The Great Deformation (29 page)

Related indicators also confirmed a broad and vigorous recovery. Wholesale prices rose by nearly 20 percent from their early 1932 bottom, marking the first sustained uptick since September 1929. The stock market quickly grasped the picture and rebounded from its depression low on the Dow Jones Index of 41 on July 7, 1932, to 80 in early September, before fears of a Roosevelt victory set it back.

The most important sign of economic rebound, however, was in the beleaguered banking sector. After having experienced nearly three hundred bank closings per month for much of the post-1929 period, bank failures dropped sharply to only seventy to eighty closings a month after June.

Indeed, for the period of July through October 1932, deposits held by banks which were reopened during that interval exceeded those of newly failed banks, a complete break with the month-after-month deposit losses that had occurred until then. In a similar vein, the United States experienced five straight months of gold inflows after July, indicating that the panicked gold flight that had commenced after the British default of September 1931 had decisively reversed.

As one careful journalistic reconstruction of events published during this period noted, “With the defeat of all threatening inflationary legislation in June … [and] the complete restoration of foreign confidence in the American gold position—the breath of recovery began to be felt over the land.”

No less an authority on the national mood than Walter Lippmann, then at the peak of his game and influence, later summarized, “There is very good statistical evidence … that as a purely economic phenomena the world depression reached its low point in mid-summer 1932 and that in all the leading countries a very slow but nevertheless real recovery began.”

By election time, however, the rebound had cooled. Subsequently, all the indicators of economic and financial activity weakened sharply during the long interregnum between Election Day and the March 4, 1933, inauguration.

As outlined below, there is powerful evidence that this setback can be attributed to a “Roosevelt panic” in the gold and banking markets that was avoidable and the result of FDR's numerous errors and provocations
during the presidential interregnum. The fact is, every other major industrial country in the world also began to recover in July 1932, but none had a relapse back into depression during the winter of 1932–1933.

THE BANKING CRISIS THAT FDR MADE

The Hoover recovery has largely been omitted from the history books, fostering the impression that the American economy had continuously plunged after October 1929 until it reached a desperate bottom on exactly March 4, 1933. That rendition of events was far from accurate, but it did mightily burnish the Roosevelt miracle legend; namely, that FDR decisively reopened the frozen banking system, restarted the wheels of commerce, and restored a heartbeat to capitalism through the swarm of acronyms which flew out of New Deal Washington during the Hundred Days.

But the received version of the March 1933 banking crisis is an invention of Arthur Schlesinger Jr. and other postwar commentators who postulated FDR's “bank holiday” as the dividing line between Hooverian darkness and the Roosevelt miracles. By contrast, the most savvy and erudite financial observers at the time saw it far differently, and for a very good reason: on the Friday evening before Roosevelt's inauguration most of the US banking system was still solvent, including the great money center banks of New York: the Chase National Bank, First National City Bank, the Morgan Bank, and many more.

Indeed, the latter had to be practically coerced into agreeing to the New York State banking holiday signed into effect by Governor Lehman at 4:30
A.M.
in the wee hours before FDR's inauguration. As it happened, the governor was a scion of the banking house bearing his name, but the circumstances of 1933 were the opposite of those which accompanied its demise in 2008.

Back then there had been no bank runs in the canyons of Wall Street because the great banks had largely observed time-tested standards; that is, they had been fully and adequately collateralized on their stock loans and were sitting on cash reserves up to 20 percent of deposits. The stock market crash of 1929–1930 had been brutal, of course, but in those purportedly benighted times officialdom had the good sense to allow Mr. Market to make his appointed rounds.

Accordingly, stock market punters by the thousands had been felled quickly and cleanly when upward of $9 billion of margin loans were called after Black Thursday. Indeed, the banks and brokerages liquidated in a matter of months the massive margin loan bubble—$1 trillion in today's economy—that had built up under the stock averages in the final years of the mania.

The fact that none of the great New York money center banks closed their doors during the four years between the crash and FDR's inauguration points to the real story; namely, that the bank insolvency problem had been in the provinces and countryside, not the nation's money center.

In fact, the run of bank failures was largely contained within the borders of the oversized 1914–1929 agricultural and industrial export economy. As the latter collapsed, overloaned banks in industrial boom towns like Chicago, Detroit, Toledo, Youngstown, Cleveland, and Pittsburgh had taken heavy hits.

In the case of the agricultural hinterlands, the Great Depression had started to roll in a decade before the crash, owing to the unique farm country boom and bust which had accompanied the Great War. The unprecedented total industrial-state warfare of 1914–1918 had drastically disrupted European agricultural production and markets, inducing an explosion of export demand, high prices, and soaring output in the American farm belt. There soon followed an orgy of speculation in land and real estate that exceeded in relative terms even the sand-state housing boom of 2002–2007.

Once the agricultural lands of Europe came back into production, however, the great American granary lost much of its artificial war-loan export market, causing farm prices to abruptly plunge in 1920–1921 and then to continue sinking for the next decade. Not surprisingly, thousands of one-horse banks dotting the countryside had been caught up in the wartime frenzy and then suffered massive, unrelenting losses during the long postwar deflation of the farm bubble.

Overall, about 12,000 banks failed during 1920–1933, but 10,000 of these were tiny rural banks located in places of less than 2,500 population. Their failure rate of more than 1,000 per year throughout the 1920s makes for eye-catching historical statistics, but they were largely irrelevant to the nation's overall GDP. Losses at failed US banks during the entire twelve-year period through 1932, in fact, accumulated to only 2–3 percent of deposits.

This extended wave of failures was an indictment of the short-sighted anti-branch banking laws that rural legislators had forced upon the states, as well as a reminder that wartime inflation and disruption had cast a long shadow on the future. The crucial point, however, is that these thousands of failed banks were insolvent and should have been closed. They were not evidence of some fundamental breakdown of the banking system, or failure of the Fed to supply adequate liquidity, or a systemic crisis of capitalism.

Even after the 1929 crash, when the failure rate accelerated to about 2,400 in the twelve months ending in mid-1932, the periodic spurts of bank closures were not national in scope. Instead, they struck with distinct regional incidence in the agricultural and industrial interior. And almost
without exception, these regional bank failure breakouts were centered on cities or banking chains which had indulged heavily in speculative real estate lending and other unsound practices.

That was certainly the case with the first significant outbreak of bank runs in November 1930 when the Caldwell banking chain collapsed. A speculative pyramid of holding companies which controlled more than a hundred banks in Tennessee, Arkansas, and North Carolina, it failed when real estate values fell sharply in the upper Cotton Belt. While there was some spillover on local banks, the runs did not spread beyond the region and quickly burned out because deposits were moved to sounder banks, not to mattresses.

The most powerful evidence of the noncontagious nature of the pre–February 1933 bank failures occurred shortly thereafter with the famous collapse of the Bank of the United States in December 1930. An upstart New York City bank, the Bank of the United States, grew by leaps and bounds in the late 1920s through serial mergers, aggressive real estate lending, and pyramiding of holding company capital.

The bank had been a stock market rocket ship, rising from $5 per share in 1925 to a peak of $230 before the crash. But its promoter, one Bernard Marcus, who had been the Sandy Weill of his day, had been more adept at making deals than making sound loans, and thereby soon rendered his hastily assembled banking empire insolvent. Yet there was virtually zero spillover to other New York banks when state banking supervisors shuttered what was then the city's third-largest institution with around seventy branches and deposits on the order of $30 billion on today's scale.

The same pattern occurred the following June in Chicago. There had been a giant real estate bubble in the Chicago suburbs during the 1920s, but owing to Illinois's particularly restrictive anti-branch-banking law the Great Loop banks had been sidelined, leaving the suburban real estate lending spree to poorly capitalized newbies.

Chicago had been an epicenter of the 1914–1929 agricultural/industrial/export boom, so when the party ended abruptly after the stock market crash, the region's economy was hit harder than any other industrial center outside of Detroit. Real estate prices experienced a particularly devastating collapse in the newly developed suburban communities, triggering a wave of defaults in loan portfolios which were heavily laden with commercial and residential mortgages.

Yet with one exception a year later, the Great Loop banks remained solvent and experienced no lines at their teller windows. By contrast, the “runs” on the suburban banks were both swift and warranted because they
were deeply insolvent. In short, the Chicago case further illuminates the fact that the wave of bank failures during 1930–1932 was not the result of irrational public sentiment and “contagion,” or a fundamental breakdown of bank liquidity, but instead was evidence of a discriminating, rational flight of depositors from unsound banks and markets.

Even when surges of bank failures extended eastward, such as in the Philadelphia runs of October 1931, there was far more rationality to the pattern than the conventional narrative acknowledges. In this case, the overwhelming share of failures was concentrated among newly formed “trust banks” which had been chartered under state law with far less stringent requirements for capital and cash reserves than was the case with national banks.

Again, the late 1931 wave of bank failures in Philadelphia quickly burned out after deposits had moved from the lightly regulated trust banks, which had been on the leading edge of real estate lending and securities speculation, to the far better capitalized national banks. Indeed, the fundamental solvency of the US banking system was dramatically evidenced during this same period when the Fed raised the discount rate in mid-October.

This Fed action is habitually and roundly criticized by contemporary advocates of central bank money printing, but it was actually the proper move under then-extant gold standard rules. Specifically, the initial impact of the British default on September 1931 had been a run on US gold out of fear that the United States would be the next to default. So a discount rate hike was necessary to stop the outflow and, in fact, the rate of gold losses fell sharply in the months ahead and eventually reversed to an inflow by mid-1932.

More importantly, there was no acceleration of bank failures after the discount rate hike, and within weeks the failure rate slackened dramatically while discount borrowings actually increased. This was proof positive that banks were failing not because they were illiquid or could not get emergency funding from the Fed but because they were, alas, bankrupt.

Indeed, Herbert Hoover's unfortunate banking cure at the time—the emergency enactment of the Reconstruction Finance Corporation (RFC) in January 1932—was designed to alleviate insolvency, not provide emergency funding or replace hoarded deposits. Accordingly, the RFC went on to become a paragon of crony capitalism, rescuing dozens of busted railroads and recapitalizing several thousand insolvent banks. Yet the outcome was perverse: the stock and bondholders of bailed-out institutions were rescued, competitors were harmed, and the nation's economy was left to slog it out with far too much railroad capacity and way too many banks.

THE BANKING CRISIS WAS OVER

BEFORE FDR GOT STARTED

Nevertheless, the so-called banking crisis was largely over on the night of FDR's November 8, 1932, election. Nationwide bank failure rates had dropped to less than two dozen per week of mostly tiny country banks, deposit levels were rising, and what remained was a modest cleanup operation for the residue of insolvent banks in the hinterlands.

This adjustment process had now been heavily politicized, meaning that banks sinking into insolvency would receive capital injections from the RFC rather than closure notices from state and federal banking supervisors. But the key point is that there was no significant liquidity problem in the US banking system. The Federal Reserve, bank regulators, and discriminating depositors had already done their jobs and had quietly and systematically moved massive amounts of deposits to sounder banks.