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August 1, 2001

The Fed's "Depression" and the Birth of the New Deal

Market failure reconsidered


According to new deal historians, capitalism failed in the 1930s. What, then, is it doing flourishing in the United States, Britain, and Europe and taking root in Latin America and China, where it was never previously present? For the past 20 years there has been a large and growing incompatibility between the verdicts of historians and the performance of capitalism.

In 1981 the United States reduced tax rates and reined in money growth. For two decades the economy has experienced an economic boom characterized by large income gains, high employment, and negligible inflation. In the U.K. similar reforms introduced by Margaret Thatcher have produced similar results. Heavily socialized countries such as France, Italy, and Spain have abandoned public ownership and privatized their economies. Political regimes in Eastern Europe and the Soviet Union, where a planning model had operated, failed both economically and politically and collapsed. Capitalism has appeared in Latin America and has taken hold of the Mexican, Chilean, and Argentinean economies. Even China’s rulers have found it necessary to risk their political power by endorsing markets and private property in order to participate in the global economy.

Big government (in terms of its presence in the economy) is everywhere in retreat. A Democratic president, Bill Clinton, declared that “the era of big government is over.” Yet the history books and much analysis of public policy during the 1930s remain unadjusted and still proclaim the failure of capitalism. The disconnect between historians and reality grows with each passing day, because historians cannot explain the Great Depression except in terms of capitalism’s failure.

Historians came to the subject with views colored by the despair of the Depression and by a belief in the efficacy of government action. This belief had been growing ever since Jeremy Bentham introduced it into the English-speaking world in the late eighteenth century. Successes attributed to the fledgling communist government in Russia and the rise of fascism in Italy led many to believe that government-directed economy was the wave of the future. This belief was kept alive into recent years by claims made for French “indicative planning” and Japanese “industrial policy.”

But historians could not have failed so badly in their judgments if economists had been able to explain the Great Depression. And economists could not. It was not until 1963, when the National Bureau of Economic Research published Milton Friedman and Anna Schwartz’s monumental study, A Monetary History of the United States, 1857-1960, that an economic explanation of the Depression appeared. This was not a propitious time for the authors. The belief in market failure had had three decades to harden into an unchallenged orthodoxy, one reinforced by exaggerated claims for Soviet economic performance under central planning. Moreover, Friedman and Schwartz’s analysis was keyed toward explaining inflation and recession in terms of the behavior of monetary aggregates. Their account of the Depression is in one chapter and has to be fashioned out of copious material by the reader’s own mind. Although their work and its implications became known to many economists, it appears to have had scant impact on historians or on the public’s understanding of the Great Depression.

A country that doesn’t understand its own history is not well equipped to deal with its future. The Great Depression was not a failure of the old order. It was the failure of the new order that had just begun.

The Federal Reserve is the most powerful institution of a new order that believed in the efficacy of government and its ability to do good. The same Federal Reserve caused the Great Depression when its wise men made a series of cumulative mistakes that contracted the money supply by one-third and wiped out purchasing power in an unprecedented fashion.

Economists could not at first explain the Depression because they were unaware of the dramatic shrinkage in the quantity of money. It was not until Friedman and Schwartz dug into the facts that the culpability of the Federal Reserve became known. Moreover, most economists found this culpability to be unwelcome information. In the 1960s economists were uniformly Keynesian in outlook. They were emotionally supportive of government intervention, and their human capital was invested in policies that rested on their belief in the effectiveness of government action. Although they could not refute the evidence, they did not warmly endorse the revelation that the Fed had caused the Great Depression.

So the great disconnect remains between the history books and the success of capitalism. By the mid-twentieth century, no country thought it could succeed with capitalism. By the beginning of the twenty-first century, no country thinks it can succeed without it.

Mistakes play a dramatic role in history. The Fed’s mistakes led to others even more serious — the New Deal and the massive delegation of legislative authority that breached the separation of powers. Here, then, is the history of those terrible mistakes, offered in the hope that it will challenge historians to abandon their ideologies, return to their craft, and give us a history that will better guide our future.

The economics of the Great Depression

In one of the great paradoxes of human history, a federal regulatory institution — created for the purpose of stabilizing the banking system and, thereby, the overall economy by functioning as a lender of last resort — caused the worst depression in our history. President Woodrow Wilson promised that the Federal Reserve Act of 1913 would provide the economy with a “Supreme Court of Finance” that would ensure the liquidity for economic growth and prosperity. Instead, the Federal Reserve collapsed purchasing power and forced 25 percent of the workforce into unemployment. The inattention and incompetence that caused this disaster are so great as to warrant, in the words of economist Clark Warburton, “a charge of lack of adherence to the intent of the law.”

This massive destruction of liquidity began when the Federal Reserve responded to the 1929 stock market crash by allowing the quantity of money to decline by 2.6 percent over the next year. This extremely tight monetary policy put the economy into severe recession.

All that was needed to turn the economy around was for the Federal Reserve to add to bank reserves by purchasing government securities. This would have expanded the money supply and was the policy called for by the Federal Reserve’s charter. Instead, the Federal Reserve made another mistake.

The most important charge in the Federal Reserve’s charter is to be a lender of last resort. This means that when a bank is in trouble and cannot meet its depositors’ demands for cash, the Federal Reserve must provide the liquidity. Otherwise, panic from inability to withdraw funds can spread throughout the banking system, forcing banks to disrupt business and shrink the money supply by calling loans and reducing deposits. The main rationale for creating twelve Federal Reserve District Banks was, as Sen. John Shafroth, Colorado Democrat, put it:

no bank should be more than one night’s train ride from its Federal Reserve bank. In cases of a run on his bank, a banker could gather up his commercial paper with maturities of thirty, sixty and ninety days, catch the train and be at the Federal Reserve Bank by morning, discount his notes and wire his bank that there was plenty of money to pay depositors. To place Reserve banks more than a night’s train ride from the member banks it served would make it impossible to meet one of the very needs for which it was designed.

When a bank exhausts its vault cash, it needs to raise more by selling (discounting) its loans to the Federal Reserve or by selling bonds from its investment portfolio to the Federal Reserve. The most direct way the Federal Reserve can provide liquidity is to conduct open market operations and purchase bonds from the banking system.

The Federal Reserve was derelict in this responsibility during the three banking crises that culminated in the Great Depression. Indeed, more often than not the Federal Reserve sold bonds and raised the discount rate, thus reducing banking liquidity when it should have increased liquidity. The first banking crisis began in the autumn of 1930 when the Federal Reserve stood aside and permitted banks to fail in the South and Midwest. The result was to undermine confidence in banks. Runs on banks spread as depositors rushed to convert their deposits into currency.

By December the Bank of the United States in New York closed from inability to meet depositors’ demand for cash. The bank was sound, as evidenced by its ability to pay off depositors 92.5 cents on the dollar when it was liquidated during the worst of the Depression. If the Federal Reserve had done its job, the bank would have remained open. The bank’s size and official-sounding name meant that its failure frightened depositors all over the country and led to a general run on banks. By the time it was over, hundreds of banks had failed, reducing the money supply by the amount of their deposits.

The second banking crisis began in the spring of 1931 when the Fed stood aside negligently while banks reduced their lending in order to meet their depositors’ demands for cash. By August commercial bank deposits had shrunk by 7 percent, a further contraction in the supply of money. Then in September, in response to the British leaving the gold standard, the Fed further deflated a deflating economy by pushing through the biggest hike in the discount rate in history. This extraordinary mistake caused commercial banks to stop their use of the discount window and to hoard cash in order to meet rising withdrawals stemming from the public’s declining confidence in banks. As Milton Friedman and Anna Schwartz put it, this put the famous multiple expansion of bank reserves into vicious reverse. By January 1932 bank deposits had declined another 15 percent. Large monthly declines in the money supply continued through June 1932.

The commercial banks’ response to the Federal Reserve’s failure to act as lender of last resort was to accumulate excess reserves in order to meet depositors’ demands for cash without jeopardizing the banks’ loan portfolios. The Fed’s negligence left banks with unacceptable alternatives to hoarding cash — discounting their loans at a loss or calling loans that could force cash-strapped borrowers into bankruptcy. The Fed foolishly misinterpreted the excess reserves as a sign of an easy monetary policy and took no action to ease the tremendous pressures on the banking system and supply of money.

In January 1933 the three-year banking crisis brought on by Federal Reserve mismanagement of the money supply entered its final phase. This time the Federal Reserve System itself panicked. Banks were failing because they could not meet frightened depositors’ demands for cash. Statewide bank holidays spread. By March 1933 bank holidays (during which banks were not required to meet their obligations to depositors) had been declared in about half of the states. The Fed responded to these events by again raising the discount rate, making it harder for banks to meet the cash demands of depositors. From January to March the money supply fell dramatically. On March 4 the Federal Reserve Banks themselves closed. Examining this gross negligence 30 years later, Friedman and Schwartz concluded: “The central banking system, set up primarily to render impossible the restriction of payments by commercial banks, itself joined the commercial banks in a more widespread, complete and economically disturbing restriction of payments than had ever been experienced in the history of the country. One can certainly sympathize with President Hoover’s comment about that episode: ‘I concluded the Reserve Board was indeed a weak reed for a nation to lean on in time of trouble.’”

When banks reopened in mid-March, 15,000 out of 25,000 commercial banks remained. The collapse in the banking system wiped out bank deposits. The result was shrinkage of the money supply by one-third and a severe depression that dramatically altered the U.S. Constitution and the character of our government. President Franklin D. Roosevelt’s New Deal, the massive delegation of legislative authority to newly created executive branch regulatory agencies, and the supplanting of the public’s faith in the market system by faith in government intervention all have their origin in these Federal Reserve mistakes.

The coming of the planners

The great depression’s most serious and long-lasting consequence was not the collapse of prices and employment, but the displacement of the traditional reliance on individual responsibility with government guarantees of security. Beginning with Social Security, these guarantees have grown into the all-encompassing welfare state.

This has changed the character of the American people, and it has changed the character of their government. Together with the growth in government income support programs came growth in government power. From a few basic agencies regulating monopolies, railroads, and food processing, federal presence in the economy has expanded to about 150 agencies, a growing number of which have independent police powers. Most of this burgeoning regulatory activity was justified by the belief that the unregulated market was the cause of the Great Depression. As Roosevelt put it in his inaugural address:

The rulers of the exchange of mankind’s goods have failed, through their own stubbornness and their own incompetence, have admitted their failure, and abdicated. Practices of the unscrupulous money changers stand indicted in the court of public opinion, rejected by the hearts and minds of men.

Business “self seekers without vision” were accused of “callous and selfish wrong-doing” and scapegoated.

The Great Depression was a life-saver for the political left displaced by 1920s prosperity. The prosperity caused by the limited government of Calvin Coolidge and Andrew Mellon had shoved intellectual schemers off the U.S. political stage. As E. Digby Baltzell noted in The Protestant Establishment, Protestants gave up intellectual pursuits and moved to Wall Street. Left-wingers enamored of the use of government power to improve society went off to pay their homage to the new Soviet state. Leftovers from the progressive era were demoralized by the workers’ contentment with Coolidge prosperity. Their spirits lifted as the country sank into depressionary gloom.

As prices sank and unemployment soared, blue collar workers, farmers and businessmen alike all looked to Washington for aid. On June 24, 1931, Business Week magazine poked fun at laissez-faire, “the legend of an ‘automatic equilibrium’ upon which we can rely.” In an editorial, “Do You Still Believe in Lazy-Fairies?” the magazine concluded that planning had to replace the market.

“Why should Russians have all the fun of remaking a world?” asked Stuart Chase in his book, A New Deal, published in 1932. Like other progressives, Chase was convinced by Soviet propaganda of the efficacy of government planning. During the 1920s Chase and Lewis Mumford led the Regional Planning Association, a group of economists and engineers enamored of social management of unified geographic areas.

Planning quickly became the intellectuals’ solution to unemployment and idle factories. Indeed, there was such a predilection for planning that the intellectual class, whose job it was to analyze the situation, remained willfully blind to the drastic monetary contraction before their eyes. On the eve of the new regulatory era and birth of the administrative state, no progressive was going to admit or acknowledge that the first foray into control by experts — monetary management by the Federal Reserve — had quickly produced the worst depression in history.

With a planning and regulatory agenda waiting in the wings, it was convenient to blame the Depression on the breakdown of the unregulated market, on private property and private profit, on “cutthroat competition,” on an unequal distribution of income, and on distrust of government.

Progressives were quick to invoke science in behalf of their planning and coordination schemes. The few skeptics were promptly branded “stupid men.” Rule by wise elites, Chase thought, “may entail a temporary dictatorship.” Chase dressed it up as “the Third Road” between dictatorship of the red (Communists) and the black (Big Business). In his inaugural speech, Roosevelt actually threatened Congress with a dictatorship if all else failed in the “war against the emergency.”

Chase’s call for a new deal was picked up by FDR in his speech accepting the presidential nomination of the Democratic Party. Roosevelt’s advisors were called “the Brains Trust” of New Dealers. In practice New Deal policies were ad hoc, but there was undeniably a common thrust.

This common thrust was to overturn the “nondelegation doctrine.” Prior to the New Deal, elected representatives crafted the law in detail. The New Deal’s expansion of government activities and regulatory authority changed this. Today a “statute” passed by Congress and signed by the president is nothing but an authorization for “expert” regulators to legislate. This practice, formerly impermissible, has been upheld by the federal judiciary, which routinely gives great deference to the regulatory agency when interpreting the law.

But in the 1930s, this great expansion of executive branch powers raised numerous constitutional issues. The federal courts balked at the regulatory intrusions into business relationships. The New Dealers were infuriated that the judiciary, “locked in horse and buggy days,” was rejecting the emergency measures. Constitutional issues were reduced to “nine old men” who stood in the way of remaking a broken society. Roosevelt finally overcame the judiciary’s constitutional scruples with his threat to pack the Supreme Court with New Dealers.

Roosevelt succeeded in adjusting the Constitution to “extraordinary needs” because he won the propaganda war. The public accepted Roosevelt’s depiction of constitutional scruples and economic rights as expressions of reactionary interests. Thus, just as the public was misled by elites as to the cause of the Depression, the public was deceived about the cure. The modern American administrative state was born in this failure of the intelligence and integrity of American elites.

Once the dike of judicial resistance was broken, the programs came fast and furious. New Deal statutory creations included: the Emergency Banking Act (1933), the Economy Act (1933), the Federal Securities Act (1933), the Tennessee Valley Authority (1933), the Civilian Conservation Corps (1933), the Federal Emergency Relief Administration (1933), the Glass-Steagall Act (1933), the Civil Works Administration (1933), the Public Works Administration (1933), the National Recovery Administration (1933), the Agricultural Adjustment Administration (1933), the Farm Credit Administration (1933), the Federal Housing Administration (1934), the Gold Reserve Act (1934), the Reciprocal Trade Agreements Act (1934), the Works Progress Administration (1935), the Public Utilities Holding Company Act (1935), the Social Security Act (1935), the National Labor Relations Act (1935), the Soil Conservation and Domestic Allotment Act (1936), the National Housing Act (1937), the Farm Security Administration (1937), and the Fair Labor Standards Act (1938).

These acts altered the relationship between employees and employers, between businesses and their customers, between state and federal governments, between citizens and the state, between owners and their property, and between individual and collective responsibility. The gold specie backing for money was terminated, and redistribution was made the basis of democratic politics.

This radical alteration of legal rights and political relationships was met with 1,600 federal court injunctions preventing executive branch officials from implementing unconstitutional New Deal laws. The tide turned for Roosevelt with his reelection in 1936, which allowed him to claim a mandate to reject the judicial rulings. The next year he exercised the mandate by sponsoring a bill to pack the Supreme Court.

The bill failed in Congress by a narrow margin, but Justice Owen J. Roberts, a Republican, lost his nerve and acceded to Harvard Law Professor and later New Deal Justice Felix Frankfurter’s importuning to be “the switch in time that saved nine.” The votes remained 5-4 but the majority switched to the New Deal side.

The four main issues before the courts were the delegation by Congress of lawmaking powers to the executive branch, the New Deal redefinition of all economic activity as interstate commerce subject to regulation, new takings of private property as a result of agricultural allotments and price controls, and the gutting of the Tenth Amendment, which reserves to the states all powers not expressly given to the federal government by the Constitution. The federal government ceased to be restrained by the U.S. Constitution and became whatever the New Dealers wanted it to be. As Justice George Sutherland observed at the time, this revolutionary change did not occur through constitutional amendment but as a result of changes in the attitudes of a few men.

To what effect? As the textbook American Legal History, Cases & Materials (1996) acknowledges, “Despite the rich harvest of legislation and the rapid growth of the new administrative network in Washington, the Great Depression persisted.” The New Deal legislation had no significant impact on the Depression.

The popular case

T he new deal lawyers thought of themselves as reformers. The Depression was attributed to the old order. Arthur M. Schlesinger Jr. dedicated his life to promoting this view. The Crisis of the Old Order is the first volume of his trilogy, The Age of Roosevelt.

But the Great Depression was the crisis of the new order. The Great Depression was the product of the first institutional creation of the new regulatory order and most certainly could not have happened without the creation of the Federal Reserve System. Until the Federal Reserve came into being, it was not possible for regulatory mismanagement to shrink the money supply by one-third. This Pulitzer Prize-winning historian gives an account of the Great Depression that leaves the Federal Reserve’s contraction of the money supply out of the story!

In Schlesinger’s crude rendering, unregulated business greed caused the Depression. He argues that “the central economic challenge” of 1920s prosperity “was to distribute the gains of productivity in a manner that would maintain employment and prosperity.” If the price and market systems had been working, prices would have fallen and/or wages would have risen. But Schlesinger says that business concentration had made the price system sluggish. Consequently, the rising productivity pushed up profits, which pushed up stock prices and brought on speculation. The Mellon tax cuts “served to make more money available for speculation,” as did Federal Reserve policy. Greed leveraged the speculation with loans until the edifice collapsed.

Let us assume that Schlesinger’s account is correct. It would explain the stock market crash — but not the contraction in the money supply that caused the Depression. Twenty-five percent of the labor force was not forced into unemployment because of a correction in the value of narrowly held assets.

New Dealers are schizophrenic about concentration, both of business and of wealth. Stuart Chase believed business concentration facilitated planned economic management, but Schlesinger blames concentration for excessive profits. Wealth concentration was blamed for preventing a healthy diffusion of buying power, thus leaving goods unsold.

Schlesinger offers no explanation or transmission mechanism by which a reduction in the wealth of rich people (with excessive savings), perhaps some 60,000 families, caused a gigantic depression. Looking back from a Keynesian standpoint, Schlesinger blames Hoover’s frugality for letting pass the opportunity to check “the cumulative forces of breakdown” with “a small amount of spending.” Schlesinger also blames the government for ignoring the “imbalance between farm and business income,” the imbalance between wages and productivity, and imbalances in the banking and financial systems. “Seeing all problems from the viewpoint of business, it had mistaken the class interest for the national interest.”

The economy failed, in Schlesinger’s account, because government served the narrow interests of business. Missing from his list of imbalances is the crucial imbalance of money. Schlesinger writes that President Wilson

had established the Federal Reserve System as a means of steadying the economy. The System had two chief instruments of credit policy. Through open market operations, it used the purchase or sale of government securities to alter the reserves of member banks and thus enlarge or contract the base of the money supply. Through the discount rate, it made the money supply tight or easy by raising or lowering the rate at which banks borrowed from the Federal Reserve.

There is something remarkable about Schlesinger’s lack of curiosity about how the Federal Reserve performed this important role during the critical period 1929-33. In the Federal Reserve he had a newly created regulatory institution, a product of progressive politics, with more power than all New Deal agencies combined. Was the Fed expanding or contracting bank reserves when bank failures were shrinking the money supply, causing dramatic imbalances between money, prices, and employment? Was the Fed raising or lowering the discount rate when banks had a desperate need for liquidity? These are the questions on which all turns, yet Schlesinger did not address them.

If the Fed drove the economy into depression with inappropriate policy, where is the justification for New Deal confidence in the wisdom of regulators vested with new powers? On the other hand, if the Fed’s actions were appropriate but unable to avert the Depression, where is the justification for the New Deal’s belief in the power of regulation? If all that was needed to restore full employment was expansion of the money supply, what is the justification for the New Deal?

The cost of the New Deal

T o those of us living in more knowledgeable times, Schlesinger’s excitement over The Coming of the New Deal, the second volume of the Age of Roosevelt trilogy, is difficult to fathom. The New Deal legislation was ad hoc and the programs ineffectual in reducing unemployment. The basis of Schlesinger’s excitement lies not in the efficacy of New Deal solutions but in the growth of government as such. In the third volume, The Politics of Upheaval, Schlesinger disposes of New Deal opponents as people lacking in compassion who are opposed to the utilization of government to provide economic security to the common man.

Yet the New Deal achieved a diminution in rights, not in unemployment. This became apparent by 1942, when Ohio dairy farmer Roscoe Filburn was prosecuted successfully by the compassionate federal government for violating the Agricultural Adjustment Act by growing grain for his family’s direct use. In a unanimous decision, the now-tamed Supreme Court ruled that Filburn had engaged in interstate commerce by not engaging in it. Filburn, the Court ruled, should have purchased the grain with which he fed his cows, chickens, and family, not raised it himself. In order to permit the federal government a wide range of action, New Dealers destroyed the doctrine of enumerated powers.

This constraint on federal power had to be removed if New Dealers were to deal with the “national emergency” by expanding Washington’s reach. The removal of this constraint meant that federal power came to occupy territory formerly inhabited by individual rights. Principal among these lost rights are the protections the Constitution gives to property and to contracts. The result has been an explosion in economic regulation and uncompensated takings of various uses of private property. With the onset of the New Deal, government abandoned its function of securing property and began violating it in the interest of redistribution and “worthy goals.” Today property rights are tenuous. They are gradually diminishing as government regulation increasingly dictates an owner’s use of property.

The New Dealers put their trust in government, not in the Founders’ Constitution. Roosevelt told the chairman of the House Ways and Means Committee in 1935, “I hope your committee will not permit doubts as to constitutionality, however reasonable, to block the suggested legislation.” New Dealer Rexford Tugwell said that New Deal policies “were tortured interpretations” of the Constitution in support of actions that the framers “intended to prevent.”

This constitutional revolution was, as Justice Sutherland said, the work of a few men. The elites entrusted with government wanted a bigger stage. They used the fear and economic uncertainty that afflicted the population to get it. The New Deal was not Congress’s idea. Nor was it the people’s. Paradoxically, the New Deal discredited democracy, especially in the eyes of those who most love liberty. Today, libertarians, eloquent in their denunciations of the New Deal, blame the people and, hence, blame democracy for doing the wrong thing. Today every camp has an agenda, which it hopes to implement by seizing control of the judiciary, not by persuading the public. Coercion of the public is the preferred, or trusted, method of change.

Coercion becomes increasingly arbitrary as time passes. Its arbitrariness provokes anger, resistance, and reaction by the public. When farmers are harassed by Environmental Protection Agency officials for cleaning drainage ditches or maintaining dikes that protect fertile bottom-lands, and ranchers are indicted for protecting their livestock or their own lives from a marauding endangered grizzly, respect for authority declines.

Consider the expanded police powers of federal regulatory agency personnel. According to the U.S. Department of Justice, “As of June 1996 Federal agencies employed about 74,500 full-time personnel authorized to make arrests and carry firearms.” Only 60 percent of these armed agents are in agencies that the public associates with police powers — the FBI, U.S. Marshals, Bureau of Alcohol, Tobacco, and Firearms, federal prison guards, immigration border guards, Drug Enforcement Administration agents, and the U.S. Secret Service. Americans should be amazed that the Internal Revenue Service, the Small Business Administration, the U.S. Railroad Retirement Board, the Social Security Administration, the General Services Administration, the Environmental Protection Agency, the U.S. Fish and Wildlife Service, the Army Corps of Engineers, the U.S. Forest Service, the National Aeronautics and Space Administration, the Federal Deposit Insurance Corporation, and the Departments of Health and Human Services, Agriculture, Labor, Housing and Urban Development, Education, Transportation, Veterans Affairs, Energy, Interior, and Defense all have federal officers authorized to carry firearms and make arrests.

This proliferation of federal police forces mirrors our lost rights. Consider the sanctity of contract. In 1934, the Supreme Court vitiated, over the dissent of Justice Sutherland, joined by Justices James C. McReynolds, Willis Van Devanter, and Pierce Butler, the contract clause of the U.S. Constitution. This clause, “No State shall . . . pass any . . . Law impairing the Obligation of Contracts,” was put in by the framers for the express purpose of forbidding state governments from rewriting contracts in favor of debtors, especially in time of financial distress. The framers viewed this practice, in which states had engaged after the Revolutionary War, to be reprehensible and undermining of the rights of property. Property has no protection when contracts can be vitiated.

In 1933 Minnesota responded to the economic crisis by protecting mortgage debtors (mortgagors) in default from foreclosure. No compensation was offered the equally straitened lenders. The purpose of a contract is to protect the parties from a lack of performance by either party to the contract. The Minnesota law constituted an uncompensated taking of this core constitutional protection, thus leaving future contracts subject to being rewritten in the interest of the nonperforming party. As Justice Sutherland observed, “If the provisions of the Constitution be not upheld when they pinch as well as when they comfort, they may as well be abandoned.”

If the federal government had wanted to protect mortgage debtors, it could have printed money and paid down the mortgages. This would have harmed no one, and it would have stopped the monetary deflation. The increase in the money supply would have halted the deflation that was the source of the problem. But the proclivity in favor of actions directed against business blinded policymakers to the real cause of the crisis. Indeed, the mortgage debtors and everyone else were in trouble because the Fed failed to protect the supply of money.

The road not taken

The great depression and its offspring, the New Deal, could both have been avoided if the Federal Reserve had performed the task assigned to it. All the Federal Reserve had to do to avoid the Depression and the subversion of the American constitutional order was to purchase $1 billion in government securities during the 10-month period from December 1929 to October 1930. The result would have been an increase, instead of decrease, in high-powered money, and the banking crisis that began in the autumn of 1930 would not have occurred.

Without this initial decline in the supply of money, the public would not have lost confidence in the banks, and the banks would not have become concerned about their own safety. This would have removed the causes of the second crisis — the run on banks and the reduction in bank lending to meet depositors’ demands for cash. It was still not too late for minor action by the Federal Reserve to prevent the disaster. Friedman and Schwartz calculate that if the Federal Reserve had increased its security holdings by $1 billion during the first eight months of 1931, these purchases would have offset the drain of currency from the banking system and increased bank reserves.

The increase in bank reserves would have freed banks from the necessity of strengthening their reserve positions at the expense of money supply growth. By its failure to protect the reserves of the banking system, the Federal Reserve caused a second decline in the supply of money. As Friedman and Schwartz note, a $1 billion purchase program by the Fed would probably have prevented the second banking crisis, but even if it had not, the open market purchases would have completely eliminated the crisis’s effect on the money supply.

Even after the second banking crisis, it was still not too late for the “wise regulators” to awake to the responsibilities in their charter. If the Federal Reserve had purchased $1 billion in government securities between September 1931 and the end of January 1932, it would have more than offset the decline in bank reserves that caused a multiple contraction in bank deposits. As Friedman and Schwartz show, “only a moderate improvement in the deposit-currency ratio” would “have enabled the stock of money to be stable instead of falling by 12 percent.”

The Great Depression occurred because the Federal Reserve missed every opportunity to take active measures to ease the internal drain on bank reserves.

The Federal Reserve did not fail in its responsibilities because central banks did not know how to stop panics. Indeed, the prescription is in the Fed’s charter. Walter Bagehot described the appropriate policies in a famous book published in the nineteenth century. The Bank of England stopped the panic of 1825 by doing exactly what the Federal Reserve should have done in 1930. The Fed failed because of “committee work” and personal rivalries and jealousies. Moreover, the existence of the Fed prevented banks from using measures taken in past panics, such as banding together to funnel reserves to troubled banks, or, when all else failed, taking concerted action as in 1907 to restrict payments of cash to customers. Banks would honor checks drawn by customers so that the payments mechanism could continue, but would not honor cash withdrawals except for regular purposes such as payrolls. By acting to prevent the loss of cash from the banking system, banks prevented the decline in reserves and multiple contraction of the money supply.

The Federal Reserve was formed to make such measures unnecessary. But the wisdom of regulators proved to be far short of the ability of bankers themselves to prevent panics from collapsing the money supply. By concentrating power over the money supply in a few hands, progressives greatly leveraged the power of mistakes. The New Deal and the Great Society are the unfortunate consequences of the progressives’ trust in wise men and their lack of faith in the market. Now that the market has triumphed everywhere and its supposed greatest failure can be seen to have lain with the unwise actions of the wise men themselves, the legacy of the progressives looks more dubious than ever.