This experience of the run on the shadow banking system that occurred in 2007 and 2008 reminds us that similar disorderly flights of uninsured deposits from banks lay at the heart of the financial panics that afflicted the nation in the late nineteenth and early twentieth centuries. The most dramatic of these episodes were the bank runs of the early 1930s that culminated in the bank holiday in 1933. Just as it was necessary, though not sufficient, to alter the environment that led to those successive deposit runs by introducing deposit insurance in order to create a stable financial system in the early-twentieth century, today it is necessary, though not sufficient, to alter the environment that can lead to short-term wholesale funding runs in order to create a stable financial system for the early twenty-first century.

The Federal Reserve, with its discount window, was well positioned to provide liquidity to banks by making short-term, collateralized loans. (The discount window was the tool the Federal Reserve could have used, had it chosen, to stem the banking panics of the 1930s.) However, our traditional tools, developed in an earlier era, were of little use in addressing panic in the shadow banking system or in the money market mutual fund industry. So, we engaged in what I call "blue sky thinking"--generating many ideas. Most were discarded, but, crucially, some led to the development of new ways for the Federal Reserve to fulfill the traditional stabilization function of central banks. Using emergency authority last employed during the Depression, we created an array of new facilities to provide backstop liquidity to the financial system (and, as a byproduct, coined many new acronyms). Thus, we were able to help restore the flow of credit to American families and businesses by shoring up important financial markets, such as those for commercial paper and securities backed by consumer loans.

Unlike in the 1930s, when policy was largely passive and political divisions made international economic and financial cooperation difficult, during the past year monetary, fiscal, and financial policies around the world have been aggressive and complementary. Without these speedy and forceful actions, last October's panic would likely have continued to intensify, more major financial firms would have failed, and the entire global financial system would have been at serious risk. We cannot know for sure what the economic effects of these events would have been, but what we know about the effects of financial crises suggests that the resulting global downturn could have been extraordinarily deep and protracted.

Without going into great detail about the {Resolution Finance Company}, I will note the four principles that Jesse Jones, the head of the RFC, employed in restructuring banks. The first step was to write down a bank’s gad assets to realistic economic values. Next, the RFC would judge the character and capacity of bank management and make any needed an appropriate changes. The third step was to inject equity in the form of preferred stock, but this step did not occur until realistic asset values and capable management were in place. The final step was receiving the dividends and eventually recovering the par value of the stock as a bank returned to profitability and full private ownership.

An interesting historical example is the bank holiday of 1933 when Roosevelt shut down the banks for a week and said we're just going to check their books and open them up only when we think they're solvent -- and a lot of banks opened up pretty quick.  So it's not really clear how much they looked through the books but when they opened them up again, people felt much more comfortable, more confident in the banks.

Part of the proposal that Secretary Geithner put out this morning is to have a supervisory review not only of the quality of assets, the reserving, and the potential future losses, but also to ask the very important question: how well would the banks do in a very, even more severe scenario -- a stress test? Are they able to have enough capital that even putting aside whether they're solvent today that they could survive in an even worse scenario and to get confidence that they could survive that scenario -- put enough capital in so they could survive that scenario? That should help to restore confidence that they are, in fact, solvent and that would, in turn, attract private capital.

REP. MILLER: Assuming there was confidence in the stress test itself.

MR. BERNANKE: Correct.

From the Q&A session

There’s no question that the spiral presents extraordinary challenges for policymakers—challenges that, in my view, are the most significant and complex since the Great Depression. However, I am encouraged that bold actions are being taken both here and abroad.      

I do not believe that deflation is a major risk right now. But deflation can be dangerous because for any given interest rate, it increases the corresponding real (or inflation-adjusted) interest rate, and thus stifles growth. For a sustained deflation to emerge, people have to believe that the money supply will fall along with the price level.  That's what happened during the first three years of the 1930s, at the beginning of the Great Depression, when the U.S. consumer price index fell by 27 percent, and the monetary base shrank by 28 percent. Central banks can prevent deflation by credibly committing to keep the money supply from contracting. Such a commitment is a natural byproduct of a credible commitment to price stability, but for a central bank that has not yet formally adopted an inflation objective, preventing deflation can present additional challenges. This is why some central banks increase the quantity of their monetary liabilities dramatically when interest rates are at zero — to convince the public they will not let the money supply contract in the future.

These are momentous steps, but they are being taken to address a problem of historic dimensions. In one respect, however, we are fortunate. We have learned from historical experience with severe financial crises that if government intervention comes only at a point at which many or most financial institutions are insolvent or nearly so, the costs of restoring the system are greatly increased. This is not the situation we face today. The Congress and the Administration chose to act at a moment of great stress, but one at which the great majority of financial institutions have sufficient capital and liquidity to return to their critical function of providing new credit for our economy.

Thus, as we take on these new challenges, I'll leave you with this quote from 1930 to illustrate my point. It is from Paul Warburg, who was appointed a member of the first Federal Reserve Board by President Woodrow Wilson.

"In a country whose idol is prosperity, any attempt to tamper with conditions in which easy profits are made and people are happy, is strongly resented. It is a desperately unpopular undertaking to dare to sound a discordant note of warning in an atmosphere of cheer, even though one might be able to forecast with certainty that the ice, on which the mad dance was going on, was bound to break. Even if one succeeded in driving the frolicking crowd ashore before the ice cracked, there would have been protests that the cover was strong enough and that no disaster would have occurred if only the situation had been left alone."1

There are many challenges ahead, many choices to make. Some I suspect will be desperately unpopular.

HAYS:  Is the Fed pushing on a string now? Are these rate cuts going to work? Do you see a Fed that will keep cutting rates until it kind of forces some -- some buoying up of a system because we've seen instances, the 10-year note yield bottomed around January 22nd, it's higher since the big rate cuts in January. You, yourself said, a lot of people can't get mortgages. Again, Fed pushing on a string.

POOLE: The string analogy dates from the 1930's and one of the things that I said last week was that the Fed could follow a massively expansionary policy and essentially eliminate the possibility of a recession if that's what we wanted to do. I think it's much more pushing on a ramrod. It may not always seem that way, but I just don't think that this left-over analogy from the 1930's holds. I don't think it's based on good evidence.

What I have in mind is that the Bank of Japan would announce its intention to restore the price level (as measured by some standard index of prices, such as the consumer price index excluding fresh food) to the value it would have reached if, instead of the deflation of the past five years, a moderate inflation of, say, 1 percent per year had occurred.

...

Reflation--that is, a period of inflation above the long-run preferred rate in order to restore the earlier price level--proved highly beneficial following the deflations of the 1930s in both Japan and the United States. Finance Minister Korekiyo Takahashi brilliantly rescued Japan from the Great Depression through reflationary policies in the early 1930s, while President Franklin D. Roosevelt's reflationary monetary and banking policies did the same for the United States in 1933 and subsequent years.

...

Eggertsson and Woodford (2003) have advanced a second argument for a price-level target for Japan in an important recent paper on monetary policy at the zero bound. These authors point out (as have many others) that, when nominal interest rates are at or near zero, the central bank can lower the real rate of interest only by creating expectations of inflation on the part of the public. Eggertsson and Woodford argue that a publicly announced price-level target of the type just described is more conducive to raising near-term inflation expectations than is an inflation target.