Tuesday, March 11, 2014

In Fed We Trust

President Herbert Hoover escorting Franklin Delano Roosevelt from the White House to the Capitol to take the oath of office as President, March 4, 1933. From LOC.gov

Trust is a funny thing. It can build empires and be broken by a promise. It is gained slowly but lost quickly. While not essential for life, we can't live without it. And in March 1933 it was in short supply.

The root of the bank crisis that led to the Great Depression can be traced to a promise broken by the Federal Reserve, so argued Milton Friedman and Anna Schwartz in their seminal book "Monetary History of the United States."

Established in 1913, in the wake of the 1907 panic, the Federal Reserve was designed to prevent major bank failures by acting as the lender of last resort. Prior to the Fed's creation, as Ben Bernanke explained in a 2002 speech, bank panics were typically handled by banks or bankers themselves. Large, solvent banks had an incentive to act because they knew that an unchecked panic would ultimately threaten their own finances.

But there was always a fear that "men may not be found in an emergency with the patriotism, courage and capacity" necessary to prevent a catastrophe. This was one of the arguments for central banking put forth by Senator Nelson Aldrich in the wake of 1907 crisis.

That isn't to say that Americans feared bank failures. Liquidationist believed that by weeding out "weak" banks, failure was a harsh but necessary component of a healthy banking system. Between 1921-1929, an average of 600 banks failed every year, according to FDIC data. Treasury Secretary Andrew Mellon advised President Hoover that it was not the Fed's job to rescue poorly managed, failing institutions.

So they didn't. In December 1930 (a year after the market crash) the Fed refused to bailout New York's Bank of the United States.* But it was not managerial weakness, per se, that caused the BUS to fail. In November, the announcement that merger negotiations between the BUS and three other banks broke down "aroused distrust in the general public," according to the New York Times. In December, a false rumor that a shareholder had not been paid for his shares sparked a run that eventually forced the bank into a liquidity crises.

When the Fed refused to insure the bank's liabilities, Americans felt duped. Unlike the small bank failures that occurred during the 1920s, the BUS was a member of the Federal Reserve System. It was also the largest ever to suspend payments, "possibly the largest in the world to close its doors." Letting it fail caused thousands to lose their life savings, and severely diminished America's faith in the Fed's ability to prevent major bank failures.

In October 1931, after Great Britain's abandonment of the gold standard sparked a run on banks, a consortium of private bankers attempted to fill the gap by organizing the National Credit Corporation. But with the existence of the Fed--the purported lender of last resort--not enough felt the need to step-up, and the organization failed within weeks.

Business leaders then appealed to the federal government. In January 1932, the Hoover Administration created the Reconstruction Finance Corporation (RFC) whose primary function was to make advances to banks, and failures subsided. By the end of 1932, the RFC had assisted over 4,000 banks and authorized almost $900 million in loans. But the appearance of a bank's name on the RFC list was interpreted as a sign of weakness,  ultimately discouraging banks from accepting its assistance.

In the winter of 1933, faith in the nation's banking system reached a nadir. The fear contagion started in Michigan on Valentine's Day. Trying to prevent the failure of Detroit's large banks, Michigan Governor William A. Comstock declared a statewide banking holiday. This succeeded in preventing bank failures, but also confirmed the public’s worst fears—that the banks needed to be closed.

As depositors in every state lined up outside bank branches, failure became a self-fulfilling prophecy. On March 5 (barely a day in office), FDR shut down all of the nation's banks, proclaiming what is known today as the Bank Holiday (a misnomer if ever there was one).

On March 9, he signed the Emergency Bank Act, declaring a sort of Martial Law on the nation's economy. The Act gave the President control of the entire banking system, and nearly unlimited resources to resolve its problems. This hasty legislation (only one copy was made and Congressmen cast their vote after having it read to them aloud) was the first bold move the President made to restore confidence.

The second occurred on March 12 (a Sunday) with the first-ever "fire side chat." At 10 PM, radios nation-wide broadcast his avuncular assurances. Using understandable language,  FDR clarified the state of America's banks. Fear abated. On Monday, depositors stood in line to re-deposit their cash.

In November 2002, at Milton Friedman's 90th birthday, Ben Bernanke thanked the Nobel-prize winning economist for his insights. "Regarding the Great Depression," Bernanke gushed, "You're right, we did it. We're very sorry. But thanks to you, we won't do it again." 

In 2008,  Ben Bernanke's Federal Reserve kept his promise. Many agree his bold and decisive actions prevented another Great Depression, though those actions were deeply unpopular.

There's no denying that by shifting the responsibility of providing liquidity in financial crises from the banks (who for the most part created the problems) to the people via government guarantees, the existence of the Fed creates a moral hazard. This is an unsavory reality. What central bankers learned from 1933, however, is that as long as the Fed exists it must keep its promises or be destroyed by them.

Watch Milton Friedman discuss the failure of the Bank of the United States and the anatomy of bank runs on YouTube.

*Things might have been less severe if the Bank of the United States had a different name. "Though an ordinary commercial bank," Friedman wrote, "its name had led many at home and abroad to regard it as somehow the official bank."
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Flannery O'Connor

You shall know the truth and the truth shall make you odd.