No, that’s not a typo. In October 1929 the discount rate was 6%, and by October 1930 the discount rate was 2.5%. So how can I say the Fed raised rates? Because interest rates are the price of credit, determined in the market for credit. And free market forces depressed the interest rate even more sharply than the 3.5% drop that actually occurred. Thus in a sense the Fed had to raise rates with a tight money policy, in order to prevent them from being much lower than 2.5% in October 1930.
Of course the discount rate is actually a non-market rate set by the Fed. But market rates such as T-bill yields fell by a similar amount in 1930.
A commenter of the Austrian persuasion recently argued that the Fed made a mistake by driving rates so low during the Great Contraction, and that if they hadn’t done so, market forces would have weeded out the weaker and less efficient firms, laying the groundwork for a more sustainable recovery (I hope I got that right John.)
But his entire argument is based on a misconception, that the Fed adopted an easy money policy in 1930. In fact, the Fed did just the opposite. In October 1929 the monetary base was $7.345 billion, and by October 1930 it was $6.817 billion. That’s a drop of over 7%, one of the largest declines in the 20th century. And the monetary base is the type of money directly controlled by the Fed. When people talk about the government “printing money” they are generally referring to the monetary base. So by that definition money was very tight. If money was not tight in October 1930, then the low credit demand of the Great Depression would have meant even lower interest rates; perhaps the 1% we saw in 2003, which prevented another Great Depression.
Now for a curve ball. So far I’ve assumed the Great Depression just happened for mysterious reasons, and that the Fed responded with tight money, thus preventing interest rates from falling as far as market forces would have taken them (assuming a stable monetary base.)
But why did the Depression happen in the first place? It’s very likely that the Fed’s decision to reduce the monetary base by 7% was a major cause of the sharp contraction of 1929-30 (after October 1930 the base rose, as the Fed partially accommodated higher currency demand during the bank panics.) So if tight money caused the Depression, why did rates fall? First we need to recall that monetary policy affects rates in various ways:
- Liquidity effect; tight money raises rates
- Income effect; tight money reduces RGDP, investment, credit demand, and real interest rates
- Inflation effect; tight money reduces expected inflation and thus nominal interest rates
Note that the effect everyone focuses on (the liquidity effect) is actually the outlier, and is also a very short term effect. Indeed I’ve seen the “long run” effects overwhelm the short run liquidity effect in a period less than three months! Thus most of the movements in interest rates that we observe are not the Fed moving rates around via easy and tight money (as most people assume) but rather the market forces moving rates around.
Indeed 1929 is a great example. The Fed only had raised rates to 6% for about three months in 1929, after which the economy started plunging so fast that the interest rates began falling sharply, even without any “easing,” without any increase in the monetary base.
Obviously all this has important implications for how 90% of our profession (and I’m being generous) badly misinterpreted the stance of monetary policy in 2008.
One final point. I used the monetary base as the benchmark of policy, of the Fed “doing nothing.” But of course a modern inflation targeting or dual mandate central bank is not instructed to target the monetary base or interest rates; they are instructed to produce stable macroeconomic conditions. Under this regime, the only sensible way of thinking about whether money is easy or tight is relative to the goals of the central banks. But that standard, monetary policy was disastrously tight in 2008-09.
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