Why The Federal Reserve Worked During The 1930s

When the Great Depression began, over 8,000 commercial banks belonged to the Federal Reserve System, but nearly 16,000 did not. There were still state banks which were not members. Those nonmember banks operated in an environment similar to that which existed before the Federal Reserve was first established back in 1914. People criticize the Federal Reserve all the time, yet offer no viable alternative.

The two-tier banking environment harbored the causes of banking crises itself in addition to the Sovereign Debt Crisis. One primary cause was the banking collapse was the practice of counting checks in the process of collection as part of banks’ cash reserves. You could write a friend a check for $1 billion and he writes you a check for $1 billion and under this system you are both billionaires while waiting for checks to clear. These “floating checks” were therefore counted in the reserves of two banks, the one in which the check was deposited and the one on which the check was drawn. In reality, however, the cash resided in only one bank assuming it did not bounce in the end.

Bankers at the time referred to their reserves using these floating checks constituting fictitious reserves. The quantity of fictitious reserves rose throughout the 1920s as the economic boom unfolded and it peaked just before the financial crisis in 1930 during the last quarter of 1929. This meant that the banking system as a whole had much lower actual cash (or real) reserves available in emergencies than appeared on the surface thanks to counting these floating checks as reserves.

Additionally, without membership in the Federal Reserve, nonmember banks were plagued by their inability to mobilize bank reserves in times of a crisis. Nonmember banks kept a portion of their reserves as cash in their vaults and the bulk of their reserves as deposits in correspondent banks in designated cities. Most of these correspondent banks belonged to the Federal Reserve System. However, this interestingly created a reserve pyramid whereby these state or local country banks had no access to reserves during times of crisis. Whenever a nonmember bank needed cash because of a run by its customers, the bank had to turn to its correspondent, which might be faced with requests from many banks simultaneously. The correspondent bank also might not have the funds on hand because its reserves consisted of floating checks in the mail, rather than cash in its vault. If such a shortage unfolded, then the correspondent bank would turn and request reserves from yet another correspondent bank. That bank, in turn, might also have a shortage of cash reserves available.