July 23, 2011

TIGHTENING MONEY INTO THE TEETH OF DEFLATION HAS CAUSED THE LAST FOUR SLOWDOWNS TOO:

In 1930 the Fed raised rates from 6% to 2.5% (Scott Summers, 7/21/11, Money Illusion)

No, that's not a typo. In October 1929 the discount rate was 6%, and by October 1930 the discount rate was 2.5%. So how can I say the Fed raised rates? Because interest rates are the price of credit, determined in the market for credit. And free market forces depressed the interest rate even more sharply than the 3.5% drop that actually occurred. Thus in a sense the Fed had to raise rates with a tight money policy, in order to prevent them from being much lower than 2.5% in October 1930.

Of course the discount rate is actually a non-market rate set by the Fed. But market rates such as T-bill yields fell by a similar amount in 1930.

A commenter of the Austrian persuasion recently argued that the Fed made a mistake by driving rates so low during the Great Contraction, and that if they hadn't done so, market forces would have weeded out the weaker and less efficient firms, laying the groundwork for a more sustainable recovery (I hope I got that right John.) [...]

Now for a curve ball. So far I've assumed the Great Depression just happened for mysterious reasons, and that the Fed responded with tight money, thus preventing interest rates from falling as far as market forces would have taken them (assuming a stable monetary base.)

But why did the Depression happen in the first place? It's very likely that the Fed's decision to reduce the monetary base by 7% was a major cause of the sharp contraction of 1929-30 (after October 1930 the base rose, as the Fed partially accommodated higher currency demand during the bank panics.)



Posted by at July 23, 2011 7:49 AM
  

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