The Fed's Monetary Expansion Isn't Necessarily a Failure

Paul Krugman argues on his blog that Milton Friedman and Anna Schwartz's Great Depression hypothesis has "taken a hit":

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.

Krugman backs up his position by charting the monetary base during the Great Depression and today to show that, in both eras, supply increased.

But here's another obvious view of the same data. The following chart plots year-over-year growth by month in the monetary base during the Great Depression (in blue) as well as money growth this time around (in red).

If one thing is painfully obvious it's that the kind of monetary expansion we're seeing now didn't start until at least three years after the onset of the Depression. This isn't to say Friedman and Schwartz are in the right, but that it's WAY too early to think they're wrong.

(Note: My starting point for both plots is the beginning of that era's recession, which for our times I assume is the beginning of this year. If we change the starting points to Aug. '07 and Oct. '29 (credit crunch/stock market crash), the gap narrows by about half a year.)

Comments

[Steven Hansen:]

the fed's monetary expansion has stopped a credit default cascade. i never assumed it would act as an economic stimulus. it has just given us time to try to repair and unwind the damage already done.

2008 Dec 01 03:00 AM

[Smarty_Pants:]

"This isn't to say Friedman and Schwartz are in the right, but that it's WAY too early to think they're wrong."


So you're saying we should expect economic recovery about 5 or 6 years after the 'big stimulus' like it took back in the 30s and 40s?

Don't worry folks, by 2014 things will be A-OK. Until then, expect hard times.

2008 Dec 01 10:16 AM

[flow5:]

Krugman knows very, very, little about money & central banking. E.g., the monetary base is not a base for the expansion of money & credit. Legal reserves are that base. Friedman and Schwartz come up short as well.

It's not an exaggeration to say that the Fed could have prevented the Great Depression. But it is impossible to say that the Fed was responsible for it's duration. That was the era where Keynesian "pump priming" was required to extract the country from desparate times. And it wasn't until WWII that this remedy was achieved.

2008 Dec 01 04:00 PM

[Vigilance:]

Clever argument but it doesn't wash. Inflation can result from two causes: Inflating the supply of paper money ( like watering down the soup) and fractional reserves...loaning more than you actually have. Inflating the money supply wasn't necessary ( from their standpoint) back then because Roosevelt confiscated everyon'es gold ( without due process). But margin requirements were extremely low, until the Fed slammed on the brakes by suddenly tightening credit.
End the Fed, restore gold and demand that the government abide by the Constitution.

2008 Dec 01 04:02 PM