Banking and the Great Depression

Opinion Pieces>Banking and the Great Depression

In the Spring of 1937, at the train station of the small town of Elizabeth, New Jersey, a man paced nervously on the platform. From a half-mile away, Roy Humphrey and his fellow commuters could hear the rumblings of the express train to New York City approaching their platform. The Pennsylvania Railroad electric locomotive – built by General Electric between 1934 and 1943 – did not normally stop at the Elizabeth station, rather making a straight shot for the city. That day, however, the usually-reliable express service would encounter an unexpected delay. As the train made its approach at a steady 50 miles per hour, Roy jumped down from the platform and lay across the tracks. His last act, as witnesses would report, was to lift his head to look at the oncoming train. 

The great depression

Roy Humphry was a qualified lawyer, but because of the dire economic conditions of the 1930s, he was forced to work as a customs inspector at the Barge Office in Manhattan, New York. For a proud and educated man, this work was extremely menial and low-paying. Roy’s suicide was one of at least 40 000 in America that year, contributing to what would be the highest suicide rate ever recorded in the US up until that date. Even eight years on from the market crash of 1929 – a year which itself saw a drastic jump in suicide rates from around 12 per 100 000 to 18 per 100 000 – it seemed the psychological effects of the Great Depression were still being strongly felt long after Black Tuesday. 

Whilst the Wall Street Crash of 29 October 1929 serves as a definitive marker for the beginning of the Great Depression, many economists and historians have argued that the stock market crash was not the only cause, or even the primary cause, of the global economic recession that would last over a decade. In fact, by the fall of 1930, with prices stabilising and a slight uptick in the markets, there was reason for some optimism that the US economy may be on course to make a relatively quick recovery. This optimism was not unfounded, as the United States had very recently bounced back from a number of market crashes, with three significant recessions and recoveries already taking place in the 1920s by the time the Great Crash in 1929 came around. But this time, things were going to be far more severe. 

Ultimately, the 29th of October would be the catalyst of the Great Depression, but beyond Black Tuesday, there were several contributing factors that would combine to turn a crash into a decade-long recession. One such significant, yet lesser discussed, factor exacerbating the recession was the weakness of the American banking system leading up to the crash, as well as the failings of the Federal Reserve to deal with this weakness through strong monetary policy and effective banking regulation interventions post-1929. In the decade after the Great Crash, more banks failed than in any other time in US history, with over 9 000 banks of varying sizes closing all across the country, and 7 000 failing between just 1929 and 1933. The staggering number of failures alone may hint at one of the problems that existed within the US banking system at the time. Before considerable consolidation of financial institutions and the extension of the Federal Reserve’s powers in the years after the Great Depression, there existed about 20 000 banks in the commercial banking system of the United States. 

The sheer number of these independently-run institutions would ultimately weaken the systemic stability of the American economy in the early 1930s. During the Roaring Twenties – with government and consumer spending at an all-time high after the nation’s successful wartime efforts and large-scale industrialisation taking place alongside the widespread household adoption of electric appliances and automobiles being manufactured in the US – it was almost impossible for these thousands of independent banking institutions not to prosper. And because of this euphoric era of free spending, excessive lending and wild speculation driven by an apparently unstoppable stock market bull run, the financial system in America became very bloated and inefficient – drunk and dozy from the unending party of the 1920s. 

One of the key elements within the banking system at the time that would significantly contribute to the liquidity crises and bank runs that would occur in the early 1930s was the McFadden Act of 1927. This Act prohibited interstate branch banking, forcing banks to remain small and local, inadvertently exposing them to the risks associated with relatively undiversified loan books, as well as the risks that are borne from having a very geographically concentrated base of depositors. The full force of these failings was felt in November of 1930, with the Bank of Tennessee’s collapse in Nashville causing a domino effect of bank failures throughout the South and eventually spreading around the country. 

The reason for the rapid spread of these failures was primarily owing to the network structure of American commercial banks at the time. Thousands of independent local branches were connected in a system of correspondent banking. In these correspondent networks, larger financial institutions (correspondents) would provide smaller banks (respondents) with many of the most basic services they and their customers required, in order to streamline the local bank’s operations and to reduce the costs of having to develop these systems themselves. One such service, which was critically important to the effective functioning of banks at the time, was the cheque clearing system. 

In correspondent networks, larger banks or financial institutions in the form of holding companies would provide cheque clearing services to smaller local branches. In this way, these larger institutions acted as a kind of central bank for hundreds or thousands of smaller banks, which would hold reserves at their correspondent banks at a fraction of the cost they would otherwise have incurred. A costly oversight of this system, however, was the timing involved in the bookkeeping between the correspondents and respondents. Whilst a physical cheque could take days or even weeks to be cleared to reflect legitimate funds in an account, for the convenience of bookkeeping the amount was immediately added to the respondent’s reserves at the correspondent bank upon receiving the cheque at the local branch. This practice resulted in what was to become known as “fictitious” reserves in the account of these small respondent banks, which if not cleared, would only be rectified many days or even weeks after the fact. 

This often-significant disparity between actual and “fictitious” reserves of a local bank branch would play an important role in the spread of bank failures following the Great Crash. One example of this was the collapse of a correspondent institution called Caldwell & Company, whose failure set in motion the Great Depression’s first banking crisis, starting in Nashville, Tennessee. When Caldwell & Company had to shut its doors in November 1930, so did the Bank of Tennessee, as well as dozens of other respondents relying on the reserves held at the correspondent. This initial crisis caused a chain-reaction throughout the southern states of America, with customers of unrelated banks panicking and initiating unfounded runs on their local banks, eventually snowballing to become a mass hysteria that would sweep across the country in 1930. In that year alone, nearly 1 000 banks failed. The failure of these respondent banks, and the knock-on effect on their correspondent banks, ultimately led to an ongoing liquidity crisis that would result in a devastating deflationary effect on the price of goods and services in the US economy. 

In the 1960s, Milton Friedman, like many economists today, argued that whilst there were obvious weaknesses in the banking system in the 1920s and 1930s, much of the pain of the Great Depression could have been avoided by a stronger monetary policy reaction by the Federal Reserve at the time. As Friedman and other monetarists argue, by not stepping in and lowering interest rates and by not increasing the monetary supply to ease the liquidity crisis, the Federal Reserve effectively stood by and watched nearly a third of all banks in America collapse, taking with them the wealth of millions of Americans and destroying the price of goods by over 30 percent in the matter of a few months. Friedman went as far as to argue that if the Federal Reserve had taken a much stronger approach to curtailing the liquidity crisis, the crash of 1929 would have been nothing more than a bump in the road for the American economy, even avoiding the subsequent banking crisis and the decade of suffering that was to come. 

In defence of the Federal Reserve, its reaction to the banking crisis in the early 1930s was somewhat hamstrung by the limitations of the Gold Standard. According to this system, the amount of Federal Reserve Notes injected into the monetary system required the backing of at least 40% of that amount in gold reserves held by the government – as these notes were in theory redeemable for their denominated amount in gold. In 1933, to protect the already under pressure gold reserves from being further depleted, and in hopes of shaking loose some much-needed liquidity into the struggling market, President Roosevelt made the private “hoarding” of gold in any form illegal in the United States, with a punishment of up to 10 years in prison for offenders. By the start of the Second World War in 1939, every nation had abandoned the Gold Standard. 

Between 1929 and 1939, like Roy Humphry who took his life at the Elizabeth train station, millions of Americans – as well as millions across the world affected by the economic shockwaves emanating from the American core – would lose their jobs, and their hope, during the years of the Great Depression. As depicted in John Steinbeck’s great American realist novel The Grapes of Wrath (1939), the agriculturalists of landlocked states such as Oklahoma, Texas and Kansas were particularly hard hit by the tough economic conditions, which were only intensified by the catastrophic droughts that plagued these rural farming communities throughout the 1930s. Steinbeck vividly describes how these Americans – mostly tenant farmers – were economically and physically suffocated by the harsh farming conditions in what was to become known as the Dust Bowl region, when massive dust storms destroyed crops year after year, deepening the wounds that the rapidly contracting economy was already inflicting on the livelihoods of these small farming communities. 

The result of these relentless dust storms and continually failing crops was ultimately the foreclosure of these tenant farmers’ land and homes by banks, leaving millions jobless, homeless and hopeless. The only choice for these farmers trapped in the Dust Bowl was to abandon their homelands, triggering what was to be the largest migration of people in a short period in American history. In the exodus from the Plains states between 1930 and 1940, over three million people packed up what little they had and began the trek across the country in search of work – with California being the final destination for a significant portion of these forsaken farmers. 

These inordinately desperate times in America created a great distrust of the financial system and many even called it the end of capitalism. From the point of view of those tenant farmers that had lost everything, the final act of the banks coming to foreclose on their land, homes and possessions left a very bitter taste in their mouths, as is harrowingly articulated in Steinbeck’s work. In The Grapes of Wrath, Steinbeck writes: “If a bank or a finance company owned the land, the owner man said, The Bank – or the Company – needs-wants-insists-must have – as though the Bank or the Company were a monster, with thought and feeling, which had ensnared them. These last would take no responsibility for the banks or the companies because they were men and slaves, while the banks were machines and masters all at the same time.” 

The banking system that had been neglected and that had been allowed to grow out of control during the 1920s eventually turned against its masters in the early 1930s. Unfortunately, however, the damage it would cause was by no means limited only to its owners. The ripple effect of the banking crisis and the subsequent contraction of monetary supply would go on to impact the entire world. On aggregate, global GDP fell by 15% between 1929 and 1932, compared to just a 1% drop in worldwide GDP following the 2007/2008 financial crisis, to put it into perspective. The lack of foresight and intervention by the US government into the proliferation of the banking system in the 1920s played a significant part in what was to become the 20th Century’s longest, deepest and most widespread global economic recession. Despite the philosophical authenticity that sat at the heart of the founding fathers’ intentions in rejecting the notion of a central bank, the implementation of a compromised version of a central bank significantly amplified the greed and excess of the Roaring Twenties and ultimately led to the eventual collapse of the entire US economic system in the 1930s. 

This article is from the Monocle Quarterly Journal, A Short History of Banking. Visit our "Journals" section to read the full issue.