A Monetary History of the United States, 1867-1960

"Let me say why I think this book is important, and why it’s a particularly appropriate one to read on monetary history. I think many people in your generation and many of your readers will have lived most of their life in an environment in which we had an independent technocratic central bank whose goal was to deliver inflation equal to a target. For the most part, central banks have succeeded in delivering that goal. For instance, over the past 25 years in the UK inflation has been at its lowest and most stable in 500 years. However, if one looks at monetary history just a century ago, one sees that often central banks do other extraordinary things. They change their operations and they change their goals in ways that are, one might argue, appropriate for the circumstances. And, indeed, the current shock, insofar as it bears similarities in some of its effects to World War II or the Great Depression , invites comparisons. When we look at the monetary history of the United States and ask whether, during those times, the central bank looked anything like it does now, the answer is ‘no’. It’s a book that addresses why that was. “I am not saying that we’re certainly going to see financial repression, but it is on the table” Second, why the Treasury-Fed Accord? Let’s talk about the Fed and the Bank of England and what they’ve done in the past few weeks. They’ve undertaken extraordinary measures. They’ve taken measures in particular that have been strongly supportive of the fiscal authorities, by intervening very strongly in the government bond markets—the gilts market in the UK, the Treasuries market in the US —and they have also provided an enormous amount of credit to the private sector. In the US the changes in the law voted in Congress effectively took away some of the independence of the central back. That hasn’t happened at the Bank of England, but has very clearly happened, in a legislative sense, in the US. That is not a bad thing per se. Again, from history and reading Friedman and Schwartz, one learns how that often happened during these circumstances. But what’s also important to understand—and this is why I picked the Treasury-Fed Accord and this lovely article by Bob Hetzel and Rich Leach, “The Treasury Fed Accord: A New Narrative Account” —is to understand how we go from the extraordinary time back to the ‘normal’ time. At the current juncture, we need to try and understand how we will transition in the next few months, maybe the next few years, from these very fiscally driven, highly interventionist central banks—which are really focused on financial stability right now—back to the old let’s-keep-inflation-stable central banks. The story of the Treasury-Fed Accord is a fantastic history of political manoeuvring. It could really inspire a political sitcom or a West Wing -type TV show, given the amount of political manoeuvring that the US Treasury and the Fed did, fighting each other to try and influence the President towards establishing an independent, inflation-focused central bank, the Federal Reserve that we know today. Get the weekly Five Books newsletter When you have an enormous amount of public debt outstanding there is big pressure for monetary policy to be mostly about keeping long-term interest rates low, so that servicing that debt and issuing new debt is a seamless process for the finance ministry. So, the central bank is, in many ways, subordinate to the finance ministry because its job is to make the job of the finance ministry easier. That situation, if maintained over a long period of time, does mean that inflation becomes volatile and unanchored. And indeed, inflation was volatile in the United States in the 1940s and in the UK through the 1950s. There comes a time when the central bank says that it should be focused on controlling inflation and no longer just on trying to keep rates low just to finance the debt. The finance ministry, of course, does not like that because now its job is going to be much, much harder. Potentially it’s going to have to deal with high interest rates, especially if it does not behave responsibly with respect to its deficits. As a result, this conflict arises. The Accord was, if you like, the peace treaty. The Accord set out the separation, with the finance ministry—the US Treasury—dealing with fiscal matters and worrying about long-term interest rate and the central bank, the Fed, setting short-term interest rates to try and control inflation. Simply that part of the nation’s economic goal is having stable inflation."

"The next books go together and are more for a general audience. Imagine that you want to know something about inflation and you don’t want to go through a lot of maths, because you don’t want to do a PhD. These are the books for you. They’re interconnected: one is sort of an updated version of the other. Friedman and Schwartz is the first book that tried to connect the monetary aggregates—which is the amount of money in circulation—and inflation with the real sector. That’s why it is important. They established a connection between stabilizing prices and stabilizing the real economy. The book covers the period from the second half of the 19th century to the 1960s. Get the weekly Five Books newsletter During most of this period, the gold standard was in operation. The gold standard meant that dollars were exchangeable for gold at a fixed rate. Under this regime, the sole role of the central bank is to defend the exchange rate of the dollar with gold so the money supply was closely connected with the amount of gold held by the government. There are two main facts presented by the authors that I found particularly interesting. First, the gold standard was weakened in several instances. When this happened, the central bank had to learn how to conduct monetary policy to achieve price and financial stability. Second, the authors show the struggle of the central bank in achieving these objectives. A striking episode is the management of the Depression after 1929, which the authors called ‘the Great Contraction.’ During this period, a contraction of the money supply worsened the output recession and generated deflation. This book is very old, therefore some of its methods are no longer up to date. First, this book is mostly about the monetary stock. Friedman and Schwartz care about the balance sheet of the central bank, whereas now we care much more about interest rates and the communications of the central bank. There are also many parts of modern economics, like expectations, that are completely missing from the book. However, I think it is an important book because it is the first attempt to link together inflation and output. In some sense, it is the basis for many of the books that have been written since about inflation, monetary policy and the real side of the economy."

"I frequently tell students: If you buy only one economics book , it should be A Monetary History . The book is obviously important for our understanding of the Great Depression, but its impact goes far beyond that. Friedman and Schwartz show us that monetary events and monetary policy have affected real output throughout American history. That’s a fundamentally important finding. It tells us that a monetary development that affects aggregate demand has an impact on the things we care about, like employment, unemployment and how much we produce in the economy. The other thing that Friedman and Schwartz do is show us how to use historical evidence on policymakers’ motivation and thinking to help establish a causal relationship between money and output. “The stresses on the US economy in 2008 were much larger than those in 1930. So why has this recession, as bad as it has been, not been a second Great Depression or even worse?” When you asked me for my list of books, I debated about whether to put The General Theory by John Maynard Keynes on the list. The General Theory is an incredibly important book, but it’s basically a theoretical explanation of how aggregate demand could affect output. It was Friedman and Schwartz who provided the empirical evidence that supported the theory. That’s why A Monetary History went to the top of my list. With regard specifically to the Great Depression, Friedman and Schwartz show that there were large declines in the money supply associated with repeated waves of banking panics. They also provide compelling evidence that bad economic ideas and a dysfunctional organisational structure were key reasons why the Federal Reserve did so little to stop the panics. One of the reasons why A Monetary History is still such a classic is that it has held up to a remarkable degree. The essence of the Friedman and Schwartz approach was very different from what modern economists do. Modern economists get data. They run regressions. It’s all statistical work. Friedman and Schwartz understood that even if you have all the data you could want on the money supply and output, it’s still going to be very hard to identify the causal relationship between the two because money changes for lots of reasons. Sometimes it changes because output is changing, and changes in output affect how much banks lend and the money multiplier. Other times, the money supply changes because the Federal Reserve makes a mistake or there’s a deliberate policy action unrelated to the state of the economy. The brilliance of this book is that Friedman and Schwartz use a lot of non-statistical or narrative evidence. They read the diaries of people running the Federal Reserve in the 1930s and they went through the records of the policymaking process. They were able to identify times when the money supply moved for relatively independent or exogenous reasons – not in anticipation of what was going to happen to output or because of other things going on in the economy. What they found was that after these relatively exogenous movements in the money supply, output moved strongly in the same direction. A Monetary History very much affected the kind of research that I’ve done in my career. There have been many times when I’ve needed to go back and read the same primary documents that Friedman and Schwartz read. What almost always strikes me is just how right they were. This book is an example of exceptional scholarship. They looked at documentary evidence carefully and honestly, and came up with an interpretation that has stood the test of time. That’s why it remains such an important book for our understanding of the macroeconomy and the Great Depression. Milton Friedman believed deeply that monetary forces had an important impact on the economy, and he never missed an opportunity to remind people of that fact. In the 1960s there was a fight between monetarists like Friedman and Schwartz, who thought that monetary forces were very important, and Keynesians like [Paul Anthony] Samuelson and Solow, who tended to focus on the impact of changes in government spending and taxes. Modern economists tend to see monetarists and Keynesians as being on the same side. They both believe, based on strong empirical evidence, that changes that affect the demand side of the economy – taxes, monetary changes or government purchases – affect output and employment."

"I got goose bumps when I picked up this book to do this interview, which is really odd given that I have picked it up many, many times before. It’s co-authored with Anna Schwartz, who was Milton Friedman’s long-time collaborator and who was associated with the National Bureau of Economic Research for many years. Unlike Money Mischief it’s a very, very hard read. If you’re looking for something to read on a vacation, you have to be a really committed monetary nerd to go for this book. The first edition came out in 1971—it’s 50th anniversary is this year. It reflects the problems of 50 years ago. It’s best known for its discussion of the Great Depression , that the Great Depression was a result of monetary policy failure, a result of the Federal Reserve failing to respond to a sharp increase in money demand. It’s also known for collecting a lot of data on the money supply. They did great work in that area. These days we take it for granted that economic data is something we just get off the computer. We have the economic data of any country in the world. Sometimes you wonder why a data series doesn’t go back beyond, say, 1973. And the reason is because the data wasn’t collected. What Milton Friedman and Anna Schwartz did was actually construct the numbers. They didn’t make up the numbers, they collected the data for the money supply in the US. In that way they also showed that the monetary contraction of the 1930s played a major role in the Great Depression. I have now come to appreciate, after reading and studying and doing the analysis, that there is a deeper monetary story that connects the international monetary regime to the one told by Friedman and Schwartz in this book. One of the problems with many US-based economists is that they are so US-centric, they fail to understand the world in a wider context and often fail to learn the lessons from other countries. Because a lot of the economic theory that has been developed over the years is US-centric, we teach economics students about a large, closed economy. But my country, Denmark, is a small, open economy, with no monetary policy of its own. We have a fixed exchange rate with the Euro, which means monetary policy in Denmark is determined in Frankfurt. And most of the cash flows in and out of the country are a result of that. So starting out with a closed economy model actually teaches no Dane anything about his economy. “Milton Friedman was a master of communication” Studying the monetary history of the United States of America on its own is tremendously interesting. But I would also say—and Friedman and Schwartz accepted this later on—that they fail to account for what happened with respect to the gold standard and, in particular, what central banks outside of the US were doing in terms of monetary policy. For instance, the fact that the Bank of France was hoarding gold and, by doing that, creating upward pressure on gold prices, which helped create these deflationary pressures, both in the US and in the global economy. The US only decoupled from that when Roosevelt devalued the dollar against gold in 1933, giving a monetary injection into the US. In the Monetary History Friedman and Schwartz describe this, but from a very US-centric perspective. We can see what happens to the money supply and that analysis is right, but it doesn’t tell the story about that global phenomenon. Another thing that we learn from Friedman and Schwartz is that money supply numbers are important. To understand what happens to inflation, to nominal demand, we need to start in the money supply. But, as Leland Yeager told us, we need to understand the balance between the money supply and the demand for money. That’s really the important thing. Friedman and Schwartz, of course, understand this and discuss it. They discuss monetary policy in the US right back in the 19th century, after the Civil War . It’s something that’s rarely talked about, but we need to understand that. It’s from 1867 to 1960. You need to be able to step away from the book, and not get lost in the detail. The bigger picture here is that when monetary policy works, when the monetary machine functions well, we don’t see monetary policy. So, in modern times, from the mid-1990s, after inflation had been brought down in Europe and the US, and up to 2008, monetary policy essentially disappeared. It was a period where economists started to write books about sports, Freakonomics , these kinds of things—which I love, by the way. But that was because there was monetary stability, the rules were well functioning and it’s really uninteresting to write monetary history about periods when things are fine. Monetary history becomes interesting when there are monetary policy mistakes. Monetary history is a long description of one monetary policy failure after another. I think what you can also learn from it is that monetary policy really isn’t made to be optimal. It’s always a gradual process. You have a system that works in a period and then it gets out of whack for some reason. The government behaves in an irresponsible way. There is a war, or the central bank asks the government to print money and suddenly you have inflation. And then a new regime is created that can provide that monetary stability, whether it’s bi-mentalism or the gold standard, or Bretton Woods after the Second World War, or inflation targeting. What they have in common is that none really works perfectly and at some point they all fail. That’s a lesson you get from reading A Monetary History. There have been these continuous failures. The question for historians is whether today we have a monetary institutional setup that is better than the pre-First World War gold standard. I’m no big fan of the gold standard, but I can’t forcefully argue that what we have today is better than what we had in that golden period of tremendous global trade, global capital flows, and increases in global incomes and prosperity, starting in the 1880s and which broke down with the First World War. A Monetary History provides the story of the struggle, over successive monetary regimes, to get the monetary system right. It doesn’t get to the last part of the story, but it gets a lot of the story, at least from a US perspective. And what you don’t get in Monetary History , you get in The Midas Paradox ."

"The idea behind my list is that these are five conservative books that changed the way we think about fundamental problems – and changed them so powerfully that there was no going back. The highly intrusive regulatory redistributionist state that was built in the 1930s was founded on an analysis of what went wrong in the horrific trauma of 1929 to 1941 in the United States. There was an accepted understanding of why it was that the economy went into this searing experience for a generation of Americans and what it was that got the US out again. That legitimated a quarter century of public policy afterwards. Friedman and Schwartz did many things in this book but the most powerful lesson for its readers is they debunked all the previous explanations of what had caused the Great Depression and showed that it was the product of a failure of monetary policy. So when the US had severe economic problems in the 1970s, it opened the way for Friedman to win that argument about how to stop the great inflation – just as he had argued that better monetary policy could have stopped the Great Depression. Capitalist economies go through cycles, good times and bad. Democratic capitalist societies will not take the same amount of pain from those cycles that pre-democratic capitalist societies did, so we are going to have to do something about these cycles. If the cycles are caused by government taxing and spending, then the answer is that in order to avert cycles, or mitigate them, the government is going to have to have a direct active response in the economy. What Friedman showed is that government can have an impact on these cycles in a much less intrusive way, through the regulation of banking and credit. By the way, this is not a call for classic laissez-faire, for doing nothing, because one of the lessons of the Friedman book is that the federal government did exactly the right thing in 2008 when it intervened to save the banking system. All these people today who say, ‘Well, the conservative thing to do would be to let the banks go under,’ will have to argue with Milton Friedman, because that is what turned the ordinary recession of 1929-1930, which was nasty but ordinary, into the extreme crisis of 1931, 32 and 33. The book is an answer to Keynes, but Friedman doesn’t refute Keynes’s book, he absorbs Keynes. That’s what great minds do with their predecessors – just as Keynes did not refute Alfred Marshall’s ideas, he absorbed them. One other lesson from Friedman is that it’s a good idea for governments to run a deficit. The people who in 1929 said the answer to the Depression was to balance the budget, Friedman thinks are just as wrong as Keynes does. According to Friedman, the reason you want the government to run a deficit is not because you want government adding to demand, but because the deficit creates money. The government is able to finance the gap between what it takes in and what it spends by creating various forms of money – whether it is cash or whether it’s bonds. It’s that addition to the money supply that stimulates the economy and not the government’s purchases as such. As often happens with policy arguments, people can converge on the same answer for radically different reasons. One way to think about what Reagan’s great contribution was in 81 and 82 is that he stood unflinchingly by the Federal Reserve as it imposed some very painful measures to squeeze inflation, not only in the US economy but in the world economy. A lot of other people would have flinched from that and his tax cuts helped to soothe the pain of the monetary policy. But it was the monetary policy that stopped inflation."

"I think it appropriately looks at the monetary financial situation that is at the core of the Great Depression crisis and also the current situation. So they focus on the role of the monetary authority and the banking panics, and you can fit into that the legislative changes – particularly under Franklin Roosevelt ­– some of which helped the situation. I think the most important of those was the introduction of deposit insurance in 1934, with the Federal Deposit Insurance Corporation. The FDIC has really worked in preventing https://fivebooks.com/book/bank-runs-deposit-insurance-and-liquidity-by-douglas-diamond-and-philip-dybvig/ since that time in the US. I think a lot of the solutions these days involve extending that concept beyond the commercial banks that were at the heart of the financial system in the 1930s, but of course the system has been much broadened since then. It’s clear that a lot of the policies that were put into place were negative, but as to sorting out how important they were, that’s a much more challenging question. And I think Roosevelt at the time recognized ex-post that some of the things he tried were failures and then his attitude was, “OK, it’s a failure. I’ll stop doing it.” Which is actually pretty positive. For example, some of the things he did was try to organize labour unions and also businesses essentially promoting monopoly – I don’t think that was a plus. He was trying really hard to keep wages and prices from falling with direct influence and that was a negative. The effect of the expenditure programs is less clear. In the mid-1930s with the New Deal there was an unusual amount of infrastructure-type of expenditures. But it’s not actually big enough to sort out in a statistical sense – to figure out how much it mattered in terms of the recovery after the trough in 1932-33. I don’t think we know that that was a mistake, but it’s not clear that it was all that important."