True freedom

"Freedom means that in some measure we entrust our fate to forces we do not control; and this seems intolerable to those positivist / rationalist who believe that men can master his fate; as if civilization and reason itself were the fate of his making"
F.A. Hayek

Monday, July 15, 2013

A Review of the Monetary Phase of the Great Depression

A Review of the Monetary Phase of the Great Depression
By: Pablo Paniagua
Date: 7/12/2013

The Digital free PDF version of this essay is here

The Great Depression was without a doubt the most catastrophic event in economic history ever since the Black Death in the XIV century. Frequently people see the Great Depression (GD) as an isolated incident, specifically seeking to identify a single culprit that might have caused or ignited the depression: greed? Wall Street speculation? The Fed? Individuals usually seek to focus on a myopic, simplistic view of the GD rather than seeing it as a complex historical event that unveiled itself through almost two decades and that it contains elements of both economic policy and public policies, which makes the GD a more intricate and complex event. However as a matter of simplicity we can identify four major phases (Reed, 1981) or aspects of the GD that can be analyzed somewhat individually (although policies and phases do overlap). The first of these four stages is the monetary phase and the business cycle period, which encompasses 1922-1933. Subsequently the Hoover administration phase and the paving of the road on public policy for the New Deal; this stage analyses the Smoot-Hawley Tariff and other policies of the Hoover administration between 1930-1932. Third was the New Deal itself and FDR period, 1933-1938, and finally The Wagner Act and WWII period. It is impossible to understand the severity of the depression and why it lasted so long without having a holistic view of all of these phases and the evolution of ever increasing catastrophic public and monetary policies involved. 

The scope of this essay will be mainly to focus on the first phase of the Great Depression in particular its monetary phase. We will review the monetary policies in the 20s and 30s; specifically we will review the expansionary monetary policies that influenced the late booming years in the 1920s and finally the period of the Great Contraction between 1929 and 1933. Most commentators start analyzing the monetary phase of the depression from 1929 onwards; however we believe that the booming period of 1922-1928 will be a great theoretical foundation to understand the underlying disorganization and structural problems that ignited the subsequent phase of monetary contraction in 1929. These two periods of monetary policy are particularly characterized by contrasting intellectual and policy positions that created two different policy environments concerning money (Timberlake, 2013).  The first part of the monetary phase is marked by the (at the time) new regime of the Federal Reserve System, established on December 23, 1913 as a centralized federal response to the national bank panic of 1907. By the beginning of the 1920s, the Federal Reserve was just becoming self-aware of the potential power they might possess in controlling the money supply, but already by 1922 the Fed was actually very different from what the Federal Reserve Act original intended (Timberlake, 2008). By that year, the Federal Reserve started drastically changing their form of influencing the economy. The Fed moved from utilizing the discount window towards utilizing open market operations on government securities (Meltzer, 1976), this policy became in the twenties the standard mechanism to influence the money supply.

By the time the Fed was established, Benjamin Strong had become the appointed governor of the Federal Reserve Bank of New York, a position that he maintained until his death in 1928. He was a sturdy first governor of the Federal Reserve Bank of New York and as well as a substantial leader of the Federal Reserve System during the twenties. He exercised a disproportionate prominence in the policy decision making of the Fed during that decade, due to his relative importance as governor of the Federal Reserve Bank of New York and his former presidency of the Banker’s Trust.

As mentioned before the monetary policy of the twenties under Strong was in radical demarcation, both theoretically and practically, from the periods that followed during the thirties. By 1922 the main instruments of monetary policy started to radically change, under the leadership of Benjamin Strong, the Federal Reserve started to move away from transmitting monetary policy only through the discount window. The board wished to avoid the discount rate to guide the lending activities of the banking system, and seek a way to make the discount rate secondary, instead of the main Fed policy (Meltzer, 1976). The Strong policy framework then, shifted towards utilizing open market operations of purchases of government securities to try to guide the lending activities and the money supply in the banking system. Strong therefore led policies by 1922 onwards, deeply influenced in the quantitative theory of money developed by Irving Fisher that aimed at a form of price stability, in other words, Strong was seeking to control the expansion of the quantity of money in order to maintain a measure of the Consumer Price Index inflation stable. This decade was characterizing by solid and fast economic growth and fairly stable prices, which led people to believe that the U.S. had indeed entered a new era of stability and affluence. We have to discuss this decade more in detail in order to understand why the new era of affluence didn’t turn out to be viable. In order to do so, we will specifically review how deep structural imbalances can form in the economy even if there is an environment of price stability and then how these imbalances (once they turned out to be unsustainable) led to particular instabilities in the banking system and the stock market.

It is important to stress that not the entire economic boom of the twenties was unsustainable or excessive; as a matter of fact, much of the economic growth in the first half of the decade was sustained by real economic reforms that led to great increases in productivity and innovation.  The Coolidge era was particularly important in creating the political framework to sustain this entrepreneurial driven era. Substantial reforms and reductions on income taxes were implemented, Coolidge eliminated the income tax for nearly two million Americans (Sobel, 1998), by 1927 only the wealthiest two percent of Americans were paying income tax (Ferrel, 1998) and other commercial tax reductions created a more propitious environment to enhance economic activity. The policies fostered new consumption of the upcoming electric appliances and improved the tax environment allowing more competition and innovation.

Between 1923 and 1929 substantial reforms were similarly made on trade regulations and substantial improvements on interstate commerce. In addition, Coolidge substantially reduced Federal expenditures and retired nearly a quarter of the Federal debt (Ferrel, 1998).  Despite these reforms, President Coolidge was by no means a laissez-faire president; rather he was a deeply committed Federalist (Ferrel, 1998). We can see how Coolidge’s policies were aimed at improving the business environment substantially; the U.S. economy enlarged its real GNP by 4.2 percent a year and its per capita GNP by 2.7 percent a year from 1920 to 1929 (Smiley, 2010). Therefore we must be very careful in defining the Roaring Twenties as simply one big bubble, because there was a real solid economic growth which only later in the decade became “adulterated” to a certain degree through the Fed’s monetary policies.
By 1923 right after a mild recession of 1920-1921, the Fed started to sell securities and increased the discount rate from 4% in order to “cool” the recovery that according to Strong was accelerating too rapidly in early 1923. However by the end of that year there were some signs of a mild contraction, due to exogenous shocks of international oil prices (Smiley, 2010); this problem manifested itself late again in the decade in 1927, with a similar response by String. These oil shocks were seen as potential threats to the US economy, and were ameliorated with accommodative expansionary monetary policies. Benjamin Strong, through the years 1923-1928, started using securities purchases to seek to ameliorate and ease these exogenous threats to the economy. Therefore by 1923-1924 the Federal Reserve started its expansionary polices with large security purchases and reductions of the Federal discount rate, which manifested themselves in an increase of the securities holdings of the Fed by over $700 million in less than 4 years (Wheelock, 1992).

Following the 1923-1924 expansion, the Fed also reduced its discount rate from 4.5 percent to 3 percent, allowing banks to borrow money from the system at a lower discount rate. Another key element that contributed in the years of the monetary expansions was Benjamin Strong’s international economic commitments and international sensitivities. Strong was probably one of the only American economists and policy makers deeply interested in the troubled financial situation of Europe in the 1920s (Meltzer, 1976), particularly the 1925 British attempt to move back to the gold standard and to return to the old pound/dollar exchange rate of $4.85 that pushed Britain to a path of deep deflation (Skidelsky, 2005). In order to achieve this policy of a higher exchange rate Britain needed to keep gold reserves in Britain; this meant keeping interest rates relatively high compared to the rest of the world in order to attract gold reserves or to avoid them leaving the country. The higher interest rates also led to heightened pressure in the economy (Skidelsky, 2005).  Strong therefore helped sustained British monetary policies by reducing American interest rates through lowering the bank discount rate and increasing the supply of credit and lowering interest rates in the Unites States. These polices helped to somewhat reverse the flow of gold back to Great Britain, helping Britain’s attempt to return to the gold standard (eventually Britain broke from the gold standard in 1931).

By 1927 the Fed undertook its second biggest purchase program during its international commitment to allow Britain and France to return to the gold standard. Strong started adopting more severe expansionary measurers than the ones it had adopted before in 1924 (Selgin, 2013). The Fed reduced the discount rate once again and committed itself to large securities purchases, this time another extra $300 million, allowing France to return to the gold standard with an undervalued currency by 1928 and allowing Britain to contain the gold outflow and meliorate their 1927 payment crisis (Wicker, 1966). Overall we can realize how the period 1923-1928 was marked by a somewhat volatile and accommodative expansionary monetary policy that allowed the money supply to grow quite rapidly compared to the years 1921-1923. When these policies are seen as expansionary of a 5 year trend, we can see that by the mid-20s part of the real growth that the US economy was experimenting started to experience underlying assets inflation and profound structural distortions on relative prices. On this perspective according to Hayek and other Austrian economists, the twenties were a period in which some of the expansive monetary policies started to create by the late 20s a phase of unsustainable growth due to distortions on the relative prices and alterations in the capital structure of business; this economic discoordination was obscure and unintelligible due to the stable price policy enacted by Strong and the exacerbated optimism of the rampant real growth experienced in the early twenties. According to Hayek’s theory of the business cycle, these underlying misallocations of capital and this disorganization due to monetary expansion at some point had to be recognized by market forces, making a correction unavoidable (Hayek, 1932). Now a recession according to Hayek’s view would have been a form of restructuring business structures, capital formations and investments time-frames, this liquidation does not have to entail general prices and income deflation driven by monetary contraction, as a matter of fact Hayek never advocated liquidations and monetary contractions as a solution to the restructuring of the business cycle (White, 2008). Hayek was as antagonistic to monetary contractions as to disproportionate monetary expansions (White, 2008).

Hence, following a Monetarist policy of price stabilization through the quantifiable management of the quantity of money through the open market operations which, was the monetary policy proposed by the economist Irving Fisher. The policies advocated by Fisher are currently known as Monetarism, but at the time were known as the “quantity theory of money” (QTM), which looked at a macro level of monetary aggregates to aim at a “desired policy” of a relative stable growth of the money supply in order to keep inflation relatively low and under control. Strong through the open market operations from 1923 onwards achieved this macroeconomic goal quite successfully, maintaining a stable level of prices between 1922 and 1928. In fact between 1922 and 1929 the Consumer's Price Index (CPI) stayed practically constant, with a slight increase of 2.3 percent over those 7 years; in addition, the Wholesale Price Index actually decreased by almost 2.3 percent (Timberlake, 2013).

Differing from these price stabilization policies, the Austrians highlighted that by the 1924-1928 period the U.S. had seen the Fed incurring quite large operations of monetary expansion that started to overtake the real underlying growth of the economy, beginning to plant the seeds of a possible economic restructuring or recession, due to the distortions that this expansionary policy was creating on the signaling mechanisms of the borrowing interest rates and the relative prices of goods and capital. Hayek and Robbins opposed Strong’s price stabilization policies, believing that the “U.S. price level should have been allowed to decline as real output grew with productivity improvements of the 1920s. Instead in their view, the price level has been artificially propped up by the Federal Reserve’s credit expansion” (White, 2008, p.756). Following this critique, in the words of professor Selgin: “According to several economists, most notably Hayek and Lionel Robbins [at the time], the Great Depression began, not as a response to post-1929 deflation, but as the collapse of a prior ‘malinvestment’ boom fueled by the Fed’s easy money policy of the latter 1920s” (Selgin, 2013, p.14, emphasis mine).

We have to note, from the past statements, that the main critique to the “quantity theory of money” is that a monetary policy that uniquely aims at a simple evaluation of broad macroeconomic aggregates will evidently obscure and muddle our deep understanding of the microeconomic foundations of the market signals, specifically relative prices of goods and services and borrowing interest rates that coordinate at a micro level the decisions of thousands of individuals. The distortions engendered on the market signals are unfortunately unrecognized and ignored under a broad macroeconomic approach such as the one advocated by Irwin Fisher. Hayek during the 20s and 30s distanced himself from the QTM due to the fact that the interaction of relative prices and the theory laid in a comparative static approach that obscured the relevant facts of the dynamic market process and coordination (O'Driscoll, 1977). In a nutshell Hayek and other Austrian economists thought that a macro aggregated quantitative approach to monetary policy had three major erroneous suppositions or implicit suggestions:

    “Firstly, that money acts upon prices and production only if the general price level changes, and, therefore, that prices and production are always unaffected by money, -that they are at their “natural” level, -if the price level remains stable. Secondly, that a rising price level tends always to cause an increase of production, and a falling price level always a decrease of production; and thirdly, that 'monetary theory might even be described as nothing more than the theory of how the value of money  is determined” (O'Driscoll, p.46, 1977).      

These erroneous propositions then inhibited Strong in grasping the secular and accumulative harmful effects that expansionary monetary policies carried on the capital structure and on the overall capacity of the market of efficiently coordinating value enhancing economic activities, which ended by eroding the healthy economic growth of the early 20s. As a lesson of these 1920s problems with monetarism, and later also in the 2000s, we can see as professor White points out: “consumer price inflation [and other economic aggregates] is [are] not our exclusive concern. The past decade has reminded us that, even with consumer inflation rates around 2.5 percent or lower, we face the serious danger of asset price bubbles and unsustainable credit booms under a central bank policy of artificially low interest rates” (White, 2013, p.19). This comment by Professor White is a clear reminder of the role of interest rates and prices in coordinating the micro foundations and the capital structure in the real economy, which could suffer from hampering processes of coordination that are unfortunately unobservable through the aggregated measure of price inflation indexes.
In October 1928 Strong died of tuberculosis and finally a different intellectual framework took over the Fed polices (Friedman and Schwartz,1963); the monetarist policies of price stability led by Benjamin Strong, based on the macro economic theories of Irwin Fisher were no longer fashionable at the Fed. Consequently the Real Bills Doctrine supporters on the Fed Board took control over the monetary policy of the country by 1928. George Harrison, the successor of Strong at the New York Fed, lacked the commitment and Strong’s intellectual framework to continue Strong’s policies of monetary stability (Timberlake, 2008). The Real Bills Doctrine, in the hands of Adolph C. Miller, a senior member of the Board of Governors that openly had criticized Strong’s QTM policies during the mid-20s, had started to emphasize a control of the money supply according to the “needs of trade”. The Real Bills supporters believed in expanding credit whenever real economic activity was booming and contracting credit whenever real trade and commerce stagnated; in this fashion then “the stock of money and bank credit rose in periods of economic expansion and declined in recessions” (Meltzer, 1976, p.3). In addition, this doctrine condemned banks for lending for speculative motives and tried to discourage long term borrowing (Timberlake, 2008 and 2013) which, according to their views, might have fueled the stock market and real state bubbles in the late 20s. The Federal Reserve, right after Strong’s death, started contracting credit at discretion and started promoting an anti-speculative agenda. On February 1929, the Fed Board sent a letter, expressing Miller’s opinion to the rest of the Fed Banks, stating the Board’s new duties:  

“[Our new] duty . . . to restrain the use of Federal Reserve credit facilities in aid of the growth of speculative credit.”[…] [They initiated] “The policy of ‘direct pressure’ [which] restricted borrowings from the Federal Reserve banks by those member banks which were increasingly disposed to lend funds for speculative purposes” (Miller, 1935, p. 453 via Timberlake, 2008).

This new policy created a sturdy discriminatory bank borrowing procedure that led to a huge systemic contraction in the borrowing capacity of banks that also culminated in the transmission of a great contraction of credit to the overall public, this created a sever contraction in the supply of money and an overall massive contraction of the money in circulation. The discriminatory and arbitrary lending procedures also rendered the discount window of the Fed almost meaningless (Timberlake, 2008), arbitrary decisions to whom to lend, created direct pressure on banks and exacerbated bank failures. These arbitrary discriminatory policies of the Fed Board of Governors created three consecutive banking crisis in 1930, 1931 and 1933 (Timberlake, 2013), contracting the money supply by nearly 30%, without a significant recovery. Unemployment started to rise rapidly with the dreadful monetary policies of the Fed, from 3.2% in 1929 to 8.9% by 1930 and arriving to catastrophic levels of more than 25% by 1933. So what could have been a mild recession in 1929 was, by 1933, already a debacle. Unprecedented reckless and erroneous political and monetary policies exacerbated what could have been only a normal recession and a short-lived healthy restructuring of the sound real economic fundamentals of the early 20s. However the Fed’s misguided policies turned the recession into a depression never seen before in history, prolonging the self-inflicted liquidity crisis well into the mid-30s. By 1933, “the M1 and M2 money stocks were 27 percent and 25 percent below their 1929 levels. Meanwhile, the Fed Banks sat on their huge hoard of gold—the gold reserves legally required for their current monetary output and the “excess” gold reserves that could have provided significant monetary increases—and did . . . nothing!” (Timberlake, 1999). On this line of argument, Schwartz (1981) has showed how since 1929 until the mid-30s the monetary growth was nonexistent and this contraction in the money supply is the best evidence of a very tight arbitrary monetary policy led by the Real Bills Doctrine. The money stock therefore fell by almost one-third between 1929 and1933 (see Figure 1).      

In consequence by 1928 the expansionary policies of Benjamin Strong over the years 1923-1928 started to seem unsustainable and dangerous under the Real Bills Doctrine framework. As a matter of fact the rest of the Fed Board of governors, following the Real Bills Doctrine, saw cheap credit and long-term borrowing as something inherently unhealthy and corrupt for the economy (Timberlake, 2013). Another explanation of the failure of the Fed to provide liquidity during the 1929-1933 periods was according to Meltzer (1968 and 1976), the failure of the Fed officials in distinguishing between the market interest rate and the real interest rate and their role in the business activity. At the time, Meltzer argues, the Real Bills Doctrine followed a classical approach of monetary policy in which monetary interventions were supposed to affect short-term nominal market interest rates. Nominal Market interest rates therefore were, for the Real Bills Doctrine, the main indicator for monetary policy. Whenever nominal market rates fell, then monetary policy was considered expansive or loose; on the other hand, when nominal market rates were relatively high, monetary policy was seen as contractionary. By the summer of 1930 the short-term nominal market interest rates were at their lowest levels in a decade (Meltzer, 1968) and the short-term market rates of Treasury notes continued to fall. However, this decline on the nominal market interest rate was mainly due to price deflation, a severe decline of the monetary base, a severe decline in the demand for business loans and a tight supply of liquidity (Meltzer, 1968). Unfortunately as market rates were falling, Fed officials interpreted this as a reflection of secular accumulated “extremely easy” monetary policies, which refrain them to increase the money supply at a moment the system needed it the most:      

“[…] most of the members of the Open Market Conference believed that policy remained "easy." In their view there was no reason to produce increased "ease." In fact, several of the members believed that monetary policy was much too "easy" during this period [1930-1931] and recommended a policy of open market sales [contractionary policies].” (Meltzer, 1968, p. 12)  

In addition to this failure of understanding the role of interest rates by the Real Bills Doctrine, the Fed by 1928 started to look with increasingly worries at the drain of its gold reserves and the faster than ever rise in the stock market. The Fed therefore started to adopt arbitrary contractionary polices through the selling of securities and, in three steps, raised the discount rate from 3.5% to 5% by July 1928. Discount rates were finally raised again a fourth time to an unprecedented 6% percent in August of 1929. By that time the massive contraction of money had already begun and the lack of liquidity in the banking system was already a systemic problem. In late October the stock market crashed as a consequence of the monetary contraction, and this finally led to a catastrophic collapse in nominal spending, real GNP fell from 1929 to 1933 by 33 percent and the subsequent banking crisis that developed as liquidity by the Fed was drying up (near 9,000 banks with $6.8 billion of deposits failed), sliding America into the Great Depression (Wheelock, 1992).
The contrast of both of these schools of thought that shaped the monetary policies of the U.S. could not have been more accentuated. The clash of views, concerning how to manage the money supply before 1928 and after 1928 is of extreme relevance to understanding money and our human capacity to manage it. This point is of particular importance, as Milton Friedman and Anna Schwartz’s Monetary History have shown us, the clashing schools of thought concerning monetary policies led to the most tumultuous times in our economic history. The great American economist Irving Fisher testified before Congress in 1935 regarding the Great Depression and stated: “Governor Strong had died and his policies died with him […] I have always believed, if he had lived, we would have had a different situation.” We clearly see the demarcation between schools of thought regarding monetary policy, how they were represented by individuals at the Fed and how they affected the Fed’s decisions. On one side, there was the discretionary and extremely arbitrary Real Bills Doctrine that conditioned credit at discretion, based on arbitrary decisions of the Board of Governors. On the other side there was the less discretionary more “quantitative based”, ‘technical’ price stability policy. How these different schools of thought determined the destiny of the economic system from 1923 until the mid-30s is an incredible case study of the power of ideas and a lesson on the danger of centralized decisions concerning the money supply; additionally under this centralized monetary system, the economy is very susceptible to changes in the ideas and passions of fallible men rather than being based on the real underlying market processes and fundamental economic conditions.

From this experience we can see that Monetarists such as Fisher and Friedman considered that if the Fed would have continued to follow Strong’s monetary policies, the collapse of the economy would have never been as severe as it was. On the other hand, Austrians such as Hayek and Rothbard and other scholars argue that if Strong’s policies would have continued, this would have only perpetuated a secular dreadful negative underlying condition of price distortions and misallocation of capital, which would have just keep accumulating and prolonging even more harmful misallocation and economic discoordinations. Regardless of the differences in views and policy, we believe that the major take away from these ideological and theoretical problems concerning money is that the greatest danger of using the incorrect monetary framework originates from the fact that decision making was made in the 20s and 30s and is still very much used today under a centralized intellectually monopolistic fashion. This creates the danger of getting things wrong extremely dangerous, since the mistakes of few man will have severe repercussions at a systemic level.

The best way to avoid large catastrophic centralized mistakes on human decision making is through a monetary framework which encourages decentralized decision making, minimizing human mistakes and facilitating a learning process through which the banking industry can be extremely benefited. When the Fed affects the money supply through centralized policies and by relying excessively on the views and passions of a few men in order to make complex decisions for the sake of the whole banking system (thus for the rest of the economy), it puts, hazardously, extremely high faith on concentrated decision making and increases the systemic risks that those few people could make bad decisions for the rest of us. Instead a rather decentralized banking system, although not perfect, could have coped better with the liquidity crises through a dispersed system of trial and error in monetary policy making. This sort of system would make additional but smaller less riskier strategies, minimizing the jeopardy of enacting bad policies for a large part of the banking community. This in turn increases the discovery and learning procedures for the rest of the banking system, in which they can imitate or correct, polices that would have worked better in order to provide systemic liquidity. Friedman and Schwartz recognized this point emphatically when declaring: “[I]f the pre-1914 banking system rather than the Federal Reserve System had been in existence in 1929, the money stock almost certainly would not have undergone a decline comparable to the one that occurred.” Friedman & Friedman in Free to Choose again argued:

“Had the Federal Reserve System never been established, and had a similar series of runs started, there is little doubt that the same measures would have been taken as in 1907—a restriction of payments. […] restriction [of payments] would almost certainly have prevented the subsequent series of bank failures in 1931, 1932, and 1933, just as restriction in 1907 quickly ended bank failures then. . . . The panic over, confidence restored, economic recovery would very likely have begun in early 1931, just as it had in early 1908” (Friedman & Friedman, 1990).

Following this line of argument then, we see how prone to failure a centralize banking system stands, and how systemically dangerous is for an economy to allow excessive centralisms of fundamental market functions on just elucidations and ideas of few “wise individuals”. Friedman and Schwartz (1963) commented on this the following:       
“It was a defect of the financial system that it was susceptible to crises resolvable only with such leadership [of single individuals]. The existence of such a financial system [a centralize one] is, of course, the ultimate [and fundamental] explanation for the financial collapse, rather than the shift of power from New York to the other Federal Reserve Banks…”

It is worth mentioning that on neither of these monetary policy theoretical environments (under Strong or under the Real Bills Doctrine), the gold standard had a significant role to play (Timberlake, 2013), even if the gold standard was the official monetary system of the Unites States. Ever since 1913 the real monetary policies were being dictated capriciously by the Federal Reserve Board despite of the gold standard, thus the gold standard was de facto a faรงade, “[…] the movements of gold into and out of the United States no longer even approximately determined the economy’s stock of common money” (Timberlake, 2008). The stabilizing properties of the dynamic adjustment process of the gold standard were not able to work during the price stability policy led by Strong or during the Real Bills Doctrine after 1928. Thus the gold standard was neither capable of contracting credit in the boom years nor supplying credit at the times of depression; gold was therefore not the mechanism in which monetary policy was based upon. In other words: “If a gold standard is managed by a Treasury Department or a central bank, it is no longer a gold standard” (Timberlake, 2010). Under this perspective, the Great Depression is hardly the gold standard’s fault but rather the fault of discretionary expansions and contractions led by the Fed. As Leland Crabbe, a Board of Governors staff member, mentioned at the time: “because the gold reserve requirement [that the Fed possessed] rarely restrained policy between 1914 and 1933, the Federal Reserve had broad discretionary powers to manage the nation’s money supply in the advancement of domestic [nationalistic] objectives” (Selgin, 2013).

Thus ever since the establishment of the Federal Reserve System in 1914, the Fed started to evermore move towards a complete sense of management and control of money: “mortal men and not the market were controlling the monetary policy and while doing it, they imposed their biased beliefs and prejudices in front of the gold standard, rendering the gold standard superfluous” (Timberlake, 2010). (Although the gold reserves provided a mathematical limit concerning the Fed Banks capacity of expanding credit). This finally created a system in which the Fed, through their Fed banks, somewhat controlled the quantity of money. Immediately following Strong’s death, if the U.S. would have moved to a real Gold Standard by early 1929, then decentralize commercial banks would have had the control of their own gold reserves and they would have expanded credit at their individual discretion, counteracting the contraction (Timberlake, 2013). Instead the Real Bills Doctrine at the Fed, centralized the hoarding of gold reserves at the Fed banks and arbitrarily started to negate credit to sound banks on liquidity troubles, violating their own regulatory ethos stated in the Federal Reserve Act. This exacerbated the contraction in the direction of the Great Depression and opened the gates for radical intellectual and social changes in the United States. The nation then moved away from the gold standard and the Federal government enacted the foundations of Social Security; it is beyond doubt that the Great Depression changed our political, economic and philosophical framework forever as a nation and this alone is enough to justify the expression “money matters.” 

Figure 1:
Source: Wheelock, 1992

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  1. This characterization of the Fed's 1929-33 error vis-a-vis the real bills doctrine misrepresents what actually occurred, and moreover ignores the crucial consideration & distinction made in the very Richard H. Timberlake article cited here: It wasn't adherence to the real bills doctrine per se; rather, it was the ~departure~ from it that accounts for the over-contraction of M1.

    The Fed could have avoided its strongly contractionary monetary policy in the years after the stock market crash of 1929. The reason it did not do so was that it was guiding its policy by a dubious ~version~ of the real bills doctrine. While microeconomically benign for competitive commercial banks, the real bills doctrine has a "dark side" if improperly implemented macroeconomically by central bank policy as the Fed did. The Gold Standard morphed into a bogus one after WWI, as did the real bills doctrine: the latter was not allowed to operate after 1929 (in the face of no shortage of real bills eligible paper presented for rediscount), for the sake of quashing inflationary non-real bills-type loans that themselves ironically represented departures from the real bills doctrine. In other words, the real bills doctrine took the rap for the ~forsaking~ of the real bills doctrine during the speculative 1920s (and the Fed's shift of policy toward price stability); thus it actually was the Fed's 1929-33 ~halting~ of the real bills doctrine that ushered-in Hayek's "secondary deflation" (reducing the money supply even below that supporting the contracting economic activity)!

    The Federal Reserve’s Role in the Great Contraction and the Subprime Crisis by Richard H. Timberlake (PDF)

  2. Thank you for your comments George, however I disagree maybe I treated the RBD differently, you are right in the sense that it was a different RBD that caused the contraction because it was one that had originally departure away from the Gold Standard to control it. So the origial RBD didnt cause the contraction but the new RBD without following the gold standard did, nontheless it was the RBD model that people at the Fed followed. As Timberlake remarks in the paper you cited:

    "My own research during the last several years has convinced me that the “something” they were looking for was the Real Bills Doctrine (RBD), the banking theory on which the Fed was founded that was supposed to rule the operations of the Fed Banks (Mints 1945: 9, 30; Humphrey 1982: 4–6). Friedman and Schwartz (1963: 191–93) critically and properly discuss
    the RBD in several places, but only its positive dimension as an
    inadequate means for providing a stable monetary policy. They do
    not explicitly link that doctrine, especially its dark side, to Fed policy
    after 1928."

    "the RBD is fundamentally unsound as a policy norm. It is not parallel and equal to a working gold standard, but depends on the gold standard to establish and maintain the monetary equilibrium under which the RBD would
    function as prescribed."

    therefore when the Fed started to move away from the gold standard to make their monetary policies the RBD became a very dangerous model to make monetary policies. Moreover people that adhere to the RBD had a particular bias towards were to channel credit as Timberlake remarks:

    "The answer is that the RBD has a dark side. Proponents of the
    RBD usually emphasize its positive side as a guide for bank lending.
    However, many of them also unequivocally condemn long-term
    loans, mortgages, government bonds, and especially speculative
    loans that support real estate bubbles and stock market exuberances.
    Such loans, they argue, are unfit and dangerous as objects for commercial
    bank lending because they do not provide any real substance
    for the newly created bank money (Friedman and Schwartz 1963:
    191–92, 417 n. 178; Humphrey 2001: 302–9)."

    So in a way the people that followed the RBD was contracting credit arbitrarily according to their views of the market and credit which was imbedded in the framework of the RBD so it was after all the RBD that with the departure from the gold standard started the great contraction after all as Timberlake remarks in the paper: "While harmless as a policy for individual commercial bank operation, the RBD is fundamentally unsound as a policy norm. It is not parallel and equal to a working gold standard, but depends on the gold standard to establish and maintain the monetary equilibrium under which the RBD would function as prescribed."