"Blood and Treasure": Exiting the Great Depression and Lessons for Today
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“Blood and Treasure”: Exiting the Great
Depression and Lessons for Today
Kris James Mitchener Joseph Mason
Santa Clara University, Louisiana State University &
Hoover Institution the Wharton School
& NBER
April 2010
Paper Prepared for the
Oxford Review of Economic Policy
JEL Codes: G21, N22, E44
Keywords: Exit Strategy, Monetary Policy, Credit Policy, Lender of last resort, Great
Depression
Prepared for the Conference “Lessons from the Great Depression for the Making of Economic
Policy,” April 16-17 in London. Mitchener: Department of Economics, Santa Clara University
500 El Camino Real Santa Clara, CA 95053 USA. Email: kmitchener@scu.edu Mason:
Department of Finance, Louisiana State University, Baton Rouge, LA 70803 USA. Email:
masonj@lsu.edu. Mitchener acknowledges the financial support of the Hoover Institution while
in residence as a National Fellow, 2009-2010.Table of Contents
I. Introduction.................................................................................................................................. 2
II. Defining Exits ............................................................................................................................... 4
III. Monetary Policy.......................................................................................................................... 6
A. Monetary Expansion?......................................................................................................... 6
B. Regional Conflicts and Fed Policymaking in the 1930s ...................................................... 7
IV. Bank and Credit Policy.............................................................................................................. 10
A. The National Credit Corporation ...................................................................................... 10
B. The Reconstruction Finance Corporation (RFC) and Federal Reserve Loans ................... 11
C. Bank Holidays and Licensing Programs ............................................................................ 12
D. Restructuring the RFC....................................................................................................... 13
E. Federal Deposit Insurance and RFC Support of Re‐opened Banks................................... 14
F. RFC Assistance to Non‐bank Firms ................................................................................... 16
1. Loans to Railroads ........................................................................................................ 16
2. Loans to Commercial and Industrial Enterprises ......................................................... 17
V. Unwinding the Expansionary Policies of the 1930s .................................................................. 19
VI. Policy Implications.................................................................................................................... 21
A. Provide Resources for Growth (Lending/liquidity)........................................................... 21
1. Go easy on accounting measures ................................................................................ 21
2. Subsidize earnings thru low interest rates................................................................... 22
3. Promote investment .................................................................................................... 22
B. Reallocate Financial Assets (Capital Allocation) ............................................................... 22
1. Maintain credit supply commensurate with credit demand ....................................... 22
2. Prevent disintermediation and preserve lending relationships .................................. 23
3. Provide bank capital and reserves to fuel charge‐offs................................................. 23
C. Resolve Failed Institutions................................................................................................ 25
1. Quarantine bad banks to alleviate asymmetric information....................................... 25
2. Improve resolution technology.................................................................................... 25
3. Get cash to creditors but avoid fire sales .................................................................... 26
D. Incorporating Resolution Rates in the Determination of Policy Exits .............................. 27
VII. Conclusions ............................................................................................................................. 29
1I. Introduction
It is not too unreasonable to view U.S. policymaking during the current financial and
economic crisis as a reaction to the events of the 1930s, and as an attempt to avoid a
meltdown as severe as that one. During the current crisis, policymakers within the
Federal Reserve and the Obama administration effectively bought catastrophe insurance
to protect themselves from such an outcome. The Fed’s insurance took the form of
interest rates that were quickly dropped to their lower bound, liquidity support to
financial markets that were malfunctioning, and credit support to financial institutions
that were suffering both illiquidity and insolvency problems. The Obama administration’s
insurance policy included a massive fiscal stimulus and a continuation, modification, and
extension of credit-support programs initiated by the Treasury Department in the last few
months of the Bush administration.1
Although the policy mistakes of the 1930s cast a long-shadow and help define how
American policymakers responded to the 20007-8 financial crisis and ensuing recession,
it is less clear how history is now shaping thought as the global economy moves into a
recovery phase. In particular, what lessons are they drawing on in order to unwind the
assistance that was provided to stave off another Great Depression? In this essay, we
offer some guidance on what we believe policymakers already know about the recovery
phase of the Great Depression and suggest what they wish they knew more about as they
shift their focus from crisis prevention to longer-run objectives.
Observers of the economy and the financial press have recently called on government
officials to define their “exit strategy” from the present policy stance. It is interesting to
apply this terminology to economic policymaking. It is usually used in the context of
unfavorable military situations, such as when the Pentagon provided an internal critique
of the decision to cut its losses at leave Vietnam; it was later used more publicly to
describe the bungled U.S. military intervention in Mogadishu, Somalia, and most recently
used with respect to Afghanistan and Iraq. Military officials speak of minimizing the loss
of blood (lives) and treasure (equipment) in any operation, so to apply the metaphor to
the current economic situation we need to define the function that policymakers are
minimizing as well as why the present policy stance is viewed as unfavorable.
Most central banks have an explicit or implicit long-run inflation target as well as a target
rate of growth for the economy’s output (usually equal to potential GDP). Since many
central banks carry out expansionary monetary policy to counteract the effects of falling
aggregate demand on equilibrium output and unemployment, it goes without saying that,
eventually, policymakers will turn course and raise rates as the economy recovers. The
challenge is to time the rate increase optimally. If rates rise too late, the cost is inflation.
If rates increase too quickly or sharply, the cost can be lost output, higher unemployment,
and the potential of a “double dip” recession. Hence, central bankers are trying to
minimize inflation and exit a low-interest rate policy stance without generating further
unemployment or losses in output, i.e., more “blood” and lost “treasure.” The present
1
For an example of how the Depression has defined policymaking, see Romer (2009).
2policy stance of loose monetary and fiscal policy is seen as unfavorable in the long run
(or at least not optimal) in the sense that, if it were maintained, it would eventually
generate unsustainable public budget deficits and inflation. Of course, as described
above, this medley of expansionary policies was implemented to protect against a “tail
event” that would be characterized by extremely severe losses in output and
unemployment, and potentially large declines in prices.
In this article, we argue it is important to make the distinction between “exits” from
garden-variety recessions versus those that were accompanied by financial crises. There
is building evidence that recessions accompanied by financial distress tend to be deeper
and longer (Claessens et al 2008, Reinhart and Rogoff, 2009). At least with respect to
central bank policymaking (the focus of this paper), we view this distinction as
important.2 All business cycles, regardless of their origins, eventually require central
bankers to shift their concerns from the short run to the medium run and long run.
Typically, this entails raising the short-term policy instrument (i.e., the Fed funds rate) to
a more neutral position in order to satisfy a long-run inflation target. However, during
financial crises, the central bank’s role as a lender of last resort (LOLR) is often invoked.
In many cases, acting as a LOLR not only changes a central bank’s balance sheet, but it
also transforms the operation of financial markets so that it begins to take on
responsibilities typically played by financial institutions. Hence, an exit strategy from a
financial crisis entails more than planning on how to return to medium and long-term
objectives for inflation: it also requires the central bank to make decisions about how and
when to cede its emergency role as a banker back to the markets.
We draw on the experience of the U.S. in the 1930s to shed light on exit strategies, and
describe how the policy response to the deflation and banking crisis of the 1930s (or lack
thereof) colored how exit from the Great Depression was approached. We suggest that
the present-day Fed already knows a considerable amount about how to exit from
traditional recessions (even if it does not always exhibit act consistently). Moreover, key
“lessons” from the 1930s seem to have already been learned by policymakers today:
traditional monetary policy was used in a more timely matter to support the
macroeconomy and liquidity and credit support was used to prevent bank failures.
The lessons from the 1930s on when to remove stimulative monetary policy are a bit
more muddled, in part because of the different trajectory of prices then in comparison to
now. The U.S. economy of the 1930s suffered severe deflation. Producer prices fell by
more 40% between 1929 and 1932. In response, the Roosevelt administration was
focused on ending deflation and expectations that prices would continue to decline and
opposing those (including bankers) who still blamed the depression on inflation. Their
goal was to change the monetary regime, and install a very inflationary monetary one
(Eggertson, 2008; Temin and Wigmore, 1990). The Fed, however, was concerned that the
growing volume of bank reserves would reignite inflation. It took preemptive action
2
One could also examine exits from fiscal policy, but changes in the deficit-GDP ratio in the mid-1930s
were small and in some years contractionary, so there is little to discuss with respect to the period of
interest.
3against inflation beginning in 1936 by doubling reserve requirements (Meltzer, 2003).
The result was a short and severe recession in 1937-8: output declined by roughly 10
percent and unemployment returned to around 20 percent. Recovery resumed after the
Fed removed these rate increases and Treasury reversed course on a decision it had made
in 1936 to sterilize large gold inflows (an action which had reduced high powered
money).
Perhaps the Fed has already applied the lesson from the 1930s regarding the movement of
prices in two ways: (1) it used accommodative monetary to prevent deflation from
happening in the first place and (2) it appears to have recognized the possibility that
removing policies that were used to combat a financial crisis too quickly can lead to a
policy-induced recession (as in 1937-8) and therefore has moved with measured steps in
unwinding its programs. That said, it is less clear how it is approaching credit policies.
We suggest that the policymakers might benefit from a better understanding of the
mechanisms that were used to recapitalize banks and prop up credit after roughly 10,000
banks failed during the Great Depression We discuss how the Reconstruction Finance
Corporation, the bank holidays Roosevelt declared, and the implementation of federal
deposit insurance changed expectations about the survival of banks and stopped the
bleeding. We also discuss how understanding the subsequent political and economic
difficulties of removing support to the banking system and unwinding programs to foster
investment and credit is crucial for timing the exit from a financial crisis.
One theme that emerges from our analysis is that there is a troubling lack of knowledge
regarding bank behavior then and now. In both periods, it is not fully understood how to
get financial institutions to lend again after a crisis. In both periods, banks built up
“excess reserves” and reduced their lending. It may be optimal for banks to do this in the
wake of a financial crisis (too few positive net present value projects to invest in, a desire
to recapitalize at the equivalent or higher level relative to assets, or heightened risk
aversion), but it complicates the central bank’s decision to remove itself from credit
markets and return banking activities to markets. We suggest that the Fed would have a
better sense of what to do today if we knew more about why banks failed to lend in the
1930s, why they held these reserves, and what their potential effects are on the path of
prices. Hence, this may be a fruitful area for future research on the Great Depression.
II. Defining Exits
Thinking about lessons from the Great Depression involves disentangling those that have
already been learned from those that remain outstanding. It is important to acknowledge
that modern central banking and monetary theory were still evolving during the 1930s.
Hence, much learning was already occurring during the Great Depression itself. As a
result, some of the “exit” involved in recovery from the Great Depression involved
reversals from historic central banking policies aimed at maintaining parity on the gold
standard.
Some of the most important policy shocks in the history of central banking include open
market sales by the Fed beginning in 1928 and through 1929 and changes in the discount
rate in 1929, which were aimed at dampening stock market speculation, a hike in the
4discount rate in 1931 in response to Britain’s departure from cold, presidential candidates
from both parties campaigning on contractionary fiscal policy in 1932, and trade policy
that turned protectionist and led to a global collapse in trade. With respect to monetary
policy, the Fed’s inability or unwillingness to prevent the collapse of monetary
aggregates after banks began to fail was a glaring error (Friedman and Schwartz, 1963),
and its failure to act as a lender of last resort helped turn the recession into a depression.
It was not until the U.S. abandoned the gold standard in April 1933, four years after the
downturn started, that monetary policy shifted course and that the money supply began to
expand dramatically (Eichengreen and Sachs, 1985; Eichengreen, 1992; and Temin,
1989).
Nonetheless, we would not consider such reversals of policy as “exit” phenomena, per se.
Rather, it is the decision to discontinue policies that emphasize the short-run over the
long-run that signal exit. In a typical recession, an exit constitutes a strategy aimed at
returning to the medium and long-run targets for inflation and growth, perhaps embodied
in central bank reaction function like the Taylor Rule. In a recession coupled by a
financial crisis, programs can be wide ranging and include support to capital markets and
intermediaries, complicating both the political will and the economic feasibility of the
exit. We define an exit strategy then as a movement back to institutional conditions
associated with steady-state growth, including stable inflation and broadly non-
interventionist credit market policies.
An exit strategy requires judgment and quite often the decision to wind down or liquidate
institutions that were created to combat a crisis; however, those decisions can become
politicized, and in some cases, this had led to the use of short-term policies long past their
shelf life. As a result, policies aimed at economic recovery in the short run can sometimes
be disruptive in the long run. This has been seen in developing countries, for example.
Policies aimed at generation inflation, devaluing exchange rates, subsidizing credit, or
even nationalizing strategic industries can have stabilizing benefits in the short run, but
can be destructive in the long term if they set the stage for crony capitalism, or worse, a
kleptocracy. One casualty can even be central bank independence. As a result of the
creation of programs to support credit and financial markets, central banks can evolve
into organs that allocate credit for political reasons. They can effectively transform into
functionaries of the state.
Before delving into the details of the 1930s, we make three initial observations about exit
strategies based on our definition. First, stimulus can turn out to be problematic if it leads
central banks to veer too far away from independence and toward government credit
policy. In the case of the 1930s, we see some evidence of the Fed becoming hostage to
the Treasury. Second, the political economy of exit will likely be challenging: agencies
created during a crisis may not wither because they have champions within government
who stand to gain electorally or personally or because too much uncertainty over the path
of the economy remains. The Reconstruction Finance Corporation is an example of an
agency that served short-term benefits, but continued to private credit to private firms
long after the distress of the 1930s had ended. This leads us to our final observation. A
full exit from the Great Depression, where institutions were wound down and the central
bank regained its independence did not occur in the 1930s – it took until the 1950s.
5The next two sections of the paper discuss the monetary and bank policy responses to the
Great Depression. Section V then reviews the story of the exit from those policies,
following them to their ultimate dismantling in the 1950s. Section VI organizes the
components of monetary and bank policy into a functional taxonomy that helps clarify
exactly what needs exiting from; and based on this taxonomy, we then propose a metric
that might help policymakers understand how to time an exit. Section VII concludes.
III. Monetary Policy
A. Monetary Expansion?
Since Friedman and Schwartz (1963) path-breaking study, it has been known that
monetary policy mistakes cost the U.S. economy dearly in the early 1930s.3 Constrained
by adherence to the gold standard, Eichengreen (1992) and Temin (1989) argue that the
Fed could not prevent banks from failing so long as it remained committed to staying on
the fixed exchange rate system of the interwar period. After the dollar was devalued,
output in the U.S. then grew at an average rate of 8 percent per annum from 1933 to
1937.
Growth stopped in 1937-38, again due to policy mistake of the Fed (the doubling of
reserve requirements between July 1936 and May 1937), but then resumed at a rate of
roughly 10 percent per year between 1938 and 1941. Romer (1992) attributes the
observed recovery of the real economy to large gold inflows, which led to a dramatic
expansion in the money supply and low or negative real interest rates through the end of
the decade. Prices and wages did not fully adjust to higher levels, so that the real money
supply (M1) grew by 27 percent from the end of 1933 to the end of 1936 and by 56
percent from December 1937 to December 1942.4
On April 5, 1933, the government outlawed the holding of gold domestically, and on
April 18th, it announced that the Treasury would no longer issue licenses to export gold.5
By making the dollar inconvertible into gold, these actions effectively ended U.S.
participation in the gold standard. Gold began to flow into the U.S. thereafter. Political
instability in Europe, beginning in the mid-1930s, and the lower value of the dollar (a
60% decline by January 1934) provided the source of the gold inflow and the means for
increasing the money supply.
Critically, the gold inflows were not sterilized by the U.S. Treasury and passed directly
into the money supply. Treasury carried out purchases of gold and silver, which they
believed would raise gold prices and prices in general, thus reflating the economy. The
rapid increase in money growth rates generated inflation expectations (Eggertson, 2008)
3
In addition to the aforementioned mistakes, the Fed began to carry out expansionary open market
purchases in the spring of 1932, but they turned out to be short-lived (Friedman and Schwartz, 1963).
4
The growth in monetary aggregates does not appear to take place through demand-induced changes in the
money multiplier as the deposit-currency ratio is fairly stable through the mid-1930s and into the first years
of the 1940s. This suggests growth occurred as a result of increases in high-powered money.
5
Congress authorized abrogation of the gold clause in public and private contracts on June 5th.
6and lowered real rates of borrowing, in turn increasing expenditure on interest-sensitive
goods, such as plant and equipment, consumer durables, and construction.
B. Regional Conflicts and Fed Policymaking in the 1930s
Lester Chandler describes Federal Reserve System officials during the early 1930s as
holding “sharply conflicting views concerning the System’s responsibilities, its proper
objectives, its powers, and the effects of its policies on the economy” (Chandler, 1971,
p.129). This divisiveness was fostered by the general wording of the Federal Reserve Act,
which “practically assured a maximum amount of conflict and controversy within the
System” (Chandler, 1971, p.6). The polar extremes in the philosophical debate were held
by the Federal Reserve Banks of New York and Chicago, whose respective geographic
domains were impacted quite differently by the early banking crises during 1929–31
(Mason, 2009).
The Federal Reserve Bank of New York was by far the Federal Reserve System’s leading
advocate of the use of monetary policy to control the economy. However, the Federal
Reserve Bank of New York’s overzealous attempts to take a leadership role in such
matters during a period of centralization of power at the Federal Reserve Board led to the
alienation of the board and the banks. Governor McDougal of the Federal Reserve Bank
of Chicago took the opposite view with respect to the desirability of the use of monetary
policy for economic stabilization. McDougal first took issue with the Federal Reserve
Bank of New York’s strong desire to control monetary policy at the June 1916
Governors’ Conference. By 1927, McDougal’s unwillingness to conform to easy-money
policy originating in the Federal Reserve Bank of New York to promote international
central bank cooperation led to a direct mandate from the board to reduce the Federal
Reserve Bank of Chicago’s discount rate. (Chandler, 1971; Wicker, 1966; Friedman and
Schwartz, 1963).
McDougal felt that domestic, and more important, local economic conditions should take
precedence over international considerations. In July 1930, the midwestern reserve banks
firmly opposed the Federal Reserve Bank of New York’s requests for an open market
purchase program.6 McDougal remained an adamant opponent of open market purchases
throughout the crises of 1931, after which many of the other Federal Reserve banks
throughout the country began to share the belief that further open market purchases
would simply cause reserves to accumulate in reserve center banks. Other Federal
Reserve banks soon realized that as regional crises progressed, reserve city banks were
seeking liquidity by calling loans and investing in short-term government securities.
Open market purchases, therefore, simply served to push the yields on such securities
lower.
Figures 3.1 and 3.2 show that the shift in bank portfolios into government notes and bills
began much earlier in the Chicago Federal Reserve District than elsewhere. The Federal
Reserve Bank of New York’s attempts to instigate a more active program of open market
6
O. M. Attebury, deputy governor at St. Louis, opined that “conditions in the Eighth District provided no
justification for further open market purchases.” See Friedman and Schwartz, 1963, p. 373fn.
7purchases waned in late 1932 as banks in that district began to accumulate large amounts
of short-term government paper, while the hoarding of governments in the St. Louis
District was less pronounced over this period. Figure 3.1 shows that banks in the
Minneapolis District on aggregate held over 10% of their portfolios in investments until
the end of 1930, when they began to divest heavily. Figure 3.2 suggests that the
disinvestment of Minneapolis District banks was a result of an early panic, since levels of
governments were drawn far below the Federal Reserve System average over 1931 and
1932. The massive flight to quality resulted in a precipitous decline in yields on notes and
bills during this period, with negative yields resulting in late 1932 (Chandler, 1971;
Epstein and Ferguson, 1984; Friedman and Schwartz, 1963; Patrick, 1993).
8The policy of the Federal Reserve Bank of Chicago was that it was better to leave the
eligible securities in the banks so that they could be used as collateral on loans, furthering
credit expansion and preventing extreme declines in yields. McDougal was not against
the provision of liquidity to bankers, rather he argued that, “on general principles, he
preferred to see the banks borrowing to secure funds.” By early 1932, Governor Harrison
of the Federal Reserve Bank of New York was forced to admit that banks’ “attitudes had
changed gradually since the last year in the face of the shrinkage in values” and that
“banks were much more interested in avoiding possible losses than in augmenting their
current income” through an expansion of the supply of credit. (Quoted in Friedman and
Schwartz, 1963, 380-5) This was as close as the Federal Reserve Bank of New York
would come to disavowing their belief that monetary policy was an adequate stabilization
tool for all economic crises.
The lack of agreement within the Fed carried over to the regional Fed’s relationship with
the Board as well as its relationship with the executive branch of the government. Indeed,
until the Banking Act of 1935, which placed the Board at the center, differences between
the Board and the regional banks may have contributed to the general passivity in Fed
policymaking in the 1930s. The Fed’s decision to increase reserve requirements in 1936-
7 in many ways stands out because it was otherwise inactive during the 1930s. In the first
part of the decade, the Fed’s failure to act as a lender of last resort resulted in the collapse
of the banking system. And after 1932, the Fed took a back seat to the Treasury and
initiatives proposed by Congress and the Roosevelt administration.7 The profits from the
1934 revaluation of gold went to establish the Exchange Stabilization Fund, and Treasury
threatened to use this Fund to carry out open market operations if the Fed did not go
7
Meltzer (2003) also suggests that passivity may have also resulted from the widespread belief among the
Federal Reserve Board and its staff that monetary policy was impotent.
9along with its efforts to expand the monetary base, keep real interest rates low or
negative, and reflate the economy through gold purchases. Hence, the Fed did not drive
policy decisions in the exit phase of the Depression. As a result, much of the remaining
discussion of the institutions and policies created to combat the financial crisis and revive
bank lending focuses on other programs initiated by Congress and the Roosevelt
administration
IV. Bank and Credit Policy
Although it is not as widely discussed as conventional monetary policy, bank and credit
policies are central to understanding exit strategies from financial crises, such as the
current crisis and the Great Depression. This section describes the institutional changes
that constituted bank and credit policy in response to the economic decline of the early
1930s. We discuss both the better known policies (the banking holidays, capital
assistance programs to banks through the Reconstruction Finance Corporation, and
federal deposit insurance) as well as programs and policies that have received less
attention, but nevertheless shaped the exit from the Great Depression, including loan
support to railroads and corporations.
A. The National Credit Corporation
International influences such as the failure of the Kreditanstalt in Austria and the British
departure from gold exacerbated the banking situation in 1931. By late in that year, the
frequency and severity of regional banking crises in the US were increasing rapidly;
however, the Federal Reserve continued to direct its policies at maintaining its nominal
anchor, even at the cost of reducing liquidity in an already unstable domestic banking
system through discount rate increases.
For many banks, reduced depositor confidence forced bankers to maintain liquidity.
Epstein and Ferguson (1984) describe how banks shifted their portfolios out of loans and
into short term assets, especially government securities, in order to maintain high levels
of liquidity from October 1929 to March 1933. Despite high reserve ratios, continuous
pressure on banks caused levels of liquid assets in even the largest banks in the US to
decline to precariously low levels in 1932. Increasingly, the Federal government was
pressured to respond to requests by banks and the public to do something to mitigate the
effects of the crisis (Commercial and Financial Chronicle, Feb. 11, 1933, pp. 936, 939;
Wigmore 1985).
In September 1931, President Hoover met with Eugene Meyer, Chairman of the Federal
Reserve Board and former Board member of the War Finance Corporation (WFC), to
propose a private corporation which would provide emergency funds to stem liquidity
crises: the National Credit Corporation (NCC). Membership in the corporation was to be
voluntary and the funding would come from the bankers themselves, with the
government providing only legal recognition of the organization. Hoover’s proposal was
met with restrained enthusiasm, however, as Meyer “...did not share the President’s faith
in the financial community” (Olson 1977, p.25).
10The NCC was formally organized on October 13, 1931, endorsed by the American
Bankers Association and, later, the Investment Bankers Association. Participating banks
were required to subscribe to an amount of NCC notes not less than two percent “of their
respective net demand and time deposits.” The corporation was to consist of many
regional subsidiaries that would oversee lending in their respective districts. Banks would
only be liable for losses incurred from the lending activities in their own districts (Miller
1931, pp.53-6).
However, the NCC was not providing broad enough assistance to stimulate a national
recovery. It lacked the authority to lend to railroads to halt the continuing deterioration of
bond prices and small country banks, often most in need of funds, were often unable to
contribute the two percent subscription required for NCC membership. Additionally, the
NCC provided no assistance to life insurance companies, savings banks, building and
loan associations, and a host of other financial institutions that held the same sorts of
frozen assets as commercial banks (Olson, 1977, pp.30-32). By November 1931 it
became apparent to Hoover that the NCC was a failure, and he made plans to introduce
the necessary legislation for a reincarnation of the WFC when Congress reconvened.
The NCC lent over $140 million in January and February of 1932, compared with only
$10 million in October and November of 1931 (Olson, 1977, pp. 29-30; Olson, 1988, p.
10).
B. The Reconstruction Finance Corporation (RFC) and Federal Reserve Loans
Ideological differences between Chicago and New York City bankers determined the
boundaries for the legislative debate over the structure of the RFC. The central points of
concern for the Chicago bankers were the eligibility of liberal classes of collateral for
loans to illiquid and closed banks. Meanwhile, New York bankers still felt that problems
in the banking system stemmed from undue credit contraction, and that there was no
reason to lend to closed, or even illiquid, banks, much less take illiquid collateral for
security.
The resulting bill was a compromise. Congress did not even consider the radical idea of
recapitalizing banks proffered by some Midwestern bankers, and they placed limits on
the amount of loans that could be used to pay off deposits of closed banks. Beyond this,
however, the bill only stipulated that loans be priced so as not to crowd out private
investment and to be “adequately secured.” The new institution was thus given powers
broad enough to meet the demands of midwestern bankers, in that it stood ready “to
assume the risk of loss -- and the losses --” of banks and depositors (Friedman and
Schwartz 1963, 303, 309; Olson 1977, 47-55; Ebersole, 1933, 467).
The RFC opened on February 2, 1932 and initially attempted to reduce bank failures by
infusing the system with liquidity through a policy of making loans to those “which
cannot otherwise secure credit.” The RFC sold capital worth $500 million – which
amounted to roughly 8.8% of bank capital or 1.4% of bank assets as of June 30, 1932 –
all subscribed by the United States of America and held by the Secretary of the Treasury.
The corporation was authorized to issue “notes, debentures, bonds, or other such
11obligations in an amount not exceeding three times its subscribed capital.” These
additional obligations could be sold to the public or the Treasury of the United States.
The amount of subscribed capital was increased several times over the 1930s as the
responsibilities of the RFC mushroomed.
The RFC was empowered to make loans to a variety of financial institutions as well as
railroads, a decision that addressed the two main concerns of the erstwhile opponents of
the NCC. But initial RFC lending policies were conservative to a fault. The RFC had
authority to extend maturities to three years; however, their practice was to set maturities
on its loans be be less than six months so that they would have greater control over
borrowers. The Board of Directors of the RFC, which included the Secretary of the
Treasury, the Governor of the Federal Reserve Board, and the Farm Loan Commissioner
as ex officio members, set loan interest rates at six percent, well above the market rate, to
ensure that RFC financing would not drive out private alternatives. Additionally, the RFC
often took a bank’s most liquid assets as security for loans, increasing the risk of default
on remaining bank debt and undermining the stabilizing effect of assistance. These
policies surely limited the effectiveness of the RFC in its first year of operation, and some
argued, may have hastened failures among vulnerable banks.
The RFC authorized $238 million in loans during the first two months of operation, $160
million of which went to banks and trust companies (James 1938). Bank suspensions fell
from 342 in January and 119 in February, to 45 in March. However, the declining number
of bank failures during this period may provide a somewhat misleading measure of the
effectiveness of the RFC. Problem banks received forbearance, but not necessarily
salvation. Of the more than $1 billion lent to banks prior to the March 1933 banking
holiday, nearly 70 percent went to banks borrowing more than once, and 15 percent to
banks borrowing more than five times. The most conspicuous episodes of such behavior
took place in Nevada and Michigan, two states which were hit especially hard during the
banking of late 1932 and early 1933 (Olson 1977; Doti and Schweikert, 1991;
Reconstruction Finance Corporation, 1932).
C. Bank Holidays and Licensing Programs
Few were surprised when President Roosevelt imposed a nationwide three-day
moratorium on banking upon his inauguration, on March 6, 1933. By March 3, 1933,
more than 5,500 banks with combined deposits of over $3 billion had already suspended
operations and only a handful of states were left without some sort of restrictions on
banking. By March 5, all 48 states and the District of Columbia had imposed various
types of moratoria on banking within their borders. (Kennedy, 1973; Olson, 1977; Jones,
1951).
Hence, even before the U.S. went off gold, the Roosevelt administration took action to
stop the fear and panic that was gripping the nation over the continued failure of banks
and mounting evidence of fraud in the industry arising from the Pecora hearings. This
cooling off period, prevented depositors from withdrawing their funds, and gave
examiners breathing room to sort out solvent banks from insolvent ones.
12In order to restore confidence in the banking system, Roosevelt then signed the
Emergency Banking Act of March 9, 1933, which authorized the secretary of treasury
and state banking departments to issue licenses to banks that were declared solvent,
reorganize and support banks through the Reconstruction Finance Corporation, and close
the rest.8 The plan for reopening banks was described by Roosevelt in his fireside chat on
March 12, with licensed banks in Federal Reserve cities opening March 13th, and if these
proceeded in an orderly fashion, it would be followed by banking openings in 250 cities
with clearinghouses on March 14th. And assuming all went well with the second round of
openings, the remaining licensed banks would be allowed to open on March 15. At the
end of the day on March 15, nearly 70 percent of the 18,390 banks in operation on March
3 had reopened, including 5,038 of the existing 6,816 Federal Reserve member banks
(Olson, 1988, pp.65-6).
Still, that left thousands of banks closed pending further investigation. The process to
reopen those banks proceeded much more slowly. Some 1,300 additional banks were
authorized by the Fed to reopen between June 1933 and December 1936, and roughly
3,900 never reopened (Board of Governors, 1943, p.16). There were also wide
differences in the rate of openings across regions, as some state banking authorities
permitted all banks to be reopened simultaneously. Credit availability in the 1930s varied
widely as a result. The RFC, therefore, used its new powers granted to it through the
Emergency Banking Act and aid marginally solvent institutions through recapitalization
and the application of liberal accounting standards.
D. Restructuring the RFC
The majority of Roosevelt’s Emergency Banking Act consisted of legislation left over
from the Hoover administration. Title I of the Emergency Banking Act formally
legitimized Roosevelt’s power under the Trading with the Enemy Act of 1917 to declare
a national banking holiday. Title II, also known as the Bank Conservation Act, provided
that conservators be appointed to national banks deemed unsound, as judged by federal
examiners. Title III granted the RFC permission to purchase a special class of preferred
stock with full voting rights in any “national banking association or any state bank or
trust company in need of funds for capital purposes in connection with the organization
or reorganization of such association” (Olson, 1977, p. 107).
The preferred stock of banks that was purchased by the RFC paid senior dividends of six
percent per annum, and was senior to all other stock upon liquidation of the firm. All
other stock dividends were limited to a specified maximum, and remaining earnings were
devoted to a preferred stock retirement fund. In addition, the RFC’s preferred stock was
not subject to double-liability requirements, could be resold to the public at the discretion
of the RFC, and carried voting rights that were often used to direct the institution toward
solvency and profitability.
8
An executive order dated March 10, 1933 commanded the Secretary of the Treasury to “license any
member of the Federal Reserve System which could obtain endorsement of its soundness from its district
Reserve bank; state banking authorities could reopen non-member banks at their discretion” (Kennedy
1973, 180).
13The RFC was prohibited from purchasing more than 49 percent of the total outstanding
voting stock in any one bank; however, it often owned the largest voting block in
commercial banks. Thus the RFC had effective control of many of the institutions in
which it had investments. In several situations, the RFC used this control to replace
officers and significantly alter the business practices of the institution.9
E. Federal Deposit Insurance and RFC Support of Re-opened Banks
The Glass-Steagall Act of June 1933 provided various reforms with respect to branch
banking, securities affiliates, and deposit insurance. Most significantly, the Act strove to
strengthen confidence in the banking industry through the provision of deposit insurance
on a national level.
Early deposit insurance schemes proved inadequate as a direct result of their inability to
diversify beyond some tightly constrained geographic area and provisions which led to
moral hazard. The new Federal Deposit Insurance Corporation (FDIC) intended to
combat these shortcomings with a comprehensive nationwide system. In so doing,
however, the plan relied strongly upon the membership of all the nation’s banks. All
Federal Reserve member banks were required to subscribe to the FDIC, and non-member
banks were allowed to join if they could prove solvency before the date the program took
effect, January 1, 1934 (Jones, 1951; Calomiris and White, 1993; Wheelock and
Kumbhakar, 1994).
During his fireside chats, Roosevelt promised the public that only solvent banks would
reopen after the holiday. However, in examiners’ haste to open as many banks as
possible, they sometimes overestimated the value of bank assets. Thus by June 1933, the
RFC was not only busy trying to reopen banks, but also assisting those shaky banks that
slipped past examiners. Jones (1951, p. 27) estimated that over 5,000 banks that reopened
after the holiday “required considerable added capital to make them sound.” The RFC
and the Federal Reserve realized that the unsound nature of these banks precluded FDIC
membership on January 1, 1934, but Roosevelt wanted them to join on that date to ensure
public confidence in the system (Burns, 1974, p. 121).
The RFC could exert considerable influence over banks that had not reopened since the
bank holiday. These banks often took on assistance packages of preferred stock
investments and loans rather readily, as these measures were necessary if the bank was to
continue operations. The unsound banks that had already reopened, however, presented
Roosevelt and the RFC with a significant problem. Open banks were reluctant to
participate in the preferred stock program because they thought RFC assistance signaled
their unsound condition to the public. The RFC had little power to force these banks to
participate.
In September 1933, Jesse Jones, Chairman of the RFC, addressed the American Bankers
Association in Chicago and rebuked bankers for their reluctance to participate in the
9
The earliest and most prominent intervention was that involving Continental Illinois National Bank of
Chicago. However, other prominent banks were assured that the situation at Continental Illinois was due to
a combination of various unusual circumstances, and would not be repeated without due cause.
14preferred stock program, and strongly urged all the leading banks in the US to sell
preferred stock to the RFC “so that depositors would not be induced to switch out of ...
banks when [recipients’] names were published.” The appeal to the American Bankers
Association convention seemed to have had some impact on the bankers, and the number
of applications received daily at the RFC increased substantially. Eventually, nearly all
the banks sold stock to the RFC, although several sold only small amounts and
immediately repaid them (Jones, 1951; Burns, 1974; Wigmore, 1985). Mason (2001b)
established, however, that the stigma that many were worried about was unwarranted.
Moreover, recent historical studies of the phenomenon typically misstate which
transactions were made public and when, confounding the problem further. Nonetheless,
since the RFC only granted assistance to sound institutions, there is no reason to believe
that such assistance was accompanied by the type of stigma feared by many. (See also,
Schwartz 1992)
In response to a backlog of assistance applications, on October 23, 1933 the RFC created
the Non-Member Preferred Stock Board to handle the most delicate cases: more than
2,500 non-Federal Reserve member banks whose financial positions were still
unsubstantiated by the Federal Reserve or the Secretary of the Treasury. At the same
time, dividend and interest rates were lowered to 4 percent, inspiring even more banks to
participate in RFC programs (Olson 1988, p. 79). By November 1933, RFC applications
were being sorted in a manner of triage. Banks “whose assets appeared to equal 90
percent of their total deposits and other liabilities exclusive of capital” were urged to seek
private buyers for their stock, believing that otherwise the RFC could end up owning a
sizable portion of the banking industry. Banks which could not meet these requirements
were put in what Jones (1951, p. 28) refers to as the “hospital,” awaiting the arrangement
of more complex assistance packages.
On December 15, 1933, more than two thousand open banks were still in the hospital and
unopened. With only two weeks until the deadline for FDIC membership, the RFC began
to seek quick solutions to gain membership for these banks and avoid another crisis of
confidence. After a fruitless appeal to the Senate Committee on Banking and Currency,
the RFC sought to soften the deadline. On December 28, Jones met with Secretary of the
Treasury Morgenthau to propose a compromise: if Morgenthau would certify the
hospitalized banks as solvent, Jones guaranteed they would be so within six months. The
hospitalized banks were thus recapitalized in a more orderly fashion than otherwise
would have occurred, and another possible crisis of confidence was avoided (Jones, 1951,
p. 28-30). “On January 1 Walter Cummings announced that the FDIC had accepted
13,423 banks as members and had rejected only 141” (Olson, 1988, p. 81).
By March 1934 the RFC had purchased preferred stock in nearly half the commercial
banks in the US (Jones, 1951). By June 1935, these RFC investments made up “more
than one third of all outstanding capital in the entire [US] banking system” (Olson, 1988,
p.82).
15F. RFC Assistance to Non-bank Firms
Between 1932 and 1937, the RFC experimented with a wide variety of programs aimed at
resolving systemic distress. It did so by attempting to stimulate credit and capital market
activity by acting as a lender of last resort, not only recapitalizing the banking industry,
but providing direct credit and capital to commercial and industrial enterprises.
1. Loans to Railroads
The Railroad loan program served two purposes over the life of the RFC. When the RFC
began operations, the railroad loan program’s objective was to directly augment the
financial intermediary loan program. Federal and state governments had recapitalized or
otherwise bailed out weak railroads since the late 19th century. Because of this implicit
bailout provision, nearly all railroad bonds were rated AAA. As the stock of US
Government securities was retired during the 1920s, banks and other financial
intermediaries increasingly relied upon railroad bonds as safe liquid investments that
were a close substitute for reserves. But when railroads were not bailed out in the early
1930s, the value of railroad bonds, and thus bank reserves, fell precipitously. In theory,
therefore, helping out railroads could increase the value of bank reserves and stimulate
credit activity, relieving the perceived credit stringency and pulling the economy out of
the debt deflation spiral.
After 1933 the railroad loan program shifted its objective to become a means to stabilize
general business activity and maintain employment. This objective, however, did not
significantly differ from that of traditional New Deal programs in that the loans were not
specifically for the relief of corporate distress. We discuss the degree to which the
program relieved corporate distress in the railroad sector and therefore relieved the
perceived credit stringency and the debt-deflation spiral.
Rather than pricing themselves out of the relevant market as with loans to financial
intermediaries, the RFC actually priced themselves into the market for railroad loans by
setting rates below even benchmark common stock yields between 1932 and 1935. Like
loans to financial institutions, railroad loans were set at six percent in 1932, five-and-a-
half percent in 1933, and five percent in 1934 and beyond. Moody’s common railroad
stock yields over this period were more than seven percent in 1932 and almost six percent
in 1933 and 1934. During 1935 and after, common railroad stock yields were below RFC
rates. RFC debt was therefore cheaper than a typical railroad equity issue between 1932
and 1934. The incentive to finance with RFC debt rather than equity and the moral hazard
implications of less-than-secured lending to railroads mandated under the RFC Act soon
placed RFC capital at risk. The RFC was forced into litigation to recover loan proceeds in
large-scale widely publicized bankruptcy proceedings.
Between February 1932 and October 1933, most RFC loans to railroads were for the
purpose of paying debt interest and principal. Between November 1933 and October
1934, the most popular use of RFC loans was to pay off short-term maturity debt
principal. Both these types of loans directly helped preserve the value of railroad
securities and thereby aided banks.
16Between February 1932 and October 1933 the RFC also dedicated a substantial amount
of resources toward purchasing equipment trust certificates, that is, debt instruments for
the purchase of operating equipment like locomotives are freight cars and secured by the
same. The purchase of equipment trust certificates maintained business activity and
employment in ancillary industries. As it later turned out, support to this sector
significantly smoothed production of railroad equipment on the eve of a high-demand
period during World War II.
By November 1934 through October 1936, the principal purpose of RFC assistance
shifted from commercial banks to industry, focusing on repurchasing railroad securities
in order to reduce railroad leverage ratios. In January 1935 the agency was further
empowered to purchase and guarantee directly the general obligations of railroads and
railways (Spero, 1939). In this way, RFC railroad loans, in practice, were initially used to
help out with bond interest payments and finance equipment, but were eventually used as
a substitute for railroad capital. As mentioned earlier, this extension of the RFC’s powers
served as acknowledgement that the Depression was now expected to last much longer
than previously believed. Therefore, the operations of the agency adapted to this
philosophical shift by providing long-term capital (or debentures) rather than short-term
secured debt.
Since RFC railroad loans were not “fully secured” under the original statute, many loans
went to railroads that failed shortly thereafter. Perverse incentives existed whereby
railroads could borrow from the RFC to pay favored creditors and investors in full before
defaulting. More importantly, since railroad capital levels were not regulated and rates on
railroad loans, unlike those on RFC loans to financial intermediaries, were favorable,
railroads had an incentive to borrow from the RFC to finance a public capital flotation,
which could be used to replace private debt (sometimes held primarily by insiders) with a
mix of equity and RFC debt before default.
Once RFC officials recognized this problem, they began pushing for changes in the
original statute. In June 1933, the RFC Act was amended so that the agency could no
longer make a loan to any railroad or railway that was in need of financial reorganization
in the public interest. In 1935, as policymakers became further convinced of the long-
term nature of the economic downturn, the RFC railroad loan program was further
restricted to only those applicants “…who could demonstrate the fundamental soundness
of their financial position and their ability to survive a reasonably prolonged period of
depression,” (Spero 1939, p.2).
Even with strict conditions, RFC loans to railroads only prevented temporarily a large
number of insolvencies, prolonging the agony of impending bankruptcy. “…Prices of
railroad bonds moved generally downward, intensifying the economic, banking, and
credit difficulties,” (Spero 1939, p.143). Like the Corporation’s loans to banks, the
underlying problems of the railroads, declining revenue, increased competition, and
burdensome debt structures, were left untouched,” (Olson, 1972a, p.181).
2. Loans to Commercial and Industrial Enterprises
17Preferred stock stabilized the banking sector. But as long as banks were primarily
concerned with default risk as perceived by depositors, they were unwilling to undertake
new lending. RFC officials and other policymakers nevertheless believed that an ample
supply of business credit was the key to unwinding the debt deflation spiral that was at
the heart of the economic downturn. In June 1934, the RFC and Federal Reserve
therefore began making commercial and industrial (C&I) loans directly to businesses in
order to relieve the credit stringency and expand economic activity.
The legislation passed in June 1934 allowed the RFC to make C&I loans with maturities
“…up to five years provided the applicant was sound, could supply adequate collateral,
and could not get credit at banks. Loans could be advanced for working capital rather
than equity or fixed capital, but could not exceed $500,000 per customer or be used to
pay off existing indebtedness” (Olson, 1972a, p.274).
In addition, §1 of the same act that granted direct C&I loan authority to the RFC also
amended the Federal Reserve Act to give equal authority to the Federal Reserve System
(Walk, 1937, p.62). The legislation “…allowed the RFC to loan up to $300,000,000 and
the Federal Reserve Banks up to $280,000,000,” in C&I loans. Of the $280,000,000
authorized to the Federal Reserve Banks, half was funded by their own surplus, and half
by the Treasury (65). Any future extensions of the $280,000,000 limit would be funded in
the same manner.
Like the railroad and preferred stock programs, the assistance provided to commercial
and industrial firms afforded the RFC “… a profound influence upon policies and
organizations of borrowers to insure soundness of their equity” (Sullivan, 1951, p.7). As
long as any portion of a [C&I] loan remained outstanding, no dividends could be paid by
any corporate borrower, nor could distribution or withdrawal be made by a partnership or
individual borrower without the consent of the RFC (Walk, 1937).
The C&I loan programs had the capacity to make up a substantial portion of C&I funding
during the early- to mid-1930s. (Commercial and Financial Chronicle, various issues). In
order to conserve capital and reintroduce banks into business credit arrangements, the
RFC and Federal Reserve developed cooperative credit arrangements with banks by
purchasing participations in C&I loans rather than originating the loans exclusively
(Olsona, 1972). Most of the RFC C&I assistance authorized after 1934 therefore took the
form of loan participations with firms’ existing banks (Agnew, 1945).
Nonetheless, the C&I loan programs’ performance was lackluster. The comparison of
RFC and Federal Reserve direct loans outstanding shows that by the end of 1937, the
RFC only authorized about $140 million in its C&I loan program, and the Fed about $150
million (Mason, 2001a).
In 193,5 Hardy and Viner concluded that “efforts to relieve [credit] stringency through
direct lending on the part of the Federal Reserve Bank of Chicago and the Chicago
agency of the Reconstruction Finance Corporation have so far had a negligible effect on
the general state of credit,” (VI). In a later study, Kimmel reached similar conclusions for
the entire period, 1933-1938.
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