Door Opens For Scrutiny Of Federal Reserve

Before the creation of the Federal Reserve, Friedman and [Anna] Schwartz noted, bank panics were typically handled by banks themselves – for example, through urban consortiums of private banks called clearinghouses. If a run on one or more banks in a city began, the clearinghouse might declare a suspension of payments, meaning that, temporarily, deposits would not be convertible into cash. Larger, stronger banks would then take the lead, first, in determining that the banks under attack were in fact fundamentally solvent, and second, in lending cash to those banks that needed to meet withdrawals. Though not an entirely satisfactory solution – the suspension of payments for several weeks was a significant hardship for the public – the system of suspension of payments usually prevented local banking panics from spreading or persisting. Large, solvent banks had an incentive to participate in curing panics because they knew that an unchecked panic might ultimately threaten their own deposits.

It was in large part to improve the management of banking panics that the Federal Reserve was created in 1913. However, as Friedman and Schwartz discuss in some detail, in the early 1930s the Federal Reserve did not serve that function. The problem within the Fed was largely doctrinal: Fed officials appeared to subscribe to Treasury Secretary Andrew Mellon’s infamous “liquidationist” thesis, that weeding out “weak” banks was a harsh but necessary prerequisite to the recovery of the banking system. Moreover, most of the failing banks were small banks (as opposed to what we would now call money-center banks) and not members of the Federal Reserve System. Thus the Fed saw no particular need to try to stem the panics. At the same time, the large banks – which would have intervened before the founding of the Fed – felt that protecting their smaller brethren was no longer their responsibility. Indeed, since the large banks felt confident that the Fed would protect them if necessary, the weeding out of small competitors was a positive good, from their point of view.

In short, according to Friedman and Schwartz, because of institutional changes and misguided doctrines, the banking panics of the Great Contraction were much more severe and widespread than would have normally occurred during a downturn. …