According to Friedman, as a result of the collapse in the money stock, economic growth followed suit. Year-over-year industrial production by July 1932 fell by more than 31 percent (see chart). Also, year over year, the Consumer Price Index (CPI) plunged. By October 1932, the CPI had declined by 10.7 percent.
But is it possible that the failure of the Fed to lift the money supply caused the collapse of economic growth? If that’s the case, money should be regarded as an agent of economic growth. The whole idea that economic growth requires monetary expansion gives the impression that money somehow sustains economic activity.
By fulfilling the role of the medium of exchange, money facilitates the flow of goods and services. Moreover, within the framework of a free market, there cannot be such a thing as “too little” or “too much” money. As long as the market is allowed to clear, no shortage of money can emerge.
Consequently, once the market has chosen a particular commodity as money, the given stock of this commodity will always be sufficient to secure the services that money provides.
The Pool of Real Savings and the Great Depression
We suggest that it is the decline in the pool of real savings that caused the economic depression of the 1930s. This decline occurred because of the previous loose monetary policies of the Fed. A closer examination of the historical data shows that the Fed was actually pursuing very easy monetary policy in its attempt to revive the economy.The extent of the monetary injections is depicted by the Fed’s holdings of U.S. government securities. In October 1929, holdings of U.S. government securities stood at $165 million. By December 1932, these holdings had jumped to $2.432 billion—an increase of 1,374 percent (see chart).
Also, the 3-month Treasury bill rate fell from almost 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 10-year T-bill and the 3-month T-bill rate. The differential increased from 0.04 percent in January 1930 to 2.80 percent by September 1931 (see Chart 5). (An upward-sloping yield curve indicates a loose monetary stance.)
The sharp fall in the money stock from 1930 to 1933 is not indicative that the Federal Reserve did not try to pump money. Instead, the decline in the money stock came as a result of the shrinking pool of real savings brought about by the past loose monetary policies of the Fed.
Thus, the yield spread increased from −0.67 percent in October 1920 to 2 percent by August 1924. Again, an upward sloping yield curve indicates an easy monetary stance.
The reversal of the stance by the Fed, which saw the yield spread decline from 2 percent in August 1924 to −1.45 percent by May 1929 burst the monetary bubble (see chart).
In addition to this, at some periods prior to the Great Depression, the monetary injections were massive. For instance, the yearly growth rate of M1 increased from minus 12.6 percent in September 1921 to 11.0 percent by January 1923. Then, from minus 0.4 percent in February 1924, the yearly growth rate accelerated to 9.8 percent by February 1925. Such large monetary pumping amounted to a massive exchange of nothing for something.
The large monetary pumping resulted in the diversion of real savings from wealth generators to various nonproductive activities that emerged on the back of loose monetary policy. This real savings diversion resulted in the depletion of the pool of savings.
As long as the pool of real savings is expanding and banks are eager to expand credit, nonproductive activities can continue to prosper. Whenever the extensive generation of credit out of “thin air” lifts the pace of wealth consumption above the pace of wealth production, the flow of real savings is arrested and a decline in the pool of real savings begins.
Consequently, the performance of economic activities starts to deteriorate, and banks’ bad loans start to pile up. In response to this, banks curtail their lending “out of thin air,” and this in turn sets in motion a decline in the money stock. Note that the pool of real savings is the heart of economic growth. (Savings sustain individuals who are employed in the various stages of production.)
After growing by 2.7 percent year over year in January 1930, bank loans had fallen by a massive 29.0 percent by March 1933 (see chart).
Now, when loaned money is fully backed by savings, on the day of the loan’s maturity, it is returned to the original lender. Thus, Bob—the borrower of $100—will pay back to the bank on the maturity date the borrowed sum plus interest.
The bank in turn will pass to Joe, the lender, his $100 plus interest adjusted for bank fees. The money makes a full circle and goes back to the original lender. In contrast, when credit generated out of “thin air” is returned on the maturity date to the bank, this results in the withdrawal of money from the economy—i.e., a decline in the money stock. The reason for this is that there was no original saver/lender since this credit was generated out of “thin air.” (Again, savings do not support the credit here.)
Observe that economic depressions are not caused by the collapse in the money stock but come in response to a shrinking pool of real savings on account of the previous monetary pumping. A decline in the money stock is the result of a decline in the pool of real savings. Note again that the decline in this pool is because of the previous loose monetary policies of the central bank and mirrors a weakening in the process of wealth generation.
Consequently, even if the central bank were to be successful in preventing the decline of the money stock, this could not prevent the economic depression if the pool of real savings is declining.
