Free to Choose Chapter 3: The Anatomy of Crisis
The Great Depression was not what you think it was. Most people believe it was the ultimate proof that capitalism is dangerous and unstable. That free markets, left alone, will eventually destroy themselves. Friedman says this story is almost exactly backwards. The Depression was not a failure of the free market. It was a failure of government – specifically, a small group of people at the Federal Reserve who had the power to prevent the disaster and chose not to use it.
This is post 5 in my Free to Choose retelling series.
The Panic That Started It All
The story begins in 1907, long before the Depression. On October 21, a large New York bank called the Knickerbocker Trust Company ran into trouble. Depositors panicked and rushed to pull out their money. The bank closed the next day. Runs spread to other banks across the country.
Within a week, banks did something drastic. They stopped paying out cash. If you had money in the bank, you could not withdraw it. Banks kept operating through bookkeeping – moving numbers between accounts – but nobody could get actual currency. Wooden nickels and homemade substitutes circulated in place of real money. At the worst point, you needed $104 in bank deposits to buy $100 in actual cash.
It sounds terrible. But here is the strange part: it worked. By refusing to hand out cash, banks stopped the bleeding. The weak banks failed, but the strong ones survived. Within a few months, confidence returned. Banks reopened fully. The economy recovered. The whole crisis lasted about thirteen months, and the worst of it only about half that.
But the experience left a scar on the national memory. Politicians decided this could never happen again. They created the Federal Reserve System in 1913.
The Federal Reserve: A Safety Net That Failed
The idea behind the Fed was simple and logical. Banks keep only a small fraction of deposits as cash – maybe $12 for every $100. This works fine in normal times. New deposits roughly match withdrawals. But when everyone panics and wants cash at once, there is not enough to go around. One bank can borrow from another, but if every bank is in trouble, there is nowhere to turn.
The Fed was supposed to be the place to turn. It could print money. It could lend cash to banks that were fundamentally sound but temporarily short on currency. It was the “lender of last resort.” No more panics. No more wooden nickels. No more restriction of payments.
For a while, it seemed to work beautifully. During the 1920s, under the leadership of Benjamin Strong, head of the New York Federal Reserve Bank, the system performed well. Strong was described by a colleague as “a genius – a Hamilton among bankers.” He expanded the money supply when the economy slowed and pulled back when it heated up. The result was stable growth, low inflation, and a widespread belief that the business cycle had been conquered.
Then Benjamin Strong died in 1928. And everything fell apart.
The Power Struggle That Doomed the Economy
Strong’s death created a vacuum. The Federal Reserve Board in Washington wanted to take control from New York. The other regional banks did not want to follow Washington either. Nobody was clearly in charge. The system, as one historian put it, “slid into indecision and deadlock.”
This power struggle would have been just boring bureaucratic politics – except that it happened at the worst possible moment.
The popular story says the Depression started on Black Thursday, October 24, 1929, when the stock market crashed. Friedman points out that this is not quite right. Business activity had already peaked in August 1929, two months before the crash. The market collapse reflected problems already building, plus the bursting of a speculative bubble.
Right after the crash, the New York Fed acted on instinct from the Strong era. It bought government bonds and injected cash into the banking system. This was exactly the right move. But the Board in Washington stepped in and shut New York down. The Board wanted to establish its authority. New York backed off.
From that point on, the Fed did the opposite of what it was designed to do. Instead of expanding the money supply to cushion the downturn, it let the money supply slowly shrink. By October 1930, the money supply had fallen 2.6 percent. That might sound small, but it was already larger than the decline seen in most previous recessions.
The Bank That Broke Everything
The recession might have ended in late 1930 or early 1931. It was severe, but recoveries from severe recessions had happened before. What turned a bad recession into an unprecedented catastrophe was a wave of bank failures.
The critical moment came on December 11, 1930, when the Bank of United States closed its doors. It was the largest commercial bank failure in American history up to that time. Its name – Bank of United States – made people at home and abroad think it was an official government bank. It was not. But the confusion made the damage far worse.
Here is the part that stings. The Bank of United States was actually a sound bank. When it was finally liquidated years later, during the worst of the Depression, it still paid depositors 83.5 cents on the dollar. If it had survived the immediate panic, no depositor would have lost anything.
Other banks and regulators tried to organize a rescue. For days, a plan to merge the bank with other institutions seemed ready to succeed. Then, at the last moment, the New York Clearing House – the association of major banks – pulled out.
Why? The Bank of United States was owned and run by Jewish bankers and served mostly the Jewish community. Joseph Broderick, the New York State Superintendent of Banks, later testified that he reminded the other bankers they had recently rescued two of the largest private banks in the city without hesitation. He warned them they were “making the most colossal mistake in the banking history of New York.” They let it fail anyway.
The consequences were immediate and devastating. In December 1930 alone, 352 banks failed. Depositors everywhere panicked. The dominoes began to fall.
The Fed Watched It Happen
This is where Friedman’s argument becomes most damning. The Federal Reserve had the tools to stop the crisis at every stage. It could have bought government bonds on a massive scale, flooding banks with cash, ending the runs, and restoring confidence. The New York Fed begged the system to do exactly this – in 1929, 1930, and 1931. Each time, New York was overruled. Not because its proposals were wrong, but because Washington and the other regional banks refused to let New York lead.
Instead of acting, the Fed stood by and watched. It got worse. In September 1931, when Britain abandoned the gold standard, the Fed actually raised interest rates – in the middle of a depression. It did this to protect its gold reserves from foreign withdrawals. The effect on the domestic economy was like pouring gasoline on a fire.
In 1932, under direct pressure from Congress, the Fed finally started large-scale bond purchases. The economy began to respond. Then Congress adjourned for the summer, and the Fed immediately stopped.
The final act came in early 1933. Another wave of bank failures. The political transition from Hoover to Roosevelt created a dangerous gap – Hoover would not act without Roosevelt’s cooperation, and Roosevelt would not take responsibility before his inauguration. On March 4, 1933, the Federal Reserve Bank of New York closed its own doors along with the commercial banks it was supposed to protect. The institution created to prevent bank shutdowns participated in the most complete banking shutdown in American history.
Herbert Hoover later wrote that the Federal Reserve Board was “indeed a weak reed for a nation to lean on in time of trouble.”
The Damage
The numbers are staggering. In mid-1929, nearly 25,000 commercial banks operated in the United States. By the time the crisis ended, roughly 10,000 had disappeared – through failure, merger, or forced liquidation. For every three dollars of deposits and currency in 1929, less than two remained in 1933. National income was cut in half. Output fell by a third. One in four workers had no job.
The Depression spread worldwide. In Germany, economic desperation helped Hitler rise to power. In Japan, it strengthened the military faction that would launch war across Asia. In China, it triggered monetary chaos that eventually brought the communists to power.
And perhaps the most lasting damage was to ideas. The public concluded that capitalism had failed and that government needed to step in. Economists embraced the theories of John Maynard Keynes, who argued that government spending was the cure for recessions. The belief that “money does not matter” took hold. Almost nobody understood that the Depression was caused not by too little government intervention, but by catastrophically bad government intervention.
Friedman argues the evidence is now overwhelming. Gold was flowing into the United States during the early years of the Depression – proof that the crisis originated here, not abroad. Under gold standard rules, the Fed should have expanded the money supply in response. Instead, it let the money supply collapse.
The Aftermath
One positive thing did emerge from the disaster. In 1934, the Federal Deposit Insurance Corporation was created to guarantee bank deposits. This simple idea – tell depositors their money is safe, so they have no reason to panic – actually worked. Since 1934, there have been individual bank failures but no old-style banking panics.
As for the Federal Reserve, it gained more power, more prestige, and a grand new building on Constitution Avenue. But Friedman notes with dry irony that bigger offices did not mean better performance. After the Depression, the Fed presided over inflation during and after World War II, a sharp recession in 1937-38, and decades of economic ups and downs. Each cycle of inflation peaked higher than the last. Unemployment gradually crept up.
And through it all, the Fed maintained one perfectly consistent habit: blaming every problem on external forces beyond its control, while taking credit for anything good that happened. It kept promoting the story that the private economy is inherently unstable. Meanwhile, its own record kept proving the opposite – that government, more often than not, is the major source of economic instability.
Key Takeaway
The Great Depression was not evidence that free markets are dangerous. It was evidence that giving a small group of officials enormous power over the money supply – and then having those officials make terrible decisions driven by internal politics – can turn a manageable recession into the worst economic disaster in modern history. The institution created to prevent banking crises made the crisis incomparably worse. The lesson is not that we need more government control over the economy. The lesson is that concentrated power, even when held by well-meaning people, is inherently dangerous – especially when nobody is held accountable for getting it wrong.
Book: Free to Choose by Milton and Rose Friedman | ISBN: 978-0-15-633460-0
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