Speech
THE FEDERAL RESERVE
AND THE FINANCIAL CRISIS
Overview of the Lectures
• These lectures review some of the causes of
and policy responses to the recent financial
crisis, focusing on the role of the Federal
Reserve.
• Understanding the role of the Federal Reserve
in the recent financial crisis requires an
understanding of
— the origins and mission of central banks
— the lessons of previous financial crises and
how they informed the Fed's decisions in the
recent one
Roadmap of the Lectures
• Lecture 1 explains what central banks do, the
origin of central banking in the United States, and
the experience of the Fed during the Great
Depression.
• Lecture 2 reviews developments in central
banking after World War II, focusing on the
recent financial crisis.
• Lecture 3 describes the financial crisis, its
implications, and the policy responses by the
Federal Reserve and others.
• Lecture 4 discusses monetary policy responses to
the recession, the sluggish recovery, post-crisis
changes in financial regulation, and implications
of the crisis for central bank practice.
Lecture 1:
Origins and Mission of
the Federal Reserve
What Is a Central Bank?
• A central bank is not an ordinary commercial
bank, but a government agency.
• Central banks stand at the center of a nation's
financial system.
• Central banks have played a key role in the
development of the modern monetary system.
• Virtually all countries have a central bank.
What Is the Mission of
a Nation's Central Bank?
• Macroeconomic stability
- All central banks strive for low and stable inflation;
most also try to promote stable growth in output
and employment.
• Financial stability
- Central banks try to ensure that the nation's
financial system functions properly; importantly,
they try to prevent or mitigate financial panics or
crises.
The Policy Tools of Central Banks
• Monetary policy
- For macroeconomic stability: In normal times,
central banks adjust the level of short-term
interest rates to influence spending, production,
employment, and inflation.
• Provision of liquidity
- For financial stability: Central banks provide
liquidity (short-term loans) to financial institutions
or markets to help calm financial panics, serving
as the "lender of last resort."
• Financial regulation and supervision
- Many central banks, including the Federal
Reserve, also supervise financial institutions. To
the extent that supervision helps keep firms
financially healthy, the risk of loss of confidence
by the public and an ensuing panic is reduced.
Origins of Central Banking
• The earliest central banks were in Sweden (1668),
England (1694), and France (1800):
- Early central banks typically began as private
institutions; over time, governments increasingly
took on central banking functions.
- An important responsibility of these central banks
was issuing paper money, usually backed by gold.
• In the 19th century, central banks also began to
serve as the lender of last resort during financial
panics.
Financial Panics
• Financial panics are sparked by a sudden loss of
confidence in one or more financial institutions,
leading the public to stop funding those
institutions, for example, through deposits.
• Panics can cause
- widespread bank runs
- restrictions on depositors' access to their funds
- bank failures
- stock market crashes
- economic contractions
A financial panic is possible
in any situation where
longer-term, illiquid assets
are financed by short-term,
liquid liabilities; and in
which short-term lenders
or depositors may lose
confidence in the
institution(s) they are
financing or become
worried that others may
lose confidence.
Lender of Last Resort
• To halt the panic, central banks must act as the
lender of last resort.
• Short-term loans from the central bank replace
losses of deposits or other private-sector loans,
preventing the failure of solvent but illiquid firms.
• Bagehot's (still relevant)
dictum: During a panic,
central banks should
- lend freely
- against good assets
- at a penalty interest
rate (to discourage
excessive use)
February 3, 1826 - March 24, 1877
English journalist and essayist
Author of Lombard Street (1873)
How Does Bagehot's Dictum
Help Stem Financial Panics?
• During a financial panic,
financial firms need to pay off
depositors and other short-term
lenders. Without another
source of funds, they would
have to sell assets quickly and
thereby worsen the panic.
Many firms might go bankrupt.
• If financial firms can borrow
freely from the central bank,
using their assets as collateral,
they can pay off depositors,
avert "fire sales" of their assets,
and restore the confidence of
their depositors.
Origins of the Federal Reserve:
Financial Stability Concerns
• After the Civil War and
through the early 1900s, some
financial stability functions
were provided by private
organizations, notably the New
York Clearing House.
The New York Clearing
House in the 19th century
• But, as evidenced by the many
banking panics of this era,
these organizations were
unable to provide the stability
needed.
• The United States needed a
lender of last resort with
sufficient resources to stop
runs on illiquid (but still
solvent) banks.
U.S. Financial Panics: 1873 to 1914
• Financial panics in
1873, 1884, 1890,
1893, and 1907 led to
bank closings, losses
by depositors and
investors, and often to
broader economic
slowdowns.
• The 1907 financial
panic led Congress to
consider the creation
of a central bank.
[chart:] Bank Closings During Banking Panics:
1873-1914
[For
thesee
accessible
version of this
figure,
please
the accompanying
HTML.]
• Before the Federal
Reserve was fully
established, the
country was hit by
another serious
financial panic in 1914.
Origins of the Federal Reserve:
Economic Stability Concerns
• The gold standard as an
alternative to a central bank
- In a gold standard, the value of
the currency is fixed in terms
of a quantity of gold.
- The gold standard sets the
money supply and price level
generally with limited central
bank intervention.
• Problems with the gold standard
- The strength of a gold standard
is its greatest weakness too:
Because the money supply is
determined by the supply of
gold, it cannot be adjusted in
response to changing economic
conditions.
- All countries on the gold
standard are forced to maintain
fixed exchange rates.
- As a result, the effects of bad
policies in one country can be
transmitted to other countries if
both are on the gold standard.
- If not perfectly credible, a gold
standard is subject to speculative
attack and ultimate collapse as
people try to exchange paper
money for gold.
- The gold standard did not
prevent frequent financial panics.
- Although the gold standard
promoted price stability over
the very long run, over the
medium run it sometimes
caused periods of inflation and
deflation.
William Jennings Bryan
• In the second half of the
19th century, a global
shortage of gold reduced
the U.S. money supply and
caused deflation (falling
prices).
• Farmers were squeezed
between declining prices for
crops and the fixed dollar
payments for their
mortgages and other debts.
[imageof]William Jennings Bryan
March 19, 1860 - July 26, 1925
Three-time Democratic
candidate for President
(1896, 1900, and 1908)
• William Jennings Bryan ran
for president on a platform
of modifying the gold
standard.
"You shall not press
down upon the brow of
labor this crown of
thorns, you shall not
crucify mankind upon a
cross of gold."
-William Jennings Bryan,
July 9, 1896
Establishment of the Federal Reserve
• In 1913 Congress passed the
Federal Reserve Act,
establishing the Federal
Reserve.
A painting by the artist Wilbur G.
Kurtz, Sr. shows President Wilson
signing the Federal Reserve Act.
Photo courtesy of the Woodrow Wilson
Presidential Library, Staunton, Virginia
• The Federal Reserve Act
called on the Fed to
- serve as a lender of last
resort
- manage the gold standard
to avoid sharp swings in
interest rates.
• The Congress gave
all regions of the
country a voice in
Fed policy by
establishing Federal
Reserve Banks across
the country, with a
Board of Governors
in Washington, D.C.
[map
showing
districts:
1.
Boston
2.
New
York the locations of the Federal Reserve Banks and their
3.
Philadelphia
4.
Cleveland
5.
Richmond
6.
Atlanta
7.
Chicago
8.
St.
Louis
9.
10.
Kansas
City
11.Minneapolis
Dallas
12.
San
Board
ofFrancisco
Governors,
Washington DC.]
The Roaring Twenties
• The 1920s-the "Roaring
Twenties"—was a
period of prosperity in
the United States.
Elsewhere many
countries struggled to
recover from World
War I.
[artworkdepictingadancingcouplefromthe20s]copyrightJ
Used by the Board of Governors of the
Federal Reserve System with the
permission of Illustration House, Inc.
The Great Depression
• In 1929, however, the world was
hit by a Great Depression. The
U.S. stock market crashed in
October 1929, and the largest
bank in Austria failed in 1931.
Output and prices fell in many
countries, and many
experienced political turmoil.
• The Depression continued until
the United States entered World
War II in 1941.
Stock Market Crashes in 1929 and
Continues to Fall until 1932
S&P Composite Equity Price Index
[For the accessible version of this figure, please see the accompanying HTML.]
Output Plummets and
Prices Fall (Deflation)
Real GDP
[For the accessible version of this figure, please see the accompanying HTML.]
Consumer Price Index
[For the accessible version of this figure, please see the accompanying HTML.]
Unemployment in the Great Depression
Unemployment Rate
[For the accessible version of this figure, please see the accompanying HTML.]
Bank Failures in the Great Depression
Bank Failures
[For the accessible version of this figure, please see the accompanying HTML.]
What Caused the Great Depression?
• There were many causes, including
- economic and financial repercussions of World
War I, including the effects of reparations
payments
- the structure of the international gold standard
- a bubble in stock prices
- financial panic and the collapse of major financial
institutions
What Caused the Great Depression?
- "liquidationist" theory, which viewed the
Depression as a necessary corrective to the
excesses of the 1920s
"Liquidate labor, liquidate stocks, liquidate the
farmers, liquidate real estate."
- Andrew Mellon, Secretary of Treasury, 1931
(as reported by Herbert Hoover in 1937)
Monetary Policy in the Great Depression
• Policy errors included
- tightening of monetary policy in 1928 and 1929 to
stem stock market speculation
- policy tightening in 1931 to halt a speculative
attack on the dollar
- policy inaction in 1932, despite high
unemployment and falling prices
Monetary Policy in the Great Depression
• The Fed's tight monetary policy led to sharply
falling prices and steep declines in output and
employment.
• The effects of policy errors here and abroad were
transmitted globally through the gold standard.
• The Fed kept money tight in part because it
wanted to preserve the gold standard. When
FDR abandoned the gold standard in 1933,
monetary policy became less tight and deflation
stopped.
Lender-of-Last-Resort Policy
in the Great Depression
• The Fed responded inadequately to bank runs
and the contraction of bank lending, providing
only minimal credit to banks.
• Bank failures swept the country. More than
9,700 of the nation's 25,000 banks (at the end of
1928) suspended operations between 1929 and
1933. Failures continued until deposit insurance
was established in 1934.
• The Fed appeared to agree with the liquidationist
thesis, believing that banking and credit had
expanded too much in the 1920s and needed to
be reduced.
Roosevelt's Economic Policies
• FDR tried many policies to end the Depression.
Two particularly successful policies were
- Deposit insurance for banks ended runs.
- Abandonment of the gold standard allowed the
money supply to increase and ended deflation.
Policy Lessons from the Great Depression
• The Great Depression was global, and had many
causes. However, policy errors in the United
States and abroad played an important role.
• The Federal Reserve failed in both parts of its
mission:
- It did not use monetary policy to prevent deflation
and the collapse in output and employment.
- It did not adequately perform its function as
lender of last resort, allowing many bank failures
and a resulting contraction in credit.
• We will want to keep these lessons in mind as we
consider the Fed's response to the crisis of
2008-2009.
• The next lecture reviews developments in central
banking after World War II, including the sources of
the recent financial crisis.
THE FEDERAL RESERVE
AND THE FINANCIAL CRISIS
Cite this document
Ben S. Bernanke (2012, March 19). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_20120320_bernanke
@misc{wtfs_speech_20120320_bernanke,
author = {Ben S. Bernanke},
title = {Speech},
year = {2012},
month = {Mar},
howpublished = {Speeches, Federal Reserve},
url = {https://whenthefedspeaks.com/doc/speech_20120320_bernanke},
note = {Retrieved via When the Fed Speaks corpus}
}