The Federal Reserve during the Great Depression

Posted: January 4th, 2023

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The Federal Reserve during the Great Depression

The Great Depression of 1929 remains a significant era, whose lessons remain pertinent to economic scholars and policymakers to date. The lessons are not so much from the devastating effects of the depression to the United States and global economies, but from the role of the Federal Reserve. Specifically, great lessons emerge from the monetary policy undertaken by the Federal Reserve, level of government involvement and the influence of the Federal Reserve on the banking community. The Great Depression era was characterized by a 37-percent reduction in industrial production, 33% in prices and 30% in GDP along with a 25-percent rise in unemployment in the United States.[1] With the United States being the financial center of the world today, the role of the federal reserve remains pertinent in current times as it was in the 1920s, 30s and 40s.[2] The Federal Reserve is expected to protect banks and the national economy from the adverse effects of the regular recessions that afflict a capitalistic economy. However, the actions or inactions of the Federal Reserve during the Great Depression era exhibit the costly blunders that it can make due to conflicts of interest, political patronage and assumptions from overconfidence in market forces.[3] This paper discusses the role of the Federal Reserve in the Great Depression and its blunders that are often ignored to date.

Background of the Great Depression

The Great Depression punctuates a tumultuous era in the economy of the United States and the global economy due to its devastating and extended effects. This era commenced at a time when the United States was enjoying robust economic growth. The country has experienced an economic boom due to the industrial expansion that followed the Civil War.[4] Even the country’s politicians were upbeat with the widespread prosperity and confidence about the future. Moreover, the government was contemplating its interventions in the domestic economy, in which overproduction and indebtedness were rampant. The rapid expansion rate was unsustainable, with the industrial capitalists benefiting the most and the rural folks, the least. This growth was concentrated in the urban industrial cities and enjoyed by the urban populations, which were interacting with new technologies such as radio, home appliances, motor vehicles and an American-dream lifestyle.[5] In this regard, the Great Depression marked the transition from the progressive era to the New Era, in which the government recalibrated its involvement in domestic economic matters without stifling capitalism or developing a socialist state. The federal government greatly expanded following the Great Depression by taking up more responsibility directed towards the social welfare ofo Americans.[6]

However, in mid-1929, the economic growth was already slowing down, although the effects were mild and not widespread nationally. A recession was already underway due to the banking crisis in the South and Midwest regions of the country and the business slow down. All this while, these failures occurred in other places and no not in New York and Wall Street. The recession was not a crisis then. The first signs of the Great Depression were the collapse of the stock market in October of 1929, followed by the failure of the Bank of the United States in 1931. The recession reached crisis levels when market and banking failures reached New York, the financial capital of the country at the time. These events triggered panic and bank runs and, subsequently, reduced consumption and investments. Monetary deflation, unemployment, foreclosures, and bankruptcies became widespread. The crisis permeated spread to foreign countries through the gold standard and international trade. Although it is widely believed that the failure of capitalism caused the great depression, the actual culprit was the Federal Reserve for refusing to avert it.      

The Federal Reserve

The Federal Reserve System was established in 1913 by the Federal Reserve Act to avoid financial panics and forestall financial crises.[7] While the US economy had weathered much financial turmoil in the past and recovered from it, the banking crisis of 1907 proved troublesome because it caused massive panic and bank runs. Usually, to forestall such panic and capital depletion, banks would restrict withdrawals tactfully and the crises would be short-lived. They would also agree to bailout each other through interbank loans. However, on this occasion, the Knickerbocker Trust Company, the 3^rd largest trust company at the time, was a culprit of financial challenges.[8] Its closure caused tremendous runs in the trust companies country-wide, which precipitated a recession, despite payment restrictions. Moreover, banks and financiers such as J. P. Morgan often rescued financial institutions in distress to avoid business disruptions and forestall crises. It was evident that the fragmented approaches of safeguarding depositors’ money and restoring confidence to avoid panics and bank runs were insufficient and unsustainable in dealing with large-scale banking problems.

By acting as a bank of last resort, the twelve Federal Reserve banks were meant to save commercial banks in their jurisdiction from collapsing and regulate money supply in the market.[9] The establishment of the Federal Reserve came after prolonged debate on the role of the government in the American economy and the need to strike a balance between private enterprise and government regulation. However, the Federal Reserve Banks are private banking organizations, despite being mandated by the Congress, which gives them a public-private character. As such, despite being accountable to the Congress, they do not benefit from federal funding but rather rely of their profits. This way, the Federal Reserve System enjoys autonomy, allowing it to make independent and objective divisions to safeguard the U.S. economy and the financial wellbeing of Americans.  

The Role of the Federal Reserve in the Great Depression

Contrary to popular belief and myth, the Federal Reserve caused the great depression and not the collapse of capitalism. The bank did not move in to prevent panic among the American public and restore their confidence in the banking institutions and system in the country. Even when it did intervene, the initiatives failed to deliver the desired outcomes. Consequently, a recession that would have otherwise fizzled out in a few weeks exploded into a financial crisis whose effects were experienced globally.

Conflicts of interest, anti-immigrant sentiments and malicious rumors instigated the inactivity and unresponsiveness of the Federal Reserve to the unfolding bank failures across the country. Banks were allowed to fail without being helped by the Federal Reserve to meet their depositor’s cash demands. If the Federal Reserve would have provided the challenged banks with cash, the banks would have services their customers and dispelled the panic that had caused the bank runs in the first place. Once public confidence is restored, bank runs would nave ceased and the financial crisis averted. None of these interventions occurred as the Federal Reserve withheld money and watched banks shutdown after massive runs. This apathy was in contravention of the critical mandate of the Federal Reserve, which was to prevent panic, bank runs and payment restrictions.[10]

The closure of the Bank of the United States is instrumental to understanding how the Great Depressions scaled up from a recession to a national crisis and later, a global depression. Considering that this bank was experiencing the difficulties pervading the American banking sector due to the stock market collapse, the outcomes were influenced by its brand, market segment and market position and Federal Reserve lackluster involvement. Firstly, the name Bank of the United States, gave the impression that the bank was affiliated to the federal government or the official government bank in the country. This sentiment was prevalent among immigrants who were yet to understand the banking sector in the country and were constantly evoking feelings of reservations among the original settlers in the United States. Therefore, other bankers thought that the Bank of the United States, which was an ordinary commercial bank, enjoyed unprecedented advantages from its name, thus attracting many depositors, particularly immigrants. Secondly, the bank was owned by Jews and catered predominantly for Jewish clients. This unique character of ownership and clientele was disliked by the bankers from the settler communities, who felt that the bank was taking advantage of its ownership to serve a specific segment of the society.[11] These sentiments occurred in a backdrop of rising antisemitism at the time, which is linked with the Second World War. Thirdly, the bank had a large customer base comprising of numerous small and medium-sizes businesses and entrepreneurs, most of who were immigrants. Therefore, the bank enjoyed robust growth and had become one of the largest banks in New York and country at the time. As such, no one expected that it would fail and shut down. Consequently, when the Federal Reserve attempted to secure the Bank of the United States with the help of the Superintendent of Banking in the state of New York, other banks rejected the plan. Specifically, the plan was to merge the bank with other banks and to create a guarantee fund financed by commercial banks to bailout those in distress. These actions would have assured the customers of the Bank of the United States that their deposits were safe. However, after much deliberation, the proposal was rejected by the commercial banks, and the Bank of the United States was allowed to fail. This closure caused panic that spread across the country and caused bank runs that depleted the banks cash, while the Federal Reserve watched unresponsively. These effects were unprecedented by the banks, who expected that they would local.

The unresponsiveness of the Federal Reserve and the shift of power to the bankers explain the spiraling of the recession to depression proportions. As banks experienced runs and their cash became depleted, the Federal Reserve was expected to borrow from the government by purchasing government bonds to obtain the money that would bailout banks.[12] However, the Federal Reserve avoided this option hoping to use it when the crisis was severe enough to deserve it. Instead, it allowed the quantity of money to decline slowly between 1929 and 1930 following the Great Crash.[13] The Federal Reserve followed a similar approach in 1931 following another banking crisis due to bank failures. The no action approach is advocated by capitalists in the United States and Europe, and explained by Say’s law of markets. According to this law, depression is a necessary economic therapy against slow production because it weeds out the weak enterprises (). As such, the lack of interventions by the government during depressions can trigger a corrective mechanism that leaves the economy more hygienic. Unfortunately, the money decline not only distorted the monetary structure but denied the growing American economy the cash it needed to avoid deflation. Besides, the Federal Reserve had been overruled by the banking community after they rejected the Fed’s bailout plans. The Federal Reserve was also unable to prevent the banking communities from spreading malicious rumors about the Bank of the United States, thus allowing bank runs and subsequent closure of the banks. From another perspective, it is speculated that the Federal Reserve leadership capability had been curtained with the death of Benjamin Strong in 1928. Strong was a steadfast governor of the Federal Reserve Bank of New York who has steered the system firmly, considering that the New York branch has a permanent veto in the Federal Reserve System.[14] His demise may have caused a power struggle and diffused power to less competent officials who were unable to recognize the necessity for stringent and aggressive monetary policies. It is also likely that Strong failed to have a countercyclical policy in place to stimulate the economy during downturns.

When the Federal Reserve acted, the decisions worsened the Great Depression. Notably, the Federal Reserve increased the interest rate sharply to avert the drain of gold from the country following the abandonment of the gold standard by Britain (Temin 145).[15] Such gold flight would have reduced the money reserves in the country and affected international trade adversely. Unfortunately, this action was deflationary by pressurizing businesses and commercial banks further. Similarly, the Federal Reserve finally decided to buy bonds in the open market on a large scale in 1932, to gather money for assisting banks to make payments to depositors.[16] Again, this failed to deliver the desired effects because it was short-lived. The Federal Reserve ceased the purchases immediately after the Congress adjourned. This demonstrated that the Federal Reserve resisted any government intervention or advice that was not entrenched in law.   

Since the Federal Reserve System is run by private individuals representing their banking enterprises, conflict of interest many have influenced the monetary policy decisions. From the decline to help failing banks, particularly, the bank of the United States, to allowing the slow erosion of monetary value, are actions that implicate partisanship and interests in the Federal Reserve. Looking at the major players that influenced the Federal Reserve decisions and the beneficiaries of the Great Depression, individuals such as J. P. Morgan are implicated. Morgan and other affluent bankers are reputed to have bailed out trouble banks through their banking enterprises and even using their personal resources, making them significant stakeholders in the Federal Reserve System. It is likely that these individuals convinced the Federal Reserve to withhold its assistance to failing banks so that they could acquire them at discounted prices.     

Lessons from the Great Depression and Their Implications on the Federal Reserve

The Great Depression produced valuable lessons about the role the government and the Federal Reserve System. The Federal System had been established 16 years before the great depression occurred. Its initial purpose was to prevent public panic and bank runs that stifled the circulation and value of money. As such, the Federal Reserve was created to be the banker of banks and the government, and therefore, the central bank of the United States.[17] Moreover, the government has endeavored to interfere minimally in the monetary policy to allow the market economy to flourish. Indeed, a free market economy allows market forces to dictate the demand and supply of goods and services with minimal government interference. However, the membership and operational modes of the Federal Reserve demonstrate partly, the selfish interests of capitalists and the pertinence of government to protect the masses from such capitalistic maneuvers.

Government should influence the decision-making process of the Federal Reserve in matters that affect customers, and in turn, American citizens. The increased involvement of the federal government is evident in the expanded roles of the Federal Reserve during the Great Depression. The main responsibility of the Federal Reserve is to maintain the Americans confidence in the banking system to prevent runs following panics. When the Federal Reserve was unable to prevent bank runs, the president of the United States stepped in by declaring a banking holiday.[18] The action by the executive indicates that the Federal Reserve needs political good will for its actions to be effective and the stabilization of the economy was a collective effort of the public and private sectors. In addition, the Federal Reserve’s responsibility to balance the private enterprise interests with the governments mandate is illustrated by the protecting of consumer credit rights and regulating the banking industry in the country. Specifically, the New Deal is a raft of initiatives undertaken by the federal government to facilitate recovery from the Great Depression.[19] The federal government intervened through social programs, public works and fiscal reforms to accelerate economic recovery and similar crises in future. Laws like the Emergency Banking Act of 1933 and The Banking Act of 1933, which created the federal Deposit Insurance Corporation (FDIC) demonstrate the government’s involvement in monetary matters and calling the Federal Reserve to action.[20] Since then, the government has intervened in the Federal Reserve System periodically as economic challenges evolve.            

Conclusion

The Great Depression was a great test for the newly formed Federal Reserve System. Banks then, as they are today, were creative, engaging in speculative and risky business for profits’ sake. The Great Depression demonstrated capitalist cannot be left free to control the monetary policies and avert financial crises. To avoid capitalistic interests from superseding the public good, the federal government needed to influence the actions of the Federal Reserve. However, the setup of the Federal Reserve ensures that there a balance between commercial interests and government obligations so that neither the federal government nor private bankers act excessively, to the detriment of the American economy and citizens. Moreover, the Federal Reserve had transformed from a passive onlooker and reactive body to a proactive force able to shape the monetary structure in the world.   

Works Cited

Al-Zanganee, Shlair Abdulkhaleq. “The Great Depression: Slow recovery & policy mistakes.” International Journal of Social Sciences & Educational Studies, vol. 2, n. 3, 2016, pp. 19-23.

Burton Jr, Folsom. New Deal or Raw Deal: How FDR’s Economic Legacy has Damaged America, Threshold Editions: New York, 2008.

Crafts, Nicholas, and Peter Fearon. “Lessons from the 1930s great depression.” Oxford Review of Economic Policy vol. 26, no. 3, 2010, pp. 285-317.

Eichengreen, Barry. Hall of Mirrors: The Great Depression, the Great Recession, and the Uses-and Misuses-of History. Oxford University Press, 2015.

Friedman, Milton and Rose Friedman. Freedom to Choose: A Personal Statement. New York: Harcourt Brace Jovanovich,1980.

Friedman, Milton, and Anna Jacobson Schwartz. The Great Contraction, 1929-1933. Princeton University Press, 2008.

Kennedy, David M. Freedom from Fear: The American People in Depression and War, 1929-1945. Oxford University Press, 1999.

Temin, Peter. “Great Depression.” In Banking Crises. Palgrave Macmillan, London, 2016, pp. 144-153.

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[1] Nicholas Crafts and Peter Fearon. “Lessons from the 1930s great depression.” Oxford Review of Economic Policy, vol. 26, no. 3, 2010, p. 286.

[2] Crafts, Nicholas, and Peter Fearon. “Lessons from the 1930s great depression.” Oxford Review of Economic Policy, vol. 26, no. 3, 2010, pp. 289.

[3] Milton Friedman and Anna Jacobson Schwartz. The Great Contraction, 1929-1933. Princeton University Press, 2008, p. 11.

[4] David M. Kennedy, Freedom from Fear: The American People in Depression and War, 1929-1945. Oxford University Press, 1999, p. 10.

[5] Kennedy. Freedom From Fear. p. 15.

[6] Shlair Abdulkhaleq Al-Zanganee. “The Great Depression: Slow recovery & policy mistakes.” International Journal of Social Sciences & Educational Studies, vol. 2, n. 3, 2016, p. 20.

[7] Friedman, Milton and Rose Friedman. Freedom to choose: A personal statement. New York: Harcourt Brace Jovanovich,1980, p. 72.

[8] Milton Friedman and Rose Friedman. Freedom to Choose, p. 71.

[9] Milton Friedman and Rose Friedman. Freedom to Choose, p. 75.

[10] Milton Friedman and Rose Friedman. Freedom to Choose: A Personal Statement. New York: Harcourt Brace Jovanovich,1980, p. 72.

[11] Milton Friedman and Rose Friedman. Freedom to Choose: A Personal Statement. New York: Harcourt Brace Jovanovich,1980, p. 81.

[12] Milton Friedman and Rose Friedman. Freedom to choose: A personal statement. New York: Harcourt Brace Jovanovich,1980, p. 83.

[13] Milton Friedman and Anna Jacobson Schwartz. The Great Contraction, 1929-1933. Princeton University Press, 2008, p. 112.

[14] Milton Friedman and Rose Friedman. Freedom to choose: A personal statement. New York: Harcourt Brace Jovanovich, 1980, p. 78.

[15] Peter Temin. “Great Depression.” In Banking Crises. Palgrave Macmillan, London, 2016, p. 145.

[16] Friedman, Milton, and Anna Jacobson Schwartz. The Great Contraction, 1929-1933. Princeton University Press, 2008, p. 149.

[17] Barry Eichengreen. Hall of Mirrors: The Great Depression, the Great Recession, and the Uses-and Misuses-of History. Oxford University Press, 2015, p. 6.

[18] Shlair Abdulkhaleq Al-Zanganee. “The Great Depression: Slow recovery & policy mistakes.” International Journal of Social Sciences & Educational Studies, vol. 2, n. 3, 2016, p. 22.

[19] Folsom Burton Jr. New Deal or Raw Deal: How FDR’s Economic Legacy has Damaged America, Threshold Editions: New York, 2008, p. 6.

[20] Milton Friedman and Rose Friedman. Freedom to choose: A personal statement. New York: Harcourt Brace Jovanovich,1980, p. 76, 89.