Milton Friedman, Monetarism, and the Great and Little Depressions

Brad Delong has a nice little piece bashing Milton Friedman, an activity that, within reasonable limits, I consider altogether commendable and like to engage in myself from time to time (see here, here, here, here, here , here, here, here, here and here). Citing Barry Eichengreen’s recent book Hall of Mirrors, Delong tries to lay the blame for our long-lasting Little Depression (aka Great Recession) on Milton Friedman and his disciples whose purely monetary explanation for the Great Depression caused the rest of us to neglect or ignore the work of Keynes and Minsky and their followers in explaining the Great Depression.

According to Eichengreen, the Great Depression and the Great Recession are related. The inadequate response to our current troubles can be traced to the triumph of the monetarist disciples of Milton Friedman over their Keynesian and Minskyite peers in describing the history of the Great Depression.

In A Monetary History of the United States, published in 1963, Friedman and Anna Jacobson Schwartz famously argued that the Great Depression was due solely and completely to the failure of the US Federal Reserve to expand the country’s monetary base and thereby keep the economy on a path of stable growth. Had there been no decline in the money stock, their argument goes, there would have been no Great Depression.

This interpretation makes a certain kind of sense, but it relies on a critical assumption. Friedman and Schwartz’s prescription would have worked only if interest rates and what economists call the “velocity of money” – the rate at which money changes hands – were largely independent of one another.

What is more likely, however, is that the drop in interest rates resulting from the interventions needed to expand the country’s supply of money would have put a brake on the velocity of money, undermining the proposed cure. In that case, ending the Great Depression would have also required the fiscal expansion called for by John Maynard Keynes and the supportive credit-market policies prescribed by Hyman Minsky.

I’m sorry, but I find this criticism of Friedman and his followers just a bit annoying. Why? Well, there are a number of reasons, but I will focus on one: it perpetuates the myth that a purely monetary explanation of the Great Depression originated with Friedman.

Why is it a myth? Because it wasn’t Friedman who first propounded a purely monetary theory of the Great Depression. Nor did the few precursors, like Clark Warburton, that Friedman ever acknowledged. Ralph Hawtrey and Gustav Cassel did — 10 years before the start of the Great Depression in 1919, when they independently warned that going back on the gold standard at the post-World War I price level (in terms of gold) — about twice the pre-War price level — would cause a disastrous deflation unless the world’s monetary authorities took concerted action to reduce the international monetary demand for gold as countries went back on the gold standard to a level consistent with the elevated post-War price level. The Genoa Monetary Conference of 1922, inspired by the work of Hawtrey and Cassel, resulted in an agreement (unfortunately voluntary and non-binding) that, as countries returned to the gold standard, they would neither reintroduce gold coinage nor keep their monetary reserves in the form of physical gold, but instead would hold reserves in dollar or (once the gold convertibility of sterling was restored) pound-denominated assets. (Ron Batchelder and I have a paper discussing the work of Hawtrey and Casssel on the Great Depression; Doug Irwin has a paper discussing Cassel.)

After the short, but fierce, deflation of 1920-21 (see here and here), when the US (about the only country in the world then on the gold standard) led the world in reducing the price level by about a third, but still about two-thirds higher than the pre-War price level, the Genoa system worked moderately well until 1928 when the Bank of France, totally defying the Genoa Agreement, launched its insane policy of converting its monetary reserves into physical gold. As long as the US was prepared to accommodate the insane French gold-lust by permitting a sufficient efflux of gold from its own immense holdings, the Genoa system continued to function. But in late 1928 and 1929, the Fed, responding to domestic fears about a possible stock-market bubble, kept raising interest rates to levels not seen since the deflationary disaster of 1920-21. And sure enough, a 6.5% discount rate (just shy of the calamitous 7% rate set in 1920) reversed the flow of gold out of the US, and soon the US was accumulating gold almost as rapidly as the insane Bank of France was.

This was exactly the scenario against which Hawtrey and Cassel had been warning since 1919. They saw it happening, and watched in horror while their warnings were disregarded as virtually the whole world plunged blindly into a deflationary abyss. Keynes had some inkling of what was going on – he was an old friend and admirer of Hawtrey and had considerable regard for Cassel – but, for reasons I don’t really understand, Keynes was intent on explaining the downturn in terms of his own evolving theoretical vision of how the economy works, even though just about everything that was happening had already been foreseen by Hawtrey and Cassel.

More than a quarter of a century after the fact, and after the Keynesian Revolution in macroeconomics was well established, along came Friedman, woefully ignorant of pre-Keynesian monetary theory, but determined to show that the Keynesian explanation for the Great Depression was wrong and unnecessary. So Friedman came up with his own explanation of the Great Depression that did not even begin until December 1930 when the Fed allowed the Bank of United States to fail, triggering, in Friedman’s telling, a wave of bank failures that caused the US money supply to decline by a third by 1933. Rather than see the Great Depression as a global phenomenon caused by a massive increase in the world’s monetary demand for gold, Friedman portrayed it as a largely domestic phenomenon, though somehow linked to contemporaneous downturns elsewhere, for which the primary explanation was the Fed’s passivity in the face of contagious bank failures. Friedman, mistaking the epiphenomenon for the phenomenon itself, ignorantly disregarded the monetary theory of the Great Depression that had already been worked out by Hawtrey and Cassel and substituted in its place a simplistic, dumbed-down version of the quantity theory. So Friedman reinvented the wheel, but did a really miserable job of it.

A. C. Pigou, Alfred Marshall’s student and successor at Cambridge, was a brilliant and prolific economic theorist in his own right. In his modesty and reverence for his teacher, Pigou was given to say “It’s all in Marshall.” When it comes to explaining the Great Depression, one might say as well “it’s all in Hawtrey.”

So I agree that Delong is totally justified in criticizing Friedman and his followers for giving such a silly explanation of the Great Depression, as if it were, for all intents and purposes, made in the US, and as if the Great Depression didn’t really start until 1931. But the problem with Friedman is not, as Delong suggests, that he distracted us from the superior insights of Keynes and Minsky into the causes of the Great Depression. The problem is that Friedman botched the monetary theory, even though the monetary theory had already been worked out for him if only he had bothered to read it. But Friedman’s interest in the history of monetary theory did not extend very far, if at all, beyond an overrated book by his teacher Lloyd Mints A History of Banking Theory.

As for whether fiscal expansion called for by Keynes was necessary to end the Great Depression, we do know that the key factor explaining recovery from the Great Depression was leaving the gold standard. And the most important example of the importance of leaving the gold standard is the remarkable explosion of output in the US beginning in April 1933 (surely before expansionary fiscal policy could take effect) following the suspension of the gold standard by FDR and an effective 40% devaluation of the dollar in terms of gold. Between April and July 1933, industrial production in the US increased by 70%, stock prices nearly doubled, employment rose by 25%, while wholesale prices rose by 14%. All that is directly attributable to FDR’s decision to take the US off gold, and devalue the dollar (see here). Unfortunately, in July 1933, FDR snatched defeat from the jaws of victory (or depression from the jaws of recovery) by starting the National Recovery Administration, whose stated goal was (OMG!) to raise prices by cartelizing industries and restricting output, while imposing a 30% increase in nominal wages. That was enough to bring the recovery to a virtual standstill, prolonging the Great Depression for years.

I don’t say that the fiscal expansion under FDR had no stimulative effect in the Great Depression or that the fiscal expansion under Obama in the Little Depression had no stimulative effect, but you can’t prove that monetary policy is useless just by reminding us that Friedman liked to assume (as if it were a fact) that the demand for money is highly insensitive to changes in the rate of interest. The difference between the rapid recovery from the Great Depression when countries left the gold standard and the weak recovery from the Little Depression is that leaving the gold standard had an immediate effect on price-level expectations, while monetary expansion during the Little Depression was undertaken with explicit assurances by the monetary authorities that the 2% inflation target – in the upper direction, at any rate — was, and would forever more remain, sacred and inviolable.

24 Responses to “Milton Friedman, Monetarism, and the Great and Little Depressions”

  1. 1 dajeeps March 31, 2015 at 4:19 pm

    This post is outstanding, probably the only post I’ve ever read that ties all of the pieces of what happened to cause the Great Depression together in a succinct, digestible package. Thank you for writing it and sharing it with us all!

  2. 2 maynardGkeynes March 31, 2015 at 7:42 pm

    @ dajeeps: I’ll sleep a little better tonight knowing that the causes of the Great Depression are now fully understood.

  3. 3 markcrawfndp March 31, 2015 at 7:48 pm

    I especially liked this post having just read The Holy Grail of Macroeconomics by RIchard Koo. He argues that when demand for funds is shrinking fast , whether gold is coming in or going out of the country is largely irrelevant, because that is not where the constraint lies. “The Fed’s passivity in the face of contagious bank failures” was not the key problem, so monetary easing was not the key solution.

  4. 4 Lorenzo from Oz March 31, 2015 at 8:59 pm

    I put Richard Koo and Steven Keen in the same boat–followers of Irving Fisher’s Debt-Deflation theory who don’t understand the Deflation part.

  5. 5 Lorenzo from Oz March 31, 2015 at 9:05 pm

    Central bankers caused the Great Depression, Central bankers caused the Great Recession: how you went in either primarily depended on how badly your central bank screwed up (in the case of the former, clung to the gold standard) and how soon it came to its senses (in the case of the former, left the gold standard).

    Hence contemporary outcomes range from Australia (RBA) and Israel (BoI)–hardly noticed–to Eurozone (ECB: thorough and continuing train wreck). With Canada (BoC) close to the RBA/BoI end and the US (Fed) starting at the ECB end but got somewhat better. (A very low benchmark, admittedly.)

  6. 6 François Godard March 31, 2015 at 11:54 pm

    A Platonic experience: thanks for taking me out of the monetarist cave.The two contradictory forces — stimulating devaluation and depressing production regulation — were equally at work during the 1936-37 French Front Populaire government.

  7. 8 JKH April 1, 2015 at 3:10 am

    I guess 2 % is the new gold standard.

  8. 9 Nick Rowe April 1, 2015 at 5:11 am

    You are convincing me David. Global phenomena need a global explanation. (Notice how in the recent recession Americans also tend to look a bit too much for a US-only explanation?)

  9. 10 dan April 1, 2015 at 6:30 am

    This statement of fact caught my eye as it seemed at odds with the usual story:
    “Unfortunately, in July 1933, FDR snatched defeat from the jaws of victory (or depression from the jaws of recovery) by starting the National Recovery Administration, whose stated goal was (OMG!) to raise prices by cartelizing industries and restricting output, while imposing a 30% increase in nominal wages. That was enough to bring the recovery to a virtual standstill, prolonging the Great Depression for years.”

    The data I have always seen show both inflation and real gdp increasing in each year from 1934 through 1937. I relied on this website for the data:
    http://www.measuringworth ‘dot’ com/datasets/usgdp/result.php

    What do you mean when you state that the recovery was brought to a virtual standstill presumably following July 1933, and prior to 1938 when gdp and inflation both turned negative. (I am assuming you share the common explanation for the 1938 slowdown?)

    Thank you,

  10. 11 David Glasner April 1, 2015 at 9:29 am

    dajeeps, Thanks, glad you found it helpful.

    Lorenzo, Nicely put.

    Francois, I normally don’t think of myself as a Platonist but I appreciate the compliment anyway.

    Marcus and JKH, It’s not that bad, but still.

    Nick, Always feel better when I know that you’re on my side.

    Dan, In my haste, I was a bit sloppy. I meant that the brief explosion of output from April to July 1933 was stopped. The recovery did resume in 1934 thanks to further dollar devaluation and in 1935 the Supreme Court mercifully declared the NRA to be unconstitutional thereby adding some supply side stimulus to the recovery. But if there had been no NRA, the recovery might have been largely complete by 1936 or 1937.

  11. 13 csissoko April 1, 2015 at 10:27 am

    Since this seems to be your bailiwick, I have a question. It’s always been my personal theory that the worst banking failures of the Depression were related to England leaving the gold standard in 1931 (which of course had a severe adverse balance sheet effect on anyone holding sterling-denominated assets), while the U.S. stayed on the gold standard until 1933. Do you have any thoughts on how this event played into the U.S. experience of the Depression?

  12. 14 joemac April 1, 2015 at 10:33 am


    But what about banking crises and financial crises in general? The west has experienced them periodically since the 1700s. Are you saying that banking/financial crises are always monetary in nature?

    For example, was the banking crisis in the fall of 2008 causes by monetary forces?

    P.S. Perhaps you might consider at some point reviewing “Hall of Mirrors”?

    P.P.S. What is your opinion of the Minsky’s theories?

  13. 15 Miguel Navascués April 1, 2015 at 11:24 am

    Thanks very much, David, for that exercise of clarity and knowledge. Nonetheless, I’m quite surprised by the last paragraph: is really the fault of “2%” the relentless of recovery? I don’t know, really. I yet see a hole in monetary theory. In any case, I agree with Delong: the velocity is not independent of interest rate. An I doubt that “2%” explains that.

  14. 16 David Glasner April 1, 2015 at 12:03 pm

    Marcus, Thanks for the link.I actually think that there are certain benefits from slow growth. Rapid growth is disruptive, and disruption can be upsetting. For a nice and relatively happy community, change and disruption can cause more problems than they solve. Not obvious that there couldn’t be slow growth and full employment.

    csissoko, The Bank of Unites States failure preceded England’s departure from gold by about 9 months. The latter event certainly caused financial distress in countries still on the gold standard, but I’m not sure that it was the most important factor in causing subsequent bank failures. Certainly the 1933 crisis was largely the result fears that FDR would take the US off of gold. Going off gold was the right policy, but the expectation that it would happen was itself destabilizing.

    joemac, No I am not saying that they are always monetary, but monetary factors are a very important cause, usually operating in combination with specific banking and financial problems that increase the vulnerability of the banking system.

    Good idea, but I’m not promising.

    Minsky was a very insightful guy who is certainly worth reading. My friend June Flanders just published an essay about him in the January edition of Econ Journal Watch, which is very much worth reading. Here’s a link:

    Miguel, I agree with Delong about velocity, too. But with higher inflation, velocity would not have gone down as much as it did.

  15. 17 JP Koning April 1, 2015 at 12:28 pm

    “Rather than see the Great Depression as a global phenomenon caused by a massive increase in the world’s monetary demand for gold, Friedman portrayed it as a largely domestic phenomenon”


    Funny, this reminds me of Ben Bernanke’s recent criticism of Larry Summer’s secular stagnation thesis — its shortcoming it that it is a domestic theory, not an international one.

  16. 18 Frank Restly April 1, 2015 at 8:29 pm


    “Ralph Hawtrey and Gustav Cassel did — 10 years before the start of the Great Depression in 1919, when they independently warned that going back on the gold standard at the post-World War I price level (in terms of gold)”

    What insights into the world supply (both mined and unmined) of gold did Hawtrey and Gustav have?

    The last major gold rush on the American continent was the Porcupine Rush from 1909-1911, though the Mount Baker (Washington state) lasted from 1897 thru to the 1920’s. Would going back to the gold standard have been a big deal if major discoveries of gold continued for the next 40, 50, 100 years even in the face of deflation?

    Personal preference, but I think Fisher’s debt deflation analysis of the Great Depression makes more sense in that it relies on the certainty of debts coming due, rather than the uncertainty of additional supplies of gold being discovered.

  17. 19 dan April 2, 2015 at 2:57 pm

    So what would Hawtrey and Cassel recommend today, right now?
    Would they basically be arguing for Nominal GDP targeting?

    And if so, do you happen to know if Sumner admires Hawtrey and Cassel?

  18. 20 dan April 2, 2015 at 3:01 pm

    Oh, I just found that Sumner recommends Hawtrey and Cassel in the FAQ section of his blog that answers the Q, what books do you recommend:

    21. What books should I read?

    I think someone interested in money should start with the classics. Irving Fisher’s “The Purchasing Power of Money” or “The Money Illusion.” Or Fisher’s 1925 article on the Phillips Curve… Hawtrey and Cassel are also good. Keynes’s “Tract on Monetary Reform” is his best monetary book.

  19. 21 peterschaeffer April 5, 2015 at 7:58 am

    Mr. Glasner,

    This is a great post. However, you have your industrial production numbers a bit off. The actual numbers don’t refute your thesis (at all), but you should use them. See for the raw data. The industrial production index for April 1933 was 4.053. The index for July was 5.9586. That’s a change of 47%.

    The big picture story is that industrial production (the index) rose from 3.7845 in March 1933 to 8.2938 in July of 1937 (above the 1929 peak of 7.9180). At that point the numbers declined in the second downturn until WWII sent them soaring.

  1. 1 TheMoneyIllusion » Brad DeLong needs to reread the Monetary History Trackback on April 1, 2015 at 3:29 pm
  2. 2 Brad, Ben (Beckworth?) and Bob | The Market Monetarist Trackback on April 2, 2015 at 12:28 pm
  3. 3 10 Good Friday Reads | The Big Picture Trackback on April 3, 2015 at 4:00 am

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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