The New Deal was a Good Deal: Part I, Monetary Causes and Solutions

This topic really is too large to handle in a single post, so here is part I.

In this post I view the great depression through the lens of Friedman, and argue that the monetary policies of the first new deal provided solvency for the underlying monetary causes of the great depression.

I plan to provide at least a second part when time permits, which will discuss more of the demand side and stimulative spending, viewing the great depression thought the keynesian lens.

The New Deal was a Good Deal: Part I, Monetary Causes and Solutions

The New Deal was a good deal, and it was an appropriate response to the Great Depression. The primary reason the New Deal, in particular the “100 days” was appropriate was that it addressed the underlying monetary causes of the “Great Contraction” and begin to solve them. In particular, the steps FDR took to leave the gold standard, and address the banking crisis were instrumental in the economic recovery that began in 1933 and continued to 1937 when a much smaller contraction occurred.
In order to understand how the New Deal addressed the causes of the great depression, you must first identify what the causes were. Although the causes of the great depression have been widely debated, and still are to some degree, some consensus has emerged around the Nobel Prize winning work of economist Milton Friedman, who focused on monetary causes. Specifically in A monetary History of the United States, he and Anna Schwartz argue that four major mistakes, which were all a tightening of monetary policy by the Federal Reserve Bank, caused the great depression.
Before discussing the four mistakes by the Fed, a discussion of the gold standard, the monetary system in place at the time is in order. The gold standard was a major factor in the Fed’s inability to ease monetary policy, and also a major contributor to the collapse of the banking system that occurred. Under the gold standard, the value of our currency was legally fixed, or “pegged”, to the value of gold. An important implication of this is that the exchange rate of our currency was also fixed to any other country that used the gold standard (which was a lot, in particular Great Britain). This left the dollar, and many other currencies world wide, open to “speculative attack”. Meaning that when depositors felt that a country would not be able to maintain the legally mandated value, they would immediately move to withdraw funds and convert them to gold.. Another important implication of this is that it forces one country to link its economic policies to that of another. For example, if country A raises its interest rates, investors in country B with lower rates will begin to move their assets to country A with higher returns. This will begin to deplete the gold reserves in country B. As a result country B will be more or less forced to also raise its interest rates. So, for these reasons, the gold standard was integrally related to the four mistakes in monetary policy Friedman and Schwartz identify as causing the great depression.
First, the Fed increased interest rates in 1928 to curb speculative investment. Essentially, the Fed was concerned that speculative investment by brokers was leading to a bubble in the stock market, so they tried to convince banks not to lend to speculators, but only to borrowers engaged in actual production. When this effort failed, they decided to use interest rates to curb lending altogether. This led them to raise interest rates in 1928. Although many point to the stock market crash of 1929 as the cause of the great depression, most economists agree that it was not the root cause, and many argue that this tightening of monetary policy facilitated the crash. That being said, the crash certainly exacerbated the problem by crushing public confidence in the financial sector.
Second, the Fed again raised interest rates in 1931 to protect the dollar. In the fall of 1931, economic slow down would seem to warrant an expansion of monetary policy. However, many investors began to withdraw deposits and, as a result, the United States gold reserves were becoming depleted. In order to stop this, the Fed raised interest rates in hopes that investors would leave deposits in dollars since returns would be higher. In the short term this did defend the dollar somewhat, but it did little to address underlying deficiencies in the deposit security, and it forced a tightening of the money supply when it should have been eased.
Third, the fed did not ease monetary policy in 1932 as Congress asked. They did some at first, this time using open market operations rather than interest rates, but as soon as congress adjourned the tightened the money supply again. This was mainly due to two main schools of thought among economists at the time. First, they believed that the money supply was already loose enough. They were mistaken, in large part due to the fact that they analyzed the nominal rate of return instead of the real rate of return. Meaning they did not take changes in currency value into account. Second, a substantial amount of economists at the time thought that taking any action to prevent recession was a bad idea, and that actually one was necessary to “cull the herd” if you will, meaning that they actually wanted weak banks to fail. This type of theory was referred to as “liquidationist”, and was held by many inside the Fed. So again, instead of easing the money supply when they should have, they tightened it.
Fourth, during 1931 and 1932, the fed did nothing to address the problems in the banking sector. This was an incredibly important factor. It is important to understand that the money supply is not just the base money supply (1.e., the amount of dollars that exist), because banks do not hold all of the money deposited in reserve (they lend out more than they have) bank deposits actually are a part of the money supply. As a result, when the devaluation of the dollar, combined with the general panic about the security of deposits caused huge run on the banks, this was also a huge reduction in the supply of money. Instead of taking action to prevent this, like lending more money to banks or putting more money into the economy, the Fed did nothing to address the banking crisis. In large part due to the “liquidationist” theories discussed above.
So when FDR took office in 1933, he was faced with huge challenges and during his first hundred days in office he set about finding a way to repair the already severely damaged economy. He immediately declared a “Banking Holiday” which shut down all banks until they could be declared financially secure. This stopped the hemorrhaging, and FDR passed the Emergency Banking Relief Act, which allowed the banks to reopen, and receive increased lending from the federal government. Within 300 days 5,000 banks had reopened, and deposits flowed back in. Even more importantly, this legislation ended the gold standard. Citizens were mandated to trade in their gold for dollars. The U.S. would no longer pay gold for dollars on demand, gold would no longer be considered legal U.S. tender, and gold clauses in contracts became illegal. The dollar was devalued to about 40 percent of its former value, which brought an end to cycle of deflation. This also represented a huge expansion in monetary policy, since now gold would now buy more than twice as many dollars. Even though the dollar was only allowed to “float” briefly (until 1971 when it became permanent), this represented a significant shift in U.S. policy which began to address many currency problems.
In order to more permanently address the serious problems with deposit security, later that year the Glass-Stegal act was passed. This act created the FDIC (Federal Deposit Insurance Corporation) which at that time guaranteed deposits up to $5,000, and today insures deposits up to $100,000. The passages of the Glass-Stegal act essentially ended the possibility of a run on the banks, and in so doing forever prevented one of the major causes of the great depression. So, with regard to the monetary causes and solutions to the great depression, it becomes clear that the New deal was an appropriate response.