Deregulation and the Federal Reserve (activist, solutions, March, myth)

[Tonyafd]

There is a growing controversy regarding the value of the Federal Reserve.

The argument that the Federal Reserve contracted the money supply at the start of the Great Depression is bogus. It should be noted that three months after the stock market crash, forty billion dollars shareholder assets disappeared. These assets are in 1929 dollars, not current dollars. This was a crushing blow to the economy of ninety years ago. Banks closed their doors because they were not immune to the crash. Depositors lost their savings and many people stopped spending.

The FED was originally set up to rescue member banks in the event of a bank panic. They've grown over the years to be a mechanism that regulates banks and puts the brakes on the economy by raising interest rates when the economy overheats.

Attacks on the FED have become more numerous in recent years because the wealthiest of us don't want to be regulated. You've seen efforts at deregulation time and time again as part of the Republican party platform.

The information above can be found in "A Monetary History of the United States 1867 - 1960" by Milton Friedman and Anna Schwartz. Milton Friedman is regarded as the father of free market economics. The copyright date is 1963.

[Tonyafd]

Supporting documentation from: WHAT ROLE DID THE FED PLAY IN CAUSING THE GREAT DEPRESSION

WHAT ROLE DID THE FED PLAY IN CAUSING THE GREAT DEPRESSION?

A favorite conservative argument is that the Federal Reserve Board caused the Great Depression by contracting the money supply.

This is a complete myth. According to the Federal Reserve's own records, at no time did the Fed pull money out of the system. Although it's true that the money supply contracted 31 percent between 1929 and 1933, this was not because of the Fed. Rather, the contraction was caused by three dramatic runs on banks, which would close 10,000 banks by 1933. So many failures were significant, because bank deposits formed 92 percent of all the money in circulation.

The Fed's Actions in the Great Depression

To see why the Federal Reserve did not cause this contraction, recall that the Fed has at least two methods of increasing the money supply. By far the most common and important method is buying U.S. debt from commercial banks, in the form of U.S. securities. The lesser way is to cut the prime interest rate that the Fed charges commercial banks.

Between October 1929 and February 1930, the Fed actually pumped significant money into the economy. It made major purchases of U.S. securities, and cut interest rates from 6 to 4 percent.

After this sudden infusion of money, however, the Fed made only very modest purchases of securities. It cut the discount rate only twice between March 1930 and September 1931. In the final months of 1931 it briefly raised the rate twice, but then cut it again in 1932. The modest security purchases counterbalanced the brief raises in rates and resulted in no significant change in the amount of money available to the public. However, this period of inaction by the Fed is the target of much criticism, as we shall see.

In 1932, the Fed overcame its idleness and once again made large purchases of U.S. securities.

The Run on Banks

So what caused a 31-percent contraction in the money supply? Pretty clearly, the public run on banks. The first banking panic occurred in late 1930; the second in the spring of 1931, and the third in March 1933. When it was over, 10,000 banks had gone out of business, with well over $2 billion in deposits lost.

Banking panics occur when the public fears that monetary institutions are on the verge of collapse. The securities market falls so fast that investors scramble to convert their holdings into cash, thus creating a public run on banks. But banks, whose loans are based on fractional reserves, cannot afford to give everyone their money all at once, and therefore go bankrupt. A chain reaction follows as deposit-owners who have lost their money can no longer afford to pay off other debts and costs of business, driving others to scramble for cash as well.

Today we know how to prevent banking panics from developing into a chain reaction -- thanks to lessons learned from the Great Depression. For example, the stock market crash of 1987 was even larger than the Crash of '29, but timely government action prevented a run on banks. One of the solutions is to make sure that banks have enough reserves to cover their deposits - that is, expand the money supply. This is why the Fed's relative inaction between 1930 and 1931 has come under such intense criticism. But, to be fair, monetary theory was undeveloped at the time, and nobody was aware of the solutions.

Milton Friedman's Spin

So where do we get the myth that the Fed contracted the money supply? The impression is strongly given by Milton Friedman, lifelong foe of the Federal Reserve System. Friedman's arguments are not shared by his peers in the economics profession, but they have gained widespread fame among everyday conservatives.

Friedman begins his criticism of the Fed by defining "money" differently from other economists. Most economists define "money" as cash in circulation plus whatever reserves are held by banks, including checking accounts. But Friedman has devised a different measure, "monetary aggregates," which include difficult-to-reach money like savings accounts and money market accounts. This broader definition of money tends to blur the lines between cause and effect. For example, if you claimed that tallness contributes to excellence in basketball, I could "refute" your claim by defining everyone as tall.

Friedman points out that during recessions, his monetary aggregates always decline. What this means exactly is open to question. It could mean that allowing monetary aggregates to decline is the cause of recessions. Or it could mean that recessions cause everything in the economy to decline, including monetary aggregates.

After listening to Friedman's version of the Great Depression, many come away thinking: "The Fed reduced the monetary aggregate, and turned what would have been a normal recession into a catastrophic depression." But a closer look at his arguments reveals that he doesn't quite say this. What he actually says is: "The Fed failed to inject enough money into the system to sustain the desired minimum level of monetary aggregates. Because it failed to do this, the public run on banks resulted in a contraction in the money supply, which caused the Great Depression." At no time does Friedman claim that the Fed pulled money out of the system; instead, he criticizes it for not intervening in the crisis. Which, one must admit, is an ironic argument, given Friedman's legendary disdain of activist government.

Conclusion

If the Fed is to be criticized for aggravating the Great Depression, then it's not because it intervened, but because it did not intervene enough. It is yet one more example of how Hoover's laissez-faire policies failed to head off the Depression.

Roosevelt would go on to create the Federal Deposit Insurance Commission to protect the American economy from bank runs in the future. And although the 1987 crash on Wall Street was the largest in American history, these safeguards worked admirably to prevent a bank panic from depressing the economy.

The information does not seem to be copyrighted, but the source is above anyway.