Federal Reserve and Financial Crisis
- Based on Lecture (1) by Ben Bernanke in George Washington University
- Based on Lecture (1) by Ben Bernanke in George Washington University
This lecture explains
what central banks do, the origin of central banking in the United States, and
the experience of the Fed during the Great Depression.
A central bank is not a regular bank but is a government agency. They are at the centre of the financial system and play a major role in the economic policy. Today virtually every country has central banks, except, in the currency unions where several countries share a common central bank, for example, the European Union.
The missions of a nation’s central banks are
1. Macroeconomic stability: All the central banks strive for low and stable inflation; most also try to promote stable growth in output and employment
2. Financial stability: Central banks try to ensure that the nations financial system functions properly; importantly, they try to prevent or mitigate financial panics
The tools available for central banks to achieve these objectives are
1. Monetary policy (for macroeconomic stability): Central banks adjust the level of short term interest rates (by buying and selling securities in the open market) to influence spending, production, employment, and inflation
2. Provision of liquidity (for financial stability): Central banks provide liquidity (short term loans) to financial institutions to help calm financial panics, serving as the “lender of last resort”
3. Financial regulation and supervision: To the extent that supervision helps keep firms financially healthy, the risk of loss of confidence by the public and an ensuing panic is reduced. This instrument, however, is not unique to central banks. For example in the United States, the FDIC or the Office of the Controller of the currency work with the fed in supervising the financial system
Where do Central Banks come from? The earliest central banks were in Sweden (1668), the Bank of England was founded in 1694 and for several decades was the most influential central bank in the world, while France had introduced central banks in the 1800s.
The bank of England in 1694 wasn’t set up from the scratch, in fact, it was a private institution and over the time it acquired some of the functions of central banks, such as issuing currency. Over time then they became government agency. One of the most important responsibility of central banks was to manage the gold standard, that is, issuing paper the currency that was backed by gold.
The lender of the last resort function became important only in the 19th century and the Bank of England had achieved mastery in it. So, in the latter part of 19th century, while, the United States was suffering from a banking crisis, the United Kingdom’s banking structure was quite stable. Thus the Bank of England in a way set up some practices which are still used today by other central banks around the world. The United States had suffered severe panics in 1873, 1884, 1890, 1893 and 1907 which led to several bank closures, losses to depositors and economic slowdowns. It was only after the 1907 panic that Congress considered the creation of a central bank.
Coming onto financial panics. It occurs by the sudden loss of confidence in one or more financial institutions, leading the public to stop funding those institutions, for example through deposits. Formally, financial panic is possible in any situation where the longer-term, illiquid assets are financed by short-term, liquid liabilities; and in which short-term lenders may lose confidence in the institution they are financing or become worried that others may lose confidence. Suppose there were no deposit insurance, no FDIC and imagine a bank, which as usual makes loans and finances itself through the deposits of the public. Now if for some reasons a rumour goes around that the bank has made some bad loans and is running losses. Since the individuals might not know if the rumour is true or not and one might think that if others believe the rumours to be true and pull out their money, the last individual might not get anything. So, all the depositors will try to pull their money out. Now, since no bank holds all its deposits (since they are lent as loans), so after the reserve cash is exhausted, the only way to get liquidity is to dispose of their loans. But this is a time taking process for banks. Thus, panic can lead to a closure of the bank and act as a self-fulfilling prophecy. Problems in one bank might also propagate to other parts of the system. In the pre-FDIC time, the banks would simply close their windows and reject to provide money to the depositors in order to save from bankruptcy. But this creates problems for depositors, obviously. These were also accompanied by stock market crashes, and overall were bad for the economy.
The way the Fed can help under such situations of panic are by buying the loans and providing cash to the bank. Thus the bank can pay the depositors and as long as the bank is solvent, the panic can be quenched. Therefore, by taking up the illiquid assets (the loans), federal reserve can pump liquidity into the system, pay off depositors and short term lenders, and end the panic. It was actually a journalist, Walter Bagehot who had a dictum that the central banks should lend freely, against good assets and charge a higher interest rate (a penalty rate) on the lent amount. Without this lender of the last resort function, many institutions will have to close their door or they could go bankrupt. If they have to sell their assets at discount fire-sale prices, that would also create problems because other banks would find the value of their assets going down and so the panic can spread throughout the banking system. Thus it is important to go into the system and provide liquidity and reduce the stress on the system.
The 1910s - Origins Origins of the Federal Reserve: The Federal Reserve law was passed in 1913 under president Woodrow Wilson and it was founded in 1914. After the civil war, any kind of financial stability function that couldn’t be done by the treasury was done privately, notably the New York Clearing House. It was the club of big banks in the New York and it was called the clearinghouse because it served as a place where banks could clear cheque’s against each other. But with time, the clearinghouse started to act as the central bank, in the sense that if one of the banks comes under pressure the other banks would come together and lend to save the other bank. But the system also had issues in the sense that they were non-governmental institutions which created credibility issues. Also, the system did not have enough resources. It was only after the financial crisis of 1907 that a detailed report was requested by Congress to create the central banking system in the US.
During the creation of the central bank, and even now, there has been quite a debate about the gold standard. In a gold standard, the value of the currency is fixed in terms of the quantity of gold. A true gold standard thus automatically creates a monetary system. The gold standard sets the money supply and price level generally with limited central bank intervention. On the downside,
The 1920s - stable
A central bank is not a regular bank but is a government agency. They are at the centre of the financial system and play a major role in the economic policy. Today virtually every country has central banks, except, in the currency unions where several countries share a common central bank, for example, the European Union.
The missions of a nation’s central banks are
1. Macroeconomic stability: All the central banks strive for low and stable inflation; most also try to promote stable growth in output and employment
2. Financial stability: Central banks try to ensure that the nations financial system functions properly; importantly, they try to prevent or mitigate financial panics
The tools available for central banks to achieve these objectives are
1. Monetary policy (for macroeconomic stability): Central banks adjust the level of short term interest rates (by buying and selling securities in the open market) to influence spending, production, employment, and inflation
2. Provision of liquidity (for financial stability): Central banks provide liquidity (short term loans) to financial institutions to help calm financial panics, serving as the “lender of last resort”
3. Financial regulation and supervision: To the extent that supervision helps keep firms financially healthy, the risk of loss of confidence by the public and an ensuing panic is reduced. This instrument, however, is not unique to central banks. For example in the United States, the FDIC or the Office of the Controller of the currency work with the fed in supervising the financial system
Where do Central Banks come from? The earliest central banks were in Sweden (1668), the Bank of England was founded in 1694 and for several decades was the most influential central bank in the world, while France had introduced central banks in the 1800s.
The bank of England in 1694 wasn’t set up from the scratch, in fact, it was a private institution and over the time it acquired some of the functions of central banks, such as issuing currency. Over time then they became government agency. One of the most important responsibility of central banks was to manage the gold standard, that is, issuing paper the currency that was backed by gold.
The lender of the last resort function became important only in the 19th century and the Bank of England had achieved mastery in it. So, in the latter part of 19th century, while, the United States was suffering from a banking crisis, the United Kingdom’s banking structure was quite stable. Thus the Bank of England in a way set up some practices which are still used today by other central banks around the world. The United States had suffered severe panics in 1873, 1884, 1890, 1893 and 1907 which led to several bank closures, losses to depositors and economic slowdowns. It was only after the 1907 panic that Congress considered the creation of a central bank.
Coming onto financial panics. It occurs by the sudden loss of confidence in one or more financial institutions, leading the public to stop funding those institutions, for example through deposits. Formally, financial panic is possible in any situation where the longer-term, illiquid assets are financed by short-term, liquid liabilities; and in which short-term lenders may lose confidence in the institution they are financing or become worried that others may lose confidence. Suppose there were no deposit insurance, no FDIC and imagine a bank, which as usual makes loans and finances itself through the deposits of the public. Now if for some reasons a rumour goes around that the bank has made some bad loans and is running losses. Since the individuals might not know if the rumour is true or not and one might think that if others believe the rumours to be true and pull out their money, the last individual might not get anything. So, all the depositors will try to pull their money out. Now, since no bank holds all its deposits (since they are lent as loans), so after the reserve cash is exhausted, the only way to get liquidity is to dispose of their loans. But this is a time taking process for banks. Thus, panic can lead to a closure of the bank and act as a self-fulfilling prophecy. Problems in one bank might also propagate to other parts of the system. In the pre-FDIC time, the banks would simply close their windows and reject to provide money to the depositors in order to save from bankruptcy. But this creates problems for depositors, obviously. These were also accompanied by stock market crashes, and overall were bad for the economy.
The way the Fed can help under such situations of panic are by buying the loans and providing cash to the bank. Thus the bank can pay the depositors and as long as the bank is solvent, the panic can be quenched. Therefore, by taking up the illiquid assets (the loans), federal reserve can pump liquidity into the system, pay off depositors and short term lenders, and end the panic. It was actually a journalist, Walter Bagehot who had a dictum that the central banks should lend freely, against good assets and charge a higher interest rate (a penalty rate) on the lent amount. Without this lender of the last resort function, many institutions will have to close their door or they could go bankrupt. If they have to sell their assets at discount fire-sale prices, that would also create problems because other banks would find the value of their assets going down and so the panic can spread throughout the banking system. Thus it is important to go into the system and provide liquidity and reduce the stress on the system.
The 1910s - Origins Origins of the Federal Reserve: The Federal Reserve law was passed in 1913 under president Woodrow Wilson and it was founded in 1914. After the civil war, any kind of financial stability function that couldn’t be done by the treasury was done privately, notably the New York Clearing House. It was the club of big banks in the New York and it was called the clearinghouse because it served as a place where banks could clear cheque’s against each other. But with time, the clearinghouse started to act as the central bank, in the sense that if one of the banks comes under pressure the other banks would come together and lend to save the other bank. But the system also had issues in the sense that they were non-governmental institutions which created credibility issues. Also, the system did not have enough resources. It was only after the financial crisis of 1907 that a detailed report was requested by Congress to create the central banking system in the US.
During the creation of the central bank, and even now, there has been quite a debate about the gold standard. In a gold standard, the value of the currency is fixed in terms of the quantity of gold. A true gold standard thus automatically creates a monetary system. The gold standard sets the money supply and price level generally with limited central bank intervention. On the downside,
1. It also incurs large costs, since the gold
needs to be dug up and brought back and kept in the vaults of New York banks
2. Another problem is that since the money
supply is determined by the supply of gold, it cannot be adjusted in response
to changing economic conditions. The variability in output and inflation was
much greater under the gold standard
3. Additionally, it also creates a system of
fixed exchange rates. As a result, the effect of bad policies in one country will
be transmitted to the other country. For example, in 1900 the value of an ounce
of gold was equivalent to a dollar. At the same time, the British roughly set
their ounce of gold with four sterling pounds. In this way, the dollar and sterling
were fixed. Another example, until recently China had tied its currency with
the dollar. So, if the Fed reduces the interest rates, China would be forced to
do the same, since the interest rate needs to be same in both the countries
tied with fixed exchange rates, and those low-interest rates might not be
suitable for its economy
4. The central banks kept only some amount of
gold to back the entire currency because they relied on their credibility. If
for some reasons the market loses confidence in maintaining the gold standard then the
currency might suffer a speculative attack. This is what happened in 1931 to the
British. For reasons, investors lost confidence that sterling would be tied to
gold, as similar to the bank run, everyone ran to exchange their paper currency
with gold and soon the Bank of England was out of gold they needed to support
the money supply and thus they had to leave the gold standard
5. Although the gold standard promotes price
stability and inflation over the long run (decades), but in the medium run, it
can create periods of inflation or deflation. This is because the value of
money would vary with the gold strikes. In the second half of 19th
century, a global gold shortage led to deflation. This squeezed the income of
farmers, but their debt payments were intact and thus created problems for them
Finally, in 1913 Congress
passed the Federal Reserve Act, establishing the Fed in 1914. The fed was created to
serve as a lender of last resort and to avoid the sharp swings in interest rates
created in the gold standard regime. The Federal Reserve actually consists of
12 fed’s located at major cities in the US and is governed by the board of
director’s in DC.
The 1920s - stable
So, the 1920s were a
stable period for the US. Elsewhere, however, the countries were struggling the
post-world war 1 effect.
The 1930s - The Great depression
Unfortunately, in 1929 the world was hit by the great depression. The US stock market crashed, outputs plummeted, unemployment rose (nearly 25% at its peak) and prices fell drastically. Not only banks in the US suffered bankruptcy, but even bank in Austria, Credit-Anstalt collapsed taking with it several other European banks. The depression continued until the United States entered World War 2 in 1941.
The 1930s - The Great depression
Unfortunately, in 1929 the world was hit by the great depression. The US stock market crashed, outputs plummeted, unemployment rose (nearly 25% at its peak) and prices fell drastically. Not only banks in the US suffered bankruptcy, but even bank in Austria, Credit-Anstalt collapsed taking with it several other European banks. The depression continued until the United States entered World War 2 in 1941.
The main causes of the
great depressions were
1. Economic and financial repercussions of world war 1
2. The structure of the international gold
standard
3. Bubble in stock prices in the late 1920s
4. Financial panic and the collapse of major
financial institutions
5. “Liquidationist” theory, which viewed the
depression as correctness to the excess bloomings of the 1920s
Unfortunately, the Fed failed
this test because
1. The fed did not ease the monetary policy
the way it was expected from them during a deep recession for a variety of
reasons, one amongst which was fear of speculative attack as the British had
faced earlier. In order to preserve the gold standard, they increased the interest
rates than lowering them, as it would keep the US investments attractive. The tight
policy led to deflation and declines in the output. Further, the policy errors
were transmitted globally through the gold standard. After the US left the gold
standard in 1933, the deflation stopped
2. The fed responded inadequately to the bank
runs and the contraction of bank lending. As a result, almost 10,000 banks
failed in the 1930s, and it continued till the deposit insurance was created in
1934. The fed acted in this way because some banks were insolvent and nothing could
be done in that case, but also, the fed agreed with the liquidationist
believing the system needed to be reduced
In 1933 Roosevelt came
into power and took several steps to combat with depression including,
1. Creation of deposit insurance
2. Abandonment of the gold standard
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