Wake Forest University
The Federal Reserve’s behavior during the Great Depression of 1929-33 is generally believed to have increased that downturn’s depth and duration.1 Different writers emphasize different factors, as we will see, but they agree that monetary policy was mistaken and harmful. In particular, its tight-money stance at the end of the ’20s and into the next decade caused or contributed to large and prolonged declines in money, prices, and employment. However, there is little agreement about why the Fed behaved as it did. Its policy guide, depending on the writer, was the fallacious real-bills doctrine, a confusion of market and natural rates of interest, a desire for the liquidation of speculative excesses, an obsession with the stock boom, misperceived constraints of the gold standard, or a narrow focus on financial stability. These errors are not mutually exclusive, and some are contradictory, but each has been advanced as the principal explanation of the monetary policies that brought or worsened the Great Depression.
There is evidence for all of them. Each found its way into official policy statements, if only occasionally, and with liberal interpretations can be reconciled with some Federal Reserve actions. Isolated incidents and talk do not make a policy, however. The purpose of this paper is to confront alleged policy models with the data to determine which, if any, of them explains monetary policy. I consider the period from 1922, when the Fed became a free agent, that is, after the U.S. Treasury had released it from the obligation to support bond prices and the economy had weathered the large postwar inflation and deflation, through 1932, after which the New Deal took control of monetary policy.
Anticipating the conclusion, the data suggest that one, and only one, of the proposed explanations explains a significant part of monetary policy throughout the period: the concern for financial stability. Others have made this point (Wicker 1966, 330; 1969; Brunner and Meltzer 1968; Wheelock 1991). This paper reexamines and, as it turns out, reinforces their work.
There might have been more to policy, however, and I try to find out which, if any, of the other proposed explanations made a contribution. While more detailed or sophisticated examinations might find otherwise, I find no support in the data for claims that the real-bills doctrine, stock prices, the gold standard, the desire for liquidation, or a misinterpretation of interest rates governed monetary policy in our period, including the Great Depression.
Each of the next six sections examines a proposed explanation of Fed behavior during the Great Depression. The real-bills-doctrine section is longest because it introduces the data and its meaning needs to be clarified. The conclusion draws implications of the Fed’s behavior before 1933 for the institutions of monetary policy today.