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Monetary Central Planning and the State, Part 3: The Federal Reserve and Price Level Stabilization in the 1920s


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The Great Depression was not the result of “reckless capitalism” combined with “passive, indifferent government.” The Great Depression was caused by monetary mismanagement by America’s central bank, the Federal Reserve System. And the Depression’s intensity and duration were the result of government interventionist and collectivist policies that prevented the required readjustments in the economy that would have enabled a normal recovery in a much shorter period of time.

The roots of the Great Depression were laid with the establishment of the Federal Reserve System in 1913. While the American monetary system had many serious flaws before 1913 — practically all of them connected with federal and state regulations and controls over the banking industry — the Federal Reserve System became the mechanism for centralization of control over the monetary and banking structures in the United States. And those controls became the mechanism for monetary central planning that generated a large inflation during the period of the First World War, the illusion of “stabilization” in the 1920s, and the reality of the Great Depression in the early 1930s.

In the first seven years after the Federal Reserve came into full operation in 1914, wholesale prices in the United States rose more than 240%. How had this come about? Between 1914 and 1920, currency in circulation had increased 242.7%. Demand (or checking) deposits had gone up by 196.4%, and time deposits had increased by 240%.

With the establishment of the Fed, gold certificates began to be replaced with the new Federal Reserve Notes. Unlike the older gold certificates that had 100% gold backing, Federal Reserve Notes had only a 40% gold reserve behind them, enabling a dramatic expansion of currency. Member banks in the new system were required to transfer a portion of their gold reserves to the Fed to “economize” on gold in the system. At the same time, reserve requirements on deposit liabilities were lowered by 50% from the pre-1914 average level of 21% to 11.60%; and they were lowered even further in June 1917 to 9.67%. Reserve requirements on time deposits were set at only 5% and diminished still more to 3% in June 1917.

The decreased reserve requirements on outstanding bank liabilities created a tidal wave of available funds for lending purposes in the banking industry. And, indeed, between 1914 and 1920, bank loans increased by 200%. Much of the additional lending ended up being in U.S. government securities, especially after American entry in the First World War in April 1917. Between March 1917 and June 1919, bank loans to the private sector increased by 70%, while investments in government securities went up by 450%.

C.A. Philips, T.F. McManus, and R.W. Nelson explained in their important work, Banking and the Business Cycle: A Study of the Great Depression in the United States (1937):

“Had it not been for the creation of the Federal Reserve System, there would have been a [lower] limit to the expansion of bank credit during the War. . . . The establishment of the Federal Reserve System, with its pooling and economizing of reserves, thus permitt[ed] a greater credit expansion on a given reserve base. . . . It is in the operations of the Federal Reserve System, then, that the major explanation of the War-time rise in prices lies.”

The years 1920-1921 saw the postwar slump. Prices fell by about 40% during these two years, and unemployment rose to a height of over 10%. But the depression, though steep, was short-lived. Why? Because the American economy still had a great degree of wage and price flexibility. The imbalances in the market created by the preceding inflation were soon corrected with appropriate adjustments in the structure of wages and prices to more fully reflect the new postwar supply-and-demand conditions in the market. But this postwar adjustment did not return prices to anything near the prewar levels. Prices in the United States were still almost 40% higher in 1922 than they had been in 1913. This was not surprising, since the money supply contracted by only about 9% to 13% during this period (according to Monetary Statistics of the United States by Milton Friedman and Anna Schwartz).

Following 1921, the Federal Reserve System began its great experiment with price level stabilization, which Irving Fisher praised so heartily in 1928. (See “Monetary Central Planning and the State: Part II,” Freedom Daily , February 1997). That this was the Fed’s goal was confirmed by Benjamin Strong, chairman of the New York Federal Reserve Bank through most of the decade and the most influential member of the Federal Reserve Board of Governors during this period. In 1925, Strong said, “It was my belief . . . that our whole policy in the future, as in the past, would be directed toward the stability of prices so far as it was possible for us to influence prices.” And in 1927, he once again emphasized, “I personally think that the administration of the Federal Reserve System since the [depression] of 1921 has been just as nearly directed as reasonable human wisdom could direct it toward that very policy [of price level stabilization].”

Did the Federal Reserve succeed in its policy of price level stabilization? An index of wholesale prices, with 1913 as the base year of 100, shows that the average level of prices remained within a fairly narrow band: 1922 — 138.5; 1923 — 144.1; 1924 — 140.5; 1925 — 148.2; 1926 — 143.2; 1927 — 136.6; 1928 — 138.5; 1929 — 136.5. During the entire decade, wholesale prices on average were never more than about 7% higher than in 1922. And at the end of the decade, before the Great Depression set in (1929), wholesale prices, as measured by this index, were in fact about 1.5% lower than in 1922.

Like Irving Fisher in his praise of Federal Reserve policy in 1928, John Maynard Keynes, in his two-volume Treatise on Money (1930), pointed to the Fed’s record during the decade, and said, “The successful management of the dollar by the Federal Reserve Board from 1923 to 1928 was a triumph . . . for the view that currency management is feasible.”

By how much had the Federal Reserve changed the supply of money and credit during the decade to bring about price level stabilization? The answer to this depends on how one defines the “money supply.” Milton Friedman and Anna Schwartz, in their famous Monetary History of the United States, 1867-1960 (1963), estimate that between 1921 and 1929, the money supply increased about 45% or approximately 4.6% a year. They used a definition of money that included currency in circulation and demand and time deposits (a definition known as “M-2”).

Murray Rothbard, in America’s Great Depression (1963), used a broader measurement of the money supply that included currency, demand and time deposits, savings-and-loan shares, and the cash value of life-insurance policies. Using these figures, Rothbard estimated that the money supply had increased by 61.8% between 1921 and 1929, with an average annual increase of 7.7%.

While shares owned in savings-and-loan banks increased by the largest percent of any component of the money supply 318% between 1921 and 1929 it represented only between 4% and 8% of the total money supply during the period, as measured by Rothbard. The cash value of life insurance policies increased by 213% during the period; and it represented between 12.5% and 16.5% of the money supply, as measured by Rothbard.

If the cash value of life insurance policies is subtracted from Rothbard’s measure of the money supply, and if deposits at mutual-savings banks, the postal-savings system, and the shares at savings-and-loans are added to Friedman and Schwartz’s definition (which, in fact, they do to calculate a broader money definition called “M-4”), the results practically coincide. The money supply, by both measurements, increased by about 54% for the period, with an average annual increase of approximately 5.5%.

During the decade, this monetary increase did not, however, occur at an even annualized rate. Rather, it occurred in spurts, especially in 1922, 1924-1925, and 1927, with monetary slowdowns in 1923, 1926, and late 1928 and early 1929. These were not accidents, but rather represented the “fine-tuning” methods of the Federal Reserve Board of Governors in their attempt to counteract tendencies toward either price inflation or economic recession, with price level stabilization as a crucial signpost of success.

The two main Federal Reserve policy tools for influencing the amount of money in the economy were open-market operations and the discount rate. When the Fed purchases government securities, it pays for them by creating new reserves on the basis of which banks can expand their lending. The sale of government securities by the Fed drains reserves from the banking system, reducing the ability of banks to extend loans.

The discount rate is the rate at which the Fed will directly lend reserves to member banks of the Federal Reserve System. Throughout most of the 1920s, the Fed kept the discount rate below the market rates of interest, creating a positive incentive for member banks to borrow from the Fed and lend the borrowed funds to the market at higher rates of interest, earning the banks a profit. Even when the Fed sold government securities at certain times during the 1920s, member banks were often able to reverse the resulting drains of reserves out of the banking system by borrowing them back from the Fed at the below-market discount rate.

Increases in currency in circulation were a negligible fraction of the monetary expansion, representing less than 1% of the increase. Demand deposits increased by 44.6% and time deposits expanded by 76.8%. This fostered a major economic boom. As Philips, McManus, and Nelson explained in Banking and the Business Cycle :

“As a result of the plethora of bank credit funds and the utilization by banks of their excess reserve to swell their investment accounts, the long-term interest rate declined and it became increasingly profitable and popular to float new stock and bond issues. This favorable situation in the capital funds market was translated into a construction boom of previously unheard-of dimensions; a real estate boom developed, first in Florida, but soon was transferred to the urban real estate market on a nation-wide scale; and finally, the stock market became the recipient of the excessive credit expansion.”

Trying to rein in the stock market boom, the Fed all but froze the money supply in late 1928 and the first half of 1929. The monetary restraint finally caught up with the stock market in October 1929.

But why did the stock market downturn develop into the Great Depression? Other than the boom in the stock market, there were few outward signs of an unstable inflationary expansion that would have suggested a need for a recessionary adjustment period to reestablish certain fundamental balances in the economy. The wholesale price index, as we saw, had remained practically unchanged between 1927 and 1929.

Clearly, however, there were forces at work beneath the surface of a stable price level that were generating the conditions for a needed correction in the economy. But depressions had occurred before and recoveries had followed, usually not too long afterwards. Why, then, did this downturn become the Great Depression?

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    Dr. Richard M. Ebeling is the BB&T Distinguished Professor of Ethics and Free Enterprise Leadership at The Citadel. He was formerly professor of Economics at Northwood University, president of The Foundation for Economic Education (2003–2008), was the Ludwig von Mises Professor of Economics at Hillsdale College (1988–2003) in Hillsdale, Michigan, and served as vice president of academic affairs for The Future of Freedom Foundation (1989–2003).