The Great Depression: Where Was the Fed?

David Wheelock: So what was the Fed up to? The Fed was asleep at the wheel. Why didn’t — the Fed didn’t measure the money supply in those days. But why weren’t they more responsive to these banking panics? After all, the Fed was created, as Bernanke said in his NBR lecture yesterday, the Fed was created to promote economic financial stability. It was to deal with the instability of banking panics and crises that we'd had throughout the 19th century.

And the last great one, The Panic of 1907, led to the National Monetary Commission report in 1910 and the creation of the Fed: the Federal Reserve Act in 1913. So, the Fed was created just to do this job and it didn't do it. Why not?

Well, as somebody pointed out, many of the banks that failed in 1930s were small banks located in rural locations. They were not members of the Federal Reserve System. Originally, only banks with a federal charter — that is, national banks — had to become members of the Federal Reserve System. Banks chartered by the state governments, which most of them were, were not required to become members of the Fed, and most of them didn’t. And only those that were members of the Fed could borrow from — directly from the Federal Reserve. So those non-member banks couldn't borrow from the Fed. That was a flaw of the Federal Reserve Act that was ultimately corrected not — actually in 1980. And the Fed really didn't feel much concern about those non-member banks.

Also, interest rates were very low. Interest rates were zero. Kind of just like they are now. The overnight interest rate — I thought we’d never see this — I never would have believed that if you told me 10 years ago that we would live in a period of zero interest rates. We’re back there, today, just as we were in the 1930s. The Fed’s viewed zero interest rates as meaning they had done all they could do. Interest, there’s plenty of money out there.

In addition, the Fed’s member banks were not coming to the discount window to borrow reserves, in part because they didn’t want to show any sign of weakness to their borrower or to their depositors. They didn’t — they feared that that would trigger more runs. The Fed completely misinterpreted what was going on. As I mentioned, nominal interest rates fell to almost zero.

By 1933, the best borrowers, like the U.S. federal government, could borrow money short-term and pay nothing, pay no interest. Essentially like today.

Interest rates were very low. But were they really low? Were real interest rates really low? No, they were actually rising because of deflation. Again, going back to my example... well, take another example. You're a farmer, you borrow money in the spring to plant your crop, expecting that at the end of the fall you'll be able to harvest that crop, pay back your loan, and have a profit. That's the hope at least. So, if prices for your crops rise over that period and it makes it easier to pay back the loan and have enough money left over for spending, for buying things, for putting away for the future.

But what if prices fall? Makes it much more difficult to repay your loan, right? And that’s exactly what was happening. Farm prices were plunging, the prices of manufactured goods were plunging, people’s earnings were plunging in many cases to zero. So the pain, if you will, of having a loan, having a debt was much, much higher than that zero nominal interest rate.

We have this concept called the real interest rate, which equals the nominal interest rate stated on your loan contract minus the inflation rate. If inflation is positive, like it was say in the 1970s, it really was subsidizing people who owed money because their prices are rising, incomes are rising. It was easier to pay back a fixed-interest rate loan. But in the 1930s, just the opposite was happening. Prices and incomes were falling, making it much harder to borrow money.

So for example, if your interest rate on your loan — really nice, 2% interest rate on your mortgage or whatever — but if prices are falling by 10%... don't think prices, think your income, is falling by 10%. As a lot of people are experiencing now with furloughs and whatnot, their incomes are falling. That makes it much harder to repay their their loans.

So that 2% interest rate is really like paying a 12% interest rate if prices are falling by 10%. And that's exactly what happened.

At those high real rates, firms stopped investing because consumers stopped borrowing money to buy cars, firms stopped investing in plant and equipment. They stopped, you know, employing people and many borrowers could not repay their loans. Hence bankruptcies went up, as people lack their incomes to repay the debts.

And then banks failed because borrowers didn’t repay their loans. That’s ultimately why banks failed: It’s because borrowers default. Banks, you know, they don’t want to foreclose on houses because they never make any money on a foreclosed house or on foreclosed machinery or anything else. They’re not in the business of, you know, holding a portfolio of real estate or machinery or whatever.

So banks failed, people saw the banks failing, so they ran on the banks that were still open, and you get this vicious cycle. OK, think of it as a contractionary spiral. It's like a funnel of water going down the drain.

So in real terms, borrowing is very expensive. Here I’ve plotted the real interest rate skyrocketing in the Thirties when the nominal rate fell.

So what caused the recovery? So, when the price level started to recover from deflation, we turn the corner and prices started rising. When prices came up, the real interest rate went down, making it cheaper for firms to invest in plant and equipment. Putting people back to work like these ladies in a sock factory. And you get increased spending in the economy. So here’s business investment plunging to very low levels as a result of rising real interest rates, but when real interest rates came down, business investment recovered.