Academic journal article Atlantic Economic Journal

Financial Collapse: 1933

Academic journal article Atlantic Economic Journal

Financial Collapse: 1933

Article excerpt

ALLAN H. MELTZER [*]

Financial collapse in the winter of 1933, culminating in the "bank holiday" of early March, was a climactic event. It ended the downswing phase of the great depression. It produced widespread losses to depositors and owners of bank capital, which, soon after, led to the establishment of the Securities and Exchange Commission, separation of commercial and investment banking, federal deposit insurance, and other landmark financial legislation. It put an end to the gold standard in the U.S., followed in a few years by the remaining adherents of that standard. (JEL D2)

Introduction

U.S. Congress established the Federal Reserve in 1913 in part to prevent financial panics. The Federal Reserve took a few, hesitant expansive actions until 1932, offered no advice to the administration, responded slowly to administration requests, and watched as bank failures and state bank holidays spread during January and February 1933. In contrast, its legal staff prepared for a national bank holiday. That work served as the basis for the March holiday.

A year earlier, in February 1932, the Federal Reserve had started the largest open market purchases ever undertaken. Within six months, it completed more than $1 billion in purchases. Purchases stopped in August 1932 and did not resume. During the climactic events in February 1933, the open market committee did not meet, although the New York reserve bank made some modest purchases.

Understanding why purchases ended in the previous summer helps to explain why the Federal Reserve, facing a financial collapse, did not resume purchases in the winter. This is only part of the story. There is also an extraordinary tale of officials unable to make decisions, political maneuvering by the new administration, and a lack of understanding about the role the Federal Reserve could play.

End of the Purchase Program

Large sustained open market purchases began in February 1932. The intent was to stop the decline. By May, the decline in portfolios ended at weekly reporting member banks. Bank loans continued to fall but the rate of decline slowed. Interest rates declined at all maturities. Several governors commented on the program's success at the April meeting of reserve bank governors.

Opponents of purchases remained unconvinced. They believed that purchases of government securities financed speculative credit. Only purchases of real bills (credit expansion that financed production or trade) would help. Such purchases could not be induced by increasing speculative credit.

The slight signs of improvement did not last. By the end of May, the risk premium, measured by the spread between Baa and Aaa yields, rose to the highest level experienced in the depression. Despite open market purchases of more than $100 million a week, Aaa rates were back to the December level, and Baa rates were at a new high. Gold outflow to Europe, mainly to France, increased during the spring. The gold stock fell below the level reached at the previous cycle peak in 1929, one of the few times this had occurred during the downswing. Perhaps influenced by the new rules for collateral under the Glass-Steagall Act, or fear of Congressional monetary action, the members of the Governors' Conference paid little attention to the gold movement and authorized additional purchases of $500 million, at a reduced weekly rate.

Bank lending, commercial paper and acceptances continued to fall. Industrial production fell 5 percentage points in May to a level 9 percentage points (15 percent) below the December 1931 level and 50 percent below the 1929 peak. Wholesale and consumer prices continued to decline, and the index of farm prices was 16 percent below the previous December level, a 38 percent annual rate of decline.

Banks held as excess reserves more than one-third of the $600 million purchased in April and May. Governors Young (Boston) and Martin (St. …

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