Friedman and Schwartz ’ s Monetary Explanation of the Great Depression : Old Challenges and New Evidence

For many, Friedman and Schwartz’s Monetary History of the United States (1963) is synonymous with the notion that monetary contraction and errors by the Federal Reserve caused the Great Depression. Though that is one of the book’s conclusions, this quick summary both sells the book short in important ways and oversells its findings about the 1930s. The crucial way it sells the book short is that the contributions of the Monetary History extend far beyond the Depression. Friedman and Schwartz use an extensive reading of the historical record over nearly a century to identify times when the money supply moved for reasons unrelated to current or prospective macroeconomic conditions. That output moved in the same direction as money following these “crucial experiments” remains some of the strongest evidence we have that monetary shocks have real effects. At the same time, saying that the book proves that monetary shocks caused the Great Depression is a stretch. Of the monetary shocks Friedman and Schwartz identify, those for the early years of the Depression are arguably the most tenuous. And crucially, the book provides scant discussion about the mechanism by which monetary shocks affected the economy. This weakness is most pressing in the discussion of the Depression. Because nominal interest rates fell precipitously early in the Depression and remained low throughout, it is hard to appeal to the standard transmission mechanism operating through the nominal cost of credit. Yet Friedman and Schwartz provide little guidance as to how they believe monetary contraction nonetheless led to deep output declines in this period. This paper seeks to fill in the gap in the Friedman and Schwartz explanation of the Depression by investigating this missing transmission mechanism. In Section I, we discuss the challenge to Friedman and Schwartz’s explanation provided by the anomalous behavior of nominal interest rates. Previous work has shown that expectations of deflation can explain how falling nominal interest rates could be consistent with a high real cost of borrowing. But we argue that the monetary explanation requires not just that there were expectations of deflation, but that those expectations were the result of monetary contraction. Because previous work has been largely silent on this issue, we are left without evidence about a necessary link from monetary shocks to the Depression. In Section II, we analyze one component of the business press in detail to see if there was a link between monetary shocks and expectations of deflation in the central years of the downturn—1930 and 1931. We find evidence that these professional observers did indeed expect deflation in substantial part because of Federal Reserve behavior and monetary contraction. This suggests that monetary shocks in the Depression may have affected output and employment by raising real interest rates.