Friedman's and Schwartz's Understanding of the Cause of the Depression

“If you want to understand geology, study earthquakes.”[1] That quote from Ben Bernanke explained his view on the centrality of the understanding of why one should examine the Great Depression if one were going to understand economics.

To that end, Milton Friedman and Anna Jacobson Schwartz were part of what is known as the Monetarists or the Chicago school of economics.  Together they wrote A Monetary History of the United States, 1867-1960 in dealing with the causes of the Great Depression.  This book “had a profound impact on the way economists think about monetary theory and policy.”[2]

In their work, they revolutionized the way in which many economists viewed monetary policy in light of the Great Depression.  Hugh Rockoff, in a review of their work, argued that their view became “accepted, at least in some measure, by most economists.”[3]  The thought was simply that a central bank should keep interest rates low during times of high unemployment, and unemployment and wage rates caused inflation. 

Friedman and Schwartz offered a list of case studies to prove their idea that monetary policy was the major point of the Great Depression and destroyed economy.  First, they took the 1879-1896 and 1896-1914 economies and contrasted them based on prices.  Second, they contrasted the economies between World War I and World War II.  Lastly, they examined the “restrictive actions” or the Federal Reserve in 1937.[4]

In 1879, the US went to the gold standard.  And as a result, Friedman’s and Schwartz’s contrast of the 1879-1896 economies compared to the 1896-1914 economies, they discovered that prices fell by 0.93 percent annually during 1879-1896.  Then deflation ceased and prices rose 2.08 percent annually.  During that same time, “money per unit of output” rose by 2.99 percent during the former and 4.23 percent during the latter.  They viewed that as a result of new gold stores from South Africa. This, they believed, was a correlation between money and the prices of goods.  This occurred while on a gold standard without a Federal Reserve or central bank.[5]

Then, they pointed out that prices increased more during World War I than in World War II though World War I was more minor than World War II was for the United States.  Again, they tied this phenomenon to the fact that money rose by 8.45 annually during World War I as prices rose 10.84 percent.  During World War II, money rose only 7.9 percent while the price also rose less at 6.65 annually.  This flew in the face of what would have been expected otherwise as it would have been expected to have been World War II that saw a higher growth in money supply and inflation due to greater US involvement in the Second World War.  That occurred, however, because of a lower deposit-reserve ratio.  That proved, in Rockoff’s mind, as well as Friedman’s and Schwartz’s, that the connection of prices and money output than that of “intensity of mobilization.” This occurred with the Federal Reserve following the lead of the Treasury.[6]

Lastly, the 1937 recession saw the Federal Reserve double reserve rations.  Money fell 0.37 percent while prices fell 0.5 percent and output fell by 8.23 percent.  A decline in stock money led to a decline in economic activity.  At this time, the Federal Reserve was acting independently concerning monetary policy.[7]

Ben Bernanke, a Neo-Keynesian, chose to not address the reason for the initial downturn, but he chose to look at the “macroeconomy” and further developments that led to a deepening of the Great Depression.[8]  He agreed with Friedman and Schwartz, but sought to offer a third explanation in addition to theirs.  He stated that they proved that there was a reduction in wealth of bank shareholders and a rapid decline in money supply.  He, however, argued that lower-level borrowers such as lesser households, farmers, and others found that it was too difficult to get credit and it was too expensive if they could get it.  Thus, the depression became longer and deeper.[9]

Twelve years later, Bernanke took an approach that understanding the Great Depression was the “Holy Grail of macroeconomics,” and he stated the attempt to understand it gave “birth to macroeconomics.”[10] He further stated that looking beyond just the United States to other countries has helped to strengthen the idea that “monetary contraction [was] an important cause of the Depression.”[11]

Christina Romer, however, pointed out that there was a low output from the economy during the 1930s as a cause of at least the depth of the Depression.  She focused mainly on the recovery though, stating that the low output is why it continued.  Furthermore, she assessed that Friedman and Schwartz had focused too much on the inaction of the Federal Reserve as a cause of the Depression, and they focused too little on how the Federal Reserve had pulled the country out of it.[12]

 

 

Bernanke, Ben S. “The Macroeconomics of the Great Depression: A Comparative Approach.” Journal of Money, Credit and Banking 27, no. 1 (1995): 1–28. https://doi.org/10.2307/2077848.

 

Bernanke, Ben S. “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression.” The American Economic Review 73, no. 3 (1983): 257–76. http://www.jstor.org/stable/1808111.

 

Ip, Greg. “Long Study of Great Depression Has Shaped Bernanke’s Views.” Wall Street Journal. December 7, 2005.

Rockoff, Hugh. Review of A Monetary History of the United States, 1867-1960, by Milton Friedman and Anna Jacobson Schwartz. https://eh.net/book_reviews/a-monetary-history-of-the-united-states-1867-1960.

Romer, Christina D. “What Ended the Great Depression?” The Journal of Economic History 52, no. 4 (1992): 757–84. http://www.jstor.org/stable/2123226.

 

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[1] Greg Ip, “Long Study of Great Depression Has Shaped Bernanke’s Views,” Wall Street Journal, December 7, 2005.

[2] Hugh Rockoff, review of A Monetary History of the United States, 1867-1960, by Milton Friedman and Anna Jacobson Schwartz, https://eh.net/book_reviews/a-monetary-history-of-the-united-states-1867-1960.

[3] Ibid.

[4] Ibid.

[5] Ibid.

[6] Ibid.

[7] Ibid.

[8] Ben S. Bernanke “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression,” The American Economic Review 73, no. 3 (1983): 257. http://www.jstor.org/stable/1808111.

[9] Ibid., 257-258.

[10] Ben S. Bernanke, “The Macroeconomics of the Great Depression: A Comparative Approach,” Journal of Money, Credit and Banking 27, no. 1 (1995): 1. https://doi.org/10.2307/2077848.

[11] Ibid., 25.

[12] Christina D. Romer, “What Ended the Great Depression?” The Journal of Economic History 52, no. 4 (1992): 757-758. http://www.jstor.org/stable/2123226.