Was the money supply not behind the Great Depression?

Over at Paul Krugman’s blog he discusses the idea that monetary authorities could have prevented the Great Depression and how that relates to now (ht Economist’s View). Specifically he states that recent events imply that “the thesis of the Monetary History (Friedman’s book) has just taken a hit”.

I am not sure I agree with Krugman’s argument here. He states that the Fed controls the money stock. Given that the money stock grew through the late part of the Depression, and given the money stock has increased meteorically now he states that we can’t “blame” the Fed for either slowdown.

Now, is this actually the thesis of Monetary History? Krugman says himself that the central point was that monetary authorities “could” have prevented the slowdown.

Looking at Krugman’s own evidence we know that the stock of money was unchanged during the first two years of the Great Depression – but the velocity of money collapsed, implying that the “quantity of money” was falling, in turn providing deflation.

This matters because it made products and services with downward sticky prices more expensive – the primary one of these was labour. As a result, real wages rose while labour productivity fell – leading to mass unemployment.

Recent actions by the Fed have been put in place to avoid the catastrophic unemployment of the Great Depression. The increase in the money stock combined with more flexible labour institutions will prevent the sort of mass unemployment that we saw during the Great Depression.

As a result, whether current events support the thesis of, and corresponding work based on, Monetary History remains to be seen – stating that it is not working ignores the fact that we don’t know the counter-factual. Looking at the money stock and making this sort of conclusion is a little cheeky 😉

Note: On the issue of blame, the Fed controls the stock of money – but their target is the quantity of money, as a result since they took this duty upon themselves it sort of was there fault that the quantity of money collapsed during the Depression 🙂

Update:  Probably a better take on the data by Alex Tabarrok 😉

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  • JO

    It could even be a bit more complicated than that. Was the fact that the Fed allowed the massive expansion of the money supply prior to the market collapse the ultimate culprit? In other words, this led to an unsustainable level of indebtedness and risk taking much like we have today. So the Fed sowed the seeds for the 1929 bubble and collapse as it has done again with the current housing bubble and ensuing collapse. Money creation might not matter as much once the bubble has taken form and burst because the “demand” for money will be nonexistent as businesses and consumers attempt to repair damaged balance sheets. This is why velocity matters in the current environment. A second depression here in 2008-09, though not at the extreme of the 1930s, would prove that the Fed pushes on a string when trying to “fix” the economy on the heels of a secular and unsustainable credit market expansion.