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THE FREEMAN
Letters to the Editor

Thanks to Milton Friedman’s brilliance, charisma and diplomacy he became an ardent spokesman for many free market reforms in this country. And now Ivan Pongracic, Jr. (The Great Depression According to Milton Friedman, September 2007) gives him credit for convincing Fed officials that the Fed itself was responsible for precipitating the crash and the 1929-1933 monetary contractions that followed. But the contractions were only the spark that brought the boom to an end; the seeds of the depression itself were sown in the preceding boom.
Pongracic says Keynes had “rejected the view that the boom-bust cycle was due to over-expansive government monetary policy. . . . Keynes claimed that private investment is inherently unstable due to what he called the ‘animal spirits’ of businessmen/capitalists. . . . Like sheep that blindly follow other sheep in the herd, it is easy for businessmen to become ‘irrationally exuberant.” Friedman and Schwartz in their massive history of money apparently accepted that Keynesian explanation, at least in part — attributing the stock-market crash of October 1929 to a “speculative investment bubble,” the cause of which was “a somewhat controversial topic.” But the cause of that “bubble,” the seeds of the crisis, were actually inherent in the very principles on which the Fed was founded.

When the Fed was established in 1913 it was set up in the hope of avoiding crises due to a shortage of funds such as banks and their clearing houses had encountered periodically. The Fed was to create a “flexible” money supply to satisfy the “needs of business” and to serve as the lender of last resort to banks in crisis. Thus its very purpose was inflationary. It fostered “easy money” by making loans available at relatively low interest rates. The new “easy money” lured businessmen to undertake enterprises they would not have considered profitable at market interest rates. Thus business boomed. The stock market flourished. If there had been no boom, there would have been no monetary contraction. Thus, the Fed’s responsibility for the depression extends to the preceding boom.

It was in 1912 in his first book on monetary theory that Ludwig von Mises laid the groundwork for the Austrian Theory of the Business Cycle. He pointed out then that the monetary boom/bust cycle stemmed from the encouragement given by central banks to expand credit. He described the process in some detail in 1928:

If the banks discount at a lower, rather than at a higher, interest rate, then more loans are made. Enterprises which are unprofitable at 5%, and hence are not undertaken, may be profitable at 4%. Therefore, by lowering the interest rate they charge, banks can intensify the demand for credit. Then, by satisfying this demand, they can increase the quantity of fiduciary media in circulation . . . .

Now, in extending circulation credit, the banks do not proceed by pumping a limited dosage of new fiduciary media into circulation and then stop. They expand the fiduciary media continuously for some time, sending, so to speak, after the first offering, a second, third, fourth, and so on. They do not simply undercut the “natural interest rate” once, and then adjust promptly to the new situation. Instead they continue the practice of making loans below the “natural interest rate” for some time.

The crisis breaks out only when the banks alter their conduct to the extent that they discontinue issuing any more new fiduciary media and stop undercutting the “natural interest rate.” . . .

Mises then asks what will happen if the banks do not stop but continue on their inflationary path, “permitting new quantities of fiduciary media to flow into circulation continuously and proceeding always to make loans below the rate of interest which would prevail on the market in the absence of their interference with newly created fiduciary media. . . . Would they then be able to make the boom eternal?”

They cannot do this. The reason they cannot is that inflationism carried on ad infinitum is not a workable policy. If the issue of fiduciary media is expanded continuously, prices rise ever higher and at the same time the positive price premium also rises. . . . It is precisely because, and only because, no end to the prolonged “flood” of expanding fiduciary media is foreseen, that it leads to still sharper price increases and, finally, to a panic in which prices and the loan rate move erratically upward. . . .
Sooner or later, the crisis must inevitably break out as the result of a change in the conduct of the banks. The later the crack-up comes, the longer the period in which the calculation of the entrepreneur is misguided by the issue of additional fiduciary media. . . . The crisis, with its unique characteristics, is followed by stagnation. The misguided enterprises and businesses of the boom period are already liquidated. Bankruptcy and adjustment have cleared up the situation. The banks have become cautious. They fight shy of expanding circulation credit. They are not inclined to give an ear to credit applications from schemers and promoters. Not only is the artificial stimulus to business, through the expansion of circulation credit, lacking, but even businesses which would be feasible, considering the capital goods available, are not attempted because the general feeling of discouragement makes every innovation appear doubtful . . .
The problem to be solved is the recurrence of fluctuations in business activity. . . . Many authors believe that the instigation of the banks’ behavior comes from outside, that certain events induce them to pump more fiduciary media into circulation and they would behave differently if these circumstances failed to appear. I was also inclined to this view in the first edition of my book on monetary theory [1912]. . . . Only later did I become convinced that it was useless to look to an outside stimulus for the change in the conduct of the banks. Only later did I also become convinced that fluctuations in general business conditions were completely dependent on the relationship of the quantity of fiduciary media in circulation to demand.
The fact that each crisis, with its unpleasant consequences, is followed once more by a new “boom,” which must eventually expend itself as another crisis, is due only to the circumstances that the ideology which dominates all influential groups — political economists, politicians, statesmen, the press and the business world – not only sanctions, but also demands, the expansion of circulation credit.

Once the Fed started trying to create a “flexible” money supply it found itself between a rock and a hard place. Of course its founders didn’t then realize this. But the Fed faced a dilemma: to expand and to keep on expanding the quantity of money would lead to a catastrophic boom and runaway inflation. But when and if it stopped expanding it would cause an economic crisis. Friedman apparently recognized this later. But as far as I know, he gave no indication that he realized it was inherent in the very principle on which the Fed was based. But then he was an inflationist; he believed that only by constantly and steadily increasing the money supply, to keep abreast of increases in production and population size, can an economy prosper.

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