treasury, the
Federal Reserve System of 12 regional banks and the Federal Reserve
Board in Washington, and the commercial banking system of 20,000-odd
banks. These institutions were not created equal, however. Only the gold
standard and the Fed, with a notable assist from the Treasury, were
important in initiating either monetary policy or the monetary
happenings of the period. The commercial banks could only take what came
their way from the central bank and the gold standard. They, too,
created money. But their money-creating activities were all
unintentional and strictly a byproduct of their lending operations.
The gold standard after World War I was anything but
the autonomous, self-regulating institution that the Founding Fathers
had prescribed-quite the contrary. The Federal Reserve Bank officers,
particularly presidents, and the governors on the Federal Reserve Board,
based then in the Treasury Building in Washington, exercised a monetary
policy that often finessed the gold standard.
When gold came into the U.S. economy from a foreign
country, importers deposited it in a commercial bank, The commercial
bank in turn sent the gold to the regional Federal Reserve Bank to which
the commercial bank belonged. The Fed Bank would credit the reserve
account of this member bank, credit its own gold asset account by the
same amount, and deposit the physical gold in the Treasury. If the
member bank needed currency instead of an additional balance in its
reserve account, the regional Fed Bank would issue its own Federal
Reserve notes, dollar for dollar, based on the gold it had received. In
either case, the Fed Bank was simply a monetizer of the gold. It
converted the gold into dollars just as an ordinary commercial bank
would have done in the absence of a central bank.
The monetary system thereafter had more dollars of bank
reserves and deposits, or dollars of currency, because gold had come
into he country. All other legal tender items, such as silver currency
and greenbacks, were accounted in the Fed Banks in the same way as the
gold . Fed Banks, therefore, were the custodians of a large fraction of
the economy's basic money stock - the currency and bank reserves behind
the checking accounts that households and businesses used for everyday
transactions.
Blocking the Effects of Gold
Of course, the Federal Reserve System did not come into
existence to be a custodian of the economy's base money and nothing
else. The Fed Banks also had the legal power to create bank reserves and
currency using the gold and other legal tender they held as their
reserves, the Fed Banks could themselves become fractional reserve
institutions. They could expand the reserves of their member commercial
banks, or issue additional currency to them, by buying certain
interest-earning "eligible" assets from the banks, If Fed Banks wished
to block the effects of gold deposited with them to prevent the creation
of common money based on the new gold, they could restrict their own
lending to the commercial banks or sell off some of their
interest-earning assets. Within limits, the Fed's money managers could
deliberately and purposively supplement or counteract what the gold
standard machinery did as a result of market forces. It was this
particular machination to which Rothbard properly objected.
The Fed Banks' institutional authority derived from the
Federal Reserve Act of 1913. The Act gave the Fed Banks the role of
sequestering most of the banking system's gold, and the power, explained
above, either to enhance or hinder the monetary effects of any incoming
gold. At the same time, the congressional founders of the Fed saw the
new institution only as a supplement to the official gold standard. In
the Federal Reserve Act itself, they inserted a provision stating:
"Nothing in this act ... shall be considered to repeal the parity
provisions [between gold and the dollar] contained in an act approved
March 14, 1900." That referred to the Gold Standard Act, which made gold
the sole legal tender monetary metal in the U.S. system. The new Federal
Reserve System was supposed to act only within this official gold
framework.
To show how the Fed's hands-on controls worked during
the 1920s, I have constructed a table that summarizes the major monetary
elements in the combined Fed Banks' balance sheet for the 1921-1933
period. It also includes the level of prices as measured by the Consumer
Price Index (CPT).
The column labeled MI measures the stock of common
money-currency and checking account balances. From 1921 to 1929 this
stock of everyday money increased on average 2.5 percent per year
(compounded).3 The column labeled "Total Fed" shows the
Federal Reserve base on which this common money rested. Although this
base increased slightly from 1924 to 1928, it declined over the whole
eight-year span at an annual rate of 1.6 percent.
Fed-held gold and other reserve assets increased
nominally at 1.1 percent per year primarily because of gold inflows.
Federal Reserve policy prevented some of this gold from becoming a basis
for new money by ''sterilizing" it. That is, as the gold came into their
tills, the Fed Banks allowed their holdings of other assets, which were
primarily debts of the member banks, to decline: The member banks paid
off some of their debts by reducing their reserve account balances at
the Fed Banks. Changes in "net monetary obligations" of the Fed Banks
(the column labeled "Net Fed") accurately reflects this deflationary
policy. "Net monetary obligations" are total monetary assets minus gold
and other legal tender reserves. This datum, which faithfully indicates
the intent of Fed policy, declined at an annual rate of 8.0 percent over
the eight-year period.
Fed policy successfully offset the gold inflows so that
prices rose only slightly-0.5 percent per year for the eight-year
period. This much of a change can hardly be labeled an "increase"
because it is less than the statistical construction error of the index.
One thing is certain: it was not any kind of an inflation. All the
economic chronicles for the period, besides the monetary data, confirm
that Fed policy was braking against possible gold-inspired price
increases in the United States. The Fed's primary purpose was to further
international monetary policies, particularly to help the Bank of
England achieve and maintain gold payments for the pound sterling-but
that is another story.
In their Monetary History of the United States, Milton
Friedman and Anna Schwartz conclude their summary of the monetary events
of the 1920s with this paragraph: "Gold movements were not permitted to
affect the total of high-powered money [bank reserves and currency].
They were ... sterilized, inflows being offset by open market sales,
outflows by open market purchases." 4 They observe further:
"The widespread belief that what goes up must come down.... plus the
dramatic stock market boom, have led many to suppose that the United
States experienced severe inflation before 1929 and [that] the [Federal]
Reserve System served as an engine of it. Nothing could be further from
the truth. By 1923, wholesale prices had recovered only a sixth of their
1920-21 decline. From then until 1929, they fell on the average of 1
percent per year... Far from being an inflationary decade, the twenties
were the reverse. And the Reserve System, far from being an engine of
inflation, very likely kept the money stock from rising as much as it
would have if gold movements had been allowed to exert their full
influence." 5
Ironically, the Federal Reserve System that has
provided itself in recent decades with the well-deserved label "engine
of inflation" was in the 1920s an "engine" preventing gold inflation.
Any gold inflation would have been very mild; so the question of whether
Fed policy was proper is arguable-until we look at what happened
afterward.
Given that its intervention prevented a minor gold
inflation, did the Fed then reverse itself as bank failures occurred and
economic contraction threatened? Following approved central bank
doctrine, did it lend freely during the ensuing contraction at stiff
interest rates until its remaining gold reserves would not have been
enough to plate a teaspoon? 6 Let's see what happened.
Disaster Hits
As everyone knows, the following four years, 1929-1933,
were a deflationary disaster. Not quite so clear is what the Federal
Reserve did, or, more important, did not do during that time. Fed
spokesmen have often alleged that the Fed tried "everything in its
power" to turn around the contraction, and that it used its gold
reserves to their utmost. Again, nothing could be further from the
truth.
By 1929, the Fed's monetary liabilities - commercial
banks' reserve-deposit accounts in Fed Banks, and the public's holdings
of Federal Reserve currency-were $4.25 billion. These monetary items
exceeded the Fed's gold asset holdings by only $1.39 billion. Put
another way, the gold that came into the Fed Banks, which the commercial
banks would have held in the absence of a central bank, was $2.86
billion. Federal Reserve policy actions had created the remaining $1.39
billion. By August 1929, the Fed's gold and other reserves had grown to
$3.12 billion (not shown in the table). The Federal Reserve Act required
half these gold reserves to back outstanding Fed liabilities, but the
other half of them, $1.56 billion, were "excess" and available for
whatever monetary purposes the Fed managers thought appropriate.
During the following three-and-a-half years, the Fed
Banks' managers continued to build up the Fed Banks' gold holdings-even
as the financial system spiraled downward as a result of three serious
banking crises. By February 1933, owing to the Fed's tight money policy,
the economy was in shambles and constricted to the point of monetary
suffocation. The Fed Banks' gold stock had increased to $3.36 billion,
and "excess" gold reserves were still $1.35 billion! (The higher figure
in the table is for June 1933.) This damning statistic is seen in the
column labeled "Fed Gold." While the Fed had enjoyed an increase of $700
million in its gold and other reserve holdings, its monetary output had
increased by only $680 million: Commercial banks had $20 million less in
reserves than they would have had with no Federal Reserve System.
This statistic, however, is not the end of the story.
Since total commercial bank reserves were $2.29 billion in February
1933, the $1.35 billion of excess gold reserves Fed Banks held could
have enhanced the banking system's reserves by another 60 percent-to
$3.64 billion.
"Real Bills Doctrine"
The Fed Banks were truly absorbers of gold. They simply
extended and intensified the tight money policy they had begun in the
1920s, but for a different reason. Instead of helping the Bank of
England return to a gold standard, the Fed managers had become
enthralled with the idea that production of goods and services initiates
and promotes the production of money. Economists sometimes refer to this
as the "real bills doctrine." While it has a grain of truth in it when a
true gold standard is in place, it has no validity at all in a system
dominated by a central bank. With this flawed doctrine governing their
thinking, the Fed Banks' managers marked time waiting for new production
to appear so that they could in good conscience expand their monetary
obligations in support of the private economy.
It never happened.
The U.S. banking system went through three serious
contractions and the money stock continued to shrink. By 1933, the MI
and M2 money stocks were 27 percent and 25 percent below their 1929
levels. Meanwhile, the Fed Banks sat on their huge hoard of gold-the
gold reserves legally required for their current monetary output and the
"excess" gold reserves that could have provided significant monetary
increases-and did ... nothing!
Truly, when such a crisis appears, all the central
bank's gold is excess. A proper central bank can never be faulted for
"running out of gold." If the Fed Banks had followed the established
(Bagehot) doctrine of the time, they would sensibly have expanded their
loans, discounts, and accommodations to their "member" banks until their
gold stock was a cipher.
Of course, they would not have had to run their gold
reserve ratio down to zero. Long before they had expanded or used up
their gold reserves, the crisis of central-bank mismanagement would have
ended (or, more probably, would never have begun). The economy would
have been back to normal, and none of the ugly governmental machinations
of the later 1930s would have occurred. No Supreme Court conflicts would
have appeared; no New Deal bureaucracies would have emerged to plague
the economy; the Leviathan would have been kept in its constitutional
cage. Most important, many of the freedoms we are now trying to restore
would still be commonplace.
One would think that with this experience behind them,
the "monetary authorities" and the congressional wheelers and dealers
would have learned some lessons about U.S. monetary machinery and its
relationship to the economy. They did not.
Next month I will treat the reserve requirement debacle
of the mid-1930s, which added additional travail to the monetary
mistakes made in the early part of the decade.
At the time of the original publication, Richard
Timberlake was a professor of economics retired from the University of
Georgia, and author of Monetary
Policy in the United States: an Intellectual and Institutional History
(University of Chicago press, 1993)
1. Murray N. Rothbard, America's Great Depression
(Kansas City: Sheed and Ward, 1963, 1972), p. 87. Emphasis in the
original.
2. Ibid., p. 88.
3. The M2 money stock, which includes all of MI plus
time deposits at commercial banks, increased 5 percent per year from
1921 to 1929, and then fell at 13 percent per year from 1929 to 1933. No
basis exists for a more inclusive money stock than M2.
4. Milton Friedman and Anna J. Schwartz, A Monetary
History of the United States, 1867-1960 (Princeton: National Bureau of
Economic Research and Princeton University Press, 1963), p. 297.
5. Ibid., p. 298. Emphasis added.
6. This well-understood doctrine for central bank
procedure was proposed by Walter Bagehot in his classic work, Lombard
Street, rev. ed. (London: Kegan, Paul, Trench, Toubner & Co., 1906
[1873]).
Reprinted with permission from The
Freeman, a publication of The Foundation for Economic Education, Inc.,
April 1999, Vol. 49, No. 4.
Yourname@libertyhaven.com
