The Roots of America’s Great Depression: Big Government and the Federal Reserve System

  • NOTE: This article was originally posted on my old blogsite on Dec. 9, 2010. 

In the vast realm of politics, the fight between good and evil is significantly represented by an epic duel between individualism and collectivism— between freedom and statism— between freedom of action and government control. For most part of human history collective good was always considered highly superior to individual freedom owing to the mystical notion that every individual exists merely to serve the good of many, or to serve the interest of society. Collective good or public good is one of the main justifications deftly employed by the statists in pushing for more interventionist government rules to control and regulate certain sectors of society or certain individual actions, which are deemed inimical to public interest or social welfare.

All man-made catastrophes and tragedies in the past centuries were primarily caused by man’s failure to think— or by the failure of the individual to use reason in order to guarantee his survival. The past more than 100 years saw the rise of collectivism and dictatorship in many countries across the world— from Soviet Russia to Germany to Imperial Japan to China and so on— because of the failure of the people to defend their individual freedom and rights against the poetic altruist-collectivist rhetoric of political demagogues who promised ‘heaven on earth.’ These collectivist countries showed or demonstrated how excessive or absolute government controls could ruin the individual, his freedom and rights, his life, and his future.

Despite a long list of historical facts and evidence confirming that state intervention or government controls led to the ultimate collapse of the ruthless, evil dictatorships of the past century, many people today— those who still have vestigial beliefs in the interventionist power of the state—clamor for more government powers to rule our lives. It is this unthinking herd who preach that monstrous, mediocre lie that laissez-faire capitalism or lack of government intervention caused many economic and social disasters over the past century. They observed the comfortable state of today’s businessmen who continue to create wealth and jobs for the unemployed, so they arrived at a mediocre conclusion that failure of government control and too much economic freedom were to blame for most of history’s economic turmoil. They saw the sorry fate of the jobless, the penniless, and the dying souls in depressed areas, so they concluded that the state must play a bigger role to guarantee social justice and equality for all. They were appalled at the widening income gap between the poor and the rich so they devised a plan to correct this atrocity and injustice: sacrifice the successful, the rich and the productive in the name of the common good or the greater good.

What these statists (composed of progressives, leftists, neo-liberals and altruists) failed to grasp is that all economic, political and social disasters were caused by government controls and intervention into the economy. From the centuries-reign of Egypt up to the barbaric rule of the Romans to the plundering empires of Europe, absolute state control caused the death of countless souls and the destruction of many nations and societies. It was only with the establishment of a new nation of law, not of men— the United States of America—that a revolutionary social-economic system was created to spread the virtue of individual and economic freedom throughout the world.

Big Government and the Federal Reserve System

However, one of the worse, if not the worst, creations of collectivist mentality in the United States, a nation which originated and ‘somehow’ applied the noble concept of free market capitalism, is the all-powerful Federal Reserve System created in 1913 with the enactment of the Federal Reserve Act. This statist creature from Jekyll Island was given the power to conduct the nation’s monetary policy, supervise and regulate banking institutions, maintain the stability of the financial system and provide financial services to depository institutions, the U.S. government, and foreign official institutions.[i]

Only a few years following its creation, the Federal Reserve, along with excessive government intervention into the American economy caused one of the most notorious economic disasters in the past century: the Great Depression.

However, it is important to understand that there are a number of theories that offer explanation of the Great Depression. The statists or advocates of government control claim that the Great Depression was brought about by too much economic freedom and the failure of the state to regulate the economy. Part of this statist axis is the Keynesian camp that argues that intervention was necessary to solve the depression.[ii] The Keynesian school of economics, pioneered by John Maynard Keynes, looks at the increasingly uneven distribution of income in the 1920s, which then resulted in increasing savings of the wealthy people, and these savings were then invested in the stock market and caused a resulting drop in consumer spending on housing and durable goods.[iii] Before 1929, the stock market was over-valued due to speculation pumped by a flurry of investments by affluent Americans and massive loans from banks.[iv] However, this stock market fanfare started to plummet in the fall of 1929, which caused public uproar and panic, as stock prices started to fall. This also led to a drastic cut in consumer spending and reduced investment. Keynesian economists believe that the Hoover administration, and later the Roosevelt administration, should have played a major role by pumping massive deficit financing and other fiscal policies into the economy.

The Austrian School, on the other hand, offers a different explanation for the cause of the Great Depression. Unlike the Keynesian economists, the Austrians argue that the Federal Reserve gets much of the blame, as they contend that this semi-private money-making entity caused the expansion of the money supply in the 1920s that resulted in an unsustainable credit-fueled boom.[v] According to the Austrian theory, the expansion of the money supply that forced an unsustainable boom in both capital goods and asset prices (e.i., stocks and bonds) caused the crisis. The Austrians explain that it was far too late for the Federal Reserve to tighten in 1928, as a massive economic contraction was already unpreventable. The belated intervention to save the economy from an inevitable collapse proved to be a big trouble prior to the depression, according to the Austrians.

Between these two clashing explanations of the Great Depression, I go for the Austrian theory.

There is a need to understand the nature, function, and power of the Federal Reserve in order to know how this semi-private agency played a major in changing America’s economic landscape prior to the depression. The Fed is undeniably the most influential and most powerful institution that characterizes absolute faith in the power of the state and its capability to serve collective good. One of the most dangerous powers of the Fed is to force a boom-and-bust monetary policy similar to what it did before the Great Depression hit millions of Americans in 1929 and beyond. Over its nearly 100 years of existence, the Fed has been so consistent with its dangerous policy of inundating the economy with worthless paper money that was/is severely affecting America’s middle class and the dollar currency holders across the globe.

The free-market economists offer the best explanation of the Great Depression because of the simple fact that they look at both economic and political realities. They clearly understand the impact of one government policy not only on one particular social sector, but on the society as a whole. In the case of the Fed, the free-market economists understand how this statist entity incompetently used and employed its powers to make boom-bust policy that led to recession or depression over the past few decades.

The Great Depression

The first phase of the depression was a period of boom and bust, wherein the government, with the help of the Federal Reserve, had forced a boom through pumping easy money and credit into the economy, which soon followed by the inevitable bust. Five years before the 1929 economic collapse, the Federal Reserve System under the administration of Pres. Calvin Coolidge embarked on reckless credit expansion.[vi] Following a steep decline in business, the Reserve banks in 1924 pumped additional US$500 million in new credit into the economy. This unprecedented move, which was designed to help the Bank of England in its willingness to preserve pre-war exchange rates, caused a bank credit expansion of more than US$4 billion in less than a year. The short-term impacts of this sudden expansion of the supply of money and credit appeared to be beneficial, forcing a desired economic boom and offsetting the 1924 economic decline, however, its long-term effect proved to be most disastrous on the whole economy of the United States. What forced the dreaded stock-market collapse in 1929 was the initiation of a monetary policy that hurt the country’s economy.

In 1927, the Federal Reserve upped the country’s inflation, which led to an increase in the total currency outside banks plus demand and time deposits from US$44.51 billion at the end of June 1924 to a disastrous US$55.17 billion in 1929.[vii] The victims of this bum-bust disaster were farmers and small business owners, as the size of urban and farm mortgages increased from US16.8 billion in 1921 to US$27.1 billion in 1929. Other sectors were also affected, such as financial, industrial, and even state and local governments. The artificial increase in the supply of money and credit was coupled with rapid increase in real-estate and stock prices, which gave wrong signals to investors. According to Standard & Poor’s common stock index, prices for industrial securities increases from 59.4 in June of 1922 to 195.2 in September of 1929. Also, public securities increased from 82.0 to 375.1, while railroad stock prices rose from 189.2 to 446.0.[viii]

There’s no tinge of doubt that it was the Federal Reserve’s expansion of the money and credit supply that made 1929 economic collapse inevitable. This is due to the fact that credit expansion and inflation always accelerates malinvestments and maladjustments that must later on be liquidated. The disastrous effect of this expansion was that it artificially cuts and fakes interest rates, thus sending wrong signals to businessmen and investors to make wrong investment decisions. These wrong signals lured investors to believe that lower interest rates suggest expanding supplies of capital savings, thereby encouraging them to embark on new investment projects. When the Federal Reserve pumped new money and credit into the country’s economy, this forced an artificial economic boom.

Following a failed attempt to stabilize the economy in 1928, the Federal Reserve decided to halt its disastrous easy-money policy and then sold government securities at the beginning of 1929.[ix] In August of the same year, the Fed then increased its discount rate to 6 percent.

In his article on the history of the Great DepressionHans F. Sennholz wrote: time-money rates rose to 8 percent, commercial paper rates to 6 percent, and call rates to the panic figures of 15 percent and 20 percent. The American economy was beginning to readjust. In June 1929, business activity began to recede. Commodity prices began their retreat in July.”[x]

He further states:

“The security market reached its high on September 19 and then, under the pressure of early selling, slowly began to decline. For five more weeks, the public nevertheless bought heavily on the way down. More than 100 million shares were traded at the New York Stock Exchange in September. Finally it dawned upon more and more stockholders that the trend had changed. Beginning with October 24, 1929, thousands stampeded to sell their holdings immediately and at any price. Avalanches of selling by the public swamped the ticker tape. Prices broke spectacularly.”[xi]

In his book Capitalism: A Treatise on Economics (p. 524), Economist George Reisman confirmed that there was sharp increase in money supply of World Wart I and an aggressive easy money policy on the part of the Federal Reserve System from June of 1921 to the end of 1925. He said that from June of 1921 to June of 1925, the increase in the money supply was more than 4.6 percent. To explain the rise in velocity in the 1920s, Reisman said there was a belief that the Federal Reserve “had the power to prevent depressions and achieve permanent prosperity. Despite the rapid increase in the money supply during the first four years, there was only 1.1 percent increase from June of 1925 to June of 1929.

Reisman said: “The disastrous monetary contraction of the period of 1929-1933 can be explained on the basis, first, of an undue increase in the quantity of money, coupled with the conviction that the Federal Reserve System would prevent any future depression. These factors reduced the demand for money and raised the velocity of money to levels that could not be sustained in the absence a continued rapid increase in the money supply that did not occur. When, as a result, the demand for money finally increase and velocity correspondingly fell, the effect was reduced spending, hence revenues and incomes, and thus a decreased ability to pay debts.”

This, Reisman correctly pointed out, led to the dreaded bank failures and an actual drop in the quantity of money, “as fiduciary media were wipe out under the fractional-reserve monetary system of the time.” He further said that the decrease in the quantity of money triggered a further drop in spending and, consequently, a further decline in incomes and revenues, and thus the ultimate inability to pay debt, which in turn led to more bank collapses and a bigger reduction in the quantity of money.

The Evil of Big Government

Instead of freeing the market, the Hoover administration resisted any significant readjustment. Highly influenced by the ‘new economics’ of state control or government planning, President Hoover asked businessmen and investors not to reduce wages and cut prices. He instead urged them to raise wages, capital expenditure, and other spending so to allegedly sustain purchasing power. Under the premise that the government must stimulate the economy, he then encouraged states and municipalities to increase their borrowing for more public works  and embarked on deficit spending. President Hoover also created the Farm Board in 1929, which allowed the federal government to maintain the prices of cotton, wheat, and other farm products.  Foreign imports, under the Hoover administration, were also curtailed.

Another proof that excessive government intervention caused the ‘real depression’ was when the Smoot-Hawley Tariff Act of June 1930 was implemented, which increased American tariffs to unprecedented levels. This statist act practically closed the American borders to affordable foreign goods, which would have benefited financially troubled Americans. American economists and historians claimed that the 1930s was the beginning of the ‘real depression’ and the crowning folly of the whole troubled period from 1920 to 1933.[xii][xiii][xiv]

According to American economist Benjamin Anderson[xv]:

“Once we raised our tariffs, an irresistible movement all over the world to raise tariffs and to erect other trade barriers, including quotas, began. Protectionism ran wild over the world. Markets were cut off. Trade lines were narrowed. Unemployment in the export industries all over the world grew with great rapidity. Farm prices in the United States dropped sharply through the whole of 1930, but the most rapid rate of decline came following the passage of the tariff bill.”

This proves that government interference in the form of tariffs and other protectionist policies led to the cutting off of markets, thereby causing economic disasters. Industrial stocks broke 20 points in just one day after President Hoover proclaimed that he would sign the protectionist bill into law. This means that the stock market correctly predicted the depression.

According to Sennholz[xvi], “the protectionists have never learned that curtailment of imports inevitably hampers exports.”

“Even if foreign countries do not immediately retaliate for trade restrictions injuring them, their foreign purchases are circumscribed by their ability to sell abroad. This is why the Smoot-Hawley Tariff Act which closed our borders to foreign products also closed foreign markets to our products. American exports fell from $5.5 billion in 1929 to $1.7 billion in 1932. American agriculture customarily had exported over 20 percent of its wheat, 55 percent of its cotton, 40 percent of its tobacco and lard, and many other products. When international trade and commerce were disrupted, American farming collapsed. In fact, the rapidly growing trade restrictions, including tariffs, quotas, foreign-exchange controls, and other devices were generating a worldwide depression. Agricultural commodity prices, which had been well above the 1926 base before the crisis, dropped to a low of 47 in the summer of 1932. Such prices as $2.50 a hundredweight for hogs, $3.28 for beef cattle, and 32¢ a bushel for wheat plunged hundreds of thousands of farmers into bankruptcy. Farm mortgages were foreclosed until various states passed moratoria laws, thus shifting the bankruptcy to countless creditors.”

There’s also a need to look at the important role of farmers during those years. American farmers borrowed money from the rural banks. When the whole agricultural sector was in great financial trouble, the banks closed their doors. According to economic historian Sennholz[xvii], “[s]ome 2,000 banks, with deposit liabilities of over $1.5 billion, suspended between August 1931, and February 1932. Those banks that remained open were forced to curtail their operations sharply. They liquidated customers’ loans on securities, contracted real-estate loans, pressed for the payment of old loans, and refused to make new ones. Finally, they dumped their most marketable bond holdings on an already depressed market. The panic that had engulfed American agriculture also gripped the banking system and its millions of customers.”

However, the year 1931 was largely regarded as a tragic period for the Americans. Not only did the United States of America fall into the claws of despair and depression, but the whole world as well. The Hoover administration was in great denial that its economic and political policies caused the depression , as it put the blame on American businessmen and speculators. This ‘culture of denial, still stays up to these days when it has already been proven that big government and Keynesian economics have failed. What President Hoover did was that the summoned the nation’s industrial leaders and asked to embrace his program to sustain wage rates and spread out construction.

The president then focused on federal public works and granted state subsidies to ship construction. He also adopted a failed program to benefit the financially troubled farmers. A number of federal agencies adopted price-stabilization policies that produced larger crops and surpluses, which in turn slowed down the prices of products even further. Instead of fixing the economy, the economic programs of President Hoover disastrously failed, as economic conditions in the United States went from bad to worse, and joblessness in 1934 averaged 12.4 million.[xviii] In 1932 unemployment averaged 36.3 percent for non-farm workers, while Hoover estimated that unemployment totaled 12.4 million and 19 million were on relief in July 1932.[xix]

The role of Inflation

Since many people today believe that the alleged cause of America’s Great Depression was deflation, there is a need to explain the inflation of the money supply by the Federal Reserve from 1921 to 1929. With respect to this particular issue, there is a need to understand that there were two influential forces at work on prices in the 1920s: the unprecedented growth in productivity which lowered prices and costs and the monetary inflation which drove prices upward. In an economic perspective, increased productivity means more supply of goods and lower prices and costs. However, this economic scenario is equalized by the monetary inflation. Such an artificially stabilized situation appeared or appears desirable to many, but if analyzed closely, it prevents the gains and benefits of a higher standard of living from being spread as extensively as it would have been in a capitalist economy, and it triggers the boom and depression of the business cycle.

It is widely known that the economic boom of the 1920s started about July of 1921— following more than a year of quick recession— and expired around July of 1929, a period wherein business activity and production began to decline. It is also generally acknowledged that the historic stock market crash hit in October of the same year. Government data show that on July 30, 1921, the total money supply in the United States was US$45.3 billion. From 1921 to 1929, the country’s money supply swelled by US$28 billion, a 61.8 percent increase over the eight-year period. This means that there was an average annual increase of 7.7 percent, which suggests a very substantial level of inflation. In terms of total bank deposit there was an increase of 51.1 percent, while savings and loan shares increased by 224.3 percent. On the other hand, net life insurance policy increased by 113.8 percent. These unprecedented increases occurred during the following periods— 1922-1923, late 1924, late 1925, and late 1927. However, a sudden bust took place in the first half of 1929, when banks deposits began to deteriorate and the overall supply of money remained almost steady.

Economist Murray Rothbard[xx] wrote:

“ To generate the business cycle, inflation must take place via loans to business, and the 1920s fit the specifications. No expansion took place in currency in circulation, which totaled $3.68 billion at the beginning, and $3.64 billion at the end, of the period. The entire monetary expansion took place in money-substitutes, which are products of credit expansion. Only a negligible amount of this expansion resulted from purchases of government securities: the vast bulk represented private loans and investments. (An “investment” in a corporate security is, economically, just as much a loan to business as the more short-term credits labeled “loans” in bank statements.) U.S. government securities held by banks rose from $4.33 billion to $5.50 billion over the period, while total government securities held by life insurance companies actually fell from $1.39 to $1.36 billion. The loans of savings-and-loan associations are almost all in private real estate, and not in government obligations. Thus, only $1 billion of the new money was not cycle-generating, and represented investments in government securities; almost all of this negligible increase occurred in the early years, 1921-1923.”

Rothbard argued that inflation does not pertain to increase in total money supply— “it is the increase in money supply not consisting in, i.e., not covered by, an increase in gold, the standard commodity money.” Rothbard observed that the increase in total gold in Federal and Treasury reserves was only US$1.16 billion from 1921 to 1929, negating the popular claim that the monetary expansion was merely the natural effect of an increased supply of gold in America.[xxi]

Cause of inflation

What caused the 63 percent inflation of America’s money supply during the 1920? Economic data and facts point to two factors— bank deposits and other monetary credit, as the amount of currency in circulation during the eight-year period was not increasing at all. According to Rothbard, the most crucial component in the total money supply is the commercial bank credit base. There are three factors that were responsible for the unprecedented increase in commercial bank credit. Since banks were mandated by law to maintain a minimum percentage of reserves in their deposits, these possible factors are the following: 1) a lowering in reserve requirements; 2) an increase in total reserves, and 3) a using up of reserves that were previously over the minimum legal requirement.

Rothbard argued that the lowering of reserve requirements created excess reserves, which caused multiple bank credit inflation.[xxii]

Rothbard wrote:

“During the 1920s, however, member bank reserve requirements were fixed by statute as follows: 13 percent (reserves to demand deposits) at Central Reserve City Banks (those in New York City and Chicago); 10 percent at Reserve City banks; and 7 percent at Country banks. Time deposits at member banks only required a reserve of 3 percent, regardless of the category of bank. These ratios did not change at all. However, reserve requirements need not only change in the minimum ratios; any shifts in deposits from one category to another are important. Thus, if there were any great shift in deposits from New York to country banks, the lower reserve requirements in rural areas would permit a considerable net overall inflation. In short, a shift in money from one type of bank to another or from demand to time deposits or vice versa changes the effective aggregate reserve requirements in the economy. We must therefore investigate possible changes in effective reserve requirements during the 1920s. Within the class of member bank demand deposits, the important categories, for legal reasons, are geographical. A shift from country to New York and Chicago banks raises effective reserve requirements and limits monetary expansion; the opposite shift lowers requirements and promotes inflation. Table 3 presents the total member bank demand deposits in the various areas in June, 1921, and in June, 1929, and the percentage which each area bore to total demand deposits at each date.”[xxiii]

It is important to note the significant expansion of demand and time deposits during the 1920s. For instance, demand deposits comprised 51.3 percent of the total deposits in 1921, but the figure dropped to 44.5 percent by 1929. This increase indicated a significant lowering of the mandatory reserve requirements for banks— a 10 percent reserve backing was required for demand deposits, while only 3 percent reserve backing for time deposits. This significant shift from demand to time deposits was a crucial element in allowing the monetary inflation of the 1920s. This is clearly evidenced by the fact that demand deposits swelled by 30.8 percent from 1921 to 1929, while time deposits expanded by no less than 72.3 percent.

During that historic period time deposits comprised deposits at commercial banks, which were engaged in the supply of demand deposits, and at mutual savings banks, which kept only time deposits. The main factor in the shift from demand to time deposits were the commercial banks that increased the quantity of their time deposits by 79.8 percent during the eight-year period.

It should be noted that the unprecedented expansion of time deposits was not unintentional. Prior to the creation of the Federal Reserve System, American banks were not legally allowed to pay interest on time deposits. Banks were also required to maintain the same minimum reserve against time deposits as against demand deposits. However, with the establishment of the Federal Reserve System, national banks were then permitted to pay interest on time deposits. Apart from cutting the required reserve ratio by half, the Federal Reserve Act also cut required reserves against time deposits to roughly 5 percent and to 3 percent in 1917. This Federal Reserve-imposed scheme highly encouraged banks to do their best to shift from demand deposit to time deposit category.

Below shows the increases over the period in the various categories[xxiv]:

  • Savings Banks 61.8%
  • Commercial Banks 79.8%
  • Member Banks 107.9%
  • Country Banks 78.9%
  • Reserve City Banks 128.6%
  • Central Reserve City Banks 450.0%

The data above show that the most active categories of time deposits were specifically the ones that expanded the most in the 1920s. However, the most active of them all— the Central Reserve City accounts—swelled by 450 percent.

Rothbard also identified two factors that may cause bank inflation: a change in total bank reserve at the Federal Reserve Bank and a shift in effective reserve requirements.

The period of 1921 to 1925 saw a greater monetary expansion compared to the period of 1926 to 1929. During the first half of the eight-year period, the total contribution of the member bank to the total money supply expanded by US$6.9 billion, or 37.1 percent, but only increased by US$3.9 billion, or 15.3 percent, in the second half.

Rothbard correctly observed:

“Evidently, the expansion in the first four years was financed exclusively out of total reserves, since the reserve ratio remained roughly stable at about 11.5 : 1. Total reserves expanded by 35.6 percent from 1921 to 1925, and member bank deposits rose by 37.1 percent. In the later four years, reserves expanded by only 8.7 percent, while deposits rose by 15.3 percent. This discrepancy was made up by an increase in the reserve ratio from 11.7 : 1 to 12.5 : 1, so that each dollar of reserve carried more dollars in deposits. We may judge how important shifts in reserve requirements were over the period by multiplying the final reserve figure, $2.36 billion, by 11.6, the original ratio of deposits to reserves. The result is $27.4 billion. Thus, of the $29.4 billion in member bank deposits in June, 1929, $27.4 billion may be accounted for by total reserves, while the remaining $2 billion may be explained by the shift in reserves. In short, a shift in reserves accounts for $2 billion out of the $10.8 billion increase, or 18.5 percent. The remaining 81.5 percent of the inflation was due to the increase in total reserves.”[xxv]

This means that the main factor in causing the inflation of the 1920s was the expansion of total bank reserves, as this caused the unprecedented  increase of the member banks and of the non-member banks, which maintained their reserves as deposits with the member banks. The 62 percent increase in the total money supply (from US$45.3 billion to US$73.3 billion) was primarily due to the 47.5 percent expansion in total reserves (from US$1.6 billion to US$2.36 billion). Rothbard argued that a mere US$760 million expansion in reserves was so powerful due to the nature of a state-controlled banking system. “It could roughly generate a $28 billion increase in the money supply,” Rothbard pointed out.

Periods of the Depression

What generated the expansion in total reserves? In answering this question, Rothbard listed down ten factors of increase and decrease of bank reserves.[xxvi]

  1. Monetary Gold Stock. This is, actually, the only uncontrolled factor of increase—an increase in this factor increases total reserves to the same extent. When someone deposits gold in a commercial bank (as he could freely do in the 1920s), the bank deposits it at the Federal Reserve Bank and adds to its reserves there by that amount. While some gold inflows and outflows were domestic, the vast bulk were foreign transactions. A decrease in monetary gold stock causes an equivalent decrease in bank reserves. Its behavior is uncontrolled—decided by the public—although in the long run, Federal policies influence its movement.
  2. Federal Reserve Assets Purchased. This is the preeminent controlled factor of increase and is wholly under the control of the Federal Reserve authorities. Whenever the Federal Reserve purchases an asset, whatever that asset may be, it can purchase either from the banks or from the public. If it purchases the asset from a (member) bank, it buys the asset and, in exchange, grants the bank an increase in its reserve. Reserves have clearly increased to the same extent as Federal Reserve assets. If, on the other hand, the Federal Reserve buys the asset from a member of the public, it gives a check on itself to the individual seller. The individual takes the check and deposits it with his bank, thus giving his bank an increase in reserves equivalent to the increase in Reserve assets. (If the seller decides to take currency instead of deposits, then this factor is exactly offset by an increase in money in circulation outside the banks—a factor of decrease.)
  3. Bills Discounted by the Federal Reserve. These bills are not purchased, but represent loans to the member banks. They are rediscounted bills, and advances to banks on their IOUs. Clearly a factor of increase, they are not as welcome to banks as are other ways of increasing reserves, because they must be repaid to the System; yet, while they remain outstanding, they provide reserves as effectively as any other type of asset. Bills Discounted, in fact, can be loaned precisely and rapidly to those banks that are in distress, and are therefore a powerful and effective means of shoring up banks in trouble. Writers generally classify Bills Discounted as uncontrolled, because the Federal Reserve always stands ready to lend to banks on their eligible assets as collateral, and will lend almost unlimited amounts at a given rate. It is true, of course, that the Federal Reserve fixes this rediscount rate, and at a lower rate when stimulating bank borrowing, but this is often held to be the only way that the System can control this factor. But the Federal Reserve Act does not compel, it only authorizes, the Federal Reserve to lend to member banks. If the authorities want to exercise an inflationary role as “lender of last resort” to banks in trouble, it chooses to do so by itself. If it wanted, it could simply refuse to lend to banks at any time. Any expansion of Bills Discounted, then, must be attributed to the will of the Federal Reserve authorities.
  4. Other Federal Reserve Credit. This is largely “float,” or checks on banks remaining temporarily uncollected by the Federal Reserve. This is an interest-free form of lending to banks and is therefore a factor of increase wholly controlled by the Federal Reserve. Its importance was negligible in the 1920s.
  5. Money in Circulation Outside the Banks. This is the main factor of decrease—an increase in this item decreases total reserves to the same extent. This is the total currency in the hands of the public and is determined wholly by the relative place people wish to accord paper money as against bank deposits. It is therefore an uncontrolled factor, decided by the public.
  6. Treasury Currency Outstanding. Any increase in Treasury currency outstanding is deposited with the Federal Reserve in the Treasury’s deposit account. As it is spent on government expenditures, the money tends to flow back into commercial bank reserves. Treasury currency is therefore a factor of increase, and is controlled by the Treasury (or by Federal statute). Its most important element is silver certificates backed 100 percent by silver bullion and silver dollars.
  7. Treasury Cash Holdings. Any increase in Treasury cash holdings represents a shift from bank reserves, while a decline in Treasury cash is spent in the economy and tends to increase reserves. It is therefore a factor of decrease and is controlled by the Treasury.
  8. Treasury Deposits at the Federal Reserve. This factor is very similar to Treasury cash holdings; an increase in deposits at the Reserve represents a shift from bank reserves, while a decrease means that more money is added to the economy and swells bank reserves. This is, therefore, a factor of decrease controlled by the Treasury.
  9. Non-member Bank Deposits at the Federal Reserve. This factor acts very similarly to Treasury deposits at the Federal Reserve. An increase in non-member bank deposits lowers member bank reserves, for they represent shifts from member banks to these other accounts. A decline will increase member bank reserves. These deposits are mainly made by non-member banks, and by foreign governments and banks. They are a factor of decrease, but uncontrolled by the government.

10.  Unexpended Capital Funds of the Federal Reserve. They are capital funds of the Federal Reserve not yet expended in assets (largely bank premises and expenses of operation). This capital is drawn from commercial banks, and, therefore, if unexpended, is a withdrawal of reserves. This is almost always a negligible item; it is clearly under the control of the Federal Reserve authorities.

Factors of Increase

Monetary Gold Stock……………………………………………uncontrolled
Federal Reserve Assets Purchased………………………………controlled
Bills Bought
U.S. Government Securities
New Bills Discounted……………………………………………….controlled
Other Federal Reserve Credit……………………………………controlled
Treasury Currency Outstanding…………………………………controlled
Factors of Decrease
Outside Money in Circulation………………………………..uncontrolled
Treasury Cash Holdings……………………………………………controlled
Treasury Deposits at the Federal Reserve……………………controlled
Unexpended Capital Funds of the Federal Reserve……..controlled
Non-member Bank Deposits at the Federal Reserve…….uncontrolled
Bills Repaid……………………………………………….uncontrolled

In analyzing what really caused the Great Depression and what happened in the 1920s, Rothbard divided the eight-year period into 12 stages.[xxvii]

Period I (June 1921-July 1922): The main inflationary factor was not the heavy gold inflow, but the banks paying off their loans at such a rapid rate that uncontrolled factors fell by US$303 million. Instead of remaining passive, the government pumped in US$462 million of new reserves, making a net increase of US$157 million.

Period II (July 1922-December 1922): This period saw a speedy acceleration of the inflation of reserves. “Increasing at an average rate of $12 million per month in Period I, reserves now increased at a rate of $35 million per month. Once again, uncontrolled factors declined by $295 million, but they were more than offset by increases in controlled reserves pumped into the economy. These consisted of Bills Discounted ($212 million), Bills Bought ($132 million), and Treasury Currency ($93 million).”

Periods III and IV (December 1922-June 1924): This period saw the inflation come roughly to a halt. Reserves actually fell slightly (by $4 million per month) in Period III (December 1922-October 1923), and rose only slightly (by $6 million per month) in Period IV. Simultaneously, bank deposits remained about level, member bank demand deposits staying at about $13.5 billion. Total deposits and total money supply, however, rose more in this period, with banks shifting to time deposits to permit increases. (Demand deposits rose by $450 million from June 1923 to June 1924, but time deposits rose by $1.5 billion). Total money supply rose by $3 billion. The economy responded to the slowdown of inflation by entering upon a mild minor recession, from May 1923 to July 1924.

The slight fall in reserves during Period III was brought about by selling U.S. Government Securities (-$344 million) and reducing the amount of bills held (-$67 million). This, indeed, was a positive decline, more than offsetting uncontrolled factors, which had increased by $132 million. The decline in reserves would have been even more effective, if the Federal Reserve had not increased its discounts ($266 million) and Treasury currency had not increased ($47 million).

Period IV (October 1923-June 1924), however, began to repeat the pattern of Period I and resume the march of inflation. Uncontrolled factors this time fell by $149 million, but they were more than offset by a controlled increase of $198 million, led by the heavy purchase of government securities ($339 million)—the heaviest average monthly buying spree yet seen in the 1920s ($42.4 million).

Period V was the most rapid reserve inflation to date, overreaching the previous peak of late 1922. Reserves increased by $39.8 million per month. Once again, the inflation was deliberate, uncontrolled factors declining by $262 million, but offset by a deliberate increase of $461 million. The critical factors of inflation were Bills Bought ($277 million) and U.S. Securities ($153 million).

The pace of inflation was greatly slowed in the next three periods, but continued nevertheless. From December 31, 1924 to June 30, 1927, reserves increased by $750 million; demand deposits adjusted, of all banks, rose by $1.1 billion. But time deposits rose by $4.3 billion during the same period, underscoring the banks’ ability to induce customers to shift from demand to time deposits, while savings-and-loan shares and life-insurance reserves rose by another $4.3 billion. In 1926, there was a decided slowing down of the rate of inflation of the money supply, and this led to another mild economic recession during 1926 and 1927.

In Period VI (November 1924-November 1925), a tendency of uncontrolled reserves to decline was again more than offset by an increase in controlled reserves; these were Bills Discounted ($446 million) and Bills Bought ($45 million).

Period VII (November 1925-October 1926) was the first time after Period III that uncontrolled factors acted to increase reserves. But, in contrast, this time, the Federal Reserve failed to offset these factors sufficiently, although the degree of inflation was very slight (only $2.4 million per month).

In Period VIII (October 1926-July 1927), the degree of inflation was still small, but, ominously, the Federal Reserve stoked the fires of inflation rather than checked them; controlled factors increased, as did the uncontrolled. The culprits this time were the U.S. Government’s Securities ($91 million) and Other Credit ($30 million).

Period IX (July 1927-December 1927), was another period of accelerated and heavy inflation, surpassing the previous peaks of latter 1922 and 1924. The per-monthly reserve increase in latter 1927 was $42.0 million. Once again, uncontrolled factors declined, but were more than offset by a very large increase in controlled reserves, emanating from Bills Bought ($220 million), U.S. Government Securities ($225 million), and Bills Discounted ($140 million).

Period X was the sharpest deflationary period (in reserves) in the 1920s. Uncontrolled factors rose, but were more than offset by a controlled decrease. Bills Discounted rose ($409 million), but the deflationary lead, was taken by U.S. Government Securities (-$402 million) and Bills Bought (-$230 million). The decline of over $200 million in reserves generated a decline of about $600 million in member bank demand deposits. Time deposits rose by over $1 billion, however, and life-insurance reserves by $550 million, so that the total money supply rose substantially, by $1.5 billion, from the end of 1927 to mid-1928.

With the boom now well advanced in years, and developing momentum, it was imperative for the Fed to accelerate its deflationary pressure, if a great depression was to be avoided. The deflation of reserves in the first half of 1928, as we have seen, was not even sufficient to offset the shift to time deposits and the other factors increasing the money supply. Yet, disastrously, the Fed resumed its inflationary course in latter 1928. In Period XI, a tendency of uncontrolled reserves to decrease, was offset by a positive and deliberate increase ($364 million of controlled reserves, against -$122 million of uncontrolled). The culprit in this program was Bills Bought, which increased by $327 million, while all the other reserve assets were only increasing slightly. Of all the periods of the 1920s, Period XI saw the sharpest average monthly rise in Bills Bought ($65.4 million).

In the final Period XII, the tide, at last, definitely and sharply turned. Uncontrolled factors increased by $390 million, but were offset by no less than a $423 million decrease in controlled reserves, consisting almost wholly of a reduction of $407 million in Bills Bought. Total reserves fell by $33 million. Member bank demand deposits, which also reached a peak in December, 1928, fell by about $180 million. Total demand deposits fell by $540 million.

Free Market vs. Big Government

It is utterly wrong to place the blame on the free market for the cause and effects of the Great Depression. Yet there are those who dogmatically believed that more government intervention was needed to avoid the Great Depression. These are the kind of people who are out to destroy great nations on earth today. The evil spirit of the pre-Depression era still abounds today: the spirit of progressivism and big government.

The first quarter of the 20th century saw the rise of the progressives mostly composed of the educated elites who favored government regulation and big government over free market capitalism. As result, a number of progressive or statist laws were established from 1890 to 1920, such as the Interstate Commerce Act enacted in 1887 that regulated railroads, the Sherman Antitrust Act enacted in 1890, a law that prevents large firms from controlling a single industry, and the Federal Reserve Act of 1913 implemented during the term of President Woodrow Wilson. Also in 1913, the Sixteenth Amendment was ratified, which led to the institution of income tax in the United States.

President Wilson, who bitterly regretted his role in creating the Federal Reserve System, wrote:

I am a most unhappy man. I have unwittingly ruined my country. A great industrial nation is controlled by its system of credit. Our system of credit is concentrated. The growth of the nation, therefore, and all our activities are in the hands of a few men. We have come to be one of the worst ruled, one of the most completely controlled and dominated Governments in the civilized world — no longer a Government by free opinion, no longer a Government by conviction and the vote of the majority, but a Government by the opinion and duress of a small group of dominant men.

The ultimate cause of the Great Depression was nurtured in the hearts and minds of the American people. No society of civilized people would like to experience the painful effects of any depression. But the people, through their passivity or expressed support, voted for the very government policies that made the great tragedy unavoidable— progressive labor laws, inflation and credit expansion, higher taxes and state policies that legitimized the redistribution of wealth.

In his speech at the U.S. Congress in 2002, Republican Rep. Ron Paul[xxviii] called for the abolition of the Federal Reserve.

Ron Paul states[xxix]:

Since the creation of the Federal Reserve, middle and working-class Americans have been victimized by a boom-and-bust monetary policy. In addition, most Americans have suffered a steadily eroding purchasing power because of the Federal Reserve’s inflationary policies. This represents a real, if hidden, tax imposed on the American people.

From the Great Depression, to the stagflation of the seventies, to the burst of the dotcom bubble last year, every economic downturn suffered by the country over the last 80 years can be traced to Federal Reserve policy. The Fed has followed a consistent policy of flooding the economy with easy money, leading to a misallocation of resources and an artificial “boom” followed by a recession or depression when the Fed-created bubble bursts.

With a stable currency, American exporters will no longer be held hostage to an erratic monetary policy. Stabilizing the currency will also give Americans new incentives to save as they will no longer have to fear inflation eroding their savings. Those members concerned about increasing America’s exports or the low rate of savings should be enthusiastic supporters of this legislation.

Though the Federal Reserve policy harms the average American, it benefits those in a position to take advantage of the cycles in monetary policy. The main beneficiaries are those who receive access to artificially inflated money and/or credit before the inflationary effects of the policy impact the entire economy. Federal Reserve policies also benefit big spending politicians who use the inflated currency created by the Fed to hide the true costs of the welfare-warfare state. It is time for Congress to put the interests of the American people ahead of the special interests and their own appetite for big government.

Abolishing the Federal Reserve will allow Congress to reassert its constitutional authority over monetary policy. The United States Constitution grants to Congress the authority to coin money and regulate the value of the currency. The Constitution does not give Congress the authority to delegate control over monetary policy to a central bank. Furthermore, the Constitution certainly does not empower the federal government to erode the American standard of living via an inflationary monetary policy.



[i] Federal Reserve (n.d.) Mission [online] available from <> [accessed 06 December 2010]

[ii] Folsom, W.D. & Boulware (2004) Encyclopedia of American Business. Infobase Publishing, p. 271. Developed in the 930s during the height of the Great Depression, Keynesian economists supported government intervention into the market place during periods of insufficient private-sector demand.

[iii] Perelman, M. (1996) The End of Economics. London: Routledge, p. 151.

[iv] Tomkins, M. (2008) The Great Depression Compared to the Current Financial Crisis [online] available from [accessed 06 December 2010]

[v] Clark, B.S. (1998) Political Economy: A Comparative Approach. Maryland: Greenwood Publishing, p. 134.

[vi] Sisung, K.S. (1999) Federal Agency Profiles for Students. GALE.

[vii] Sennholz, H.F. (1975) The Great Depression [online] available from [accessed 9 Dec. 2010]

[viii] Ibid

[ix] Ibid

[x] Harding, J. (2009) The Great Depression: A Short History [online] available from[accessed 06 December 2010]

[xi] Ibid

[xii] Sennholz, H.F. (1979) Age of Inflation. Western Islands. The Smoot-Hawley Tariff Act of June 1930 raised tariffs to unprecedented levels, which practically closed our borders to foreign goods. This was the crowning folly of the whole depression period from 1920 to 1933 and the beginning of the real depression.

[xiii] Mises, L.V & Hayek, F.A. (1971) Toward Liberty: Essays in Honor of Ludwig von Mises on the Occasion of his 90th Birthday, September 29, 1971. Volume 2. Institute for Humane Studies.

[xiv] Patterson, R.T. (1965) The Great Boom and Panic, 1921-1929. H. Regnery Co. “The third phase of the depression went from autumn, 1932, to early March, 1933. During 1930 the market continued on its  Smoot Tariff Bill of June, 1930, was the crowning financial folly of the whole period from 1920 to 1933.

[xv] Anderson, B.M. (19769) Economics and the Public Welfare: A Financial and Economics History of the United States, 1914-1946. Liberty Press.

[xvi] Sennholz, H.F. (2009, June 25) The Great Depression [online] available from <> [accessed 9 Dec. 2010]

[xvii] Sennholz, H.F. (1988)

[xviii] Kindleberger, C.P. (1986) The World in Depression, 1929-1939. California: University of California Press.

[xix] Wigmore, B.A. (1985) The Crash and its Aftermath: A History of Securities Markets in the United States. Maryland: Greenwood Publishing.

[xx] Rothbard, M. (2000) America’s Great Depression. Ludwig von Mises Institute.

[xxi] Ibid

[xxii] Ibid

[xxiii] Ibid

[xxiv] Ibid

[xxv] Ibid

[xxvi] Ibid

[xxvii] Ibid

[xxviii] Paul, R. (2007) Paul Introduces H.R. 2755 to Abolish the Federal Reserve [online] available from [accessed 9 Dec. 2010]

[xxix] Ibid


Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s