A Fall in the US Money Supply and the Great Depression—any Relation?
In his writings, Milton Friedman blamed central bank policies for causing the Great Depression. According to Friedman, the Federal Reserve failed to pump enough reserves into the banking system to prevent a collapse in the money stock.1 The adjusted money supply (AMS), which stood at $26.6 billion in March 1930, had fallen to $20.5 billion by April 1933—a decline of 22.9 percent.2
According to Friedman, as a result of the collapse in the money stock, economic activity followed suit. Thus, by July 1932 year-on-year industrial production had fallen by over 31 percent (see chart). Also, year-on-year the Consumer Price Index (CPI) had plunged. By October 1932 the CPI was down 10.7 percent (see chart).
A close examination of the historical data shows that the Fed was actually extremely loose and pumped reserves into the system in its attempt to revive the economy.3
The extent of the reserve pumping is depicted by the Fed’s holdings of US government securities: in January 1929 these holdings stood at $446 million, but by December 1932 they had jumped to $2.437 billion—an increase of 446.4 percent (see chart).
Also, the three-month Treasury bill rate fell from 1.5 percent in April 1931 to 0.4 percent by July 1931 (see chart). Another indication of a loose monetary stance on the part of the Fed was the widening in the differential between the yield on the ten-year T-Bond and the three-month Treasury bill. The differential rose from 0.04 percent in January 1930 to 2.80 percent by September 1931 (see chart).
The sharp fall in the money stock from 1930 to 1933 is not indicative of the Federal Reserve’s failure to pump money. Instead, it is indicative of a shrinking pool of real savings brought about by the previous loose monetary policies of the central bank.
Indeed, the yield spread increased from –0.67 percent in October 1920 to 2 percent by August 1924 (an upward sloping yield curve indicates loose monetary stance) (see chart).
In addition to this, at some stages monetary injections were massive. For instance, the yearly growth rate of AMS jumped from –12.1 percent in September 1921 to 10.9 percent by January 1923.
Then, from –0.2 percent in February 1924, the yearly growth rate accelerated to 9.9 percent by February 1925.
Such large monetary pumping amounted to a massive exchange of nothing for something and to a severe depletion of the pool of real savings needed to sustain economic growth.
As long as the pool of real savings is expanding and banks are eager to expand credit (credit out of “thin air”), various nonproductive activities continue to prosper. Whenever the extensive creation of credit out of “thin air” lifts the pace of real wealth consumption above the pace of real wea