Thomas Rustici on Smoot-Hawley and the Great Depression
Jan 4 2010

Thomas Rustici of George Mason University and author of Lessons from the Great Depression talks with EconTalk host Russ Roberts about the impact of the Smoot-Hawley Act on the economy. The standard view is that the decrease in trade that followed Smoot-Hawley was not big enough to be a significant contributor to the Great Depression. Rustici argues that this Keynesian approach that looks at aggregate spending misses a crucial mechanism for understanding the impact of Smoot-Hawley. Rustici focuses on the impact of Smoot Hawley on bank closings and the money supply. Smoot-Hawley launched an international trade war that reduced world trade dramatically. This had large concentrated regional effects in the United States and around the world in areas that depended on trade. Those were the areas where the first banks collapsed, contracting the money supply via the fractional reserve banking system. Rustici argues that the Keynesian indictment of the price system ignores the policy failures that destroyed the institutions that make the price system work.

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Explore audio transcript, further reading that will help you delve deeper into this week’s episode, and vigorous conversations in the form of our comments section below.


Sam Lundstrom
Jan 4 2010 at 1:41pm

It seems that Thomas Rustici explanation of the paradox of thrift differs somewhat from an explanation given by a previous guest (I do not recall his name now) Rustici explains that savings are equivalent to stuffing money in a mattress since it is assumed that banks do not lend the money out. Your previous guest did not require that the banks refrain from lending for the paradox of thrift to occur. Your previous guest’s point was this: my decision to save more necessarily impacts the income of the business owner where I previously spent this money. Therefore that business owner would have to save less. My increase in savings is offset by his reduction in savings so the total loanable funds is not increased. Whether or not the bank is willing to lend is irrelevant to the argument I think.

Sam Lundstrom
Jan 4 2010 at 1:54pm

I’m commenting as I’m listening here so I apologize for the trail of thoughts. If I understand the argument, Rustici seems to imply that Keynes recognizes that interest rates adjust with the increase in savings, but if investors are sufficiently fearful about the future, the interest rate adjustment will not be enough to entice them to borrow. As I understand Keynes, this is not quite the whole story. The paradox of thrift implies that the interest rate will never adjust since the total supply of loanable funds never actually increases.

Sam Lundstrom
Jan 4 2010 at 3:25pm

To conclude, however, this was a fascinating interview. This is the main point he seems to be making: Smoot Hawley had a meaningful impact on the monetary system. Since our banking system is (by design) a fractional reserve system, small changes in the monetary base will result in huge effects down the monetary chain.

John Strong
Jan 4 2010 at 5:33pm

Sam, I think the EconTalk guest you refer to is: Steve Fazzari. Fazzari refers to himself as a “radical Keynesian.”

Fazzari defended the paradox of thrift in the podcast. As you say, he claimed that the paradox of thrift does not depend on banks hoarding money. He kept repeating that “there is no net saving” when a person saves, because by failing to spend, the saver robs someone else (the erstwhile beneficiary of his spending) of the opportunity to save.

Robert Murphy gives a refutation of this line of argument. As Murphy explains, the paradox of thrift assumes that prices are sticky, i.e. they do not adjust in response to the reduced spending of savers.

Jan 4 2010 at 6:27pm

Amazing podcast. I feel like this discussion put together a lot of the pieces of the puzzle for me.

arc of a diver
Jan 4 2010 at 7:57pm

Very fun to listen to, although I have to admit I haven’t put all the pieces together — lots of pieces. Definately worth a second listen.

Jan 4 2010 at 9:25pm

Another great podcast … I’d put this on in the top 20%.

I admit I was starting to get lost through the 3rd quarter of the podcast but it was brought together nicely by the end.

The discussion of the correspondence between the dips in the stock market in ’29-’30 and likelihood Smoot-Hawley would become law was intriguing. I wonder if a similar case could be made that the 2008 crash was “caused” by the end of the Palin bounce and the certainty of an Obama win. (I can almost hear Russ cautioning against ex-post storytelling 🙂 )

Sam Lundstrom
Jan 5 2010 at 1:47am

to John Strong:
thank you for your response. I remember after I listened to the Fazarri interview I searched on the internet for a refutation of the “paradox of thrift” argument. It seemed like a bizarre concept but I could not come up with a logical counter. I will check out Robert Murphy.

Another thing I liked about this podcast (Rustici) was the emphasis on empirical economics. Rigid devotion to theory and economic models seems to be a core problem with modern economics.

As was mentioned in a previous comment, this is certainly worth a second listen.

Jan 5 2010 at 2:26am

Fascinating podcast!

My education taught that Smoot-Hawley contributed significantly to the Great Depression. But it was always framed as a reduction of trade; never a word of a concentrated monetary affect.

I hope Rustici comes back and explains why one would deposit their money in a bank under Free Banking or under our Central fractional-reserve system… It seems like a huge irrational risk to me.

Joshua Cross
Jan 5 2010 at 7:08am


Excellent interview.

For those interested, Jude Wanniski gives a very similar “headlines”-style analysis of the way politics influenced the economy and expectations of the future during the Great Depression in his book The Way the World Works. Some may find the analysis a bit dry (it’s buried in the middle of the book), but is worth looking at if you liked how it was done in this podcast.


Jan 5 2010 at 10:35am

I was delighted to see Dr. Rustici’s name when I updated my feed yesterday morning! His lecture on this topic is truly one of the greats, if any of you happen to be enrolled in GMU and are looking to take a Macro class.

Towards the end I had to laugh, because for as long as I’ve known him Rustici has never been able to budget his time and his classes always ran over; it was funny to see that he ended up taking EconTalk over time as well!

Robert P. Churchill
Jan 5 2010 at 11:39am

I would be interested to see if this work references Wanniski on the S-H headlines or if the inspiration came from a different source. Anyone had a look at the footnotes?

John Flanagan
Jan 5 2010 at 12:18pm

Great Podcast(s)

While growing up, I never understood how each night there would be just 30 minutes of news. That your podcast ran so long beyond “normal” is why I wondered. You two got into a subject(s) that needed more time, and you took it, with gusto.

All of it requires more thinking for me, but I was especially fascinated by Rustici’s digression into White’s thesis about privatized banking.

And, of course, I warmed each time he mentioned that the “Depression” was a product of government failures, Smoot-Hawley being one of a related number, not market failures.

So, might it be that, with the Fed, we’ve opted for geographically extensive, deep and prolonged bubble bursting, as opposed to local, shallow and quick bankruptcies. Fractional reserve banking has risks and rewards, yet, make it one-size-fits-all nationally mandated, and both are apparently magnified. Just say: “Super size me”.

It would be, I suppose, consonant with your educational bent, Russ, if from time to time you’d post some “peer” reviews of Rustici’s most interesting hypothesis. Those supposedly dead Austrians continue to haunt and demand answers.

Jan 5 2010 at 12:53pm

John F.:

If you’re interested in free banking, you should check out the EconTalk with George Selgin on the subject:

Jan 5 2010 at 1:03pm

This was excellent. I listened to it twice. Thanks for the interesting discussion.

While you are drawing from GMU resources, might I recommend Robert Axtell from Mason’s Center for Social Complexity? I know that Kling is skeptical of the type of agent modeling done there. Might be fun to hear Axtell’s case.

Jan 5 2010 at 10:09pm

Hey Russ

Always enjoy your podcasts.

I want to second the request of someone a week or so ago. Would you try to bring a neo chartalist like Randall Wray or Warren Mosler on your show. I’ve been dabbling in the stuff and think it explores some things that really need exploring. Theres an Aussie named Bill Mitchell that would be an interesting interview as well.


Scott Packard
Jan 5 2010 at 10:29pm

I usually listen to your podcasts twice; this one I’ll probably listen to 3 to 4 times (I’ve already listened twice so far). I’ve sent it to some family members, hoping they listen (since they’re children of the Great Depression and ex-farmers I think they could appreciate what their parents were going through).

I’ve also enjoyed your other recent guests, talking about different aspects of the Great Depression.

I’m a bit worked up by the podcast, especially because tonight my local Congress-critter sent me a survey with 8 choices of what I think is the most important thing Congress should do this year and all except one of the choices involves massive government intervention.

Jan 6 2010 at 11:20am

Excellent podcast and I agree that I will have to listen to this multiple times as I had to his lectures at George Mason University. One of the most influential professors I have every had.

I hope that his message gains momentum and becomes more public because I am certain that most people have no idea what is going on with the economy during the depression and now.

Jan 6 2010 at 1:37pm

I don’t mean this to be a rhetorical question but how could the years 1827 to 1857 be considered an era of “free banking” when women didn’t even have a clear right to own property (independent of their husband)in many states and about 4 million Americans were enslaved? Seems like a system should be defined as free, first by the extent to which it is open and accessible to equally to any and all individuals.

Michael Tate
Jan 6 2010 at 5:27pm


It seems to me that the main point of the argument made here is that Smoot-Hawley caused ag. exports to fall and the future profits of the farmers in the midwest to stop making payments to their lenders, causing the series of bank failures. (in late 1930)

But I think you’re missing something huge. The Dust Bowl. That started in 1930, so to me it would make perfect sense that a year of drought would totally destroy any money the farmers could bring in, not the lack of ability to export their goods. This also makes sense to me as to why all these collapses happened in Nov and Dec 1930. AFTER the harvest would have taken place.

Unless I’m missing something…

Jan 6 2010 at 8:15pm

Enjoyed the podcast very much; however a sentence from Von Misses’ Human Action kept popping in my head:
It has been asserted that the historian himself cannot avoid judgments of value. No historian-not even the chronicler or newspaper reporter-registers all facts as they happen. He must discriminate; he must select some evens which he deems worthy of being registered and pass over in silence other events. This choice, it is said, implies in itself a value judgment it is necessarily conditioned by the historian’s world view and thus not impartial but an outcome of preconceived ideas. History can never be anything else than distortion of facts; it can never be really scientific, that is neutral with regard to values and intent only upon discovering truth.


Jan 7 2010 at 9:13am

Michael Tate,

Even if it was true that that’s part of what was going on in agriculture, Dr. Rustici pointed out that a lot of other export-dependent industries were hit as well.

Michael Tate
Jan 7 2010 at 4:18pm


I understand he said that other industries were hit, but unless I missed something he never mentioned any non-ag related industry that was hit in 1930.

I also remember him saying something about the auto industry taking a hit between 1930 and 1933…well there was a depression going on, of course there is going to be a drastic reduction in the auto sales. In this case the effect can’t be the cause of the effect.

I’m honestly open to the premise of his argument but I just can’t see how the facts prove it. It seems like he was really searching desperately for facts that just arn’t there.

Again though I just might be wrong and he might have given a good example and I just missed it.

Jan 7 2010 at 4:53pm

Sam Lundstrom,

I agree that both Rustici’s and Russ’s characterization of the paradox of thrift seems to have an over-simplified straw-man nature. In general Keynes seems to get this treatment (not surprisingly).


Whenever Keynes is discussed you seem to just spout off non-sequiters about animal spirits and irrational exuberance. What little I know about Keynes this seems like an over-simplification at best. Also Rustici seems to say that Keynes didn’t believe in supply and demand and that people only spent and saved based on tradition… Unless I’m confused about what was said or what Keynes believed this seems misleading at best… completely unfounded at worst.


I do not see how the 2008 election can be comparable to the argument related Smoot-Hawley for a couple of reasons. Rustici seems to be saying that the depression was not related to a general overvaluing of the stock-market or other asset price. It was related to the international effect of the potential and eventual passage of S-H causing a collapse in foreign demand for US products. The devaluing of real-estate had been occurring since mid to late 2007… hardly plausible to relate this to the potential of Obama’s presidency. I know of very few people that argue that some kind of major financial restructuring was avoidable at the time of Obama’s lock on the presidency.

General comments,

Isn’t there a benefit in the reduction of transaction costs in a central banking system? It may seem plausible on a local, or maybe national, level to expect people to posses some knowledge and discrimination in their banking practices but especially in a global economic system it seems like the transaction costs would become extraordinary if international agencies had to request all transactions in gold or had to worry about the solvency of each banks currency with which it deals. The euro makes it much easy to make individual purchases and transactions with european union members. It seems to me that a fractured banking system would turn this simple transaction into a nightmare… unless I’m missing something. Not to mention I’m skeptical that governments could organize such a transition to some form of free-banking without causing chaos in the markets.

Dennis Bullock
Jan 7 2010 at 6:34pm

Excellent podcast and enlightening discussion. I am in overall agreement with Dr. Rustici in his assertion that the S-H tariff is important and often overlooked as a contributing factor to the Great Depression. However, as Dr. Rustici indeed claimed, it is a piece to the puzzle, and I would argue it is better to argue it exacerbated many already extant problems rather than playing a fundamental role in creating the depression.

That said, I believe Dr. Rustici made a glaring historical error during the podcast: He claimed the Federal Reserve raised interest rates drastically in 1931 to stop “stock market speculation,” which Dr. Rustici made to sound absurd. It would be absurd, if it were the actual reason. It was not. The Fed raised interest rates at the time because foreign governments were seeking to (and had already started to) pull their gold deposits out of US banks because of the ever-escalating bank runs in the US. Indeed, some $30,000,000 of gold had already been shipped overseas when the Fed decided to try to stop it. By raising interest rates, the Fed was attempting to convince these foreign governments to leave their gold here. Most of these deposits were in larger, more stable banks—but if the gold were withdrawn, these banks would destabilize as well. With the benefit of much higher interest rates, these nations would be making a better investment by leaving the gold here. And, in turn, the Fed reasoned that the banking system and overall money supply would remain more stable. The Fed’s action did stop the exodus of gold (notwithstanding the other damage it caused the economy).

We know today that many actions taken by the Fed—as well as the Hoover Administration—turned out to be injurious to the economy and perpetuated the depression. However, it is not fair to say they did not have a valid rationale for this decision; we were on the gold standard, just like all other Western nations at the time (though Britain came off in that very same year). The Fed had to make a choice, and they made it; it saved the gold reserves, but at a terrible economic cost to commerce.

Richard W. Fulmer
Jan 8 2010 at 12:46pm

Jude Wanniski in his book, “The Way the World Works,” makes the same point about the link between the Smoot-Hawley debate in Congress and the stock market. The book documents how the market tracked the debate – falling when the bill’s passage looked more likely, and rising when passage appeared in doubt.

Justin P
Jan 10 2010 at 11:29am

I’m glad you and Dr. Rustici started the talk on how easily people try to disregard SH as one of the many causes of the GD. Far to often is the notion that a Government policy could wreck the economy discounted with no actual look at the evidence, merely because it doesn’t fit a priori views. In this case, that Government intervention is a “good thing.” This is my main problem with Keynesian economics. Keynes had some good ideas and some really crappy ones. I view his “General Theory,” as his absolute worst work. Paradox of thrift is one of the worst ideas, second only to the magik of G.
Smoot-Hawley flies in the face of the “Government is good” meme, so it’s no wonder why mainstream Keynesians stick their head in the sand and dismiss any such argument that SH was a major contributor.
The big flaw I find in their reasoning is the notion of Animal Spirits. Keynes never goes into the cause of recession, another big flaw in his theory, instead laying all at the feet of irrational people ie Animal Spirits. Why don’t they want to find out what spooked those spirits in the first place? As I see it, SH as a major cause of the Depression fits in quite nicely in the Keynesian framework of Animal Spirits.
People saw a major piece of legislation coming down the pipes and reacted to it, which is Rustici’s thesis.
Now why do they still disregard “SH as a cause” analysis, because they’d have to admit that G isn’t always benevolent. That G can be on net negative. I think for some, that’s just to hard, it’s much easier to ignore SH and therefore ignore the possibility that G can be bad. Then they can go about their merry way advocating more government spending as a solution to all life’s problems. Unicorns and Pixies dust I say to that.

Simon C
Jan 11 2010 at 7:44pm

I’m just thinking more about the point that something which affects just a small part of the economy can nonetheless have a substantial impact on the economy. I have two points. One was the point that in any complicated system such a number is misleading. I think this was what by the Panama canal amount of water analogy. Another comparison might be to see the economy as an organism and the apologists of SH as saying, “Well, only 3% of the blood was going to this organ.”

The second point is on similar lines. The thing that people most seem to dislike in economic performance, large scale unemployment, is something that can be brought about by a sudden need for massive reorganisation of the economy. If a large number of people have to stop one job, move to another place and find a new one, even if the demand is in place for this, the process will cause a lot of structural unemployment. A bursting bubble seems to do this and perhaps causes the unemployment we see now. Could not a change like SH also shift the balance of the economy also such that such a large structural change was required?

Jan 12 2010 at 12:26pm

Sure, S-H was poor policy, but claiming that it’s a primary cause of the depression? Post hoc ergo propter hoc.

When pushed by Russ on this issue(near the end of the podcast), Rustici responds by listing a number of bank failures that occurred sometime afterward S-H (although not in Canada, where S-H was also part of the economic environment). I could make the causal argument for shorter hemlines just as convincingly.

Jan 15 2010 at 2:29am

I agree with Bruce. Association does not prove causation. The rooster crows therefore that is why the sun rises.

Emmanuel Martin
Jan 15 2010 at 3:23am

Nice podcast.
It’s also interesting to use the Adam Smith/Allyn Young/George Stigler/James Buchanan argument on the relationship between the size of the market and division of labour to fully appreciate the effects of the SH. The level of division of labour or the roundaboutness of the capital structure of an economy depend on the size of the market.

If suddenly the size of the market shrinks by political decision, it means that the degree of roundaboutness investment in the economy suddenly becomes inadequate, i-e uneconomical. This helps better understand why the effect is not “linear” but brutal : it’s not just temporary bad news for 7% of the national industry. It’s the whole level of roundaboutness of this industry and its ramifications, that is suddenly out of sync because of the SH.

That ‘s exactly what investors understood during the crash. For those who read French I have a short Oped here :


Jan 18 2010 at 4:06am

Very interesting and informative podcast. I found the impacts of the depression on Canada’s banking system particularly interesting. Can you recommend further reading on this subject?

Jan 24 2010 at 12:30am

Interesting history about the Smoot-Hawley and the “intended” impact on the world’s economy. The below quote is taken from the United States Banker Magazine from 1892. In the time when people were clamoring to get the quantity of money increased by the re-introduction of silver. This would have negatively impacted the bankers who preferred the gold standard. If people knew that their government could effectively meet the demands of increased quantities of money by the use of silver we wouldn’t need bankers “help” to control the money supply.

“Our top leaders are perfectly aware of the truth. They are presently working at establishing an imperialism of the capital to rule the world. But while they are implementing this plan, they must keep the people busy with political antagonisms.

“We’ll therefore speed up the question of reform in the custom rates [tariffs] by the political organization called the Democratic Party; and we’ll put the spotlight on the question of protection and of the reciprocity by the Republican Party.

“By dividing the electorate this way, we’ll be able to have them spend their energies at struggling amongst themselves on questions that, for us, have no importance whatsoever, and on which we only touch upon as instructors of the common flock.

“It is thus that, through discreet acts, we can maintain what was so generously projected and executed with such a remarkable success.”

Dave P
Feb 1 2010 at 5:18pm

Man this brings back memories of school in a good way. I was very fortunate to have taken three courses with Rustici.

Feb 2 2010 at 10:20pm

@ Bruce
“When pushed by Russ on this issue(near the end of the podcast), Rustici responds by listing a number of bank failures that occurred sometime afterward S-H (although not in Canada, where S-H was also part of the economic environment). I could make the causal argument for shorter hemlines just as convincingly.”
Canada did not have the banking regulation we had. They could branch, for instance, so when a bank (like one that served farmers) had a problem, it could get funds transferred from a branch that was doing fine (like one serving, say, a mining community). U.S. banks could not. This left them much more susceptible to shocks, like the one created by S-H. There’s more to it, of course, but that’s just a taste. Another government failure…

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Podcast Episode Highlights
0:36Intro. [Recording date: December 30, 2009.] Smoot-Hawley tariff as cause of the Great Depression. First, Keynesian theory of business cycle and economic growth. In the Keynesian model, what is the cause of recessions and depressions? Lack of aggregate demand--total spending--usually arises from an increase in the demand to hold money. People start hoarding cash, don't spend; and in that model, spending is what creates income. Size of the real economy is determined by total demand from investors, consumers, government spending. Demand-driven model, often called an over-production, under-consumption model; Mercantilistic model. Pre-classical view of the world with more sophistication and algebra. Output of the economy is given; it's demand that is the defining limit for how big the economy is. Aggregate supply is just there. If we produce but don't consume it, then we enter a downturn. Everything in the Keynesian model is a spending model--spending is what drives the actual size of the real economy. Keynesian policy advocates that--stimulate consumers to spend, the government to spend. Making up the gap. In that hoarding of money, anxiety on the part of consumers, does Keynes or his followers talk about that? Keynes uses the phrase "animal spirits" to capture the uncertainty of people's feelings about the future. Is that just exogenous? Yes; the volatility of money demand drives the Keynesian system. People just become fearful, expectational fears of the future, fearful they might lose their job--they do lose their job--therefore they start holding back. Money accumulates and doesn't circulate in exchange. Price level in the Keynesian model is given, parametric. If prices don't adapt to this shift to aggregate demand then quantities have to adapt. Keynesian system is about quantities adapting, not prices adapting. Justified historically by Keynesians by prices or wages being sticky downwards; unemployment in labor market is a result. Important point: Keynesians have a view of money supply itself as an endogenous variable--money supply adapts to money demand.
5:13Paradox of thrift. They Keynesian argument, brought up in The General Theory of Employment, Interest and Money: if people save, in the aggregate, that people are poorer. Classicals'--pre-Keynesians, up to around 1930--view was that if people save, and did not spend for current consumption, the money went into the banks, the banks loaned it out for productive investment, capital accumulation; this increased productivity and real wages; higher standard of living. Straightforward; savings beneficial to productivity; better off if we consumed less in the present and more in the future. Keynes turned the world on its end. Paradox of thrift: he argued that if we all try to save more, savings will leave the flow of spending; the money goes in the bank but the bank doesn't lend it back out. Like in a mattress--it leaves the circuit of transactions. Think of savings in the Keynesian model like a black hole--goes in and nothing comes back out. Puts pressure to contract the whole real economy. If people save it doesn't lead to capital accumulation; it leads to lower income because people are not spending. Real economy shrinks to that level of spending that is left. If we all save more, we are all poorer. The General Theory came out in 1936, a time when there wasn't a lot of investing. We are in a time right now when people put money in the bank and the banks are not so anxious to lend, and there aren't so many willing to take risks and borrow. So the standard classical model would say if there is this increase in savings, for whatever reason, interest rates will fall, which will make some investments more attractive that once were unattractive. That should cause equilibrating effect; more productive stuff. In the middle of a downturn, though, there are times when the money just sits in the bank; there are times when that Keynesian worry about savings could be correct? Can understand the logic of the Keynesian model if the price system is broken; and that's exactly what Keynes is doing, macro with no micro, no price system. Reality is that money going into the banks and consumers not spending it, investors spending it, is just shifting around who is doing the spending. The black hole argument that the money goes in and becomes excess reserves of the banks, borrowers not borrowing because they are fearful they can't repay it, is an empirical question. Interest rate emerges between borrowers and lenders, investors and savers--if we are arguing that that doesn't function, we have to ask the question why.
9:55Intermediation: just a fancy word for the fact that when people are willing to postpone consumption--which we call savings--and there are other people who want to invest, and have access to more money--borrow--there is an information problem. Lender needs to find the folks who want to borrow. Munger podcast on middlemen--a bank is just a middleman, middle thing, intermediary that links the lenders to the borrowers, takes a cut for its comparative advantage in this brokering activity and for the risk it is taking. If someone says aren't doing their job, something might be wrong with the banking system, then that's what we ought to look at. Banks are the brokers, middlemen, coordinate savers and borrowers. Problem with the Keynesian model, the original way it is written, is that what Keynes is observing is institutional collapse, and not giving proper weight and criticism on the policies that structured those institutions. The price system doesn't have inherent flaws that make it fail. The laws of supply and demand and the competitive process--short of public goods and negative externality arguments--price system based on incentives, respond unless you are in institutional collapse. At higher rates of interest, savers are willing to save more. At higher interest rates, borrowers do not want to borrow as much; at lower interest rates they are encouraged to. If supply-demand for loanable funds through the bank are not responding in the way that incentives in a normally-functioning institution would operate under competitive forces, then we have to ask what are the policy questions. Keynes never does this; not an empiricist in this regard; pure theory without much evidence. Why do you call that institutional collapse? Taping end up 2009, to air the first week of 2010. If great idea for new business, this wouldn't be the week or month to want to borrow a lot and risk family's future; would wait. Totally rational. Wouldn't require institutional collapse. Don't care how cheap money is; just nervous. Real empirical question is the volatility of money demand under normal and abnormal circumstances. Keynes will think the abnormal circumstances are the normal conditions of life. Current monetary crisis we are in--financial institutional crisis; at the edge of institutional collapse. Public policy has encouraged them to lock up by absorbing enormous volumes of risk.
15:14The Great Depression. Close parallels. Institutional collapse of the 1930s and Smoot-Hawley. Standard view of Smoot Hawley--a tariff act passed in 1930 which set off a round of reciprocal tariff increases by our trading partners. Discouraged economic trade between the United States and the rest of the world. On the surface it had an attractiveness to the general citizen--let's keep out their stuff and that way people will buy more of our stuff; and through a Keynesian argument of aggregate demand people this will keep our factories going. Standard view of Smoot Hawley: In 1930 trade wasn't nearly as important in percentage terms in the U.S. economy--about 5-7% of U.S. economy. If you pass a tariff and that number fell, it can't have the magnitude necessary to explain the contraction we saw in the 1930s--a 36% decline in the economy from 1930-1933. So, Smoot-Hawley has been dismissed as an important contributor to the Great Depression. Why argue with that? Many problems with the way we model that tariff today, partly because of that Keynesian influence. We model the as C+I+G+X-M (Consumption Spending + Investment Spending + Government Spending + Exports - Imports); when you add that up, that's 100% of total spending. Can take total spending and parse it amongst consumers, investors, government and net exports. Most modern economists basically argue that it was a negative policy, reduced the economy, but not near the magnitudes, sideshow; and they argue that free marketers have exaggerated the argument. The time it was passing, most of the world's economists argued it was vastly destructive. Why did the economics profession at the time have such a unified and loud voice to this, that it was central to the Great Depression; yet economists today with econometrics and modeling techniques argue it was a sideshow? We're smarter now. Or: in pre-Keynesian times, economists saw these things as more integrated, more effects than can be quantitatively measured in any macro model. Keynesians and New Classicals, e.g., Robert Lucas, alike argued it was not the main story. The main story today is predominantly the monetary story, which comes from Milton Friedman and Anna Schwartz. Most economic historians accept the monetary hypothesis: institutional collapse of 10,421 banks--40% of the banks--in three years; the money supply declined catastrophically. Don't dispute that. Tendency today to do one of two mistakes: macro dissipation effect or micro trivialization effect. If you look at the water in the Panama Canal, it's a very small amount of water compared to the Atlantic and Pacific Oceans. If you look at a broad map of the oceans, one might infer that the volume of world trade that occurs in the Panama Canal has to be small, because it's a relatively small amount of water. But we know that's not true--it's very critical water there. We are tempted with Smoot-Hawley to dissipate it into the background and say this is just a little small thing relative to all this other stuff. Conversely, when we do micro modeling of it and look at the Harberger triangles, deadweight losses for tariffs--losses of people artificially induced to buy the more expensive products and use more resources for steel than it needs to because of the tariff--we get into compartmentalization, where we hermetically seal off the effects of that tariff to other institutions. Hypothesis came from two monetary economists--Larry White and also Alan Meltzer, who in his article in 1976 Journal of Monetary Economics pointed out that Smoot Hawley may have had a very significant monetary effect.
24:21Non-obvious channel. We usually think of trade as being a micro phenomenon or aggregate macro. Why would it have monetary implications? Book: monetary implosion, collapse of the banking system, financial disintermediation, etc. is the main culprit in why it was a catastrophic rather than normal downturn. But what caused that collapse? Authorities to cite: Friedman and Schwartz, in their Monetary History of the United States, were the first to point out that the proximate cause was the Federal Reserve and allowing a series of bank runs over four years. Fractional reserve system; only a fraction of the deposits are ever in the bank at any one time. Credit structure is based on that. Base money changes have massive effects throughout the entire economy. If the Fed behaves properly and wisely, shouldn't be a problem. Can have runaway inflation or deflation. People don't trust the banks and pull money out. Where were the first bank runs? We had the stock market crash in October 1929--precedes Smoot-Hawley. The legislative history of Smoot-Hawley: Herbert Hoover was elected on a promise to impose tariffs--to protect the farmers in America. But America at this time--about half of its export income came from the farm sector. We were the world's largest exporter of agricultural goods--as we still are today. So tariffs would hurt farmers, not help them. In March and April of 1929, right after inaugurated, tariff went through the House of Representatives; passed the House in fall of 1929. House very protectionist at this time; expanded tariff to virtually everything, very high rates. Senate at this time was more free trade; 16 free trade Senators blocking Smoot-Hawley in the Senate. On October 21, 1929, the 16 free trade Senators log-rolled; said they'd join in if you give tariffs for the industries in our states. The Senate then supported the Smoot Hawley bill. Tariff increases from 38%-60%--almost a doubling. Immediate ramifications. The day the 16 Senators switched, on October 21, is when the market began its slide; lost 1/3 of its value before the Crash on October 29, 1929. When you read the financial papers--Wall Street Journal, New York Times--they have front page stories on one side with markets decline and other side Smoot-Hawley passes; nobody connecting the dots. The reason they have something to do with each other--speculators are acquiring and processing information about the future. Hugely protectionist stand; traders around the world are seeing this and can anticipate; train coming right at them. Expect it to hit not only our export companies--automotive, radios--expect their prices to collapse; and expect commodities market, grains, also to collapse. Why? We put up tariffs to the rest of the world's goods. Any goods that come into the United States will have to have a higher price to absorb this tax that has to be paid by the importer. Foreign governments retaliated; in early 1929 when Smoot-Hawley was going through the House and the Senate, a lot of countries started preemptive strikes on us, e.g., Spain, and raised tariffs to American goods. Speculators around the world saw the impending tariff war; tariff wars have a tendency to proliferate, so not just Spain against America, but Spain against France, Britain, etc. Exactly what ended up unfolding. Foreign buyers that were buying about 30% of our wheat, corn, cotton, put up tariffs to our goods; buying corn, wheat, cotton from other places, like Canada. Farmers dependent on the export market were also hit. Not only get the capital market on all of our foreign products, electronics, steel, automotive industry to take a severe hit, stock market slide. But more important is the quantity side--less production. A lot less corn, cotton sold to the rest of the world. More available here, pushing price down; but total amount will shrink.
33:29Interesting what happened after the stock market crash. Smoot-Hawley, Federal Reserve in fall of 1929 raised interest rates dramatically, started earlier, deliberately trying to squelch what they called stock market speculation--but market was not overvalued by any financial criteria. Same thing happening today. Monetary contraction in late 1928, early 1929, slows economy down. Depression actually started in July-August 1929. What happened after the stock market crash: Senate and House bills for Smoot-Hawley were different bills. Tried to reconcile them in November and December. Couldn't agree; looked like the bill was dead. NY Times even declared it was dead. Stock market, which had lost more than a third of its value gradually started to come back. Wasn't finally passed until June of 1930. Congress meets in January 1929 and starts on reconciliation; changes made in schedules to get the tariff to pass. Got back to 8% of where it had been at the beginning of 1929; but in spring of 1930, 36 countries lodged 59 formal protests with the State Department, start to get retaliation by countries. On May 5, 1930, 1,028 professors of economics, professional economists signed a petition to Hoover saying not to sign this bill. Made the point in that letter that it would have monetary effects. Today there are maybe 10,000-20,000 economists; back then many fewer, and they all agreed enough to sign the petition. In June the final bill went to Hoover, June 14; on the following Monday he signed the bill to keep his campaign promise. Stock market took a big hit. In first two weeks of June, stock market lost 20% of its value. Second-biggest drop in the history of the stock market. Stock market is just a barometer. People tend to think it has its own causal effects, and it has some; but this was as a barometer. Not just American stock markets. In 10 different countries, all of our trading partners, also massive collapse in their stock markets. England, Germany, Italy. Something worldwide going on. Economists at this time realized that trade had monetary effects.
40:05Will be less efficient as an economy, less trade, everyone dealing with it, but 2-3% less. Missing something. If you have a 2% lose of Gross National Product, it sounds like everything moves down 2%. Reality is that if you have a 2% loss in your real economy but it's showing up in 5 or 10 states, that is catastrophic for those states. Modern modeling, tend to think everything is in unison, but everything is not in unison. There are distributional effects. When you take $2 or 3 billion out of 5 or 10 states at this time, catastrophic--10-15% drops in those states. What are those states? Where did those bank failures start to occur? Went back to Friedman and Schwartz, and they make the point that the first bank runs occur in November and December of 1930, and they occur in 6 Midwest farm states--agricultural export markets. Massive drop in farm income. Total of 600 banks failed in two months. Not 600/50, rounding number of states, which was 48 at the time--it was concentrated in those 6 states. One big bank that went down was the Bank of the United States in New York, sixth largest bank in America, own unique significance; all the rest of these banks started to fail in the Midwest. In the years 1920-1929 we had an average of 600 banks per year nationwide close their doors, small farm banks spread all across America. Now you get 600 in two months, plus one huge bank in NY. In 1931, more bank runs in spring, summer, and fall; hundreds more banks go down. 1300 banks go down in 1931. Primarily starting with the agricultural regions. 1931 catastrophic worldwide--a lot of bank failures in Europe. In the U.S. the bank runs start in the South and Midwest, migrate north and east; go from rural to cities. In Europe, same pattern. Domino effect. In 1929 in Austria, largest farm credit bank--government had been subsidizing farmers; in 1930, forced it to merge with the largest commercial bank; combined was bankrupt when it reopened its doors. Hungary general credit bank, Germany's 3rd largest bank went down; bank runs over this period moving from country to country. All tied to subsidies given to specific sectors on the world export market. The world tariff war--the loans made to special interest groups were not sustainable when the tariffs started to escalate. The farmers who had borrowed the money on the expectations of future profits--those profits disappeared when world trade collapsed; as a result they couldn't repay their loans in those regions; and as a result of that the banks didn't have the cash flow they expected; loss of confidence. Banks that had loans to businesses in the world export market failed when the world export market went down.
48:34Question is: if those banks fail, what's the proper response? If those failures lead to contagion or general fear of the bank system collapsing--none of the European banks had deposit insurance; we didn't have deposit insurance. Most of the Europeans created central banks after 1920--after WWI. So, now, what does a central bank to do? Supposed to support the base money and the inverted credit pyramid. If people are pulling their money out of the banks out of fear they will lose their principal, then you have to inject liquidity to keep those banks open. If you don't, those banks come down, and that's what they did. European and our central banks both derelict in this. Flawed institutional financial structure; and the tariff, via international retaliation, put enormous pressure on the banking institutions. Why aren't the central banks responding? Discussion in free banking literature; they didn't see it coming. Right in the middle of the collapse they thought they had an easy money policy--at the same time the money supply is contracting. They didn't have the data we have today. Can think of this as a fleshing out of the Friedman and Schwartz story, to uncover the mechanism that led to the collapse of the banking system; and the subsequent contraction of the money supply. Inverted pyramid--small amount of base money held by the banks, supporting to the fractional reserve system and lots of loans. If loans fail, create an insolvency problem for those banks. Difference between illiquidity and insolvency. Illiquidity is what the Fed can prevent by having elastic currency, open market operations, being the lender of last resort. The problem was there wasn't a lender of last resort. In a central banking system on a fractional reserve, you absolutely have to have a lender of last resort. Entire concept of central banking structurally flawed. Nevertheless that's one of the institutions we have; but during the Great Depression, the Federal Reserve did everything wrong. In 1931 during the height of the bank runs, banks had gone down, money supply had already contracted in double digits, the Fed was selling assets through open market operations, pulling reserves out of the system. Alan Meltzer argues it was because they were wedded to the Real Bills Doctrine--credit should go along with the needs of trade. Very pro-cyclical: if the economy is in a downturn, there is less trade going on; therefore you need to supply less currency. Would magnify the downturn. Or: if the economy is picking up, you have more trade, you need more money; print more money--procyclical view of the world. Some truth to that. At the time the Federal Reserve Board--now the Board of Governors--you didn't have to be an economist or have any credentials in economics. Three had no training in economics--one a farmer, another a politician, another a "used-car salesman--I don't know what he was." No background. Didn't have the data. We still have that problem today--lags now, and the lags then were worse.
53:45Full circle: implications. Two examples. Want to get back to opening question of institutional collapse. When you are in a world where banks are failing because of expectations of profit not being realized as the tariff rug is being pulled out from under them, you are going to have inability of these institutions to perform helping lenders and borrowers get together. Will get to that. Two examples. Farm and industrial activity. In the tariff war following Smoot-Hawley, we had a retaliation from Canada, our largest trading partner. Canada had a very different monetary system, much more free banking: no limits on branch banking. No bank failures during the Great Depression even though 1/3 of their GDP came from foreign trade. Took massive tariff hit but the monetary system didn't dive. It absorbed that hit. Their money supply only dropped 13% vs. ours dropping 29%. They had no bank failures; we had 10,421 bank failures. Their financial system didn't become an aggravating factor. Their downturn in real output was much smaller than ours. Lessons to be learned. We put up tariffs to a lot of Canadian goods. After 1930 they deliberately went after our iron and steel exports to Canada. We were exporting about $200 million a year in iron and steel to Canada. After Smoot-Hawley when the Canadian government retaliated--specifically iron and steel but also other items--our exports to Canada dropped to $29 million a year--an 85% drop. Looking at the 17 months between the tariff retaliation by Canada and the decline in exports of iron and steel to Canada, in first 17 months, $359 million less exports. Why 17 months? Seventeen months after Smoot-Hawley, something happens in a particular city: Pittsburgh, city of iron and steel. Eleven of Pittsburgh's banks go insolvent and have to shut their doors. Depositor losses of $69 million, main structure of the entire banking system. If we are going to take most of the iron and steel out of the Pittsburgh economy, this is a good reason why you might have so many losses in the banks that were shut down. Furthermore, if you look at the interregnum period between Roosevelt being elected in November 1932 and being inaugurated in March 1933 (when we did inaugurations at the time), what we find is the big collapse occurred--4000 banks went down in those four months--while Hoover was still President, but lame duck. The Detroit banks, the main banks the Reconstruction Finance Corporation was worried about--in February, the Reconstruction Finance Corporation examined the banks in Detroit directly tied to the auto industry and came up with a rescue plan, which would have required about $12 million to save all of the banks tied directly to the auto industry. They went to Henry Ford and asked for $7.5 million of his money to be subordinated deposits he wouldn't withdraw to give the cash to the banks; and then went to the other companies--Hudson Motors, Chrysler, General Motors, to come up with $4.5 million. For about $12 million they argued they could stabilize the banking system in Detroit. Look back at the auto industry following Smoot-Hawley, in book, auto industry our largest export, along with iron and steel--like planes today--and what we find is the three-year cumulative loss from the time of Smoot-Hawley's passage to the time of the Detroit banking crisis in January-February 1933, cumulative volume in dollars of auto exports declined $1.5 billion. Had we not had those tariffs and maintained our world exports, Detroit would have seen a billion and a half dollars flow right into it. They needed $12 million to save those banks. The entire Detroit system decimated by this law. Henry Ford backed out and withdrew $25 million of his own cash when the other companies wouldn't agree, and put it in his own personal vault; precipitates whole collapse. Notion that Smoot-Hawley was a little trivial sideshow is misleading. Have to start disaggregating, looking at the micro connections. All this inefficiency ultimately shows up in the financial system. All mistakes in investments, all investments that are not going to fulfill expectations, all end up in the insolvency of those banks. We did not have leaders of central banks that responded correctly, even though it was an insolvency problem that could have prevented the contagion.
1:02:26Not surprisingly, people don't want to use that intermediary at that point in time. Keynes argument about savings. Keynes, in The General Theory, when he argues that people save not according to interest rates, but tradition: we have notions of tradition and inertia, we save because our fathers and mothers saved, not responding to price incentives--and we invest based on animal spirits, psychological factors, overconfidence or fear, nothing to do with that price or incentives--before 1933 and there's no deposit insurance, and the central bank is not acting like a lender of last resort, which would stabilize those bank runs; and you are on a fractional reserve and have a massive exogenous hit to regional economies: If I put $100 in the bank and the interest rate on my savings in 3% and someone says put it over in this bank at 7%, I have an incentive to put it there, but if I am worried about losing my principal there, the 7% doesn't matter to me. It's a matter of getting my principal back because there was no deposit insurance. Is the bank safe? Movie: It's a Wonderful Life--bank runs like that happened worldwide. "Your money's not here." Keynes's "broken joint" between savers and investors might make sense of a world of institutional collapse. Instead of Keynes's blaming government policy, he blames the price system. But prices are not just floating abstractions--they are connected to property, connected to ownership, connected to institutions. Keynes has no clue about institutions. Blames price system for the failings of government--the tariff, the central banking system; fractional reserves per se are not necessarily unstable but a monopoly on that is. But we had bank runs before the Federal Reserve system. How can you claim that the bank runs in the late 1920s and early 1930s were a function of the Federal Reserve? What's different here is we did have bank runs in the 1920s. Fed policy different. State banks, not part of the Federal Reserve system. Bank failures from 1929 tend to be small unit banks, farm banks; when you look at total depositor losses through the decade of the 1920s, yearly loss for depositors was $62 million per year on average nationwide. Failure of the Bank of the United States took down $200 million by itself. By the time you get to 1929--about 5000 bank failures in ten years; don't get the major runs. Last run before the creation of the Fed, 1907, was Knickerbocker Trust in NY, and JP Morgan saved that system. Created the Fed because we said we don't have to privately save the banking system. In the 1920s, main person at Fed was Benjamin Strong, never let the contagion happen. Money supply steadily growing about 5-6% a year; though there was deposit insurance at the state level and every deposit insurance system failed. Trying to challenge argument that Keynes blames the wrong culprit: failure of the bank as coordinator of savings and lending collapses during the Great Depression. Keynes blames that on animal spirits, the price system, etc. You are suggesting the bank system failed because the Fed--per Friedman and Schwartz--could have averted it. Deeper point: if we didn't have fractional reserve banking and monopoly supply money from the Federal Government, that that more competitive world would be a more stable world and wouldn't have to rely on these lender of last resort arguments. Challenge: in pre-Fed days, you still had instability in the banking system. In the 1920s understandable; but before the Fed we had all this instability. Difference between asking about the interest rate versus the institutional structure. In America, we only had one era close to free banking--end of the Second Bank of the United States up to the Civil War. Roughly 1827 for 30 years. Look at that era--not totally free banking. From Civil War onwards, two tracks--national banks under Federal regulation, State banks under State regulation. Most of those crises that we like to attribute to the banking system, can look at the policies. Not as if you had laissez faire. Wildcat era of free banking, but not free banking because of branching laws. Also have states that will put up unit banking laws--can't have a second one within a state. California unique--didn't have branching laws, survived better. Rolnick, Weber, Rockoff, and others. Era of free banking more stable, no major inflation, no catastrophic downturns. Huge spread of financial services. Small empirical window--could say that about the Great Moderation of the post WWII period. Difference: in American history, we had this experience. Look at depositor losses; 80% came in a handful of states, which had a requirement for anyone who opened a "free bank" that they had to have a certain percentage of their assets in State Bonds. Indiana, Michigan. You can open a bank, but part of your capital has to be that you have to purchase our bonds. Not a free bank. Those states defaulted on their bonds. In percentage terms, not even a fraction of a percent. Then you look at the Federal Reserve system, from its inception through 1933, vastly higher relative to deposits. Free banking vastly superior even with the distortions even then. Canada, other countries. Free trade matters; free banking matters; money matters. Brittle, rigid system with all the wrong incentives--deposit insurance, moral hazard, previous branching restrictions, unit banks, dual-track regulatory system with some banks in and others out of the Fed.
11:15:44It's one thing to say Smoot Hawley's magnitude can't be important because its magnitude isn't important; can't just look at the volume of trade, have to look at the impact on the monetary system. Still a question of magnitude. In Pittsburgh, 17 months, Detroit 3 years. Confident that those banks' contraction can be pinned on Smoot Hawley? How about the contraction in the money supply? Agriculture for starting point--but not just Detroit or Pittsburgh. Nevada, minerals, copper. We know how much the state lost in income. Twelve banks, a fourth of the banks in the state went down. Boise, Toledo, Chicago; look around the world. A lot of banks failed. Interesting research question. Insolvency problem hits these banks. Insolvency crisis in agricultural and city banks--Smoot-Hawley has a big thing to play with. Insolvency creates illiquidity. Can't solve an insolvency problem with a liquidity solution--Anna Schwartz. Caldwell and Company Bank System--140 banks, Tennessee and Arkansas. What kind of reactions to your research? Boring book--detailed book. Review from John Allison--banker but not economic historian. Monetarists or any economic historians in the past who have been skeptical of Smoot-Hawley? Elgar criticism: not sure the tariff could have had that much effect; maybe worse than we can econometrically measure, have to dig in further. Maybe those 1028 economists who signed that petition saw something on the ground that we are not seeing here. Pattern, no one has disputed that pattern. Sure, there are other factors. Douglas Irwin made point that 2% job but tariff might have had monetary effects.

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