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.
IV. THE MONETARY BASE
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.
V. FED POLICY RESPONSE: THE MONETARY BASE
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.
VI. FED INACTION AND THE REAL BILLS DOCTRINE
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.
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