Table of Contents

A Look Into the Monetary Policies During the Great Recession and the Great Depression - Part 8

367 Sterilization Policy

The First World War changed the face of gold standard as countries began to devalue their currencies to meet their debt obligations. The US, on the other hand, accumulated high levels of gold reserve during the First World War. It took advantage of gold outflows from other countries to increase its own inflow. This increased inflow of gold in turn, increased bank reserves and the overall money supply within the economy. Though the inflows stopped when the US entered the war, the amount of money remained within banks and the US economy. When the war ended, a good amount of gold had gone out of the country to finance the war. As a result, the reserves of banks went down, so the discount rates increased. Overall, this move led to a decline in the money supply and resulted in deflation. The next few years saw violent inflation and deflation cycles within the economy, as is evident from the graph below.

To stabilize the situation, the Fed intervened within the economy to prevent gold outflows. It restricted these outflows by rediscounting business bills, open market purchases and by giving advances on collateralized bank promissory notes. The Fed,  believed this move was essential to protect the reserves of banks. This was a good move because gold was a source of banking system reserves then, so gold inflows added to the stock of reserves.  In this sense, the gold inflow had the same effect as that of the Fed's purchase of securities, both of which increased the bank reserves This increase in reserves meant banks could lend more, and this meant banks and individuals had more access to cash..  As a result, the inflation trends increased within the economy in the early part of 1920s. The Fed, thus limited the outflow of gold, to stabilize the price level. Such a stability gave a false impression that everything was fine within the economy because the Fed used monetary tools to controls these rates. Had the Fed left it to the market forces, the economy could have corrected itself or the policy-makers could have seen the depression coming. In this sense, the sterilization policy contributed to the Great Depression.

In 1928, the Fed raised its discount rate to further restrict the outflow of gold and to dampen the growing stock market. The aim behind these restrictions is to control the perceived inflation that the Fed believed was harming the economy. As a result, the economic activity was stemmed, and in turn, this measure contributed to the Great Depression.

During the 1920s, the differences in currency was offset by outstanding Fed credit, so the total amount of bank reserves did not change much, though this move by the Fed helped to stave off contractions in money supply later. However, this policy formulated by Strong was also discontinued by the Fed after the death of Strong. As a result, money supply declined and contraction began to accelerate after 1931.

The argument given by the Fed in 1931 for not purchasing securities from the open market was that they did not have eligible collateral. However, this justification is not sufficient because the Fed had enough gold reserves. A look at the balance sheet of the Fed showed that it had $3.01 billion in gold and cash reserves and $1.58 in federal reserve credit, accounting for a total of $5.46 billion in assets (St.Louis Fed, 1992).  This money was sufficient to purchase securities without asking for an eligible collateral. Also, the Fed had the power to suspend the reserve requirements of banks for a temporary period of time. The Fed did not take any of these actions either because of heightened fears of gold outflows, so it missed an opportunity to curtail the depression.

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The only respite for this situation came from the Glass-Steagall Act of 1933 that removed the restrictions related to providing government securities as collateral for the Fed notes. This removal of restriction gave the Fed the authority to make open market purchases, so it made the largest ever open market purchase in the history of the Fed's monetary policy. It bought more than $1.1 billion of securities, and this directly led to an increase in the reserves of member banks that soared to more than $194 million. Finally, the program ended in 1937 because Fed officials realized it did not have any impact on the economy.  However, this conclusion by the Fed may not have been right because the program was operational for only a short period of time, so the reaction time was also short. Had the Fed continued this program for a longer period of time, it could have been successful because the program would have brought in more liquidity within the economy.

Due to this policy, the money supply condition did not fall, but it did not rise either because gold outflows were not offset by an increase in Fed credit. As a result, the economy did not get the stability it wanted, and the economy continued to plummet. A respite for this situation came from Roosevelt when he declared a bank holiday to suspend gold shipments. This move goes to show the inability of the Fed to employ the right sterilization policy to stem the outflow of gold, and to increase the money supply within the economy.  In this sense, the sterilization policy of the Fed or even the lack of it, accelerated the economic condition from a moderate recession to a deep depression. Wage policies of American businesses

The personnel of American businesses changed during the Great Depression. Though this reason by itself is not a contributor to the great Depression, it nevertheless slowed down the recovery phase, so in that sense, it can be attributed as an ancillary cause of the Great Depression. Before going into the personnel policy changes, it is important to look at the different types of unemployment that emerged during the Great Depression as this understanding is essential to understand the impact of policy changes.

There are three kinds of unemployment that can plague an economy during its cycle. The first kind is the cyclical unemployment which happens due to the regular up and down cycle of unemployment, and where the worker is not at fault. The second kind is frictional unemployment, which is the normal unemployment that happens even during boom times. The third kind of unemployment is the structural unemployment, which is a mismatch between job vacancies and job seekers. This third kind of unemployment was the biggest problem during the Great Depression. When the recovery began in the early part of 1930s, many businesses did not want to hire the “hard core” unemployed because companies distrusted the job qualifications of those who were laid off for a long period of time (Jensen, 1989).

This increase in the hard core structural unemployment was caused by two factors, namely, the depression itself, and the personnel policies of American businesses.

Prior to the Great Depression, the general theory was that higher unemployment brought the wages down because when more people were unemployed, business would tend to take advantage of this situation to keep the wages low. However, during the Great Depression, the wages did not fall, rather it held steady or even rose in some industries. The table below shows a bird's eye view of the hourly labor rates during the period from 1927 to 1940.

These rates remained high because many businesses believed that prosperity was dependent on increased consumption levels, and consumption was in turn dependent on high incomes for workers. Due to this perspective, the labor costs continued to be high for businesses. The big question is why businesses chose this theory to keep the labor costs high when they could have obtained the same level of talent for a much lower cost.

The only explanation to this situation was that it was practicing macroeconomics instead of microeconomics. In other words, they should have been following a policy based on efficient wages, instead of following the theory of high wage and prosperity. Due to this policy, hard core unemployment persisted for a longer period of time, thereby making recovery difficult for the economy.

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Besides this wage policy, other policy changes also contributed to the continued levels of structural unemployment. Businesses brought in innovations to increase the efficiency of workers such as removing authority from foremen and putting it on executives in offices, using application forms for hiring to keep away those who were unemployed for more than two years, mandating tests to ensure that the new workers still had the knowledge and expertise needed for work, and checking the background and previous employment history of workers.  Such changes had an impact on the employment situation of the country as well.

Thus, each of the above reasons has had their share of agreements and disagreements. Instead of arguing which was the sole reason that contributed to economic decline, it is prudent to say that all the above factors contributed in some way to the depression. A close analysis will show that these reasons are also inter-dependent on one another, so they are all linked together, as historical event usually are, and eventually, these combination of factors led to the depression.

Now that the causes of the Great Depression are understood, it is important to understand the causes of the Great Recession too, as this will make it easy to draw a comparison between the two economic events.

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