The Anatomy of Crisis – The Great Depression as a Failure of Government, Not Capitalism
A pivotal argument in Free to Choose is a direct and forceful challenge to the most widely accepted economic narrative of the twentieth century. The conventional story holds that the Great Depression of the 1930s was the ultimate failure of free-market capitalism, a system inherently prone to instability, speculation, and collapse. This perceived failure, in turn, provided the justification for a fundamental transformation in the role of government, ushering in the New Deal and the era of large-scale government intervention that continues to this day.
The Friedmans argue that this entire narrative is a myth. The Great Depression, they contend, was not a failure of the free market. On the contrary, it was a tragic, catastrophic, and entirely preventable failure of government. Specifically, it was the result of the gross mismanagement of the nation’s money supply by the Federal Reserve System, a government institution established for the very purpose of preventing such disasters. This misinterpretation of the Depression’s cause, they argue, led to the wrong cure—decades of expanding government—and understanding this historical error is crucial to diagnosing the problems of the present.
To comprehend this argument, we must first set aside the popular imagery of the Depression and look at the underlying mechanics of the monetary system. The story does not begin with the dramatic stock market crash of October 1929, but years earlier, with the creation of the Federal Reserve itself.
Before 1913, the United States had a banking system without a central bank. It was a system of “fractional reserve” banking, meaning that banks held only a fraction of their depositors’ money as cash reserves and loaned out the rest. This system was essential for creating credit and fueling economic growth, but it had an inherent vulnerability: the potential for banking panics. A bank “deposit” is a misleading term; it is not a bailment where the bank stores your specific dollars in a vault. It is a loan you make to the bank. If rumors spread that a bank is in trouble—whether true or not—depositors may rush to withdraw their cash all at once. This is a “bank run.” No fractional-reserve bank, no matter how sound and prudently managed, can withstand a run if all its depositors demand their cash simultaneously, just as a theater cannot accommodate everyone leaving at once if someone falsely shouts “Fire!”
Before the Federal Reserve, the banking system had a crude but effective way of dealing with such panics: the “restriction of payments.” When a panic began, banks would collectively agree to stop converting deposits into cash on demand. They would continue to operate, clearing checks between banks and allowing depositors to pay each other via bookkeeping entries, but they would not hand out large amounts of currency. This action acted as a circuit breaker. It quarantined the panic, gave sound banks time to demonstrate their solvency, and allowed confidence to return, after which the restriction could be lifted. This happened during the Panic of 1907, a severe but short crisis. The disruption was real, but the system recovered.
The Federal Reserve System was created in 1913 precisely to provide a more sophisticated and less disruptive solution. Its primary purpose was to act as a “lender of last resort.” If a bank run began, the Fed was supposed to provide liquidity—that is, fresh cash—to solvent banks by lending to them against their good assets. The Fed, with its power to create money, was meant to be the fire department, capable of putting out financial fires before they could spread into a system-wide conflagration. It was intended to make the old, blunt instrument of “restriction of payments” obsolete.
With this background, we can trace the actual sequence of events that led to the Great Depression. The economic downturn began in the summer of 1929, a few months before the famous stock market crash in October. The crash, while dramatic, was more a symptom of a brewing recession and the bursting of a speculative bubble than its ultimate cause. It deepened the recession by shattering confidence and reducing spending, but on its own, it would have likely resulted in a severe but not catastrophic downturn, similar to others the nation had experienced.
The truly fatal turn of events began a year later, in the fall of 1930. A series of bank failures, particularly in the agricultural Midwest and South, began to shake public confidence. The pivotal event occurred in December 1930 with the failure of the Bank of United States in New York City. Though a private bank, its official-sounding name led many at home and abroad to believe it was a government institution, making its collapse a devastating psychological blow.
The failure of the Bank of United States was a tragedy of errors. It was not an insolvent bank ruined by bad investments; it was a solvent institution destroyed by a bank run. Subsequent liquidation during the worst years of the Depression still managed to pay depositors over 90 cents on the dollar. An attempt was made by other New York banks to arrange a merger to save it, a standard procedure in previous crises. However, the plan fell apart, partly, it is said, due to anti-Semitic prejudice within the banking establishment against the bank’s Jewish ownership and clientele.
This was the moment of truth for the Federal Reserve. This was precisely the kind of situation it was created to handle. The proper response would have been swift and decisive action. The Fed should have stepped in and acted as the lender of last resort, flooding the system with liquidity. It could have done this by making loans directly to banks and, more importantly, by purchasing government bonds on the open market. These purchases would have paid for with newly created money, injecting cash into the banking system and giving banks the reserves needed to meet the demands of panicked depositors, thus calming the public’s fears.
Instead, the Federal Reserve did almost nothing. It stood idly by and let the Bank of United States fail. And then it continued to do nothing as the contagion of fear spread, leading to a wave of bank failures across the country.
The consequences of this inaction were cataclysmic. The failure of the Fed was worse than if it had never existed. Its very presence created a fatal moral hazard. First, it gave commercial banks a false sense of security, leading them to believe they didn’t need to arrange their own cooperative rescue plans as they had in the past. Second, it prevented the use of the old emergency measure, the restriction of payments. With the Fed on the scene, such a drastic measure seemed unnecessary and was never implemented. The new, supposedly superior safety net had failed, but in the process, it had also dismantled the old one.
The failure of the Fed to act transformed a manageable banking crisis into a downward spiral of monetary contraction. As people lost faith in banks, they started hoarding cash. Every dollar of currency pulled from a bank vault and stuffed under a mattress was not just a dollar removed from one bank; it was a dollar of “high-powered money” removed from the very foundation of the banking system. Under the fractional reserve system, each dollar of reserves supported several dollars of bank deposits. Therefore, as the public’s demand for cash drained reserves from the system, banks were forced into a multiple contraction of their loans and deposits.
To get cash to pay depositors, banks had to call in loans and sell their assets (bonds and mortgages) on a distressed market. This process of forced liquidation drove down the value of assets, making even previously sound banks appear insolvent. Businesses that relied on bank credit found their loans called in and were unable to get new ones, forcing them into bankruptcy. This created a vicious feedback loop: bank failures led to a shrinking money supply, which led to business failures and falling prices, which in turn weakened more banks and caused more failures.
This disastrous pattern was repeated in subsequent waves. A second banking crisis erupted in the spring of 1931. The Fed again failed to act decisively. Then, in the fall of 1931, when Great Britain abandoned the gold standard, the Fed made a catastrophically wrong move. Fearing that foreigners would pull gold out of the U.S., the Fed sharply raised interest rates to make holding dollars more attractive. This was the economic equivalent of tightening a tourniquet on a patient already bleeding to death. It put immense deflationary pressure on the economy, accelerating the wave of bank and business failures.
The final collapse came during the interregnum between Herbert Hoover’s election defeat and Franklin D. Roosevelt’s inauguration in early 1933. The political uncertainty fueled a final, massive banking panic. In the ultimate irony, the Federal Reserve Banks themselves, including the flagship New York Fed, joined the commercial banks in closing their doors during the national “bank holiday” declared by Roosevelt upon taking office. The institution created to prevent the suspension of payments had itself suspended payments.
Between 1929 and 1933, the total amount of money in the United States—currency plus bank deposits—fell by a staggering one-third. No economy could withstand such a monetary shock. It was this monetary collapse, engineered by the failures of government policy, that turned a recession into the Great Depression. It was not a crisis of capitalism; it was a crisis of government incompetence.
This analysis allows us to address several key questions. Was the monetary collapse a cause or an effect of the economic collapse? It was both, in a reinforcing spiral, but the initial and decisive push came from the monetary side. Without the Federal Reserve’s failure to prevent the banking panics and the subsequent collapse of the money supply, the recession of 1929-30 would have been severe, but it would have been a recession, not a decade-long depression. The economy would likely have recovered, as it had from all previous financial panics.
Could the Federal Reserve have prevented the monetary collapse? The answer is an unequivocal yes. The power to create money and purchase government bonds was explicitly granted to it in the Federal Reserve Act. The knowledge of how to use this power also existed; leaders at the Federal Reserve Bank of New York, for example, repeatedly urged the central board in Washington to engage in large-scale open market purchases. Their advice was ignored, not because it was technically flawed, but because of internal power struggles within the System and a profound lack of leadership and understanding at the top.
Did the Depression originate abroad and spread to the U.S.? The evidence shows the opposite. In the first two years of the contraction (1929-1931), gold flowed into the United States. Under a gold standard, this is a clear sign that a country’s economic downturn is more severe than that of its trading partners, causing it to import less and pull in money from abroad. The U.S. was not the victim of a worldwide collapse; it was the epicenter, exporting the deflationary virus to the rest of the world through its monetary failures.
The ultimate tragedy of the Great Depression, in the Friedmans’ view, is not just the immense human suffering it caused, but the profoundly wrong lesson that was learned from it. The public, the intellectuals, and the political leaders concluded that the free market was fundamentally flawed and that only a powerful, activist central government could provide economic stability and security. This misdiagnosis led to the prescription of the New Deal and the subsequent fifty years of ever-expanding government control over the economy. The New Deal programs did not end the Depression—unemployment was still at crippling levels in 1939. It was the massive government spending of World War II that finally did. But the myth persisted: capitalism had failed, and government had saved the day.
This myth became the founding justification for the modern regulatory and welfare state. The Great Depression is the primary historical exhibit used to argue for the necessity of government programs from financial regulation to price supports to public works projects. By demonstrating that the Depression was in fact a failure of government, the Friedmans seek to demolish the intellectual foundation upon which much of big government rests. If the greatest economic crisis in modern history was caused by government, not the free market, then the argument for handing ever more power to government in the name of economic stability is not just weakened; it is turned on its head. The crisis becomes a powerful warning, not of the dangers of the free market, but of the immense harm that can be done when government is entrusted with powerful tools that it does not know how to, or does not have the political will to, use correctly.