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Investment Outlook - Fourth Quarter 2017

Unraveling the Mystery of the Federal Reserve

By: Denny Fulmer, CFA
Wednesday, January 17, 2018

Unraveling the Mystery of the Federal Reserve

Understanding Federal Reserve policies can be agonizing for people regardless of their understanding of the financial industry. To offer some clarity, we review the historical parallels between the Great Depression of the 1930’s and the Recession in 2008.

 Why the Fed was created back in 1913. Throughout the 1800’s, the nation suffered a series of severe economic declines, mostly caused by banks that failed. One bank has too many loans in a booming industry, such as water canals or railroads, but borrowers are unable to service their loans. As rumors spread, and depositors rush to withdraw their money, the bank’s assets consist primarily of loans that are difficult to sell. Some loans are in default while others are still good; the bank has to close when it cannot meet the depositors’ requests for money. This panic spreads to other banks which builds the momentum of alarm and failure. The result is a majority of depositors depleted, few people have any money to spend, and a significant economic decline spreads across the country. These events were known as Financial Panics, and the largest was in 1893 and 1907. J.P. Morgan stopped the 1907 panic by assembling his wealthy friends and using their assets to provide cash to struggling banks.

 In 1908, a commission was formed to search for a long-term solution to this recurring problem. After a political debate on whether the solution would be controlled privately, corporately, or federally, the Federal Reserve Act of 1913 was passed. A compromise resulted in 12 regional banks dispersed across the country. The Act created a nationwide currency, called Federal Reserve Notes, whereas before individual banks had their own currencies. The goal of the Act was to stop the series of panics which preceded depressions. It empowered the Fed to buy and sell Treasury bonds, and loan money to banks. The Fed took over the role of Mr. Morgan and was supposed to provide lines of credit to banks when they faced a liquidity squeeze.

 If the Fed was around for the 1930’s, why was the Great Depression so bad? Our colleague Lynn Hamilton discovered the book, “The Great Depression, a Diary,” by Benjamin Roth, an attorney from Youngstown, Ohio. In June of 1931, Roth started recording the events he saw unfolding. This interesting book reveals why passbooks from closed banks were changing hands at about 50% of the account’s dollar value. Since some landlords could no longer collect rent on their buildings, they aspired to reduce their tax burden by destroying the structures. They would only owe tax on the land in hopes that they then could hold on to their property until the economy improved.

 The depression, in Youngstown, Ohio and throughout the country, was much more than a stock market event. Very few people had cash. Homeowners defaulted on their mortgages; the banks repossessed houses but could not sell them. Scared depositors withdrew their cash to safeguard it in a mattress or safe deposit boxes. Widespread panic exacerbated the problems that the banks faced. The stock market collapse was brutal on the stock-owning wealthy class, who saw its net worth disappear. Local examples were Youngstown Sheet and Tube, whose shares plummeted from $175 to $6 in late summer of 1932, and Republic Steel that sank from $140 to $2.

 When would the Federal Reserve take action? It was clearly not doing what it was allowed to by the 1913 law; it sat on the sidelines while the banking panic spread across the country. Some fiscal spending in 1932 added money to a cash-starved economy, and this started to stabilize the collapsing situation. In 1933, Congress awarded Veterans Bonus payments which put more cash into circulation. Finally, in 1933, Congress helped the banks by enabling them to trade their frozen mortgages for liquid government bonds. The government also bought millions of dollars of preferred stock in the local Youngstown banks. This allowed the banks to resume operations and remove any restrictions on deposits. The economy dramatically improved.

 These events demonstrate the importance of a stable banking system. The Fed failed to prevent this downward cascade of bank closings that led to the Great Depression. There are also striking parallels between the actions in the 1930’s and the 2008-2009 Crisis. TARP, the Troubled Asset Relief Program, signed into law on October 3, 2008, by President Bush, is nearly identical to what the government did in 1933. It exchanged the troubled subprime mortgage securities for government bonds and bought preferred stocks in the banks. This was called an unprecedented bailout by critics in 2008; it mirrors the actions from 1933. Former Fed Chairman Ben Bernanke’s economic stimulus comment, “dropping money from helicopters,” resembles the Veterans Bonus payments from 1933.

 In summary, a shrinking money supply results in a weak economy which is best demonstrated by the extreme 30% money contraction of the 1930’s. The 2008 crisis was quickly turned around by decisive actions to stop a snowballing crisis. Since then, the economy has had nearly ten years of steady but unremarkable growth. Asset prices usually rise when the Fed adds liquidity to the financial system; conversely, they decline when liquidity is reduced by attempting to restrain inflation. The Fed is the major influencer of liquidity, but an abrupt change in willingness to take a risk by investors can also reduce liquidity in the financial system, such as in a panic and the Fed is supposed to counteract.

 In summary, the Federal Reserve should not be viewed as something too complex or mysterious. Its role of maintaining a solvent and stable banking system is very important as illustrated by the contrasts and similarities of the Great Depression versus the 2008 Financial Crisis.

 Additional sources: Federal Reserve website, Wikipedia, YouTube videos of Milton Friedman.

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