Why Did A Mild Recession in 1929 Become the Great Depression of the 1930s

Overview Why did a mild recession turn into the Great Depression? Alleged causes of the Great Depression The Fed explained More likely causes of Great Depression Failed monetary policy Failed fiscal policy Failed international trade policy Implications for today

What Did It? In the 1920s, jobs were plentiful and the economy was growing and the standard of living was rising. Between 1920 and 1929 homeownership doubled. Most home-owning families enjoyed amenities such as electric lights and flush toilets. 60% of all households had cars, up from 26%. More teenagers were attending high school.

What Did It? By 1933… One fourth of the labor forces was unemployed. Families were losing their homes and many were going hungry. Adolescents who should be in school were riding around the country in freight cars, looking for jobs.

What Did It? What happened? The United States possessed the same productive resources in the 1930s as it had in the 1920s. Great factories and productive machinery were still present. Workers had the same skills and were willing to work just as hard. How could life have become so miserable for so many in such a short period of time?

1920s Prosperity of the 1920s was based largely on purchases of homes and cars. Toward the end of the decade sales began to decline.

End of the 1920s Machinery workers stand. Car sales people stand. Auto workers stand. Steel workers stand. Construction workers stand. Furniture sellers stand. Furniture workers stand. Clothing sellers stand. Restaurant workers stand. Grocery workers stand.

Business Cycle

1929 Normally, people start buying again as automobiles wear out and incomes improve.

Expansion Begins Again Machinery workers sit. Car sales people sit. Auto workers sit. Steel workers sit. Construction workers sit. Furniture sellers sit. Furniture workers sit. Clothing sellers sit. Restaurant and grocery workers sit. Grocery workers sit.

What Are the Alleged Causes of the Great Depression? The Stock Market Crash of October 29, 1929 Excessive borrowing to purchase stocks and consumer goods Excessive competition leading to low prices Overproduction of goods and services Low farm prices and low wages, leading to an uneven distribution of income

It’s primarily about money, banks, and the Federal Reserve System Why did a mild recession in 1929 become the Great Depression of the 1930s? A Hint It’s primarily about money, banks, and the Federal Reserve System

Quick Review of the Fed

Are banks the same as hardware stores? Banking Terms Are banks the same as hardware stores? Money Reserve Requirement Required Reserves Excess Reserves Do banks create money?

Basic Money and Banking What is Money? Anything generally accepted in payment for goods and services. Medium of Exchange Store of Value Unit of Account Fiat system

Measuring Money- 2010

M1 Money Supply

The Money Creation Process I walk into Bank A and deposit $1,000 cash into my checking account. What does Bank A do with the money? Bank A places $100 in reserves and makes a $900 loan. What does the person that takes out the $900 do the money? Deposit in Bank B. Bank B puts $90 into reserves and makes an $810 loan. $1,000 cash has turned into: $1,000 + $900 + $810 = $2,710 and it keeps going.

Why a Federal Reserve System? Central Bank of the United States Created in 1913 by Congress (Federal Reserve Act) Response to nations’ recurring bank panics Severe panic in 1907 – bank failures, business bankruptcies, economic downturns The United States lacked a central bank until the twentieth century, although there were two attempts to establish a central bank in the early 1800s (killed by politics). Without a money manager, the nation's financial system was like the nation itself--diverse and subject to uneven growth. As a result, there were frequent economic depressions and financial panics – state chartered banks had their own currency back then – 10,000 different bank notes in circulation in 1912. Reform was difficult. In the more established eastern cities, business leaders wanted to create a national financial system. In the West and South, small businesses and farmers feared a national financial system would not provide enough easy credit to support their developing economies. In 1913, after considerable debate, Congress passed the Federal Reserve Act to balance the financial needs of the country. – think about how different parts of the US were at that time – big cities on east coast, little in the west, etc. Difficulty in establishing was an American problem – distrust of centralized power – still some that believe it’s creation was a big conspiracy from big business – part of the military, etc. – will explain why structure is so unique – web search tons of conspiracy’s next slide.

Goals of the Federal Reserve Safe, flexible and stable financial and monetary system. Dual Mandate: Stable Prices Maximum Employment

The Federal Reserve System Three Parts: Board of Governors – building on the left Federal Open Market Committee – meeting room in this building 12 Federal Reserve Member Banks – 12 banks on the right Show White House and Congress – appointment and oversight relationships.

Reserve Banks There are 12 Federal Reserve Districts, each is served by an independent Reserve bank. There are also 24 branch offices. Federal Reserve Branch city, by District: (4) Cincinnati, Pittsburgh (5) Baltimore, Charlotte (6) Birmingham, Jacksonville, Miami, Nashville, New Orleans (7) Detroit (8) Little Rock, Louisville, Memphis (9) Helena (10) Denver, Oklahoma City, Omaha (11) El Paso, Houston, San Antonio (12) Los Angeles, Portland, Salt Lake City, Seattle

Federal Reserve Banks Conduct economic research in general and on their local economy. Supervise and examine bank holding companies and commercial banks in their region. Provide bank services (hold reserves, make loans, clear checks and other payments, move currency into and out of circulation). Provide services to the US Treasury and Federal Government. Provide services to the community. Handout current Beige Book for Chicago region Reserve bank activities serve primarily three audiences--bankers, the U.S. Treasury and the public. Reserve banks are often called the "bankers' banks," because they store commercial banks' excess currency and coins and they process and settle their checks and electronic payments. Reserve banks also supervise commercial banks in their regions.    As banks for the U.S. government, Reserve banks process the Treasury's payments, sell its securities and assist with its cash management and investment activities. Finally, Reserve banks conduct research on the national and regional economies, prepare Reserve bank presidents for their participation in the FOMC and disseminate information about the economy through publications, speeches, educational workshops and web sites. 9 board of directors for each bank – 3 professional bankers from area; 3 leaders from industry, labor, agriculture, etc.; 3 appointed by Board of Governors – not allowed to be involved in banking: trying to diffuse power make bank act in the interest of all Americans.

Broad of Governors Located in Washington DC. Responsible for setting and implementing the nation’s monetary policy (control of the money supply). Consists of 7 members appointed by the president and confirmed by the Senate. Each member serves one 14-year non-renewable term with one member appointed every two years and one member is appointed as the chair for a 4-year renewable term.

Broad of Governors Board membership is relatively stable since a new president can be sure of appointing or reappointing only two members in a presidential term. Board structure was designed to insulate monetary authorities from short-term political pressure by elected officials.

Federal Open Market Committee Consists of the 7 board governors plus 5 presidents of the Reserve Banks (one is always NY Fed president and the rest rotate– next slide) Sets monetary policy Meets 8 times per year The Federal Open Market Committee (FOMC) has increasingly become a household word as the media reports its activities, but few people know much about the committee itself. Met on Wednesday – read news report The FOMC has 12 voting members--the seven members of the Board of Governors and five Reserve Bank presidents. The Chairman of the Board of Governors serves as the permanent Chairman of the FOMC. The president of the Federal Reserve Bank of New York serves as the permanent Vice Chairman of the FOMC and is, therefore, always a voting member. The 11 other presidents serve one-year terms on a rotating basis. While all 12 Reserve Bank presidents participate in every FOMC meeting, only those serving as FOMC members may vote. The FOMC meets eight times a year in Washington, D.C. For each session, economists at the Board of Governors and the Reserve Banks prepare extensive economic analysis of statistics from every region and industry in the country. The FOMC also gets valuable grassroots information from the boards of directors of the Reserve Banks. For each meeting, Reserve Bank presidents bring reports on their Districts' economies, based on information from Reserve Bank directors, other District residents, and the Banks' Research departments. These reports are part of the briefing materials used by the FOMC in formulating monetary policy (Beige Books – look at in a second). Twice a year, the Chairman of the Board of Governors reports to Congress on the FOMC's economic views and projections, as well as the issues likely to affect near-term monetary policy decisions. The long-term goals of the Fed remain constant: a strong economy with stable prices, maximum sustainable employment, and ample opportunity for sound economic growth (more later).

Federal Open Market Committee Conducts open market operations Purchases and sales of U.S. government securities by the Fed Most important tool of monetary policy Conducted by NY Fed Bank The Federal Open Market Committee (FOMC) has increasingly become a household word as the media reports its activities, but few people know much about the committee itself. Met on Wednesday – read news report The FOMC has 12 voting members--the seven members of the Board of Governors and five Reserve Bank presidents. The Chairman of the Board of Governors serves as the permanent Chairman of the FOMC. The president of the Federal Reserve Bank of New York serves as the permanent Vice Chairman of the FOMC and is, therefore, always a voting member. The 11 other presidents serve one-year terms on a rotating basis. While all 12 Reserve Bank presidents participate in every FOMC meeting, only those serving as FOMC members may vote. The FOMC meets eight times a year in Washington, D.C. For each session, economists at the Board of Governors and the Reserve Banks prepare extensive economic analysis of statistics from every region and industry in the country. The FOMC also gets valuable grassroots information from the boards of directors of the Reserve Banks. For each meeting, Reserve Bank presidents bring reports on their Districts' economies, based on information from Reserve Bank directors, other District residents, and the Banks' Research departments. These reports are part of the briefing materials used by the FOMC in formulating monetary policy (Beige Books – look at in a second). Twice a year, the Chairman of the Board of Governors reports to Congress on the FOMC's economic views and projections, as well as the issues likely to affect near-term monetary policy decisions. The long-term goals of the Fed remain constant: a strong economy with stable prices, maximum sustainable employment, and ample opportunity for sound economic growth (more later).

The Fed’s Monetary Policy Tools Open Market Operations – buy and sell U.S. Government securities to influence federal funds rate. Discount Rate – interest rate charged to banks on loans received from their regional Reserve Bank. Reserve Requirements – amount of funds banks must hold against deposits in reserve. Much more later Read about in my “Fed Year of Transition” article – students explain each one. Open Market Operations – NY Fed buys and sells government bonds from banks to influence FFR. Recall, banks must hold a certain % of their deposits in reserves (cash – actually at fed). If a bank is short (M&I) they can borrow to meet their requirement from a bank that has extra – and pay the FFR (overnight lending). If Fed wants to lower FFR they buy bonds from banks and pay $ - this increases supply of $ and interest rates fall, vice versa, sell bonds to banks, take $ and raise the rates. Discount Policy – interest rate banks can borrow from Fed. Reserve Requirement – could change amount of reserves banks have to hold. Hold less, increase supply of money and visa versa. Much more detail on TU.

How do Open Market Operations Work? The FOMC sets a target for the federal funds rate. The Fed uses Open Market Operations to move the federal funds rate to its target. The federal funds rate is the interest rate paid in the Federal Funds Market for overnight loans between banks. The rate influences other key rates.

Lowering the Federal Funds Rate Why would they do this? Economy is weak and they want to increase business and consumer borrowing/spending. How do they do this? Instruct New York Fed Bank to buy treasury bonds from banks. The Fed pays these banks by crediting their reserve accounts. This increase in the supply of reserves (money) lowers the price of money (Federal Funds Rate). Other interest rates in the economy then typically follow.

Federal Funds Rate

Back to the Great Depression…

Interest Rates The world financial system that emerged after World War I was based upon the gold standard. The United was a safe haven for gold. The United States and Great Britain guaranteed that they would exchange their currencies for gold at a fixed rate ($20.67) for an ounce of gold. Other major countries agreed to exchange their currencies for gold, dollars, or pounds.

Gold Standard and Interest Rates In 1927, several countries, most notably Germany and Austria, experienced serious bank runs. Many foreigners exchanged their currencies for dollars in order to withdraw gold from the U.S. The United States experienced a serious outflow of gold. To encourage foreign investors to buy American investments (exchange gold for dollars to invest) and encourage an inflow of gold, the Federal Reserve raised interest rates in 1929.

“We Did It.” The Fed failed to act as the “lender of last resort.”

Number of U.S. Banks Closing Temporarily or Permanently, 1920-1933 Year Number of Bank Closings 1920 168 1921 505 1922 367 1923 646 1924 775 1925 618 1926 976 1927 669 1928 499 1929 659 1930 1352 1931 2294 1932 1456 1933 4004

Money in Circulation Year Money in Circulation* 1929 $26.2 1930 $25.1 1931 $23.5 1932 $20.2 1933 $19.2 *Currency plus bank deposits, in billions of dollars.

“We Did It.” In 2002, at Milton Friedman’s 90th birthday Ben Bernanke, then Federal Reserve Board Governor, said: “ I would like to say to Milton and Anna: Regarding the Great Depression, you were right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”

Why Did the Fed Fail to Act? The Board of Governors believed that many banks were unsound. They wished to protect the value of the dollar by keeping interest rates high. They wished to protect the nation against inflation which they thought was the main problem.

Smoot-Hawley Tariff In 1930 Congress approved the Smoot-Hawley Tariff. It raised rates from 20% to 34% on agricultural products. Tariffs were raised on 887 items. The number of items listed as dutiable commodities increased to 3,281.

Smoot-Hawley Tariff American farmers lost nearly one third of their markets. Farm prices plummeted. Thousands of farmers went bankrupt. Rural banks failed in record numbers. Trade partners such as Germany (Weimar Republic) were also hurt.

Revenue Act of 1932 Corporate and estate taxes were raised. By 1932, federal revenues had declined and spending had increased. In 1932, Congress approved and Hoover signed the Revenue Act. It doubled the income tax. The lowest bracket went from 1.25% to 4%. The top bracket ($100,000) went from 24% to 63%. Exemptions were lowered. Corporate and estate taxes were raised. New gift, gasoline, and auto taxes were imposed.

How Did the U.S. Respond to the 2007-2008 financial crisis? Did the Fed let banks fail in large numbers? Did the Fed raise interest rates? Did the Federal government raise taxes and balance the budget? Did the Federal government increase trade restrictions?

Bank Failures Great Recession Great Depression 2008 to Oct 6, 2009 bank failures= 123 $322.2 billion in deposits … or 2.3% of GDP 1930-1933 bank failures= 9,106 $6.9 billion in deposits … or, 7.2% of GDP FDIC created in 1933 FDIC Bank Failures http://www2.fdic.gov/hsob/SelectRpt.asp?EntryTyp=30 http://www.fdic.gov/bank/individual/failed/index.html See http://www.sjsu.edu/faculty/watkins/depmon.htm for a discussion of the behavior banks, the Fed, and the money supply during the Great Depression. 1929 GDP from http://www.sjsu.edu/faculty/watkins/recovery.htm This figure $790.9, which is in 1992 $, was adjusted by 2009/1992 CPI to get 1929 in current dollars (215/140) x 790.9= $1,214.8. $6.9 billion was adjusted by 2009/1929 CPI to get current dollars (215/17.04)x$6.9= $87.09

Discount Loans: Fed as Lender of Last Resort

Interest Rates

Questions?