My previous post (on December 23) described the origins of the Federal Reserve System, which just celebrated its 100th anniversary. Centralizing bank reserves in the central bank, appropriately called the Federal Reserve System because of that was designed to prevent cash or reserve shortages in one or more banks from being transmitted to other banks in the system. Access to the Fed’s new “discount window” would make the reserve base flexible, or elastic, by permitting needy banks to borrow reserves from the Fed, thus expanding the reserve base, without draining reserves from other banks. The only tool the Fed had to influence that process was the ability to raise or lower the discount rate.
Open market operations were not foreseen as an instrument of monetary policy in the beginning. They began, sort of, as a result of the recession of 1921 reducing the Fed’s earnings. The Fed bought government securities initially to obtain earning assets to help pay its expenses. Over time, it observed that its open market purchases of Treasury bills would expand the reserve base and the deposits of the banking system while its open market sales would do the opposite. Thus a new policy instrument evolved. The formal creation of the FOMC to formalize and oversee that process did not come until the banking laws of the 1930s, twenty years after the Fed’s inception.
Going into the 1930s, reserve requirements existed, but the Fed had no authority to change reserve requirements for policy purposes. The new banking laws created that ability by taking the existing reserve requirements and making them the lower end of a range and doubling them to form the upper end of the range. Within the range the Board of Governors of the Fed was authorized to change bank reserves for policy purposes.
Unfortunately, the Fed didn’t use its new third tool of monetary policy wisely. The devaluation of the dollar in terms of gold had caused an inflow of money into the economy and made the banking system flush with reserves—more reserves than were needed to meet the legal reserve requirements. The Fed thought these “excess reserves” created a buffer that insulated the banking system from its actions; so, in two stages, it raised existing reserve requirements—yes, in the middle of the 1930s—to “mop up” those excess reserves. The banks, unfortunately, reacted by contracting since those “excess” reserves were not excess to the bankers under the circumstances of the great depression, including bank runs and failures.
This confusion of excess reserves in a legal sense and excess reserves in a practical sense prompted critics of the Fed during and after the recent financial crisis, recession and slow recovery to call on the Fed to repeat that mistake. After all, the reserves were and are in excess of what was needed by the banks; so they should be mopped up to prevent them becoming the fuel for renewed inflation. Fortunately, Chairman Bernanke was very familiar with the earlier episode and didn’t make that same mistake.
The above was a bit of a diversion. Getting back to the 100 year history of the Fed, popular critics today don’t focus so much on the excess reserve fiasco. Rather they are more aware of the major charge that Milton Friedman and Anna Swartz leveled at the Fed in their Monetary History of the United States: that the Fed allowed the money supply to shrink during the Great Depression. If it had kept money growing, the depression would not have been so severe, they argued.
They had a point, and Chairman Bernanke a few years ago, with Friedman in the audience, said something to Friedman along the lines of “Yes, we did it. We’re sorry. And, thanks to you, we won’t do it again.”
I probably should leave it there. However, I’m compelled not to defend the Fed’s 1930s performance entirely, but to call attention to what we Texans call “extenuatin’ circumstances.”
First, recall that in the early 1930s we were still under the gold standard whose rules said that a nation’s money supply should be determined by gold flows. The Fed was supposed to provide financial stability and an elastic currency within the context of the gold standard, not replace central functions of the gold standard. Second, as I described above, the Fed didn’t have its full tool kit until the mid-1930s—just the discount rate. Third, the shrinkage of the money supply was primarily the result of bank failures during the early years of the depression. Deposit insurance, the most effective insurance against runs on banks, didn’t come until the mid-1930s. Fourth, monetary policy and fiscal policy in the modern sense hadn’t been invented yet. The classical (pre-Keynesian) economists thought of the economy as a self-equilibrating automatic mechanism best left alone. The Keynesian tool-kit for fighting recessions didn’t fully emerge until the publication of the “General Theory of Employment, Interest and Money” in 1936. In other words, the economic and intellectual institutions were not conducive to an activist monetary or fiscal policy designed to combat unemployment. That didn’t become an official goal of government policy until the enactment of the Employment Act of 1946.
The Fed has served us well, but not so well in the Great Depression. But please remember those extinuatin’ circumstances.