During the 1930s, almost no one believed that the Fed caused the Great Depression. After a pathbreaking study of Milton Friedman and Anna Schwartz, published in 1963, the economics profession gradually changed its view. By 2002, even a top Fed official like Ben Bernanke conceded to Friedman:

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.

Now Paul Krugman is contesting this view, in a new column in the NYT:

Friedman’s claim that monetary policy caused the Depression was central to his whole argument that governments, not the private sector, are responsible for economic instability, that depressions are caused by governments, not the private sector. . . .

And during the Depression, the monetary base didn’t shrink as the economy cratered — it actually grew, a lot:

Friedman and Krugman don’t disagree about the basic data for the monetary base, or the broader aggregates such as M1 and M2.  Rather they disagree with how to interpret that data.  I disagree slightly with Friedman’s views, but much more strongly with Krugman’s views.  Here’s what actually happened, using the monetary base as a policy metric:

1. In 1929 the Fed tried to institute a tight money policy, in order to restrain the stock market boom.  At first they failed.  But in the fall of 1929, they raised their target rate to 6%, an astoundingly high level for an economy experiencing zero inflation.  The monetary base immediately began declining, falling by over 7% between October 1929 and October 1930.  By that time, industrial production had already fallen more than 27% below its July 1929 peak.  The economy was now in a deep depression.  Contrary to popular imagination, there was no financial crisis during the first year of the Great Depression—it was 100% tight money.

2. Krugman’s comment about the monetary base refers to the period after October 1930.  A mild banking crisis began in November 1930, and then much more severe crises in 1931, 1932 and early 1933.  This caused a large increase in currency hoarding by the public, as there was no deposit insurance at that time.  This is where Krugman’s interpretation differs from Friedman (and me).  The Fed was created primarily to supply adequate liquidity in times of banking distress.  Before it was created, the banking industry had ways of dealing with financial crises that were certainly not optimal, but crudely effective.  JP Morgan famously helped to quickly end the 1907 crisis, for instance.  After responsibility for this duty was given to the Fed, it failed miserably.  The financial crisis of the early 1930s was far worse than anything that came before the Fed was created.  Although the Fed did inject some extra liquidity—increasing the monetary base—it was far too little to be effective.  Friedman and Schwartz also note that the Fed also took counterproductive steps such as dramatically raising interest rates (by 200 basis points) at the worst possible time—in the fall of 1931.  So it wasn’t all “errors of omission”.

[As an aside, the real problem in the US was unit-banking regulations, which explains was less heavily regulated Canada avoided banking crises.  But that’s another topic.]

There is no doubt in my mind that the Great Contraction of 1929-33, when NGDP fell roughly in half, was caused by tight money.  The Great Depression tells us absolutely nothing about the supposed “inherent instability of capitalism”, whatever that meaningless expression is supposed to mean.  (Unstable under what monetary regime?)  Nonetheless, I do have some reservations with Friedman’s interpretation.  The Great Depression was global, and while the Fed’s role was very important (and destructive), so was that of the Bank of France, which hoarded large quantities of gold. 

But the mistakes of the Bank of France would have had far less impact if it were not for the Fed’s tragically misguided tight money policy of 1929.  It was that policy that indirectly set in motion a series of events (US bank panics, German debt crisis, UK leaving gold), which explain much of the massive French gold hoarding.  Later in his life, Friedman conceded that he should have paid more attention to the role of the Bank of France (and other gold bloc members such as Switzerland, Belgium, Netherlands, etc.)

There is an uncanny similarity between the causes of the Great Depression, and the causes of the far milder Great Recession of 2008-09.  As with the depression of the 1930s, the recession that began in December 2007 was triggered by a tight money policy that cased the growth rate of the monetary base to slow sharply.  As in the 1930s, roughly a year into the 2008 recession a severe banking crisis caused a big increase in base money demand.  As in the 1930s, the Fed partially accommodated that increased demand, but not fully.  As in the 1930s, the Fed instituted a foolish policy that increased the demand for base money (higher reserve requirements in 1936-37, IOR in 2008.)  As in the 1930s, there were bond-buying programs, and as in the 1930s the program was made much less effective by communication that led the public to see it as temporary policy that would not lead to higher inflation.

I don’t mean to suggest the mistakes in 2008 were anywhere near as bad as in the 1930s; indeed the Fed also did much better than the ECB during the Great Recession.  But the mistakes were similar in nature, despite being much less severe.

You can dismiss my critique of the Fed as the raving of a monetary crank.  I don’t care.  All I care about is that the Fed seemed to quietly accept much of the market monetarist critique, and in 2020 did what we said they should have done back in 2008—commit to quickly returning prices and/or NGDP back to the previous trend line.  And it worked—NGDP is right back on trend and jobs are easy to find, unlike in the early 2010s.  (Maybe they overshot a bit, but at least they avoided a long period of a weak job market.)