The Federal Reserve was founded in 1913 with the primary goal of stabilizing the banking system and providing an elastic currency.  Under the Federal Reserve Act, the system comprised a Board in Washington and 12 regional Reserve Banks, each with its own president and directors.  National banks were required to become members (purchasing stock in their Reserve Bank) and hold reserves there; state banks could join voluntarily .  Member banks could obtain additional funds by borrowing at the “discount window” of their local Reserve Bank, pledging short-term commercial paper as collateral.  This mechanism was intended to let the money supply expand and contract with the economy and to serve as the lender of last resort to solvent banks .  In other words, the Fed’s early legal mandate was to support the flow of credit and prevent panics, rather than to target prices or output explicitly .  (Congress did not add a price stability objective until much later.)  In practice the Fed’s power was deliberately decentralized: Board governors in Washington had to coordinate with the 12 Reserve Banks, each of which set its own discount rate. The Fed’s founders hoped that by tying currency issuance to the level of commercial lending and by rediscounting bank loans, the central bank could help prevent the periodic banking panics of the 19th century .

However, historians note that the early Fed often acted timidly in crises.  Although discount window lending and open-market purchases were legally authorized, Fed leaders in the 1920s rarely used these tools aggressively to counter downturns .  In testimony before Congress in 1928, Fed Governor Benjamin Strong famously remarked that stabilizing prices “without regard to the penalties of violation of the gold standardGold Standard Full Description:The Gold Standard was the prevailing international financial architecture prior to the crisis. It required nations to hold gold reserves equivalent to the currency in circulation. While intended to provide stability and trust in trade, it acted as a “golden fetter” during the downturn. Critical Perspective:By tying the hands of policymakers, the Gold Standard turned a recession into a depression. It forced governments to implement austerity measures—cutting spending and raising interest rates—to protect their gold reserves, rather than helping the unemployed. It prioritized the assets of the wealthy creditors over the livelihoods of the working class, transmitting economic shockwaves globally as nations simultaneously contracted their money supplies.” was impractical – reflecting a rigid adherence to gold parity over countercyclical policy .  In sum, by 1929 the Fed was structured as a cooperative system of regional banks under limited federal oversight, charged mainly with preserving banking stability and defending the dollar’s gold parity, but lacking a clear mandate to stabilize the broader economy .

Monetary Policy, Bank Failures and Gold (1929–1933)

In late 1928 and early 1929, the Fed deliberately tightened monetary conditions.  Concerned about stock market speculation, the New York Fed (then the most powerful Reserve Bank) raised its discount rate, and the Open Market Committee (a predecessor to the FOMC) let bank reserves decline .  As Bernanke (2004) recounts, Friedman and Schwartz later termed this Fed action “the first grave mistake” – it raised interest rates when the economy was only barely out of a mild recession .  The rate hikes curbed bank lending to brokers and slowed industrial activity, helping to trigger a recession by August 1929 .  In Bernanke’s words, the Fed succeeded in breaking the speculative boom, but “the cost of this ‘victory’ was very high.” By one official chronology, industrial production had already fallen 27% below its July 1929 peak by late 1930, at which point the economy was fully in a deep Depression (monetary data).

After the 1929 crash, the Fed’s policy became mixed.  Initially the Fed did not aggressively expand reserves.  For nearly two years following the stock crash, the Fed largely “sterilized” gold and currency flows to keep reserves stable, and it made only modest open-market purchases .  In effect, the Fed held the money supply roughly constant – despite rising bank failures and falling economic activity.  When banking panics broke out in 1930–31, the Fed failed to act decisively as a lender of last resort.  Instead of flooding troubled banks with liquidity, Fed leaders (influenced by the old real-bills and even liquidationist doctrines) were reluctant to expand credit much. The result was catastrophic: about 9,000 banks (roughly one quarter of the nation’s banks) suspended operations between 1930 and 1933 .  Money market interest rates remained low, but the banking system collapsed under deposit runs and insolvencies.  In sum, from 1929 to early 1933 the monetary base barely rose – indeed the money supply fell nearly 30% – as Fed policy (and related Treasury actions) turned inadvertently contractionary .

During 1929–33 the economy suffered unprecedented contraction (real output down ~30%) and deflationDeflation Full Description:Deflation is the opposite of inflation and is often far more destructive in a depression. As demand collapses, prices fall. To maintain profit margins, businesses cut wages or fire workers, which further reduces demand, causing prices to fall even further. Critical Perspective:Deflation redistributes wealth from debtors (the working class, farmers, and small businesses) to creditors (banks and bondholders). Because the amount of money owed remains fixed while wages and prices drop, the “real” burden of debt becomes insurmountable. This dynamic trapped millions in poverty and led to the mass foreclosure of homes and farms. (prices fell ~10% annually), and unemployment surged to ~25% by 1933 .  The photograph above of unemployed men in a New York City bread line in 1930 illustrates the human toll of the Fed’s policy errors.  By failing to offset banking failures and hoarding of currency, the Fed allowed the money stock to collapse, which greatly exacerbated deflation and debt burdens .  As Bernanke observes, the Fed’s “most serious sin of omission” was not preventing this fall in money, which stemmed directly from collapsed banks and Treasury “banking holiday” policies .

An underlying constraint on Fed action was the gold standard.  In 1931–33 the Fed felt bound to defend the dollar’s parity in gold, so it avoided aggressive monetary easing.  When Britain left gold in September 1931, Paris and London markets panicked.  Many investors converted dollars into gold, causing the U.S. gold stock to fall dramatically.  The Fed responded by raising its discount rate again in fall 1931 to attract gold inflows .  (Bernanke notes that in late 1931 the Fed raised rates by 200 basis points in a futile bid to stop gold outflows .)  Thus international gold pressures forced the Fed’s hand – maintaining the gold standard overrode domestic stimulus.  In effect, the Fed’s monetary policy in 1930–31 was as tight as possible under gold convertibility, which only deepened the slump .  In January 1933, under President Roosevelt, the U.S. finally suspended gold payments and devalued the dollar, freeing the Fed to expand the monetary base more fully.

The Recession of 1937–38: Premature Tightening?

By 1935–36 the economy had largely recovered, but a new downturn hit in 1937.  Many historians view this double-dip recession as a case of premature Fed tightening.  In 1936 the Fed was concerned about rising bank reserves and potential inflation.  It doubled reserve requirements (from 10% to 20%) and resumed sterilizing gold inflows to soak up bank credit .  These actions abruptly reversed the liquidity expansion that had supported the recovery.  As noted by Friedman and Schwartz, the combined effect of higher reserve ratios and Treasury’s halted gold sterilization cut off the monetary growth and turned the money stock into a decline .  The Fed also raised rates on government securities and reduced open-market support in late 1937.

The results were swift.  Real GDP plunged about 10% and unemployment surged back toward 20% (figure: industrial production fell ~32%) .  Bernanke (2004) emphasizes that Friedman and Schwartz attributed much of this relapse to Fed policy: by late 1937 the Fed’s “misguided tightening” had choked off the expansion .  (The timing was widely criticized: with prices already deflating, raising nominal rates raised real rates sharply.)  Thus in historical retrospect many economists conclude that the Fed misjudged the recovery – withdrawing stimulus too early – and this policy error was a primary cause of the 1937–38 downturn .  Notably, once the Fed reversed course in mid-1938 (lowering reserve requirements and easing policy), the economy quickly rebounded.  This episode became a cautionary tale – showing the dangers of austerity and igniting later debates on fiscal vs. monetary triggers.

Scholarly Interpretations of the Fed’s Role

Economic historians have vigorously debated why the Fed’s actions were contractionary, and how important those errors were.  Milton Friedman and Anna Schwartz, in A Monetary History of the United States (1963), laid the foundation.  They argue that the Fed’s policy mistakes in 1928–33 (both commission and omission) “caused” the Great Contraction.  In Friedman–Schwartz’s view, the Fed made several key errors (tightening in 1928–29, raising rates in 1931, resisting easing in 1932–33, and raising reserve requirements in 1937) that each led to sharp drops in the money supply .  This monetarist interpretation contends that the Fed’s lax policy in the 1920s followed by severe stringency in 1929–33 was the “smoking gun” behind the price deflation and output collapse .

Ben Bernanke, who famously acknowledged “You’re right, [Friedman] did it” (2002), largely agrees that monetary policy was pivotal.  In his analysis, Bernanke highlights the same episodes Friedman–Schwartz emphasize. He elaborates that Fed officials in 1928 framed policy around speculative versus productive credit, which led them to tighten too aggressively in 1928 .  He also describes how the Fed remained on “automatic pilot” under gold, delaying aggressive response to banking panics.  Importantly, Bernanke adds nuance: he emphasizes financial frictions and the collapse of banking (and FX) channels.  For example, when foreign investors hoarded gold and runs hit U.S. banks in 1931, Bernanke argues that the Fed’s inaction (partly due to gold constraints) transmitted crisis through the credit system.  His later work (1995, 2000) and speeches underscore the non-monetary damage of bank failures, but still conclude that if the Fed had injected sufficient liquidity it could have prevented much of the deflationary spiral .

Other historians broaden the focus beyond the Fed alone.  Barry Eichengreen stresses the international gold standard regime.  In Golden Fetters (1992) he shows how all leading economies – U.S., Britain, France, Germany – initially sought to maintain gold, and that global coordination failures (e.g. Britain’s 1931 exit) spread deflation worldwide.  In Eichengreen’s view, the Fed’s commitment to gold was a policy constraint, not purely a judgment mistake: the Fed lacked the flexibility to devalue like others did .  Similarly, Peter Temin (1989) examines both monetary and fiscal factors.  Temin agrees the Fed contributed by contracting credit in 1929-33, but he also highlights the role of fiscal tightening (Social Security taxes, balanced budgets) and the collapse of demand.  Temin often emphasizes that deflation eroded real wages and spending, so the Fed’s contraction had far-reaching indirect effects.  In short, Eichengreen and Temin interpret the Fed’s errors in the context of global gold-led monetary constraints and broader “liquidity trap” dynamics, not just domestic mistakes.

In recent decades, the consensus among scholars is that monetary factors were crucial but not the sole cause.  Even critics of Friedman–Schwartz concede that the fall in the money supply in 1930–33 was largely self-inflicted by the Fed’s conservatism.  Disagreements remain over whether the 1928–29 tightening alone would have caused such a collapse, or whether other factors (banking structure, debt overhang, war reparations, etc.) magnified the shock.  For example, Arnold Kling and Scott Sumner note that while the Fed tightened in 1928, those actions mainly took effect after the crash – hinting that the Fed’s ongoing failure to supply liquidity during the banking panics of 1930–33 was even more damaging than its pre-crash moves .  (Sumner also stresses the role of banking regulation and the difference with Canada, which escaped panics partly by allowing branch banking.)

Overall, the scholarly interpretations align on this: Friedman & Schwartz identified how Fed actions tightened money; Bernanke added why (financial channels, decisionmaking); Eichengreen/Temin embedded it in the global gold-monetary context; and all agree the Fed could have mitigated the downturn by aggressive lending and open-market purchases.  By contrast, pre-1930 orthodoxy (often associated with “liquidationists” like Andrew Mellon) held that the Depression was a market purge.  Today’s historians reject that view: as Bernanke and others emphasize, the Fed’s inaction — whether due to ideology or institutional structure — “did it.”

Comparisons with Other Central Banks

The U.S. experience can be contrasted with how other central banks responded.  The Bank of England in 1931 also faced speculative attacks and runs, but its choices diverged from the Fed’s.  Under Winston Churchill’s 1925 return to gold, the pound was overvalued; by 1931 Britain was suffering a balance-of-payments crisis.  When runs hit the pound in September 1931, Britain abandoned gold.  Freed from its parity, the Bank of England quickly cut interest rates and expanded the money supply, igniting a relatively faster recovery .  In other words, Britain’s move away from gold allowed an earlier easing, whereas the Fed’s adherence delayed U.S. expansion until 1933 .  (Eichengreen stresses that France and other “gold bloc” countries similarly stayed on gold longer and had deeper slumps.)

Germany’s Reichsbank had its own story.  Germany’s economy was already weakening by 1930 under heavy reparations and tight monetary policy.  In July 1931, the Reichsbank cut rates dramatically (from 4% to 3%) trying to ease credit, but it still went into crisis that summer.  Once Hitler took power in 1933, the new regime effectively left the gold standard and the Reichsbank under Hjalmar Schacht pursued inflationary credit policies to finance rearmament.  By mid‑1930s Germany was growing again, in stark contrast to the U.S. until 1933 and Britain until 1932.  As Bernanke notes, “the severity of the [Great Depression] varied widely across countries,” with some (like Germany and Sweden) beginning recoveries as early as 1931–32 .  These comparisons underscore that policy choices mattered: countries that dropped gold and eased — even at the cost of inflation — tended to shorten their downturns, whereas those that held the line on gold suffered longer and sharper deflation.

In summary, the Fed’s conduct can be understood in a global context.  All major central banks in the early 1930s believed faithfulness to gold was paramount.  The Fed raised rates in 1928 and 1931 because other central banks did likewise; international coordination was weak.  Only after the political break with gold did monetary policy fully turn expansionary.  Thus comparative studies by Eichengreen, Temin, and Bernanke all emphasize that the U.S. Fed’s mistakes were partly systemic and partly reflective of a global regime that many countries soon rejected.

Lessons and Legacies: Reforming Central Banking

The failures of Fed policy in the 1930s prompted profound changes in central banking.  In the short run, sweeping financial reforms were enacted.  In 1933 Congress created federal deposit insurance (FDIC) to prevent bank runs.  The Glass-Steagall Banking Act imposed new reserve requirements, expanded federal regulation, and strengthened the Fed’s powers.  By 1935 the Fed itself was restructured: the Banking Act of 1935 created the modern Federal Open Market Committee (FOMC) and transformed the Federal Reserve Board into a powerful, seven-member Board of Governors in Washington .  (Previously, the NY Fed chief and rotating presidents had de facto led policy.)  From then on, Open Market Operations became the Fed’s main tool for managing reserves, coordinated at the national level.  As one Fed historian notes, the 1935 Act “created the modern FOMC… the Fed’s principal monetary policymaking committee” .  These institutional changes ensured much tighter coordination and authority: no Reserve Bank could again act completely independently of the Board, and the Fed developed a full-time staff and research capability to forecast and respond to macroeconomic conditions.

Longer-term, the Great Depression reshaped the theory of central banking.  The consensus that emerged is twofold.  First, stability-minded policy took precedence over rigid rules: central banks must combat deflation and credit crunches proactively.  Second, the Fed’s early errors taught that sizeable monetary stimulus is needed to halt a slump.  In the words of Bernanke (2004), the Depression “helped forge a consensus” that government (and central banks) bear responsibility to stabilize the economy, leading to institutions like FDIC and the SEC .  Moreover, economists applied these lessons in later decades: KeynesianismKeynesianism Full Description:Keynesianism emerged as a direct response to the failure of classical economics to explain or fix the depression. It posits that the “invisible hand” of the market is insufficient during a downturn because of a lack of aggregate demand. Therefore, the state must step in as the “spender of last resort,” borrowing money to fund public works and social programs. Critical Perspective:Structurally, this represented a fundamental shift in the role of the state—from a passive observer to an active manager of capitalism. It was essentially a project to save capitalism from its own contradictions, using public funds to prevent the kind of total social collapse that often leads to revolution. gained appeal partly because it advocated countercyclical fiscal (and implicit monetary) support.  Even after Keynes, Milton Friedman himself used the Depression as evidence of how dangerous monetary contraction can be.

By the late 20th century, central banking doctrine had been fundamentally altered.  Many countries abandoned gold permanently (fixed exchange systems gave way to flexible rates or Bretton Woods and later fiat regimes), giving their central banks freedom to set policy without gold constraints.  Fed policymakers have often cited the Great Depression as rationale for prioritizing price stability while also ensuring adequate liquidity.  Most central banks now have clear mandates to maintain stable prices (a reaction to the 1920s’ price swings) and to serve as effective lenders of last resort.  For example, since 1977 U.S. law explicitly adds inflation control to the Fed’s objectives, a far cry from the 1920s ambiguity.  And after the 2008 financial crisis, Fed chairs often remarked that “we learned our lesson” – promising to avoid the kind of paralyzing inaction that prolonged the 1930s .

In institutional terms, the legacy of the Depression is evident.  The Fed today possesses a vast array of tools (discount window lending, open-market operations, quantitative easing) precisely to avoid letting the monetary base collapse as it did in 1930–33.  The very organizational structure – a national board with unified policy – was a post-Depression reform.  Even the Fed’s culture changed: subsequent chairmen like Greenspan and Bernanke internalized Friedman’s dictum that a central bank must act preemptively against deflation.  In short, the Great Depression convinced economists and policymakers that central banks cannot remain passive in crises.  As Bernanke summarized, Friedman and Schwartz “had found the smoking gun” proving that reckless monetary tightening can cause a prolonged downturn .  This insight underlies modern central banking: avoid deflation at all costs, and use monetary policy aggressively when needed.

The social legacy is no less important.  The New DealThe New Deal Full Description:A comprehensive series of programs, public work projects, financial reforms, and regulations enacted by President Franklin D. Roosevelt. It represented a fundamental shift in the US government’s philosophy, moving from a passive observer to an active manager of the economy and social welfare. The New Deal was a response to the failure of the free market to self-correct. It created the modern welfare state through the “3 Rs”: Relief for the unemployed and poor, Recovery of the economy to normal levels, and Reform of the financial system to prevent a repeat depression. It introduced social security, labor rights, and massive infrastructure projects. Critical Perspective:From a critical historical standpoint, the New Deal was not a socialist revolution, but a project to save capitalism from itself. By providing a safety net and creating jobs, the state successfully defused the revolutionary potential of the starving working class. It acknowledged that capitalism could not survive without state intervention to mitigate its inherent brutality and instability.
Read more measures (FDIC insurance, Glass-Steagall barriers, Social Security) and the Fed’s own structural reforms owe much to lessons of the 1930s .  Central bank theory likewise evolved: the Fed of today is more independent, more data-driven, and more willing to provide liquidity.  Although debates continue (for example, over rules versus discretion), nearly all policymakers agree that the mistakes of the 1930s – principally allowing the money supply to collapse – must not be repeated.  In this way, the institutional and intellectual landscape of central banking was indelibly transformed by the experience of the Great Depression .

References

Bernanke, B. S. (2004), Money, Gold and the Great Depression: An Address at the H. Parker Willis Lecture, Federal Reserve Board (Washington, DC) . Carlson, M.A. and D.C. Wheelock (2013), “The Lender of Last Resort: Lessons from the Fed’s First 100 Years,” Fed. Res. Bank St. Louis WP 2012-056 . Friedman, M. and A.J. Schwartz (1963), A Monetary History of the United States, 1867–1960, Princeton Univ. Press. Wheelock, D.C. (1992), “Monetary Policy in the Great Depression: What the Fed Did, and Why,” Econ. Rev. (St. Louis) Mar/Apr 1992 . Bernanke, B.S. (2002), Remarks at AEA meeting (cited in Fed history) . Eichengreen, B. (1992), Golden Fetters: The Gold Standard and the Great Depression (Oxford). Temin, P. (1989), Lessons from the Great Depression (MIT Press). Federal Reserve History, “The Great Depression” essay (Gary Richardson) and “Recession of 1937–38” (Patricia Waiwood) . Federal Reserve Bank of St. Louis, Annual Report 2013 (Wheelock), “The Banking Act of 1935” . Bernanke, B.S. (2002), Speech at Milton Friedman conference (quoting “We did it”) .