The years between 1929-1933 represented the most severe downturn in economic affairs in modern world history. Output declined at a markedly fast rate during this period and has been referred to as the “Great Contraction” and the “gloomy years”. Life was certainly gloomy, in the United States during these years. The downward spiral of the price level and shockingly high unemployment rate were unrelenting. The yearly intervals of 1929-1930, 1930-1931, 1931-1932, and 1932-1933 saw real income decline by 11 percent, 9 percent, 18 percent, and 3 percent respectively, or in totally of the four years by 36 percent. This depression was the first true test of the United States’ lender of last resort and central bank, the Federal Reserve System. Friedman and Schwartz place great blame on the Federal Reserve System for not stopping or at least mitigating the collapse of the monetary system.
During the late 1920’s, the United States’ stock market was experiencing at what could best be called a speculative fervor. The rapid increase in stock market prices led to increases in bank loans made to brokers, and it was here where conservative economists of the time claimed that credit was going to more speculative ventures than productive ones. This led to calls from the conservatives for Federal Reserve to tighten its monetary policy to curb the speculation, but their opponents argued that if the easy-money policies adhered to for most of the decade were curtailed then business would be hurt and the gold standard threatened in Europe. Bernanke also notes that commodity prices were declining, there was little to no inflation, and the economy had just recently escaped the trough of the last recession in November 1927; this is not a scenario where we would normally expect to see a central bank or lender of last resort to embark on a policy of monetary tightening.
The Federal Reserve acquiesced to the wishes of conservatives and in the first six months of 1928 the rediscount rate was increased from 3.5 percent to 5 percent. The amount of government securities held by the Federal Reserve also declined from $617 million to $235 million. A further increase in the rediscount rate was made to 6 percent in August of 1929. August of 1929 is also regarded as the cyclical peak before the onset of the United States most severe prolonged economic decline. Two short months later, the famous stock market crash of 1929 occurred, and for the next 12 months production, wholesale prices, and personal income fell at rates of 27 percent, 13.5 percent, and 17 percent, respectively. Since there was underlying deterioration of economic fundamentals before the rediscount rate was raised, the Federal Reserve decision to tighten cannot be held as a primal catalyst for the beginning of the contraction. However, the tightening certainly contributed at least partly to the crash in the stock market, which, in turn, increased the severity of the contraction.
After the occurrence of...