One of the most important aspects of the Great Depression that stands out in economists’ minds is the surge of bank panics and failures during the depression’s onset (1930-1933). However, an institution created with the intention of preventing such a string of disasters failed to fulfill its obligation as a “lender of last resort.” This is the Fed, and its failure to prevent the early bank panics of the Great Depression is a very interesting economic issue. So why did the Fed fail to fulfill its duty? The reason for the Fed’s actions (or lack thereof) was a combination of the strict elitist leadership in the Fed and the results of adaptive expectations on immature monetary policy.
The Fed had only been created in 1913, and while there were previous experiences with bank panics (1907), the consequences were much less drastic, and so the elitists were unable to foresee the heavy blow to the money supply that would result from the failure of so many small banks. In 1907 the money stock fell by 5% due to bank panics; the Fed had no idea that bank panics would strongly contribute to the 31% decrease in the money supply by 1933(Friedman 156). While it may seem obvious that this might occur when 10,000 banks close, most of the banks that closed were non-members, and since these banks felt the opportunity cost of keeping reserves with the Fed was too great, the Fed returned the sentiment by denying them aid when they closed. Also, many of these banks were very small, and the Fed did not expect these small banks to have such a large effect on the money supply (Friedman).
All this is supported by the writings of Milton Friedman, Charles W. Calomaris and Richard H. Timberlake. According to Friedman, the closing of the Bank of United States drew concern among the fed. Between December 1930 and April 1931 the directors of the New York Reserve bank discussed the “responsibilities of the Reserve Bank with respect to member bank suspensions and of the actions it could take to prevent them (Friedman 357).” They realized the importance of the situation and the effect it would have on the public’s confidence in the system. Later it was determined that “bank failures were a problem of bank management which was not the systems responsibility (Friedman 358).” This is the first example of the Fed’s apathetic and elitist attitude; this attitude prevented them from seeing that bank panics are contagious. If the public looses confidence in the system because it knows the Fed will not help them, this will only cause more runs on banks.
The truth is that the Fed was every bit as responsible for the bank panics as poor bank management was. The Fed did not want to admit to this, and so further separated itself by declaring that non-member banks were not its problem either (Friedman 358). From 1921 to 1930 most failed banks were non-members. The Fed felt no responsibility for these banks, and this is proved by the fact that directors meeting minutes during this time are only concerned with the failures of member banks; they didn’t even discuss the closing of non-member banks (Friedman). The lack of the Fed’s action on non-member banks is also interesting because the Fed was created largely in response to the bank panics of 1907, a time when all banks were non-members. However, perhaps the Fed used adaptive expectations as a predictor for what would happen if they stood idle. Since the money supply “only” dropped 5% percent in 1907, they may have used adaptive expectations to predict the same would happen in 1930. This may be one reason that they were unable to foresee that the closing of all these banks would lead to a 31% decrease in the money supply, and hence took no actions to prevent it (Friedman).
Friedman also states that “the failures for that period were concentrated among smaller banks and, since the most influential figures in the System were big-city bankers who deplored the existence of smaller bank, their disappearance may have been viewed with complacency (Friedman 358).” This elitist attitude completely overlooked the importance smaller banks, and as stated before, also overlooked the fact that bank panics are contagious. They start out at small banks and then infest larger banks. Charles W. Calomaris also supports the view that the Fed was inactive because of an elitist attitude. He largely suggests that the Fed was inactive because they believed that only unhealthy banks were failing and this was a form of discipline; the Fed needed to make an example of these banks. Calomaris studied the panics of Chicago in 1932 and discovered that most of the banks that failed were already very weak and had risky assets months before the panic. This evidence supports that bank failures stem not from “uniformed panic, but rather fundamental weakness (Calomaris 7)” and this is why the Fed was so inactive. This is very interesting, because as stated earlier, the Fed’s creation was tied to the panics 1907, and was constructed as a means of insurance.
So once again the Fed has taken an elitist position and refused to help weak banks in order to set an example. In reality it was a way of making one of its primary functions unnecessary. Perhaps the reserves the Fed held were very low and it did not actually have the means to save these banks. This would have led it to refuse the early banks in an effort to cause other failing banks to restructure their asset and liability management, because these banks would know that they would receive no help from the Fed. Ultimately though, the Fed failed to see the strong effect this policy would have on the confidence of the public, which is one the banking systems greatest assets. Information technology was young though, and they probably thought the public would not find out. They did however, and in the form of 10,00 bank failures.
According to Timberlake, the Fed also was operating under a very strict monetary policy at the time, a policy that would prevent them from being lenient with banks. At the time the Fed was operating under “the real bills doctrine(Timberlake).” Timberlake describes this as: “the economy's production preceded the creation of new money to pay for the new product. Given a decline in the output of goods and services, less money was ‘needed.’ Consequently, Fed policy makers allowed the economy to spiral downwards as they ‘successfully’ managed an ongoing reduction in the money stock. Prices, wages, incomes, and output spun down toward zero as Fed officials grimly held to their strategy(Timberlake).” Preventing bank panics would have definitely interfered with this policy, and so the Fed refused to aid failing banks in order to lower the money supply. Timberlake also proves this point by pointing out that the Fed “Sterilized” incoming gold reserves that would have increased the money supply and thus helped prevent some bank panics. This, coupled with the fact that the declining currency deposit ratio lowers the money multiplier, really sent the money supply spiraling downward.
The Fed’s strict, elitist policies clearly blurred their vision, and thus prevented them from seeing the consequences of their actions, and this is why they were so passive. Overall, the Fed did not prevent bank panics because it did not feel they were its responsibility. According to Friedman, they saw panics as a result, and not a cause of the depression. The Fed did not know what its responsibilities were, and as a result failed to see the connection between the public’s confidence, banks and the money supply. While the Fed’s monetary policies blew up in their face, it did present them with the undeniable need for deposit insurance. Ultimately the Great Depression shocked the Fed into reality, and because of this future depressions will be averted.
Calomiris, Charles W. “Runs on Banks and the Lessons of the Great Depression” Regulation 22.1: 4-7
Friedman, Milton, and Schwartz, Anna. A Monetary History of the United States 1867-1960. Princeton , N.J.: Princeton University Press. 1963
Timberlake, Richard H. “The Roots of the Great Depression.” (Interview) Navigator. (2001).