Could something like the Great Depression happen again? During that unpleasant episode, the stock market dropped by 90%, unemployment rose to 25%, and gross domestic product fell by 30%. In making a financial plan, is this a scenario that’s worth worrying 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 in preventing 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 by 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 exercised these powers in increasingly proactive ways.
The first test of this new mandate came in 1989, 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 of $3.6 billion to stabilize the situation.
During the 2008 financial crisis, the Fed took an even more proactive stance. 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. And finally, it worked to rescue banks and major employers that were at risk of failing.
The Fed, in other words, has become much more active over the years. That said, 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 Fed chair Ben 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 in the system.
Despite Bernanke’s quip that the Fed’s job is just 2% action, the Fed has become increasingly active in recent years. When the pandemic struck in 2020, unemployment spiked, GDP dropped and the 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, though, 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 necessarily 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.
