Friedman & Schwartz, Monetary History of U.S.(II),Federal Reserve System, gold standard, Crash of 1929, Great Depression

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

Introduction:

The Federal Reserve System gained freedom of action after the unpleasantness of the 1920 to 1921 depression, Milton Friedman and Anna J. Schwartz explain in "A Monetary History of the United States (1867-1960)." Its gold and other reserves were abundant, and the Treasury had no major deficits to fund.
&

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, E) "Great Depression Bust" and F) "Power & Limitations of Monetary Policy," below, and Friedman & Schwartz, "Monetary History of U.S.," Part III, "The Age of Chronic Inflation (1933-1960)," at section H) "Conclusion: The Impacts of Fluctuations of the Money Stock."
&
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. &
	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. & 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. &
	Price statistics leave much to be desired during this period, especially for consumer or general price levels. The authors make use of indexes based on calculated - or "implied" - prices, and so refer to "implicit" prices rather than consumer or general prices. They rely heavily on wholesale prices since these statistics are more available.

From 1920s prosperity to 1930s Depression:

The belief arose that the central banks could together assure both domestic and international stability.

The 1920s were a period of general prosperity and monetary stability, with monetary growth proceeding at a regular rate. The reputation of the Federal Reserve System (the "System") soared, and it cooperated closely with the great central banks of Britain, France and Germany. The belief arose that the central banks could together assure both domestic and international stability.

The authors do not deal with the multitude of financial crises in Europe in the 1920s. See, James, "The End of Globalization," at Ch. 2, pp. 31-100. They mention only briefly U.S. loans to financially stressed European nations.

The Great Depression began like previous depressions - although it was immediately sufficient not only to slow monetary expansion but to cause some decline in the money stock. By the end of 1930, however, this changed drastically, as bank runs, failures and crises reached unprecedented proportions.

The impacts of major wars and crop failures in various parts of the world influenced economic adjustment mechanisms and were dramatically reflected in monetary flows. The authors note this with respect to the overseas crop failures of 1879 to 1881, 1891 to 1892, and 1897 to 1898 that were followed by immediate crop surplus as foreign crop levels recovered and farmers responded to the temporarily higher prices by increasing production. See, Friedman & Schwartz, "Monetary History of U.S." Part I, "Greenbacks and Gold (1867-1921)," at sections C) "The Gold Standard and 'Free Silver' Movement," segment on "The adjustment process of the gold standard," and D) "Inflation Under the Gold Standard," segment on "Gold inflation." But somehow, they completely fail to note the far more serious nature of this phenomenon as it developed between the period of overseas scarcity during WW-I and the record and near record crops and vast surplus carryovers of 1928, 1930 and 1931. They fail to note the role of government price supports and trade war levels of tariffs in extending the problem and making the period of adjustment drastically more difficult and damaging.

By 1933, when a banking holiday brought the collapse to a conclusion, the money supply had declined by one-third, as had the number of banks through failure and merger. The Fed had the power to mitigate these contractions but failed to act - presumably because of a higher priority given to external than to internal stability.

Federal Reserve monetary policy:

Promoting internal stability and balance in international accounts and the prevention or moderation of financial crises were the tasks of the Federal Reserve System (the "System").
&

The abnormally high rate of bank failures in the 1920s - concentrated in small, nonmember, agricultural sector banks - were attributable to lingering agricultural dislocations from WW-I and did not threaten confidence in the banking system as a whole.

Extensive studies were undertaken on these subjects. The prosperity and general stability of the 1920s seemed to indicate that these tasks had been mastered. At various times, the System even extended credit to foreign nations - Poland, Czechoslovakia, Great Britain, Belgium, Italy, France.
&
The Federal Reserve Board (the "Board") noted and kept statistics and records on bank suspensions and failures, but until well into the 1930s, felt no obligation to intervene. The authors agree with the Board view that the abnormally high rate of bank failures in the 1920s - concentrated in small, nonmember, agricultural sector banks - was attributable to lingering agricultural dislocations from WW-I and did not threaten confidence in the banking system as a whole.
&

The use of open market operations as well as rediscounting as means of regulating the money markets was recognized before the middle of the decade. A committee was organized to coordinate the buying and selling of government securities for all the Federal Reserve Banks (the "Banks").
&
Open market operations expand the money supply in public hands by System purchases of government securities or eligible bills from the public. This replaces government or commercial debt with high-powered money - monetizing a portion of the debt. They contract the money supply in public hands by selling these debt instruments from System inventory as a means of withdrawing money from circulation. System rediscounting of eligible commercial bills also expands the money in circulation.
&
The relation between open market activities and discount levels - the tendency of open market purchases of government securities to reduce the volume of discounting and vice versa - the "scissors" effect - was recognized.

"[When] the System has wanted to tighten credit conditions it has generally both sold securities and bills and raised discount rates. The sale of securities and bills has reduced reserves of member banks, thereby increasing their desire to discount at any given rate, and conversely. In general, this effect has been stronger than the direct effect of the rise in the rate, so that the level of discounts has generally moved in the same direction as the discount rate rather than in the opposite direction -- this is the 'scissors effect' of open market operations and discount rates."

The System had to learn how to use its tools.
&

The gold standard had its problems, but it had provided easily understood answers and was generally effective in peacetime given reasonably responsible government financial policies.

Unfortunately, the System remained uncertain as to when to use its tools. The "problem of devising criteria to replace the gold reserve ratio" remained unsolved. The gold standard had its problems, but it had provided easily understood answers and was generally effective in peacetime given reasonably responsible government financial policies. Quoting the System's Tenth Annual Report (for 1923) - which constituted an important analytical effort to guide policy - the authors note the vagueness of the guidance available.

"[There] is no simple test such as the reserve ratio, the exchange rate, or a price-index number that can serve as an adequate guide for policy; that policy 'is and must be a matter of judgment,' based on the fullest possible range of evidence about changes in production, trade, employment, prices and commodity stocks."

This report emphasized the need to "interpret" conditions and rely on "judgment" to do the right thing at the right time, "with only the vaguest indications of what is the right thing to do."
&

The System's monetary policy tools were blunt instruments, and much confusion was created in trying to find ways to apply them that would discourage the speculative use of credit without constraining the commercial use of credit - an impossible task.

There was concern about distinguishing "productive" from "speculative" use of credit. The commodities speculation that collapsed in the 1920-1921 depression remained very much in mind. Concern about the speculative use of credit for securities transactions would not arise until the stock market boom at the end of the decade. Unfortunately, the System's monetary policy tools were blunt instruments, and much confusion was created in trying to find ways to apply them that would discourage the speculative use of credit without constraining the commercial use of credit - an impossible task.
&
When interest rates rise, all business feels the pain - whether that business is trivial or fundamental, speculative or productive. Rising discount rates or open market sales of securities sufficient to reduce the money stock to curb speculation will curb business activity in general.
&
This difficulty naturally led to efforts to devise means of applying "direct pressure" on banks to limit loans that supported speculative activities. Experienced bankers quickly rejected any such possibility. "The 'Tenth Annual Report' section on 'guides to credit policy' had emphasized the impossibility of controlling the ultimate use of System credit, and other reports had repeatedly noted the same point." It is as impossible to ration credit as to ration currency, but the Board persisted in the attempt. Reluctance to use the blunt tools at its command "largely paralyzed monetary policy during almost the whole of the important year 1929."
&

Wholesale prices trended slightly lower throughout the period. Indeed, they didn't recover from their 1920s decline until after WW-II.

"Apparently the steadiness of the price movement is far more important than its direction."

As usual, a buoyant expansion followed the severe contraction of 1920 to 1921. In the 22 months after the depression bottom, industrial production rose 63%, the money stock expanded by 14%, and wholesale prices rose by 9%. Net national product rose 23% in the corresponding two calendar years.
&
Steady growth - interrupted by two brief, mild recessions - characterized the next 6 years to the summer of 1929. Wholesale prices trended slightly lower throughout the period. Indeed, they didn't recover from their 1920s decline until after WW-II. The money stock grew at a steady rate until early 1928, after which it was tightened considerably by the System.
&
Although this period of prosperity was shorter, there were many similarities with two previous periods of prosperity - from 1873 to 1892, and from 1897 to 1913. Total real income grew 3½% per year and real income per capita grew between 1.3% and 2% per year - although prices declined 2% per year in the first period and rose 2% per year in the second period and were essentially flat in the 1920s. "Apparently the steadiness of the price movement is far more important than its direction."
&

The state and federal banking authorities competed with each other to attract banks to their respective systems. They relaxed banking restrictions.

"The high prosperity of the twenties and the spreading belief in a new era understandably led to an increasingly optimistic evaluation of the prospects for repayment and hence to an increasing readiness to lend on a given project or collateral."

The banking system underwent extensive changes in the 1920s. The state and federal banking authorities competed with each other to attract banks to their respective systems. They relaxed banking restrictions, thus permitting substantial expansion of the types of activities engaged in by banks.
&
Commercial loans and investment banking, trust functions and real estate loans were the primary activities. Affiliates engaged in underwriting and distributing and even speculating in stocks and bonds. Banks also increased their financing of installment finance companies - principally engaged in automobile financing.

"These developments in banking were part of the general surge of financial activity so distinctive of the twenties. The main features of the financial activity, which culminated in the great stock market boom, were the public flotation on a large scale of foreign securities for the first time in U.S. history, the widening shift by domestic concerns from bank loans to public issue of bonds and stocks as a means of raising funds. One result of these developments was that they apparently led to a reduction in the average quality of credit outstanding, in the sense that the securities issued and the loans made in the late twenties experienced larger frequency of default and foreclosure than those issued in the early twenties. - - - The high prosperity of the twenties and the spreading belief in a new era understandably led to an increasingly optimistic evaluation of the prospects for repayment and hence to an increasing readiness to lend on a given project or collateral."

Fluctuations in credit quality are not a cause of the business cycle, the authors point out, but may contribute to its scope - especially to the severity of contractions when they occur. It is as bad for the economy to become too risk averse as to become recklessly venturesome.
&
Bank failures and suspensions were a common phenomenon even in good times - although far more frequent in bad times. There were about 30,000 commercial banks at the beginning of the decade, but less than 25,000 in 1929 due to mergers as well as suspensions and failures. Nearly 6,000 commercial banks were suspended from 1921 through 1929 - but a large fraction of these had capital of $25,000 or less and were located in small towns of 2,500 or less. Competition from large banks and difficulties in the agricultural sector explain much of this.
&

The Federal Reserve System contributed to confidence, and thus contributed to the steady rise in the deposit to currency ratio. The existence of the System as a lender of last resort induced member banks to reduce their actual reserves closer to the minimum levels required. A market in "federal funds" developed to facilitate interbank lending among member banks - leading to further reduction of actual reserve levels.
&
The WW-I policy of emphasizing circulation of Federal Reserve notes rather than gold certificates was reversed in 1922. Gold and gold certificates rose from 10% to 17% of high-powered money by August, 1929.

The gold exchange standard:

The monetary gold stock rose significantly until 1927. However, this was offset by the rapid decline of Federal Reserve credit outstanding during the 1920-1921 depression and 1923-1924 recession and by the minimal rate of recovery of Federal Reserve credit outstanding thereafter.
&

The Board decided to "sterilize" the gold inflow so it wouldn't have an inflationary impact on the money supply and prices. The Board did this by reducing or restraining the growth of its credit outstanding sufficiently to keep the money stock stable.
&
As nations went back to fixed exchange rates after WW-I, most relied on hard currencies - sterling or the dollar - rather than on gold. This "gold exchange standard" had less play in it than the pure gold standard. There was sufficient play in the system to avoid contagion from small recessions, but a major price decline in any major nation would inevitably attract sufficient gold inflows to affect all other nations.
&
Hard currency reserves were kept in reserve deposits to support public confidence in softer domestic currencies that were issued in much larger amounts. If adverse international payments imbalances forced expenditure of reserves below prudent levels, that could force large declines in soft currency domestic money stocks. This depressed business conditions in the soft currency nation until prices declined sufficiently to stem imports and boost exports and regain balance in international payments.
&

The U.S. was inexperienced and unwilling to take the responsibility for its actions that was required of such leadership. Its short-sighted policies were narrowly self-interested and undermined financial stability worldwide.

If some nations sterilize gold flows, the full burden of the adjustment process - whether involving price inflation or price deflation - falls on the rest.

WW-I left the U.S. as a leading player in this system. Great Britain had played the leading role before WW-I, but the war left her financially weakened. The U.S. was inexperienced and unwilling to take the responsibility for its actions that was required of such leadership. Its short-sighted policies were narrowly self-interested and undermined financial stability worldwide. It became the bull in the financial china shop - blatantly heedless of the international impacts of its domestic policies.
&
The sterilization policy undermined the international adjustment mechanism of gold flows, made it more difficult or even impossible for other nations to re-establish gold standards, and contributed to the financial turmoil in Europe. (So did the extraordinarily high U.S. tariffs enacted in 1922 - the impact of which the authors don't mention.) France, too, pursued a sterilization policy.
&
If all nations sterilize gold flows, the authors point out, the adjustment process breaks down. If only some adopt this policy, the full burden of the adjustment process - whether involving price inflation or price deflation - falls on the rest - in this case, primarily on Great Britain. In 1926, Britain resumed gold standard transactions at the pre-WW-I par of $4.86. Great Britain was trying to pay for its wartime expenses without stiffing its creditors.
&

Britain's economy was no longer flexible enough to make such post-war adjustments.

"[If] gold flows had been permitted to affect the quantity of money they would thereby have set in motion forces tending to reduce their magnitude."

But par proved to be too high. Britain's economy was no longer flexible enough to make such adjustments. It suffered from persistent deflationary pressures right into the Great Depression, contributing to the stagnant economic conditions throughout Europe. U.S. gold sterilization policies (and high tariffs) played a major role in the failure of Britain's efforts and the destabilization of finances throughout Europe.
&
Because the gold inflow was prevented from impacting the money stock by System monetary policies, U.S. prices tended downwards instead of upwards during the 1920s. But the increase in domestic stability was clearly artificial, and it delayed needed adjustments, magnifying the pressures on the international system.
&
This contributed to the total breakdown of both the U.S. domestic and international monetary systems beginning in 1929. Gold inflows continued until the British devaluation crisis in September, 1931. However, instead of expanding the money stock in the U.S. as gold stocks increased, the Federal Reserve Board sterilization policy resulted in further contraction of the money stock.
&
"[If] gold flows had been permitted to affect the quantity of money they would thereby have set in motion forces tending to reduce their magnitude," the authors point out.

"Our money stock moved perversely, going down as the gold stock went up. In August, 1929, our money stock was 10.6 times our gold stock; by August, 1931, it was 8.3 times the gold stock. The result was that other countries not only had to bear the whole burden of adjustment but were also faced with continued additional disturbances in the same direction, to which they had to adjust."

The authors are, of course, correct about the noxious impact of U.S. gold sterilization policy - but the impact of U.S. tariffs were even worse. If foreign dollar debtors had not been blocked by tariffs from selling into the U.S. market, they might have been able to earn enough to service their dollar debts and keep their economies afloat. There might have been no trade war, and international trade and finance would not have collapsed.

Criticism was justifiably directed at the U.S. from around the world. (The U.S. directs similar criticism today at Japan and China.) U.S. loans to foreign nations - Germany, Austria, Hungary, Rumania - and the floating of foreign government bonds on the New York markets - prevented earlier collapse - but were mere palliatives. As the financially weakest nations experienced deflationary economic difficulties, these difficulties were in turn transmitted to other nations (ultimately including the disastrous collapse of U.S. export markets).
&
There were nations - like China - that were on a silver standard, and others that maintained floating exchange rates. These were insulated from the effects transmitted by the gold standard.

However, the terms of trade of the silver standard nations were substantially adversely affected by the rapid decline in the gold price of silver.

The authors point out that recovery in country after country followed abandonment of the gold exchange standard. This is used as proof that gold standards - and the U.S. as the dominant player - played a dominant role in the worldwide Great Depression.

Correlation, of course, is not causation. The abandonment of a gold standard was always just a part of the mix of policies used to deal with the crisis in individual nations. As always whenever devaluation is forced upon a nation, it might have been necessary, but it was never sufficient.
&
Great Britain, for example, followed abandonment of fixed exchange rates with policies of financial austerity that quickly restored faith in the pound at its new lower levels, and eventually stabilized it at a lower level. Trade policies differed from nation to nation. The policies required for monetary stability and economic success under floating exchange rates are very similar to those required for stability under fixed exchange rates, but floating exchange rate flexibility is a big advantage when major adjustments are required.
&
Nations around the world have since continued to avail themselves of the benefits of fixed exchange rates. Fixed exchange rates enhance confidence in weak currencies, impose discipline on unreliable political leaders, and can thus reduce the costs of capital. It was the irresponsible and disruptive policies of one of the gold standard's major components - the United States - that changed benefit into vast liability. This at least temporarily forced recourse to the greater flexibility of floating exchange rates to facilitate the adverse adjustments needed by many nations.
&
Those abandoning fixed exchange rates based on gold and the dollar often defaulted on their dollar debts at the same time as they devalued their currencies. By breaking their financial ties to the United States, they freed themselves from some of the massive disruptions that U.S. trade and monetary policies were causing - as well as from much of the financial legacy of the Great War. They had in any event by that time already lost access to the financial resources of the New York market.

Federal Reserve System failure (I):

Board monetary policy seemed effective during the two business cycles in the mid-1920s. The Board raised discount rates one or two half point steps to restrain the exuberance of growth - accompanied by open market activities designed to drain money from circulation and reduce credit - and reversed course as recessions developed - apparently contributing to keeping them mild. But by 1926, the great stock market boom had already begun.
&

The record indicates that System operations actually failed to mitigate the two mild recessions of the twenties - in 1923-1924, and 1925-1926. System credit outstanding declined in both. The System significantly increased its holding of government securities. However, bills discounted declined sharply and even open market purchases of bills declined. Money stock growth slowed during these recession periods, but substantial increases in the deposit to currency-in-the-hands-of-the-public ratio prevented any actual decline. Indeed, the rising deposit to currency ratio accounted for 54% of the 45% money stock increase between the cyclical trough in July, 1921, and the August, 1929 peak.
&

Despite no evidence of any price inflation, from early 1928 the Board began raising its interest rates and selling its government securities. It was reducing the money in circulation and credit availability. By that summer, the discount rate was up to 5% and System holdings of government securities had been reduced from $600 million to $210 million.
&
However, the effort was frustrated by the "scissors effect." As money tightened, commercial interest rates rose faster than the discount rate. Despite the higher discount rate, this increased the profitability of borrowing funds from the System for use in commercial loans.
&
An open feud broke out between the influential N.Y. Federal Reserve Bank (the "N.Y. Fed") and the Board about further discount rate increases. The rate in New York remained constant at 5% until August, 1929 as the stock market roared on. The bureaucratic mechanism for fixing the discount rate became frozen.
&
A more flexible tool than the discount rate was the rate for the purchase of bills - 60 day acceptances - commercial instruments thought unrelated to speculation. This remained at 4½% through December, 1928 - below the discount rate - then rose in 5 steps to 5½% in March, 1929 - above the discount rate. This effectively achieved a rapid rise and then a rapid decline in the System's bill holdings - initially expanding money and credit while the Board was trying to constrain it.
&

The Board persisted in emphasizing efforts to apply "direct pressure" on member banks to discourage the speculative use of System credit.

The tug of war between the Board and the N.Y. Fed over this and lesser policy disputes had simmered throughout the twenties. George L. Harrison was governor of the N.Y. Fed., and Roy A. Young was governor of the Board until September, 1930, after which Eugene Meyer was governor of the Board. Details of these disputes over policy and control of bank activities pertinent to monetary policy, and control over the Open Market Investment Committee, are provided by the authors.

This dispute took place amidst a background of already wildly fluctuating stock and commodity markets and increasing financial stress abroad - not covered by the authors - yet essential context for understanding various phases of the dispute and the impact of monetary policy on the development of the October, 1929 stock market crash. Stability was being maintained in the U.S., while the financial and political world disintegrated around it - a disintegration that began to wash ashore from Europe in the summer of 1929, and swept away values in U.S. as well as in international commodity markets in the first half of 1930. It destroyed financial stability in the U.S. as well as in the rest of the world during the British pound devaluation crisis of September, 1931.

The question of whether System credit could be directed away from speculative use raged throughout 1929. The N.Y. Fed voted to raise its discount rate to 6% eleven times, but each time the rate hikes were disapproved by the Board. The Board instead persisted in emphasizing efforts to apply "direct pressure" on member banks to discourage the speculative use of System credit.
&

Already, some were expressing fears that rate hikes would cause a depression worse that that of 1920-1921 - and that the response in Congress would lead to a loss of Board independence.

However, the call money market in New York was a major source of commercial financing as well as a major source of speculator financing. Any effort to restrict lending through it could cause call money interest rates to sky rocket and panic the markets. (Call money short term interest rates had already been at and above 15% in March, April, June and July 1929, and had hit 20% in March.)
&
Call money lending was impersonal. There was no way to distinguish between commercial and speculative purposes. Already, some were expressing fears that rate hikes would cause a depression worse than that of 1920-1921 - and that the response in Congress would lead to a loss of Board independence. The large N.Y. banks felt a responsibility - indeed, a need - to prevent turmoil in the call money market.
&
Moreover, there were seasonal demands for credit - especially during the harvests and Christmas in the fall and early winter. Direct action had to be suspended at such times.
&

In 1928, the Board decided that continuous indebtedness at the Reserve Banks was an "abuse of reserve bank facilities."

Indebtedness to the System came to be viewed as a sign of financial weakness, and made many banks reluctant to use the System rediscount facility.

The System was a "lender of last resort," the Board emphasized. It was not a source of continuous finance. In 1928, it decided that continuous indebtedness at the Reserve Banks was an "abuse of reserve bank facilities." Its "Annual Report" for 1928 explained that "the proper occasion for borrowing at the reserve bank is for the purpose of meeting temporary and seasonal needs."
&
Pressure was in fact applied to certain N.Y. member banks that were continuously borrowing large sums from the System. However, the banks countered that they had bought federal bonds in the belief that the bonds could always be used as collateral for System loans. Any withdrawal of "accommodation" would reduce the value of the bonds. But indebtedness to the System came to be viewed as a sign of financial weakness, and made many banks reluctant to use the System rediscount facility.

"The decision to rely on a tradition against continuous borrowing rather than on a higher discount rate has had important consequences. It helped to make open market operations rather than rediscounting the main instrument for quantitative control. It established relations between member banks and Reserve Banks that facilitated attempts at qualitative control, e.g., over the stock market in 1929. Finally, by making discounting seem a source of weakness of banks, it contributed notably to the problem, which is said to have troubled the Reserve System in the early 1930s, of securing enough eligible paper to serve as collateral for Federal Reserve notes."

Confusion about its various monetary policy tools continued into the Great Depression period. Board members drew invalid distinctions between discounts of commercial paper and government securities. This led to inconsistent actions. Purchase and discounting of commercial paper was thought clearly supportive of productive commerce, while purchase or discounting of government securities increased money in circulation for any purpose - speculative as well as productive. In reality, the authors note, the only valid distinction is between System purchases and System discounts, since banks that are already in debt to the System on the basis of discounted bills and notes are somewhat more reluctant to expand their lending activities with the public.
&
In the heat of battle in 1928, 1929 and 1930, this led to some remarkable inconsistency in System policy.

"[The] system at times undertook actions that in retrospect seem self-defeating, such as increasing acceptance holdings in the last half of 1928 while desperately trying to hold down discounts; lowering acceptance rates in August, 1929 while raising discount rates; great unwillingness to expand government security holdings in early 1930 despite a sharp decline in acceptances, and a simultaneous willingness to acquire acceptances, accompanied by complaints about their unavailability."

The Board was paralyzed with respect to the blunt application of monetary constraints, and thus invoked "direct action" and "moral suasion" primarily "to demonstrate to itself and others that it was taking some action to meet clear and pressing problems."

"Direct pressure," like "moral suasion," is doomed to disappoint, the authors conclude. In fact such efforts have shown only minimal impact whenever tried - as in 1919, 1929, and during WW-II until 1951.

"In retrospect, it seems exceedingly doubtful that 'direct pressure' had any significant effect on the amount of security loans, though it may have produced some minor changes in their source."

The authors conclude that the Board was paralyzed with respect to the blunt application of monetary constraints, and thus invoked "direct action" and "moral suasion" primarily "to demonstrate to itself and others that it was taking some action to meet clear and pressing problems."
&

The Board finally agreed on a rate hike to 6% on August 9, 1929 - hoping that it would not unduly affect seasonal credit in the rest of the country. It considered preferential rates for agricultural paper or acceptances drawn for the purpose of crop movements - negotiable bills of lading and warehouse receipts. However, the rate for the purchase of bills was already declining in steps to 5¼%.
&
The authors interpret this inconsistent pattern as indicating that the Board had realized that the decision to increase the discount rate in August was an error. The need had passed. Gold had already begun flowing out of the country.
&
The discount rate hike couldn't be cancelled, but it didn't remain in effect very long. It was lowered in November. The individual Federal Reserve Banks began reducing their bill rates in August. Torn between two objectives, the Board had not imposed enough restraint to stop the stock market boom, but the authors assert that it had succeeded in imposing too much deflationary pressure on the economy to permit healthy economic growth.
&
The authors find evidence for this assertion in the money supply statistics. High-powered money failed to grow or even declined a bit during the 1928 to 1929 boom. The money stock also declined during the 16 months prior to the cyclical peak in August, 1929 - the only time since monthly statistics became available in 1907 that this had happened during prosperous times.
&
The authors point out that the Board had not concerned itself with the Florida land boom that crashed in 1926, and assert that the stock market boom should not have been considered any of its business, either.
&

The Board had learned a lot about its monetary policy tools, but still faced fundamental conflicts of purpose.

Was Board responsibility for promoting healthy economic growth more important than its responsibility for restraining stock market or commodity market speculation?
Should the Board accommodate the money and credit needs of commerce when commerce was expanding and contract availability when economic contraction reduced the need - thus reinforcing the business cycle - or should it constrain the availability of funds during prosperous times and expand circulation during economic contractions - thus hoping to lean against the business cycle?
Should the Board permit gold flows to impact the domestic money supply and thus impact domestic prices and economic activity so that international gold standard mechanisms can work - or should it act to counter that impact in order to foster greater domestic stability - at the risk of contributing ultimately to greater instability both internationally and domestically?

Yet, the bust came anyway - with great virulence - and the economic system could not recover. Why? The authors provide only a monetary answer.

The 1928 to 1929 boom had occurred without either monetary or price inflation. It was unaffected by the cyclical inflationary forces that usually accompany such cycles. And the Federal Reserve System played a major role in preventing the generation of those inflationary forces. Yet, the bust came anyway - with great virulence - and the economic system could not recover. Why? The authors provide only a monetary answer.

"The bull market brought the objective of promoting business activity into conflict with the desire to restrain stock market speculation. The conflict was resolved in 1928 and 1929 by adoption of monetary policy, not restrictive enough to halt the bull market yet too restrictive to foster vigorous business expansion. The outcome was in no small measure a result of the internal struggle for power within the System - - -. How to restrain speculation became the chief bone of contention: the Banks, led by New York, urged quantitative measures of higher discount rates and open market sales; the Federal Reserve Board urged qualitative measures of direct pressure on banks making security loans. A stalemate persisted throughout most of the crucial year 1929, which not only prevented decisive action one way or the other in that year but also left a heritage of divided counsel and internal conflict for the years of trial that followed."

This comment ignores the powerful international and domestic economic forces that had already rendered it impossible for the System to continue to "foster vigorous business expansion." WW-I reparations obligations and WW-I foreign dollar debts and post WW-I foreign dollar debts were impossible to service. Trade war levels of tariff constraints on international markets had been imposed by the U.S. and many other nations. There was vast agricultural overcapacity, and international markets for U.S. automobiles, and agricultural and other commodities were collapsing.
&
These all played a far more important role in the onset and duration of the Great Depression than Board monetary policies - as important as those policies undoubtedly were as a triggering factor in the onset of the crisis and in the failure to mitigate the financial aspects of the crisis that subsequently developed. The only monetary policy that could be included among the fundamental causes of the Great Depression was the gold inflow sterilization policy that undermined the adjustment mechanism of international gold standards.
&
Many economists object that foreign trade accounted for "only" eight percent of U.S. economic activity at that time. However, this objection ignores the well-known fact that markets are moved by marginal developments. It also ignores the importance of the sectors - especially the agricultural sector at that time - which were severely impacted by crumbling international markets. These economists also ignore the fact that a wide variety of domestic markets were inevitably impacted by price collapse on international commodity markets that resulted in the widespread destruction of asset values

The Crash of '29:

"The Great Contraction" is what the authors call the first 3½ years of the Great Depression - from the August, 1929 peak to the March, 1933 trough. See, seven Great Depression Chronology articles beginning with The Crash of '29,
&

It was indeed a "great contraction" in every way - not just financial.

Net national product in current prices - down more than one half.
Net national product in constant prices - down more than one third.
Implicit prices - down more than one quarter.
Wholesale prices - down more than one third.
Money income - down 53%.
Real income - down 36%.
Money stock - down more than one third.

More than 20% of commercial banks - holding more than 10% of deposits - suspended operations. With mergers and liquidations and consolidations, the total number of banks fell by more than one third. A quarter of the workforce was unemployed at the trough. The income gains of a quarter of a century had been erased.
&
The authors here briefly acknowledge the existence of other domestic and international contributing forces, and that even with aggressive monetary policy, the Great Depression might have been "relatively severe." However, they insist that more aggressive monetary policy could have greatly mitigated the Great Depression and shortened its duration.

With respect to the banking crises, they are undoubtedly correct. However, even with respect to the banking crises, the extent of mitigation possible through monetary policy given the limited authority and resources available to the System is inherently unknowable - and certainly not as great as the authors imply.

The N.Y. Fed purchased $160 million in government securities - far in excess of anything contemplated by the System's Open Market Investment Committee - to expand liquidity in the N.Y. market. There was no bank panic. The panic was confined to the stock market. While already severe, there was nothing apparently unusual during the first year of the Great Depression.

The bank arrangements were unwound in the following months - at a profit.

This was the highest deposit to currency ratio on record other than a short spike during the Crash. Clearly, the public still had great confidence in its banking system.

A flight of capital hit the markets for brokers loans and other credit during the 1929 stock market crash. Out-of-town banks and foreign banks, often acting as agents for investors, had been funneling vast sums into the brokers loan market. They now withdrew $4.5 billion - (just under 50% of the total) - from the brokers loan market.

For purposes of providing a reference figure for judging the magnitudes of these events, the total capitalization on the N.Y. Stock Exchange at its peak in September, 1929, was slightly over $90 billion. There was over $40 billion in bonds on the N.Y. Stock Exchange bond market.

The N.Y. City banks stepped into the breach, supported by open market purchases by the N.Y. Fed to increase member bank reserves. The N.Y. Fed purchased $160 million in government securities - far in excess of anything contemplated by the System's Open Market Investment Committee - to expand liquidity in the N.Y. market. There was no bank panic. The panic was confined to the stock market. While already severe, there was nothing apparently unusual during the first year of the Great Depression.
&
For the time being, the authors note, these actions were timely and effective. They avoided panicky spikes in interest rates, avoided major defaults on loans, and maintained confidence in the banking system. The stock markets were able to continue functioning through the Crash.

The stock markets overcame great volatility during November and December, 1929, and rebounded substantially through April 10, 1930. The bankers group - which had rallied to support the market by making large purchases of blue chip stock during the darkest moments of the Great Depression Crash - reported that they had successfully unloaded their holdings by the end of February - at a profit.

Monetary gold stocks declined as foreign money continued to be withdrawn from the N.Y. money market. The stock of money thus declined in November, but recovered in December due mainly to shifts in demand deposits. The money stock trended a bit lower until the October, 1930, banking crisis.
&
High-powered money had declined by 5% between August 1929, and October 1930, but an increase in the deposit to currency-in-the-hands-of-the-public ratio of 7% cut the impact on the money stock about in half. This was the highest deposit to currency ratio on record other than a short spike during the Crash. Clearly, the public still had great confidence in its banking system.
&

The banks showed no inclination to increase their reserves during this period.

The discount rates of the N.Y. Fed were rapidly dropped in steps to 2½% by June, 1930 - but discounts declined sharply anyway. Demand for bank loans had dropped sharply as capital fled to safe assets. Money market interest rates also dropped sharply - even more sharply - reducing the attractiveness of discounting at the Fed.
&
There were many who thought the discount rate should have been lowered faster and further. The N.Y. Fed had persistently voted for rate reductions, but on several occasions was blocked by the Board.
&
In the event, over $1 billion in bills that had been discounted and bills that had been bought flowed out of the System, reducing the System credit outstanding and the money stock during this period.
&
The authors reject the argument that a more aggressive monetary policy would just have created funds that would have been sucked into bank reserves. The banks showed no inclination to increase their reserves during this period, they point out. The decline in the stock of money "is attributable to the decline in Federal Reserve credit outstanding" that could have been reversed by aggressive open market purchases.
&
The authors provide the annual breakdown of the statistical decline and compare it with previous depressions - including the 1839 to 1843 depression following the lapsing of the federal charter of the Second Bank of the United States that had left the nation without an acting central bank. The decline of the stock of money that first year after the 1929 Crash was severe - 2.6% - but less than during a number of previous severe contractions.

"The decline in the stock of money is especially notable because it took place in a monetary and banking environment that was in other respects free of marked difficulties. There was no sign of any distrust of banks on the part of depositors, or of fear of such distrust on the part of banks."

There is no sign of any flight to liquidity. Currency in circulation declined much more than bank deposits, and there was no special effort to expand bank reserves.

"[The] decline in the stock of money up to October, 1930 reflected entirely a decline in Federal Reserve credit outstanding which more than offset a rise in the gold stock and a slight shift by the public from currency to deposits."

Federal Reserve System failure (II):

The first banking crisis began in October, 1930, involving primarily small banks in agricultural areas. By the end of November, banks holding about $550 million in deposits were involved. (There had been a great collapse of agricultural commodity prices in the first half of 1930, which resumed in the second half and was joined at various points by the price collapse of many industrial commodities.)
&

These bank runs resulted in the first substantial increase in currency in circulation during the Great Depression. It naturally initiated efforts by banks to strengthen their reserves. There was also a shift of deposits into the postal savings banks. Deposits there would increase from $100 million in 1929 to $1.1 billion in March, 1933.
&

The existence of the Federal Reserve System - with its discounting facility - relieved the stronger member banks of any perceived need to engage in the concerted action needed to stabilize the situation.

Then, in December, the Bank of United States, with $200 million in deposits, failed in New York - the largest commercial bank failure up to that time. (Its large portfolio of building and real estate mortgages had been hit hard.) Details of the efforts to save it are provided by the authors.
&
The existence of the Federal Reserve System - with its discounting facility - relieved the stronger member banks of any perceived need to engage in the concerted action needed to stabilize the situation. Indeed, there was widespread reliance on the System to deal with the problem. Governor Harrison of the N.Y. Fed spearheaded the effort to save the bank, but the N.Y. City bankers rejected his efforts and refused to participate.
&
The authors assert that, before the System, the problem would have been solved by a temporary restriction of convertibility of deposits into money. This restriction would have provided time to liquidate enough assets to satisfy demands for withdrawals, and the panic would have passed.

"By cutting the vicious circle set in train by the search for liquidity, restriction would almost certainly have prevented the subsequent waves of bank failures that were destined to come in 1931, 1932, and 1933, just as restriction in 1893 and 1907 had quickly ended bank suspensions arising primarily from lack of liquidity. Indeed, the Bank of United States itself might have been able to reopen, - - - . After all, the Bank of United States ultimately paid off 83.5 per cent of its adjusted liabilities at its closing on December 11, 1930, despite having to liquidate so large a fraction of its assets during the extraordinarily difficult financial conditions that prevailed during the next two years."

Here is one of the places where the authors forget the extraordinary non-monetary factors still driving the Great Depression at this time. The international financial situation was still worsening, the purchasing power of nations on a silver standard was plunging with the plunging price of silver, exports and imports were declining at multiple double digit rates - especially impacting agriculture, autos, and textiles - agricultural price supports were adding massively to huge agricultural surpluses, the trade war had actually been intensified by the Congress of the United States, and real estate values were plunging. Prices on international markets for all manner of commodities and products were plunging - international cartels in copper, steel and rubber were busted - undermining values in domestic markets. Until such factors were dealt with there could be no real recovery, and the rapid continuing decline would inevitably impact more banks and renew pressure on any banks that were temporarily rescued.
&
Restriction of payments on deposits is designed to prevent a temporary liquidity problem from undermining bank solvency. Now, however, currency was readily available, but solvency was being threatened by an economic contraction that was not temporary. The Great Depression was not susceptible to ordinary economic adjustment processes. The major causes were the result of political policies of enormous stupidity. Thus, effective adjustment required political change or abandonment of those policies. See. Great Depression - Summaries of Controversies and Facts.

Confidence began to erode after the October, 1930 banking crisis. This was reflected in rapid declines in the two bank deposit ratios. These declines resulted in a 3% decline in the money stock in three months from the end of October, even though high-powered money rose 5%. Federal Reserve System credit outstanding rose $117 million - helping to offset some of the effects of the banking crisis. However, System credit outstanding was still just 84% of its summer 1929 level. The discount rate was lowered to 2%.
&
The entire increase in System credit outstanding was permitted to unwind after December, 1930. Gold was flowing in, but the decline in System credit was greater, resulting in a decline in high-powered money. Deposit ratios rebounded somewhat as the banking crisis ebbed.
&

Corporate bond prices were by now being affected. Prices fell as investors sought liquidity or the safety of government bonds. The capital adequacy of the banks was undermined by the falling prices of their bond holdings.
&
The authors note the seasonal business revival early in 1931 as a likely point from which recovery might have begun if reinforced by aggressive monetary policy. (They ignore the even more vigorous seasonal revival a year earlier - early in 1930 - which also proved unsustainable.) They note the banking crisis beginning in March, 1931, which ran for several months. It preceded the renewed business decline by a month or more and then accompanied it.

The authors again ignore the far more important factor - the continued rapid decline of agricultural prices when the Farm Board announced that it could no longer maintain price supports. Price supports had induced another bumper crop adding massively to the vast overhang of agricultural surpluses from the record 1928 and bumper 1930 crops. And, wheat exports - equivalent to as much as 40% of the North American crop - had been cut by 75% by the trade war.
&
Aggressive open market securities purchases could not have sold one more automobile or one more bushel of wheat into the nation's crumbling export markets, or eliminated one bale of cotton from the surplus, or sustained the value of rural real estate, or materially supported international commodities markets. However, if aggressive enough to reverse the gold inflow, it might have saved the British pound - but at the expense of reducing System ability to expand high-powered money and the money stock during the crises that were still sure to come.
&
Central banks always unwind emergency credit extensions as soon as feasible after the passing of a temporary liquidity crisis in order to restore their ability to deal with subsequent events. However, the Great Depression was not a temporary crisis, and any unwinding of System securities purchases would have just transferred the problem to a later, probably more vulnerable point.

The authors do note the worsening financial turmoil in Europe during this period - as major banks closed in Austria and Germany and elsewhere. The Hoover Moratorium on international loan payments was agreed to in July, 1931, and loans were arranged in the U.S. and France for Great Britain - providing some temporary relief for the hard pressed pound. (But temporary relief was not sufficient because the Great Depression was not temporary.)
&

Devaluation of the pound:	The second banking crisis ran from March, 1931, into the British devaluation crisis in September. &
The deposit ratios nose-dived as deposits were withdrawn and banks sought to strengthen their reserves.	Confidence was fragile to begin with, as might be expected by this time, and was shattered by the renewed troubles in the banking system. The deposit ratios nose-dived as deposits were withdrawn and banks sought to strengthen their reserves - driving down the money stock 5½% in six months even though high-powered money rose 4% during the four months from March. & "Despite the unprecedented liquidation of the commercial banking system," the authors point out, "the books of the 'lender of last resort'" show a level of discount activity lower than seasonal norms through August, 1931. Open market purchases of securities in response to the crisis was only a "timid" $80 million. &
The decline in the money stock accelerated, and the Board did almost nothing to stem the tide.	Now, capital, and gold, were flooding into the U.S. - but U.S. banks were left holding substantial amounts of the frozen short-term dollar obligations of foreign banks. Worldwide, everybody was seeking liquidity and banks were trying to strengthen their reserves. As banks liquidated their bond portfolios or fled to the safety and liquidity of government bonds, the price decline in corporate bonds accelerated. & Thus, the decline in the money stock accelerated, and the Board did almost nothing to stem the tide. Commercial bank deposits declined by $2.7 billion - at more than double the previous rate. Yields on commercial paper continued to fall, tracking just above the decline in the discount rate which was reduced in steps to 1½%. &

The banking system was now being drained externally as well as internally.

When Britain was forced off the gold standard in September, 1931, and the pound was devalued, the worldwide financial crisis reached catastrophic proportions. Two dozen other countries quickly followed. Suddenly, gold was king. Not even the dollar was trusted. More than $700 million in gold flowed out of the U.S. gold stock in little more than 6 weeks.
&
The banking system was now being drained externally as well as internally. In August and September, 1931, banks with $414 million in deposits suspended operations - involving over 1% of the remaining deposits in commercial banks. Depositors were withdrawing currency, and foreigners were withdrawing gold - just as the seasonal peak in demand for currency and credit was beginning.
&
The money stock declined 12% in five months from August, although high-powered money rose 4½%. The deposit to currency ratio collapsed as depositors fled the banking system and weak banks called in the reserves that they had deposited with stronger banks. They had to make funds available for depositor withdrawals.
&

This would have been another opportunity for a pre-Federal Reserve Bank system to stabilize the system by temporarily restricting payments on deposits, the authors assert. This "likely would have prevented at least the subsequent bank failures." They note the business revival in late August and early September (but fail to mention that this was the usual seasonal business increase and how much more modest it was than in 1930).
&

"It was the necessity of reducing deposits by $14 in order to make $1 available to the public to hold as currency that made the loss of confidence in banks so cumulative and so disastrous."

Bank runs and failures accelerated. In the 6 months through January, 1932, 1,860 banks with $1,449 million in deposits suspended operations. Five times that amount drained away from the deposits of the rest as faith in banks crumbled. The money stock fell by 12% in those 6 months - the fastest decline ever. Banks were driven to access the System's discount facility in the two months after the devaluation of the British pound despite the higher rates. However, this was all unwound by January, 1932.
&
The authors point out that the System could have offset these drains by open market purchases designed to increase the circulation of high-powered money. They argue that an additional $400 million in high-powered money provided by the Federal Reserve System for bank reserve deposits would have prevented a $6 billion decline in total deposits. Excess reserves were too low, so required reserves had to be drawn down, with a multiple effect on bank capacity that the authors calculate to roughly 14.

"It was the necessity of reducing deposits by $14 in order to make $1 available to the public to hold as currency that made the loss of confidence in banks so cumulative and so disastrous. Here was the famous multiple expansion process of the banking system in vicious reverse. That phenomenon, too, explains how seemingly minor measures had such major effects. The provision of $400 million of additional high-powered money to meet the currency drain without a decline in bank reserves could have prevented a decline of nearly $6 billion in deposits. - - -
&
"The more extensive use of deposits -- widely regarded during the twenties as a sign of the great progress and refinement of the American financial structure -- and the higher ratio of deposits to reserves -- widely regarded as a sign of the effectiveness of the new Reserve System in promoting 'economy' in the use of reserves -- made the monetary system more vulnerable to a widespread loss of confidence in banks. The defenses deliberately constructed against such an eventuality turned out in practice to be far less effective than those that had grown up in the earlier era."

At no time during the first three years of the Great Depression were gold reserves inadequate to support aggressive monetary policy - including substantial open market purchases.

System gold reserves at the start of the British devaluation crisis were over 80% of System note and deposit liabilities in July, 1931, 74.7% in September, and didn't fall below 56.6% in October during the rapid outflow of gold. It was in excess of required reserves by well over $1 billion at its lowest. At no time during the first three years of the Great Depression were gold reserves inadequate to support aggressive monetary policy - including substantial open market purchases.
&
Indeed, the U.S. had accumulated $4.7 billion in gold - about 40% of the world's monetary gold stock - a primary reason for the worldwide financial turmoil. This is one - major - aspect of the Great Depression that a responsible and mature monetary policy by the U.S. could have resolved.
&
Even with the end of the bank crisis, deposit ratios and money stock trended downwards as confidence remained shaky and precautionary measures continued.
&
The System did purchase an additional $500 million in bills in the six weeks after the devaluation of the pound, but that was clearly inadequate.

"The result was that the banks found their reserves being drained from two directions -- by export of gold and by internal demands for currency. They had only two recourses: to borrow from the Reserve System and to dump their assets on the market. They did both, though neither was a satisfactory solution."

Despite the 3½% discount rate, banks were now borrowing heavily from the System - the burden falling hardest on banks outside the financial centers. They were now liquidating their most basic assets - government bonds and negotiable commercial paper. Government bond prices declined precipitously - by 10% - for the first time during the Depression, and commercial paper yields rose with the precipitous rise in the discount rate, lowering their prices. High grade corporate bonds declined 20%, and lower grade bonds declined even more. Railroad bonds fell off the eligible list for securities satisfying minimum bank reserve requirements.
&

Various financial measures - a private National Credit Corporation formed in October, 1931 - and the Reconstruction Finance Corporation ("RFC") established in January, 1932 - were tried with no more than limited temporary impact. The Glass-Steagall Act of 1932 passed in February. It broadened the collateral eligible at the Federal Reserve System, and widened the circumstances under which banks could borrow from the System. In July, 1932, the Federal Home Loan Bank Act authorized the organization of federal home loan banks to make advances to savings institutions on the security of first mortgages. Various reform and relief measures outside the financial sector were also proposed - and some were enacted - but to little avail.
&

Federal Reserve System failure (IV):

In April, 1932, pressure from Congress finally forced action. 1932, after all, was an election year, and all manner of price support schemes were being proposed in Congress. By this time, system gold reserves had climbed to 70%, and it was finally recognized as inexcusable to not use these great financial resources to support the crumbling financial system.
&

By this time, system gold reserves had climbed to 70%, and it was finally recognized as inexcusable to not use these great financial resources to support the crumbling financial system.

The Conference of Reserve Bank governors added $500 million to the executive committee purchase authorization, and directed immediate implementation. $100 million of government securities per week were purchased in the next five weeks. Another $500 million was authorized in May. By the end of June, $1 billion in government securities had been purchased - but $500 million in gold had fled and there had been a $400 million reduction in bills bought and discounted - for a mere $100 million net increase in System credit outstanding. There had been no apparent impact on the economy.

Was the capital flight and reduction in discounting just an unfortunate coincidence or might they just have been in some way connected to the sudden decision to monetize $1 billion in government debt?

This could have gone on considerably further, but not indefinitely. The gold reserve ratio in N.Y. had fallen to 50%. It was 58% for the System as a whole. Several of the other Federal Reserve Banks - especially in Boston and Chicago - opposed the program and wouldn't participate.
&
When Congress adjourned on July 16, the program was allowed to lapse. Only $30 million was purchased in the next month to avoid the appearance of too abrupt a halt - but System holdings of government securities remained flat for the rest of the year. Discounts and bills purchased declined from July on, so that Federal Reserve credit outstanding peaked in July and then declined $500 million in about 6 months.
&
High-powered money kept rising due to a resumption of gold inflows and an increase of $140 million in national bank notes issued in response to the liberalization of eligible government securities under the Home Loan Bank Act of July, 1932. However, total money stock kept declining for awhile - albeit at a slower rate. Demand deposits began to rise in July, the money stock in September. While the increases were small, the shifts from rapid decline were major. However, the deposit to reserves ratio remained in sharp decline, as banks sought to strengthen their reserves against the storms to come.
&
There was a wave of 40 bank failures in Chicago in June - but this did not undermine the improved financial and economic tone. This crisis was finally stemmed when the RFC made a major loan to a leading Chicago bank.
&

There are some who believe that July, 1932, marked the trough of the Great Depression. There were sharp declines in all interest rates. Wholesale prices, agricultural prices and industrial production increased - and the lowest point in the spectacular decline of stock market values was finally reached. The stock market bottom came in July, with N.Y. Stock Exchange capitalization down to about $15 billion.
&
All of this had been preceded by the System open market action The authors assert that this strongly indicates that monetary policy played some role in bringing the contraction phase of the Depression to an end.

"After three years of economic contraction, there must have been many forces in the economy making for revival, and it is reasonable that they could more readily come to fruition in a favorable monetary setting than in the midst of continued financial uncertainty."

This was, in fact, a critical test for the capacity of aggressive monetary policy to impact a crisis like the Great Depression. In addition to the $1 billion increase in System credit outstanding from the open market purchases in 1932, the RFC loaned $808 million to banks during 1932 - and about $400 million to railroads and other businesses. There were also powerful business reasons for the summer revival.
&
The Farm Board was no longer supporting prices, so crops were reduced precipitously below domestic market needs. There were poor crops elsewhere around the world. The Russian grain crops produced by their recently collectivized farms continued to collapse. Indian and Egyptian cotton crops were hit by severe drought. There was a brief upsurge in agricultural exports. Agricultural commodity prices soared.
&
The result that summer was one of the sharpest bull markets in stock market history - albeit from a very low base - up over 100% in two months. This confirmed the market sense that the surplus in agricultural production was one of the primary causes of the Great Depression. All of this added to the impact of the suddenly aggressive monetary policy of the System and the contributions of the new RFC - yet all together, it was still to no avail.
&
WW-I reparations obligations and dollar WW-I loans were now slipping into default - providing the world with a much-needed discharge in bankruptcy at the expense of the United States. The borrowers could anyway not service these international obligations and dollar loans because of U.S. trade war level tariffs and because of the U.S. monetary policy of sterilizing gold inflows. Protectionist sentiment still reigned supreme among both Republicans and Democrats in the Congress. Both exports and imports kept declining at multiple double digit rates despite the summer revival.
&
When Europe thereafter again reported that it had tariff protected crops sufficient for its needs, agricultural exports suffered their final collapse. There would essentially be no grain exports for the rest of the Depression decade. The trade war had destroyed export markets - including well over one third of the wheat market and about 20% of the market for automobiles with similar declines in other manufacturing exports. And, agriculture was still at this time the nation's largest employer. It was this - not the cessation of System monetary policy efforts - that pulled the rug out from under the summer rally.
&
Except with respect to the Board's gold sterilization policy, there was nothing the System could do about any of this. Abandonment of the massive agricultural surpluses would not come until prices again collapsed that fall - to a point so low that the crops weren't worth storage or transport costs and were thrown out on the ground. Thus was "solved" one of the primary causes of the Great Depression. Only after that and the widespread default of international dollar obligations might aggressive monetary policy have had some lasting impact.
&
But the trade war - now worse than ever - would remain of the basic causes of the Great Depression. And it would be intensified by the FDR administration. This would be one of the factors preventing full recovery even under the aggressive monetary policy of the New Deal until the revival of export markets at the beginning of WW-II in Europe.

Member bank reserves were now in excess of legal requirements, but not in excess of prudence given the course of events. Thus, the authors again argue, System open market purchases would not have merely supplemented bank reserves, but would have facilitated bank lending activities and reduced the decline in deposits.

However, it would not have restored the profit inducement to borrow - the demand for money - at interest rates high enough to cover the bank's risks. The authors totally neglect this demand factor of the credit markets. There had been almost from the beginning a massive adverse credit shift, leaving many borrowers not credit-worthy at the low existing interest rates at which they might have wanted to borrow.
&
Without profitability and without the confidence that supports credit-worthiness, monetary expansion can indeed amount to "pushing on the end of a string."

There was no real recovery - and the financial strain again took its toll among the banks. The collapse was becoming general, as depositors fled with their cash - when they could get it. Perhaps $1 billion in scrip was in circulation in various localities.
&

Collapse of the Federal Reserve System:

The Conference was anxious to begin unloading its government securities holdings - and actually began sales in January 1933 - when events interrupted its plans. Soon, modest purchases resumed in vain efforts to stem the torrent. There was no Conference meeting in February, as the System broke down under the pressure of events.
&

"In the final two months prior to the banking holiday, there was nothing that could be called a System policy. The System was demoralized."

The final banking crisis from January to March, 1933, repeated past patterns - only worse. For this short period, money stock declined 12%. Discounts rose, leading to some increase in high-powered money, but the deposit ratios crashed. The bank holiday in March rendered that month's statistics non-comparable.
&
Free to act on its own, the N.Y. Fed reduced its bills buying rate to ½% and quickly acquired $350 million, but it was forced to raise bill and discount rates by the end of February by the flight out of dollars and in to gold. There were, after all, reserve limits to its authority to increase System credit outstanding. It also purchased $27 million in government securities to help banks liquidate. All to no avail.

"In the final two months prior to the banking holiday, there was nothing that could be called a System policy. The System was demoralized. Each Bank was operating on its own. All participated in the general atmosphere of panic that was spreading in the financial community and the community at large. The leadership which an independent central banking system was supposed to give the market and the ability to withstand the pressures of politics and of profit alike and to act counter to the market as a whole, these -- the justification for establishing a quasi-governmental institution with broad powers -- were conspicuous by their absence."

There was a flight from the dollar. Everybody was seeking gold and foreign currencies.

Faith in the dollar was evaporating with the approach of the new administration of Franklin Delano Roosevelt ("FDR") and the expectations of dollar devaluation. The internal drain was now in part gold and gold coin. The drain on N.Y. banks was now external as well as internal. There was a flight from the dollar. Everybody was seeking gold and foreign currencies.
&
Gold coin had been increasing since April, 1931, but the Federal Reserve System had been issuing Federal Reserve notes rather than gold certificates where feasible. The increase in the public's gold holdings came despite System efforts to discourage it.
&
With the collapse of the banking system, the economy plunged to new depths - but the stock market stayed above its July, 1932 low and agricultural commodity prices, too, stayed above their Depression lows. (After all, there no longer were those outsized agricultural surpluses.)
&
RFC loans to banks became counterproductive when Congress revealed the identities of borrowers - thus revealing which banks were in trouble and precipitating runs on them. State banking holidays became common - in almost half the states by March, 1933. Currency in the hands of the public soared. Interior banks withdrew $760 million from N.Y. City banks in February and March, 1933 - the N.Y. City banks reduced their holdings of government securities by $260 million - thus contracting the money supply.
&

During this five month long interregnum period, both Pres. Hoover and Pres. elect Roosevelt refused to act - either alone or together.

The Federal Reserve System raised its discount rate to counter the external drain, but conducted practically no open market purchases. It did raise its buying rate on acceptances, but attracted only small amounts of bills. But banks were driven to discount bills even at the higher discount rates and to dump securities on the market, sharply pushing up interest rates.
&
Interest rates soared as the financial markets crashed in panic mode. Bank reserves plunged below legal limits. Thus, on March 3, the Board suspended legal reserve requirements for 30 days. Now, major states - including New York - joined in declaring bank holidays.
&
It was not just the System that was paralyzed. During this five month long interregnum period, both Pres. Hoover and Pres. elect Roosevelt refused to act - either alone or together - (undoubtedly one of the primary reasons for the general collapse).

"The central banking system, set up primarily to render impossible the restriction of payments by commercial banks, itself joined the commercial banks in a more widespread, complete, and economically disturbing restriction of payments than had ever been experienced in the history of the country. One can certainly sympathize with Hoover's comment about that episode: 'I concluded [the Reserve Board] was indeed a weak reed for a nation to lean on in time of trouble.'" (But it was Congress - and Hoover himself - who were far more responsible parties than the Federal Reserve Board.)

The banking holiday:

On March 6, Franklin Delano Roosevelt, the new President, declared a nationwide banking holiday and suspended gold redemptions and shipments abroad.
&

There had been similar restrictions, the authors point out - in 1814, 1818, 1837, 1839, 1857, 1873, 1893 and 1907 - but few banks had actually totally shut down - even for one day. Commerce had not been seriously disrupted. There had been some pressure to increase reserves, but that impacted the money stock generally for no more than a year.

"Restriction was - - - a therapeutic measure to prevent a cumulation of bank failures arising solely out of liquidity needs that the system as a whole could not possibly satisfy. And restrictions succeeded in this respect. In none of the earlier episodes, with the possible exception of the restriction that began in 1839 and continued until 1842, was there any extensive series of bank failures after restriction occurred. Banks failed because they were 'unsound,' not because they were for the moment illiquid."

Here, again, it bears repetition. The primary factors driving the world wide Great Depression were not temporary. The banking crises of the Great Depression were definitely not "solely out of liquidity needs." The banking system was not suffering just a temporary liquidity crisis in a basically sound economy successfully adjusting to its problems. The liquidity crises were the result of political policies that were not susceptible to alteration by ordinary economic adjustment processes. The resulting conditions could only be resolved by political change or abandonment of those policies.

The 1933 suspension for the first time involved suspension of all payments - not just payments of deposits into currency. Over 5,000 banks failed to resume business at the end of the bank holiday - over 2,000 were permanently closed. This suspension clearly had come too late to be therapeutic.
&
Here, the authors admit uncertainty as to why the economy failed to recover in the summer and fall of 1932. The monetary factors, however, are clear. Failure to act sooner had fatally weakened the entire banking system.
&

The refusal of FDR to deny rumors of intent to devalue led to months of gold outflows that undermined the whole system.

The Federal Reserve System refused to act, and the RFC loans were almost useless - branding the borrowing banks as weak and taking their best assets as collateral.
&
Political action was paralyzed first by the presidential election campaign and then by the interminably long five month interregnum period before the new administration took office. The refusal of FDR to deny rumors of intent to devalue led to months of gold outflows that undermined the whole system.

Paralysis of the Federal Reserve System:

From the October, 1930 banking crisis, the bank deposit ratios declined so precipitously that the money stock went into substantial decline even though high-powered money persistently rose. This reflected the extent to which confidence in the entire banking system was eroding over time. The money stock declined a whopping 35% from August, 1929 to March, 1933. (But the implicit price decline of about 25% increased the purchasing power of the money that remained in circulation, reducing the impact of the money stock decline.)
&

More than 9,000 bank suspensions occurred in the four years 1930 through 1933 - 3,500 after the bank holiday. They resulted during the four years in losses to depositors estimated at $1.3 billion, $0.9 billion to bank stockholders and something in the neighborhood of $300 million to other creditors.
&
This was small potatoes compared to losses in real estate values and in the securities and commodities markets and in the value of private businesses. However, deposits declined about $7 billion, with drastic impact on the money stock and commerce.

The authors note that Canada, too, suffered a Great Depression - albeit somewhat less than in the U.S. However, there were no bank failures in Canada.

In Canada, bank contraction took the form of the closing of numerous branch banks - painful in their own right but far superior to the closing of thousands of banks in the U.S. It was government policy in the U.S. that prevented the development of branch banking.

The authors dispute the assertion that bank lending standards had been reduced as prosperity and confidence surged in the 1920s. The greater default rate of later loans was clearly due to the Great Depression, not to any reduction in credit quality. The tight monetary conditions and high interest rates in 1928 and 1929 undoubtedly led banks to be more selective in their extensions of credit. Of course, the small, rural agricultural sector banks were as usual vulnerable to agricultural market conditions.
The authors point out the damage caused to banking system reserves by declining bond prices. In the year from the middle of 1931, railroad bonds declined about 36%, public utility bonds about 27%, industrial bonds about 22%, and even U.S. government bonds 10%. As weaker banks were forced to liquidate their reserves to meet runs, they sold their bonds, driving prices lower, and they withdrew reserve deposits from stronger banks - both serving to undermine the stronger banks.

But it was the inaction of the Federal Reserve System that permitted the increasingly destructive waves of bank failures, the authors assert.

"[The] composition of assets held by banks would hardly have mattered if additional high-powered money had been made available from whatever source to meet the demands of depositors for currency without requiring a multiple contraction of deposits and assets. The trigger would have discharged only a blank cartridge. The banks would have been under no necessity to dump their assets. There would have been no major decline in the market prices of the assets and no impairment in the capital accounts of banks. The failure of a few bad banks would not have caused the insolvency of many other banks any more than during the twenties when a large number of banks failed. And even if an abnormally large number of banks had failed, because they were bad, imposing losses on depositors, other creditors, and stockholders, comparable to those actually imposed, that would have been only a regrettable occurrence and not a catastrophe if it had not been accompanied by a major decline in the stock of money."

No amount of increase in System credit outstanding could have prevented the precipitous price declines in agricultural commodities and rural real estate and the general decline in credit-worthiness that had to be reflected in declining bond prices. Foreign bond defaults became common, and the ability of the railroads to service their debts declined rapidly until the Reconstruction Finance Corporation was created to help them. The Wabash Railroad went into receivership in December, 1931. By 1932, railroad earnings were $200 million short of the sums needed to service their debts and preferred dividends. No amount of monetary manipulation could have supported the value of their bonds.

The Federal Reserve System at all levels was aware of the damage to confidence caused by the failure of the Bank of the United States in December, 1930. Policy discussions on the subject thereafter occupied the attention of the Board, the Federal Reserve Banks, the boards of member banks and the Open Market Policy Committee. However, the "general tenor of the System comments, both inside and out, was defensive, stressing that bank failures were a problem of bank management which was not the System's responsibility."
&
While some - especially among the technical personnel at the N.Y. Fed - understood the interconnections between bank failures, runs, deposit contraction, and bond market weakness, most of the governing officials did not. To them, banking problems were the result of bad practices and prior speculative excesses - not something connected to the credit situation.
&
Also, failures initially involved mostly small non-member banks of no great concern to the big city bankers. The management practices of the Bank of the United States were suspect in some banking circles. It was not until the British devaluation crisis in September, 1931, that the big city banks began to feel threatened.
&

The N.Y. Fed and George L. Harrison, its governor, generally favored aggressive monetary intervention - preferably through open market purchases of government securities - to extend System credit into the banking system, reduce pressures on the banking system and encourage bank lending. (This assertion is disputed by Meltzer, "History of Federal Reserve," vol. 1, Part II, at segments on "Failure of the administered alternative" and "Panic," where Harrison's extraordinarily cautious attitude is convincingly demonstrated.) However, only during the 1929 stock market crash did it feel independent enough to act without Board approval. Despite the effectiveness of those actions, it was criticized by most of the System officials.

Indeed, this incident reveals the limits of emergency monetary interventions. The effectiveness of the N.Y. Fed intervention probably helped to temporarily restore sufficient financial stability to facilitate the vigorous spring, 1930 business and stock market revival that the authors - for some unknown reason - do not mention. However, it had no impact on the underlying causes of the Great Depression which proceeded to undermine that revival as early as February, 1930, when Europe announced that its tariff protected agricultural sector would fulfill all European needs. Farm Board efforts to sustain U.S. agricultural prices were swamped and the collapse of stock market and agricultural commodities prices were renewed in April, 1930.

The result of this criticism and pressure from the Board was that Harrison felt the N.Y. Fed could no longer act independently to meet crisis conditions that subsequently arose. Its discount rate and acceptance rate decisions were frequently rejected by the Board and thus delayed. It managed to use existing authority to purchase $180 million of government bonds to extend System credit into the N.Y. banking system when the Bank of the United States failed in December, 1930 - clearly to good effect - but hard money sentiment on the Board forced it to unwind this position by February, 1931.
&
Over time, some members of the Board joined Harrison - especially the new Board governor, Eugene Meyer. However, nine of the Federal Reserve Bank governors remained opposed, and the System was paralyzed. When Congressional pressure forced it to act in April, 1932, the Board promptly ended open market purchases soon after Congress adjourned in August.
&

The authors provide extensive coverage of the policy disputes and bureaucratic maneuvers between the Board, the N.Y. Fed, the Open Market Investment Committee of five of the twelve Bank governors, and the Open Market Policy Conference of all 12 governors that succeeded the Committee in 1931. The new Conference was more bureaucratic and was given less authority than the old Committee. The Conference's decisions were executed by a five member executive committee.
&

There simply was widespread doubt "as to the power of cheap and abundant credit, alone, to bring about improvement in business and in commodity prices." After all, short term interest rates were quickly hitting rock bottom. Money was already "cheap" (but credit was not "easy" as the Depression caused a widespread and continuing adverse shift in credit worthiness).
&
It was long term money - especially the bond market - that was getting increasingly hard to access. Price declines were hitting an increasing variety of bonds. "Improvement in the bond market would have done much to avert the subsequent bank failures," the authors point out. And credit conditions outside the major cities were considerably tighter.
&
In an exchange of letters in July, 1930, nine of the twelve Bank governors made clear their opposition to Harrison's views. Only two agreed.
&
By the summer of 1930, the Bank governors argued, credit was "cheap and abundant." Promotion of the bond market - which included foreign bonds - was not "within the province of the Federal Reserve System." There were other reasons for current economic problems - including the new increases in tariffs. (They certainly got that right!) There was no way to direct where the newly extended System credit would go - no way to be sure it would go to the bond market. Federal Reserve credit "was not wanted and could not be used" under current depressed business conditions.
&

However, with all speculation driven out of the markets, and the banking system still making full use of its assets, the authors respond, "any expansion of credit would likely be - - - restricted to productive uses."
&
The authors point out that the N.Y. Fed had years of experience in the conduct of monetary policy in New York and in cooperation with banks in money centers around the world. Most of the other Federal Reserve Banks were concerned primarily with local and regional matters, and the Board actually had no important operational functions at that time.
&

Opportunities for monetary intervention:

The authors argue that the $1 billion in open market purchases of government securities in 1932 that was insufficient to materially affect matters at that late stage might have been more than adequate at earlier stages.
&

If implemented at the beginning of 1930, it would have reversed the decline in the money stock, supported bank reserves, and led to expanded lending activities, since banks were still fully using their resources. It also would have reversed the gold inflow, relieving financial pressure abroad. The first bank panic at the end of the year would have been avoided or greatly reduced.

In fact, the government did pump hundreds of millions of dollars into the economy in the beginning of 1930 - through the agricultural price support efforts of the Farm Board - which undoubtedly helped rural agricultural sector banks at that time. However, it was all to no avail.
&
When the money ran out, the price supports could no longer be continued, and agricultural commodity prices plunged - along with the value of agricultural real estate. The unintended consequences were the planting of another bumper crop, less exports, bigger surpluses overhanging the markets, and crashing agricultural commodity markets. Federal Reserve System monetary expansion could not have affected any of this.

If implemented at the beginning of 1931, it would have had similar results. The second banking crisis would have been avoided or greatly reduced.

In fact, the Farm Board supported the 1931 crop, too - with the same results as with the 1930 crop - and agricultural surpluses that had grown to monumental size. The cotton surplus exceeded a full year's consumption.
&
By the summer of 1931, it was observable that the banks had plenty of money to lend at low interest rates, but the adverse credit shift had proceeded to the point that there were few credit worthy borrowers and a sharp decline in the list of securities that were considered acceptable collateral. Demand for loans had also declined sharply with the decline in the profit inducement to borrow - all as confirmed by the low nominal interest rates.

If implemented in September, 1931, in response to the British abandonment of the gold standard and devaluation of the pound, it would have fulfilled the second requirement of the classic response to such crises - not only to counter the outflow of gold with high discount rates, but to avoid internal distress by "a policy of free lending."
&
Open market purchases would have extended sufficient System credit to more than satisfy the $720 million in currency withdrawals of the public, and there would have been a $610 million increase in member bank reserves rather than the $390 million decrease that actually occurred. The entire banking situation would have been greatly eased - but, by this time, the authors acknowledge, it probably would not have been enough to stem the economic deterioration.

The authors are clearly correct to emphasize from December, 1930 onwards, the extent to which increasing problems with credit and liquidity - with banks and the money supply - added to the existing fundamental causes of the Great Depression. But these were clearly intermediate causes - not fundamental causes. See, "Summaries of Depression Controversies and Facts," at section I), "Causes and Cures." To the extent that better banking regulation and monetary policy could have mitigated these increasing financial problems, the authors are correct to emphasize the actual drawbacks of the policies pursued.
&
However, it was never within the power of the Federal Reserve System to halt the economic deterioration of the Great Depression. And the authors never acknowledge the key difference between the Great Depression and past depressions. There was nothing temporary about the Great Depression.

This was not a temporary panic that could be dealt with by temporary monetary measures expanding liquidity. The continuing impacts of crumbling international markets and vast commodity surpluses in any event increasingly worked to undermine the financial system as well as all other aspects of economic activity.

It was clearly not money, banking or credit conditions that was driving the Great Depression - albeit better System monetary policy might well have mitigated its financial impacts. Canada, after all, also suffered a Great Depression - although it was able to avoid bank closures and perhaps for that reason suffered somewhat less than the U.S. But it had branch banking, and lost many bank branches. Given the complex nature of banking that had heedlessly evolved in the U.S., and the restrictions under which the Federal Reserve System operated, there were definite limits to its financial resources and how effective the System could have been.
&
The fundamental causes of the Great Depression were not natural economic phenomena - Marxist and Keynesian interpretations to the contrary notwithstanding. They were all the results of government policies - and they would thus continue until those policies were politically changed or abandoned. In fact, by the end of 1932, many had been or were being abandoned, and the agricultural surpluses had been destroyed.
&
The Great Depression could not end as in the ordinary course of economic adjustment during a business cycle. The monetary policy aspects - monetary policy errors and sterilization of gold flows - were just a part - and not the most important part - of the ways in which government - in particular the U.S. government - was at that time destroying domestic and international economic systems. Efforts to resolve periodic banking and liquidity crises could not be more than mere palliatives in the absence of measures to deal with the fundamental political causes of the Great Depression.
&
Ironically, the New Deal remedy for this vast failure of government policies was to massively increase reliance on government economic policy. As explained in Friedman & Schwartz, "Monetary History of U.S.(1867-1960)," Part III, "The Age of Chronic Inflation (1933-1960)," the New Deal achieved some remarkable successes with its regulatory efforts. However, it is not surprising that its command economy experiments would actually make matters worse during the remainder of the Great Depression. Government administered alternatives to market mechanisms - "industrial policy" - would have their ultimate test in the 1970s, and would again fail miserably.

See, Friedman & Schwartz, "Monetary History of U.S." Part I, "Greenbacks & Gold (1867-1921," and Friedman & Schwartz, "Monetary History of U.S.," Part III, "The Age of Chronic Inflation (1933-1960)."

Outline of monetary history (1921-1933)	Roaring twenties boom (1921-1929)	Sterilization of gold
Stock market boom	Great Depression bust (1929-1933)	Power & limits of monetary policy