To read prerequisite Parts 1-3 of the series see the links
at the bottom of this article.
X. FDR: BANK HOLIDAYS AND DEPOSIT INSURANCE
As incoming President Franklin Roosevelt was being
inaugurated in March of 1933, a giant banking panic was consuming the nation.
During the campaign Roosevelt had refused to address rumors that he might
devalue the dollar or take America off the gold standard completely. As FDR was
sworn in, depositors panicked in a “run on the dollar,” pulling not only cash
out of the system but also gold in case FDR arbitrarily decided the gold
content of the dollar was to be officially reduced.
By early March of 1933 Herbert Hoover had considered
declaring a national bank holiday to stop Americans from withdrawing more cash
or gold from the system, but he wasn’t sure the federal government had
authority to do so during peacetime under the 1917 Trading with the Enemy Act.
Hoover advised President-elect Roosevelt he would execute
such powers anyway provided FDR would follow up upon inauguration, but
Roosevelt was still unsure what policy he was going to pursue (his “Brain
Trust” chief Raymond Moley was still working out a plan). His response to
Hoover was vague and noncommittal so Hoover deferred until the new President
was to take power.
Meanwhile several states had taken matters into their own
hands and declared bank holidays. These were mostly counterproductive or even
destructive. During a bank holiday no one could get cash to make payments, so
commerce ground to a halt in those regions. Many consumers and businesses had
to resort to writing their own scrip or temporary private money to keep
commerce moving until banks were reopened.
Another problem was interstate contagion. When residents of
Illinois watched the governor of Michigan close down all the banks in his
state, they rushed to Illinois banks to withdraw cash before an anticipated
bank holiday came to their own state—real or imagined. Thus disparate state
bank holidays spread panic to nearby states worsening the problem.
On March 5, 1933—the day after his inauguration—FDR
announced an eight-day national bank holiday during which time Congress would pass
emergency banking legislation and the Treasury Secretary and Fed officials
would determine what criteria separated sound banks from unsound.
In a marathon series of allnight deliberations, the Treasury
directed the Federal Reserve to begin issuing new Fed notes and bank reserves
that were unbacked by gold. Although the new notes didn’t contain a pledge to
“pay to the bearer on demand,” they looked like traditional Federal Reserve
notes in every other respect and the public was generally fooled into believing
they were no different from the pre-crisis Fed notes.
The irony of course is that the Fed had the means and power
all along to issue not only new Fed notes backed by gold, but new banks
reserves throughout the 1929-1933 period. Yet it had mostly abstained in
accordance with the Real Bills doctrine. Roosevelt effectively forced the Fed
to do three years late what it should have been doing all along.
More important than the new notes was a Treasury plan to
separate all banks into three classes. Class A banks were those determined to
be solvent and eligible to open immediately. Class B banks were those that
needed a little help with recapitalization either through new share issuances
or a small government loan. Class C banks were so insolvent that they were to
be closed.
Once the bank holiday went into effect a new chaos struck
the U.S. where, absent a banking system to convert deposits to banknotes, cash
was in short supply. Workers and businesses could not get paid, and the value
of American dollars overseas nosedived. Famously Princess Erik of Denmark found
herself cashless and relying on scrip written by her Pasadena hotel to survive.
Elsewhere across the country scrip was frantically written and the disruptions
stemming from the bank holiday marked the low point of the entire Great
Depression.
However the turning point was on March 12, 1933 when FDR
conducted the first of his famous fireside chats. Over radio broadcast the new
President explained to the public which banks would be reopened and closed. His
conversations were clear, free of technical jargon, and imbued a sense of
confidence with Americans that the reopened banking system would be sound since
unsound banks would not be allowed to resume business.
When the banks reopened on March 13 the response was very
positive. Large numbers of Americans returned their currency and banks were not
only moderately recapitalized, but the deflationary trend was halted as banks
were for the first time seeing their reserves increase instead of contract.
FDR’s bank holidays and bank classifications finally put an
end to the mystery and uncertainty of which banks were safe and which would
fail. At the lowest depths of an unprecedented spiraling panic, one can credit
FDR and government action for finally stopping the bleeding of public
confidence.
However no comprehensive history is complete without
forcefully reminding readers that the spiral and panic itself were caused by
the Federal Reserve and the thoroughly destructive economic interventions of
the Hoover administration to begin with. In other words, the arsonist
government does get credit for finally showing up with a fire hose, but only
after he had already burned down half the house. Unfortunately all too many
government-adoring historians and economists who laud federal action for
“saving the economy” forget the critical first half of the story: the federal
government put the economy in peril in the first place.
XI. REINFLATION
Once the banking system was stabilized and the deflation
stopped, the White House’s next concern was reinflating the price level.
Although prices were rising from their March nadir, the White House wanted to
restore prices to a pre-1929 level. So long as prices remained substantially
below 1929 levels, Americans were still weighed down by deflation and higher
real debt payments that spawned bankruptcies. American economist Irving Fisher
vaguely estimated the “correct” price level to be “halfway back to 1929”
(Fisher, 1932). FDR chose for himself a price level from 1926.
The track record of FDR’s reinflationary policies is more
uninspiring.
On the positive side, the trend of customer deposits
accelerated in June with the passage of the Banking Act of 1933 which
established Federal Deposit Insurance and the FDIC. Although deposit insurance
would not officially go into effect until January 1, 1934, the announcement
itself was itself enough to send more Americans back to their local banks to
deposit currency. U.S. bank deposits also sharply increased at the beginning of
1934 as the FDIC took effect.
Although freer banking systems such as Canada’s (1817-1935)
with no central bank, no deposit insurance, and far less regulation fared much
better (zero banks failed in Canada during the 1930’s versus over 10,000 in the
United States), the regulated, splintered, and inherently fragile American
system—compounded by the Federal Reserve’s blunders—was significantly
stabilized by the FDIC. The guarantee on deposits has also prevented widespread
bank runs ever since. Milton Friedman and Anna Schwartz noted in their 1963
book “A Monetary History of the United States”…
“Federal insurance of bank deposits was the most important
structural change in the banking system to result from the 1933 panic, and,
indeed in our view the structural change most conducive to monetary stability
since state bank notes were taxed out of existence immediately after the Civil
War.”
However two more controversial measures imposed by Roosevelt
had little impact on the stability of the banking system, and a third empowered
the Federal Reserve to further inflate the money supply even though it was
probably unnecessary:
-Executive Order 6102, signed in April of 1933, mandated all
Americans surrender their gold to the U.S. government in exchange for $20.67
per ounce.
-In June 1933 Congress voted to nullify the right of
American holders of dollars to redeem them in gold, effectively taking the U.S.
off the domestic gold standard.
-In January of 1934 Congress passed the Gold Reserve Act
which devalued the dollar by 41% to $35/oz for overseas holders (central banks
resolving international balance of payments).
Executive Order 6102: Forcing Americans to surrender their
gold provided a larger gold base for the Fed to further reinflate the money
supply, but gold holdings had always been sufficient for the Fed to do so
during the 1929-1933 period.
Taking America off the domestic gold standard gave the Fed
further room to inflate the monetary base since the discipline of domestic
redemptions was removed. But again, insufficient gold to inflate the base had
never been a problem.
Finally devaluing the dollar also enabled the Fed to create
more dollars (which it could have done all along), but it also boosted U.S.
exports in an instance of “beggar thy neighbor” economic policy.
Other Congressional banking initiatives were figurative
“stabs in the dark,” regulating anything remotely viewed as a source of crisis.
The so called Glass-Steagall provisions of the Banking Act blamed the crisis on
commercial banks issuing securities on behalf of their clients or underwriting
bonds.
But as we’ve already seen, the crisis reached record depths
not due to bondwriting but due to an initial Fed QE bubble (1927-1929) and then
a combination of Fed inaction and catastrophic economic interventions by
Herbert Hoover (1929-1933). Also Canadian banks had engaged in the same
business practices, were even less regulated, had no central bank until 1935,
and had no Glass-Steagall type provisions during the 1920’s and early 1930’s.
Yet Canada suffered no panics and zero bank failures.
Ironically the Glass-Steagall provision made an exception
allowing commercial banks to underwrite and invest in government bonds which
guaranteed a huge pool of credit for Washington DC and state treasuries, so
evidently alleged risktaking was acceptable so long as it benefited the
government.
Regulation Q, added by Alabama Congressman Henry Steagall,
blamed the crisis on overcompetition and forbid banks from paying interest on
deposits. Not only was blaming paying interest on deposits ludicrous, but the
provision was added by Steagall to protect the monopolies of “unit banks”
within his home state—small banks that were granted exclusive legal license to
serve a small geographic area. Ending interest on deposits prevented a
competing bank in a nearby county from drawing customers out of another unit
bank’s operating region and thus solidified their territorial fiefdoms.
What is the final verdict on both the March 1933 and
subsequent monetary policy measures?
On the whole the Economics Correspondent’s view is that
FDR’s banking holiday and public classification of banks based on safety was
sufficient to stabilize the banking system and the money supply. His emergency
measures finally stopped the bleeding although it should again be noted that
the “bleeding” was the product of perverse and destructive Federal Reserve and
federal government fiscal, wage, and trade policies. In the correspondent’s
view, FDR’s famous March fireside chat, while very effective, should have disclosed
blame where it was due even as the new president implemented measures to stop
the freefall.
But politicians rarely blame Washington, DC when it’s the
source of the dysfunction and prefer the scapegoat of “capitalism” and “the
free market” in their quest for more economic controls. FDR was no exception
and later went out of his way to implicate bankers and businessmen for problems that
had been manufactured by the Fed and the Hoover administration.
The introduction of deposit insurance was successful in further
inflating the monetary base and money supply when announced in mid-1933.
However since 1933 the FDIC has also served as a mitigating tool to counter
future crises/panics that have mostly stemmed from loose Federal Reserve
policy. Therefore, barring total reform of the financial system towards a more
stable framework, deposit insurance can be considered a reasonably successful
policy.
However the additional measures such as gold confiscation,
ending the gold standard, and devaluing the dollar in international gold terms
were probably unnecessary and simply annulled a right Americans had enjoyed
since colonial days. Predictably, the end of dollar convertibility was and
remains praised by Keynesian/inflationary policymakers then and now as the
removal of a major obstacle to central bank hegemony and perpetual devaluation.
Additional measures like separating commercial from
investment banking operations and outlawing interest on deposits were at best
unproductive wild guesses or at worst political crony capitalist measures meant
to serve the interests of businesses back home.
In short, the Economics Correspondent’s opinion is that FDR
should have stopped after the bank holidays and at most deposit insurance. If
afterwards he had torn down Smoot-Hawley trade barriers, reversed Herbert
Hoover’s 1932 tax hikes, and then taken a decade-long vacation the Great
Depression would have probably ended by 1935 or 1936. Instead as Roosevelt
intervened deeper and deeper into the economy the slump dragged on until 1946.
XII. LESSONS APPLIED IN 2008 AND OVERCOMPENSATION
When the 2008 financial crisis struck, the Federal Reserve
was chaired by a lifetime scholar of the Great Depression. Ben Bernanke,
formerly chair of the Economics Department at Princeton University, had spent
his academic career studying the monetary policy failures of the 1930’s.
Indeed, in 2002 at Milton Friedman’s 90th birthday celebration Bernanke (acting
as a Fed governor) gave a speech on Friedman and Schwartz’s contributions to
understanding the 1930’s Fed’s mistakes and ended his talk with the following
tribute:
“I would like to say to Milton and Anna [Schwartz]:
Regarding the Great Depression. You're right, we did it. We're very sorry. But
thanks to you, we won't do it again.”
Bernanke was mostly correct in his indictment of Fed
inaction, and when the 2008 crisis struck he was determined not to repeat the
errors. In the midst of crisis his immediate focus was to ensure the country
did not endure a massive wave of bank failures and deflation that would send
prices tumbling by a third as they had during the 1929-1933 period.
Thus Bernanke adopted diametrically opposite policies from
Fed officials during the Great Depression—putting his foot on the pedal and
then to the floorboard. Instead of refusing to use Fed power to buy assets and
expand the monetary base, Bernanke launched QE1 (2008), QE2 (2011), and Q3
(2013) which nearly quintupled the monetary base in about six years (see
chart).
Instead of allowing banks to run out of reserves and fail,
he bought up trillions of dollars in Treasuries and lousy mortgage securities,
loading U.S. and even some international banks with excess reserves.
Instead of refusing to make emergency liquidity loans at the
discount window, Bernanke loaned furiously and did so on lousy collateral and
at very low interest rates (breaking two of Walter Bagehot’s famous rules for
central bankers—lending on good collateral only and at punitive interest
rates).
He encouraged giant financial institutions that weren’t Fed
member banks—in fact which weren’t even banks at all—to apply for an endless
wave of discount window loans and asset purchases. Non-commercial bank firms
instantly lined up to change their status to Fed member bank in order to get a
share of the helicopter money.
Insurers like AIG, Hartford, and John Hancock bought tiny
community banks (whose deposits represented less than a day of their giant
insurance operations) in order to access Federal Reserve money. Surviving investment
banks Goldman Sachs and Morgan Stanley changed their status to commercial bank
to do the same.
Fortune 500 company finance arms like GE Capital, GMAC, and
Ford Credit also hopped into the banking business to get their share of central
bank loans. By the fall of 2008 firms that were never meant to be part of the
Federal Reserve system were all taking Fed money and Ben Bernanke was happy to
oblige, his “take no chances” stance flooding the financial sector with new
reserves and liquidity.
In the Economics Correspondent’s view, the 2008-2009 Fed
went much further than it needed to in order to prevent a 1930’s style
meltdown. It’s understandable that Ben Bernanke was determined not to oversee a
Fed that “sat idly on its hands” in a 1930’s repeat, but to avoid the mistakes
of the Great Depression the 2008 Fed needed only to do what the 1930’s Fed had
not:
-Carry out the Fed’s lender of last resort charter for
commercial banks.
-Buy sufficient assets from member banks to prevent a
deflationary collapse.
-Let the FDIC (which didn’t even exist as a ameliorating
agency in the early 1930’s) persuade depositors to leave their money in the
bank.
Loading up virtually every financial firm in America with
what would ultimately become $2.7 trillion in excess reserves was simply
unnecessary, but in the heat of the crisis Bernanke decided Fed action would
have no limits.
In fact, only QE1 was enacted during the crisis itself. QE2
and QE3, far from being emergency measures to “save” the financial system, were
Keynesian stimulus measures to accelerate economic growth out of the dismal
depths it had drifted into during the first Obama term.
So in the end, yes, the Fed avoided another 1930’s style banking collapse. But that’s a pretty low bar to set given what the world has known
about the mistakes of Great Depression monetary policy for a half century now.
And in the meantime, by creating trillions of dollars in excess reserves the
Fed has found itself in the awkward position of paying nearly $40 billion a
year to member banks in risk-free, zero maturity interest payments on those
reserves as it struggles under pressure from Congress to reduce its balance
sheet. It has also reinflated not only the housing bubble, but also pushed
stocks, bonds, commodities, and other assets to record levels.
Finally a word about the Fed’s alleged rescue of the
economy. We’ve heard countless times from the liberal press, academics,
politicians, and of course the Fed itself that its 2008 actions “prevented
another Great Depression.” While doing nothing like the 1930’s Fed would have
resulted in a worse crisis, alleging that the result would have been another
Great Depression is simply exaggerated chest-beating meant to lionize
government intervention.
As even this series of articles has shown, the Great
Depression was not just the result of bad monetary policy. The deflation was
worsened by government price and wage controls that prevented economic
adjustments, thus preventing the market from clearing while creating surpluses
of “unsold” goods and unemployed workers. The Hoover administration over
doubled real government spending, then raised the top tax rate from 25% to 63%
while on average doubling the tax burden of the working class. FDR raised the
top rate again to 79% and again to 84% years before the U.S. entered World War
II. Both administrations bought up huge surpluses of crops that rotted in
storage, and then paid farmers to destroy produce and slaughter and burn their
own livestock while Americans were going hungry. The Hoover administration
launched an international trade war that reduced global trade by two-thirds
within two years.
Had the George W. Bush or Barack Obama administrations and
Congress been stupid enough to implement such policies in 2008 and 2009, then
yes, combined with Fed inaction the United States could indeed have suffered
another Great Depression. But neither president nor the either Democratic or
GOP Congresses ever considered coming anywhere near such suicidal policies.
Even Obama’s modest tax hike on the rich, Obamacare, and new
regulations look like a small drag on the recovery when compared to the
wholesale destruction launched by both Herbert Hoover and later Franklin
Roosevelt’s interventions.
So yes, the Fed helped prevent a worse monetary crisis and
spared the United States a good degree of short-term pain. But those who
declare “the Federal Reserve saved us from another Great Depression” need to
reread their Great Depression history.
Parts 1-3 of this Federal Reserve history are available at:
Part 1
Part 2
Part 3
http://www.cautiouseconomics.com/2019/02/the-great-depression-05a.html
