The Monetary History of the United States

Paul Krugman notes that we now have an ongoing test of Keynes-Bernanke vs. Friedman-Schwartz accounts of the Great Depression:

Paul Krugman: Has anyone else noticed that the current crisis sheds light on one of the great controversies of economic history? A central theme of Keynes’s General Theory was the impotence of monetary policy in depression-type conditions. But Milton Friedman and Anna Schwartz, in their magisterial monetary history of the United States, claimed that the Fed could have prevented the Great Depression — a claim that in later, popular writings, including those of Friedman himself, was transmuted into the claim that the Fed caused the Depression.

Now, what the Fed really controlled was the monetary base — currency plus bank reserves. As the figure shows, the base actually rose during the great slump, which is why it’s hard to make the case that the Fed caused the Depression. But arguably the Depression could have been prevented if the Fed had done more — if it had expanded the monetary base faster and done more to rescue banks in trouble. So here we are, facing a new crisis reminiscent of the 1930s. And this time the Fed has been spectacularly aggressive about expanding the monetary base: And guess what — it doesn’t seem to be workiing.

I think the thesis of the Monetary History has just taken a hit.

Comments

[Bruce Wilder]

Well, I noticed, but, then, I think both Bernanke and Friedman were wrong about the Great Depression. But, I was also under the impression that Bernanke basically agreed with Friedman that the Fed could have prevented the Great Depression. Bernanke's difference with Friedman was about how to execute that prescription; Bernanke, pro-central-bank, thought the Fed could have done good, by being very, very aggressive about preventing the collapse of the banking system and, maybe even, substituting inflation for deflation. Friedman's policy inclinations were more passive and ambiguous.

So, I'm a bit confused. The course of the present crisis is very rough on the Friedman-Schwartz account -- and pretty rough on the Bernanke account, as well, truth be told -- but where's the alternative hypothesis hiding? Where's the alternative hypothesis that takes some account of trends and events in the so-called "real economy"? Where's electricity, automobiles, rising farm productivity and falling agricultural prices? Where's the struggle over extremes of income distribution?

Amity Shlaes and Cole and Ohanian are at the ready, to assure us that driving down wages would have rescued the U.S. economy from the Great Depression ever so much faster than FDR's New Deal. Are they the alternative hypothesis? If so, may the Lord have mercy.

[Brian g]

by what basis are we judging that "it doesn't appear to be working?"

We are not seeing massive deflation, massive unemployment spikes (23%), starvation, massive GDP contraction.

Agreed, it's not a magic bullet, but neither is deficit spending. The opposing thesis (keysian spending) is at least as flawed as the Friedman thesis, and comes with the added disadvantage of claiming real future cash flows.

[Denis Drew]

Here is an alternative hypothesis (my one note tune of course):

Boost the economy in a radical way for America -- conventional, almost old fashioned for the rest of the modern OECD world -- pay labor the maximum its utility will justify, not the least that monopsony can squeeze its price down to.

Quickest jump start for the economy -- with only $350 billion? Which the taxpayer wont have to ante up?

Double the federal minimum wage which will shift about $350 billion (2 1/2 % of the cost of GDP output or 4% of personal income share) into the pockets of the 40% lowest wage Americans -- who would spend it not save it. ($500/wk -- today's 40 percentile wage! -- still not be enough to cover a realistic minimum needs budget for a family of two -- today's 40 percentile wage!).

2 1/2% is about how much GDP grows every couple of years. If everyone got their inflation raises but forwent their growth raises, a doubling of the minimum wage could pass almost unnoticed for half the country.

Doubling the minimum wage would only be the beginning of the larger overhaul of our underpaying labor market. Re-institute fair and balanced bargaining power via sector-wide labor agreements. Only sector-wide collective bargaining has the potential to eventually shift the other 11% of income share lost by the bottom 90% of earners (15% altogether) to the top 3% over the past three and a half decades.

Takes years to raise the minimum wage (three years?; $1 every 6 months?)? Would take time to convert our labor market to even the French-Canadian "lite" version of sector-wide (in French-Canada non-union firms merely accept terms worked out by non-union firms)? Once 90% of the workforce are assured they are in for (continuous) raises, in proportion to their propensity to spend, IOW in proportion to how unnecessarily (working) poor they are now, everyone's wallets will open up again.

[MattYoung]

A one trillion dollar test of the theory!

[David]

But monetary policy did end the Great Depssion as shown by Christina Romer & others. Yes, it was unconventional monetary policy–-FDR devaluing dollar, gold inflows from abroad, Treasury choosing not to sterilize the inflows–-but at the end of the day it was a policy choice to allow the money supply to expand that ended the depression. See more on this point at http://macromarketmusings.blogspot.com/2008/11/monetary-policy-ended-great-depression.html

[Barry]

Brian g: "We are not seeing massive deflation, massive unemployment spikes (23%), starvation, massive GDP contraction."

IIRC, the Great Depression did not happen in 1929; things unfolded over 1930, at least, to show that it wasn't just a market crash + recession. How do we compare on a day by day timeline? And when would 'the Crash' be dated for the current melt-down? It seems to be a slow-motion disaster, which, of course, might be what the current policies are doing - cushioning and delaying a shock, but not preventing the decline.

[Denis Drew]

http://hnn.us/articles/55614.html...
...at which history professor James Livingston explains simply that if business squeezes too much money out of labor, then, demand drops and business has no healthy place to invest its excess profits (plant and equipment) and heads out in search speculative paper which the only alternative (dot.com start ups with no realistic business model, risky real estate): leading us from bubble to bubble.

http://hnn.us/articles/55368.html...
...at which Livingston saith:
"By 1937, industrial output and national income had regained the levels of 1929, and the volume of new auto sales exceeded that of 1929." "That rising demand was a result of net contributions to consumers’ expenditures out of federal deficits, and of new collective bargaining agreements, not the eradication of unemployment."

[MattYoung]

I clicked through Denis's links to the articles by Dr. Livingston.

He is relatively unclear as to why, in the 1920s income distribution became unstable, except to mention in passing the new technologies increased production efficiency. He should be more specific.

Why wasn't the new technology, yielding more efficiency, resulting in lower prices? If he implies a delay, then why the delay in lowering prices at this (1930s) time, as opposed to other times.

He might claim that technology arrived to fast for adjustment, but what adjustment was needed?

He didn't take the argument far enough. His argument, to complete it, is that the new technology changed the method of goods distribution such that transportation bottlenecks resulted. The bottlenecks were severe and required many years to resolve, and they were resolved piecemeal. The revolutionary technology that caused the change was very inexpensive, information transfer.

So, you had a rapidly deployed information technology and a much slower transportation infrastructure trying to catch up. The old method of goods distribution, without the new information technology, was abandoned early because it shows much less efficiency.

Go back to an article Brad posted over a year ago on the McGill university study of medieval wheat yields. The author showed that our ability to grow wheat in high yields resulted from bottlenecks in transportation, it was cheaper to develop high yields on smaller plots close to the city then ship from larger, lowering yielding fields. My conclusion then was that we know more than we do, we are restricted by the cost of goods transportation.

We now know a lot more about the value of goods, we are stubborn, and await the transportation upgrades so we can get goods distributed in a manner that matches what we know.

[Daniel Reeves]

@Denis Drew:

"Quickest jump start for the economy -- with only $350 billion? Which the taxpayer wont have to ante up?

Double the federal minimum wage which will shift about $350 billion (2 1/2 % of the cost of GDP output or 4% of personal income share) into the pockets of the 40% lowest wage Americans -- who would spend it not save it."

Oh, boy, another person who comes into one of these topics to spout his off-topic ideas on how we should get through the recession. This one is especially interesting because he seems to think the minimum wage is a magic bullet.

Really, the last thing we're going to want to do right now is raise the minimum wage. Actually, raising the minimum wage at any time is a pretty bad idea compared to other policy alternatives such as raising EITC funding (see the CBO link at the bottom of this post). But especially now, you don't want to raise the minimum wage... You know, because the minimum wage basically acts as a tax on low skilled labor, paid for by those who hire the labor, and at this time we have a dearth of laborers out there laboring.

If you want to get money into the hands of low wage Americans who are more likely to spend it... just give it to them already. Sheesh. Wage is a straw man. What we care about is income. That's why we have the EITC, and the EITC's inability to distort the labor market with a price floor is why it's so much more desirable than the minimum wage (and even if the price floor doesn't do much in the first place, I guarantee that the EITC does less). I'd say to get rid of the minimum wage altogether and replace it with a huge boost in the EITC, but it's politically unfeasible because people are so convinced that people need "living wages" as opposed to simply "living incomes," the latter of which being better provided through the EITC.

http://www.cbo.gov/ftpdocs/77xx/doc7721/01-09-MinimumWageEITC.pdf

[nathan]

"It seems to be a slow-motion disaster, which, of course, might be what the current policies are doing - cushioning and delaying a shock, but not preventing the decline."

The decline this year was fairly steep and quick. How did the steepness compare to previous declines? One might say it is possible that one positive aspect to the current decline is that we did not take 3 years to see the S&P 500 drop around half.

Many people may be exhausted and do not want to spend money - even if interest rates are low. It has not been easy since the year 2001.

[CN]

It's probably only a contributing factor, (since financial machinations bear a large part of the blame), but the constant pressure to lower real wages over the last 20 years has finally come home to roost. Henry Ford realized that by paying his workers decently, they could afford to buy his product, thus creating his own market. Somebody seems to have forgotten that, or, more malevolently, assumed that the working class and middle class would keep buying no matter what was done to them. And they did, by burying themselves in debt, until they could no longer sustain it.

Sounds suspiciously by the 1920's, doesn't it? Republican economics at his finest.

[Denis Drew]

Daniel Reeves,
To stay on topic as much as possible -- for a moment anyway -- raising low incomes is an avenue of stimulus that is open because they have fallen so unnecessarily low that there is a lot of HEADROOM -- the opposite of the case with the fed interest rate which has run out of room to go lower. From the standpoint of stimulus, doubling the minimum wage and instituting sector-wide labor agreements just happens to be a still available tactic because they have so much natural room to climb.

Now to get off topic I had an idea last night that our hellish housing projects and drug dealing ghettos are today's "Hoovervilles" -- a direct result of what I call the "Great Wage Depression", A.K.A., "inequality", the latter a weak expression for those who understand the unnecessary cratering of wage levels in the almost wholly unprotected US labor market.

Ghetto schools don't work. Why should students kill themselves to prepare for jobs whose pay levels appeal only to immigrants desperate to hang on in America? The EITC isn't going to spur a natural level of student motivation either. Why not just pay them; sheesh? :-)

What happens when the minimum wage is raised is not what that old one-dimensional price-demand chart suggests. Economics is three-dimensional. When income is shifted by higher prices, folks who pay more get less then they used to but folks who get paid more spend more than they used to. The Illinois state minimum wage recently went pretty quickly from $5.15/hr to $8.00/hr. My neighborhood McDonalds enjoyed an obvious uptick (agreed by others I eat with) in business, all in the third world end: minimum wagers now able to afford what they sell?

Talking about the minimum wage or unions etc., tends to be automatically off topic on progressive economic blogs. Never hear either mentioned unless they are part of some long list of inadequate (in quantity) steps to address so-called "inequality" -- and then no discussion.

[Daniel Reeves]

@Denis Drew:

"My neighborhood McDonalds enjoyed an obvious uptick (agreed by others I eat with) in business, all in the third world end: minimum wagers now able to afford what they sell?"

I have trouble believing your anecdotal evidence solely based on the fact that McDonald's is already insanely cheap, and everybody needs to eat food. About three hours ago, I had a McChicken, and it was only one dollar! It was so good and cheap that I bought another.

You still haven't convinced me that our main concern should be people's incomes (and not wages), of which wages are a part. And, for the record, I haven't denied that the minimum wage reduces inequality. What I argue is that it's a rather inefficient and cumbersome way of reducing inequality, especially during a recession.

[Denis Drew]

Daniel Reeves,
On topic: I don't know; $350 billion more in the hands of people who will spend all of it doesn't sound too "inefficient" a stimulus to me. Remember that 350 only represents 4% shift in overall income out of the 15% I want to shift back to people who people who will save less and spend more. Again, it may take years to affect the shift but once 90% of earners fully understand it is coming to the them that should loosen up the purses.

Off topic (but my favorite subject): I'm so glad you think Mac is super cheap anyway because fast food is by far the highest user of labor and minimum wage labor at that. If fast food bus' isn't hurt -- hopefully even helped by funneling more bucks to its most likely customers -- there is no reason it should hurt any business (except maybe Cartier).

Paul Krugman did an quick essay on higher wages tending to ameliorate a depression economy this morning:
http://krugman.blogs.nytimes.com/2008/11/29/changes-in-money-wages-and-amity-shlaes/

[joel]

[wherein I bravely thrust myself between Denis and Daniel]

I am not an economist. I am here as a student, observer, and citizen. With that said.

The fundamental problem now, as in 1929, is that there is a surplus of investment dollars relative to consumer dollars.

We pretend that all dollars are equal, but they are not. Consumer dollars drive the economy. People have money, so they go to market and buy things they find necessary or useful.

Investment dollars have economic utility as well, provided they are used to create jobs and increase wages (that is, investment dollars are economically useful if they can be turned into consumer dollars). This drives the business cycle and results in more dollars all around -- more consumer dollars, and more investment dollars because investors take part of business profits as gains on their investment.

In an idealistic well-functioning economy, consumer dollars and investor dollars would increase in rough equilibrium and the economy would grow at a pleasing and steady rate forever.

In 1975 the supply-side school was formed and argued that the economy could be grown faster by letting investors keep and invest more of their dollars. Those dollars would be used to create jobs and wages (consumer dollars); workers would make things; then they would go to market and buy things; and so forth.

But, that's not how things happened in practice. Instead, investors decided that rather than splitting profits between investment dollars and consumer dollars, they would rather take more investment dollars for themselves. Companies were merged and jobs were cut. Unions were busted and wages suppressed. Factories were off-shored and jobs lost. Business investment was reduced and stock dividends increased. Business focus shifted away from long-term growth strategies and toward quarter-over-quarter revenues.

All the while, aggregate consumer dollars have been flat or falling while aggregate investment dollars have been massively increased. At some point the scales became tipped to an extreme such that there were just too few consumer dollars to drive the economy. If this was bad for consumers, it was equally bad for investors. With business profits stagnating there was no more opportunity to create new investment dollars from old. What to do, what to do?

The solution took at least a couple of forms. One was to take greater risk by investing money into speculative new economies. The chief example is the dot-com boom of the 1990s. At least in the short-run, investor dollars were turned into consumer dollars which fueled the economy at a very heated pace for a while. If investments and business models had been more sound, we could actually have seen a supply-side success story. But they weren't and we didn't.

The other form for driving the economy was the modern easy credit market. There is ultimately only one way to put more dollars in the pockets of consumers: create jobs and increase wages. But contemporary business practice is aimed at reducing jobs when possible and cutting or stifling wage growth. Again, what to do? The answer was to use tomorrow's wages to pay for today's consumption, all underwritten with investment dollars. Investors freely loaned their dollars to consumers. Consumers used tomorrow's wages to pay for today's consumption, paying a premium to investors along the way. So, tomorrow's consumer dollars plus today's consumer dollars were turned into investment dollars. But the fundamental problem is that due to stagnant or falling aggregate consumer wages, tomorrow's consumer dollars are not sufficient to cover both tomorrow's consumption plus today's consumption, and we have collectively maxed out on our credit limits.

--

To the point of monetary theory:

Monetary policy can be a part of the solution, but not the entire solution, to our current problem.

Using monetary policy to relax the credit markets is precisely the wrong solution because, in the present case, relaxed credit markets are the problem to start with. The right approach is to allow a controlled and modest rise in inflation and wages, with a simultaneous controlled and modest devaluation of debt obligations. This will create some pain for investors, because they will see their investment values weaken. But weakened is better than crumbled.

This will also tend to drive employment down, which is why Keynesian fiscal stimulus is so important to drive the recovery.

There are two ways for the government to do this.

The first is to simply give consumers money, in the form of tax credits or unemployment benefits or make-work or what have you. This works well for mild recessions but its value is short-lived when dealing with larger systemic collapse.

The second is to use government funds to directly create jobs and drive industry. The wisest course is to create first-generation dollars in the form of jobs, and second-generation dollars in the form of continued economic utility. Build the public infrastructure. Build wind turbines and solar panels and a new, green energy grid. Build light rail in cities and high-speed rail between cities. Promote urban development around multi-use neighborhoods where city dwellers can live-work-play in a fairly small geographic area. String broadband lines into the rural nooks and crannies of the plains so small-town Americans can catch up to the information age. Design agriculture policies not to subsidize legacy surplus crops but to create demand for the necessary crops to meet tomorrow's needs.

Along the way, we need to revisit HOEPA and lending standards in general so we don't repeat today's errors in the future. We need to allow expanded Chapter 13 reorganization, to include primary-residence mortgages, so consumers and investors can have the assurance that debt can be paid off and the debt-to-income picture can be normalized. We need to reinstate progressive taxation (of capital income as well as wage income) and estate taxation so that too-excessive investment dollars can be returned to consumer dollars and so maintain the equilibrium. We need to get back to healthy job creation and wage growth that keeps consumers and investors advancing in tandem.

---

I've heard it said that building infrastructure leads to a slower recovery than other forms of stimulus. But here's a personal anecdote.

I spent Thanksgiving in a rural farmhouse that first received electricity thanks to the Rural Electrification Program, and still gets serviced by a descendant of the local REP electrical cooperative. The attached family farm generated millions of dollars in income over the last 80 years, but once almost fell to bankruptcy save for the efforts of the AAA.

To get to and from the family homestead, I drove along the Interstate Highway system. For the last mile, I was on local roads and had to stop for a while as a train passed. That train ran along tracks that carried my great-grandfather's cotton and grain to market for decades.

Infrastructure improvement might lead to a slow recovery, but it's a damned sure recovery that reaps economic rewards for decades to come. From 19th century railroads to the New Deal to Ike's highway program, public infrastructure investment has reaped economic benefits to generation upon generation.

[SMG]

What Lauchlin Currie's point: What was the Fed doing raising interest rates (to burst the stock market bubble) when world prices were facing downward pressure at the time?

[SMG]

Oops. The above should read:

What about Lauchlin Currie's point (JPE, Apr 1934): What was the Fed doing raising interest rates (to burst the stock market bubble) when world prices were facing downward pressure at the time?

[Thesis Writing]

the financial crises are effecting to all countries