Sunday, February 24, 2019

Lessons from the Great Depression: Monetary Policy and the Federal Reserve System (Part 3 of 4)

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7 MIN READ – The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff continues his series on Federal Reserve policy during the Great Depression with a greatly depressing account of Fed inaction during the worst financial crises in American history.

The story of the Federal Reserve’s policy blunders of 1929-1933 is one of the most complex analyses in this series of Great Depression columns requiring multiple, interdependent installments. To read prerequisite Parts 1 and 2 of the series go to…

Part 1

Part 2


While the Fed’s alleged failures in managing the monetary base are still debated (it didn’t do enough, but the data show it clearly did not contract the monetary base), its performance as lender of last resort is almost universally condemned.

As we discussed in Part 1, the primary reason the Fed was established in 1914 was to act as lender of last resort (LOLR). During pre-1914 panics larger private banks had tried as best they could to carry out the LOLR role for smaller banks, but were limited by legal unit banking restrictions which fragmented the system into over 25,000 small local banks, 95% of which had no branches (Calomiris).

When the Panics of 1930, 1931, and particularly 1933 struck, most American banks were still solvent. That is, even in the midst of severe depression, their loan portfolios and other assets were worth more than their customer deposit liabilities. However as their customers increasingly panicked and pulled cash and gold from the system, the quantity of liquid reserves (ie. cash) contracted quickly.

Hence the time had come for the Federal Reserve to step up and carry out the very policy it had been created to implement: to act as LOLR and make emergency cash loans to banks to shore up their liquidity which the banks would repay once depositor hysteria had subsided.

Instead, as we’ve alluded to earlier, the Fed did nothing. It sat by and watched as hundreds, then thousands of perfectly solvent banks ran out of cash and failed.

The results were devastating as we shall see in a moment. But why did the Fed do nothing?

The Fed’s governors had plenty of time to consider their policy. The first banking panic struck in the fall of 1930, after which the Fed had nearly a year to consider its LOLR policy before the next panic which began in late 1931, and more than a year to consider again until the final, calamitous panic of February/March 1933.

Yet even with over two years between the first and last panics of the early 1930’s, Fed officials still elected to do virtually nothing when the most destructive crisis engulfed the nation in early 1933.

It’s no coincidence. The Fed’s hands-off response was a direct reflection of its own policies, two of which we will mention here.

First, as we discussed in Part 2 the Fed had been governed by the now defunct “Real Bills” doctrine of monetary policy. That is, the Fed was run by officials who believed short-term loans to commercial banks should not be made unless the money was to be used towards business activity that would create a corresponding increase in real goods and services. This lending practice would be reflected by the banks’ holdings of short term commercial paper (hence the name “Real Bills”). Or another way of considering Real Bills is that the Fed refused to expand the money supply further than the rate at which the real economy was expanding lest they feared they might stoke inflation. Ironically the economy was contracting in the early 1930's so consistent with its own doctrine the Fed pursued a perverse contractionary monetary policy.

Many banks in 1930’s America were rural unit banks that loaned to farmers. Their notes were not the kind short-term commercial bills Fed officials deemed necessary to collateralize LOLR discount loans. Also many banks holding short term commercial paper were asking for LOLR loans simply to replenish customer cash withdrawals, not to make new loans for real economic-expanding ventures. Hence the Fed refused to make LOLR loans to thousands of institutions—a death knell during a crisis for banks that would otherwise have survived.

Second, the Fed had frowned upon speculation. Thus the Fed adopted a “direct pressure” policy towards member banks applying for loans and reserves that it perceived had previously financed stock market or real estate speculation. The policy forced banks into a lengthy and overburdensome application process that often triggered an even more lengthy cross-examination designed to discourage application and in most cases simply being denied (Timberlake).

So again, as member banks lined up for LOLR loans the Fed discouraged or outright denied them due to what it considered irresponsible behavior, even if their portfolios were still solvent. The result was predictable: thousands of unnecessary bank failures ensued.


By March of 1933 newly inaugurated President Franklin Roosevelt had declared a national banking holiday and Congress was taking up new emergency measures to stabilize the financial system.

As previously mentioned, over 10,000 banks had failed (compared to zero in Canada which had no central bank until 1935) taking the deposits of millions of Americans with them.

The aftermath was unprecedented in American history.

First, to state the obvious, when over 10,000 banks fail and the remaining banks are on life-support, the credit-issuing mechanism of the financial sector freezes up. Businesses and farmers can’t get credit which is the lifeblood of the economy. Such credit crunches inflicting the U.S. in pre-1914 banking panics were responsible for the recessions that followed afterwards.

But during the 1930’s the seizing up of bank credit was compounded by nearly unprecedented deflation. 

The overall money supply as measured by both M1 and M2 fell by a third, from approximately $47 billion to $32 billion (M2 source: North-Mises Institute, Wheelock-St Louis Federal Reserve. See attached chart, green line). As a result, prices fell by nearly 30% as well and the deflation boosted the purchasing power of the dollar by 40%.

With the dollar gaining value so rapidly, the real value of debts and interest payments rose accordingly. Prices and revenues fell due to deflation, but businesses, farmers, and individuals found it difficult or impossible to pay or service loans that remained in constant pre-1929 dollars. If you can imagine as an individual your mortgage, auto, and credit card loan payments going up by 40% in two or three years you have some idea what uphill battle debtors face during periods of rapid deflation.

The result was bankruptcies that spread throughout the nation.

Those bankruptcies resulted in more loan losses and exacerbated bank failures in a vicious cycle that American economist Irving Fisher dubbed the “debt-deflation spiral.”

Also as prices fell rapidly, consumers and businesses that were already reluctant to spend on consumption and investment tended to hoard in anticipation of their money being worth more in the near future. While theories of deflationary hoarding are generally invalid during periods of gentle, secular deflation (such as the 1865-1914 period marked by rapid increases in productivity and falling unit costs), the deflation of the 1929-1933 was so extreme that it induced widespread hoarding.

Individuals are unlikely to defer purchases simply because their money will be worth 0.5% or 1% more in a year or two, but if their money is worth 40% more in two or three years, especially while a frightening depression and major banking panics are underway around the nation, people absolutely will feel compelled to withdraw and hoard every dollar they can.


Furthermore while deflation alone was bad enough, deflation combined with government price controls precipitated mass unemployment. Shortly after the 1929 stock market crash President Herbert Hoover pressured American businesses to maintain their 1929 nominal wages. His belief was that high purchasing power and the demand it spurred would end the depression within months.

But businesses found themselves paying workers 40% more in real terms even as depression sapped their sales and debt/interest payments rose by the same 40% in real terms. So as the deflation relentlessly raised the worker wage floor corporate managers were forced to lay off millions. By the end of 1931—even before the worst of the banking panics—unemployment already stood at 15.8% and it peaked at 26% in 1933.

For more on Herbert Hoover’s high-wage policy see CO’s “Lessons From the Great Depression: Wages” at:

On a side note I’ve alluded twice to the “nearly unprecedented” deflation of 1929-33 during which the U.S. money supply and prices contracted by approximately a third. 

However what’s little known is that during the post-panic slump of 1839-43 U.S. prices also fell by approximately a third (Hummel). 

But unlike the Great Depression, the four year period of 1839-1843 produced an annual real GDP growth rate of about 4% (Bordo, Rothbard) and full employment by the final year of 1843. By contrast during the 1929-1933 deflation, unemployment reached 26% at the end of the four year deflation and real GDP fell by about 30%.

Why the enormous difference in economic performance despite both periods producing roughly the same severe deflations? Unlike during the Hoover years where wages and prices were kept tightly controlled and downwardly rigid, wages and prices were free to adjust during the 19th century allowing goods and labor to clear the market more rapidly via the classical model. 

Ironically, flexible prices and wages stem from the same classical model that John Maynard Keynes argued was invalid in his book “The General Theory of Employment, Interest, and Money” and which Keynesians continue to criticize today. Instead, both Keynes and his modern day disciples argue for government action to artificially raise  prices and wages to boost aggregate demand, a policy that Herbert Hoover followed faithfully to the country’s miserable detriment.

Finally a word about aggregates: M1 and M2 both fell by nearly a third, but the Federal Reserve gold stock and monetary base (see attached chart, blue line) actually rose slightly from 1929 to 1933. Why such a divergence?

The answer leads us to our conclusion. The 1930’s great contraction of the money supply and prices was not due to a deliberate contraction of the monetary base by the Fed, but rather its failure to counter bank failures by providing solvent banks with new reserves. As gold flowed into the U.S. the Fed tragically sterilized it. As banks approached the Fed for new reserves they were rejected because their paper assets didn’t qualify under the discredited Real Bills Doctrine. And as solvent but cash-strapped banks approached the Fed's discount window for LOLR short-term liquidity loans Fed officials turned them away for the same reason.

On the biggest, most critical policy decisions the Federal Reserve failed on three out of three.

Had the Fed simply made new reserves available to banks in exchange for their assets, or at the very least provided new reserves with LOLR loans (ie. carried out the role it was created to conduct in the first place), widespread bank failures would not have ensued nor would have the subsequent banking panics those failures triggered.

On a related note, the stage for the beginning of the 1929 slump that precipitated the tragedy of the next four years was itself also set by the Fed with its then-unprecedented QE that fueled asset speculation and overinvestment in a late 1920’s boom and bubble. 

So the Fed not only started the fire with interventionist policies in the late 1920’s, it also added fuel to the fire by sitting on its hands in the 1930’s.

You can read more about the Fed’s 1927-28 QE and the Bank of England’s analogous gold-exchange experiment at:

Part 1

In the upcoming final installment we will review FDR’s New Deal remedies for the monetary collapse and how lessons learned from the Fed’s mistakes of the thirties guided Fed policy during the 2008 financial crisis.

Monday, February 18, 2019

U.S. Oil Exports: Indian Oil Corp Signs First Annual Deal for U.S. Crude

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1 MIN READ - An update on rising U.S. oil exports from The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff

Read Reuters story here

"Indian Oil Corp, the country's top refiner, has signed its first annual deal to buy U.S. oil, paying about $1.5 billion for 60,000 barrels a day in the year to March 2020 to diversify its crude sources, its chairman said on Monday...

"...Indian Oil buys about 75 percent of its oil needs through long-term deals, mostly with OPEC nations.

"The term deal will help cut IOC's dependence on OPEC crude, said Sri Paravaikkarasu, head of east of Suez oil for consultants FGE in Singapore.

"Lots of geopolitical issues are going around. We expect lots of volume going away from Venezuela, west Africa and Iran, so it makes sense to have guaranteed term supplies from the U.S., where crude production is increasing," she said."

In conclusion:

“But we can’t just drill our way out of this problem. While we consume 20 percent of the world’s oil, we only have 2 percent of the world’s oil reserves."

-Barack Obama, March 3, 2012

Tuesday, February 12, 2019

A Quick Footnote: Friedman and Schwartz on Gold Inflows in the Early 1930's

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1 MIN READ - From the Cautious Optimism Correspondent for Economic Affairs and other Egghead Stuff... to those who have followed his series on the Federal Reserve System and monetary policy during the Great Depression:

A beautiful summary from Friedman and Schwartz on the effects of sterilization of gold inflows by the Federal Reserve in the early 1930's:

"The international effects [of deflation] were severe and the transmission rapid, not only because the gold-exchange standard had rendered the international financial system more vulnerable to disturbances, but also because the United States did not follow the gold-standard rules. We did not permit the inflow of gold to expand the U.S. money stock. We not only sterilized it, we went much further. Our money stock moved perversely, going down as the gold stock went up... ... The result was that other countries not only had to bear the whole burden of adjustment [due to suppression of the Hume Price-Specie Flow Mechanism that would normally allow international prices to readjust upwards] but also were faced with continued disturbances in the same direction, to which they had to adjust. As [New York Fed Governor George] Harrison noted in early 1931, foreign commentators were particularly critical of the monetary policy of the United States..."

-Milton Friedman and Anna Jacobson Schwartz, "The Great Contraction" (1963, p. 109)

Yet 56 years later modern Neoclassical and Keynesian economists and historians continue to blame "the gold standard," not interference in its automatic workings by central banks, for the tragic 1930's deflation.

As George Mason University's Lawrence H. White has perceptively reminded his profession:

"The interwar period shows us a case where central banks—not the gold standard—ran the show.”


“Several authors identify genuine historical problems that they blame on the gold standard, when they should instead blame central banks for having contravened the gold standard.”

-"Recent Arguments Against the Gold Standard" (2013 Cato Policy Analysis)

The Economics Correspondent's detailed and running series on Federal Reserve policy during the early 1930's can be read at:

Parts 3 and 4 will be forthcoming.

Saturday, February 9, 2019

Lessons from the Great Depression: Monetary Policy and the Federal Reserve System (Part 2 of 4)

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12 MIN READ –  The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff thanks Professor Jeffrey Rodgers Hummel of San Jose State University for his assistance in detailing the precise anatomy of the 1929-1933 U.S. monetary base and its surprisingly hard-to-nail-down components.

The story of the Federal Reserve’s policy blunders of 1929-1933 is one of the most complex analyses in this series of Great Depression columns requiring multiple, interdependent installments. To review prerequisite Part 1 of this series go to:

Monetary economists of all schools overwhelmingly blame Federal Reserve inaction and even counterproductive action as the single largest factor contributing to the Great Depression. Of the Fed’s five primary functions (monopoly issuer of paper currency, member bank clearinghouse, bank regulator, lender of last resort, and administrator of monetary policy) we’ll examine the first of two that the central bank was entrusted with to fight contractionary monetary forces: monetary policy.


The Fed’s maintenance and support of the monetary base is a very complex mechanism to describe. To understand the Fed’s role and where it succeeded and failed, it’s helpful to define what the monetary base was in the early 1930’s and how changes in the monetary base impacted bank credit and overall price movements in the economy.

In the early 1930’s the United States monetary system operated under both a gold coin and bullion standard and fractional reserves. This made it much like other industrialized countries except that Great Britain and Europe had adopted a hybrid gold-paper standard that treated the paper pound sterling as a gold reserve substitute (the disastrous gold-exchange standard).

How did the U.S. gold standard and fractional reserves work?

For centuries prior gold had been mined and coined as a basic and trusted unit of money, then deposited at commercial banks in exchange for more convenient banknotes that served as on-demand claims for gold coins. Private banknotes then circulated throughout the economy but a noteholder could submit the note at the bank of issuance at any time to demand immediate gold coin redemption.

Since banknotes were more convenient to use than gold coins, it was rare that large sums of banknotes were returned to their issuing bank for redemption at the same time. Thus banks began the practice of “fractional reserve banking.” That is, they would print and lend out quantities of banknotes above and beyond just the notes they had already issued to the original depositor.

For example, if a customer deposited $100 in gold coins at Bank A (approximately five ounces in the 19th century), he received $100 in banknotes and Bank A held the gold coins as a reserve against its $100 banknote liability. Assuming no other changes the bank then operated on a 100% reserve.

However banks are in the business of lending at interest for a profit, so if Bank A chose to operate on only a 10% reserve, it could print up $90 more in notes and lend them to a borrowing customer. Once that customer spent the new money and the banknotes found their way to be deposited at competing Bank B, the notes would be submitted through a clearinghouse system to its original issuer Bank A, and $90 in gold coins would transfer from Bank A to redeeming Bank B. Thus original Bank A would still have its original depositors’ first $100 in banknotes circulating and the new $90 in banknotes would be retired, but it would only have $10 in gold coin remaining to back its remaining $100 banknote liability—hence a 10% reserve.

Assuming we maintain the hypothetical 10% fractional reserve, this process repeats from bank to bank and the entire monetary system could produce up to ten times the amount of paper claims that it had available in physical reserves.

For the record, on the eve of the Great Depression legal reserve ratio requirements in the United States were 13% for large central reserve city banks, 10% for mid-size city reserve banks, and 7% for country banks (source: St Louis Federal Reserve).

This process, known as fractional reserve banking, is controversial in some circles, but without going into detail to explain the theory and history of fractional reserve banking in greater detail, banks have historically been very good at managing their claims-to-reserve ratios and whenever an unmanageable quantity of redemption claims has appeared at once there has nearly always been a panic or crisis underway. However, lightly regulated systems such as Canada’s (1817-1935) and Scotland’s (1716-1845) experienced zero systemic crises and fractional reserves never posed much of a problem.

As the second half of the 19th century progressed, demand deposits (aka checkbook money) began to command a greater share of the “paper money” market. Simple ledger entries in bank accounting statements indicating customer deposit balances proved more convenient than banknotes, and large commercial transactions were conducted increasingly using checkwriting. However the general principle remained the same: both demand deposit balances and banknotes were direct claims on gold coin and banks had to manage the amount of each they created through their lending practices.

When the Federal Reserve was established in 1914, commercial banks sent most of their physical gold to the Fed where it was melted down into bullion to centralize what were previously divided and fragmented reserves that could not move easily between banks or across state lines. Now with such a large concentration of gold at its disposal, the Fed would issue its own banknotes, paper reserves, or credit to member banks in need of new reserves for commercial lending purposes or for temporary liquidity.

This is a key change with the introduction of the Federal Reserve system worth stressing.

Whereas before commercial banks redeemed their own banknotes and demand deposits into gold coin, under the new system the banks no longer issued private banknotes. Instead they redeemed their demand deposits into Federal Reserve banknotes (the Fed was granted a monopoly on banknote issuance by the 1920’s) and Federal Reserve banknotes were themselves redeemable into gold coin.

So the fractional reserve system was expanded from two layers to three. At the base was mostly Fed gold (1), in the next layer were Fed issued paper currency and Federal Reserve deposits (both reserves) for member banks (2), and at the top were member bank-created demand deposit balances fractionally backed by paper currency and Federal Reserve deposits (3).

The Fed printed up banknotes or created new commercial bank reserves against its own gold reserves on a fractional reserve: namely 40%. To inject the new notes or reserves into the banking system it typically bought assets such as short-term commercial loans from banks using newly printed Fed notes or by making a ledger entry in its own books indicating the member bank had a higher reserve balance with the Fed itself (Federal Reserve deposits)—provided the Fed did not extend the quantity of these instruments beyond 250% of its gold reserves, the inverse of a 40% reserve ratio.

Which brings us to the definition of monetary aggregates. What economists refer to today as the monetary base is the portion of the money supply that the central bank has a great degree of control over. In the 1930’s that was

-Fed notes (a multiple of gold reserves)

-Federal Reserve deposits it provided to commercial banks  (a multiple of gold reserves)

and to a much smaller degree...

-gold coins held outside the Fed/Treasury

-Treasury-issued gold certificates held outside the Fed/Treasury

Or in other words, the early 1930’s monetary base (MBASE) = any Fed notes + Federal Reserve deposits + gold coins + Treasury gold certificates held outside the Fed system or the Treasury.

Since gold coins and Treasury certificates were relatively small, the monetary base can be simplified down to primarily Fed notes and Federal Reserve deposits for the purpose of this discussion—both then treated as reserves by commercial banks.

Once a commercial bank knew what its own reserves were it could lend out demand deposits or checkbook money on its own fractional reserve. The total amount of commercial bank demand deposits and Federal Reserve notes circulating in public hands was and remains known as the M1 aggregate. M1 has always been larger than the monetary base.

There was and still is another aggregate layer atop M1 called M2 which represents monetary instruments that are claims on M1 checkbook money—typically time deposits, savings deposits, and in the modern age money market shares and certificates of deposit under $100,000. For the purpose of the 1930’s we will temporarily exclude M2 from the policy discussion since much of that aggregate is not very liquid and had a far smaller impact on the financial system than M1.

So the Fed had a great deal of control over the amount of bank reserves and Fed notes, and less control over gold reserves (coin and bullion) as it was always subject to gold redemption claims and gold inflows/outflows via international balance of payments.

The commercial banks had a much greater degree of control over the larger M1 aggregate just as they do today, since M1 is largely dependent on banks’ willingness to lend and bank customers’ willingness to borrow.


Now that we’ve defined the fundamentals of the monetary base and M1, what happened to both during the Great Depression and how did the Fed react?

Well as is the case with most depressions, particularly those accompanied by banking panics, both aggregates fell. Borrowers got nervous and began paying down debts which reduced M1. Banks were reluctant to lend and their customers just as reluctant to take on new debt which prevented M1 from reflating.

If banks fail completely there’s a larger contractionary effect on M1 because all its demand deposit promises become worthless (its checks are viewed as “no longer good”). M1 balances being wiped out due to bank failures is the basis of the commonly told story about bank customers losing their life savings during the 1930’s.

When customers rushed to withdraw Fed notes, M1 contracted because banks were required to maintain a certain reserve ratio backing their demand deposit balances. With fewer Fed note reserves, they couldn't lend as much and often called in loans to maintain that ratio. In other words, the banks' reserves contracted therefore so did their demand deposits.

At an even more fundamental level if holders of Fed notes began redeeming them for gold and pulling gold coins out of the banking system, M1 also contracted since gold coins were part of the monetary base that served as a reserve backing demand deposits. If large holders (such as foreign central banks) started redeeming gold bullion, the monetary base itself contracted since bullion was the 40% reserve upon which the Fed backed the majority of the monetary base—Fed notes and commercial bank deposits at the Fed. Since M1 is a multiple of the monetary base it contracted in parallel.

All of these problems materialized during the Great Depression, just as they had during previous banking panics, although their nature and degree varied from the panics of 1930, 1931, and 1933. It was the young Federal Reserve’s job to counteract these forces, a role it was created to carry out from its inception.

Which leads us to a debated and slightly controversial claim about a Fed failure: that the Federal Reserve not only oversaw a contraction of the monetary base from 1929-1933, but that it deliberately contracted it. This claim is made by some within the mainstream economics community, propagated by some members of the Keynesian school.

The truth as we shall see is that the Fed indeed didn’t do all it could to expand the monetary base, but the claim that the monetary base was deliberately contracted or contracted at all is technically inaccurate. From the October 1929 stock market crash to the final banking panic of March 1933, the monetary base actually rose slightly from $6.122 billion to $7.032 billion (source: FRED).

So why is the Fed still so criticized for not doing enough?

Well it’s a perfectly valid criticism. One thing that is missing so far from the story that Friedman and Schwartz highlighted is gold inflows. During the early 1930’s the United States was running surpluses with its trading partners and therefore claimed overseas gold which flowed into the Federal Reserve system.

Also many European governments continued to make debt repayments to American banks and investors for financing their World War I expenditures. Furthermore, when Britain went off gold in 1931 the Fed responded by raising interest rates to “defend the dollar” which in turn stemmed some of the gold outflows and actually attracted sizable inflows of international gold back to the U.S.

What the Fed is roundly and rightfully criticized for is refusing to create new bank reserves against those gold inflows—effectively “sterilizing” the gold which can be viewed as putting it in under lockdown. So as new gold arrived it wasn’t “monetized,” and new reserves that could have been provided to counter the forces of cash withdrawals and gold redemptions went uncreated.

A little known fact is that even with all the domestic and foreign withdrawals of gold from the banking system, the Fed’s own gold reserves were actually higher at the end of 1932 than during the 1929 stock market crash ($3.15 billion vs $2.95 billion, source: St Louis Federal Reserve). And even as the final panic struck in March 1933 Fed gold reserves were even slightly higher at $3.25 billion.

Indeed by the time of the final and most devastating banking panic of 1933, the Federal Reserve System held 40% of the world’s entire gold reserves—a point not lost on the incoming Roosevelt administration's new Brain Trust.

Under the pre-WWI classical gold standard, gold inflows would have been multiplied by the decentralized banking system and both stabilized the banks' reserves and reinflated prices. But the 1920's and 1930's were an era where central banks ran the show, not the automatic mechanisms of the classical gold standard, and the Federal Reserve "broke the rules" of the game.

Why did the Fed sterilize gold inflows? This leads us to the second as yet unmentioned Fed policy problem.


From its inception, the Fed was officially governed by the now discredited “Real Bills” doctrine of monetary policy. Real Bills was written into the 1913 Federal Reserve Act itself, but largely ignored under the leadership of New York Fed Governor Benjamin Strong.

The Real Bills Doctrine defined a solvent bank as one that held a large quantity of commercial loans to businesses and on very short terms. The idea was not only that newly created central bank reserves could be rapidly repaid by banks when their short-term commercial paper liquidated, but also short-term commercial lending was viewed as an “appropriate” means of conducting banking business.

The Real Bills Doctrine was also justified on anti-inflationary grounds. The thinking was that the Fed should not create inflationary reserves unless the receiving bank is involved in some activity that increases the real quantity of goods and services in the economy. With new money creation consummated with new production, inflation would remain tightly controlled. Or to put it another way, the direction of Fed monetary policy should align closely with the overall direction of the real economy.

This may seem counterintuitive to those of us in the modern era who watch the Fed conduct countercyclical monetary policy—to slow down money creation when the economy grows quickly and accelerate money creation when the economy slows—but Real Bills was the governing doctrine for Fed leadership after Benjamin Strong’s died in 1928.

During the early 1930’s many banks were suffering the overhang of lending for stock market and real estate speculation. Of those that had loaned for tangible business purposes and held short-term commercial paper, many seeked out new reserves, but only to replace those reserves they were losing due to customer cash withdrawals—not to lend out for economic-expansionary reasons. Thus the Fed considered both types of institutions ineligible for new reserves and much of its gold inflows remained dormant and sterilized.

To put the perverseness of this policy into perspective, consider that during the Panic of 1930 most troubled banks were in the Midwest farming regions. Most of those banks had made farm loans which are typically of longer duration than short-term commercial paper.

Yet according to Real Bills Doctrine a bank holding longer-term farm loans was not considered “solvent” and thus its assets could not be discounted (sold to the Fed for reserves minus a discount for time the Fed must wait before the paper matures). So the Fed sat on its hands and 608 midwestern banks failed (Friedman, Schwartz).

To be fair, many of those banks were not Federal Reserve members, and 608 mostly smaller, rural bank failures may not seem earthshattering in the scheme of America’s then 25,000+ banks. But when a larger panic struck in 1931 Fed officials adopted the same stance. This time 2,293 banks failed and many were Fed members. 1,493 more banks failed in 1932 and more than 4,000 failed in the great 1933 panic.

By the time the Banking Act of 1935 mandated the Federal Reserve discount any security it deemed necessary to maintain monetary stability, over 11,000 of America’s more than 25,000 banks had closed their doors for good.

Ironically the Fed’s belief that creation or destruction of reserves should move in tandem with economic growth became a self-fulfilling prophecy. According to the tenets of the Real Bills Doctrine, 1930’s Fed officials saw the quantity of goods and services in the real economy contracting, so they responded accordingly by refusing to make new reserves available. The result was bank failures and a contraction of the money supply (ie. a financial disaster) which led to further economic contraction. But it all conformed with the doctrines of Fed policy.

Finally, Fed officials were perfectly aware that refusing to make new reserves available to stressed institutions would certainly drive many to close their doors, but they viewed such failures as a process of clearing out “bad” banks that would leave the system as a whole stronger, dominated by banks that were more aligned with Real Bills precepts. And while this may have been partially true for truly insolvent banks that had loaned unwisely during the 1920’s boom, such a mindset would prove disastrous when insolvent bank failures spread to solvent ones.

It was also a contradictory repudiation of the Fed’s most fundamental obligations to provide temporary liquidity.

We’ll discuss the Fed’s simpler but crucial lender of last resort role in Part 3.