Lessons Learned? Comparing the Federal Reserve’s Responses to the Crises of 1929-1933 and 2007-2009 David C. Wheelock The financial crisis of 2007-09 is widely viewed as the worst financial disruption since the Great Depression of 1929-33. However, the accompanying economic recession was mild compared with the Great Depression, though severe by postwar standards. Aggressive monetary, fiscal, and financial policies are widely credited with limiting the impact of the recent financial crisis on the broader economy. This article compares the Federal Reserve’s responses to the financial crises of 1929-33 and 2007-09, focusing on the effects of the Fed’s actions on the composition and size of the Fed balance sheet, the monetary base, and broader monetary aggregates. The Great Depression experi - ence showed that central banks should respond aggressively to financial crises to prevent a col lapse of the money stock and price level. The modern Fed appears to have learned this lesson; howev er, some critics argue that, in focusing on the allocation of credit, the Fed was too slow to increase the monetary base. The Fed’s response to the financial crisis has raised new questions about the appropriate role of a lender of last resort and the long-run implications of actions that limit financial losses for individual firms and markets. (JEL E31, E32, E52, E58, N12) Federal Reserve Bank of St. Louis Review , March/April 2010, 92 (2), pp. 89-107. he financial crisis of 2007-09 is wide ly nomic contractions by the National Bureau of viewed as the worst financial disrup - Economic Research (NBER). The recent reces sion tion since the Great Depression of began in December 2007, according to the NBER. 1929-33. The banking crises of the Great Although their Business Cycle Dating Committee TDepression involved runs on banks by deposi - has not officially identified the end of this reces - tors, whereas the crisis of 2007-09 reflected panic sion, many economists believe that it ended in in wholesale funding markets that left banks the middle of 2009; thus, the data used for this unable to roll over short-term debt. Although recession span December 2007 through June 2009. different in character, the crisis of 2007-09 was In terms of duration, decline in real gross fundamentally a banking crisis like those of the domestic product (GDP), and peak rate of unem - Great Depression and many of the earlier crises ployment, the recent recession ranks among the that preceded large declines in economic activi ty most severe of all postwar recessions. 1 However, (Gorton, 2009). Table 1 reports information about every U.S. 1 recession since the Great Depression of 1929- 33— The recession of 1945 was marked by a sharp, but short-lived decline in output as industries sharply reduced the production of more specifically, the periods designated as eco - war material at the end of World War II. David C. Wheelock is a vice president and economist at the Federal Reserve Bank of St. Louis. The author thanks Michael Bordo, Bob Hetzel, Rajdeep Sengupta, and Dan Thornton for comments on a previous version of this article, which was presented at the conference “The History of Central Banking” at the Bank of Mexico on November 23, 2009. Craig P. Aubuchon provided research assistance. © 2010, The Federal Reserve Bank of St. Louis. The views expressed in this article are those of the author(s) and do not necessarily reflect the views of the Federal Reserve System, the Board of Governors, or the regional Federal Reserve Banks. Articles may be reprinted, reproduced, published, distributed, displayed, and transmitted in their entirety if copyright notice, author name(s), and full citation are included. Abstracts, synopses, and other derivative works may be made only with prior written permission of the Federal Reserve Bank of St. Louis. FEDERAL RESERVE BANK OF ST . LOUIS REVIEW MARCH /APRIL 2010 89 Wheelock Table 1 Key Macro Performance Measures Across U.S. Recessions Real GDP: Unemployment: CPI: Decline peak Maximum value Change peak Recession Duration (months) to trough (%) during recession (%) to trough (%) 1929-33 43 –36.21 25.36 –27.17 1937-38 13 –10.04 20.00 –2.08 1945-45 8 –14.48 3.40 1.69 1948-49 11 –1.58 7.90 –2.07 1953-54 10 –2.53 5.90 0.37 1957-58 8 –3.14 7.40 2.12 1960-61 10 –0.53 6.90 1.02 1969-70 11 –0.16 5.90 5.04 1973-75 16 –3.19 8.60 14.81 1980 6 –2.23 7.80 6.30 1981-82 16 –2.64 10.80 6.99 1990-91 8 –1.36 6.80 3.53 2001 8 0.73 5.50 0.68 2007-09 20* –3.66 9.50 2.76 *The current recession end date has not yet been determined by the NBER; data are through 2009:Q2. the recent recession was mild compared with the Bernanke noted that, in contrast, monetary pol icy economic declines of 1929-33 and 1937-38. For was “largely passive” during the Great Depression. example, real GDP fell 36 percent during 1929- 33, This article summarizes the Federal Reserve’s and the unemployment rate exceeded 25 per cent. response to the financial crisis of 2007-09 and Moreover, the price level, measured by the con - compares it with the Fed’s response to financial sumer price index (CPI), fell by 27 percent. By con - shocks during the Great Depression. First, the trast, the CPI rose 2.76 percent between December article describes the Fed’s actions as the recent 2007 and June 2009. crisis evolved. Initially, the Fed focused on mak - Monetary, fiscal, and financial policies are ing funds available to banks and other financial widely credited for limiting the impact of the institutions, but used open market operations to financial crisis of 2007-09 on the broader econ omy. prevent lending to individual firms from increas - In nominating Ben Bernanke for a second term ing total banking system reserves or the mone tary as chairman of the Board of Governors of the base. As the crisis intensified, the Fed drew on Federal Reserve System, President Obama cred ited authority granted during the Depression to pro - Bernanke with helping to prevent an economic vide emergency loans to distressed nonbank firms. freefall. 2 Chairman Bernanke (2009c) has also The Fed also lowered its target for the federal cited “aggressive” policies for insulating the global funds rate effectively to zero and eventually pur - economy, to some extent, from the financial cri sis. chased large amounts of U.S. Treasury and agency debt and mortgage-backed securities. The article 2 The White House press release ( www.whitehouse.gov/the_press_ shows the effects of these actions on the Fed’s office/Remarks-By-The-President-and-Ben-Bernanke-at-the- balance sheet, the monetary base, and broader Nomination-of-Ben-Bernanke-For-Chairman-Of-the-Federal- Reserve/ ) provides the text of the president and Bernanke’s remarks. monetary aggregates. 90 MARCH /APRIL 2010 FEDERAL RESERVE BANK OF ST . LOUIS REVIEW Wheelock The Fed was considerably less responsive to able as a source of funding” (Board of Governors the financial crises of 1929-33. It neither lent sig - [BOG], 2007). Subsequently, on August 17, the nificantly to distressed banks nor increased the Board of Governors voted to reduce the primary monetary base sufficiently to arrest declines in credit rate by 50 basis points and to extend the the money stock and price level. The article dis - maximum term of discount window loans to 30 cusses alternative explanations for the Fed’s fail ure days. Then, in September, the Federal Open Market to pursue a more aggressive policy during the Great Committee (FOMC) lowered its target for the fed - Depression. It also examines the impact of the Fed’s eral funds rate in the first of many cuts that took doubling of reserve requirements in 1936-37, when the rate essentially to zero by December 2008. 3 officials feared that a large increase in excess Financial strains eased somewhat in September reserves posed a significant inflation threat. and October 2007 but reappeared in November. On The next section summarizes the Fed’s December 12, the Federal Reserve announced the response to the crisis of 2007-09 and examines its establishment of reciprocal currency agreements impact on the composition and size of the System’s (“swap lines”) with the European Central Bank balance sheet, the monetary base, and the growth and Swiss National Bank to provide a source of of broader monetary aggregates. Subse quently, the dollar funding in European financial markets. article describes the Fed’s actions in response to Over the next 10 months, the Fed established the financial shocks of the Great Depression, again swap lines with a total of 14 central banks. focusing on the effects of the Fed’s actions on the On December 12, the Fed also announced the monetary base and broader monetary aggregates. creation of the Term Auction Facility (TAF) to lend Finally, the article compares the Fed’s responses funds directly to banks for a fixed term. The Fed to the crises of 2007-09 and 1929-33 and high lights established the TAF in part because the volume mistakes made during the Great Depression that of discount window borrowing had remained low the Fed did not repeat during the recent crisis. despite persistent stress in interbank funding mar - kets, apparently because of a perceived stigma associated with borrowing at the discount win dow. THE FED’S RESPONSE TO THE Because of its anonymity, the TAF offered a source of term funds without any of the associated stigma.