An End to Private Banking: Early New Deal Proposals to Alter the Role of the Federal Government in Credit Allocation
Phillips, Ronnie J., Journal of Money, Credit & Banking
In his recent study of federal credit allocation, William Gale finds that since 1980, the federal government has subsidized, guaranteed, or directly extended more than one third of all borrowing by nonfederal sectors. For 1987, Gale estimates the welfare loss of these government interventions in the lending market to be one-third percent of Gross National Product (Gale 1991, p. 134). These programs take the form of direct loans to small businesses, rural businesses, farmers, foreign traders, disaster victims, minority enterprises, and students, and in guarantees to private firms. The mortgage market has a variety of government programs intended to increase credit for the housing sector (Kane 1977, p. 59).
Many of the current federal credit allocation programs were implemented during the Great Depression. In some cases (the Farm Credit System and Federal Home Loan Banks, for example) the New Deal merely expanded existing programs. The New Deal legislation grew from administration and Congressional efforts to shore up the financial markets and from frustration with what politicians (and perhaps the public) perceived to be the reluctance of private bankers to make loans to aid economic recovery. The argument presented then was that bank lending was crucial for economic recovery, banks were not lending (for whatever reason), and therefore the federal government would have to take a greater role in the allocation of credit. Similar arguments have been expressed today, especially in Congress.
The solution adopted in the New Deal period to perceived inadequacies of private credit markets was the centralization of monetary power in the hands of the Federal Reserve Board and the Federal Open Market Committee, and the creation of federal government institutions such as the Reconstruction Finance Corporation to directly allocate credit. Further, there was establishment of secondary markets which allowed, as an example, for the securitization of home mortgages. The path taken in the 1930s set us on the road to the socialization of lending. The result today is that we are confronted with growing demands for even greater government credit allocation and at the same time, face a decline in the effectiveness of Federal Reserve monetary policy to stimulate bank lending (Kahn 1991; Bernanke and Blinder 1988). The question which confronts us today is: how can we improve the conduct of monetary policy by the Federal Reserve and reduce the demands for federal credit allocation programs?
The answer to this question can be found in the debates over financial reform that took place in the early New Deal period (Phillips forthcoming). Proposals that were put forward by a number of economists, and widely supported in Congress, faced squarely the problem of distinguishing between money and credit and therefore monetary and credit policy. In these proposals, government had a role in providing a safe and stable payments system, but government interference with the private credit markets was minimized. Though these alternatives impacted the New Deal legislation, they were not enacted in their entirety. Had these proposals been implemented in place of the New Deal banking legislation, the evolution of the financial system, and especially the role of the federal government in credit allocation, might have been radically different.
These proposals, which involved definite provisions for government's role in money and credit, are directly relevant to the problems we face today: how to assure adequate private sector credit, yet avoid extensive government involvement. In this paper, these proposals for reform of the financial system will be presented and evaluated, and the reasons they were not adopted will be examined. Lessons can then be drawn for policy changes today which would both enhance the Federal Reserve's monetary control and at the same time reduce the demands for more federal government involvement in the private credit markets. …