Today we bring you Part VI of “A Brief Monetary History of the United States” from the Ron Paul Monetary Policy Anthology. The full series can be found at the following links:
The Great Depression
The Federal Reserve’s monetary inflation throughout the mid- to late-1920s resulted, not surprisingly, in the Great Depression. As with any credit-induced economic boom, the newly created credit caused a distortion in the allocation of resources. Instead of economic growth resulting from increased real savings and investment, the boom of the 1920s was caused by an artificial increase of credit in the banking system by the Federal Reserve.
Whereas savings-induced growth aligns consumers’ present and future preferences, credit-induced growth does not. An artificial increase in credit allows banks to make more loans to businesses, and these increased loans signal to businesses that consumers are saving more in the present in order to consume more in the future. Businesses begin to undertake longer-term, more capital-intensive projects which, once they are finished, they find to be unsustainable because consumers either do not actually want them or cannot afford them because they have not saved enough money to purchase the goods. These resources have been malinvested, or invested badly, into sectors of the economy that do not actually serve the needs and wants of consumers. And it is not just one or two businesses which find themselves in such straits, but a whole slew of businesses, often across many different sectors of the economy.
The way out of a crisis had traditionally been to allow these malinvested resources to liquidate. Bad debts had to be liquidated so that prices could fall in order for markets to clear. In doing so, resources that were malinvested would be shifted to be used productively in other sectors. This was what was done during the Depression of 1920-21, in which President Harding refused to allow any sort of intervention by the federal government to alleviate the crisis. As we have seen, that crisis, although quite sharp, came to a quick end as the economy rebounded and returned to normal.