in 1914. this really was a very serious problem for the u.s. economy. so financial stability concerns were a major reason why congress decided to try to create a central bank in the beginning of the 20th century. but remember the other major mission of central banks is economic stability. monetary and economic stability. now the monetary history of the united states is pretty complicated. won't try to go through it all. but in the period after the civil war, towards -- until world war i, and then really all the way into the '30s, the united states was on a gold standard. and as you probably know, a gold standard is at least a partial alternative to a central bank. now what is a gold standard? what a gold standard is is a

monetary system in which the value of the currency is fixed in terms of gold. so, for example, by law, in the early 20th century, the price of gold was set at $20.67 an ounce. there was a fixed relationship between the dollar and certain weight of gold. and that in term helped set the money supply and helped set the price level in the economy. there were central banks that helped manage the gold standard, but to a significant extent, a true gold standard creates an automatic monetary system. basically, money is tied to gold. now unfortunately, gold standards are far from perfect monetary system. one small problem which is not on the slides but i'll just

mention is that there's an awful big waste of resources. what you have to do to have a gold standard is you have to go to south africa or some place and dig up tons of gold and move it to new york and put it in the basement of the federal reserve bank of new york. and that's a lot of effort and work and it's, you know, it's milton freedman used to emphasize that was a very serious cost of a gold standard. that all this gold was being dug up and then put back into another hole. so there is some cost to having a gold standard. but there are some other more serious financial and economic concerns that practical experience showed were part of a gold standard. one of them was the effect that -- of a gold standard on the money supply. since the gold standard determines the money supply, there's not much scope for the central bank to use monetary policy to stabilize the economy.

and in particular, under a gold standard, typically the money supply goes up and interest rates go down in periods of strong economic activity. so that's the reverse of what a central bank would normally do today. so again, because you had a gold standard which tied the money supply to gold, there was no flexibility for the central bank to lower interest rates in recession or raise interest rates in an inflation. now some people view that as a benefit of the gold standard, taking away the discretion. but it did have the implication that there was more volatility year to year in the economy under a gold standard than there has been in modern times. so, for example, movements in output. variablity was much greater under the gold standard. even year to year movements in

ichb flation, the volatility was much greater under the gold standard. there were other concerns also with the gold standard. now one of the things that a gold standard does is it creates a system of fixed exchange rates between the currencies of countries that are on the gold standard. so, for example, in 1900, the value of a dollar was about $20 per ounce of gold. at the same time, the british set their gold standard of saying roughly four pounds, four british pounds per ounce of gold. so $20 equals one ounce of gold. four pounds equals one ounce of gold. so $20 equals four pounds. so what that's saying is basically that a pound is $5. so essentially if both countries are on the gold standard, the ratio of prices between the two exchange rates is fixed.

there's no variablity as we see today when the euro can go up and the euro can go down. now, again, some people would argue that's beneficial, but there is at least one problem which is that if there are shocks or changes in the money supply in one country, then perhaps even a bad set of policies, other countries that are tied to the currency of that country will also experience some of the effects of that. so i'll give you a modern example. today as you probably know, china ties its currency to the dollar. it's become more flexible lately but for a long time there's been a close relationship between the chinese currency and the u.s. dollar. now what that means is if the fed lowers interest rates and stimulates the u.s. economy because, say, we're in a recession, that means also that essentially monetary policy becomes easier in china as well because interest rates have to be the same in different

countries with essentially the same currency. and those low interest rates may not be appropriate for china. and as a result, china may experience inflation because it's essentially tied to u.s. monetary policy. so fixed exchange rates between countries tend to transmit both good and bad policies between those countries and take away the independence that individual countries have to manage their own monetary policy. yet another issue with the gold standard has to do with speculative attack. now normally a central bank with a gold standard only keeps a fraction of the gold necessary to back the entire money supply. indeed, the bank of england was famous for keeping a thinned film of gold. the british central bank only kept a small amount of gold and they relied on their credibility to stand by the gold standard on

their own circumstances to -- so that nobody ever challenged them about that issue. but if whatever reason, if markets lose confidence in your willingness and commitment to maintaining that gold standard relationship, you can get a speculative attack. this is what happened in 1931 to the british. in 1931, for a lot of good reasons, speculators lost confidence that the british pound would stay on gold. so just like a run on a bank, they all brought their pounds to the bank of england and said, give me gold. it didn't take long before the bank of england was out of gold and they didn't have the gold they needed to support the money supply. and then there was essentially -- they essentially had to leave the gold standard. so there was a lot of financial volatility created by this attack on the gold standard. there's a story told that a

ficial was taking a bath. an aide came running in saying we're off the gold standard. and he said, i didn't know we could do that. but they could, and they had to because they had no choice. there was a speculative attack on the pound. moreover and related to this, as we saw in the case of the united states, gold standard had plenty of financial panics associated with it. so financial stability was not always assured by the gold standard. and finally, just one last word on the gold standard, one of the strengths that people cite for the gold standard is that it creates a stable value for the currency. creates stable inflation. and that's true over very long periods. but over shorter periods, maybe up to 5 or 10 years, you can actually have a lot of inflation, rising prices or deflation, falling prices, in a

gold standard. and the reason is that in a gold standard, the amount of money in the economy varies according to things like gold strikes. so, for example, if the united states, if gold is discovered in california, and the amount of gold in the economy goes up, that will cause an inflation. whereas if the economy is growing faster and there's a shortage of gold, that will cause a deflation. over shorter periods of time, you frequently had both inflations and deflations. over very long periods of time, decades, prices were quite stable. now this again was a very significant concern in the united states. there's a famous figure who we can see was a very good public speaker. william jennings brian.ic candi for president. in the latter part of the 19th century, there was a shortage of gold relative to economic growth. and since there wasn't enough gold, in some sense, the money

supply was shrinking relative to the economy, the u.s. economy was experiencing a deflation. that is prices were gradually falling over this period. now this caused some problems. and the people who were most concerned about it were farmers and other agriculture related occupations. think about this for a moment. if you are a farmer in kansas and you have a mortgage with a bank and that mortgage requires, say, a fixed payment of $20 each month, that amount of money you have to pay is fixed. but how do you pay that? you pay it by growing your crops and selling the crops in market. if you have a deflation going on, that means that the prices of your corn or your cotton or your grain is falling over time but your payment to the bank stays the same. so a deflation created a

grinding pressure on farmers as they saw the prices of their products going down and as their debt payments remained unchanged. and so farmers were squeezed by this decline in their crop prices and they recognized that this deflation was not an accident. the deflation was being caused by the gold standard. so william jennings brian ran for president. his principal platform, principal plank in his platform was the need to modernize the gold standard. in particular, he wanted to add silver to the metallic system so there would be more money in circulation and more inflation. but he spoke about this in the usual very eloquent way of 19th century orators. he said you shall not press down upon the brow of labor this crown of thorns. you shall not crucify man kind upon a cross of gold. and again, what he was trying to

say is that the gold standard is killing honest, hardworking farmers who are trying to make their payments to the bank and find the price of their crops going down over time. so the gold standard also created problems and again was a motivation for the founding of the federal reserve. in 1913, finally, after all the study, congress passed the federal reserve act which established the federal reserve which opened in 1914. there's a picture here which hangs in the fed of president woodrow wilson signing the federal reserve act in 1914. president wilson viewed this as his primary most important domestic accomplishment in his first -- in his term. so again why did they want a central bank in the federal

reserve act called on the newly established fed to do two things. first to serve as a lender of last resort and to try to mitigate the panics that banks were experiencing every few years. and secondly, to manage the gold standard that is to take the sharp edges off the gold standard to avoid sharp swings in interest rates and other macroeconomic variabled. so that was the objective of the federal reserve. now interestingly, the fed was not the first attempt by congress to create a central bank. there had been two previous attempts. one of them suggested by alexander hamilton and the second somewhat later in the 19th century. in both cases, congress let the central bank die. and ba a lot of disagreement between what today street.

the folks on main street could include farmers, for example. feared that the central bank would be mainly an instrument of the moneyed interest in new york and philadelphia and would nore. would not be a national central bank. and both the first and the second attempts at the -- at creating a central bank failed for that reason. so woodrow wilson had, i think, a better idea and he tried a different approach. and what he did was he created not just a single central bank, say, in washington, but he created 12 federal reserve banks located in major cities across the country. and so the picture shows the 12 federal reserve districts that we still have today and each one has a federal reserve bank in it. and then a board of governors which oversees the whole system is in washington, d.c. notice by the way how many of

the little black dots are to the right. in 1914, most of the economic activity in the united states was in the eastern part of the country. now, of course, it's much more even, but the reserve banks are in the same locations as they were in 1914. but anyway, the point here, the value of this structure was, again, creating a central bank where everybody, all parts of the country would have a voice and where therefoinformation ab aspects of our national economy would be heard in washington. and that is in fact, still the case. when the fed makes monetary policy, it takes into account the views of the federal reserve banks around the country and, therefore, we have a national approach to banking policy. so the fed was established in 1914. and for a while, life was not

too bad. the roaring '20s. the 1920s, this is called the charleston, i think. "life" magazine. you've never heard of that, but it was a very famous magazine for a very long time. the 1920s, the so-called roaring '20s was a period of great prosperity in the united states. the u.s. was absolutely dominant economy in the world at that time because most of europe was still in ruins from world war i. there were lots of new inventions. people gathered around the radio and automobiles became much more available. and so there was a lot of new consumer durables and just a lot of economic growth during the '20s. so that was a -- again, a period of prosperity, particularly in the united states and the fed had some time to sort of get its feet wet and establish its

procedures. unfortunately, in 1929, the world was hit by the first great challenge to the federal reserve in to also all u.s. policymakers which was the great depression. as i'm sure you know, the u.s. stock market crashed in october 29th. what you may not know is that the financial crisis of the great depression was not just the u.s. phenomenon. it was global. large financial institutions collapsed in europe and other parts of the world. perhaps the most damaging financial collapse was of the -- of a large austrian bank that collapsed in 1931 and brought down with it many other banks in europe. so it was a global phenomenon. and as you know, of course, the economy contracted very sharply, and the depression lasted for an incredibly -- seemed like an incredibly long time from 1929.

and it only ended when the united states entered the war after pearl harbor in 1941. so here are a few facts about the depression. i think it's important to understand how deep and severe this episode was. here's the stock market. you can see the straight line at the left, vertical line showing october 1929. very sharp decline in stock prices, unsurprisingly. this was the crash that was made famous by many writers who told colorful stories about brokers jumping out of windows and all those things. but what i want you to take from this picture is that the crash of '29 was only the first step in what was a much more serious decline. you see how the stock prices kept falling and by mid-1932, stock prices had fallen an incredible 85% from their peak. so this was much worse than just

a couple of bad days in the stock market. the real economy, the nonfinancial economy also suffered very greatly. the left-hand picture shows growth in real gdp. and so if it's -- if the bar is going -- pointing up, it's a growth period. if it's pointing down, it's a contraction period. so in 1929, the economy grew by more than 5%. it was still growing very substantially but you can see that from 1930 to 1933, the economy contracted by very large amounts every year. so there was an enormous contraction of gdp, close to one-third overall between 1929 and 1933. at the same time, the economy was experiencing deflation. deflation is falling prices. and as you can see from the right picture, in 1931 and 1932,

prices fell by about 10%. so if you were a farmer who far trouble in the late 19th century, imagine what's happening to you in 1932 when crop prices are dropping by half or more and you still have the same payment to the bank for your mortgage. as the economy contracted, unemployment soared. we did not have the same survey of individual households in the 1930s that we have today, so these numbers are estimated, they're not precise numbers. but as best we can tell, at its peak, unemployment came close to 25% in the early 1930s. and you can see the light blue line is the recession period. even at the end of the '30s, before the war changed everything, unemployment was still around 13%. so unemployment rose

tremendously. bank failures. as you might guess, with all that was going wrong in the economy, a lot of depositors ran on their banks. the picture on the right, the graph on the right, shows the number of bank failures in each year. you can see an enormous spike in the early '30s in number of failures. what caused this colossal calamity, which again i would reiterate was not just a u.s. problem but a global problem. one country in fact that had a worse depression than the united states was germany. and that led probably more or less directly to the election of hitler in 1933. so why was there -- what happened? what caused the great depression? this is a tremendously important subject and has received a lot of attention as you might imagine from economic historians. as often is the case for very large events there were many different causes. i mention a few here.

the repercussions of world war i. problems with the international gold standard which was being reconstructed but with a lot of problems after world war i. the famous bubble in stock prices in the late 1920s. and the financial panic that spread through the world. so there are a number of factors that created the depression. but the ones that i want to focus on here -- let me say one more word before turning on. part of the problem was intellectual rather than policy per se. at the time of the 1930s there was a lot of support for an approach or thinking about the economy called a liquidationist theory. the idea behind it was the 1920s was too good a time. the economy expanded too fast. there was too much growth. there was too much credit extended.

stock prices went too high. so what you need when you have a period of excess is a period of deflation. a period where all the excesses are squeezed out. so there was a point of view which said that the depression is unfortunate but it's kind of necessary. we've got to squeeze out all of the excesses that accumulated in the economy in the 1920s. and there's a famous statement by andrew mellon, who was hoover's secretary of the treasury. liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. sounds pretty heartless and i think it was. but what he was trying to convey here is we've got to get rid of all the excesses of the '20s and bring the country back to a more fundamental, sound economy. all right. so what i wanted to get into here in the last few minutes is what was the fed doing during this period? unfortunately, the fed met its first great challenge in the great depression and it failed. body on the monetary policy side

and on the financial stability side. on the monetary policy side, basic bottom line here is that the fed did not ease monetary policy the way you would expect it to in a period of deep recession. for a variety of reasons, because it wanted to stop the stock market speculation, because it wanted to maintain the gold standard, because it believed in liquidationist theory, for a variety of reasons, the fed did not ease monetary policy, or at least not very much. and so we didn't get the offset to the decline that monetary policy could have provided. and indeed, what we saw was the sharply falling prices. you can argue about causes of the decline in output and employment. when you see 10% declines in the

price level monetary policy is much too tight. so the deplace was in fact an important part of the problem because, again, it bankrupted farmers and others who relied on the sale of products to pay fixed debts. to make things even worse, as i mentioned before, if you have a gold standard then you have fixed exchange rates. so the fed's policies were essentially transmitted to other countries which also essentially therefore came under excessively tight monetary policy and that also contribute ed to the collapse. as i mentioned one reason why the fed kept money tight is because it was worried about a speculative attack on the dollar. remember, in 1931, the british had faced that situation. the fed was worried there would be a similar attack that would drive the dollar off gold. so to preserve the gold standard they raised interest rates rather than lowered them. they argued by keeping interest rates high that would make u.s. investments attractive and

prevent money from flowing out of the united states. but again, that was the wrong thing to do relative to what the economy needed. in 1933, franklin roosevelt abandoned the gold standard and suddenly monetary policy became much less tight and there was a very powerful rebound in the economy in '33, '34. the other part of the fed's responsibilities, of course, is to be lender of last resort. and once again, the fed did not meet its mandate. they responded inadequately to the bank runs, allowingthis tre decline in the banking system, as many banks failed. and as a result, bank failures swept the country. as i mentioned before, a very large fraction of the nation's banks failed. almost 10,000 banks failed in the '30s. and that continued until deposit

insurance was created in 1934. now, why did the fed not more aggressively be lender of last resort? why didn't it lend to these failing banks? in some cases the banks were really insolvent, wasn't much could be done. they had made loans in agricultural areas and their loans were all going bad because of the crisis in the agricultural sector. but part of it was the fed appeared at least to some extent to agree with the liquidationist theory which said there's too much credit, we're overbanked, let the system contract, that's really the healthy thing. but that was unfortunately not the right prescription. now, of course in '33, franklin roosevelt came into power. roosevelt had a mandate to do something about the depression. he took a variety of different actions. he was very experimental. some of those actions were quite

unsuccessful. for example, something called a national recovery act required -- tried to fight deflation by requiring firms to keep their prices high. but that wasn't going to help without a bigger money supply. so a lot of things that roosevelt did didn't work so well. but he did two things which i would argue did a lot to offset the mistakes, the problems, that the fed created. the first was in 1934, the establishment of deposit insurance and the fdic. now if you were a ordinary depositor in a bank and the bank failed, you still got your money back. therefore, there was no incentive to run on the banks. and in fact, once the deposit insurance was established, there were essentially -- we went from literally thousands of bank failures to zero. it was incredibly effective policy. the other thing that fdr did, although it drew a lot of smoke while he was doing it, basically

he abandoned the gold standard. by abandoned the gold standard, he allowed monetary policy to be released and allowed expansion of the money supply, which ended the deflation and led to a powerful short-term rebound in '33 and '34. so the two most successful things that roosevelt did were essentially offsetting the problems that the fed created or at least exacerbated by not fulfilling its responsibilities. so what are the policy lessons? it was a global depression, had many causes. the whole story requires you to look at the whole international system. but policies in the united states as well as abroad did play an important role. in particular, as i said, the federal reserve failed in its first challenge in both parts of its mission. it did not