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Monday, March 02, 2009

Past is Prologue: Repeating history lessons ignored

We want to resume our series on lessons from the Great Depression. Let's return to the thrilling days of yester year. Not to the Lone Ranger, but the period after the disasters of time period 4Q1930 and 4Q1931 Q for quarter) which 2009 is already emulating. Maybe we can learn from the past to avoid reliving it.

The economy bottomed in 1932-3 with no clear GNPr bottom. It bobbled around. Financially, the low was the collapse of the banking system in February 1933. Bank suspensions went to 3471 and Roosevelt’s first action after inauguration on March 4, 1933 was to close all banks – the “bank holiday.” When found to be sounds they were reopened. There were no “bailouts” such as in 2008-09 (and no credit default swaps CDS, collateralized debt obligations CDO, mortgage backed secutities MBS, falsely Aaa rated CDOs, CLOs, the zoo of exotics, and “toxic waste”). The Bank Act of June 1933 (sometimes called Glass-Steagall for its provision which separated commercial banking from investment banking) and the Securities Exchange Acts of 1933-34 (founding the SEC which stopped naked short selling and put in the “uptick” rule and was responsible for accurate financial reporting – issues that now exist in 2009) put a “straight jacket” on the financial industry. Note: a series of bank acts in 1980, 1982 etc took the jacket off culminating in the 1999 Graham Lench Bliley Act repealing Glass Steagall.

Due to the chaos of the bank collapse 1Q1933 is not used as an analytical starting point for the recovery. And because banking statistics of 2Q1933 are compromised by a Federal Reserve Bulletin footnote that only licensed bank statistics are reported, 3Q1933 is used as the base for the analysis of the depression recovery which from 3Q1933 to 3Q1937 had a real GNP growth rate of 9.47% and brought the unemployment rate down to 14% from 25%.

The first stage in the recovery is the initial brisk recovery featuring a substantial rise in the bank excess reserve ratio (re rising) and public dishoarding (e falling). The second setback stage features the doubling of reserve requirements and the recession of 1937-1938. The third stage from 2Q1938 to 2Q1940 features a resumption of double digit growth despite even higher excess reserves. While banks were hoarding excess reserves until leveling off in 1H1936, the public was dishoarding. So, in a rough sense the two effects cancelled. The lesson here is that the economy can grow even if the banks hoard. The dishoarding by the public cancelled the hoarding of the banks. Given that there is massive bank hoarding in 2008, perhaps it can be cancelled by expanding the Cp portion-currency held by the public of the monetary base to counter the frozen reserves. The increase in excess reserves in 1933, 1934, and 1935 were of major concern to the Fed.. Perceiving the excess reserves as a threat to its control and to unleash inflation the Fed wanted to eliminate this threat by raising reserve requirements which would reclassify excess reserves as required.
A problem was that reserve requirements had been fixed by the 1917 Amendment to the Federal Reserve Act at 7% for country banks , 10% for reserve city banks, and 13% for central reserve city banks (also 3% on time deposits). To get the legal power to change reserve requirements the Fed needed a new law. Accordingly the Fed lobbied for the power to change reserve requirements to regain monetary control and got the power to double the 7, 10, 13 limits to 14, 20, 26% in the Banking Act of August 23, 1935.

Why the banks increased their excess reserve is because banks had been made wary by bank runs, the Fed’s failure to do its job as lender of last resort, and unsure about the then temporary FDIC (made permanent in the Bank Act of Aug 23,1935), banks found a way to self insure against potential trouble spaces - accumulate excess reserves. Other potential reasons are low interest rates, low loan demand, low deposit growth, inadequate capital (a 2008-09 problem), and increased fear of default (also a 2008-09 problem). Fearing loss of control of money and credit the Fed pulled on the string. In July 1936 the Fed raised rr by 50% and to the 100% increase limit in two more stages in 1Q and 2Q1937. In our next installment, we'll demonstrate what a disaster that was.

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