After World War I, the world faced economic turmoil in its transition from a wartime economy to a peacetime economy. Losses from wartime speculation, a large drop in the price of commodities, and currency depreciation in France, Britain, and other European countries demanded a painful period of economic restructuring. Federal Reserve and the Bank of England attempted to stabilize financial markets at prewar levels by creating a system of currency exchanges which arbitrarily valued each nation’s currencies. As is often the case, implementing this system proved more difficult and complex than expected. Instability in Europe moved large volumes of capital, especially gold, to banks in the United States. In order to compensate for this increase of reserves, the Federal Reserve initiated a policy of easy money that was intended to provide liquidity to Europe and to businesses in the United States while it simultaneously weakened the dollar against the pound. The attempts by these agencies to stabilize the global economy depended on an inflationary policy throughout the twenties that promoted volatility and birthed the cluster of errors that signaled the start of the Great Depression.
The Great War
The market crash in 1929 the economic instability that ensued was in part a result of economic policies during World War I. The destruction of the war had a decisive impact on the world economy during the 1920s. For the first time in their history, the well-developed capitalist economies of Europe came largely under the control of national governments. Lionel Robbins recalled, “The needs of war called for a huge apparatus of mechanical equipment into being…For four years, the capital resources of belligerent countries of the world were devoted to providing offerings to Mars.”[1] Continuing, he wrote that only “the centralization of control of industrial operations” could give rise to the massive wartime economies which resulted.
This transformation demanded funds in the form of taxes, debt, or inflationary money creation. Government favored the latter two. At the start of 1917, the Federal Reserve Board estimated total European war debts to amount to $49,455,000,000.[2] In modern terms, this was over $2 trillion. Inflation compounded the problem. Several months before the war ended, Walter F. Ford observed the war’s effect on currencies: “With the exception of America, all the countries involved in the war have added largely to their currencies by means of paper money which is inconvertible in fact if not in name.”[3] The effects were devastating. Money created to fund the war was able “to compete for the greatly reduced supply of goods available for public use [and] could hardly fail to force up the prices of those goods.”[4] The inevitable end was that at “each stage [of uncovered credit expansion] it becomes increasingly difficult for the borrower to extricate himself, and there is always a point beyond which he cannot go without becoming bankrupt.”[5]
The problem of debt and currency expansion created not only risk of insolvency, but also rising prices. The burden of this spending fell on the shoulders of the lower and middle classes. Yale economist Irving Fischer recognized the social effects of inflation. The war, he claimed, was paid for “not out of real savings or not followed up, at least, by real savings.” He worried that “when we increase prices then we enforce saving by the poor, and the war will be financed then by the wage-earner, or more particularly by the salaried.”[6] In 1920 Herbert Hoover adequately described the economic reality as well. He wrote, “The universal practice in all the countries at war of raising funds by inflation of currency is now bringing home its burden of trouble.”[7] Belligerent states surrendered not only their economies to the war, but also sacrificed the well-being of their poor and middle-class.
Econometric data also supports this claim. By March 1919, the pound sterling’s value sagged at $3.50, a far cry from its pre-war par of $4.86.[8] Even in the United States “prices of wholesale commodities went up about 81 per cent, and of retail commodities about 47 per cent.”[9] Inflation robbed holders of national currency, mainly wage workers, by transferring wealth to the receivers of the newly minted currency. In this case the state and the war contractors profited from the wartime inflation that destroyed Europe. In addition to an increasing volume of currency, consumers worldwide had to compete with government for precious resources such as food and clothing. An increase in demand alongside a shrinking supply led to fantastic wartime commodity prices, and nearly two years after the war, a severe bust.
Post War Bust?
When the war ended, the Federal Reserve resisted tightening the credit market that expanded during the war. The Federal Reserve Board announced its reasoning shortly before the war’s end, saying, “It would be much better to hold credit within reasonable limits by intelligent cooperation, rather than to attempt to force contraction by establishing high discount rates.”[10] It hoped to avoid an abrupt transition from an inflationary wartime economy to a more sound peacetime economy by keeping inflationary credit available to businesses and by maintaining stable commodity prices. In an article titled “Federal Reserve Policy,” A. C. Miller, member of the Federal Reserve Board, explained:
Its [the Industrial Board’s] main effort was directed to bringing about revision of prices and stabilization of the expected fall of prices... Events soon showed that the policy of ‘price stabilization’ was based on a faulty economic diagnosis. It was not many months after the close of the war that prices began to rise.[11]
The Federal Reserve, in its support for the Industrial Board policy, was thus unable to control the flow of credit and its complementary price inflation.
Thanks to economic conditions encouraged by Federal Reserve policy, businesses continued to operate as they had during the war. American industries had grown dependent on demand from Europe during the war and this did not change after 11 November 1918. According to the economist Benjamin M. Anderson, in June 1919 “we had an export balance of $635 million, of which $601 million represented our excess of exports with Europe alone.”[12] After the Armistice, the U.S. government supplied Europe with over $3 billion in loans in addition to the $7 billion it had supplied during the war.[13] High levels of both loans and exports to European countries signaled coming instability. Demand driven by Europe’s unsound position as debtor – and the U.S. as irresponsible creditor – created shortages of goods in the U.S. In turn, rising prices were “accentuated by an appalling speculation in commodity prices… The year 1919 saw also a stock market boom… [and] speculation in farmlands and other real estate went dangerously far.”[14] In its attempt to stabilize the economy, the Federal Reserve only inhibited the necessary recalibration of the economy. Miller aptly observed, “If the federal reserve system had functioned as effectively in 1919 in regulating credit as it did in 1920 in retarding and eventually arresting expansion, it would have rendered an inestimable service to the country and would have prevented many of the unhealthful developments.”[15] The Federal Reserve’s inflationary postwar policy prevented the liquidation which normally ends speculative bubbles and which is required to maintain a sound economy.
By the end of 1919, the New York Federal Reserve expressed concern and “was more specific in declaring its intention of bringing member bank credit under control by introduction of higher rates.”[16] In early 1920, the Federal Reserve banks all raised their rates on commercial paper to at least 7%. While this moved forced an end to the speculative bubble, the severity of the subsequent depression suggests that the Federal Reserve was tardy in its action. “The American index for foodstuffs,” stated Joseph S. Davis, “reached its peak in June and July 1920 at 215 per cent of the 1913 average, and declined steadily during the following year to a figure of 141 in June 1921.”[17]
The popping of the bubble devastated American farmers. Workers’ wages, along with transportation, energy, and equipment costs, remained well above pre-war levels while commodity prices dropped by 50%.[18] Farmers who had taken out loans to buy land during and just after the war were threatened by default. The Federal Reserve, which was in part responsible for this problem, only aggravated the situation. It was slow to stop the boom in agriculture, and within a year of the boom’s end it began to expand credit to the competing business sector via purchases of government securities.
Historical Problem
It is at this point where many economic historians error. They often focus on the financial climate in the years which immediately preceded the crash of the stock market in 1929 and the years that followed. In his book, The Great Crash, John Kenneth Galbraith begins with a highly optimistic speech from President Coolidge given on 4 December 1928 and proceeds from there making only passing reference to the preceding years.[19] He ignores entirely the economic intervention of the Federal Reserve before 1928. His work only surveys the tail end of the boom and which ended with the crash on Wall Street. In a manner that conveys the prior years as superfluous to his study, he writes:
Until the beginning of 1928, even a man of conservative mind could believe that the prices of common stock were catching up with the increase in corporations earnings, the prospect for further increases, the peace and tranquility of the times, and certainty that the Administration…would take no more than necessary of any earnings in taxes.[20]
Galbraith leaves the impression that booms appear out of thin air and proposes two options: “An immediate and deliberately engineered collapse and a more serious disaster later on.”[21] Policies throughout the Roaring Twenties were integral to the economic boom and crash. Galbraith performs a grave disservice by ignoring this fact.
Milton Friedman and Ann Schwartz make the same mistake of confining their research to the years of 1929-32. Their conclusions differ markedly. They claim that “prevention or moderation of the decline in the stock of money…would have reduced the contraction’s severity and almost as certainly its duration.”[22] They assumed that further credit expansion by the Federal Reserve – the same sort of expansion which caused the boom that brought instability – would have stopped or at least diminished the veracity of the Great Depression. Schwartz explains further: “The Federal Reserve, by failing to act as a lender of last resort during a series of banking panics, permitted a massive contraction of the money supply that was responsible for the compression of aggregate demand, national income, and employment.”[23] Friedman and Schwartz fail to mention, or even notice, that the effects of inflation are difficult, if not impossible to control. Inflationary booms are filled with malinvestments which must be purged, not enhanced. Any rescue by a lender of last resort will result in further malinvestment and hinder, not promote, economic recovery. Market instability is a direct side effect of the monetary expansion and contraction inherent in fractional-reserve banking. Any evaluation of the Great Depression must include a holistic perspective which takes into account the broad effects of an increase in the money supply. It must investigate the causes of the economic imbalances which preceded the crisis, not identify and speculate about failed treatments in post hoc fashion.
A number of economists and historians have accounted for this need. Authors who have provided an accurate interpretation of the Great Depression include Lionell Robbins, Benjamin Anderson, and Murray Rothbard. Each of these authors pays close attention to economic intervention by the Federal Reserve in the years preceding the depression. They all realize that a central bank such as the Federal Reserve causes most other banks to act in sync with one another. In essence, a central bank promotes a national banking cartel in which nearly all banks within a country will extend or curtail credit simultaneously. The key to the success of the aforementioned historians was the Austrian Business Cycle Theory (ABCT).
Methodology
A proper methodology is required in any historical study, but is especially necessary in economic history. Such a method must use an apriori standard against which a posteriori conjectures can be tested. The ABCT provides such a perspective and a framework appropriate for analysis of economic history.
The ABCT presents a modern world view which roots itself in praxeology: the theory of human action. According to Mises, “Every attempt to reflect upon the problems raised by human action is necessarily bound to aprioristic reasoning.”[24] He continues:
There is no means to abstract from a historical experience a posteriori any theories or theorems concerning human conduct and policies. The data of history would be nothing but a clumsy accumulation of disconnected occurrences…if they could not be clarified, arranged, and interpreted by systematic praxeological knowledge.[25]
A theory of human action must draw from a source apriori because it would otherwise draw from human interpretation of reality which is itself limited and often, though not always, irreparably biased.
The Austrian school grounds its understanding in the irrefutable fact that, though one’s intellectual capacity is limited, “man makes use of his reason for the realization of wishes and desires.”[26] Unlike the desires of the ever self-interested homo economicus, Mises’ acting man holds desires which cannot be narrowly defined in advance. Any economic theories conceived through induction – economic science – must, through deduction, agree with the apriori standard of human action.[27]
Holding the axiom of human action as apriori, the ABCT asserts several basic principles and extrapolates upon them. It claims that individuals subjectively value different ends, organizing them, not according to their supposed objective value, but instead grading them in order of perceived importance.[28] An individual’s scale of subjective valuation – preference value scale – is in constant flux. It is an artificial construct which helps one to conceptualize the complexity of individual choice.[29]
The ABCT also shows that, in agreement with theory of human action, “the function of money is to facilitate the business of the market by acting as a common medium of exchange.” It is a means to an end.[30] As a secondary function, money can also serve as a tool for accounting, and further facilitate human action.[31] Individuals employ money to help determine costs and organize their preference value scale. Money helps individuals establish time-preference – their willingness to delay present consumption for future consumption which is reflected in their willingness to save.[32] This time-preference is reflected in the pure interest rate.
When governments and central banks increase the money supply, this time-preference is misrepresented by artificially lowered interest rates. The abundance of currency which results from this credit expansion alters the structure of property ownership and creates the illusion of prosperity.[33] This distortion in the capital structure also alters individuals’ preference value scales. Businessmen react to the lower interest rate by decreasing savings and investments and dedicate excess capital the production of higher order goods.[34] Individual consumers are also less likely to save because the future benefit of savings is largely diminished by a depressed interest rate. Furthermore, because true time-preferences have not changed, as this excess capital spreads through the economy, it is employed to consume lower order goods.[35] As time passes, consumers will realize that, due to decreased savings, they cannot afford to consume goods spawned from lengthened capital structures – higher order goods. Businesses then face a crisis in the value of the capital goods in which they overinvested. As the economy restructures according to the true time-preferences of consumers as represented by higher interest rates, unemployment temporarily increases until capital is reallocated according to market demand.[36]
The Federal Reserve and Fractional-Reserve Banking
The ABCT also identifies the flaw inherent in fractional-reserve banking. It lies in an unclear definition of property rights over bank deposits. Unlike a warehouse for grain, banks accept demand deposits not as a bailment, but rather as a loan. This means that deposits are placed in a pool, most of which is not readily available to depositors. The bank takes the deposit, holds on to a certain percentage of it, and invests the remainder in loans and other investments.[37] Common practice is for banks to hold a reserve of 10% for demand deposits, while they invest the other 90%.[38] The problem almost inevitably arises that in a short period of time, holders of demand deposit accounts will withdraw their deposits in a proportion too large to maintain the bank’s solvency. In the strict sense, banks that practice a fractional-reserve policy with demand deposits are never entirely solvent and, to varying degrees, are always at risk of a bank run.
The role of the Federal Reserve exacerbates this problem. The Federal Reserve Act immediately set the precedent that the Federal Reserve can buy assets on the open market and regulate interest rates.[39] In other words, the Federal Reserve provides economic “‘management’ in the shape of purchases of securities in the open market” and by lending to member banks at an interest rate not established by the market.[40] The Federal Reserve’s stated goal is to foster growth and maintain price stability, but its policy of easy credit inherently creates economic disorder in the long run. Mises writes:
Cyclical changes in business conditions stem from attempts to reduce artificially the interest rates on loans through measures of banking policy – expansion of bank credit by the issue or creation of additional fiduciary media (that is banknotes and/or checking deposits not covered 100% by gold.)…and then some businesses, which did not previously seem profitable, appear to be profitable. It is precisely the fact that such businesses are undertaken that initiates the upswing. However, the economy is not wealthy enough for them. The resources they need for completion are not available...The policy of expanding credit must come to an end – if not sooner due to a turnabout by the banks, then later in a catastrophic breakdown.[41]
Credit expansion initiated by the issuance of fiduciary currency – currency not covered by reserves – creates the illusion that resources are more abundant than they actually are and sends the economy careening on an unsustainable course bound for depression.[42] The issuance of unbacked currency in culmination with money multiplication from fractional-reserve banking made the boom of the 1920s the largest in history to that point and set the stage for the Crash of 1929 and the Great Depression.
The depression of 1920-21 marked a new stage in Federal Reserve Policy. Until that time “open market operations played a relatively unimportant part in the policies of reserve banks.”[44] In 1921, however, the Federal Reserve began to make purchases on the open market in order to employ surplus resources and earn profits for their stockholders.[45] Though the government actually decreased the budget every year between 1920 and 1923, the purchase of government securities by the Federal Reserve on the open market increased the availability of credit and artificially stimulated business.[46]
Many authorities, including Benjamin Anderson and Clay Anderson, propose that increased liquidity was an unintended side effect of open market operations, but Murray Rothbard discredits this commentary as a myth.[47] Rothbard cites a letter from Federal Reserve Governor Strong to Undersecretary of Treasury S. Parker Gilbert in which Strong claims that open market purchases would “establish a level of interest rates that would facilitate foreign borrowing in this country and facilitate business improvement.”[48] The policy was successful. Credit became more available as interest rates fell from 8% to 4% between 1920 and 1922.
Two years later, the Federal Reserve Board officially announced its activist open market policies. “The time, manner, character and volume of open market investments,” it declared, “[was to] be governed with primary regard to the accommodation of commerce and business.”[49] This also implicitly signaled that the Federal Reserve would neglect other aspects of the economy. More than any other area of the economy, the farming sector exemplifies the irresponsibility of this policy. Between 1921 and 1928 – before the great crash – over 4700 rural banks shut down because of farm foreclosures.[50] The business sector, aided by easy credit, recovered from the depression of 1920-21, but it did so on the backs of farmers who competed for workers without the benefit of abundant credit. The failing farming sector was symptomatic of the policy as a whole.
Not all economists were fooled by the apparent success of American businesses during the 1920s. From the beginning Benjamin Anderson decried the Federal Reserve’s expansionist policy. In 1924 he prophetically wrote, “We have been blowing up a credit bubble, especially in the form of long-time debts.”[51] He would later note:
In retrospect one may hold that this first dose of strychnine did little harm and some good, and may recognize it as one of the factors, although not the dominating factor, in the strong business revival of 1921 to 1923. Great harm came from the strychnine administered in 1924, and above all, from the renewal of the dose in 1927. There is no racetrack which has a code of ethics which permits doping the same horse three times.[52]
While it can provide temporary relief for some, a policy of easy money cannot, in the long run, bring health to an economy. As the Austrian school has shown, a policy of easy money sows the seeds of overconsumption and an orgy of speculation. In spite of this, the Federal Reserve committed itself to currency inflation during the 1920s.
Stimulus: Round Two
In 1924 the Federal Reserve began its first of three stimulus programs. Between October 1923 and November of 1924, member banks in aggregate repaid 642 million dollars of debt to the Federal Reserve. Meanwhile, the Federal Reserve bought 492 million dollars in government securities.[53] Chairman Strong proposed that these purchases would decrease member bank debt and facilitate economic growth by encouraging member banks not to collect on loans.[54] He was correct. Banks reacted by expanding credit through fractional-reserve lending and trade increased.[55]
The increase in the volume of currency immediately brought imbalance to the financial system. There was no increase in demand of trade, and therefore much of the new money was seen as surplus and was placed in time deposits.[57] Between 1922 and 1928, time deposits at all member banks at least doubled and in some areas, tripled in volume.[58] In the short term, this was beneficial to banks and investors. Investors received a higher rate of return while banks invested a larger proportion than would have been available if the money remained in a demand deposit account. In the long term, the shift to time deposits laid the foundation for instability. In 1917 the Federal Reserve set the minimum reserve requirements for time deposits at 3%.[59] They were less liquid than demand deposits and therefore became a tool for monetary inflation. Banks invested new deposits in businesses which otherwise would not be profitable. At the time, many interpreted the boom as genuine growth. Statistics from the Federal Reserve showed that “industrial production which had averaged only 67 in 1921 (1923-25=100) had risen to 110 by July 1928, and it reached 126 in June 1929.”[60] The American economy did not absorb the stimulus in an economic vacuum. The effects of the stimulus reached beyond America and into Europe through the Dawes plan and private investment, both of which would not have been readily available without artificially depressed interest rates.
Postwar Instability in Europe
Fighting during World War I consumed much of Europe’s existing capital and left her destitute after the war. Europe was saddled with heavy debts. Between the years 1914 and 1922, the United Kingdom’s debt grew from $3 billion to $38 billion, France’s debt from $6 billion to $52 billion, and Germany’s debt from $1 billion to $79 billion.[61] Debts were not Europe’s only impediment to financial growth.
Inflationary policy brought persistent financial instability which hindered economic growth. Both during and after the war, belligerent nations devalued their currencies. The German mark, which traded at around 12 marks per dollar in 1919, was heavily devalued. By its lowest point, the 16 trillion marks traded for one dollar.[62] By February 1920, the pound lost 34% of its prewar value. Doctor Henry Chandler, economist for the National Bank of Commerce in New York, observed the disastrous effects: “In industrial nations depending largely on international trade, sooner or later a point is reached beyond which further recovery is extremely doubtful until sound financial can be reestablished.”[63] Economic actors in Europe, due to unstable currency exchanges in the continent’s 25 countries, could not efficiently engage in trade because unstable currencies prevented prices from adequately reflecting the costs of the producers and the valuations of the consumers. Without the gold standard, trade between these countries was impossible.
The problem of gold reserves only worsened with pound devaluation. London, once the financial center of the world, lost gold as banks moved their assets to New York where the dollar remained at its prewar value of one-twentieth of an ounce of gold.[64] This gold quickly found its way to the vaults of the Federal Reserve as member banks used the incoming gold to repay their debts. Officials took note of the increase and in 1922 announced that “in formulating a gold policy they would keep in mind the goal of reestablishment of the gold standard for the world.”[65] The Federal Reserve did not simply want a gold standard though. It wanted to restore the Bank of England’s position as the dominant global financial force.
The narrowly tapered policies of the Federal Reserve actually prevented the return to a sound standard. In 1924, instead of allowing currency markets to stabilize at lower parities, the Federal Reserve expanded credit in part to stop the inflow of gold to the US and to help stabilize the pound at its old parity. Governor Strong wrote to Mellon in 1924, “The burden of the readjustment must fall more largely upon us than upon them [Great Britain]. It will be difficult politically and socially for the British Government and the Bank of England to face a price liquidation…”[66] Strong saw the devaluation of the pound to below prewar levels as untenable, but his motivations were questionable. Strong was not only concerned with stability in Britain, but also the investments of the House of Morgan:
Strong’s monetary policy was deliberately guided by the prime objective…to restore “England” – which really meant the Morgans’ English associates and allies – to her old position of financial dominance by helping her establish a phony gold standard. [67]
Strong did not seek what was best for the U.S. economy. Instead, the he propped up the pound and initiated a program of inflationary credit as a service to specific private financial interests.
Loose Credit Comes to Rescue Europe
A stagnant European market in combination with fluctuating fiat currencies provided a textbook example of Gresham’s Law – an overvalued currency which holds a legal tender monopoly naturally forces more valuable money out of circulation.[68] Benjamin M. Anderson keenly described the situation:
During recent years gold has been coming to the United States from Europe for three main reasons:
1. Europe’s great indebtedness to us on current account.
2. The desire of Europeans to place their surplus funds or temporarily idle funds in a safe place from which they could surely get them back, quickly and without loss.
The problem was compounded by US tariffs, especially as the Federal Reserve moved forward with an easy money policy before the tariff problem was remedied. Anderson explained:
If international credits were to be of any use or were ever to be repaid, that the movement of goods from country to country must be facilitated, that tariffs must be lowered, quotas or other trade barriers be removed, and that the men having bank balances in one country be free to dispose of them in the foreign exchange markets without encountering governmentally created difficulties.[70]
High tariffs prevented Europeans from sending goods to America in exchange for gold. Instead, continued instability, encouraged by high tariffs, attracted European gold to American banks.
Meanwhile, American credit to Europeans, enabled by the Dawes Plan and the Federal Reserve’s credit injections, allowed Europeans to purchase American goods without compensating with increased exports to America. Instead European gold flowed on deposit to American banks. George Norris captured the situation perfectly. He wrote, “We ask all of these nations to make payments to us, knowing as we do that those payments can be made only in goods, and at the same time that we ask for payment in goods we raise a tariff-wall to prevent the entry of the goods.”[71] In light of tariff walls, the Dawes Plan, just like inflationary Federal Reserve policy, was not sustainable. Without a healthy export market, European producers were unable to identify the needs of the consumers.
The European economy structured itself around a finite program of credit expansion which did not remove the economic impediments that troubled Europe in the first place. The American system led investors to infect the European economy with easy credit. They invested “in a reckless, emotional manner, not systematically.”[72] In 1931 French ambassador to the US, Henri M. Berenger, complained, “For seven years American bankers have been engaged in entangling the United States with Europe.”[73] He was right, but Europe faced another problem in addition to the Dawes Plan that led it to depression: The gold-exchange standard.
The Gold-Exchange Standard
As inflation from the Federal Reserve’s open market purchases devalued the dollar,the British pound nearly reached its prewar parity in early 1925. The pound reached a postwar high of $4.78 and authorities decided to return it to its prewar exchange value on 28 April 1925.[74] The shift represented the beginning of the gold-exchange standard, a quasi-gold standard intended to restore confidence to investors in Europe. The pound was backed by gold, but the ability of individuals to redeem the pound for physical gold was limited. Persons could redeem their pounds for gold, but only “in the form of bars containing approximately four hundred ounces troy of fine gold.”[75] Furthermore, native Brits were not allowed to exchange pounds for gold.[76] This limited the gold market to rich investors and banks, and therefore provided the Bank of England with the opportunity to create currency without holding additional gold reserves to compensate. Therefore, this new gold standard was only a gold standard in name. It was in fact an intermediate stage between a gold backed currency and an unbacked fiat legal tender. Without the restraint of gold, the Bank of England was free to increase the volume of currency.
The shift to prewar parity was a dramatic change in the world of European finance. Hüllsmann explains:
The significance of the gold-exchange standard of 1925-31 was that it elevated this practice of coordinated inflation into a principle of international monetary relations. Only two banks – the American Fed and the Bank of England – were to remain true central banks, but this time they would be the central banks of the entire world. All other national central banks should keep a more or less large part of their reserves in the form of U.S. dollar notes and British pound notes. This would assure the possibility of inflationary expansion for all banks.[77]
The formation of the gold-exchange standard inherently formed a banking cartel through which all European central banks all simultaneously experienced inflation. The central banks like those in Austria, Germany, and France accounted for British notes as hard currency immediately convertible to gold and kept much of their gold reserves at the Bank of England. Notes from the other central banks were then backed largely by the pound. If depositors in continental Europe wanted to exchange their bank notes for gold, they first had to convert their original notes into pounds, then exchange those pounds for gold at the minimum required amount. Authorities hoped that barriers to exchange of pounds for gold would give Bank of England the ability to inflate the pound.
England had to convince and/or coerce its neighbor countries to accept pound hegemony. Britain took advantage of its influence in the League of Nations and its financial power to accomplish this goal. Emile Moreau, Governor of the Bank of France, complained:
England having been the first European country to reestablish a stable and secure money has used that advantage to establish a basis for putting Europe under a veritable financial domination…The method consists of forcing every country in monetary difficulty to subject itself to the Committee at Geneva [associated with the League of Nations], which the British control. The remedies prescribed always involve the installation in the central bank of a foreign supervisor who is British or designated by the Bank of England, and the deposit of a part of the reserve of the central bank at the Bank of England, which serves both to fortify the pound and to fortify British influence.[78]
More powerful countries begrudgingly accepted the new monetary system. France, for example, had no alternative to the gold-exchange standard if it wished to stabilize its currency. The Bank of France was unable to use the franc to buy gold because French law demanded that gold be exchanged at prewar parity. Gold purchased with newly created francs could thus easily taken back by depositors who realized that the gold was undervalued in nominal terms. The solution was for France to hold the British pound as a reserve while allowing the value of the franc to vary against the pound. In 1926, France began to buy sterling on foreign exchange markets with newly created francs.[79] This allowed the Bank of France to increase reserves without immediately losing them due to adherence to the prewar parity. It also limited franc devaluation because the new francs were not circulated within France. The choice of central banks in smaller countries was simpler. In an article penned shortly after the establishment of the gold-exchange standard, Mises wrote:
Note-issuing central banks, especially those of small and financially weaker states, had found that the holding of large gold reserves involved costs that could be saved. They set about exchanging a part of their gold reserve, which was lying in their vaults earning no interest, for short-term gold claims on foreign countries, gold claims that in contrast to non-interest-earning gold ingots and stock of coins did earn interest.[80]
A mixture of international financial vulnerability and convenience motivated European banks to accept the gold-exchange standard. What began for many as an uncomfortable compromise soon turned into financial catastrophe which, like a sinking ship with no life vessels for those aboard, proved deadly for national economies in Europe.
The Failure of the Gold-Exchange Standard
The failure of the gold-exchange standard resulted from two major causes: the overvaluation of the pound and Britain’s refusal to raise interest rates. Rothbard notes, “At a $4.86 pound British export prices were far too high to be competitive in the world markets.”[81] While American stocks soared, British unemployment remained high and government expenditures made low interest rates a necessity. The Bank of England, like the Federal Reserve soon after it, found itself between the devil and the deep sea. Low interest rates, caused by an increase in the money supply, decreased both the value of the pound and reduced the incentive for other central banks to hold as reserves British pounds in place of gold.[82] The Bank of England could only turn to collusion in order to prevent, at least temporarily, the outflow of gold:
Very often unofficial pressure is borne upon banks to abstain from gold shipments even though they appear profitable. It is an open secret that in June of this year for several weeks the Reichsbank dissuaded the German banks from taking gold from London, although the exchange was well beyond gold export point. Similarly, the Federal Reserve Bank of New York is believed to have put pressure upon American banks to abstain from importing gold from London. As a result, both dollar and reichsmark moved considerably beyond their theoretical gold export points, which caused some uneasiness abroad as to the intentions of this country to carry out gold standard in letter and spirit, and is believed to have been the cause of the withdrawal of some foreign funds from London, accentuating thereby the adverse trend of sterling.[83]
Central bankers and other financiers knew the danger of pound weakness. If the Bank of England proved insolvent, every central bank in Europe would follow the same path.
The overvalued pound had crippled England’s economy, but the Bank of England refused to change course. In 1927, the Bank of England called together an unofficial meeting of central bankers. Benjamin Anderson was in contact several attendees at the time including Deputy Governor Rist of the Bank of France. From conversations with several contacts he was able to gather:
The Bank of England did not wish to pull up [raise interest rates]…Norman and Strong tried hard to get the four countries to go along in a concerted policy of easier money. Professor Rist and Dr. Schacht held back…Following the departure of Rist and Schacht, Norman and Strong forced through their program of cheap money in the United States.[84]
The Federal Reserve dedicated itself to saving the pound, but attempts at stabilization only led to further imbalances.
Stimulus: Round Three
In 1927 Norman and Strong initiated round three of open market purchases, and the United States entered a period of unprecedented prosperity. The Federal Reserve engaged in this program in an attempt to outpace pound inflation and push the pound to the gold import point. Americans reacted to the arbitrarily decreased interest rates by increasing consumption and engaging in speculation. The Federal Reserve’s easy money policy “encouraged business expansion, new capital issues, and refinancing at low rates, which created large profits and surplus funds in the possession of corporations and individuals.”[86] Corporate growth, sparked by abundant loans, initiated a boom in the stock market. The S&P 500 Index, for example, demonstrated growth after both major open market purchases in 1924 and 1927. With the 1927 purchases, money was once again placed in the hands of many investors who had no immediate use for it. When the program was initiated, interest rates were artificially depressed. In 1924, investors placed their extra capital in time deposits, but by 1927 that market was saturated.[87] Investors instead sought profits via riskier investments: stocks.
Stocks are not as secure as bank deposits, and they tend to rise dramatically in the late stages of a boom. Distortions in the market, artificially depressed interest rates, and a lack of safe investment opportunities made this inevitable in the late twenties. Galbraith misses this point and argues:
This view that the action of the Federal Reserve authorities in 1927 was responsible for the speculation and collapse which followed has never been seriously shaken…Yet the explanation obviously assumes that people will always speculate if only they can get the money to finance it. Nothing could be farther from the case. There were times before and there have been long periods since when credit was plentiful and cheap – far cheaper than in 1927-29 – and when speculation was negligible.[88]
If safe, profitable investments are available, investors will take advantage of those before they venture riskier investments. Galbraith’s hasty generalization that “the explanation assumes that people will always speculate if only they can get the money to finance it” pays no regard to the variety of incentives that guided investors toward risky investments.
Purchases of securities by the Federal Reserve definitely pushed investors into a speculative mania. From the moment that the Federal Reserve initiated its third round of inflation until the stock markets crashed in October 1929, the Dow Jones and the S&P experienced gains close to 100%. The Federal Reserve attempted to stop this momentous rise in stock prices in 1928, but the situation had grown too complex for a solution as simple as the sale of securities. Albeit, this was its course of action in the first quarter of 1928.[90] Between December 1927 and July 1928, the Federal Reserve sold $671 million in bills and securities and simultaneously increased its bills discounted to member banks in an attempt to increase its influence over them.[91] Still, the security sales did not offset in increase in the total money supply. Time deposits continued to increase thanks to low reserve requirements. The Federal Reserve had proven itself inept in soaking up the currency made available by previous securities purchases. Anderson described the situation with metaphor:
When a bathtub in the upper part of the house has been overflowing for five minutes, it is not difficult to turn off the water and mop up. But when the bathtub has been overflowing for several years…a great deal of work is required to get the house dry. Long after the faucet is turned off, water still comes pouring from the walls and from the ceiling. It was so in 1928 and 1929.[92]
One sale of moderate size was unable to offset five years of inflationary policy.
Higher rates did not stop the boom. The previous credit expansions and their multiplication due to fractional-reserve banking left more than enough money available to investors. Though rates rose with the Federal Reserve’s attempt at monetary contraction, high rates were due mostly to an increase in demand. Investors on Wall Street were willing to pay a high price for capital by 1927. In turn, bank customers who wanted higher yields purchased from banks securities whose funds were loaned to market speculators. This allowed banks to maintain substantial reserves while lowering liabilities owed.[93] Rising interest rates lured latent capital into the market - capital which was abundant thanks to the Federal Reserve’s three major open market purchases. An interventionist monetary policy pushed the market out of balance, and the Federal Reserve lacked the means and knowledge to remedy the crisis. There was no exit strategy.
Conclusion
The crash of October 29 was the inevitable consequence of unprecedented monetary expansion by the Federal Reserve. By November 13, 1929 the Dow-Jones fell from its September high of 311 to 164.[94] The next two years saw the downtrend continue. In any circumstance, the inflationary intervention must sooner or later come to an end as lower interest rates encourage overconsumption and misallocation of resources. Economies are highly complex systems and actors in them are unpredictable. The consequences of economic intervention by central banks, especially large scale interventions like the Federal Reserve’s open market purchases in 1922, 24, and 27, inevitably produce unintended negative consequences. In addition to this, the self-interest of central bankers and other economic authorities obscure their ability to act appropriately even if they had perfect knowledge. Both of these factors culminated in Federal Reserve policy throughout the 1920s and led to a depression that left the world impoverished.
If the same mistakes are to be avoided in the present, historians and economists must take this into account. The economy is not a vehicle to be steered. It is simply the collection of individuals and groups cooperating with one another. The Great Depression was not a result of market failure but was the child of economic intervention that attempted to override the choices of individuals. The free market is not perfect, but it is at least self-correcting. An economy that is dominated by a monetary monolith like the Federal Reserve is robbed of this self-correction and the inevitable result is that booms and busts increase in amplitude as central banks increase intervention. While central banks cannot disappear overnight, the common good – the good of all individuals – demands that their existence ceases as quickly as possible.
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[2] “Belligerents’ Debt Grows,” New York Times, 5 Jan 1917, p. 8.
[4] Ibid., 249.
[5] Ibid., 247.
[6] Irving Fisher, “How the Public Should Pay for the War,” Annals of American Academy of Political and Social Science 78, (July 1918): 114-115.
[7] Herbert Hoover, “Memorandum on the Economic Situation,” Annals of American Academy of Political and Social Science 87, (Jan 1920): 109.
[8] Murray Rothbard, A History of Money and Banking (Auburn, AL: Ludwig von Mises Institute, [2002] 2005), 352.
[9] Fisher, “How the Public Should Pay,” 114.
[10] Harris, S.E., Twenty Years of Federal Reserve Policy, Harvard Economic Studies, vol. XLI (Cambridge, MA: Harvard University Press, 1933), 71.
[11] Miller elaborated, “The main impulse came from the release of buying power which had been in restraint during the war. A seller's market began to develop in the spring of 1919. The consumer demanded goods; price was a secondary consideration. Dealers, both wholesale and retail, were bidding against one another for such supplies as there were, and manufacturers were bidding against one another for raw materials and labor. The rapid rise of prices induced buying for speculation, and speculation in its turn accelerated the rise of prices. Inflation was becoming cumulative and systemic in its effects, and pervading the whole body economic.” A. C. Miller, “Federal Reserve Policy,” The American Economic Review 11, no 2 (June 1921): 187.
[12] Benjamin M. Anderson , Economics and the Public Welfare (Indianapolis, IN: Liberty Press, [1949] 1979), 64.
[13] Ibid., 63.
[14] Ibid., 77.
[15] Miller, “Federal Reserve Policy,” 188.
[16]Harris, Twenty Years, 73.
[17] Joseph S. Davis, “World Banking, Currency, and Prices, 1920-1921,” The Review of Economics and Statistics, 3 no 9, (September 1921): 323.
[18]The farmer is the largest victim of the depression in 1921. “Wallace Calls to Aid the Farmer,” 13 Mar 1921, p. 10; Commodities graph of WWI era. Giovanni Federico, “Not Guilty? Agriculture in the 1920s and the Great Depression,” Journal of Economic History 65, no. 4 (December 2005): 957.
[19] John Kenneth Galbraith, The Great Crash: 1929 (New York: Houghton Mifflin Company, [1954] 1997), 1.
[20] Ibid., 11.
[22] Milton Friedman and Anna Jacobson Scwartz, The Great Contraction: 1929-1933 (Princeton, NJ: Princeton University Press, [1963] 2008), 14.
[23] Ibid., ix.
[24] Ludwig von Mises, Human Action (Auburn, AL: Ludwig von Mises Institute, 1998), 40.
[25] Ibid., 41.
[26] Ibid., 67.
[27] “Man is not infallible. He searches for truth – that is, for the most adequate comprehension of reality as far as the structure of his mind and reason make accessible to him. Man can never become omniscient. He can never be absolutely certain that his inquiries were not misled and what he considers as certain truth is not error. All that man can do is submit all his theories again and again to the most critical examination. This means for the economist to trace back all theorems to their unquestionable and certain ultimate basis, the category of human action, and to test by the most careful scrutiny all assumptions and inferences leading from this basis to the theorem of examination. It cannot be contended that this procedure [praxeology] is a guarantee against error. But it is undoubtedly the most effective method of avoiding error.” Ibid., 68.
[28] “Subjective value is not measured, but graded. The problem of the measurement of objective use-value is not an economic problem at all…Neither is objective exchange-value measurable, for it too is the result of the comparisons derived from the valuations of individuals.” Ludwig von Mises, The Theory of Money and Credit (Auburn, AL: Ludwig von Mises Institute, 2009), 38-39, 46-47.
[29] Mises, Human Action, 102.
[30] Ibid., 29.
[31] “Money has… become an aid that the human mind is no longer able to dispense with in making calculations. If in this sense we wish to attribute to money the function of being a measure of prices, there is no reason why we should not do so. Nevertheless, it is better to avoid the use of a term which might so easily be misunderstood. As this. In any case the usage certainly cannot be called correct – we do not usually describe the determination of latitude and longitude as a ‘function’ of the stars.” Ibid., 49.
[32] Mises, Theory of Money of Credit, 195-203; Murray Rothbard, America’s Great Depression (Auburn, AL: Ludwig von Mises Institute, [1963] 2008), 9-10.
[33] Mises, Theory of Money and Credit, 349.
[34] Ibid., 361.
[35] Eg., goods which require a relatively short production process. Rothbard, America’s Great Depression, 11.
[36] Ibid., 14.
[38] In the case of the 1920s, requirements for demand deposits hovered around 10%. Rothbard, America’s Great Depression, 99.
[39] The Federal Reserve Act of 1913 in Major Documents in American Economic History
[41] Ludwig von Mises, “The Causes of the Economic Crisis [1924]” in The Causes of the Economic Crisis and Other Essays Before and After the Great Depression (Auburn, AL: Ludwig von Mises Institute, 2006), 161-163.
[42] The Federal Reserve also holds the authority to tighten credit, but it employs this method far less often. This is evidence by the devaluation of the dollar. In terms of gold the dollar is worth less than 2% of its original value.
[43] “The major instrument of Fed control of the money and banking system is its ‘open market operations’: its buying and selling of U.S. government securities (or, indeed, any other asset it wished) on the open market.” Murray Rothbard, The Case Against the Fed, (Auburn, AL: Ludwig von Mises Institute, [1994] 2007), 122.
[44] “…Adequate business was available and hence reserve banks were not forced to resort to open market operations in order to increase their earnings.” Harris, Twenty Years, 148.
[45] Ibid., 148, 158-159.
[46] Anderson, Economics and the Public Welfare, 92, 95-96.
[47] Ibid., 96; Clay J. Anderson, A Half-Century of Federal Reserve Policy Making (Philadelphia, PA: Federal Reserve Bank of Philadelphia) 48.
[48] Rothbard, A History of Money and Banking, 375.
[49] John R. Collins, “The Stabilization of Prices and Business,” The American Economic Review, 15, no 1, (March 1925): 43.
[50]The Wilson administration saw 578 bank failures while Coolidge’s administration witnessed over 4700 bank failures. “Calls Coolidge Novelist” New York Times 18 Oct 1928, p. 13.
[51] Benjamin M. Anderson, “Cheap Money, Gold, and Federal Reserve Bank Policy,” Chase Economic Bulletin 4, no 3 (August 1924): 1.
[52] Anderson, Economics and the Public Welfare, 98.
[53] See Chart. Rothbard, America’s Great Depression, 109.
[54] Harris, Twenty Years, 510.
[55] The velocity of money began to increase at the end of 1924 and continued the trend until October 1929. A. Ross Eckler, “Recent Expansion of Bank Credit,” Review of Economics and Statistics, 11, no 1, (February 1929): 48.
[56] Specific attention should be given to the change in total money supply. It grew from $45.3 billion to $73.26 billion from 1921 to 1929. Time deposits also grew from $16.58 to $28.61 billion in that time period. Rothbard, America’s Great Depression, 92.
[57] Anderson, Economics and the Public Welfare, 140.
[58] Ibid., 141.
[59] As mentioned earlier, reserve requirements for demand deposits were 10%. This multiplied the potential for inflation by a factor of more than three. Rothbard, America’s Great Depression, 99.
[60] Galbraith, The Great Crash, 2.
[61] L. R. Gottlieb, “The Public Financial Burdens of the Principal Countries of the World,” Annals of the American Academy of Political and Social Science. 102 (July 1922): 116-117.
[63] Henry A. E. Chandler, “America’s Relationship to the European Financial System,” Annals of the American Academy of Political and Social Science, 108, (July 1923): 44.
[64] Rothbard, A History of Money and Banking, 352.
[65] Harris, Twenty Years, 358.
[66] Rothbard, America’s Great Depression, 146.
[67] Ibid., 270.
[68] In this case, overvalued European currencies forced gold to banks in America which Europeans perceived as inherently stable. Jörg G Hüllsmann, The Ethics of Money Production (Auburn, AL: Ludwig von Mises Institute 2008), 126-127.
[69] Anderson, “Cheap Money, Gold, and the Federal Reserve Bank Policy,” 10.
[70] Anderson, Economics and the Public Welfare, 116.
[71] George W. Norris, “Foreign Liabilities and Assets and the Dawes Plan,” Annals of the American Academy of Political and Social Science, 120, (July 1925): 22.
[73] Ibid., 71.
[74] Robbins, The Great Depression, 80.
[75] J. M. Keynes, “The Gold Standard Act, 1925,” The Economic Journal 35, no 138 (June 1925): 311.
[76] Ibid., 313.
[77] Hüllsmann, Ethics of Money Production, 215.
[78] Emile Moreau quoted in Rothbard, America’s Great Depression, 152.
[79] Anderson, Economics and the Public Welfare, 177-178.
[80] Ludwig von Mises, “The Return to the Gold Standard [1925],” in Between the Two World Wars: Monetary Disorder, Interventionism, Socialism, and the Great Depression (Indianapolis, IN: Liberty Fund, 2002), 146.
[81] Murray Rothbard, What Has Government Done to Our Money? (Auburn, AL: Ludwig von Mises Institute, [1963] 2008), 90.
[82]“Britain’s immediate problem stemmed directly from her insistence on continuing cheap money. The bank of England had lowered its discount rate from 5 percent to 4 ½ percent in April, 1927, in a vain attempt to stimulate British industry. This further weakened the pound sterling, and Britain lost $11 million in gold during the next two months.” Rothbard, America’s Great Depression, 153.
[83] Paul Einzig, “Gold Points and Central Banks,” The Economic Journal 39, no 155 (September 1929): 384.
[84] Anderson, Economics and the Public Welfare, 189.
[85] “Figure 25: Standard and Poor’s Common Stock Price Index, 1920 to 1930.” Gene Smiley, “The U.S. Economy,” http://eh.net/encyclopedia/article/Smiley.1920s.final
[86] Ivan Wright, “Loans to Brokers and Dealers for Account of Others [1929],” in History of Financial Disasters, 1763-1995, (London: Pickering & Chatto, 2006), 20.
[87] See chart on page 15.
[88] Galbraith, The Great Crash, 10-11.
[89] Anderson, Economics and the Public Welfare, 202.
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