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     In navigating serious economic
fluctuations, Milton Friedman in his book “A Monetary History of the United
States” touched upon certain policies that were overlooked.  He highlighted the detrimental monetary policy
that was in place while simultaneously discrediting the failure of free market
capitalism as the source of economic instability. Although his findings were
based on many of the ideas that Friedman himself advocated, there was
substantial proof in the results. The most important job of the Fed is to
constantly keep the supply of money constantly flowing if not slightly growing.

Banks were left helpless with customers demanding their money back. He firmly
believed that a monetary policy is pivotal for a healthy economy but also that
a balance between the money supply and demand had to be sustained. In
hindsight, the Federal Reserve’s failure to implement an expansionary policy is
what worsened the Recession and dragged it into a Depression.  According to Friedman and Schwartz, the key
cause of monetary collapse in 1930-33 was a series of “banking panics”, evident
in a decline in the deposit currency and deposit reserve ratio.

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     According to Bern Bernanke, The Fed
was created to prevent the recurrent “bank panics”. In order to help overturn
this, Friedman insisted the Fed should have started with a program of
“suspension of payments”. Bernanke, too, cited this as the chief objective that
the Fed should have adopted during that period because, at least temporarily,
deposits would not have been convertible to cash. This would have thwarted efforts
to withdraw large sums of money at once. It also would have allowed the Fed to
slowly grow money supply in the meanwhile while considering adopting a more
expansionary monetary policy. “A system of suspension of payments usually
prevented local banking panics from spreading and persisting” reiterated
Bernanke.  The Fed failed to intervene or
prevent the bank runs that took place between 1930 and 1931 and hence, according
to Friedman, it should shoulder a majority of the blame for the sharp fall in
money supply.

 

     We also need to consider how it all
started: This was alluded to during the discussion about the Fed’s tight
monetary policy (raising interest rates). The Fed raising interest rates was
done to preserve the dollar’s value but that in turn discouraged borrowing and
spending. The Fed was supposed to supply the banks with enough money to meet
demands of customers but eventually did not because they themselves remained
wary of the ability of banks to repay them during this time of crisis. The Fed
was unwilling to prevent the failure of the banking system – and this was
Friedman’s key argument. He believed that a less deflationary policy would have
been ideal but the Fed let the money supply shrink too far. The sum of all
these mistakes led to the collapse of the money supply by one-third.  What finally ended the Great Depression was a
combination of government spending prompted by World War 2 and what Friedman
cited as the key tool in solving the economic crisis – an expansionary monetary
policy.

     A flawed theory is bound to have
ineffectual results to the question at hand. Although John Maynard Keynes makes
some great points pertaining to the cause of the Great Depression, his theory is
simply not as concrete as Friedman’s. The foundation of this theory touches
upon “aggregate demand” defined in terms of consumption demand and also the
role of government intervention in implementing an expansionary fiscal policy.

According to the Keynesian model, during the Great Depression, the government could
have decreased taxes or increased spending and by undertaking a policy deficit
spending. This would have potentially increased aggregate demand. He attributed
insufficient aggregate demand as the key reason for the Great Depression, – a
period which, thus, naturally saw high unemployment and stagnant economic
growth. Consumption demand as mentioned above decreased due to the Great
Depression’s effect on income and employment.

     Keynes’ solution to stimulate
aggregate demand was to increase government spending or to lower taxes –
expansionary fiscal policy. It is known that during the Depression the
prevailing taxes were quite high for a brief period and application of this
policy might have been ideal to stimulate the aggregate demand, but only in the
short run. An expansionary fiscal policy is designed to be a temporary one and
once the economy would show signs of recovery, the government would have to
increase taxes immediately to pay off the expansion. If you were to enforce the
policy, it might even have worsened the deficit during the great depression and
the United Sates could have faced a long-term debt issue. In reality, his
solution would have done very little to stimulate growth because every dollar
the government injected into the economy, would have first been taxed or
borrowed from the economy. This implies that Government expenditure would have
served primarily to redistribute already existing income while insignificant
with regards to creating additional income or raising employment levels.

Keynes’ model assumes that the effect of increased government expenditure would
stimulate aggregate demand but the plausibility of that happening is minimal because
the initial deficient level of aggregate demand would remain unchanged. The
anticipated government spending would not diminish the already existing levels
of consumer demand any further than it already has. The theory did not identify
the key cause of the Depression and failed to provide a solution and hence is
fundamentally unverifiable. However, it has provided important information that
could help moving forward and could even be a source of reference for a future recession.

If, for example, we considered free market policies such as getting rid of
trade barriers and lowering marginal tax rates – they both work when the
economy is weak and strong. We could adopt these reforms to prevent a downturn
in the future and throw misguided government policies such as a bad monetary
policy by the Fed under the rug. 

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