This morning's lecture is entitled Money and Gold in the 1920s and 1930s, Defending the Rothbardian position. Marty Rothbard's book, America's Great Depression, was published in 1963, which was a year after, I believe, the publication of Milton Friedman's book, Monetary History, Milton Friedman and Anna Schwartz's book, A Monetary History of the United States. In Friedman's book, he tried to rehabilitate the quantity theory, and in particular, he tried to use it to show how the Great Depression was caused by a deflation of the money supply. That was completely unjustified, and that was engineered by the Fed, and that the prior decade, the 1920s, was in fact not an inflationary decade at all, so that absent the Fed's deliberate decrease or contraction of the money supply, there would have been at most a small and short recession in 1929 and 1930 that would have rapidly turned around into a recovery as occurred in 1921.
So Friedman was, at this point, attempting to get this view accepted by the mainstream. Okay, the mainstream accepted the Keynesian view that it was a collapse in the marginal efficiency of capital, marginal efficiency of capital, or in other words, investment spending, and also consumer spending and attempt to reduce the deficit that caused the Great Depression. And Friedman was attempting to get his monetary explanation of the Great Depression accepted, and this was really the beginning of the monetarist's counter-revolution against Keynesian economics, the appearance of this book. Now, Rothbard comes along and writes a book, it's also a free market, it's also anti- Keynesian, and that gives a radically divergent explanation of what went on in the 1920s, for Rothbard in the 1920s, extremely indeed inflationary, and why the Depression resulted in the 1930s.
Even more irritating to Friedman, he argues that the Fed was actually attempting to inflate the money supply, though unsuccessfully in the early 1930s. So the monetarists have always, from the beginning, attempted to either discredit or marginalize Rothbard's market's Great Depression by ignoring it. But every once in a while a monetarist will comment on it, and the comments are usually the same. First, somehow Rothbard contrived the definition of the money supply that made the 1920s appear to be inflationary decade in order to apply the Austrian theory of the business cycle to the explanation of the Great Depression.
And secondly, they also claim that Rothbard invented a view that the Fed was not trying to deliberately deflate the money supply or contract the money supply in the 1930s. And this all came to a head, by the way, these generally were off the cuff remarks, they weren't down anywhere, many Austrians actually accepted these minus-risk criticisms of Rothbard's book, believe it or not. The S-Rothbard suddenly came up with this very broad measure of the money supply, which in no way reflected the realities of the medium of exchange. And so Austrians tended to say, you know, accept that, because Rothbard did include, as we'll see, life insurance, net policy reserves, basically the amount of cash that someone could cash out by borrowing against his or her life insurance policy.
And also the fact that the money supply did decline severely in the early 1930s, makes it a little strange, or makes it dubious that the, the, uh, appear dubious that the Fed was actually trying to inflate the money supply. Isn't the Fed all-powerful? You can't the Fed simply increase the money supply, you know, ad libietum or at will. So, as I grew up in the Austrian movement, I would hear these criticisms of Rothbard and I would see that some of my colleagues would accept these criticisms, that Rothbard really went too far in trying to apply the Austrian business cycle theory.
So we have a bill of, or a set of criticisms, advanced in 1999 by Richard Timberlake in the Freeman, and I responded to these criticisms. He wrote three articles, a trilogy of articles, in which he criticized Rothbard, and he also criticized some of the Fed and Treasury policies, and I actually defended all three. I actually defended the Fed in at least one of his policies, and the Treasury in one of his policies, in my response. So what I'd like to do is to, is to go over that debate, let me just start by showing you Timberlake's particular criticisms of Rothbard, okay, in his own words.
He says first that, um, Rothbard has contrived a new and unacceptable, or invented a new and unacceptable meaning for the term inflation, secondly that it contrived the definition of the money supply to invent a Fed orchestrated inflation of the 1920s, uh, thirdly that Rothbard somehow mismeasured the central bank's monetary data. And lastly that Rothbard misunderstood the nature and operation of the pseudo gold standard that was controlled by the Fed after 1933, so I wanted to defend Rothbard on these points. Timberlake also goes on in these three articles, and I'll touch on this, to say that the U.S. Treasury's policy of neutralizing gold inflows, um, as well as the Fed's policy of a sharply increasing reserve requirements in the mid-1930s, um, led to, uh, or aborted an economic recovery that was just beginning, okay, and it resulted in a recession within the depression, the recession of 1938, so I'll comment on that also.
So as I said, um, Timberlake begins by claiming that Rothbard proceeds on, on, on a new and unacceptable definition of inflation, meaning that Rothbard made this up, by, by, by, by expressing it in this manner, you would think, well, no one else in the history of economic code has ever used this type of, of definition of inflation. Um, well let me start with that point. Rothbard's definition was simply that the increase in the money, well, that inflation occurred when there was an increase in the money supply, not consisting in, not covered by, that is, an increase in gold, okay, those are his words, okay, but as I show in, in, in my response, this is really an old and, and, and, and a venerable, um, definition, okay, this definition uh, developed out of the controversies between the currency school, the good guys, the sort of proto-Austrians, and the British banking school, okay, proto-Canesians, in the mid-19th century. Basically, according to the currency school, which, uh, which triumphed, uh, temporarily into debate, uh, the gold standard was not enough to prevent inflation and, and, and recessions.
Great Britain had gone back to a gold standard in 1821, um, and yet it had been plagued with the business cycle. Well, what the currency school point out, pointed out was this, if commercial banks were permitted to, um, operate on fractional reserves to lend out a part of their depositor's, um, money, what would occur would be, uh, an increase in the money supply, that is, we would have fiduciary media, unbacked notes and deposits, and that would drive up prices in Great Britain. And as prices rose in Great Britain, uh, British citizens would begin to shift their purchases to foreign products, increasing imports. At the same time since gold prices were higher in Great Britain, foreigners would reduce their purchases from Great Britain causing exports to fall.
So you'd get a budget that, you would get, um, a balance of trade or balance of payments deficit in Great Britain. And the ways would be paid for would be by gold flowing out, okay, the people who had to make purchases of water, had to, had to finance their purchases abroad, would, would take their British pounds, their paper pounds, or, or their deposits, and go to the banks and turn them in for gold. People begin to flow out of the country, okay. The banks at that point would become a little panicky, uh, they would be worried that there would be an internal drain developing as a result of the external drain, the external drain is, is gold flowing out of the country.
As people saw this, they would get nervous about being able to redeem their notes and deposits, and therefore, they would be the threat of bank runs, which is the internal drain, that is, uh, British citizens would attempt to withdraw even more gold, okay, by converting their, their, their, their bank liabilities. So to prevent this, what regularly happened was that the banks then would reverse their policy, would cut back on their loans, um, the, the money supply would fall, and there would be a decline in prices in Great Britain, and with this decline in prices, you would have deflation and, and, and depression. Eventually gold would flow back into the country because of the lower British prices, as the money supply shrunk, and you would, um, you would have a recovery eventually occurring, but then the banks would begin the same cycle again, because they want to earn interest. So as, as, as, as the positive flow back in the bank, they would then engage again in, injecting, to do sharing media into the economy raising prices and storing the cycle over again.
So what was the currency school's policy recommendation? What they said was, well, we can prevent this, okay, we have to go beyond the gold standard. We have to prevent banks from issuing notes, okay, in particular the Bank of England, um, beyond the amount of gold that they held, okay. Now, this was a marginal rule.
What they said was any note that was issued had to be backed by the full face value in terms of gold. In other words, what they wanted implemented was a, a marginal 100% rule. Every expansion in the, in the supply of notes in the economy would reflect gold flowing in to the banks from abroad, okay, or people depositing gold in the banks. So no, no, no, on back note would ever be put to circulation again, and they got this passed.
Unfortunately, it didn't stop the inflationary booms or the, or the ensuing recession depression, okay. Well, why not? Well, unlike the American currency school who followed the British currency school, um, they did not, or they neglected, or ignored the fact that bank deposits, checking account money, was also part of the money supply, and therefore that this marginal 100% rule should also apply to checking the deposits. So what the banks did then was to inflate the supply of checking account money in the economy, okay, that is increased or inject the deuceary media, unbacked, um, money substitutes by loaning, not notes, but by, by increasing deposits, by loaning money out through increasing deposits.
Okay. And as a result, we were stuck with this, um, uh, or, or, or, or, or, or, or, or, or, or continue to, to suffer from the business cycle. Now, during the brief period when the currency school trium, during the period when the, the, um, the act that implemented this lowest pass, people began to use inflation according to the currency school definition, which was, use the term inflation as a currency school to find it. That is, an increase in the money supply that exceeded the amount or increased in, in, in gold.
So one, one American financial writer, um, Charles Cole Cowell, who was an American currency school writer. He wrote that the source of inflation and other commercial crisis is in the nature of the system, which pretends to lend money, but creates currency by discounting such bills when there is no such money in existence. Okay. And so instead of using gold and silver for currency, they're merely used as a basis of the greatest possible inflation by the banks.
So it was, he said it was the artificial increase of currency only, meaning the amount of currency that was put into circulation beyond the, the, the, the gold stock that was causing the problem of inflation and then later depression. Um, and then in the last quarter of the, um, 19th century, the greatest American monetary theorist, um, Francis A. Walker also believed that inflation was an inherent feature of the issue of, of even convertible bank notes, bank notes that could be converted into, um, end deposits. Okay.
So the bank notes and deposits that could be converted into gold, um, if they were issued beyond a stock of gold, if you had fraction reserves, uh, banking, resulting in, or that, that was, um, in, in place, then in his words, there is eyes and banking money, even under the most stringent provisions from convertibility, the capability of local and temporary inflation. So what he was saying was that, um, even where banks stood ready to convert these notes into gold, because they were issuing these notes into deposits beyond a stock of gold that they held, um, you, you would get inflation. So this is not a new and invented definition by Rothbard, okay. That was the older definition of, of inflation.
Um, on the other hand, when the banking, when the, when the currency school was discredited by the continuing business cycles, again, because of, of, of the defect in their policy, which did not apply the 100% marginal reserve rule to, uh, to check and account money, uh, then the banking school, their opponents, their definition of inflation came into play. It still referred to the money supply, okay. It didn't yet refer to just an increase in prices, but their definition was that inflation was an increase in the money supply, not beyond the stock of gold in the banks, but beyond the needs of trade, okay. So if somehow there were more people that, um, were trading that according to the, uh, banking school would be reflected in the fact that more, um, borrowers would come to the banks more business borrowers demanding loans.
And that the banks had the right then to discount these loans or had the duty to discount these loans, and that would not be, uh, discount these bills that were being given, or increase the loans. And that this would not be inflationary. So that, uh, definition of inflation began to replace the currency school, uh, Rothbard, um, definition. And what was pointed out, uh, according, um, by, uh, by opponents of the, of the banking school, is that the banking school could increase the needs of trade as much as it wanted.
It could just simply lower the interest rate, the lower the interest rate, the more businesses would want to borrow. Okay. So the banking school would say, well, look, um, businesses are coming through the banks and they want to borrow. So we have, you know, because they want to borrow, that means that their needs of trade have expanded, and it's, it's, it's proper to, to, um, to fulfill those, those needs by increasing lending.
But all this did was to drive up the money supply, okay, and cause inflation. So I, to, to, to, um, to conclude this here, um, Rothbard's theory surely is not new, and to say that it's unacceptable. It's simply to express one's agreement with the preference for the banking school over the, the currency school definition. By the way, the banking school definition that inflation was an increase in the money supply beyond the needs of trade was one step away from the modern definition that inflation is simply an increase in prices.
Because the American quantity theorists, later on, okay, Irving Fisher, um, Edwin Kemmer, who were early quantity theorists in the United States, they basically said that inflation occurs whenever the country's circulating media, and by that they meant money in the positive currency, increase relative to the needs of trade, okay, because when they went beyond the needs of trade, they drove prices up. So it was a short step in the 1930s to then redefine inflation as simply an increase in prices, okay. Now, Timberlake also challenged Rothbard's physical definition of the money supply. On two grounds.
First, Rothbard included savings and loan share capital, okay. There were institutions, savings and loans that were owned by their depositors, okay. So when you went and, and deposited money into savings and loan, you were not given a checking account or you were not told that you were a depositor, you were a shareholder. Now that meant that in some sense you were, you were an owner.
So that was the first thing that Timberlake objected to. Secondly, Rothbard also included the life insurance net policy reserves. So Timberlake claimed that Rothbard included these two items in the money supply as a way of trying to make the 1920s look like a more inflationary decade than it really was, okay. And he went on arguing, Timberlake did, that the two items in question are not money because they cannot be spent on ordinary goods and services.
To spend them, one needs to cash them in for other money, that is, current to your bank graphs, okay. So let me take these one at a time. First, the share accounts offered by savings and loan associations were fixed at $1, okay. So if you put a dollar into your account, then you got $1 of a share in the savings and loan, okay.
But they were back then and always have been, okay, even until the 1980s. We had savings and loan associations that were owned by the depositors and issued share accounts and savings and loan associations that were owned by stockholders and they issued savings accounts. But economically, the accounts were exactly the same, okay. In both cases, whether it was a share account or a savings account, you could withdraw your money on demand at par.
So if you had $10,000 worth of shares in a savings and loan, okay, you could immediately withdraw that. In fact, the savings and loan associations were contractually obligated to repurchase their shares at par upon the request of the shareholder. But they could legally delay the repurchase, they could legally delay it, okay. Just as savings and loans could, other savings and loans, the non, the savings and loans that issued only savings accounts, they could delay it too by insisting on 30 days notice.
Other institution, even type of savings and loan institution, ever or to any extent, insisted on previous notice before, let's say 30 days notice before they would allow you to withdraw your shares or your deposits, okay. And in fact, one commentator points out that for many years, savings and loan associations have made the proud boast that every withdrawal paid upon demand or some similar statement. So it's certainly true as Timberlake claims that shareholders had to trade their share accounts in for currency or bank drafts, okay. But they got them at par on demand and then they were able to spend money with the services so there were really no difference in savings accounts, let's put it that way, okay.
Rockwater was simply recognizing that a legal technicality shouldn't stand in the way of identifying something as money when essentially it functioned as money, when essentially your share account allowed you to withdraw readily spendable dollars, okay. And they were just as readily spendable as dollars that were held in commercial bank savings deposits, okay, which by the way, Timberlake does include in the money supply, okay. In his definition of the money supply, he includes a savings deposit offered by commercial banks, which is the same thing, okay. Now secondly regarding this point, he does not object to Rockwater's inclusion of the savings deposits of mutual savings banks in the money supply, okay.
Although mutual savings banks are also owned by their, were owned by the depositors. So he doesn't, he doesn't object to that and they're identical in their function to savings and loan associations and we're also technically mutually owned by the depositors, but he doesn't object to people to include, to including their savings deposits, okay, that people could withdraw on demand though subject to a never enforced 30 day notice in the same way. So why then does, Timberlake insists so vehemently on treating the liabilities of these two institutions, both of which are supposedly owned by the shareholders so differently, okay. Well it goes back to Friedman and Schwartz.
Friedman and Schwartz in their book, their great book, excluded the share accounts of savings and loans and of credit unions from their definition of the money supply on the grounds that these institutions are technically not banks, as defined in accordance with the definition of banks agreed upon by the federal bank supervisory agencies, okay. Since quote holders of funds, these institutions are for the most part, technically shareholders not deposits. Who cares if they're technically shareholders? Who cares what some bank regulatory agency says?
This is just simple legalism, subject to economic analysis, okay. These items are part of the money supply, precisely because people can interchange them at par on demand for checking accounts or for cash, okay. So this brings us to the net policy reserves of life insurance companies, okay. When people have certain life insurance policies, they are permitted to borrow, take an instant loan, okay, against these whole life insurance policies, okay, up to a certain percentage.
The Rothbard then included those net policy reserves, the extent to which people could withdraw money from their insurance policies, okay, on demand. Now that's controversial, I don't believe it belongs to the money supply, and even when my Rothbard 9 in the 1980s came up with what we call the true money supply, we cooperated in coming up with a sort of endorsement of the money supply, we left out net policy reserves, okay. In any case, though, this is not Rothbard trying to contrive some sort of broader measure of the money supply, so as to make the 1920s appear as if it was more inflationary than it really was. Because if you look back in the 1960s and 1970s, and look at mainstream Keynesian textbooks, okay, on money and banking, you'll find that many of the writers included these as part of the money supply or as a very liquid asset that was very, very nearly money.
For example, a book by Walter Haynes characterized insurance companies as savings institutions, okay, and noted that these savings can't be withdrawn at any time simply by allowing the policy to collapse, a feature that marks them as a near money, okay, on a poor savings account. So here's one writer that put them on a poor savings account, ML Burstein maintained that the cash value of a life insurance policy or for quote, readily convertibility into cash was almost as liquid as a mattress full of currency, so he's saying it's almost like currency, which you're going to meet with, what, and satisfied the precautionary motive for holding liquid assets, no less than savings in loan accounts and savings bonds. Albert Hart and Peter Kennan included the net cash values of life insurance in the broadest class of financial assets possessing the attribute of moneyness, okay, so the Keynesians approach their definition of the money supply a little differently than the Austrians, they believe that liquidity determines if something is part of the money supply, how easy it is to get cash for it, and so in the broadest aggregate or monetary aggregate, as I said, Hart and Kennan include the net cash values of life insurance. Finally, Thomas Cargill, who I believe is a monitor, is ranked, ranked these net cash values or net surrender values of life insurance policies, he ranked them on a liquidity spectrum, immediately below the specifics of deposit, which are included in the current and three definitions of the money supply, so whether rock water is right or wrong in including these, he certainly was in good company, there were other economists with other definitions of the money supply that were including the net cash reserves of life insurance policies in their definitions of money, alright, well I went on and I took out these net cash reserves, okay, to see how it would affect the how inflationary in the 1920s war, and that is the rate at which the money supply increased, and what we find is the following, I'll fix that by doing the lights, here we go, is that good?
No, I'm going to write something, I just turned the thing over, what I found, when I recalculated rock water's money supply, okay, leaving out net cash value of life insurance policies, okay, so let's call it the RM for rock water's money supply, and the percent increase in rock water's money supply, did I talk something that wasn't, yep, sorry, okay, alright, it turns out that from 1921 to 1928, according to the rock water's money supply increased by 61%, now on a yearly basis that's 8.1% per year, now recalculating rock water's money supply and leaving out the net policy reserves, I found that instead of 61%, the overall increase was 55%, which yields a 7.3% per year change in the money supply, still a tremendous rate of inflation of the money supply, okay, if we do this marginally, okay, it doesn't, that 7.3% can just as easily set off the off-your-business cycle theory that's flowing through the credit markets as a banks injection money into the economy, okay, just as easily as an 8.1%, okay, I think it's a minimal difference, okay, now rock water goes on, or I'm sorry, it goes on to Chris Lachroic board for ignorance of the flawed institutional framework within which the gold standard and the central bank generated money, okay, and also mismeasurement of the central bank's monetary data. In fact, rock water was quite aware that the U.S. monetary regime of the 1920s and 1930s was not a genuine gold standard, okay, that in fact it was a watered down version of the gold standard, it was what we might call the form of the gold exchange standard, okay, it was in fact a hybrid system in which it wasn't merely market forces, okay, that is the inflow of gold from abroad and through the bounce of payments to a board that determined the money supply, okay, but the Fed fact possessed substantial power to manipulate the money supply regardless of what was happening to the stock of gold in the economy, okay, by pyramiding paper reserves, okay, both notes and deposits, on top of the stock of gold reserves. So in fact, rock water went much further than timber lake in completely separating those factors affecting the money supply that were subject to the Fed control and those factors that were not subject to the Fed control, for example, in the gold stock, okay, so now what timber lake does is the following, he says, well, the Fed was actually deflationary during the 1920s, the Fed was attempting to be deflationary during the 1920s and he arrives at this by the following, he says, look, we have the monetary base which under the gold standard includes the amount of currency in circulation plus reserves, okay, which include gold as well as bed notes, okay, banks hold both gold and bed notes as reserves, okay, so that's known as the monetary base, and what timber lake then does is to say, well, the Fed does not control the gold supply, okay, the gold supply is determined by the balance of payments which is determined by market forces, so he subtracts from this the gold stock and he calls, actually I should do that on the next line, he calls this the net Fed, what the Fed can control, the Fed can control, of his, of course that out, the Fed can control currency plus reserves minus the gold stock, so it can control the paper currency in circulation and the paper reserves that banks hold, they can't control the gold reserves because they are determined, as I said, by the balance of payments, now he says, if we look at what he calls the net Fed, okay, the part of the money supply, the base of the money supply that can control, he says that in fact this aggregate from 1921 to 1929 fell by 8% per year, so not only was the 1920s not inflationary decade, not just not the money supply, the money supply was going off and not according to the monetarist, but not at a very great rate, not at the rate that Rockboard had claimed, but not only was it not inflationary decade, the Fed itself was trying to deflate the money supply, according to, according to Timberlake, okay, it was only the uncontrolled gold stock that continued to cause the money supply to increase, this gold was flowing into the U.S., well it is true that the gold stock is uncontrolled by the Fed, but Rockboard pointed out that there are other factors that are uncontrolled by the Fed, for example, the currency in circulation is uncontrolled by the Fed, people can take currency in circulation and that they are holding and deposit in the banks and that becomes part of bank reserves, which then would cause a multiple increase in checking account money, so whenever anyone puts a dollar, let's say today, into the banking system, you cause at the limit an increase in checking account money by $10, on the other hand, if that Christmas you want more cash, if you're going to buy small gifts and so on, and you withdraw, and this does happen by the way, in a very large way during the Christmas season, you withdraw $1,000 from your checking account, that would cause a decrease of all the things equal in the money supply by $10,000, okay, so currency, which is the currency in circulation, which is controlled by the Fed, not by the Fed, but by the public, all right, so we point out that that currency in circulation, or I point out that currency in circulation, it really is improperly in timber lakes in the Fed aggregate, okay, this is not controlled by the Fed, it's controlled by the banking public, all right, that's not all, okay, under the prevailing policy regime of the 1920s, the banks themselves could reduce the amount of bank reserves, and that's the quantity of money in existence, by deliberately reducing their indebtedness to the Fed, in other words, if they wanted to borrow from the Fed, the Fed kept the discount rate, the rate at which it loans to the banks at a very low level, a level that was below the market level, so when banks came and borrowed, okay, at that rate, they could then lend at a higher rate and that would expand the money supply, so the Fed could control that, by raising interest rate, the Fed could restrict borrowing from itself and therefore control these borrowed reserves and the increase in the money supply that resulted from them, however, on the other hand, the banks themselves had the right to pay back these loans at any time, or let them lapse, not renew them, and when they paid back the loans, that decreased the money supply, now the paying back of the loans, according to Rothbard, I think it's correct here, is controlled by, not by the Fed, but by the banks, so according to Rothbard, we're going to call it the controlled factors, okay, the Fed's controlled reserves, okay, that's one of the controlled reserves, this is Rothbard's equation, you have to subtract from the monetary base, so let's start the monetary base, which is currency plus reserves, not only the gold stock, because that's not controlled by the Fed, you also have to control, I'm sorry, a contract, currency, because that's not controlled by the Fed, and finally you have to control or to crack net bills repaid, okay, so when banks pay back their loans from the Fed, that reduces the amount of reserves they hold, and that reduces the money supply, so the Fed controls then only a portion of the reserves of the banks, okay, that portion that they can inject into the system through open market operations, by going out and buying, by creating money and buying various government securities and so on, so if we readjust the factors that can be controlled by the Fed, we find, according to Rothbard, for following the, in contradiction of what Timberlake is telling us here, that there's the Fed was deflationary, or trying to be deflationary during the 1920s, Rothbard points out that the Fed increased controlled reserves, the reserves that could control by 18% per year, so the Fed was attempting to inflate the money supply during this period, okay, which brings us to the 1930s, it was claimed by Timberlake that there was an intention on a part of the Fed to deflate the money supply, okay, and its intention is reflected according to him by what is happening, the rate at which the net Fed is changing, and he claimed that the Fed was, oh, before I actually get that, I didn't want to make one more point, Timberlake makes the point that the Fed wanted to help Great Britain, Great Britain was losing gold, it went back onto the gold standard at an overvalued par, okay, it had inflated greatly during World War I to pay for World War I, the finance of the war, and therefore had increased the money supply and prices, what it tried to do to reestablish this position as a financial center of Europe and of the industrial world, it tried to go back onto the gold standard at the pre-war par, okay, now that meant that in order to do that, it had to reduce prices by at least 10% or so, because otherwise prices would be very high in terms of gold in the rest of the world, particularly the coal unions in Great Britain would not take wage cuts, so it was very difficult to deflate the money supply in Great Britain, so the president of the Bank of England asked the president of the New York Federal Reserve Bank to help Great Britain, you know, the New York Federal Reserve Bank was the most powerful bank in the system at the time, okay, and so there was agreement that the US would change its monetary policy in a way that would stop Britain from losing gold, okay, why would Britain lose gold by going back on to the gold standard at an overvalued par, precisely because its prices were so high relative to the rest of the world that its exports were low or were falling and its imports were high, so it had a balance of payments, that was losing gold, okay, so the US wanted to help Britain reverse that loss of gold, so what did the US do, okay, somehow Timberlake thinks that the Fed deflated to help Great Britain, but it's the opposite, theoretically the way you help a country that's losing gold is to raise your own prices, so that relative to their prices, so that cuts down on imports from the United States and it increases exports from Britain to the United States as our prices go up, and if that was a Fed's intention and in fact it operated on controlled reserves to bring about that intention, okay, and you know, so Timberlake himself was contradicting himself by saying, if Fed wanted to help Great Britain, wanted to stem its balance of payments deficit, but intentionally deflated or tried to deflate during the 1920s, well that wasn't the case at all, okay, it did want to help Great Britain correct, but in fact it inflated, okay, that was its intention, another monitor is named Kenneth Wayer, who actually wrote a pretty good book on monetary fiscal policy, he wrote the following, he says Great Britain was calling for help in 1924 and a Benjamin Strollen, president of the New York Fed, heard the call, expansionary monetary policy in the US would drive prices up and just raise down in this country, so that money would flow into Great Britain in search of higher interest rates, which would tend to send gold flowing towards Great Britain where prices were lower and interest rates were higher, these changes would help Americans ally build up the gold stock, there can be no question that the Fed would not have moved when it did or not for concern of the gold standard and the plight of Great Britain, by 1927 the steg and British economy needed help in the United States and the rest of Europe, just as had been the case in 1924, monetary policy was shifted to an expansionary program in order to aid Great Britain struggles to return to the gold standard, unquote, okay, and that's why a monitor is, okay, so rockwise reinterpretation of the monetary data and what the Fed could and could not control really also cuts against Timberlake's claim that the Fed quote monetarily starved the country into the worst economic crisis it has ever experienced, okay, that's Timberlake's quote, okay, on the contrary, if we look at the factors that were controlled by the Fed, okay, they continue to exercise a really highly inflationary impact on bank reserves and the money supply, from 1929 to 1932, this is precisely the period during which Friedman and Schwartz claimed that there was a great contraction of the money supply that was caused by the Fed, yes, there was a contraction of the money supply, but it was not caused by the Fed as I'll show you, it was caused by uncontrolled factors, it was caused by people pulling their currency out of the banks because they were fearful of banks would collapse and their savings accounts and checking accounts would disappear, it was caused by foreigners taking their investments out of the country and therefore causing gold to flow out of the country, it was caused by the banks themselves increasing their excess reserves, that is not lending out money when they could have, okay, instead holding the money rather than lending it out at interest because they were fearful that the lenders with the fall because of the depression.
So if we look at some of the statistics here, we'll see what Rothbard was talking about, okay, just keep in mind that there was a loss of confidence during this period in the Fed dominated, you know, phony gold standard, okay, both by the public and by foreign investors, right, so as I said, we had a decrease in current, we had an increase in current in circulation, reserves are taken out of the bank, people cashed in there, they're checking accounts with a few money from their savings accounts and so on and so the banks lost reserves and had reduced the money supply and as I said, foreign investors took their money out of the country and cashed in dollars for gold and took that out of the country, so the gold stock declined and that also caused a decline in the money supply, okay, and then finally banks increased their liquid reserves and stopped lending the maximum that they could have under regulations. So let's look at the statistics, from the end of 1929 to the end of December, to the end of December, 1931, bank reserves fell from $2.36 billion to $1.96 billion, okay, causing the Rothbard's money supply to drop, so the money supply dropped in those years from about $73.52 billion, okay, 1929, and this is in billions, to by 1931, 68.25 billion dollars, that was the end of 1931 and then it also dropped in 1932 and 1933. During 1932, it continued to decline, it fell to 64.72 and it fell by another $3 billion in 1933, so it was down to 61.72. Okay, so Rothbard agrees with the monitors, okay, there was a collapse in the money supply, where he disagrees with Timberlake and the monitors, was the causes of this collapse, it's quite a collapse, quite a decrease in the money supply, okay.
What he points out is that the Fed furiously inflated controlled reserves, in the last 10 months of the year controlled reserves rose by over $1 billion or 76%, that is in 1933, they increased reserves by 76% in the banking system, okay. Oh, actually that was 1932. The story was the same in 1933, they increased controlled reserves by $785 million in one month alone, okay, but this was defeated by the public in the banks, okay, and as I said the money supply decreased by $3 billion, let me see if I have overall figures here in terms of percent. The Fed increased controlled reserves by 17% from 1929 and 1931, okay, so you have that increase by 17%, and as I said in 1933, they continued to increase the amount of reserves in the system that they could control.
Now, the Fed defeated that, if you go back to this, this equation, okay, the Fed's controlled reserves, even though the Fed was increasing the point of the monetary base, they had to control through open market operations, banks were paying back their borrowings from the Fed because they didn't want to loan them out, interest rates were very low, the borrowers didn't have good credit, so bank reserves were falling for that reason, people were withdrawing currency from the banking system, decreasing the reserves more, and foreigners were taking their investments out of the country, and in order to do that, you had to cash in your dollars for gold. So, it was not the Fed that engineered this massive deflation, it was a phony gold standard that was breaking down that the public had lost confidence in, and that's why people were simply reclaiming their property, both foreigners and American citizens. They were reclaiming their property from a fractional reserve system that couldn't pay off, okay. Now, let me just talk about two similar points, okay, and this is where he criticizes both the treasury policy and the Fed policy.
Okay, the first criticism is the policy that the treasury filed of neutralizing or sterilizing the effect of gold, the inflow of gold on bank reserves from late 1936 to 1938. So, in other words, when gold flowed into the U.S. during this period, during those two years, instead of issuing dollars, okay, as those, or bank reserves on the basis of gold, okay, the Fed sterilized the gold inflow, which meant that as they bought the gold that came into the country, they sold government securities to the same extent, so there was no net effect on the money supply. Now, why would they do that?
The reason why they did that was because, in fact, we weren't even on a gold standard from 1936 to 1938. What had happened was that in 1934, the Roosevelt administration had the value of the dollar, that is, it raised the price of gold from $20.67 to $35, meaning it devalued the dollar by 60% in terms of the amount of gold to contain. It now contained only one 35th of an ounce of gold instead of one 25th of an ounce of gold. So, the price of gold suddenly jumped up in the United States of $35.
Well, foreigners aren't stupid, but they did was then they began to send gold to the United States in exchange for the higher prices, this was the highest price of gold at the time. So, gold did flow into the United States, but this was no longer money. American citizens weren't allowed to own gold from 1933 onward. No one could convert dollars into gold, okay.
So, gold was a non-monetized asset or a demonetized asset by that time. So, when the government was purchasing gold, this would have caused a great inflation, as they purchased gold, those new dollars would have found their way into the banking system in 1936, and it would have increased the money supply. So, rather than how that happened, let's say they purchased $1 million of gold, they would then have created $1 million that could have become part of bank reserves and increase the money supply. Well, to offset that, what the treasury did was when it purchased the gold and issued the $1 million, it brought back the $1 million by selling government securities to the extent of $1 million.
So, basically, it neutralized the inflow of gold on the United States. In fact, people at the time called it a gold in avalanche. The U.S. was an avalanche of gold pouring into the U.S.
because of this policy of Roosevelt, of devaluing the dollar, which meant increasing the price of gold in terms of dollars. So, gold was more valuable in the United States than elsewhere. You get more dollars for it in exchange for which you could then buy American products and so on. So, you had this avalanche of gold and the treasury properly did not allow this to affect the money supply.
So, from 34 to 36, we had an enormous increase in the money supply as a result of this policy. The money supply increased at rates of 14% in 1934, 14.8% in 1935, and 11.4% in 1936. Money supply of the creature had double digit figures or double digit rates during this period. And it was in 1936 that the treasury decided to stop that increase in the money supply by what they called sterilizing or neutralizing the effect of this gold inflow.
The other point I wanted to make is that let's say even if gold was what was still money, according to the currency school, when gold flows in, if you have a fractional reserve system, what's going to happen is that the money supply is going to increase by a multiple of gold. So, let's say if you have a $1 gold flowing in, the money supply can increase by $10. So, there's nothing wrong with, even if gold was a war money, which it was not, there's nothing wrong with sterilizing the extra $9 of reserves that would have come into existence as a result of gold flowing in. That's a currency school policy.
Under 100% gold standard, when $1 worth of gold flows in, the money supply increases by $1 period and the story. But under a fractional reserve system, when $1 flows in, you can have an increase in the money supply up to a maximum of $10, if the rate of the reserve ratio or the proportion of the positive you have to hold in reserve, if that's 10%, then you could get a money multiplier or a deposit multiplier of 10. By the way, as Hayek pointed out, that when you have a fractional reserve banking system, even on a gold standard, when you have a balance of payments inflow, as that money gets, as that goes gold reserves, get into the banking system and there's a multiplication of check account money, that money is loaned out through credit markets, pushes down the interest rate and brings about the business cycle and inflation followed by depression, by distorting the interest rate. So, even under a fractional reserve gold standard, as by the way the currency school saw and as it saw, you still get the business cycle.
Now, it's not as severe as it would be under a paper money, but it still can occur. Finally, Timberlake objects to the Fed's policy of raising reserve requirements in 1936 and 1937. The Fed did this because there was a massive amount of excess reserves that the banks were not lending out. And they were afraid that once the banks lent out these excess reserves that they had piled up in the 1930s, there would have been a multiple expansion of bank deposit money and as a result, you have gotten a larger place for the money supply.
And that's a correct analysis. But Timberlake advances two criticisms against his policy. First he says the policy was unnecessary because even if the excess reserves that existed on the eve of its implementation, even if they were all fully loaned out by the banks, the inflationary potential was relatively minor. Timberlake says that the 52% increase in the money supply would have resulted, would have been a 52% increase in the money supply.
He said that was only mildly inflationary because the larger money supply would have exceeded the needs of trade of a fully employed economy by 5.6% at 1929 prices, which was about 25% higher than the prices prevailing in June of 1936. Now, here's what he's saying. He's saying because prices had fallen so much from 1929 to 1936 that there's nothing wrong with the money supply exploding by 52%. Because that increase in the money supply by 52%, would simply drive prices up back to their 1929 levels.
Maybe a little beyond that, about 5% beyond that. And that's a good thing. Well, that's a strict, straight inflationism. It's saying that we get out of depression by simply reflating the money supply, by simply creating more paper money and restoring the old level of prices.
And that will put people back to work and get us moving again. But all that does is sow the seeds for a further business cycle. So in a plain language, Timberlake is literally defining a way of potential money and price inflation of huge proportions because of its, he perceives it as expedient in expanding employment and output and extricating the economy from a depression. Basically, he wants to deflect, he said, to allow the banks to inflate, plate us out of the recession.
He wanted to leave the excess reserves there as the banks began to loan them out and the money supply increase we could inflate our way out of recession. And then of course, that's contrary to the Austrian view that you have to have adjustments. And some of these adjustments may very well include as banks collapse and as people pull their currency out of banks, a reduction in the money supply and therefore prices should be reduced. The second criticism Timberlake has in this policy is that the increase in reserve requirements went way beyond closing off a potential area of recovery for the economy and actually turned it into another recession.
So he's claiming that this policy resulted in a deflation of the money supply that brought about another recession within the existing depression. The US economy was beginning to recover and he claims that recovery was aborted by its policy. But again, let's look at Timberlake's data. If you look at the money supply as defined by M2, which is what Timberlake refers, that grew from $43 billion to $45 billion or by 4.4% in the year between June 1936 and June 1937.
That was the year in which the Fed implemented that policy of mopping up the excess reserves. So you didn't have a deflation. You had a lower rate of inflation, but you certainly didn't have a deflation. Even in the last six months of the period, the money supply wasn't deflated.
It increased by very low rate, slightly below 1% per year. So even from Timberlake's monetary standpoint, it's really difficult to blame that recession of a 37-38 on deflationary Fed policy. The Fed policy wasn't really deflationary. At most, it reduced the rate of inflation.
In any case, Timberlake's emphasis on Fed deflation and that's the cause of this problem causes him to ignore a very plausible Austrian explanation of why we had a recession within the depression. And a veteran Galloway's book out of work, I highly recommend, this is an Austrian approach to explain why the depression lasted as long as it did. What happened in 1937, which was ignored, was the following. Actually, it happened initially in 1935.
In 1935, the Supreme Court upheld the National Labor Relations Act of 1935. They upheld this constitutional. This acts that up the National Labor Relations Board and it put in place mandatory collective bargaining. So if 51% of the members of a bargaining unit, let's say either a firm or a plant voted for a union, the other 49% were stuck with that union.
Even if the higher union wages and benefits caused them to become unemployed, they could not bargain to work for a lower wage. So mandatory collective bargaining was imposed in 1935. So money wages, not unsurprisingly, jumped by 13.7% in the first three quarters of the year. So during the depression, wages jumped by 13.7%.
This sudden jump in the price of labor far outstripped the increase in output prices. So now what you had was profit margins were being squeezed tremendously by this increase in the price of labor or wages, which went beyond the increase in output prices. What did that cause? Well, according to the Wall Street, with any really good new class of economists, if you have an increase in costs and no increase in prices or a little increase in prices, that's going to squeeze profit margins.
It's going to cause layoffs. And that can explain that that more research has to be done there, but that can certainly explain the recession. And in fact, if you look at the monetary data, you find that the large upward spurt in excess reserves, and then the accompanying decrease in the money supply that we observe in Timberlake's data between June 30th and 37th June 30th, 38th. So there wasn't a decrease in the money supply later on.
Why would the bank suddenly increase in excess reserves even more? Well, you're in the middle of another recession. Business aren't doing good. They're not demanding loans, or you're very, very reluctant to lend them money because you're fearful that they'll fail and default on the loan.
So what an Austrian would say looking at these data is that, in fact, it was the recession caused by a Supreme Court decision that put into place mandatory collective bargaining and caused an increase in wages. It was that recession that brought about an increase in excess reserves in 37 and 38. After the recession had already begun, this recession was 37, 38 recession. That caused a fall in the money supply.
So banks were increasing their excess reserves, and as you increase your excess reserves, you decrease the money supply. But that was in reaction to the fact that business is born doing well during the recession. So what's the conclusion? My conclusion then is that the Fed's monetary policy, except for brief periods, notably during 1928, 29, and 1936, 37, when it did turn disinflation, it didn't really cause a deflation, but it turned disinflation or very, very mild deflationary.
It was outside those two short periods. It was consistently inflationist from mid-1921 to the end of the 1930s. I believe in other Westerns that followed up, I believe, that disinflationism was a cause of the Great Depression, and one of the reasons why it was so protracted is because you didn't allow prices to fall to their natural levels and the economy to adjust. So I'll stop there and I'll take any questions on this.
Or on, yeah, then. Well, right now I was looking at it last time, I'm going to talk a little bit about this this afternoon. It would be over $4,000. If you want to back up by 100% all currency and checking deposits.
If you're getting about savings deposits and other components of what the Westerns call the money supply, simply back up 100% currency and checking deposits, you would divide, we have about $1.2 trillion of currency and checking deposits in our country in the U.S. economy. You would divide that by what I believe to be 260 million ounces of gold that the U.S. government is holding in basically the New York Federal Reserve Bank, and the quotient of that is $4,000, $4,80 or something like that.
Yeah, that would back up both currency and demand deposits. Back there would be, there were different plans, and I don't want to discuss it, but the transition to the gold standard can be something that's very difficult because if we suddenly raise the price to $4,80, all the gold in the world the rest of the world is selling at $350, $400, which flowing to the United States, we'd have a massive inflation, a once and for all massive inflation. So that may, at this point, that may not be the best way to do it. We'll talk about a plan that Mises has, a plan that Haslett has, and also you might want to supplement the gold with silver, but that is a, we know that the gold standard is the gold, that's what we want, but getting there is, there are going to be problems, okay, and I think more research has to be done now.
Back when the price of gold that you would have needed to back up everything by 100% was lower, it was closer to the market price, it would have been easier, but now it's so far away from the market price, it may be very difficult. Yes, it was more, I don't think that that was a big problem with Great Britain at that point, okay. Yeah, right, right, lending the money, yeah, yeah, yeah, lending the money, right. That certainly had something to do with the balance payments deficit, I mean, in other words, that's one of the reasons why you would lose gold, okay.
Or that's one of the, that's, the balance payments is equal to the balance of trade, the difference between exports and imports plus the capital account. So if you have to make payments on capital account, on the capital account, that's going to add to the deficit if you have a deficit on the balance of trade. In other words, the payback of your capital account, you have to run a surplus. So they couldn't run a surplus because their prices were so high relative to the rest of the world.
Okay, they were buying more from the rest of the world than they were selling to the rest of the world because they're high prices, okay. So you're a bad place to buy from and you're a good place to sell to. And if you're trying to go back on a gold standard at overvalued parity, you're going to be losing gold and the US wanted to help Great Britain by raising its own prices. So Timberlake is completely wrong here by saying that in fact the US was trying to help Great Britain by having fed, trying to deflate the money supply, okay.
And as I mentioned, Kenneth Wayer, the other monetarist that I cited pointed this out, that in fact inflation was the way the Fed chose to aid Great Britain. Yes. I've heard Ben is so focused. He was a close friend of Montague Norman, the director of the Bank of England.
I don't think all the press, I said that, I believe it's the director of the Bank of England. So it wasn't an annual file, okay. Now, you're saying, did he have any monetary interests? No, we have legitimate interests.
No, no, I think, I think, you know, as the ordinary citizens certainly have an interest in helping Great Britain out, okay. What Great Britain could have easily done, which they refuse to do, was simply to go back to gold at a lower parity, okay. In other words, devalue the pound to reflect the fact, the value pound by 10%, reflect the price of a 10% higher. In other words, raise the gold price, sorry, raise the price of gold in terms of the pound, which means that now each pound would contain less gold.
They didn't want to do that because they thought it would be a loss of prestige. So the US was trying to help them, or Benjamin Storm in particular was trying to help the British, retain their position as sort of a financial center. Yes, Dan. Well, you're asking, you know, that's something that you can't predict.
You can't predict what the market will choose, okay. So you're asking me if I'm a constructivist from the high-air point of view. What I do, yeah, I am a partial constructivist in the following sense. I think we should go back to what we had before the government moved us to a fiat currency, okay, before there was an intervention that destroyed the commodities here.
Now, we go back to gold and it turns out that gold is so scarce in relation to commodities, obviously, the tremendous growth that it would be inconvenient to carry, you know, for small purchases and so on. Then I think the market would monetize silver, for example, or possibly other commodities. But I think gold and silver, I think gold and silver would tend to win out, okay. But what I, for example, Larry White has one, you know, said, well, why not go to silver standard?
Why does it have to be gold? Well, because we have to be constructivist in reconstructing the commodity standard which was destroyed by government intervention. At that point, then we can let things go. If people want to choose another commodity, that's fine.
So somebody who is an advocate of the gold standard, gold is simply the commodity that has over the centuries emerged from voluntary market actions. So when I say I'm a gold standard advocate, I'm really a market money advocate. If gold needs to be supplemented by some other commodity or displaced by it, and the government has nothing to do with that process, then I'm all in favor of it. You know, Holzmann thinks that silver would eventually replace gold.
We'll talk about those types of questions because those are very important, this transition period. Yes. What was the actual decision? Is this a British?
Right, right. If you had it in earmarked and it was put in a secure, it's a deposit box, then they have to give you back, they have to keep it there, and they have to give you back the exact same coins, okay. But if you have what's called a general deposit warrant, in other words, if you get checking account receipts or bank no receipts for a fungible commodity like gold, they don't have to give you back the exact same property that you deposited. And moreover, in this decision they went beyond that, I believe and said that in fact it's not actually a bailment, it's a loan to the banks, okay, right, right, right, it's strengthened in the blue galley.
By the way, two things I might bring up. One is grain warehouses for a while used to loan out their grain, or at least print up full receipts to grain that that that former has had deposited with them, and then print out these receipts and lend them to speculators with them and speculator commodity markets, commodity markets with them, and that was ruled to be illegal, you know if the grain was fungible and the farmers didn't get back the same grain, that was ruled not to be a loan of grain, okay, that you know that you would have to have, you could have a fraction reserve a grain warehouse, right, as long as they have the grain there when a grain depositor comes in, well then there's no problem, but they rule against that. The second interesting anecdote has to do with an iron and core company, this was in the 1880s, I'm sorry 1980s, there was an article in the Wolfie Journal and I cut it out, I don't have it with me, but it turns out the iron and core companies, I thought they had to deliver the money immediately, but they have warehouses where they just store the money, and they can store money for a week or whatever, before they deliver it to where it's supposed to go, well it turns out that one of these iron and core companies was loaning this money out, okay, and they were charged with fraud, now how is that different from a bank loaning the money out, it's a bailment, it's a clear bailment, okay, now then you might argue following this case that well the bags are marked with the, I don't call them the positor, but the balor's name, so the store that gives the iron and core of the money, that pays the iron and core company to deliver the money, the money is closed up in a bag and so on, so it's clearly not a loan, all right, maybe that argument can be made, but it's extremely close to what banks initially did, right, when they began to loan out the depositor's money, okay, yes, right, yes, okay, I think that theoretically, we can determine what should be out, but when we apply the theory to determine what items are being in and out as Rothbard tried to do, there's going to be a fuzzy line, okay, there's going to be a gray area, our net cash reserves of insurance companies, are they, in fact, part of the money supply, I would say no, Rothbard said yes, so you're going to have some gray area, certainly we have anything that is interchangeable at par and on demand and is guaranteed through the FDIC, which is backed up by the Fed, I would say has to be included, okay, so you have to include savings deposits, you have to include government deposits, for example, and so on, right, whether you should include other people, look, when they put their money in a bank or when they deposit their money, all they care about is that FDIC sign, everyone trusts it, they'll immediately get that money and be able to throw that money, okay, and so I think that you have to look at the institutional features, to what extent do they reflect the theoretical definition of the median exchange, that is, whether it itself is accepted routinely universally, such as paper dollars or whether like checking accounts and savings accounts, you can interchange them on demand at par for the paper dollars, because really the median exchange is embodied in the paper dollars for the Fed notes that we carry, okay, so anything that's immediately interchangeable into them on demand and is secure, okay, and certainly anything that is guaranteed by the Fed is secure, I would include the money supply, okay, and I don't think there's any gray area going in the spectrum going from cash all the way through savings deposits, okay, even savings bonds, because the treasury would, they're guaranteed by the full faith and credit of the federal government these savings bonds, even though, and you probably would have the Fed creating money and loaning the treasury to pay off those, so I would go up through that, okay, the net, the surrender values or the net cash reserves of insurance companies, I would include, okay, they're certainly not guaranteed by the Fed, and I don't think people necessarily think of them as part of their cash balances, okay, yeah, yeah, well, the ATM just make it more convenient to get it out, but let's say someone has gold or cash, and they bury it, and they have a vacation house up in Maine, and they bury it on the floorboards there, it's very, very inconvenient to go get that, but I would say it's the part of the money supply, right, so because some people say, well, you know, you can't really pay with your, in the old days we had passbook savings accounts, I guess you still have them, you can't walk into a store and give them the passbook savings account, and somehow transfer the credits on that to them, no, but you can go to the bank next door or down the street, okay, and just show them the passbook and get withdrawal money from the savings account, how's that different from flying up the Maine to get the money that's hidden on the floorboard, so I don't think it's necessarily just convenience, but did you mean proximity to your money, or did you mean closeness between the various items, you know, I don't think that convenes as you come in, because people can, look, you can own two automobiles, and one, you, again, you leave at your vacation house or something, I mean, you own it in any sense, in any sense, is that sort of less of an automobile to you than one that you have right here, no, you want to give more utility, you have allocated to a different area of your property, I think the same thing is true with money, you're allocating your money balances in a way that maximizes your utility, on a gold standard we would have a lot of these problems, okay, because you would have simply gold coins and you would have fully back checking account deposits or checking deposits, okay, any other questions? I think we can stop here, thank you.