Apologies for the delay in my commentary. I was thinking on how better to explain the historiographical relevance of the Friedman and Schwartz book and I thought it would be necessary to explain the theoretical background that becomes crucial to understand the (ravaging) critique of the Federal Reserve in The Great Contraction. Bear with me, please!
Friedman and Schwartz’s The Great Contraction is the reprint of a chapter of their work A Monetary History of the United States, 1867-1960, published in 1963 as part of a collection dedicated to the study of business cycles. This explains why they opt to name the Great Depression a contraction: for them, this is an episode in the much larger history of the business cycles in the US.
When published, A Monetary History proved to be the major piece of empirical evidence supporting the revival of the quantitative theory of money in the version advocated by Friedman and originally developed by Irving Fisher (1867-1947). The quantitative theory of money, in its most basic incarnation, is based on a national accounting identity, namely, that the nominal product (and income) will be identical (≡) to the amount of money in circulation in a given period of time.
Let P indicate the price level, Y the level of income, M the amount of money in circulation, and V the velocity of money, i. e., the number of times the numeraire circulates within an economy:
P Y ≡ M V
When the identity is used to predict the price level in any given time series, we will have equation (1), which states that the price level should be a direct function of the amount of money in circulation and the velocity of money, and that the price level will be an inverse function of the level of product in the economy.
(1) P = (M V) / Y
If an economy has an increased amount of means of payment, this will lead to an increase in prices, all the other variables constant: this has to occur since an excess in the money supply can only be accommodated through the loss of purchasing power of existing money. If the velocity of money accelerates, inflation will also happen, since the same money is being used more quickly to purchase the same goods. If an economy faces an increase in product or income, without a corresponding increase in the amount of money in circulation, prices will have to adjust downwards, and deflation will happen, since the amount of money in circulation is insufficient vis-a-vis the new level of goods available and thus the purchasing power of money has to increase to accommodate the rise in output.
Now, for monetarist economists, the question is, what is the behavior of these variables? Monetarists thought the velocity of money (V) was constant (k), since for them this variable was affected mostly by technological change and institutional practices. They also thought that the price mechanism operated without frictions: if prices and wages adjust instantly, then the economy is always producing an optimum level of output, corresponding to its potential (Y*). Thus we have equation (1′)
(1′) P = kM / Y*
Now, equation 1′ adequately shortens the monetarist dictum, that is, inflation is first and foremost a monetary phenomenon. The price level in the economy will be primarily a function of the amount of money in circulation. If this amount drops, as it happened in the Great Depression, prices will fall. If the amount of money in circulation increases, prices will rise. Equation (1′) shows that inflation (or deflation) is largely a problem of monetary authorities.
Now, why are falling prices worse than rising prices? Deflation is probably the worst of all economic phenomena in that it increases the amount of indebtedness in real terms. If someone borrows 100 dollars today, and prices rise (i. e., inflation happens), when that person repays her debt, she will repay less in real terms than he actually borrowed, for the same amount of money can purchase less goods than it did before (thus lenders charge an interest rate higher than the expected inflation to cover the inflation risk). However, if someone borrows 100 dollars today, and prices fall (as they did due to depressed consumption and investment demands in the Great Depression), when that person repays her debt, that debt will actually be higher in real terms, for the same money can buy more goods than it did before. This is known as the debt deflation problem, and was also studied by Irving Fisher. The increase in real indebtedness in households and firms drags an ailing economy for it further diminishes the propension to demand consumption goods or to invest in capital goods.
In Friedman and Schwartz’s view, deflation was a result of a restrictive monetary policy on the part of the Federal Reserve System. Had the Fed increased the monetary supply enough, deflation would have been avoided, and enough inflationary pressure would have been a good thing improving the expectations of both households and firms. In their view, a policy rule that works as an anchor to inflationary expectations is the best way to go if an economy is to have a public agency overseeing monetary matters: their revision of the US experience prior to the creation of the Fed in 1913 allows them to advocate instead for an economy whereby money is supplied by private intermediaries, without central regulation.
Now, a critique can be advanced on the Friedman and Schwartz position, in the sense that the Federal Reserve System was operating under the gold standard. The gold standard was a commodity-based monetary system where all countries ultimately exchanged gold to settle their trade and investment accounts with one another.
If the US had a trade superavit, or an inflow of investment from the rest of the world, the US would receive an inflow of gold: this augmented gold stock would increase the monetary supply and put an inflationary pressure on the domestic economy, a pressure that could be neutralized if the Fed retired sufficient liquidity from the system or decreased the reference rate of interest, encouraging investors to take their funds to other countries with better rates (and in turn stimulating the economy through a reduction of financial costs). If the US had a trade deficit, or an outflow of investment to any other country, the US would have an outflow of gold: the reduced existences of gold would diminish the amount of money in circulation and this would amount to a deflationary pressure unless the Fed provided sufficient liquidity or increased the rate of interest to attract foreign capital (and increasing the cost of lending, thus depressing the consumption and investment demand).
The main advantage of the gold standard (the almost stable exchange rates between national currencies) is that it provided a monetary mechanism that accommodated the expansion of liberal capitalism before World War I, the main disadvantage was the adjustment mechanism led to very volatile rates of inflation (and deflation).
The convenience of the gold standard was almost unanimously accepted in academic, business and political circles, and thus a deviation from this intellectual and policy consensus on the part of the Fed officers as proposed by Friedman and Schwartz is hard to think of. This argument is thoroughly developed by Barry Eichengreen in his book Golden Fetters. The historical actors were unaware of what is now called the “trilemma” of monetary policy: if an economy with fixed exchange rates wants to have free circulation of foreign capital, the economy must renounce to an assertive domestic monetary policy, and accommodate passively the performance of its external sector.
Friedman and Schwartz also criticize the performance of American central bankers with regards to their most important role during crises: that of providing liquidity. Any bank is run with a fundamental liquidity problem: their liabilities are highly liquid (let’s say deposits), whereas their assets are highly illiquid (let’s say, loans and investments). If a bank faces a run in the form of all depositors claiming the return of their money, a bank can only return a limited amount of money, for it only holds the necessary cash to conduct its daily operations. What the Fed should have done as a central bank is to act as a lender of last resort, a function first theorized by Walter Bagehot (1826-1877), an editor of The Economist: in critical conjunctures, a central bank must provide unlimited liquidity to troubled banks so that a crisis of liquidity does not turn into a crisis of solvency. The Fed did not perform much of this, but again, one must mention the intellectual and policy consensus in favor of the “liquidationist” position: many businessmen, financiers and politicians were convinced of the need to get rid of what they saw as the “weakest” competitors in all markets, in what echoes the libertarian creed of today.
The 1930s were a decade of learning for central bankers everywhere, and in my view, before we blame them directly for the worsening economic conditions, we must take into account what the intellectual consensus limiting expansionary monetary policy was, as well as the larger institutional framework regulating the international monetary system of the time.