What The Fed's Past Can Tell Us About Our Future

by: Justin Weinstein

Economic crisis often has a way of repeating itself time and time again. Although there are many differences between the Great Depression and today, similarities exist. The analysis I have done below is particularly fitting for the current state of our economy.

Though the landscape of our global economy differs from that of the 1920s, this evidence proves quite pertinent, as our nations Federal Reserve policy will need to change in the coming years to accommodate higher interest rates and a mounting US debt.

When interest rates rise, the question will become whether our nation is strong enough to withstand the economic shift in policy, or whether we will repeat the history of 1929. I do not believe the will result in a situation as dire as that in the Great Depression, but the question is worth asking: Could this happen again given the current debt, unemployment, and fiscal layout of our nation?

17 years before the worst financial crises in American History, Congressman Charles Lindbergh stated, "from now on, depression will be scientifically created." What Lindbergh failed to realize was that the true catalyst behind the banking crisis of 1929 was an unlikely source: the very institution he was working for.

The question of what a government institution's primary responsibility is, is one that has been debated since the founding of our nation's Constitution in 1788. Most believe the government should act on behalf of its people and work in their best interest. Hindsight is 20-20 and it can be concluded that the actions of the Federal Reserve during the period before that of the Great Depression was catastrophic in creating a financial "perfect storm."

The systemic risk the Federal Reserve took in making lending so easy; bringing war debts to the hands of banks in 1922, allowing leverage to be used in open markets during the majority of the 1920s, and tightening the supply of money so quickly in 1928 created a situation of adverse affect like no other financial crisis in history. The uncertainty within the Fed: changes in administrative personnel and fluxuation in interest rates, resulted in a change in the strategic vision and with that change came uncertainty - the very basis of fear. Three strategic events in a single decade: selling war debts in 1921, allowing rates to stay low, artificial growth to occur in 1921, and a tightening of the supply of money in 1928 caused 1929 to be the year remembered as the worst in modern, financial history.

The 19th century was one where the economy of America caught up to the vision that was born at its inception in 1776. With this change to being a world superpower came responsibility and a need for government regulation. The Fed decided that debt needed to be taken off the hands of individuals and put into those of banks; crafting a system to take long-term bonds and convert them into short-term assets.

This decision was a short term fix for the government to raise money to pay off war debts, but a long term blunder as was illustrated by the consequent effect in later years - lending beyond anyone's estimates with war debts at its roots. Much of these debts were taken on by banks due to their simple ability to carry debt at low cost. For this reason, banks in later years, 1923-1925, began to sell/issue credit or debt to individuals at extremely low rates.

The only step to make the Federal Reserve an effective institution was to lower rates to extraordinarily low levels so banks could lend this debt to individuals and create an environment of growth. What happened in 1922 was a microcosm of what would occur within the Federal Reserve - drastic change in policy that would lead to eventual financial instability.

Under Section 8 of the Constitution it states: "To make all laws which shall be necessary and proper as any of the States now existing shall think proper to admit, shall not be prohibited by congress." Within this piece of legislature is the assumed - the federal government is based on need; not excess, improvement; not corruption. Why then did the Federal Reserve fail to accomplish its main task? The answer is multi-facetted but one very important angle to be examined is that of the change of executive personnel, and therefore vision.

From 1916-1922, William P.J. Harding was the chairman of the Federal Reserve and was responsible for setting the strategic vision for stabilizing the economy. The inaction that occurred was a result of the three Fed chairman's different opinions and the lack of forward thinking on all of their behalf. Stability is brought to financial markets by a sound vision for the future, all three of these men had different visions and thus stability was unachievable because the net result was a consistently changing vision - Harding's sell of bonds, Kissinger's complacency, and Young's inability to lower rates equaled gross incompetency and an appalling depression around the corner.

True growth in an economy is material, real; it is intrinsic, value is created. The period of 1920-1928 was a period of growth that was unparallel and with it came optimism and thus speculation. This period was not one of little occurrence on a linear plane to personal fortunes; it was one characterized by a new idea of a truly "global economy" as well as the absence of a gold standard backing currency.

What the American people and the British alike did not realize was that they were creating a US economy fueled by pure speculation and the prospect that America was thriving based on an intrinsic increase in value of land, housing, companies, and product. If this boom was fueled by true growth, then a bust would not have occurred: leaving America without 25% unemployment and GDP-Debt at nearly 300%. In this way it can only be stated that although Elmus Wiker makes a convincing argument the Fed created an open market without reliance on a gold standard, it failed in its most critical role: to create stability and security within the US economy.

The five year stretch between 1922-1927 was not characterized by growth unforeseen in economies from around the world, but rather it was a time of growth due to an industrializing America and a monetary policy conducive to growth, but also due to low interests rates which were conducive to investing in business. The time of true growth (fictional it was) was that of 1928. Expansion was greatest and speculation flowed through the veins of Wall Street as well as Main Street. As many Americans did not know, Benjamin Strong - Chairman of the Federal Reserve - died unexpectedly (executive change). Strong was responsible for maintaining a consistent policy throughout his tenor, while it may seem as though he did not foresee the future, he did keep a sound economy in place.

George Harrison took over Strong's position, not knowing the precarious landscape that lay ahead. What allowed this were banks willingness to lend to nearly anyone creating an environment that led to expansion in the NYSE, but did not result in expansion of the true gross economy. Wavering in any policy within government creates weakness and panic. An economic history conducted by Ohio State University sheds light on the fact that rates were relatively low in 1925-1927, but after Strong's death rates increased under Harrison's guidance beginning a cycle into a place of peril: true economic catastrophe comes with change but also with one straw that can bring the house down (Member bank borrowing and fed).

In essence, the variable that changed in 1929, Federal Reserve Chairman's hike of interest rates, caused the true situation to appear and a domino effect to occur on the rest of the economy with the vicious circle of decrease in demand, increase in supply and a result of overproduction, layoffs and downturn (below). What would follow would not be the Federal Reserve coming to the rescue; rather a monetary policy that exacerbated the problem at hand.


The wavering of interest rates prior to the crisis of 1929 was jointly responsible (along with other issues) for the peril that arrived on Wall Street's door but what the Federal Reserve was "supposed" to do was stabilize an economy, come to its rescue. The relationship between the reserve and the American people is one of interesting note. When crisis hit it was because the Fed did not reassure the American people that this crisis would pass, they rather argued about what to do and through doing so created an environment of instability.

The reserve did not create an "accommodative" monetary policy during the crisis of 1929, and through that action turned what could have been a moderate recession into a depression. Secretary Mellon Sheds light on the "hand to mouth finance" (i.e. having no capital reserves for banks and individuals in place) that occurred before 1929, but in 29 the response to peril would have been to lower rates quickly and inject funds into the economy. Instead, through lack of cohesion within the reserve, the lowering of rates occurred at a very low rate (Keynes). Everyday with inaction created further ramifications. What can be gathered from this information is if the FED had had a more "accommodative" monetary policy the Great Depression would not have been as severe.

Reassurance was not given to the American people that the Fed would do all in its power and worst of all - inaction was the new policy of the reserve. While rates stayed stagnant, American investors searched for answers and none were given. Within the pages of the American Economic Review it explains that although the Fed took action during the period leading up to the panic of 29, they did not change course once their policy was not reversing the effects of contraction:

In the critical situation, which developed in the second half of the year 1928 the [Federal Reserve] board followed the course of waiting for proposals by the reserve banks to be submitted to it for review. No such proposals were made… (Miller)

The very sentence depicts the failed philosophy of the Fed; showing that within the time they were "waiting" they should have been crafting a plan to accommodate the ailing American people who were soon to be in a state of panic, characterized by the iconic images of bread lines and people running through New York City to get the pennies which their bank accounts still hold. This time directly before the crisis was of great significance because it depicts the mindset of the Fed - complacent.

The true question that needs to be answer is: How did a government institution that was supposed to serve to provide stability fail to do so in all ways? The answer to this question merely lies within the facts of what happened: an un-accommodative monetary and fiscal policy, alongside an American population that could not curb speculation when it came knocking on their door.

The assertion that the Fed was complacent in its inaction can be linked to the fact that overarching confidence existed in the American economy; proved to be a detrimental mistake. The corruption and the lack of cohesion within the reserve stopped any action within its tracks - leaving America in a state of peril, shooting a lifeline into the air while receiving little aid in return.

Intellectuals from around the United States have developed financial theories about what would have narrowed the scope of the Great Depression and analyzed the action of the Federal Reserve during the period. The Freidman-Schwartz hypothesis is regarded as a viable take on the period leading up to the crisis as well as that of during.

The hypothesis states that a more "accommodative" monetary policy i.e. lower interest rates, the ability to aid the ailing economy through stimulus/capital infusion, would have lessened the great depression to a severe recession. What is of important note is within an analysis done by the Federal Reserve in 2003 (the source itself): giving note that the FED was completely ineffective during the Great Depression and before the crisis because it failed to pursue, "consistently expansionary policy resulting in an incorrect understanding of monetary policy in an environment of very low short-term-nominal interest rates" (Governors FED, 1).

This sheds light that although the strategy of the FED was to lower interest rates, they did not provide a monetary policy that regulated and withdrew from corruptive practice. This ties directly from the findings within the journal (above), which says that if policy would have been consistent with expansion and providing "security" for Americans, resulting in a policy that promoted inflation not deflation, growth not wane, security not instability.

A financial depression is not caused by one specific action, one specific person, one specific issue: it is rather the culmination of many decisions that all lead to a "perfect storm." The Federal Reserve failed to create an environment of equilibrium and therefore failed the American people. The Federal Reserve was created in 1914 to do just what it failed to: provide a balanced economy that has the correct equation for expansion, lending, and control within an open market economy. Any company, country, or government institution has a strategic vision that when executed provides a result that is anticipated.

What the Federal Reserve had were several strategic visions that all differed slightly and thus resulted in a financial collapse like no other, one that could not be foreseen. The 16th president of the United States, Abraham Lincoln, stated, "You cannot escape the responsibility of tomorrow by evading it today." This statement is profound and applies to the Federal Reserve because it was evading the future of America by progressing a strategy that had irresponsibility at its heart; short term gain, not long term vitality. The Federal Reserve from 1921-1929 represents government corruption, a lack of thoughtful reaction, a story of disjuncture syllogism, and a failure to provide its greatest ability to the American people - Stability, security, equilibrium.

The Federal Reserves action in the 1920s triggered the largest financial crisis in US history. This lapse in judgement was due to a policy of change and inconsistency. Though Federal Reserve policy has stayed constant over the past several years (at 0% interest), this will need to change. The question becomes whether the rate shifts to come and ending of quantative easing will result in anything like what occured in 1929. Time will tell.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.