A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  Opposition to deposit insurance came from two sources. First, past attempts by states had produced mixed results, in part because of problems of moral hazard, in part because local banks were not diversified. Second, many small banks wanted insurance, but large banks believed they would be forced to pay most of the cost and thus subsidize small, weak banks. The history of failures before the depression supported this argument. Opponents favored liberalized branching to produce more diversified financial institutions (White 1997, 3).

  The 1933 provision started as a proposal to deal with the liquidation of failed member banks. The Federal Advisory Council argued that the government should pay the liquidation costs for member banks just as the RFC paid for nonmember banks. The compromise proposal took $150 million from the RFC and half the surplus of the reserve banks on January 1, 1933—$138 million—to establish the Temporary Deposit Insurance Fund, which opened in January 1934 (Todd 1995, 28). Insurance was limited to $2,500 of deposits. Large bankers wanted any fund restricted to member banks, but the legislation admitted nonmembers if they undertook to join the System within two years. This provision was unpopular with small banks, and it was removed in the Banking Act of 1935.36 The latter act changed the fund’s name to the Federal Deposit Insurance Corporation (FDIC), made it a permanent agency, and raised maximum insurance to $5,000 (White 1997, 4–5). By 1980 the government insured deposits up to $100,000, the equivalent of $16,000 at 1934 prices.

  35. In 1932, with the help of Speaker John Nance Garner, later vice president, a deposit insurance bill passed the House. Glass was opposed, so the bill died (Kennedy 1973, 214). See Calomiris and White 1994 for a thorough discussion of Steagall’s role.

  36. The Banking Act of 1933 made the fund permanent beginning July 1934, but later amendments postponed the start of permanent operations. The fund had independent directors, one of whom was the comptroller of the currency. Hence, until 1936 the comptroller served as a member of the Federal Reserve Board and as a director of the FDIC.

  The Federal Reserve’s failure to serve as lender of last resort, principally from 1931 to 1933, is the main reason for deposit insurance. Deposit insurance, however, is not a substitute for the lender of last resort; the insurance fund cannot protect against systemic or widespread failure. For that, the financial system required improvements in monetary policy that the 1930s legislation did not address. Without the many bank failures, the many depositors who lost money in failed banks, and others who feared such losses in the future, political pressure for deposit insurance most likely would have remained weak. Glass and Roosevelt would most likely have prevailed.

  There is no record of the Federal Reserve’s opinion about deposit insurance, but there is some evidence in the minutes of the executive committee of the New York directors for April 10, which Secretary Woodin attended. The dominant view was opposition, but some directors accepted insurance for national banks. Harrison opposed the plan and criticized the proposal to use the Federal Reserve banks’ surplus to finance the insurance fund.37

  Roosevelt had opposed guarantees and insurance in discussions about the bank holiday, and he did not quickly change his position. Glass opposed insurance, as he had earlier. The Senate bill provided only for a sinking fund limited to member banks. Change began after Senator Arthur Vandenberg (a Michigan Republican) offered a substitute amendment authorizing $2,500 of insurance. Most midwestern senators voted for the bill, urged on by thousands of telegrams and letters from citizens with deposits in failed banks.38 At its start, on January 1, 1934, 13,201 institutions joined the new system. Only 1 percent of state banks that applied did not qualify at the opening (Patrick 1993, 179–81).

  Deposit insurance seemed a great success until the banking failures of the 1980s once again highlighted the problems of moral hazard and adverse selection that were recognized at the time of passage.39 Almost all banks have chosen to be insured, and insurance of savings and loans, credit unions, and stock market accounts followed. Most mutual savings banks stayed out of the federal system.

  37. Earlier, there is a Board staff memo that recognizes the need for a new policy because of failure to stop bank runs. The memo discusses a guarantee of deposits and a policy of marking deposits to the market value of bank assets. The memo also considers the use of clearinghouse certificates in a crisis (memo Riefler to Goldenweiser, Board of Governors File, box 2222, February 23, 1933). The memo, written during the crisis, is concerned mainly with current problems.

  38. There are several histories of deposit insurance and the legislative battle. A main conclusion is that the proponents were mainly small rural banks and their representatives, who expected to gain; the opponents were led by large city banks who expected to subsidize the small banks. After the bank holiday, the public overwhelmingly supported insurance, partly in the hope of repayment of losses, partly because many blamed Wall Street and big bankers for the depression. With Vandenberg’s intervention, the issue was likely to be a major issue in the 1934 campaign. Glass, who had opposed deposit insurance for years, urged Roosevelt to accept it. See Calomiris and White 1994 and Golembe 1960.

  White (1997, 35) concludes that the FDIC did not reduce costs of bank failures from 1945 to 1994 and may have raised them. He places the cost of resolving bank failures in these years at $39 billion, with a present value of $7.8 billion. His estimates exclude the much larger costs of savings and loan failures in the 1980s and do not include the benefit of avoiding bank runs. Bank runs almost disappeared under the FDIC, in part because the FDIC absorbed part of the losses and encouraged mergers of failing banks into stronger banks. Instead of a run to currency, depositors in banks and savings and loans, with very few exceptions, held their insured deposits or moved them to another insured bank.

  Although deposit insurance appears less successful now than before the 1980s, it retains broad public support. The failures of the 1980s convinced Congress that moral hazard was a real problem. Legislation strengthened capital requirements and required banks with less than minimum capital to close. After 1980, national and regional banking, proposed in the 1930s as an alternative to insurance, increased diversification of portfolios and the banks’ average size.

  Contemporary beliefs that speculation had caused financial collapse, and Senator Glass’s powerful role in the Banking Act of 1933, greatly enhanced the Federal Reserve’s ability to respond to speculation. The new legislation included the power to fix the percentage of a bank’s capital and surplus invested in loans secured by stocks or bonds, restrict discount privileges by banks ordered to stop lending to customers using stock as collateral, warn banks not to lend to stock exchanges or loans from the Federal Reserve would come due immediately, and suspend a bank using its facilities for purposes not related to sound credit (“Power of the Federal Reserve System to Restrain Speculation in Stocks and Bonds,” Board of Governors File, box 1297, July 6, 1933). Most of these powers were rarely, if ever, used. Their presence after 1933 shows that Congress accepted Glass’s explanation of the financial collapse.40

  39. Friedman and Schwartz (1963, 442) call deposit insurance far more important than reform of the Federal Reserve, but they recognize that some of the reduction in bank failures resulted from FDIC actions to merge failing banks rather than permit failures (440).

  40. Glass’s view was widely held. One of the Board’s senior economists, Woodlief Thomas, claimed: “More effective control of stock-market credit is necessary for business stability. Adequate control may be exercised over the supply of funds only by making stock-market activity the principal guide of credit policy” (Thomas 1935, 21).

  Operations of the Reconstruction Finance Corporation

  Nonmember banks that failed or required capital infusion to survive became the responsibility of the RFC. After the Emergency Banking Act authorized banks to issue preferred stock, the RFC assisted banks by buying their preferred stock or debentures. During its twenty-five years of operation, the RFC made 15,400 loans, totaling more than $2 billion, t
o more than 7,300 banks and trust companies. It ended operations in 1957 (Beckhart 1972, 273).

  Beginning in June 1934, Congress authorized the RFC to lend to business enterprises. The same statute added section 13b to the Federal Reserve Act authorizing commercial and industrial loans in cooperation with financial institutions or on its own. The volume of such loans outstanding and authorized was never large. It varied between $35 million and $60 million. The number of applications ranged from eight thousand to ten thousand a year (Board of Governors of the Federal Reserve System (1943, 345). Discussion of section 13b loans absorbed a considerable amount of time at directors’ meetings.

  OPEN MARKET POLICY IN 1933–34

  The New York reserve bank closed with its gold reserve ratio about 25 percent, far below requirements. Although the Board had been unwilling to require Boston and Chicago to participate in open market operations, it now instructed five reserve banks to rediscount $245 million for New York at 3.5 percent. This was the first use of interdistrict lending since 1922 and the last use to date.41 New York repaid its borrowings in mid-April.

  The monetary base and the money stock continued to fall in March and April as banks repaid discounts made during the emergency. The Federal Reserve was busy reopening banks and preparing legislative proposals, so the Open Market Policy Conference did not meet. Early in April, New York lowered its discount rate by 0.5 percent to 3 percent. Late in May, it reduced the rate again to 2.5 percent, where it remained until October. Other banks followed, but Richmond, Minneapolis, and Dallas kept their rates at 3.5 percent until February 1934.

  The Open Market Policy Conference met on April 21 and 22 and voted to purchase up to $1 billion in securities over time “to meet Treasury requirements.” Harrison told his directors that the Governors Conference was not in favor of purchases, but referring to the Thomas bill, he was afraid of “undesirable legislation coming out of Congress” (Harrison Papers, Directors’ Meeting, April 27, 1933). The Board deferred action and made no purchases. This was Meyer’s last meeting. On May 12, with Meyer gone, the Board approved purchases of up to $1 billion. The amount was 60 percent of the portfolio held at the time.42

  41. Chicago supplied $150 million, Cleveland $50 million, Boston $20 million, St. Louis $15 million, and Richmond $10 million. Boston also bought $15 million from Philadelphia. New York paid a fine of $10,200 for violating the reserve requirement.

  Governor Black first met with the executive committee on May 23. Under pressure from the administration, Black urged the members to purchase $100 million to $200 million. The OMPC favored $25 million. Before Black agreed to the lower amount, he obtained agreement that the committee would make heavy purchases if business activity and prices fell off. The committee agreed, subject to approval by a majority of the OMPC. Fears of a renewed decline did not materialize, but the purchases continued. In the next two months, the Federal Reserve purchased $200 million, at the rate of $20 million to $25 million per week.43

  Most of the purchases were Treasury notes with up to five years maturity. Between May and December, note holdings increased by $700 million. The System sold shorter-term securities, mainly certificates (under one year), lengthening the portfolio’s maturity. The increased risk alarmed some of the governors, who pointed out that a rise in interest rates could wipe out the reserve banks’ capital.44

  With the passage of the Banking Act of 1933, the Open Market Policy Conference became the Federal Open Market Committee (FOMC). At its first meeting on July 20, the FOMC chose an executive committee consisting of the same five members as before to carry out its instructions—Boston, New York, Philadelphia, Cleveland, and Chicago. Harrison remained as chairman. The committee voted unanimously to continue purchases and renewed the authority to purchase up to $1 billion.45

  42. John H. Williams joined the New York bank as assistant Federal Reserve agent on May 1. Williams taught economics at Harvard. He had considerable influence on policy throughout a long career at the Federal Reserve and was an ardent proponent of international coordination under the gold standard (Tavlas 1997, 168–70).

  43. Dallas did not participate in some of these purchases.

  44. Letters and telegrams from Governor Seay (Richmond) to Burgess and Black make Richmond’s reluctance to participate clear. He participated, nevertheless, because of the “inflation bill” (Thomas amendment) then in Congress. Seay wrote that he preferred to purchase securities directly from the Treasury because it would be “credit inflation pure and simple” (Seay to Burgess, Open Market, Board of Governors File, box 1437, May 8, 1933).

  45. The meeting was held on the day the National Industrial Recovery Administration announced policies to raise prices and wages. The stock market broke under this news. The decision to purchase may have reflected these developments or renewed bank failures and rising demand for discounts (Minutes, New York Directors, July 20, 1933, 113–15).

  As excess reserves rose, some members of the FOMC became more reluctant to continue purchases. The System continued purchases, however, to avoid displeasing the administration and from fear of new legislation. On June 8, W. Randolph Burgess used Riefler-Burgess reasoning at the New York directors’ meeting to argue that there was not much reason, other than the psychological reaction, to continue purchases. On July 6 Harrison told his directors that Governor Black believed purchases should stop but that the president had said publicly that he wanted higher commodity prices, so this was a poor time to stop purchases. Oliver M. W. Sprague talked about the need to assist the Treasury in debt finance (Board Minutes, July 21, 1933, 1). On August 10 Harrison reported he had told Secretary Woodin that, with excess reserves at $500 million, the FOMC saw no reason for additional purchases. The Treasury responded that the president wanted purchases to continue.

  Oliver Sprague was again present at the August 10 meeting. Sprague was working at the Treasury and served as an intermediary with the Federal Reserve. Asked to describe the administration’s monetary policy, Sprague replied that he could not because no particular policy had been adopted. Various policies had adherents in the administration. He warned that some wanted more radical approaches, so they hoped Federal Reserve policies would fail. Harrison complained again that it was difficult to know what to do, since he didn’t know what the administration’s policy was. One of his directors disagreed: the Federal Reserve, he said, should pursue its own correct policy.

  The following week, Harrison reported that the president wanted purchases of up to $50 million. After an initial recovery, the economy was slowing down and commodity prices had fallen. The directors were reluctant to approve large purchases. They authorized only $25 million.46 A week later, Governor Black and Secretary Woodin came to New York. Black told the executive committee of the New York directors that purchases of $10 million or even $25 million a week would achieve little. He wanted purchases of $50 million a week. This was a relatively large rate of purchase, and Black would not say how long he thought it should continue. Much of the discussion at the meeting was not about the economy but about the risk of legislation to force inflation. The directors approved purchases of $50 million for that week with only one director voting against. Woodin urged that the vote be unanimous so he could tell that to the president; the recalcitrant director reluctantly changed his vote.

  46. Roosevelt appointed a special committee to consider monetary policy. He asked the committee to recommend issuing greenbacks under the Thomas amendment. The committee did not want to go along, so the president withdrew the request and asked, instead, to have open market purchases of $50 million.

  The president knew how to keep the Federal Reserve under his control. He agreed not to issue greenbacks during September, but he did not offer a longer-term commitment. The New York directors’ meeting of August 25 was reluctant to approve the $50 million rate of purchase agreed to by its executive committee. Owen Young of General Electric voiced the sentiment of many. He was opposed to directives from the government. If there was to be a policy of
inflation, it should be a consistent policy, not one that changed every week.

  Late in August, Governor John U. Calkins (San Francisco) wrote to Black suggesting larger purchases, up to $100 million a week. But he added that he did not expect them to be effective: “It is my view that the Federal Reserve System should do its full part [to encourage expansion], even at the risk of subsequently having to realize that its efforts were ineffective.” Black replied that he agreed “with the expressions in your letter” (Calkins to Black and Black to Calkins, Board of Governors File, box 1449, August 23 and 31, 1933).

  The FOMC continued to authorize purchases in September and October. Member bank borrowing declined to about $125 million, and excess reserves rose to between $700 million and $800 million. By Federal Reserve standards, policy was easy and there was no reason for further purchases. Harrison’s memo for the September FOMC meeting referred to the volume of excess reserves as evidence of an easy money market position. The governors agreed that further purchases were unnecessary from a banking and credit perspective, but they feared an issue of greenbacks and for that reason wanted the Board to indicate that it favored further purchases. Governor Black gave that assurance, and the executive committee of the FOMC voted to maintain the $36 million per week rate of purchase for another week.47

  Opposition to Purchases

  Between the July and October meetings, the Federal Reserve purchased almost $300 million, bringing total purchases to $500 million of the $1 billion authorized in April. Prime commercial rates fell to 1.25 percent and acceptance rates to 0.25 percent, far below the discount rates at Federal Reserve banks.