After building up billions of dollars in reserves placed through NYC banks into Street loans, or call money, the crash of ’29 created a profound disturbance in not just stocks but banking. Here too we get little mainstream examination into the link between stocks and the liquidity event that unleashed at least three discrete and successive waves of bank failures; and not just in the US, but globally. Again, the orthodox explanation runs toward gold being the primary culprit, the agent of contagion. The data, however, argues that it wasn’t gold but foreign “reserves” that tied it all together.
In the 1930 annual report for the Bank of France, redistributed in the March 1931 Federal Reserve Bulletin, the Bank makes note of liquidity as it was being displaced by fear and panic.
When on various occasions they [French banks] were confronted with large demands for francs in their own market during 1930, they naturally preferred to repatriate part of those unproductive [overseas, largely US$’s in NYC] balances rather than have recourse to the rediscount facilities obtainable at the Bank of France.
It wasn’t gold that was in high demand to spread shock initially, it was the pile of liquid reserves that had come to build up asset prices around the world. This effort to remove liquidity for national purposes was obviously reflected in the cascaded withdrawal of call money in NYC.
Interbank liquidity was reflected here as the vast majority of funds on the way down were removed from “other accounts.” Again, the timing of liquidity movements reflects directly in stock prices. But note that in the week following the crash, NYC banks stepped into the call market with a massive infusion of their “own account.” This was the famous photo op for Richard Whitney publicly buying US Steel and other blue chips at premium prices on behalf of the big NYC banks.
Combined figures for the weekly reporting member banks in leading cities showed an increase in total loans and investments from October 2 to October 30 [1929] of $1,600,000,000. Practically all of this unprecedented growth occurred during the last week of the month and nearly all was at banks in New York City. The taking over by the New York City banks of brokers’ loans of nonbanking lenders and the extension by these banks of additional loans to their customers was reflected in a growth from October 23 to October 30 of $1,500,000,000 in the New York banks’ net demand deposits and in a consequent large growth of their reserve requirements…
The November 1929 Bulletin goes on to note that the Federal Reserve system was active in providing liquidity, increasing its discounts for member banks by $150 million while purchasing a further $150 million in government bills during the last week in October 1929. But that was short-lived as the discounting was ended as gold was flowing back to the US. The Fed went back to targeting total base money through money rates.
This is the primary mistake that the ancient Fed gets pummeled for, the one that the modern Fed has vowed never to make again. Policy is thought to have been too “tight” during this period given the highly unstable conditions. This is also where nominal interest rates were very deceiving, as low money market rates, especially a dramatic decline in call money rates, did not indicate liquidity but lack of demand and fragmentation.
But there is another problem with that interpretation as it relates to NYC banks stepping up into the call market. As you can see from the first chart above showing Street loans, NYC banks were engaging in providing liquidity backstops all the way to September 1930 (in almost exactly the same fashion as the big banks were “forced” into liquidity backstops of CDO commercial paper conduits for their sponsored SIVs). Allocations of call money by these vital reserve banks grew by some 70% in that time, but did little to stop the flood of money out, particularly foreign reserves heading elsewhere.
While these central reserve city banks in NYC were tying themselves up trying to keep call markets calm, and by extension stock prices, how much of those resources might have been both better directed elsewhere and at the same time an immense measure of uncertainty for banks down the liquidity chain? Remember, correspondent banks held deposit balances at these central reserve city banks for clearing, who then fed that liquidity chain to smaller correspondents in smaller cities, and then finally to the largely standalone country banks. As a correspondent bank with a balance on deposit at one of these large NYC money center institutions, you might become more than a little uneasy at the prospect of that bank stepping in with its own money to further tie its fate to stock prices. After all, if those loans defaulted as stocks sunk further and took down the bank, your deposit balance is gone with it (leaving you as an illiquid creditor).
Uncertainty had clearly grown as the fractional reserve system was imploding, and the central reserve city banks were tying up nearly $2 billion in call money (increasing their own reserve requirements by about $250 million) instead of providing liquidity to correspondent banks that were clearly calling for it (and not getting it from the Fed). That showed first in a mini-wave of bank failures in June 1930 before all hell broke loose in November and December. Just prior to that breaking point and the first true wave of bank panics, NYC banks finally relented on the call market (as withdrawals accelerated from “other” and “out of town” correspondents) meaning they could no longer do both, though by then it was already too late.
That spark of “deflation” that blew to global conflagration came in spite of a huge increase in the quantity of gold. Total global gold stocks rose about 18% between 1927 and 1933, a massive spike belying the standard gold standard blame. In reality, it wasn’t the quantity of gold that was the problem as contagion, but rather its distribution. France had obtained a huge amount after its resumption of parity, and the United States never relinquished more than a small portion of the gold inflow it absorbed during the floating currency period after WWI.
That imbalance in distribution, though, wasn’t the primary problem either as it led to the great and huge imbalance in reserve accounts that linked all of this together. The call money and interbank markets served as a bottleneck on the way down as all of it flowed through the NYC money center banks. So the same access point for all these foreign reserves into and out of the US was the same conduit into which all domestic bank operations depended – and now all of it linked to the fate of the stock market. That acted as a negative force multiplier into which liquidity was shed in far greater proportion because of dual “exposure” at the primary access point. Stock market prices affected the loss perceptions of system participants exactly where it would do the most damage.
It was not the gold standard so much as the reserves created by so much “flexibility” that served to spread illiquidity first in the US and then further out across the global system. The more foreign banks were short of liquidity, the more they withdrew from foreign markets, particularly dollar markets, which served to tighten the noose further. Interbank markets which were supposed to operate as a backstop could not function in that manner because they were impaired by very accounts that served to build them on the way up. Liquidity is often so fickle and undependable, but that was never taken into account as banks fell under the spell of the false comfort provided by such huge and growing wholesale balances, expecting them to be useful when and where they were most needed. That was why gold had held its place as true money for millennia – liquidity meant nothing more than possession, free of all these newly created and dispersed financialisms and attendant entanglements.
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