Right now, the biggest story on Wall Street is the Federal Reserve’s communication problem. The remarks Ben Bernanke made last week were supposed to tell investors that the Fed would be very careful and deliberate about “tapering,” or gradually ending, the $85 billion monthly bond-buying program that has been propping up the markets since 2011. Instead, investors took Bernanke’s words to mean that the bond program was definitely ending, soon, and freaked out, leading to a massive market sell-off and a bunch of other Fed governors scrambling to walk back Bernanke’s taper-talk.
These seem like new problems for the Fed. But they’re actually very old ones. In fact, to find the closest analogue to what’s currently happening on Wall Street, you have to look all the way back to 1936.
In 1936, economic policy-makers in Washington were feeling cautiously optimistic. The economy was recovering quickly from the Great Depression, and unemployment had fallen dramatically. And seeing all of this improvement, they began to come up with a plan to gradually take away the stimulus they’d been using to prop up the economy for years, which they feared would cause speculative bubbles and excessive risk-taking.
One of the components of the plan they came up with was increasing reserve requirements at banks — essentially, forcing banks to store more money in vaults, rather than making it available for deployment. The idea behind this seemed simple: In the four years since the low point of the Great Depression, banks had accumulated massive amounts of cash. The Fed feared that, if banks got too cash-rich, an “injurious credit expansion” could result. They also knew that banks probably wouldn’t mind being required to hold more cash with the Fed, since they were sitting on huge piles of it, anyway. So they took the existing reserve requirement and doubled it. A year later, they increased it again.
The Fed insisted these weren’t huge, telling steps. Raising reserve requirements wasn’t a reversal of the easy-money policies banks had been accustomed to. It was simply a preventative measure that would make the economy a little safer, without requiring much more of banks. At a meeting in 1936, the Fed’s board of governors insisted that “easy money policy remains unchanged and will be continued.”
But banks didn’t see it that way. To them, having the Fed double the size of their reserve requirements represented a signal that the Fed was no longer interested in supporting their renewal and stimulating the markets. They took it as a sign of monetary tightening, even though the Fed had said exactly the opposite. And, as one leading scholar of late-thirties economic policy (who happens to be my grandfather Kenneth Roose) wrote, panic followed. “The Board was unprepared for the heavy selling wave of government securities immediately before and after the announcement of the second reserve increase.”
Today, our situation is marked by a similar lack of trust between Wall Street and the Fed. The Fed has been trying for weeks to reassure the market that the end of quantitative easing isn’t coming soon — and that even if it were coming soon, a slow tapering of bond purchases wouldn’t represent a departure from all other easy-money policies. By all accounts, this is actually when Ben Bernanke and other Fed policy-makers believe. And it’s what they’ve said, over and over. And yet the market isn’t buying it.
In the case of 1936, the decision to increase reserve requirements turned out to be a huge mistake. Banks made up for their lost excess reserves by cutting off lending; bond prices dropped sharply; the stock markets fell; and the economy settled into a double-dip recession that would last all of 1937 and 1938 and that would only be ameliorated by the start of World War II. As my grandfather put it in a 1950 paper, “It seems plausible to conclude that Federal Reserve action on reserve requirements touched off a series of events leading to a weakening of the securities markets.”
Ben Bernanke is no stranger to the lessons of 1936. He’s been a scholar of the Great Depression and knows full well that if the Fed cuts off support for the economy too quickly — or even talks to Wall Street in a way that suggests that it might cut off support prematurely — the markets could go wild, and the economic gains of the past few years could be erased in a matter of months.
In a fragile, recovering economy, sentiment is almost as important as policy. Which is why, right about now, everyone involved in the Fed’s decision-making process should be rereading their late-thirties economic history. The Fed’s mistake then was making a small policy change that was wrongly interpreted as a massive, tectonic shift. It’s on the verge of making it again.