Bank Failures Cause the Great Depression

The monetarists' explanation for the Great Depression focuses on changes in the money supply.  In this case, the changes were not the result of a deliberate policy experiment, but were instead the outcome of a lack of Federal intervention in the banking sector at a time when conditions for banks were quite perilous.

The impacts of the pressures on banks are apparent in simple counts of the numbers of banks.  In the early years of the Depression, banks with loans to investors in the stock market were immediately at risk.  Bank runs compounded these problems even for apparently healthy banks.  Of the more than 25,000 banks in business in 1929, fewer than 15,000 survived to 1933.

The collapse in the banking sector precipitated a parallel contraction in the money supply.  A severe contraction in the money supply, whether as a result of a policy or as a result of bank failures, then leads to a severe contraction in economic activity.

A reasonable question might be "How could the government let the money supply fall like this?"  Milton Friedman, author (with Anna Schwartz) of A Monetary History of the United States, 1867-1960, provides us with the answer.

"We did learn something from the Great Depression. ... We learned that you ought to have numbers on the quantity of money.  If the Federal Reserve System in 1929 to 1933 had been publishing statistics on the quantity of money, I don't believe that the Great Depression could have taken the course that it did."1

The data on the quantity of money during the Depression was calculated after the fact by researchers such as Friedman and Schwartz.  At the time, economic theory did not suggest that changes in the quantity of money could cause business cycles and, consequently, money supply statistics were not published.

1Milton Friedman and Walter W. Heller, Monetary vs. Fiscal Policy:  A Dialogue, W.W. Norton & Company, Inc. (1969), pp. 79-80.

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