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 Explaining the Great Depression and failures of "New" Keynesian interest rate suppression policy without ideological clap trap, theory confirmation bias or political spin.

Table of Contents & Introduction
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A MONETARY HISTORY OF THE UNITED STATES (1867-1960)
by
Milton Friedman & Anna J. Schwartz

Part III: The Age of Chronic Inflation (1933 to 1960)

Page Contents

Outline of Monetary History (1933-1960)

New Deal (1933-1939)

History of Monetary Silver (1792-1960)

New Deal Failures & Successes

Monetary Policy During World War II (1939-1948)

Monetary History During the Cold War (1949-1960)

Velocity of Money (1867-1960)

Impacts of Monetary Fluctuations

FUTURECASTS online magazine
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Vol. 9, No. 7, 7/1/07

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Introduction:

 

 

&

  The monetary role of gold in the United States and the world was greatly reduced by New Deal policies, Milton Friedman and Anna J. Schwartz explain in "A Monetary History of the United States (1867-1960)." As a result, as might be expected, the United States and nations that pegged their domestic currencies to the dollar persistently suffered fluctuating levels of inflation from 1933 through 1960 (and entered an age of chronic inflation).
 &

  The narrow focus of this book is emphasized by the authors. The money stock is influenced by other economic factors and influences those other factors in turn. Monetary factors played a major role in the economy's cyclical movements, "and conversely, non-monetary developments frequently had major influences on monetary developments; yet even together," there is much in business cycle history that they acknowledge is not covered in the book.

  At a few strategic points in the book, the authors insert a sentence to remind us of this, but occasionally they themselves seem to forget it. As a result, they sometimes overstate the role of monetary factors and the power of monetary manipulation to alter cyclical economic events.
 &
  This weakness appears most dramatically in the book's discussion of the Great Depression. This would be just a minor weakness in this otherwise masterful book - if not for the tendency of many of those who follow Milton Friedman's views to also overlook the limitations of monetary manipulation - and for the dramatic assertion by the authors in the book's conclusion that a more aggressive monetary policy response to the Great Depression by the Federal Reserve System "would have cut short the spread of the crisis, would have prevented cumulation of bank failures, and would have made possible, as it did in 1908, economic recovery after a few months." See, Friedman & Schwartz, "Monetary History of U.S.," Part II, "Roaring Twenties Boom - Great Depression Bust," at sections E) "Great Depression Bust," and F) "The Power and Limitations of Monetary Policy." See, also, section H) Conclusion: The Impacts of Fluctuations in the Money Stock," below.
 &
  Allan Meltzer takes an even more extreme view of the power of monetary manipulation. See, Meltzer,  "A History of the Federal Reserve, vol. 1 (1913-1951)," Part I, "The Search for Stability (1913-1923)," Part II, "The Engine of Deflation (1923-1933)," and Part III, "The Engine of Inflation (1933-1951).

High-powered money and bank system money:

  The total money stock includes currency held by the public plus money created through deposits in the commercial banking system. 
 &

Under the New Deal, the retirement of the national bank notes was provided for, but as of  the end of 1960, there was still an estimated $55 million in circulation. Much of this had undoubtedly been lost or destroyed after almost a century of circulation, and much is secluded in numismatic collections. With the nationalization of gold, the currency included Federal Reserve notes, silver certificates and subsidiary silver and minor coins.
 &
  Money that can be used as liquid reserves
for bank deposits is considered "high-powered" money, since the fractional reserve banking system serves to increase the total stock of money. In 1867, the public held about $1.20 in deposits for each $1 in currency. This rose quickly to $2 by 1873, reflecting the rapid rise of the commercial banking system. It stayed about at that level until 1880, rose -with numerous spikes and troughs - to $12 in 1929, and then fell sharply during the Great Depression - recovering just to $6 for each $1 in currency in 1960. See, Friedman & Schwartz, "Monetary History of U.S." Part I "Greenbacks and Gold."
 
&
  A bank deposit available to the depositor on demand is money to the depositor as well as money to the borrower from the bank. The larger deposits are in relation to reserves and in relation to the currency in the hands of the public, the more bank system money is being created.
 &
  The amount added to the money stock by bank deposits depends both on the willingness of the public to use the banking system, and the amount of deposits bankers are willing and able to lend to the public over and above retained reserves. This addition to the money stock is calculated using two bank deposit ratios - the "deposit to currency" held by the public ratio and the "deposit to reserve" ratio.  It can include time deposits if in practice they can be withdrawn on demand. Inclusion of other short term liquid assets results in broader measures of the money stock that are outside the purview of this book.
 &
  The confidence of the public in the banking system, and the confidence of the bankers in the stability of the economy and the financial system are key variables. The government controlled variables include bank reserve requirements and government additions to high-powered money.
 &
  General or consumer prices continue to be referred to as "implicit" prices throughout this part of the book.
 &

A) Outline of Monetary History (1933-1960)

The search for stability:

 

Federal deposit insurance ended the occurrence of periodic bank panics that had plagued the economy.

 

 &

  The New Deal reaction to the Great Depression included:

  • The enactment of federal deposit insurance, which assured confidence in the banking system and ended bank panics. Bank failure thereafter became a rarity (until the savings and loan crisis of the 1980s).

  • Enhancement of the powers of the Federal Reserve Board (the "Board"). It was given authority over bank reserve requirements.

  • The abandonment of the gold standard. Monetary gold was nationalized, melted into bullion, and limited to use for settling foreign payments balances.

The U.S. government was no longer so concerned about its credit or its creditors as after previous major conflicts, so monetary inflation became viewed as a convenient means of paying down government debts and price inflation became chronic.

 

"No country succeeded in curbing inflation without adopting measures that made it possible to restrain the growth of the stock of money."

  With the reopening of the banks in 1933 and the restoration of confidence in the banking system, deposits and money supply rose sharply. Soon, political turmoil and then the threat of war in Europe sent gold fleeing from Europe to the U.S. The Board responded by doubling reserve requirements over a six month period beginning in 1936. This coincided with a sharp relapse in the Depression in 1937 and 1938, which was probably worsened by the Board action and may actually have been triggered in substantial part by that action.
 &
  During WW-II, the money stock grew 2 1/2 fold. When price controls were lifted after the war, prices responded with a sharp increase (about 50%), reflecting the full extent of WW-II inflation. The Korean War saw further sharp increases in money supply and price inflation. The U.S. government was no longer so concerned about its credit or its creditors as after previous major conflicts, so monetary inflation became viewed as a convenient means of paying down government debts and price inflation became chronic.
 &
  The connection between rapid monetary growth and price inflation has been confirmed by experiments throughout the world, the authors note. "No country succeeded in curbing inflation without adopting measures that made it possible to restrain the growth of the stock of money."
 &
  In the post WW-II period - from 1948 to 1960 - the money stock grew at a rate of almost 3% per year while money income grew at 5%. In the previous years covered by this book, money had expanded faster than money income. The authors suggest that this ability of money to support more income after WW-II - to increase its "velocity" - was due to the increase in confidence in the stability of the economic system

B) The New Deal (1933-1939)

Banking and currency reform:

  Emergency banking and currency measures were enacted during the banking holiday.
 &

  The 1933 Emergency Banking Act extended the President's wartime powers over banking and currency to peacetime national emergencies. He was empowered to regulate or prohibit payment of deposits.
 &
  The Act provided for the operation and reorganization of certain impaired national banks that otherwise would have been liquidated, and for the issuance of non-assessable preferred stock to recapitalize them. Investors in these bank securities thus - like other stock investors - only risked the sums invested and were not - as heretofore - subject to further assessments to cover bank obligations.
 &
  The Reconstruction Finance Corporation (the "RFC") was authorized to purchase these shares and similar shares from state banks. The Federal Reserve System (the "System") was authorized to make emergency advances to member banks on their own notes secured by any acceptable assets. This provision would be continued in the 1935 Banking Act as authority not limited to emergencies.
 &
  Emergency issuance of Federal Reserve Bank notes without gold reserve backing was authorized on the basis of the face value of government obligations or 90% of the estimated value of eligible paper. There had been a 40% gold reserve requirement up to that time. Over $200 million of these fiat notes were issued. They were thereafter retired as fast as possible up to WW-II.
 &

  The end of the banking holiday came on March 13, 14 and 15, 1933. Less than 12,000 member and nonmember banks began reopening under System and state licensing procedures. Over 2,000 of the 17,800 banks in existence before the banking holiday never reopened.
 &
  The RFC invested over $1 billion in bank capital. This investment constituted one-third of the total capital for all banks - member and nonmember - national and state. These investments helped 6,139 banks - more than half of those immediately licensed to reopen. About 51% of this investment would be retired by February, 1939. RFC loans to banks for distribution to depositors expanded from the approximately $1 billion prior to the banking holiday to $2 billion. The RFC was also active in arranging mergers of weak banks with strong banks.
 &
  Money stock statistics before and after the banking holiday cease to be comparable because of shifts in the treatment of various bank deposits, among other things. The authors provide two alternative estimates, neither of which they have much confidence in. There are problems with circulating currency statistics due to the uncertain treatment of the approximately $50 million in vault cash of unlicensed banks, and about $1 billion of local substitutes for currency.
 &
  The supply of "money" from this time on as used by the authors is currency held by the public plus demand and time deposits, adjusted, in commercial banks. They recognize that there are both narrower views of "money" - without time deposits - and broader views - including a variety of other liquid assets.
 &

  There was rapid economic recovery after the banking holiday ended - much of which was due simply to the immediate reopening of the banking system and the gradual restoration of confidence in it.

  In addition, by this time, the agricultural surplus problem had been solved by the destruction of the stored commodities when prices had fallen so far that the crops were not worth the cost of storage or transport.
 &
  In addition, by this time, the WW-I reparations and international dollar war debts and many post-WW-I international dollar debts had been defaulted - providing the world with a much needed discharge in bankruptcy - at the expense of the U.S. However, these debts were not collectable in any event - due in large part to U.S. tariffs that prevented the debtor nations and business entities from earning the dollar wherewithal to service their debts. It was also due in part to the U.S. monetary sterilization policy that undermined the international gold standard adjustment process during the 1920s and that continued into the 1930s.
 &
  The trade war destruction of international markets - predominantly the result of U.S. policies - was the remaining primary cause of the Great Depression in the U.S. - but was soon joined by the burdens imposed by New Deal command economy experiments as continuing obstacles to full domestic economic recovery. These prevented a return to trend of U.S. economic growth.

The U.S. remained the bull in the international monetary china shop - heedless of the impact of its domestic policies on other nations and on international commerce.

  U.S. gold accumulation policies and  sterilization of gold continued to be a problem for gold standard nations until the total collapse of the international gold standard system in 1936. In addition, U.S. silver accumulation policies drained silver from silver standard nations and quickly caused collapse of those monetary systems, also. The U.S. remained the bull in the international monetary china shop - a young irresponsible giant - heedless of the impact of its domestic policies on other nations and on international commerce.
 &

Deposit insurance with very extensive coverage greatly reinforced depositor confidence in the banking system. Bank panics and widespread runs were eliminated.

  Radical improvements in the nation's banking systems were made by the Banking Acts of 1933 and 1935. The authors emphasize deposit insurance as the most important of the reforms.
 &
  Deposit insurance with very extensive coverage greatly reinforced depositor confidence in the banking system. Bank panics and widespread runs were eliminated. Between 1943 and 1960, there was never as many as 10 bank suspensions in any single year - counting both insured and noninsured banks. But the primary purpose, the authors note, was not so much to protect depositors as to protect the circulating medium.
 &
  Deposit insurance was a creation of Congress, not the New Deal. It was fifty years in the Congressional mill - and was preceded by many experiments among the states. (But, of course, it was the New Deal government that finally got it enacted and thus does deserve credit for it.)
 &

  The Federal Deposit Insurance Corporation (the "FDIC") was created to administer the program. It supplemented and duplicated the powers of existing agencies.
 &
  System member banks were required to join, and nonmember banks could obtain coverage upon application and approval by the FDIC. Deposits were insured up to $5,000 in 1934 - enough to cover more than 98% of all deposits - but this deposit insurance had the effect of protecting all deposits. The limit was raised to $10,000 in 1950.
 &
  There has thus been overlapping authority to examine the various insured banks. Since 1950, in addition to the FDIC, national banks were subject to examination by the Federal Reserve System and the Comptroller of the Currency. State banks insured by the FDIC could be examined by the FDIC and their state banking authorities.  In practice, agreements have been worked out to avoid duplicate examinations.
 &
  The FDIC now gets involved in arranging mergers of unsound banks with strong banks. It facilitates these arrangements by assuming responsibility for losses resulting from depreciated assets. There is thus no contagion, as depositors at other banks remain insured. FDIC insurance thus "tends to reduce the contingency insured against."

  "[Banking] panics have occurred only during severe contractions and have greatly intensified such contractions, if indeed they have not been the primary factor converting what would otherwise have been mild contractions into severe ones. That is why we regard federal deposit insurance as so important a change in our banking structure and as contributing so greatly to monetary stability -- in practice far more than the establishment of the Federal Reserve System."

Earnings were so low on bank assets in the 1930s and 1940s that, instead of offering interest to attract deposits, banks instead began imposing service charges for the service of holding them.

  There were a variety of other banking changes. Eligibility for System membership was expanded to include Morris Plan and mutual savings banks. Branch banking was slightly liberalized. Double liability for stockholders in member banks was eliminated. Their shares were no longer subject to additional assessment to cover bank obligations. Investment banking was separated from commercial banking.
 &
  Restrictions were imposed on bank lending for real estate and for securities and commodities trading - greatly reducing the call loan money market as a convenient means for the investment of secondary reserves. Interest rates on time deposits became regulated by the System for member banks and the FDIC for nonmember banks - and interest payments for demand accounts were prohibited.
 &
  The authors readily debunk the arguments used to justify this government imposed cartel arrangement on deposit interest rates. Earnings were so low on bank assets in the 1930s and 1940s that, instead of offering interest to attract deposits, banks instead began imposing service charges for the service of holding them. Competition thus migrated to the charges imposed and the services offered. There were, as might be expected, continuous problems with fixing the rates of interest thought suitable for time deposits.

  This view is inconsistent with the subsequent assertion by the authors that there was unsatisfied loan demand that would have induced the banks to make productive use of further extensions of System credit into the banking system prior to and during the 1937 contraction. In fact - with occasional blips - the banks were busy increasing reserves throughout this period. The profit inducement to borrow was simply still not there - as reflected in the continuance of extraordinarily low interest rates. Risk perception remained high - as reflected in the spread between short term and long term rates, and the still constrained view of credit worthiness.

The Board was authorized - within statutory limits - to set reserve requirements, an important increase in its monetary policy powers. The Banks were permanently authorized to make advances to member banks on any satisfactory security at any time. The Board was authorized to set margin requirements for bank and brokers loans to securities investors.

  The authority of the Board of Governors of the Federal Reserve System (the "Board") was enhanced and governors were given higher salaries and status and longer terms. The Federal Open Market Committee (the "FOMC") was changed under this new name to consist of seven members of the Board and five representatives of the Federal Reserve Banks (the "Banks"). Board members were now all entitled "governor" and executive heads of the Banks were entitled "presidents."
 &
  The Secretary of the Treasury and similar officials could no longer be members of the Board. Power over monetary policy was effectively transferred to Washington - to the Board and the FOMC. The Banks were required to obtain Board permission for open market transactions for their own accounts. The Banks still shared power with the Board over rediscount rates.
 &
  The Board was authorized - within statutory limits - to set reserve requirements. This was an important increase in its monetary policy powers. The Banks were permanently authorized to make advances to member banks on any satisfactory security at any time. The Board was authorized to set margin requirements for loans to securities investors by banks and brokers.
 &

  These were additional tools of monetary policy. They were tools of control over credit and over its price and use. They were tools of banking supervision.
 &

New Deal economic and monetary policy:

  There were also command economy experiments to establish cartel prices fixed above market levels. The National Recovery Act (the "NRA") promulgated "codes," and the Agricultural Adjustment Administration established production controls.
 &

Surviving banks stressed liquidity in their excess reserve positions and by favoring shorter term securities and marketable securities over loans. This continued throughout the 1930s.

 

Bank standards for loans became extraordinarily tight. Working capital loans of sound businesses were liquidated.

  Surviving banks stressed liquidity in their excess reserve positions and by favoring shorter term securities and marketable securities over loans. This continued throughout the 1930s.

  This fact, too, is inconsistent with the subsequent assertion by the authors that there was unsatisfied loan demand that would have induced the banks to make productive use of further extensions of System credit into the banking system prior to and during the 1937 contraction.

  As a result, banks soon held 50% of the U.S. bills - which mature in less than one year when issued - and notes - which mature between one and five years when issued. U.S. bonds mature in more than 5 years when issued. The demand for these bills and notes was such that yields dove to ridiculous fractions of one percent (0.014% in 1940). This increased the attractiveness of holding cash, since little interest income was being given up.
 &
  Most important at that time, bank standards for loans became extraordinarily tight. Working capital loans of sound businesses were liquidated. One study found "a genuine unsatisfied demand for credit on the part of solvent borrowers, many of whom could make economically sound use of working capital." This had, of course, serious implications for the prospects for recovery. It was not until after 1940 - during and after WW-II - that this extraordinary degree of bank "liquidity preference" began to dissipate. (The problem was the adverse shift in perceived credit worthiness - not mere solvency.)
 &
  Even as late as 1960, member bank statistics show a substantial shift in favor of marketable securities rather than loans - although not nearly as great as during WW-II. WW-II financing statistics, however, cannot be evaluated without considering government wartime interventions in the credit markets.
 &
  Here yet again the authors argue that the large "excess reserves" kept by banks in the 1930s were there because the banks wanted them - not because they could find no use for the funds. A monetary policy designed to expand bank assets would have expanded these assets above desired reserve levels and would have been used for investments and loans, they assert. It would have provided stimulation for the economy - more than mere "pushing on the end of a string." The demand for more credit for productive purposes existed.

  This view is inconsistent with the authors' acknowledgement of how low profits on bank assets remained throughout this period. If there really was that much unsatisfied loan demand by borrowers perceived as credit-worthy, interest rates charged and bank profits realized would have been higher.
 &
  The authors acknowledge that interest rates actually declined during the 1933 to 1937 period despite the renewal of economic activity. They acknowledge that banks were imposing service charges on depositors rather than competing to attract additional depositors. The authors indicate no apparent awareness of these inconsistencies.

The gold exchange standard:

  The FDR administration nationalized gold in 1933.
 &

Gold payment clauses in public and private contracts were abrogated - an action upheld by a 5-to-4 decision of the Supreme Court.

  It ordered holders to surrender gold and gold certificates above $100 in return for other currency or deposits to be provided at the legal price of $20.67 per fine ounce. Exceptions were made for industrial and artistic use in reasonable amounts, and for rare coin collections. The "export" of gold was forbidden unless authorized by license from the Secretary of the Treasury.
 &
  Most of the estimated $1,220 million was turned in, but well over an estimated $287 million in gold coins remained unaccounted for at the beginning of 1934. Gold certificates continued circulating as ordinary currency, but in ever declining amounts - estimated at just $30 million in 1960. Gold payment clauses in public and private contracts were abrogated - an action upheld by a 5-to-4 decision of the Supreme Court.
 &
  The dollar remained stable for more than a month after the end of the banking holiday. After all, the U.S. had more than enough gold to resume gold payments as it had after similar emergencies in the past. However, on April 20, 1933, FDR announced his intention to devalue the dollar as a means of forcing up domestic prices.
 &
  The dollar floated in foreign exchange markets at between $27 and $35 an ounce until the January 30, 1934 passage of the Gold Reserve Act. However, it was not a clean float. From September, 1933, on, the Treasury and the RFC actively bought domestically mined gold and gold on foreign markets at ever higher prices - in large enough quantities to affect world market prices. RFC purchases were financed with funds borrowed by issuance of RFC securities.
 &

The gold purchase program forced deflationary adjustments on remaining gold standard countries. U.S. demand for gold pushed up its relative value - reducing prices in terms of gold for everything else.

  As the dollar devalued, the dollar price of commodities rose on world markets - as the administration desired. Financial adjustments to accommodate these extraordinary activities went smoothly under floating exchange rates. The primary impact was the adverse change in the terms of trade that is the usual result of currency devaluations.
 &
  Once again, the U.S. government was demonstrating a heedless disregard for the international impact of its actions. The purchase program forced deflationary adjustments on remaining gold standard countries. U.S. demand for gold pushed up its relative value - reducing prices in terms of gold for everything else. Gold standard countries had to deflate or abandon fixed exchange rates. A World Monetary and Economic Conference held in London in June, 1933, to resolve international economic problems and stabilize exchange arrangements was bluntly informed by President Roosevelt that the U.S. would not cooperate.
 &

The government reaped the benefit of the dollar appreciation of gold - completing an expropriation of 60% of the value of the gold seized and imposing an implicit tax on all money balances. Henceforth, the transfer of gold bullion was limited to settlement of international payments balances.

  The U.S. quickly returned to fixed exchange rates - at $35 per ounce - a devaluation of almost 60% - on January 31, 1934, under the Gold Reserve Act of 1934. The government took title to all gold coin and bullion, gold coinage ceased and gold coins were melted into bullion. The Federal Reserve System replaced the RFC as a purchaser of gold. The government assumed authority over all international transactions and imposed complete reporting requirements. It reaped the benefit of the dollar appreciation of gold - completing an expropriation of 60% of the value of the gold seized - and imposing an implicit tax on all money balances. Henceforth, the transfer of gold bullion was limited to settlement of international payments balances.
 &
  On the basis of the increased dollar value of its gold holdings, the Treasury printed $3 billion in additional gold certificates and handed them over to the Federal Reserve System in return for a deposit credit that it could pay out to private citizens by check or Federal Reserve notes. This doubled the amount of fiat currency authorized under the Thomas Amendment to the 1933 Agricultural Adjustment Act. $2 billion was to be used as a stabilization fund to fix the gold value of the dollar and its exchange rate with other major currencies in international markets. $645 million was used for redemption of old national bank notes. Because gold purchases were paid for with newly printed fiat money, the program had no budget impact.
 &

When reductions brought reserves down near the 40% requirement in 1945, the reserve requirement was just reduced to 25%. Price inflation would henceforth be no more than kept in check. Reversing inflation would no longer be a concern. Existing creditors were stiffed - and future creditors would have to factor chronic inflation into their lending calculations.

  The gold reserve requirement is no longer viewed as a limiting factor in the issuance of currency. When reductions brought reserves down near the 40% requirement in 1945, the reserve requirement was just reduced to 25%. Price inflation would henceforth be no more than kept in check. Reversing inflation would no longer be a concern. Existing creditors were stiffed - and future creditors would have to factor chronic inflation into their lending calculations.
 &
  The international impacts of these actions are explained by the authors in some detail. They also explain the adverse change in the U.S. terms of trade. The U.S. had to produce and sell a higher volume of exports for international markets to receive less in imports - but the Roosevelt administration valued the increase in work required.

  "For all gold-standard and gold-producing countries except the United States and for nongold-standard and nongold-producing countries, the gold purchases meant a reshuffling of international trade in response to a decreased U.S. demand for products other than gold, and an increased demand for such products by gold-producing countries; the program meant an increased supply of products from the United States and a decreased supply from gold-producing countries. Finally, international trade had to adjust to measures adopted by gold-standard countries to meet loss of their reserves."

  Gold production soared in the U.S. and around the world - more than doubling in the U.S. by 1940 and increasing more than 60% worldwide. The weight of gold held by the Treasury more than tripled - to 630 million ounces - 1 times aggregate world output during that period. U.S. gold reserves hit an all time high in 1949, but were on their way down already - at 510 million ounces - in 1960 (on the way to the devaluation crises of the 1970s).
 &
  The authors grapple with the problem of finding some accurate way of defining the resulting fixed exchange rate standard. They come up with the phrase "discretionary fiduciary standard" "so long as the exchange rate between the dollar and other currencies is kept fixed." This phrase is "as vague and ambiguous " as the standard it denotes.
 &
  Events in Europe by this time were muddling the impact of these measures. Capital was already fleeing Hitler and the approach of WW-II. This capital inflow increasingly offset the adverse impact on the U.S. terms of trade by increasing the demand for dollars. It played a major role in the flow of gold to the U.S.
 &
  The authors analyze at some length the comparative impact of the devaluation and gold purchases and the flight of capital to the U.S. as determinants of trade and capital flows and price levels. Recognizing the inexact nature of the statistics, they conclude that the gold purchase program was the dominant factor.
 &
  In 1936, the final international abandonment of the gold standard began when France and Switzerland devalued.

C) History of Monetary Silver (1792-1960)

Monetary silver:

  The periodic rises and falls of monetary silver took another turn at this time.
 &

  The history of the nation's bimetallic money system runs back to 1792, when the price for monetary silver was set at $1.2929 per ounce. From 1834, monetary gold was overvalued, pushing the market price of silver higher than $1.29+, so none was coined. With the exception of the greenback period during and after the Civil War, the U.S. was on a gold standard from 1834 to 1873.
 &
  Silver prices relative to gold began falling in the 1870s and generally kept falling except during the silver purchase program 1889 to 1890 and during WW-I. Except during WW-I, the market price since 1900 had been less than half the nominal mint value. Silver was thus involved just in coinage - including the silver dollar circulated principally in the West - and the continued circulation of legacy silver certificates.
 &
  By the end of 1933, the Treasury had 650 million ounces of silver worth nominally $840 million - of which $340 million was in subsidiary coin. However, the market value was just $285 million.
 &

  The Thomas Amendment to the 1933 Agricultural Adjustment Act provided sweeping authorization for the purchase of silver. The Amendment was intended to expand the money supply and support the price of silver for the benefit of the silver mining industry. It authorized the purchase of silver at over 64 an ounce. The market price at the end of 1933 was about 44. The U.S. Treasury quickly became the purchaser of all domestic silver offered.
 &
  The Silver Purchase Act of 1934 directed purchases of silver until either the market price hit $1.29+ an ounce or until the Treasury's silver stock reached one third of the monetary value of the gold stock. This purchase authority was still in effect in 1962 - as this book was going to press. The Treasury had 3,200 million ounces of silver - the largest purchases coming from before 1937. Treasury prices ranged from 64+ to 90.5+.
 &
  From 1955, Treasury prices rose to levels close to market prices. When the Treasury stopped selling silver on November 28, 1961, the market price rose above the Treasury price. It continued up towards the nominal monetary price of $1.29+, at which point the silver certificates and silver coinage became a problem.
 &

  The domestic results of this silver purchase program were that 2,210 million ounces were purchased abroad on the world market. Roughly $2 billion was spent from December 31, 1933. The purchase program by itself failed to either raise silver prices to $1.29+ or bring silver stocks to the one-third relationship with gold. The closest it came until the gold drain of the post WW-II inflation was 1 to 5.
 &
  Ultimately, it was the chronic general inflation that raised the silver price to and above $1.29+ in the 1960s.

  "[As] with gold and wheat, the silver program offers dramatic evidence of the high elasticity of supply of stockpiled products and the resulting difficulty of substantially altering their relative prices by a government purchase program, even one of very large size relative to initial outputs. Domestic silver output more than tripled - from under 2 million ounces a month to nearly 6 million ounces -- in the four years from the Presidential proclamation of December 21, 1933, to December 31, 1937, the period covered by that proclamation."

  The WW-II and post war inflation had reduced the purchasing power of the dollar so that $1.29+ was no longer above the market price. Inflation does indeed provide some relief from rigid administered and cartel prices. There were years of solemn pledges from high government officials that the silver coinage would be maintained - but those pledges were abandoned without a qualm soon after this book was published. Low rates of chronic inflation had become an accepted aspect of U.S. monetary policy, and inflation inevitably began the undermining of public esteem for government that continues to this day.

  Over $2 billion in additional silver certificates were in fact issued - another purpose of the program. However, the authors speculate that this probably did not increase the stock of money that much. The silver certificates may simply have substituted for some Federal Reserve notes. The other purpose - to support the silver industry - cost anywhere between $5 and $25 for each $1 of benefit delivered to the silver miners - a rate of inefficiency remarkable even for government programs.
 &

"The silver program is a dramatic illustration of how a course of action, undertaken by one country for domestic reasons and relatively unimportant to that country, can yet have far-reaching consequences for other countries if it affects a monetary medium of those countries."

  The program had international consequences, however. Once again, the U.S. was the young, heedless giant - the bull in the international financial china shop - unconcerned with the international ramifications of its actions. One of the unintended results was to substantially reduce the monetary use of silver all around the world - by draining silver from weaker nations - with great disruptive impact.

  "The silver program is a dramatic illustration of how a course of action, undertaken by one country for domestic reasons and relatively unimportant to that country, can yet have far-reaching consequences for other countries if it affects a monetary medium of those countries."

  China, in particular, at a critical time in its history, had its monetary system disrupted by the uncontrollable outflow of silver to the U.S. Forced to abandon its silver standard, it began its disastrous experiment with fiat money - something it probably anyway would have been forced into by the conflicts raging within its borders. Mexico was another of the silver standard nations adversely impacted.
 &
  Silver certificates rose from just under 12% of currency in circulation in 1933 to almost 25% in 1938, but by 1960 was back down to just over 12%. Federal Reserve notes had risen steadily from 56.3% of currency in circulation to 84.5% on those dates. The Silver Purchase Act was repealed on June 4, 1963 as this book was going to press, and silver certificates were being replaced by Federal Reserve notes.

D) New Deal Failures and Successes

Rebound:

  With the restoration of the banking system, the economy rebounded vigorously - as it always had after severe periods of banking system suspensions and related economic contractions.
 &

The economy did not get back on trend. The nation did not recover its export markets until the beginning of WW-II, and New Deal command economy experiments would deliver a new blow to productivity. 

  The contraction attributable to the banking holiday crisis had been huge, so the rebound was great. Just getting the financial system working again had to restore a great deal of economic activity.
 &
  However, the economy did not get back on trend. The nation did not recover its export markets until the beginning of WW-II in September, 1939, and the  economy would take a new blow to its productivity with the advent of New Deal command economy experiments.
 &

Money income was still 17% below its 1929 peak. Because of the 6% population growth, per capita output, too, was still below its 1929 peak.

  The percentage increase in net national product from the 1933 trough to the 1937 peak was 59% in constant prices - the most rapid peacetime expansion between the Civil War and 1960. However, it was from a very low base - such a low base that money income was still 17% below its 1929 peak. Because of the 6% population growth, per capita output, too, was still below its 1929 peak.
 &
  And the recovery was still very fragile. The short relapse in 1937 was extraordinarily steep. Economists view that relapse as a unique instance of one deep depression following "immediately on the heels of another."

  The public experienced it  - correctly - as one long Great Depression decade with a partial easing of conditions in the middle due to the reopening of the banking system. Any "recovery" that still leaves about 11% unemployed at its peak despite a massive increase in government employment is no real recovery.
 &
  Keynesian theory to the contrary notwithstanding, expansion in the government sector is NOT a substitute for activity in the private sector. Government activities - like business overhead - are sometimes essential and sometimes desirable - and sometimes even bestow substantial competitive advantages. However, government is overhead for the economy and can't make up for profit center decline without undermining the growth potential of the entire economy.

  The authors do not break out for us how much of the recovery was in the private economy, but do note the disproportionate concentration of the recovery in services and non-durable goods and goods "for government purchase."

  "The difference reflected largely an unusually low level of private capital formation. Net private investment remained negative until 1936. When it became positive in 1936 and early 1937, an unusually large part consisted of additions to inventories. At its highest in early 1937, private construction was only one-third of the highest level reached in the mid-twenties."

  In short, economic adjustments still fell short of eliminating the remaining underlying causes of the Great Depression. This was at most a recovery from the banking collapse - a "dead cat bounce." It was not a recovery from the remaining political policy causes still driving the Great Depression.

  The recovery was prone to relapses from the start. There was a sharp short contraction in industrial production before the end of 1933, another in 1934, and mild short contractions in each of the following two years.
 &

Labor strikes and anti-business political rhetoric further undermined the economic climate. Competition in major sectors was stifled by government cartel schemes - with inevitable declines in productivity. The impact of all this on business confidence was reflected in the disappointing net private investment numbers.

  Command economy measures inhibited and undermined economic growth (something that became more familiar in the heyday of command economic experiments in the 1970s). Labor costs were increased by the National Industrial Recovery Act codes - declared unconstitutional in 1935 - and then through the National Labor Relations Act and minimum wage laws. Payroll taxes for social security and unemployment compensation were added in 1936 and 1937. There were tax increases on profits and a host of regulations. Some of the regulatory schemes - such as those under the Securities Acts and Banking Acts - were quite beneficial - providing elegant solutions to decades old problems. But the bank reforms had serious flaws (that were not fully addressed until the end of the century).
 &
  New government agencies began competing with private business from positions strengthened by overwhelming tax and subsidy advantages. Labor strikes and anti-business political rhetoric further undermined the economic climate. Competition in major sectors was stifled by government cartel schemes - with inevitable declines in productivity. The impact of all this on business confidence was reflected in the disappointing net private investment numbers.
 &

There was little recovery in business confidence, and investors favored the most secure and the shortest term investments.

  Savings remained idle in bank vaults for lack of loan demand by those borrowers that were perceived as suitably credit-worthy.

  This has NEVER happened during a truly prosperous period in the two century history of U.S. and English capitalism, Keynesian and Marxist theory to the contrary notwithstanding. See the two articles on Keynesian theory beginning with Keynes, "The General Theory," Part I, "Elements of the General Theory," and the six articles on Marxian theory beginning with Karl Marx, "Capital (Das Kapital)," vol. 1, Part I, "Value Determined by an Abstract Labor Standard."

  And there was a new substantial flow of capital coming from abroad - fleeing political conditions in Europe. It was all more than the still depressed economy could profitably put to work. Interest rates actually declined during the 1933 to 1937 rebound period.
 &
  Interest rate movements told an unmistakable story of continued Depression. Interest rates for high grade bonds - which were 4% to 5% in the 1920s stayed at 3% to 3% in the 1930s. But the spreads between them and lower grade bonds widened. Commercial paper remained below 1% until early 1937 and Treasury bill rates were a fraction of that - but the spread with longer term rates widened. There was little recovery in business confidence, and investors favored the most secure and the shortest term investments. Nevertheless, these extraordinarily low interest rates undoubtedly accounted for much of the easing of conditions.

  Only a Keynesian would consider this a period of prosperity. And no Keynesian would want to explain how - despite high levels of unused industrial capacity and unemployment rates that never dipped below 10% - monetary inflation could be reflected in price inflation.

  The stock of money rose 53% from the 1933 trough to the 1937 peak - closely paralleled by wholesale prices that rose 50%. The rise in the cost of living was estimated at 13%. The authors suspect the cost of living index understates the price inflation because recorded prices are more stable than the prices people actually bargain for.

  The recorded prices probably failed to accurately reflect how low prices actually dropped in 1933. There were thus sharply negative real interest rates for a period of several years - and still the economy couldn't come close to recovering back to trend. 

  The stock of money actually declined 3% in 1937 - an indication of the severity of the 1937 contraction. During most economic contractions, the stock of money just slows its rate of increase.
 &
  The authors compare this with the increase in wholesale prices during similar periods in the past that experienced similar monetary growth (and less unemployment) - the resumption boom of 1879 to 1882 and the post depression years 1897 to 1899. Those periods of wholesale price inflation were less than two-thirds that of 1933 to 1937.

  "What accounts for the greater rise in wholesale prices in 1933-37, despite a probably higher fraction of the labor force unemployed and of physical capacity unutilized than in the two earlier expansions? One factor, already mentioned, was devaluation with its differential effect on wholesale prices. Another was almost surely the explicit measures to raise prices and wages undertaken with government encouragement and assistance."

This time, however, inflation was not caused by a worldwide increase in gold production but by the gold inflows from capital fleeing Europe, and was thus domestic in extent rather than worldwide.

  This was another gold inflation - as after 1900. Monetary inflation was not caused by government expansion of the money stock.
 &
  This time, however, inflation was not caused by a worldwide increase in gold production but by the gold inflows from capital fleeing Europe, and was thus domestic in extent rather than worldwide. Indeed, this gold inflow didn't end until lend lease was enacted early in 1941, providing authorization for the U.S. to fund much of the war effort of a financially exhausted Great Britain and the other Allies.
 &
  The New Deal actually inhibited economic recovery, the authors (correctly) conclude. A more business friendly economic climate would have attracted even more capital, profits would have recovered, investments and loan demand would have increased, private output would have recovered faster so prices would not have risen so sharply, and interest rates would not have declined and might even have shown a normal cyclical increase. Money income would have increased more, and the fraction attributable to output would have been greater.
 &
  The bank deposit to reserve ratio would not have fallen so far if confidence had not remained so fragile, and the capital inflow would have provided all the increase in money stock desired. (But it would not alone have restored international markets.)
 &

  The deposit to bank reserve ratio fell sharply and persistently from the 1933 economic trough to well after the start of WW-II in Europe, as banks sought liquidity and funds were piled up in the banking system. This reflected the continuing and worsening level of confidence within the banking and financial community.
 &
  However there was a sharp initial recovery in the deposit to currency in-the-hands-of-the-public ratio in the first two years after the end of the bank holiday. This ratio then stopped rising and remained level until the beginning of WW-II. As people then - typically - found increased uses for cash under wartime and high tax conditions, the deposit to currency ratio declined. The banks found uses for their funds during the war, so the deposit to reserve ratio recovered during that time.

  Indeed, so disappointing was the economic response to the New Deal by this time that WW-II saved the reputation of the FDR presidency and its New Deal command economy policies. But during WW-II, FDR returned the favor by saving the world.

  The substantial rise in the money stock thus was closely related to the increase in high-powered money.
 &
  Moving in opposite directions both before and after the beginning of WW-II, the two bank deposit ratios pretty much cancelled each other out with respect to their impact on the money stock. Since silver certificates were largely offset by the retirement of national bank notes, the rise in the gold stock is most closely related to the rise in high-powered money and the rise in the total money stock. Under the new monetary regime, this was reflected on the government's liability side in a rise in deposits in Federal Reserve Banks.
 &
  The authors warn that both of the bank deposit ratios are unreliable during the period just after the end of the bank holiday because of the way the vault cash of unlicensed banks was treated as the banks were licensed or merged. Thus, the initial rise in the deposit to currency ratio was not as sharp as it looks. It never recovered anywhere near 1920s levels. Part of this was because of a continued lack of confidence, but part of it was because interest was not being paid on demand deposits - and instead service charges were imposed - making bank deposits less attractive to the public.
 &

Monetary policy:

 

 

 

&

  Even though monetary gold could not circulate, the connection between the high-powered money supply and the gold inflow arose directly. The Treasury would pay for the gold by check on a Federal Reserve System account, but would also issue a gold certificate to the System to refill its accounts at the System Banks. It thus acquired the gold without any budget impact - without any decline in its accounts - and its checks increased the money supply as they circulated and increased deposits in the banking system.
 &

  This practice came to a temporary halt for nine months during 1937, when the Treasury decided to pay for gold with borrowed funds - thus "sterilizing" the gold inflow so that it did not increase high-powered money and the money stock. This unfortunately coincided with a period of Board tightening of bank reserve requirements and initiated a period of tight money conditions just before the sharp 1937 economic contraction. This sterilization program began to be unwound in September, 1937, a process that was completed in February, 1939.
 &

The margin requirements on securities loans and reserve requirements for member banks were the tools the System now relied upon.

 

The System had shifted from "credit control" to "market control." The lack of appreciation for the importance of control of the money stock continued.

  Monetary policy at the Federal Reserve System was shifted away from its old tools to its new tools. Federal Reserve credit outstanding was almost constant - with not even seasonal variations - and the discount rate remained unchanged for unprecedented lengths of time. The margin requirements on securities loans and reserve requirements for member banks were the tools the System now relied upon.
 &
  The System had shifted from "credit control" to "market control." The lack of appreciation for the importance of control of the money stock continued - something the authors continue to deplore.
 &
  The rediscount rate stayed at 1% from March, 1933 to August, 1937, when it was lowered to 1% as a result of the 1937 contraction. It stayed at 1% for 5 years. Nevertheless, the rediscount rate remained above market rates for commercial paper - which had the effect of rendering negligible the impact of rediscounting from 1933 through 1941.
 &

Any rediscount rate above market rates is tight, even if the rate is below 2%. The unattractiveness of the rediscount facility induces banks to hold larger reserves.

  Any rediscount rate above market rates is tight, the authors point out, even if the rate is below 2%. The unattractiveness of the rediscount facility induces banks to hold larger reserves. This directly contradicts the assertions of System officials that they were maintaining "monetary ease" to facilitate economic recovery.
 &
  Whatever the reasons for the low money market interest rates, System policy was not one of them. When it did act for monetary policy purposes, it was always restrictive on balance.
 &
  In early 1937, the System did purchase $96 million in bonds to extend System credit into a money market that had become tight after the Board had significantly raised bank reserve requirements. After further increases in bank reserve requirements, it purchased another $38 million in November, 1937, as the economy suffered a sharp downturn. Those were the only open market monetary policy moves between the end of the banking holiday and the middle of 1939.
 &
  Considering the large inflows of gold, the authors conclude that "a relatively tight discount policy was probably the correct policy."
 &

Excess reserves:

 

&

  Reserve requirements for member banks could be set by the Board pursuant to authority in the Banking Act of 1935. Margin requirements for loans for the purchase of public securities could be set by the Board pursuant to authority in the Securities Exchange Act of 1934.
 &

  Margin requirements were doubled - to 50% - in 1936 to counter inflation. They were cut to 40% in 1937 as the stock market swooned during the 1937 contraction - and maintained at that level into WW-II.
 &
  It was a doubling of bank reserve requirements
in three steps in 1936 and early 1937 - to just over 25% for central reserve city banks - that was the System's major monetary policy move.
 &
  A huge "excess" in banking system reserves above minimum requirements was piling up. These reserves had grown as a result of bank liquidity preferences after the trauma of the bank holiday, and due to a lack of loan demand by the diminished class of borrowers perceived as credit-worthy. The gold inflows kept adding to excess banking system reserves as the Treasury used its gold purchases to increase the supply of high-powered money which thus expanded both bank deposits and reserves in almost equal amounts. During 1936, these excess reserves exceeded $3 billion.
 &
  This was a huge sum - equal to one-quarter of high-powered money in circulation and 20% larger than all the securities held by the System. The System could sell all its securities into the market and not sop up all these excess reserves.
 &

  This was the reason for the passivity of System monetary policy. The System didn't have to counter seasonal trends because the bank reserves could and did absorb them. Discounting and open market purchases couldn't help stimulate the economy because the banks already had all the loan funds that were required and were offering it at very low interest rates. But now in 1936, the worry was about inflation - and a stock market that was again booming.
 &
  On the other hand, despite the sharp recovery and the inflation of prices, the country - rightly - still considered itself in the midst of a terrible Depression. Congress would not have been amused by any System tightening prior to 1936. In any event, there were so few securities in the System portfolio earning so low a rate of return at those interest rates that any sales substantial enough to restrain monetary growth would have left the Federal Reserve Banks with insufficient income to cover expenses.
 &
  The authors conclude that the lack of policy moves prior to 1936 became a deterrent to subsequent policy moves since any moves would have been seen by the public as signaling some dramatic change in monetary policy. Open market purchases were thus limited to keeping the portfolio of securities fairly constant as they matured and had to be replaced. Some bids were put into the government bond market to assure that it remained orderly to facilitate the funding of the government's deficits.
 &
  The authors review the extensive deliberations that took place as System authorities became increasingly worried about the growing bank reserves and the continuing price inflation. Excess liquidity could make inflation uncontrollable - but everybody was loath to do anything that might derail economic recovery. Until those reserves were reduced, the traditional tools of System monetary policy would be ineffective.
 &
  Ultimately, a major increase in bank reserve requirements was chosen, because authority over bank reserves resided specifically in the Board. The divided FOMC shared power with the Board over open market policy, and the Federal Reserve Banks shared power with the Board over rediscount rates.

  "There was no consideration -- systematic or unsystematic -- of the total stock of money as a magnitude that either was or should be controlled by the System, nor of changes in the stock as measuring the impact of the System. The System's role was seen exclusively in terms of conditions in the money market, i.e., the market for loans and investments."

Since the 1937 experience, the System has often coupled its shifts in bank reserve requirements with open market operations in the opposite direction to ease the transition. The system-wide change in reserve requirements is a blunt instrument, while open market operations can be more precisely calculated.

  Bank reserve requirements were increased in August, 1936, and then twice more, in March and May, 1937 - doubling to over 25% for central reserve city banks. This coincided with the Treasury's decision to sterilize gold inflows, and practically stopped the growth of both high-powered money and the total money stock in their tracks.

  "The desire to tighten in early 1937 is entirely understandable. Economic expansion had been proceeding irregularly for four years and steadily for two; wholesale prices had risen nearly 50 per cent since March, 1933; stock market prices had roughly doubled between 1935 and the end of 1936. [Many System authorities] felt strongly that, in the past, the System had always been late in reacting; by their criterion of the absolute level of interest rates, the money market was abnormally easy."

  Soon, banks were scrambling to restore their "excess" reserves to levels they thought prudent during the Great Depression decade. Money stock growth was sharply reduced in the second half of 1936, peaked in March, 1937, and fell generally for the rest of the year. Interest rates rose sharply - resulting in sharply lower bond prices that impacted both bank reserves and the Treasury Department's funding efforts.
 &
  Since the 1937 experience, the System has often coupled its shifts in bank reserve requirements with open market operations in the opposite direction to ease the transition. The system-wide change in reserve requirements is a blunt instrument, while open market operations can be more precisely calculated. The two open market purchase moves that were undertaken at that time came in response to criticism by Treasury Secretary Henry Morgenthau, Jr., who was concerned about any disruption in the market for his government bonds.
 &

  The sharpness of the 1937 contraction apparently caught the System's technical staff by surprise. It wasn't until April, 1938, that bank reserve requirements were reduced slightly - eliminating only one-quarter of the previous increases. However, that move came two months before the 1938 cyclical trough.
 &
  The authors review the bureaucratic power shifts of the New Deal and the policy disputes that permeated the monetary and financial policy discussions within the System. Nobody was concerned with the impact of changes in the money stock. Some - ultimately including John Maynard Keynes - were concerned with the impact of policy on interest rates and the use of credit - the "credit" effect. Others - also ultimately including Keynes - emphasized the budget tools of deficit spending - of government expenditure and taxation.

  Except for Sec. of State Cordell Hull, who began to negotiate some - relatively ineffective - reciprocal trade agreements, nobody concerned themselves with the continued destruction of the nation's international markets - and there is no evidence in this book that the authors did, either.

  An estimation of the time lags in the banking system is derived from this experience. The bulk of the decline in the deposit to reserve ratio came in just 6 weeks from January, 1934, due in large part to large gold inflows. Treasury purchases of gold flooded the country with high-powered money - inevitably reflected in massive increases in bank demand deposits and bank reserves and deposits by member banks in the Federal Reserve Banks.
 &
  The authors calculate that it took about 7 months for the banks to substantially adjust to this influx, to put some of the new funds to work, and use the rest to achieve the desired deposit to reserve ratio. They calculate that it took 3 years to complete all the desired adjustments. It wasn't until 1943 - about 7 years after the initiation of FDIC deposit insurance and the resulting sharp decline in bank runs and failures - that bank liquidity preference began to decline substantially - leading to reduced reserves and a rising deposit to reserve ratio.
 &

  The authors note the Keynesian tendency to attribute the 1937 depression mainly to a shifting of the Federal budget from deficit to surplus.
 &
  Others stressed the combined impacts of the Treasury sterilization policy and System increase of bank reserve requirements. This resulted in higher yields and lower securities prices. It increased capital costs at a time when labor costs and taxes on profits were also rising, and profits and profit expectations were falling.
 &

  However, the close correlation of monetary events to the peaks and troughs of the business cycle are here again stressed by the authors. Significant changes in monetary growth and decline preceded the peaks and troughs by about 2 months. "Doubtless, other factors" helped account for these business cycle movements, they acknowledge, but the restrictive monetary shifts certainly helped undermine the business climate, and the return to "rapid increase in the money stock certainly at the very least facilitated" the cyclical recovery.

  "How different the history of the fateful dozen years might have been if the money stock had grown steadily at its average rate of 2 per cent per year, let alone at the higher long-term historical rate, instead of first falling by one-third from 1929 to 1933 and then doubling from 1933 to 1941."

  The authors are on much sounder ground with this conclusion for 1936 to 1939 than for 1929 to 1933. Nevertheless, a return to 1920s levels of economic performance - a return to trend in economic growth - would still have had to await the restoration of international markets and now the removal of some of the economic policy mistakes of the New Deal.
 &
  Moreover, the recommendation that monetary authorities should simply maintain an automatic low rate of money stock increase relies upon the continued stability of monetary velocity. See, section G), "The Velocity of the Money Stock (1867-1960)," below. However, subsequent experience would reveal such reliance to be unwarranted. Velocity became much less stable after 1964, during the period of inflation arising from Keynesian policy. Monetarism achieved great successes in the 1980s as a tool for reducing the inflationary pressures flowing out of the previous decade. However, like other regularities discerned by economists - like the supposed "Philips curve"' tradeoff between inflation and unemployment which also disappeared during that period of inflation - the stability of monetary velocity disappeared as soon as governments tried to take advantage of it in their economic policy. There is even a name for this phenomenon - "Goodhart's law."
 &
  Instead of remaining stable, the demand for money varied radically as a stream of financial innovations kept shifting the amounts of money people wanted to hold. Indeed, this became so bad that attempts to achieve price stability by controlling money have currently been abandoned in favor of the direct targeting of price inflation. Needless to say, this has put intense pressure on how price inflation statistics are calculated and evaluated, and some dubious changes have been made in calculation methods that make inflation rates look lower than they would have in the 1970s. Substantial shifts in credit-worthiness remain relatively uncontrolled. And the financial aspects of globalization greatly reduce the short term control exercised by even the major central banks.

E) Monetary Policy During World War II (1939-1948)

The WW-II period:

 

&

  Monetary inflation was used in part to finance WW-II - just as in the Civil War and WW-I. The war ended in August, 1945, but wartime price inflation didn't peak until August, 1948. Wartime price controls delayed the price inflation - but couldn't delay the loss of purchasing power. (Indeed, price controls undoubtedly made both worse. See, "Understanding Inflation.")
 &

  In the 9 years from August, 1939, to August, 1948, high-powered money increased 9% per year, the stock of money increased 12.3% per year, wholesale prices increased 8.2% per year, the implicit price deflator rose 6.5% per year. Money income rose 10.5% per year and real income rose 4.2% per year.

  "Substantial though these rates of change are, the rate of rise in the money stock was slightly lower than in World War I and about half the rate in the Civil War; the rate of rise in prices was less than three-fifths the rate in World War I and only one-third that in the Civil War."

  But the totals were comparable because of the greater length of the WW-II period.
 &

This was another gold inflation period.

  Lend Lease - beginning in March, 1941, marked the financial entry of the U.S. into WW-II. Before then, Britain paid for its supplies by draining itself of $2 billion in gold, $234 million in dollar balances, and $335 million in U.S. securities - mostly requisitioned from British subjects.
 &
  Gold inflows accounted for all the increase in the money stock during the period of U.S. WW-II neutrality - as it did for 80% of the increase during the similar period of WW-I. The money stock grew 29% during the period of neutrality. The bank deposit ratios moved in opposite directions largely offsetting each other. The deposit to reserve ratio rose as reserve levels declined. The deposit to currency-in-the-hands-of-the-public ratio fell as wartime uses for currency increased. This continued throughout WW-II, as it had during WW-I.
 &
  The Treasury Department and Federal Reserve System made no move to sterilize the gold inflow. Wholesale prices rose 23% - again similar to experience in the WW-I neutrality period. This was another gold inflation period.
 &
  The System did purchase $400 million in government securities immediately after the start of WW-II in September, 1939, to counter selling pressure against government bonds. This action was quickly unwound in the next few months. There was $300 million in sales in the last half of 1940, but open market operations otherwise were limited to maintenance of the System's portfolio during the rest of the period of neutrality.
 &

  Controls were imposed on consumer installment credit under a Presidential executive order in August, 1941. The Board imposed minimum down payment and maximum maturity restrictions for installment sales of listed items. Durable items became unavailable after the December 7, 1941 Pearl Harbor attack, so this action is mostly notable because of its use after the war. It is another example of efforts to control specific types of credit.
 &
  Bank reserve requirements were raised back to the maximum permitted by law - just over 25% for central reserve city banks - in November, 1941. This cut the $4.7 billion in excess reserves by $1.2 billion. Banking confidence was such by now, however, that banks continued to reduce their remaining excess reserves as they found uses for the funds.
 &

"The jump in the price index on the elimination of price control in 1946 did not involve any corresponding jump in 'prices'; rather, it reflected largely the unveiling of price increases that occurred earlier."

  The cash accounts of the government budget experienced a $10 billion deficit in 1941, nearly $40 billion in 1942, over $50 billion in 1943, over $45 billion in 1944 and over $35 billion in 1945. These sums averaged nearly 30% of contemporary net national product. (In evaluating these sums, it must be kept in mind that the dollar has since lost more than 90% of its value - and the population of the nation has more than doubled.)
 &
  High wartime taxes caught up with expenditures within 6 months of the end of the fighting - again similar to WW-I experience. But WW-II was far more a "total war" for the use of economic capacity.

  "During the period of price control, there was a strong tendency for price increases to take a concealed form, such as a change in quality or in the services rendered along with the sale of a commodity or the elimination of discounts on sales or the concentration of production on lines that happened to have relatively favorable price ceilings. Moreover, where price control was effective, 'shortages' developed, in some cases -- such as gasoline, meats, and a few other foods -- accompanied by explicit government rationing. The resulting pressure on consumers to substitute less desirable but available qualities and items for more desirable but unavailable qualities and items was equivalent to a price increase not recorded in the indexes. Finally, there was undoubtedly much legal avoidance and illegal evasion of the price controls through a variety of devices of which the explicit 'black market' was perhaps the least important. The result was that 'prices,' in any economically meaningful sense, rose by decidedly more than the 'price index' during the period of price control. The jump in the price index on the elimination of price control in 1946 did not involve any corresponding jump in 'prices'; rather, it reflected largely the unveiling of price increases that occurred earlier."

  Explicit taxes financed about 48% of total federal expenditure during WW-II. This was considerably more than in WW-I, but the deficit was nevertheless much larger because of the larger magnitude of the economic effort during WW-II. Of the rest, direct government money creation financed 7%, interest bearing government securities financed 31%,  and private money issue financed 14%.
 &
  However, the authors warn about the imperfections of the statistics available for apportioning the share of expenses born by explicit and implicit taxes and savings. They also analyze the relative levels of price inflation between Britain and the U.S. and a couple of neutral nations, but because of rationing and price controls, these do not reflect the actual losses of purchasing power.
 &

The U.S. had not previously stiffed its creditors for its wartime expenses. Wartime inflation had been reversed after both the Civil War and WW-I.

 

Many "experts" expected the Great Depression to return after the war.

  Wartime inflation was probably reduced somewhat by public post-war expectations, the authors surmise.
 &
  Expectations from the WW-I experience were that prices would tumble soon after the war. The U.S. had not previously stiffed its creditors for its wartime expenses. Wartime inflation had been reversed after both the Civil War and WW-I.
 &
  Moreover, many "experts" (succumbing to Marxist and Keynesian beliefs that had become popular during the Great Depression) expected the Great Depression to return after the war. This induced people to save much of their wartime income.
 &
  Both of these factors were reflected in a reduced "velocity" for the money stock during the war. This was reversed soon after the war as peacetime economic production resumed (and it became increasingly apparent that this time the U.S. cared not about sustaining the purchasing power of its financial obligations).
 &

The System surrendered its ability to control money. It had to create whatever fiat money was needed to maintain the fixed yield for government bills.

  Most of the increase in high-powered money and the money stock after December 7, 1941, was accounted for by the increase in Federal Reserve credit outstanding rather than gold - again similar to WW-I experience. The System sold the government's bonds - some of which it bought itself in exchange for fiat money.
 &
  Between November, 1941, and January, 1946, government debt outstanding grew by $178 billion, System credit outstanding rose $22 billion, commercial banks acquired $69 billion of this debt, and currency held by the public increased $17 billion.
 &
  The FOMC fixed the yield on Treasury bills at 3/8 of one percent in 1942 - which had a stabilizing effect on all government securities. These price supports turned government securities into a form of money. These income yielding securities were now liquid and reliable enough so that banks could substitute them for reserve holdings in excess of minimum requirements.
 &
  The result was that the System surrendered its ability to control money. It had to create whatever fiat money was needed to maintain the fixed yield for government bills. If yields had been permitted to rise, the authors assert, the public would have purchased more of them, less fiat money would have been created, and less price inflation would have been experienced. (Of course, this impact would have been somewhat modified by the increase in the government's debt servicing costs.)
 &
 Reserve requirements were reduced in 1942 - to 20% for central reserve city banks.
 &

  Interest rates in WW-II were lower than in WW-I - undoubtedly explaining much of the higher rate of investment in government securities by the non-bank public in WW-I. However, the general savings rate during WW-II was greater - demonstrated by the lower velocity of money. Money balances averaged 45% of one year's national income from 1914 to 1920, but 69% from 1939 to 1948.
 &
  The yield from the implicit tax on the money stock from inflation was thus 50% greater during WW-II - one explanation why lower annual inflation rates were generated during WW-II. A higher rate wasn't needed.
 &
  The banks - as the creators of bank deposit money - acquired a share in the yield from this implicit tax from inflation. (But bank loans were a part of the money stock subject to this implicit tax.) In WW-I, the total money stock increased $6.92 for every dollar of government created money. This figure was just $4.74 for each dollar in WW-II. The deposit to reserve ratio was higher during WW-I, permitting a greater rate of bank deposit money creation. Also, public use of the banking system was greater during WW-I, so the deposit to currency ratio was higher.

  "[The] government was able to acquire twice as large a fraction of average annual income -- 1.6 instead of 0.8 -- by direct money creation, yet produce only seven-eighths as large an increase in the total stock per year -- 11.1 per cent instead of 12.7 percent --. This smaller increase in the total money stock was in its turn equivalent to a decidedly larger fraction of average annual income -- 7.7 per cent instead of 5.8 per cent -- so that both directly and indirectly money creation was a more effective device for acquiring resources for government purposes [in WW-II]."

Post WW-II period:

 

&

  The post WW-II recession during the shift to peacetime production was brief and not very deep. The collapse back to Great Depression conditions confidently predicted by Marxists and Keynesians perversely refused to materialize - like so much else of their ideological expectations.
 &

Price inflation then began to reflect more closely the true magnitude - the true loss of purchasing power - due to wartime inflation.

  Price inflation jumped when price controls were lifted in 1946. It then began to reflect more closely the true magnitude - the true loss of purchasing power - due to wartime inflation. As goods became available, the velocity of money began to recover - but the recovery was quite modest.
 &
  Money stock growth retreated to normal peacetime averages - approximately 4% per year. Most of this was attributable to growth in high-powered money produced by gold inflows - mostly in the first year after the war. The U.S. was the only major source of supply for the worldwide demand for peacetime goods. U.S. international loans and vast aid programs mitigated the resulting gold inflows after that first year.
 &
  The rest of the money stock growth was attributable to a rise in the deposit to currency ratio as money returned to the banking system. Fiat money was being reduced. The deposit to reserve ratio declined slightly - mainly in 1948 as the Federal Reserve System reacted to price inflation by increasing the bank reserve requirement back to its legal maximum - which Congress had slightly increased.
 &
  The modest extent of the increase in the money stock from May, 1947 to August, 1948, is attributed by the authors to bank efforts to meet the higher reserve requirements. Banks sold government securities that the System had to purchase to prevent a decline in the price of the securities. This resulted in an increase in the System credit outstanding. After January, 1948, the money stock was actually declining slightly - foreshadowing as in previous instances the economic recession of 1948 to 1949.
 &

  The Board also made use of its other tools of monetary policy. Margin requirements on securities purchases were increased to 100% in January, 1946, but fell back to 75% in February, 1947, as Congress removed this Board authority. In November, 1947, Congress removed Board authority to regulate consumer credit - but restored it for about 10 months in August, 1948.
 &
  Interest rates rose steadily throughout this period.
Support rates for government securities were raised from August, 1947. Treasury and System purchases of government bonds still amounted to about $6 billion from November, 1947 to March, 1948, but the increase in short term rates was enough to narrow the spread with long term rates and resulted in $6 billion in System sales of government short term securities - limiting any impact on the money stock of the bond purchases.
 &
  Discount rates were increased, but without impact as they remained above market rates, so banks kept getting their short term funds from the money markets.
 &

The public expected the wartime price inflation to be reversed - as after the Civil War and WW-I. They had no historic experience with chronic inflation. The U.S. government had never stiffed its creditors to pay for its conflicts.

  Thus there is a puzzling public willingness to hold liquid assets during a period of rapid price inflation. This is reflected in low overall interest rates and monetary velocity that remained well below 1939 and historic levels.
 &
  The government budget surpluses from 1946 through 1948 - about $14 billion - provide one answer. These surpluses tended to increase funds available for loan and hold down interest rates.
 &
  Fear of a return of Depression conditions provided a second answer. (Those who did not live through those times cannot understand the depth and extent of this fear during the years just after WW-II.) By 1950 - during the Cold War buildup and the Korean War - this fear began to be outweighed by fears of inflation. (But some people never got over it - especially those who had succumbed to socialist beliefs. Many allowed their lives to be terribly constrained by it.)
 &
  The rise in stock yields relative to bonds before 1948, and the fall of stock yields relative to bonds after 1950 - supports the view about this substantial change in public expectations, as people preferred the safety of bonds in the first period, and the capacity to hedge against inflation with stocks in the second period.
 &
  In short - the public expected the wartime price inflation to be reversed - as after the Civil War and WW-I. They had no historic experience with chronic inflation. The U.S. government had never stiffed its creditors to pay for its conflicts. (But this was a new age of left wing economic theories that cared little for credit and creditors.)

F) Monetary Policy During the Cold War (1949-1960)

Leaning against the business cycle:

  Full employment and price stability became the responsibility of government as a result of experience with the Great Depression and the New Deal.
 &

  At first, it was budgetary manipulation through changes in taxation and deficit spending - "fiscal policy" - that was thought the primary tool. However, the budgetary process is too slow and inflexible - and Korean War and Cold War needs soon commanded a higher priority. Budgetary manipulation simply could not be effectively tuned to the business cycle.
 &

Dissatisfaction arose because of the System's impotence in dealing with the price inflation surge during the Korean War. It could not both fix interest rates on government securities and constrain inflation.

  So, focus shifted to "monetary policy" - manipulation of the rate of growth of the money stock and efforts to administratively control interest rates. The Federal Reserve System initially was committed to support the prices - and thus limit the interest yields - of government bonds and notes as well as bills. Ultimately, the FOMC decided to limit its open market support operations to bills. Dissatisfaction arose because of the System's impotence in dealing with the price inflation surge during the Korean War. It could not both fix interest rates on government securities and constrain inflation.

  "[The Korean War] rise in interest rates pushed up yields to levels at which the Reserve System was committed to support government security prices and occasioned widespread concern, within the System and outside, that the support program would become the engine for a large and uncontrollable expansion of the money stock."

  System credit outstanding thus swelled by $3.5 billion in the last half of 1950, but was offset by other factors, so money stock growth was modest. Nevertheless, despite the tightening of reserve and margin requirements and discount rates, wholesale price inflation soared to a 22% annual rate in the last half of 1950. The authors attribute this mostly to a rapid increase in the velocity of money in circulation.
 &
  Until its commitment to support government securities prices ended in March, 1951, the Board relied more on the comparatively blunt instruments of securities margin requirements - at best a tool of relatively narrow impact - as well as on bank reserve requirements. The ending of this commitment after March, 1951, did not mean that the System would no longer be concerned with the orderliness of the market in government securities. As interest rates rose, the System in both 1958 and 1960 again provided substantial support - in excess of $1 billion in purchases on each occasion - to prevent the failure of government bond issues.
 &

Around the world, this Keynesian theory collapsed, and nations were forced to rely on monetary restraint to curb the resulting post WW-II surges in price inflation.

  Extreme Keynesian beliefs that "money does not matter" were undermined by the surges in price inflation after WW-II not just in the U.S. but around the world. The Keynesians asserted that the stock of money tended to adapt itself passively to any level of economic activity - and that thus a low interest "cheap money" policy was desirable. Around the world, this theory collapsed, and nations were forced to rely on monetary restraint to curb the resulting post WW-II surges in price inflation. Their success proved that, indeed, money matters.
 &

Micromanaging the economy:

  The importance of the behavior of the monetary stock was first emphasized within the System after 1951. The authors didn't have access to any personal papers of cognizant officials for this period, so they had to rely on the official published documents.
 &

  One of the criteria for monetary policy after 1951 was to restrain or sustain monetary growth at levels consistent with "the requirements of a growing economy operating at a high level without inflation." The System had previously been concerned "almost exclusively with the credit aspects of its operations - - - their effects on interest rates, availability of funds in the market, the cost and availability of credit -- not with changes in the stock of money." These criteria were comparatively nebulous. They also included efforts to limit the speculative use of credit.
 &
  The connection between excessive monetary expansion and inflation was, of course, well known, but ordinary changes in money stock were not recognized as providing "a relevant immediate criterion of policy." Indeed, it was not until 1944 that monthly data on the money stock was even published - not until 1955 that seasonal adjustments were made.

  "[The] central principle of the System [has been]: if the 'money market' is properly managed so as to avoid the nonproductive use of credit and to assure the availability of credit for productive use, then the money stock will behave correctly and can be left to take care of itself."

  But mainly the System was trying to "lean against the wind" of the business cycle - to mitigate business cycle swings. Just how to recognize which way the "wind" would be blowing in the months ahead was not explained. Difficulties in the timely calculation of velocity was another complication. Knowing just how hard the System should lean was yet another complication. "Judgment" was still at the helm.
 &

  An accelerating and chronic outflow of gold after 1958 presented yet another unwelcome problem (that the System would be unable to solve). Aside from noting this new problem, the authors do not discuss it. (There is no indication in the book that at that time they realized its profound significance.)
 &
  The remarkably steady rate of growth of the money stock
in the dozen years to 1960 is noted by the authors. This did not prevent the business cycle from taking three short turns into recession - in 1953 to 1954, 1957 to 1958, and 1960 to 1961. Each recession was accompanied by a decline in the velocity of money. However, there was no inflation in wholesale prices after the Korean War, and inflation was very modest as calculated in "implicit" prices. Thus, confidence rose in the ability of monetary manipulation - "monetary policy" - to control inflation and assure prosperity.

  By 1958, however, the U.S. was already expending serious amounts of gold to sustain the value of the dollar and absorb inflationary pressures.

  The recovery of velocity after WW-II was fairly sharp. The authors assert that this "underlying trend" prevented a decline in the money stock from causing a much sharper recession in 1948 to 1949. However, velocity did actually decline during that recession as in most recessions during the 20th century.
 &
  Economic recovery was vigorous, and became heated during the Korean War. Fear of inflation now largely supplanted expectations of deflation. There was a substantial surge in consumer buying and a buildup of business inventories. Money stock growth was very modest, but velocity of the money in circulation soared 20% from 1949 to 1951, and is viewed by the authors as the primary factor in the Korean War price inflation. Velocity actually declined somewhat in 1951 and 1952, so that even a 5.1% rate of money stock growth did not prevent some modest decline in prices.
 &

  The bank deposit ratios were in a sustained rise by 1951 - especially the deposit to reserve ratio - as confidence increased and inflation made it increasingly important to find employment for money balances. In March, 1951, the System's obligation to support government securities prices was terminated, and it was free to restrain monetary growth when needed. Monetary restraint then became quite severe in response to the Korean War inflation.
 &
  Rapid credit expansion and speculative fever once again became a prime concern of the System in 1953 despite the absence of any sizable rate of price inflation or even of stock market excess. A modest increase in discount rates - some jawboning on speculative loans - and the cessation of System support for government bonds - resulted in a rapid sell-off of and price fall for government bonds.
 &
  The System reacted swiftly to ease monetary policy - purchasing almost $900 million in government securities in two months to stabilize the market. It lowered reserve requirements a month later just as the economy was turning down - moves that the authors suggest kept the 1953 to 1954 recession mild. Further easing steps came in 1954.
 &
  Wholesale price increases were modest during the period after this first 1950s recession, but were only slowed - not reversed - by the second one. Fears of secular price inflation were again aroused. The authors suggest that the rapid rise in velocity after the 1953 to 1954 recession may be attributable to this fear of inflation and may have prevented any price decline during the 1957 to 1958 recession.
 &

The results of efforts to mitigate the business cycle by accelerated growth in the money stock were an acceleration of price inflation, stubbornly high rates of unemployment, and a chronic outflow of gold reserves.

  The System responded vigorously to the second recession - resulting in a sharp increase in the money stock at the end of 1957 - and probably shortened the recession. An acceleration of consumer price increases - to 2.3% - was one result. Another was a stubbornly high rate of unemployment. Yet another was an outflow of gold that was becoming chronic - shown by the book's graphs but not remarked upon by the authors.
 &
  Again, in 1960, a decline in the money stock preceded the final recession in this history. The recession was met vigorously by a 6% rate of monetary expansion (a pattern that would be repeated with increasing inflationary impacts until the ultimate failure of Keynesian monetary manipulation policy in the 1970s).
 &
  Bank reserve requirements were reduced as part of the Board's efforts to counter each of these last three recessions. From 1952 through 1960, they were never increased. After the Board was freed from its obligation to support government securities prices, it sometimes acted with manipulation of its credit outstanding in an opposite direction to mitigate the blunt force of its reserve requirement changes.
 &
  These changes in reserve requirements appear to have had considerable impact. Confidence levels in the banking system resulted in the substantial reduction of the reserve levels that were in excess of minimum requirements. The Board reductions in reserve requirements after 1952 were closely reflected by a rising deposit to reserve ratio.
 &

The 1953 to 1954 recession began a period of increasingly frantic and increasingly large discount rate swings through to the end of the period covered by the book.

 

The System intentionally attempted to sterilize the accelerating outflow of gold in 1958 by reductions in both the bank reserve requirements and discount rates and by a sharp increase in System credit outstanding. It thus prevented any contraction of the money stock.

 

During the last years covered by this history, the System monetary policy whipsawed yet once again.

  The employment of discount rate shifts had been quite restrained after WW-II. However, the 1953 to 1954 recession began a period of increasingly frantic and increasingly large discount rate swings through to the end of the period covered by the book. These frequent shifts in monetary policy as the Board undertook the task of micromanaging the economy made little overall impact on money stock growth, although there were periodic spikes and dips. But the Board simply couldn't satisfy its critics. It was criticized for every spike in inflation in one direction or unemployment in the other.
 &
  The whipsawing of monetary policy pushed the economy to new levels of inflation by 1959. The System attempted to sterilize the accelerating outflow of gold in 1958 by reductions in both the bank reserve requirements and discount rates and by a sharp increase in System credit outstanding. It thus prevented any contraction of the money stock.
 &
  During the last years covered by this history, the System monetary policy whipsawed yet once again by ending the surge in System credit outstanding, bouncing discount rates in steps sharply higher - to 4% - only to have to pull them down again as the economy fell into its final recession of this period. A major steel strike played some role in this final recession.
 &
  The authors note this increase in volatility at the end of the period covered by the book, and express the hope that "the process is not explosive but self-limiting."

  Economic instability would raise increasing difficulties towards the end of the 1960s and become explosively uncontrollable in the 1970s. System monetary policy manipulations based on Keynesian concepts - designed to stabilize the economic system - instead again resulted in increased - ultimately uncontrollable - instability.

G) The Velocity of the Money Stock (1867-1960)

Velocity:

  The trend for the "velocity" of money had been decline from 1867 to 1941 - albeit with many spikes and valleys associated with the business cycle and war.
 &

  People were holding more money relative to their income as the nation prospered. Fewer people were living hand-to-mouth, so money circulated more slowly. The development of and growing confidence in commercial banking in which people could conveniently hold their funds is one explanation for this trend up to the beginning of WW-I.
 &
  However, from 1942 to 1960, the trend reversed. People have been holding less money relative to their income - so money has been circulating faster. Indeed, from 1946 to 1960, velocity increased 45% - but most of that increase came before 1952. Aside from the period during and immediately after WW-II, the authors find this trend reversal puzzling, and offer some suggestions.
 &
  One reason for holding a smaller stock of money is the rising interest rates offered on relatively liquid and secure investments  - on "near money." Related to this is the recognition after the Korean War that it is inflation that is most to be feared - not deflation. The increasing availability of "near money" substitutes, like shares in savings and loan associations, also may have played some role. Rising confidence in the overall economy - that a repeat of the Great Depression is not imminent - is another reason why people would invest more of their wealth and hold less in the liquid form of idle money balances.
 &

  The measure of "velocity" varies with the definition of "money." The inclusion of time deposits with currency and demand deposits increases the amount of "money" in circulation and thus materially reduces the magnitude calculated for its velocity. From 1952 to 1960, it also reduces the rate of increase in velocity. Time deposits do provide an interest yield, after all, and that yield increased as interest rates rose during this period.
 &
  From 1946 to 1960, the interest rates on long term government bonds doubled - from about 2% to about 4%  - with long term corporate bonds also rising about two percentage points. Commercial paper yields rose from less than 1% to just over 4%.
 &
  The authors convincingly demonstrate that factors other than interest rates play major roles in determining velocity. Viewed over the more than nine decades covered by this history, there is no fixed relationship between interest rates and velocity. Even when there is directional correlation, the magnitudes shift dramatically.
 &

  In particular, expectations of economic stability are emphasized by their studies as the primary factor. Uncertainty increases the attractiveness of liquid assets - resulting in the declines in velocity during wartime and major economic contractions - while prosperity and relative stability increase the attractiveness of investment assets. As confidence in economic stability rose in the 1950s, money balances tended to decline relative to income - leading to a rise in the velocity of the money in circulation. (But the trend velocity from 1880 to 1914 - a period of massively increasing prosperity - was down.)

H) Conclusion: The Impacts of Fluctuations in the Money Stock

Money matters:

  The many points of relationship between the changes affecting money and those affecting the economy are emphasized by the authors in their conclusion.

  • Acceleration or deceleration of money stock growth or actual decline have always preceded by just a few months corresponding peaks and troughs in the business cycle. These relationships have held despite radical changes in the nature of the U.S. monetary system.

  "From 1862 to 1879, the United States had an independent national money, convertible into neither gold nor silver nor the money of any other country at any fixed ratio. The stock of money could therefore be determined internally. From 1879 to 1914, U.S. money was convertible into gold at a fixed ratio specified by law and maintained in practice. The stock of money and internal prices had to be at levels that would produce a rough balance in international payments without abnormal gold movements. The stock of money was a dependent, not an independent variable, though, of course, there was some leeway in short periods. Both before and after 1879, until the Reserve System was established, the U.S. unit banking system was divided between national and nonnational banks, each having roughly half of total deposits, and neither subject to any central control except as the Treasury from time to time undertook central banking functions.
 &
  "From 1914 to 1933, U.S. money continued to be rigidly linked to gold, but the number of other national moneys so linked had diminished. The United States had achieved a far more important role in the world economy, and foreign trade had become a smaller part of U.S. economic activity. The links between U.S. money and international trade were therefore far looser than in earlier years. In addition, the Federal Reserve Act not only established central control over most of the banking system but also provided an agency that could deliberately intervene to alter or even reverse the relation between international payments and the domestic stock of money."

   But the exercise of these discretionary powers would ultimately incur intolerable costs in terms of economic instability in the 1930s and inflation and economic instability in the 1970s..

  "In early 1933, the rigid link between U.S. money and gold was severed. A year later, a rigid link was reestablished at a different ratio. However, the gold standard then re-established and legally prevailing ever since [through 1960] was very different from the pre-1933 standard. Gold was eliminated from circulation, and ownership of monetary gold by private citizens was made illegal, so that the national money was no longer freely convertible into gold at a fixed ratio. The loosening of the links between money and gold and, consequently, between money and international trade was completed by other countries, many of which went even further in severing all connection between national money and gold. [In 1960] gold is primarily a commodity whose price is pegged rather than the keystone of the world or the U.S. monetary system. However, the legacy of history and the use of gold as a vehicle for fixing exchange rates still give it a monetary significance possessed by no other commodity subject to government price-fixing."

  In the 1970s, gold would prove that it cannot indefinitely be pegged in terms of any fiat paper currency. In terms of purchasing power, the dollar currently is far from an independent variable. The U.S. government does not have the power to "fix" the fiat dollar price of gold.

  • Smoothness seems to be important. It is the smoothness of the long run rate of growth in the money stock that appears vital for the long run increase in money income - not the actual rate of growth. As long as the rate of price level change is no more than about 2% - up or down - it is its smoothness rather than its direction that seems most important for economic growth.

    The provision of federal insurance for bank deposits brought to an end the periodic runs and panics that had always bedeviled the U.S. banking system and money stock. This greatly smoothed the slow upwards trend in the deposit to currency ratio. Rapid declines in this ratio during periods of severe economic contraction had been creating strong downwards pressure on the total money stock as the public sought to withdraw cash from its bank deposits. Deposit insurance and confidence in the banking system seems to have had a similar smoothing influence on the deposit to reserve ratio.

  • Monetary changes have often been predominantly influenced by economic phenomena. Both of the deposit ratios have clearly been impacted by cyclical business movements, with corresponding impacts on money stock growth. Particularly during the shorter-run cyclical business movements, those impacts predominantly ran from the economy to the money stock. "The resumption and silver episodes, the 1919 inflation, and the 1929-33 contraction reveal clearly other aspects of the reflex influence of business on money."

  Resumption of the gold standard in 1879 was a political decision made possible by monetary restraint during the greenback period - but it was made possible predominantly by economic growth rather than by the laudable monetary discipline.

  "Changes in money stock are therefore a consequence as well as an independent source of change in money income and prices, though, once they occur, they produce in their turn still further effects on income and prices. Mutual interaction, but with money rather clearly the senior partner in longer-run movements and in major cyclical movements, and more nearly an equal partner with money income and prices in shorter-run and milder movements -- this is the generalization suggested by our evidence." 

  • Monetary changes have also been caused by clearly independent phenomena on many occasions. "[They] have often not been an immediate or necessary consequence of contemporaneous changes in business conditions."

  A worldwide inflation of gold supplies was the independent variable from 1897 to 1914. Periods of gold inflation in the U.S. - driven by political factors rather than economic factors - came at the start of both world wars.
 &
  Often, monetary changes were the result of intentional alterations of monetary policy. The decisions to resume the gold standard in 1879 and to initiate episodes of silver purchases were driven by political rather than economic considerations. Federal Reserve monetary policy decisions since WW-I provide a series of monetary shifts - some reactive to economic conditions but others largely discretionary. Three sharply restrictive monetary policy moves - January to June, 1920 - October, 1931 - and July, 1936 to January, 1937 - all followed by sharp declines in the stock of money and sharp economic contractions  - are particularly noted by the authors.

  • That money matters is demonstrated by the Great Depression. If the Federal Reserve System had just not adopted the practice of sterilizing gold inflows to prevent them from impacting the stock of money, the gold inflows would have resulted in major increases in high-powered money during the first two years of the Great Depression that would have mitigated its impact. A more aggressive monetary policy response to the Great Depression by the System "would have cut short the spread of the crisis, would have prevented cumulation of bank failures, and would have made possible, as it did in 1908, economic recovery after a few months."

  This conclusion - one of the most important in the book and one of its most widely cited - is clearly untenable - as explained by several comments in Friedman & Schwartz, "Monetary History of U.S." (Part II), sections E) "Great Depression Bust," and F) "The Power and Limitations of Monetary Policy." Monetary policy played a significant - but not determinative - role in the initiation of the Great Depression. It could have mitigated some of the worst impacts on the banking system - but would have been hindered by the limits of the Federal Reserve System's authority and resources - and the failure of Congress to abandon the economic policies that were the remaining fundamental causes of that world-wide catastrophe.
 &
  Not until the late Fall of 1932 could an aggressive monetary policy have played a major role in ending the Great Depression. Even then, the total collapse of the nation's international markets would have limited the extent of the recovery. See, seven Great Depression Chronology articles beginning with The Crash of '29,  New Deal monetary policy was indeed far more aggressive than the Federal Reserve System had either the resources or authority to conduct prior to the New Deal. For several years, there were negative real interest rates. Yet it was all to no avail. The Great Depression would continue on its tragic course through to the end of the decade.

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