Criticism of The Federal Reserve - The Great Depression (1929)

The Great Depression (1929)

Perhaps the most widely-accepted criticism of the Fed was first proposed by Milton Friedman and Anna Schwartz – that the Fed exacerbated the 1929 recession, sparking the Great Depression. After the stock market crashed in 1929, the Fed continued to contract (decrease) the money supply and refused to save banks that were struggling due to bank runs. This mistake, critics charge, allowed what might have been a relatively mild recession to explode into catastrophe. Friedman and Schwartz believed that the depression was “a tragic testimonial to the importance of monetary forces.”

Before the establishment of the Federal Reserve, the banking system had dealt with periodic crises (such as in the Panic of 1907) by suspending the convertibility of deposits into currency. In 1907, the system nearly collapsed and there was an extraordinary intervention by an ad-hoc coalition assembled by J. P. Morgan. The bankers demanded in 1910-1913 a central bank to address this structural weakness. Friedman suggested, however, that if a policy similar to the Panic had been followed during the banking panic at the end of 1930, it might have stopped the vicious circle of the forced liquidation of assets at depressed prices, just as suspension of convertibility in 1893 and 1907 had quickly ended the liquidity crises at the time.

Essentially, in the monetarist view, the Great Depression was caused by the fall of the money supply. Friedman and Schwartz note that "rom the cyclical peak in August 1929 to a cyclical trough in March 1933, the stock of money fell by over a third." The result was what Friedman calls the "Great Contraction"—a period of falling income, prices, and employment caused by the choking effects of a restricted money supply. The mechanism suggested by Friedman and Schwartz was that people wanted to hold more money than the Federal Reserve was supplying. People thus hoarded money by consuming less. This, in turn, caused a contraction in employment and production, since prices were not flexible enough to immediately fall. Friedman and Schwartz argued the Federal Reserve allowed the money supply to plummet because of ineptitude and poor leadership.

Many have since agreed with Friedman and Schwartz's theory, including current Chairman Ben S. Bernanke, who said:

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.

Friedman has said that ideally he would "prefer to abolish the federal reserve system altogether" and replace it by a computer. He would prefer to replace the organization with a mechanical system that would increase the money supply at some fixed rate, and thought that "leaving monetary and banking arrangements to the market would have produced a more satisfactory outcome than was actually achieved through government involvement."