The Federal Reserve and the Financial Crisis
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In the end, though, these kinds of private arrangements were just not sufficient. They did not have the resources or credibility of an independent central bank. After all, people could always wonder whether the banks were acting in something other than the public interest since they were all private institutions. So it was necessary for the United States to get a lender of last resort that could stop runs on illiquid but still solvent commercial banks.
This was not a hypothetical issue. Financial panics in the United States were a very big problem in the period from the restoration of the gold standard after the Civil War in 1879 through the founding of the Federal Reserve. Figure 1 shows the number of banks closing during each of the six major banking panics during that period in the United States.
You can see that in the very severe financial panic of 1893, more than five hundred banks failed across the country, with significant consequences for the financial system and for the economy. Fewer banks failed in the panic of 1907, but the banks that did fail were larger. After the crisis of 1907, Congress began to think that maybe they needed a government agency that could address the problem of financial panics. A twenty-three-volume study was prepared for the Congress about central banking practices, and Congress moved deliberatively toward creating a central bank. The new central bank was finally established in 1914, after yet another serious financial panic. So financial stability concerns were a major reason that Congress decided to create a central bank in the early twentieth century.
Figure 1.. Bank Closings during Banking Panics, 1873–1914
Sources: For 1873–1907, Elmus Wicker, Banking Panics of the Gilded Age (NewYork: Cambridge University Press, 2006), table 1.3; for 1914, Federal Reserve Board, Banking and Monetary Statistics, 1914-1941.
But remember that the other major mission of central banks is monetary and economic stability. For most of the period from after the Civil War until the 1930s, the United States was on a gold standard. What is a gold standard? It is a monetary system in which the value of the currency is fixed in terms of gold; for example, by law in the early twentieth century, the price of gold was set at $20.67 an ounce. So there was a fixed relationship between the dollar and a certain weight of gold, and that in turn helped set the money supply; it helped set the price level in the economy. There were central banks that helped manage the gold standard, but to a significant extent a true gold standard creates an automatic monetary system and is at least a partial alternative to a central bank.
Unfortunately, a gold standard is far from a perfect monetary system. For instance, it is a big waste of resources: you have to dig up tons of gold and move it to the basement of the Federal Reserve Bank in New York. Milton Friedman used to emphasize that a very serious cost of a gold standard was that all this gold was being dug up and then put back into another hole. But there are other more serious financial and economic concerns that practical experience has shown to be part of a gold standard.
Take the effect of a gold standard on the money supply. Since the gold standard determines the money supply, there is not much scope for the central bank to use monetary policy to stabilize the economy. In particular, under a gold standard, typically the money supply goes up and interest rates go down in periods of strong economic activity, which is the reverse of what a central bank would normally do today. Because you have a gold standard that ties the money supply to gold, there is no flexibility for the central bank to lower interest rates in a recession or raise interest rates to counter inflation. Some people view that as a benefit of the gold standard—-taking away the central bank’s discretion—and there is an argument to be made for that, but it does have the side effect that there was more year-to-year volatility in the economy under the gold standard than there has been in modern times. Volatility in output variability and year-to-year movements in inflation were much greater under the gold standard.
There are other concerns with the gold standard. One of the things a gold standard does is to create a system of fixed exchange rates between the currencies of countries that are on the gold standard. For example, in 1900, the value of a dollar was about twenty dollars per ounce of gold. At the same time, the British set their gold standard at roughly four British pounds per ounce of gold. Twenty dollars equals one ounce of gold, and one ounce of gold equals four British pounds, so twenty dollars equals four pounds. Basically, one pound is valued at five dollars. So essentially, if both countries are on the gold standard, the ratio of prices between the two exchange rates is fixed. There is no variability, unlike today, when the euro can go up and down against the dollar. Again, some people would argue that is beneficial, but there is at least one problem: if there are shocks or changes in the money supply in one country and perhaps even a bad set of policies, other countries that are tied to the currency of that country will experience some of the effects.
I will give you a modern example. Today, China ties its currency to the dollar. It has become more flexible lately, but for a long time there has been a close relationship between the Chinese currency and the U.S. dollar. That means that if the Fed lowers interest rates and stimulates the U.S. economy because, say, it is in a recession, essentially monetary policy becomes easier in China as well because interest rates have to be the same in different countries with essentially the same currency. And those low interest rates may not be appropriate for China, and as a result China may experience inflation because it is essentially tied to U.S. monetary policy. So fixed exchange rates between countries tend to transmit both good and bad policies between those countries and take away the independence that individual countries have to manage their own monetary policy.
Yet another issue with the gold standard has to do with speculative attack. Normally, a central bank with a gold standard keeps only a fraction of the gold necessary to back the entire money supply. Indeed, the Bank of England was famous for keeping “a thin film of gold,” as John Maynard Keynes called it. The British central bank kept only a small amount of gold and relied on its credibility in standing by the gold standard under all circumstances, so that nobody ever challenged it about that issue. But if, for whatever reason, markets lose confidence in a central bank’s commitment to maintain the gold standard, the currency can become subject to a speculative attack. This is what happened to the British. In 1931, for a lot of good reasons, speculators lost confidence that the British pound would maintain its gold convertibility, so (just like a run on the bank) they all brought their pounds to the Bank of England and said, “Give me gold.” It did not take very long for the Bank of England to run out of gold because it did not have all the gold it needed to support the money supply, which essentially forced Great Britain to leave the gold standard.
There is a story that while a British Treasury official was taking a bath, an aide came running in saying, “We’re off the gold standard! We’re off the gold standard!” And the official said, “I didn’t know we could do that!” But they could, and they had to. They had no choice because there was a speculative attack on the pound. Moreover, as we saw in the case of the United States, the gold standard was associated with many financial panics. The gold standard did not always assure financial stability.
Finally, one of the strengths that people cite for the gold standard is that it creates a stable value for the currency, it creates a stable inflation. That is true over very long periods. But over shorter periods, maybe up to five or ten years, you can actually have a lot of inflation (rising prices) or deflation (falling prices) with a gold standard because the amount of money in the economy varies according to things like gold strikes. So, for example, if gold is discovered in California and the amount of gold in the economy goes up, that will cause inflation, whereas if the economy is growing faster and there is a shortage of gold, that will cause deflation. So over shorter periods, a country on the gold standard frequently had both inflations and deflations. Over long periods—decades—prices were quite stable.
This was a very significant concern in the United
States. In the latter part of the nineteenth century, there was a shortage of gold relative to economic growth, and since there was not enough gold—-the money supply was shrinking relative to the economy—the U.S. economy was experiencing deflation, that is, prices were gradually falling over this period. This caused problems, particularly for farmers and people in other agriculture-related occupations. Think about this for a moment. If you are a farmer in Kansas and you have a mortgage that requires a fixed payment of twenty dollars each month, the amount of money you have to pay is fixed. But how do you get the money to pay it? By growing crops and selling them in the market. Now, if you have deflation, that means that the price of your corn or cotton or grain is falling over time, but your payment to the bank stays the same. Deflation created a grinding pressure on farmers as they saw the prices of their products going down while their debt payments remained unchanged. Farmers were squeezed by this decline in their crop prices, and they recognized that this deflation was not an accident. The deflation was being caused by the gold standard.
So William Jennings Bryan ran for president on a platform the principal plank of which was the need to modify the gold standard. In particular, he wanted to add silver to the metallic system so that there would be more money in circulation and more inflation. But he spoke about this in the very eloquent way of nineteenth-century orators. He said, “You shall not press down upon the brow of labor this crown of thorns; you shall not crucify mankind upon a cross of gold.” What he was saying is that the gold standard was killing honest, hardworking farmers who were trying to make their payments to the bank and found the price of their crops going down over time.
So the gold standard created problems and was a motivation for the founding of the Federal Reserve. In 1913, finally after all the study, Congress passed the Federal Reserve Act, which established the Federal Reserve. President Wilson viewed this as the most important domestic accomplishment of his presidency. Why did they want a central bank? The Federal Reserve Act called on the newly established Fed to do two things: first, to serve as a lender of last resort and to try to mitigate the panics that banks were experiencing every few years; and second, to manage the gold standard, that is, to take the sharp edges off the gold standard to avoid sharp swings in interest rates and other macroeconomic variables.
Interestingly, the Fed was not the first attempt by Congress to create a central bank. There had been two previous attempts, one of them suggested by Alexander Hamilton and the second somewhat later in the nineteenth century. In both cases, Congress let the central bank die. The problem was disagreement between what today we would call Main Street and Wall Street. The folks on Main Street—farmers, for example—feared that the central bank would be mainly an instrument of the moneyed interests in New York and Philadelphia and would not represent the entire country, would not be a national central bank. Both the first and the second attempts at creating a central bank failed for that reason.
Woodrow Wilson tried a different approach: he created not just a single central bank in Washington but twelve Federal Reserve banks located in major cities across the country. Figure 2 shows the twelve Federal Reserve districts (which we still have today), and each one has a Federal Reserve Bank.2 Then a Board of Governors in Washington, D.C., oversees the whole system. The value of this structure was that it created a central bank where everybody, in all parts of the country, would have a voice and where information about all aspects of our national economy would be heard in Washington—and that is, in fact, still the case. When the Fed makes monetary policy, it takes into account the views of the Federal Reserve banks around the country and thus has a national approach to making policy.
The Fed was established in 1914 and for a while life was not too bad. The 1920s, the so-called Roaring Twenties, was a period of great prosperity in the United States. Its economy was absolutely dominant in the world at that time because most of Europe was still in ruins from World War I. There were lots of new inventions. People gathered around the radio, and automobiles became much more available. There were a lot of new consumer durables and a lot of economic growth during the 1920s. So the Fed had some time to get its feet wet and establish procedures.
Figure 2. Federal Reserve Regions and Locations of Federal Reserve Banks and
Unfortunately, in 1929 the world was hit by the first great challenge to the Federal Reserve, the Great Depression. The U.S. stock market crashed on October 29th, and the financial crisis of the Great Depression was not just a U.S. phenomenon: it was global. Large financial institutions collapsed in Europe and other parts of the world. Perhaps the most damaging financial collapse was of the large Austrian bank called the Credit-Anstalt in 1931, which brought down many other banks in Europe. The economy contracted very sharply and the Depression lasted for what seems like an incredibly long time, from 1929 until 1941, when the United States entered the war following the attack on Pearl Harbor.
It is important to understand how deep and severe the Depression was. Figure 3 shows the stock market, and you can see at the left a vertical line showing October 1929, a very sharp decline in stock prices. This was the crash that was made famous by many writers including John Kenneth Galbraith and others, who told colorful stories about brokers jumping out of windows. But what I want you to take from this picture is that the crash of 1929 was only the first step in what was a much more serious decline. You see how stock prices kept falling, and by mid-1932 they had fallen an incredible 85 percent from their peak. So this was much worse than just a couple of bad days in the stock market.
Figure 3. S&P Composite Equity Price Index, 1929-1933
Source: Center for Research in Securities Prices, Index File on the S&P 500
The real economy, the nonfinancial economy, also suffered very greatly. Figure 4a shows growth in real GDP. If the bar is above the zero line, it is a growth period. If it is below, it is a contraction period. In 1929, the economy grew by more than 5 percent and was still growing very substantially. But you can see that from 1930 to 1933, the economy contracted by very large amounts every year. So it was an enormous contraction of GDP, close to one-third overall between 1929 and 1933. At the same time, the economy was experiencing deflation (falling prices). And as you can see in figure 4b, in 1931 and 1932 prices fell by about 10 percent. So if you were a farmer who had had difficulty in the late nineteenth century, imagine what is happening to you in 1932, when crop prices are dropping by half or more and you still have to make the same payment to the bank for your mortgage.
Figure 4a. Real GDP, 1925-1934
Note: Shading represents years of the Great Depression.
Source: Historical Statistics of the United States, Millennial Edition (New York: Cambridge University Press, 2006), table Ca9.
Figure 4b. Consumer Price Index, 1925-1934
Source: Historical Statistics of the United States, Millennial Edition, online, table Cc1.
As the economy contracted, unemployment soared. We did not have the same survey of individual households in the 1930s that we have today, and so the numbers in Figure 5 are estimated; they are not precise numbers. But as best we can tell, at its peak in the early 1930s, unemployment approached 25 percent. The shaded area is the recession period. Even at the end of the 1930s, before the war changed everything, unemployment was still around 13 percent.
Figure 5. Unemployment Rate, 1910-1960
Note: Shading represents years of the Great Depression.
Source: Historical Statistics of the United States, Millennial Edition, table Ba475.
As you might guess, with all that was going wrong in the economy, a lot of depositors ran on their banks and many banks failed. Figure 6 shows the number of bank failures in each year, and you can see an enormous spike in the early 1930s.
What caused this colossal calamity (which, I reiterate, was not just a U.S. problem but a global problem)? Germany had a worse depression than the United States, and that led more or less directly to the election of Hitler in 1933. So what happ
ened? What caused the Great Depression? This is a tremendously important subject and has received a lot of attention from economic historians, as you might imagine. And as often is the case for very large events, there were many different causes. A few are the repercussions of World War I; problems with the international gold standard, which was being reconstructed but with a lot of problems after World War I; the famous bubble in stock prices in the late 1920s; and the financial panic that spread throughout the world. So a number of factors caused the Depression. Part of the problem was intellectual—a matter of theory rather than policy per se. In the 1930s, there was a lot of support for a way of thinking about the economy called the liquidationist theory, which posited that the 1920s had been too good a time: the economy had expanded too fast; there had been too much growth; too much credit had been extended; stock prices had gone too high. What you need when you have had a period of excess is a period of deflation, a period when all the excesses are squeezed out. This theory held that the Depression was unfortunate but necessary. We had to squeeze out all of the excesses that had accumulated in the economy in the 1920s. There is a famous statement by Andrew Mellon, who was Herbert Hoover’s secretary of the Treasury: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.” It sounds pretty heartless and I think it was, but what he was trying to convey was that we had to get rid of all of the excesses of the 1920s and bring the country back to a more fundamentally sound economy.
Figure 6. Bank Failures, 1910–1940
Source: Federal Reserve Board, Banking and Monetary Statistics, 1914–1941, table 66
What was the Fed doing during this period? Unfortunately, when the Fed confronted its first major challenge in the Great Depression, it failed both on the monetary policy side and on the financial stability side. On a monetary policy side, the Fed did not ease monetary policy as you would expect it to in a period of deep recession, for a variety of reasons: because it wanted to stop stock market speculation, because it wanted to maintain the gold standard, because it believed in the liquidationist theory. And so we did not get the offset to the decline that monetary policy could have provided. And indeed, what we saw was sharply falling prices. You can argue about causes of the decline in output and employment, but when you see 10 percent declines in the price level, you know monetary policy is much too tight. So deflation was an important part of the problem because it bankrupted farmers and others who relied on selling products to pay fixed debts. To make things even worse, as I mentioned earlier, if you have a gold standard, then you have fixed exchange rates. So the Fed’s policies were essentially transmitted to other countries, which therefore also essentially came under excessively tight monetary policy and that contributed to the collapse. As I mentioned, one reason the Fed kept money tight was because it was worried about a speculative attack on the dollar. Remember that the British had faced that situation in 1931. The Fed was worried that there would be a similar attack that would drive the dollar off the gold standard. So, to preserve the gold standard, the Fed raised interest rates rather than lower them. They argued that keeping interest rates high would make U.S. investments attractive and prevent money from flowing out of the United States. But that was the wrong thing to do relative to what the economy needed. In 1933, Franklin Roosevelt abandoned the gold standard, and suddenly monetary policy became much less tight and there was a very powerful rebound in the economy in 1933 and 1934.