Great Depression Bank Failures

In my last blog, I focused on how government attempts to protect the economy from foreign competition helped turn a recession into the Great Depression. Now I want to focus on how government inaction further helped take the economy in this direction. This time I will focus on bank failures. But first I need to explain how the government got involved in this arena.

In 1913, the government established the Federal Reserve Bank to be the lender of last resort. This means that the Federal Reserve stands ready to lend a bank money in an emergency bank run when no one else would. Before this, banks banded together in associations to rescue each other in the event of a bank run. Clearinghouses, which cleared bank checks also took up this role. A bank run occurs when depositors panic all at the same time and run to the bank to withdraw their deposits. Since a bank never keeps all the deposits, and lends out most of the money, a bank run can destroy a bank unless some entity steps in early and provides enough cash to convince depositors that the bank won't close and their deposits are safe. The government took over this role in 1913 when they established the Federal Reserve system.

Now banks fail every year. However, the number of bank failures doubled in 1930, and then doubled again in 1931. On December 10, 1930, a run started on one of the largest banks, the Bank of United States in New York. The next day, December 11, 1930, it failed. The Federal Reserve, still relatively new, did not act to save it. When people heard that a bank as large as the Bank of United States failed, they feared the money in any smaller bank where they held their money could not be safe. It triggered a run on banks across the nation and more and more banks failed. As a result, the money supply across the nation fell by about a third, and the private sector lacked the money to recover from the recession. This is because in economic terms, banks create money as they turn a percentage of deposits into loans. As banks failed, not only deposits were lost, but the money created through loans were lost.

Had the Federal Reserve stepped in and saved the Bank of United States, and then other large banks, it is unlikely the panic that ensued would have happened. The Federal Reserve should have done so because it had taken over this function from the private sector. Had it done so, it could have prevented the large scale bank runs that followed and the fall in the money supply. The economy would likely have recovered on its own as usually occurs in a business cycle. However, this combined with the slowdown in worldwide trade from the increase in tariffs from the Smoot-Hawley Act (see 2/8/08 post) helped to spiral the recession down into the Great Depression.

The bank situation, as well as the money supply began to get better by 1934 after the bank holiday imposed by President Roosevelt in 1933. However, by that time, most of the damage to the banking system and to the money supply had been done and helped to turn the recession of 1929-30 into the Great Depression.