Question

Why did the Federal Reserve fail to act as a lender of last resort during the Great Depression, and why did the Fed allow the money supply to contract and prices to fall by so much?

Answer 1

Leaders of the Federal Reserve disagreed about the best approach to banking crises. Some governors have subscribed to a theory close to Bagehot's dictum, which says central banks will loan funds during financial panics to solvent run-stricken financial institutions. Many governors signed on to a policy known as real legislation. This theory suggested that, during economic expansions, central banks would provide more funds to commercial banks, when individuals and firms needed additional credit to finance production and trade, and less during economic contractions, when demand for credit contracted.

The doctrine of real bills did not explicitly define what to do in banking panics, but many of its followers saw panics as signs of contractions when central bank loans were to contract. A few governors subscribed to an extreme version of the actual bills doctrine called "liquidationist," which suggested that central banks would stand aside during financial panics so that distressed financial institutions collapse. This pruning of weak institutions will speed up the creation of a more stable economic system. This strategy was supported by Herbert Hoover's treasury secretary, Andrew Mellon, who had served on the Federal Reserve Board.

Such analytical pressures and the dysfunctional decision-making process of the Federal Reserve made it difficult, and often impossible, for Fed leaders to take meaningful action. Such differences of opinion led to the most serious sin of omission on the part of the Federal Reserve: inability to curb the decrease in money supply. The money supply dropped by nearly 30 per cent from the fall of 1930 through the winter of 1933. Declining funding supply lowered average prices by an equal amount. This deflation increased debt burdens; skewed economic decision-making; reduced consumption; increased unemployment; and forced bankruptcy of banks, companies , and individuals.

The Federal Reserve could have avoided deflation by avoiding the failure of the financial system, or by counteracting the failure with monetary base growth, but for many reasons it failed to do so. The economic crisis had been drastic and drastic. Decision-makers lacked appropriate processes to assess what went wrong, lacking the power to take adequate measures to stabilize the economy. Some decision-makers misinterpreted signs about the state of the economy, such as the nominal interest rate, due to their adherence to the theory of actual bills.Some found maintaining the gold standard to be safer for the economy by increasing rates and the the supply of capital and credit than helping ailing banks with the opposite behavior.