Saturday, January 26, 2019

Lessons from the Great Depression: Monetary Policy and the Federal Reserve System (Part 1 of 4)

Click here to read the original Cautious Optimism Facebook post with comments

9 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff continues his more than year-long investigative series on the Great Depression. This time he tackles the complex subject of monetary policy and tragic errors made by the Federal Reserve.


In chapters 1-6 of this Great Depression series, we’ve examined herculean blunders in federal tax, spending, wage, and agriculture policy as well as the monetary roots themselves of the Great Depression including the failed gold-exchange paper-sterling standard foisted upon Europe by Great Britain from 1925-1931.

Many of these missteps are still noted by economic historians today while economists of the more statist bent tend to downplay them as insignificant factors or more commonly omit them completely from the discussion.

However if there’s one Great Depression consensus among economists of all stripes, it’s that the single greatest American economic policy failure of the early 1930’s lies with the Federal Reserve in the banking and monetary sphere.

Initially not a well-recognized failing, Milton Friedman and Anna Schwartz brought the Federal Reserve’s blunders to the forefront of the academic discussion in their 1963 book “A Monetary History of the United States: 1867-1960.”

Friedman and Schwartz’s work instantly changed the entire Great Depression debate and future central bank policy responses, and Friedman received the 1976 Nobel Prize in Economic Sciences for his work.

Before 1963 the mainstream view was that the Fed had acted appropriately by providing adequate reserves to the banking system in the 1930’s, but that it was powerless to force commercial banks to lend out those new reserves to prevent the money supply from contracting (the so-called “pushing on a string” dilemma).

Since banks were in no mood to lend during the crises of the early 1930’s, the only other solution, according to the dominant mindset of the day, was fiscal policy—governments borrowing and spending heavily to prop up aggregate demand and entice consumers and businesses to spend the economy out of depression.

Since 1963 however both the mainstream Keynesian and Monetarist schools, and even many members of heterodox disciplines such as the Modern Monetary Theory (MMT) and Austrian School, have adopted a different stance: that the Fed either obstructed monetary re-expansion or failed to make the very emergency loans to distressed banks it was created for, and that these monetary policy failures were the single largest contributing factor in transforming what should have been the Recession of 1929 into The Great Depression.

A personal diversion/observation: The Economics Correspondent parts ways with the mainstream schools that hold the Federal Reserve nearly solely responsible for the Great Depression. Yes, the Fed’s missteps were the largest single contributing factor, but far from the only culprit. The traumas inflicted by steep government tax hikes, ballooning spending, price controls, wage floors, a deluge of burdensome new regulations, forced cartelization and price collusion programs, and the launching of an international trade war—both under the Herbert Hoover and Franklin Roosevelt administrations—were collectively greater than the Federal Reserve’s missteps alone.

To understand the magnitude and nature of the Fed’s failures, we have to go back briefly to the American banking system before 1914 and why the Fed was created to begin with.


In the years before the 1914 establishment of the Fed, the United States banking system was fragmented and unstable. Mainstream economists and economic historians often fail to pinpoint the origins of this instability and leave it to readers to assume the 1792-1913 period was one of monetary laissez-faire, but in fact it was a series of perverse state-level and national regulations that contributed to the banking system’s fragility.

A detailed discussion of pre-1914 bank regulations including unit banking, the 1862-1913 National Banking System, and America’s antebellum central banks—the First and Second Banks of the United States—will come in a future column. However the comparison between the American banking system and that of its northern neighbor illustrates the contrast quite well.

Canada’s very lightly regulated, nearly laissez-faire banking system also had no central bank (until 1935), and during the 1792-1935 period Canada suffered from zero banking crises. The United States banking system endured no fewer than seventeen crises during the same period in 1792, 1797, 1819, 1837, 1839, 1857, 1873, 1884, 1890, 1893, 1896, 1901, 1907, 1920, 1930, 1931, and 1933.

(Note: Some economic historians cite the Canadian Rebellions of 1837-1838, an insurrection falling just short of civil war, and the resulting widespread banking suspensions of redemption, but the Economics Correspondent has never seen that single exception elevated to the status of systemic banking crisis since only one major bank failed)

One of America’s biggest vexations during the pre-Fed era was temporary illiquidity. That is, banks accepted customer deposits that could be withdrawn on demand, but made loans that took longer—years often—to pay back, a phenomenon economists call the temporal mismatch of maturities.

Thus, even with a pristine loan portfolio worth far more than its deposit liabilities, a perfectly solvent bank could still fail if too many of its customers demanded reserves (at that time usually gold coin) at once—called a “bank run” which typically occurred within an atmosphere of financial panic. Even if a bank demanded immediate repayment of so-called “call loans,” it usually couldn’t raise enough liquid funds to satisfy panicked depositors.

Canadian banks of course had similar business practices and in theory could suffer from the same illiquidity problems, but didn’t absent the perverse regulations imposed on American banks. For example, Canadian banks weren't prohibited from branching nationally and thus enjoyed highly diversified loan portfolios, were highly capitalized, and could move capital from stable provinces to regions that were experiencing loan losses. U.S banks were prohibited by law from interstate branching.

After the Panic of 1907 the illiquidity problem in the United States had become so great that Congress recognized the need for reform. In simplest terms America could choose from two different directions: moving towards the more stable, laissez-faire Canadian system by dropping the most perverse regulations that had led to repeated panics, or retain the unstable unit banking system and create a European-style central bank that centralized the entire system’s reserves and provided emergency liquidity loans to banks to quell a crisis.

Congress set up the National Monetary Commission to discuss the options, but in reality the commission had already made up its mind before any studying began. Banking interests and state governments (who selected their U.S. Senators before the 17th Amendment) had already convinced legislators to retain most of the fragile system but place a central bank atop it to “bail out” banks that get into temporary liquidity trouble.

The political motives behind the decision are an interesting history, but to make a long political story short the Federal Reserve Act was passed on December 23, 1913 and signed into law by President Woodrow Wilson late that evening; the night before Christmas Eve, when most of the country was not watching political doings in the nation’s capital.

What were the major changes in the central bank’s new charter?

1. All paper currency would be supplied by the Fed and privately issued national banknotes phased out.

2. The Fed would provide a national clearinghouse system to resolve balance of payments and check clearing between member banks, replacing several private clearinghouse systems.

3. Most importantly, bank gold reserves would be centralized at regional Federal Reserve district offices and the Federal Reserve would stand ready to issue cash against centralized fractional gold reserves. The idea was that during times of crisis the Fed would use those centralized reserves to provide cash to its member banks in the form of a temporary liquidity loan that the bank would pay back when the crisis had abated.

If a bank was technically solvent but just suffering a drain on liquid assets, the bank would approach the Fed’s “discount window” for a loan and the Fed would step in and provide the short-term credit against good bank collateral (the definition of good collateral would pose enormous problems later). But if the bank was insolvent, if its assets fell far short of its liabilities, the Fed would allow the bank to fail.

This function, known as the “lender of last resort” (LOLR) was originally proposed by English financier Walter Bagehot in his 1873 book “Lombard Street” and its recommendation that the Bank of England lend freely to solvent banks during crises remains the policy bible of central bankers around the globe today.

Shortly after 1914 the Fed also began to act as a conduit to overseas banks, intermediary to foreign central banks, and one of America’s primary bank regulators. It also became a fiscal agent of the federal government (World War I), and engaged in macroeconomic monetary policy through open market operations (1922).

But its primary role from the very beginning, it’s raison d’etre so to speak, was to act as lender of last resort (LOLR) in times of crisis.

Prior to the Fed large commercial banks and their private clearinghouses had acted unofficially as LOLR’s but their actions were voluntary, often not well coordinated, and not nationwide (due again to unit banking and interstate branching prohibitions which limited their operational range).

The Federal Reserve replaced the disparate private system and provided a single, uniform, and national LOLR institution to help banks in temporary liquidity need. Fed architects, Congress, and President Wilson hailed a new era in American banking that would eliminate financial crises altogether and greatly smooth out the depth and frequency of business cycles.


Beginning in July of 1927 the Federal Reserve engaged in a sizable quantitative easing to help Great Britain curb its trade deficits with the United States. The Fed’s balance sheet grew by 55% in just seventeen months and new money spilled over into stock market and real estate speculation.

To read more about the motivation behind the destabilizing Fed QE read “What Really Caused the Great Depression?” at the following Cautious Optimism links:

Part 1

Part 2

Part 3

Upon the death of New York Fed Governor Benjamin Strong in October of 1928, the Fed promptly ended its monetary expansion in December and the economy entered recession in the summer of 1929 with the stock market collapsing famously in October of 1929.

With many bank loans tied to speculative investments and the economy in general entering depression, banks began to face rising loan losses. Particularly hard hit were banks in those areas of the country that were adversely affected by the Smoot-Hawley trade war (minerals, autos, steel, and agriculture were targets of retaliatory export tariffs).

States that prohibited intrastate branch banking also saw a larger share of loan losses and distressed institutions since state-mandated small unit banks were unable to diversify their loan portfolios.

A single unit bank in a small Iowa corn town could easily fail if the price of corn plummeted. Likewise a single unit bank on the Canadian border could be crushed by a dropoff in Canadian trade resulting from the Smoot-Hawley tariff.

On the other side of the Canadian border, banks were large and nationally branched. Therefore their loan portfolios were highly diversified which helped Canada avoid a banking panic during the same period. Indeed, not a single Canadian bank failed during the entire Great Depression.

Over the course of the 1929-1933 period three banking panics struck the United States during which depositors began to convert their checkbook balances to cash or even gold.

The first and smallest was in 1930 which was limited to the agricultural, Midwest region. In September of 1931 the Bank of England suspended gold convertibility and foreign holders of American cash and deposit balances began to withdraw gold from the U.S. system. And in February of 1933 the largest banking panic in American history struck, launched by rumors that FDR was going to devalue the dollar or worse yet go off the gold standard completely (rumors that later both turned out to be true).

In each case, smaller numbers of insolvent banks failed, but news of the failures stoked fear in the customers of nearby solvent banks and they ran for the exits. As cash started to flow out of the system, solvent banks’ balance sheets were strong enough to withstand the panic, but they simply needed the temporary liquidity that the Fed was created to provide as lender of last resort.

But the Fed didn’t act as lender of last resort. Altogether the Fed stood idly by and did nothing while solvent bank after bank failed due to lack of liquid cash to provide their customers.

And as customers withdrew cash and stuffed it under their mattresses, the system’s overall reserves contracted (Fed notes/cash being a reserve). The Fed had the capacity to issue more cash but only up to a limit: cash plus bank deposit balances at the Fed itself could not exceed 250% of the entire system’s gold reserves—a 40% fractional reserve cover ratio.

Furthermore, with foreigners pulling gold out of the United States, and in 1933 American citizens converting their Fed notes into gold, the overall gold stock upon which the entire financial system was based experienced downward pressures as well.

In Parts 2-4 of this series we’ll provide a more detailed explanation of the Fed’s policy action and inaction during the critical 1929-1933 period.

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