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Table of Contents

A Look Into the Monetary Policies During the Great Recession and the Great Depression - Part 6


3.3 Rothbard

Rothbard (2000) analyzed the events during the Great Depression using the Austrian theory of business cycle. This theory and its implications gave a new perspective on what really led to the Great Depression. The central theme of his argument is that the wrong policy of the central bank led to an unusual growth in the 1920’s, thereby laying the ground work for the crash of economy at the end of the decade. Rothbard reasserted the Austrian theory of economic boom and bust while studying about the causes of the Great Depression. Though this theory of boom and bust applies to all economic downturns, Rothbard has not given much specifics on why the Great Depression was so severe when compared to others.

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Despite this lack of detailed explained, Rothbard contributed to the development of macroeconomic thought by contrasting the causes with competing views on the interwar events. Rothbard stated that low interest rates caused a mismatch between the production plans and the underlying consumption preferences, and this contrast was evident in the preference for people to save. Many investment projects stimulated by low interest rates were not completed because of falling consumer spending. Huge resources were committed to the early production stage while few resources were left for the late production stage across any industries. Therefore, the boom appeared to be artificial, and he believed that it was this artificial nature of the boom that eventually led to its bust. He argued that if growth was backed by a strong economy, then the fall would not have occurred.

Rothbard further stated that the Federal Reserve should have deflated the dollar instead of boosting it during the early 1930’s. He believed this move was one of the mistakes of the Fed, and his opinion is akin to the opinions expressed by other Austrian economists on the same subject. In fact, Rothbard believed that the effects would linger longer than the Fed expected, and he even linked it with the technology bubble burst of early 2000s by predicting it way before. Though he died in 1995, his work was used as the basis by many economists such as Skousen and Tucker. To this end, Skousen's books, namely, “The Structure of Production” published in 1990 and “Economics on Trial” published in 1991 bring out interesting revelations about the economy. Furthermore, Skousen wrote several books such as “The Power of Economic Thinking” in 2002 and “EconoPower: How a Generation of Economists is Transforming the World” in 2008. In  the former book, he talks about capitalism and how ecoomics can be used to solve many of the problems facing the society while in his latter book, he explains the seven core principles that is driving economics worldwide today.As for Tucker, his book titled “Bourbon for Breakfast: Livig Outside the Statist Quo” talks about how the state has intervened in everyday life and he provides insight into how to change this. In this book, he makes references to how the state has impacted the society for the last two decades.

In 1929, when the stock market crashed, the Federal Reserve responded with inflating the money supply. In the beginning of 2000’s, the Federal Reserve cut the rate of federal funds and the discount rate to help the economy grapple with the Dot com burst. Furthermore, in the 1930’s, President Hoover’s administration responded to the economic downturn with a tough interventionist policy that included implementing bankruptcy reforms favoring debtors, implementing bank holidays to stop bank failures, implementing public programs targeting reduction of unemployment, forming government enterprises to reduce the number of foreclosures, pouring money into the U.S. financial system, stopping short-selling, and working with the largest enterprises attempting to keep wages and prices stable. Similar to the monetary policy implemented in 1930’s, in 2007-2008, President Bush dumped money into the financial system aiming to provide credit market liquidity. Also, Bush’s administration increased FDIC guarantee of depositors’ accounts, passed a bailout to financial institutions, seized control of AIG, Fannie Mae, and Freddie Mac. In addition, a huge economic stimulus package was passed by the Obama administration, ownership interest was taken in large banks, the homeowners were proposed a direct aid, and the short-selling of financial stocks was blocked.

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Rothbard stated that such government intervention in the form of increased government spending was the wrong approach to mitigate the effects of any recession because money inflows into government increased, but added little economic value. At the same time, the money could have been directed to support industrial production, which could have generated jobs. Furthermore, he argued that the government should have used an opposite approach – to cut spending and to reduce load on the taxpayers. According to Rothbard, a monetary policy of the Federal Reserve implemented at the end of 1920’s contributed to the growth of unsustainable global economic activity that was the main reason for the Great Depression. This comparison and its explanation brings up the question of whether the Fed or the government should intervene at all during a future economic downturn.

3.4 Friedman

Friedman and Schwartz (2008) discussed the role of the monetary policy from the Civil War to the middle of 1920’s, and they state that the monetary policy played an active role in the Great Depression. The authors argue that bank failures and currency withdrawals caused reduction of money supply thus exacerbating economic contraction. Friedman and Schwartz (2008) further criticized the policy of the Federal Reserve Bank for its failure to keep the money flow steady because they believe that the failure of commercial banks deepened the economic depression. Contrary to Rothbard, Friedman and Schwartz (2008) outlined several policy mistakes made by the Federal Reserve that led to decline in the money supply conditions within the economy. According to them, the Federal Reserve started to tighten monetary policy in the second quarter of 1928 that resulted in increased interest rates. The Federal Reserve continued this policy till the third quarter of 1929, thus triggering the stock market crash. Later on, in 1931, the Federal Reserve started to raise interest rates to defend the national currency in response to speculations on currency. However, these measures caused significant difficulties to commercial banks.

In the beginning of 1932, the Federal Reserve lowered interest rates that brought positive results. However, interest rates were raised once again in the late 1932 causing further contraction of the U.S. economy. According to Friedman and Schwartz (2008), the worst mistake of the Federal Reserve was the way in which they neglected these problems that plagued the commercial banking sector in the early 1930’s. In this sense, the Federal Reserve had failed to provide a stable environment for the banking sector by not acting as a lender of last resort. The Fed failed to lend money to some institutions because they did not meet the collateral requirements, and this, Friedman believes was a crucial mistake.

Friedman and Schwartz (2008) further argued that an excessively tight monetary policy turned a normal recession into the Great Depression. Contrary to popular opinion, they believe that consumer and investor confidence caused by the crash of Wall Street stock exchange was the primary reason of the Great Depression.

The book of Friedman and Schwartz (2008) Monetary History of the United States, 1867-1960 was acknowledged as one of the most influential books on this topic. However, the book is often used by monetarists to justify using the monetary policies as the economic stabilizer. In fact, monetarist views became more popular after Keynesian stabilizers failed to normalize the stagnation of 1970’s, and when the government intervention in regulating economy became extremely unpopular after the crises that occurred in 1980’s and 1990’s. In the 1980’s and 1990’s the Federal Reserve was seen as an important institution that set interest rates to stop excessive inflationary processes and to prevent deflationary situations that lead to economic distresses. In general, Friedman and Schwartz (2008) explained the need for money supply in understanding the fluctuations of the U.S. economy in 1930’s. Contrary to Smiley (2013) , Friedman and Schwartz (2008) paid little attention to the previous boom and credit expansion that artificially lowered interest rates, thus causing misallocation of resources. They argued that the constant level of prices was taken as economic health, while misallocation of resources would require further reallocation and liquidation.

Nelson (2007) summarized these views of Milton Friedman who wrote extensively about the U.S. monetary policy developed after 1960. The work he presented both criticized and supported Friedman’s view on the role of monetary policy in the stabilization of financial crises. Also, Nelson (2007) analyzed changes in Friedman’s view on monetary practice caused by the changing economic environment. The effects of monetary policy on regulation of the financial crises that took place in the U.S. were analyzed and evaluated. The analysis of Friedman’s views showed that he laid the framework for a rule of fixed money growth in the future.

3.5 Hetzel

Hetzel's work threw more light on the causes of the Great Recession. Though the public consensus was that the Great Recession was caused by greedy “Wall Street” bankers who took large risks with investors' money, the truth is that the deregulation of the banking system was the true culprit. Hetzel argued that the repeal of the Glass-Steagall Act in 1999 gave commercial banks the opportunity to get into investment banking. This idea of combining commercial with investment banking, and that too without any kind of regulation, was criminal as it gave banks a free hand to do whatever they wanted.. With this argument, Hetzel put the blame for the Great Recession solely on the banking policy of the country.

At the same time, he does not believe that bankers were virtuous people either. He argues that the different banks and its management who created complex financial products were in some ways, responsible for the financial collapse too. . “He argues that the ability of bankers to hold concentrated portfolios of risky assets, funded largely by short-term deposits, was a result of the widespread public perception that large banks, and not even very large banks, were the beneficiaries of the government's explicit and implicit safety net” (Brash, 2012, p.2)

Therefore, he advocates for a stronger regulation than before that would keep banks on their toes, and policies that would truly protect the money of the public. He ends his argument by saying, that a “steadily expanding financial safety net, even combined with heavy regulation, has increased financial instability. There is a need for more regulation of the risk-taking of banks, but that regulation should come from the market discipline imposed through severe limitation of the financial safety net, especially elimination of [too big to fail]” (Hetzel, 2012, p.150).

Furthermore, Hetzel attributes that monetary policies of the government is the single biggest cause of the Great Recession. Though the housing bubble burst in 2007, it could have just led to a mild recession that would have affected only a small segment of the country like the Dot-com burst of 2000.

When the housing bubble popped in 2006, the Fed raised its rate from five to 5.25 percent because of the fear of inflation. Therefore, the Fed ignored clear signs of distress in the mortgage market, and instead focused on inflation. Higher interest rates will reduce consumer spending, and the overall demand for goods will go down. While this move would have curbed inflation under normal circumstances, it was unwarranted at this time for two reasons. Firstly, inflation was 3.99 percent in 2006, which was not alarming by itself. This inflation was fueled by the rise in oil prices to some extent, but it was not too high. Secondly, the Fed failed to see the downside of this interest hike on businesses. Since these rates were high, the demand began to drop and this timed perfectly with the housing bubble burst and the beginning of the Great Depression. Hence, this rise in rate hastened unemployment which was a serious issue.

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Later, in the summer of 2008, the Fed cuts its rate to near zero levels because the primary reason for the cut was to increase investment and consumption. However, at that time, the economy was well into a recession, and there was little incentive to invest or consume more. Therefore, reducing the interest rates was done too late by the Fed.

Hetzel blames not only the US Fed for the worldwide recession, but also the central banks of other countries for the combined monetary policy that brought the entire world economy down. This trend was evident when the core CPI inflation as well as the overall GDP fell in most industrialized nations in North America, Europe and Japan. Based on all these data and theories, Hetzel concluded that faulty monetary policy led to the Great Recession. Therefore, he advocates that these policies should be drafted after keeping in mind both the macroeconomic and micro-economic factors such as inflation, real output and declining NGDP, in order to prevent such economic catastrophes in the future.

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