The Federal Reserve and Its Impact on the Great Depression

 

There are many theories as to why the Great Depression occurred at the end of the 1920s. There were three main theories that were discussed in more detail. Nick Lioudis defines two of these as “Keynesian Economics”, which focuses on how government spending controls the economy, and “Monetarism”, which focuses on the control of the money supply to control the economy.”[1] And the third, known as the “Austrian Theory”, which promotes more individual subjective choices and the limits on which choices are made.[2]

In reviewing the different theories on the cause of the Great Depression, they tend to favor the one by Ben Bernanke [Monetarism] that says it is because of some of the mistakes that the Federal Reserve made leading up to 1929, which led to the “worst economic disaster in American history."[3] Congress established the Federal Reserve in 1913 to help maintain economic stability within the United States.[4] When the Federal Reserve failed to provide economic stability, a series of financial crises arose, including a major stock market crash in October 1929, followed by a run on local banks, and ultimately culminating in the collapse of many commercial financial institutions in the United States.

Gary Richardson wrote about the Great Depression and how it resulted in probably the worst financial situation in the history of the United States, which lasted more than ten years and only ended when World War II started.[5] Arthur Lewis, in his book Economic Survey, 1919-1939, explains that America was the center of the Great Depression, and what happened in other countries can be explained by what happened in America in its downturn.[6] What happened in the United States quickly spread to other industrialized nations of the world. The United States was not alone in this time of economic depression. There were varying degrees of how the Great Depression affected other countries.

To gain an understanding of who the Federal Reserve is and its role in the United States as the custodian of money in commercial banks, it is helpful to examine what was happening just before the Great Depression struck.  According to Gary Richardson, before the start of the Great Depression, decision-making was mostly decentralized and not very effective within the Federal Reserve. There was a district governor who set policies for their district, but some decisions needed the Federal Reserve Board’s approval from the Washington, DC office.  The various Boards did not have the authority to make decisions on their own, and this caused issues within the Federal Reserve[7]  Before the collapse in October of 1929, according to a piece by Christina Romer, the US economy was slowing down in the summer of 1929. And the most likely reason for the cooling off was the 1928 policy, where the Fed started the tightening of the monetary resources.[8]

Many decisions made by the Federal Reserve during this period worked against the economy of the United States. An example of one of these decisions, according to Bernanke, was when the Fed decided to raise interest rates in 1928 and 1929. This was done to try and limit the Fed from theorizing what might happen in the securities markets. By the Fed taking this path, it caused a slowing in the United States economy.  This, in turn, caused recessions in other parts of the world because of the link between the international gold standard and interest rates and monetary policies in other countries.[9]  In another journal piece by Christina Romer, entitled “What Ended the Great Depression”, Romer agrees with Richardson that the Federal Reserve did not understand the time delays with monetary policy and their effect on the economy. And when the economy did not respond to an increase in interest rates in early 1920, the Fed raised the discount rate again later in 1920. It became obvious that the inexperience of the Federal Reserve caused a problem; they did not solve one.[10] Eight years before the Great Depression, the Federal Reserve was making unwise decisions that were affecting the economy. It was going to be just a matter of time before these decisions were going to affect the United States’ economy, and in 1929, it happened.

 In an article by Robert Samuelson entitled “Revisiting the Great Depression, Samuelson quotes Friedman and Schwartz: [both were considered advocates of Monetarism][11]  “The Federal Reserve caused the Depression by failing to rescue the banking system. From 1929 to 19ЗЗ, more than two-fifths of the nation's 24,970 banks disappeared through failure or merger. The nation's money supply, basically, bank deposits plus currency in circulation, shrank by a third.”[12]  Samuelson also brings out in his piece that what should have been a normal, and maybe even a severe recession, became a depression.  Friedman and Schwartz blamed the Fed's weak response on the death in 1928 of Benjamin Strong, head of the New York Federal Reserve Bank. They believed that Strong was the Fed's most vocal advocate and would have, more than likely, acted forcefully to keep bank failures to a minimum.[13]

From this information, it appears that the Federal Reserve did not have a clear understanding of its fiduciary responsibilities for overseeing a stable economy for the United States. Nor did it have in place strong leadership to see it through these difficult times in the US economy, especially in the commercial banking industry. Too many times, the Governors of the Federal Reserve acted alone and in what they perceived as best for their locations.

Richardson concludes that the Federal Reserve could have prevented the collapse of the banking system with an expansion of the monetary base, but it failed to take any action.  This type of collapse had not been seen before, so the Federal Reserve did not have policies in place to deal with this monetary crisis. One of the biggest mistakes was that no one had any authority to make decisions to try and right the ship. Some decision makers could not see what was happening to the economy because they were focused on what was called the real bills philosophy, which was one of the many ideas pushed by some in the Fed that were short-term promissory notes or bills of exchange. Others wanted to defend the gold standard by raising interest rates and lowering the supply of money and credit, instead of trying to aid some of the failing banks.[14]

Because of all the issues and failures that surfaced during the time of the Great Depression, Congress established the Reconstruction Finance Corporation Act in 1932 to assist banks in surviving the Depression and to help increase the banks’ lending capabilities.[15]  This step by Congress to try and shore up the Federal Reserve did have a positive impact on helping the United States recover from the Great Depression, although it did not happen overnight.

Richardson reminds them that the Federal Reserve, because of reforms in the 1930s, 40s, and 50s, was turned into a modern central bank. This helped create a modern cognitive framework and primary policy of economics that is used today. This new combination of a modern centralized central bank with new and effective policies enabled Bernanke to state confidently that "we won't do it again.’[16]

Although there are many theories as to what triggered the Great Depression and the aftermath that followed, there is good evidence that the lack of oversight, communication, and other key factors by the Federal Reserve in the 1920s led to the economic collapse of the United States and into the Great Depression for the next ten years. What is encouraging is to read that recent Federal Reserve Chairmen have recognized the issues that propelled the United States into the Great Depression and have vowed that it will not happen again.

A bread line at Sixth Avenue and 42nd Street, New York City, during the Great Depression (Photo: Historical/Corbis Historical/Getty Images)

 

Clerks at the Reconstruction Finance Corporation computing interest on RFC loans, c. 1937 (Harris & Ewing via Library of Congress Prints and Photographs collection, LC-DIG-hec-22421)

 

Bibliography:

 

Bernanke, Ben, Board of Governors of the Federal Reserve System (U.S.), 1935-, and Council of             Economic Advisers (U.S.). "On Milton Friedman's Ninetieth Birthday." Remarks before                         the  Conference to Honor Milton Friedman, University of Chicago, Chicago, Illinois, November              8, 2002, https://fraser.stlouisfed.org/title/453/item/8873, accessed on July 14, 2025.

Boettke, Peter. “Austrian School of Economics.” The Library of Economics and Liberty                                     https://www.econlib.org

Friedman, Milton, and Anna Jacobson Schwartz. A Monetary History of the United States, 1867- 1963.           New Jersey: Princeton Press, 1963

Gou, Michael, Gary Richardson, Alejandro Komai, and Daniel Park. “Reconstruction Finance                          Corporation Act.” Federal Reserve History (November 2013)                                                                    https://www.federalreservehistory.org/essays/reconstruction-finance-corporation

Lewis, Arthur. Economic Survey, 1919-1939.  Australia: Unwin University Books/George Allen Ltd.,              1949.

Lioudis, Nick. “Keynesian Economics vs. Monetarism: What's the Difference?” Investopedia                          (June 2024)  https://www.investopedia.com/ask/answers/012615/what-difference-between-                      keynesian-economics-and-monetarist-economics.asp

Richardson, Gary, “The Great Depression:1929-1941.”  Federal Reserve History (November  2013)                https://www.federalreservehistory.org/essays/great-depression

Romer, Christina D.  “The Nation in Depression.” The Journal of Economic Perspectives 7, no. 2                    (1993):26. http://www.jstor.org/stable/2138198.

Romer, Christina D.  “What Ended the Great Depression?” The Journal of Economic History 52, no. 4            (1992): 757–84. http://www.jstor.org/stable/2123226

 Samuelson, Robert J. “Revisiting the Great Depression.” The Wilson Quarterly (1976-) 36, no. 1                    (2012): 36–43. http://www.jstor.org/stable/41484425.

 

 

 


[1] Nick Lioudis, “Keynesian Economics vs. Monetarism: What's the Difference?” Investopedia (June 2024) https://www.investopedia.com/ask/answers/012615/what-difference-between-keynesian-economics-and-monetarist-economics.asp

[2] Peter Boettke, “Austrian School of Economics.” The Library of Economics and Liberty https://www.econlib.org

[3] Ben Bernanke, Board of Governors of the Federal Reserve System (U.S.), 1935- and Council of Economic Advisers (U.S.). "On Milton Friedman's Ninetieth Birthday." Remarks before the Conference to Honor Milton Friedman, University of Chicago, Chicago, Illinois, November 8, 2002, https://fraser.stlouisfed.org/title/453/item/8873, accessed on July 14, 2025.

[4] Gabriel Kolko, The Triumph of Conservatism: A Reinterpretation of American History, 1900-1906 (New York: The Free Press, 1963), 256.

[5] Gary Richardson, “The Great Depression:1929-1941.”  Federal Reserve History (November 2013) https://www.federalreservehistory.org/essays/great-depression

[6] Arthur Lewis, Economic Survey, 1919-1939 (Australia: Unwin University Books/George Allen Ltd., 1949), 52.

[7]  Gary Richardson, “The Great Depression:1929-1941.”  Federal Reserve History (November 2013) https://www.federalreservehistory.org/essays/great-depression

[8]  Christina D. Romer “The Nation in Depression.” The Journal of Economic Perspectives 7, no. 2 (1993):26. http://www.jstor.org/stable/2138198.

[9] Gary Richardson, “The Great Depression:1929-1941.”  Federal Reserve History (November 2013) https://www.federalreservehistory.org/essays/great-depression

[10]  Christina D. Romer “What Ended the Great Depression?” The Journal of Economic History 52, no. 4 (1992): 757–84. http://www.jstor.org/stable/2123226.

[11] Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867-1963 (New Jersey: Princeton Press, 1963)

[12] Robert J. Samuelson, “Revisiting the Great Depression.” The Wilson Quarterly (1976-) 36, no. 1 (2012): 36–43. http://www.jstor.org/stable/41484425.

[13] Ibid

[14] Gary Richardson, “The Great Depression:1929-1941.”  Federal Reserve History (November 2013) https://www.federalreservehistory.org/essays/great-depression

[15] Michael Gou, Gary Richardson, Alejandro Komai and Daniel Park, “Reconstruction Finance Corporation Act” Federal Reserve History (November 2013) https://www.federalreservehistory.org/essays/reconstruction-finance-corporation

[16] Gary Richardson, “The Great Depression:1929-1941.”  Federal Reserve History (November 2013) https://www.federalreservehistory.org/essays/great-depression

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