By John Steele Gordon
For much of American history, the federal government did not regard the economy as being within its purview. During the recurrent depressions that marked the 19th century, the federal government did little more than try to balance its budget. Companies survived in hard times as best they could.
Only with the onset of the Great Depression did the federal government begin, very tentatively at first, to manage the American economy and help distressed companies and individuals.
As most people seem not to know, this did not begin under Franklin Roosevelt, but under Herbert Hoover. In 1932, as the Depression rapidly worsened, Hoover pushed through Congress the Federal Home Loan Bank Act, which created Home Loan Banks which could lend to banks based on their mortgage portfolios, which the Federal Reserve Act of 1913 did not allow the Federal Reserve Banks to make. This had the effect of freeing up banking liquidity in the smaller banks, saving many from collapse.
He also pushed authorization of a Reconstruction Finance Corporation through Congress, capitalized at $500 million (more than 25 percent of federal revenues in 1932). It was authorized to issue up to $2 billion in tax-exempt bonds to make emergency loans to banks, farm mortgage associations, railroads and other institutions that might otherwise have failed. The RFC would prove to be the model for many of the later New Deal programs.
Divided between commercial banks and thrifts, American banking in the postwar era was closely regulated, with fixed interest rates.
But when serious inflation began in the 1970s, Wall Street began offering money market funds that, while they were not guaranteed, could pay much higher interest on deposits than banks and thrifts could. In 1980, the limit on interest was lifted and federal guarantees on deposits were increased from $40,000 to $100,000. Moreover, the cap on brokered deposits from Wall Street, which was “hot money” flowing to the highest interest rates, was lifted.
Having to pay ever-higher interest rates to keep their deposit base while still stuck with their long-term, low-paying mortgage portfolio, many thrifts went broke and the federal government had to pay out billions to make the depositors whole.
In September 2008, as the subprime mortgage market began to implode, the fourth largest investment bank in the country, Lehman Brothers, heavily leveraged and with insufficient capital, found itself in big trouble. A year and a half earlier, the Federal Reserve had arranged for the sale of another investment bank, Bear Sterns, to JPMorgan Chase to…
Read More: A Short History of Economic Rescues