The Great Depression (Part 1) – Contraction of Money Supply & Tax Increase Explained

When I was in secondary school, the Great Depression (GD) use to be a major topic together with World War 1 and 2 in our history lessons. Many years ago, I also watched several documentaries on GD and Great Financial Crisis which kickstart my interest in financial blogging and research.
For those who are unaware, the GD was the worst economic downturn in the history of the industrialized world, lasting from 1929 to 1939. It began after the stock market crash of October 1929, which sent Wall Street into a panic and wiped out millions of investors.
If you “wiki or google” Great Depression” and try to find the cause of it, you will find two main causes take precedence. Monetary and Keynesian reasonings. In this article, I will focus on what is the Monetary and Keynesian theories, and why did the US government back then push policies that contracted the money supply, or even raise interest rate during the worst crisis.
Monetarists believe that the GD started as an ordinary recession, but the contraction of the money supply by Federal Reserve greatly exacerbated the economic situation, causing a recession to descend into the GD. There is a general consensus that the Federal Reserve back then should inject money (e.g. literal printing like what is happening now) to save the economy and not just allow liquidations of companies, which monetarists believe is the main cause of GD. In a speech honouring monetarists Milton Friedman and Anna Schwartz, Ben Bernanke (former Fed Chair 2006-14 ) stated:
“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.” — Ben S. Bernanke

Another school of thought is from British economist John Maynard Keynes. Those who studied economy in JC or University like myself, will know Keynesian theory is the basis of our modern economic studies. Keynesians explained that if there is a fall in consumer spending due to recession, savings will increase. This cause interest rate to decline, which will then lead to increase borrowings and spending. But investments will not necessary increase due to drop in interest rate. This is because business make investments based on expectation of future profits. Therefore, if the consumption crunch is anticipated to be long-term, business investments which requires a great degree of optimism will fall, leading to rising unemployment and worsening of the economy. Henceforth, Keynes argued that the GD is caused by the lack of government spending to increase employment and to help the economy recover the money that normally will have spent by consumers and business firms.  
Republican Herbert Clark Hoover became US President in Mar 1929. Shortly after he took office, the stock market crash. The next four year of his presidency spells the worst nightmare for the nation. In dealing with the crisis, Hoover administration underestimate the gravity of the crisis, and opted for non-intervention policy. They contracted money supply and allowed companies to go bankrupt, and even raise tax to reduce budget deficit, which led the worst crisis in the history of US. Monetarists and Keynesians put almost all blame of the GD on the incompetence of Hoover administration.

So why did Hoover implemented deflationary policy? Is he really that stupid with so many so-called experts in his administration.
Hoover administration believed that companies who is badly run with high debts should be allowed to go bankrupt.  The free market economy will then self-adjust to absorb the bankruptcy. Injecting excessive liquidity from taxpayers’ monies by the Federal Reserve will only postpone the bad debts and magnify the social costs in the long term.
The argument was not without basis! When dealing with the economic crisis of 1920-21, US implemented deflationary policies and allowed liquidation of companies, which subsequently created the economic growth later in the decade. Nevertheless, the magnitude of the 1929-1930s crisis is too big. Not only that deflationary policy did not work, it worsened the crisis.
Why not print money? – The Gold standard
US had almost always adhere to the gold standard until 1971 when President Nixon introduced fiat currency. For non-fiat, currency has to be backed by gold. For e.g. in 1905, US$20 bill is called demand note, backed by 1 oz of gold. This mean the US$20 bill is a note that can demand for 1 oz of gold or equivalent silver. The Federal Reserve Act in 1913 requires the central bank to have gold backing 40% of its demand notes. The adherence to the gold standard prevented the Federal Reserve from expanding the money supply (i.e. money creation) to stimulate the economy, or to fund insolvent banks and fund government deficits that could possibly pump up an expansion, although long term structural problems will worsen.   
Real interest rate increase
From 1929 to 1933, unemployment was as high as 20-25% in 1932-33 and inflation was more than negative 10% in 1931-32. While the nominal interest rate decrease, the real interest rate actually increases due to the negative inflation. This is because bad debts and bank runs driving huge number of banks into insolvency. And banks that survive makes business borrowing criteria more stringent as repayment ability drop. Hence while nominal interest rate decrease, borrowing levels drop.

Why increase Interest rate?
In the midst of the crisis, the US dollars loss its value as no international investors will want to invest into America. Hence demand for dollars plummeted. In the early 1930s, in order to attract foreign investors, Federal Reserve defended the dollar by contracting the Money Supply and raising interest rates, aiming to increase the demand for US dollars. Target is to have net inflow of investments or money (gold and silver) into USA to improve the budget deficit.

Bank Runs
When the crisis worsened, bad debts resulted in bank collapse. Years of savings were just wiped out like that. The fear of more banks’ collapses led to bank runs. A bank run occurs when large number of depositors lost confidence in the security of the bank, and started to withdraw their funds all at once. Banks typically hold only a fraction of cash reserve, lending out the rest to borrowers or purchase interest-bearing assets like bonds. During a bank run, a bank must quickly liquidate loans and sell its assets often cheaply to meet cash withdrawals. In extreme cases like in 1930s, bank’s reserves are insufficient to cover the withdrawals leading to insolvency. When deposits in banks plummeted, money supply contracted.
Hoarding Precious metals leading to Gold Reserve Act
Since the dollar bill is a demand note for gold or silver, and seeing banks collapsing, people fear that their demand notes can no longer exchange for gold and silver which they deem as a better store of value rather than the dollar bill. People began to hoard precious metals. At the same time, there is farm crisis due to drought, and people also rush to stockpile food supplies. Money supply further contracted.  
On 30 Jan 1934, US congress passed the Gold Reserve Act changing the value of the dollar from $20 to the troy ounce of gold to $35 to the troy ounce, a devaluation of over 40%. This is money creation, not much different to the modern Quantitative Easing (QE) to print money digitally.
After reading the above article, most people will take at face value that either Monetary or Keynesian theories or poor decision by President Hoover MUST be the direct root cause of GD.  
IT IS NOT TRUE. I believe that the non-implementation of monetary or Keynesian policies are just indirect consequential reasons for the GD. There are not the root causes of the depressions.
In my opinion, the root cause is really the sinful nature of human of greed and the love of self and pleasure.  It is the over-confidence, over-optimism, over-spending, irrational stock market exuberance during the “roaring twenties” period, that cause the onset of the crash.
Stay tune to Part 2.

Warren Buffett talks about Great Depression – Nobody knows what the market is going to do tomorrow

Wall Street Vs Main Street (Part 1) – Irrational Exuberance

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