Remembering 'The Forgotten Man'

Reason, April, 2008 by Bettina Bien Greaves

Amity Shlaes says in her interview ("Remembering 'The Forgotten Man,'" January) a lot that should be said. But she also says some things that shouldn't be said, especially about the Federal Reserve. Shlaes adopts Milton Friedman's thesis that the Fed failed in its duty by contracting the quantity of money between 1929 and 1932. She cites Irving Fisher, whom she admires, as saying, "There must be more money!"

True, there was a shortage of money after the collapse of the stock market in 1929. But the contraction had such a catastrophic effect because of the previous expansion.

The Fed was established in 1913 in the hope of avoiding crises due to a shortage of funds such as banks and their clearinghouses had encountered periodically. The Fed was to create a "flexible" money supply to satisfy the "needs of business" and to serve as the lender of last resort to banks in crisis. Thus its very purpose was inflationary. It fostered "easy money" by making loans available at relatively low interest rates. The new easy money lured businessmen to undertake enterprises they would not have considered profitable at market interest rates. Business boomed. The stock market flourished. If there had been no boom, there would have been no monetary contraction. Thus, the Fed's responsibility for the depression started with the preceding boom.

It is true that the 1929-1932 monetary contractions precipitated the crash and the depression that followed. But the contractions were only the spark that ignited the depression; the kindling had been gathered in the preceding boom. Friedman and Anna Schwartz's massive history of money, today's acknowledged authority on the theory that the quantity of money matters, apparently accepted the Keynesian explanation, at least in part, attributing the stock market crash of October 1929 to a "speculative investment bubble," the cause of which, they say, was "a somewhat controversial topic." But the cause of that "bubble," the seeds of the crisis, were inherent in the very principles on which the Fed was founded. The fact that each crisis, with its unpleasant consequences, is followed once more by a new boom, which must eventually expend itself as another crisis, is due only to the ideology--dominant among political economists, politicians, statesmen, the press, and the business world--that not only sanctions but demands the expansion of circulation credit.

Once the Fed started trying to create a "flexible" money supply, it found itself between a rock and a hard place. Of course its founders didn't then realize this. But the Fed faced a dilemma: to expand and to keep on expanding the quantity of money would lead to a catastrophic boom and runaway inflation. But if and when it stopped expanding, it would cause an economic crisis. Friedman apparently recognized this point later, although as far as I know he gave no indication that he realized the problem was inherent in the very principle on which the Fed was based. But then he was an inflationist; he believed an economy can prosper only when the money supply is constantly and steadily increased to keep abreast of increases in production and population.

Bettina Bien Greaves

Hickory, NC