Money in the 1920s and 1930s

Nowhere Is Monetary Ignorance More Apparent than in an Analysis of These Decades


Richard Timberlake is a professor of economics retired from the University of Georgia, and author of Monetary Policy in the United States, An Intellectual and Institutional History (University of Chicago Press, 1993). This article is the first in a series.

One of the most enduring and troublesome mysteries in economics is money: how it is created, what sorts of institutions initiate the process, what kinds of mystique and priestcraft central bankers use in managing monetary systems, and what rules, laws, or customs limit their actions.

Perhaps the common ignorance about money is harmless. After all, the millions of people who use this money drive sophisticated automobiles and manipulate complex computers without knowing much about the technical properties of either. As long as cars, computers, and money behave themselves, can we perhaps ignore them? The answer is that we can for cars and computers but we should not for money.

For one thing, ignorance about money has side effects that are not comparable to ignorance about technical equipment. Competitive markets drive the production and sale of all household durables, but the production of money in every country in the world today (and yesterday, too) is the province of governments. Through the offices of their associated central banks, states monopolize the machinery of money. Each central bank determines within very close tolerances just how much money an economy has and the rate at which the current stock of money will change. Unquestionably and inevitably, political pressures that are rarely visible even to experienced observers influence these operations.

Because they have the power to create money without license, governments also have the complementary incentive to claim that depressions and inflations resulting from the mismanagement of money occur because of unusual and unexpected economic developments—“shocks,” as they are labeled. The term implies a sense of impending and inevitable drama. No such social catastrophes result from the public’s incomplete knowledge of computers and automobiles, nor of “shocks” that might affect their production and distribution. However, neither do governments monopolize that production and distribution, and therein lies the difference.

Fateful Decades

Nowhere is monetary ignorance more apparent than in bystander evaluations of the economic and monetary events of the 1920s and 1930s. Although several decades have passed, the various popular accounts continue to misinterpret the causes of the disequilibrium that occurred and also the federal government’s aggravation of the problem. Government apologists of many persuasions not only argue that the massive interventions of the 1930s were necessary; they also contend that the lack of response in the private sector to the multitudinous government programs put into place proved that the economic system was moribund.

Nothing, they argue, could have prevented the debacle. They encourage the popular belief that the market economy zealously overextended itself in the 1920s. The boom, they contend, led to the stock market crash in 1929, and to the several banking crises of the early 1930s. These financial failures, the legend continues, provoked exhausting industrial liquidations, and the other devastations of the 1930s. The role that the central bank—the Federal Reserve System—and its managers played in the catastrophe of the 1920s and 1930s is largely unknown and therefore unappreciated.

Other observers, for example, many Austrian economists, believe that all the trouble started with a central bank “inflation” in the 1920s. This “inflation” had to be invented because it is a necessary element in the Austrian theory of the business cycle, which seems to describe most Austrian economic disequilibria. Austrian “inflation” is not limited to price level increases, no matter how “prices” are estimated. Rather, it is any unnatural increase in the stock of money “not consisting in, i.e., not covered by, an increase in gold.”[1]

Once the Austrian “inflation” is going, it provokes over-investment and maladjustment in various sectors of the economy. To correct the inflation-generated disequilibrium requires a wringing-out of the miscalculated investments. This purging became the enduring business calamity of the 1930s.

The late Murray Rothbard was the chief proponent of this argument. Rothbard’s problem is manifest in his book America’s Great Depression. After endowing the useful word “inflation” with a new and unacceptable meaning, Rothbard “discovered” that the Federal Reserve had indeed provoked an inflation in the 1921–1929 period. The money supply he examined for the period included not only hand-to-hand currency and all deposits in commercial banks adjusted for inter-bank holdings—the conventional M2 money stock—but also savings and loan share capital and life insurance net policy reserves. Consequently, where the M2 money stock increased 46 percent over the period, or at an annual rate of about 4 percent, the Rothbard-expanded “money stock” increased by 62 percent, or about 7 percent per year.[2]

Here, Rothbard mistakes some elements of financial wealth with money. The latter two items he specifies as money are not money. They cannot be spent on ordinary goods and services. To spend them, one needs to cash them in for other money—currency or bank drafts. Increases in their quantity do not pervasively spill over into all other markets causing serious macroeconomic disequilibrium. Their appearance as financial assets in people’s possession is just as likely to be deflationary as not, because their purchase and sale require money that would otherwise be used for transactions of conventional goods and services.

Apologists for central banking, by way of contrast, see stock market “speculation” instead of over-investment as the culprit. They argue that the  System did all it could to counteract the “inevitable” contraction that followed the 1929 stock market boom, but that its best effort could not be good enough. Since earnest and sophisticated men operated the federal government and the Federal Reserve System, something had to be wrong with the economic system itself. Markets just could not be trusted to provide full employment and steady real growth.

The Mismeasure of Money

Careful scrutiny of the monetary system and its associated monetary data reveals that neither of these views is analytically correct. Their defects result from ignorance of the flawed institutional framework within which the gold standard and the central bank generated money. Both also suffer from mismeasurement of the central bank’s monetary data.

Four definable institutions created the money in use during the 1920s: the gold standard, the U.S. Treasury, the Federal Reserve System of 12 regional banks and the Federal Reserve Board in Washington, and the commercial banking system of 20,000-odd banks. These institutions were not created equal, however. Only the gold standard and the Fed, with a notable assist from the Treasury, were important in initiating either monetary policy or the monetary happenings of the period. The commercial banks could only take what came their way from the central bank and the gold standard. They, too, created money. But their money-creating activities were all unintentional and strictly a byproduct of their lending operations.

The gold standard after World War I was anything but the autonomous, self-regulating institution that the Founding Fathers had prescribed—quite the contrary. The Federal Reserve Bank officers, particularly presidents, and the governors on the Federal Reserve Board, based then in the Treasury Building in Washington, exercised a monetary policy that often finessed the gold standard.

When gold came into the U.S. economy from a foreign country, importers deposited it in a commercial bank. The commercial bank in turn sent the gold to the regional Federal Reserve Bank to which the commercial bank belonged. The Fed Bank would credit the reserve account of this member bank, credit its own gold asset account by the same amount, and deposit the physical gold in the Treasury. If the member bank needed currency instead of an additional balance in its reserve account, the regional Fed Bank would issue its own Federal Reserve notes, dollar for dollar, based on the gold it had received. In either case, the Fed Bank was simply a monetizer of the gold. It converted the gold into dollars just as an ordinary commercial bank would have done in the absence of a central bank.

The monetary system thereafter had more dollars of bank reserves and deposits, or dollars of currency, because gold had come into the country. All other legal tender items, such as silver currency and greenbacks, were accounted in the Fed Banks in the same way as the gold. Fed Banks, therefore, were the custodians of a large fraction of the economy’s basic money stock—the currency and bank reserves behind the checking accounts that households and businesses used for everyday transactions.

Blocking the Effects of Gold

Of course, the Federal Reserve System did not come into existence to be a custodian of the economy’s base money and nothing else. The Fed Banks also had the legal power to create bank reserves and currency. Using the gold and other legal tender they held as their reserves, the Fed Banks could themselves become fractional reserve institutions. They could expand the reserves of their member commercial banks, or issue additional currency to them, by buying certain interest-earning “eligible” assets from the banks. If Fed Banks wished to block the effects of gold deposited with them to prevent the creation of common money based on the new gold, they could restrict their own lending to the commercial banks or sell off some of their interest-earning assets. Within limits, the Fed’s money managers could deliberately and purposively supplement or counteract what the gold standard machinery did as a result of market forces. It was this particular machination to which Rothbard properly objected.

The Fed Banks’ institutional authority derived from the Federal Reserve Act of 1913. The Act gave the Fed Banks the role of sequestering most of the banking system’s gold, and the power, explained above, either to enhance or hinder the monetary effects of any incoming gold. At the same time, the congressional founders of the Fed saw the new institution only as a supplement to the official gold standard. In the Federal Reserve Act itself, they inserted a provision stating: “Nothing in this act . . . shall be considered to repeal the parity provisions [between gold and the dollar] contained in an act approved March 14, 1900.” That referred to the Gold Standard Act, which made gold the sole legal tender monetary metal in the U.S. system. The new Federal Reserve System was supposed to act only within this official gold framework.

To show how the Fed’s hands-on controls worked during the 1920s, I have constructed a table that summarizes the major monetary elements in the combined Fed Banks’ balance sheet for the 1921–1933 period. It also includes the level of prices as measured by the Consumer Price Index (CPI).

The column labeled M1 measures the stock of common money—currency and checking account balances. From 1921 to 1929 this stock of everyday money increased on average 2.5 percent per year (compounded).[3] The column labeled “Total Fed” shows the Federal Reserve base on which this common money rested. Although this base increased slightly from 1924 to 1928, it declined over the whole eight-year span at an annual rate of 1.6 percent.

Fed-held gold and other reserve assets increased nominally at 1.1 percent per year primarily because of gold inflows. Federal Reserve policy prevented some of this gold from becoming a basis for new money by “sterilizing” it. That is, as the gold came into their tills, the Fed Banks allowed their holdings of other assets, which were primarily debts of the member banks, to decline: The member banks paid off some of their debts by reducing their reserve account balances at the Fed Banks. Changes in “net monetary obligations” of the Fed Banks (the column labeled “Net Fed”) accurately reflects this deflationary policy. “Net monetary obligations” are total monetary assets minus gold and other legal tender reserves. This datum, which faithfully indicates the intent of Fed policy, declined at an annual rate of 8.0 percent over the eight-year period.

Fed policy successfully offset the gold inflows so that prices rose only slightly—0.5 percent per year for the eight-year period. This much of a change can hardly be labeled an “increase” because it is less than the statistical construction error of the index. One thing is certain: it was not any kind of an inflation. All the economic chronicles for the period, besides the monetary data, confirm that Fed policy was braking against possible gold-inspired price increases in the United States. The Fed’s primary purpose was to further international monetary policies, particularly to help the Bank of England achieve and maintain gold payments for the pound sterling—but that is another story.

In their Monetary History of the United States, Milton Friedman and Anna Schwartz conclude their summary of the monetary events of the 1920s with this paragraph: “Gold movements were not permitted to affect the total of high-powered money [bank reserves and currency]. They were . . . sterilized, inflows being offset by open market sales, outflows by open market purchases.”[4] They observe further: “The widespread belief that what goes up must come down, . . . plus the dramatic stock market boom, have led many to suppose that the United States experienced severe inflation before 1929 and [that] the [Federal] Reserve System served as an engine of it. Nothing could be further from the truth. By 1923, wholesale prices had recovered only a sixth of their 1920–21 decline. From then until 1929, they fell on the average of 1 percent per year. . . . Far from being an inflationary decade, the twenties were the reverse. And the Reserve System, far from being an engine of inflation, very likely kept the money stock from rising as much as it would have if gold movements had been allowed to exert their full influence.”[5]

Ironically, the Federal Reserve System that has provided itself in recent decades with the well-deserved label “engine of inflation” was in the 1920s an “engine” preventing gold inflation. Any gold inflation would have been very mild; so the question of whether Fed policy was proper is arguable—until we look at what happened afterward.

Given that its intervention prevented a minor gold inflation, did the Fed then reverse itself as bank failures occurred and economic contraction threatened? Following approved central bank doctrine, did it lend freely during the ensuing contraction at stiff interest rates until its remaining gold reserves would not have been enough to plate a teaspoon?[6] Let’s see what happened.

Disaster Hits

As everyone knows, the following four years, 1929–1933, were a deflationary disaster. Not quite so clear is what the Federal Reserve did, or, more important, did not do during that time. Fed spokesmen have often alleged that the Fed tried “everything in its power” to turn around the contraction, and that it used its gold reserves to their utmost. Again, nothing could be further from the truth.

By 1929, the Fed’s monetary liabilities—commercial banks’ reserve-deposit accounts in Fed Banks, and the public’s holdings of Federal Reserve currency—were $4.25 billion. These monetary items exceeded the Fed’s gold asset holdings by only $1.39 billion. Put another way, the gold that came into the Fed Banks, which the commercial banks would have held in the absence of a central bank, was $2.86 billion. Federal Reserve policy actions had created the remaining $1.39 billion. By August 1929, the Fed’s gold and other reserves had grown to $3.12 billion (not shown in the table). The Federal Reserve Act required half these gold reserves to back outstanding Fed liabilities, but the other half of them, $1.56 billion, were “excess” and available for whatever monetary purposes the Fed managers thought appropriate.

During the following three-and-a-half years, the Fed Banks’ managers continued to build up the Fed Banks’ gold holdings—even as the financial system spiraled downward as a result of three serious banking crises. By February 1933, owing to the Fed’s tight money policy, the economy was in shambles and constricted to the point of monetary suffocation. The Fed Banks’ gold stock had increased to $3.36 billion, and “excess” gold reserves were still $1.35 billion! (The higher figure in the table is for June 1933.) This damning statistic is seen in the column labeled “Fed Gold.” While the Fed had enjoyed an increase of $700 million in its gold and other reserve holdings, its monetary output had increased by only $680 million: Commercial banks had $20 million less in reserves than they would have had with no Federal Reserve System.

This statistic, however, is not the end of the story. Since total commercial bank reserves were $2.29 billion in February 1933, the $1.35 billion of excess gold reserves Fed Banks held could have enhanced the banking system’s reserves by another 60 percent—to $3.64 billion.

“Real Bills Doctrine”

The Fed Banks were truly absorbers of gold. They simply extended and intensified the tight money policy they had begun in the 1920s, but for a different reason. Instead of helping the Bank of England return to a gold standard, the Fed managers had become enthralled with the idea that production of goods and services initiates and promotes the production of money. Economists sometimes refer to this as the “real bills doctrine.” While it has a grain of truth in it when a true gold standard is in place, it has no validity at all in a system dominated by a central bank. With this flawed doctrine governing their thinking, the Fed Banks’ managers marked time waiting for new production to appear so that they could in good conscience expand their monetary obligations in support of the private economy.

It never happened.

The U.S. banking system went through three serious contractions and the money stock continued to shrink. By 1933, the M1 and M2 money stocks were 27 percent and 25 percent below their 1929 levels. Meanwhile, the Fed Banks sat on their huge hoard of gold—the gold reserves legally required for their current monetary output and the “excess” gold reserves that could have provided significant monetary increases—and did . . . nothing!

Truly, when such a crisis appears, all the central bank’s gold is excess. A proper central bank can never be faulted for “running out of gold.” If the Fed Banks had followed the established (Bagehot) doctrine of the time, they would sensibly have expanded their loans, discounts, and accommodations to their “member” banks until their gold stock was a cipher.

Of course, they would not have had to run their gold reserve ratio down to zero. Long before they had expanded or used up their gold reserves, the crisis of central-bank mismanagement would have ended (or, more probably, would never have begun). The economy would have been back to normal, and none of the ugly governmental machina-tions of the later 1930s would have occurred. No Supreme Court conflicts would have appeared; no New Deal bureaucracies would have emerged to plague the economy; the Leviathan would have been kept in its constitutional cage. Most important, many of the freedoms we are now trying to restore would still be commonplace.

One would think that with this experience behind them, the “monetary authorities” and the congressional wheelers and dealers would have learned some lessons about U.S. monetary machinery and its relationship to the economy. They did not.

Next month I will treat the reserve requirement debacle of the mid-1930s, which added additional travail to the monetary mistakes made in the early part of the decade.


  1. Murray N. Rothbard, America’s Great Depression (Kansas City: Sheed and Ward, 1963, 1972), p. 87. Emphasis in the original.
  2. Ibid., p. 88.
  3. The M2 money stock, which includes all of M1 plus time deposits at commercial banks, increased 5 percent per year from 1921 to 1929, and then fell at 13 percent per year from 1929 to 1933. No basis exists for a more inclusive money stock than M2.
  4. Milton Friedman and Anna J. Schwartz, A Monetary History of the United States, 1867–1960 (Princeton: National Bureau of Economic Research and Princeton University Press, 1963), p. 297.
  5. Ibid., p. 298. Emphasis added.
  6. This well-understood doctrine for central bank procedure was proposed by Walter Bagehot in his classic work, Lombard Street, rev. ed. (London: Kegan, Paul, Trench, Toubner & Co., 1906 [1873]).


April 1999

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