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Calming the Panics of the Great Depression: The creation of effective Federal Reserve and banking policy

2000-2001 Student Essay Contest Winner

Kelly Brooks - Edina High School, Edina, Minnesota

Published June 1, 2001  |  June 2001 issue

2000-2001 Student Essay Contest

The Great Depression: Could it happen again?

While the strength of the U.S. economy is a current topic of interest, few worry about a repeat of the Great Depression. But, could it happen again? Ninth District high school juniors and seniors grappled with this question in the Minneapolis Fed's 13th annual essay contest. This is the first-place essay, selected from more than 200 entries.

"The causes lie deep and simply—the causes are hunger in a stomach, ... hunger for joy and some security, multiplied a million times. ? This you may say of man—when theories change and crash, when schools, philosophies, when narrow dark alleys of thought, national, religious, economic, grow and disintegrate, man reaches, stumbles forward, painfully, mistakenly sometimes. Having stepped forward, he may slip back, but only a half step, never the full step back."

—John Steinbeck, The Grapes of Wrath 1

In 1928, Fred Bell was living the American Dream as a millionaire in California. In 1929, the same man, now unemployed, humbly stood outside on the corner of a busy street, selling apples for income. 2 Across the country, millions of Americans experienced losses of their own, triggered by the stock market crash of 1929 and definitively reinforced with the failure of their banks. Real gross national product plummeted 30 percent from previous output, and unemployment reached an unprecedented high of 25 percent.3 Though acting in good faith, the Federal Reserve's tight money policies spurred the failure of banks across the nation. The loss of resources incurred was responsible for the severity and length of the era known as the Great Depression. Fortunately, the knowledge accrued as a result of the Federal Reserve's actions has served as a basis to rework policies and redefine monetary approaches. Both structural and attitudinal reforms with regards to monetary policy ensure that the United States will never again suffer a catastrophe similar to the Great Depression.

Through a series of misguided policies, the Federal Reserve's contractionary monetary actions were the ultimate cause of bank failures and the economic turmoil that ensued. Though the stock market crash was certainly a shock to many investors, the effects were not substantial enough to have produced the economic downturn. 4 The real problem began in 1928 when, upset by an increasing amount of credit expansion used for speculation, the Federal Reserve tightened monetary policies.5 Between January 1928 and May 1929, the Federal Reserve sold $405 million worth of government securities and increased the discount rate from 3.5 percent to 5 percent. 6 Because banks purchasing these securities must pay for them from their reserves, this maneuver effectively decreased the nation's monetary base. In addition, raising the discount rate made it increasingly difficult for banks in trouble to borrow money.

The tightened money stock was detrimental to banks experiencing pressure from the stock market crash in 1929. After watching much of their wealth disappear in stocks, many Americans like Fred Bell rushed to their bank to withdraw deposits. Unfortunately, banks operate on the assumption that not every customer will request their money simultaneously; though the required reserve ratio is always kept on hand, many deposits are lent to businesses and are not immediately accessible. This reality, compounded with the drop in money stock by approximately one-third7 due to the Federal Reserve's securities purchases, meant that banks could not meet demands for withdrawals. With their ability to borrow from the Federal Reserve crippled by the new discount rate, 11,000 banks folded.8 These closures induced $2.5 billion losses to the very individuals and businesses recently hit by the stock market crash, causing investment and consumer spending to fall dramatically.9 Of the subsequent drop in GNP, consumer spending accounted for an unprecedented one-half of the decline, no doubt due to losses realized from bank failures. 10

Established in response to the detrimental bank runs, the Federal Deposit Insurance Corp. precludes the possibility of widespread bank failures by reforming banks and reassuring consumers and businesses. In 1933, Congress created the FDIC deposit insurance program under the Glass-Steagall Banking Act. This law guaranteed up to $5,000 in a bank deposit, which instilled a sense of consumer confidence in banks.11 If insured, struggling banks would be reorganized under new management and the FDIC would assume losses in assets.12 Insured deposits strengthened banks' safety nets, and since their advent, they have been successful in preventing bank panics by assuring customers of the stability of their deposits.13 Though the funding of the FDIC could not support the loss of all deposits at once, the Act has increased confidence enough to prevent initial bank failures that were so costly in the early '30s.14 Thus, federal deposit insurance has proven an effective solution to the type of bank collapses that plagued the nation in the 1930s and cemented the economy into a state of depression.

Perhaps more lasting than legal reforms, the radical change in the Federal Reserve's approach to macroeconomic policy prevents the possibility of the ill-conceived monetary responses destructive in the '20s and '30s. The founders of the Federal Reserve System operated under a faulty understanding about monetary theories.15 These misconceptions are mirrored in the Federal Reserve's incorrect assumption that bank failures were due to mismanagement and were "not the System's responsibility," ironic, considering the Fed's role in causing the collapses.16 Due to a lack of comprehensive macroeconomic research, many economists during the Great Depression mistakenly believed that business cycles were inevitable, and assistance from financial institutions like the Federal Reserve was unnecessary.17

Fortunately, among Federal Reserve officials today there exists a more accurate understanding of banking operations. This new commitment to bank soundness is exemplified in actions taken during the [stock market drop] of 1987. Following the fall of the Dow Jones industrial average, Chairman of the Board of Governors Alan Greenspan made a public appearance announcing that the Federal Reserve stood ready to provide liquidity and support to commercial and member banks.18 This approach reversed the economic downturn by improving consumer confidence and by providing banks with the courage to lend to ailing businesses and individuals.19 In addition to appropriate policy action, the Federal Reserve has also altered its view of its responsibilities to the system, indicating in a 1987 report that officials would "maintain ... commitment to the stability of the banking system through judicious use of ... deposit insurance and the discount window."20 In sharp contrast to the hands-off attitude with regards to failing banks and the increased discount rate of 1929, this mission statement clearly illustrates a Federal Reserve dedicated to proper monetary action in the face of a recession.

In light of the banking reforms and improved understanding of macroeconomic monetary theory, our economic situation is such that no recession will ever transform into the prolonged agony of the Great Depression. Businesses and individuals placing savings in banks can be reassured that should their bank fail, the FDIC will reimburse their deposits up to $100,000. This faith in the system in turn prevents the mass bank runs that worsened the situation at the beginning of the Depression. Federal Reserve officials like Alan Greenspan have exhibited appropriate and effective monetary responses to fluctuations in the economy, as opposed to the harmful actions taken by the Fed in the 1920s and '30s. By assessing the Federal Reserve and banks' actions in the past, we have ensured that the same mistakes will never be repeated again, and our country will never have to experience another calamity such as the Great Depression.

Endnotes

1 Steinbeck, John. The Grapes of Wrath. New York: Penguin Books, 1992, (405-406).

2 Schraff, Anne E. The Great Depression and the New Deal. New York: Franklin Watts, 1990, (64).

3 "A Debate that Rages On: Why Did It Happen?" Business Week. 3 Sept. 1979.

4 Federal Reserve Bank of Minneapolis. Achieving Economic Stability: Lessons From the Crash of 1929." Annual Report, 1987, (12).

5 Federal Reserve Bank of Minneapolis, 5.

6 Hall, Thomas E., and Ferguson, J. David. The Great Depression: An International Disaster of Perverse Economic Policies. Ann Arbor: The University of Michigan Press, 1998, (64).

7 Friedman, Milton, and Schwartz, Anna J. A Monetary History of the United States 1867-1960. Princeton: Princeton University Press, 1963, (352).

8 Hall, 85.

9 Friedman and Schwartz, 351.

10 Hall, 67-68.

11 Schraff, 26.

12 Friedman and Schwartz, 440.

13 Federal Reserve Bank of Minneapolis, 16.

14 Friedman and Schwartz, 441.

15 Friedman and Schwartz, 407.

16 Friedman and Schwartz, 358.

17 Bernstein, Michael A. The Great Depression: Delayed Recovery and Economic Change in America. 1929-1939. Cambridge: Cambridge University Press, 1987, (216-217).

18 Federal Reserve Bank of Minneapolis, 13.

19 Federal Reserve Bank of Minneapolis, 14.

20 Federal Reserve Bank of Minneapolis, 17.

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