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COULD SOMETHING like the Great Depression happen again? During that unpleasant episode, the stock market dropped 90%, unemployment rose to 25% and gross domestic product fell 30%. In making a financial plan, is this a scenario we should worry about?
While no one can predict the future, it’s worth taking a closer look at one key variable: the Federal Reserve. Today, the Fed has a reputation for helping smooth out economic cycles. But those who worry about Depression-like scenarios point out how powerless the Fed was to prevent the collapse that occurred in the 1920s and 30s. How should we think about this?
As a starting point, it’s important to understand the Fed’s origins. The Federal Reserve System was created by Congress in 1913 in response to an event known as the Panic of 1907, which saw a number of banks fail and the market drop 50%. The crisis only came to an end when J.P. Morgan committed his own personal funds to help shore up the system.
Seeing how vulnerable banks were, Congress decided that the government needed to take a more active role in regulating and supporting the banking system. Thus, when the Federal Reserve came into being, its focus was limited almost exclusively to that role. This explains, in large part, why the Federal Reserve did little to avert the Great Depression. That simply wasn’t its job.
The Fed’s structure also contributed to its hands being tied during the Depression. Because its primary role in those days was to support local banks, decision-making authority was decentralized. While its headquarters and overall governance were in Washington, the Fed’s 12 regional banks operated independently and weren’t necessarily required to cooperate. Authority was so decentralized that each regional bank could even set its own interest rates. This probably seems surprising today, but it helps us understand why the Fed wasn’t more organized and more proactive in trying to avert the Depression.
In the years after the Great Depression—and largely in response to it—the Fed did begin to expand beyond its narrow role as a bank regulator. The 1933 Banking Act created a new entity within the Fed called the Federal Open Market Committee (FOMC). As its name suggests, this new committee gave the Fed the ability to engage in market operations, buying and selling securities to help influence market prices and interest rates.
During World War II, the Fed used these new powers to help the government finance the war. By purchasing U.S. Treasury bonds, the Fed allowed the Treasury to borrow at very low interest rates. It wasn’t until 1978, though, that the Fed’s mandate was formally expanded to include the language that today is known as the “dual mandate.” This gave the Fed responsibility for managing both inflation and employment, and gave it broad powers to carry out those goals. In the years since, the Fed has been increasingly active in exercising these powers.
The first test of this new mandate came in 1998, when the hedge fund Long-Term Capital Management (LTCM) teetered on the edge of bankruptcy. LTCM was highly leveraged, and the Fed feared that, if the firm failed, it could bring down other firms with which it had trading relationships. To avoid this, the Fed organized a bailout of LTCM, pulling together 14 financial institutions, which—at the Fed’s urging—agreed to commit an aggregate $3.6 billion to stabilize the situation.
During the 2008 financial crisis, the Fed was even more active. In addition to dropping rates quickly, it engaged in significant open market operations, purchasing government bonds to help provide liquidity to the system. It backstopped money market funds when one “broke the buck,” and it provided liquidity to financial institutions when markets dried up. It also worked to rescue banks and major employers that were at risk of failing.
Despite the Fed’s increasingly active role, former Fed Chair Ben Bernanke used to joke that his job was actually 98% talk and just 2% action. This highlights another way in which today’s Fed is a far different institution from the one that stood idly by during the Depression. Until just 30 years ago, the Fed didn’t even communicate its policy decisions, but that has changed significantly. In 1994, the FOMC began to issue press releases following each of its meetings. In 2004, the committee began to telegraph its thinking in advance with a practice it calls “forward guidance.” A further step came in 2011, when Bernanke began holding press conferences four times each year. Current Chair Jerome Powell doubled this to eight.
The Fed now also publishes a document it calls the Summary of Economic Projections. It provides insight into FOMC members’ thinking, with multi-year projections for inflation, GDP, interest rates and other economic measures. This type of detailed communication is another way the Fed works to maintain stability.
Along with this increased communication has come increased action. When the pandemic struck in 2020, unemployment spiked, GDP dropped and the stock market sank more than 30%. In response, the Fed dusted off many of the tools it had employed in 2008—and then went further. March 23, 2020, was a particularly notable day. In a single press release, the Fed announced a long list of new policy actions and programs to support nearly every corner of the economy and of the market.
In addition to the standard Fed actions—lowering rates and purchasing Treasury securities—additional actions included backstops for money market funds, banks, municipalities, brokers, large employers and holders of consumer debt. In a move that was particularly novel, the FOMC said it might even purchase corporate bonds and exchange-traded funds holding corporate debt. Prior to that, open market operations had been limited to Treasury securities. The result? Precisely on the day of the Fed’s announcement, the stock market reversed its slide. By August, it had fully recovered its earlier losses and continued rising higher.
In the absence of these actions, it’s anyone’s guess how much worse the situation would have gotten—and how much longer it would have taken to recover. In my view, the Fed’s posture in 2020 illustrates how much the institution has changed over the years. Ironically, critics of the Fed now argue that it has become too willing to intervene in times of crisis. But I think this helps answer the earlier question: In making a financial plan, is it necessary to plan for a Depression-like scenario? While every crisis takes a different form—and while it always makes sense to maintain a diversified portfolio to guard against an uncertain future—I do think that the Fed is different enough today that we shouldn’t worry about a repeat of the 1930s.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
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So how good has the Fed been for keeping our economy running smoothly? The value of the U.S. dollar has fallen by 96% since the Fed was created. They get an “F”. Yeah, call me crazy. “The Panic of 1907 caused a 50% market drop.” Then with the help of the Fed, the market dropped 90% in 1929-1936. Call me crazy again.
As Ronald Reagan warned, run when you hear “I’m from the government, and I’m here to help”.
It was a mistake to save the banks in trouble in 2008-09, just as it was to save Silicon Valley Bank in 2023. The latter was particularly egregious since the government simply ignored the $250K maximum FDIC limit, and made all depositors whole. They changed the rules AFTER the horse left the barn.
Why, if I wasn’t told better, I would think that these folks running the Fed, the FDIC and the government are stupid beyond belief. Yes, crazy again.
If my recollection of history is correct, the Fed may have contributed to the severity of the Great Depression by raising interest rates in 1928 and 1929. They did this presumably to limit spiraling stock prices. The result was reduced consumer spending and business investment when both were sorely needed.
A more potent contributor to the severity of the Great Depression was likely the Smoot-Hawley Tariff Act which, along with tariff barriers erected by other nations in retaliation, severely reduced international commerce.
As Adam points out, the Fed today is certainly better positioned to thwart another economic depression. Perhaps what retirement planners should be more concerned with is misguided legislation by a Congress tempted to “do something.”
Some great, informative history, Adam. Thanks, that was a fun read.
I would say that the only true preparations for another Depression would be gold coins and big guns, and neither interest me, so I’ll be happy to leave it in the hands of the Fed.
Every time the market drops more than 5% I find myself indulging my survivalist instincts by buying two trays of bottled water at Costco instead of one, and maybe 30 cans of soup at a time when there’s a BOGO sale. And, in a remnant from Covid, I keep lots of toilet paper in the hall closet.
But beyond that, I’m pretty much a fatalist.
I think the Fed has done a great job over the last 20 or so years. A concern of mine is when the national debt becomes impossible to ignore.
They’re the government! What could go wrong?🫣
Adam, thanks for the interesting history and insightful perspective. There is a lot of discussion on HD about the challenges in projecting one’s retirement income and expenses, as well as longevity and market performance. I can’t imagine how tough it must be to have to make projections and decisions on the nation’s and world economies and markets. It must be humbling and terrifying at the same time.
There are some people that I know from both the left and the right who want to ‘end’ the Fed.
I always ask them if they wanted the other side to be in control of the dollar.
The typical response is … silence.
Sure, the Fed isn’t perfect. I don’t know what on earth is these days.
So true Winston. I only want the president to have line item veto power when my guy is in the Whitehouse.
I’ve heard it said that if both sides don’t like you, you are probably doing a pretty good job of balancing responsibilities.
To your last point, in undergraduate Thermodynamics the professor taught us that the 2nd law proves that nothing in life is, or could be, perfect. He found that if we try to be perfect we will lead an unhappy life. But the first law tells us we can strive for excellence, and that was his recommendation for a happy life. It was a lesson that has stuck with me for over 45 years.
Interesting history lesson. Many thanks for these observations.