Saturday, February 9, 2019

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

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

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.

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