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The Great Contraction 1929-1933

Milton Friedman and Anna Jacobson Schwarz, Princeton University Press, 2008, 320 pages, £11.95.

As contemporary economists rush to print to offer their prescriptions to avoid impending economic doom, inevitably in many cases to find that by the time they have gone to press they have been overtaken by events, there is benefit in considering what history can already teach us. To this end, the reprint of Milton Friedman and Anna Jacobson Schwarz’s account of the economic meltdown in the US, first published in 1963, is timely.

The central thesis of the book is that the Great Contraction was wholly avoidable being as it was a product of inept monetary policy; it was “a tragic testimonial to the importance of monetary forces.” They reach this conclusion by showing that money stock, output and prices fell together and then rose between 1929 and 1933.

By conducting four ‘natural experiments’ – episodes in which the money supply moved for reasons unrelated to the state of the economy – Friedman and Schwartz show that the fall and rise of the money stock, output and prices are not simply correlated but there is a causal relationship between the money supply and prices and output: the contraction was a monetary phenomenon. As central bankers around the world conduct their own experiments in depression-avoidance economics – with, for example, quantitative easing in the US – the question is can we avoid history repeating itself, and another Great Contraction?

Friedman and Schwartz warn of the perils of inaction, which could lead to the economic decline cascading out of control: “Because no great strength would be required to hold back the rock that starts a landslide, it does not follow that the landslide will not be of major proportions.”

In this light comments reprinted from a lecture given by Ben Bernanke in 2002 at the University of Chicago to mark Milton Friedman’s 90th birthday have an especial piquancy: “Regarding the Great Depression. You’re right, we did it. We’re very sorry but thanks to you, we won’t do it again.” Friedman and Schwarz contend that the particular tragedy of the Great Contraction was not that central bankers did not have the tools and knowledge at their disposal but rather they did not exert strong leadership. With the premature death of Benjamin Strong (the head of the Federal Reserve Bank of New York who played a role not dissimilar from that of the today’s Fed Chairman) in 1928, a leadership vacuum was created.

But even knowledge of this may not be enough. The book is most useful in highlighting the differences, rather than the similarities, between the original depression economics and today’s circumstances. Rather than a mis-pricing of risk (today in the sub-prime mortgage market through associated derivative products), Friedman and Schwarz contend that a policy of ‘leaning against the wind’ to slow an asset bubble (perceived excessive stock market speculation back then) caused the economy to slow in the months preceding the October 1929 crash, worsening the effects of the crash, and indeed possibly causing it. Compare that to today’s criticisms from some quarters of Alan Greenspan for not doing enough to stop an asset bubble developing.

Perhaps Friedman and Schwartz’s most telling comment is, “It was a defect of the financial system that it was susceptible to crises resolvable only with such leadership. The existence of such a financial system is, of course, the ultimate explanation for the financial collapse, rather than the shift of power from New York to the other Federal Reserve Banks.”

Hopefully in thirty years time there will be no need for economists to be writing about today’s policy failures as crisis will be avoided. Moreover, one can hope we will have learnt lessons about what led to today’s crisis and history will not repeat itself. Because if not, and ‘we do it again’ with policy failure leading to full blown contraction, we can expect a whole new wealth of literature on depression-avoidance economics.

Alasdair Keith

Consultant, Outsights Ltd

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