A public choice theory of the Great Contraction: Further evidence

Abstract

In recent issues of this journal, perhaps no other paper has inspired as intense interest as our (Anderson, Shughart and Tollison, 1988) challenge to the Friedman-Schwartz (1963) "mistake theory" of the Great Contraction. In that article we advanced an hypothesis of Fed behavior grounded in the political self-interests of the banking system's regulators and their overseers in Congress. Specifically, we argued that the Fed obtained two important benefits from the massive contraction in the money supply over which it presided between late 1929 and the middle of 1930. First, because of the differentially higher failure rates of nonmember banks during this period, the proportion of the commercial banking industry under the Fed's control increased dramatically. The second benefit came in the form of a change in the Fed's method of finance which freed the Board of Governors from the normal congressional budgetary process. Putting the Great Contraction in interest-group terms, we suggested that during 1929-1933, the Fed was acting rationally as the agent of congressmen serving on important oversight committees who, in turn, were representing the interests of the member banks in their states and districts. We tested this hypothesis using bank failure rate data across states and found that, holding other things equal, the failure rates of nonmember banks in the early 1930s were significantly higher in states with representation on the House Banking