Case Analysis:
The United States Financial Crisis of
1931
The United States Financial Crisis of 1931
The rapid
deterioration of the economy in September of 1931 was sparked by Great Britain
leaving the gold standard, in addition to the US policymakers’ inability to use
decisive measures to combat the currency runs.
Policy solutions available today such as insuring bank deposits, a
floating exchange rate and the Federal Reserve’s use of open market operations
are essential to the strength of the financial sector and overall economy.
Fearing a
debasement of the dollar in relative terms of gold, the article highlighted the
willingness of investors to exchange dollars for gold in a time of panic. The policy of refusing to exchange currency
for gold in Great Britain on September 21st resulted in a direct loss of $116
million in U.S. gold reserves the following day. By the end of October, the U.S. banking
system lost approximately 15% of bullion reserve, or $727 million.[1] The lack of deposit insurance was devastating
to bank shareholders, leading to over 500 bank failures and a severely
constrained money supply. The advent of
the Federal Deposit Insurance Corporation in 1933 was a direct response to the
massive bank failures that occurred during the crisis (Harvard Business School 1983) .
The Federal Reserve System
The structure
of the Federal Reserve System played a fundamental role during the panic. Established by the Federal Reserve Act of
1914, the Fed used a decentralized structure of member banks in each region of
the country, with the Federal Reserve Board located in Washington, D.C. The
relationship between the member banks and the Board was complex and undefined,
with a profound effect on the way the supply of money and credit was allocated
throughout the system (Moss 2007) .
The Fed used
three primary tools to control the supply of money- the discount rate, purchasing
acceptances in international transactions and conducting open market
operations. Of the three measures, the
discount rate was the most widely used policy tool for controlling credit (at
the time of the crisis). The discount
rate was a lever used to inject liquidity.
A higher discount rate would imply less borrowing in the banking system
through higher interest rates. Through
acceptances, the New York Fed had the autonomy to guarantee short-term loans by
charging a fee, or acceptance rate. The
New York Fed created friction among other Reserve banks by their unique
position in the market, justifying the need to meet constantly-changing market
conditions. Open market operations were
an unrestricted monetary policy tool of buying (or selling) securities in the
market. The open-ended nature of open market operations was the most
controversial at the time and not fully realized under fixed-rate exchange
system. The conflict between the New York Fed and the Board among acceptances
and open market operations led to reorganization with diminished political
clout and more direct control in Washington (Harvard Business School 1983) .
Like other banks, the Fed’s position
in providing credit was stipulated upon receiving productive assets. In turn, the Fed held a gold standard equal
to a minimum of 40% of the value of bank notes, along with 35% of the deposit
base. Additionally, government
securities purchased in the market were not valid forms of collateral or
insurance. These stringent collateral
requirements were instrumental in restricting the ability of the Fed to deal
with the crisis sufficiently and hindering the effectiveness of open market
operations. When inevitable bank runs
occurred, depositors demanded gold putting significant pressure on the Fed’s reserves. This resulted in political pressure by the
Fed to raise the discount and acceptance rates to stop bank runs in October of
1931.[2]
The false sense of security in higher
interest rates may have helped the Fed retain gold reserves, but it hurt the
ability of commercial banks to borrow money and expand the economy. The belief that tight money was a sufficient
response to a liquidity crisis proved to be a disastrous form of monetary
policy, even though the Fed won approval from the Hoover administration and news
organizations such as Business Week
and the Commercial and Financial
Chronical. The gold standard was a
fixture in U.S. policy at the time, lacking the political capital to follow the
British lead. The foreseeable
international crisis that ensued when the British dropped the gold standard was
compounded by strict regulations requiring the Federal Reserve to collateralize
bank notes the Treasury issued with a deteriorating supply of commercial paper
and bullion (Harvard Business School 1983) .
Central Issue
The central issue for policy makers
and stakeholders was how to shore up the banking system, preventing bank
failure and instilling confidence in the financial system. Underlying this issue was the departure of
Montagu Norman from the gold standard, sparking investors to seek safety for
their money. The belief that money could be transferred into gold at a fixed
value provided stability and insurance. Gold had benefit of being a desirable
asset, an alternative to paper money and immune to the decisions of
policymakers.[3] However, this asset class was devastating in a
deflationary business cycle- the bullion supply could not be expanded quickly
enough to meet the demand of central banks when the asset was needed most.
Instead, central banks were forced to contract the money supply, charging
higher rates of interest to keep confidence in the system and gold in the
vaults.
When the Bank of England removed the
gold facility, Montagu inferred a devaluing of the pound against gold. Because
the pound conversion rate was previously fixed at a higher exchange rate than
the dollar, the move implied that the fixed dollar rate conversion at $20.67
per ounce was not justifiable – dollars were now worth less, even though the
exchange rate remained fixed. The
banking system’s fixed exchange rate proved to be problematic in times of
crisis. Based on current policy, the dollar exchange rate was not able to freely
adjust to take into account exogenous shocks to the system. Franklin D. Roosevelt (FDR) ended the policy
of exchanging dollars for gold in 1933 (Moss 2007) . Moreover, the Fed lacked the necessary policy
tools to maintain confidence in the banking system.
Policy Recommendation #1: Open Market Operations
One policy solution would be to let
the New York Fed conduct open market operations more freely, injecting capital
into the system, encourage borrowing at lower rates of interest and expanding
the monetary base . This has the advantage of creating liquidity through excess
reserves that the banking system desperately needed. The premise of open market operations is that
lower rates will spur borrowing, investment and demand for assets as the
dollars multiply throughout the system. The disadvantage is that the excess
liquidity may not necessarily create new money in the form of loans and capital
investment. According to the case study,
borrowing from the Fed declined 83% between July of 1929 and September of
1930. Unfortunately, the widely assumed
theory at the time implied that raising discount and acceptance rates would
increase cash flow and earnings, albeit without additional liquidity. The political desire for open market
operations was mute. The widespread
belief by the committee was that money was freely available, where the New York
Fed unsuccessfully lobbied for expansion through open market operations in
January of 1930 (Harvard Business School 1983) .
Policy Recommendation #2: Free Floating Exchange Rate
Allowing the exchange rate to float
is another recommendation for improving economic conditions at the time. This policy implies that the dollar-gold
exchange rate would change dynamically with market conditions. Another
advantage was that it allowed the Fed to control how much money was created (Moss 2007) . In reality, the demand and price of gold
fluctuated because of its scarcity- indicating downward pressure on real prices
(even though the nominal exchange rate remained fixed). The advantage of a floating currency is the
Federal Reserve would not be required to exchange gold at the fixed rate of $20
per fine ounce. For example, a floating exchange rate from a devalued dollar
would imply $35 per ounce if the shift in market expectations was drastic. This
would alter investors’ decisions about whether they should exchange dollars for
gold at the devalued price, since $35 per ounce would not be as attractive (Moss 2007) . The effect of a
floating exchange rate is the Fed would experience significantly less stress on
the excess reserves in deflationary environments, increasing the ability to
maintain higher levels of capital.
The disadvantage of this policy is
the possibility of inflation and unpredictable consumer behavior. Consumers may fear the worse and still end up
exchanging dollars for gold at the lower price (driving the price of dollars
down further). Additionally, foreign
investors may exchange dollars for other forms of currency with higher rates of
return, causing further downward pressure.
Allowing a currency to float had the ability to bring about inflation.
With a gold standard, the ability to print money was limited by the amount of
gold available in reserves. On the other
hand, a free floating currency could print as many dollars as necessary to
devalue the currency, expand the economy and facilitate inflation (or prevent
deflation).
Franklin D. Roosevelt accomplished
part of this policy by devaluing the dollar against gold by 40% (Moss 2007) . Executive order
6102, signed in April of 1933 prohibited the hoarding of gold by private
citizens. The order maintained the
Federal Reserve was the only entity allowed to do so legally (Peters and
Woolle n.d.) .
This policy had many of the same benefits as does a freely floating exchange
rate system, creating excess liquidity and relieving the Fed of the stress of
constantly removing dollars from the system.
Policy Recommendation #3: Insuring the Consumer Deposit Base
The insurance of consumer deposits
was an instrumental policy strategy, manifesting in the creation of the Federal
Deposit Insurance Corporation in 1933. The FDIC proved to be a unique strategy,
aimed at providing protection to citizens in the event of bank failure. The bank runs were sparked out of fear that
the customer’s money would be lost for good.
The mistrust in the banking system and inability to insure citizens that
their dollars were safe led to massive bank failures in the late 1920’s and
early 1930’s (FDIC n.d.) .
The main goal of the FDIC was to
establish confidence in financial sector, limiting the bank runs and insuring
consumers that their money was safe. The
FDIC would be funded by premium charged to banks for insuring their deposit
base. The long-run disadvantage of
insuring deposits is that the corporation could go bankrupt in the event of
widespread bank failure, exactly what it was designed to prevent. Moreover, it could be difficult to set
guarantee fees to anticipate future crisis. It is inevitable that premiums
charged to depository institutions may be too high in times of panic and too
low when the economy is expanding (FDIC n.d.) . Despite the disadvantages, deposit insurance
could be the swiftest, least controversial and most effective policy tool if
issued as Executive Order based on emergency measures.
Conclusion
The U.S.
Financial Crisis of 1931 was ignited by Norman Montagu’s decision to take Great
Britain off a fixed gold-pound exchange rate in September of that year. This led to momentous losses in U.S. gold
reserves. Policymakers eventually
implemented powerful solutions to shore up confidence in the financial sector,
but were slow to react to the dynamic changes in the market economy. The gold standard hindered the ability of the
Federal Reserve to conduct open market operations and devalue the dollar against
the bullion. Ultimately, 1933 saw the creation of the FDIC helped prevent bank
runs by insuring citizens that their money was safe. Furthermore, FDR outlawed the hoarding of
gold by private citizens and devalued the dollar against the bullion using an Executive
Order, creating desperately needed liquidity.
The timely implementation of these solutions could have helped prevent
additional bank failures, job losses and lessened the impact of the Great
Depression.
Works Cited
Ahamed, Liaquat. Lords of Finance: The Bankers who
Broke the World. 2009.
FDIC. History of the FDIC. n.d.
http://www.fdic.gov/about/history/index.html (accessed February 2013).
Harvard Business School. "The United States
Financial Crisis of 1931." Harvard Business School.
http://www.hbsp.harvard.edu, 1983.
Moss, David A. A Concise Guide to Macro Economics.
Boston: Harvard Business Review, 2007.
Peters, Gerhard, and John T. Woolle. Franklin D.
Roosevelt: 34 - Executive Order 6102 - Requiring Gold Coin, Gold Bullion and
Gold Certificates to Be Delivered to the Government. n.d.
http://www.presidency.ucsb.edu/ws/index.php?pid=14611.
Salsman, Richard M. The Bank Runs of the Early
1930s and FDR's Ban on Gold. April 2011.
http://www.forbes.com/sites/richardsalsman/2011/04/06/the-bank-runs-of-the-early-1930s-and-fdrs-ban-on-gold/
(accessed February 2013).
[1]
Franklin Roosevelt abandoned the conversion of dollars into gold in 1933. The
policy of fixed exchange rate would come back into favor again, but vanished
completely during the Nixon administration in 1971.
[2]
Raising the discount and acceptance rates had the effect of contracting the
money supply when demand for liquidity was at its peak. This is the exact
opposite of policy used today by the Federal Reserve Board.
[3]
Gold was immune in the sense that it could not be created artificially through
policy decisions. Germany’s crisis of hyperinflation in the early 1920’s to
repay war reparations with worthless currency left a lasting impression of the
dangers of hyperinflation.
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