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

by: Zubin Jelveh

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.)

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