https://www.alt-m.org/2023/03/28/the-new-deal-and-recovery-part-27-deposit-insurance/

Of the many steps taken to combat the depression during the Roosevelt administration’s famous first hundred days, none was more significant than the passage of the June 16, 1933 Banking Act providing for the establishment of the Federal Deposit Insurance Corporation (FDIC).

No step was more significant, and none has been more misunderstood. To delve into that misunderstanding is to realize, among other things, just how hard it can be to answer the question, "how much credit does the New Deal deserve for ending the Great Depression?"

Deposit Insurance Myths

The Banking Act of 1933 was the most sweeping reform of the United States banking system since the passage of the Federal Reserve Act. Also known as the Glass-Steagall Act, after its Democratic co-sponsors Virginia Senator Carter Glass and Alabama Congressman Henry Steagall, it subjected commercial banks to three new sorts of regulation: it prohibited them from underwriting or otherwise dealing in corporate securities; it imposed limits on the interest rates they could pay on deposits; and it established the FDIC, compelling all Federal Reserve member banks to take part in its deposit insurance scheme, and giving non-member state banks the option of doing so, on the condition (which was later modified to apply to large state banks only) that they also become Fed members. While all three reforms had important consequences, either at once or in the long run, deposit insurance had the most obvious bearing on the course of economic recovery, and it’s with that reform alone that this essay is concerned.

Because banks needed time both to qualify for insurance and to contribute to the FDIC’s funding by purchasing shares in it, the FDIC’s opening was scheduled for January 1, 1934, when it would start insuring deposits. Under a temporary plan, all deposits would be insured up to $2500. That plan was supposed to give way to a permanent one, with much higher coverage limits, on July 1, 1934. But in mid-June, Congress decided to put off the permanent plan until July 1, 1935, while raising the temporary plan’s coverage to $5000 for all accounts. The start of the permanent plan was postponed once more, until August 31, 1935, by a Congressional resolution. Finally, just days before that deadline, the 1935 Banking Act put a new permanent plan, preserving the $5000 coverage limit, into effect. In the meantime, the National Housing Act, passed on June 17, 1934, provided for the establishment of a Federal Savings and Loan Insurance Corporation (FSLIC), to guarantee deposits at savings and loans much as the FDIC guaranteed those kept at banks.

So much for the settled facts. The misunderstandings have mainly to do with the novelty of the deposit insurance plan, the purpose it was meant to serve, and the part that the Roosevelt Administration played in its adoption. In 1960, Garter Golembe (1960), a highly regarded bank consultant then working at the FDIC, tried to set the record straight. "Deposit insurance," Golembe wrote, "was not a novel idea; protection of the small depositor, while important, was not its primary purpose; and, finally, it was the only important piece of legislation during the New Deal’s famous ‘one hundred days’ which was neither requested nor supported by the new administration."[1]

Relief or Recovery?

Golembe’s second point justifies treating deposit insurance as having made an important contribution to the process of economic recovery. Instead of merely being aimed at protecting depositors, as many suppose, the more crucial purpose of insurance was, Golembe says, to "restore to the community, as quickly as possible, circulating medium destroyed or made unavailable as a consequence of bank failures" (ibid., 189). Insurance was, in other words, an element of monetary or, if one prefers, macroeconomic, policy, rather than one of mere redistribution, with the correspondingly more ambitious goals of getting people to put their paper money back into the banks, ruling-out further bank runs, and reviving bank lending.

To appreciate the need for some such reform, one need only realize that the banking system that emerged from the national bank holiday was essentially the same one that led to it. Of course many closed banks would never be licensed to reopen; but thousands would be, including many rural banks of the sort that accounted for most of the pre-holiday failures. In the short run,  the Fed’s agreement to cover all cash withdrawals from such banks, together with Reconstruction Finance Corporation (RFC) capital injections, would help bolster confidence in the reopened banks. But those measures were mere stopgaps that could neither rule out future runs nor convince people to redeposit all the paper currency they’d hoarded. If confidence in banks was to be fully restored, and prevented from ever melting away again, something more had to be done.

In defending his insurance plan on May 19th, 1933, Steagall made the macroeconomic case for it clear. The public, he said, was still

afraid to deposit their money in the banks, and the banks are afraid to employ their deposits in the extension of bank credit for the support of trade and commerce. Businessmen and investors are victimized by the same fear. The result is curtailment of business, decline in values, idleness, unemployment, breadlines, national depression, and distress. We must resume the use of bank credit if we are to find our way out of our present difficulties.

In fact, had deposit insurance not served a macroeconomic purpose, Congress would almost certainly have spurned Steagall’s plan, just as it spurned scores of similar plans introduced to it over the course of the previous four decades. And it would have done so for perfectly good reasons.

History Lessons

The FDIC wasn’t the world’s first national-level deposit insurance arrangement—Czechoslovakia beat the United States to that punch by a decade. Nor was it the United States’ first experiment with such insurance. Various state governments tried guaranteeing both banknotes and bank deposits. The first to do so was New York, which established a bank "Safety-Fund" in 1829. The permanent FDIC plan shared many features in common with the Safety Fund, including (ultimately) the latter’s provision exempting the owners of banks that contributed to the fund from double liability—a then-common arrangement that required shareholders of a failed bank to fork up as much as their shares’ par value if that proved necessary to make the bank’s creditors whole.[2]

Begun with high hopes, the Safety Fund ended up a fiasco: by the early 1840s, it was broke, so the government had to lend it the money with which it continued to meet its outstanding commitments. What Howard Bodenhorn  (2002, 157, 182) refers to as a "combustible" mixture of inadequate supervision (including ineffectual or nonexistent portfolio restrictions), "mispriced insurance premia, a limited ability to impose emergency assessments, and fraud" caused the fund to quickly fall victim to "the standard insurance problems of moral hazard and adverse selection."[3]

The Safety Fund’s undoing came too late to stop Vermont and Michigan from setting up similar systems, with similar results. Michigan’s fund, established in 1836, went bust just five years later, having failed to pay a nickel to any of the creditors it was supposed to insure (Golembe 1960, 185). Vermont’s version, set up in 1831, survived longer, but ultimately went awry by letting its members quit whenever they pleased! By 1859, none were left, so it could only cover 72 percent of its obligations, leaving Vermont taxpayers holding the bag for the rest (Golembe and Warburton 1958, 108).

Three other antebellum insurance schemes—in Indiana, Ohio, and Iowa—did much better. But unlike the New York, Vermont, and Michigan arrangements—and also unlike the FDIC’s plan— they depended on the unlimited mutual liability of their members. Mutual liability gave participating banks a powerful incentive to police one another and to close down suspect banks before they became deeply insolvent. All three systems had good records, and all were still solvent when a federal tax on state banknotes, aimed at compelling state banks to join the then-new national banking system, shut them down (Calomiris 1990, 288; Selgin 2000).

Because the tax on state banknotes nearly did away with state banks altogether, for a while it looked as though the United States had seen the last of its experiments with state-sponsored deposit insurance.  But over time, as checks came to be more widely used in payments, non-note-issuing banks became increasingly viable; and it was not long before hundreds were being chartered every year. The outcome of this was the "dual" banking system, consisting of a mix of banks with federal ("national") and state charters, that survives to this day.

Until several decades ago, most United States banks, whether state or national, were "unit" banks, with a single office only, and correspondingly heavy exposure to local shocks. Because state banks tended to be smaller than national banks, they were especially vulnerable. Not surprisingly, such banks failed relatively often, putting pressure on their sponsoring governments to come up with ways to protect their creditors. So it happened that what first looked like state deposit insurance schemes’ last curtain call turned out to be a mere intermission between two acts, with eight new schemes coming on stage between 1917 and 1927.

Alas, these later schemes merely "repeated and compounded the earlier errors of New York, Vermont, and Michigan" (Calomiris 1990, 288), and so ended up faring no better. Thanks mainly to the agricultural bust of the 1920s, by the spring of 1930  every one of them had gone belly-up.

Insurance vs. Branches

Those early twentieth-century deposit insurance schemes were all established in states—Oklahoma, Kansas, Nebraska, Texas, Mississippi, South Dakota, North Dakota, and Washington—where there was strong opposition to branch banking; where laws either prohibited branching altogether or put very strict limits on its growth; and where "business prosperity in general depended on one or two commodities" (White 1983, 191).[4] That was no coincidence. Not letting prospective bank depositors choose between unit and branch banks was one way to keep poorly-diversified unit banks in business. But it still left them exposed to runs once they got into hot water.

That’s where insurance came in. Here again, Carter Golembe (1960, 195) zeros in on the truth. "[I]t is not reading too much into history," Golembe says, to regard deposit insurance  schemes as "attempts to maintain a banking system composed of thousands of independent banks by alleviating one serious shortcoming of such a system: its proneness to bank suspensions, in good times and bad." Henry Steagall, who was second to none in his determination to save the United States’ small unit banks, made no bones about this. "This bill," he said, referring to his May 1933 effort, "will preserve independent dual banking in the United States. … This is what the bill is intended to do" (ibid., 198).

Insurance and branching were, in short, rival reform options; one sought to preserve the unit banking status quo, and particularly state-chartered unit banks, despite their inherent weaknesses; the other would instead have allowed banks to branch statewide, if not nationwide, which would have meant more relatively large and well-diversified banks with branches, and many fewer smaller unit banks. Steagall favored the insurance option, while opposing branch banking tooth-and-nail. Carter Glass, his Senate Banking Committee counterpart, took the opposite position.

Until the Great Depression began, despite scores of attempts on behalf of each, neither federal deposit insurance nor branch banking seemed capable of gaining political traction. But as the Great Depression took its toll, and the number of bank failures mounted, so did the pressure to do something to stop runs, limit bank depositors’ losses, and otherwise overhaul the United States banking system. That pressure, plus some expert logrolling, finally broke the impasse. But it did so only after one of the more determined opponents of deposit insurance blinked.

That determined opponent was none other than Franklin Delano Roosevelt.

Outliving a Cat

"In June 1933," then Council of Economic Advisers chair Christina Romer testified in 2009, "President Roosevelt worked with Congress to establish the Federal Deposit Insurance Corporation." The occasion was a hearing on "Lessons from the Great Depression" being conducted by the Subcommittee on Economic Policy of the Senate Banking Committee.

Of course it’s true that Roosevelt helped establish the FDIC, in so far as it was his signature that turned the Glass-Steagall bill into a law. Yet Romer’s testimony is more than a little misleading: what she doesn’t say is that Roosevelt opposed the Glass-Steagall bill’s deposit insurance provision until the eleventh hour, even threatening to torpedo the whole bill unless it was taken out.

FDRs opposition to deposit insurance was sincere, earnest, and perfectly conventional. In October 1932, while campaigning for the presidency, he responded, privately, to a letter from a supporter urging him to publicly declare his support for federal deposit insurance as doing so would reassure the public while gaining him votes. Roosevelt demurred. Though it might be popular, he said, insurance was also "dangerous," for in time it "would lead to laxity in bank management and carelessness on the part of both banker and depositor," one result of which would be "an impossible drain on the Treasury" (Gates 2017, 310).

Once he was in office, Roosevelt’s opposition to deposit insurance became what one of his biographers calls his "major quarrel" with Congress on banking legislation (Freidel 1973, 441-2). Asked his opinion of deposit insurance during his very first press conference, on March 8th, Roosevelt repeated, off the record, the argument he’d made privately in his letter of the previous October. He added a rather nice numerical example of what he had in mind, and concluded by saying that he opposed "having the United States government liable for the mistakes and errors of individual banks and not [sic] putting a premium on unsound banking." When a reporter pressed further, Roosevelt replied emphatically:

Q: You do have in mind guaranteeing deposits of banks on the new basis?

FDR: No; no government guarantee.

Q: You would have to have that guarantee under the new banking system.

FDR: There would have to be a guarantee? Oh, no. The government isn’t going to guarantee any banks.

In fact, Roosevelt was not being entirely candid, for as we saw in a previous installment, by various provisions of the 1933 Emergency Banking Act the government and the Federal Reserve were in effect planning to guarantee the deposits of reopened banks for a time (Silber 2009). Roosevelt apparently saw no inconsistency between his acceptance of those emergency provisions and his opposition to more explicit and permanent deposit insurance; in any event, the emergency provisions, being stopgaps only, did not end the legislative battle for fundamental reform of the banking system that raged through 99 of the Roosevelt Administrations first 100 days.

By mid-May, however, the tide of that battle was turning decidedly in favor of insurance. A new Steagall bill had made it to the Senate Committee, and Carter Glass, who had already gone so far as to include an optional deposit-insurance plan in his own bill, was persuaded to amend it further, to provide for temporary but mandatory and immediate insurance of all Fed member bank deposits. Arthur Vandenberg, who did that persuading, rose in the Senate to explain why he’d done so. "There is no remote possibility," he said, "of adequate and competent economic recooperation [sic] in the United States in the next twelve months . . . until confidence in normal banking is restored; and in the face of the existing circumstances I am perfectly sure that the insurance of bank deposits immediately is the paramount and fundamental necessity of the moment." Glass accepted Vanderberg’s suggested amendment, on the understanding that Steagall would in turn support his plan for separating investment and commercial banking. The amendment passed handily, allowing Glass’s bill to join Steagall’s in conference.

When Roosevelt learned what had happened, he was anything but pleased. Instead, on June 1st he called both Glass and Steagall to a meeting at the White House, whose other attendees were a motley assortment of Administration critics of deposit insurance (Gates 2017, 316). He also wrote both Glass and Steagall individually, and the conference committee, threatening to veto any compromise that included deposit insurance. But knowing that the whole measure would fail without that provision, they all called the president’s bluff. At last he resigned himself to endorsing the reconciled bill’s insurance provisions, taking comfort in the temporary plan’s limited coverage, and joking with reporters afterwards that the bill had enjoyed "more lives than a cat."

Role Reversal

How is it that Roosevelt so often gets credit for deposit insurance, despite having opposed it so relentlessly? One part of the explanation is that, once he’d signed off on it, Roosevelt himself took credit for it. His doing so merely amused his professional contemporaries; but it has confused later generations who have taken his self-praise at face value. Another is that Roosevelt’s criticisms of deposit insurance were often made either privately or off the record, while his efforts to kill it in Congress all took place behind closed doors. Finally, Roosevelt did sign the Glass-Steagall Act after all, instead of vetoing it as he’d threatened to do, so he at least deserves credit for that. Otherwise—if, say, Congress had instead had to override Roosevelt’s veto—deposit insurance would only qualify as a New Deal measure on strictly chronological grounds.

If the popular view of FDR as a champion of deposit insurance is more fiction than fact, the equally common view that Hoover opposed insurance isn’t much better. It’s true that, for most of his career, Hoover’s views on deposit insurance, and on banking reform more generally, differed little from Roosevelt’s, just as Roosevelt suggested in his March 8th press conference. Instead of favoring insurance, both men preferred Carter Glass’s original reform program. Thus on December 8th, 1931, Hoover (1951, 122) asked Congress to look into "the need for separation between the different kinds of banking; an enlargement of branch banking…; and the methods by which enlarged membership in the Federal Reserve System may be brought on," without mentioning insurance, which he, like Roosevelt and Glass, still considered a bad idea.

But while Roosevelt continued to oppose insurance months after the February-March banking crisis, as that debacle worsened, it caused Hoover to change his mind. On February 28, 1933, he wrote the Federal Reserve Board, asking whether it considered it desirable

1) To establish some form of Federal guarantee of banking deposits; or

2) To establish clearing house systems in the affected areas; or

3) To allow the situation to drift along under the sporadic State and community solutions now in progress (Myers and Newton 1936, 359).

Despite his undeserved reputation as a "do nothing" President, Hoover certainly considered the third option unacceptable, including it only to compel the Board to choose between the others. On March 2nd, with the banking system in free fall, the Board replied that it wasn’t prepared to recommend deposit insurance, given the history of States’ experiments with it, and its "inherent dangers" (ibid., 362). To this Hoover at once replied as follows:

I am familiar with the inherent dangers in any form of federal guarantee of banking deposits, but I am wondering whether or not the situation has reached the time when the Board should give further consideration to this possibility (ibid., 364).

Hoover even included a "rough outline" of an insurance plan, asking the Board for its advice. But the Board replied that it preferred a nationwide bank holiday to any sort of guarantee. Two days later, Hoover handed the reins to FDR; who announced the bank holiday a day later.

FDR’s Last Laugh

If Roosevelt has gotten too much credit for the FDIC’s establishment, he deserves more credit than he’s received for having recognized the dangers it and similar deposit schemes pose, and for having preferred other options for that reason.

That deposit insurance wasn’t the only way to keep a banking system from collapsing was evident enough in 1933 from other countries’ experiences. Hoover (1951, 24), for one, had no trouble recognizing it:

That it was possible, by proper organization and inspection, to have a banking system in which depositors were safe was demonstrated by Britain, Canada, Australia, and South Africa, where no consequential bank failure took place in the depression. Their governments gave no guarantee to depositors. Their economic shocks were as great as ours.

Hoover might also have mentioned Bulgaria, Denmark, Finland, Greece, Lithuania, the Netherlands, Portugal, Spain, and Sweden, none of which had either deposit insurance or a banking crisis during the ’30s. According to Richard Grossman (1994), although the examples of France and Belgium showed that the presence of banks with extensive branch networks was no guarantee against crises, other things equal, banking systems characterized by fewer, larger banks with extensive branch networks tended to be considerably more stable than others.[5]

That uninsured banking systems could be stable explains the fact that, apart from the United States and Czechoslovakia, no other nation chose to guarantee its banks’ deposits until the 1960s; and only a score had done so as late as 1980. Furthermore, those that opted for insurance didn’t necessarily do so because their banking systems had proven unstable without it. Canada, for example, decided to establish its Canadian Deposit Insurance Corporation in 1967 even though no Canadian commercial bank had failed since 1923, and none was then in danger of failing.

Nor does the spread of deposit insurance since the 1960s appear to have occurred in response to policymakers’ perception that their banking systems were at risk of failing without it. Instead,  many nations appear to have jumped on the deposit insurance bandwagon either because (mostly U.S.-trained) economists at the World Bank and the IMF pressured them to do so (Demirgüç-Kunt et al. 2008) or simply because doing so had become fashionable (Demirgüç-Kunt and Detaigiache 2002, 1394).[6]

But what about FDR’s claim that deposit insurance was "dangerous"—that, once insured, "the weak banks would pull down the strong ones" (Freidel 1973, 442), as happened in those states that tried insuring banks before the Great Depression?[7]. It turns out that Roosevelt was wrong—for a while. "Despite initial concerns to the contrary," Eugenie Short and Gerald O’Driscoll (1983, 1) wrote in the early 1980s,

the federal deposit insurance system has worked remarkably well in reducing the number of bank failures and in eliminating depositor loss. The total number of insured bank failures since 1933 has not greatly exceeded the average number of bank failures in any single year during the 1920s… . Moreover, between 1933 and 1982, nearly 99 percent of all deposits in insured banks that failed were recovered by depositors.

But just as Short and O’Driscoll were saying this, serious cracks were forming in the deposit insurance edifice; and soon what once seemed like a banking Arcadia would appear to have been a fool’s paradise. Short and O’Driscoll were themselves well aware of what was happening. The FDIC, they recalled (ibid., 1-2), was part of a package of regulations, the other parts of which—prohibiting banks from underwriting securities and limiting the interest rates they could pay on deposits— served, together with barriers to branching and other constraints on competition, to reduce banks’ incentives and ability to attract insured deposits by taking on greater risks.

However, rising inflation and interest rates, increased international competition, and the rise of money market mutual funds, took an increasing toll on regulated depository institutions during the 1970s, regulators felt compelled to start peeling risk-constraining regulations away while simultaneously boosting insurance coverage. In particular, the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) of 1980 and the Garn-St. Germain Act of 1982 encouraged excessive risk taking by phasing-out deposit rate limits while raising both FDIC and FSLIC insurance coverage from $40,000 per account, where it had been set since 1974, to $100,000 (Keeton 1984; Bundt, Cosimano, Halloran 1992)

This combination of relaxed regulations and increased explicit insurance coverage, coupled with the implicit insurance of banks regarded as "too big to fail," created just the sort of dynamics Roosevelt and other critics of deposit insurance feared, with the sad twist that reforms they had seen as better ways to strengthen the United States banking system, such as allowing banks greater freedom to branch, would now also allow them to compete more aggressively for under-priced, insured funds to invest in risky assets. Soon enough, weak banks, including some very big ones, were toppling, and pulling down, not just stronger ones, but their insurers.

For the FDIC, the reckoning took the form of what one of its publications describes as "an extraordinary upsurge in the number of bank failures" between 1980 and 1994 that put extraordinary strains on its resources, eventually costing it $36.6 billion (FDIC 1997, i, 3). But that was nothing compared to what happened in the $617 billion savings and loan industry. There, after breaking yet another batch of state-run insurance schemes, moral hazard problems put paid to the FSLIC as well, thanks to regulators’ willingness to allow insolvent institutions to keep trying their luck while using accounting gimmicks to boost their reported net worth (Kane 1992). The result was scads of high-risk gambles by S&Ls whose owners had nothing to lose that left the industry even deeper in the red, bankrupting the FSLIC and making it necessary for taxpayers to cover $132.1 billion of failed S&L’s $160.1 billion in insured deposits. Though it wasn’t actually "impossible" for the Treasury to pay that bill, it was certainly proof enough of the danger Roosevelt warned against.

It was, ironically, just as these events were unfolding in the United States that national deposit insurance schemes started to proliferate elsewhere. By the summer of 2018, 107 countries had joined the deposit insurance craze. Most have since struggled with moral hazard problems, with depositors losing their incentive to look out for risky banks, and banks taking greater risks in turn. In dozens of cases, where insurance coverage has been high and supervision lax, instead of enhancing banking-system stability insurance has done just the opposite, "increas[ing] the likelihood of bank crises significantly" (McCoy 2007, 423; see also Demirgüç-Kunt and Detragiache 2000 and Anginer and Demirgüç-Kunt 2018). This, too, must be accounted part of the 1933 Glass-Steagall Act’s legacy.

***

So, we come back to the question, "How much credit does the New Deal deserve for ending the Great Depression?" and, in particular, "How much credit does FDR deserve for the decision to insure bank deposits?" The answer, I think, is that he deserves much less credit than he’s often given. Much less credit; and absolutely no blame.

Continue Reading The New Deal and Recovery:

• Intro
• Part 1: The Record
• Part 2: Inventing the New Deal
• Part 3: The Fiscal Stimulus Myth
• Part 4: FDR’s Fed
• Part 5: The Banking Crises
• Part 6: The National Banking Holiday
• Part 7: FDR and Gold
• Part 8: The NRA
• Part 8 (Supplement): The Brookings Report
• Part 9: The AAA
• Part 10: The Roosevelt Recession
• Part 11: The Roosevelt Recession, Continued
• Part 12: Fear Itself
• Part 13: Fear Itself, Continued
• Part 14: Fear Itself, Concluded
• Part 15: The Keynesian Myth
• Part 16: The Keynesian Myth, Continued
• Part 17: The Keynesian Myth, Concluded
• Part 18: The Recovery, So Far
• Part 19: War, and Peace
• Part 20: The Phantom Depression
• Part 20, Coda: The Fate of Rosie the Riveter
• Part 21: Happy Days
• Part 22: Postwar Monetary Policy
• Part 23: The Great Rapprochement
• Part 24: The RFC
• Part 25: The RFC, Continued
• Part 26: The RFC, Conclusion
• Part 27: Deposit Insurance

_____________________

[1] To this list we might add a fourth item, noted by Golembe in a subsequent interview, to wit: that the deposit "insurance" provided for by the 1933 Banking Act wasn’t really insurance at all. Unlike genuine insurance policies, it covers depositors for losses regardless of whether the losses were due to recklessness on their or their banks’ part. And unlike genuine insurance funds, the FDIC’s insurance "fund" is an accounting fiction, the truth being that the "premiums" it collects from banks go into the federal government’s general coffers. "The government’s guarantee of deposit," Golembe explains, "was given the name ‘insurance’ because that sounded much less radical than ‘guarantee.’ … [M]any of the bold initiatives of the New Deal were characterized originally as ‘insurance’ in order to make them more acceptable, such as: ‘flood insurance,’ ‘old age insurance’ or ‘crop insurance.’ The problem with calling it ‘deposit insurance’ which it clearly is not, is that some bankers and most academics began to believe it!" For a humorous take on the FDIC’s insurance fund, by one of its former chairs, go here and scroll down a bit.

[2] The 1933 Act did away with double liability for national bank shares issued after its passage, but left it in place for outstanding ones. The 1935 Banking Act allowed any bank to exempt all its shareholders from double liability six months after it publicly announced its intent to do so. Most state bank regulators also did away with double liability during the depression. Jonathan Macey and Geoffrey Miller (1992, 32 and 61) argue, compellingly, that double liability had in fact proven "remarkably effective at protecting bank creditors, including depositors," and "that the nation took a wrong turn" by replacing it with government-administered deposit insurance.

[3] In the deposit insurance context, "moral hazard" refers here to the tendency of depositors to take advantage of having their deposits insured by placing them with relatively risky banks. "Adverse selection" refers to the tendency of riskier banks to be most likely to lobby for, join, and stay enrolled in, deposit insurance schemes.

[4] Although some Mississippi banks had banks head-office city only. Washington provided for branching between 1907 and 1920, when it also prohibited the establishment of further branches.

[5] Significantly, Grossman (1994, 674) also found that "despite anecdotal evidence and the great stress placed on its importance in the literature," the extent of central bank last-resort lending was not an important determinant of banking system stability.

[6] Another contributor to the multiplication of deposit insurance schemes during the 1980s and 1990s was the publication, in June 1983, of Douglas Diamond and Philip Dybvig’s famous article, for which they recently won the Bank of Sweden prize, purporting to offer a rigorous, theoretical case for such insurance. Because it assumes that banks make only safe investments, while depicting bank runs as random events, the Diamond-Dybvig theory implies that any uninsured banking system might fall victim to runs at any time, without allowing for any adverse effects of insurance. It, therefore, makes insurance seem like a no-brainer. Apart from the dubious assumptions that inform it, the Diamond-Dybvig model has many other serious shortcomings, which I review here and here.

[7] Though there’s plenty of anecdotal evidence of moral-hazard problems in all of the state-sponsored insurance arrangements, Kansas’s has been especially well documented for the Kansas case. See Alston, Grove and Wheelock (1994); Wheelock and  Wilson (19942), and Wheelock and  and Wilson (1995).

The post The New Deal and Recovery, Part 27: Deposit Insurance appeared first on Alt-M.

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(In writing this series, I allowed myself to skip over some topics. But now that I’m turning the series into a book, to be published by the University of Chicago Press, I have to close those gaps. The most important gap by far concerns the Reconstruction Finance Corporation. Although the RFC was originally established by Herbert Hoover, the Roosevelt administration not only allowed it to survive but turned it into the largest and most powerful of all New Deal agencies. Hence a three-part essay, of which this is the first installment.)

Hoover’s New Deal

There are few more successful examples in history of the propaganda technique known as the "big lie" than the charge that Herbert Hoover was a "do nothing" president. In fact, Hoover was being perfectly truthful when, in the course of the ’32 campaign, he said. "We might have done nothing. … Instead, we met the situation with … the most gigantic programs of economic defense and counterattack ever evolved in the history of the Republic." So, for that matter, was his opponent, who accused the Hoover administration "of being the greatest spending administration in all our history" (Lyons 1948, 287). On public works alone, the Hoover administration spent more than the previous nine administrations combined, notwithstanding that their undertakings included the Panama Canal (ibid., 269). No previous administration, David Kennedy (1999, p. 48) observes, ever "moved so purposefully and so creatively in the face of an economic downturn."

The centerpiece of the "Hoover New Deal"—the Reconstruction Finance Corporation (RFC)—went on to play an even more important role in the Roosevelt version. Under the leadership of Texas entrepreneur Jesse H. Jones, it became nothing less than "America’s largest corporation and the world’s biggest and most varied banking organization" (Jones 1951, 3).[1]

But did it help the U.S. economy recover from the Great Depression?

A Shadow Fed

Although Hoover ultimately supported it, credit for the RFC’s establishment is mostly due to Eugene Meyer, a staunch Republican whom Hoover made governor of the Federal Reserve Board in 1930. Between 1918 and 1925 Meyer served as managing director of the War Finance Corporation  (WFC), the original goals of which were making cheap credit available to firms producing war materials and propping up the price of Liberty Bonds. After the war, Meyer kept the WFC alive by converting it into an agricultural credit agency. But Meyer stepped down in 1925, and the WFC quit extending credit of any sort, though it didn’t officially close until it finished collecting on its debts 14 years later.

As bank failures mounted after 1930, Meyer, in his new post as head of the Federal Reserve Board, pushed hard both for a relaxation of the Fed’s own credit eligibility requirements and for the WFC’s revival. But Hoover favored a private and voluntary alternative, so Meyer instead tried to get bankers to cooperate toward that end. Thanks to Great Britain’s suspension of the gold standard on September 18, 1931, which led to large-scale withdrawals of gold from the United States banking system, and that many more bank failures, he finally succeeded.

The result, announced by Hoover in the wee hours of October 7th, was the National Credit Corporation (NCC), a half-billion-dollar private credit pool to be established and run by bankers and insurance executives. Because the NCC was prepared to rediscount bank assets the Fed wouldn’t accept, and could do so for financial institutions that weren’t Fed members, Hoover and the bankers hoped that the Fed and NCC between them could keep all the nation’s banks liquid enough to avoid suspending en masse. But Meyer himself was far from sanguine; and it was owing to his importuning, rather than to any enthusiasm for the idea on Hoover’s part, that Hoover agreed to declare, in announcing the NCC, that "if necessity requires, I will recommend the creation of a finance corporation similar in character and purpose to the War Finance Corporation, with available funds sufficient for any legitimate call in support of credit.[2]

Nor did it take long for the NCC’s inadequacy to show itself: it took a month just to open for business, and still longer to start making loans. By December it had lent only $10 million.[3] By then Meyer had a bill ready calling for a revived WFC, to be known as the "Reconstruction Finance Corporation." Congress pushed the legislation through as quickly as it could, allowing for the holiday recess; and Hoover made a law of it on January 22, 1933. The new executive agency thus established began with a capital stock of $500 million subscribed by the Treasury, and was authorized to borrow three times that amount. Serving as its head was Chicago banker and former Vice President Charles G. Dawes.

Thrown for a Loop

As long as Dawes was in charge of it, the RFC’s lending was limited to financial institutions and railroads; and its precise remit, according to Hoover’s remarks upon signing it, was narrower still. "It is not created for the aid of big industries and big banks," Hoover said. "Such institutions are amply able to take care of themselves. It is created for the support of smaller banks and financial institutions, through rendering their resources liquid, to give renewed support to business and agriculture."

Yet just which banks the RFC had been helping during its first five months remained shrouded in mystery, for its quarterly reports only revealed the aggregate sums lent to various broad categories of borrowers, with nothing about particular loan recipients. In other words, as journalist John T. Flynn (1933) later complained, "it passed round hundreds of millions of dollars of public money to banks and railroads without affording either to the public, or even to Congress itself, a grain of information about the identity of the objects of its bounty."

A change came following Chicago’s banking crisis. In early June 1932, Dawes abruptly resigned; days later, as he boarded a train to Chicago, he explained that he was heading there to take charge of the Central Republic Bank, of which he was still nominal chairman. Just over a week after he arrived, as the Democratic National Convention was about to convene in the Windy City, Dawes coolly informed a group including Chicago’s leading bankers and RFC board member Jesse Jones, that the Central Republic, which was one of several Loop banks that had been hemorrhaging money for weeks, wouldn’t open the next morning. Fearing a general collapse, Jones quickly arranged, with Hoover’s approval, to have the RFC lend it $90 million—by far its biggest loan yet—to allow it and the other Loop banks to open the next morning.

When word of the so-called "Dawes Loan" got out, accusations of favoritism went flying.[4] Congress’s response became part of the Emergency Relief and Construction act signed by Hoover on July 17th, 1932. On the plus side, this amendment to the RFC Act increased the RFC’s borrowing authority to $3.3 billion dollars, for use in supporting state and local relief agencies,  public works programs, and various agricultural credit agencies, among other things. But the amendment also placed new limits on the RFC’s lending. It forbade loans to financial institutions whose officers or board members included anyone who sat on the RFC’s board, or had done so within a year prior to the date on which a loan was granted; and it called for the corporation to submit monthly reports on its activities, including borrowers’ names, to the Senate and House, or, if Congress wasn’t in session, to the Senate Secretary and House Clerk.

Bigger Isn’t Better

Although the publicity clause wasn’t made retroactive, Congress eventually asked the RFC to supply it with details concerning the loans it had made during its first five months, which it did on January 25th, 1933. It was then possible for Congress and the general public to see just how well the RFC had lived up to President Hoover’s claim that it wasn’t there to help big banks.

What they discovered was that, during the RFC’s first five months, the Central Republic was far from being the only big bank to receive its help. Although the corporation’s officers and champions, including Hoover himself, had technically been telling the truth when they repeatedly pointed out that "most of its loans" went to small banks, the claim obscured the fact that most of the RFC’s money went to relatively large ones. For example, after the corporation had been in business for five weeks, the White House declared that it had lent $61 million, most of which went to 255 "mostly small country banks." What it didn’t say was that more than two-thirds of that amount went to just three banks, all located in fair-sized cities. During the whole of the RFC’s first five months, before its loan recipients’ names were routinely furnished to Congress, more than 40 percent of the $642 million of loans it had authorized went to banks in just seven good-size cities, with banks in Chicago and San Francisco alone receiving $136 million (Flynn 1933). Furthermore, many of the RFC’s loans to smaller banks were aimed at indirectly helping larger ones to which the smaller banks owed money.

Actually, there were good reasons for this record. The pattern of RFC lending to large banks was roughly consistent with the distribution of U.S. banks by size, and with the fact that, other things equal, bigger banks tended to lose more deposits than small ones. And, despite Hoover, some big banks, like Central Republic, were quite unable to "take care of themselves." Finally, the failure of a big bank was more likely to cause other banks to fail. In fact, contemporary complaints notwithstanding, economic historians have not found much evidence that politics shaped the pattern of the RFC’s loans to banks (Mason 2003).

Even so, once it had to submit detailed monthly reports, the RFC quit making very large loans to very big banks. Indeed, it made fewer loans to banks of all sorts. Jesse Jones (1951, 83), who sat on the RFC’s board at this time, and later became its most famous chairman, believed that the publicity "prevented many bankers from applying for help that was sorely needed," owing either to pride or to fear of having their banks stigmatized.  Whatever the reason, it didn’t make the RFC’s job any easier.

Lent to Death

Of course the Hoover RFC didn’t keep the U.S. financial system safe from "unexpected shocks"; neither did it otherwise stop the U.S. economy’s downward spiral. "Perhaps it is too much," Harvard’s Franklin Ebersole (1933, 484) observed, in reviewing its one-year record, "to expect the Corporation should have effected a cure for the crisis and depression. But the label ‘Reconstruction’ offered more than hope and mere salvage." Unfortunately, although Hoover’s RFC authorized $951,000,000 in loans to open banks and trust companies, and another $200,000,000 to closed banks’ receivers, for distribution to their depositors, these amounts simply weren’t enough to either keep open banks liquid or pay off deposits at closed ones in full.

But did they at least help?  "To criticize the Corporation for not keeping banks open or stimulating business recovery," Ebersole (ibid., 486) says, "assumes a large objective—the maximum achievement." But perhaps, he allows, it was only supposed to tide banks, railroads, state relief agencies, and farmers over until other steps could be taken. Alas, he concludes, "even for such a limited objective, it must be said…that [Hoover’s RFC] was a gamble that failed." Charles Calomiris and his coauthors (2013, 528) go still further: they find, not merely the RFC’s loans were generally unhelpful, but that they seem to have made banks that took advantage of them worse off. Besides disqualifying many banks, the RFC’s strict collateral requirements also stripped those that secured loans from it of their best collateral. The fact that the Corporation had priority over banks’ other creditors gave better-informed depositors a reason to steer clear of banks that borrowed from it, and this in turn gave bankers a reason to think twice before asking for the RFC’s help. According to Joseph Mason (2001, 90), this problem was especially important before July 1932, when (owing largely to Eugene Meyer’s influence) the RFC’s collateral requirements were especially strict.

The verdicts of some other economists aren’t quite so severe. Ernest Klemme (1939, 366) and Berylt Sprinkel (1952, 218) maintain that the RFC’s loans reduced bank suspensions and bolstered depositor confidence until the Michigan banking crisis proved the last straw. James Butkiewicz (1995) finds that the RFC’s loans helped before it was compelled to publicize them, cutting bank suspensions "almost in half," but that they made little difference afterward. Joseph Mason (2001, 89), on the other hand, finds "a positive significant relation  between loan publicity and bank survival." One explanation for such apparently contradictory findings is that the most vulnerable banks were also the ones that chose not to seek the RFC’s help once they could no longer have it confidentially.

Standing back from all of this research, the picture one takes in shows an RFC hampered in its efforts to keep the banking system liquid, but not always for the same reason. The corporation’s strict collateral requirements limited its success through July 1932, while banks’ fear of adverse publicity did so afterward. The result, either way, was that the RFC’s bank lending program failed to deliver the goods.

6000 Bailouts

Five days after FDR took office, with all of the nation’s banks closed and economic activity practically at a standstill, no one doubted that, considered as a recovery device, the RFC had been a flop. "Despite unprecedented efforts on behalf of the private economy," James Stuart Olson (1982, p. 17) writes, "the RFC had not revived commercial credit, business investment, production, or employment." The Roosevelt administration "was not even sure the RFC was really strengthening the banking system."

So far as the nation’s banks were concerned, the fundamental problem, which became all too evident in the course of the national bank holiday, was no longer a lack of liquidity. They needed capital, and plenty of it: on mark-to-market terms, the U.S. banking system as a whole was broke (Kimmel 1939, 9).  And the RFC was about to start giving it to them, by not just lending to them but buying their preferred stock shares, notes, and debentures. Although the RFC would still lend to banks after its share purchase program began, its loans would no longer have to keep struggling banks alive as their primary aim. Instead, they would mostly be used to assist in the liquidation of banks that died.[5]

Although the share purchase program was the first major New Deal addition to the RFC’s powers, several Fed officials had first proposed it in the wake of the Chicago banking crisis. Although Hoover resisted the idea at first, in late January 1933, having at last been won over, he asked for legislation to be drawn up. But like most Hoover administration ideas for dealing with the then unfolding banking crisis, this one could get nowhere without Democratic support, which Hoover couldn’t secure. So a modified version of the plan ended up becoming the Title II Emergency Banking Act (Olson, 38-39).

Two sorts of banks and trusts benefited from the RFC’s "capital correction plan." First, of the 4215 banks that couldn’t be licensed to reopen immediately after the holiday, 3100 were considered salvageable with the help of RFC-supplied capital. The RFC would also inject capital into several thousand others which, though they’d been licensed to reopen, lacked enough capital to qualify for FDIC insurance when that became available. Regulators were determined to see most if not all banks enrolled in the new insurance scheme once it was running, whether they were legally required to or not, and the FDIC helped them accomplish that goal by agreeing to insure still under-capitalized banks provided the RFC promised to recapitalize them within six months of its doing so.

Despite these ultimately impressive numbers, as the figure below (reproduced from Mason 2000) shows, the RFC’s share purchase program got off to a slow start. The same stigma problem that had limited bank’s willingness to borrow from the RFC once its loans were routinely publicized now made them hesitate to sell their shares to it. So, for that matter, did their fear that the RFC would end up interfering with their management—as it eventually did, in some instances. During its first months, the RFC only received offers from a few dozen banks and trusts. But as 1934, and banks’ need to qualify for insurance, approached, the trickle became a torrent. When the government’s temporary deposit insurance program went into effect on January 1, 1934, 90 percent of the nation’s commercial banks and 36 percent of its savings banks were able to take part in it; by March the RFC had purchased stock from more than half of the nation’s banks (ibid., 23). But it still had to inject more capital into many to help them meet the FDIC’s stricter capital requirements when those kicked in the following July.

Not surprisingly, the RFC’s share purchase program proved more capable of keeping banks alive than its bank lending program had been (Calomiris et al., 543); and the program deserves to be considered a crucial part of the government’s solution to the banking crisis. It also rescued untold numbers of bank depositors who might otherwise have lost their savings, or endured long delays in recovering them.

But important as the RFC’s contributions to financial stability and relief were, they fell short of achieving its ultimate objective, which was the revival of bank lending (Olson 1982, 128; Mason 2000, 24). Disappointed, and observing how bankers were sitting on substantial excess reserves, RFC officials and others blamed them for not living up to their end of the bargain, and determined that, if they wouldn’t do their part, the government would do it for them.

(To be continued.)

Continue Reading The New Deal and Recovery:

• Intro
• Part 1: The Record
• Part 2: Inventing the New Deal
• Part 3: The Fiscal Stimulus Myth
• Part 4: FDR’s Fed
• Part 5: The Banking Crises
• Part 6: The National Banking Holiday
• Part 7: FDR and Gold
• Part 8: The NRA
• Part 8 (Supplement): The Brookings Report
• Part 9: The AAA
• Part 10: The Roosevelt Recession
• Part 11: The Roosevelt Recession, Continued
• Part 12: Fear Itself
• Part 13: Fear Itself, Continued
• Part 14: Fear Itself, Concluded
• Part 15: The Keynesian Myth
• Part 16: The Keynesian Myth, Continued
• Part 17: The Keynesian Myth, Concluded
• Part 18: The Recovery, So Far
• Part 19: War, and Peace
• Part 20: The Phantom Depression
• Part 20, Coda: The Fate of Rosie the Riveter
• Part 21: Happy Days
• Part 22: Postwar Monetary Policy
• Part 23: The Great Rapprochement
• Part 24: The RFC

___________________________

[1] Attempts to correct the record regarding Hoover’s willingness to resort to government intervention in response to the depression have been made by both his champions and his critics.  See Patrick O’Brien and Philip Rosen (1966, in two parts) for an excellent survey. Although, in one of his own otherwise excellent contributions to that literature, Steven Horwitz (2011) attributes the phrase "Hoover New Deal" to Murray Rothbard, Rothbard himself (1972, 128n21) points out how Chase National Bank economist Benjamin Anderson first used it back in the day.

[2] The fons et origo of the myth that the RFC was Hoover’s idea appears to be Jesse Jones’s 1951 memoir (1951, 14). Despite their opposite party affiliations, Meyer and Jones were friends until 1942, when The Washington Post, which Meyer had owned since 1933, published an editorial harshly critical of Jones’s handling of the RFC’s synthetic rubber program. When the two men ran into each other that evening at the entrance to the Willard Hotel ballroom, where the Alfalfa Club was holding its annual dinner, the confrontation ended in fisticuffs. Meyer, the younger of the two,  was 66. Asked about the fight the next day, Roosevelt remarked, off the record, that he hoped "there wouldn’t be a second round" (Tuttle 1981, 35-6).

[3] In fairness to Hoover, and to the bankers behind it, the NCC’s failure was not solely its own fault. Instead, its efforts were frustrated by the Federal Reserve’s refusal to loosen its own credit eligibility requirements, as the NCC’s organizers had hoped it would do so in its dealings with it.

[4] Other large RFC loans also raised eyebrows because prominent Republicans were among their recipients’ directors. They included loans for more than $26 million that the RFC made to two Cleveland banks whose directors happened to include Charles Dawes’s successor, Atlee Pomerene, and Joseph Nutt, the treasurer of the Republican National Committee. Although it may have been a coincidence, the fact is that Republicans commanded the boards of almost every big bank that the RFC helped during the Hoover years. (Flynn 1933).

[5] The importance of the RFC’s loans to defunct banks shouldn’t be underestimated. These may, indeed, ultimately have accomplished more than its loans to open banks. As Lester Chandler (1970, 149) explains, besides allowing depositors at failed banks to be paid relatively quickly, they allowed those banks’ liquidators to avoid having to sell their assets in a hurry, which would have meant realizing less on them as well as harming other institutions holding the same assets by depressing their prices. Between March 1933 and October 1937, the RFC authorized more than $875 of such loans. The Fed’s 13b lending program was, if anything, even less successful than the RFC’s version.

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