The facts are that the FED’s structural problems caused excess reserves to be quickly wiped out by the massive “runs” on the banks. I.e, the FED couldn’t expand the money supply – even if there weren’t any panic stricken “runs” on the banks. To say that the money supply declined is to ignore the real source of the problem.

As if failing to make the Federal Reserve a universal system was not enough of a handicap to effective monetary management, the Congress created twelve Federal Reserve Banks. I was not until 1933 that legislation was passed enabling the open market operaations of the various banks to be coordinated. I.e, before 1933 one FRB could be expanding credit, creating bank reserves and laying the foundation for a multiple expansion of money, while another FRB was doing the opposite. Since 1933, all open market operations of the twelve FRB are executed through the manager of the open market account in the FRB of New York (our central bank).

From 1933-1942 the centralization of the open market power was of little consequnce. So pervasive was the trauma of the Great Depression, and the lack of what the banks considered “bankable loans”, expansion of reserve bank credit typically led to more excess reserves rather than more loans, and money.

At the onset of the Great Depression, Federal Reserve Notes had to have a minimum backing of 40 percent “eligible paper” and a maximum backing of 60 percent “eligible paper”. The FED neither had sufficient gold nor the banks sufficient discountable “eligible paper” to meet the panic-inspired massive demands of the public for currency. Hence, bank failures were more than numerous; they would have been virtually universal if Roosevelt had not declared a “bank holiday” in March, 1933.

It was not until 1933 that we began to unshackle our paper money from the numerous and unnecessary restrictions pertaining to its issuance. With the numerous types of paper money in circulation at the time, this would seem to have been a nonproblem. Here is the list: gold certificates, silver certificates, National Bank notes, United States notes, Treasury notes of 1980, Federal Reserve Bank notes, and Federal Reserve notes.

With that array of paper money there should have been plenty to meet the liqudity demands placed on the banks by the public. But the volume of each type that could bde issued was so circumscribed by restrictions that even the aggregate group could not begin to meet the panic demands of the public.

Today the Federal Reserve Note has no legal reserve requirements, and the capacity of the FED to create IBDDs (interbank demand deposits) has no legal limit.

There is only one restriction placed upon its isssuance. No Federal Reserve Note can be put into circulation unless there is a prior transaction involving the relinquishing by the public of an equal volume of bank deposits, and an equal diminution of holdings of IBDDs on deposit with the Federal Reserve District banks. In other words, the issuance of our paper money contains no inflationary bias. Its issuance does not increase the volume of money. It merely substitutes one form of money for another form.

“That is that one country’s guarantees of its bank deposits have attracted deposits from neighbor countries without such guarantees. That has led to follow the leader reactions and a better understanding of the unintended consequences of well-meaning policies.”

For me, this is very important. Take this quote from Across The Curve:

“One trader said that the competition from the FDIC guarantee has been a real wet blanket for the entire sector and there is no active marginal buyer.”

And Brad Setser:

“Prior to Lehman, there was an almost unshakable faith that the senior creditors and counterparties of large, systemically important financial institutions would not face the risk of outright default,” notes Neil McLeish, analyst at Morgan Stanley.”

Much of the infrastructure of modern finance in effect rested on an expectation of a government backstop for the creditors of large financial institutions – a backstop that allowed a broad set of institutions to borrow short-term at low rates despite holding large quantities opaque and hard to value assets on their balance sheets.

That observation has a number of implications, not the least that the leverage – and resulting capacity for outsized profits — of some parts of the financial sector was made possible by the expectation that the government would protect the key creditors of the financial system from losses.

Lehman’s default shattered this implicit guarantee. The end result likely will be a series of explicit guarantees – and a rather significant government recapitalization of the financial sector.”

The importance of guarantees, both implicit and explicit, has not been well examined. I believe that the system of implicit and explicit government guarantees is the most important point in this crisis, although there is a lot more to it. When Lehman wasn’t allowed government help, I believe that markets and investors panicked at the thought that they would actually be on their own, and had no real plans to deal with the problems without the government’s help, including the Fed. I simply believe that the massive amounts of risk taken by banks and other investors wouldn’t have occurred without an assumption of government intervention and help. This also explains some of the movements of cash once the crisis began. Once full government intervention was apparent, the crisis began to be addressed in earnest.

As you point out, on the other hand, FDIC insurance and the Fed and government spending are important in keeping a really serious downturn from occurring. So what to do?

I would recommend what I call Bagehot’s Principle’s:

If the B of E exists, it will be the lender of last resort, and you need to figure that into your analysis. Consequently, you need to determine policies that make such a last resort unlikely. Here’s a view points:

Regulation or supervision that advocates transparency and capital requirements on transactions.

Real moral hazard for banks, say, long before a crisis can occur.

Onerous terms in the case of a crisis and government help is needed.

There might well be others. But in this crisis, we had:

Poor regulation or supervision

No real moral hazard until the crisis

Far too lenient of terms, e.g., TARP

Even if I’m wrong about all of this, the importance of investing based on implicit and explicit guarantees by government needs to be examined, and, going forward, the terms and conditions of government intervention need to be spelled out.

Finally, since the taxpayer is the ultimate guarantor of these guarantees, it would not be amiss for taxpayers to demand a system that limits risk and forces a more conservative investment strategy on the market. Whether that is wise or unwise for growth is a good question, but to the extent that taxpayers are the ultimate guarantors, surely they should have some say in the conditions that could lead to their being called upon to produce large amounts of money.