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A Review of the Monetary Phase of the Great Depression

A Review of the Monetary Phase of the Great Depression

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The scope of this essay will be mainly to focus on the first phase of the Great Depression in particular its monetary phase. We will review the monetary policies in the 20s and 30s; specifically we will review the expansionary monetary policies that influenced the late booming years in the 1920s and finally the period of the Great Contraction between 1929 and 1933.
The scope of this essay will be mainly to focus on the first phase of the Great Depression in particular its monetary phase. We will review the monetary policies in the 20s and 30s; specifically we will review the expansionary monetary policies that influenced the late booming years in the 1920s and finally the period of the Great Contraction between 1929 and 1933.

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Published by: Pablo Paniagua Prieto on Jul 15, 2013
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A Review of the Monetary Phase of the Great DepressionBy: Pablo Paniagua
 Date: 7/12/2013The Great Depression was without a doubt the most catastrophic event in economic history ever sincethe Black Death in the XIV century. Frequently people see the Great Depression (GD) as an isolated incident, specifically seeking to identify a single culprit that might have caused or ignited the depression:greed? Wall Street speculation? The Fed? Individuals usually seek to focus on a myopic, simplistic viewof the GD rather than seeing it as a complex historical event that unveiled itself through almost twodecades and that it contains elements of both economic policy and public policies, which makes the GDa more intricate and complex event. However as a matter of simplicity we can identify four majorphases (Reed, 1981) or aspects of the GD that can be analyzed somewhat individually (although policiesand phases do overlap). The first of these four stages is the monetary phase and the business cycleperiod, which encompasses 1922-1933. Subsequently the Hoover administration phase and the pavingof the road on public policy for the New Deal; this stage analyses the Smoot-Hawley Tariff and otherpolicies of the Hoover administration between 1930-1932. Third was the New Deal itself and FDRperiod, 1933-1938, and finally The Wagner Act and WWII period. It is impossible to understand theseverity of the depression and why it lasted so long without having a holistic view of all of these phasesand the evolution of ever increasing catastrophic public and monetary policies involved.The scope of this essay will be mainly to focus on the first phase of the Great Depression in particular itsmonetary phase. We will review the monetary policies in the 20s and 30s; specifically we will review theexpansionary monetary policies that influenced the late booming years in the 1920s and finally theperiod of theGreat Contraction between 1929 and 1933. Most commentators start analyzing the monetary phase of the depression from 1929 onwards; however we believe that the booming period of 1922-1928 will be a great theoretical foundation to understand the underlying disorganization andstructural problems that ignited the subsequent phase of monetary contraction in 1929. These twoperiods of monetary policy are particularly characterized by contrasting intellectual and policy positionsthat created two different policy environments concerning money (Timberlake, 2013). The first part of the monetary phase is marked by the (at the time) new regime of theFederal Reserve System,  established on December 23, 1913 as a centralized federal response to the national bank panic of 1907.By the beginning of the 1920s, the Federal Reserve was just becoming self-aware of the potential powerthey might possess in controlling the money supply, but already by 1922 the Fed was actually verydifferent from what the Federal Reserve Act original intended (Timberlake, 2008). By that year, theFederal Reserve started drastically changing their form of influencing the economy. The Fed moved fromutilizing the discount window towards utilizing open market operations on government securities(Meltzer, 1976), this policy became in the twenties the standard mechanism to influence the moneysupply.
 
2By the time the Fed was established,Benjamin Strong had become the appointed governor of the Federal Reserve Bank of New York, a position that he maintained until his death in 1928. He was asturdy first governor of the Federal Reserve Bank of New York and as well as a substantial leader of theFederal Reserve System during the twenties. He exercised a disproportionate prominence in the policydecision making of the Fed during that decade, due to his relative importance as governor of the FederalReserve Bank of New York and his former presidency of the
Banker’s Trust.
 As mentioned before the monetary policy of the twenties under Strong was in radical demarcation, boththeoretically and practically, from the periods that followed during the thirties. By 1922 the maininstruments of monetary policy started to radically change, under the leadership of Benjamin Strong,the Federal Reserve started to move away from transmitting monetary policy only through the discountwindow.The board wished to avoid the discount rate to guide the lending activities of the bankingsystem, and seek a way to make the discount rate secondary, instead of the main Fed policy (Meltzer,1976). The Strong policy framework then, shifted towards utilizing open market operations of purchases of government securities to try to guide the lending activities and the money supply in the bankingsystem. Strong therefore led policies by 1922 onwards, deeply influenced in the quantitative theory of money developed by Irving Fisher that aimed at a form of price stability, in other words, Strong wasseeking to control the expansion of the quantity of money in order to maintain a measure of theConsumer Price Index inflation stable. This decade was characterizing by solid and fast economic growthand fairly stable prices, which led people to believe that the U.S. had indeed entered a new era of stability and affluence. We have to discuss this decade more in detail in order to understand why the
new era of affluence didn’t turn out to be viable. In order to do so
, we will specifically review how deepstructural imbalances can form in the economy even if there is an environment of price stability andthen how these imbalances (once they turned out to be unsustainable) led to particular instabilities inthe banking system and the stock market.It is important to stress that not the entire economic boom of the twenties was unsustainable orexcessive; as a matter of fact, much of the economic growth in the first half of the decade was sustainedby real economic reforms that led to great increases in productivity and innovation. The Coolidge erawas particularly important in creating the political framework to sustain this entrepreneurial driven era.Substantial reforms and reductions on income taxes were implemented, Coolidge eliminated the incometax for nearly two million Americans (Sobel, 1998), by 1927 only the wealthiest two percent of Americans were paying income tax (Ferrel, 1998) and other commercial tax reductions created a morepropitious environment to enhance economic activity. The policies fostered new consumption of theupcoming electric appliances and improved the tax environment allowing more competition andinnovation.Between 1923 and 1929 substantial reforms were similarly made on trade regulations and substantialimprovements on interstate commerce. In addition, Coolidge substantially reduced Federalexpenditures and retired nearly a quarter of the Federal debt (Ferrel, 1998). Despite these reforms,President Coolidge was by no means a laissez-faire president; rather he was a deeply committedFederalist (Ferrel, 1998). We can see how Coolidge
’s
policies were aimed at improving the business
 
3environment substantially; the U.S. economy enlarged its real GNP by 4.2 percent a year and its per capita GNP by 2.7 percent a year from 1920 to 1929 (Smiley, 2010). Therefore we must be very carefulin defining the Roaring Twenties as simply one big bubble, because there was a real solid economicgrowth which only
later in the decade became “adulterated”
to a certain degree through the
Fed’s
monetary policies.By 1923 right after a mild recession of 1920-1921, the Fed started to sell securities and increased the
discount rate from 4% in order to “cool” the recovery that according to Strong was accelerating t
oorapidly in early 1923. However by the end of that year there were some signs of a mild contraction, dueto exogenous shocks of international oil prices (Smiley, 2010); this problem manifested itself late againin the decade in 1927, with a similar response by String. These oil shocks were seen as potential threatsto the US economy, and were ameliorated with accommodative expansionary monetary policies.Benjamin Strong, through the years 1923-1928, started using securities purchases to seek to ameliorateand ease these exogenous threats to the economy. Therefore by 1923-1924 the Federal Reserve startedits expansionary polices with large security purchases and reductions of the Federal discount rate,which manifested themselves in an increase of the securities holdings of the Fed by over $700 million in lessthan 4 years (Wheelock, 1992).Following the 1923-1924 expansion, the Fed also reduced its discount rate from 4.5 percent to 3percent, allowing banks to borrow money from the system at a lower discount rate. Another key
element that contributed in the years of the monetary expansions was Benjamin Strong’s international
economic commitments and international sensitivities. Strong was probably one of the only Americaneconomists and policy makers deeply interested in the troubled financial situation of Europe in the1920s (Meltzer, 1976), particularly the 1925 British attempt to move back to the gold standard and toreturn to the old pound/dollar exchange rate of $4.85 that pushed Britain to a path of deep deflation(Skidelsky, 2005). In order to achieve this policy of a higher exchange rate Britain needed to keep goldreserves in Britain; this meant keeping interest rates relatively high compared to the rest of the world inorder to attract gold reserves or to avoid them leaving the country. The higher interest rates also led toheightened pressure in the economy (Skidelsky, 2005). Strong therefore helped sustained Britishmonetary policies by reducing American interest rates through lowering the bank discount rate andincreasing the supply of credit and lowering interest rates in the Unites States. These polices helped tosomewhat reverse
the flow of gold back to Great Britain, helping Britain’s attempt to return to the gold
standard (eventually Britain broke from the gold standard in 1931).By 1927 the Fed undertook its second biggest purchase program during its international commitment toallow Britain and France to return to the gold standard. Strong started adopting more severeexpansionary measurers than the ones it had adopted before in 1924 (Selgin, 2013). The Fed reducedthe discount rate once again and committed itself to large securities purchases, this time another extra$300 million, allowing France to return to the gold standard with an undervalued currency by 1928 andallowing Britain to contain the gold outflow and meliorate their 1927 payment crisis (Wicker, 1966).Overall we can realize how the period 1923-1928 was marked by a somewhat volatile andaccommodative expansionary monetary policy that allowed the money supply to grow quite rapidly

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