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November 2011

Then and Now: Fed Policy Actions During the Great Depression and Great Recession

by David A. Lopez

"Regarding the Great Depression. You're right, we did it. We're very sorry…we won't do it again."
—Federal Reserve Chairman Ben S. Bernanke, November 8, 2002

Any mention of the Great Depression conjures up images of unemployed masses queuing in bread lines and frantic crowds trying to withdraw money from banks. And yet these illustrations tell only part of the story. The Great Depression was undoubtedly the most severe economic downturn in the United States and caused untold suffering among millions. To contextualize it, national output fell by about 33 percent and consumer prices plummeted by over 25 percent between 1929 and 1933; one in four workers was unemployed by 1933. The resulting protracted slump only ended at the onset of World War II.1 In contrast, during the Great Recession of 2007-09, national output fell by only 5 percent, consumer prices increased by 1 percent, and unemployment peaked at 10.1 percent.2

Scholars have posited a variety of causes for the Great Depression, and the role of central banks in exacerbating the crisis has emerged as a key point. This article thus considers (i) how Federal Reserve policies during the Great Depression weakened economic conditions and (ii) how policymakers used the lessons learned from the Depression to stabilize the economy during the Great Recession.

Federal Reserve actions in the run-up to the Great Depression were important in hastening the decline in economic conditions. The speculative effects of the stock market boom in 1928-29 caused the Fed to increase interest rates to curtail the bullish trend.3 While this policy action dampened excessive borrowing to finance stock purchases, it also brought unintended consequences. Capital spending (e.g., for equipment and infrastructure) slowed dramatically in many sectors of the economy, leading to a drop in industrial production and output growth. The infamous stock market collapse in October 1929 finally ground the economy to a halt, and the Depression hit with full force soon after.

In the early 1930s, continued policy missteps by the Fed significantly lengthened the Depression. Specifically, the Fed failed to prevent four massive banking panics from battering the economy in 1930-33. On each occasion, anxious depositors descended on banks to withdraw cash because the public had lost confidence in the ability of financial institutions to service deposit obligations. Due to fractional banking procedures,4 banks did not have enough cash on hand to meet this increased demand. The Federal Reserve, as the lender of last resort, was in a prime position to limit the fallout by providing emergency funds to banks under distress. However, Fed policy at that time dictated that only banks with sufficient collateral or member banks of the Federal Reserve System were eligible for these funds. Consequently, cash-starved banks failed in large numbers.

The effects of the banking panics were catastrophic: The money supply5 fell precipitously and a prolonged bout of deflation set in. As the institution directed to maintain price stability, the Fed should have flooded the economy with additional liquidity6 to stop consumer prices from falling. However, policymakers dithered and hampered the prospects of a quick recovery. With a decline in the price level, real (or inflation-adjusted) interest rates soared.7 As a result, borrowers became saddled with higher debt burdens, contributing to wide­spread defaults and bankruptcies. In addition, the increase in real borrowing costs depressed consumer and business investment, further slowing economic activity.

By 1933, government policy actions (e.g., provision of deposit insurance) helped stabilize the banking system and the economy improved significantly in the mid-1930s. As investor confidence grew, gold and other funds began to flow into the United States once again, expanding the money supply. Fed officials, though, became increasingly alarmed at the prospect of high inflation and increased reserve requirements for banks (the percentage of deposits that banks must hold in reserve). Some experts suggest that this increase caused a decrease in lending, which in turn caused the money supply to decrease once again.8 The recession that followed in 1937-38 temporarily derailed the recovery. Although the economy rebounded again in 1939, the nation's unemployment rate returned to its pre-crisis level only after the United States entered the war in late 1941.

By contrast, Fed policies implemented during the 2007-09 Great Recession were markedly different from those during the Great Depression. When the Recession began, the Fed acted decisively to stave off the collapse of the financial sector. Specific policies included decreasing the federal funds rate to nearly zero percent and establishing programs that lent money to banks on a short-term basis. The latter was especially significant in providing stopgap funding to American International Group (AIG), whose failure could have plunged the financial sector into further chaos. Through an expansion of its balance sheet, the Fed also facilitated the sale of distressed investment bank Bear Stearns to a commercial bank (JPMorgan Chase). In addition, to reduce the risk of deflation that devastated the economy during the Depression, the Fed made large-scale purchases of Treasury bonds in two rounds of quantitative easing.

Philosopher George Santayana (1863-1952) said that "those who cannot remember the past are condemned to repeat it." Recent experience shows that the Federal Reserve avoided the policy pitfalls of the Great Depression. During the 1930s, inadequate Fed policy compounded the downward slide in the economy. This experience served as a wake-up call for the Fed, however, resulting in more assured policy measures that prevented the meltdown of financial markets during the Great Recession.


1 As determined by the National Bureau of Economic Research, the Great Depression officially lasted from August 1929 to March 1933. Although output rebounded significantly from 1934-37, the effects of the Depression lingered throughout the 1930s and the economy only returned to full employment when the United States entered World War II.
2 As determined by the National Bureau of Economic Research, the Great Recession lasted from December 2007 to June 2009.
3 Prior to this, the Fed reduced the discount rate on loans made to banks from 4 percent to 3.5 percent between July and September 1927. Some observers contend that this prolonged an unsustainable boom in the stock market and that the Fed should have tightened monetary conditions sooner.
4 Fractional-reserve banking is a system where banks hold a portion of their deposits (cash) in vaults or at the Federal Reserve and use the remaining cash for lending activities. 

5 The two most common measures of money supply are called M1 and M2. Further information can be found here.
6 In this case, liquidity refers to the ease of obtaining credit and meeting the demand for money. The Fed increases liquidity by purchasing Treasury securities, which increases bank reserves and, all else equal, lowers nominal interest rates.
7 The real interest rate is the difference between the nominal interest rate and the inflation rate. During the Depression, nominal rates were close to zero percent and the inflation rate was negative, leading to very high real interest rates. For further information, see 
Carlstrom, Charles T. and Fuerst, Timothy S. "Perils of Price Deflations: An Analysis of the Great Depression." Federal Reserve Bank of Cleveland Economic Commentary, February 2001.
8 More recent research, however, finds that an increase in the reserve requirement did not significantly affect the supply of money at that time; see Calomiris, Charles C.; Mason, Joseph R. and Wheelock, David C. "Did Doubling Reserve Requirements Cause the Recession of 1937-1938? A Microeconomic Approach." Working Paper No. WP2011-0021, Federal Reserve Bank of St. Louis, January 2011.

© 2011, Federal Reserve Bank of St. Louis. The views expressed are those of the author(s) and do not necessarily reflect official positions of the Federal Reserve Bank of St. Louis or the Federal Reserve System.