FDR's solution to the Banking Crisis - a model for Obama

Despite a $700 Billion Wall Street Bailout, despite the Federal Reserve scooping over a $Trillion of questionable bank assets onto its balance sheets, despite an alphabet soup of new programs designed to aid the banking system, and despite -- or perhaps in part because of -- the almost-daily rule changes in the banking system I have dubbed Global Financial Calvinball; the economy and the financial emergency continues to worsen.
This is imho precisely because, as Jim Kunstler puts it:

Alas, the financial impairment is still on-going world-wide and has quite a ways to run before it's finished working its hoodoo on the so-called advanced economies. The lame duck US economic posse so far has done everything possible except the two things that really matter: allow the fraudulent securities at the heart of the problem to be exposed to the light of day to determine their actual value; and allow those companies who trafficked in them to suffer the full consequences by going out-of-business. For the moment, they're content to shovel cash into the truck-bed of every enterprise in America that shows up at the Treasury loading dock.

Washington and Wall Street continue to want to treat the problem as one of liquidity when really it one of solvency. If I owe you $100, and I have $1000 in the bank, but I can't access it today, I have a liquidity problem. If I owe you $100 but I only have $80 in assets, I have a solvency problem. There are an unknown set of companies who are insolvent. Because other companies don't know who they are, and can't find out -- i.e., there is a lack of transparency -- they refuse to lend to anybody since there is no way of knowing if their money is disappearing into a black hole. This is exactly what a credit crisis is.

As I have said many times here and elsewhere, and as Kunstler so eloquently captures it, the remedy for a lack of transparency is not liquidity. Access to collateral does not solve the problem of others knowing who is solvent and who isn't. No, the remedy for lack of transparency is -- transparency.

A similar, but far more deadly, crisis faced Franklin Delano Roosevelt at the time of his inauguration. His actions then are an instruction manual for us now. As described in the history of the FDIC (n.b.: all unattributed quotes in this blog are to the FDIC site):

During the winter of 1932-1933, banking conditions deteriorated rapidly.... Banks, especially in states that had declared bank moratoria, accelerated withdrawals from correspondents in an attempt to strengthen their position. Currency holdings increased significantly, partially in anticipation of additional bank moratoria.

....[T]he suddenness of the withdrawal demands in selected parts of the country that started a panic of massive proportions. State after state declared bank holidays. The banking panic reached a peak during the first three days of March 1933.... By March 4, Inauguration Day, every state in the Union had declared a bank holiday.

Roosevelt knew that both immediate action and a permanent fix were necessary, and that the public need to have confidence that his new Administration had the solution at hand. With that goal, he immediately declared a bank holiday, shutting down all banks temporarily for 4 days. Within just a few days, he went on the mass media of his time -- radio -- to reassure the American public, instill confidence, and describe his plan in simply understood terms. The text of this very first "fireside chat" is here. Even better, you can listen to the actual audio of the address by FDR here.

The plan, as Roosevelt described it to the public, addressed exactly the central issue noted by Jim Kunstler above -- transparency:

President Roosevelt reviewed the events of the past several days and outlined the reopening schedule. Following proper certification, member banks in the twelve Federal Reserve Bank cities were to reopen on March 13. Member banks in some 250 other cities with recognized clearinghouses were to reopen on March 14. Thereafter, licensed member banks in all other localities were to reopen. The President indicated that the Secretary of the Treasury already had contacted the various state banking departments and requested them to follow the same schedule in reopening state nonmember banks. Before concluding his radio address, the President cautioned that he could not promise that every bank in the nation would be reopened. About 4,000 banks never reopened either because of the events of the previous two months or the bank holiday itself.


Administration officials quickly began to draft legislation designed to legalize the holiday and resolve the banking crisis. Early in their deliberations they realized that the success of any proposed plan of action primarily would hinge on favorable public reaction....

To secure public support, officials formulated a plan that relied on orthodox banking procedures. Few members of Congress knew what was contained in the Administration's bill when they convened in extraordinary session at noon on March 9.... After only 40 minutes of debate, during which time no amendments were permitted, the House passed the bill, known as the Emergency Banking Act. Several hours later, the Senate also approved the emergency legislation intact.

The Emergency Banking Act legalized the national bank holiday and set standards for the reopening of banks after the holiday.... It authorized the [Reconstruction Finance Corporation] to invest in the preferred stock and capital notes of banks and to make secured loans to individual banks.

To insure an adequate supply of currency, the Act provided for the issuance of Federal Reserve Notes.... After the Act was signed into law, the Bureau of Engraving and Printing promptly went into 24-hour production to manufacture the currency....

It was agreed that licenses would be issued by the Secretary of the Treasury upon the recommendation of the district Federal Reserve Bank, the chief national bank examiner and the Comptroller of the Currency. Several hundred banks soon reopened for business on the certification of the Treasury. As the reopenings proceeded, public confidence increased significantly and widespread hoarding ceased.

During the next 2 months, the public redeposited more than $2 billiion (about $60 billion in today's dollars) back into the banking system.

After some semblance of order had returned to the financial system, efforts were renewed in Congress to enact deposit insurance legislation. Although a deposit insurance bill had been passed by the House in 1932, the Senate had adjourned without acting on the proposal. Insurance proponents hoped that legislative efforts would prove successful this time, since the banking crisis was still fresh in the public's mind. In their view, recent events had shown that a system of federal deposit insurance was necessary to achieve and maintain financial stability

Despite widespread opposition to bank depository insurance in Washington, including that of Senator Glass, unlike the recent Wall Street Bailout bill in which Congress simply ignored overwhelming public sentiment, the New Dealers , including Glass, "simply had yielded to public opinion:"

It became perfectly apparent that the voters wanted the guarantee [deposit insurance], and that no bill which did not contain such a provision would be satisfactory either to Congress or to the public. Washington does not remember any issue on which the sentiment of the country has been so undivided or so emphatically expressed as upon this.

In response to that public pressure:

In mid-May, both Senator Glass and Representative Steagall formally introduced banking reform bills, which included provisions for deposit insurance....

[T]he Glass bill was amended to incorporate Senator Arthur Vandenberg's proposal calling for the creation of a temporary deposit insurance fund. Vandenberg opposed a delay in the start of deposit insurance because "the need is greater in the next year than for the next hundred year." On the day Vandenberg introduced his proposal, Vice President Garner was presiding over the Senate ... Garner instructed [Vandenberg] to introduce the amendment when signaled. Several minutes later, Garner suspended the court proceedings and ordered the Senate into regular session to consider more banking legislation. With Garner sitting by his side, Vandenberg then offered his deposit insurance amendment, which was overwhelmingly adopted.

The amendment stipulated that, effective January 1, 1934, the temporary fund would provide insurance coverage up to $2,500 for each depositor and would function until a permanent corporation began operations on July 1, 1934. If demands on the temporary fund exceeded available monies, the Treasury would be obliged to make up the difference. The amendment also provided that solvent state banks could join the fund.

Despite intense opposition from big banks, the Glass-Steagall Act of 1933 passed both Houses of Congress and was promptly signed into law by Roosevelt on June 16, 1933. Section 8 of the Act created the Federal Deposit Insurance corporation through an amendment to the Federal Reserve Act. The Banking Act of 1933 also created the Federal Reserve Open Market Committee and imposed restrictions on the permissible activities of member banks of the Federal Reserve System.

As noted by an investment encyclopedia, "Roosevelt's actions helped restore credibility (and thus functionality) to the banking system and the creation of the Federal Deposit Insurance Corporation under this legislation helped provide a more permanent solution."

FDR's response to the much more severe banking crisis of 1933 was instructive:

- His new Administration acted with confidence and authority.

- He told the public what he intended to do so solve their problem, and then he did it.

- His Administration correctly treated the crisis as if it were a communicable deadly disease. First there was a quarantine. Then there was a triage to separate the healthy from the fatally infected. The healthy banks were identified and reopened with an official "seal of approval." Public confidence was restored. Ordinary banking resumed.

- Permanent measures were adopted to assure the public that the epidemic would not reoccur.

Contrast this with the Bush/Paulson fiasco. Bush himself has all but disappeared from the debate. His brief appearance in September, giving several speeches urging the public to "Panic NOW!" into supporting the Wall Street Bailout, were a disaster as consumers responded by hunkering down in fear. The Administration and the Fed improvise from day to day. They do not communicate to the public ahead of time what they are doing or how their acts will (allegedly) solve the crisis. And every action is designed to continue to hide which banks and other institutions are walking dead.

What is particularly galling about this episode is that there was never an inherent danger of Main Street following in Wall Street's collapse. As Robert Reich points out today:

Banks are important to the economy because they're financial "intermediaries." They connect savers with investors and borrowers. This is a vital function, but there's nothing magical about it. At any given time the world contains a vast pool of money that can be put to all sorts of uses. Financial intermediaries simply link the pool to the uses.

To be sure, savers need to believe that intermediaries are trustworthy; otherwise, savers will prefer the underside of their mattresses. That's why governments regulate intermediaries, insure deposits, and do whatever else needs to be done to make savers feel safe. What governments and societies fear most are "runs" on banks -- panicked efforts by depositors to pull their money out all at once, before banks can possibly collect the money from all those who have used it to borrow or invest. That's what happened in the 1930s.

But the current panic on Wall Street is not a "run" in this sense. It has almost nothing to do with banks' roles as financial intermediaries. It's a run on the shares of Wall Street banks, not a run on the pool of savings they oversee. The mutual funds, pension funds, and deposits they hold are perfectly safe.

.... Even if Citigroup were to go belly up, the real economy would not be seriously harmed. The funds overseen by Citi would be remain; fund managers would shift them to other banks.

Much as the buying of stocks on 10% margin in 1929 precipitated the stock market collapse, so the usage of 30- and 40- to 1 and worse (that's. 2.5% to 3.3% margin!) ratios of leverage by investment banks led to the inevitable calamity now.

There is no hope that the Bush mal-Administration will sort things out in their remaining two months of office.

The Administration of President-elect Obama, however, is another matter entirely. Immediately after January 20, hopefully they will act with confidence and authority to quarantine the infected sector; to mandate immediate disclosure of leveraged positions and counter-party risks (at very least to the Treasury and the Fed); to disclose those facts publicly as quickly as possible; to separate the healthy companies from the zombies; if necessary the creation of new, clean investment banks in which the public has an equity interest; and meanwhile to tell the public, simply and clearly, what they are doing and how their actions will solve the problem. And finally, to enact permanent measures -- for example, making the disclosure of all leveraged positions by any financial actor to the Fed and the Treasury permanent, and to designate deliberate avoidance of same a crime with mandatory jail time; the ability of the Fed or Treasury to universally limit leverage when it appears under any guise to a reasonable amount; and to prevent the concentration of financial power into a few firms that are each "too big to fail" --that will guarantee the problem does not recur.




Geithner as Treasury Secretary has some of his testimony and opinions either in the piece of in comments.

My impression so far when they say "regulatory reforms" is he is just talking about leveraging ratios versus actually putting a spotlight on the shadow banking system once and for all and they are talking about one huge agency instead of alphabet soup agencies to streamline regulation.

I sure don't hear anything about hedge funds or regulation of the derivatives market. I could be wrong of course.

Further, although regulation has to focus first on the stability of the core of financial institutions, it cannot be indifferent to the scale of leverage and risk outside the regulated institutions. That said, the Fed official does not believe it would be either desirable or feasible to extend capital requirements to hedge funds or private equity firms. But, at the same time, regulators cannot be indifferent to the scale of leverage and risk that exists outside the regulated financial institutions.

So to me that says yeah, they might look at leverage but I don't see how specifically that tackles derivatives and these unregulated markets.

Since Rubin (this guy is a Rubin clone) was one of the main people who fought to have the Enron rule as well as the Gramm legislation, I sure don't feel confident that they are going to do a true FDR regulatory reform here.

I mean has anyone even heard mention the repeal of the Commodity Futures Modernization Act (Phil Gramm), which allows all of this unregulated CDSes, hedge funds, private equity?

What the Federal Reserve Bank study had to say about it

According to the history books and the facts at hand, FDR, in 1937, attempted to follow economic orthodoxy at that time and attempted to balance the budget... to get a bit away from Keynesian 'prime the pump' government spending policy, this being after the Great Depression had been churning on for about seven years and with his presidency since 1932 -- five years as his responsibility. Accordingly, FDR adjusted his economic policies to stimulate the economy further after the recession of 1937, and things began to change for the better. Demand-side economics, or Keynesianism had won the day,

"Official thinking on what was proper in fiscal policy underwent considerable modification in FDR's second term. In early 1937, Roosevelt still sought to submit a balanced budget (defined the old-fashioned way) for the next fiscal year. The objective seemed reachable without undue strain. After all, 1936 had been a good year, the best since 1929, and the momentum of recovery appeared solidly established. That upbeat mood was rudely punctured in August 1937, when the economy went into an unanticipated tailspin. Production and employment fell more precipitously than they had following the stock market crash of October 1929. This sudden reversal of fortunes was perplexing. Business-cycle theorists of the time were at a loss to explain why a downturn should occur when the economy was operating at a level far short of its capacity.

The intellectual challenge posed by the recession of 1937-38 inspired the formulation of a new "model" with fresh implications for the government's economic role. Unlike the earlier claimants for FDR's attention, economists that the New Deal had brought to Washington, not eminent professors at the nation's leading universities, had developed this new mode of analysis. Prominent among these economists was Lauchlin Currie -- a 1934 refugee from Harvard, where his sympathies for New Deal experimentation had not endeared him to the academic establishment -- now on the research staff of the Federal Reserve Board.

The new model focused on links between the government's fiscal operations -- specifically the "net contribution of government to spending" -- and economic performance. Currie's post- mortem on the 1937-38 recession drew attention to the fact that the government had been distinctly stimulative in 1936, due to the payout of the Veterans' Bonus, a once-and-for-all transaction. In 1937, the impact of governmental fiscal operations reversed direction. Nothing replaced the stimulus provided by the transfer payments to veterans. Meanwhile, government had shrunk private purchasing power by beginning the collection of payroll taxes to fund the Social Security system, which was not scheduled to make regular distributions to beneficiaries until 1942.

The analyses generated by Currie and fellow governmental insiders seemed to provide a plausible explanation for the onset of recession. They also suggested that the way in which government deployed its taxing and spending powers was a significant determinant of the level of economic activity. This point of view is often associated with the analysis presented by John Maynard Keynes in his General Theory of Employment, Interest, and Money, which appeared in 1936. But a similar mind-set emerged in the United States, quite independently, as a by-product of the struggle to comprehend the recession of 1937-38. And its persuasive power was enhanced by the fact that it was expressed with an American accent. "

(Federal Reserve Bank of Boston, Regional Review)
FDR's Big Government Legacy
Summer 1997
by William J. Barber