what did consumer habits,goverment economic policies,and the federal reserve?

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Question by KING N: what did consumer habits,goverment economic policies,and the federal reserve?
what did they have to with the great depression

Best answer:

Answer by gray shadow
The causes of the Great Depression is the subject of much academic debate. The short answer is that the Roaring Twenties over stimulated the economy. The result was that businesses became overextended in investment, inventory, and speculative loans. When the shock of the crash came, those speculative loans were the first dominoes to fall, causing a ripple effect.

Perhaps the best way to describe the government/Fed reaction was confusion and indecision. The prevailing economic theory back then for government was laissez-faire; i.e. don’t interfere too much and let the market place adjust. Indeed many felt that the cheap money and labor should surely jumpstart the economy.

The monetary power structure was much different back then than it is today. The Board of Governers was essentially chaired by the Secretary of the Treasury. The 12 branches had relative independence from each other and, to some extent, the Board of Governors. The Board could only issue ‘recommendations’ which Branches could opt out if they wish. (Usually the branches didn’t completely ignore such recommendations if they didn’t like them, just ‘foot dragged’ on them; there was some fear of political consequences if it appeared there was open rebellion.)

Following the October 1929 crash, the NY Branch immediately purchased $ 100M in T-Bills (i.e. added $ 100M to the money supply). But when the Open Market Investment Committee recommended buying abother $ 200M, not all Fed parties agreed and precious time passed before it was finally executed. There continued to be differences of opinion on how to deal with the crisis so it was difficult to arrive at consensus. In the 1930s, the bank failures continued as the Fed system continued to bicker on the right response.

Contrary to popular perception, the Fed system did indeed pump in more money during this period but the money supply continued to drop. Why the paradox? The money supply is made up of two parts: The Monetary Base or M0 (essentially all currency in circulation) and new deposits as a result of loaning on originally deposits, a.k.a M1/M2. The drop in the money supply was the result of people pulling currency out of banks and into mattresses+cookiejars. Currency in a bank can be loaned to create new economic activity; currency in a cookie jar cannot. The problem was not strictly of an inadequate monetary base (M0); the problem was a well-founded confidence crisis in the banking system.

To compounded it further, the banks themselves had a confidence crisis of their own. Seeing other banks failure made them doubt the Federal Reserve System ability to come to their rescue in time of need. (Indeed the large bank dominated branches were somewhat callous to their competitions financial woes). As a defensive measure, these banks increased their reserves (i.e. decreased the amount of deposit money that could be loaned) thus reducing M1/M2 further.

So this was bad enough but then we had the gold crisis. In September 1931, approximately $ 700M in gold left the U.S. for Europe when Britain dropped the gold standard (the particulars would require another short dissertation). The effect was a minor disaster for an already struggling nation. By law (back then), Federal Reserve banks had to hold 40% gold against the currency they issued. Some banks had no choice but to constrain their currency in their district to match this legal requirement. Later it was observed that the Fed system as a whole had enough gold that no such contraction was necessary but with the 12 branches acting independently, the gold could not be easily shifted.

By 1932, confusion just got worse. Low interest rates, normally an economic stimulant, was not working. The problem was still a lack of confidence by consumers and banks.

The final bank panic of 1933 was the worst. There was practically no action as the Board and branches had no idea how to stop people from pulling money from banks. This was further compounded by public demands for gold and gold certificates which would (for reasons described above), would reduce currency even further.

The failure of the Federal Reserve system to prevent and properly react to the early years of the great depression lead lead to the biggest change in the Federal Reserve history. The Bank Act of 1935 centralized power with the Board of Governors. For the first time, the country had a single body responsible for monetary policy. The Board became responsible for the banking system as a whole. The branches were reduced to day-to-day operations though their chairmans actively participate in Fed boards.

It was a good move, but I think most economists would agree the confidence crisis was best addressed by the passing of the FDIC act which insured all deposits against failures.

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