The US Great Depression of the 1930s still ignites heated controversy, with divergent views as to what was going wrong and how it could have been avoided. Uncanny parallels with some current economic woes emphasise that this is more than just a historical curiosity.

The Great Depression was a very striking phenomenon – a previously thriving economy that had provided the American people with the opportunity to make full use of their talents and the nation’s resources, instead floundered. Although all of the necessary manpower and resources were still immediately to hand, they were left idle and great suffering resulted from the unemployment and lost production. This malaise continued until the start of WWII when the economy was transformed by the massive demand for war equipment with consequent full employment and widespread prosperity.

This 1933 quote from Marriner Eccles exemplifies the underconsumptionist view of what was going on,

It is utterly impossible, as this country has demonstrated again and again, for the rich to save as much as they have been trying to save, and save anything that is worth saving. They can save idle factories and useless railroad coaches; they can save empty office buildings and closed banks; they can save paper evidences of foreign loans; but as a class they can not save anything that is worth saving, above and beyond the amount that is made profitable by the increase of consumer buying. It is for the interests of the well to do – to protect them from the results of their own folly – that we should take from them a sufficient amount of their surplus to enable consumers to consume and business to operate at a profit. This is not “soaking the rich”; it is saving the rich. Incidentally, it is the only way to assure them the serenity and security which they do not have at the present moment.”

Today, instead, the mainstream view is that the Great Depression could have best been avoided by deployment of monetary policy. Monetary policy has the fantastic attribute that almost everyone finds it politically palatable. It simply involves the central bank making purchases from willing counterparties. If it really can do the trick, then that is fabulous. For just that reason, politicians have been bowled over and have widely abdicated much responsibility for unemployment and price stability over to the central bankers who conduct monetary policy. The problem though is that if monetary policy is incapable of rectifying the problem, then relying on it becomes a dangerous delusion.

According to the monetarist view, the 1930s Great Depression was all down to the phenomenon of monetary deflation. Prices fell but debt burdens and wage contracts were still in place that had been negotiated when prices were higher. Such debts and wage costs  could not be met from the reduced revenue as prices fell. In reaction to that, firms cut costs and directed revenue towards paying down debts. Defaults and bankruptcies caused lenders to become ever more wary of extending credit even to those still seeking it. Unemployment, and the fear of it, reduced consumer spending. That all caused a lack of demand and so further price falls and a destructive deflationary spiral was set off. Proponents of monetary policy claim that it has ample capacity to ward off any such episode.

Such monetary policy consists of central bank purchases of financial assets in exchange for freshly created base money (aka central bank liabilities). If there is a tight shortage of base money (such as was the case in the 1920s and then again in the 1980s) then relieving that shortage can dramatically lower interest rates and so encourage credit expansion throughout the economy. However in the 1930s (as now) there was a glut of monetary base such that interest rates were at the zero lower bound. In fact, Treasury bill rates were actually negative when the Great Depression was at its worst. Prices fell not because there was a shortage of base money overall but because the money was not being used. This was recognised at that time as shown by another 1933 quote from Marriner Eccles,

In 1929 the high level of prices was supported by a corresponding velocity of credit. The last Federal Reserve Bulletin gives an illuminating picture of this relationship as shown by figures of all member banks. From 1923 to 1925 the turnover of deposits fluctuated from 26 to 32 times per year. From the autumn of 1925 to 1929 the turnover rose to 45 times per year. In 1930, with deposits still increasing, the turnover declined at the year end to 26 times. During the last quarter of 1932 the turnover dropped to 16 times per year. Note that from the high price level of 1929 to the low level of the present this turnover has declined from 45 to 16, or 64 per cent.  I repeat there is plenty of money today to bring about a restoration of prices, but the chief trouble is that it is in the wrong place; it is concentrated in the larger financial centers of the country, the creditor sections, leaving a great portion of the back country, or the debtor sections, drained dry and making it appear that there is a great shortage of money and that it is, therefore, necessary for the Government to print more. This maldistribution of our money supply is the result of the relationship between debtor and creditor sections – just the same as the relation between this as a creditor nation and another nation as a debtor nation – and the development of our industries into vast systems concentrated in the larger centers. During the period of the depression the creditor sections have acted on our system like a great suction pump, drawing a large portion of the available income and deposits in payment of interest, debts, insurance and dividends as well as in the transfer of balances by the larger corporations normally carried throughout the country. The maladjustment referred to must be corrected before there can be the necessary velocity of money. I see no way of correcting this situation except through Government action.”

Nevertheless there is still today a popular view that even when interest rates are essentially zero, further increasing the monetary base nevertheless increases prices. It has to be stressed that this is not about conferring purchasing power to people or institutions who lack it (conferring such benefits would be fiscal policy and not monetary policy). This is about exchanging base money for other liquid financial assets (such as government debt securities) that are worth as much as is being paid for them by the central bank and that can be effortlessly exchanged for money within the private sector anyway. The idea is that somehow the overall quantity of monetary base causes all prices to adjust so as to regain some natural ratio between the monetary value of available goods and services and the quantity of monetary base. Central banks don’t themselves make such a claim but some of the most ardent advocates for monetary policy do. Scott Sumner is perhaps the most strident purveyor of that view.

Scott Sumner acknowledges that the immediate effect of boosting the monetary base is to reduce its “velocity” (the frequency with which each dollar is used). However the claim is that this lack of a short term effect on prices nevertheless projects into a robust effect over the long term. I struggle to comprehend how this short term to long term transformation is supposed to take place. The (hand waving) explanation is that it entails “inflation expectations”. The idea is that for instance employers will keep staff employed, even when the wage bill is too high, in the anticipation that prices will rise enough such that sales and so revenue will cover staff costs. Consequently such high staff costs are actually paid (perhaps funded using extra debt) and the anticipated inflation becomes realised.  So apparently, once interest rates are at the zero lower bound, increases in the monetary base have a purely propaganda role-they supposedly work because they are believed to work. It is claimed that the observed lack of pronounced inflationary impetus from quantitative easing (QE) in Japan, USA and UK is because QE is supposedly expected to be reversed. It is claimed that if people believed QE were permanent, then prices would rise via this “expectations” mechanism.  By that reasoning, this alleged “inflation expectations” mechanism could equally be conducted via some sort of inflationary rain dance. I suspect the fly in the ointment is that people aren’t so gullible and, even when they are, they often are constrained by immediate considerations such as bankruptcy and becoming unemployed.

My view is that QE instead acts to make it harder for the central bank to raise interest rates in the future. The more QE we have, the less likely it is that we have an interest rate rise in the next few years. Currently the Federal Reserve pays interest on reserves so as to prevent interest rates falling below 0.25%. The funds to pay for this come from the interest received by the Federal Reserve on the assets in its own portfolio. Thus the interest paid on reserves cannot exceed the interest received from the assets exchanged for the reserves in the first place. Previous episodes where interest rates have been set high have necessarily relied on a scarcity of monetary base such that banks had to bid against each other to obtain it. From where we are today, such scarcity could be brought about only after the current excess stock had been vastly diminished by government budget surpluses or rendered insignificant by inflation and economic growth. The price impact of any attempt to sell off the Fed’s portfolio of longer maturity assets would thwart any attempt to use such sales to gather back enough of the excess monetary base to induce a scarcity.

A receding risk of future significant interest rate rises does constitute an genuine and rational “expectations” channel BUT it is all about interest rate expectations and not inflation expectations. People may be more willing both to take on more debt and to lend when assured that rates are not going to rise. Central banks have recently offered “forward guidance” saying that they are not going to raise rates for the next year or so. Perhaps QE serves as a demonstrable “bridge burning” exercise that adds considerable heft to such forward guidance. The central bank puts itself into a position where it no longer has any capability to significantly raise interest rates even if it were to want to.

I am not convinced however whether even the certainty of zero-interest rates for decades is really enough to cure an economic depression. To me it looks more like a palliative measure that kicks the can down the road allowing the current imbalances to be perpetuated for a bit longer so debt burdens are serviced rather than defaulting. Debt burdens may be maintained but there is only so much revenue that can be passed through as debt interest if those payments don’t somehow circulate back around from the creditors to the debtors. Expectations of zero interest rates won’t induce such circulation.

Perhaps some of the rationale for the belief in the monetary base setting prices stems from ideas of how the gold standard led to long term price stability. During the gold standard period both in the USA and the UK, prices oscillated but over the long term, inflations were matched by deflations. Subsequently, since leaving the gold standard there has been a steady overall inflation. However the gold standard had its effect by forcing monetary tightening that foreshortened boom periods.  When credit expansion and increased economic activity outgrew the capacity of the monetary base provided by the stock of monetary gold, a tight money recession would lead to debt write downs, fire sales of assets and inventory and a consequent resetting of prices such that the monetary base was once again sufficient. Note that there is a clear mechanism by which insufficient monetary base curtails nominal growth and price rises BUT that is totally different from imagining that adding more monetary base will raise prices when the current stock of monetary base is more than sufficient and yet prices are suppressed due to other constraints.

As mentioned above, in the Great Depression there was a glut of monetary base and interest rates were at the zero bound. The trade surplus between the USA and Europe and the WWI debts that Europe was saddled with had caused a massive transfer of gold from Europe to the USA. That together with the newly created Federal Reserve system, allowed the 1920s boom period to extend for longer than was typical under the gold standard system. Credit growth continued for longer. Eventually debt fueled consumption and speculation could no longer be sustained as funds failed to recirculate from creditors back to debtors and the crash and depression ensued. Perhaps the Great Depression was a manifestation of the more extensive polarisation between debtors and creditors that had built up due to the extended 1920s boom on top of all of the accumulations from the industrial and agricultural developments of the previous century.

Another key assertion from Scott Sumner is that hyperinflations demonstrate that, “Monetary stimulus can make NGDP grow as fast as you like, as we saw in Zimbabwe”. I think it is very misleading to describe such currency slide hyperinflations as being driven by central bank balance sheet expansion. They are typically the result of futile attempts to service unpayable foreign currency denominated debt burdens and in the worst cases also have involved massive supply shocks from loss of production due to political conflict. If bizarrely such a scenario were chosen on purpose, it would not be in the central bank’s power to induce it. The Treasury would need to take on such foreign currency denominated debt and the security services would need to damage productive capacity so as to induce a supply shock. The central bank obviously takes part by way of supplying the ballooning monetary base BUT that is entirely different from claiming that central bank balance sheet expansion provides sufficient cause.

There is however one clear example of monetary policy successfully raising prices during the Great Depression. In 1934 the exchange rate between the US dollar and gold was reset from $20.67 per ounce to $35. That did reset the prices of imports since at that time gold was the unit of account for international trade. It has to be stressed however that after that point in the Great Depression, the fixed  $35 per ounce gold peg acted to limit appreciation of the dollar. If the dollar had been a free floating currency, the price of gold would have fallen in dollar terms as evidenced by the considerable inflows of gold sold to the US Treasury in exchange for dollars. I guess in principle the monetary authorities could have made a commitment to continuously devalue the US dollar against gold by say 10% per year every year. That would obviously have had the primary effect of simply inducing an  impetus to hoard gold. At the time US citizens were prohibited from owning gold so it might instead have acted to induce holding of foreign currency or other stores of value such as other metals, diamonds, art work or land. It would undoubtedly have also instigated a worsening of the international trade disputes and barriers that already bedevilled the period. Perhaps it would have brought forward abandonment of the gold standard by all of the other countries and so rendered the policy impotent. What I am not convinced it could have done is to have shifted spending towards employing and providing for the American people.

I think the crux of this debate revolves around the attempt to shoe horn four contrasting economic conditions of prosperity, inflation, deflation and “tight money” into an overly simplistic model where prosperity is conflated with inflation and deflation is conflated with “tight money”. A simplistic view that sees a straight axis of inflation/prosperity to deflation/“tight money” leads to policy designed to remedy the “tight money” condition being deployed even when there is deflation in the hope that it will be inflationary in the hope that that will cause a shift towards prosperity. In reality many factors need to be in place for prosperity to prevail. Prosperity requires a financial system that supports the wide population in making full use of their talents and property so as to provide whatever is wanted by anyone. It requires a delicate balancing act where financial power is sufficiently distributed to the most competent and yet needs to include the whole of the population such that no one’s potential contribution or needs are left out. Throughout the 1980s and 1990s, many “third world” countries exhibited stalled economic development with mass unemployment and underemployment in conjunction with inflation due to sliding currency values. Wealth polarization with economic exclusion of much of the population and political cronyism will ensure an economic depression irrespective of the inflation level. Tackling those issues is beyond the scope of monetary policy.

Related previous posts

Fiscal autopilot

Bail out the customers not the banks.

Rich people could benefit if everyone else were also rich.

Political Consequences of risk free financial assets

Sustainability of economic growth and debt

direct economic democracy (pdf)

Related stuff on the web:

U.S. Monetary Policy & Financial Markets – Ann-Marie Meulendyke, Federal Reserve (ht Mark A Sadowski)

Testimony of Marriner Eccles at Investigation of Economic Problems 1933

Leash the Dogma -John P. Hussman

Quantitative Easing: Entrance and Exit Strategies- Alan S. Blinder

The United Kingdoms’s quatitative easing policy: design, operation and impact -Joyce, Tong and Woods, Bank of England

Deflation: Making Sure “It” Doesn’t Happen Here -Ben S. Bernanke

The Macroeconomic of the Great Depression: A comparative approach -Ben S. Bernanke

Why (and when) interest-on-reserves matters… -Interfluidity

Some Peculiar Dynamics with Long Term Money Neutrality -Nick Edmonds

1682 days and all’s well -JP Koning

Rates or quantities or both -JP Koning

The Case Against Monetary Stimulus Via Asset Purchases -Ashwin Parameswaran (link added 30nov2013)

A non-monetary explanation for inflation -Matt Busigin (link added 27dec2013)

Money creation in the modern economy-Bank of England (link added 19march2014 ht JKH)