Chapter 5: Why Did Monetary Policy Fail in the Thirties?

Posted: 9 Feb 1998

See all articles by Allan H. Meltzer

Allan H. Meltzer

Carnegie Mellon University - David A. Tepper School of Business

Date Written: December 1994


The monetary policy of 1923 to 1929 led up to the great depression. French and U.S. deflationary policies forced deflation on other gold standard countries. The Federal Reserve did little as deflation and depression bankrupted firms, produced waves of bank failures and increased unemployment. This chapter considers why the Federal Reserve behaved as it did. A series of charts, including mainly data available at the time, show what was known at each meeting of the open market committee during the 43 months of decline. The chapter finds that Federal Reserve's failure stemmed mainly from acceptance of the real bills doctrine and the framework developed in the 1920s by two Federal Reserve economists, Winfield Riefler and W. Randolph Burgess. The latter frameworks focused attention on member bank borrowing. If borrowing was low, as it mostly was, open market purchases were unnecessary. The alternative conception--the real bills doctrine--left the initiative for expansion to member banks. If banks did not borrow by discounting real bills, the Federal Reserve should not act. Open Market purchases of government securities were especially bad because they based credit expansion on government debt, a type of speculative credit. Real bills proponents analyzed the depression as the "inevitable consequence" of the inflationary policies of the 1920s. To a modern reader this seems strange. The price level fell gradually from 1927 to 1929. This was irrelevant to the real bills proponents. Banks and the Federal Reserve had financed the expansion of the stock market. Speculative credit had to be purged. The differences between these views were resolved mainly by inaction. Large open market purchases did not begin until 1932, and much of their effect was offset by a gold outflow from the United States. After the fact, the Federal Reserve claimed that the so-called "free gold" problem prevented expansion. The minutes of the period suggest that this argument was not the main reason for inaction at the time. Economic decline from 1929 to 1933 was not a steady decline. A series of monetary and non-monetary shocks was interrupted by pauses or brief recoveries. The chapter identifies these shocks. Using a Kalman filter, I find nine large negative shocks and six large positive shocks to nominal GNP. This evidence alone rejects the popular belief that the depression was caused by the fall in stock exchange prices. Much additional evidence supports this conclusion. Some economists blame the international gold standard for the depth and severity of the depression. The chapter is skeptical of this explanation. The Federal Reserve did not follow gold standard rules and did not depend on foreign central banks. The deliberate behavior of the Federal Reserve and the Bank of France, not gold standard rules, created the deflation. Gold standard rules spread the deflation to other countries until the standard was abandoned. The beliefs that contributed most to the great depression were widely held in Congress, in the business community, and among academic economists. These beliefs were so deeply held that the Riefler-Burgess framework continued as a general guide to policy action and interpretation for many years.

JEL Classification: E42, E51, N12, N22

Suggested Citation

Meltzer, Allan H., Chapter 5: Why Did Monetary Policy Fail in the Thirties? (December 1994). Available at SSRN:

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Carnegie Mellon University - David A. Tepper School of Business ( email )

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