Stormy Weather

Fed Up with the Fed

A Review of Milton Friedman’s Great Contraction: 1929-1933

An American Nobel Laureate economist, Milton Friedman was the twentieth century’s foremost advocate of free markets. Friedman was awarded the Nobel Prize in economics in 1976 for “his achievements in the field of consumption analysis, monetary history and theory, and for his demonstration of the complexity of stabilization policy.”


The Great Contraction is a reprint of the seventh chapter of Milton Friedman’s Monetary History of the United States. One of the most influential economics books of the twentieth century, the book is a comprehensive study of money and its effects on the economy. The Great Contraction is a term coined by Friedman which refers to the shrinking or “contracting”—of the money supply of the United States that caused the Great Depression. He asserts the severity of the contraction, which had “no parallel in…more than fifty years.”1 In the book, Friedman states that the Great Depression was largely the result of the inept application of monetary policy by the Federal Reserve System. The Federal Reserve had ample power to stop the devastating process of monetary deflation and the collapse of the banking system; if they had used this power in late 1930 or even in early or mid-1931, the successive crises that typify the contraction could almost certainly have been prevented. To Friedman, the most important contributing factor to the contraction was the drastic reduction in the supply of money. The money stock fell by almost 33 percent and had a devastating effect on the economy and largely resulted in the infamous Great Depression.

Friedman begins his book with a comprehensive review of the widespread effects of the Great Contraction. From 1929 to 1933, the contraction was the “most severe business-cycle contraction during the near-century of U.S.. history.”2 A devastating disaster, the contraction had no parallel in economic history. Friedman focuses on the drastic decline of the money stock during the contraction. Commercial banks across the United States were devastated, and many were forced to halt operations. In 1933, state bank holidays and a national banking holiday suspended all commercial banks and even Federal Reserve Banks. As a result of these financial difficulties, a sudden rise in economic speculations and theories arose. The contraction threatened the widely-accepted idea of the importance of monetary factors in the cyclical system. After the contraction, money was seen as more of a minor factor and monetary policy was generally regarded as ineffective. Friedman states that the financial disaster ultimately resulted in a fall of 53 percent in money income and a total of 36 percent of real income. At the depression’s peak, one-fourth of the nation’s population was unemployed. The annual averages of money in circulation decreased at a lower rate than the decline of money income. Friedman calculates that the rate fell by nearly one-third; he accounts this to the deduction that “velocity tends to rise during the expansion phase of a cycle and to fall during the contraction.”3 Friedman attributes this to the public’s unwillingness to deposit their wealth after a series of bank failures. The economic health of the nation suffered another blow when the stock market crashed in 1929, worsening the severity of the contraction. The crash dissuaded the general spending of money. The public began to distance itself from stocks and money holdings. In 1930, however, a sudden surge in deposits by withheld banks occurred. The Bank of the United States- the nation’s most active commercial bank- failed with close to $200 million of deposits. The fall of the Bank of the United States greatly undermined the reputation of the Federal Reserve System.

After a series of banking crises, a recovery program was enacted. However, the government’s attempt to mend the situation was largely unsuccessful. Banking complications continued after the brief interruption in 1932. Problems with currency erupted, state bank holidays were implemented, and business activity levels dwindled. Established in 1932, the Reconstruction Finance Corporation had been provided with the ability to provide loans for struggling banks. Though initially somewhat effective, the loans provided by the RFC proved ineffective in controlling the swell of bank failures. Foreign drain further troubled the Federal Reserve System and commercial banks. Private banks began to acquire foreign currencies at the speculation of the devaluation of domestic currency. Suddenly, gold was in high demand in exchange for reserve notes and paper currency. City banks were devastated by these withdrawals. The reaction of the Federal Reserve System strongly resembled its course of actions in September 1931 where it attempted to ease the financial situation by raising discount rates and buying rates on acceptances. However, the panic in 1933 was much more severe and widespread. Commercial banks and the central banking system decided to enforce heavy restrictions on payments. In March, President Roosevelt proclaimed a national banking holiday and suspended the exchange of gold. An important factor to the unexpected banking panic after the temporary recovery was the instable and vulnerable state of commercial banks. This vulnerability could have been remedied by either a raise in market values or readily available Finance Corporation funds. In addition, the monetary policies of the government worsened the relapse. Both internal and external drain occurred after a wide demand for gold which resulted after rumors of Roosevelt’s policy of “altering the gold content of the dollar as a means of reflating prices”arose.4 Changes in the stock of money between 1929 and 1933 occurred with unprecedented factors and consequences. Usually, high-powered money–which refers to the financial responsibilities of a central bank–directionally moves opposite that of the total stock of money. If a change in high-powered money had occurred, it would have resulted in a decline of 25 percent in the stock of money. Holders of securities tried to liquidate to reduce their loans. However, attempts to liquidate only resulted in the reduction of prices matching intended sales. Luckily, after the crash, New York banks promptly took over the loans. The banks’ loans resulted in a large creation of debt. Those who had received loans from the New York banks agreed upon deposits in the banks as reimbursing their loans. As a result, demand deposits steeply increased. The New York banks then moved to obtain additional reserves to expand deposits. Due to the New York Reserve Bank’s efforts, market rates generally stayed moderate.

In March 1933, the final banking crisis occurred. During this crisis, high-powered money increased due to larger discounts offered by the banks. The stock of money declined at 4.5percent and the money held by the public – along with high-powered money- reached close to $600 million. During previous banking disasters, internal drain by gold coin and certifications had been present, but they had experienced fluctuations. In the final banking crisis, however, the demand for gold sharply increased. Bank failures resulted in losses to both owners and depositors alike. The failures were generally composed of a decline in the stock of money. During the period of the contraction, the value of preferred and common stock declined by approximately $85 billion in the United States. Bank failures were generally responsible for the severe decline in the stock of money. Interestingly, bank failures were not results of immediate incitations, but rather arose from indirect monetary factors. Early bank failures during the 1930s may have been consequences of poor loans and investments made in the 1920s. To later bank failures, however, the quality of loans and investments were less significant. After the fall of the Bank of United States, the directors of the New York Reserve Bank worked to prevent suspensions of banks and to restore confidence. Owen Young, the deputy chairman of the board of directors, told the board members that the bank’s failure had “shaken confidence in the Federal Reserve System more than any other concurrence in recent years.”5 Although great concern was shown for the bank failures, the Federal Reserve System did not take needed action. Instead, the System blamed the failures on incapable bank management. The bank failures and the contraction, as a whole, had a pronounced effect worldwide. As a major member in world trade, the contraction produced worldwide movements, particularly in gold stock. As the United States’ economy began to deteriorate, foreign countries were forced to modify to economic changes. The disturbance in gold exchange weakened the international financial system and also greatly altered the inflow and outflow of gold. Countries on silver standards – such as China- were generally unscathed by the disturbances of gold exchange.

Monetary policy during the contraction was greatly influenced by the Federal Reserve System. Immediately after the crash, the New York Bank pursued restorative steps. The bank purchased $160 million of government securities. The New York Bank began to encourage discount rates and the mass purchase of bills and securities. During the contraction, the Federal Reserve System allowed its discount rate and total credit outstanding to decline. The Federal Reserve System’s most effective tool—open market operations—had been devastated by the bank failures. By the banking holiday, the System had fallen to a state of ineffectiveness. Banks worked independently and there was a void of capable leadership in the banking and market systems. Despite the alarming financial crisis, the Federal Reserve System did not act. As Friedman explains, “the monetary system collapsed, but it clearly need not have done so.”6

In this work, author Milton Friedman explains how the Federal Reserve’s monetary policies—and not the stock market crash—were to blame for the Great Depression. An advocate of free-markets, Milton analyzes the economic troubles of the Great Depression with clearly understandable data and reasoning. Throughout the book, Friedman clarifies the importance of monetary policy in the economy of a nation. Friedman criticizes the fiscal policies implemented by the Federal Reserve and asserts that the Great Depression was greatly exacerbated as a result of the Federal Reserve’s negligence. Although Friedman does not entirely absolve the stock-market crash of 1929 of blame, he explains how the economy could have been able to quickly recover if not for the policies of the Federal Reserve. Friedman uses a metaphor in his book when he compares a financial collapse to a landslide; he states “because no great strength would be required to hold back the rock that starts a landslide, it does nto follow that the landslide will not be of major proportions.”7 Friedman suggests the Federal Reserve was unaware of the drastic consequences of bank failures. Attributing the bank failures to inadequate management and faulty banking policies, Federal Reserve Officials disregarded their responsibilities to remedy the financial collapse. Largely influenced by the Chicago school of economics, Friedman was a proponent of the theory of free market libertarianism. Unlike a controlled market, a free market operates generally without the intervention and regulation of the government. Although a supporter of Keynesian economics at first, Friedman later rejected the Keynesian concept of “priming the pump” for monetarist policies.

Milton Friedman’s ideologies and viewpoints established in his book are expounded upon in an article by Michael D. Bordo entitled “The Great Contraction and the Current Crisis: Historical Parallels and Policy Lessons” and a written speech by Governor Ben S. Bernanke celebrating Milton Friedman’s ninetieth birthday. In Bordo’s article, the author relates the Great Contraction with modern-day parallels. Bordo concurs with Friedman on the idea that the Great Depression was largely caused by the inaction of the Federal Reserve. The nation’s current recession, Bordo explains, did not result from a traditional banking failure, but rather from a collapse of housing prices and a stock market crash. However, Bordo states that—like the Great Contraction- a banking crisis is still a significant factor of the recession. Bordo—unlike Friedman- acknowledges the Federal Reserve’s attempts to remedy the financial situation. Ben S. Bernanke, a renowned economist in his own right, praises Friedman’s contributions to the field of economics in his speech. Bernanke declares Friedman’s book as the “leading and most persuasive explanation of the worst economic disaster in American history.”8 Bernanke applauds Friedman’s theories presented in his book, and especially recognizes Friedman’s method of utilizing historical examples in explaining cause and effect situations. Bernanke particularly praises Friedman’s usage of “natural experiments” in his work. In conclusion, Bernanke asserts the paramount importance of the book as a lesson regarding monetary forces and economic inaction.

Milton Friedman is, unquestionably, a brilliant economist and statistician. His work The Great Contraction is worthy of Friedman’s reputation as a renowned analyst on economic theories. With this work, Friedman provides a comprehensive study of the true factors regarding the Great Contraction. Friedman successfully argues against the idea of the stock market crash as the primary cause for the economic collapse when he states the System “Promptly relapsed into its earlier passivity.”9 Instead, Friedman proves his theory that the contraction was a result of the Federal Reserve System’s incompetence. Friedman’s effectiveness lies in his usage of historical examples to illustrate his, otherwise, complicated concepts. The book itself is technically complex and would present a difficult challenge for those without solid backgrounds in economics. Nevertheless, Friedman provides solid insight and invaluable advice for monetary policies.

The Great Depression was, undeniably, one of the darkest periods of United States’ history. A severe economic depression with unprecedented consequences, the Great Depression was, by far, the nation’s worst economic failure. Despite its rather gloomy and bleak aspects, the period of the Great Depression significantly marked a watershed in American economic history. Milton Friedman would undoubtedly have agreed that the Great Depression was a sign for the nation – a wake-up call regarding for the renovation of the economic and fiscal aspects of society. Friedman, himself, was a major force in the changes in economic and monetary policies after the Great Depression. Criticizing the Federal Reserve’s inaction, Friedman believed that the Great Depression had been a “tragic testimonial to the importance of monetary forces” and a severely overblown collapses of an otherwise normal financial disruption.10 The Great Depression, along with Friedman’s theories, resulted in changes in monetary theory. After the Great Depression, the Federal Reserve System would play a greater role in maintaining financial stability throughout the nation. The Great Depression prompted President Roosevelt to implement his “New Deal” plan in order to halt declining unemployment rates and to recover the sorry state of the nation’s economy.

The period between 1929 to 1933 in the United States marked one of the worst disasters in economic history. The Great Depression resulted in both economic and social change. The traditional economic liberal method was abandoned for a Keynesian approach. The federal government began to play a greater role in the national financial and economic fields. President Hoover and President Roosevelt both implemented federal programs for the recovery of the United States. Friedman theorized how “prevention…of the decline in the stock of money…would have reduced the contraction’s severity.”11 Today, the aftereffects of the Great Depression are present in the national economy where federal supervision—although neither severely restrictive nor limiting—maintains financial stability. Without the Great Depression, the problems of small banks throughout the nation would have been regarded as trifle and insignificant to larger banks and directing boards. The Great Depression demonstrates how negligence and inaction can result in drastic consequences. Even during the contraction, the Federal Reserve neglected the growing dangers of the failing economic and financial system. The nation gradually recovered from its collapse by abandoning the gold standard, encouraging monetary growth, and implementing effective economic policies. The Great Depression resulted in crucial changes in monetary policies, macroeconomic theories, and the nation’s economic structure.

Overall, Friedman’s work is an invaluable asset to the field of economics and monetarism. The book thoroughly explains the causes of the Great Depression with evidence and data. The book emphasizes the influence of the fiscal supply in an economy. In his work, Friedman successfully accomplishes his goal of proving that the Federal Reserve System was responsible for the irrational severity of the Great Depression and, in addition, provides insightful theories on monetary policies. Friedman concludes that “small events at times have large consequences.”12 Friedman proves his point by showing how a series of monetary and financial mistakes resulted in a catastrophe as terrible as the Great Depression.



1: Friedman, Milton. The Great Contraction: 1929-1933. Princeton: Princeton Press, 2007. 11.
2: Friedman, Milton. 11.
3: Friedman, Milton. 15.
4: Friedman, Milton. 29.
5: Friedman, Milton. 104.
6: Friedman, Milton, 186.
7: Friedman, Milton, 207.
8: Bernanke, Ben. “On Milton Friedman’s Ninetieth Birthday,” 2002.
9: Friedman, Milton, 207.
10: Friedman, Milton. 13.
11: Friedman, Milton. 14.
12: Friedman, Milton. 15.

Student Bio

Chris Huh was born in Riverside, CA in 1993. In his spare time, he enjoys playing video games, skateboarding, jamming on the guitar, and eating good food. Chris plans to be a chef de cuisine of a famous restaurant in the near future.


© 2010 Advanced Placement United States History. All rights reserved.