How the Federal Reserve Created the Second Great Depression

By Robert Genetski
May 2, 2009

A year ago Beryl Sprinkel (chief economic advisor to President Reagan) and I wrote that "The Fed has inadvertently adopted an overly restrictive policy that has hastened the spread of bankruptcies and financial failure." We concluded that "While it is too late to avoid a recession this year, the Fed can still mitigate its damage by shifting to a more expansive policy."

Unfortunately, rather than adpot an expansive policy the Fed did the opposite. It adopted the most restrictive monetary policy since the 1930s. In doing so, the Fed has repeated the very mistakes it made in the 1930s and has created conditions for a second Great Depression.

A year ago, Fed Chairman Bernanke stated that the Fed had added liquidity and created an expansive monetary policy. In the Minutes of its meeting in March, 2008 the Fed's policy making committee concluded that the economy "was expected to begin to recover in the second half of the year, supported by recent monetary policy easing and fiscal stimulus." Instead, spending collapsed. It collapsed because the Fed misinterpreted its own policy.

Today, the Fed again believes that it has adopted an expansive monetary policy. If this belief is as wrong today as it was a year ago, then the current downturn will get progressively worse in the months ahead. While the details associated with monetary policy are different today than they were a year ago, the end result is the same—less spending, bankruptcies, significant layoffs and a panic reliance on government spending in a futile to attempt to rescue the economy.

Monetary policy is a powerful tool. The Federal Reserve has the power to create money out of thin air. When the Fed increases the amount of money, it creates pressures that boost spending. When it reduces the amount of money, spending can actually decline. A decline in spending leads to financial crises and ensuing bankruptcies.

The Fed increases the amount of money by purchasing securities. Since the Fed is the bankers’ bank, it pays for its purchases by informing banks that they have an increase in their deposits with the Fed. Bank deposits at the Fed are called bank reserves. These reserves are also referred to as high-powered money, since banks can loan or invest these reserves and thereby expand the high-powered money several times over. In the entire history of the Federal Reserve there have been only two occasions where the Fed has reduced bank reserves for three consecutive years. The first was at the beginning of the Great Depression of the 1930s. The second time was recently, beginning in late 2004.

A year ago, the Fed claimed it was adding liquidity to the system. It was not. While it was increasing bank reserves by purchasing securities from private companies, at the same time it was selling government securities from its portfolio. The net result was little change in bank reserves. As recently as last August, the level of bank reserves was less than in late 2004. Although economic activity had increased by over 20% during that period, the Fed had reduced the amount of reserves available for loans and investments to less than had existed four years earlier. This monetary squeeze contributed to the crisis in financial markets.

Last September, when it became obvious that the economy was in serious trouble, the Fed belatedly began an all out effort to increase bank reserves. Between August and January bank reserves rose by over $750 billion. This is seven times more bank reserves than the Fed created in all of its history.

Ordinarily, the Fed’s behavior since last August would lead to an unprecedented boost in spending this coming spring. However, just as the Fed inadvertently adopted a restrictive policy a year ago, it has inadvertently produced an even more restrictive policy since last summer.

Creating bank reserves is merely the first step in creating liquidity. If banks were either to keep the new reserves as cash in their vaults or keep their reserves on deposit with the Fed, the reserves are not used to support loans or investments. A similar situation would occur if the public chose to hold cash instead of depositing its funds in the banking system. In either of these cases, the impact of high-powered money can lose some or all of its impact to boost spending.

The Fed has the power to offset such behavior on the part of banks and the public and make sure there is more liquidity in the system. However, instead of encouraging banks to loan and invest the high-powered money, the Fed has done the opposite. Beginning in October it has encouraged banks to hold excess reserves at the Fed by paying them interest.

This policy, along with widespread economic uncertainty, has led banks to increase their excess reserves at the Fed. Between August and January banks increased their holdings of excess reserves with the Fed by far more than the Fed’s increase in bank reserves. As a result, the latest data indicate that the total amount of bank reserves supporting loans and investments was only $71 billion in January. This is 25% less reserves supporting loans and investments than existed last August.

When there are less bank reserves supporting loans and investments, there are pressures on the public to reduce spending to the level supported by the reduced amount of bank reserves. As during the 1930s, policymakers are resorting to massive government intervention and spending in a futile attempt to offset the impact of a highly restrictive monetary policy. These moves make matters worse.

When spending declines to accommodate the amount of money that is available, government policies that attempt to shift resources into housing or autos are particularly counterproductive. The main impact of such policies is to shift spending away from certain areas and toward the areas government policymakers believe to be more important.

Markets tend to allocate resources to their most efficient uses. Government intervention into the allocation of credit and other resources means that instead of using the market to allocate resources, resources are being allocated by political forces. This creates inefficiencies that not only weaken the economy today, but that will limit the ability of the economy to recover once the Fed corrects its current destructive policy.

The fastest and most direct course for a healthy, sustained recovery involves two things. First, the Fed should immediately begin charging banks for holding excess reserves with the Fed. This will quickly increase the amount of reserves available to support loans and investments. At the same time, the Fed should make it clear that to limit future inflation it will reduce the current massive increase in bank reserves as the economy recovers.

Second, there has never been a period of strong growth when government spending has increased faster than spending in the rest of the economy. Reducing government spending, taxes and regulations has been the only reliable way to create a healthy economy. Hence, policymakers must do the opposite of what they have been doing. Instead of massive increases in government spending, taxes and regulation, a true recovery will involve massive cuts in government spending, taxes and regulations. Such policies ushered in the Roaring Twenties, the Reagan recovery and the boom in the last half of the 1990s. They are the only ones that have ever been successful at restoring prosperity.