To monetarists such as Milton Friedman and Anna J. Schwartz (1963), the primary cause of the Great Depression was the decline in the stock of money produced by the withdrawal of currency from the banking system and the decisions of banks to hold more reserves.104 The only way banks could maintain or increase their reserves was by decreasing their lending, a decision that led to a multiple contraction of bank credit and deposits. According to the quantity theory of money, when the stock of money contracts, people try to restore the relationship between their money balances and their incomes by spending less. The result is a fall in the GDP. Thus, monetarists believe that the fall in the stock of money from $47 billion in 1929 to $32 billion in 1933, as shown in Table 23.2, was a major cause of the fall in GDP from $104 billion to $56 billion. They blame the Federal Reserve for not acting as a lender of last resort to prevent the decline in the stock of money.
Monetarists do not claim that the fall in the stock of money was the only factor at work. Note that the ratio of money to GDP rose (see column 3 of Table 23.2), showing that people were hoarding rather than spending. During the first year of the depression, in particular, the ratio of money to GDP rose, probably because of the stock market crash, while the money supply fell only slightly. Nevertheless, monetarists insist that any decline in the money supply is significant, because the money supply normally rises from year to year.
It is difficult to believe that the collapse of the stock of money did the economy any good, and most financial historians now follow the monetarists in assigning a major role to the monetary collapse. There has been some controversy, however, over exactly how much weight to assign to the banking crisis compared with other causes. The most skeptical view about the role of the money was expressed by Peter Temin (1976). Temin claimed that, although there was a correlation between money and GDP, much of the causation ran from the fall in GDP to the fall in money.
About by the stock market crash, according to Temin, produced a downward spiral in which profits fell, workers were laid off, and many borrowers could not repay their bank loans. This triggered the waves of bank failures and the decline in the money stock. This was a tragedy, to be sure, but in Temin’s view it was another symptom of the depression rather than the cause. The key piece of evidence, according to Temin, is the behavior of the rate of interest. He contends that if the decline in the money stock were the initiating factor, we would have seen interest rates rising. After all, if there is a shortage of wheat, we expect the price of wheat to rise, and if there is a shortage of money, we expect the rate of interest to rise. But we observe just the opposite: Short-term interest rates (see column 4 in Table 23.2) fell from 5.78 percent in 1929 to 1.67 percent in 1933. (Economic Insight 23.1 provides a more detailed look at Temin’s analysis.) To some extent, the debate centers on the years one stresses. Temin focuses on the events of 1929 and 1930, while Friedman and Schwartz concentrate more on 1930-1933.
World History
