Introduction
You often struggle to understand what drives economic instability, inflation, and severe financial crises. Mainstream economic analysis frequently ignores the dominant role of monetary forces, leaving you without a clear framework to interpret market fluctuations.
Changes in the stock of money are closely associated with changes in economic activity, money income, and prices, demonstrating that monetary policy is the primary driver of economic fluctuations.
Milton Friedman and Anna Jacobson Schwartz trace nearly a century of United States monetary experience from 1867 to 1960. The book examines how alterations in the quantity of money influence income and prices through proximate determinants like the deposit-reserve ratio and the currency-deposit ratio.
The authors divide this vast timeline into distinct structural eras. You will explore the greenback period, the operations of the classical gold standard, the institutional failures leading to the creation of the Federal Reserve, the catastrophic monetary collapse of the Great Contraction, and the subsequent New Deal reforms alongside postwar policy adjustments.
- How did the resumption of specie payments alter the American price level?
- What caused recurring banking panics before the establishment of the central bank?
- Why did the Federal Reserve fail to prevent the unprecedented money stock collapse from 1929 to 1933?
1. The Greenback Period and Specie Resumption
The post-Civil War period from 1867 to 1879 featured an inconvertible fiduciary standard with freely floating exchange rates, where secular price deflation occurred alongside rapid economic growth because output grew up to the money stock.
The post-war financial system operated on an inconvertible fiduciary currency standard.
Suspension of convertibility occurred in 1862, and the subsequent period saw fluctuating market exchange rates for the greenback standard. No government agency sold gold at a fixed price during these years. Official U.S. transactions played no significant part in gold or exchange markets. Concurrently, the price level fell by half while economic growth proceeded rapidly. This outcome challenges the view that secular price deflation and rapid growth are incompatible.
Fiduciary Standard and Output Growth
A drastic and sustained price decline occurred despite a mild rise in the money stock. This happened because of an extraordinarily rapid rise in real economic output. As the economy grew rapidly in population, railroad mileage, and manufacturing output, the economy grew up to its money stock.
In New York State, the freight carried on railroads nearly quintupled and surpassed canal freight for the first time. The population increased by 30 per cent over the period, representing a rate of 2.3 per cent per year. The assumed annual rate of decline in prices ran at 3.5 per cent from January 1867 to February 1879. The mint par price of the pound sterling in terms of the dollar was $4.86 before the Civil War. At the end of June 1867, the approximate premium on gold reached 38.3 per cent.
Resumption Act Politics and Economics
The political struggle over currency contraction and expansion culminated in the Resumption Act of 1875. This legislation set a fixed date for returning to the prewar gold parity. Political factions divided sharply between hard-money advocates and greenback-inflationists. The Greenback party nominated Peter Cooper for President in 1876 on a platform demanding unconditional repeal of the Resumption Act. The Greenback party won 10 per cent of the vote share in the elections of 1878 along with 14 seats in Congress.
The Resumption Act mandated a return to specie payments on January 1, 1879. The Treasury accumulated a gold reserve by selling bonds and using surplus revenues. Secretary of the Treasury John Sherman began serious attempts to accumulate a specie reserve starting in March 1877. The Treasury refunded $845 million of public debt between 1877 and 1879. Successful resumption of specie payments was primarily permitted by the massive growth in real output that lowered domestic prices to match world levels.
2. Gold Standard and Silver Politics
Under the gold standard, monetary trends were governed by international trade and gold discoveries, while political agitation for silver created severe crises of confidence without changing basic economic mechanisms.
Under a gold standard with fixed exchange rates, a minor country's stock of money is ultimately controlled by external influences rather than domestic policies. The primary channel of influence runs from fixed exchange rates through the balance of payments to the money stock, and then to internal prices consistent with those exchange rates.
International Gold Movements and Price Trends
The 1879 to 1914 gold standard era splits into two distinct periods of contrasting price trends driven by gold supply changes and economic output. From 1879 to 1897, world gold prices declined secularly due to slowing gold stock increases and expanding country adoptions, showing an average money stock growth of 6 per cent per year and a price fall of over 1 per cent a year. From 1897 to 1914, new gold discoveries in South Africa, Alaska, and Colorado, combined with the cyanide process, reversed this into a rising price trend with an average money stock growth of 7.5 per cent and a price rise of over 2 per cent a year.
Political conflict over silver dominated the late nineteenth century until new gold discoveries and extraction techniques secured the gold standard. Downward price trends following the Civil War spurred greenbackism and free silver movements, creating crises that shook confidence in the gold standard.
Silver Legislation and the 1893 Panic
Political agitation for silver harmed the economy not through direct money creation, but by generating distrust in the maintenance of the gold standard. Fears that silver inflation would force the United States off the gold standard caused capital flights, gold outflows, and forced a severe domestic price deflation in order to stay on gold.
In July 1896, following William Jennings Bryan's nomination, short- and long-term capital flight sharply accelerated until a syndicate of foreign exchange houses formed to block gold outflows. This dynamic pushed the Treasury gold reserve to a low of $45 million in January 1895.
The 1893 financial panic led banks to restrict cash payments, temporarily creating a dual monetary system where currency and deposits were not interchangeable at par. Distrust of bank solvency provoked widespread runs and suspensions, mostly in the West and South, forcing banks to restrict cash convertibility and causing currency to trade at a premium over checks.
Clearing house certificates and factory pay checks were issued locally as emergency currency when banks restricted cash payments in the summer of 1893. During that year, 360 national and state banks suspended operations with $110 million in liabilities. The silver episode period from 1893 to 1897 finally closed with the Presidential election year of 1896 marking the defeat of William Jennings Bryan.
3. Banking Reform and the Federal Reserve Era
Recurrent banking panics driven by structural vulnerabilities in the fractional reserve system culminated in the creation of the Federal Reserve System, designed to provide an elastic currency.
Severe banking crises in 1873, 1884, 1890, 1893, and the panic of 1907 involved bank runs and the suspension of convertibility into currency. These events culminated in the Aldrich-Vreeland Act of 1908 and the Federal Reserve Act of 1913. The Federal Reserve System began operations in 1914.
From 1879 to 1907, the ratio of deposits to currency grew from two to nearly six. The ratio of deposits to reserves rose from 4.4 to 8.9. This structural change left the money stock fifty percent more vulnerable to deposit-currency shifts than it was in 1892.
Following the suspension of the Knickerbocker Trust Company due to runs, public and interior bank distrust caused a scramble for liquidity. New York banks and subsequent nationwide banks suspended the convertibility of deposits into currency, issuing clearing house loan certificates and substitutes for cash.
The Knickerbocker Trust Company, the third largest trust company in New York with $62 million in deposits, experienced a run and was forced to suspend on October 22, 1907, after its clearing agent refused to support it. Total clearing house loan certificates issued in New York reached $256 million, and currency traded at a maximum premium of 4 per cent over deposits during restriction.
The Panic of 1907 and Aldrich-Vreeland Act
Passed as a temporary stopgap after the 1907 panic, the Aldrich-Vreeland Act permitted banks to issue emergency currency backed by commercial paper and approved bonds through national currency associations under penalty tax rates. Upon the stock exchange closing in July 1914, nearly $400 million of Aldrich-Vreeland emergency currency was issued, which completely prevented a banking panic and restriction of payments. The maximum amount of emergency currency outstanding on a single date reached $364 million.
To use this mechanism, you had to follow specific legislative steps:
- Form a National Currency Association with at least 10 national banks holding a combined capital and surplus of at least $5 million.
- Deposit commercial paper up to 75 per cent of its value or approved state and local government bonds up to 90 per cent of market value.
- Issue emergency currency subject to an initial tax rate of 5 per cent per annum, increasing by 1 per cent each month up to 10 per cent.
The fundamental innovation of the Federal Reserve Act was to provide an elastic currency through Federal Reserve notes and central bank deposits, replacing older forms of high-powered money. By 1920, 69 per cent of high-powered money consisted of Federal Reserve notes and deposits. Power was divided between the Federal Reserve Board and individual Reserve Banks, creating systemic struggles for centralization.
Wartime Inflation and the 1920 Rate Hike
Faced with rapidly depleting reserve ratios and a gold outflow, the Federal Reserve Board executed the sharpest single discount rate hike in its history in January 1920, raising commercial paper rates to 6 per cent. The System reserve ratio reached a trough of 40.6 per cent in March 1920.
J.S. Alexander, a New York Bank director, warned that an immediate 6 per cent rate would cause public panic and make people think the Federal Reserve had lost its head. Following a further rate hike to 7 per cent in June 1920, wholesale prices collapsed dramatically, falling by June 1921 to 56 per cent of their May 1920 peak. The stock of money fell by 9 per cent, and high-powered money fell by 17 per cent from peak to trough. Bank failures jumped from 63 in 1919 to 155 in 1920 and reached 506 in 1921.
4. The Great Contraction
The monetary contraction from 1929 to 1933 was the most severe in U.S. history, caused by inept Federal Reserve policy, widespread bank failures, and a catastrophic drop in the money stock.
From the peak in August 1929 to the trough in March 1933, the stock of money fell by over a third. U.S. net national product in current prices fell by more than one-half. Over one-fifth of commercial banks suspended operations during this period.
Onset of the Contraction and Banking Panics
A crop of bank failures in agricultural and midwestern states sparked widespread contagion in October 1930. You saw depositors attempt to convert deposits into currency as liquidity crises cascaded through subsequent years. In November 1930, 256 banks failed with $180 million of deposits. In December 1930, 352 banks failed with over $370 million of deposits.
The Bank of United States, the largest commercial bank ever to fail up to that time with over $200 million of deposits, closed its doors on December 11, 1930, severely damaging public confidence.
Britain's abandonment of the gold standard in September 1931 provoked an external gold drain from the United States. Between September 16 and October 30, 1931, the gold stock declined by $725 million. In October 1931 alone, 522 commercial banks with $471 million of deposits closed their doors.
Under heavy congressional pressure, the Federal Reserve bought roughly $1 billion of government securities between April and August 1932. This open market purchases program lowered interest rates and temporarily moderated the contraction. In May 1932, the corporate Baa bond yield peaked at 11.63 per cent.
A relapse in late 1932 brought renewed bank failures and hoarding. From January to March 1933, the money stock fell 12 per cent at an annual rate of 78 per cent. The banking panic culminated in a nationwide banking holiday lasting from March 6 to March 13, 1933.
Policy Ineptitude and Counterfactual Analysis
The Federal Reserve possessed ample powers to prevent the collapse through high-powered money injections but failed to use them effectively.
Alternative expansionary monetary policies, such as a $1 billion government security purchase program in 1930 or 1931, would have changed the monetary situation. Injecting high-powered money via open market purchases would have met the public currency drain. This intervention could have freed commercial banks from forced asset liquidation.
The inept policy stemmed from a fatal shift of power away from the New York Bank and Benjamin Strong to a decentralized committee structure. Until his death in 1928, Strong provided enterprising leadership. Afterward, an unwieldy Open Market Committee proved prone to drift and inaction.
5. New Deal Reforms and Wartime Inflation
The New Deal introduced federal deposit insurance and devalued the dollar, ending banking panics, while World War II brought massive monetary expansion and price controls.
President Roosevelt proclaimed a nationwide bank holiday from March 6 to March 9, 1933, using wartime powers under the act of October 6, 1917. The Emergency Banking Act of March 9, 1933 validated and extended these actions. Nearly 17,800 commercial banks operated at the turn of 1933, dropping to 17,300 at the end of the bank holiday, with fewer than 12,000 licensed to open.
New Deal Structural Changes and Deposit Insurance
Federal deposit insurance became the most effective structural change for monetary stability since the Civil War. It eliminated public fears of losing convertibility into currency and halted destructive contagion.
Senators Henry B. Steagall and Carter Glass agreed to combine their proposals into the Banking Act of 1933. A temporary deposit insurance system was introduced via an amendment by Senator Arthur Vandenberg and later made permanent by the Banking Act of 1935.
Insurance limits started at $2,500 on January 1, 1934, were raised to $5,000 on July 1, 1934, and reached $10,000 on September 21, 1950. Losses borne by depositors averaged $146 million annually from 1921 to 1933, but dropped to an average of $706,000 annually over the subsequent twenty-seven years.
The Gold Reserve Act of January 30, 1934 devalued the gold dollar to 59.06 per cent of its former weight, setting a fixed price of $35 an ounce. Treasury gold stock rose from 200 million ounces in early 1934 to 630 million ounces by the end of 1940.
The Board of Governors raised reserve requirements to the maximum legal limit in three steps within a nine-month period. This initial reserve requirement increase reduced excess reserves by $1.5 billion. The money stock reached an absolute peak in March 1937 and fell with only minor interruptions through the end of the year, while the business cyclical peak occurred in May 1937.
World War II Money Growth and Falling Velocity
World War II ushered in a protracted inflation during which the money stock nearly tripled and wholesale prices more than doubled. Real income rose while velocity fell.
By the August 1948 postwar price peak, wholesale prices more than doubled and the implicit price deflator somewhat less than doubled. The money stock nearly tripled and money income multiplied more than two-and-a-half-fold. On average, wholesale prices rose 8.2 per cent per year, money stock 12.3 per cent per year, and real income 4.2 per cent per year while velocity fell at an average rate of 1.7 per cent per year.
In April 1942, the Federal Open Market Committee announced it would keep the Treasury bill rate fixed at three-eighths of 1 per cent by buying or selling any amount demanded. A rigid pattern of rates was established ranging from short-term bills to 2.5 per cent long-term bonds. To maintain these fixed prices, the Federal Reserve was forced to create whatever high-powered money was demanded.
6. Postwar Policy and Core Principles
The postwar era achieved monetary stability following the Treasury-Federal Reserve Accord, confirming that changes in the money stock exert an independent causal influence on economic activity.
Milton Friedman analyzes that the relative stability of the money stock growth rate was accompanied by steady output and price rates. From 1948 to 1960, the money stock grew at an average rate of 2.9 per cent per year, while money income grew at 5.0 per cent per year. Unlike long-term historical trends, money income grew faster than the money stock due to changing economic expectations.
The Treasury-Federal Reserve Accord
The Treasury-Federal Reserve Accord of March 1951 ended the central bank's responsibility for supporting government securities at pegged prices. Committed to supporting government bond prices, the Federal Reserve had been impotent against inflationary pressures. The March 1951 Accord liberated the central bank from this constraint, helping to halt the rise in wholesale prices and velocity by letting long-term bond prices decline.
Long-term 2.5 per cent bonds supported at 100 and three-quarters at the start of 1951 were quoted at 97 during the last half of the year.
Uncertainty increases the demand for cash due to its versatility and maximum flexibility in emergencies. The Great Contraction instilled an exaggerated fear of instability that depressed velocity, whereas the successful avoidance of major contractions after World War II gradually restored confidence and drove velocity back up.
Four Generalizations of Monetary History
A near-century of American monetary experience reveals four fundamental common elements that consistently govern economic activity. You can observe these recurrent principles across the entire period from 1867 to 1960.
The Federal Reserve System undertook three sharp acts of explicit restrictive policy that served as quasi-controlled experiments proving the causal power of money. Each action was followed within months by sharp declines in the money stock and severe contractions in industrial production.
In January and June 1920, the Federal Reserve raised the rediscount rate to 7 percent; in October 1931, it raised the rate to 3.5 percent during a banking panic; and in 1936-1937, it doubled reserve requirements in three stages. Following these actions, industrial production declined by 30 per cent in 1920, 24 per cent in 1931, and 34 per cent in 1936-1937.
10 Key Ideas
- Milton Friedman and Anna Jacobson Schwartz trace nearly a century of United States monetary experience from 1867 to 1960 to demonstrate that alterations in the quantity of money influence income and prices through proximate determinants like the deposit-reserve ratio and the currency-deposit ratio.
- The post-war financial system operated on an inconvertible fiduciary currency standard where a drastic and sustained price decline occurred despite a mild rise in the money stock because output grew up to its money stock.
- Under a gold standard with fixed exchange rates, a minor country's stock of money is ultimately controlled by external influences rather than domestic policies, while political agitation for silver created severe crises of confidence by generating distrust in the maintenance of the gold standard.
- Recurrent banking panics driven by structural vulnerabilities in the fractional reserve system—such as the growth in the ratio of deposits to currency and reserves—left the money stock fifty percent more vulnerable to deposit-currency shifts.
- The monetary contraction from 1929 to 1933 was the most severe in U.S. history, caused by inept Federal Reserve policy, widespread bank failures, and a catastrophic drop in the money stock that the central bank possessed ample powers to prevent through high-powered money injections.
- Federal deposit insurance became the most effective structural change for monetary stability since the Civil War because it eliminated public fears of losing convertibility into currency and halted destructive contagion.
- The New Deal structural changes included the Gold Reserve Act of 1934 devaluing the gold dollar and the Board of Governors raising reserve requirements to the maximum legal limit, which successfully reduced excess reserves by $1.5 billion.
- World War II ushered in a protracted inflation during which the money stock nearly tripled and wholesale prices more than doubled because the Federal Reserve was forced to create whatever high-powered money was demanded to maintain a rigid pattern of pegged interest rates.
- Uncertainty increases the demand for cash due to its versatility and maximum flexibility in emergencies, causing the Great Contraction to instill an exaggerated fear of instability that depressed velocity until post-war stability gradually restored confidence and drove velocity back up.
- The Federal Reserve System undertook three sharp acts of explicit restrictive policy in 1920, 1931, and 1936-1937 that served as quasi-controlled experiments proving that changes in the money stock exert an independent causal influence on economic activity.