The Contraction

Minsky located the cycle's cause in the instability of private finance. Milton Friedman and Anna Schwartz located it elsewhere — in money, and in the failures of the institution that governs the supply of it. In their monumental history of American money, they argued that the cycle is, above all, a monetary phenomenon: that sharp swings in the quantity of money drive the swings in output and employment, and that the greatest slump of all, the Great Depression, was not the failure of the market it appeared to be but the failure of the central bank to perform its most basic duty. This is the monetarist account of the cycle, and it stands as the principal rival to the Keynesian explanation of the very same events — a disagreement, at bottom, over whether the catastrophe of the 1930s was made in the market or in the policy that governed money.

Friedman and Schwartz traced, in patient detail, what happened to the quantity of money in America between 1929 and 1933. As the downturn began, waves of bank failures rolled across the country; and a bank failure, in that era before deposits were insured, simply destroyed money — the depositors' balances vanished with the bank. The frightened public, seeing banks fail, rushed to pull their savings into cash and hold it; the surviving banks, equally frightened, hoarded reserves rather than lend them, to guard against the runs they feared. By these mechanisms together — the destruction of deposits, the public's flight to cash, the banks' hoarding — the stock of money in the economy shrank by about a third in four years. This was the Great Contraction, as they named it. A shrinking supply of money meant ever less spending chasing the economy's goods, falling prices, and a deepening slump; the monetary collapse, in their telling, was what turned an ordinary downturn into the abyss of the 1930s. The Depression was, before all else, a contraction of money.¹

The heart of their indictment is that this contraction was preventable. The Federal Reserve had been created, in 1913, precisely to be a lender of last resort — to stand ready, in a panic, to supply cash to the banking system, halting the runs and keeping the quantity of money from collapsing. In the early 1930s it failed to do so. It looked on as banks failed by the thousand; it did not flood the system with the liquidity that would have stopped the runs and arrested the monetary decline; at moments, disastrously, it even tightened, raising rates to defend the gold standard while the economy strangled. The tools to prevent the Great Contraction existed, and they were in the Fed's own hands; they were simply not used. So the Depression, in Friedman and Schwartz's account, was neither an act of nature nor an indictment of capitalism but a failure of policy — the central bank's failure to perform the single function for which it had been built. Had the Fed acted as a lender of last resort, they argued, the slump would have been no worse than the ordinary recessions that pass and are forgotten.²

From this history Friedman drew a general theory of the cycle: that the quantity of money is its dominant force. Money, in this view, is not a passive veil over the real economy, as a strand of classical thought had held, but an active driver of it. When the supply of money grows steadily, the economy tends to grow steadily; when it lurches — collapsing, as in 1929 to 1933, or swelling too fast — the economy lurches with it, into slump or into inflation. The great fluctuations, on this account, are mostly the shadow that monetary instability casts on output and employment. And the policy that follows is the opposite of both the financial bailout and the fiscal stimulus: the way to tame the cycle is not to manage demand directly but to make money itself stable and predictable — to have the central bank expand the money supply at a steady, announced, rule-bound rate, year in and year out, neither contracting it into a slump nor inflating it into a boom. Steady money, Friedman held, would yield a steady economy; most of the violence of the cycle was the work of the monetary authorities, and the cure was to bind their hands to a rule.³

The monetarist account is a direct challenge to the Keynesian one, and the two divide most sharply over the meaning of the Depression itself. For the Keynesian, that catastrophe proved that the market can fail — that demand can collapse and stay collapsed, and that only the government, by spending, can fill the gap and restore employment. For the monetarist, it proved no such thing: it proved that the government, in the person of the Fed, had failed, and that the remedy was not fiscal activism but competent central banking. The disagreement could hardly matter more for what one concludes about markets and the state. Was the Depression a failure of the market, to be cured by public spending — or a failure of policy, to be prevented by better monetary management? Friedman pressed the latter: that the market, supplied with stable money, would have proved far steadier than the authorities who mismanaged it; that the cycle's great disasters were made not in the marketplace but in the institutions governing money. The quarrel has never been wholly settled, and the honest verdict keeps both insights alive: that demand can indeed fail, as Keynes showed, and that money mismanaged can be what makes it fail so catastrophically, as Friedman showed.⁴

The modern view absorbs something from each. It grants that a slump is, in its proximate form, a failure of total spending to reach what full employment would require; and it grants that the quantity of money — and therefore the central bank — powerfully shapes that total spending, for good or for ill. Whether the trigger is a financial mania that cracks (Minsky), a monetary collapse the central bank fails to prevent (Friedman), or a failure of confidence and investment (Keynes), the outcome converges: total spending falls below what full employment needs, and the economy slides into the slump. Which brings the volume, at last, to the deepest question — the one Say's Law had declared could never even arise. Grant that spending can fall short, by whatever cause. Why does that shortfall produce idle workers rather than merely lower prices? Why does the labor market not simply clear at a lower wage, as the orthodoxy promised, restoring everyone to work? Why, in plain terms, can a willing worker fail to find a job at all? That is the central scandal of the cycle, and the flagship confronts it head on. The next plate is the idle.⁵

Friedman and Schwartz located the cycle in money. The Great Depression, they showed, arrived with a collapse of the money supply by a third, as banks failed and the public fled to cash — the Great Contraction — and this monetary catastrophe, rather than any inherent flaw of the market, turned an ordinary recession into a decade of ruin. The Fed could have stopped it and did not; the slump was, at root, a failure of policy. From this they built the monetarist theory: that the quantity of money drives the cycle, and that stable, rule-bound money is the road to a stable economy. The account is the great rival to Keynes: where Keynes read the Depression as a market failure to be cured by government spending, Friedman read it as a government failure to be prevented by better central banking. Both insights endure — that demand can fail, and that money mismanaged can make it fail catastrophically. But neither has yet answered the deepest question: why a shortfall in spending idles willing workers, instead of merely lowering wages and prices until all are employed again. The next plate is the idle.