FEDERAL RESERVES

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The Great Depression proved that all elements of the economy depended on one another. It wiped out middle class and working class jobs alike. Many families evicted from there homes, sat on the curbs surrounded by their belongings. The Great Depression was an era that was the worst in the history of the United States of America. Most of this was caused by the Federal Reserve. This massive destruction of liquidity began when the Federal Reserve responded to the 1929 stock market crash by allowing the quantity of money to decline by 2.6 percent over the next year. This extremely tightens the monetary policy which put the economy into severe recession. In order for the economy to turn around and get back on its feet, all the Federal Reserve had to do is to add to bank reserves by purchasing government securities. This would have expanded the money supply, but instead the Federal Reserve makes a mistake. Federal Reserve’s charter jobs is to be the lender of the last resort, this means that when a bank is in trouble and cannot meet its depositors’ demands for cash, the Federal Reserve must provide the liquidity. The most direct way the Federal Reserve can provide liquidity is to conduct open market operations and purchase bonds from the banking system. The Federal Reserve was derelict in this responsibility during the three banking crises that culminated in the Great Depression. Indeed, more often than not the Federal Reserve sold bonds and raised the discount rate, thus reducing banking liquidity when it should have increased liquidity. The first banking crisis began in the fall of 1930 when the Federal Reserve stood aside and permitted banks to fail in the South and Midwest. The result was to undermine confidence in banks. Runs on banks spread as depositors rushed to convert their deposits into currency. By end of the year 1930 the Bank of the United States in New York closed from inability to meet depositors’ demand for cash. The bank was sound, as evidenced by its ability to pay off depositors 92.5 cents on the dollar when it was liquidated during the worst of the Depression. If the Federal Reserve had done its job, the bank would have remained open. The bank’s size and official-sounding name meant that its failure frightened depositors all over the country and led to a general run on banks. By the time it was over, hundreds of banks had failed, reducing the money supply by the amount of their deposits.

The second crisis began in the year1931 when the Fed stood aside negligently while banks reduced their lending in order to meet their depositors’ demands for cash. By August commercial bank deposits had shrunk by 7 percent, a further contraction in the supply of money. Then in September, in response to the British leaving the gold standard, the Fed further deflated a deflating economy by pushing through the biggest hike in the discount rate in history. This extraordinary mistake caused commercial banks to stop their use of the discount window and to hoard cash in order to meet rising withdrawals stemming from the public’s declining confidence in banks. As Milton Friedman and Anna Schwartz put it, this put the famous multiple expansion of bank reserves into vicious reverse. By January 1932 bank deposits had declined another 15 percent. Large monthly declines in the money supply continued through June 1932. The commercial banks’ response to the Federal Reserve’s failure to act as lender of last resort was to accumulate excess reserves in order to meet depositors’ demands for cash without jeopardizing the banks’ loan portfolios. The Fed’s negligence left banks with unacceptable alternatives to hoarding cash and discounting their loans at a loss or calling loans that could force cash-strapped borrowers into bankruptcy. The Fed foolishly misinterpreted the excess reserves as a sign of an easy monetary policy and took no action to ease the tremendous pressures on the banking system and supply of money.

The three-year banking crisis brought on by Federal Reserve mismanagement of the money supply entered its final phase in the year 1933. This time the Federal Reserve System itself panicked. Banks were failing because they could not meet frightened depositors’ demands for cash. Statewide bank holidays spread. By March 1933 bank holidays had been declared in about half of the states. The Fed responded to these events by again raising the discount rate, making it harder for banks to meet the cash demands of depositors. From January to March the money supply fell dramatically. On March 4 the Federal Reserve Banks themselves closed. The central banking system, set up primarily to render impossible the restriction of payments by commercial banks, itself joined the commercial banks in a more widespread, complete and economically disturbing restriction of payments than had ever been experienced in the history of the country. When banks reopened in the middle of March only fifteen thousand commercial banks remained. The collapse in the banking system wiped out bank deposits. The result was shrinkage of the money supply by one-third and a severe depression that dramatically altered the U.S. Constitution and the character of our government. President Franklin D. Roosevelt’s New Deal, the massive delegation of legislative authority to newly created executive branch regulatory agencies, and the supplanting of the public’s faith in the market system by faith in government intervention all have their origin in these Federal Reserve mistakes.