John H. Wood
Abstract The Federal Reserve is generally believed to have caused or at least worsened the Great Depression of 1929-33. Its tight-money stance at the end of the ’20s and into the next decade caused or contributed to the large and prolonged declines in money and prices. However, there is little agreement on why the Fed behaved as it did. Its policy guide, depending on the writer, was the fallacious real-bills doctrine, a confusion of market and natural rates of interest, desire for the liquidation of speculative excesses, an obsession with the stock boom, misperceived constraints of the gold standard, and a narrow focus on financial stability. These guides are not mutually exclusive, and some are contradictory, but each has been advanced as the principal, or only, explanation of the monetary policies that brought or worsened the Great Depression. There is evidence for all of them. Each found its way into official policy statements, if only occasionally, and with liberal interpretations can be reconciled with some Federal Reserve actions. Isolated incidents and talk do not make a policy, however, and there has been no attempt to compare the significance of all these postulated causes within a unified framework. The purpose of this paper is to confront postulated policy effects with the data to determine which, if any, explains or helps explain monetary policy. It is not enough to correlate Fed actions with an alleged determinant in the absence of a model of policy in its absence. Before attributing Fed actions to stock prices or gold, for example, there must be an understanding of what it would have done in their absence, and for that it is necessary to look for a pattern of behavior before the Great Depression. I consider the period from 1922, when the Fed became a free agent, that is, after the U.S. Treasury released it from the obligation to support bond prices and the large postwar inflation and deflation had finished, through 1932, after which the New Deal took control of monetary policy. Conclusions are tentative, but so far the data suggest that only one of the proposed explanations explains a significant part of monetary policy throughout the period: the concern for financial stability. Others have made this point. This paper reexamines and, as it turns out, reinforces their work. There might have been more to policy, however, and I try to find out which, if any, of the other proposed explanations made a contribution. So far there is no support for claims that the real-bills doctrine, stock prices, the gold standard, the desire for liquidation, or a misinterpretation of interest rates ever governed monetary policy.