The Federal Reserve had been created in the wake of the panic of 1907 for the purpose of preventing future crises by acting as a lender of last resort. This was a well-accepted function of central banks. Walter Bagehot famously had argued that the banking system required a lender of last resort in his classic book, Lombard Street (1873) (see Economic Insight 12.1). For a number of reasons, however, the Federal Reserve failed to act as lender of last resort during the Great Depression.
A scene from “It’s a Wonderful Life.” Mary Bailey (Donna Reed) turns over the money she has saved for a second honeymoon to George Bailey (Jimmy Stewart), so he can end the run on his savings bank. The Federal Reserve should have handled the crisis the way Mary did.
One reason is that the members of the Federal Reserve Board simply failed to appreciate the magnitude of the crisis and the actions needed to combat it. In his diary entries during August 1931, Charles S. Hamlin, then a member of the Federal Reserve Board, wrote that the Open Market Committee voted 11 to 1 against open-market purchases of $300 million worth of government bonds—which would have pumped reserves into the banking system as bond sellers deposited the checks drawn on the Federal Reserve— substituting $120 million instead. The governors of the regional banks, who were still in control, simply could not grasp the magnitude of the crisis, and Governor Meyer of the Federal Reserve Board was even worried about inflation.
To some extent, the failure to appreciate the magnitude of the collapse was the result of the tendency at the Federal Reserve to look at the wrong indicators of monetary policy. Many officials at the Federal Reserve believed that low nominal interest rates—col-umn (4) of Table 23.2—were a certain sign that financial markets were awash with money and that trying to pump in more would do little good. Had they looked at real interest rates—column (5) of Table 23.2—they would have reached a different conclusion. The Federal Reserve also misread the fall in the stock of money. The data was available to them, but Fed officials viewed the decline in the stock of money merely as a sign that the need for money had fallen (Steindl 1995).
In its 1932 annual report, the Federal Reserve Board argued that its power to purchase bonds was limited by the requirement that Fed notes be backed 40 percent by gold and 60 percent by either gold or eligible paper (loans sold by the banks to the Federal Reserve). The only “free gold” the Federal Reserve owned, to use the technical
Term, was the amount of gold that it held in excess of the amount it was legally required to hold. This amount, it argued, was simply too small to permit substantial open-market purchases. Such purchases would have led banks to cut their borrowing from the Fed (why borrow reserves at interest if reserves are already adequate?), depriving the Fed of loans that it could count against notes. The result would be that the Fed’s free gold, then about $416 million, would disappear, violating the rules that committed the United States to the gold standard.
Friedman and Schwartz (1963) advance a number of arguments to show that the free gold problem was merely a rationalization, not the real reason for the Federal Reserve’s reluctance to expand the stock of money. For one thing, when the rules defining what the Fed had to hold in reserve against notes were eased by the Glass-Steagall Act in February 1932, the Federal Reserve did not respond by increasing its open-market purchases of bonds commensurately. Concern about the maintenance of the gold standard, however, as Barry Eichengreen (1992) has shown, rather than technical concerns about the amount of free gold, may have been an important psychological constraint on Federal Reserve actions. Indeed, in his view, central banks throughout the world made the mistake of putting the maintenance of the gold standard above expanding the stock of money to fight the depression.
A shift of power within the Federal Reserve System identified by Friedman and Schwartz (1963, 407-419) was another important factor. In the 1920s, the Federal Reserve Bank of New York, under its charismatic president Benjamin Strong, had dominated the system. After Strong’s death in 1928, the Federal Reserve Board in Washington tried to assert its authority by resisting pressures from New York. This power struggle took its toll in the 1930s, when the New York bank pushed for more expansionary monetary policies and the Federal Reserve Board resisted for internal political reasons.
The precise weight to be put on each of these factors is a matter of debate, but the important point is that as a result of them, the Federal Reserve, although created in 1913 to protect the nation’s banking system in times of crisis, failed 20 years later to stop the greatest banking crisis in American history.
World History
