The Banking Crises

The devastating impact of the stock market collapse came in the early stages of the depression. Morale might have improved, and the stock market and the economy might have regained some buoyancy, had it not been for the banking crisis.

The economy was repeatedly buffeted in the early 1930s by waves of bank failures. The first of these, as shown in Table 23.1, began in October 1930 with the failure of banks in the South and Midwest. Although losses were heavy, these failures drew little attention from the Federal Reserve or the national media, perhaps because they were similar to the failures that had occurred in the 1920s (White 1984; Wicker 1996, chapter 2). Then on December 11, the Bank of United States in New York failed. This failure was significant for several reasons. It was the largest failure, measured by deposits, in the United States up to that time. Although it was an ordinary bank (chartered by the state of New York), its name may have led some people to believe that a bank having a close association with the government had failed. Its location in New York City (although it was not a Wall Street bank), moreover, may have produced fears that the heart of the nation’s financial system was now in danger.

The Federal Reserve at this point, most economic historians agree, should have acted as a lender of last resort. It should have lent generously to the Bank of United States and other failing banks to break the cycle of fear that was undermining the banking system. This was standard practice in financial crises: In financial panics central banks, it was agreed, should follow Bagehot’s rule (see Economic Insight 12.1) and lend freely at high rates. For a variety of reasons that we will discuss in detail later, however, it did not do

TABLE 23.1 A CHRONOLOGY OF THE FINANCIAL MELTDOWN, 1929-1933

Source: Derived from Friedman and Schwartz 1963, 301-324, and other histories of the period.

So. To the Federal Reserve, it seemed that the banks that were failing were simply badly managed banks that should be eliminated to make the system more efficient. At times a rumor that a bank was in trouble would send people running to the bank to try to get their money out before the bank closed its doors, the classic sign of a panic. More generally, the fear of bank failures led people to convert deposits into cash, depriving the banks of reserves. The banks, moreover, to build up their reserves refused to make new loans or renew old ones. The result was shrinkage in the amount of deposits and bank loans available. In retrospect, we can see that it was important to end this downward spiral, but the Federal Reserve did not recognize it at the time.

For a few months, things seemed calmer, but a more intense crisis began in March 1931 and continued throughout the summer. This time events abroad reinforced the crisis in the United States. In May 1931, the Kreditanstalt, a major bank in Vienna, Austria, failed. Because gold was the base of the money supply in most industrial countries, failures such as this one convinced people worldwide that it was time to convert paper claims to gold into the real thing. In July 1931 the panic had spread throughout central Europe, and the German government was forced to close the German banks. In September 1931, Britain, still one of the world’s financial centers and a symbol of financial rectitude, left the gold standard. The British pound would no longer be convertible on demand into gold. This, in turn, increased the pressure on the dollar, which was still convertible into gold.

The final banking panic in the United States began in 1933. Between 1930 and 1932, more than 5,000 banks containing more than $3 billion in deposits (about 7 percent of total deposits in January 1930) had suspended operations. In 1933, another 4,000 banks containing more than $3.5 billion in deposits would close. The banks’ weakened condition after years of deflation, uncertainties about how the new administration of Franklin D. Roosevelt would handle the crisis, and the general atmosphere of distrust and fear all contributed to the final crisis. By the time that Roosevelt took office on March 4, 1933, the financial system had ceased to function.

One of President Roosevelt’s first acts was to announce a nationwide bank holiday beginning on March 6, 1933. This action, which followed a number of state bank holidays, closed all of the banks in the country for one week. How could such an action improve things? The public was told that during this period, the banks would be inspected and only the sound ones allowed to reopen. Questions have been raised about the way this was handled. Probably many sound banks were closed and unsound ones allowed to remain open. But the medicine seemed to work, even if it was only a placebo; the panic subsided.

In addition to the bank holiday, the federal government took a number of other actions that helped to restore confidence in the financial system. Gold hoarding was ended by the simple expedient of requiring everyone to turn their monetary gold over to the Federal Reserve in exchange for some other currency. Perhaps most important, the Federal Deposit Insurance Corporation (FDIC) was established to insure bank deposits. The insurance took effect on January 1, 1934, and within six months, almost all of the nation’s commercial banks were covered. Deposit insurance dramatically changed the incentives facing depositors. No longer would a rumor of failure send people rushing to the bank to try to be first in line; they now knew that they would eventually be paid their deposits in any case. Together these policies drastically changed the rate of bank failures. The number of bank failures fell from 4,000 in 1933 to 61 in 1934 and remained at double-digit levels through the rest of the 1930s. (By way of contrast, the lowest number of bank failures in any year from 1921 to 1929 was 366 in 1922.) Although the Great Depression was to drag on for the remainder of the decade, the banking crisis had been surmounted. The introduction of deposit insurance and the

Decline in bank failures that followed are a striking example of Economic Reasoning Proposition 3, incentives matter.