How the Fed Prevented Another Great Depression

By Nathalie Pierrepont
Columbia Journalism School, C’12

Four months before the recession technically ended in June 2009, Federal Reserve Chairman Ben Bernanke defended his decisions to bail out the world’s largest financial institutions through unprecedented lending programs. “Extraordinary times call for extraordinary measures,” he said.

From the onset of economic decline in 2007, it was clear that Bernanke, a former academic who had studied the Great Depression, did not want to repeat history. The Fed achieved economic stability through bold, unconventional mechanisms that alleviated strains on different parts of the economy. As a result, even at its worst moments, the recession did not sink the economy to the lows of the 1930s.

“Very early on in financial crisis, we were on the edge of a precipice,” said Karen Dynan, co-director of the Economic Studies program at the Brookings Institute. “Credit markets were threatening to seize up, and a flow of credit is essential for the economy to function. If credit markets had seized up, we may be in a very different place today.”

The Fed’s transparency about its plans for the benchmark interest rate, the rate at which banks lend to one another, was instrumental in keeping credit flowing. Bernanke communicated regularly with the public about the course of the economy and the Fed’s intentions. In 2008, the Fed said it was cutting the benchmark rate to “exceptionally low levels… for some time,” and in 2009, it said they would remain there “for an extended period.” Investors were desperate for information, so even these vague phrases significantly reassured the financial market.

The Fed also ensured banks had sufficient access to credit, averting the widespread bank failures of the Great Depression. Although large financial institutions, such as Lehman Brothers and Bear Stearns, fell victim to the recession, the damage did not compare to that of the first years of the Great Depression, when over half of the nation’s banks failed. The Fed’s decision to lend hundreds of millions of dollars to the nation’s largest banks in 2008 prevented the financial system from reaching the level of instability it had during the early 1930s.

The Fed also addressed buckling institutions outside the financial sector. The commercial paper market, which enables businesses to secure loans to meet their payrolls and other short-term obligations, was frozen, heightening concern about the solvency of non-financial institutions. “Fear had overtaken the market,’’ said Dynan. “The fundamentals were still sound, but people were nervous. The market seized.”

To improve the short-term funding markets, the Fed established one program that helped money market funds meet the demands for redemptions by investors, and another that increased the availability of credit for businesses and households.

“Federal Reserve interventions in the money market helped prevent the commercial paper market from melting down to the extent seen during the early 1930s,” said John Duca, a senior policy advisor at the Federal Reserve Bank of Dallas, in a paper released earlier this year. Real commercial paper outstanding fell 74 percent during the 25 months between July 1930 and August 1932, but only 44 percent between July 2007 and August 2009.

To cope with flagging demand, the Fed reduced borrowing costs by purchasing large amounts of assets. This mechanism was enacted in two steps. In 2008, the Fed announced purchases of housing agency debt and agency mortgage-backed securities. In 2009, the Fed expanded its purchases of agency-related securities and decided to purchase longer-term Treasury securities, as well.

Stimulating aggregate demand by reducing long-term interest rates can also boost employment, which, along with price stability, is the Fed’s chief responsibility. At 9 percent, compared to 4.5 percent in November 2006, the unemployment rate remains a serious concern for the Fed. However, even Bernanke acknowledges the Fed’s primary tools are limited today. “Monetary policy can be a powerful tool, but it is not a panacea for the problems currently faced by the U.S. economy,” he said in congressional testimony in October. “Job creation is a shared responsibility of all economic policymakers.”


This article was written for the Columbia Journalism School’s seminar on business and economics journalism in the fall of 2011.

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