Banking Panics during the Great Depression

One of the key events of the Great Depression was the bank panics, which significantly added to the severity of the Contraction of the US economy. About every second bank failed during this dramatic period, causing money supply shrinkage, which, in turn, led to still deeper contraction of the economy. Despite the real power to ease the situation, the Federal Reserve is believed to have failed to perform its function of stabilizing the banking system. Yet the banking panics of the Great Depression was a very valuable lesson for the economists of the US and the world, which helped to avoid big depressions and bank panics in the US since.

Contents

1. Reasons for the Bank Panics
2. Banking Panic and Money supply
3. Timeline of the Great Depression Bank Panic
4. Points of View on the Great Depression Banking Panics
5. Lessons of the Banking panics of the Great Depression

Russia had just experienced the worst financial crisis in its recent history, when I got the opportunity to conduct a research for US Economic History class. I chose a similar banking crisis in America during the Great Depression. I concentrated my research on the reasons for and the consequences of the banking panics, traced the chronology of the series of bank crises of 1931-33, conducted a survey of opinions about the interpretations of the bank failures, and finally discussed several preventive measures to the problem.

Reasons for Bank Panics

It's worth going over the reasons for banks panics before starting to evaluate the real facts of the Depression. Banking panics were very frequent during the Roaring Twenties and the Great Depression. During that time there did not exist a Deposit Insurance System in the United States. That meant that if a bank were holding your savings and went bankrupt, you could say "bye-bye" to your money. Your savings were gone with the wind, or to be more precise, with the bank. Obviously depositors felt uncomfortable every time they started to believe their bank was about to fail. What most people would do is to go to the bank and take their money out. The problem was that everybody did the same thing, the result being so called a run on the bank. And since most people are risk averse and love money they will not wait for the facts about the actual bank position and would rush to their banks with the first rumor heard.

What this means to a bank is a huge outflow of deposits. Its reserves quickly depleted, bank lacks liquidity and weather it had been a junk bank or a healthy one, it goes bankrupt if the run lasts for a long enough time. The run on the bank stops when the bank fails or something happened to restore people's confidence in the bank. Here we come across the concept of the public and private cost benefit contradiction. Where as it is to great benefit of individual depositor to withdraw his or her funds from the bank it is far from beneficial to the depositors as a whole, because the more funds withdrawn from the bank, the more likely it is to fail.

A failure of one bank can cause depositors of other banks suspect that their bank can also fail. A new run on a bank starts, and the cycle continues until most of the banks fail; the process is known as a domino effect.

Interestingly, bankers� efforts to avoid runs on their banks can only make the situation worse. To prepare itself for deposits outflows banks start to accumulate liquid assets - selling securities, and calling in outstanding loans (the process is known as "scrambling for liquidity"). This, in turn, results in outflows of deposits from other banks and multiple contraction of deposits. In all, this means it is more likely that other banks will fail. The banking system as a whole is now more vulnerable to crisis.

Banking Panic and Money supply

Occurrence of bank panics are not only a consequence of, but also a reason for bad economic conditions in the country, they affect the situation also. This interrelationship is mainly brought through money supply. Depositors trying to avoid losses from bank failures convert their deposits into currency causing Currency/Deposits ratio to rise. There is less money for the multiple expansion process, the money multiplier decreases, causing, in turn, the fall in overall money supply. In addition, banks start to scramble for liquidity - starting to increase their excess reserves relative to the level of deposits to meet potential outflows of the deposits (Excess reserves / deposits ratio rises). This also takes out another portion from the money base of the multiplying process, which also causes the money supply to fall. So a bank panic will have very negative affects on the money supply (Mishkin 379).

Not surprisingly so that the worst decline in the money supply in the US history occurred during the bank panic of the Great Depression, which started in late 1929 and ended in March of 1933.

Timeline of the Great Depression Bank Panic

The banking sector experienced strong growth during the first two decades of this century. The number of banks almost tripled in this period and was about 30000 in 1920 (Wood). The same time the rate of banks' failures averaged about 70 a year, or one out of every 300. The agricultural depression of 1920s raised the suspension rate to more than 600 per year, or 1 out of every 50. The poor banking statistics did not show any positive signs when the America entered the Great Depression ('What role...").

In the fall of 1930 the number of failures increased sharply. The failure of 256 banks with $180m of deposits in November was followed by the close of additional 352 with over $370m of deposits in December with the most dramatic one being the Bank of United States with $200m of deposits (Friedman and Schwartz 308-309). The depositors and bankers acted as they always did under such circumstances. The former were trying to insure their savings by converting them to currency, the later in anticipation of future runs improved their liquidity position. Despite the large withdrawals of deposits which worked to deplete banks' reserves, reserves actually increased slightly in absolute terms and sharply relative to deposits.

The first crisis did not last long. Suspensions ceased in January 1931, banks stopped scrambling for liquidity. Ratios of currency to deposits and reserves to deposits were slowly falling back to pre-crisis levels. For that period the money stock declined by 3%, which was the result of the sharp increase in deposit ratios as the monetary base increased by 5% (Friedman and Schwartz 342). The increase in the base was due to two major factors - inflow of gold and rise in the Federal Reserve's credit outstanding. Both of them helped to offset some of the immediate effect of the banking crisis. Unfortunately this rise in Federal Reserve bank's credit was temporal and later on the Fed virtually did nothing to decrease any consequences of the further crises and depression.

In March 1932 a second banking panic started a new decline in money stock at an accelerated rate. People resumed converting deposits to currency and bankers resumed scrambling for liquidity. As Milton Friedman and Anna Schwartz put it in their "A Monetary History of the US" "once beaten, twice shy, both depositors and bankers were bound to react more vigorously to any new eruption of bank failures." The currency/deposit ratio started to rise at much higher rate than it was during the first panic. For the six months of the second crisis the deposits declined about 7 % and currency at hand had risen as well. The downward pressure on the money stock, which resulted from another increase in deposit ratios, was again partially offset with gold inflows from abroad. Unfortunately this was the only force against the money decline. The Federal Reserve System did not take any actions in preventing this negative situation. As a result the second bank panic was much more sever than the first one. The money stock decline rate was rising from March to August money supply fell 5.25%, or phenomenal annual rate of 13% (Friedman and Schwartz 343).

International turmoil added to American financial crisis in September 1932, when Great Britain left the gold standard. Other major world players followed the suite so that the membership of the "gold club" fell from 47 countries in 1931 to only 7 by the end of 1932, including the US (Atack 610). The loss of so many members contributed to general uncertainty about the American dollar. The Fed reaction to the fears of the dollar's devaluation was to increase the discount rate, making it more expensive to borrow from the Reserve System for banks. The banking situation worsened once more. "In October 522 ceased, and in the six-month period from August 1931, 1860 banks with deposits totaling almost $1.5 trillion suspended operations" (Atack 611).

The following several months of recovery turned out to be temporal; by the end of 1932 bank failures once again started to pile up. State wide bank holidays started to become more and more popular When runs on individual banks in Nevada were about to spread out to the whole state, a state banking holiday was declared on October 31, which allowed banks to get away from meeting their obligations. Other states followed the suit and by March 1933 holidays were declared in about half of the 50 states. Bank problems were transferred from one state to another - when a holiday was declared in one state its banks withdrew funds from their correspondents to strengthen their position. At long last a nation wide bank holiday was proclaimed on March 6 by president Roosevelt . All banks were closed until March 13-15 depending on its location. The final banking crisis was the most difficult of the three. The money supply declined 12 % in the first two months of 1933, or 78 % annually (Friedman and Schwartz 330). As in the earlier crises the high-powered money continued to rise. The other negative trends of the first two panics were also present. The reaction of depositors and bankers were the same but the magnitude was much greater in response to the greater severity of the crisis. Currency holdings of the population rose 16 % from the end of 1932 to February 1933 (Friedman and Schwartz 326).

In all, the series of the banking crises were the main cause of the unprecedented contraction of 31 % in money supply - the largest in American history. Even more remarkable is the fact that during the period monetary base almost constantly had increased by 20 %. This fact illustrates how essential the deposit ratios can be. during bank panics in the determination of the money supply.

Points of View on the Great Depression Banking Panics

The causes and consequences of the bank panics are still far from clear. Each economist has his or her own view on the topic, in many cases different from the rest of them. For example, in 1994, Robert Whaples surveyed members of the Economic History Association with questions about American economic history. The members showed considerable agreement on a wide variety of topics, including the profitability of slavery and the role of the railroads in nineteenth century American economic growth. However, this did not hold true for the questions about the causes of the Great Depression. 48 % of respondents agreed with Friedman and Schwartz that monetary forces were the primary cause of the Great Depression. The rest - 52 percent - disagreed. Slightly more (61 percent) agreed with Temin that a fall in autonomous spending as the primary explanation for the onset of the depression. Yet, quite a few (39 percent) generally disagreed with this theory. Finally, 32 percent generally agreed that the Fed had enough power to stop the banking collapses and the depression at an early stage. The largest group (43 percent), "agreed - but with provisos" with this proposition, while 25 percent generally disagreed with it (Whaples). It can be seen that there are several view points on the horizon - I think it would be valuable to learn some of them.

One leading interpretation of causes and reasons for the Great Depression and banking panics is found in Milton Friedman and Anna Schwartz's "The Great Contraction" and "A Monetary History of the US." They conclude that "monetary forces were the primary cause of the Great Depression." They believe that series of bank panics caused the multiple contraction of deposits, which in turn caused the money supply to decrease sharply to unprecedented levels. As a result the economy as whole went bankrupt. Friedman and Schwartz blame the Reserve System for not recognizing the threat and its passivity during this important period for the US. "Proper action would have eased the severity of the contraction and very likely would have brought it to an end at a much earlier date" (Friedman and Schwartz xi).

Another leading interpretation rejects much of this line of reasoning and argues that the banking failures were a symptom, not a cause, of the depression. The most notable proponent of this argument, Peter Temin ("Did Monetary Forces Cause the Great Depression?", New York, 1976), maintains that "a fall in autonomous spending, particularly investment, is the primary explanation for the onset of the Great Depression" (137).

In "The Banking Panics of the Great Depression", Elmus Wicker makes detailed analysis of the pre-crisis and crisis situation and came up with interesting findings and conclusions. First, Wicker found a new banking panic in June 1932 in Chicago that other researchers had overlooked. Second, he argues that the panics were not nationwide but local and spread unlike the previous banking panics from rural areas rather than from New York. Also, Wicker argues that panics were caused mostly by managerial mistakes of particular weak banks - large, secure banks had little to worry about. In addition, Wicker shows how idiosyncratic the final, devastating run (February and March, 1933) was. He argues that this panic was actually a panic among politicians (especially state governors and legislators who shut down banks, declaring a "bank holiday") rather than among depositors.

As for the Federal Reserve's role, Wicker thinks the Fed "could and should have done a lot more" (Whaples). Friedman and Schwartz argued that the Fed was not merely guilty of inaction (i.e. allowing banks to fail by doing little to stop the bank panics) but that the Fed's perverse actions helped cause the Great Depression - when it increased its rate of interest to banks at a critical juncture in the banking panic of October 1931. Wicker deflates this argument by showing that this banking panic was well underway and nearing an end before the Fed's actions. The Fed did not exercise leadership and did not take seriously its responsibility as a lender of last resort to banks on the brink of failure. On the other hand, Wicker praised the Fed for trying to provide "an elastic currency" in accordance with the Federal Reserve Act, which might have meant actions to ensure a growing stock of money.

Lessons of the Banking panics of the Great Depression

The banking panics of the Great Depression proved to be very devastating to the banking industry, depositors and to the economy as a whole. Here comes the legal question - how can they be prevented from happening and what should all the concerned parties - bankers, depositors and government - do to avoid them. I found at least four possible solutions to the problem, let us look at them one by one.

One possible strategy banks can pursue during a banking panic is to pool together and support troubled banks with supplying them enough reserves to survive the run. This would prevent the domino effect in case that troubled bank failed and the panic extended to other financial institutions. However, it would not be very helpful if a large financial crisis begins (like during the Great Depression). And the whole banking sector is too weak to support itself. In this case the need for external support of the collapsing industry is obvious.

Another alternative is to declare a bank holiday to stop the panic. This practice is in detail discussed in Milton Friedman's "A Monetary History of the US." By declaring a bank holiday a state or federal government allows banks to suspend payments to their creditors, particularly conversion deposits to currency. This bank holiday was common throughout the history of the banking system in the US. Before the Great Depression only one class of payments was suspended, conversion of deposits into currency, to sustain other types of operations: banks actually stayed open, making loans, transferring money by check, etc. The bank holiday of 1933, according to Friedman, was of different nature. All banks were closed, all operations were stopped. In addition, the holiday itself was not timely, declared after the liquidity crisis, not before, which could result in nothing but bank bankruptcy. Out of 5000 banks still in operation on the day of declaring the holiday, 2000 never reopen their doors thereafter. "The 'cure' came close to being worse than the decease" (Friedman and Schwartz 330).

Yet another alternative to save the banking system during a banking panic is the Federal Reserve System. As a lender of the last resort the Fed is to supply enough reserves to the banking system so that bankers have enough money to handle the withdrawals of the deposits. Moreover if the Central bank is known to perform this function the depositors will no longer have the incentive to take out their money from the banks and bankers to scramble for liquidity accumulating excess reserves. Unfortunately the Federal Reserve System failed to perform this valuable function of the lender of the last resort in the banking crisis of early 1930s, which resulted in the dramatic consequences for the US economy.

The final and the most important alternative to prevent bank panics is establishing a government insurance of bank deposits, so that in case of bank failure every depositor could receive their money back. The full coverage of the bank deposits would eliminate any incentive for depositors to withdraw their money from banks.

For this purpose the Federal Deposit Insurance Corporation began its operations on January 1, 1934. Initially the FDIC covered only $2500 of the deposits held by individuals in an insured bank. The limit was raised several times to the current $100'000 limit (Golfeld 105). The FDIC is financed with insurance premiums, which accounted to 1/12 of 1% of total deposits of the insured banks. Out of these premiums the Corporation pays its operational expenses and adds to insurance reserve, from which payments to failed banks' depositors are made. To ensure the soundness of the banking system in general and every bank in particular, the FDIC conduct inspections of the insured banks. Even by moderate standards operations of the FDIC have been success. Since its establishment the number of banks failures have been relatively low. Moreover, those that occurred did not expand to other banks and, thus, did not turn into a panic.

In conclusion, I want to mention that the banking panics of the Great Depression were the most sever and extensive the US economy ever experienced. The number of banks that failed was unprecedented. Total number of banks decreased from 29'788 in 1921 to 13'949 in June 1933 with the net fall of 15'839, or 53%! (Woelfel 86). Many analysts agree that inaction of the Federal Reserve was one of the key factors in this financial; turmoil. Yet the Great Depression and the banking panics proved to be unfortunate lessons, which helped to prevent large depressions and bank panics ever since. This was achieved mainly though the two institutions of the United states: the Federal Reserve System, which has been acting as the lender of the last resort to the troubled banks; and the Federal Deposit Insurance Corporation, which insures bank deposits and thus eliminates a primary reason for a bank panic.

List of Works Cited