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http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021108/default.htm
Remarks by Governor Ben S. Bernanke
At the Conference to Honor Milton Friedman, University of Chicago,
Chicago, Illinois
November 8, 2002
On Milton Friedman's Ninetieth Birthday
I can think of no greater honor than being invited to speak on the
occasion of Milton Friedman's ninetieth birthday. Among economic
scholars, Friedman has no peer. His seminal contributions to economics
are legion, including his development of the permanent-income theory of
consumer spending, his paradigm-shifting research in monetary economics,
and his stimulating and original essays on economic history and
methodology. Generations of graduate students, at the University of
Chicago and elsewhere, have benefited from his insight; and many of
these intellectual children and grandchildren continue to this day to
extend the sway of Friedman's ideas in economics. What is more, Milton
Friedman's influence on broader public opinion, exercised through his
popular writings, speaking, and television appearances, has been at
least as important and enduring as his impact on academic thought. In
his humane and engaging way, Milton Friedman has conveyed to millions an
understanding of the economic benefits of free, competitive markets, as
well as the close connection that economic freedoms such as property
rights and freedom of contract bear to other types of liberty.
Today I'd like to honor Milton Friedman by talking about one of his
greatest contributions to economics, made in close collaboration with
his distinguished coauthor, Anna J. Schwartz. This achievement is
nothing less than to provide what has become the leading and most
persuasive explanation of the worst economic disaster in American
history, the onset of the Great Depression--or, as Friedman and Schwartz
dubbed it, the Great Contraction of 1929-33. Remarkably, Friedman and
Schwartz did not set out to solve this complex and important problem
specifically but rather addressed it as part of a larger project, their
magisterial monetary history of the United States (Friedman and
Schwartz, 1963). As a personal aside, I note that I first read A
Monetary History of the United States early in my graduate school
years at M.I.T. I was hooked, and I have been a student of monetary
economics and economic history ever since.1
I think many others have had that experience, with the result that the
direct and indirect influences of the Monetary History on
contemporary monetary economics would be difficult to overstate.
As everyone here knows, in their Monetary History Friedman
and Schwartz made the case that the economic collapse of 1929-33 was the
product of the nation's monetary mechanism gone wrong. Contradicting the
received wisdom at the time that they wrote, which held that money was a
passive player in the events of the 1930s, Friedman and Schwartz argued
that "the contraction is in fact a tragic testimonial to the importance
of monetary forces [p. 300; all page references refer to Friedman and
Schwartz, 1963]."
Friedman and Schwartz's account of the Great Contraction is
impressive in its erudition and development of historical detail,
including the use of many previously untapped primary sources. But what
is most important about the work, and the reason that the book is as
influential today as ever, is the authors' subtle use of history to
disentangle complicated skeins of cause and effect--to solve what
economists call the identification problem. A statistician
studying data from the Great Depression would notice the basic fact that
the money stock, output, and prices in the United States went down
together in 1929 through 1933 and up together in subsequent years. But
these correlations cannot answer the crucial questions: What is causing
what? Are changes in the money stock largely causing changes in prices
and output, as Friedman and Schwartz were to conclude? Or, instead, is
the stock of money reacting passively to changes in the state of
economy? Or is there yet some other, unmeasured factor that is affecting
all three variables?
The special genius of the Monetary History is the authors'
use of what some today would call "natural experiments"--in this
context, episodes in which money moves for reasons that are plausibly
unrelated to the current state of the economy. By locating such
episodes, then observing what subsequently occurred in the economy,
Friedman and Schwartz laboriously built the case that the causality can
be interpreted as running (mostly) from money to output and prices, so
that the Great Depression can reasonably be described as having been
caused by monetary forces. Of course, natural experiments are never
perfectly controlled, so that no single natural experiment can be viewed
as dispositive--hence the importance of Friedman and Schwartz's
historical analysis, which adduces a wide variety of such episodes and
comparisons in support of their case. I think the most useful thing I
can do in the remainder of my talk today is to remind you of the genius
of the Friedman-Schwartz methodology by reviewing some of their main
examples and describing how they have held up in subsequent research.
Four Monetary Policy Episodes
To reiterate, at the heart of Friedman and Schwartz's identification
strategy is the examination of historical periods in the attempt to
identify changes in the money stock or in monetary policy that occurred
for reasons largely unrelated to the contemporaneous behavior of output
and prices. To the extent that these monetary changes can reasonably be
construed as "exogenous," one can interpret the response of the economy
to the changes as reflecting cause and effect--particularly if a similar
pattern is found again and again.
For the early Depression era, Friedman and Schwartz identified at
least four distinct episodes that seem to meet these criteria. Three are
tightenings of policy; one is a loosening. In each case, the economy
responded in the way that the monetary theory of the Great Depression
would predict. I will discuss each of these episodes briefly, both
because they nicely illustrate the Friedman-Schwartz method and because
they are interesting in themselves.
The first episode analyzed by Friedman and Schwartz was the
deliberate tightening of monetary policy that began in the spring of
1928 and continued until the stock market crash of October 1929. This
policy tightening occurred in conditions that we would not today
normally consider conducive to tighter money: As Friedman and Schwartz
noted, the business-cycle trough had only just been reached at the end
of 1927 (the NBER's official trough date is November 1927), commodity
prices were declining, and there was not the slightest hint of
inflation.2
Why then did the Federal Reserve tighten in early 1928? A principal
reason was the Board's ongoing concern about speculation on Wall Street.
The Federal Reserve had long made the distinction between "productive"
and "speculative" uses of credit, and the rising stock market and the
associated increases in bank loans to brokers were thus a major concern.3
Benjamin Strong, the influential Governor of the Federal Reserve Bank of
New York and a key protagonist in Friedman and Schwartz's narrative, had
strong reservations about using monetary policy to try to arrest the
stock market boom. Unfortunately, Strong was afflicted by chronic
tuberculosis; his health was declining severely in 1928 (he died in
October) and, with it, his influence in the Federal Reserve System.
The "antispeculative" policy tightening of 1928-29 was affected to
some degree by the developing feud between Strong's successor at the New
York Fed, George Harrison, and members of the Federal Reserve Board in
Washington. In particular, the two sides disagreed on the best method
for restraining brokers' loans: The Board favored so-called "direct
action," essentially a program of moral suasion, while Harrison thought
that only increases in the discount rate (that is, the policy rate)
would be effective. This debate was resolved in Harrison's favor in
1929, and direct action was dropped in favor of a further rate increase.
Despite this sideshow and its effects on the timing of policy actions,
it would be incorrect to infer that monetary policy was not tight during
the dispute between Washington and New York. As Friedman and Schwartz
noted (p. 289), "by July [1928], the discount rate had been raised in
New York to 5 per cent, the highest since 1921, and the System's
holdings of government securities had been reduced to a level of over
$600 million at the end of 1927 to $210 million by August 1928, despite
an outflow of gold." Hence this period represents a tightening in
monetary policy not related to the current state of output and prices--a
monetary policy "innovation," in today's statistical jargon.
Moreover, Friedman and Schwartz went on to point out that this
tightening of policy was followed by falling prices and weaker economic
activity: "During the two months from the cyclical peak in August 1929
to the crash, production, wholesale prices, and personal income fell at
annual rates of 20 per cent, 7-1/2 per cent, and 5 per cent,
respectively." Of course, once the crash occurred in October--the
result, many students of the period have surmised, of a slowing economy
as much as any fundamental overvaluation--the economic decline became
even more precipitous. Incidentally, the case that money was quite tight
as early as the spring of 1928 has been strengthened by the subsequent
work of James Hamilton (1987). Hamilton showed that the Fed's desire to
slow outflows of U.S. gold to France--which under the leadership of
Henri Poincaré had recently stabilized its economy, thereby attracting
massive flows of gold from abroad--further tightened U.S. monetary
policy.
The next episode studied by Friedman and Schwartz, another
tightening, occurred in September 1931, following the sterling crisis.
In that month, a wave of speculative attacks on the pound forced Great
Britain to leave the gold standard. Anticipating that the United States
might be the next to leave gold, speculators turned their attention from
the pound to the dollar. Central banks and private investors converted a
substantial quantity of dollar assets to gold in September and October
of 1931. The resulting outflow of gold reserves (an "external drain")
also put pressure on the U.S. banking system (an "internal drain"), as
foreigners liquidated dollar deposits and domestic depositors withdrew
cash in anticipation of additional bank failures. Conventional and
long-established central banking practice would have mandated responses
to both the external and internal drains, but the Federal Reserve--by
this point having forsworn any responsibility for the U.S. banking
system, as I will discuss later--decided to respond only to the external
drain. As Friedman and Schwarz wrote, "The Federal Reserve System
reacted vigorously and promptly to the external drain. . . . On October
9 [1931], the Reserve Bank of New York raised its rediscount rate
to 2-1/2 per cent, and on October 16, to 3-1/2 per cent--the sharpest
rise within so brief a period in the whole history of the System, before
or since (p. 317)." This action stemmed the outflow of gold but
contributed to what Friedman and Schwartz called a "spectacular"
increase in bank failures and bank runs, with 522 commercial banks
closing their doors in October alone. The policy tightening and the
ongoing collapse of the banking system caused the money supply to fall
precipitously, and the declines in output and prices became even more
virulent. Again, the logic is that a monetary policy change related to
objectives other than the domestic economy--in this case, defense of the
dollar against external attack--were followed by changes in domestic
output and prices in the predicted direction.
One might object that the two "experiments" described so far were
both episodes of monetary contraction. Hence, although they suggest that
declining output and prices followed these tight-money policies, the
evidence is perhaps not entirely persuasive. The possibility remains
that the Great Depression occurred for other reasons and that the
contractionary monetary policies merely coincided with (or perhaps,
slightly worsened) the ongoing declines in the economy. Hence it is
particularly interesting that the third episode studied by Friedman and
Schwartz is an expansionary episode.
This third episode occurred in April 1932, when the Congress began to
exert considerable pressure on the Fed to ease monetary policy, in
particular, to conduct large-scale open-market purchases of securities.
The Board was quite reluctant; but between April and June 1932, it did
authorize substantial purchases. This infusion of liquidity appreciably
slowed the decline in the stock of money and significantly brought down
yields on government bonds, corporate bonds, and commercial paper. Most
interesting, as Friedman and Schwartz noted (p. 324), "[t]he tapering
off of the decline in the stock of money and the beginning of the
purchase program were followed shortly by an equally notable change in
the general economic indicator. . . . Wholesale prices started rising in
July, production in August. Personal income continued to fall but at a
much reduced rate. Factory employment, railroad ton-miles, and numerous
other indicators of physical activity tell a similar story. All in all,
as in early 1931, the data again have many of the earmarks of a cyclical
revival. . . . Burns and Mitchell (1946), although dating the trough in
March 1933, refer to the period as an example of a 'double bottom.' "
Unfortunately, although a few Fed officials supported the open-market
purchase program, notably George Harrison at the New York Fed, most did
not consider the policy to be appropriate. In particular, as argued by
several modern scholars, they took the mistaken view that low nominal
interest rates were indicative of monetary ease. Hence, when the
Congress adjourned on July 16, 1932, the System essentially ended the
program. By the latter part of the year, the economy had relapsed
dramatically.
The final episode studied by Friedman and Schwartz, again
contractionary in impact, occurred in the period from January 1933 to
the banking holiday in March. This time the exogenous factor might be
taken to be the long lag mandated by the Constitution between the
election and the inauguration of a new U.S. President. Franklin D.
Roosevelt, elected in November 1932, was not to take office until March
1933. In the interim, of course, considerable speculation circulated
about the new President's likely policies; the uncertainty was increased
by the President-elect's refusal to make definite policy statements or
to endorse actions proposed by the increasingly frustrated President
Hoover. However, from the President-elect's campaign statements and
known propensities, many inferred (correctly) that Roosevelt might
devalue the dollar or even break the link with gold entirely. Fearing
the resulting capital losses, both domestic and foreign investors began
to convert dollars to gold, putting pressure on both the banking system
and the gold reserves of the Federal Reserve System. Bank failures and
the Fed's defensive measures against the gold drain further reduced the
stock of money. The economy took its deepest plunge between November
1932 and March 1933, once more confirming the temporal sequence
predicted by the monetary hypothesis. Once Roosevelt was sworn in, his
declaration of a national bank holiday and, subsequently, his cutting
the link between the dollar and gold initiated the expansion of money,
prices, and output. It is an interesting but not uncommon phenomenon in
economics that the expectation of a devaluation can be highly
destabilizing but that the devaluation itself can be beneficial.
These four episodes might be considered as time series examples of
Friedman and Schwartz's evidence for the role of monetary forces in the
Depression. They are not the entirety of the evidence, however. Friedman
and Schwartz also introduced "cross-sectional"--that is,
cross-country--evidence as well. This cross-sectional evidence is based
on differences in exchange-rate regimes across countries in the 1930s.
The Gold Standard and the International Depression
Although the Monetary History focuses by design on events in
the United States, some of its most compelling insights come from
cross-sectional evidence. Anticipating a large academic literature of
the 1980s and 1990s, Friedman and Schwartz recognized in 1963 that a
comparison of the economic performances in the 1930s of countries with
different monetary regimes could also serve as a test for their monetary
hypothesis.
Facilitating the cross-sectional natural experiment was the fact that
the international gold standard, which had been suspended during World
War I, was laboriously rebuilt during the 1920s (in a somewhat modified
form called the gold-exchange standard). Countries that adhered to the
international gold standard were essentially required to maintain a
fixed exchange rate with other gold-standard countries. Moreover,
because the United States was the dominant economy on the gold standard
during this period (with some competition from France), countries
adhering to the gold standard were forced to match the contractionary
monetary policies and price deflation being experienced in the United
States.
Importantly for identification purposes, however, the gold standard
was not adhered to uniformly as the Depression proceeded. A few
countries for historical or political reasons never joined the gold
standard. Others were forced off early, because of factors such as
internal politics, weak domestic banking conditions, and the local
influence of competing economic doctrines. Other countries, notably
France and the other members of the so-called Gold Bloc, had a strong
ideological commitment to gold and therefore remained on the gold
standard as long as possible.
Friedman and Schwartz's insight was that, if monetary contraction was
in fact the source of economic depression, then countries tightly
constrained by the gold standard to follow the United States into
deflation should have suffered relatively more severe economic
downturns. Although not conducting a formal statistical analysis,
Friedman and Schwartz gave a number of salient examples to show that the
more tightly constrained a country was by the gold standard (and, by
default, the more closely bound to follow U.S. monetary policies), the
more severe were both its monetary contraction and its declines in
prices and output. One can read their discussion as dividing countries
into four categories.
The first category consisted of countries that did not adhere to the
gold standard at all or perhaps adhered only very briefly. The example
cited by Friedman and Schwartz was China. As they wrote (p. 361), "China
was on a silver rather than a gold standard. As a result, it had the
equivalent of a floating exchange rate with respect to gold-standard
countries. A decline in the gold price of silver had the same effect as
a depreciation in the foreign exchange value of the Chinese yuan. The
effect was to insulate Chinese internal economic conditions from the
worldwide depression. . . . And that is what happened. From 1929 to
1931, China was hardly affected internally by the holocaust that was
sweeping the gold-standard world, just as in 1920-21, Germany had been
insulated by her hyperinflation and associated floating exchange rate."
Subsequent research (for example, Choudhri and Kochin, 1980) has
identified other countries that, like China, did not adhere to the gold
standard and hence escaped the worst of the Depression. Two examples are
Spain, where the internal instability that ultimately led to the Spanish
Civil War prevented the country from re-adopting the gold standard in
the 1920s, and Japan, which was forced from the gold standard after
being on it for only a matter of months. The Depression in Spain was
quite mild, and Japan experienced a powerful recovery almost immediately
after abandoning its short-lived experiment with gold.
The second category consisted of countries that had restored the gold
standard in the 1920s but abandoned it early in the Depression,
typically in the fall of 1931. As Friedman and Schwartz observed (p.
362), the first major country to leave the gold standard was Great
Britain, which was forced off gold in September 1931. Several trading
partners, among them the Scandinavian countries, followed Britain's lead
almost immediately. The effect of leaving gold was to free domestic
monetary policy and to stop the monetary contraction. What was the
consequence of this relaxed pressure on the money stock? Friedman and
Schwartz noted (p. 362) that "[t]he trough of the depression in Britain
and the other countries that accompanied Britain in leaving gold was
reached in the third quarter of 1932. [In contrast, i]n the countries
that remained on the gold standard or, like Canada, that went only part
way with Britain, the Depression dragged on."
Third were countries that remained on gold but had ample reserves or
were attracting gold inflows. The key example was France (see p. 362),
the leader of the Gold Bloc. After its stabilization in 1928, France
attracted gold reserves well out of proportion to the size of its
economy. France's gold inflows allowed it to maintain its money supply
and avoid a serious downturn until 1932. However, at that point,
France's liquidation of non-gold foreign exchange reserves and its
banking problems began to offset the continuing gold inflows, reducing
the French money stock. A serious deflation and declines in output began
in France, which, as Friedman and Schwartz pointed out, did not reach
its trough until April 1935, much later than Great Britain and other
countries that left gold early.
Fourth, and perhaps the worst hit, were countries that rejoined the
gold standard but had very low gold reserves and banking systems
seriously weakened by World War I and the ensuing hyperinflations.
Friedman and Schwartz mention Austria, Germany, Hungary, and Romania as
examples of this category (p. 361). These countries suffered not only
deflation but also extensive banking and financial crises, making their
plunge into depression particularly precipitous.
The powerful identification achieved by this categorization of
countries by Friedman and Schwartz is worth reemphasizing. If the
Depression had been the product primarily of nonmonetary forces, such as
changes in autonomous spending or in productivity, then the nominal
exchange rate regime chosen by each country would have been largely
irrelevant. The close connection among countries' exchange rate regimes,
their monetary policies, and the behavior of domestic prices and output,
is strong evidence for the proposition that monetary forces played a
central role not just in the U.S. depression but in the world as a
whole.
Of course, those familiar with more recent work on the Great
Depression will recognize that Friedman and Schwartz's idea of
categorizing countries by exchange rate regime has been widely extended
by subsequent researchers. Notably, in the paper that revived Friedman
and Schwartz's temporarily dormant insight, Choudhri and Kochin (1980)
considered the relative performances of Spain (which, as mentioned, did
not adopt the gold standard), three Scandinavian countries (which left
gold with Great Britain in September 1931), and four countries that
remained part of the French-led Gold Bloc (the Netherlands, Belgium,
Italy, and Poland). They found that the countries that remained on gold
suffered much more severe contractions in output and prices than the
countries leaving gold. In a highly influential paper, Eichengreen and
Sachs (1985) examined a number of key macro variables for ten major
countries over 1929-35, finding that countries that left gold earlier
also recovered earlier. Bernanke and James (1991) confirmed the findings
of Eichengreen and Sachs for a broader sample of twenty-four (mostly
industrialized) countries (see also Bernanke and Carey, 1996), and Campa
(1990) did the same for a sample of Latin American countries. Bernanke
(1995) showed that not only did adherence to the gold standard predict
deeper and more extended depression, as had been noted by earlier
authors, but also that the behavior of various key macro variables, such
as real wages and real interest rates, differed across gold-standard and
non-gold-standard countries in just the way one would expect if the
driving shocks were monetary in nature. The most detailed narrative
discussion of how the gold standard propagated the Depression around the
world is, of course, the influential book by Eichengreen (1992).
Eichengreen (2002) reviews the conclusions of his book and concludes
largely that they are quite compatible with the Friedman and Schwartz
approach.
The Role of Bank Failures
Yet another striking feature of the Great Contraction in the United
States was the massive extent of banking panics and failures,
culminating in the Bank Holiday of March 1933, in which the entire U.S.
banking system was shut down. During the Depression decade, something
close to half of all U.S. commercial banks either failed or merged with
other banks.
Friedman and Schwartz take the unusually severe and protracted U.S.
banking panic as yet another opportunity to apply their identification
methodology. Their argument, in short, is that under institutional
arrangements that existed before the establishment of the Federal
Reserve, bank failures of the scale of those in 1929-33 would not have
occurred, even in an economic downturn as severe as that in the
Depression. For doctrinal and institutional reasons to be detailed in a
moment, however, the extraordinary spate of bank failures did occur and
led in turn to the massive extinction of bank deposits and an abnormally
large decline in the stock of money. Because the decline in money
induced by bank panics would not have occurred under previous regimes,
Friedman and Schwartz argued, it can be treated as partially exogenous
and thus a potential cause of the extraordinary declines in output and
prices that followed.
Before the creation of the Federal Reserve, Friedman and Schwartz
noted, bank panics were typically handled by banks themselves--for
example, through urban consortiums of private banks called
clearinghouses. If a run on one or more banks in a city began, the
clearinghouse might declare a suspension of payments, meaning that,
temporarily, deposits would not be convertible into cash. Larger,
stronger banks would then take the lead, first, in determining that the
banks under attack were in fact fundamentally solvent, and second, in
lending cash to those banks that needed to meet withdrawals. Though not
an entirely satisfactory solution--the suspension of payments for
several weeks was a significant hardship for the public--the system of
suspension of payments usually prevented local banking panics from
spreading or persisting (Gorton and Mullineaux, 1987). Large, solvent
banks had an incentive to participate in curing panics because they knew
that an unchecked panic might ultimately threaten their own deposits.
It was in large part to improve the management of banking panics that
the Federal Reserve was created in 1913. However, as Friedman and
Schwartz discuss in some detail, in the early 1930s the Federal Reserve
did not serve that function. The problem within the Fed was largely
doctrinal: Fed officials appeared to subscribe to Treasury Secretary
Andrew Mellon's infamous 'liquidationist' thesis, that weeding out
"weak" banks was a harsh but necessary prerequisite to the recovery of
the banking system. Moreover, most of the failing banks were small banks
(as opposed to what we would now call money-center banks) and not
members of the Federal Reserve System. Thus the Fed saw no particular
need to try to stem the panics. At the same time, the large banks--which
would have intervened before the founding of the Fed--felt that
protecting their smaller brethren was no longer their responsibility.
Indeed, since the large banks felt confident that the Fed would protect
them if necessary, the weeding out of small competitors was a positive
good, from their point of view.
In short, according to Friedman and Schwartz, because of
institutional changes and misguided doctrines, the banking panics of the
Great Contraction were much more severe and widespread than would have
normally occurred during a downturn. Bank failures and depositor
withdrawals greatly reduced the quantity of bank deposits, consequently
reducing the money supply. The result, they argued, was greater
deflation and output decline than would have otherwise occurred.
A couple of objections can be raised to the Friedman-Schwartz
inference. One logical possibility is that the extraordinary rate of
bank failure of the 1930s, rather than causing the subsequent declines
in output and prices, occurred because depositors and others
anticipated the collapse of the economy--that is, that the banking
panics were endogenous to the expected state of the economy. Friedman
and Schwartz's institutional arguments persuade me that this is
unlikely. If previous arrangements had been in place, bank panics would
not have been allowed to progress to the degree they did, independent of
the severity of the downturn. Moreover, I don't find it plausible that,
in 1930 and 1931, depositors and bankers fully anticipated the severity
of the downturn still to come.
A second possibility is that banking panics contributed to the
collapse of output and prices through nonmonetary mechanisms. My own
early work (Bernanke, 1983) argued that the effective closing down of
the banking system might have had an adverse impact by creating
impediments to the normal intermediation of credit, as well as by
reducing the quantity of transactions media. Friedman and Schwartz
anticipated this argument and adduced as contrary evidence a comparison
of the United States and Canada (p. 352). They pointed out that (1)
Canada's monetary policy was tied to that of the United States by a
fixed exchange rate; (2) Canada had no significant bank failures; but
(3) Canada's output declines were as severe as those of the United
States. Friedman and Schwartz concluded that Canada's economy declined
because of its enforced monetary contraction--whether that monetary
contraction took place through bank failures or was enforced by the
exchange-rate regime was immaterial.
I would argue that Canada, both being a commodity exporter and being
unusually highly integrated with the United States, may not have been
fully representative of the experience of all countries in the 1930s.
For example, in Bernanke (1995, table 3), I showed using a sample of
twenty-six countries that, with the exchange-rate regime held constant,
countries suffering severe banking panics had subsequent declines in
output that were significantly worse than those in countries with stable
banking systems. This result supports the possibility of an additional,
nonmonetary channel for bank failures. At the same time, my results were
also strongly supportive of the view that adherence to the gold
standard, and the associated monetary contraction, was of first-order
importance in explaining which countries suffered severe depressions.
Thus, as I have always tried to make clear, my argument for nonmonetary
influences of bank failures is simply an embellishment of the
Friedman-Schwartz story; it in no way contradicts the basic logic of
their analysis.
Benjamin Strong and the Leadership Vacuum
Finally, what is probably Friedman and Schwartz's most controversial
"natural experiment" stems from the premature death, in 1928, of
America's preeminent central banker, Benjamin Strong. Strong, who was
Governor of the Federal Reserve Bank of New York and the de facto
equivalent to a Fed Chairman today, had led the Federal Reserve
throughout the 1920s. Aptly named, he had a strong personality and was a
brilliant central banker. Quite plausibly, his personality and skills
created a leadership position within a Federal Reserve System that--as
suggested by its name--was intended by the Congress to be a relatively
decentralized institution.
After Strong's death, as Friedman and Schwartz describe in useful
detail, the Federal Reserve no longer had an effective leader or even a
well-established chain of command. Members of the Board in Washington,
jealous of the traditional powers of the Federal Reserve Bank of New
York, strove for greater influence; and Strong's successor, George
Harrison, did not have the experience or personality to stop them.
Regional banks also began to assert themselves more. Thus, power became
diffused; worse, what power there was accrued to men who did not
understand central banking from a national and international point of
view, as Strong had. The leadership vacuum and the generally low level
of central banking expertise in the Federal Reserve System was a major
problem that led to excessive passivity and many poor decisions by the
Fed in the years after Strong's death.
Friedman and Schwartz argued in their book that if Strong had lived,
many of the mistakes of the Great Depression would have been avoided.
This proposition has been highly controversial and has led to detailed
examinations of what Strong's views "really were" on various matters of
monetary policymaking. This counterfactual debate somewhat misses the
point, in my opinion. We don't know what would have happened had Strong
lived; but what we do know is that the central bank of the world's
economically most important nation in 1929 was essentially leaderless
and lacking in expertise. This situation led to decisions, or
nondecisions, which might well not have occurred under either better
leadership or a more centralized institutional structure. And associated
with these decisions, we observe a massive collapse of money, prices,
and output. Thus, it seems to me that the death of Strong does qualify
as one more natural experiment with which to try to identify the effects
of monetary forces in the Great Depression.
Conclusion
The brilliance of Friedman and Schwartz's work on the Great Depression
is not simply the texture of the discussion or the coherence of the
point of view. Their work was among the first to use history to address
seriously the issues of cause and effect in a complex economic system,
the problem of identification. Perhaps no single one of their "natural
experiments" alone is convincing; but together, and enhanced by the
subsequent research of dozens of scholars, they make a powerful case
indeed.
For practical central bankers, among which I now count myself,
Friedman and Schwartz's analysis leaves many lessons. What I take from
their work is the idea that monetary forces, particularly if unleashed
in a destabilizing direction, can be extremely powerful. The best thing
that central bankers can do for the world is to avoid such crises by
providing the economy with, in Milton Friedman's words, a "stable
monetary background"--for example as reflected in low and stable
inflation.
Let me end my talk by abusing slightly my status as an official
representative of the Federal Reserve. I would like to say to Milton and
Anna: Regarding the Great Depression. You're right, we did it. We're
very sorry. But thanks to you, we won't do it again.
Best wishes for your next ninety years.
Endnotes
1. Accordingly, I hope the reader will forgive the
many references to my own work in the list of references below. They
arise because much of my own research has followed up leads from the
Friedman-Schwartz agenda. Return to
text
2. However, as Athanasios Orphanides pointed out to
me, by 1929 the rate of output growth was strong, which may have
provided additional motivation for a tightening.
Return to text
3. Apparently the Board was not entirely clear on
the point that funds used to purchase stock are not made unavailable for
productive use. Of course, as stock sales are merely transfers of
existing assets, funds used to purchase stock are not dissipated but
only transferred from one person to another.
Return to text
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