What caused the Great Depression? Too few nickels

A recent post by Arnold Kling contrasted Keynesian and monetarist views of nominal income determination.  At one point Kling expressed some doubts about the efficacy of open market purchases when the economy is in a liquidity trap.  This is of course a complicated issue, and it mostly depends on whether the currency injections are expected to be permanent or temporary.  (It doesn’t really matter whether rates are at the zero bound.)  But one particular analogy caught my attention:

In other words, as a central banker, you can go on for years observing a nice relationship between a monetary aggregate and the economy. However, the minute you attempt to manipulate the economy by altering the supply of that monetary aggregate, the relationship will break down.

For example, suppose that the central bank were focused on the quantity of nickels in circulation. Over the past twenty years, let us say, the velocity of nickels (that is, the ratio of nominal GDP to the number of nickels in circulation) has evolved along a predictable trend. One day, the economy sinks into recession, and the Fed decides that it wants to use its control over the quantity of nickels to try to boost nominal GDP. It undertakes a massive open market operation, in which it exchanges vast quantities of nickels for pennies, times and dollar bills. Based on the trend velocity of nickels, the Fed expects this to have a dramatic effect on the price level and on nominal GDP.

In fact, it is hard to imagine that a vast open market operation to exchange nickels for other currency denominations would have much effect on GDP. People would probably keep more nickels in the drawer and fewer coins of other denominations. The velocity of nickels would plummet, and otherwise life would go on.

In today’s economy, it is difficult to imagine the Federal Reserve exerting tight control over the medium of exchange. Many transactions use credit cards and debit cards. Many mutual funds allow checks to be written against the assets in the fund.

I think his argument is wrong, but it is wrong in an interesting way.  Of course he is right about all the problems with the Quantity Theory of Money—it is not a reliable relationship.  But the nickel analogy doesn’t show what he thinks it shows.

In our monetary system the Fed controls the monetary base (directly or indirectly), and then lets the public decide how to partition the base among the various currency denominations.  We know exactly what happens if the Fed (or Treasury) doesn’t do this–you get coin shortages or surpluses.  If the Fed arbitrarily exchanges dimes for nickels it will not be inconsequential, as Kling seems to suggest.  There are two possible outcomes, either the value of nickels will rise above par value, or more likely there will be shortage of nickels.  People will go to the bank, ask for a roll of nickels, and find that the bank is out of them.  Then they will waste time checking out other banks (the equivalent of queuing costs.)  Alternatively, banks might charge $3 for a role of nickels that normally costs $2.  Either way, Kling’s analogy doesn’t hold.

If nickels sell for $3 a roll, or 7 1/2 cents each, then they are no longer “money” in the sine qua non sense of all monetary models–they are no longer the medium of account.  Monetary theory is the theory of the value, or purchasing power, of the medium of account.  More likely there would be shortages, but the par value would stay at 5 cents.  But even in that case the analogy doesn’t work, as (unlike nickels) changes in the overall monetary base through open market operations do not result in surpluses or shortages of base money.  Instead, the prices of all other non-monetary goods, services, and assets adjust to equate the supply and demand for base money.  Of course in the long run it is goods and services prices that adjust.  But since those prices are sticky, asset prices (including interest rates) adjust in the short run.  But even in the short run there is no shortage or surplus of base money.  People can always get cash in exchange for foreign currency, or stocks, or T-bonds, if they so choose.  So either way the nickel analogy doesn’t work.

But my response to Kling has a very interesting implication; a reduction in nickel supply caused the Great Depression.  This is a point I made last year in a post entitled “The Autistic Macroeconomist.”  I don’t recall it attracting as much controversy as I expected–maybe people thought I was joking.  The basic ideas were as follows:

1.  For any given monetary base, the quantity of nickels in circulation is endogenous, determined by the public’s preferences.

2.  Nickels are generally used in transactions (or piggy banks), and are not widely hoarded during financial crises.

3.  In the early 1930s the monetary base rose sharply, while M1 and M2 fell sharply.

4.  In the early 1930s the quantity of smaller transactions denominations fell, while the larger denominations that tend to be hoarded rose sharply.

5.  The Fed doesn’t directly control the supply of nickels, or the supply of M2, rather both respond endogenously to changes in NGDP, which responds to changes in the supply and demand for base money.

6.  If the Fed had adopted a monetary policy that led to continued normal growth in small denominations, the Great Depression never would have happened.

7.  It is just as true that the Great Depression was caused by a reduction in nickel supply, as a reduction in M2 (Friedman and Schwartz’s claim.)

If I had to pick one post to have Paul Krugman read, it would be (part 1 of) ”The Autistic Macroeconomist.”  It’s probably my favorite post.  I took his criticism of Friedman and Schwartz’s focus on M2, and went one step further.  Plus he likes clever counterintuitive stuff, and I think this might be my most counterintuitive post.  If only I had recalled it when the GMU professors asked me for my most outrageous belief.

PS.  If you are a new reader to my blog, you should know that my favorite posts are in 2009.  In 2010 I am (rather pathetically) cannibalizing 2009 posts. 

PPS:  Here is US nickel output:

1929:   52.5 million

1930:   28.3 million

1931:   1.2 million

1932:   0

1933    0

Back then a nickel was more like 50 cents or a dollar today.

PPPS:   Kling starts his post with the following observation:

Here is the long-awaited section on monetary theory. If you ask me the question, what will happen if the Fed stops paying interest on reserves, my answer would differ from Scott Sumner’s. I would say, “Not much will happen in the overall economy.”  Bank profits will be a little lower, and Federal Reserve profits (which are rebated to taxpayers) will be a little bit higher, and that is about it.

That’s a fair comment, but just to be clear I believe the removal of interest on reserves might have a significant expansionary effect.  I would certainly concede that it might not, especially if the Fed continues its contractionary policy of promising to shrink the bloated monetary base before inflation can rise.


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18 Responses to “What caused the Great Depression? Too few nickels”

  1. Gravatar of Morgan Warstler Morgan Warstler
    10. July 2010 at 06:53

    Question: what would happen if the Fed immediately took all its toxic MBS securities (let’s say $1T worth to make my math easy), unwound them, and sold them in a short window auction to retail buyers with at least 30% cash down.

    Doesn’t this dramatically improve the balance sheets of the guys with dry powder an thus boost the AD, as they both improve their new properties, and sell them for quick profits to spend elsewhere?

    Question: Does a reduction in rents – specifically the money being paid to banks which are growing reserves, increase AD, as the savings is used elsewhere with greater velocity?

  2. Gravatar of Philo Philo
    10. July 2010 at 07:11

    “[Krugman] cit[ed] the fact that massive base injections by the Fed had mostly been hoarded as ERs” (from “The Autistic Economist”). If banks are being paid *interest* on reserves, you can’t call holding “excess” reserves “hoarding.” (I’m confident about this, though in general I am not sure when “holding” something crosses the line into “hoarding.”)

  3. Gravatar of Philo Philo
    10. July 2010 at 07:24

    “You find an aggregate that is correlated with NGDP, and then you argue that the Fed just needs to expand the base enough to keep that aggregate growing at a steady, non-inflationary rate. . . . I think the Fed did have the ability to keep demand for pennies rising at a fairly steady rate. . . . If they did have that ability, then one could argue that the reduction of penny production caused the Great Depression.” (From “The Autistic Economist.”)

    Well, it wouldn’t be much of an *argument*. The lack of expansion of that “aggregate” (the stock of pennies or whatever) wouldn’t be the cause of the Depression: it would be a collateral effect of the cause. Accordingly, one has to doubt that the shrinkage of M1 or M2 deserves to be called “the cause” of the Great Depression. Is it even clear that the behavior of “base money” was truly causal rather than collateral?

  4. Gravatar of Still Jackasses, Arnold Kling | EconLog | Library of Economics and Liberty Still Jackasses, Arnold Kling | EconLog | Library of Economics and Liberty
    11. July 2010 at 05:25

    [...] than a real interest rate that is too high, as in New Keynesian theory. Pointer from Mark Thoma. Scott Sumner writes, If the Fed arbitrarily exchanges dimes for nickels it will not be inconsequential, as Kling seems [...]

  5. Gravatar of scott sumner scott sumner
    11. July 2010 at 09:15

    Morgan, No, it would reduce the money supply and probably would reduce AD. The money going to banks is new money. If your proposal was followed there would be no new money to allocate elsewhere.

    Philo, I don’t much care what it is called. Perhaps the term ‘hoarding’ isn’t appropriate, but it seems fine to me. In any case, no important issues hang on the precise use of terminology in this case.

    My point is that it is just as a much a cause as saying. “The Fed allowing M2 to fall was the cause.” Or “the Fed’s deflationary policy was the cause.” But many people who would think I am nuts accept Friedman and Schwartz’s view.

  6. Gravatar of Morgan Warstler Morgan Warstler
    11. July 2010 at 11:27

    Scott,

    Once again we see your “I only have a hammer” thinking…

    Money not being spent is the problem. More Reserves, more savings, more disagreement about property prices – this is our problem.

    We need velocity, we need to figure out WHY capital isn’t being spent, and nothing brings money to the table faster than SUPER CHEAP AUCTION PRICES.

    Your approach is to try and SCARE capital with inflation. Spend it or else! Mine is far more sexy.

    “If your proposal was followed there would be no new money to allocate elsewhere.”

    Finally you misunderstand my point, if the Fed can always go print more money, WHY NOT do the liquidation FIRST?

  7. Gravatar of Morgan Warstler Morgan Warstler
    11. July 2010 at 13:01

    http://4.bp.blogspot.com/_a4SkQcTayak/TDiT1JQlXwI/AAAAAAAAACE/av4LgcNZslA/s1600/curdia.png

    Look at that! Surely a good percentage of those MBS represent a ton of foreclosed or zombie homes, that plenty of good small businessmen would love to break out their wallets for and buy for deep discounts. And overnight, their own balance sheet improves! Their confidence goes up.

    Man it just breaks my heart thinking about how much cheaper rents could be, how much more economic activity there would be as such.

    Why continue pretending homes are worth so much?!? Why artificially insist on having so much of people’s depressed wages go to towards a lie?

  8. Gravatar of Philo Philo
    11. July 2010 at 19:58

    “My point is that it is just as a much a cause as . . . the Fed['s] allowing M2 to fall . . . or the Fed’s deflationary policy . . . . But many people who would think I am nuts accept Friedman and Schwartz’s view.”

    I understand, I agree, and I sympathize with you for being misunderstood (by others). My point was to wonder what you would offer as the *real cause* of the Great Depression. Not a shortage of nickels, obviously; not the Fed’s allowing M2 to fall, by your insightful argument. But maybe it *was* the Fed’s deflationary policy: this answer might be vague enough to survive the charge–fatal to the first two–that it offers not a true cause but merely a *collateral effect*. Of course, it would be nice to have it specified just what were the actions by which the Fed carried out its deflationary policy; but it would still be informative to be told that (a) there were such actions and (b) they were the cause (not just a collateral effect) of the Great Depression.

  9. Gravatar of ssumner ssumner
    12. July 2010 at 09:47

    Morgan, You said;

    “Your approach is to try and SCARE capital with inflation. Spend it or else! Mine is far more sexy.”

    Sex appeal is in the eye of the beholder.

    Morgan#2, Other commenters already pointed out that the Treasury has already essentially nationalized the Fannie and Freddie debt. So the Fed is essentially buying T-bonds when it buys MBSs. Blame the fiscal authrotities, not the Fed.

    Philo, In February and March I posted some chapters from my manuscript. The real cause was the US, France and other countries hoarding gold.

  10. Gravatar of Morgan Warstler Morgan Warstler
    12. July 2010 at 11:10

    Scott, nothing I said had anything to do with whether MBS is secure. And notice: you aren’t really responding to the point.

    The point is the Fed owns a bunch of homes… participating in a sham on market prices… and we’re all looking for a magic lever they can pull to kick start the economy… so they should liquidate those foreclosed toxic assets for pennies on the dollar.

    This would have a tremendous positive effect on private capital:

    1. it would improve balance sheets of main street (small businessmen sitting on cash) – acquiring valuable assets cheap – and either selling short term for immediate profits, or holding long term with lowered rents.

    2. it would reduce rents – the percentage of wages that workers spend on housing would decrease.

    Those who don’t like this: the banksters who have assets on their balance sheets they don’t want to be worth less money.

    So far, I’m not getting any downside here. We prepare a thinning of the herd with banks, we essentially reset on housing prices, we offer no assistance to the banks that are insolvent – and we go through the pain we put off two years ago. FDIC covers deposits, and the Fed lets everybody see who is swimming naked.

    It would be so cathartic. The Tea Party would love it. Animal spirits would reign supreme.

  11. Gravatar of Philo Philo
    12. July 2010 at 20:28

    “The real cause was the US, France and other countries hoarding gold.” So if the Fed had sold a lot of gold, the Great Depression would have been averted. And hoarding (= declining to sell) gold is the implementation of a “deflationary policy.” So the Fed’s deflationary policy *did* cause the Great Depression (in spite of the involvement of France and other countries). But the shortage of nickels and the decline in M2 *did not*.

    Am I accurately expressing your view?

  12. Gravatar of scott sumner scott sumner
    13. July 2010 at 08:27

    Morgan, You said

    “The point is the Fed owns a bunch of homes… participating in a sham on market prices… and we’re all looking for a magic lever they can pull to kick start the economy… so they should liquidate those foreclosed toxic assets for pennies on the dollar.”

    I don’t agree, the Fed is no better or worse off whether the loans are repaid or not. The Treasury is on the hook. At least that is what I have been told.

    Philo, I agree up until the last part about nickels and M2. I was trying to express “causation” in a format that you preferred. My own view is that the meaning of the term “cause” is very vague. I think of it in terms of policy counterfactuals. If doing X would have prevented the Depression, then not doing X caused the Depression. Errors of omission can be viewed as causes in my view. Thus there are dozens of ways of explaining the Fed’s contractionary policy, all partially correct. But as to which “causal” explanation is the most useful, that is another story. I don’t think it is particularly useful to think of too few nickels as being the cause, because I don’t think it is a reasonable policy for the Fed to be targeting the nickel supply.

  13. Gravatar of Steve Steve
    18. July 2010 at 11:29

    I found your statistics on US nickel production chilling due to the parallels today in quarter production. I view the quarter today as similar in utility to the nickel in the 1930s. I know, the quarter has half as much purchasing power today as the nickel did then, but since we don’t generally circulate larger coins, the quarter today serves as the primary medium of exchange (and change) in small transactions. Anyway, here are quarter mintages in recent years:

    2006 2,928,800,000
    2007 2,712,440,000
    2008 2,438,200,000
    2009 636,200,000
    2010 177,200,000 (January through June)

  14. Gravatar of ssumner ssumner
    19. July 2010 at 06:02

    Steve, Thanks, I’ll do a post on that.

  15. Gravatar of TheMoneyIllusion » Will the Fed refill America’s piggy banks? TheMoneyIllusion » Will the Fed refill America’s piggy banks?
    19. July 2010 at 07:28

    [...] recently pointed out that there is a sense in which the low production of nickels during the early 1930s [...]

  16. Gravatar of Will the Fed Refill America’s Piggy Banks? Will the Fed Refill America’s Piggy Banks?
    19. July 2010 at 14:08

    [...] recently pointed out that there is a sense in which the low production of nickels during the early 1930s “caused” [...]

  17. Gravatar of melt melt
    29. July 2010 at 13:52

    take a look at coinstar’s comp sales for its coin counting machines this quarter, certainly looks like people are holding on to their nickles (the recent positive comps appear to be due to its 10% price increase – so less than 10% revenue increase is still a volume drop off.)

    Coin Kiosk Same Store Sales
    2010 0.5% 7.9% – - – - – - – - – - – - – -
    2009 -5.0% -4.3% -5.4% -3.9%
    2008 -0.2% -3.2% -1.8% -5.0%
    2007 4.3% 4.4% 3.7% 1.7%
    2006 7.8% 7.6% 7.0% 6.2%

  18. Gravatar of ssumner ssumner
    30. July 2010 at 05:54

    Melt, Thanks for that interesting data.

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