Writing in the June 1965 issue of theEconomic Journal, Harry G. Johnson begins with a sentence seemingly calibrated to the scale of the book he set himself to review: "The long-awaited monetary history of the United States by Friedman and Schwartz is in every sense of the term a monumental scholarly achievement--monumental in its sheer bulk, monumental in the definitiveness of its treatmentof innumerable issues, large and small . . . monumental, above all, in the theoretical and statistical effort and ingenuity that have been brought to bear on the solution of complex and subtle economic issues."
Friedman and Schwartz marshaled massive historical data and sharp analytics to support the claim that monetary policy--steady control of the money supply--matters profoundly in the management of the nation's economy, especially in navigating serious economic fluctuations. In their influential chapter 7, The Great Contraction--which Princeton published in 1965 as a separate paperback--they address the central economic event of the century, the Depression. According to Hugh Rockoff, writing in January 1965: "If Great Depressions could be prevented through timely actions by the monetary authority (or by a monetary rule), as Friedman and Schwartz had contended, then the case for market economies was measurably stronger."
Milton Friedman won the Nobel Prize in Economics in 2000 for work related to A Monetary History as well as to his other Princeton University Press book, A Theory of the Consumption Function (1957).
REVIEW
A tremendous amount of work combined with a misspecified model Friedman and Schwartz(1963)did a great deal of worthwhile data compilation.The problem(an identical problem occurs in the 1956 work of Philip Cagan) occurs when they attempt to fit the data to the standard quantity of exchange equation MV=PO,where M is the supply of money(Friedman always selects MI to beequal to M),V is the velocity,P is the price level,O is real GNP(GDP),and PO is nominal GNP(GDP).The correct specification of the equation of exchange is M(Vw)=PO,where w is defined on the unit interval between 0 and 1.w is Keynes's measure of the weight of the evidence or Ellsberg's (rho)measure of the confidence a decision maker has in the information set he will use to calculate the probabilities of different outcomes.Friedman is a lifelong adherent and advocate of the Ramsey-De Finetti-Savage subjective approach to probability which argues that ,while the existence of vagueness(J M Keynes's weight of the A Treatise on Probability(uncertainty of the General Theory) or Ellsberg's ambiguity)is undeniable,it can't be modeled in a decision theoretic context.Only risk,represented by a normal probability distribution and its mean+ or- 3 standard deviations,can be operationalized.Friedman's section 4 of chapter 12,titled "Expectations about Stability ",discusses exactly what Savage called vagueness,Keynes called uncertainty,liquidity preference being a function of uncertainty AND NOT RISK,AND ELLSBERG CALLED AMBIGUITY.Friedman has no variable in his model to deal with it.He admits this on the second paragraph of p.675.Friedman's analysis abstracts from the role that expectations,confidence,uncertainty,and the flexibility of money(Keynes's liquidity preference)play in the demand for money .All of the Friedman-Schwartz analysis needs to be redone using the correct specification of the equation of exchange.Friedman's existing specification only holds in the special case where w=1.0,i.e.,that there is no uncertainty,ambiguity,or vagueness. MV=PO is a correct specification of the equation of exchange only if risk,measured by the normal probability distribution's standard deviation(or the standard deviation divided by the mean),is the only decision theoretic variable.All current forms of the equation of exchange ignore ambiguity and/or uncertainty and conflate risk with uncertainty.The equation of exchange has been misspecified from Hume to Friedman and Lucas.Only Keynes correctly derived a generalized equation of exchange.Keynes's analysis is contained on p.209 and chapter 21 of the GT.Lucas has already admitted that his framework of analysis breaks down completely if Keynesian uncertainty or Ellsbergian ambiguity prevents him from using his normal probability distribution.The massive 50 plus years of statistical analysis by Benoit Mandelbrot of data from all financial markets(stock,money,commodities,futures,currencies,bond) provides overwhelming empirical support for not using the normal distribution.Keynes,of course,would agree that, if the only decision theoretic variable of consequence is risk(Mandelbrot's mild risk),velocity would be stable or predictable.The fact that velocity is not constant or predictable means that Friedman's monetarism is only a very special case of Keynes's general theory,which,in terms of Mandelbrot's definitions,deals with mild and wild risk.Friedman can only deal with mild risk.
The Monetary History of the Great Depression The Great Contraction is an expanded reprint of the seventh chapter of the authors' A Monetary History of the United States, 1867-1960 which was first published in 1963. That monograph was a comprehensive study of money and its effects on the economy and the nation. It was one of the most important works of economics ever written; so well regarded, in fact, that it contributed to Dr. Friedman's winning of the Nobel Prize in Economic Sciences in 1976.
Milton Friedman is one of the most eminent economists of the twentieth century. His pioneering efforts in the field of monetarism revolutionized the way that economists thought about and studied the economy. (In short, monetarism emphasizes the role of money, especially the supply of money, in the functioning of the economy. This is contrasted with Keynesian economics which gives central importance to expenditures, particularly government expenditures.)
The basic premise of The Great Contraction is that the economic and financial collapse that occurred between 1929 and 1933-the most severe business cycle contraction in United States history-was largely the result of the inept application of monetary policy by the Federal Reserve System. The Federal Reserve had ample power to stop the devastating process of monetary deflation and the collapse of the banking system. Had they used that power in late 1930 or even in early or mid-1931, the successive crises that typify the contraction could almost certainly have been prevented. Appropriate action would have lessened the severity of the contraction and probably brought it to a much earlier end.
The most important contributing factor to the contraction, the authors believe, was the drastic reduction in the supply of money. From 1929 to 1933, the money stock fell by 33 percent, a continuous annual rate of 10 percent. This had a devastating effect on the economy. When the money supply decreases, the amount of funds available for loans decreases. This causes interest rates to rise, making it more expensive for businesses and individuals to borrow money, and, consequently, making them decrease expenditures on consumption and investment. This results in the economy shrinking.
During the contraction of 1929-1933, however, the effects were even more severe. Due to the huge decrease in the money stock, banks were unable to acquire enough high-powered money (vault cash plus funds on deposit at the Federal Reserve) to meet the demands of depositors. This forced banks to liquidate their assets at deep discounts in order to remain open. This was a dire short term remedy that wreaked havoc not only on the banks' balance sheets, but on the bond markets as well. The rapid selling off of assets, usually corporate or government bonds, drove prices through the floor which added to the panic in the financial markets.
When their level of assets dropped low enough, or they were unable to obtain enough funds, banks were forced to close. These bank failures further decreased the money stock, resulting in even more banks closing their doors. More than onefifth of the commercial banks in the United States, with deposits of close to $7 billion, eventually suspended operations. Total commercial bank deposits fell by $18 billion, a drop of over 42 percent. This vicious circle finally culminated in March of 1933 with the declaration by President Roosevelt of a one week banking holiday. These bank failures played a key role in the downturn in the economy. They eradicated people's confidence, caused an erosion of the financial system, and, most importantly, sharply curtailed the supply of money.
The Federal Reserve System was conspicuously absent during this period, especially during the final banking crisis at the beginning of 1933. The banks in the System abandoned their leadership role and instead participated in the general atmosphere of panic. The proper role for the System at that time, as always, was to act as a stabilizer for the nation's financial and banking systems and to ensure a constant flow of money and credit. It failed in both of these tasks. It is clear what course of action should have been taken, just as it was clear at the time. The Fed should have engaged in a program of aggressive open market operations (i.e. the purchase of government securities). This would have increased the money stock, particularly the amount of high-powered money held by banks, and would have helped to stave off the contraction of deposits and the subsequent bank failures. It was not until 1932 that the System undertook such a policy (under pressure from the Congress), but it was too little, too late. Its efforts only partially offset the previous contraction of credit and did nothing to stimulate an expansion of credit. The Fed also should have reduced reserve requirements (the amount of funds banks are required to hold against deposits), something they did not do until 1933, and then only for thirty days. Finally, it should have decreased the discount rate (the interest rate the Fed charges banks to borrow money), which was actually increased at times during this period.
Since the Federal ReserveSystem had the ability to undertake measures that almost certainly would have reduced the severity of the contraction, why did they not do so? The authors attribute that failure to a limited understanding on the part of the Board of Governors of the connections between bank failures, bank runs, the contraction of deposits, and the weakness of the bond markets. The Governors tended to regard bank failures as the result of bad management and banking practices, or as a consequence of the financial and economic collapse. They did not realize that the failures were instead a cause of that collapse, so they did nothing to prevent them. Furthermore, during this period there was a great deal of internal conflict within the System, particularly between the Governor of the New York Bank and the rest of the Board. Prior to 1929, the New York Bank had primacy in the setting of Federal Reserve policy, something the other members of the Board resented. Therefore, when the New York Bank advocated taking strong measures to combat the plunge in the money stock, the rest of the System resisted and argued against those recommendations. Thus, the proper course of action was thwarted and the contraction increased.
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Citation Details Title: Why A Monetary History has had a long life. Author: Anna J. Schwartz Publication:The Cato Journal (Refereed) Date: January 1, 2004 Publisher: Cato Institute Volume: 23 Issue: 3 Page: 353(3)
