‘To economists reading this essay in 2010, perhaps the most remarkable single fact to note about monetary policy at the end of the interwar period” — the author, Columbia University economist Charles Calomiris, is of course also talking about the end of the Great Depression — “is that its architects were, for the most part, quite pleased with themselves. Far from learning about the errors of their ways during the interwar period, Fed officials congratulated themselves on having adhered to appropriate principles, and to the extent that they were self-critical, it was because they thought that they had been too expansionary.”
Almost all economists today agree that monetary policy during the Depression, especially its early stages, was disastrously tight, indeed that this contractionary policy is the principal reason the Depression became Great. But perhaps we should not judge the central bankers of America in the 1930s too harshly. For one thing, as Calomiris notes, smart economists are still arguing about the precise nature of the Fed’s policy mistakes. He himself presents evidence against the received view that the Federal Reserve precipitated the “recession within a recession” of 1937 by raising banks’ reserve requirements and thus discouraging lending.
More important — and more disturbing — is that it is not at all clear that we have learned from the mistakes of the 1930s. Those central bankers believed that money was easy because interest rates were low and the monetary base (the supply of money under the Fed’s control) had expanded. They worried that further easing would reduce confidence in the dollar. British economist R. G. Hawtrey, writing in the late 1930s, described the climate of opinion in his country at the start of the decade: “Fantastic fears of inflation were expressed. That was to cry ‘Fire! Fire!’ in Noah’s Flood.” The economy was actually deflating, not inflating. Under the influence of the “real-bills doctrine,” some central bankers believed that the money supply should respond only to traders’ need for credit. Anything else would only fuel speculative excess.
Today’s inflation hawks employ the same reasoning that those firefighters did. And they are not wholly wrong. Easier money can lead to a destabilizing run on the currency. Inflation can be associated with low real interest rates and an expanded monetary base. But not always: Not in the 1930s, and almost certainly not today, either. The late Milton Friedman, perhaps the most famous inflation hawk of his generation, spotted the fallacy in his analysis of 1990s Japan: Low interest rates can also be a symptom of an excessively tight monetary policy that has choked off opportunities for growth. A looser policy, by increasing expectations of future economic growth, could actually raise real interest rates.
To see why changes in the monetary base are also an unreliable guide to whether money is loose or tight, I’m afraid it’s necessary to look at an equation. Friedman and others familiarized us with the equation of exchange: MV=PY. What that means is that the money supply (M) times the speed with which money changes hands (V, for velocity) must equal the price level (P) times the size of the real economy (Y). If velocity holds constant and the money supply goes up, either prices must go up or the economy must expand or both.
If, on the other hand, velocity drops — if people have an increased desire to hold money balances — then either prices must drop or the economy must shrink or both. And prices, especially wages, are sticky. They won’t automatically and evenly fall in response to a shock. So at least some of the reduction in PY, and maybe a lot of it, will have to come from real economic contraction. What this suggests is that if velocity drops unexpectedly, stabilizing the economy will require increasing the money supply to make up for it. Another way of putting it is that if the demand for money balances increases, the money supply has to grow to accommodate it. If the Fed does not increase the money supply, its inaction in the face of changing economic conditions amounts to passive tightening.