Wars tend to generate a temporary increase in demand for goods and services. Funding for reconstruction following the Civil War generated some banking demand, but not at a level that overcame the usual problems of shrinking employment and adjustment from wartime production to peacetime demand. Many people became dislocated due to a lack of jobs. Thousands of soldiers who were hardened by war and not trained to perform available civilian jobs stood idle. The inability of former Confederate supporters to change their thinking, animosity from retribution at the time of the North’s occupation during Reconstruction, and other limitations combined to enflame race relations. This led, eventually, to a shameful period during which the federal government averted its eyes and allowed reenslavement to run rampant in the South. A century passed before the nation forcefully addressed many of the racial issues that were generated during the late 1800s.

During the period between the Civil War and the Great Depression, the United States became the world’s leading economic power. The Gilded Age brought personal fortunes to railroad and industrial pioneers, and to the bankers and speculators who financed them. Many were built on a foundation of squandered natural resources, labor and safety abuses, and by the abuse of legal process. There were outrageous legal precedents whereby states wrote laws that excused bribery of officials, eliminated voting rights for former slaves, and replaced slavery with forms of peonage that proved even more onerous. Most who sought to challenge these developments were intimidated or murdered, as courts blinked when confronted with harsh realities.

In finance, robber barons speculated under cover of pyramidal trust and corporate structures. They borrowed off-balance sheet using subsidiaries and reported only their net positions as holding company assets when selling shares to investors. Lawrence Mitchell argues that “the stock market became the driving force of the American economy in the first decade of the twentieth century as a result of the birth of the giant modern corporation” (Mitchell 2007). He contends that the legal, financial, economic, and social transformations precipitated by the emergence of the public stock corporation

allowed financiers to collect companies and combine them together into huge new corporations for the main purpose of manufacturing stock and dumping it on the market. Businessmen started to make more money from legal and financial manipulation than from practical business improvements like innovations in technology, management, distribution, and marketing.

It was only through Depression-era securities laws that most firms were finally required to account to owners on a consolidated basis, disclosing the leverage incurred at subsidiaries. An important point discussed later in this book is that in the 1930s consolidated reporting became required for financial firms and industrial firms, but not for industrial firms and the finance subsidiaries they owned. As a result, General Motors (GM), Ford, and General Electric (GE) did not consolidate General Motors Acceptance Corporation (GMAC), Ford Motor Credit, and GE Capital Corporation, respectively, into their financial reporting until the early 1990s.

Bankers followed the pattern of hiding leverage in subsidiaries before the Depression by creating holding companies for their banks. The holding companies created nonbank subsidiaries to issue guarantees of loans made by affiliated banks. This device allowed double-dipping into holding company equity in order to prevent subsidiary bank losses due to defaulting borrowers from being recognized. Many banks, of course, failed as these abuses came to light.

Probably the most important financier of that time was J. Pierpont Morgan. When a panic threatened New York banks in 1907, he famously gathered bankers together and “persuaded” them to invest enough to prevent the panic from spreading. The House of Morgan was the de facto central bank of the United States in that day, a role exemplified by the fact that it did not belong to the New York Clearinghouse. Instead it made other banks stand in the lobby along with retail customers. Less noted is that it appears the largest loan funded by the money Morgan raised in 1907 allowed U.S. Steel to buy its only significant competitor, Tennessee Coal, Iron and Railroad Co. (TC&I), at perhaps five cents on the dollar. TC&I also appears to have been the South’s largest employer of reenslaved African Americans. Its labor practices did not change for decades thereafter.

A few years later, Morgan hosted a meeting that produced the draft legislation creating the U.S. Federal Reserve System. The new entity was ostensibly to take up the role Morgan had played in 1907 as lender of last resort. Unnoticed for the most part before 2000 was a clause that made it difficult for the new Fed to undertake that role.

When a panic hits, money withdrawn from the banks being squeezed has to go somewhere. Even if that somewhere is into a pillowcase under a bed, any responsible entity that serves as a lender of last resort needs to attract the frozen money over time. The Federal Reserve Act, however, precluded the Fed from paying interest on the reserves that banks deposited at the Fed. But money center banks (e.g., Morgan’s bank) were permitted to pay interest on various interbank funding mechanisms, giving them an advantage in the markets in times of financial stress. As a consequence, excess reserves that ran to banks that continued to be considered safe flowed to banks like Morgan’s but not to the Fed, an illustration of Bagehot’s dictum about keeping interest rates high to attract liquidity back into the markets. In the days of Bagehot, however, the money he wanted to attract back into circulation was gold, which was attracted by the high deposit rates paid by banks. Banks could then expand their lending based on the higher levels of reserves on deposit, an illustration of the rigidity of the central banking model of England in the 1800s.

A century ago, the Fed could only stimulate business lending by banks that were short of funds by acquiring assets suitable for repurchase agreements (or repos). Prior to 2008, to further stabilize the overall money supply, the Fed found itself limited to demanding a higher level of mandatory reserves (at 0 percent interest to depositing banks) from all banks in order to obtain funds to help weaker institutions.

Demanding larger mandatory reserves in that way both unfairly reduced the earnings of safe banks and increased the liquidity needs of marginal banks, generating a need for even more liquidity. Preventing the Fed from paying interest on deposits, therefore, had the effect of (1) limiting its ability to stabilize banks in a crisis, and (2) increasing the potential for Morgan’s bank (and his friends) to profit in a crisis. Yet resistance to the idea of the Fed paying banks interest on reserves prevented this meaningful reform for almost a century. Even today, many observers bristle at the idea of the Fed paying banks for deposits, even though the systemic benefits of such an arrangement are obvious to those that understand the processes used to resolve the 2007–2009 crisis.

Milton Friedman recognized the need to permit the Fed to pay interest on reserves more than 40 years ago. The Fed finally convinced Congress to let it pay interest on reserves in 2006, effective in 2011. Thankfully, the TARP law (Troubled Asset Relief Program) advanced the effective date from 2011 to the fall of 2008. Doing so allowed the Fed to attract (and retain, as needed) reserves to purchase and hold Treasury debt and mortgage securities. It can thereby affect market rates (and to some extent credit spreads) on longer term assets as part of a low interest rate regime using quantitative easing, or QE.

On the first day in 2008 that the Fed could attract excess reserves by paying interest, some money center banks apparently had underestimated the amount of reserves the Fed would attract. As a result, that day is commemorated by a large spike in the rate banks paid for overnight funds as trading ended. That spike meant some banks found themselves short as the funding window was shutting for the day.

That situation corrected itself the next day, however, as banks that now had to compete with the Fed for funds took its presence (and published rate) into account.

It was the Fed’s unconstrained ability to raise funds in competition with money center banks that made its role as lender of last resort rather seamless after 2008. The authority to pay interest on reserves also makes it comparatively easy for the Fed to wind back liabilities as its several-trillion-dollar asset portfolio shrinks through sales, or, if it chooses, by letting the portfolio mature. Via QE, the Fed purchased risk-free financial assets while giving cash to banks that used the funds to stabilize prices for other securities.

As the Fed becomes able to unwind its portfolio, it provides a good indication that investor sentiment is improving. With the ability to change rates paid on reserves, the Fed can manage daily funding needs simply by adjusting its own deposit and overnight repurchase agreement rates (as all banks do). Without the ability to pay interest on reserves, conducting similar operations on the scale needed to stem a nationwide run before TARP would have raised many extraordinary and unpredictable issues.

This former limitation on the Fed’s authority is one of many examples in finance where what seems to be a legal technicality has great consequence for the economy as a whole. When the Fed acts as a lender of last resort, all normal market responses have ceased. The Fed must engage in an activity of enormous magnitude, therefore, to change market perceptions and perform its stabilizing role.

That’s why, for example, the problem of shorts (short sellers) taking swipes at the bonds of European nations in the period between 2009 and 2012 (and the United States during its 2011 and 2013 budget battles) only subsided when central bankers credibly announced they would do whatever was needed to stabilize markets. Facing a monetary authority with an infinite capacity to print money and the determination to prevent a short seller’s squeeze tactic from succeeding, all shorts eventually resort to intimidation through media hype for a while, but only while they’re unwinding positions.

In the nineteenth century, robber barons who specialized in watered stock taught the world about the need for a central bank to provide liquidity when confidence fails. Financier Daniel Drew summed up the problem for a short seller in that circumstance: “He who sells what isn’t his’n, must buy it back or go to pris’n.” In a small transaction, it is unlikely the perpetrator will actually get “pris’n,” so investors will proceed in the face of illegality. When there is even a tiny legal problem with a trillion-dollar trade, however, that small problem can trigger a catastrophe for investors and society as a whole.

When viewing the role of the Fed before and throughout the Great Depression, a 1925 decision by the U.S. Supreme Court also greatly complicated the Fed’s ability to follow Bagehot’s dictum. Louis Brandeis, perhaps the most respected scholar then on the court, opined that a common law pledge of collateral “imputes fraud conclusively.” The decision meant that a receiver could challenge any pledge of collateral made to the Fed before receivership if the pledging bank continued to collect on the loan. The case caused enormous debate in the legal profession and slammed shut the door on fraudulent incomplete sales and pledges of assets. It stifled private credit creation in the United States for more than three decades. The relevant part of the Brandeis decision said:

But it is not true that the rule stated above and invoked by the receiver is either based upon or delimited by the doctrine of ostensible ownership. It rests not upon seeming ownership because of possession retained, but upon a lack of ownership because of dominion reserved. It does not raise a presumption of fraud. It imputes fraud conclusively because of the reservation of dominion inconsistent with the effective disposition of title and creation of a lien.

Brandeis took a squarely Progressive stance against the prevailing business practices of the day and literally shook the ground of commercial finance. In the Benedict v. Ratner opinion, he considered the many ways in which a purported pledge of collateral could be hidden from creditors. He found the process so entirely opaque that he could not justify allowing unsecured creditors to lose rights while creditors favored by the borrower took all the entity’s liquid assets. In many cases, such pledges precluded effective reorganization of the debtor and the consequent preservation of jobs.

Importantly for the problems of today, Brandeis also noted that an incomplete sale of assets likewise “imputes fraud conclusively.” This failure to perfect a true sale of assets to another party would play a significant role in the S&L crisis of the 1980s and the subprime debacle that started in 2007. Just as the Securities Act of 1933 embodied Brandeis’s vision of public disclosure of financial information, the decision in Benedict was another piece of a larger puzzle for the justice known as “the People’s Lawyer.” We will come back to that point, however, later in the book.

At this point, we will only note that a mere four years before the 1929 stock market crash the highest judicial panel in America, in an opinion written by its most respected and militant jurist, declared that accepting a common law pledge of collateral (as Bagehot directs when making loans of last resort) “imputes fraud conclusively.” Anyone sitting on the Federal Reserve Board at that time, before proceeding with a program to loan more money than anyone had ever done in history, would demand an unqualified “full faith and credit” opinion that every step required by Justice Brandeis was fulfilled. As a result of Brandeis’s passion for financial accountability, the Fed and private lenders were hamstrung in terms of providing credit to the U.S. economy for decades after the decision.

Indeed, it would take a combination of three then-nonexistent laws, the Uniform Commercial Code (UCC), the U.S. Bankruptcy Code (USBC), and the Uniform Fraudulent Transfer Act (UFTA), all of which were adopted between the mid-1950s and 1990s, to address the concerns of Justice Brandeis and assure that pledges for secured lending by banks and other true creditors would be upheld in U.S. bankruptcy and receivership proceedings. Thankfully, by 2008 all of those ducks were finally in order. That fact allowed the Fed to accept pledges and apply Bagehot’s dictum in service as the U.S. lender of last resort without any limitations.

The resolution of the 1925 Brandeis decision and the ability to draw excess bank reserves by paying interest are why the Fed under Chairman Bernanke was able to avoid the mistakes of the 1930s, when the Fed was a relatively minor player. In that era, the Fed could not act with the necessary timing and assurance of sufficient continued funding. Outright expenditures, using bonds to fund other government agencies such as the Reconstruction Finance Corporation, were needed while the FDIC undertook the long process of restructuring banks with insured deposits and federally backed bonds.

The Roaring Twenties, built on speculation hidden from investors and constrained by the inability of lenders to secure advances, therefore, came to a screeching halt after the stock market crash of 1929. By law, the Fed could not act to stabilize the system by paying interest to attract money hoarded by banks that stopped making loans or by accepting general pledges of loans from banks that continued to make and manage them (as prescribed by Bagehot’s dictum). It was not until 1940, and then only to address the financing needs of the manufacturing sector for what would soon become World War II, that Congress finally passed a law that allowed banks to rely on payments due from the U.S. government as collateral for loans to wartime manufacturers. That process, moreover, proved so complicated that it was used only for very large projects.

Some prescient managers were able to change course in time to avoid the worst of the Great Crash of 1929. General Motors, for example, dismissed its founder, William Durant, in 1920. He was replaced in 1923 by Alfred Sloan, who structured the company as a fortress within what became the nation’s “fortress of democracy” during World War II. Unlike Ford Motor Company, which almost failed during those terrible years, Sloan’s GM lost money in only one year during the Great Depression, and produced some 10 percent of all goods used in the war effort.

GM made dealers pay the wholesale price of cars immediately on delivery, then financed the dealers’ purchases through its AAA-rated finance subsidiary, GMAC. Moreover, by paying suppliers more than 180 days after their delivery of parts, GM was able to construct plants and meet short-term capital needs on its accumulated float. Indeed, the genius of Sloan was that he understood the power of leverage, properly used, while Ford was still operating on a cash basis and did not offer credit to customers until it was forced to imitate GM in 1927. By then GM was so much larger than Ford that the latter was often compared to a single division—Chevrolet—of the former.

GM and its major suppliers were financially sound enough that banks justifiably relied on GM payables as collateral for loans to suppliers even after the Supreme Court ruled that a pledge “imputes fraud conclusively.” But all things change. Following the recession caused by the S&L debacle of the 1980s, in 1993 GM came within a few weeks of declaring bankruptcy. As a result of the market debacle of 2008, GM was finally forced to reorganize in bankruptcy, a result made feasible by investments the government made in major banks under the TARP law.

The banking collapse of the Great Depression started in Detroit early in 1933. When Henry Ford defied President Hoover and threatened to withdraw his money from the Union Guardian Trust Company and other banks, Michigan Governor William Comstock ordered a bank holiday on February 14, 1933. In the two weeks between Comstock’s action and the inauguration of FDR, more than thirty states followed suit and closed their banks. The banks remained closed for months. That is when President Roosevelt said, “We have nothing to fear but fear itself.”

The Great Crash had such an enormous impact on Detroit that its effect can still be seen. While not a direct cause of Detroit’s 2013 bankruptcy filing, seldom-told consequences of the Depression will be referenced as we move to the next topic.